This blog has been relatively inactive for the past two months as I try to determine its future.
From my perspective there is and has been a great deal of hyperbole regarding “green” stocks that fundamentals such as valuation and balance sheet strength are essentially ignored.
There may always be companies with better technologies but if the price is high relative to value the chances are strong that unless you’re a very short term trader you’ll eventually have a significant loss. While there is no perfect formula for investing, not all methodologies are created equal nor do they produce the same results in the long run.
Our methodology revolves around growth at as low a cost as reasonably possible. Many of our investments are socially “neutral” where the investment has little or no social, environmental or humane impact. Ideally we would all love to own a very green proactive portfolio but the volatility and risks associated with being totally proactive are simply too high. The bottom line is you must make money for yourself in the long run hence we blend both old school fundamental analysis with environmental screening.
And The Beat Goes On….and On…………………and On
In January I wrote to you with the basic premise that 2010 would be a year of positive but modest returns. But an unexpected phenomenon occurred in the US that may throw a wrench into expectations for a peak in prices expected this Spring….the economy and earnings are stronger than expected while Europe got weaker courtesy of Greece, which makes the US more attractive. As I write this to you in mid April it appears my conservative stance while warranted at the time has been premature with the U.S. stock market up 32 out of the last 46 trading days. While I still anticipate some sort of short term peak in stock prices soon, one can’t help but recollect the relentless trading appears to be the complete inverse to that of 1st quarter 2009, which reminds us all why it’s so important to be invested once the damage to markets has already been done.
While there are always negatives to consider in any market environment the most troubling in my mind are the high levels of investor complacency. Investors are very optimistic and comfortable at the moment and have pushed our readings to extreme levels normally associated with short term market peaks. In fact, in mid January readings became so extreme that we placed our first series of hedges on portfolios in almost a year. We were able to anticipate the selloff in January but it was relatively shallow at just 7% and the U.S. market staged and immediate bounce back. Since January, I’ve been very hesitant to increase our defensiveness due to substantial market strength.
While investment sentiment may be very positive (a negative) at the time, the present state of interest rates and rising investor appetite for risk is affecting the decision making processes as Q1 2010 saw a stampede out of near 0% money market funds. Money market assets have shrunk in Q1 at a 29% annualized rate or $24 billion per week to the lowest level since October 2007. While bond funds attracted 30% of the outflow it’s likely that a sizeable portion of the remaining assets have found their way in the stock market. In addition to the stock market, outflows were probably spent by the consumer as well. Despite the consumer deleveraging, the consumer is back and contributing to the economy.
While it’s wonderful to sit back and feel content that this current wave of outflows will continue the rush appears to resemble a sugar buzz of euphoria as sentiment levels are at extremes which warrants caution. One must also consider that these funds are controlled by investors who have allowed the markets to race upward near 50% and thus this may be a move of desperation, “Smart Money” ummm probably not.
However, my conservative posture from earlier this year remains firm but flexible. While the stock market is always prone to sudden setbacks, the strength and breadth of this rally implies that any top will be short term in nature and not the start of a new Bear move down. It does not appear that a significant selloff will be the result of failing earnings reports as companies are now showing improved top line revenue figures along with improved net profits. Using 1st Q estimates the S&P earnings figure is now at $59 which is the best in two years.
Stocks will always be a forward looking asset class and there is a good chance that the improved earnings and revenue reports are already baked in the cake. It could then be concluded that it might take a new ingredient to the mix to continue to propel stocks higher, otherwise a multi month trading range would be expected based upon past precedents. At present the median valuation of the S&P 500 is now 21 which is relatively high and suggests that our rally in stock prices is discounting a very strong economic rebound past 2010. But the question of continued economic expansion in the US is still very much a question as we have unusual headwinds to consider. If we see a choppy market through the remainder of 2010 we might then be in position to benefit from the question of continued expansion with earnings volatility subsiding to normal measured levels. In other words, we could use a break from the advance in stocks which could propel us in 2011.
But what if the expansion does not slow down as expected and we see a traditional V-shaped recovery? If growth continues as it has been the past six months and short term interest rates remain low, then earning and interest rates could trump sentiment and the expected 2Q market weakness would be a shallow pullback and little more than that.
All of which brings me to this conclusion: Market valuations are not cheap at 21x earnings which normally would warrant a much more defensive profile to the stock market (lower stock % and higher bond %). However, interest rates remain low and the Fed is unlikely to make any move to raise rates higher this year. Economic growth is better than expected and it’s possible that the most bullish estimates from a year ago will actually fall short of reality. Leading indicators increased a steep 1.4% in March, which is indicative of above-trend economic growth. (Expectations were for a 1.1% increase.) Market breath and strength are more in tune with early Bull markets than old and tired ones ready for a fall. Investments overseas have chilled with Europe stymied by the Greek crisis and China raising interest rates to slow down their stampeding economy, hence the U.S. doesn’t look bad at all in comparison. So, despite the cycle chart below I remain very cautious that a major dip will not occur and that an outsized ratio of stocks to bonds (70%/30%) will remain appropriate for the near term. In sum, getting very cautious now could be premature while we witness such significant internal market strength which could be indicative of a mini global economic boom.
When to become worried about the stock market? The usual suspects for a cyclical bear market in stocks are not present currently. However, a critical element for a cyclical bear market would be when short term interest rates equal or move higher than long term interest rates. Whenever this happens it means the cost of borrowing money is becoming too expensive for consumers and businesses and an economic slowdown typically occurs. With the Federal Funds rate presently at 0.25% and long term Treasury bonds in the 4% range, inversion won’t be happening any time soon.
RMHI Asset Allocation: We remain at approximately 70%/30% stock to bond despite model readings which indicate 53%/47% ratio of stocks to bonds. This is because the internal strength of the stock market is significant enough to warrant an above average asset allocation for the time being. Market breadth and other internals are confirming the new high in the stock market and suggest that the US stock market is in the early stages of a rally and not the tail end. Should market internals begin to deteriorate I’d cut exposure to the suggested allocation.
RMHI Equity Model portfolios: The quarter was a bit frustrating return-wise in the first quarter although we made up for it in the first half of April. Because our portfolios have significant international exposure, the weakness in Emerging Markets in South America and China weighed down returns. The international markets RMHI focuses on remain in a secular bull market status and weakness this past quarter appears short term in nature. One bright note regarding Emerging Markets is that EM bonds yield under 6% which bodes well for EM stocks since the relative value of the EM stocks is higher now relative to the lower bond yields.
The Chinese stock market lagged the US market in the 1st Quarter as a selloff was incurred as Chinese regulators raised interest rates in an attempt to cool off and temper the 13% annualized GDP growth. Targeted growth remains at the 7%-8% level and Chinese equities have shown recent gains but their indices remain underwater for 2010. In my opinion, the Chinese market continues to have the best combination of growth and valuation of any market in the world. Growth is stimulated by the emerging middle class consumer which is driving many companies to growth rates of 30%+ with P/E’s in the single digits: SOKO Fitness and Spa being a great example.
The Chinese market took a hit in January as their government raised interest rates to cool off the economy. As the chart shows is revisiting its low for 2010.
Barclay’s Emerging Markets Trust which is indicative of worldwide emerging markets has treaded water so far this year and has lagged the US as well.
Bonds: I believe most high quality bonds and Treasuries are in the early stages of their own bear market and don’t offer value for the long term investor at present. But despite the wave of data that supports weakness in treasury prices, the lack of issuance in corporate debt in the past two years appears to be leaving little choice for large investors but opt for treasuries. In 2009 financial markets debt increased by only 3% the smallest rise since 1986 while Treasury debt increased by 25%. So until there is a large increase in bond issuance the long awaited bear in Treasuries might be held at bay.
Aside from surge in Treasury bond issuance, the Federal Reserve has done their best to discourage investors for short term treasuries and money markets with 0% yields but there are income choices that continue to offer value:
Municipal Bonds: Tax rates are going up and this class of tax advantaged bond has some attractive tailwinds supporting them. Bond issuance has dried up in the past two years while the future attraction for them is increasing as tax rates rise and especially if the dividend tax exemption is allowed to expire.
High Yield: High Yield might be the best choice for the time being for non taxable accounts as yield spreads between High Yield (JNK for example) and treasuries remain elevated despite the rise in price over the past year. Keep in mind that High Yield tends to correlate closely to small cap stocks. But this class of debt should do well with the improving economy which is something that cannot be said for treasuries.
Sincerely,
Brad Pappas
It has been a while since our last post when we opted for a bullish stance based on the rapid improvement in our sentiment models. Those very same model along with our proprietary valuation model are rapidly moving to the same position they were in mid January, not a good thing.
In addition, our cycle analysis is predicting an intermediate term market peak soon. Impossible to say exactly when with any degree of accuracy but probably within a month.
Its my estimation that based upon our indicators any gains made in the near term will be given back within 1-2 months. The momentum has been extraordinary but at the same time we detect a shift in equity price leadership as we’ve not had the traction in gains as we had last year, this is typical market evolution. So, raising some cash here in preparation for future hedging will do us good longer term as we need to comply with the emerging new leadership. Leadership appears to be in the form of high quality large cap stocks, names recognizable to most everyone.
Be careful out there,
Brad
A few hours ago I sold off our Bearish ETF’s which were our portfolio hedges for either a very small loss or no gain. Accounts preserved their value in the decline and now my best guess is that we could rally into the month of March.
The decline of the last month has thrown a bucket of ice water on investors who were quite overheated in mid January. I would have liked to have seen a greater decline in the market but it appears I’m not going to get it.
Brad
Long: none
I’ve received questions relating to account volatility so this post is probably well timed.
The purpose of our hedging strategy is to take a position in securities in the accounts we manage that will rise in value should the stock market fall. The value of the assets that increase in value should the market decline will offset the decline in the value of stocks, thus buffering the decline so you don’t take as big of a hit had you done nothing.
Essentially, we’re taking a much more aggressive approach to preserving account value by reducing downside volatility. Our hedging strategy does not include the use of Option or Futures. The value of the portfolio could still decline in value, especially on days where the stock market falls significantly but the decline would be a fraction of the loss had the account not had the hedges.
Should the market rise while the hedges are in place, the account would appreciate at a slower relative pace as well, since the hedges would act as a drag to upside returns.
I do not expect that hedging will be a frequent practice. Hedges are expected to be utilized with the Intermediate or Long Term market values are at risk.
This is our way of addressing account volatility in what I believe is the most effective way possible and I must admit, my response to doing our best to never allow a situation like our experience in 2008 to happen again.
My goal is to aggressively attempt to maintain account values near their highs by keeping declines to a modest level. We don’t need to be too concerned about making money when the market is moving higher, our proprietary model has done an excellent job of that. My motivation is to see that clients have some downside protection which also feels great when the market falls.
Be Careful Out There
Brad
2009 net returns which include all fees and expenses associated with RMHI accounts are soon to be posted on our primary website.
RMHI Growth: 43.8%
RMHI Moderate Growth: 24.6%
S&P 500: 26.5%
