Wednesday, July 7, 2010
- In mid-to-late June the stock market rallied strongly. The market may rally from here (up to 1,100 points on the S&P 500), but it may be a sucker’s rally.
- From its inception in 2001 Berkshire Money Management has argued that we are in a secular bear market that will be punctuated with violent volatility, on the upside and the downside.
- Due, in part, to the market’s likelihood to rally from current levels with said violent volatility, portfolios are positioned to be “uncomfortably conservative.” The other part of that uncomfortable conservatism is based on the current pullback being a correction, not a bear market. Corrections resolve themselves to previous highs in the matter of months (as opposed to years for bear markets). Being in cash is a risky proposition in so much that we are flirting with missing a big part of any big run-up, should the rally prove to be the start of a new bull market.
- We see considerable challenges for the stock market for the third quarter of 2010, which puts us a little more at ease in regards to being “uncomfortably conservative” for at least the next few months.
On June 1, 2010 we published a paper titled “Summer Rally?” which placed heavy – heavy – emphasis on the question mark found in that title. And, as suggested, indeed there was a rally – from June 8th to June 21st the S&P 500 rallied nearly nine percent.
However, found in the body of that article were some points that were more pertinent than simply the expectation of a rally. Notably, we wrote in that piece:
“As earlier indicated, while a Summer Rally is likely, there is concern regarding whether it will last the entire summer. Signs of a sustainable, high quality advance would be broad breadth (many stocks participating) and high & rising volume (continued increase of buying interest). If we do not see these prerequisites, and the rally appears to be low in quality, then any renewed rally that pushes optimism readings higher would warn of another correction into the third quarter (thus the correction in its entirety could last five-to-six months).”
And, in that same article, under the subtitle “What Happens for the Rest of The Summer?” we wrote:
“Given that the market had declined below our expectation of 1,085-points on the S&P 500, we are tightening our outlook and strategy, at least at the margin. While our overall strategy (for example, to be “growth & income” oriented) might be designed for the longer term (longer than one year), our defensive strategy (for example, raise the allocation of cash by five-to-fifteen percent) currently only gets us through summer and fall….this correction is expected to be choppy and extended, likely spanning into the third quarter of 2010.”
As we consider the prose for this, our 2010 Mid-Year Update, bearishness about the stock market has appeared to reach a crescendo. The media has been loud with the direst of predictions, and this negative psychology has been further reinforced by last week’s drop in major U.S. stock market indices to levels below those that had been identified as important support levels.
The stock market, at its very core, is the most perfect example of the Law of Supply and Demand. Supply has been driven down to levels where it can be described as a point where “everybody who wants to sell has sold” (i.e. Supply –aka “selling” will, at least temporarily, slow considerably). Even if Demand does not pickup, that shift to reduced Supply strongly suggests yet another attractive rally is at hand.
However, while we acknowledge that such a rally could be the beginning of something long-term and wonderful, we are hesitant to position portfolios aggressively before that move. Instead, we warn investors not to be lulled into a false sense of security that this correction has ended (note: whether the decline of the market is ultimately sixteen percent or twenty-six percent, we view this as a correction and not as the resumption of a new bear market; more on this important distinction later).
Last week was a very bad one for the stock market (a five percent drop), and there were no signs that any of those days of intense selling sent prices low enough to reenergize buying interest. To the contrary, last week (as now) bearishness reached levels where the market should have rallied violently. That the market continued to decline in the face of such negative sentiment extremes suggests that there are still sellers in the market (bearishness has yet to reach the contrarian level where it has gotten so bad, that it’s good – it’s just bad enough to be bad).
This failure to rally suggests a degree of market weakness likely to lead to even lower prices. That said, given the market’s current oversold condition, investors should remain alert to the possibility of a six-percent-ish rebound rally up to 1,085-points on the S&P 500 (what was support has now become resistance). There is usually some seasonal strength in early July, and given that the market is oversold there is a high probability of a rally (another nine percent rally, like the earlier one we predicted, would actually bring the S&P 500 back up to 1,100 points).
As unlikely it may now seem, a rally on strong and advancing Demand (i.e. increased volume and improved breadth) and contracting Supply could suggest an important low has been reached and a sustainable advance is underway. But if that is the case, we are content missing much of the early part of any important start to a new bull market as too many concerns remain.
The Really Big Picture
When Berkshire Money Management (BMM) started business in April 2001 we were very loud in our opinion that we were early on in what would ultimately be identified as secular bear market – a period of time spanning fifteen to twenty years – where the stock market would largely go nowhere from beginning to end. However, the interim would be composed of violent, volatile swings (such as the period from 1966-1982). So far, we have been right. Important to secular bear markets are these violent, volatile cyclical bull markets (or intermediate-term rallies within longer-term declines). BMM took advantage of those swings and participated in the stock market rally from 2003-2007 as well as in 2009 (all while sitting out most of the declines of 2001-2002 and 2007-2009).
We have spent considerable time in previous reports regarding this official BMM view, so we’ll spare you the details. But suffice it to say, we continue to believe that we remain in a secular bear market. And while cash may be trash, we are quick to raise cash during bearish environments.
While we promised to spare you the details, we will at least add to the already long list of evidence we have previously presented to support our opinion. For instance, while household debt burdens have fallen sharply, they have yet to revert back to long-term averages, much less get to very low levels from which to build up again (i.e. we’re still all deleveraging our personal balance sheets). Similarly, the household savings rate is still well below historical averages, and far from the double-digit levels we saw at the start of the last secular uptrend, in 1982.
Not many people listened to us in 2001, but nowadays we have more company joining us in the opinion that we are mired in a long-term secular bear market. But we at BMM are proud that we did not come to this conclusion after a lost decade of stock market returns. We are not perma-bears; we know that a new secular bull market could be a mere half-decade away and we are excited about getting there.
We typically do not use these reports as a soap-box from which to rant, but for the benefit of our clients we feel as if we must do so, if only briefly. If you or someone you know continues to have money managed by those that believe we are still in a secular bull market, do yourself a favor and ask them what they plan on doing the next time the stock market falls fifty-percent, as it has done twice in the last decade. Or better yet, just fire them before they lose more of your money.
It’s Not Us, It’s the Discipline
Before we go sounding too full of ourselves, we do not pretend to be doing anything different from what you, our clients, would do if you had the time and inclination to manage the portfolio yourselves. While we strive to be proactive in raising some cash prior to market tops, we also recognize that an overvalued stock market can continue to get overvalued (take, for example, the three glorious years of stock market returns you might have missed by going to cash in 1996 – the year of “irrational exuberance”). So much of what we do at BMM is just what you would do – we act intuitively. When times are bad we get more conservative; when times are good we get more aggressive.
For example, in November 2007 the S&P 500 hit a high of 1,576 points in October 2007. On November 20, 2007 we posted an article on BerkshireMM.com titled “Cut and Run at 1,438”. A few months later we posted a similar article titled “Cut and Run at 1,312”. The numbers 1,438 and 1,312 referred to levels on the S&P 500 – odd numbers to be sure, but they had some level of technical relevance to us at the time.
In October 2007 there was certainly evidence that the market could have gone higher from there, but it didn’t. Times got bad and we got more conservative. And that is what we are doing now; that’s the discipline.
A mid-year update does little good if we do not update our predictions for the remainder of the year. While the remainder of the year is admittedly a short-sighted view, we’ll be even more short-sighted and focus on the third quarter (Q3).
A quick mention of a Q3 challenge that has, so far, drawn little attention; public data on mutual funds show that they remain fully invested. The cash/assets ratio of stock mutual funds remains elevated (i.e. optimistic) while the public remains skeptical. Mutual funds may need to rebuild some liquidity by selling assets should the public continue to withdraw funds. If you sell a mutual fund it does not hurt the stock market so long as fund managers have cash available for redemptions. But when they have to start selling stocks to satisfy liquidity needs, that is a challenge for stock prices.
As the quarter progresses, there are seasonal headwinds that will increase. September has tended to be the weakest month of the year. And our broader cycle composite, which also includes the four-year Presidential cycle as well as the ten-year decennial cycle influences, also warn of headwinds by the end of the summer.
There are also the challenges of diminishing economic confidence. In a short period of time conversations have shifted from the economic recovery being stronger than that of the previous two recessions (which it has been) toward concerns of a double-dip recession. While BMM’s official view is that the U.S. does not enter a double-dip recession, we certainly are cognizant that such conversations do not inspire a risk-appetite from investors holding trillions of dollars in money market accounts that lie waiting for the “all clear” signal that it is safe to get back into the stock market.
To position ourselves for these Q3 challenges we are uncomfortably conservative. This uncomfortable feeling is due to the opinion that we view the current decline as a correction, and not as a resumption of the bear market. The definition of a correction vs. a bear market has popularly become a line-in-the-sand type of definition – a decline of 19% is a correction; a decline of 20% or more is a bear market.
If the stock market drops 15% or 20% or 25% you can call it whatever you want –a correction, a bear market, or a banana – but it doesn’t matter; it feels the same way on the way down. The difference between a correction and a bear market is not the drop in prices, but the reflex at the bottom. Bear markets take years to again reach their prior highs (it took 2003-2007 to get back to the 2000 highs). Corrections take months to get back to their prior highs (the 18% drops in 1998 and 1991 come to mind).
In our May 16th 2010 article “Disruption of the Primary Trend” we wrote:
“The magnitude of the current pullback is in keeping not only with this bull market, but with past bull markets.
Such a swift drop, coupled with such a notable rise in volatility, naturally begs the question if this is the start of a new bear market. In regards to investing, it is a dangerous game to utter the phrase ‘this time it’s different’. And while it is possible that sometimes, albeit rarely, it is actually different, the odds favor this pullback being nothing more than a painful correction that will be resolved with higher highs in the stock market (even if later, rather than sooner).
Typical signs of an impending bear market are not present. For example, at significant market tops there are non-confirmations of price highs for indices by advance-decline lines and the number of new highs for stocks. That’s industry jargon for saying that a stock market’s continued advance is suspect if it continues to go higher based on fewer and fewer individual stock prices propping up the market as a whole.”
It makes us uncomfortable to be so conservative when it will likely take only months to reestablish new highs again. Coming out of 2002, and then again in 2009, BMM clients had the good fortune of moving from cash and then back into the capital markets at or near the lows for that cycle. However, during those periods, even if we were months late we would have had a great deal of time (and returns) in which to participate.
Normally during corrections we just sit, grind our teeth, and bear it. For example, from March 2009 to the April 2010 low there were four corrections of five percent or more (in the order of 5.4%, 7.1%, 6.1% & 8.1%) as well as numerous such moves from 2003-2007. But nobody remembers them. Why? Because those type of moves are normal, regular, and ordinary (although they always feel painful at the time).
True, pullbacks in the stock market of the twenty-percent variety, too, are normal, regular, and ordinary (they occur, on average, once every three-and-a-half years). But they are just far too large for us not to at least try to protect your portfolios. At the same time, just as we said, being so conservative is extremely uncomfortable because we cannot afford to be slow when it comes to reinvesting. Waiting even a few weeks means potentially missing out on half of the rally getting us back to recent highs.
Yes, BMM is absolutely a risk manager. But at the same time nobody chooses to invest just because they are looking for protection (a safety deposit box, or even a mattress, can provide you that sense of security). Aside from being risk managers we are also reward managers – we cannot sit in cash forever. And it makes us uncomfortable to know that we do not have the luxury, in this instance, to be slow and deliberate in reinvesting that cash.
What about Q4?
Seasonal and cyclical influences will turn positive in the fourth quarter, and both the aforementioned four-year Presidential cycle and ten-year decennial cycle support the prospects of rallying into 2011. For Q4, a lot depends on what happens in Q3. Will we see the stock market rally from here, proving our cautiousness to be unwarranted? A low quality rally for the rest of Q3 could set up potential and substantial declines heading into 2011.
However, should this already steep correction prove to be even stiffer over the coming months, improved valuations coupled with excessive pessimism (i.e. pent up Demand for purchasing stocks) will allow for upside potential into and through 2011.
Those are questions we will be better able to address when Q4 starts appearing on the horizon, but for now we are concerned that this already steep correction will prove to be even stiffer (hence our conservative allocations in client portfolios). As referenced, that sets up a potentially polished silver lining, but it may not be that fun getting there.
The most frequently cited concern by clients is that inflation will run rampant and eat into the value of their portfolios. We, too, share that concern. However, we feel that the concern of rampant inflation is far from immediate.
One measure of inflation, the Consumer Price Index (CPI) is up a mere 2.0% year-over-year, about a full percentage point below historical averages. And there are a number of reasons why the inflation rate should stay low for the next year or so:
- Lower rents because of an excess supply of housing units,
- An abundant supply of labor putting downward pressure on wages,
- A stronger U.S. dollar and corresponding weaker commodity prices (for now),
- Private sector debt reduction.
Lots of folks cite concern regarding that the “printing of dollars” will lead to 1970s like inflation. We do not wish to contend that such printing of dollars does not have its own unique long-term problems (even if does present some short-term solutions). But it may be worth remembering how inflation got so high back in the 1970s, and it’s all about Nairu.
Nairu stands for the “nonaccelerating inflation rate of unemployment”, or sometimes called the natural rate of unemployment. There are a lot of factors that affect a nation’s Nairu such as, the bargaining power of unions, the productivity of the workforce, minimum wage laws, the willingness of workers to relocate, etc.
In the 1970s the Federal Reserve estimated the Nairu to be about four percent. With unemployment high, the Fed kept their rates very low in hopes of stimulating demand, growing the economy, and reaching that four percent rate of unemployment (keeping unemployment low is a part of the Fed’s dual mandate). It turned out that the Nairu was closer to seven percent, so holding interest rates too low from seven percent to four percent was inflationary (rates being low is like printing too much money, it adds excess liquidity) and policy makers ended up having to raise their benchmark rate to twenty percent in the early 1980s to subdue double-digit rate inflation, at a tremendous cost to the economy (remember the double-dip recessions of 1980 and 1982?).
Prior to the Great Recession of 2007-2009, it was thought that the Nairu was about 5%. Nobel Prize-winning economists argue over what the current rate is, but the range seems to be between 6.3% and 7.5%. Assuming that those figures are accurate, and knowing that the current unemployment rate is 9.5%, we may have a couple more years before we should legitimately worry about inflation as it will likely take that long to drop two percentage points from the unemployment rate.
Looking at it anecdotally, the verbal equation of inflation is “too much money chasing too few goods.” If you dismiss the above described Nairu lesson then you must absolutely believe that there is “too much money.” Accepting that premise, you could also reasonably argue that there are “too few goods.” Yet that would leave the connecting verb of “chasing,” which simply means “buying.” In this anecdotal example, inflation would be side-affect of a vigorous and healthy economy, where households and businesses were doing a lot of buying. BMM would be happy to deal with inflation caused by such activity as we would simply invest in commodities.
And when inflation becomes a problem that is how we intend to protect your portfolio. When it comes to inflation, the best defense is a good offense, and we would play that game by increasing your exposure to a diverse basket of commodities.
Given that Nairu has a role to play in inflation, naturally the next part of our conversation should pertain to our expectation of unemployment. We expect the unemployment rate to remain elevated for years (which should suppress inflation). Our reasons include:
- Alternatives to hiring permanent employees (temporary workers, increase average workweek, and the substitution of capital for labor to maintain competitiveness in the global marketplace),
- Shifts in structural unemployment (many of the jobs lost are not coming back, i.e. real estate agents, construction sector of residential & commercial real estate),
- Reduced labor mobility (with nearly one-fifth of all mortgages “under water” there is a hesitancy to sell homes to relocate),
- Limited new business creation.
We believe in the global growth recovery story, but we expect growth from here to be sluggish compared to previous recoveries following sharp recessions. This would be consistent with past recessions associated with financial crises.
A close second to the most frequently cited client concerns is that of a double-dip recession. From the “Second Quarter Update for the Economic Outlook for 2010” we wrote:
“We ruled out a double-dip recession long ago. But we certainly are not dismissive of the problems that exist. We have often said that the business cycle is a powerful force that is capable of eating up any of those problems. There are always problems that remain in the headlines as the economy shrugs off recession and moves into recovery – always. And the economic tailwinds always overwhelm those headwinds. If they didn’t we’d always be in recession and never in recovery or expansion.
But is it different this time? A February feature story in the Wall Street Journal reminds us that “many economists say the U.S. may be moving toward recovery, but they figure the chances are one in four or five that the fragile upturn could be snuffed out by certain problems.” One of those “problems” discussed in the Journal story was “high unemployment, [which] creates a ‘fright factor’ that inhibits spending by those who are employed.” By the way, that February article did not run in February 2010, but rather February 1983. Back then the unemployment rate was 10.4% (versus the recent peak of 10.1%, and 9.7% currently). It turned out that the “fragile recovery” of 1983 was anything but. The recovery from the deep 1981-1982 recession pumped out a 5.1% Gross Domestic Product (GDP) figure in the first quarter of 1983, then 9.3% in the second quarter. Then GDP grew at 8% or better for the next three quarters in a row. It was amazing.
We don’t expect anywhere near that sort of growth in 2010. Still, the growth rate for the second half of 2009 saw a 2.2% bump in Q3, followed by a 5.6% jump in Q4 (better than the previous two recoveries – twice the growth rate of the last recovery, and one-and-a-half times the early 1990’s recovery). “
But that was then. What about now? The recovery in the private sector first took hold in manufacturing as firms restocked low levels of inventory, which is typical coming out of a recession. The recovery is broadening.
To be sure, businesses remain cautious (which is also typical coming out of a recession) as they maintain levels of concern about what is still viewed as a fragile recovery, especially considering the talk regarding the Eurozone’s economy.
Still, global commerce is expanding. One telltale sign of that expansion is that in its most recent tally, the non-defense capital-equipment orders (excluding aircraft) rose 2.1% for the month, and was 18.4% above its year-earlier level. Also, according to the Wall Street Journal, Federal Express, a bell-weather company in so much that it moves our products across the globe and thus is a proxy for consumer demand, plans to spend some $3.2 billion on equipment and facilities in this fiscal year, up from $2.8 billion last year. According to the company’s CFO, “two thirds is for growth and only one-third is to maintain our current businesses, so we’re very bullish.”
There are reasons for other companies to be bullish. Corporate profits for Q1 2010, for instance, were up thirty percent from a year ago. Historically, that type of dramatic jump has been associated with companies spending and hiring in order to, at least, keep pace with their competition. (Those who wish to actually gain market share would have to be a bit more aggressive.)
Federal Funds Rate
Given that growth may be sluggish (relative to past recoveries following deep recessions), but still strong enough to shrug off the media-favorite topic of a double-dip recession, the Federal Reserve may be in a tug-of-war regarding when to raise interest rates (the Fed’s key interest rate is the Federal Funds rate, it is the interest rate on overnight loans between banks, and it has an influence on market rates such as mortgage rates, corporate bond rates, etc.). It is our view that the Fed will resist raising rates until 2011, due to the following:
- An elevated unemployment rate (part of the Fed’s dual mandate is to keep unemployment low),
- Low inflation (part of the Fed’s dual mandate is to control inflation, and with currently low inflation the Fed will not have to raise rates to combat it),
- No asset bubbles to pop,
- Reemergence of stress in the financial system due to European-default concerns,
- Available alternatives to achieve a tighter monetary policy (shrinking the Fed’s balance sheet).
Bottom Line: The stock market is extremely oversold and is expected to rally from current levels. We made the same observation in early June and the stock market rallied nine percent, only to fade back to new lows (which was highlighted as a likelihood in that same forecast). Given the possibility that the next rally could be the beginning of something more sustainable, we are very uncomfortable with our conservative portfolio allocations.
There have been no signs that the pullback to date is anything other than a stiff correction, as opposed to a new bear market. During its decent, a discussion of a correction vs. a bear market may prove to be a distinction without a difference. The important difference is not the descent, but rather the ascent. Corrections resolve themselves to new intermediate highs in the matter of months, whereas bear markets take years. The sharp, strong reflexes from correction lows also make us uncomfortable with our conservative portfolio allocations as we will not have the luxury of being slow and deliberate in reinvesting cash. Despite being uncomfortable, our discipline is to err on the side of conservatism.