How to Position your Investment Portfolio

EXECUTIVE SUMMARY

• The correlation between a weakening housing market and the stock market suggests that a defensive investment stance is prudent at the present time.

• While the recent advance in stocks is impressive on the surface, a more detailed look yields some cause for skepticism.

• History tells us that the probability of the Federal Reserve being able to engineer a soft landing in the housing market is very low.

• The economic impact of the recent housing boom has been greater than even the largest stock market booms. It will be difficult, if not nearly impossible, to replace this economic activity from another sector of the economy.

• Since the interest rate cycle should be similar to what followed the Interest bust, a detailed review (see charts on page 2) of asset class and investment performance between March of 2000 and October of 2002 can help investors make better decisions should the stock market peak in the near future.

• Since history rarely repeats itself in exact form (especially in the financial markets), it is also prudent to look at some possible differences between the previous cycle and our current environment.

Housing Has A Strong Correlation To Stocks

As shown by the National Association of Homebuilders (NAHB) Homebuilders Index (see blue line in chart above), the slowdown in housing has now reached significant levels. NAHB produces the Housing Market Index (HMI), a weighted, seasonally adjusted statistic derived from ratings for present single-family sales, single-family sales in the next six months, and buyer traffic. A rating of 50 indicates that the number of positive or good responses received from the builders is about the same as the number of negative or poor responses. Currently, the weighted rating is firmly in the negative camp at 32. This represents a pessimistic outlook for real estate in the next six months, which in turn is not good for stocks. The chart above was taken from a report by David Rosenberg, North American economist for Merrill Lynch. Mr. Rosenberg comments on how the weak housing market may affect stocks:

"The chart above is rather intriguing - the NAHB homebuilders index leads the S&P 500 by 12 months and with a near-80% correlation - a correlation that over time has actually strengthened, owing to the growing influence that the real estate market has exerted on the overall economic and financial landscape over the past five years. In fact, we can trace almost two-percentage points of the 3 1/2% average annual rate in real GDP over that time frame to the boom in housing construction and home prices - the direct impact on homebuilding, the spin-offs to other sectors like real estate services, architecture, engineering, legal, etc and the multiplier impact from the 'wealth effect' on consumer spending, especially on home improvements and household furnishings."

The statement above means that during the past five years housing has either directly or indirectly accounted for 57% of economic activity. The latest release of new home sales shows a 21% year-over-year decline (view PDF report).

Using the 12-month lag of the S&P 500 as shown in the chart above, the actual correlation between the S&P 500 and the homebuilders index is .79, which would give us the following calculation to forecast where the S&P 500 may be 12 months from now (roughly August 31, 2007):

• The homebuilders index had a reading of 67 in August of 2005 (12 months ago)

• The reading of the index as of August 2006 is 32

• A move from 67 to 32 represents a 52% decline

• With a .79 correlation to the S&P 500, we need to reduce that decline by 79%, which gives us roughly 41% (reduced from 52%)

• If the correlation holds, which it may not, the S&P 500 would be 41% lower 12 months from now (or roughly on August 31, 2007).

That is a sobering stat. While I am not forecasting that the S&P 500 will be 41% lower a year from now, I am in the camp that believes it is prudent to take a more defensive posture with our investment portfolios. This is a correlation that cannot be ignored by investors.

It is also interesting to note that the last intermediate peak in the homebuilders index was made in October of 2005. This means according to the 12-month lagging correlation the S&P 500 would hit an intermediate peak sometime in or near October of 2006. As the chart below illustrates, most recessions have been preceded by a period where housing prices decline (prices shown are adjusted for inflation - recessions are shown by shaded areas).

The Recent Advance In Stocks Is Suspect

While the recent advance in stocks is somewhat impressive, the statistics below the surface paint a picture which warrants concern about the sustainability of the rally. We have not seen figures in volume, new highs vs. new lows, common stocks vs. preferred stocks, etc., that produce a favorable risk/reward profile for taking substantial risk in the general stock market at the present time. Dr. John Hussman covers this topic in more detail in his article "A House Built On Sand", which contains the two informative charts below (my comments have been added to charts):

The U.S. stock market has gone over three years without a 10% correction. This has happened only three other times in modern market history. The average decline after the previous three runs was over 18%.

It Will Be Hard For The Fed To Bail Out The Housing Market

We are all hoping for the proverbial soft landing in housing, which in turn would enable a soft landing to take place in the economy as measured by GDP (the value of all good and services produced in the U.S.). If we use the boom in Internet stocks as a proxy, it is difficult to assume we will get the soft landing in housing. The chart below, taken from an August 2005 article in Forbes magazine, shows the Internet boom and the housing boom side by side. Fueled by low interest rates and thus cheap access to credit, the similarity between the two booms is striking.

Once the Internet bubble started to burst, the Federal Reserve tried to engineer a soft landing by cutting interest rates 11 times in just 12 months, moves which are still without precedent today. Despite this aggressive action, we all know that the proverbial soft landing did not occur in the Internet space. The bond market's recent gains in price are signaling that the Fed may be lowering rates in the future in an attempt to slow the tide of the housing decline.

The media and Wall Street are always hoping for the soft landing or "Goldilocks" economic scenario. Unfortunately, the odds are stacked against having a soft landing after a series of interest rate hikes. During the last 16 interest rate cycles, there has been a grand total of one soft landing (see 1994). Using this one historical fact, there is a 6.25% (1/16th) probability that we get a soft landing. With these odds is it worth taking on too much risk with your hard-earned investment dollars?

The Economic Impact Of The Housing Boom

Economic gains in the United States in recent years have relied heavily on the rapid appreciation in the housing sector. According to a report on housing from Scotiac Capital:

"Consumer spending on furniture and household equipment has grown at more than 3½ times the pace of the overall economy during the current expansion, accounting for a 14% share of overall growth (nearly three times its share of the economy). Growth in residential investment has been double that of the overall economy during the same period, accounting for 10% of overall growth (compared with a 5% share if the economy). Finally, the construction, home improvement, and real-estate related sectors accounted for nearly 20% of overall private sector job creation in 2004 and 2005, double their share of private sector employment. Considering the amount of housing-related stimulus the economy has enjoyed in recent years, we expect a noticeable deceleration in the pace of real GDP growth over the forecast period - from the +3½ average of the past three years to something closer to +2½."

Forbes makes an argument that the overall economic impact of the recent housing boom is greater than the largest ever stock-related booms:

"The total value of residential property in developed countries has increased from $40 trillion to $70 trillion over the past five years (8.2000 to 8.2005), which (as The Economist points out) represents a larger potential bubble in terms of equivalent gross domestic product than either of the stock market bubbles of 2000 or 1929."

The Current Environment - Similarities & Differences To 2000-2002

Since housing is such an important contributor to our economic well being, it is safe to assume that the Federal Reserve will attempt to engineer a soft landing just as it did after the Tech bust began in 2000 (read the Fed will lower interest rates). With the current readings of inflation, it is also safe to assume that any rate cutting campaign may have to be shorter in terms of calendar days and lesser in terms of degree. The Fed will have trouble taking rates as low as they did in the last economic slowdown since lower interest rates tend to feed inflation. While the next rate cutting cycle may look different and the global economic picture is different than it was in 2000, we can still benefit from reviewing economic and investment trends from 2000 to 2002.

When global investment markets peaked in early May of this year, we did not have as much evidence of a possible future economic slowdown as we do today. For example the NAHB's Homebuilders Index was still above 50 as of April 30, 2006, which means builders were split about 50-50 on the outlook for housing the next six months. As a result, there were much better odds in May that the investment landscape would remain similar to the one that had been present in the last 12 months (commodities strong, emerging markets strong, etc). That is no longer the case.

Commodities and emerging markets did rally off their June lows, but that rally may be in jeopardy as market participants have more fully embraced that the economy is slowing. The market's recent interest in more economically sensitive issues seems to have some questionable circular logic. Here is my read on what the stock market is forecasting in the next 6 to 12 months:

• Slower economic growth which will lead to...

• A reduction demand for commodities such as oil (this makes sense)

• Lower oil prices mean more discretionary spending and a stronger than expected economy (or a less severe slowdown)

But, doesn't a stronger than expected economy or a less severe slowdown mean that the demand for commodities (mainly oil) will also be stronger than expected? If so, doesn't that eventually take us back to where we were in early May with a strong economy fueling the demand for commodities, which in turn is helping fuel inflation?

The economic evidence seems to suggest:

• Slower economic growth - maybe slower than many are prepared for in terms of their investment allocation. It seems the stock market has underestimated the probable negative impact of housing on economic growth

• A slowdown in the demand growth rates for oil and commodities in general, but not a move to negative growth rates or a reduction in demand from present levels for any significant period of time. The more likely outcome is that energy demand growth rates will remain positive, but experience a slowing in their positive rate of growth. For example, if you assume energy demand is growing at an average annual rate 2.4%, we may see that figure soften to a growth rate of 1.7% per year during an economic slowdown. With billions of new people in Asia moving to a more energy intensive lifestyle, it is hard to forecast declining demand for energy for any significant period of time. In terms of investment, energy and commodities still appear attractive long-term, but they may not perform well in the next 12 to 18 months as the markets price in a slowing economy. Whether or not demand for commodities really slows significantly, the important thing here is that the perception is that the demand will slow. After a bull market correction, which could be significant, commodities should benefit from a continued expansion of credit and the money supply (especially if the Fed is forced to lower rates sometime in the next 3 to 9 months).

• More persistent inflation than the markets have currently priced into stocks. An inverted yield curve (when a 2-year CD pays the holder more interest than a 5-yr CD) has historically produced above average short-term inflation pressures. There is also a meaningful correlation between government spending and inflation. Inflation is more prevalent in periods where the government spends more then it collects. This is the situation that we have today.

  

• A possible return to stagflation which was last experienced from 1973 to 1982. Stagflation is a period of above average inflation rates accompanied by slower economic growth (see charts below). During the previous stagflationary period, commodities significantly outperformed both stocks and bonds.
• Below-average, inflation-adjusted returns for U.S. stocks. Stocks may rise in nominal terms, but vs. gold, the world's true currency, the returns may not be significant.

The charts below help illustrate two important points:

The commodities bull market is most likely not over, but it may experience a significant correction and/or period of consolidation. Both gold and a diversified basket of commodities experienced strong gains from 1972 to 1975, which is similar to what we have seen from roughly 2001 to 2006. While the bull market was far from over, commodities basically went sideways (consolidated) from 1975 to 1977. We can see a similar consolidation in gold during the same period. From 1977 to roughly 1980, the bull market in gold resumed and rewarded investors who better understood long-term market cycles. In a similar manner, a diversified basket of commodities also reverted back to bullish mode from 1975 to 1982

At the present time, it may be prudent to lighten up on some of your exposure to gold. Slowing economic growth and the perception that slower growth always leads to lower inflation (not always the case) will continue to create a period where gold may lose some of its appeal as an inflation hedge. However, as economic weakness picks up and the market begins to sense that the Federal Reserve may be closer to lowering rates, the appeal of gold will again start to increase as investors realize that any lowering of rates by the Fed will increase downward pressure on the U.S. Dollar. The true appeal of gold is that it offers protection from paper currencies that can be debased by governments. We still like gold very much in the long run, but also must acknowledge the case for possible weakness before the next major leg up. As the chart above shows, there can be painful corrections in a long-term bull market.

In a similar vein, commodities also remain very attractive on a long-term basis, but they may continue to come under pressure as long as perceptions remain that growth is slowing and the Fed may not be done raising rates. Commodities will become more appealing once the Fed signals that rate cuts may be in the cards. As the chart below shows, much like gold, commodities in general also may experience a period of consolidation before resuming a long-term uptrend.

Details Of The Last Economic Slowdown 2000-2002

If we are entering a period of slower economic growth and declining asset prices (housing), we may experience a similar economic and investment cycle that was present after the S&P 500 topped in March of 2000. Stocks did not bottom until October of 2002. In order to become further prepared for economic weakness, I recently took a more detailed look at investment performance from March of 2000 to October of 2002. I broke this period into six sub periods where investors varied their economic outlook from positive to negative and then back to positive again. The phases look at how the financial markets react to moving from economic expansion to slower economic expansion (or recession), and where the Federal Reserve is transitioning from a rate raising cycle to what eventually becomes a rate lowering cycle.

Before we make some comments about the charts below, it is important to mention that economic cycles and market reactions rarely, if ever, follow historical patterns in the exact same way (timing, magnitude, and correlations always shift in some way). As an investor, you must balance history with current market conditions and always listen to what the current market is telling you. Said another way, no matter how compelling a bullish or bearish case you have in hand, never stubbornly hold on to any beliefs in the short run. The market may be seeing things that you have missed. Your confidence should rise when your opinion or forecast starts to be confirmed by market activity. It can be very expensive to invest based on what you think the market should be doing vs. what it is actually doing.

Based on my research, I feel we are approaching the end of Phase I. Phase I most likely began in today's market in early May 2006. Phase I in the year 2000 began when the S&P 500 topped in March of 2000. Phase I is a feeling out process where the market is unsure of how much growth is going to slow, and if the Fed is done raising rates yet. You can view all six phases by using this link (click here)

In the year 2000, Phase I took 153 calendar days to complete. In 2006, if we assume that Phase I began on May 5, 2006, then 153 calendar days would take us to October 6, 2006 (roughly two weeks from now). I would not put too much stock into that date, but it tells us that Phase I of the current cycle may be getting close to completing.

Since I believe Phase I is almost over or should complete sometime in the next 30 to 60 days, I want to focus our attention on Phases II thru XI with an emphasis on Phases II and III.

The chart above shows Phase II (once stocks shift to a long-term down trend) to Phase VI (where the stock market bottoms in anticipation of the next expansionary cycle). The winners in the previous economic slowdown where gold stocks, hedged stocks (via options or shorting), long maturity bonds, physical gold, short maturity bonds, and foreign real estate. Since we all hold U.S. real estate, our analysis focused on real estate outside the U.S. The investments that performed poorly during Phase II through Phase VI were most stocks (foreign and domestic), including oil stocks.

If you are wondering how a diversified basket of commodities performed from Phase II to Phase VI, the answer is much better than the S&P 500, but basically flat (it was up roughly 1.04%).

Phase II (chart above) is when the market really starts to acknowledge that the economy is slowing (maybe more than most had planned for) and the odds are increasing that the Fed is done raising rates. Stocks become weak after the focus moves off the Fed and shifts to future corporate earnings and a weakening economy. On the long side, bonds provide some cover, but only short sellers of stocks or those who have hedged stock positions (using options contracts) perform well during Phase II.

We have not yet entered Phase II where stocks have topped, but it is prudent to at least have a plan in place to migrate to should we enter Phase II sometime in the coming weeks or months.

Phase III (see above) shows that even after we have started a downtrend for stocks, there will be several false rallies as stocks continue to make lower and lower lows. You can see all Six Phases of the last bear market by using this link.

The Obvious Wildcard - Inflation

Inflation is the greatest variable that will most likely change the way the current cycle evolves vs. what happened from 2000 to 2002. If inflation is already in check, then the results of the previous cycle will be a more accurate proxy for what may happen in the next 6 months. On the other hand, if inflation continues to be a problem, it may force the Federal Reserve to initiate further interest rate hikes. This scenario would put into question the safe haven status of bonds until the Fed can get inflation under control.

What Does It All Mean?

We are still uncertain if the Fed is finished raising rates or if the stock market has already made significant highs in May of 2006. As a result, it is important to keep an open mind concerning how the next six months may play out. I feel the evidence is compelling enough to begin reducing exposure to assets that did not perform well in Phase II of the year 2000 cycle (shown on charts above). You may also want to increase your exposure to bonds. With the uncertainty associated with the Fed, a mix of shorter and longer maturity bonds may be prudent. Parking some money in a money market may not be a bad idea either. It will give you an opportunity to see how things play out in the next 30 to 120 days while earning an easy 5%. Taking a more conservative view of how gold and a basket of diversified commodities may perform in the next 6 months may also be a good idea. With the government in significant deficit spending mode, inflation may be with us for quite some time, which means a stagflation portfolio may have appeal after Phase II has completed. This may also be an excellent time to consider doing some research on possible ways to hedge your U.S. stock positions. This can be done with options or via selling short. This may take the form of a very small portion of your assets; say 5% to 10%. This small position can help hedge other positions from possible weakness.