There’s Something Happenin’ Here,
What it is ain’t exactly clear…
“For What It’s Worth” – Buffalo Springfield
My friend Josh Brown (okay, he’s linked to some of our stuff; maybe friend is a bit of an exaggeration) often quotes and links to videos of rap songs on his blog, The Reformed Broker. At the age of 50 (51 this month), my knowledge of rap stops somewhere around 1988 (NWA) and based on what I’ve heard of the more modern version that is unlikely to change. Classic rock (at 51 am I a “classic” too or just getting old?), on the other hand, is the soundtrack of my life and when I think about the markets, lyrics often pop into my head. Watching the markets this week, I kept hearing Neil Young’s stunningly simple riff and the opening line to the Buffalo Springfield song quoted above. The rest of the song is more appropriate to what is happening in the political arena – There’s battle lines being drawn, Nobody’s right if everybody’s wrong – but the opening line just about perfectly describes my feelings about the market recently.
For most of this year the dull, classically defensive stocks have been leading the market higher. Utilities, pharmaceuticals and basic consumer goods stocks with good dividends have been bid higher almost continuously by yield starved investors looking for a remedy to the financial repression of the Fed. In fact, as I pointed out last week, these stocks are now pretty richly valued and I think highly unlikely to be the safe havens so many believe them to be. Overpaying for slow growth companies just because they have a solid dividend record is not a sound investment strategy. Buying an asset because Fed policy has forced you to is even worse. We own some of these stocks at Alhambra – some for years – but we’re eyeing those valuations and wondering if it might not be time to pay our capital gains taxes and move on. It is hard to sell a high quality company but everything has its price.
The last couple of weeks the stock market has continued its march higher but it isn’t the defensive stocks that are leading, it’s the cyclicals. Companies whose fortunes are tied to economic growth such as CAT, DE and EMR have made some pretty dramatic moves off their lows. In addition to the move in stocks, commodities have been moving higher as well. The GSCI commodity index ETF (GSG) is up 17% from its late June low. Some of that is due to the drought running up agriculture prices but oil prices are also up and industrial metals prices have at least stopped falling. As backdrop to this, the commodity currencies ($A and $C) have moved higher along with the emerging market currencies. Emerging market stocks are also starting to outperform, up nearly 13% just since early June. And wonder of wonders, even the yield curve has steepened ever so slightly as well. In normal times, I would take all these as indicators that the market is starting to anticipate higher growth.
Of course, these aren’t normal times and markets are not always right in the short term. Those are humans buying cyclical stocks and they could easily be wrong about the future growth course of the economy. Those are also humans buying commodities and we have no idea what is motivating their buying. In addition, we have the complicating factor of expectations of further monetary action by the world’s central banks. What we’re seeing in the markets right now may be nothing more than the world’s speculators buying inflationary assets in anticipation of another round of money creation by the Fed, ECB, BOC and BOJ.
Does it matter? Well, that’s what makes this such a difficult time to invest. We won’t know whether the market is rallying in anticipation of further easing or because of better growth prospects until we can don those 20/20 hindsight glasses sometime in the future. There are plenty of market pundits who will tell you that further monetary easing will lead to the higher growth the market is telegraphing, but as you probably already knew before getting to this part of the sentence, I’m not one of them. Quantitative easing, whatever its form, is a self defeating policy because it raises inflation expectations and along with it commodity prices, especially oil – and that is just the obvious negative. Higher oil prices are not a stimulative outcome for the US economy. So, if cyclical stocks are rallying based on expectations of more monetary easing, I suspect the buyers will be disappointed.
The other possibility is that stocks are starting to anticipate better economic policy in the near future while the move in commodities is coincidental and due to exogenous factors. There has been a lot of digital ink spilled over the Fiscal Cliff and the supposedly dire consequences of that new year event but I see it as an opportunity. I think we have finally reached a point where serious decisions will have to be made about the structure of our economy. Love him or hate him, the selection of Paul Ryan as Romney’s VP candidate ensures that we will be having a serious debate about the economy between now and election day. No matter the outcome of that debate, fiscal policy in 2012 will not be decided by the Fiscal Cliff. And I expect we’ll be better off for having had the debate.
In the short term – and the long term for that matter – asset prices are determined by supply and demand. Right now, the demand is shifting to the risk asset side of the ledger and prices are following. The pessimism that has pervaded the market since spring has lifted slightly but in general the mood is still skeptical toward this nascent bull market. Short interest is still high but starting to fall, adding a bid to the market. The option market still shows a preponderance of put buying and while the spot VIX is fairly low, futures further out on the curve show a decided fear of future volatility. Economic data is still mixed with a bias toward ugly but there are still enough bright spots to keep me in the no recession – yet – camp.
The future is, as always, uncertain but markets do generally give us a heads up. Right now, I think the action is pointing to better policy and better economic growth in our future. As the political campaign heats up, I believe those expectations will grow and the market will move accordingly. Stocks may be ahead of themselves a bit here so a pullback would not be surprising, but stocks rallying into November would merely conform to the typical election year trend. After the election is another story entirely however and until we know the outcome of the coming economic debate, that is something on which I won’t offer an opinion. In the meantime, the market is trying to tell us something and I think we’d be wise to listen.
For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: firstname.lastname@example.org or 786-249-3773.
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