The U.S. and World stock markets remain in bull-mode, which was my expectation based on my April 2009 letter. This move up was triggered by data that revealed things were not as bad as the consensus expected which caught the majority by surprise since the sentiment of investors was intensely negative in March. Stock markets are rebounding on par with previous waterfall declines and the emergence of the economy from recession to growth. The lows in March will likely be the lows for decades.
Based upon numerous studies of past waterfall market declines I would expect the stock markets to churn higher as evidence continues to mount confirming the end of the recession which in turn will give investors more confidence. In a complete reversal of last Fall’s sentiment of “Get me out I can’t take it anymore!” we are now hearing “Get me in, I can’t take it anymore!”
Recent data indicates that the U.S. economy is now out of recession and that July will mark the first month of growth. Looking back to previous periods of recession segueing to growth, stock market declines are usually shallow and short of single digits which don’t allow investors an easy entrance. In addition, as Summer turns to Fall “performance anxiety” will start to be a major driver forcing investors and professionals to commit to risk as it will be clear that the Bearish majority opinion favored early this year is clearly out of sync at present. There may a “melt-up” as the anxiety to perform becomes intolerable.
I would caution investors against allowing the fear and risk aversion that was rampant in the past year from coloring their view going forward. The portfolio that was well positioned last year for the crisis will be poorly positioned to handle the economic recovery now forming.
Its extraordinary to watch the talking heads on CNBC wax wondrous about the stock market when the majority of them were cowering under their desks or outright bearish this Spring. Fear is dissipating and a return to risk taking continues as credit spreads shrink. Within the last week Goldman Sachs and Credit Suisse have upped their year-end targets for the S&P 500 to the vicinity of my own target of 1050-1100. While its good to have company, which in turn will instigate more buying pressure, my views on the market rally are no longer in the minority opinion so I must keep an eye out for a potential development that could break the bullish consensus.
The most perplexing question I face at the moment is whether the traditional seasonal market weakness from August to October will occur this year. In past transition years, noticeable market weakness within six months of a transition from recession to expansion is rare. In 2003, which was our last transition year there was no noticeable weakness until 2004, we may see the same lack of pullbacks this time. Typically in post waterfall declines we could expect this current rally to live for at least another six months to early 2010. In contrast, research on market cycles from Ned Davis, which I showed in chart form in April predict a market top in August, leading to weakness thru October followed by a strong rally thru December.
Based on past conference calls with clients there seems to be confusion at how we could be moving to a period of economic expansion with headlines so bleak. So, if you find yourself scratching your head at how we could be moving from recession to expansion I’d like to quote Anirvan Banerji of the Economic Cycle Research Institute:
“Indicators are typically judged by their freshness, not their foresight.”
Generally little context is ever provided to shed light on the data as to whether the data is peaking or not, as to whether a leading, coincident or trailing indicator. For example employment is a lagging data point and typically peaks after the economic trough. The lag time varies considerably from one month (1982) to 19 months (2003).
Stock Selection: Small versus Large: Performance data continues to suggest that our strategy of preference for Small Cap Growth stocks with modest valuations otherwise known as GARP (Growth At A Reasonable Price) has been spot-on. Small GARP stocks out-performance will likely be a long-term, multi-year trend. For example, the average length of Small Cap out-performance versus the S&P 500 since 1926 is 71 months and as of this month I estimate we’re only in month 14.
The effects of a newly expanding economy with increased desire for risk are having a profound impact on our domestic Small Cap Holdings. Our biggest winner of the year has been Global Cash Access LLC (GCA), which we were able to acquire initially at just under $4 a share and has reached $9 a share.
Domestic and Emerging Markets: In addition to our preference for Small Cap stocks, I have significantly increased our exposure to Small Cap Emerging Markets stocks. Emerging Markets have displayed superior relative strength to the U.S., Brazil and Chine in particular. While this performance is a reflection of increased confidence in their ability to manage the downturn, they are also not hindered by a depleted, over-leveraged consumer or anemic GDP growth. With these factors in mind I continue to believe the Emerging Markets have superior risk/reward over the next 2-3 years versus the U.S. markets. I am very concerned that the U.S. stock market may drift sideways for an extended period after our present rally. Diversification into Emerging Markets is a strategy to reduce our dependency upon the U.S. economy and stock market. In fact, one should consider that a significant percentage of our demand expansion in the U.S. is originating and being driven from Asia, specifically China.
The returns from our EM holdings have been beyond my expectations, our holdings in China have been spectacular. Our “Green” holdings in China Green Agriculture (CGA), RINO International (RINO) have exceeded 100%. We were fortunate enough to identify both CGA and RINO before they gained a listing on the NYSE or NASDAQ. Once they received approval to trade on our exchanges their appeal broadened due to the increased exposure to U.S. investors. Benign companies such as China Automotive (CAAS) and Chinacast Education have been outstanding as well and helped to lift accounts back into positive territory after a dismal 1st Quarter. These stocks are not without volatility and saw their valuations decimated in 2008 which created an amazing situation of highly profitable and growing companies priced at rock bottom valuations.
Bonds: As stated in previous client letters Treasury Bonds were due for a decline. Since December, at the height of the credit crisis the Ishares 10-20 year Treasury Bond ETF (symbol TLH) traded at $123 a share but by last month the shares were down to approximately $104 which highlights the risk of following massed emotions during the crisis. Insult to injury to those investors who panicked and sold off their stocks to buy Treasuries. On the other hand we took advantage of the declines in economically sensitive debt which were abandoned during the crisis. Yields on Corporate and Preferred Debt reached 14% to 17% during the late 1st Quarter and have since rebounded to 8% to 13% (yields decline as prices rise).
Treasuries are no longer as unattractive as they were six months ago as the bubble in Treasury prices has popped. If the economic rebound is as anemic as suspected, Treasuries could become a haven against economic weakness. Hence, recent debt purchases have been in high grade Treasuries or TIPS (inflation protected Treasuries).
Potential signs of the end of the rally: Rallies emerging from waterfall declines can exceed in breadth and duration beyond the most optimistic investors, I would not be surprised to see our current rally last through the end of the year without nary a pullback beyond a handful of percentage points. Sometimes the hardest position to take as a strategist is to do nothing….to let the rally run its course.
Premium valuation – If the market were to exceed 18x earnings of $60 a share or 1100 on the S&P 500.
Rising corporate bond interest rates – Since early November the gap between corporate and government bond yields has been shrinking, if this spread were to begin to widen once more it would be cause for concern.
Excessive investor exuberance – Markets do move on psychology and just as the March lows saw investor despondency, sentiment has been steadily improving (or getting worse depending on your point of view due to the inverse nature of psychology) and we must be on the alert for frothy behavior. We are getting close to excessive exuberance but not quite there yet.
2010: It’s my belief that the negative views of the Bears, which are being ignored at present, will manifest themselves in 2010. By no means am I predicting a crash or another bear market, “lackluster” might be a good word to describe the broad indices next year. By 2010 stock market valuations will no longer be cheap, inflation pressures could emerge, or anemic economic growth peters out with the lack of stimulus. By 2010 the economy will be forced to walk on its own legs without the support of massive economic stimulus. Fears of a Double Dip recession with accompanying national debt could emerge which would likely put pressure on stock prices, especially in the US. It would be unwise to assume that economic growth from here will be any more than lumpy, inconsistent and anemic.
Our present rally will continue to assume economic growth into 2010 and 2011. These assumptions could be set the stage for potential disappointment if they fall short. While it feels wonderful now to believe in the potential for growth, investors should keep a balanced view and err on the side conservatism until future market weakness and investor sentiment reaches the point to have factored in lower than average corporate earnings growth next year.
RMHI Blog: In an effort to provide clients with current information regarding market outlook, holdings, etc, I’ve created the RMHI Blog which you’ll be able to view at our new updated website at: www.greeninvestment.com/blog. Its my hope the Blog will bridge the information gap between quarterly letters and give clients a feel for what’s going in the financial universe.
July 23, 2009