In the last edition of Worth Considering I commented on the early strength of corporate earnings. As earnings season rolled on, the majority of reports stayed strong. Granted, the bar was set low, but it was comfortably cleared. It is this concept of a low bar that I want to spend a little time on in this issue.
Markets find their tops when things are going very well and confidence is too high. Expectations get out of hand to the upside, and eventually a high bar can’t be cleared and markets begin to correct. Markets find their bottoms in that mirror image. When expectations are so low and pessimism reigns, things begin to pick up amidst the negativity. Often times it happens with very little fanfare or public awareness. Opinions tend to stay negative long after bottoms are formed. This isn’t only true of individual financial assets or business sectors, but also for an overall national or global economy.
Back in early 2009, the University of Chicago Booth School of Business and the Northwestern University Kellogg School of Business teamed up to create the Financial Trust Index. The latest readings from July 2012 show that just 21% of Americans trust the financial system and only 15% trust the stock market. These dismal numbers clearly form the framework for a low bar of expectations in nearly everything financially related. Can you imagine how these readings would have looked in 1999? The euphoria of that era ushered in unrealistically high expectations and a set of bars no Olympic gold medalist could have cleared.
And can you imagine the upside potential of financial assets when only the clear minority of investors have any real conviction? In simple terms, things fall when everyone already owns them and new buyers become scarce. Likewise, things tend to rise when the masses are still future buyers; not current optimistic owners. Negativity can be an investor’s ally, but it can also be his worst enemy. Of course, the same can be said of unbridled optimism. The optimal investment approach is more objective and balanced with the largest percentage of a portfolio’s assets. There is most likely some room for emotionally charged speculation within an overall portfolio depending on someone’s time horizon and financial wherewithal. But their core capital should take a balanced and disciplined approach to assure a compounding of wealth over time instead of a see-sawing motion that has highs and lows that usually end up showing no real progress as valuable years peel off the calendar. It goes without saying that this also takes a toll on your blood pressure.
When looking at today’s market I continue to be optimistic within reason. I say ‘within reason’ because I don’t believe we’ll see an all-out bull market that moves dramatically higher in the short run. Instead, I continue to believe we’ll grind higher in most assets worldwide in the coming years. With such low bars in so many areas, the long and bumpy path of least resistance is still upward.
One specific area worth noting is the continuation of improving data from the housing market. The bar in this sector has all but hit the floor in recent years. And now we’re seeing signs of life in this crucial segment of our economy. Recent data shows new housing starts rising, inventory shrinking, and values stabilizing as a national average. I don’t think housing prices are set to skyrocket, but the trend lower has clearly stopped and we’ve actually snuck higher consistently for months now. The significance here isn’t in housing prices themselves or owner’s equity; it’s about economic activity and job creation. The housing sector has tentacles throughout the economy, so improvement in this sector is more important than most others. If we continue to see even tepid improvement in the housing sector, the positive ripple effect throughout the economy will likely catch most analysts and investors by surprise.
Leadership Rotation?
The clear leadership group within the markets for a while has been the domestic large caps. Bigger has been much better; and companies paying dividends in excess of the ten year treasury rate have been the particular standouts. But we are starting to now see the beginning signs of possible rotation to mid and small sized companies. This would be a healthy development – a sort of confirmation of the rally we’ve recently seen in the markets. Of course, the US markets have outpaced the international markets given the entanglements in Europe and the slowdown concerns in China. As I’ve commented previously, this too shall pass, and as it does, we’ll see the currently lagging areas begin to catch up and likely exceed other areas. This is also true of the commodity spaces like metals and energy. They have been hit particularly hard in recent quarters and they too are poised to be leaders again in the not too distant future.
While I feel these are great probabilities, I wouldn’t yet suggest taking too much money away from large cap domestic investments in the effort to capitalize on these changing trends. I say that because I believe in staying on a proven course and avoiding the pitfalls of market timing as much as possible. I don’t believe these currently lagging areas beginning to catch up will mean that the past leadership areas do poorly. I continue to hold the belief that we’ll see asset prices in general do well in the coming years and would suggest a balanced approach a little longer until we see these early trends confirmed. If they are confirmed, the best step will be to reduce the more conservative holdings in high quality and/or government bonds and add to equity exposure. This is what I believe investors should be preparing themselves to do, but not actually doing just yet. It is better to first be sure the Europeans continue to come closer to an agreement on their plans and also that we don’t see dangerous rhetoric pick up regarding the fiscal cliff debate here at home.
What’s important from a market perspective is to see this rotation in leadership. Most investors have flocked to the mega-cap dividend paying blue chips solely as a margin of perceived safety rather than a true vote of confidence in the economy. They have begun, in my opinion, to pay too much for a false sense of security. If the global economy really falters, these types of companies are likely to lose less than most others, but they would still lose. On the other hand, if the global economy stays the course of stumbling forward, they have a lesser chance of growing their earnings base and bottom line profitability from current levels. I’ve applauded these CEO’s loudly here before for the way they have guided their companies through such difficult times. But without genuine economic health, they can only do so much. You can only cut overhead so much before there is no additional benefit to streamlining efficiency.
A shift in market leadership would likely be a leading indicator that the global economy is stable, or even improving ever so slightly. If that’s the case, I believe we have several years of expansion ahead; albeit at a slower than historically normal pace. With that said, it would still be an era in which equities outperform virtually all other assets; and there would be plenty of time to increase exposure to growth assets without missing the bulk of the trend or risking substantial capital too soon.
It is clear, therefore, that investors would like to see more money flowing into small and mid-sized companies both here and abroad. If that trend doesn’t continue, I would be afraid to be overly optimistic about the markets moving up much from here. I don’t believe they’d enter a solid downtrend, but they’d likely get stuck in the mud for quite some time. This is why investors still need to be sure their portfolios provide solid income and total return potential and not just the hope of price appreciation alone.
The takeaways:
- As far as the markets and the economy is concerned, this was a good summer. Earnings were solid and expectations are still low, which is a good combination.
- The calm of summer is about to give way to the chaos of the election season. The media will have a series of field days trying to dramatize every potential meaning of any comment made by a candidate. Listen for entertainment if you would like, and certainly educate yourself as much as possible about the reality of what is being said. But do not make serious investment decisions on the headlines alone.
- If market sectors other than domestic mega-caps become leaders, we will likely see the market move comfortably higher. If not, we’re most likely to stand still a while longer.
- This is still a time in the markets where both fear and greed need to take a back seat to sensible balance.
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