*Strategy update: Downgrading financials, other changes and why they have been made.
*July 1, 2007
June was a difficult month for stocks and bonds. We expect this 2007 summer rocky period to extend into the autumn or longer. We have moved our stance to a more cautious strategy. We have raised some additional cash. We have altered our sector allocation. Details follow.
Stock markets in the United States performed poorly in June. Treasury bond interest rates moved into the 5%-handle zone from the 4%-handle level. Credit spreads have started to widen. Similar observations can be made about much of the rest of the world.
In addition, the 10 major central banks in the world with floating rate currencies are either raising rates or have an anti-inflation tightening bias. 5 of the 10 have raised rates in the last month. Seven of them have raised rates this year. Canada has now turned to a tightening bias and will probably raise rates within a month or two. In addition, we see a gradual move to a tightening policy in the world’s major pegged currency. China is raising rates and worrying about inflation pressures internally.
US stock markets were hit with four blows. First to arrive was the IRS attack on stock buybacks. Secondly, we saw the two-pronged tax attack on private equity.
The third item is the rise in interest rates and the now positively sloped yield curve. This is a significant change and comes with some foreboding. Ned Davis Research has tracked three periods in which the yield curve steepened because the long end rose. He contrasted this with the six periods when the curve steepened because the short end fell. The outcomes are quite different. To quote Ned: “…..a year after steepening caused by rising long-term rates, the S&P 500 has performed worse than the all-period performance in all three cases.” Ned’s date references for the start of the each sample are 9/18/81, 1/26/90 and 2/19/99. Note that the market did go up in these one year periods by an average of 5.4%. But also note that cash outperformed the market in all three cases by a wide margin. So did bonds after a shorter lag. Contrast this with the six periods when steepening occurred because long rates fell. In those times the stock market averaged a 16% gain and the bond market often faltered.
Cheerleaders for the steeper curve vs. inversion may be celebrating too quickly. There is an absolute difference between short rates falling and long rates rising. We have had the latter.
Lastly, we have the signs of sub-prime meltdown. And this time it is not speculative. The news about Bear Stearns infusion of money to save their hedge funds is widely reported. The issue is more complex than this one fund. Bottom line: we have securities carried at book value when the current pricing indicators (ABX) are suggesting they are worth 60 cents on the dollar. We think this is big and that there are many more shoes to drop. We expect to see write downs and earnings restatements in the financial sector. We expect some private funds will become insolvent when their portfolios are marked to the market. We see the risk rising in some of those who are counter-parties in derivative transactions. In sum, we take this deteriorating trend in the financial sector very seriously and have acted accordingly.
We have reduced our exposure to financials to an extreme under weight.
Financials are about 21% of the S&P 500 average. They have contributed largely to the earnings and growth during the four year bull market in US stocks. Now they are heading into troubled waters. The question is not “if?” but “how much?” When a heavy sector gets into trouble it is best to stay away. The outlook for financials now is either flat or down. It seems very unlikely that they (financials) will continue to go up in the face of (1) the yield curve we have just described (2) the two-pronged tax attack outlined above and (3) when serious troubles hit a portion of their assets measuring in 100s of billions.
We rarely go to an extreme under weight in anything. We have done so in the financial sector.
Taking a 21% sector weight so low by definition means underweighting the entire market and that means raising cash. We now have a cash reserve in all US ETF portfolios. On the positive side, we have over weighted the tech sector and we do like the healthcare sector. Both are somewhat insulated from the financial meltdown and both derive substantial earnings from foreign subsidiaries. Both participate in globalized growth. Consistent with the negative view on financials we continue to avoid anything related to the home builders and housing in general. That leads us to also under weight the discretionary side of the US consumer.
The sub-prime issues are starting to show in widening credit spreads.
This is in a very early stage. It is too soon to know if these spreads will become a cont ...
