Last week, the investment team met to discuss whether the events of the past few weeks, namely an important election, an announcement of additional quantitative easing by the Fed, and the recent close of the S&P 500 Index above its April high, means that we should change our investment stance. There has clearly been a change in the leading indexes that are so important in forecasting the economy's direction. Market-based indices like copper, broad-based commodities, and the Baltic Dry Index, as well as the Conference Board, ECRI, and the OECD, have all shown significant improvement. The stock market has reacted positively to the change in Fed policy from discussions about removing stimulus earlier this year, to keeping the current stimulus this summer, to the latest announcement that they are adding $600 billion of new stimulus. Key interest rate spreads that are early warning indicators of systematic market risk seem to be subdued, with the exception of the recent blow-out in PIIGS bond spreads. We are now into the 7th consecutive quarter of above-expected earnings growth where estimates have gone vertical for 2010 and estimates for 2011 are still staying steady at about $95 for the S&P 500. At an S&P price of 1,200 the P/E ratio for the market based on 2011 estimates is only 12.6 times earnings, hardly expensive in a zero interest rate environment.
There is a well-documented bearish case to be made, which we have explored in depth in this blog as well as our quarterly market reviews. The longer-term structural problems with the U.S. economy, and consequently the global economy, are frightening. But the shorter-term questions about the durability of the latest growth cycle remain in doubt as well. There seems to be little doubt that with the Republicans in control of the House of Representatives, investors shouldn’t count on fiscal stimulus to help the market going forward. And now that the Fed has committed to adding $600 billion to their balance sheet, there seems to be little chance of more monetary stimulus in the near future. So the question is where is the organic growth in the economy going to come from? The most popular answer seems to be that growth in the emerging markets will rescue the developed world from a dangerously slow growth scenario. Or perhaps the Fed’s prescription of zero interest rates and quantitative easing will do the trick. I remain a skeptic on both counts.
For now the team agrees that a minimum of benchmark levels of risk are appropriate across all of our investment policies, with the possibility that we could be more aggressive in our DA and DUA policies. The problem is that we are “running a little cool” in terms of risk assets at a time when the market looks very overbought on short-term sentiment measures. In short, investors are too bullish at the moment for us to feel comfortable adding to risk right now. The plan is to buy the dips, if we can get one or two before year-end. The tactics are sound, the plan seems to make sense, and we have high conviction in our assessment of the overbought condition of the market. Now all we need is for the market to cooperate and come back to us. A 5% correction from the recent high takes us right back to the 50-day moving average which is a great place to do a little nibbling. As always, timing is everything.
