Don’t ask market gurus for their opinion;
ask to see their portfolios. Bullish advisors that sit in cash have little credibility. Fully invested advisors with “
cautiously optimistic” opinions don’t strike me as being very cautious. At May-Investments, with most “red money” (growth oriented) portfolios now sporting cash positions of 20% to 30%, our concerns about recent market activity have shown up in portfolio holdings.
In the short run, there are numerous technical indicators that have forced us to a more cautious stance. In the long run, there are still many reasons to be optimistic – but recent events are suggesting that
the possibility of a bad surprise has increased. Rather than cross our fingers and hope that things don’t get worse, in the past few weeks we have shifted portfolio holdings to cut back on the amount of risk to which portfolios are exposed.
- While stocks (the S&P 500, at least) are still up 3.8% year-to-date through the end of trading today, the market direction has shifted enough that momentum investors are heading for the exits.
- Investor interest in the stock market is flagging, which shows up in very low trading volume.
- Moreover, on days with greater activity, the market trend is often lower – suggesting that when trading volume returns, it won’t lead to an upsurge in the market.
- Money flow indicators, which have been positive for most of 2012’s rally, appear ready to go negative.
- Defensive sectors, by and large, are outperforming the broad market while commodities, technology, financials, and cyclical stocks lead the market lower.
- Investors Business Daily’s “Market Pulse” indicator switched to “market in correction” on May 4, which is when May-Investments began reducing our stock weighting in some portfolios as well.
Perhaps the action which has us most concerned has been the very dramatic sell-off in the commodities sector, reminiscent of July 2008. While newspaper headlines focus on the political and banking situation in Europe, a more compelling explanation to me is that the situation in China continues to deteriorate. The chaos in Europe, while unprecedented, really shouldn’t be surprising to anyone. The banks over there need to be recapitalized, which means that this week’s takeover of a bank in Spain is just the first step in a long line of dramatic steps that result from the sovereign debt problems over there. Maybe the market is just responding to the unfolding of the inevitable, but what worries me more than Europe is that the bad news out of China keeps coming.
Our hope, as the year began, is that the U.S. and China would avoid the recession which had already begun in Europe. If China continues sinking into recession as well, it is very hard to imagine the U.S. avoiding a similar fate. That, to me, is the real news that the market is digesting. Throw in a little uncertainly about our own political incompetence, and it’s not too hard to imagine that a correction (or worse) might be just around the corner.
As always, however, it is important to look at both sides of the coin. There are a number of long term factors which still favor continued growth, unless China does continue toward an implosion of its own.
First, our portfolios have very little direct exposure to the problems in Europe, and haven’t for over a year. The U.S. market, generally, has performed much better than the international markets and client portfolios have been focused on domestic stocks. Most of our international exposure comes through our gold and precious metals holdings.
Second, as in 2008, having a significant amount of cash on the sidelines gives us significant buying power should a market correction unfold. We have always said that corrections feel a whole lot worse when investors are fully invested. If there is money available for investment at “the bottom,” then a correction becomes an opportunity which can be a silver lining to the otherwise cloudy sell-off.
Third, the May-Investments U.S. Leading Indicator Index remains pretty strong. It flattened out for a few months, but the preliminary numbers for the month of April show continued growth in U.S. economic activity.
Fourth, regulators have had some time to prepare for the financial crunch sweeping across Europe. Even in the midst of this week’s angst, Spain was able to sell bonds at auction. Banks, using money borrowed from the European Central Bank, can buy bonds at 6% and pay just 1% on the borrowed funds. True, as in the U.S., this funny money is being created out of thin air, but the plan hatched late in 2011 does provide liquidity to the system. It is my guess that the U.S. will soon be asked to tap into the Federal Reserve balance sheet for a trillion dollars or so. We will lend money to the European Central Bank, which will lend it, in turn, to banks on the continent. Japan and other countries may also make funds available. This rescue has been at least a year in the making, and the printing presses aren’t even close to running out of ink. (It helps that all of this fiat money is being created digitally, on electronic balance sheets on both sides of the pond.)
Fifth, May-Investments new custom wealth management approach has been working well. Last fall, we tweaked some disciplines around our portfolios’ “flexible middle” to make the decision to move to cash more objective, less stressful, more gradual and less disruptive to the portfolio. Beginning in early May and continuing step-by-step as the warning signs began to accumulate, we gradually reduced our risk exposure to the point where now we have a significant stash of dry powder in the event the sell-off continues. The sales were made more quickly. The main problem with 2011 was a delay in August as we wanted to get past the budget impasse – a decision which meant that we weren’t reducing risk until too late during the sell-off. The process was more objective and less subjective. It will also be easier to reverse, if and when markets begin to recover. Thus far, the portfolio tweaks made late last year have worked very well.
Sixth, market valuations remain very attractive. Note that these valuations are a function of forward earnings estimates, which are themselves a function of what the U.S. economy does during the remainder of 2012 and into 2013. At this point, however, the domestic indicators remain strong, so corporate profits may stay the course. If the U.S. indicators start going down, it will make sense to take even more risk out of the portfolio. In 2008, the economic indicators lead the market decline. This time, the market is weakening in advance of any decline in U.S. economic fundamentals.
The technical indicators that are waving red flags are too numerous to ignore. It is possible that we could be whipsawed again, as happened in 2011 when we reduced our equities at the height of the European crisis but, when solutions finally began to appear, the markets surged higher and our portfolios missed out on the recovery. We will be quick to buy back in if things settle down (because of the numerous long-term positives mentioned above), but it is easier for us to risk the opportunity cost of a market recovery than it is to think about the losses that could accrue to investors if these red flags are right, this time.
We remain long-term optimists, but the news coming out of China also can’t be ignored. We are reminded of John Maynard Keynes response to criticism for changing his mind, who replied, “when the facts change, I change my mind. What do you do, sir?” The slowdown in China is morphing toward something worse, which would put the U.S. recovery at great risk.
If, as I hope, the European markets settle down and China starts showing signs of stabilizing, the market would likely go back into rally mode and we will put the cash to work. At the moment, however, we are concerned that the market has enough downside from here that it makes sense to reduce the amount of capital at risk in the long-term portfolios.
It almost goes without saying, but we’ll say it anyway, it’s also appropriate to be absolutely certain that only long-term money is invested in the “red money” portfolios. At this point, from the market’s high water mark, the S&P 500 Index is down less than 9%. At this point,
volatility has not spiked and the downturn is well within the range of normal market ups and downs. No one should consider it “
too late to sell.” Investors should be certain that long-term portfolios have only long-term money invested in them.
And remember that this, too, shall pass. But buckle up.
Douglas B. May, CFA, is President of
May-Investments, LLC and author of
Investment Heresies .
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