Where We Are
Every Wednesday we have a strategy meeting to review the markets and determine if our themes need to be changed. Here were our conclusions from yesterday:
Most of the improvements in earnings (generally) can be attributed to cost cutting (layoffs) and improved margins. Stock prices are now discounting a rapid increase in revenues in the second half of next year due to expectations of an improving economy. Another factor on a smaller scale is companies borrowing at low interest rates and buying back their stock (reducing float and increasing earnings per share). There are a few companies, like IBM, that have done this to a large degree.
Liquidity has mostly found its way into financial assets. The affect of this liquidity is predominantly seen in changed investor psychology: raising their tolerance for risk. Despite some positive anecdotal evidence of some improvement, the real economy still shows lower than normal (for a "recovery" cycle, which itself is longer than normal) industrial production and capacity utilization (74.4%).
The excess liquidity has also found its way into commodities and especially gold; this should continue. This will accelerate if prices for financial assets begin to decline.
A next leg up in the U.S. equity market would most likely come from foreign buying, if their psychology changes as well to believe in an accelerating U.S. economic expansion. This will be evidenced by a stronger dollar as they buy dollars to buy U.S. financial assets. The dollar currently remains only 2% off of its 5 year low.
So in our minds the key for a next leg up in financial asset pricing remains the dollar. We do not believe a lower dollar will have near the positive effect that some predict for U.S. manufacturers and consequently the U.S. economy in general. We believe a lower dollar will hurt U.S. financial assets. Given the tenuous position of the dollar, any breakdown has a high probability of increasing equity volatility.
The convertible bond basis (relative prices) has improved dramatically over the last two months due to this liquidity. This is unlikely to continue, at least to the extent that it has. We continue to liquidate this part of the portfolio.
Volatility has continued to drop and has reached levels where "intrinsic" (a base level of volatility that must exist) has been reached in many individual stocks. This is now low enough for offensive position. As convertibles are liquidated and the size of the volatility portfolio is not needed as protection (defense), we are now comfortable in retaining it for offensive purposes: our main focus remains the financial sector.
And again, Minyans, I share these thoughts with the hopes that it adds to your understanding of the process--not as advice or a recommendation to act.
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