Between a Rock and Hard Place

Money managers, investment advisors and investors alike face a daunting emotional and financial challenge in these markets as a result of all the conflicting signals the markets and the economy are giving. In addition, when what you hear, see and feel do not match up, seasickness or motion sickness may set in.

Economists are reporting that the rate of economic worsening is slowing down, treasury yields are rising again at the long end, and there are so-called green shoots. Government is signalling a turn in the economic outlook.

The stock market has enjoyed what some are calling (hoping) a new bull market and others, a massive bear-market rally, and corporate earnings beat severely beat-down earnings forecasts in the latest reporting season. Questions remain as to what is stable, and what is not?

In a recent post, Barry Ritholtz referred to Randall Forstyh's "Green Shoots = Ganga" article in Barron's:

Randall Forsyth elicits chuckles via his clever phrase-turning. He turns his poison pen on the ubiquitous nonsense known as “green shoots”  that has been so in vogue amongst the perma-wrong crowd:

“So, why the attraction of green shoots? One can only speculate that they must be in some ways intoxicating. Perhaps not the shoots exactly, or the stems or seeds, but the leaves of a certain plant. Those might be smoked or otherwise ingested to bring about a euphoric effect. From what I’ve read, the current crop is far more potent than the commodity available in years past. How else to explain the mind-bending notion that an economy that is declining less quickly is somehow improving?”

Like all great inventions, it obvious in hindsight.

Once someone else has invented it, everyone says (or at least thinks to themselves) “How on earth did I not come up with that myself . . . ?”

Dan Dorfman discusses an interview with an asset manager who repeatedly referred to himself as an idiot, to make the point about "the unrelenting pressures facing Wall Street's performance-oriented big guns, many of them leery, and offers a credible reason why the beleaguered stock market could get another significant shot in the arm provided it doesn't cave in first."

When I told him of my interest in writing a piece on his latest market thinking, he chuckled and shot back: "Why would you solicit the views of an idiot?"

Why such a disparaging reference?, I asked. "Because my gut and the facts tell me the market is going lower, maybe a couple of thousand Dow points lower, and that the economy, contrary to what a lot of economists are saying, will not bounce back very much in the second half," he says. "Yet, I've been reducing cash reserves and buying some stocks fairly aggressively," he tells me. "Only an idiot would do that."

Then why buy? Because the performance pressures from clients are enormous, he explains. "My phone is ringing off the hook at all hours of the day and night. My clients all know the market is up about 30% from its March lows and all they want to hear is how much money I'm making for them after a lousy 2008. With the kind of explosive rally we've had," he says, "they can't imagine my not being an active participant in it, and you really can't explain to people something they don't want to hear -- that it could be a buying trap or a bear market rally.

In one of this week's posts published here, the legendary and incredibly modest Jeremy Grantham, of GMO, as interviewed by Smart Money (May 21, 2009) discusses why he changed his mind about the market after over a decade of being characterized as a perma-bear:

SM: Why were you so certain things were going to get so ugly?

G: There wasn’t a whole lot of doubt where I was coming from. I thought the fair value of the S&P was 925; the S&P went to 1500. And by 2006 the housing bubble was at a 100-year peak. This was the 32nd asset bubble that we’ve tracked, and all but the U.K. housing bubble have popped.

SM: … for the first time in years, you like US stocks.

JG: We think a fair price for the S&P 500 index is 900. By sheer divine intervention we bought into the market on Mar. 6, the day it hit the recent low of 666. It’s likely, but far from certain, that we’ll go back and make a new low. You aren’t going to get to buy at the absolute low unless you have a time machine.

SM: Anything else besides US stocks?

JG: US stocks were nicely cheap, and frankly, the rest of the world was even cheaper. In early March, when we bought, we invested only in stocks we thought would have a 10 to 14 percent average annual return after inflation. That’s magnificent. We haven’t seen anything like that in 20 years. It was somewhat disappointing that prices moved up so fast in just a couple of weeks. The odds are a bit more than 50-50 that we will go back and test that low.

SM: So you’ve made a quick buck. Now what?

JG: You have a set of possibilities. First, if the market nosedives, it’s easy: You buy. The second is confusing, when the market just goes sideways, between 700 and 800. The market is irritatingly cheap then, but not super cheap. The longer that goes on, the less probability we will set a new low, so we’ll ultimately put money each month into the market.

SM: What if stocks keep rallying?

JG: If the market goes higher, above 950, and then starts moving sideways, between 950 and 1050, we probably do very little. Then the market is moderately overpriced.

David Rosenberg, Gluskin Sheff's Chief Economist (ex-Merrill), has the following to say in yesterday's Breakfast with Dave:

Okay, the gloves are off. Just as was the case in the summer of 2007, the bond bears are coming back out of hibernation, and we see and hear that they have a new set of pencils and rulers out and declaring, yet again, the end of the secular bull market in Treasuries. Not so fast.

About longer-term Treasury Bonds...

We think that this sharp correction in Treasuries (4.5% loss so far this year) started off as a flight-out-of-safety when the Obama economics team put a floor under the financials, then the second stage were the ‘green shoots’, followed by recurring asset mix rebalancing, and then by talk and technicals — the exact stage when the blowoff occurs; and the blowoff is what provides the opportunity.

Let’s not forget what the upcoming round of data releases are going to look like after GM declares bankruptcy — jobless claims are likely going to test the old highs, ISM the old lows, and the boom in consumer confidence is going to seem like a distant memory by Labour Day.

About equities

Well, we have a sneaking suspicion that the nearby peak was May 8 when the yield on the 10-year T-note was 3.29%. That was the tipping point for the stock market, which has only done backing and filling ever since; and some wild swings (three triple-digit up Dow sessions; four triple-digit down days).

We would have to think that a 4.63% yield compares quite favourably with a 2.6% S&P 500 dividend yield — the spread hasn’t been that wide in at least eight months. Not only that, but the stock market has become increasingly “less cheap” — over the last six months, 2009 consensus earnings estimates have been pared from +30% growth expectations to a mere +9%. The S&P 500 is trading at multiples of around 17-18x, which is no bargain in our view.

Now for the rock and the hard place. Do you stay invested in equities as though its a new bull, or do you take the precautionary measures in case the bears are right?

Its not always clear, but after reading through a fair bit of opinion it seems that the simple, sensible thing to do next, may be to rebalance from equities to bonds. Equities and government bond yields have had quite a run up on the 'green shoots' and Obama's 'floor-under-financials', and upcoming economic data may be, very mildly put, uninspiring.

Finally, some advice on seasickness:

There are three things which trigger sea sickness, and it is advisable that you avoid them, if you are prone to it, or try to do as little as possible: if you go below the deck for a long time (there the wag is bigger), if you look through binoculars or other optical device, and finally - if you read a book, look at a compass or do any work that requires gazing at one point for a long time. Just try to keep your peripheral vision on objects that your brain will interpret as stable (because in fact they are not, and there will be clash in the sensory information and it will end in sea sickness).

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