“Cautiously Optimistic”

Cautiously optimistic is a classic fence-sitter cliché. Most Wall Street strategists invoke the term so they can claim to have forecast whatever happens next. If the market falls, they can cite their “cautious” outlook. If the market rises, then their optimism was justified. The problem is not with the cautiously optimistic outlook, per se, but rather with the fact that they always have that outlook, at market tops and bottoms, and that an outlook that never changes is the same thing as having no opinion at all.

So, it is with great humility, that we confess to being cautiously optimistic. Looking back, we’ve been less than happy campers about the outlook for this market, generally, and the financial sector in particular. So, in our defense, though we’re forced to use the cliché today, it’s not the only opinion in our forecasting toolbox. In addition, at the worst of the recent liquidity crisis, when funding for Bear Stearns dried up in a fortnight, our portfolio positions matched our bearish outlook. Our fund portfolios had 40% of the portfolios invested in bonds or bear market funds to attest for our concerns about the market.

In our hearts and our guts and our minds, we remain pretty cautious. We think that problems in the financial sector are not past. Though the worst of the liquidity crisis is hopefully in the rearview mirror, money remains tight in the mortgage and private equity sectors. When companies like AIG stumble, the markets remain skittish. Looking ahead, even if the funding crisis is past, it’s hard to know how much a bank will earn in this new world of conservative lending, and after the share dilution that is occurring as the sector recapitalizes itself. Technology and industrials might lead us into a new bull market, but we’re not looking to the financials to lead the way. Add in high gas prices and the inability of mortgage rates to move lower, and our caution seems pretty rational.

The optimism in our outlook comes from the market itself, which has held up very well in the face of this crisis. The economy, too, has held up in spite of plunging consumer confidence and a disaster in the financial and real estate sectors. We’re nine months into probably the worst real estate contraction since the depression, yet we’re still not even sure if we’re in a recession and reasonably strong payroll growth is absorbing most of the laid off workers.

It’s hard to ignore the fact that the market is telling us that things are fine. Last Fall, while the market was setting new highs, we were convinced the market was overlooking the facts. Now however, with the facts laid bare for all to see, the market still refuses to blink. Maybe it sees something good around the corner that we’re missing. This month we are reducing our bond weighting and increasing, slightly, our exposure to the potential for good news. Let’s hope the market is right!

On June 2 our ETF model sold its Long-term Treasury Bond iShare holdings, which suggests some interesting potential scenarios going forward.

In the optimistic scenario, the progression beyond the abyss of the March liquidity crisis combined with very reasonable stock valuations based on forward looking earnings projections could mean that the recent lows provided an excellent opportunity to buy stocks. In April, the Alger Funds CEO and Chief Economist opined that, “we firmly believe that years from now the present will be seen as one of the great ‘if only’ markets, a time when the stocks of quality growth companies could be purchased for a song.”

In this sunny scenario, there is no way that bonds can keep up with the long-term profit potential of great stocks purchased at a discount to intrinsic value.

However, one of the reasons that many strategists are so bullish on stocks is that they are priced so inexpensively as compared to historically low long-term interest rates. Could it be that the market is telling us that bonds, not stocks, are currently mispriced? Treasuries are especially expensive. Corporate bonds, high yield bonds, mortgage-backed products haven’t experienced a rate dip. If anything, rates have trended higher in those areas. Heck, even long-term treasuries haven’t come down much from pre-crisis levels. The rates that have fallen most are short-term Treasury rates. This is typical of a liquidity crisis, where money seeks safety at any price.

So if we’re past the liquidity crisis (and let’s hope we are), then interest rates are probably headed higher. That is what the fundamentals suggest, and that is probably the message from our long-term Treasury iShare. Owning it since December, we sat out the worst of the stock market sell-off. Going forward, however, the market might be thinking that long-term Treasuries, which are very sensitive to changes in the level of interest rates, might not be the safe haven that investors expect.

The message from our model might not be that “the coast is clear,” but rather simply confirmation that long-term rates are headed higher.

The stock market will respond to other factors. If stocks are headed higher, it will be because the sinking dollar means that our manufacturing sector has regained its competitive position in world markets. Continued economic expansion will allow our globally dominant technology sector companies to keep growing profits. A resolution to the political worries might bring investors back into the health care sector. There’s plenty of money on the sidelines. The key question in our minds is whether the economy can rebound in the face of $130 crude oil prices.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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