At this point, it is clear that my January expectations weren’t right. What is less clear is whether or not I’ll eventually be proven wrong.
The recent correction doesn’t worry me. The market was way “overbought” in April, so much so that we welcomed the correction. A market that grows to the sky far into overvalued territory has nowhere to go but down. With the market now have fallen more than 10 percent from its recent high, the market has fallen into “oversold” territory and in normal markets I would be buying into this weakness.
When I look at individual stocks in the custom wealth management portfolio, more than half of them look to be extremely “oversold.” Typically, it makes sense to buy on weakness, especially when the market is well off its top. In fact, our portfolios have money on the sidelines for just such an occasion as this. It would typically require a major market downturn, which just doesn’t happen very often, for it to make sense to continue sitting on the sidelines. What makes us think that such a downturn might be upon us?
First, China has stopped stimulating. Probably as a result, emerging market stocks and most commodity stocks have been among the weakest asset classes in which to invest. Whether or not the China bubble has popped is a question that I’ll leave to others to debate. For the moment, I’m just pleased not to be watching those holdings sinking lower in my portfolio.
Second, Greece matters. Whether Greece signaled the end of the Euro or, as it turned out, the need for a trillion dollars in unfunded stimulus, the end result is that global investors who have been forced to seek an alternative reserve currency now know that the Euro is no longer a viable reserve currency. In fact, the Euro looks so bad that many currency speculators have been forced to retreat back into U.S. assets. The worry stems from the fiscal straight jacket that Germany and the Club Med countries have been forced to wear. The cutbacks in government largess will almost certainly force Europe into a severe recession. Greece matters. Money matters. Money is no longer easy, in Greece, in Spain, in Ireland, in California, and in many more socialist regimes. Europe, California, and maybe China look to be headed for a double dip recession. How can the U.S. not follow?
Third, the U.S. economy remains shaky. Has the recession ended? Has the economy recovered? Alas, those are two very different questions.
If you define the “end of recession” as “having recovered,” we are nowhere near recovery. Money is still tight, in spite of last year’s stimulus package and near-zero interest rates. The government has wiped out savers’ incomes in order to finance deficits as far as the eye can see. Banks aren’t lending. Consumer credit is shrinking. Retiree incomes have plummeted. The employment situation remains a disaster. Recovery remains a long way off.
However, a “recovery” is more accurately defined as an end to declining economic activity. When “growth” resumes, from whatever level, the recovery has started. By this measure, the recovery began on July 1 of 2009. We remain at a level of economic activity that is well below what we experienced in 2006 and 2007. The current level is the “new normal” that pundits talk about. We have recovery, and high unemployment. We have a better manufacturing environment along with bankers who are making things worse by calling in loans of borrowers who are current with their payments. Retail sales and corporate profits are definitely stronger than I had anticipated, however construction hasn’t recovered so much (but it’s no longer dropping like a stone). This “new normal” is an uncomfortable status quo, even if things are improving slightly from day to day.
Will the U.S. economy double dip back into recession? You tell me. Unemployment claims are once again nearing the 500,000 per week level. States and municipalities have been forced to recognize the financial reality that businesses have faced since late-2008. The Federal Government threw a trillion dollars of kerosene onto the U.S. economic fire but it has burned off and it doesn’t look like the logs have reignited yet. With China and Europe now set to rain on our parade, the May-Investments double-dip fears suddenly have a bit more company.
Fourth, the market is not valued cheaply enough to offset these red flags. In March 2009, with the market off more than 50% from its peak, a lot of bad news was already baked into that market. Even after today’s 4 percent sell-off, however, this market is still up 50 percent from the March lows. Based on current earnings instead of projected/anticipated earnings, the market sells for nearly a 16X multiple. That is not the low end of the range. "Valuation" is not a reason to ignore the red flags. In March 2009, brave investors could at least take solace in knowing that they were at least buying on the cheap.
Fifth, and very importantly, market “volatility” is extremely high. The “VIX Index” has soared in recent weeks. Typically, it takes a major sell-off or news event to stabilize the market. Europe’s trillion dollar bailout of Greece didn’t calm the waters. So what will?
Maybe Europe will come out with a more robust fix for the Club Med sovereigns than the trillion dollar fixer-upper that has already been announced, but I doubt it. Maybe some U.S. economic statistics will be surprisingly strong, as has been the case most of this Spring, and turn investors attention away from problems overseas. Perhaps corporate earnings will continue rebounding as strong as current forecasts project.
However, to me the most likely "catalyst" for the VIX to peak and then reverse direction is a market sell-off that takes stocks back down to attractive levels. I’ve said before that I think that “fair value” for this market is around 9,000 on the Dow (still a 10 percent fall from today’s close). In fact, the market typically falls below fair value before it stabilizes.
I don’t think that the market needs to revisit the March 2009 lows, when it fell below 7,000. Another 10 percent drop, however, wouldn’t surprise me. That is why we’re not buying more stocks today, despite stocks having fallen into an “oversold” condition. If this is the double-dip I’ve been expecting, then there is no point in buying too early.
Hopefully I’ll be wrong. However, given the number of red flags waiving, we are glad to have been “defensive” in our holdings (glad to have some cash on the sidelines) and we are actively considering whether there is still time to move more to the sidelines to reduce our Beta (exposure to portfolio volatility) even more. If the economy is starting its double dip, and the stock market is entering a new bear market, then adding a “bear market fund” might help us preserve wealth better while the market adjusts to this “new normal” in which we find ourselves.
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.
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