I wrote last week that investing today requires a huge dose of humility and so with that in mind, I have to admit that I’ve been…..well, to be kind to my ego, I’ll just say I’ve been too cautious about the market recently. Anyone who bothers to read these weekly missives knows that I turned more cautious about the economy around the first of the year and have questioned whether the stock market rally is built on sound fundamentals or just the air of QE forever. I’m still not convinced that the economy is improving at the pace the stock market seems to imply but neither can I deny that the economic data recently has been pretty good.

Last week’s data produced a series of better than expected reports and the stock market reacted as one would expect with the Dow making a series of new highs. The string of better than expected reports included:

  • The ISM Non Manufacturing index (56.0) with both new orders and backlog rising. The employment component stayed strong at 57.2.
  • Factory orders were down 2% but less than expected and ex-transportation were up 1.3%. More importantly, capital goods orders, again ex-aircraft, were up a very strong 7.2%.
  • Mortgage applications were up almost 15%.
  • The trade balance worsened to -$44.4 billion with exports down 1.2% but imports up 1.8% indicating strength in the US economy if not the rest of the world.
  • Jobless claims fell to a post recession low of 340,000
  • Payrolls rose by 236,000 and the unemployment rate dropped to 7.7%

Reports that looked weak were:

  • Weekly readings on retail sales from Goldman and Redbook which show year over year gains of around 2%.
  • Chain store sales were generally weak showing slowing rates of growth.
  • Challenger job cut report showed a surge in layoffs to over 55,000
  • Wholesale trade showed a rise in inventories (1.2%) and drop in sales (0.8%) with the inventory to sales ratio rising to 1.21 and the highest of the recovery.
  • A revision to productivity and costs in the 4th quarter reminded us that the former was down and the latter up in the last quarter.

And last week’s data follows pretty good data from the previous week when new home sales and pending home sales both looked good for housing, durable goods orders ex-transportation looked a lot like the factory orders report and the Chicago PMI and the ISM manufacturing survey showed strength in manufacturing. As Jeff Snider points out though, the wholesale trade inventory report shows that some of that may just be catch up from inventory liquidation in the 4th quarter. The point however is that, contrary to my expectations, the economic data, at least for now, appears to be improving. The question for those of us who have been cautious about the stock market though is whether it can be sustained and given the continued fiscal and regulatory challenges I’m not yet convinced. We still haven’t seen the full effect of either the tax hikes or Obamacare (although the surge in part time workers could be related) not to mention what the politicians might cook up in coming months during the debt ceiling debate (again, sigh).

As I’ve written before, our view of the markets is driven by our expectations about growth and the US Dollar (or more generically the national currency when looking at foreign markets). We classify economies under four scenarios with the most positive being a rising dollar, accelerating growth environment. That scenario is by far the most positive and the one we associate with an aggressive allocation to stocks. So, at this point we are faced with a dilemma. If the economy is accelerating – and at least the most recent data would seem to indicate that it is – and the dollar is rising – which it did strongly Friday after the employment report – we need to – gulp – raise our allocation to stocks in a market sitting near all time highs.

Needless to say, that isn’t an easy thing to do and I’ll tell you right now it isn’t at the top of my to do list. There are other considerations when it comes to changing our asset allocation which right now is more conservative than normal. First and foremost is valuation and while the stock market isn’t outrageously priced as it was in 2000, it isn’t cheap either. On trailing GAAP earnings, the S&P 500 is trading at almost 18 times earnings (slightly less if you use operating earnings) which is at best average. The earnings yield at about 5.5% looks appealing compared to Fed suppressed bond yields but with stock and bond yields both rising the gap is narrowing. Looking at longer term measures such as Shiller’s 10 year CAPE makes the valuation picture look quite a bit less appealing.

Another consideration – and the more important one – is that a lot of what is going on in the stock market and the economy is artificial, a result of a monetary policy intended to accomplish what fiscal and regulatory policy makers will not. Companies and individuals are taking actions that are motivated by nothing more than artificially suppressed interest rates. Retirees are buying junk bonds at all time low yields and any stock with a dividend because Ben Bernanke has denied them a safer alternative. Hedge funds are buying houses and renting them for low to mid single digit cash on cash yields, hoping the Fed’s money printing will raise their returns through price appreciation. Companies are borrowing at artificially suppressed rates to buy back stock sitting at all time highs (even as insider selling spikes higher by the way). Margin debt is near an all time high as the Fed’s low rates make it cheap to speculate on continued Fed largesse and short sellers are quickly becoming an endangered species.

Because we have never experienced a market with this degree of monetary intervention, we have no way of knowing what will happen if it continues or especially when it ends (which admittedly doesn’t appear to be anytime soon). Being a student of economic history I find it hard to believe that if the Fed’s money printing ways continue it won’t eventually morph into something other than just asset inflation. Bernanke & Co. seem convinced they will know when and how to reduce the size of the Fed’s balance sheet but they also missed the internet bubble and the housing bubble and thought sub prime was contained so take that with a giant grain of salt.

So what should investors do right now? Well, I just spent some time looking over our passive allocation models and if we were to rebalance right now – and we may do exactly that this week – we would be forced to sell stocks and REITs while buying bonds and commodities. The value of a passive approach is that it forces you to sell the things that have gone up and buy the things that have gone down. That is still the essence of investing – buy low, sell high – and it has worked for a very long time so I won’t question it. Given all the supposedly impossible things that have happened in the market during my career, bonds and commodities rising at the same time seems entirely possible.

As a fiduciary my only duty is to invest our clients’ assets prudently. It is hard to justify on that basis an increased allocation to stocks and so for now I’ll have to take the slings and arrows of those who have been more bullish – and right – than I have. It isn’t the first time I’ve been wrong – or maybe just early? – and it surely won’t be the last.

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@4kb.d43.myftpupload.com or   786-249-3773.

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