Monday, October 11, 2010
That Disruption of the Primary Trend We Talked About…
At the end of last year, BMM supposed the S&P 500 could hit 1,200 points in April 2010. When that occurred, BMM took action to reduce risk by neutralizing much of the beta bias created by our sector positions.
Some market tops warrant more protective action than others (some market tops warrant no action). This was a large-enough correction to have captured our attention.
The pullback from the April highs, while large, has been more characteristic of a market correction than that of a decline that would initiate the resumption of a new bear market.
On December 30, 2009, in our Economic Outlook for 2010 we wrote that
“After another quarter or two of the stock market rallying the advance will become vulnerable to corrections of more than the 4-7% nature we have experienced since the March 2009 bottom. A probable worst-case scenario would be a 1977-like decline of about 21% after “only” reaching 1,200 points on the S&P 500 (which would rival the 1975 advance) in April of 2010 (bringing the market down to our Risk-Level of 950 points sometime in September of 2010).”
It turned out, even if only by luck (although we seem to get lucky a lot), that the S&P 500 did reach 1,200 points in April. And while the index did not hit 950 points in September, it did hit close at 1,020 points in July (and then re-tested close to that level in August). The stock market’s action during the third quarter appears to have been the later stages of the corrective phase that started in April.
As risk-managers, in mid-April we began to raise cash and then over the following weeks we reduced the risk profile of our managed portfolios. Many new clients asked us why we didn’t move to a nearly full cash position in April, as we did in 2001-2002 and as we did in 2007-2009. Instead, as we believed stocks would enter a particularly choppy corrective phase, we made an effort to simply neutralize much of the beta bias created by our sector positions. There were two reasons for that.
First, our greatest proficiency is in identifying and acting proactively to major market turns (that’s why we shorted the market in November 2007 and got back into the markets in March 2009). We can do that because (in addition to being flexible and proactive) the larger and thus more material the top or bottom, the more precise and reliable our indicators. Of course that’s when you need this sort of information the most – when it is most material – when you could be exposed to greater risks and losses, and when you can exploit bigger rewards and gains. All of the other market squiggles, no matter how big, rank a distant second in importance.
But sometimes those squiggles, as suggested, are big. The market’s drop from April’s high was about 16% – that’s big, certainly big enough to encourage some protective measures on our part. The buy-and-sell brokers (pretty much all of our competition) will argue that a 16% correction is ordinary and regular. And, yes, they would be right. But that does not mean we should participate in that type of drop (admittedly, we care less about smaller drops, those in the five percent range). But, the smaller the squiggle (the further away from a major to or bottom; i.e. a correction and not a crash), the more difficult it is to get the timing perfect. And it is an inconvenient truth that when said squiggle is short in duration, the more perfect the timing must be. So that’s the first reason why we a) raised only some cash and b) modified the risk profile of portfolios.
(Other money managers seem to think that since there are no tools to get the timing exact, that your portfolio should just ride out the big swings. Berkshire Money Management acknowledges that far too often people let the perfect be the enemy of the good. Even if we can’t be perfect, we can be better than others).
The second reason we “only” raised some cash and modified risk profiles is because, as we explained in our May 16th White Paper, this pullback was not the resumption of the bear market, but rather simply a “Disruption to the Primary Trend.”
In that same-titled report we wrote that:
“…the current correction is nothing more than a disruption of the primary trend. And the primary trend continues to be a cyclical bull market. Not only were there few of the historical indications of a major market top in place prior to the April highs, but the recent pullback itself has so far appeared more characteristic of a market correction than that of a decline that initiates the resumption of a new bear market.”
When you put that all together, you can put together a theme: when there are going to be big moves in the market, BMM will make big changes; when there are going to be smaller moves in the market, BMM will make more appropriate changes. The magnitude of BMM’s portfolio modifications are absolutely commensurate with expected risks and rewards.
What Was, What Is, and What Will Be
The correction that started in April 2010 appears to be giving way to a more sustainable advance.
Bursts of strong Demand (buying) has moved the market to a make-or-break level at a time when seasonals act as a tailwind for stock prices.
Berkshire Money Management is betting on a stock market break out.
Thanks, in part, to the best September for stock market returns since 1939, the correction that started in April 2010 appears to be giving way to a more sustainable advance. (It is worth noting that the September rush by itself does not make us more optimistic. After all, over the two-and-a-half years after the September 1939 rally the market fell nearly forty percent). A year-end rally would be true to form given that some of the concerns that triggered the April sell-off (the Greek debt crisis, the double-dip debate, excessive optimism/overbought indicators) have been reduced.
Often times we are all guilty of getting caught up in the minutia of the day, whether it is an article in the Journal that captures our attention, or even some random interview on financial television. Certainly the financial media make it easy for us to get caught up as they treat every minor blip in the market as carrying great importance. The danger in all this is the prevailing temptation to extrapolate long-term consequences from these short-term gyrations (I once heard someone insightfully refer to this as “forecasting for dummies”). In an effort to distance all of us from this, it may be helpful to consider and examine the bigger picture for the market, at least for the intermediate-term. To do so, it may make sense to briefly review the last few months beginning with the April market peak.
As you may recall, it was not too long after the stock market peaked in late April that talk began to surface that the bull market from the March 2009 low was now legitimate. However, quickly after prices turned down, the bearish financial chatter grew louder and continued even after prices entered a prolonged trading range.
As we take that step back and examine the market’s internals to see what was actually happening in terms of stock selling (Supply) and stock buying (Demand), the market treaded water from late-May to mid-September. If the market were preparing to embark on a new bear market, there should have been more clear signs of distribution. Instead, Demand steadily rose and remained in an uptrend while the growth rate of selling declined – a pattern of accumulation (bullish), not distribution (selling). These signs of market strength did little to dissuade the bears, as talks soon emerged of ‘head and shoulders’ tops, ‘death crosses’, and the dreaded Hindenburg omen. Admittedly, in the short-term, the bears were absolutely correct to be concerned; these were all decisively negative technical indicators, and what buying that could be found was far from abundant. In fact, the volume was so light that it would not have taken much distribution (selling) to overwhelm accumulation (buying), thus pushing down prices. (BMM did have concerns of the S&P 500 temporarily hitting 950-points, but only in the context of a severe correction and not in the context of a new bear market.)
Rather than breaking down into a new bear market, the stock market began to rally in late-August and by late-September was at the top of a nearly five-month trading range. The market had reached a make-or-break level – would it break out, or fail and drop back to the bottom of the range? While it has yet to be decisive, Berkshire Money Management is betting on a stock market break out.
BMM has been encouraged by a series of 90% Up Days (“up” volume is 90% or greater than the total of all volume; “up” price movement is 90% or greater than that total of all price movement) on September 20th, September 24th, and October 5th. Typically, sustainable (emphasis on “sustainable”) breakouts occur on a bust of strong demand. And, frequently, sustainable breakouts are followed by a light volume test of the breakout level (as occurred in the first full week of October).
Putting all of those pieces together, there was a market top in April, but no signs the bull market has ended. A subsequent and admittedly scary sixteen percent decline ensued, followed by a prolonged trading range. This range was resolved by breakouts and follow up rallies showing very strong Demand. All that indicates a correction in a bull market giving way to the renewal of the long-term rally, and not the clutches of a primary bear trend.
Also supportive are seasonals. Equities tend to perform relatively well in the fourth-quarter, and that is especially the case in the fourth-quarter of a mid-term election year. Historically, the following three quarters (through the first-half of 2011) of the four-year Presidential Cycle are stronger than most other quarters.
Thus if the market starts caving in to the seasonal pressure and dips, perhaps even dips hard, during the month of October, that would leave stock prices positioned to benefit from an expected decisive turn in seasonal and cyclical influences that will occur as we move through the fourth quarter.
Certainly more important to the outlook than favorable seasonals is the improvement of indicators (fairly geeky stuff, like advancing volume as a ratio of the sum of total volume, breadth thrusts, percentage of stock prices hitting new recent highs versus those hitting new recent lows, etc.). Especially encouraging is that although our sentiment charts have bounced from recent lows, they have yet to show excessive optimism. (Remember, when everybody is optimistic that means everybody who wants to buy stocks has already bought stocks, thus leaving no new buyers to increase stock price via increased demand. Stock owners want pessimism, and there is still a healthy dose of that in the market place.).
That’s not to suggest an “all clear” signal exists. Caution is warranted for the near-term. Not only is the stock market short-term overbought, but seasonal tendencies would suggest that stock prices could face some obstacles in October. Also, the September rally was a low-volume gift; it wouldn’t take much selling for Supply to overwhelm Demand, thus pushing down prices in a short period of time. This is especially true as we approach mid-term elections which could prompt stocks to price in any number of uncertainties. But given the improvement of our indicators it is most probable that any correction would again merely be a “disruption to the primary trend” which would carry the market higher not only through the remainder of 2010, but into 2011.
The Only Problem with Dividend Payers: Nobody Cares About Risk Adjusted Returns
The economic and earnings cycle support accelerating dividend growth, especially as regulation uncertainties clear. Investors should tilt their portfolios toward dividend payers as the cyclical bull market and economic expansion mature.
Talk of a dividend tax hike has not killed the dividend story. To the contrary, investors already discounted the tax hike and have since been stealthily buying dividend payers due to their safety and attractiveness relative to Treasury bond yields.
Given that “nobody cares about risk adjusted returns”, a caveat is appropriate: Should our expectation for a fourth-quarter rally indeed happen, low-beta areas (dividend yielding stocks, preferred stocks, etc.) should lag the overall market – not necessarily go down, but lag.
One problem for the U.S. economy is that corporations are hoarding cash (aka “the paradox of thrift” – cash hoarding is good for the entity singularly, and cash hoarding is good for the longer-run, but cash hoarding is a headwind for the economy in the nearer-term). Dating back to 1950, companies currently hold a record 14.6% of their net worth in cash. The economic and earnings cycle support accelerating dividend growth, especially as regulation uncertainties clear. But even if dividend growth is held in check, investors should tilt their portfolios toward dividend payers as the cyclical bull market and economic expansion mature.
During recessions companies try to avoid cutting their dividends as it implies poor financial health. But inevitably some succumb due to the decline in earnings and cash flow. The severity of the recession and cash crunch was evident in the record number of dividend cutters: the July 2009 peak of 78 was 30% higher than the previous peak in September 1975. The amount of dividend cuts was also dramatic with year-over-year dividend growth plummeting 21% in the fourth quarter of 2009, the worst since 1939.
Dividends tend to rebound along with the economy, with the number of cutters peaking a median of two months after the end of the recession (the National Bureau of Economic Research tagged June 2009 as the end of the recession). This cycle the dividend cutters peaked in July 2009, one month after the recession. While this time around the amount of dividends paid is lagging typical recoveries (hence the record amount of cash held), the year-to-year change in S&P 500 “indicated” annual dividends (dividends for the next year based on current payouts) turned positive in June 2010 for the first time since October 2008.
Looming over the dividend debate is the expiration of the “Bush dividend tax cuts” that lowered the tax rates on dividends to 15%. Congress is weighing options, but if they do nothing then the dividends will again be taxed as ordinary income.
There is not much historical precedent for a dividend tax rate increase. In 1954, dividends did go from being mostly tax exempt to being taxed as ordinary income. Also in 1954, the economy was emerging from a recession. The top marginal tax rate at that time was 91% (not a typo) and the stock market recovery prevailed.
Talk of a dividend tax hike has not killed the dividend story. To the contrary, investors already discounted the tax hike and have since been stealthily buying dividend payers due to their safety and attractiveness relative to Treasury bond yields. Bond yields are the major force behind the dividend yield/bond yield relationship today (i.e. Treasury yields are lower than dividend yields being higher). Deflation concerns and high fiscal debt are pushing bond yields lower. For the time being, the trend in bonds yields is down-to-sideways, making dividend yields attractive.
Stocks that comprise the Utilities sector almost always have dividend yields and the highest payers are traditionally either Integrateds or Distributors. In the last thirty years, dividend yields in these two Utility groups have usually been less than ten-year Treasury bond yields. Spreads of 1.5 times are rare, making today’s dividend yields in Utilities very attractive. An interesting side note is that the Power Producers, the one group that traditionally does not pay dividends, has lagged the rest of the Utilities sector during the recent flight to high-yielders. This adds to our assertion that investors would rather own stocks with dividends than not.
Clearly we believe dividends look attractive. However, a caveat is that if our expectation for a fourth-quarter rally does indeed happen, low-beta areas (dividend yielding stocks, preferred stocks, etc.) should lag the overall market – not necessarily go down, but lag. As we stated above, the magnitude of BMM’s portfolio modifications are absolutely commensurate with expected risks and rewards.
Longer-term (longer than a year-end rally lasting into 2011), the U.S. stock market remains in a secular bear market. With stock prices largely kept in check, dividends are set to become a larger portion of market returns.
Still, as optimistic as we are for a rally over the next three quarters, we have our doubts that the stock market’s surge will be as robust as history would suggest, making value stocks in general (and dividend-payers in particular) more attractive than growth (i.e. high beta) stocks. The current consensus for S&P 500 operating earnings in 2011 is 16.1%. If that comes true, dividend-paying stocks should appreciate handsomely, but they will lag the overall market decisively.
To get even half of that much earnings growth (8%, instead of 16.1%), we estimate that nominal Gross Domestic Product will have to grow about 4.7% in 2011. (GDP is typically measured in “real” numbers, which is the nominal amount minus inflation). In the long run, there is a close relationship between profits and nominal GDP. In the 7th through 10th quarters of economic recovery (so calendar year 2011 in this instance, given that the recession ended June 2009), profits have historically increased 1.7 times that of nominal GDP, on average. Applying that multiple to a 4.7% nominal GDP estimate yields 8% profit growth (4.7 x 1.7 = 8.0%).
We will be happy if we experience a 16.1% earnings growth rate because while our relative returns might lag the overall market, it would mean that our actual returns were larger than they might have otherwise been. Therefore, we see little risk in currently aligning ourselves with the safer option (even if nobody cares about risk-adjusted returns).
Emerging Markets are experiencing a secular bull market, while most developed markets are in a continuing secular bear. These trends are likely to continue for several years.
Emerging economies will account for sixty-percent of global expansion this year and next, up from about twenty-five percent ten years ago.
Since late 2008, the monthly average flow into emerging markets funds has trended to a new high of $2.3 billion, while the monthly average flow into developed market funds has been flat-to-lower (notably, even including a robust September, the U.S.’ cumulative flows have been negative year-to-date). The flow of funds reflect growing interest in emerging markets
We maintain a strong overweight position in Emerging Markets, and our long-term outlooks remains bullish. Emerging Markets are experiencing a secular bull market, while most developed markets are in a continuing secular bear. These trends are likely to continue for several years.
This is a serious departure from the 1990s, when emerging markets were a more risky asset class and the advanced economies were better-managed and promised safer returns. These days, emerging markets means fast-growing economies, combined with low debt levels and high foreign reserves. As an example, while here in the United States there is conversation regarding unleashing Quantitative Easing and additional federal stimulus funds to prop up the economy, China is more concerned about an overheating economy (given that China’s forward-looking purchasing managers index is showing a strong pickup in manufacturing, it appears as if the government is far from concerned enough to do anything about the gathering momentum of domestic demand on the Mainland. And it doesn’t hurt that the whole of Asia emerged stronger from the credit crisis, having swelled foreign-exchange reserves from $1 trillion to $5 trillion.) Emerging economies will account for sixty-percent of global expansion this year and next, up from about twenty-five percent ten years ago.
Should the domestic equity market trend higher as we expect, the advance will reflect positive expectations not just for domestic economic growth, but also for global economic growth. And the relative performance of the different foreign markets will reflect the varying expectations for said economic growth: relatively robust for emerging markets; relatively subdued for the U.S.
The potential restraining influences for the U.S. markets include likely tax increases, earnings reports coming in below expectations, stock prices already trading near fair value (based on some metrics), and the painful fact that the U.S. stock market remains in a secular bear market environment characterized by structural unemployment, deleveraging, and a retrenched consumer.
Alternatively, the positive influences for emerging markets include low debt, improving consumption prospects, and generally faster economic growth. Emerging markets live in a low-debt world. Where the U.S.’s external debt as a percent of GDP is 96.0 (and much higher for Italy, Germany, France, & the U.K.), for the popular BRIC countries (Brazil, Russian, India, & China) the ratios are 12.0, 31.7, 21.6, and 8.5, respectively.
In years passed, investing in emerging markets was often seen as an indirect, but fairly pure, investment solely into commodities. And while it helps that these markets are commodity rich, they are made more attractive because of their diversification. The BRIC countries, in particular, are aggressively diversifying. The diversification process is occurring in two primary ways.
First, emerging economies are building partnerships with other fast-growing countries. For example, last year China overtook the U.S. to become Brazil’s biggest trading partner. Following its announced deals in mining, steel, construction equipment, & electricity transmission, China may become the biggest direct investor in Brazil. And Russia is diversifying its energy exports away from Europe and toward China. While exports account for twenty percent of the BRIC’s GDPs, sales to the U.S. compose less than five percent – data that supports diversification (decoupling?) away from developed (debt burdened?) countries.
Second, emerging economies are focusing on domestic demand and domestic consumers. Russia is developing its high technology, and Brazil is investing heavily in its infrastructure (partially to support preparations for the 2014 World Cup and 2016 Olympics). Efforts like these raise country’s per capita income and develop a necessary middle-class.
Overall, emerging economies are well placed to continue to successfully navigate a world that has been rendered unstable by crises in industrial countries.
In regards to valuation metrics, there has been a lot of financial engineering over the last decade which makes earnings questionable (especially for the U.S.). Still, the majority of regional and individual emerging markets have earnings yields that are above their full-history norms. What cannot be engineered are dividends (either they are paid or they are not paid) and the dividend yields, too, are above their full-history norms.
Valuations are relatively unimportant compared to buying and selling. Stocks can be cheap, but get cheaper if investors are selling. Stocks can be expensive, but get more expensive if investors are buying. Since late 2008, the monthly average flow into emerging markets funds has trended to a new high of $2.3 billion, while the monthly average flow into developed market funds has been flat-to-lower (notably, even including a robust September, the U.S.’ cumulative flows have been negative year-to-date).
The flow of funds reflect growing interest in emerging markets, which has been in place since 2003, about when Berkshire Money Management became major investors in Asia, with an emphasis in China (an emerging market). As the commitment to emerging markets is still relatively small, the flows can be viewed as a bullish sign of demand. (Long-term trends would be more at risk if perhaps we saw valuations or relative market capitalizations more out of line with historical norms).
It would be amiss of us at this point if we were not to neglect what might appear to some as hypocrisy. Berkshire Money Management has repeatedly made it clear that it prides itself as a contrarian – being greedy when others are fearful, and being fearful when others are greedy. But BMM has never been contrarian for the sake of being contrary. And it is important to discuss this as we explain that the current flow of funds into emerging market equities is supportive of the bullish trend.
The public is often the subject of ridicule by the professional Wall Street analytical community, citing the “dumb money” that got into stocks in 2000, and again in late 2007. And they are certainly right in both of these cases. But those are crowd extremes – the exact sort of thing BMM avoids; the sort of instance where BMM would make major changes (the magnitude of BMM’s portfolio modifications would be large, and commensurate with expected risks and rewards).
No matter how one might try to explain it, pretty much all of the net gains in stock prices since 1960 (the last half century) have occurred when the public was buying stocks, while the market actually lost money (on average) when the public was a seller. At extremes the public is wrong (like buying stocks in 2000, or selling stocks in 2009), but most of the time the law of Supply and Demand prevails – prices go up when investors buy (Demand) and go down when investors sell (Supply).
June 2009: Into the Recovery Room, but Still Ailing
On September 20th, 2010 the NBER declared that the recession “officially” ended in June 2009.
On July 7, 2009 Berkshire Money Management predicted that the recession would be over before the Summer’s end.
The U.S. economy has officially moved into the recovery room. A patient in the recovery room, while healing, is typically still unhealthy.
On July 7, 2009 (fifteen months ago) in our Second Half Update for the Economic Outlook for 2009 we wrote:
“We are calling an end to the recession over the next few months (note: the official arbiter of the beginning and end of recessions, the National Bureau of Economic Research, typically takes a year or so to pinpoint dates…we may not get “official” word of such until late 2010).”
On September 20th, 2010 the NBER declared that the recession “officially” ended in June 2009. Fortunately Berkshire Money Management did not wait for more clarity as to the timing of the business cycle, and instead began moving from our huge cash position and back into the markets in March 2009.
Part of our comfort in getting re-invested in March 2009, and part of our comfort in calling a correction starting in April 2010 (as opposed to the resumption of the bear market) was derived from our expectation that the possibility of a double-dip recession was off the table. Still, we recognize the economic headwinds. These headwinds will result in the Federal Open Market Committee staying on hold for most of 2011, keeping Treasury interest rates very low.
This will keep upside resistance to the Treasury’s ten year note yields at the upward range of 3.25%. In turn, this will keep CD rates and money market rates low, forcing yield-hungry investors to remain in corporate bonds, preferred stocks, and Ginnie Mae bonds.
Inflation for 2010 has been in the range BMM predicted at the start of the year. While at some point inflation will be a concern, we continue to expect low inflation in the near-to-intermediate term.
While it will be a problem at some point, we continue to see a period of low inflation. In our Economic Outlook for 2010 we wrote:
“Inflation is low and inflation expectations are tethered…. Judging by the ‘break even’ rate of inflation, the point at which inflation-linked bonds would make the same pay-out as the fixed-interest bonds over the next ten years, the market is currently expecting continued 2.2% inflation in the US.”
Over the last six-months, the range for year-over-year changes in the Consumer Price Index, or CPI, (the most popular measure of inflation) has been between 1.2% and 2.2%.
As also stated in the Economic Outlook for 2010:
“Inflation trends are closely watched by the Fed, which has said it will keep short-term interest rates near zero for an ‘extended period’, meaning at least several more months. And while this balance holds, this, of course, has important implications for fueling the economic recovery as well as the primary bullish trend for the stock market.”
Berkshire Money Management did get correct the call regarding the Fed keeping interest rates near zero although, admittedly, it was one of our easiest to make given the Federal Reserve’s transparency on the matter. BMM’s expectation of continued subdued inflation further supports our aforementioned call that the Fed will continue to keep rates low, which will in turn continue to support asset prices.
Bottom Line: The capital markets and the global economy has so far unfolded in 2010 much as Berkshire Money Management had expected, and chronicled, in our “Economic Outlook for 2010.” In a few months we will posit more on our year-ahead expectations as we pen the upcoming “Economic Outlook for 2011.”
Until then, for the remainder of the year we note that the stock market’s action during the third quarter appears to have been the later stages of the corrective phase that started in April, and appears to be giving way to a more sustainable advance.
BMM has been encouraged by a series of relatively high-volume breadth thrusts that have pushed the market to the top of a nearly five-month trading range. The market had reached a make-or-break level – will it break out, or fail and drop back to the bottom of the range? BMM is expecting a stock market break out.