September 8, 2009
Showtime for Visible Roots and Fruit
The markets have built a full head of steam around a consensus that the U.S. economy has bottomed and will begin to recover during the second half of this year. My own reservations about this conclusion should be clear from previous weekly comments – the greatest of these reservations is the large extent to which prior economic recoveries have relied on the expansion of debt-financed economic activity such as housing starts, capital spending, and other forms of gross domestic investment, as well as sustained automotive demand (beyond a brief Cash for Clunkers jolt). Debt-financed economic activity typically leads broader economic activity by nearly a year. It strikes me as hopeful to expect this at present, in the face of continued deleveraging pressures, fresh highs in mortgage delinquencies and foreclosures, and a huge second-wave of adjustable rate mortgage resets on Alt-A and Option-ARM mortgages that were initiated at the peak of the housing bubble (which will become pressing beginning in November and December, and will continue through 2010 and 2011).
Still, despite maintaining a strong downside hedge in the Strategic Growth Fund, we continue to hold about 1-2% of assets in index call options as something of an “anti-hedge.”
In my view, the next 12-16 weeks will be extremely important in shedding light on any incipient economic recovery. Investors have become so used to the idea that stocks often foreshadow economic strength that actual, convincing evidence has been dispensable – beyond the excitement over “less bad” economic news. The next 12-16 weeks will change that. As it happens, aside from the unemployment rate (which is a lagging indicator), past economic recoveries have been very forceful in generating clear evidence of real economic improvement in the months immediately following the economic low. Not every indicator moves at once, or in every cycle, but the composite movement of economic indicators of production, new orders, temporary workers, and housing starts has been clearly and almost immediately positive as soon as a recovery begins. Notably, except for a few months in the aftermath of 9/11, even net job growth (not just temporaries) has turned positive within three months of a recession low. (For a look at how temporary employment leads overall payroll figures, see Bill Hester's new article Is The Job Market Ready for a Recovery? - additional link at the end of this comment).
Essentially, we have now entered the window in which growth – not simply slowing of deterioration – is required to support the idea of an economic recovery. The next 12-16 weeks will be the first hurdle on that front. I don't rule that possibility out (hence our index call position), but I do remain skeptical. Beyond that first hurdle, there is a second, which is the impact of the second wave of adjustable rate mortgage resets. My impression is that the changes in mark-to-market rules early this year have quietly allowed bank balance sheets to experience unreported deterioration in recent months, but I suspect that there will be a point very late this year or early next year when the financial officers of major banks will refuse to sharpen their pencils to a stub, and banks will be forced into a fresh round of capital-eliminating asset writedowns.
Again, we have an “anti-hedge” in index call options which will gradually and somewhat automatically move us to a more constructive stance if the stock market advances relentlessly (despite strenuous overbought conditions and what I view as serious economic headwinds). So my skepticism should not be taken as resolve to “fight” the market if it advances. Rather, our primary resolve is to accept market risk only in proportion to the probable return per unit of risk that we can expect, and that is what prevents us from openly lifting off significant portions of our hedge and exposing ourselves to downside risk that still appears very pertinent. In effect, we will accept market exposure if an advance provides it to us by moving our call options “in-the-money,” but we are not lifting off our protection against downside risk here.
The time for green shoots is now behind us. If the economy is turning, we are now at the point where a recovery should develop visible roots and bear fruit.
As of last week, the Market Climate for stocks was characterized by moderately elevated valuations and continued mixed market action – clearly strong breadth and general index trends, but little robust sponsorship evidenced in trading volume. Short-term market action is strenuously overbought, and overbullish from a sentiment perspective. We don't have the level of overvaluation that would signal high downside risk on the basis of an “overvalued, overbought, overbullish” syndrome, but the market's vulnerability to disappointments is increasing given that trends are so stretched. Despite that, we retain a couple of percent of assets in index call options as an “anti-hedge,” because even in an overbought market, we have to allow for a continuation of purely speculative enthusiasm on the basis of recovery hopes. Overall then, we aren't impressed with the long-term return prospects of the market, and are aware of the potential for disappointments to cause rapid damage from overbought conditions, but we are also allowing for the possibility of continued speculation based on momentum alone.
In bonds, the Market Climate last week was characterized by relatively neutral yield levels and slightly favorable yield pressures. The Strategic Total Return Fund continues to carry an average duration of about 3 years, largely in TIPS, but also including some intermediate-term straight Treasuries. Presently, the yield curve is so steep and incipient inflation pressures are sufficiently weak that Treasuries shorter than about 10-years in maturity have reasonable (though not unusually attractive) yield characteristics. Risks of fresh credit concerns could also help to press the 10-year / 3-month Treasury spread down toward the 2.5%-3% area, which would give 10-year Treasuries total return prospects in the high single digits despite a low yield to maturity.
While I continue to expect significant inflation pressures and dollar weakness several years out, and continuing through the next decade, there is very little such pressure here, so the very steep yield curve coupled with reasonable yield trends at present are supportive of some amount of exposure in straight Treasuries. Below about 3% on the 10-year, however, I would again become concerned about longer-term risk (as I was in December when the yield was pressing toward 2%). For now, both straight (intermediate) Treasuries and TIPS are reasonable holdings.
While there is significant long-term risk of inflation several years out after credit problems are more fully exhausted, I continue to believe that near term inflation concerns are as misplaced as the economic recovery hopes that have prompted them. On significant strength in precious metals shares and foreign currencies last week, we clipped our positions in these moderately. The Strategic Total Return Fund currently holds about 12% of assets in precious metals, foreign currencies and utility shares. I expect that we will add back some exposure in the event of price weakness, as is our habit.
We Thought You'd Never Ask
A couple of years ago, my friend Paula Kluth and I spent two days in Baltimore filming a set of interviews with several people with autism, at all levels of the "spectrum." A few of the people I met changed my entire understanding of what we call disability. Before then, I thought that I understood what it was to "presume competence" of people with various conditions like autism. By the end of two days of filming, I realized how much I had still been willing to judge these people - these amazing books - by their covers, using notions like "low functioning" and "high functioning" as an excuse to do it. A couple of the people we interviewed - Jamie Burke and Sue Rubin - have since become wonderful friends. Which is an interesting word to apply to these people with autism, who the world seems to believe are uninterested in such things as friendship, and incapable of such things as empathy. We've got a lot to learn.
The reason for noting all of this is that PBS has picked up the film for broadcast, which we titled "We Thought You'd Never Ask" - Voices of People with Autism. Next week, local PBS stations can record it from NETA for subsequent broadcast (no broadcast times scheduled yet). If you'd like to prod your local station to air it, just print out the film description and uplink schedule, write a note on it, and send it to your local PBS station. Thanks! - John
NEW from Bill Hester: Is The Job Market Ready for a Recovery?
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