July 2010 |
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Since the recent peak set on April 23rd the stock market promptly fell 15% through June. This downdraft has a lot of people concerned. Their concern stems from a generalized anxiety that the nascent US economic recovery is fading just as the government stimulus is tapering off. In our opinion, this anxiety is valid and supports our ongoing investment strategy. In recent weeks, there have been a number of pieces of data that point to a broad slowing of the economy. For example, auto sales in June were down about 5% from May and now rest at the same level posted at the start the year. The latest housing data has been ugly with both new and existing home sales posting disappointing numbers following the expiration of the government tax credits.
Retail sales, after stripping out the most volatile categories, have gone flat since March. This makes sense, given that we haven’t seen much job growth in this recovery. In fact, according to the government's Household Survey conducted each month, after showing some improvement since the start of the year, the number of employed workers in the US fell in both May and June.
To back this up, initial claims for unemployment benefits were also falling to start the year, but in March the four-week average of new claims for benefits started to rise again. The figure now rests at about 450,000 new claims each week and normally you need to post sub-400,000 readings to see some real net job growth.
Further, while the ISM Purchasing Manager’s Survey Indexes for both the manufacturing and the service sector do still indicate economic growth, both ticked down around May/June. We are obviously very interested in watching for turns, or inflection points, in economic data.
Added to the above indications, the yield on 10-year US Treasury's has abruptly fallen from 4% to below 3% just since early April. This is not an inconsequential move in yields. It demonstrates investors' desire for safety and could very well be indicating an oncoming (or a continuation of) recession.
All of these things and more, taken one by one are simply forward-looking economic indicators of how things look in real-time. It’s important to note that the recent performance of the stock market is also one of these indicators.
As much as we like to dismiss the stock market as being all-knowing, its movements often contain actionable information. To consistently and reflexively dismiss other investors as behaving irrationally demonstrates a dangerous level of hubris. Balancing that reflex with the humility to show just a little bit of respect for their opposing views is an important challenge for conscientious investors. We battle this time and time again.
Encapsulating the data points above, there has been a good amount of attention paid to a leading economic indicator called the “ECRI Weekly Leading Economic Indicator”. While the Economic Cycle Research Institute (ECRI) doesn’t publish its proprietary formula to track current changes in economic activity, we're sure that it contains many of the components mentioned earlier and many more. Most importantly, the growth rate in the ECRI's Weekly Leading Economic Indicator has an enviable record in forecasting past recessions.
Today, the growth rate on this index sits at a -8.3%. It has dropped for fourteen straight weeks and has posted a negative reading for the last five weeks. This speed of its decent has caught the attention of knowledgeable investors.
While this index's forecasting record is not perfect, we have never before avoided a recession with recorded readings at these depths. While there may be some technical mathematical peculiarities to contend with as we review this data, this indicator is hard to ignore.
For those interested in reading a good study we found on the track record of this indicator, we've posted it on www.frontstreet.com/ecri.
Putting this all together, we are concerned and we feel justified in our continued conservative positioning for clients' portfolios. In recent weeks, we took our caution to another level and, for all intents and purposes, we've once again completely hedged away our net exposure to the stock market.
Of course, we do own individual stocks with generally defensive and attractive attributes; such as businesses and securities with less economically sensitive revenues and/or provide ample dividend income (telecoms, utilities, consumer staples, commodity pipeline, preferred stocks) as well as businesses that have strong balance sheets and/or strong growth prospects at attractively low prices (mostly various technology companies). Yes, these types of investments are designed to do better in tough markets. But, that relative-value argument rings hollow to us.
It makes sense that no matter how concerned with the big picture at any given moment, we'll always like some stocks. Nonetheless, despite the defensive characteristics of our chosen stocks, we will not delude ourselves into thinking that regardless of the health of the economy or sentiment of the market, our portfolios would avoid sizable losses if left un-hedged against a negative turn for the worse.
If left un-hedged, in a double-dip recession or even with disappointingly slow economic growth, our portfolios would most certainly post losses. Remember, a 15% drop is only half the typical loss for stocks during a recession. Further, in the event of back-to-back recessions - this time with very few policy-bullets left to fire in response - we wonder if it could prove more damaging and lasting, as the fracture in confidence would be hard to heal quickly.
Owning stocks that we think will do relatively better than the market while simultaneously betting against the entire market helps to hedge out the negative consequences of a slowdown. This strikes us as a balanced and prudent policy.
It is important to note that this is simply a strategy driven by the current climate. To varying degrees, we've been operating under this line of thinking for three years now.
A natural secondary benefit is - if our stocks do beat the general market in this cycle – the possibility that we’ll post gains in a tough environment. Obviously, we’ll take this result if it comes to us as it did this past quarter, but it is not the primary focus of the strategy.
As we reach the inflection point between a government-induced recovery and what could be an oncoming recession or slowdown, we believe that our strategy to shield our clients from overall stock market risk and unsettling volatility is the right one.
As Franklin (that’s Aretha, not Benjamin) once said, it is time to show some R.E.S.P.E.C.T. (just a little bit) for the indicators we’re seeing right in front of us.
