"The bull market is going to go on forever. Unless of course, it doesn't. Often in economics, things that ought to go on forever, such as stock market hounds getting fatter by the day, stop going on forever. Afterward, economists tell you why; for predicting though, they are not that great."
Russell Baker (1925-) New York Times
After the first 140 days of 2007, the jury is still out on how the remaining 225 days play out. However, it does not require a Ph.D. in Economics to surmise the forecast of a weak U.S. housing market leading to a recessionary slowdown in the U.S. and global economy appears to be quite a bit less probable than it was in the second half of 2006. While the housing slump and its full economic impact on the consumer may not be fully realized, there are several signs that point toward continued dominance by the bulls during the next twelve months.
Many investors have been well prepared for a U.S. housing led slowdown that has yet to deter the global financial markets. While it is less than optimal to be allocated in a defensive stance when the market is advancing, it is not nearly as painful as watching your account drop 38%, 49%, or 78%, as the major U.S. indices did during the 2000-2002 bear market. Since the recent gains in U.S. stocks have left many scratching their heads, it is helpful to push the opinions and economic forecasts aside for a moment and consider what the financial markets are possibly saying about the next six to twelve months. For several reasons, which I will outline below, it appears prudent to continue to overweight growth oriented investments or those labeled "Expansion Holdings" and "All Weather Holdings" in Figure 2A.
Markets Are Extended
Markets rarely move in the almost vertical fashion that we have witnessed in the Dow for the last few weeks. While overbought markets can and may move higher, the odds favor a pullback prior to the next leg up. Recent sentiment readings, a contrary indicator for stocks, indicate the next pullback will not be a major top or a reversal point to kick-off a new bear market. As of May 15th, The Hulbert Stock Newsletter Sentiment Index (HSNSI) stood at 40.2%, which is less than half the record reading of bullishness of 79.7%. According to Hulbert,
"If the current market advance conforms to the historical pattern, a major top will not come until the vast majority of advisers are inclined to interpret the glass as half full."
Asset Classes Have Their Say
Our multiple asset class approach, which is described in the study Protecting Your Wealth From Inflation & Investment Losses, gives us a unique window into the financial markets if we choose to use it. Since our allocations include exposure to stocks, bonds, commodities, precious metals, timber, etc., we have one of the best economic forecasters built right into our portfolios. If we follow the relative movements of this wide variety of asset classes, we can garner some meaningful insight into the current, and possibly future, state of the world. Using an oversimplified example, assume you have just four asset classes; U.S. stocks, U.S. bonds, foreign stocks, and foreign bonds. In good economic times, the stocks should outperform the bonds. In less than ideal economic times, the bonds should outperform stocks or at least begin to close the return gap.
The beauty of financial markets is they tend to perform based on anticipated future economic conditions vs. solely relying on current conditions. The skeptics in the crowd will counter, "Yeah, but what if the market is wrong?" From a risk management perspective, a multiple asset class strategy may offer some balance in the event that the market misreads the tea leaves in the short term, which it will from time to time. As you'll see below, by focusing your attention on long, intermediate, and short-term asset class trends, you have the ability to adjust to changing market conditions by rebalancing portfolios based on different time horizons. To illustrate the financial market's ability to look forward, here is a statement taken directly from the Federal Reserve Bank of Philadelphia's website:
"The persistent strength in the U.S. economy continues to surprise forecasters; therefore, the survey's panelists are, again, revising upward their expectations for growth in real GDP in 2000. In the current quarter, the forecasters expect real GDP to grow at an annual rate of 4.2 percent, marking an upward revision of 1.1 percentage points from the previous survey's estimate of 3.1"
This statement was posted on May 22, 2000. The portion "the U.S. economy continues to surprise on the upside", means economic numbers published in April and early May 2000 were strong. On that basis, one might guess May of 2000 was a good time to be in stocks. As we know in May of 2000, the financial markets were not as upbeat as the Fed or the recent economic numbers. The Dow had topped four months earlier in January of 2000. The S&P 500 and the NASDAQ had also made major tops two months earlier in March of 2000. Was the market right? Soon after May of 2000, the U.S. entered a recession with three of the next five quarters posting negative GDP figures. Even as the Fed made rosy economic statements in May of 2000, the major U.S. stock indices had already entered a bear market that would see the Dow fall 38%; the S&P drop 49%, and the NASDAQ plummet 78%. 2002 would become a backbreaker for many investors.
Using the daily prices of all our current holdings going back to January 1, 1995, I recently began to study the relative price movements of each investment, and more importantly of each asset class. My goal was to see if there was a meaningful, and more importantly useful, correlation between recent relative asset class performance and future performance. The basic premise of the study was to better understand how relative asset class past performance correlates to future performance as illustrated below.
The study analyzed three separate correlations using three separate time periods as shown in the rectangles below.
In order to capture both longer, intermediate, and shorter-term asset class trends in the real world, a simple average of the three-month, six-month, and one-year recommended allocations from the study is used to produce a single recommended asset allocation To increase your confidence in the basic theory, it may be helpful to know that stock prices are one of the major components in the Conference Board's Leading Economic Indicators (LEIs), a widely used barometer of future economic activity. A similar approach to investing, using relative performance as an asset-rebalancing tool, is outlined in Gerald Appel's recent book "Opportunity Investing". It was encouraging to see that Appel's approach and findings are similar to mine.
Let's assume we used the results to allocate our assets in 2006. The study and model are geared toward rebalancing portfolios in early January and late June of each year, basically every six months. Assuming buy-and-hold from January 2006 to the end of June 2006, a rebalance, and buy-and-hold for the remainder of the year, the model portfolios would have returned 20.02% for full year 2006. Continuing into 2007 as May 18th's market close, the YTD returns would have been 4.21%. For those of you who are prudently concerned about how a trend-following or relative performance system might fare in a bear market, I went back to see how the model would have allocated portfolios in 2002, a year where the S&P 500 lost over 22%. Even in that whipsaw environment, the full year 2002 returns using the relative performance model would have been a gain of 15.92%.
Moving back to the present, what is the model telling us today about the next six months, and the next year? It recommends the following:
Based on the model's recommended weightings, here is my take away in terms of what the financial markets are forecasting in the next six months to a year:
Global growth will remain respectable (if not much better).
Foreign assets will continue to outperform U.S. assets.
The U.S. will not experience a prolonged, serious economic contraction even though housing may have more tough times ahead. A continued U.S. slowdown in the coming months is still a distinct possibility.
Global inflation will remain near present elevated, but not out of control, levels (at least in terms of how inflation is calculated and represented to the public).
The Federal Reserve will most likely keep interest rates near present levels, which could include a few small rate cuts.
The U.S. stock market will not slip into a protracted bear market during the next pullback. This statement is based on the model as well as sentiment, which is subject to rather rapid change.
It is important to keep in mind the above allocation is based on the average outcome over a twelve-year period (1995-2006). Therefore, you must expect and plan for variances in actual outcomes. Said another way, all historical models have some serious limitations when used in the real world. However, the results are statistically significant, which means over the long run they should be able to add meaningful value to an investor's quest for a proper balance between risk and return.
Cheap Money Fuels Asset Values In The Face of a Weakening U.S. Housing Market
There are obviously an almost unlimited number of factors which play into market behavior, but here are a few that seem to be primary drivers, many of which we have discussed at length in the past (globalization, technology flattening the world, weak dollar, increased demand for commodities, etc.). If I had to focus on one single bullish issue that many have missed in recent months, it is the ability of private equity firms, businesses, individuals, etc. to borrow money at low rates and invest those funds in the hope of capturing a rate of return that exceeds their borrowing costs. As outlined recently by PIMCO, the disparity of potential growth rates of G7 nations (United Kingdom, the United States, France, Canada, Italy, Japan and Germany) vs. all nations (including emerging economies such as China, India, Singapore, etc.) plays a key role in the global financial markets. G7 nations have lower growth rates and in simple terms that translates into lower borrowing costs and accommodative monetary policies to support those economies. Non-G7 nations have higher growth rates and in some cases, a need to keep borrowing costs higher in an attempt to reign in rapidly expanding economies. China has raised rates 4 times in the last year in an effort to slow down the economy and investment boom. This growth disparity and borrow cost disparity are the real source of the carry trade (borrow cheap / invest for better returns). What strikes me when thinking about this situation is it is not likely to significantly change in the near term, which could propel asset markets higher.
Private equity firms raised $33 billion last year and they are looking for places to invest. Keep in mind; the $33 billion will be significantly leveraged via borrowing, which in turn leverages their purchasing power and the simulative effect to the financial markets. In many cases, private equity buys public companies (by buying their stock). This is why so many acquisitions are occurring on Wall Street. The perception in many circles is that private equity will step in during any market sell off providing support for the rest of us. In a May 9th TheStreet.com article, Jim Juback wrote:
"It all comes down to cheap money. Cheap money is fueling the buyout boom. Cheap money is prompting companies to buy back billions of dollars of their own shares. Cheap money is fueling big increases in corporate dividend payouts. Cheap money is keeping the current rally running."
A recent Barron's article weighed in on the current buyout boom:
"Just because everyone seems to believe the acquisition fever is in itself making stocks drop-dead attractive doesn't make it wrong -- yet. This year has seen $5 billion-plus acquisitions on 26 of its 95 trading days (on which the single-day return doubled its average for the year). Deals have thus far been logical, strategic moves, not the frenzied buying associated with exhaustion tops. And despite the increasing concerns of international regulators that the current liquidity glut may be overdone, the spread between regulatory concern and action should give investors plenty of time enjoy the 'resilient ticker tape' before they need to get out. The froth is yet to come."
Some studies show that leveraged (meaning using borrowed money for a large part of the payment) buyouts, on average, do not create value in our economy. Therefore in the long run, many of these deals will be harmful to the average investor. However, the important driver for the near-term is the perception that buyouts are good for the market. As long as credit is cheap, the global economy will continue to create bubbles. You can follow the bouncing bubble from tech stocks to housing to buyouts. The buyout boom will most likely end with some casualties, but in the current credit environment, a new bubble will soon be inflated. I think future bubbles will include Asian assets (real estate may be more attractive than stocks right now), energy related investments, and both silver & gold.
Is It Time To Give The "All Clear" Signal To Investors? No Our decision to continue to increase our exposure to the center and left side of Figure 2A (growth assets and all weather assets) in relation to the right side of Figure 2A (more conservative assets) does not mean we have decided to throw all caution to the wind. It simply means we feel it may be prudent to take on some additional risk, while maintaining a reasonable amount of diversification to offset that risk.
If the spread between G-7 growth and non-G-7 growth and the resulting borrowing cost spread are driving investment prices, it stands to reason that any threat to either the growth spread or the interest rate spread is a threat to investment prices. Creeping inflation in G-7 countries appears to be one of the biggest concerns for investors. Higher inflation may help close the favorable interest rate spread and make the global carry trade less profitable. Some factors driving inflationary trends:
The increased demand for commodities caused by globalization.
The cheap labor available in many non-G7 countries will over time demand better wages and add to the price of U.S. imports / Asian exports.
The availability of credit and vast increase in the global money supply means we have more money chasing a limited number of assets.
Other major concerns include the ever-growing sentiment in Washington to impose tariffs; some are recommending a 27.5% tariff on Chinese imports. While the idea of protecting American jobs seems commendable on the surface, it would be dangerous to possibly anger your biggest source of funds to finance America's habit of consuming more than we produce (that's the trade deficit). China currently holds more than $416 billion in U.S. securities (mainly Treasury bonds), which means they are a major factor in keeping U.S. interest rates low, which in turn keeps the global carry trade alive. If you upset China with a big tax on goods exported to the U.S., they may be less willing to buy our government debt. This would equate to reduced demand for U.S. Treasuries. Reduced demand leads to falling bond prices, falling bond prices lead to higher interest rates. Higher interest rates close the favorable borrowing gap for the carry trade and mean higher interest costs for all credit cards, mortgages, home equity loans, etc. According to Stephen Roach,
"After years of talk, protectionism no longer seems like an empty threat. Trade sanctions against China are all but inevitable."
The housing problems in the U.S. most likely have further to run, which means more pain and less home equity to borrow against. This is still an issue that may lead to a more significant slowdown in the U.S., and possibly a recession. As stated previously, the financial markets do not seem to be forecasting a dooms day scenario in relation to this topic. That is always subject to change.
Valuations in the carry trade world are extended in almost all asset markets, which is an additional reason to remain somewhat cautious and selective when choosing entry points for cash. We must also be aware of the numerous bubbles that have been and will be created within the context of the current financial landscape.