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 January 2006 Positive Reality, Negative Perception
From an investor's point of view, 2005 was lackluster at best. Neither the stock nor bond market had a particularly good year. Stocks ended at about the same level they started the year. Bonds were relatively flat, too, but in the face of the Federal Reserve's ongoing tightening, that was actually a small victory. Like consumers, investors weren't overly optimistic but then they weren't overly pessimistic, either. With the bull market moving into its fourth year and the Fed still pushing on interest rates, many had resigned themselves to slower growth, potentially higher inflation, and vapid financial markets. But does this perception fit the facts? With 2005 now in the history books, it really doesn't matter about last year, but it does for the 2006. If the facts don't support current perceptions, there's opportunity for the savvy investor.
Economic Reality On the contrary, the facts at the close of 2005 are quite different:
The last two items are especially noteworthy inasmuch as they come in the wake of the Republican tax cuts that were vilified as polarizing the country into haves and have-nots. Truth be told, tax revenues have actually increased in the years following the tax cuts -- just as proponents said they would. The domestic economy is actually stronger, or at least more resilient, than the numbers indicate. After the tremendous loss of lives and capital resulting from last year's hurricanes, most economic indicators had returned to pre-storm levels by the end of December. An economy teetering on recession could not have done that. With the exception of China and South Korea, economic activity in the U.S. continues to exceed that of our major trading partners. While the Federal Reserve was raising short-term interest rates, other central banks have held steady or even considered slashing rates to stimulate their sluggish economies. This broadening rate differential was enough to spark dollar gains against foreign currencies, surprising most market watchers.
Of course that's not to say it's all good -- it never is. The economy is cyclical in nature and despite the best attempts to smooth its peaks and troughs, it will always remain so. As a result, it's prudent to keep an eye on the horizon for the first signs of change. As we start 2006, there are a number of things to watch; the first being the duration of the current expansion. Both GDP and equities are enjoying their fourth consecutive year of growth. While this isn't unprecedented, the longer it continues, the more likely a pause becomes. That's not to say either will simply die of old age, there's usually a catalyst sparking a reversal. Currently, the most likely is interest rates.
Interest in Rates After thirteen consecutive ¼% increases, the Fed Funds rate now stands at 4¼%, much closer to historical averages. At some point, the Fed will conclude it has reached a "neutral" level and cease the increases. Some Fed watchers think this has already been foreshadowed by the minutes from the December FOMC meeting. The deciding factor will obviously be the Fed's perception of inflationary threats. The entire tightening process was undertaken to bring interest rates back to neutral and minimize the threat of potential inflation. So far it's seemed to work as core inflation has remained under control even as energy prices soared. But long-term interest rates haven't reacted as they normally do when the Fed tightens. Although the Fed only controls interest rates at the short end of the yield curve, long-term rates usually respond in like manner. In fact, they often react to a greater extent than short-term rates. That's because longer-term bonds are much more sensitive to changes in interest rates than are their short-term counterparts. Investors typically demand higher yields for longer maturities to compensate for the extra risk of tying up their cash for longer periods and weathering more market gyrations. So Fed action on short maturities is often magnified in longer ones. That, however, hasn't happened in the current cycle. Back on June 14, 2004, about two weeks before the first rate increase, the Fed Funds rate stood at 1.0%. As of December 31, 2005, it's 4.25%, up 3.25%. That compares with the two-year Treasury Note which has risen by approximately 2.4% over the same period. On the other hand, he ten-year yield has actually fallen by about 0.5%. This has led to a situation typically referred to as an "inverted" yield curve. The yield curve is a simple graph mapping Treasury yields versus maturities. The December 30, 2005 curve is shown in Chart 1 along with the December 31, 2004 version. Because investors normally want higher yields to compensate them for longer term risks, the curve is usually slopes upward toward longer maturities as it did in 2004. But that's certainly not the case now. Instead, the curve is virtually flat. In fact, it inverted on December 27th when the 2-year Note finished the day yielding .01% more than the 10-year Note.
This is the real reason for concern because in the past it has been a warning of troubled times ahead. Over the last 50 years, inverted yield curves have preceded six recessions while only issuing two false alarms. That's why the Dow Jones Industrials and Nasdaq both fell 1.0% on December 27th when the curve first inverted. The predictive power of the inverted yield curve is more than just superstition; the curve's pattern has ties to current and expected economic conditions. While the Federal Reserve controls the short end of the curve, the long end is moved by inflationary expectations. When the curve inverts, it's often signaling that high short-term rates are expected to stifle economic activity which should also lead to lower long-term inflation. (By contrast, when the curve slopes steeply upward, low prevailing interest rates provide ample liquidity for growth while higher long-term rates -- and inflation -- are anticipated as the economy surges forward.) This is a major concern for bond investors and also has implications for equity investors as well as the overall economy.
Different This Time? As Alan Greenspan told Congress, "Many factors can affect the slope of the yield curve, and these factors do not all have the same implications for future output growth." These factors include: •FOREIGN PURCHASES OF U.S. TREASURY BONDS -- In light of the rate differential between U.S. Treasury securities and those of foreign countries, the former have enjoyed considerable demand from overseas which has led to lower yields. A recent study by the Fed concludes foreign buying has probably reduced the yield on the 10-year Treasury Note by ¾% and possibly as much as 1½%. Without this demand, the yield curve would still have a clearly positive slope. •GROWING DEMAND FROM DOMESTIC PENSION PLANS -- As baby boomers near retirement age and as pension rules grow more stringent, plan administrators are finding the need to invest more fully to match maturities with future obligations. As a result, many are turning to the relative safety and predictable income streams of longer-term Treasury securities, again pressuring yields. •THE FED'S SUCCESS IN RESTRAINING INFLATION -- As proxies for long-term inflationary expectations, yields have fallen as investors' confidence in the Fed has risen. Under Chairman Alan Greenspan's leadership, the Fed has come to be perceived (there's that perception thing again) as a steady and reliable force combating inflation. Fed governors are often able to nudge the market through public speeches rather than actual rate-tweaks. As investors' faith in their inflation-fighting ability rises, longer term Treasuries are viewed as less risky resulting in higher prices and lower yields.
The timing and magnitude of the recent yield curve inversion is also questionable. The gap between long and short term rates has been narrowing for quite some time, but it didn't invert until the week between Christmas and New Years when most traders were away from their desks. Thin volume and the dearth of financial news made this a bigger even than in really was. Once again, perception played and important role. As of late December, the two-year Treasury note yield has only been a few hundredths of a percentage above that of the 10-year. No one was really concerned until this happened, but can a few hundredths really make that much difference? Isn't it still more accurate to describe the curve as flat rather than inverted? Over the past few decades, the difference between the long and short end of the yield curve had to be roughly 2% before there were any negative consequences for the economy. False alarms occurred in those instances when it was less than this magnitude. If the Fed really is near the end of the tightening cycle, upward pressure at the short end will relax long before the difference with the long end reaches 2%. Yet even if the inverted yield curve isn't heralding a recession, the effects of higher short-term interest rates shouldn't be overlooked. The place to watch is the the housing market. For months, analysts have warned of a bubble forming in the housing market. Low interest rates have made it possible for consumers to buy larger or newer homes. This increased demand drives up home prices making homeowners feel (there's that perception again) richer and more willing to spend on other items. Others have tapped the rising value of their existing homes to refinance at lower rates or draw out equity for other purposes. Either way, consumers have more cash to spend, fueling the economic upturn. But higher rates threaten to short-circuit this cycle. As mortgage rates rise, home sales are starting to level off and even fall. Slower sales reduce selling prices and curtail rising home equity values. Higher rates also make refinancing less attractive, keeping equity in houses and out of consumers' pockets.
The current economic expansion has been led by the consumer. After taking a brief break in the aftermath of the summer hurricanes, consumer spending again picked up in the final months of 2005. Should the housing market cool, a more frugal consumer will slow spending and the overall economy. If the housing market is truly in a bubble, the consequences could be much worse. Bullish market watchers see an anticipated increase in capital spending as the catalyst for the economy. Up until now, businesses have been content to shore up their balance sheets and build cash reserves. At some point, however, the need to buy new equipment and technology will spur the next wave of capital spending. Many analysts had expected that to occur in 2005, but it didn't. Now they're anticipating it will happen in 2006. Maybe it will and maybe the consumer will pass the economic torch to businesses. The only thing you know for certain is that it hasn't yet happened. Aside from the Federal Reserve staying the course on inflation, the best thing Washington could do would be to extend the President's tax cuts which are slated to phase out through 2009. Part of the reason businesses are reluctant to spend their growing piles of cash is because they're uncertain what the future tax code will affect them. With a greater degree of certainty, they would be willing to make long-term plans including those involving capital spending. Individuals also benefit from lower tax rates because every dollar they don't pay Uncle Sam is a dollar available for investment or spending. As promised, the President's tax cuts were one of the major factors -- if not t the major factor -- in the consumer-led recovery. Making them permanent would help to extend it. For whatever reason, Republicans have failed to trumpet this success. Instead, The Democrats have done a much better job shaping public perception against tax breaks for "The Rich". Rather than attack the country's budget deficit through spending cuts, they'd rather raise taxes and slow the economy. The Democrats are winning the perception battle on this one.
Diversification: A Contrarian Approach The general consensus has the Fed raising short-term rates to 4½% - 5% by mid-year and then moving to neutral. Some pundits even see a rate cut in the second half if the economy falters. Under this scenario, bonds should at least return their coupon and possibly more if a late-year rate cut comes to pass. Most analysts are predicting a late bull market scenario for stocks, with overall returns expected in the mid to upper single-digit range. As was the case last year, large cap stocks are expected to outperform smaller stocks. It didn't happen in 2005, so maybe 2006 will be the charm.
As rates rise and the economy slows, the talking heads are advising a move into defensive sectors such as Consumer Staples and Healthcare. They also expect growth to outperform value in 2006. While these predictions are certainly plausible, there are at least two problems. First, they sounded plausible last year, too, but none of them occurred. Interest rates continued to rise beyond the levels predicted 12 months ago. Long-term rates stayed much lower than expected. Large cap stocks again fell behind small caps although the small cap rally was already long in the tooth at the beginning of 2005. The Energy sector was the biggest winner although almost no one called that in advance. Despite predictions to the contrary, growth didn't beat value. Aside from the fact that a stopped clock is eventually correct twice a day, is there any reason to believe these predictions will be any more accurate in 2006 than they were in 2005? The second problem is the fact that everyone seems willing to agree on the consensus. If everyone's already on board, who's left to buy? Everyone wants to be ahead of the trend, not behind it. When everyone's been of the same opinion in the past, it was always a good time to be a contrarian. Oddly enough, diversification is a contrarian concept as we kick off the New Year. Although no one's certain of the path ahead, almost no one is suggesting investors hedge their bets -- so that's likely to be the best strategy. With the Fed still tightening, you shouldn't run out a load up on bonds, but you shouldn't avoid them, either. If the inverted yield curve is really here for awhile, there's no reason not to consider short-term bonds in the 2-4 year range. Coupons are over 4%, not far from the consensus' expected return for stocks. If you hold on until maturity, you have nothing to lose. Large cap stocks may indeed outperform, and perhaps they should be overweighted, but not at the expense completely avoiding other capitalizations. Mid cap stocks were the actual winners in 2005, outshining both large and small caps. It could happen again in 2006 and there's no reason to completely shun any capitalization segment in favor of another. The same holds for growth and value. Growth may indeed come out ahead, but why make a bet on one style with little else to go on? Pundits like to predict a "stock picker's market". Isn't it always a stock picker's market? Even in the big equity run-up of the 1990s the rising tide still didn't lift all boats. Value stocks clearly trailed while certain sectors (e.g. Utilities) also lagged. Generally the "stock picker's market" description is supposed to apply to a situation where there aren't any definitive trends or leading sectors. Rather than attempting to be a stock picker isn't it more prudent to diversify your portfolio to make sure you have at least some exposure to the top-performing areas of the market? Picking winning stocks might be one way to do it if you're some sort of wizard or just lucky, but wouldn't diversification with exchange traded funds (ETFs) make more sense for those of us with more human abilities? Of course with a diversified portfolio, you give up the chance to hit a homerun with a handful of stocks. On the other hand, you do minimize the risk of one or two bad bets sinking your entire portfolio. Here again it comes down to a simple matter of perception. Search this site! Just enter you key word or words:
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AS 2005 A GOOD YEAR or a bad year? Without a doubt, there were elements of both good (e.g. economic growth, low unemployment, and manageable inflation) and bad (e.g. natural disasters, spiraling energy prices, and the ongoing conflict in Iraq). Sentiment in the U.S. rose and fell with the latest news report or development in Washington. Support for the President declined while the opposition offered no alternative policies.
