Thursday, November 3, 2011

Our Latest Assessment...

Yesterday the Investment Team met to discuss the state of the markets. The agenda was ambitious: We needed to assess Europe’s Grand Plan, recent economic data, technical conditions, and what smoke was coming from the independent analysts we follow. Ultimately we had to decide whether or not our allocation was consistent with the weight of the evidence.

Here is a summary of the meeting and our thoughts.

The European Grand Plan

Is the latest European bailout plan a game changer? No. Most of us felt the plan was an improvement over earlier efforts, but all of us agreed that it lacks details and doesn’t appear to be enough to stem the European problems in the long term. Though equity markets have celebrated, we have not seen credit markets confirm, particularly on the European periphery. Whether it can stabilize things in the short term is more questionable, and the surprise referendum was proof of how fragile the situation is. In short, the plan is an improvement over previous offerings, but is not enough to shift our view.

[In the time since our meeting, we’ve seen rumors that the Prime Minister of Greece will be resigning... and then another that he’ll be staying... and still another that the referendum will be scrapped. Stay tuned. There should be two or three more rumors before the day is over.]

Business Cycle Data

The discussion covered three regions of the globe...

United States
We acknowledged that 3rd quarter data was quite a bit stronger than we expected. However, equity markets appear to have already recalibrated expectations of growth back to moderate levels, and the team was uneasy that many leading indicators still point to slower growth ahead, and that the trend of much of the data we follow is still down. We also noted that other parts of the globe are slowing, which will impact the U.S. In our judgment, it’s still worth defending against the risk of anemic growth, or even oncoming recession. However, if the data continues to surprise us on the upside, we may be forced to change our view on the U.S. economy and admit that we missed it on this front.

From a monetary perspective, the team thinks the Federal Reserve is likely to pursue further options if the situation deteriorates. However, after the recent firming in the data and the equity rally, it’s unlikely that the Fed will start a new program in the imminent future. Fiscally, it doesn’t appear that the government will come up with a material program before the election, and the super committee is unlikely to make the kinds of budget cuts necessary to fix long term problems before November 23rd.

[Since our meeting the Fed left rates unchanged and has not started a new quantitative easing program.]

Europe’s economic situation continues to get worse, and the Euro-zone might even be recessing. The economic weakness in Europe will likely flow through the globe and press against the U.S. and Emerging Markets, due to the interconnected nature of the world economy. From a monetary perspective, there’s a good chance that new ECB President, Mario Draghi, will start cutting rates to combat the deteriorating economic situation. While that’s good news, the rate cuts will be reactive, not proactive, and it’s questionable whether cutting from a 1.5% starting point will be enough to keep the European barge from turning in a negative direction.

[Draghi cut rates by 25 bp this morning.]

Chinese data continues to slow, and its prior tightening policy will likely continue to move through the system and inhibit growth. China has shown interbank lending stress and is at risk of a property market slowdown, which creates a layer of system risk in the entire region. The good news is that China has recently stopped tightening and some of the emerging market countries have begun cutting rates, but the effects will take time to work through the system. Part of Asia’s challenge is dealing with a very slow developed world, which will put pressure on exports out of the region.

Technical Conditions

Intermediate technical conditions don’t appear to have turned, but there are definite improvements in the shorter term technical outlook. Given how depressed sentiment got during the latest downturn -- along with the fact that we’re entering a more positive seasonal environment -- most of the Investment Team believes the rally will continue to drift up, perhaps toward the old highs of 1360. Without intermediate measures turning, we have to decide what to do about a short term rally of this nature. The risk to our current outlook is that the money that had been kept on the sidelines is now pouring back into the market, which engenders confidence and brings more investors back into the game. The market is at a crucial point right now: A confirmation or failure could determine the direction the market will take into the year’s end.

Independent Analysis

A number of our independent analysts have gotten more bullish, and while some stay bearish, there are no new bears emerging to confirm our stated view. We don’t rely on any single analyst or view, but the overall tone is getting more positive and we can’t ignore that.

Is the Allocation Consistent with the Current Weight of the Evidence?

None of us are bullish on fundamentals right now, but there has been enough change in technical conditions and analyst opinion to consider whether the allocation is still consistent with the overall weight of the evidence.

Ultimately, the combination of some better-than-expected U.S. data, improving short term technicals, and a change in tone from the independent analysts we follow give us less certainty that the markets will make their way back to levels of 950-1050. Therefore , the allocation needs to reflect this by getting slightly less defensive. In no way are we turning bullish at this time, but we are going to play a bit less defense to acknowledge some of the evidence against our current view.

Magnitude and Tactics

In terms of magnitude, removing our last stop-loss amount (roughly 5% equity) is a reasonable response to the changes. We are currently working out the details of how best to execute our strategy. Stay tuned for details.