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Market Perspective

March 16, 2011 Editor’s Note: Mark started writing this most recent update on March 10th but as the events in Japan unfolded we decided not to publish.  The below article includes Mark’s thoughts on March 10th and then, in italics, some updated comments as of March 15th. Treasury bond yields seem to have found a trading range.  For the 10 year it is 3.45%-3.75%; for the 5 year it is 1.95%-2.45% (note than shorter maturities are more volatile).  All eyes will be on the bond market as we approach the end of the Federal Reserve’s second round of quantitative easing (QE2).  Some (including PIMCO’s Bill Gross) warn of a potential spike in interest rates, but right now there is little sign in current prices or futures prices that rates are going to jump when the Fed leaves the market.  I expect yields to rise maybe 10-25 basis points just because of the uncertainty as June 30th nears.   March 15 update – Treasury bond yields fall to 3.25% on the disaster in Japan.  Obviously this was not something I or anybody expected, but there is a reason why tactical asset allocators love treasuries – in a crisis, there is no substitute.  In February I remarked that sentiment was too negative on government bonds, and subsequent events only pushed things further.  Last week Bill Gross told us all that his flagship fund had completely exited Treasuries.   Making money as a contrarian seldom gets any easier.  That said, I’d begin to lighten up into strength. In recent weeks volatility in the stock market has increased.  Since peaking on February 18th, the Dow has had four down days of more than 100 points.  This is more than they had in the entire run-up that began on September 1st.  It would appear that the bull market is facing stiffer headwinds now as it gets long in the tooth, namely: a.      Rising commodity costs (oil, grains, base metals, cotton) are affecting profit margins in many industries, from airlines to packaging to consumer staples to apparel.  This is typical late cycle behavior as commodity demand outstrips supply when the global economy is growing briskly. b.      Aggressive easy monetary policy is on the cusp of being replaced by more neutral monetary policy in the United State and Europe.  Neutral monetary policy is being replaced by more restrictive credit conditions in China, India, Brazil and other emerging markets. c.       Valuations, while fair on the basis of expected future earnings, are nevertheless expensive based on a smoothed 10-year earnings, which has historically been more reliable.  In other words, if we can assume strong earnings growth and unusually high margins will continue in to the future, then stock prices are reasonable.  On the other hand, if we make the historical assumption that margins will begin to be squeezed as the cyclical advance continues because both material and labor costs rise, then today’s stock prices are expensive.   Personally, I am not worried much about labor costs but materials costs (as stated above) are already marching upward. If you think about market cycles as being like waves (how was that for an unfortunate metaphor?), we have passed the “sweet spot” in the middle of the wave and are approaching the crest; put another way, we have gone from the high reward-low risk northwest quadrant of the risk-reward spectrum to the high reward-high risk northeast quadrant.  It doesn’t mean the stock market goes down from here, it simply means that volatility is likely to be a lot greater now.  March 15 update – we have hit that point where as many investors are inclined to sell strength and buy weakness, which gives the stock market a different feel.  Valuation doesn’t matter when the market is going up but when the advance stalls, suddenly it matters a great deal. d. The weak performance of the technology sector over the last three weeks is interesting, inasmuch as technology tends to be a bellwether sector. Persistent strength in Apple masks a continued deterioration in this sector.  March 15 update –  That said, the natural resources sector has fared the worst since the earthquake.  The thought is that global industrial demand is going to drop.  Actually, demand for resources in the intermediate term is going to rise.  Natural disasters are like mini-wars.  After the effects of the disaster end, you have increased production (to rebuild) and an increase in inflation (because there is pressure on the supply of materials necessary to rebuild).  Ultimately we want to be buyers of materials stocks on this weakness.  Utilities have also done poorly, obviously those that have nuclear exposure have done a lot worse than those that don’t. 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