Here are a few good lessons. Perhaps describing his oracle, from Warren Buffett in 1979, “The future is never clear,” and “You pay a very high price for a cheery consensus.” And from Frank Napolitano, the irascible head of the firm who bank rolled my trading career in 1996..”Dougie, always remember…Cash is King!”
If you’ve been following our weekly analysis, you’ve noticed that we’ve begun to question the ravenous risk appetite displayed in financial markets, an 11% S&P 500 rally since mid-November. We are currently concerned that the price we see is reflective of “cheery consensus.” And if this turns out to be true, it would sure be nice to have some cash on hand to pick up some bargains.
Let’s pause for an assessment. Fiscally, both spending cuts and tax increases are still in the debate, as the delayed dawn of another debt ceiling approaches. The government has already voted to take a higher percent of current income from some households plus direct more current income to the health care sector. On the monetary side, we continue to have policy that is extremely accommodating. This is neither comforting nor beneficial. The fundamentals in the private sector of the economy show pockets of strength; but, on the whole, they are not inspiring. Sentiment is extremely bullish accompanied by upside is momentum.
- Monetary and Fiscal Policy: At Alhambra, we like good growth. Q4 S&P 500 reports show EPS growth of only about 4% on revenue growth of 2.3%. Revenue growth of 2.3% in S&P 500 companies looks, to me, a lot like “just inflation.” As the government reduces its role in the economy, the Fed fills the void. If Atlas steps aside, will the sky fall? Bernanke has forced the market into an unfamiliar and uncomfortable place, ZIRP. We have flown below the horizon, real rates are negative. The cost of money and the cost of capital are not just blurred they are intangible. Risk, especially the probability for future volatility, is elevated.
As the government steps aside, will we still grow GDP? The following graph shows construction spending since 2008 (red bar = private sector spending, blue bar = total spending). The private sector has seen 20+% annual growth for the past 5 months. But, the blue line is falling. The government sector is taking a step back and more than offsetting the strength in the private sector.
- The Real Economy: The world feels awfully cheery to me right now, it is a nice feeling. But, contemplating the recent rally in stocks and all the positive sentiment, we are caught wondering…could the media be, just as easily, writing stories of the US trying to script a “soft landing.”
Here are some trends to watch:
Yes, there was escalated growth post recession. To a certain extent, this is the math of normalizing. It is partially Keynesian stimulus (excessive spending by a government borrowing at cheap rates). And, at some point mom and pop had to replace their mid 90’s gas guzzler and buy some new underwear, at least for the kids.
As the government steps away, there are signs of private sector strength. Recent strength in private construction spending is a good sign as this industry has a vast reach in the economy. Income is showing some signs of improvement, but wage growth is still below inflation.
This week we sold some risk assets. At the end of the day, this trade was much about sentiment. Sentiment and market rallies can persist. Admittedly, this rally may be in its infancy. But our research shows empirical evidence that in the presence of extreme positive sentiment, markets tend to under perform mean return expectations at the short to medium term time horizon. We would not refer to the current environment as mass euphoria, or irrational exuberance. But, we would describe this as a small psychological bubble. Here are 2 of my favorite sentiment indicators.
We see an economy challenged by political and monetary decisions, both past and yet to come. As a result, we see elevated future risks; especially from monetary policy which could be described as concerted experimentation, because “Yes we can.”
Investing can be a relative value game, but we also must step back and assess value for value’s sake. Would you loan money to Russia, Turkey, Brazil and Croatia to make 3.4%? This is the current SEC yld or essentially the Yield To Maturity of the portfolio of bonds in EMB, the most widely held emerging market bond ETF. To put this in perspective, the yield on US 10 year treasury bonds was never this low from 1962 until 2003.
We took some money off the table during the election. We unfortunately balked at adding risk during the post election ebb as cliff debates and other fiscal headwinds had us concerned and looking for a lower buy point. And, this week we did a bit more selling. Here are the portfolio moves made in discretionary accounts.
Global Bond – Sell Emerging Market Bonds add Short term European debt. The primary motivation was to get out of EM bonds and lower duration (interest rate exposure). Fed policy adds risk and we feel a dollar hedge in the bond portfolios was the prudent move.
World Allocation – Sell WOOD, EMB and 20% of the QQQ position.
Global Opportunities – Rebalance top performing stocks back to target weight, proceeds to cash. These include Aflac, Amgen, Bank of New York, Celgene, and Dassault.
Select Countries: – Sell Brazil, Sell 20% of South Korean position, sell gains in Taiwan and rebalance to a slightly lower target.
As always I welcome your comments and my phone line is open for any questions or concerns.
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For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Douglas R. Terry, CFA is reachable at: email@example.com