Well, the first quarter is in the books and what a quarter it was for US stocks. The S&P 500 and Russell 2000 both rose 12%, the NASDAQ almost 19% while the Dow lagged the field, up a mere 8%. As for us, while our stock portfolio lagged the S&P 500 slightly for the quarter, our outperformance over the longer term remains intact and considerable. Given that we spent most of the last month of the quarter selling into the rally – our cash levels have risen to nearly a quarter of the portfolio – the minor underperfomance over this short time frame is not something that overly concerns me. Our mandate is to preserve and grow our client’s capital over the long term, not match a random index quarter to quarter. And capital preservation, not growth, dominates our thinking right now.
I believe we are still in the midst of a secular bear market that probably still has years to run. Bullish interludes such as we’ve recently seen will occur periodically but until there are significant changes to economic policy, I see little reason to believe that a new bull market has been calved. Bull markets are born from low valuations and widespread skepticism, neither of which is extant in the current environment. At best, stocks are currently at average historical valuations; at worst, based on measures such as the Shiller P/E, they are considerably overvalued. Sentiment, as measured by the various surveys, is approaching euphoric levels. I don’t know yet what will upset the bullish mood but the last few years have proven beyond a shadow of a doubt that when it happens, the move down will not be pleasant for the fully invested.
The list of potential mood changers is lengthy and well known: China and emerging markets slowing down, Europe in recession, high gas prices, a return of the European debt crisis with Portugal or Spain in the lead role this time, a stalling of the alleged US economic recovery and maybe most important for markets, a lull in the torrent of central bank liquidity. The ECB has probably done what it can for now and the Fed’s Operation Twist will wind down over the next few months. As with the end of previous incarnations of central bank inflation, markets will probably not react favorably to the removal of their monetary IV drip. Twist, by the way, does not appear to have been particularly effective anyway. Long term interest rates have been rising of late and the real estate market – the stated target of the policy – has lately been disappointing on the downside.
From a longer term perspective, the last few years of monetary and fiscal distortion have, at best, only delayed the inevitable anyway. The Fed’s inflationary policies have allowed the federal government to run massive deficits, which have in turn minimized the drop in consumption and allowed corporations to cut their labor bill while expanding profit margins. That, of course, cannot continue indefinitely and when it ends – either by choice or because the market forces it – margins will revert to the long term mean. Stocks, needless to say, will not look nearly as cheap when that day arrives. Inflation has also engendered another round of malinvestment that will be revealed in time just as the previous malinvestment in real estate was revealed. The boom in shale oil production is a prime example and the day of reckoning may be closer than most believe. Crude oil inventories are already rising and it is only a matter of time before the shale oil boom turns to bust.
My shorter term concern is that the US economic data appears to be taking a turn for the worse. Of the 10 economic data points released last week, 8 came in less than the consensus. While most of the indicators were still relatively positive, the peak rate of change may have already been passed. Markets are discounting mechanisms and so expectations are extremely important to the future direction of the market. If the data continues to surprise in negative fashion, markets will have to adjust at some point to the new reality of slower than expected growth. With a slew of data on tap next week, including an employment report, that may happen soon. We will also be entering the corporate earnings season soon and with expectations high, disappointments seem likely. Corporate profits may have peaked in the 3rd quarter of last year; 4th quarter profits, according to the revised GDP report released last week, were down quarter to quarter.
As stated above, last week’s data, while generally still pointing to growth, was almost uniformly less than expected. Of particular note, were the manufacturing surveys which all showed less activity than anticipated. The Dallas survey came in at 10.8 versus expectations of 15.5, Richmond 7 versus expectations of 18 and the Chicago PMI 62.2 versus expectations of 63. All the reports did show continued expansion but also reported a slowing in the expansion of new orders. The Chicago National Activity Index also turned negative which indicates growth below trend. Durable goods orders also disappointed, rising 2.2% versus the expected 2.9%. Business investment rebounded somewhat from the drop in January but rose a relatively tame 1.2%. Companies still appear reluctant to invest.
Pending home sales fell 0.5% in February confirming the softness in the new and existing sales data released last week. As I said above, Operation Twist does not appear to have been effective in reviving the housing market. Mortgage applications, which have been falling of late, were down again last week with refinancing activity continuing a recent weak trend.
Consumer spending rose 0.8% in February but it came at the expense of savings as income only rose 0.2% and the savings rate dropped. Inflation continues to eat up income gains as the PCE price index rose 0.3%. The Goldman and Redbook retail reports were mixed with Goldman’s reading falling 0.5% on the week and the year over year change down to 2.7%. Redbook reported a 3.8% year over year gain but also noted that the strength was partially explained by warmer weather. Jobless claims continue to be a relative bright spot, posting a 4 year low – after some revisions – of 359k. This week’s employment report should prove interesting.
With market expectations for growth relatively high and the actual data somewhat disappointing, now is not the time for aggressive portfolio allocations. The stop/go monetary policy of the last few years has been mirrored in the financial markets and I don’t think this time will be any different. The Fed may still ride to the rescue of financial markets but that would only come after a further deterioration of the economic statistics. In the meantime, we’re happy to hold cash as the best alternative in a universe of bad options.
For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: firstname.lastname@example.org or 786-249-3773.
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