Joshua M Brown
September 5th, 2011
I’d love to be wrong about this and see another buoyant September in the tradition of 2010 or 2009 but something tells me we will not be quite so fortunate this year.
Here’s how I’m preparing myself for the month to come:
In my practice:
For most of my households I’m running a Core Satellite strategy with weightings that are highly contingent on the macro and technical picture – we like to say that we have “strong opinions that are loosely held” in our shop, no asset class or sector gets a permanent slot in the lineup. As such, these accounts are running a maximum weighting of 50% stocks since August 1st and the majority of that exposure is toward high-quality dividend payers.
Alongside the Core, for some clients I’m running a Tactical Asset Allocation strategy that moves back and forth between Treasurys and stocks depending on its own business cycle and economic inputs, on August 1st it did a total flop over to full-on Treasurys, zero stocks. On September 1st, the algorithm came out of its hole, sniffed the air, and decided to stay put in bonds and out of equities entirely. Fine by me.
I’ve also got some more aggressive trading accounts that went 100% cash on August 1. In addition, the muni bond separate managers I work with are still doing their thing, albeit at one-to-six year durations and very close to the benchmarks.
For a reference point on my weightings, see this media appearance from August 3rd.
In short, I’m not bullet-proof, but I feel pretty good about the limits on my risk as well as what those cash positions will allow me to do when the time comes.
Most stock markets are coming into the month of September bruised, battered and technically broken. Standard & Poors follows 45 markets around the globe and notes that August has left 43 of them down from July. The average decline has been 7.7%, a remarkable beating for a normally quiet late-summer time period. It is against this backdrop that the traders return to business this September, the failed month-end markup rally of last week notwithstanding.
China and Brazil:
I can’t stop thinking about China. I had dinner a month ago or so with one of the most noted China bears on The Street. I came away thinking about how the rampant accounting fraud happening with small caps that have listed stateside could be just the tip of the iceberg (“The People’s Republic of Madoff” was how he phrased it). But that’s a longer-term issue, in the short term I’m still freaked out about how Brazil has gone from raising rates to ward off inflation to cutting rates out of nowhere. While Brazil has done a nice job of allowing their internal middle class to flourish, one cannot forget the fact that the main driver of the economy is mineral exports and the main customer is China. The two markets are inseparable, like auto parts and auto manufacturing. When the factory stops calling for windshields, the glaziers probably have a tough slog ahead of them. The question becomes: “Was Brazil’s rate cut purely in response to the unwelcome strength in the Real? Or did they perhaps get a whiff of some demand destruction coming from the east?”
China’s stock market has slowdown written all over it, for those not keeping score – the Shanghai Composite just printed a 14-month low with a crucial CPI datapoint coming Friday. If prices show no sign of having cooled off then China’s relentless rate and reserve hikes may have to continue. If we have any hope of global growth in 2012 we’ll need China’s Soft Landing to actually happen. The only trouble is, I can’t think of any notable “soft landings” that have actually occurred in the last 15 years, and certainly none in an economy of that size and velocity.
US Stocks and Joblessness:
The rational person is over-weighting stocks versus bonds here. The metrics by which we historically judge the cheapness or richness of stock valuations all point to some amazing values in whole swathes of the market. Balance sheets are so cash-rich that it seems impossible that we won’t get the type of dividend issuance and buyback authorization that could only make stocks even more attractive. At a 12x multiple to earnings, we’re paying quite a bit less for the market than the historic average PE ratio of 16. Many well-run companies are selling for somewhat less than that 12 times earnings and have been for quite awhile. In other words, the value isn’t just relative to the 2%-yielding ten-year Treasury, there is also absolute value of historic proportions.
So what’s the catch? There are a few hiccups here…
First, multinational companies have been driving much of the earnings growth. While this is a trend that could continue for decades, in the short run I fear that it may hit a wall. For starters, tighter monetary policy in the emerging countries will mean a slowdown in demand for US goods and services as surely as night follows day. In addition, through May 2011, the US dollar lost a whopping 15% of its value, providing a significant tailwind to US exporters and multinats. The question becomes, how likely are we to see a repeat performance in the next 12 months? In addition, the mean reversion in home prices continues apace, prices have further to fall just to get back to trend, let alone plunge through to the downside (as most mean reversions are wont to do). The unemployment situation, while inextricably linked to the housing sludge bucket, has in many ways become its own thing at this point, the focal point of virtually all economic and political debate as we head into the fall. Stocks were able to shrug off the anemic housing market and the open-sewer jobs situation so long as they had ceased getting worse. With the extraordinary stimulus Hail Mary passes over for now, this is no longer the case. Stocks are moving with the data in a Fed-lite atmosphere and the data is moving lower, period.
The market will be watching Obama’s speech this week on unemployment for signs of creativity and force from the White House. But we are advised to remember that even if we like and believe in the initiatives that are announced, they will take months (quarters!) before they are widely felt, that’s just the nature of the beast.
The Federal Reserve:
With interest rates low, it is tempting to simply say “don’t fight the Fed” and load up on “cheap” equities here. But the Fed does not require us as sparring partners anymore as it has begun to fight against itself; dissent over policy is now the norm as Ben gradually loses control of the situation. Which means that, other than keeping the Fed Funds target rate at zero, it is likely the central bank will remain on the sidelines in the short-term, content to point its finger at Congress and fiscal policy for our collective failure to get moving.
It is worth mentioning here that the historical record of bull markets expanding without a well-performing Financial Sector is a mighty thin one. It is almost impossible for the major stock indexes to make solid, sustainable forward-progress with broken banks. And while these indexes were all banked up for too long, the weighting of the sector has fortunately begun to shrink. That said, there’s still work to do and this will be an annoying and painfully slow process. Financials are still about 14% of the S&P 500 versus a long-term average of being only 12% – and once again, it is unlikely that we simply hit that historical trendline and pause, it is more likely that this “meanest of reversions” takes us through to the downside for a time. This puts a fairly substantial hurdle in front of any kind of “new bull market”.
The FHFA’s landmark lawsuit, announced late Friday against 17 financial institutions who’ve sold $196 billion in mortgage products to Fannie and Freddie, certainly won’t be helping matters but will hasten the shrinkage of our banking sector one way or the other.
Finally, the European horror show has become something much more than just a Black Swan…it is an accident in progress that we are watching from afar. We are watching the participants flail about for solutions and consensus when both are impossible. We know that defaults of ad hoc bailouts and interventions will be a continuing feature of the next year as the pace of destruction speeds up. One does not need to be a macroeconomics expert to understand that a Pan-European bank and sovereign debt meltdown has the potential to become quite possibly the contagion risk of all contagion risks.
Without getting into superfluous detail, I’ll simply mention that Europe started off the week without us in dramatic fashion – with a continent-wide crash.
Germany’s DAX was down an eye-popping 5.3% on the day while both the Spanish IBEX 35 and the French CAC 40 index lost 4.7%. The FTSE-100 also lost 3.6% on the session proving that no one and nothing is immune at this stage of the game. In short, a rough start as developed markets begin undeveloping right before our eyes as the month gets underway.
Technically, fundamentally, and economically everything that can go wrong is going wrong for the stock market – all at once. Which is a positive development for those who understand the need for closure and rock-bottom. In life, the fear of future events is typically worse than when those fears are realized, particularly when the overhang drags on for so long a period of time. I think I speak for most market participants when I say that I’m pleased to see the endgame approaching faster up ahead, because it is only on the other side of these issues that we can progress to the next phase.
So bring it, September. As Alexandre Dumas (Pere) once wrote, speaking defiantly though the Count of Monte Cristo, “Do your worst! For I shall do mine!”