August 18, 2008
Something is About to Give
The stock market remains relatively overbought in an unfavorable Market Climate, which continues to pose substantial downside risk. Overbought conditions in unfavorable climates, and oversold conditions in favorable climates, are about the only times when I have any expectations at all about near-term direction. There's a relatively high degree of complacency here, reflected by the suppressed level of implied volatility and the general consensus that bad news has been priced into stocks. But against that, we're seeing a fresh blowout in credit spreads, now extending beyond financials and into a broader range of corporate debt (witness the spike in the ratio of Moody's Baa/Aaa yields). Meanwhile, the persistently high level of new claims for unemployment, along with a wide range of other economic data, is entirely consistent with the thesis that a U.S. recession began in January.
Bill Hester has a nice research piece this week - The Beginning of the Middle - reviewing where the economy and the stock market might be in the context of a U.S. recession (additional link to that article at the bottom of this comment).
In short, I remain convinced that the market has not yet priced in the recognition that the U.S. economy is in a recession. To the extent that such recognition hasn't occurred yet, there's a risk that significant downside will be realized at the point that investors capitulate to that view.
The residual (and I believe, misplaced) confidence that the U.S. has dodged a recession, coupled with a growing recognition that foreign economies are turning lower, has triggered a burst of surprising strength in the U.S. dollar over the past couple of weeks. This dollar rally has amplified legitimate weakness in the commodity markets (based on softening global demand) into a full blown plunge in oil prices as well as metals and agricultural commodities. While I expect that the general pressure on commodity prices will continue (yes, I still anticipate somewhere about $60 oil by the time this is over), the dollar move strikes me as a trap, and in the event the dollar reverts lower, we're likely to observe at least some amount of near-term strength in commodities.
Accordingly, we added a few percent of fresh exposure to foreign currencies in the Strategic Total Return Fund last week, but resisted the inclination to add more precious metals exposure to our modest holdings. It's quite true that the Gold/XAU ratio (which I've written about in prior comments) is quite high on a historical basis, but so was the ratio during the plunge from the gold price spike of the late 70's. As we know from the equity markets, seemingly attractive valuation multiples can be misleading if the fundamentals are likely to weaken. So we're standing pat with a little bit of precious metals exposure – and likely to eliminate that on any substantial strength – but we're moving closer toward a 20% exposure to foreign currencies.
Analytically, the euro, British pound, and Japanese yen have all reverted to levels that appear very reasonable from the standpoint of our “joint parity” models of currency valuation (see Valuing Foreign Currencies for more information on that). Meanwhile, the U.S. is a Hoover vacuum of foreign capital – with a reliance on foreign inflows that is largely undampened by recession, thanks to the need to recapitalize banks, investment companies, and GSEs like Fannie Mae and Freddie Mac.
In short, further evidence of recession is likely to provide investors with what will appear to be the worst of all worlds – weakness in stocks, a plunge in the U.S. dollar, growing evidence of credit risk beyond financial companies alone, and (at least initially) upward pressure on the commodity markets. I do expect the commodity portion of that pressure to be short-lived, so again, we are fairly resistant to substantially increasing our exposure to precious metals shares in response to current weakness, since any rally in commodities could be of the fast, furious, prone-to-failure variety and we may abandon our remaining exposure rather quickly if a bout of fresh dollar weakness gets underway.
As usual, it's important to recognize that both my expectations and our current investment positions are driven by the prevailing condition of valuations and price/yield pressures in various investment markets. Our investment positions would be essentially the same, based on the evidence alone, even if I had no expectations at all. That is, valuations and market action appear unfavorable in stocks, warranting a defensive stance, while corresponding conditions appear favorable in foreign currencies, and only slightly favorable for precious metals and bonds. So no forecasts are actually required, but given current conditions, it's possible to “tell a story” that is consistent with all that evidence.
The basic story, from my perspective, is that investors are increasingly recognizing economic weakness abroad while largely denying it at home. Something is about to give.
As of last week, the Market Climate for stocks remained characterized by unfavorable valuations, unfavorable market action, and still unfavorable pressures in interest-sensitive areas as well as credit spreads. This is a particularly negative combination that has historically warranted a high degree of defensiveness. Accordingly, the Strategic Growth Fund remains fully hedged, with our hedges in a “staggered-strike” position that reinforces our defense against potential market weakness. The difference between this position and a standard fully-hedged stance is a fraction of one percent of assets in time premium. Given the depressed level of option premiums (as measured by the VIX), I view this as reasonably inexpensive insurance.
In bonds, the Market Climate last week was characterized by relatively neutral yield levels and relatively neutral yield pressures, holding the Strategic Total Return Fund to a relatively short 2.5 year duration, primarily in Treasury securities. I would expect that we'll observe some downward pressure on yields as evidence of economic weakness accumulates, but as we've seen in recent months, yield levels are already at levels which don't provide much “investment merit” in terms of long-term yield-to-maturity. So the case for accepting interest rate exposure here is primarily speculative, and while I do expect that we'll observe some further downward pressure on yields, we will continue to carefully manage our duration – generally adding modest duration on periodic spikes in yield and cutting our duration a bit when yields decline. As noted above, we added modestly to our foreign currency holdings last week (though currencies remain less than 20% of the Fund's portfolio). The Fund continues to have about 6-8% of assets in precious metals shares.
New from Bill Hester: The Beginning of the Middle
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