RMHI 4th quarter client letter

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