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Bear Out On A Limb

Like most investors, investment advisers are a consensus seeking lot. Most of them are not willing or psychologically able to do anything that is outside the accepted current trend. That doesn’t make them evil or dishonest or anything else bad; it just makes them human. It is always hard to stick out from the crowd when the consequences of doing so and being wrong are so severe. Investors have little patience for an adviser who doesn’t fully participate in a bull market and even less for an adviser who can’t avoid a bear market. Losses generally affect people more than gains; the joyful emotion of a gain is swamped by the despondency associated with a loss. That neither thing is as simple as it seems with the benefit of hindsight is rarely a consideration for a population raised in Lake Woebegone.

At Alhambra our tag line is We Are Different and we do our best to live up to that motto. To really do that, we know we will at times have to crawl out on a limb and do things that are outside the consensus. It would be easier and possibly more profitable – at times – to just go along with the crowd but if we do that we aren’t really any different than anyone else in this business. And we don’t aspire to just be average. We aspire to be truly outstanding stewards of the assets that have been entrusted to us. That isn’t merely a matter of being right about the near term direction of the stock or bond markets. We have a responsibility to invest our client’s funds in a prudent manner and that means making intelligent judgments about the value and the risks associated with the investments we make on behalf of our clients. Continuing to hold a normal allocation to an investment that we believe to be overvalued is contrary to the spirit of the prudent man rule by which we operate. The fact that an overvalued security can become more overvalued is not a valid reason to ignore our responsibilities.

And so with that as preface, I think it is time to start preparing for not just a market correction but another bear market. Or if you prefer, a resumption of the secular bear market we have been in since 2000. We have been relatively bearish all year as our valuation work continues to point to low expected future returns for stocks and most other asset classes. We have held more cash than normal and while we could have performed better in the short term holding more stocks, we could not and will not ignore the risks associated with doing so. Just because the risk has not been realized – yet – does not mean it does not exist. In a sense, we have been preparing for the next bear market all year and turning even more bearish now is just a continuation of that process.

A number of recent developments have, in my opinion, made the bearish case more clear and urgent:

1. China appears to be approaching a crisis: I do not believe they are any more immune to the aftereffects of a credit boom than any other country. One of the consequences of a large slowdown in Chinese growth – even assuming they avoid a “hard landing” – is the prospect of a big drop in oil prices. While that may be positive for the US long term, the short term effects could be quite negative. I think the downside for WTI is at least in the 50s and since these things often overshoot, a drop into the 30s is not out of the question. I am old enough to remember the effects on Texas of the last oil bust in the 80s and this time we can add in ND and the other fracking states. I don’t know the banks’ exposure to oil but the 80s bust saw numerous bank failures in Texas although it was more related to real estate than oil lending directly. In addition to the commodity fallout, there is the potential for financial feedback from a China bust.

2. Sentiment: It will be interesting to see what happens to the AAII sentiment polls if the market has a minor selloff. Despite recent volatility we have bears in the low 20s and printed less than 20 two weeks ago. Less than 20% bears has almost always marked at least some kind of top. Fund flows also show the public quite bullish with steady retail inflows no matter what they say in polls. The Consensus, Inc. polls of investment advisers now shows 67% bulls for stocks and just 25% bulls for bonds. Naturally, we feel almost compelled to take the other side of that trade. A low VIX reading would seem to indicate a similar complacency among traders. I also continue to see a lot of gloating from the bulls on Twitter and the blogs.

We also have still high margin debt levels although we may have passed the peak with a small drop last month. Looking at the past, the market has generally started to fall hard a few months after the peak in margin debt.

3. Continued deterioration in economic fundamentals: We have seen some recent pickup in the regional manufacturing surveys but other than that, I don’t see a lot of positive momentum. The housing recovery also seems to be reaching some kind of peak. A lot of the pick up in starts over the last few years has been in multi-family and a lot of supply is starting to hit the market. Investors buying single family homes to rent is also past its peak with rents providing only low single digit returns. New home sales last week were a positive surprise but existing home sales were a disappointment. With the rise in prices over the last year approaching 20%, more supply coming to the market seems likely as formerly underwater “homeowners” now have a chance to get out whole.

4. Politics: The President’s speeches last week I think were a precursor to a showdown with Republicans this fall over the budget. His rhetoric seemed specifically designed to antagonize the opposition. Whether this is an attempt to provoke a budget crisis that can be used for political purposes in the mid terms or something else I don’t know. Whatever the case, this will come to the forefront in September after the August recess. I have said for some time that better long term economic performance is dependent on an improvement in tax and regulatory policies. I see no reason to expect this Congress or this President to do anything other than what they have done since Republicans took control of the House – bicker endlessly and position for the next election. Better policy will apparently have to wait until we have better leaders.

5. Earnings: Earnings this quarter have been slightly better than expected but the overall growth rate is pretty anemic, about a 4% gain over last year. Revenues are down about 0.5% so we’ve seen a slight rebound in margins but I don’t think that is sustainable if the rest of the world continues to slow down. Europe could be stabilizing but stopping the fall doesn’t mean a return to growth and Latin America and other commodity producers are hurting with the China slowdown. Currency effects are part of the problem but combine a stronger dollar with a slowdown in foreign sales and things could get a lot worse. Paying 19 times trailing earnings for stocks in this slow growth environment seems wildly excessive. If slow growth turns to slow contraction, valuations are even more excessive. Only if earnings meet the expectations for double digit growth in the second half does the market look fairly priced. That doesn’t mean all stocks are overvalued, but the market as a whole is far from cheap.

6. Low quality leading the market: Micro cap and small cap stocks have recently been outperforming. Speculative stocks tend to lead the market near the end of a bull phase. Stocks like Tesla leading the market is not a sign of sober reflection on the part of “investors”. The current mania for everything biotech is another sign of the triumph of hope over experience.

What all this means for us is that we will continue to transition to a capital preservation mode. That means reducing further our allocation to stocks and likely increasing our allocation to bonds. In some ways the bond market call is trickier than the stock market call since we don’t know what the Fed will do in coming months. On the other hand, with just 25% bullish right now, buying bonds is certainly not the consensus thing to do and that makes it a little easier. At least it does for us; We Are Different and proud of it.

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“Wealth preservation and accumulation through thoughtful investing.”

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@alhambrapartners.com or   786-249-3773. You can also book an appointment using our contact form.