The market is always moving, but it doesn’t only move “up” and “down.” It also changes in character – the type of stocks with the biggest moves up or down varies through the course of the market cycle – on a weekly, daily, and even intra-day basis. We do our best to monitor these changes and, ideally, stay in the way of what’s working and get out of the way of what isn’t working.
At the moment, international investing isn’t working. The U.S. stocks have been dominating the performance derby for the past few months. At the beginning of the year, perhaps coincident with the Arab Spring events, commodities rocketed higher and dominated the market’s move higher. Most recently, however, defensive stocks have been moving into the spotlight.
Many of the sectors that are doing better than average are considered “defensive” sectors. Consumer staples (soft drinks, personal care products, drug stores) have started doing better than average. Healthcare stocks, like the pharmaceutical and biotech companies in which we’re invested, are moving up near the top of the performance derby. Utility stocks, which were on the verge of getting kicked out of the portfolio a couple of months ago, are now back “above water” (doing better than the market over the past six months).
One problem that I have, personally, in trying to “hide out” in defensive stocks is that when they are doing best, often you would have been better being out of the market altogether. If you try to hide out in stocks that are going down less than the market, then you have good “relative performance,” which means that when the stock market turns in dismal performance, the good news is that the amount of money that you lose isn’t quite as bad – but losing money is always bad! The last time we bought consumer staples was in 2008. While the sector gave us good “relative performance,” we would have much rather just owned cash.
Good “absolute” performance means that your money wouldn’t have gone down at all. The problem that I have in hiding out in defensive sectors is that, often, you would have been better not being invested in stocks at all during those periods. If you knew that stocks were selling off, then rather than tweak the portfolio by owning defensive stocks, you would cash out of stocks altogether. Then, again, there’s that Will Rogers 20/20 hindsight problem. Without a crystal ball, sometimes it will make sense to stay on the sidelines, and at other times buying consumer staples truly does represent an opportunity to make more money than the broad market.
In any case, signs that defensive stocks are doing relatively better is a red flag that concerns us. In spite of a few economic variables that concern me – including a slight inventory build and unemployment starting to get slightly worse – our Leading Indicators remain stable. But problems in Europe seem to be serious, getting worse, and potentially as devastating as the sub-prime problems. Greek two-year bonds yield 25%. The market is clearly expecting a default in Greece, and worries about Spain are increasing as the dominos overseas weary of leaning against one another in order to support the fiscal irresponsibility of the European Union’s weaker and most profligate members.
There’s also our own government deficit in the U.S., and the unwillingness of either party to risk offending their political base in order to solve the problem. If a “Mediscare” can be used to win elections, then “truth” and problem-solving will be sacrificed to the greater God of partisan politics, until we experience Greece-like interest rates in this country.
Many client portfolios recently sold off gold, in spite of our long-term concerns about inflation and the dollar. Similarly, this week we further reduced our commodity position, which was starting to lag and really acted as a drag on portfolio performance during three successive sell-offs over the past two months. The main reason, I think, for commodities to decline is that the U.S. economy may be joining other global economies in a slowdown. In the long-run, the dollar may decline and inflationary pressures may continue, but if the U.S. economy goes back into recession, industrial demand for commodities will slow and commodity prices, likely, will fall.
If a slowdown is indeed what is being priced into the market, apparently it’s too early for it to show up in our Leading Economic Indicator. Though the LEI could be turning down, it hasn’t yet. However, the sell-off in commodities has been serious enough for us to sell out of some of our commodity investments and for now the proceeds of the sales remain in cash.
We’re taking reinvestment on a day-by-day basis. There are some new asset classes and industry choices that are beginning to show up as “buyable.” Most of the new alternatives are these “defensive” sectors. If they are just going to fall at a slower pace than the rest of the market, then perhaps we would be better off holding cash.
Hopefully the pause will be temporary and the economy can work through this. However, I still believe that the potential upside, from this level, is not as large as the potential downside should Europe implode. These problems in Europe, which caused us to get defensive a year ago, were never really resolved. Things are worse now. It is somewhat reminiscent of the sub-prime problems which were pooh-poohed by the incompetent bank managers that created them, and when the Fed started cutting rates in 2007 the strategists said that the issues were resolved. In fact, they weren’t, and a year later the bank panic unfolded with the bankruptcy of Lehman Brothers.
A year ago, the international bankers told us that they had bailed out Greece, and the problem would not spread beyond that country. They also implied that if problems did spread, they would be solved, just like the Greek bailout solved Greece’s problem. A year later, we know for a fact that the problems did spread and the the Greek problem wasn’t solved. The problem is growing and spreading and threatening Europe’s largest banks. Will Rogers also observed that, “If you ever injected truth into politics you’d have no politics.” So true. Like the old saw - how do you know that a politician is lying? Answer: his mouth is open.
Europe might well experience 2008 redux. It won’t be centered in the U.S., this time, but it would be silly to think that the U.S. would be immune to a bank panic on the other side of the pond. Since we never fixed our own “too big to fail” problem, a crisis will likely bring another round of misguided and costly political response. The risks are large enough to justify selling off a portion of our beloved commodities position, if only for a little while.
For the past year, we’ve been asking our “red money” clients to re-affirm that the long-term appreciation portfolios are truly invested with a long-term investment horizon. I don’t know if we’re going to have another big dip or not, but it’s always a good time to be certain that your long-term portfolios have only long-term money invested in them.
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .
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