Muddling through today's markets

I haven’t posted much on my blog in the last few months. This is in part because I have been busy with other items on my agenda, but also because - frankly - current markets have been very difficult to interpret, and to save readers’ time, I prefer to post when I have greater clarity on issues.

What has made current events difficult to interpret is wave after wave of (mostly) bad news for the US, followed by a market that - on the whole - seems to ignore it and struggle upwards. My own bearish positions have been hurt lately by this action, and it hasn’t been fun, but I continue to believe that they are the right positions for the medium term.

It’s often said that down markets are times for bargain hunting, and so one interpretation of the market’s stubborn refusal to listen to bad news and rise anyway is that every piece of bad news may make investors feel that “the worst is over, so it’s time to jump back in.” Now, bear market rallies are part of most extended bear markets, so this is somewhat to be expected, but to sit and watch all the iceberg tips floating out there while the market is attempting to run full steam ahead seems like risk of - pardon the pun - Titanic proportions.

It has been historically true that the stock market tends to recover before the rest of the economy, and that is because the stock market is a forward-looking mechanism. Other things equal, the best time to own a stock is just before earnings and dividends (if any) begin a sustained rise. A recovering economy is one of those things that should produce a sustained rise in earnings, and should do it broadly across companies and industries. Put together, then, the stock market should rise as the economy bottoms out in the business cycle, and that rise should be sustained as earnings do in fact improve (if earnings don’t improve, there should be more sellers than otherwise, depressing prices).

So the big question is “are we out of the woods yet?” And my answer is “I can’t see how we can get off this easily.” Many financial companies have written down substantial assets, and perhaps they’ve done enough there, but employment figures still look bad, and it looks like we haven’t even begun to see the tsunami (more naval references here, sorry) of foreclosures that are likely to happen as rates reset. Even for those who are not about to lose their homes, the hit to home price equity is going to take a chunk of change out of America’s favorite ATM. Add to this the escalating cost of gasoline and food, which very likely have been pushed to their elastic limits already, and we see a very bleak consumer spending picture, which may make up as much as 2/3 of US GDP.

So, in short, I don’t think we’re anywhere near bottom in the economy as a whole, although the correction in the financials sector may be close.

Now the weak dollar may help some sectors, particularly US services that are exported, and US manufactures (what’s left of them) that cater to export markets. If US automobiles could meet foreign fuel-efficiency standards and design models that cater to foreign tastes, there might be some good opportunities there, but neither of these preconditions appear to have been priorities for Detroit.

My positions in gold companies have been hammered lately, even though I think gold is still a good long term counter to threats of stagflation and increasing political instability across the world. My positions in TIPS have also been hurt, even though they were bought in anticipation of rate cuts and inflation, both of which should have made TIPS a sensible place to store value until some clear bets appear.

What went wrong there? For me, I forgot to consider the tremendous liquidity that must already have been stored there, ready to sell the moment the market appears ready to recover. Thus, the moment that Mr. Market felt optimistic, other mania-inspired traders liquidated positions to reinvest in more risky assets and brought gold and TIPS prices down. For gold positions, this was not such an issue for me, since I had been there for a long time, but for TIPS, this turned out to be a serious oversight that I will strive not to repeat. The Fed may be taking a pause in rate cuts for a while, but that inflation component is still likely to kick in... except for the fact that the drop in home prices may be making the TIPS inflation indices understate the actual rates of inflation that ordinary consumers feel in their pocketbook.

So the best strategies at the moment may be relative strategies combined with a bearish or market neutral equity exposure. The differentiator in performance is still likely to be the degree to which a company’s returns depend on the US consumer vs. exports.