Bennet Sedacca: Expect a Rocky 2006
The market has become a futures-dominated casino controlled by speculators.
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As we wind down the year, one that has muted returns in just about every asset category, we must ask ourselves as portfolio managers what to expect for the balance of the year. Much has changed since mid-October when pessimism was thick in stocks. It is said that seasonality starts to turn positive on the 18th business day of October and the market responded right on cue. We have had a move of about 5% in the S&P 500 index since then. However, pessimism has now been replaced with near unanimous enthusiasm and bullishness. For example, our proprietary sentiment poll has gone from extreme pessimism to extreme optimism in just 3 short weeks. The American Association of Individual Investors poll of bullish percentage has reached levels associated with market tops. And mutual fund cash is at a record low as a percentage of assets in equity funds. So we have no choice but to remain on the defensive (I might add that those sectors like health care, consumer staples and value are performing admirably again). If sentiment polls get a bit frothier, we would look to pull back a bit more as we expect a rather rocky 2006.
Why do we expect a rocky 2006? As stated here many times, perhaps ad nauseam, that the bubble in housing stocks has broken (Toll Brothers (TOL) affirmed that for us this week) and that the bubble in parts of housing will bust in 2006. Housing is simply no longer affordable, and according to Freddie Mac (FRE), equity withdrawals from homes will slide dramatically in 2006. With the savings rate negative here and in Canada, economic growth forecasts are called into question, in our view. By any measure, the median home is no longer affordable for the median American, let alone in the speculative markets. This will prove a drag on the economy in our minds. In addition, this will occur with both a tapped out consumer and government. Something will have to give.
Turning to bonds, seasonality has now turned positive for municipal bonds. The best three months of the year are upon us (seasonality usually turns positive on the 9th). This is due to decreased issuance and large coupon payments and maturities. Municipals, relative to treasuries, are the cheapest I've seen in my 26 year career. So we are aggressively adding these where appropriate by either selling shorter dated bonds or using cash reserves. In addition, some closed-end bond funds are coming under pressure (non-leveraged funds are all we are focusing on at present). At year-end, we expect massive tax-loss selling in the leveraged closed end municipal bond funds and we expect to pounce at that time. I did this in both the bear markets of 1994 and 1999 in bonds and all I can say is that we were handsomely rewarded early in 1995 and 2000 once the tax-selling pressure was over.
Lastly, what I find interesting is that although only $1 trillion is in the hands of hedge funds (relative to $30 trillion in equities), hedge funds and brokerage firms now dominate nearly 75% of all trading on the NYSE every day. It is why the market appears random in its movements lately. The market has become a futures-dominated casino controlled by speculators. The market is essentially being dragged around by the futures market. Despite the money the prospective new Fed Chairman Bernanke may drop from helicopters as he promised in the deflation fright of 2003, we still feel an inevitable sharp correction lies in front of us. We will continue to be defensive and opportunistic until we feel the risk/reward ratio has shifted. We expect this in the summer or fall of 2006.
Bennet Sedacca, President Atlantic Advisors
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