Yield on high yield debt rose in the month of May the most since February 2009 while Investment Grade debt was little changed. High Yield is now back above 10% which accounts for a spread of approximately 7% versus medium term treasuries. However, attractive yield spreads aside high yield will perform along with the economy and its inherent risks.
One of the potential trends we have our eyes on is a serious rise in long term treasury yields. In an interview with St. Louis Federal Reserve head Bill Poole on Bloomberg, Poole remarked that with the Fed having no where to turn in lowering short term rates if the economy soften significantly the Fed might consider buying long term treasuries to lower their yields which will flatten the yield curve.
Asset Allocation: At present we remain at a 70/30 ratio of stocks to bonds which has been the case for close to a year. Models suggest that a move to 55% equities might be in order but the timing is questionable. Should the Advance / Decline line of the stock market not surpass the January high, we will likely pare back our equity stakes. The A/D line typically peaks before major market highs and for the past year has been rising quite nicely. However if the stock market were to become bifurcated with a smaller number of stocks advancing it would be a warning of trouble ahead.
NY Times: China Leading Global Race to Make Clean Energy
Be careful out there
Long JNK, HYD, HYG, SHY
Summary: The epic rally of the past 7 months has appears to have hit a wall at 1100 on the S&P 500. This does not mean we cannot rally beyond 1100 or that the market must now decline, trending sideways for a period of months may be the likeliest scenario. The time period of November to April is historically the strongest six months of the year, particularly November and December, so strength into the year- end is a possibility. Lowry’s Research has stated they expect the current pullback to be short term. Our strategy of Small Caps over Large Caps is still in force although I’m reviewing future holdings as the weaker Dollar tilts the odds to favor Large Caps. My thought is that going forward the disparity between Small and Large Cap stocks will narrow. The US stock market is no longer “Undervalued” but merely “Fairly Valued” in my estimation we are reducing exposure to stocks periodically on strength which I expect by December.
Back in the Spring I proposed that the stock market would initiate a rally of historic proportions with a target of 1100-1150 sometime in 2009. This prediction was based on past precedents the belief that no one at the time was discounting the end of the recession by Summer. This target was breached on October 21st. While I consider the stock market now fairly valued, the signs of a classic major top in the stock market are simply not present at this time. The current pullback has the ingredients of a short-term correction rather than the start of a new leg down. Major tops take time to develop and our timing service Lowry’s points out that “Every major market top in Lowry’s 76 year history has been preceded by a sustained rise in Selling Pressure.” There is no evidence of a sustained rise in Selling Pressure at this time.
Adding to the lack of incentive for a new down-leg in stock prices is the fact that interest rates are at minimal levels and while market valuations are fairly valued at 14.5 normalized earnings, which is about 2 multiple points less than historical averages. Since 1932, the six months after the end of the recession has seen gains on average of 9%. Curiously, the two market years most resembling the past year: 1938 and 1975 saw gains of only 3% for the next six months after the end of the recession. In addition, small cap outperformance is maintained by an average return of 7% in the six months following the end of a recession. The issue of Small Cap outperformance is subject for review due to the effects of the declining dollar. A declining dollar assists the performance of Large Cap stocks. Small Caps peaked on September 19 and if the trend of Small Cap’s lagging performance persists for another month, future additions will be Large Caps.
Believe it or not we’re going to get an economic recovery, it may be anemic by historical standards but it will be a recovery. Due to the stimulus package there will be a significant infrastructure build out in the US starting in 2010. Warren Buffet’s purchase of Burlington Northern is a classic smart move to get in front of the infrastructure build.
The 3rd Quarter of 2009 turned into quite a prosperous quarter for RMHI clients as our exposure to small cap equities with international diversification has been a winner since the market bottom in March. While the past few months have been quite good, I believe that going forward gains will moderate especially if we stay in a trading range with 1100 on the S&P 500 being the top end of the range.
Historically speaking, the period post-recession has produced gains but to a lesser degree than the period preceding the end of the recession. In other words, its likely that the “easy money” has been made (as if its ever “easy”!) but there still are gains to be made although our exposure to equities will be reduced as the risk reward is not quite what it was in March. There is always the chance that unknown world events could throw a Molotov cocktail into the markets, so having cash off the table could prove to be prudent.
Until there is solid revenue growth in the US, my view is that we could be entering a period of market digestion, not unlike what we experienced in 2004 (the SP 500 did return +8% in ’04). Gains were still made just not nearly at the rate in 2003. Small cap GARP (Growth at a Reasonable Price) should still outperform, just at a lesser pace.
It seems to me that in the past 10 years we’ve bounced from Bubble to Bubble which eventually pop sooner or later. The current interest rate environment is unsustainable in my view, but the hazards of reaching for yield by going out farther and farther on maturities could be the next major bubble to pop. Timing is next to impossible to predict but it could be within the next two years.
The current 0% interest rate environment induced by the Federal Reserve has created a curse on holding cash. The 0% return is forcing investor’s including retirees to invest in increasingly longer term maturities to gain incremental increases in yield. Desperate to increase their yield they’ll be very vulnerable to a pullback in bond prices. While the Federal Reserve controls the yield and price of short term Treasures, market forces have a much greater influence on longer term maturities and the Fed’s support of Treasury prices will eventually end. Fear continues to guide their decision making as equities were almost completely avoided this Spring which means they missed the 20% + returns in favor of bonds yielding 2%-4%. The lure for this move is the perception of “safety” but in the longer term this perception could be a very elusive mirage.
The catch is that our deficits and issuance of debt is having a declining effect on the dollar and at some point investors, especially foreign investors will demand higher rates for the risk of owning Treasuries. While the debate over future inflation is mute at this point, my view is that eventually interest rates must go higher eventually, especially if we experience declines in unemployment in 2010. What would happen to the prices of long term debt should rates rise to 7% or even 9%, the collapse in bond prices for those investors would be devastating. This is the basis for my belief that should employment rebound in 2010 or 2011, it could be accompanied by a significant pullback in stock prices, which would take their cue from falling bond prices and higher yields.
I realize the returns on short-term debt are almost next to nothing, but the risk inherent in owning short-term debt during an interest rate spike is not nearly as significant as longer-term maturities. I’d rather be safe with our ownership of short-term bonds rather than the higher yielding long-term maturities. Short term interest rates are set primarily by the Federal Reserve and its my view that those rates will not rise until a meaningful increase in employment is underway, this could remain elusive for most if not all of 2010.
While the declining US dollar presents problems longer term for US interest rates there are positive ways to invest with a weaker dollar in mind. Generally a weaker dollar is positive for US equities, especially Large Cap Growth stocks like Apple or Google. Both of these stocks rank very high in our model so they’ve been mainstays this year. In addition, countries and regions that are commodity oriented such as Latin America. Foreign Treasury bonds are another good option and we’ve owned them for most of the year. Gold is another interesting way to prosper from the declining dollar. With the resumption of risk appetites worldwide investors are liquidating dollars and transferring the assets to Gold. Gold also plays a valuable role in the event of a crisis that could erupt in the Middle East should Iran remain contentious regarding its nuclear plans.
All The Best,
Brad Pappas
Last night before heading off to bed I checked the overnight futures market to see we were down 10 on the SP 500. This made sense given the new and potentially increasing trade war with China. (Gee ya think a trade war with China is a good thing since we need the kindness of strangers to buy our Treasuries?)
If this market were in true Bear mode we’d probably have added to the loss of 10 points, given the news. If you went to bed Short or in cash you’d be sleeping smugly……but don’t look now as we’re actually up 5. What Chinese Trade selloff?
Look, there are lots and loads and bunches of reasons to hate this market. Baskets of reasons to say: “We’ve run too far too fast” or “the market has disconnected from our reality” and I wouldn’t disagree with you. In fact, the Bearish reasons always sound more intelligent and thought out than astandard Bullish argument which always has a tendency to sound either insane (A Bull Market Birther: Show me the birth certificate for this Bull Market) or SweetSallySunshine.
Whats undeniable is that Central Bankers round the world are putting massive amounts of cash into their systems, and while banks may not be lending that doesn’t mean they’re not investing. Managers that I have enormous respect for are getting poked in the eye each time they lay out a new series of Shorts. I just have to wonder if they might actually enjoy the pain so self inflicted?
My point is….as I usually do have a conclusive point: The market at this point in time is eerily similar to other periods of economic transition such as 2003, major selloffs are not to be found. My most optimistic guess from this Spring was no major weakness till the first quarter of 2010. Until proven otherwise….that might be the correct path to assume.
On a side note: There is a flip side that’s not so endearing to years of forest fire prevention and trimming: Mountain Pine Beetles. I have hundreds of trees on my land and this year will lose at least a dozen old Lodgepole and Ponderosa Pines. It breaks your heart to see a 150 or 250 year old tree that is doomed and must be cut down. Somehow you always wonder by cutting it down in an effort to save the surrounding trees are you doing the right thing? Without a doubt the answer is always yes. The MPB seems to be natures way of saying “if you’re not going to allow fires and harvesting to take out your old trees I’ll give you a bug of mass destruction.”
Rocky Mountain Humane Investing Outlook: April 2009 (Posted July 2009)
“Markets do have a lovely tradition of overshooting themselves both in the upside and downside”: from the RMHI 1st quarter client letter.
Is there a more droll way to describe the emotions of early March? It would have been uncommonly rare to have seen the selloff in late February and early March evolve into a lasting period of price erosion without some sort of quick rebound, only the 1929-31 period showed a lower low after such a devastating waterfall selloff. The selloff in March created a sense of investor despondency and incoming phone calls only seen at major market bottoms. This depression stood in contrast to a string of data points suggesting emerging stability that I wrote of in January:
- “Declining New Lows: On October 11th when the SP500 first reached 850, the number of stocks making new lows exceeded 3000. On January 20th the SP 500 touched 804 and the number of new lows was 186. Despite the SP500 being actually lower than 10/11, the number of stocks making new lows is only a tiny fraction of previous sell-offs. This trend has been apparent since November when the index made what might be the ultimate low for this Bear Market of 740 yet the number of new lows was just 600.” At the March low there was only 855 stocks making new lows, despite the market being 22% below the October low. In addition, volume at the October low was 2.85 billion whereas the March low volume was just 1.56 billion, clearly a marked drop in selling intensity. All major market bottoms showed this behavior.
- “Crude oil prices: Stability in oil prices may mean we’re reaching stability.” Crude oil and other commodities are frequently a barometer of worldwide economic activity. The May futures contract for crude broke out of a downtrend in the third week of February and have rebounded from $40 to $54 a barrel. In addition, industrial use metal Copper broke its downtrend at $1.40 and has rallied to $1.80.
- “Baltic Dry Index: The Baltic Dry Index of shipping rates for container ships has leveled off after a precipitous decline. The Baltic Index is a very good forward indicator of worldwide economic activity. It reflects the prices paid to hire an oceangoing freighter to haul goods or raw materials. In recent years, China has been a driver in pricing with their economic expansion.” While the Baltic Dry index is not an ideal barometer of economic activity in this cycle (a probable glut in oversupply of available ships, causing cheap pricing), the lack of continued price erosion is clear.
- “A roadmap of composite (1929-2002) post-crash DJIA performance. Ned Davis Research has done a fascinating study of post crash declines in excess of 20%. Although the “crash” phase was not the actual end of the Bear Market, the declines were not exceeded either. Retests of the market lows were very common and generally occurred within 90 days of the waterfall selloff. In our case, October 11 would be the 0 date while November 20, 2008 remains the ultimate low of this Bear decline, which perfectly parallels the composite roadmap of this chart. Other points of merit: The waterfall selloff occurred on average of 130 days before the end of the recession, but the markets started to make progress approximately 70 days before the end of the Recession. Based on analyst estimates for the Standard and Poors 500, the approximate end of the recession could be in the 2nd or 3rd quarter of 2009, which coincidently matches Davis’s chart.” While the markets did go to new lows in March, they did not break and with blazing speed erased the March decline in two weeks. Furthermore, my reference to the parallels of 1974 and 1938 continue to look accurate, especially 1938.
Mark Twain said: “History doesn’t repeat itself; at best, it sometimes rhymes.”
Economies and equities have gone through boom and bust cycles many times over the past hundred odd
years. While the reasons for the boom or bust change with each cycle, the reaction of the market place
post-collapse, which is based largely on human psychology and economics reveals a pattern that continues
to rhyme with surprising frequency and accuracy. These patterns of market behavior are most accurate in
the transitional period between Bear and Bull cycles but lose their accuracy once the transition cycle is
over, whereby the markets are on their own and trade according to new incoming data.
In January, I brought this chart to your attention:
“We are in a moment “in-between” of gray twilight between dark and dawn”
In early March we found ourselves in a period of agonizing investor angst yet improving market internals and even more astonishing…….. early signs of economic stability and yes……….improvement. The U.S. Equity market staged a rally with breathtaking swiftness and rebounded from 650 to 830 on the SP500.
In January, Ned Davis Research published a chart that has been uncanny both in terms of market seasonality and behavior and is likely a good road map for 2009. This “road map” is meaningless unless the underlying economic data support the price movement. The March rally has been unique in that it was supported not by government acts but improving economic data, a contrast to the failed rally of November and December.
Ever since the market bottom in October there have been a series of false starts where rallies petered out in a matter of a few short weeks. These rallies were only technical in nature; there was no underlying fundamental reason to support them as the economy remained in freefall. Since the bottom in early March, there have been six 90% upside volume days, a clear difference than the tepid rally in November and most importantly the rally coincided with news from Citigroup, JP Morgan and Bank of America that January and February were profitable.
A cyclical Bull Market to last till late summer, in five steps:
Step One: The composite chart above details a brief “blast off” rally in the range of 18% starting in late
February. These rallies catch everyone by surprise, as they appear to come out of nowhere but do coincide
with bottoms in the economy and investor sentiment. Our rally appears to have peaked at 23% and started
in early March rather than late February.
Step Two: A period of consolidation for the market to digest the move. The market pulls back a bit but
doesn’t break lasting for 4-6 weeks. I believe we’re in this phase now.
Step Three: A 30% rally as investors see further evidence of the economic bottom with the prospects for
the recession ending and stability in housing. This move like Step One is a virtual race to get invested by
an underexposed hedge fund industry and others. In the past 10 recessions, the stock market has staged a
lasting and major bottom on average 4 months before the end of the recession, or mid Summer 2009.
Further argument for the end of the recession by summer will be the effects of the Presidents stimulus
package, which will start to resonate within the economy in the second quarter of 2009. Earnings estimates
by Standard and Poors validate this thesis as well with a quarterly earnings jump from the 1st Q to the 2nd
of $13.00 to $14.96.
Step Four: The pause that refreshes. The months of June-July bring a second gentle period of
consolidation as the gains are digested by trending sideways. Stock market rallies coming out of
recessions are generally always exceptional but they don’t move in a straight line.
Step Five: A midsummer and final rally in the range of another 25% to the normal stock market valuation
of (100 year average) 16 times 2010 earnings of $66 or approximately 1100 on the SP500 by August. A
good chance this will be the high of the year.
I fully realize these figures sound astonishing but we can hardly forget how far we’ve fallen. A rally of this
magnitude actually falls in line with (here’s the rhyme again) 1938 and 1974, which rallied 60% and 51%
respectively. The last emergence from a recession for the stock market was (another rhyme) March 2003
where it staged an unending rally till the end of the year with a trough to peak move exceeding 50%.
The mean cyclical return for the stock market in a secular bear market is 65% over 508 days. In addition,
volatility in the markets today is much greater than in previous periods. Ned Davis’s own estimates are that
the SP 500 could reach 1200-1300 by summer, which would be wonderful. But any rally that extends into
late summer will likely be running out of steam and showing signs of exhaustion and excessive enthusiasm,
this is the stage of the rally where we must be selling. The very same panic-stricken investors who are in
cash now will be rabid to gain exposure as performance envy kicks in. There is substantial career risk for
a portfolio manager to be in cash and show nil or negative returns when market indices are substantially net
positive for the year, the NASDAQ has already returned to positive for the year.
Post Rally: The present rally will be based on the presumption that the economy has bottomed but
investors will not have had the chance to factor in unintended consequences, especially inflation. Its my
guess that inflation will return as an issue but its clearly too early to profit from that at this point in time,
the prospects for deflation need to be cured first along with housing before inflation is a substantial issue.
If inflation remains in check and Treasury bonds remain relatively stable with low yields along with an
economy that shows improvement then the stock market should merely correct itself with the normal
seasonal weakness and not commence a new Bear market. Either way, I plan on sticking to discipline and
having minimal long stock exposure by late summer.
All the best,
Brad Pappas
March 29, 2009
