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Market Perspective for 5.23.14

Stock prices have leveled off here in 2014.  The blue chip averages have recovered from both their January correction (6%) and a smaller one in mid-April (4%), but have not been able to meaningfully break out to the upside.  Meanwhile the small cap Russell 2000 has been in a steady downturn since peaking on March 4.  It currently stands 8% below its closing high on that day.  Mid cap stocks are just two percent below their all-time high on March 7th.  So together, the indices paint a picture of a bull market ever-so-gradually losing thrust, much like we saw in 2007.  Stocks moved in a narrow range for most of that year but could not push beyond very slight new highs in July and October - before decisively rolling over the following January.  Note that this is not conclusive – the stock market looked like it might roll over in June 2012 and November 2012 before embarking on a strong run through 2013.  It is just something to watch. Bonds have had a surprisingly good run in 2014, with the benchmark up 3.4% year–to-date. Terrible sentiment to begin the year allowed bond prices to become attractive.   A harsh winter and much weaker than expected consumer activity started the bond rally and this in turn forced  managers under-weight duration to aggressively pursue long Treasuries and TIPs. The credit trade appears to have stalled out as investment grade bonds have outperformed high yield bonds since mid-March.  Again, not conclusive but another thing we watch to help determine when the market might move into a more serious “risk-off” mode. That the best sectors so far this quarter and year are either late cycle (energy) or defensive (real estate, utilities, and consumer staples) is also a concern.  That said, economically sensitive sectors (industrials, materials, transports) are not at the bottom of the list, which you would expect if a major correction were at hand.  Media, biotechnology, housing, retail, and financial services are the worst performers.  My conclusion is that the manufacturing sector of the economy is still in the recovery part of the cycle but the much larger services sector is sliding towards recession. The big question, therefore, is what do we do now?  If bond yields are low and the oversold catalyst they had at the beginning of the year is spent and the high yield spread compression trade is also played out, then bonds seem pretty unattractive.  On the other hand, stocks are expensive on a price- to- trailing 12 month earnings and price-to-cash flow basis (only price- to-forward earnings estimates provides a favorable valuation level).  Earnings from consumer-oriented industries continue to disappoint.  Defensive industries had some promise at the beginning of the year because they had been heavily sold in 2H13, but after double digit gains by real estate and utilities and a high single digit return from staples, there is no longer a value argument to be made.  Federal Reserve policy has made it cheap and easy to exploit any valuation anomaly to the point where there just aren’t any cheap assets left (at least domestically).  Arjun Divecha of GMO put it best at a recent conference I attended:  “You make more money when things go from awful to merely bad than you do when they go from good to great”.  Awful doesn’t exist anywhere in our markets today.  Awful is in certain emerging markets like Brazil, but not much elsewhere.  Even Greece isn’t awful anymore, it is merely bad (and had one invested in Greek debt two years ago when it was truly awful, one would have done extremely well).  GMO’s 7 famous 7 Year Asset Class Real Return Forecast<1> is presented in Figure 1. So, to answer the question I began the previous paragraph with, I would be selectively defensive.  I would not underweight bonds, because the worst case scenario in bonds is a lot better than the worst case scenario in stocks.  I would over-weight foreign stocks relative to domestic stocks and Treasuries relative to corporate bonds.  I believe we are a lot closer to the top of the roller coaster than the bottom so I want to minimize the impact of the next down wave.  If I am wrong, it will probably be because investors were not willing to venture overseas despite favorable relative valuations, and an early 1970s/late 1990s type bubble broke out in selected large cap U.S. stocks.  I am willing to take that risk because I believe my opportunity cost (what gains I might miss if I am wrong) is among the lowest I can remember in my 28 years in the business. Figure 1


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<1> Figure 1 is GMO’s approximation of what we can expect if valuations revert to the mean.  This assumes a higher average P/E for equities in line with the more positive experience of the last 30 years.  If they were to use the data over the last 90 years (good records were kept only from 1927 on), the return expectations would be worse.  GMO’s 7 year forecasts have been surprisingly good (including their famous 1999 call of negative 7-year returns for stocks).

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