Wednesday, April 13, 2011
A short-term (think 2-4 months) Bull market peak is a possibility, not a foregone conclusion. Portfolio changes for such a possibility are being contemplated, but not yet committed to.
Berkshire Money Management has focused on a number of indicators that have the potential to cause us to make portfolio changes, most likely in a defensive direction, as the next two quarters progress.
Any market pullback over the near term will likely represent nothing more than a correction in an ongoing cyclical bull market. Still, it is prudent to be prepared.
The stock market correction of February and March appear to be over (in so much that the lows have been defined, even if they are revisited in the weeks to come), with stock, commodities, and Treasury bond yields all trending higher, mostly withstanding the negative turns of recent months. That does not necessarily mean that this year’s second or third quarter will see similar position stability, or even that the correction will not resume.
There continues to be evidence of a short-term top after the bounce from the market’s mid-March lows. First, overbought readings present on short-term indicators (think days) are now extending to the intermediate term indicators (think weeks) as well. Second, investor sentiment is now reaching levels historically associated with market peaks. For example, the most recent Investor’s Intelligence poll shows 53% bulls and 15.7% bears. The % of bears is the lowest reading since the week ending December 30, 2009. Granted, offsetting that overly-optimistic tone is the current American Association of Individual Investors poll, which does not reflect such extreme readings, with 43.6% bull and 28.8% bears. However, what investors do is usually more significant than what they say when surveyed. The most recent Investment Company Institute report showed the first inflow of funds into domestic equity funds since late February, suggesting that investors are growing more confident about the market’s rally prospects. Extreme readings of investor complacency and overbought readings have historically provided warning of an approaching market top. Readings are not yet extreme, but we are watching them closely as they have become stretched.
In addition to sentiment indicators (summed below), Berkshire Money Management has focused on a number of indicators that have the potential to cause us to make portfolio changes, most likely in a defensive direction, as the next two quarters progress. We highlight some of those indicators below:
Price Momentum. For the last decade we have been very transparent regarding the indicators BMM input into regression analysis models. Some indicators deserve more weight than others, and the movement of the tape (as we say in the industry) is three times more important than any other indicator. Certainly the price of stocks, when considered aggregately is a coincident, and not a leading indicator. But if all other leading indicators prove to be ineffective, the coincident indictor of the market’s price is a self-adjusting tool. All other indicators and tools may be perfectly rational, but as John Maynard Keynes said, “the market can remain irrational longer than you can remain solvent.”
Still, looking at just the price of an equity index is a fool’s errand. There are indicators within this indicator that are very important as leading indicators that help us determine if a price decline is just another normal correction, or the start of something worse. In particular, BMM measures breadth as defined by volume and price action (percent of up/down volume relative to total volume; the percent of points gained/lost relative to total points).
Excessive Optimism. Should our price indicators fail to impress, the risk of a stock market top would increase if this occurred as the market returned to an overbought condition. Elevated expectations for stock market gains induce buyers of stocks to enter/re-enter the market. From the perspective of individual investors, excessive optimism manifests itself by the realization that everybody who wants to buy stocks, has bought stocks – without a round of new monetary liquidity there is no room for further demand, thus no room for further price gains until prices first readjust themselves downwards.
From the institutional perspective, a renewed rise in optimism could encourage an uptrend in the total amount of initial and secondary public offerings. The increased offerings would be a negative influence on the market’s supply/demand balance (the same amount of money chasing more goods/stocks means lower prices for those goods).
Interest Rates & Valuations. We combined this bullet point because while valuations can be measured on an absolute basis, they should be considered on a basis relative to interest rates, given that capturing yield is an alternative to seeking appreciation. The yield of the ten-year Treasury note is about 3.5%. We do not feel that interest rates will begin to negatively affect the stock market or the economy without it being in the 4-5% range.
Whether it’s the top or the bottom of that 4-5% range of course depends on what is happening on the corporate earnings front at that time. If rising Treasury rates occur simultaneous to a dropping earnings yield rate (corporate profits divided by stock prices), that would be more worrisome.
Economic Growth. According to a number of leading indicators, it would not be surprising to see economic growth similar or slightly below current levels in the second half of this year. But should the momentum of leading indicators fall materially from their peaks reached in October 2010, the leading tendencies of momentum will warn us that worse market performance and economic growth lie ahead.
Crude Oil. Our March 13, 2011 “Oil Shocks and the Economy” report detailed our views on this subject. Should we experience from here an excess of a 33% year-over-year change in crude oil price, worries about inflation and/or economic implications would be likely to mitigate risk-appetite (i.e. hunger for stocks) and trigger divergences in asset class and/or sector leadership.
China. Since its secular bull market started in 2003, the Chinese market has had leading tendencies. For example, the MSCI China Index reversed ahead of the MSCI World Index at its high in 2004, low in 2008, top in 2009, and bottom in 2010. Considering that China’s high last November led the February peak in the World Index, it would be encouraging to see the China Index rise back above the November high. If the World Index returns to new highs but the China Index does not, the lack of confirmation will cast doubt on the bull market’s longevity.
To be clear Berkshire Money Management is not forecasting a resumption of the bear market. We are more concerned about a stiff correction that rivals (or is larger) than the one BMM correctly called in April 2010. We called that large correction a “disruption to the primary trend”. Like then, the weight of evidence suggests that the market’s primary uptrend remains intact. Any market pullback over the near term will likely represent nothing more than a correction in an ongoing cyclical bull market. Still, it is prudent to be prepared. And since forecasting exactly when the current bull market run ends is likely no better than a guessing game of possibilities for these types of small moves (as opposed to bigger moves, where probabilities are easier to assign), it is prudent to not only be prepared but to also itemize and monitor our concerns.
In summary, the probabilities appear to be tilting further in favor of a short-term top. At the same time, there are still no indications of a major market peak. Any pullback, either now, or in the third-quarter, should constitute nothing more than a disruption of an ongoing primary market uptrend.
If a person were to look at the managed portfolios of Berkshire Money Management from March 2003 until November 2007, one might say “oh, BMM is a manager of foreign markets.” The truth was that, during that time, our clients enjoyed a healthy over-weighted allocation to non-U.S. markets.
Today, especially relative to the aforementioned indicated time period, we are over-weighted the U.S. equity markets. The relative performance of the MSCI U.S. Index bottomed the day after Federal Reserve governor Ben Bernanke’s Jackson Hole speech (August 2010), which hinted at the QE2 (quantitative easing, part 2) announcement that was to follow. The U.S. relative strength has continued to benefit from the Fed’s accommodative monetary policy.
Given that quantitative easing may end mid-year, BMM may look to increase emerging market exposure post a global equity market correction.
The cyclical uptrend for the stock market has entered its third year. Leadership in the third year of cyclical bull markets has been mixed. Company specific factors such as relative earnings momentum has become more relevant, suggesting that the high beta players that have led the way recently (small-cap stocks, emerging markets, commodities) may not be as dominant as they have been. Therefore we are focused on both signs of a cyclical bull market peak as well as individual indicators for each theme (ex. Dividend non-payers vs. Dividend payers, small-cap vs. large cap, growth vs. value).
It is also important to note that leadership shifts, when they do happen, do not necessarily occur in unison. For example, historically dividend payers’ relative strength improves versus dividend non-payers about four months before a market peak. The relative strength of large-caps improves against small-caps about 2 months before a market peak. And value stocks begin to improve relative to growth stocks about two months after a market peak. If indicators suggest a market top to be forming, we will use market strength to shift to more defensive areas, likely starting with dividend payers.
Some of the primary indicators we look at for gauging shifts of leadership are the magnitude of an earnings slowdown for Growth vs. Value, interest rates and economic growth for Small vs. Large, and the appetite of investor risk and dividend growth for dividend non-payers vs. payers.
We are watching for signs of a potential short-term bull market peak this year. The stock market’s advance appears to be resuming, but it is doing so with the background of fairly high levels of optimism. While not a foregone conclusion that a peak will occur, it is prudent to identify and watch indicators that would suggest it is time to change our sector recommendations. Such a short-term market peak, should one occur would prompt us to move toward more defensive sectors.
Given the potential (though not certainty) that we are facing an important market call, a “wholesale” leadership shift, where we would adjust several sectors at once is a possibility, though not a probability Expected overweights would be Utilities and Consumer Staples. Expected underweights would be Consumer Discretionary and Industrials.
Again, it is worth reiterating that this type of shift to a more conservative sector allocation may not be determined prudent because the market weakness may be short-lived (a couple months) and shallow (5-10%). Longer-term, our sector allocation will likely be driven more by factors such as inflation expectations rather than by a potential market correction.
Inflation Expectations & Sectors
“Successful investing is anticipating the anticipation of others.” – John Maynard Keynes
We create our own reality. Either real or imaginary, one’s view is one’s reality. And when it comes to inflation, if enough people expect prices to rise, inflation can become a self-fulfilling prophecy.
While we may see a modest rise in “headline” inflation, as measured by the Consumer Price Index (CPI), our firm’s view is that underlying inflation (i.e. core) is not likely to be a problem this year due to the slack in the labor markets, weak housing, and still relatively low demand.
Nonetheless, inflation expectations have been rising recently in response to recent increases in commodity prices. Although it remains to be seen if these expectations can be translated into reality, the reality is that expectations are what matters when it comes to stock prices. Naturally, clients of Berkshire Money Management have been asking, “What does inflation mean for sectors and industries?”
When the year-to-year change in the Consumer Price Index has been between 1% and 4%, the top-performing sectors have been Energy, Materials, and Information Technology. The worst-performing sectors have been Utilities and Telecommunication Services. The leadership has changed to a more defensive mix as inflation has increased to the 4% to 9% level. That leadership change is likely due to the stock market also down-shifting to a negative annual rate of return. This is a key point – the market can weather moderate rates of inflation. If inflation gets too high, however, the Fed becomes restrictive, stock prices decline, and sector leadership turns defensive.
After three lean years – 1½ of recession and another 1½ of a high-unemployment recovery – the economy is on track for better times through this year. Businesses are in solid financial shape, households are quickly repairing their balance sheets, and credit is opening as the nation’s major banks are well capitalized and highly profitable. Growth will be robust, resulting in steadily stronger job gains and meaningfully lower unemployment over the next couple years
Yet the coast is not clear, and it won’t be until the forecast for stronger job growth comes to fruition. The recent surge in oil prices and prospects for more fiscal restraint (the removal of QE2) will not derail growth, but there is not much more room for anything else to go wrong. There are good reasons to be nervous, including the ongoing foreclosure crisis and prospects for more house price declines, budget cutting by state and local governments, and the European debt crisis.
The labor market is joining the broader economic recovery. Larger job gains will provide the key to sustaining growth in consumer spending and supporting the housing market. One could argue that, in regard to stocks, we are in an economic sweet spot. The unemployment rate is very high, which tends to be bullish in that it indicates economic slack, which keeps the Fed friendly, and interest rates and inflation down. At the same time, the unemployment rate is falling, which says things are improving. So long as the unemployment rate is consistently lower than it was three months prior, historically speaking this is a positive for stock prices.
Unless Federal Reserve Governor Ben Bernanke changes his view on inflation, we expect the Fed to keep rates on hold until early 2012. The Federal Open Market Committee’s (FOMC) inflation hawks want to begin raising interest rates this year, but the majority of the Fed’s policy making panel wants to maintain the status quo to support the recovery. Divisions within the FOMC are not uncommon, but they do create uncertainty about the future path of monetary policy.
Even the hawkish members of the FOMC (those that want to raise interest rates) are not pushing to tighten monetary policy immediately. Rather, they are laying the groundwork for the unwinding of the Fed’s unusually aggressive stance. We expect to see this process begin mid-year, as the central bank steps away from its large-scale purchases of long-term Treasury debt and other assets. This will allow for a smooth transition back to a more normal monetary policy.
Bottom Line: Berkshire Money Management’s baseline forecast for 2011 (as detailed in our Economic Outlook for 2011) has so far followed its expected script, but with a more bullish first quarter for 2011. Due to the front-loaded rally for the calendar year, combined with stretched levels of investor optimism/complacency, as well as implications for the Fed’s possible unwinding of QE2, the anticipated market weakness that was expected to start around August 2011 could be pulled forward by a month or two.
The aforementioned market weakness, currently being monitored closely by a number of indicators, is not expected to be a resumption of the bear market. Rather, it would be expected to be only a disruption to the ongoing bullish primary trend. Indicator data at the time of the expected market weakness will determine what, if any, course of action to take. Portfolio reallocation is being contemplated, but not yet committed to, neither in terms of specifics or in terms of the need for any portfolio changes.