Moving in Circles
by Paul J Nolte CFA, Dearborn Partners. March 27, 2008
The markets have been doing the Texas two-step for the past couple of weeks – having moved in circles around the same point for the past two plus months. At the center of the circle is a raging "debate" – are we in a recession, and what are the implications of the slowdown in the real estate markets? Depending upon the day of the week and the economic release, the markets either soar or collapse. The hand wringing about what to do, what can be done and where will we be in a year immediately follows centering on either a bombed out shell of an economy or a touch and go to newly growing economy. While we don't subscribe to either extreme, it is that tug of war going on in the financial markets daily that will eventually point the way to the end game. So what do we believe? First, we are in a recession that likely started in either December or January. Second, the financial markets, due to the dislocation within the financial world are not acting in a "normal" fashion. And third, like gall stones, this too shall pass – with some pain (even with a healthy dose of drugs).
Add the Fed to things that shouldn't be discussed in polite company as everyone has an opinion and they tend to be polar opposites. Some say the Fed is doing the right thing by being as aggressive as they are in providing liquidity to the markets and making the bold step of stepping into the Bear Stearns/JPMorgan "buyout." Others are claiming either the Fed is behind the curve (too slow to react) or that the stepping into the BSC/JPM situation was well beyond their edict. So today, we see that there will be a Senate Finance & Banking committee to look into the deal. To be fair, the Fed only has a few weapons in their arsenal and they have used nearly all of them to the maximum amount possible. Without camping out in a bank and forcing them to make a loan, the monetary system has grinded to a halt. Merger volume has fallen off a cliff – and those deals that have been announced are getting reviewed or scuttled. The short-term commercial paper market is in disrepair and the mortgage market has slowed. The major question that will not likely be answered soon is that if something needs to be done, what is it and is it being done just to do something. The Fed is in a box, the government is in a box and the consumer is being boxed.
So the million dollar question is, as always, what to do in today's environment? What makes it a tougher question than just buying gold/oil or wheat is looking at how the performance between various asset classes act and react to each other over time. The diversification "requirement" to smooth performance of portfolios is very important, however we put a wrinkle into the standard "toss something in each bucket" by rotating between various asset classes as their performance dominates the other asset classes. What we are finding today is truly an anomaly in the markets – our top two asset classes are fixed income and commodities. The correlations between the commodities and bonds have been declining over the past 20 years, as bonds have generally rallied and commodities have generally declined. But if we look at the relationship between any of the usually low correlation asset classes stocks, bonds, commodities, real estate, international or emerging markets, the correlations have been rising over the past six years to levels that are historically high (maybe low in absolute terms, but high compared to historical norms). What does that mean? Quite simply it means that spreading your money into various asset classes does not provide the diversification that it once did – look no further than big market moves over the past couple of years. What makes the analysis interesting is that the ONLY asset class that has generally been moving down and in many cases negatively correlated is bonds.
If we look at the two best asset classes and ASSUME one of them is correct (rising), then which one is it and why? Our off the cuff answer is that bonds are likely the correct answer and commodities are likely to begin a bear market sometime this year. Before you shoot off a nasty-gram, here is the logic – as warped as many may believe: Commodities have been on a bull run since mid-2001 and have more than doubled over that period of time.
While interest rates are low (and likely to go lower as the Fed continues to try to inject liquidity), there is a general belief that the Fed will still be in the interest rate cutting mode for the remainder of the year, providing positive returns to bond investors. The argument for the commodity market centers on the burgeoning economies of India and China and the huge growth potential in those two populous countries. While a valid argument, as we saw with technology stocks and real estate just in the past 10 years, not everything will continue as it has been forever. If, as the economic bears project, the US is entering a prolonged contraction, it will not happen in a vacuum. It is our belief that the US will be spending less in the future on everything from oil to housing to education. In fact, we may be revisiting the tried and true methods of the past – borrow only to buy your first home (and putting 10-20% down), put away 10% and live on the rest. Charge cards are meant for emergencies only and there better be cash in the account to back it up. The US consumer will be "getting small" and that long-term "fact" will also change the dynamics of the commodity markets.
There are changes afoot – the recession is here and we will continue to hear bad economic news because we are IN a recession. The bull market in commodities has been running for seven years due in large part to the booming global economies that are in the early stages of contraction. The US stock markets remain expensive as compared to their historical norms or global markets. What changes are on the horizon? We believe a still lower interest rate environment as consumers "get small," cutting back on their drunken spending habits of the past 15+ years.
The Dow ended lower today dropping 120.40 points to close at 12302.46, the S&P 500 dropped 15.37 closing at 1325.76, and the Nasdaq also lost today, down 43.53 with a close of 2280.83. Crude, on the other hand, was up 1.68 to close at 107.58, while gold lost 6.36 to at 947.80.
© 2006 Paul Nolte