A Distilled Markets and Macroeconomic Letter: March 2007
Stocks - Short Term - High Risk - Positive Mode in Question
With the large sell off in world markets the positive trend is now in question. The VIX (the “fear gauge”) has spiked up to 15.42 (2/28/07), which is ~50% higher than it was on 2/26/07. While this is a relatively big move there still seems to be little fear in the markets. On a valuation basis, I believe that the market is expensive. The housing downturn may be an instigating factor putting pressure on stocks worldwide.
Stocks - Medium Term - Elevated Risk
I believe that the risk is the market averages may have quite low returns for some time or potentially flat/negative returns when inflation is taken into account.
Bonds - Inverted yields pointing towards recession?
Yields are down a bit and the yield curve is still inverted. In the short run bonds may rise in price with a slowing economy but the longer-term bonds (5 year and longer) may eventually fall significantly.
The story here is that gold took a beating along with most asset classes rather than moving in the opposite direction. It may eventually return to it’s longer term negative correlation to stocks.
Oil - Probably Stays High Unless...
Oil fell to $50 during the past month and is now back to $61.60. Factors for increased price near-term: terrorism, war, or other supply disruptions. Factors for a reduced price near-term: an economic slowdown, less terrorism, Middle East Peace.
Subprime loans are in meltdown mode and the distress may spill over to other securities. Durable goods off twice what was expected. New car sales are still off. Consumers are loaded with debt.
I was wrong last month and the USD’s chart looks bad (stockcharts.com ticker: $USD). I feel that dollar based assets may be at risk in general, both near and longer term. There is a possibility for a short term rally but I now doubt it will happen.
Fed Funds still at 5.25%. Bernanke says everything is OK. Greenspan warns that risk is high. Which do you believe? More below.
Former Fed Chairman Greenspan made some interesting comments on Monday 2/26. Most market watchers have keyed in on his comment that there may be a US recession at the end of 2007. This is what I found most interesting:
“We have extraordinarily low risk premiums now. Risk is no longer perceived as major risk, at least as it was in years past and that, I must say, I find disturbing,” he said. “We do not and cannot look into history without being very concerned when you see the absence of awareness and concern about risk that we see today.” (The Wall Street Journal - My emphasis added - EH)
My translation: He’s worried about inflated prices and in the past comparable factors led to major pullbacks. The last time he made a market comment was his “irrational exuberance” speech in 1996 and he was quite wrong then. In my opinion, this time the markets are at a much higher valuation level and there is much more speculation taking place.
On a technical level, the recent up-trend in US stocks may have been severely weakened by the 2/27 downturn. We will have to wait and see. The 2/28 chart action does not look good. Stocks seem to be rejecting higher prices. Key stocks like GOOG are looking like they might really break down.
I pointed out John Hussman’s commentary last month “that there are some interesting current conditions in the markets that have, in the past, presaged rather ugly declines.” Also see his most recent comments.
Speaking of Hussman, he also wrote recently that peak to trough of bear markets averages about -28%. A -28% drop from the recent highs on the Dow would put it at around 9200. That would be about a 3500 point drop.
I’ve been concerned for some time about the markets but that does not mean that one can’t have exposure to them if it’s done in a prudent fashion. Factors that I look at when constructing portfolios are, risk, risk tolerance, overall allocation, concentrated positions, index like products, over-exposure to certain sectors, lack of diversification, etc.
The yield curve is still inverted. Or, in other words, short duration bonds are higher in price when compared to longer duration bonds. This inversion along with other indicators point to a higher likelihood of a coming recession.
Gold has continued to move higher. If gold now moves lower, I will be concerned that it is pricing in a recession. Gold stocks showing significant volatility.
Reminder: fiat currencies are not tied to anything of tangible value. They are only worth whatever the market, and the public, feels they are worth. As more fiat money is created the value of this paper money should go down. In my opinion, the U.S. is creating too much money and so are China, Japan, and Europe.
Dollar | Currencies
The Dollar has resumed its slide but has not broken down below the key level of 82. Long-term I’m still negative on the Dollar. The real story is the Dollar against gold, where the Dollar has lost a huge amount of value and may lose much more.
On Tuesday 2/27/07 the Yen made a strong move up against the Dollar. If this trend continues the “carry trade” could come to an end, which might not be a good thing for many different markets from equities to derivatives. The carry trade is the borrowing of funds from low interest rate countries to invest in other places where the investor hopes to have a greater return. When these positions are closed, the Yen loans are repaid, which can result in a greater demand for Yen causing its value to increase relative to the Dollar or other currencies.
Oil is at $61.60 (2/28/07). The risk is that oil stays high. If oil prices move downward substantially, they may be pricing in a recession. A major concern with oil is the potential for a wider conflict in the Middle East, which could crimp supply. There are many other potential geopolitical risks to oil as well.
The Fed is in pause mode and it seems that they will stay in pause mode for a while. If housing and the economy slow enough the Fed should start cutting rates again. Richard Russell thinks that there is risk that the Fed will not cut even in the face of a recession in order to support the Dollar.
I feel that the housing picture could become much worse and now, at least in the Subprime market, it seems to be happening.
~ $1 Trillion in mortgages may reset in 2007.
The key chart to reference on housing via the New York Times:
I believe that many consumers have less home equity now than before because they have taken money out of their homes and spent those funds. Consumer savings rates are very low or negative. I believe that consumers are being gradually squeezed by high oil prices on one side and rising interest rates on another.
My concept is to bring you a the most transparent look possible on the economy/markets via a quick read with plain language. This letter is geared toward the busy executive/business owner. If you are really short on time just look at the Snapshot section where I keep everything as brief as possible. In the Detail section I try to give a little more insight into my thinking without delving so deep that I stifle the reader.
When constructing portfolios, I take the client situation into consideration first and then combine that with the current economic/market factors presented in this letter along with well researched asset allocation strategies.
If you have specific questions on where I see things, or would like to discuss your portfolio, please feel free to contact me.
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