Driving Without Restrictor Plates
This past weekend saw the 54th running of the Daytona 500, an event that is the Super Bowl of stock car racing. Although I am a person of many interests, I find the droning of engines and the hours of relentless left turns to be about as interesting as a rerun of Jersey Shore. However, when thinking about the race and looking at today’s US stock market, I stopped to consider the parallels between stock car racing and stock investing in recent months:
1. Continuous left turns with no change of direction is similar to the US stock markets since September 1, 2010. During this time the markets have not veered to a downside move – all left turns.
2. NASCAR and Daytona Speedway have attempted to make the 500 “safe” and “fan friendly.” Restrictions on bumping and grinding, car safety construction, and the most recent “restrictor plate” rules (one of four races that have them) have all but eliminated the high-speed death crash potential of a Dale Earnhardt. Likewise, the SEC, FINRA, Commodity Futures Trading Commission, and Federal Reserve have attempted to make investing “safe” and “investor friendly” by the combination of “circuit breakers,” Federal bailouts, a Plunge Protection Team, and dismissing accounting mark-to-market rules that provide investors a sense of security that high-speed investment crashes, such as those of October 19, 1987 or May 6, 2010 have been eliminated. Risk on, pedal to the metal.
3. New racing rules allow mere rookies, such as Trevor Bayne, to emerge victorious over seasoned drivers, since the new rules have attempted to make everyone’s car speed the same. The restrictor plates (or air restrictors) control the flow of air intake, which limits horsepower that governs a car’s speed. The result is “car bunching” that excites the fans and keeps media viewers tuned in until the finish. But the skill required for controlling the speed of the car is diminished, and drivers are forced to hang with the pack and hope Lady Luck will step in and let them win. Similarly, seasoned value investors who have driven in fast-track competitions in the past are losing ground and losing business to our younger, more aggressive drivers, who are racing full out with Bernanke airbags and SEC restrictor plates.
“Just because there is a lack of volatility does not mean there is a lack of risk.”
Raghuram Rajan, author of Fault Lines: How Hidden Fractures Still Threaten the World Economy (a must-read)
Consider the following year-to-date performance of emerging markets versus developed (as of 2/24/11):
We have completed most of our quarterly review meetings, and the takeaways were:
1. Reduce bond exposure.
2. Reduce cash.
3. Increase allocation to large-cap quality.
4. Increase commodity-driven assets in companies and countries whose economic gains are tied to natural resources.
5. Small increase to emerging markets.
Since mid-January we have found ourselves in a quandary over “jumping in” or “diving in” to the strongly flowing bullish current of the developed markets. The warning signs have been the Mideast riots, unemployment, commodity inflation, and the US percentage of debt relative to GDP. The positives are corporate earnings, an accommodative Fed, cash-rich balance sheets, and no new taxes for now. Therefore we wanted to share with you a number of charts and statistics that are part of our process.
Our macroeconomic assumptions:
1. We do not expect any action by the Federal Reserve over the next 6-9 months, other than the possibility of Quantitative Easing III as added stimulus.
2. US domestic GDP projection of 3% growth. The combination of the tax cuts with continued government spending (borrowing) should provide modest domestic growth. The risk in this assumption is obviously the price of energy.
3. Governments under financial duress (Ireland and Greece come to mind) will manage to further delay default through rhetoric and proposals for at least the next six months. Germany will pledge support of the euro while at the same time strangling their weak sisters with austerity measures.
4. China succeeds if the government gets it right, India succeeds if the government stays out of the way, and global growth is dependent on both succeeding.
5. The third year of an election cycle is typically the most stimulative. From what I have seen from the Republican conservatives, no one is standing up to lead the charge to quell a projected $1.4 trillion 2011-12 deficit. It’s business as usual on Capitol Hill: keep kicking that can.
6. Wild card: unrest in the Middle East. The last time the US stock market declined over 50% and then returned with a two-year recovery of 100% was 1937… and now 2011. During the 1930s there emerged in a repressed Germany one Adolph Hitler – whom world leaders dismissed. I am not making any predictions here, just stating the facts.
We subscribe to a number of independent resources, and one of our favorites is Ned Davis Research, well-known for their technical analysis of markets and, more importantly, investor sentiment. The following graph is their work indicating how bullish or bearish investors are:
The top line is the S&P 500 from 2001 to February 22, 2011. The bottom line is the more important one, in that it depicts “investor sentiment” through a comparison and correlation of five sources:
It does not take a rocket scientist to conclude that the mob is overly confident and bullish. While we can still find value in particular stocks and have been wading into them; caution seems to be warranted, given the level of bullishness.
The next graph depicts the S&P 500 from two time periods: 1965-1979 (our previous secular bear market) and 1999 to present (our current secular bear market).
The white line identifies the ebbs and flows of stock prices during the last secular bear market, which essentially lasted 13 years, beginning in 1966. I have written many times that the bull market that began in 1982 and rose 1,831% over the next 18 years ended in 2000. Since then we have been in a longer-term bear market that has had periods of 20% plus and minus returns that give the appearance of long-term appreciation. If you follow the orange line, that is the S&P 500 since 12/31/1999. I have said that history never repeats but often rhymes.
We are aware that the market can extend the current bullish speculation to higher highs, particularly in light of the Federal Reserve’s interest-rate policies. From John Hussman:
Rich valuation is strongly associated with weak subsequent returns, but only reliably so over periods of 7-10 years. In contrast, the present syndrome of overvalued, overbought, overbullish, rising-yield conditions is typically associated with abrupt and often steep losses, but is more commonly resolved over a period of months rather than years. I wish that I could report that we’ve found some method to “time” these often abrupt resolutions more precisely, but we haven’t. So we are forced to deal with average outcomes rather than specific forecasts.
We cannot predict short-term corrections or short-term bullish speculation. Our asset-allocation process over complete market cycles has consistently outperformed the S&P. The biggest mistake we could make at this time would be to abandon a discipline we have practiced for over 20 years and try to become more relative to stock market returns during speculative phases, such as we have experienced over the last five months.
Any aversion to risk has all but vanished, and we are seeing investors abandon their risk-tolerance levels to be part of the herd. The Fed cannot continue to triple its balance sheet with more and more stimulus (i.e., by printing money) and our government cannot continue to run trillion-dollar deficits without repercussions. However, the investment public cares not where the growth and earnings come from or the policies that produce them. As a seasoned driver of investment portfolios, my knowledge of risk and the havoc it can wreak has given me a chronic case of “What have you done for me lately?” with regard to stocks. We will stick to our discipline.
Cliff W. Draughn
President and Chief Investment Officer
IMPORTANT DISCLOSURE INFORMATION
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly above (including the investments and/or investment strategies recommended or undertaken by Excelsia, Inc.), will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information referenced above serves as the receipt of, or as a substitute for, personalized investment advice from Excelsia, Inc. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. A copy of our current written disclosure statement discussing our advisory services and fees is available for review upon request.
