As we exit earnings season with a strong cash position, my investment strategy has shifted. I noticed that the market was entering a dumb phase – the Fed rate pause was not really a pause that refreshes. The Dow is where it was pre-earnings: 11,000~11,100.
In the first part of this posting, I will review the fundamentals driving my stock picks. The second installment will be the stock picks themselves.
Let me begin by addressing some curveballs that have altered the investment horizon. There are always some curveballs. In this case, China/India and oil have been the biggest. China/India because they kept inflation down by providing cheap goods & services. That meant US companies got to keep most of the profit. One byproduct was that a wealthier China used up more resources and pushed up commodity prices. And oil costs are higher, which adds a layer of inflation.
I am a believer in the Business Cycle framework of investments. Partly because it follows common sense and the evidence abounds, and partly because money managers follow it – and they drive the stock market.
This framework ties investments in the stock market to capital investments in the macroeconomy. It assumes that there is a fundamental over-investment and under-investment type of fluctuation. For example, a Chinese demand for raw materials coupled with a US construction boom made raw materials scarce. In response to that demand and cheap money, manufacturers invested in steel plants and now steel is in over-supply.
As investors, we should choose a strategy that considers where the over- and under-supplies are occurring. Better still, we want to anticipate.
To keep it simple, here’s a basic approach.
Phase 1: The trough. Declines in inflation, short term interest rates, yields & commodity prices. People aren’t spending and companies aren’t building.
Phase 2: Economy shows signs of strengthening. People start spending and so do companies, and the economy stabilizes. Declines stop in inflation, interest rates, and commodity prices. Stock market begins to grow.
Phase 3: The economy is strong and evidence is clear. Stock market is growing but at a slower rate. Inflation, interest rates and prices are picking up.
Phase 4: The peak. The economy has grown beyond its potential. People aren’t buying at the same pace because they already upgraded their cars, furniture, TVs, etc. The pressure of higher prices drags the economy down. Momentum slows in the rate of increase in inflation, interest rates and prices. Stock market struggles.
Where are we?
The effect of China and cheap money made us rush through Phases 1 & 2. Phase 3 lasted until early this year and we are entering phase 4. I think the past 4 months are signs of the market accepting that transition.
Inflation is starting to slow, as are interest rates. Prices are actually not as clear because of oil.
According to this chart, we are at the economic peak and the Early Bear. We should be in Healthcare and consumer non-cyclicals and getting ready to buy Utilities (because they pay dividends and everyone has to pay their water/gas/electric bills). We should also buy bonds.
We should be far away from
Financials (we shorted CFFN, a bank).
Technology (we shorted Juniper, but went long on TRID, ZRAN)
Capital Goods, Industry (we shorted aluminum)
We should be shifting away from Energy, Precious Metals (we are still long energy services and titanium)
Obviously, this is for basic guidance because real life events alter the results. Take oil as an example. Oil prices drop as demand drops, so you exit energy at the peak of the market. However, energy prices have not and do not look to be dropping for a while. You might also notice that most equity investing takes place after the economy tanks.
From Fidelity:
“Consumer Non-CyclicalsStocks in consumer non-cyclicals (food) and consumer growth industries (cosmetics, tobacco, beverages) tend to experience fairly steady demand and are less sensitive to changes in the business cycle.
HealthcareIn general, stocks in this sector move similarly to consumer non-cyclicals. This sector is considered defensive, meaning companies in this sector are generally unaffected by economic fluctuations. The healthcare industry consists of pharmaceutical firms, HMOs, biotechnology firms and medical equipment suppliers. Pharmaceutical companies are affected by competitive market shares, the pace of FDA approvals, patent lives, and the strength of the R&D pipelines. Many biotechnology firms are still in the development stage with their fortunes largely determined by investor perceptions of the relative merits of their R&D pipelines. With future new financing likely to be more difficult to obtain than in the past, strategic alliances between major drug companies and biotech firms are expected to increase.”
Sure enough, Tobacco stocks like Altria rose, as did GILD, DNA and a few other healthcare stocks.
Until a few months ago, picking the right investment was as simple as finding companies that were set to outperform expectations and watching the market reward the results. Today, the market seems to be largely anticipating a slowdown and moving defensively, regardless of actual corporate performance. That is a sign of being in that early bull phase.
We also turned mostly defensive (cash and puts). The puts I selected on housing and cyclicals may have been a tad premature. For some reason furniture and dishwashers are still expected to sell well despite a rapid decline in housing. I don’t think so, and we have a few months for my view to play out.
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About 9 months ago, I believed that we were somewhere in the middle to late bull. I stated my fundamental premise: the economy was still growing strongly and that oil was the only spoiler. I believed that oil would moderate somewhat. I was almost correct: the economy grew at 5%+ in the first quarter and almost 3% in the second quarter. I was wrong about oil.
Oil has turned instead into a big economic distraction. It is taking away from consumer spending directly and indirectly (prices are rising). Until now, oil has yet to show signs of eroding corporate profits directly (outside of transportation) but it will start very soon. Manufacturers are starting to struggle in the face of higher energy and commodity costs. The weak dollar isn’t helping: it drives up the prices of oil and commodities.
We are in the late stages of the recovery and that puts us in the early bear cycle. That transition is evidenced by the data. Everyday there seems to be both a positive data point followed by a negative data point. The economy is strong, but unemployment is inching up. Inventories are up but consumer spending is up more than expected.
Stripped to the basics, I see a few fundamental conditions
Liquidity is being drained (but not as much as you think). Liquidity is the availability of money. From 2001-2003, interest rates were dropped low and made borrowing super cheap. That spurred the economy and led to asset price inflation (houses in particular). As interest rates rise, the opposite is happening – the economy slows and asset values drop. However – and this is key – the actual liquidity remains somewhat high.
In 2000, interest rates were ~7%, inflation (CPI) was around 3.5% - the delta being 3.5%
In 2003, interest rates were ~2%, inflation was 2% - the delta being 0%. Borrowing cost nothing in real interest terms.
Today, inflation (CPI) is at 4.2% and interest rates are at 5.25%. The delta being 1%.
In effect – real interest rates are 1% and money is again practically free relative to inflation. This partly explains to me why consumers are still spending.
Now, here’s the kicker. What if inflation is actually slowing? In that case, the gap between interest rate and inflation is growing. Which will lead to a liquidity drain.
But what if oil continues to boost inflation rates above even a flexible Fed target. The Fed likes to look at core CPI – a metric which excludes food and oil from inflation. But even core CPI is growing at ~4% annualized because oil affects the prices of everything. In that case, more interest rate hikes.
The Fed wants a soft landing (aka managed interest rate hikes). I think the Fed paused because it believes that the business cycle has peaked. That is, any additional rate hikes will slow the economy even further, and maybe too much. If I’m correct, then inflation figures become critical for the Fed. I think that the Fed has plenty of room to move – rates are not very high in real or nominal terms. Also, the Fed can drop rates when they want. However, skip the will-he-or-won’t-he talk and get to the bottom line - the Fed is saying the economy is slowing.
Housing market is slowing fast. History will pick over the bones of the housing boom and bust and pass judgment over the whys and wherefores. Suffice it to say that there was a housing boom. With that boom came an echo of other booms. Consumer durables to outfit the house (furniture, dishwashers, etc). This is a very pertinent quote from last week by the chairman of Toll Brothers, the largest home builder in the US
“It appears that the current housing slowdown ... is somewhat unique: It is the first downturn in the 40 years since we entered the business that was not precipitated by high interest rates, a weak economy, job losses or other macroeconomic factors,” he said in a statement.
Housing is also falling faster than expected. (Again, I won’t go into why the market for houses is falling because I think it is all explained by cheap money/asset price inflation.)
We are witnessing drops in housing prices across the country. At the same time, the cost of re-financing ARMs is rising.
A few months ago I minimized the blowback on consumer spending because I saw a stronger economy able to absorb the hits. I no longer believe that. Consumer spending will follow the housing market down.
However, I think that the upcoming holiday season will hide and delay the impact. One last hurrah, so to speak.
Strength of world economy – I think the economy around the world will get hit as the US economy slows. China and India are still building their own economic infrastructure and Japan seems to be emerging, but their economies are affected by ours. A slowdown in our economy hits the stockmarket in 3 ways:
Corporate earnings begin to drop – the value of our stocks begin to go down
Countries withdraw investments from the US because of falling values and because their economies are getting hit
Bonds look more valuable relative to equities.
So where does that bring us?
The economy is slowing but degree and rate of slowdown are open to question. Inflation may be growing thanks to oil. Attempts to manage inflation via steeper interest rates could cause a deeper than desired recession.
While the economy slows, a housing slowdown could deepen it.
In the midst of this, I am selecting investments carefully. I am interested in three kinds of investments
Defensive – dividend paying stocks (especially utilities) or the healthcare/non-cyclicals
Companies still growing and still beating earnings
Companies falling apart worse than expected – for buying puts
