The investorsā great dilemma was, and still is, the near-zero return on safe, liquid, short-term assets and the heightened, uncomfortable risk associated with attempts to get higher returns. The level of risk, however, fluctuates and there are a number of variables which are helpful in making assessments. Some of these are: 1) changes in liquidity; 2) valuation levels; 3) psychological extremes and 4) the technical position of the market.
At the bottom in March 2009, these were aligned in a very positive configuration and our bullish posture was based on that. As readers know, we have maintained our overall positive stance on equities and risk assets in general, because most of these factors have remained favourable. The one questionable issue is the technical state of the market and here, there is disagreement. Trend followers point to the weakness of the market vis-Ć -vis its long-term moving averages, suggesting the trend is down. Followers of some other methods believe there is a good chance that the market has found support and could soon rise. Given the disagreements, from a technical perspective, the outlook is not clear.
The four sets of indicators should be read as a whole. Our inclination, at this point, is not to put undue weight on the trend-following indicators because valuation is positive and central bank liquidity remains very expansionary. Near-zero interest rates create a powerful impetus for investors to seek out better returns in higher risk assets. Following the euro crisis (which has abated for now) investor psychology became extremely negative. Investors, in general, have built up huge cash positions to protect against another 2008-2009 meltdown. The media is full of bad news on the slowing economy. While a weak economy is never good for profits, it does guarantee sustained low interest rates and central bank expansion. These will provide an important offset.
Last month (Volume 2.8 - Asset Allocation Thoughts, June 29, 2010) we indicated that our overall stance was still bullish but suggested the market could go lower in the short run. Since then, the market has been pretty flat on balance. We still think there is a risk of further weakness in the short term but we do not see a major bear market at this point. Rather, a more likely scenario is market recovery after the period of seasonal summer weakness and then a wide trading range. The S&P 500 has been in a trading range between 1550 and 750 since the top in early 2000. The mid-point is around 1150, slightly below the current price level. The average P/E based on expected earnings over long periods is about 15, well above the current 13. However, the long-term average includes periods of high interest rates and inflation. When these periods are removed to make comparisons with the current low inflation and interest rate environment, the current level appears even more favourable.
While we have often stated that value does not help with timing, it does provide a cushion. Hence, we do not see huge downside at this point. But we must remember that the world is fragileāsurprises, shocks and volatility should be expected. Therefore, be sure that your āriskā assets are of the highest quality. Balance sheet strength is critical and you should focus on value.
A portfolio positioned for capital preservation requires allocations to other assets. Bonds of the highest quality do not yield much but they offer good diversification. In the current environment, risks to the economy are all on the downside and highest quality bonds will improve in price if the deflation threat increases. The global economy is depressed, operating far below potential and choking on excess savings. These savings must find a home. Sovereign bond issuance, on the whole, will be absorbed. Individual countries may have a problem but not the world as a whole.
In keeping with heightened risk aversion and wealth preservation, investors should hold above average liquidity, either in cash, near cash or liquid funds that are either market neutral or negatively correlated with risk assets.
The currency of choice remains a complex issue in todayās highly unbalanced and fragile world. The big fourāU.S. dollar, yen, euro and sterling are all a dogās breakfast and, hence, deciding on which is like choosing the best looking horse in the glue factory. The saving grace is that they canāt all sustain devaluations. The euro, for example, seems to have found a recent limit at U.S. $1.20 and has rallied strongly. The best approach is to have a balanced portfolio of all four and rebalance when one or more becomes too cheap or too dear. For those with more flexibility, we continue to favour the currencies of those countries which are financially strong, resource based and have low inflation. These would include the Canadian & Australian dollars and Norwegian kroner.
Gold deserves a place in most portfolios as insurance against ultimate monetary debauchery. This will occur if governments are unable to get their fiscal houses in order but it is still a distant threat. For many, living in countries with suspect banking systems or governments financially too weak to bail out banks in the event of another financial meltdown, gold provides protection. This assumes, of course, that desperate governments donāt try to confiscate it.
Gold has an evidence-based track record of protecting wealth for thousands of years. Ask almost anyone if they would rather have a hundred dollar bill or a hundred dollars worth of gold coins and you will get the answer as to how deep the psychological attachment to gold is. At present, gold has other positives going for it. In a world of near-zero short-term interest rates, the cost of carry (opportunity cost) is negligible. It has a nicely rising trend behind it, which is
attractive to the herd. Production appears to have peaked (āpeak goldā) and demand in emerging market countries is strong. And, very importantly, it has been negatively correlated with risk assets during each crisis spasm in recent years.
However, all of this is well known, triggering massive financial demand, which could increase with more fear; or, it could reverse if fear subsides and the trend reverses. In other words, gold has lots of risk now. The quadrupling in price in ten years has made gold expensive to everything else and expensive insurance.
In short term, it looks toppy and the next run may have to wait for another crisis. In the meantime, it could correct further.
Copyright (c) Boeckh Investment Letter
