Market Perspective for 4/14/11
A few thoughts:
1. Forecasting the markets near term path is difficult under any circumstances. That said, when the Federal Reserve maintains an easy monetary policy and the economy is growing at a 2-4% pace (in other words, sustainable), history suggests stocks have a very good chance of going up.
2. There is a principal of physics that says that an object in motion tends to stay in motion. Applied to the investment world, this means that a trend in motion tends to stay in motion. Therefore, it is always risky to call an end to a trend. A week or even a month early is acceptable. Eight months or a year early is too much.
3. Strategists are no good if they only tell you what is already known. Waiting until a trend change has occurred improves their “batting average”, but it does clients no good. With this in mind, I am going to suggest two areas that I believe are vulnerable to a negative trend change; small cap stocks and high yield bonds.
a) Small cap stocks have been in favor for more than a decade. 2007 was the only year in the last 11 in which small caps underperformed large caps, and even then it was by less than 5%. From 2000 through 2004 small cap stocks had a compelling valuation argument over large cap stocks. This was closed by the end of 2004 as small caps had a performance advantage in that time period by close to 4600 basis points. From then on, small caps rode the tide of very easy monetary policy. The only time from 2005 to the present where small caps lagged was again back in 2007 when the Federal Reserve was raising rates. QE2 is scheduled to end in June, and I cannot imagine that it would be politically possible to do a QE3. That tells me liquidity is going to be adversely impacted. I believe that the stock market has already begun to take notice. Small caps have led the decline so far this quarter.
b) High yield bonds have had an exceptional run since the stock market bottomed in March 2009. Like small cap stocks, their returns correlate very closely with easy monetary policy. I am not predicting that credit is suddenly going to be tight, but consider the following:
- · High yield credit default rates are currently less than 0.8%, well below their historic average of 3-4%. Default rates of less than 1% historically tend to coincide with market peaks.
- · The spread between high yield bonds and government bonds is at the lowest level in several years and, again, suggestive of market peaks.
- · Increasingly, bonds are being issued “covenant-lite”. Prior to every great credit crash underwriting standards slip. That was true in the late 1980s (think of Drexel Burnham Lambert) and it was true before the last crash. Covenant-lite issuance is on pace to be the second largest in history since 2007.
4. I still don’t see a plausible scenario of soaring rates. The U.S. cannot and will not flood the world with dollars if the rest of the world can’t absorb them. On the other hand, it is unwise not to borrow if you can get favorable terms. The doomsday scenario assumes an inability to refinance existing debt and a government that would respond by printing massive amounts of money to pay off its debtors. No economic team or political party is so clueless as to not understand the implications of such a policy.
5. The end of the Federal Reserve’s QE2 program at the end of June is going to be a dominant theme in markets over the next few months. A lot of money is invested to take advantage of this environment (that is to say in economically sensitive industries and currencies). In theory, the end of QE2 is negative for these types of risk assets. Markets hate uncertainty. This part of the market is especially vulnerable as we get into May and June (which are seasonally two of the poorer months anyway).
6. Alternative investments are very hot right now. One type attracting a lot of buzz is managed futures. One of the attractions of managed futures is that several have a track record that compares favorably with stock and bond returns over the past decade. Another is that they have historically had a very low correlation to stocks and bonds. It is important to note that an average correlation of 0 or -0.1 does not mean that at any given time the correlation might not actually be very high. For example, managed futures funds had a very high correlation to the stock market on average in the summer of 2008 as they reflected surging energy prices. By November, the correlation was strongly negative as they were shorting many of those same commodities. On AVERAGE the correlation was zero, but that didn’t describe the funds at any particular time. What I’m saying is, there is a place for managed futures in most portfolios, but be careful. You might find they add to volatility instead of mitigating it.
7. After dramatically underperforming from 2008 through 2010, large cap value funds are improving on a relative basis. They are already beating large cap growth funds rather handily so far this year. The health care sector (yes, these stocks are now considered value stocks due to a ten year contraction in earnings multiples) is partially responsible for the out-performance.
Past Performance is no assurance of future results.
All index data provided by Telemet Orion or Morningstar Advisor Workstation. Numbers do not reflect fees, brokerage commissions or other expenses of investing.
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