Say Goodbye to May
David R. Kotok,
June 2, 2012
“Sell in May and go away.” Boy, would that have been a good idea. In May, markets were down over 6% in the United States. European markets were a sea of red, and the rest of the world followed suit.
We did not expect this to be the case. In April, we suggested that, during this election year and with the economic data stream then apparent, (1) the very low worldwide interest rates and the (2) appealing valuations of the stock market would combine in a strategic sense. Hence, we concluded that this was not the year to sell in May.
We were wrong. It would have been better to sell in May, raise cash, sit the month out.
It is now June. Will “June [be] bustin’ out all over” as they sang in Carousel, or will there be a June swoon, a continuation of the May malaise?
The market focus continues to be on Europe. France will have parliamentary elections on the 10th and 17th of June. Greece will have crucial elections on the 17th of June. The European Central Bank (ECB) seems to be on hold until the political situation is more stable. Clearly, there is a demand for more liquidity in Europe, and the ECB holds the keys. We expect an ECB action at any time.
In the US, the Federal Reserve seems to be in permanent neutral. In fact, the balance sheet of the Federal Reserve is gradually shrinking, because the Fed is permitting some runoff of its holdings. Operation Twist ends in June. QE3 is going nowhere. The rhetoric of the Fed, the message from the Fed, the discussions originating out of the members of the FOMC, coalesce to suggest that the Fed will do nothing. That is our outlook, unless there is a massive shock of some type or the economy goes into recession. Neither shock nor recession is likely. Thus, we expect no changes at the Fed until after the end of this year.
In Japan, political change is underway and the composition of the Japanese Central Bank may change. How those politics play out remains to be seen. The Japanese Central Bank’s balance sheet seems to be headed in an expansive direction. And, of course, there are the ongoing discussions in the UK and the Bank of England about its monetary-policy making. Where the UK goes also remains to be seen.
As we survey the world, we find a continuing expectation of extremely low short-term interest rates. Credit spreads, interest rates, and central bank balance sheets are all updated on Cumberland’s website, www.cumber.com. When you look at those charts, the striking impression is that the distribution of rates is truly remarkable.
There is an extension of those very low interest rates out into the intermediate section and long section of the yield curves, where the high-grade sovereign debt is priced. There is a widening of credit spreads in many sectors, from junk bonds in the US to junk sovereign debt in Europe. The high-grade interest rates are bordering on the bizarre in terms of pricing.
What do we mean by bizarre? When the two-year German government bond trades at a negative yield, that is bizarre pricing. When the ten-year US Treasury trades at 1½%, that is bizarre pricing. When the thirty-year US Treasury bond trades under 3%, while a very high-grade, AAA, tax-free municipal bond trades close to 4%, that is bizarre pricing.
The investing professional and the serious individual are each bewildered by the circumstances that confront them every single day. In the financial-markets, the market-clearing, pricing mechanism seem to be broken. Very few of my colleagues would spend their own money buying a ten-year US Treasury note in return for a 1½% interest rate. They (I) wouldn’t do it for their (my) personal account. In our firm, that means we will not buy it for clients.
That bewilderment doubles when you compare the ten-year riskless yield with the US stock market. There you can purchase the benchmark S&P 500 Index and get close to a 2½% yield from dividends. Compare the two choices if you are a longer-term, strategically thinking investor. Would you take the riskless ten-year note and receive 1½%, or would you take the composition of the 500 large companies in the S&P 500 Index and say, “I’ll get 2½% in yield today, and sometime in the next ten years I expect the price of that index to be higher than 1300, and I will have a capital gain. Also in the next ten years, I expect the collective dividends on these 500 companies to rise. Thus, my ongoing yield will probably escalate.”
That is the choice facing investors. To us, that choice is clear. We would rather bet strategic investment money on Johnson & Johnson, Exxon, IBM, and the others who compose the S&P 500 Index; derive a higher yield while we do it; and have an expectation of higher stock prices sometime in the next decade. That looks like a better choice to us than the ten-year US Treasury note. The policy at Cumberland is to make the strategic choice, and that favors being invested in the stock market.
What about the bond market? We will not buy the ten-year Treasury note. It does not make sense to us. The only reason we would want to own the ten-year Treasury note at a 1½% yield is if we thought there would be a protracted deflationary recession in the United States and that it would go on for a number of years.
We think the evidence for a deepening recession is not there. The data sets we examine, the economics that we apply, suggest to us that the US economy is headed for a protracted period of slow but steady recovery. Furthermore, it looks to us like that recovery will begin to accelerate over time.
The acceleration will come from three sectors. The first is a housing sector that stabilizes and then begins to return to normalcy over the next few years. The second is the manufacturing sector in the United States that is also gradually and continuously recovering. The third is the US energy sector, particularly with the evolution of natural gas in its new form (shale) throughout the country.
Put those three sectors together, and you can add a point or more to the annual GDP growth rate as it unfolds during the next decade.
To us, this looks like an opportunistic place to be.
Are we worried about Greece? Are we concerned about the euro zone? Are we worried about the growth rate in China? Of course, we are! There a million things to worry about. You can focus on them by looking at Tehran, Damascus or Cairo. You can peer into Beijing, Tokyo or Seoul. You can fret about Rome, Athens, or Madrid.
However, do you make your investment decisions only based on the deteriorating, negative strategic view? If yes, sit in cash. It earns zero yield. And it has zero volatility and zero growth.
At Cumberland Advisors, we are taking the other side of this trade. We have been though over a decade of malaise and weak performance. We have witnessed the brutal adjustment of real estate prices throughout the world. That is not over yet but much of it is already behind us. We have endured financial crisis, banking crisis, investment-banking crisis, and central banking policy changes of monumental proportion. That is all old news.
Over the next decade, the question is: what is the new news? In our view, it is more likely to be positive than negative. The fact that markets are not pricing in the positive outcomes makes them even more attractive.
June is here; May is over. We shall see whether June busts out or if May’s negative momentum continues through the summer.
We are fully invested in the US stock market ETF accounts. We favor the sectors that would participate in a growth setting.
We are greatly underweighted in Europe in the international ETF accounts. Our exposure to Europe is limited to Germany in the euro zone. We own some UK, Sweden, and Poland. Note that those three are not in the euro zone, but they are in Europe.
“It’s June, June, June” says the song. The melody is appealing.
David R. Kotok, Chairman and Chief Investment Officer