May 15, 2006
“The Committee judges that some further policy firming may yet be needed…”
- FOMC Statement, May 10, 2006
Yet (adv.) 1. in spite of everything: used to stress that it remains possible that something will happen or that you are still determined to do something despite present difficulties; 2. so far: up to now or a particular time; at the same time; 3. for longer: used to indicate that something will go on happening for a particular length of time; by continuance from a former state; still; ( n. ) 4. mollusk: any one of several species of large marine gastropods.
- Encarta World English Dictionary, Online Plain Text English Dictionary
Which one is it?!! “Yet” as in “in spite of everything, so far, and for longer,” or “yet” as in “large marine gastropod”? This obscure Fedspeak is so frustrating.
The market's sharp decline last week probably had a number of causes. First was the fact that the Fed signaled that it wasn't necessarily finished with its tightening cycle. Now, as I noted fairly early this year, there's no statistical evidence at all that stock prices or corporate earnings perform well in the 18 months or so following the end of a rate-tightening cycle. But despite this, the end of tightening has been widely hoped on as a catalyst for further stock market gains. And even though market participants were already well aware that the Fed only saw the possibility of a “pause,” my impression is that once the latest statement was out, a lot of investors suddenly realized that they couldn't talk about the tightening cycle being over, nor could they talk about it being over at the next meeting. In fact, it might be months before the end – and if there's one thing that markets don't like, it's uncertainty.
So a good part of last week's decline was probably the injection of fresh uncertainty into the monetary picture. At the same time, the dollar fell apart. This is important, because I've noted for a long time that sudden dollar weakness would probably be among the first signs of oncoming economic weakness, especially if accompanied (at the same time or shortly thereafter) by widening credit spreads. That's what to watch for now – things like the difference between commercial paper yields and Treasury bills, the difference between Moody's BAA and AAA yields, the difference between the Dow Jones Corporate Bond Index yield and 10-year Treasury yields, and so forth. This sudden dollar weakness is probably not benign.
At present, the major indices have made a quick trip from overbought to moderately oversold conditions, so anything is possible here. Even if this weakness is set to continue, investors should be very aware of the tendency for the market to enjoy what I call “fast, furious, prone to failure” advances in order to clear those short-term oversold conditions. These tend to happen fairly unpredictably, because it's also a tendency of declining markets to become more persistently oversold than they ever do during healthy uptrends. So unlike a condition where valuations are good and market action is uniformly strong (where the rare oversold condition typically presents an unusually good buying opportunity), oversold conditions aren't particularly reliable entry points when valuations are rich and market action is unfavorable.
Another part of the story is that investor reactions here are likely to be somewhat “non-linear” in response to interest rates and oil prices. A good example of a “non-linearity” is the image of a single straw breaking a camel's back. For a good while, we've observed interest rates and oil prices moving higher, and investors have remained fairly oblivious. Some analysts have even suggested that the lack of response is a sign that the market “wants” to go up (I always worry about analysts who ascribe feelings to the market). It's more likely, in my view, that investors have simply been getting closer to their “tipping point,” and that small further increases from here may have disproportionately large effects. In other words, it's probably not a safe assumption that stocks will remain well-behaved in response to further rate and oil price increases simply because they've been well-behaved until now.
Precious metals have enjoyed a fairly explosive advance in recent months. This may partly reflect some accumulation of precious metals as reserve assets by central banks such as China and Japan. The concurrent weakness in the U.S. dollar is consistent with some degree of "diversification" of reserve assets by these foreign central banks. That said, precious metals have advanced to the point where it would not be surprising to see some amount of normal retracement. The Strategic Total Return Fund has reduced its exposure to precious metals shares to about 8% of assets, but is likely to increase rather than decrease this exposure on weakness in this group. The broad fundamentals – particularly an enormous current account deficit and reasonable prospects for stagflation – continue to be favorable for this group.
That reference to stagflation is based on two factors. First, historically, and internationally, it's not the rate of money growth per se, but the growth of government spending as a share of GDP (particularly spending that doesn't add to the productive capacity of a nation), that drives inflation pressures. Second, the enormous current account deficit means, by definition, that a substantial portion of U.S. gross domestic investment is currently being financed by foreign capital inflows. There are only two ways out of this deficit – invest less domestically, or save more domestically. Given a profligate fiscal policy and a low propensity to save among U.S. households (saving more requires income growth to outpace consumption growth), “saving more” is probably not a likely source of adjustment. More likely, we'll adjust a good part of the current account deficit through weakness in U.S. gross domestic investment (mostly via a housing slowdown, in my estimation). In any event, the U.S. has virtually zero likelihood of enjoying a sustained “investment boom” anytime soon – whatever growth we observe in capital spending is likely to come from a contraction in housing investment, leaving gross domestic investment relatively flat.
So “stagflation” isn't an outside chance, but a reasonable likelihood here. My impression is that the Fed will have a fair amount of difficulty with this outcome, as central bankers have always had. It's very difficult to manage inflation just by determining whether government liabilities take the form of cash or government bonds (which is what the Fed does) if you can't control the explosion of government liabilities itself (which only Congress and the executive branch can do). As a sidenote, statistically, periods of slower economic growth do tend to be correlated with higher, not lower, inflation (a result that follows from the “monetary exchange equation”).
In short, credit spreads are worth watching here, as well as the dollar, interest rates, and oil prices. Valuations remain rich, and internal market action remains very unfavorable. There's a tendency for oversold markets to unpredictably enjoy fast, furious, prone-to-failure advances to clear those oversold conditions, so those shouldn't be ruled out, but until we observe some compelling improvement in market internals, we're likely to remain fully hedged against the impact of market fluctuations.
As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and unfavorable market action. The Strategic Growth Fund remains fully hedged against the impact of market fluctuations. It's important to recognize that a fully-hedged stance is not a “standard” or even “typical” position for the Strategic Growth Fund. While recent years have held our position to a fairly defensive position, this is a function of the level of valuation and the quality of market action, not a general policy. The Fund can and will accept a substantial amount of impact from market fluctuations when the combination of valuations and or market action is sufficiently favorable (which represents the broad majority of historical market periods). So while the Strategic Growth Fund remains fully hedged at present, it's important to recognize that this is not at all a position that I prefer, or that I believe will persist indefinitely.
In bonds, the Market Climate remained characterized by relatively neutral valuations and still unfavorable market action. The Strategic Total Return Fund continues to carry a duration of about 2.5 years, mostly in Treasury inflation protected securities, as well as a roughly 8% position in precious metals shares.
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