What the Rest of the Year May Bring Us
Speaking of housing, it is already slowing...'for sale' signs are staying on front lawns longer.
I am acutely aware of the risks of trying to 'predict' what markets will do in the future. In our business, however, we are faced with the job of positioning client's hard earned capital with the goal of consistency, capital gains and lack of downside during rough times. To be sure, this is much more of an art than a science and we simply strive to be right more than we are wrong. In fact, being correct twice as much as wrong (the equivalent of a .667 hitter in baseball) is what I personally strive for. The key, of course, is to try to keep the losses small or cut them short if expectations of a certain event doesn't work out. Like I have said many times, my mother always warned me of what you put in print, as it stays there forever. With that risk known, I will still share with you what we think may happen for the remainder of the year.
The Bond Market
In the first place, we are faced with an unusual circumstance of an inverted yield curve. Simply stated, the highest yield on the treasury curve is at 6 months at 4.68%, with the lowest yield on the 30 year part of the curve at 4.50% (note that there are some 'off the run' bonds in the 25 year area offer 4.75% or so, but these rarely trade). The Fed has raised rates from 1% in 2004 to 4.5% on January 31, probably on the way to 5% by May. Usually, longer rates would rise with them as the Fed fights inflation. Yet those longer rates have not responded. Why? In our opinion, it is a direct result of the extreme amount of leverage that exists in the form of Adjustable Rate Mortgages and other loans, like consumer installment debt, tied to prime or LIBOR. However, we are about to enter the worst seasonal period of the year for Treasury bonds. The ten year note is sitting precariously on multi-year support - see chart below - a low we have a feeling will break and then form a low in the May timeframe, when seasonality turns positive again. This break, if it were to occur, could take 10 year rates to 5-5.25% from the current 4.53% (yes I know this is a dangerous prediction).
The obvious impact would be higher mortgage rates, slowing the important growth vehicle in housing. Speaking of housing, it is already slowing, with companies like Toll Brothers (TOL) announcing two disappointing quarters in a row. Its stock is already roughly 50% below its July 2005 high. In addition, inventories are building across the industry and new units continue to be planned. In my hometown of Orlando, companies like Centex (CTX) are already offering $50,000 bonuses just to buy one of their homes. And 'for sale' signs are staying on front lawns longer, so a .75% rise in rates is a body blow that we feel the industry just can't take. We will see. As I said, it is dangerous to make these sorts of predictions, but it seems like the most likely scenario to us. We are positioned defensively in short term treasurys and short-duration mortgage backed securities and will be happy to pounce on bonds at lower prices.
The Stock Market
This call is a bit dicier. Readers of our work know that we track sentiment and seasonality closely in addition to valuations. First, let me address sentiment. Sentiment can be summed up in one word right now - complacency. Nearly every poll I look at suggests complacency, anecdotal evidence from TV reporters reflects it, and it is particularly evident in the options market. In the options market, investors, mainly hedge funds starved for yield, are 'selling forward volatility naked' hoping that the options expire worthless. For beginners, I realize this is a foreign concept, but take my word for it, if the market were to turn lower quickly; these volatility sellers will get smoked, actually exacerbating a decline. I also see complacency in the world of mutual funds, where funds now have on a hand a whopping 3.4% of their assets in cash, an all-time low by my reckoning. The other times it was near here were around the 1974 and 2000 tops. The potential issue here is if the market turns down, and investors sell or redeem mutual fund shares, fund managers have no choice but to sell as going to zero cash is not something fund managers usually do. This last happened in July 2002, resulting in a nasty, waterfall decline.
As for seasonality, we use a combination of annual, decennial and Presidential cycles (courtesy of our good friends at Ned Davis research). We have talked many times about these cycles, but the most important part of this analysis is that markets tend to bottom in October of the 2nd year of Presidential cycles. The combination cycles revealed the following at the beginning of the year. A January rally, a decline into President's Day followed by a weaker (less advancing issues) run into an April 1 high, then a decline into October. The exact level reached at the April high is hard to predict however. The rally then resumes as seasonality once again turns positive. See the chart below
Conclusion-the 'Big Picture'
For years, we have been talking (and writing) about the 'debt bubble' in our country. Everywhere you turn; there are MONSTER amounts of risk relative to GDP. Credit market debt, government debt (and deficits), consumer installment debt, mortgage debt-the list is very long. Why is this so important? Think about it like a simple balance sheet where the left side is assets and the right side represents liabilities. If the right side of the balance sheet grows too large (we think it has), the left side needs to grow perpetually in order to support the right side. After all, the debt also grows as a function of debt service that goes along with it. We have already had a stock bubble and a housing bubble. Small cap stocks and emerging market stocks are flying, while the bigger, mainstream stocks get left in the dust. This is all occurring at a time when the savings rate in the U.S. and Canada hover near zero. Some people think that money made on real estate or stock investments is savings. We feel, and will always feel, that that is preposterous. When I was taking Economics 101 in college, we learned that 'S=I'-or savings=investment. My point here is obvious. Without savings, only consumption, eventually we will be faced with a recession, or worse, that I would rather not go into at this time.
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