What’s Going On?
Since the Fed decision to increase interest rates on May 10th, the market has taken a completely different character. The Fed did not signal that a pause in the rate hike regimen was imminent, leaving the door open for policy flexibility. Some market participants interpreted this to mean that the Fed was going to kill economic growth. As a result, they started selling any stock that had a cyclical character. When this selling started, hedge fund managers on a short-term momentum strategy also started selling. Individual investors joined the panic. Even some investment managers now say that it is time to stand back and see where buying emerges. Technical analysts note that the major averages are in a downtrend and have fallen to critical support levels.
What is wrong with this?
The key point for any investor to grasp is the need to look forward, not backward. The fact that stocks have declined, and that cyclical stocks have declined the most, is a backward-looking event. The key question is whether the "marginal trader" in the market is really looking forward.
How to find the facts?
Our view at "A Dash" is eclectic. We do not pretend to know the answers, but we are very good at recognizing the experts on each issues. Partly we do this based upon their past performance, and partly it is based upon the logic of the analysis.
It is important to understand that the markets are not really efficient (more on this in upcoming posts) and that one needs to parse the commentary to learn the facts.
- The economy. The facts are that it is very strong. The economic strength has continued in spite of increased energy prices and a series of interest rate hikes. The reason is that energy prices are less important than they were thirty years ago. There has been a drag on the economy, but it is still strong. The real evidence is from consensus economic predictions and also the predictions from CEO’s in the Business Roundtable. Both show strong growth.
- Corporate profits. The naysayers have been predicting that earnings estimates must decline, and they have been saying this for two years. They have been wrong, and they are still wrong. Corporations have strong balance sheets. Profits have increased at double-digit rates for a record period of time. Estimates are still rising. Corporations got lean and mean in 2001 and have expanded cautiously. They are poised to take action, spending to stimulate growth and buying back stock.
- Inflation. This is a widely misunderstood topic. Hedge fund managers and pundits think that they understand inflation better than the real experts. There are good indicators of expected inflation. Things like the spread between TIPS (inflation protected bonds) and regular bonds show modest inflation expectations. Economists predict the same. The ten-year note is at a modest 5% yield. These are the facts. It is easy to find anecdotal evidence of some higher prices, but more difficult to balance this with the overall picture.
- The Fed. The Fed looks at specific inflation indicators, mostly geared to personal consumption (the PCE index) and core inflation rates. They do this because of the volatility in other inflation measures. Consider this: If oil and gas prices remain at current levels, that does not portend additional inflation. If the economy is slowing a bit, not crashing, but easing to normal strong growth levels, this does not stimulate more inflation. The Fed’s mission is to kill the expectation of more inflation, so that we do not get a spiral of wage and price increases. At the moment there is no indication of such a spiral, and the Fed wants to keep it that way. The new chair, Mr. Bernanke, got off to a slow start with some dovish commentary. He wants to kill inflationary expectations, as he should.
How Do We Make Money from This?
Let’s start with how one loses money, which is blindly following those who have been wrong and ignoring the real experts on the economy and inflation. We have the sweet spot of forecasting when economists and CEO’s agree. There is a disconnect between their read, and that of the average investor and the rookie hedge fund managers. This is an opportunity.
Our models show the market as a whole to be undervalued by 35% and cyclical stocks, tech stocks, and selected biotechs undervalued by 50%. Even if we are wrong by a fair margin, it is a great buying opportunity.
Is the Current Market in a Crash Situation?
Those making comparisons with 1987 or 2000 are not looking at fundamentals. Corporate earnings are strong, much stronger than in 2000. PE ratios are low, and even lower when compared to interest rates.
Are We Entering Stagflation?
A problem with using the ‘staglfation’ term is that most of the current managers were not following the market in the 70’s when interest rates soared above 15% and growth went to recession levels. There is no comparison to today’s market.
There is a little more inflation than a few years ago when the problem was global deflation — a serious economic risk. A little inflation goes with the territory of economic strength.
How Will It Play Out?
The key question is whether the Fed balances interest rate tightening with economic expansion. Most maket players are following a simple heuristic: Don’t Fight the Fed. This is alliterative and makes a lot of sense when the Fed is determined to crush the economy to stop rampant inflation. That is not the current situation. Most of the Fed tightening simply brought interest rates from an extremely low level, designed to combat deflation, back to a "neutral" range. We are now in that neutral range.
Looking at every Fed tightening cycle for the last 60 years is not very helpful. Almost all of these cycles started from much higher levels and faced different inflation situations. The only circumstances that were vaguely comparable were from the Eisenhower era, when the landscape of derivatives, adjustable mortgages, world trade, and other factors were vastly different. Despite these obvious problems, one of the major research houses — widely quoted on TV and followed by hedge fund managers and pundits — reports these results as if they were indicative of the current situation.
What to Do?
The current market, as it has been since 2004, remains the opposite of the 1998-99 market. There is a great opportunity for investors who do not follow the crowd. The exact timing is difficult. No one knew exactly when the 2000 "bubble" would burst. We cannot know with certainty when this "reverse bubble" will play out.
Having said this — sometime pretty soon the Fed will pause, trying to assess the impact of past actions while still talking tough. Stocks will rise. Hedge fund managers will jump in to chase performance. Individual investors will see more opportunity in stocks than in real estate, already showing weakness. Mutual fund managers will allocate away from emerging markets. Momentum investors will pile on.
The asset allocation among stocks, bonds, and real estate will reach equilibrium. More likely, stocks will overshoot. When this happens, we will shift out of stocks, just as we did in 2000.
Our method has gotten the big cycles just right. This one is taking longer than expected — torturing us — but the facts have not changed.