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PATH FINANCIAL LLC
Registered Investment Advisor
1990 Main Street #750
Sarasota, FL 34236
941-350-7904
Raul Elizalde - Thursday, June 10 2011
For about two years stocks have been on a tear. The S&P 500 rallied 100% since the March 2009 bottom. Apart from a bumpy second quarter in 2010, it took a tsunami, nuclear blow-ups and huge uprisings in the Middle East and North Africa to create a pause last March. By May prices were even higher.
The natural sequence to this would feature the last of a dying breed of bears throwing in the towel and taking the stock market higher still. A bit of that was seen at the LinkedIn IPO in mid-May, when its share price doubled on the first day of trading. Never mind that the company does not expect to be profitable in 2011.
The mood darkened after that. Stocks are now about 6% below the May highs. Judging by market commentaries and anecdotal evidence, investors are now quite less confident that stock prices will be higher by Labor Day. They may have good reasons to be cautious.
For the last two years the government injected heavy fiscal and monetary stimulus on an economy that seemed at the verge of collapsing. This prevented a worse crisis, but the distortions that these lifesavers may have introduced are still unknown.
The rally in stocks and commodities of the last couple of years could be the result of record corporate profits and red-hot growth in emerging markets, respectively. On the other hand, it could also be due to the massive liquidity injections by the Fed and other central banks around the world. The high correlation between stocks and commodities gives further credence to this argument.
The problem, therefore, is that the data so far fits both explanations but the conclusions are different. If the profit/growth argument is correct, then the rally in asset prices is legitimate and based on solid foundations. If on the other hand the main reason why prices are higher is simply excessive liquidity, then it further injections are needed to keep the pace.
One way or another, the near future is inauspicious: whether the rally is backed by economic growth or by injected liquidity, both are likely to wane.
First, it seems clear that global demand is declining. Chinese economic activity, for example, central to the global recovery of the last year or two, is not likely to continue as Chinese authorities fight inflation with higher interest rates and a real estate bubble with restrictions on loans. Brazil, although still going strong, slowed down in the first quarter and is expected to slow down further in the second. Economic growth in the West is unlikely to pick up strongly since austerity, in varying degrees, has been embraced by all politicians, especially in Europe. And last December’s expectations for 3.5%-4% 2011 growth in the US seem now wildly optimistic given the 1.8% growth figure for the first quarter and a similar expectation for the second.
Second, the end of the current monetary stimulus program in the US (QE2) and Bernanke’s indication that a new round is not at all likely set the stage for reduced liquidity going forward. Also, note that both president Obama and congressional Republicans are in full agreement on tightening fiscal policy. The battle is only waged on whether this should be done by hiking taxes or cutting spending. If the Fed walks away from monetary stimulus, then asset prices will have no support left from government policy.
All this suggests that, barring an unexpected revival of economic growth, asset prices are likely to be under pressure in the months to come. Commodities might fare better than equities because supply appears vulnerable from weather problems, OPEC squabbles and turmoil in Middle Eastern and North African countries. If so, then commodities and stocks may finally decouple.
For equities support seems rather weak. A 15%-20% drop from current levels would merely keep them within their medium-term range of the last 10 years (see graph above). This would be consistent with other long periods in history when stocks remained basically range-bound for a decade or two (see graph below). Coming from a 100% rally makes a retracement only more likely.
In practical terms, this does not mean that investors should abandon stocks. Rather, it means that getting the asset allocation right is as crucial as it has ever been. Staying with stocks just because they do well “in the long run” ignores the fact that the long run can be really, really long. Many investors can’t ride a big wave down and wait for years to be made whole (For more on this see our newsletters of November 2008, Slouching Towards Nowhere, and May 2009, On Being Japan)
The proper combination of stocks, bonds, commodities, currency exposure and inflation hedges could make a great difference if stocks stay within a range in the next few months or years. And by the look of it, a long-term bull trend that would take stocks above their historic highs isn’t likely anytime soon.
N.B.- Greek Debt will be covered in an upcoming newsletter
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We use quantitative measures to build and maintain portfolios for our clients, which we rebalance every quarter. We described our investment process in previous newsletters. If you would like to know more about how Path Financial’s investment process works, call us or send us an e-mail at the address below. We’ll be happy to set up a confidential meeting to discuss new paths to financial success.
Raul Elizalde | raul@pathfinancial.net | 941-350-7904
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