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 March 2008 Act Accordingly
It's time to realize these realities and act accordingly regardless of the official state of the economy. Those that do will benefit the most when conditions turn more favorable. So how do you do that? The first thing to acknowledge is that what's been working in the past isn't anymore -- and probably won't again for quite awhile. Buying on the dips hasn't worked for months. Cyclical stocks can't pick up any momentum, and financials' problems are well documented. Materials and energy have held up better, but who doesn't know that? At some point there's no one left to buy so these shares will also peak -- maybe even sooner than than you think.
Consumer staples and utilities are must-have products. It doesn't matter if the economy is headed up or down, you need toothpaste, toilet paper, and electricity in any part of the cycle. These shares tend to hold up better in a recession. This one is no exception. But those are investments to hold through the depths, and unless we're headed for a "lost decade" like Japan's 1990s, they're not where you want to be positioned for the long-term. On the other hand, it's too early to jump into the most beaten down areas. Financials will probably experience a tremendous recovery, but not immediately. So what do you do now?
Too Late and Too Early Crude oil prices started March hitting new all-time highs -- both inflation-adjusted as well as nominal. Interestingly, this runup really wasn't spurred by supply or demand, but rather by speculation. U.S. stockpiles are near their highs and industrial production is declining. Neither is driving the price. Investors, led by hedge funds, are instead seeking an alternative to equities. Low domestic interest rates are weighing to the dollar, driving it down versus its international counterparts. Crude oil is priced in dollars, so the commodity is viewed as an effective hedge against currency. This is where the demand for crude futures is coming from, even if it's not matched by the demand for oil itself. Arguably, it will take some time before the underlying demand for the oil brings it back in line with the current price. If that's so, there's little for investors to gain from buying now. Unless you're willing to buy overpriced shares now in the hope of selling them at an even more overpriced level later, energy isn't what you should be considering. Other commodities and materials have done well as well. Silver, copper, and other industrial commodities have been in demand in rapidly developing countries around the world. This has given emerging markets a major boost and will continue to do so as long as demand for finished products remains strong. That, however, hinges on a different issue.
Time to Come Home Until this year, a healthy foreign allocation has helped U.S. investors. The top performing domestic equity funds have been those with significant foreign exposure. As the year started, it looked like this would be a winning formula again in 2008.
But things seem to be changing. Foreign equities haven't started so hot this year. Could this be the effect slowing U.S. growth? Many finished products are sold in the U.S. With domestic consumers becoming more cautious, these sales are beginning to slow. Demand for industrial commodities stands to decline as well. Of course there are those who argue the weak dollar will continue to enhance foreign returns. Any profit earned overseas increases when it's converted back into weaker dollars. The U.S. central bank has aggressively lowered rates in an effort to jump start the economy, but its foreign counterparts haven't responded in kind. The European central bank still fears inflation more than recession and has been stubbornly holding the line. The Bank of England and the Canadian central banks have lowered rates, but not anywhere near the extent of the Fed. Other rates, (e.g. Australia and New Zealand) have held at relatively high levels. Australia even raised rates in the first week of March. While this has disparity has favored foreign investment, it too may be poised to change. Again, a lot depends on the U.S. consumer. Reduced exports to the U.S. could easily slow foreign economies as well. If so, the differential between the dollar and foreign currencies would likely reverse. The time for betting on the exchange rate has passed.
It's Not Bonds But now the question becomes how much lower rates can go? The Fed has aggressively eased, but there's less and less room to maneuver. The fixed income market is already pricing additional reductions, so even if they occur, there's precious little appreciation left for new investors. Longer-term bonds that have remained stubbornly high, may offer greater potential, but not as long as inflation remains a real threat. Instead, their yields will remain elevated to protect investors against inflation's corrosive effect. Longer-term bonds may offer some appreciation potential down the line, but that's only if inflation doesn't get out of hand. Right now, that's a big "if" because indicators are suggesting inflation is anything but contained. Not only are the PPI and CPI on the rise, so is the Fed's favorite measure, the Personal Consumption Expenditure Index. If inflation remains a threat, the Fed will eventually have to reverse course and push rates higher. When that happens, long rates will remain steady if not increase, sending prices down. Against this backdrop, cash is arguably the best fixed income alternative. Yes, money market and T-bill rates are remarkably low, but at least they're safe without the exposure to capital losses. In the short-term, safety trumps yield. There is one sector which welcomes the newly steepened yield curve: financials. Banks and other financial institutions base their profits on the ability to access deposits at low short-term rates while lending at longer, higher ones. Up until September when the Fed finally started cutting short-term rates, there was no spread for them to work with; the yield curve was essentially flat. Now, with the Fed aggressively lowering rates at the short end while inflation keeps longer-term yields considerably higher, the spread has once again moved in their favor.
You really haven't seen much benefit from this yet, but eventually a steeper yield curve will be one of the catalysts for banks' recovery. Once the subprime chargeoffs subside, the wide spread will again become a source of profits.
More Shoes Than an Octopus "Catching a falling knife," is an often used description -- and probably an accurate one -- for investing in financial stocks under the current market conditions. Yes, they'll recover, but it's also a question of when. Right now it appears to be later rather than sooner. Ever since the subprime crisis came to a head last autumn, the financial sector has had a series of false hopes and false starts. Whenever it seemed that the worst was over, there was always another shoe left to drop. How many remain is anybody's guess. So far there's been more than could satisfy even the most well shodden octopus. Even so, there are a few things to keep an eye on. First, with so many financial firms struggling under the weight of subprime loans and with so many chargeoffs already announced, the Street has grown somewhat immune to further announcements. In other words, write-downs have become such a common occurrence, financials won't face the same penalties they would have just a few months ago. As a result, there's more of an incentive to write off the bad loans plus the kitchen sink. Which leads to the second thing to watch: Many of the writeoffs that have and will occur are simply paper losses rather than actual realized losses. That means much of their value can be recouped when market conditions improve. Indeed, this is the reason many financial institutions resisted negative announcements, believing they would never actually occur. Now that they've finally stepped forward to write them off, they may ultimately report offsetting gains. Wherever they come from, future profits will drive share prices higher. Third, while financials represent roughly 20% of the S&P 500, they play a disproportionate role in the economy. Besides serving as the basis for their own sector's value, they also act as financiers for the entire economy. Although businesses in other sectors such as healthcare and technology have little if any exposure to subprime loans, they still rely upon financing for their businesses. As long as lending institutions struggle, this essential pipeline will remain seriously constricted. It's not until financials can regain their footing that the overall economy will as well. If you only watch one indicator, this is the one to choose. Here and Now
At some point, you'll want to rebalance back to your target percentages. There's no rush -- particularly back into financials -- but now's the time to get your shopping list in order. If you know what you'll eventually want to own, you'll be better enabled to move quickly if you take the time now to create your shopping list. A large portion of a bull market's gains come in it's first few days and weeks. If you know what you want to own and can move quickly, you'll be able to participate in these early gains. And that's another reason to keep a cash reserve, regardless of current yields. Cash on hand provides the flexibility to jump back in when the opportunity arises. But again, there's no reason to be in a hurry. Now more than ever, there's no difference between being early and being wrong. This is particularly true in a volatile market. While this is a great time to start thinking about what you want to buy, there's no rush to actually buy it. Over the short-term healthcare stocks should hold up well. They're fairly insulated from subprime loans and produce those necessary products in any economy. Trading at some of their lowest P/Es in over a decade, they stand to benefit in almost any environment. Longer term, tech stocks should also fare well. Many businesses have deferred upgrading their hardware and software as they've cut corners in their budgets. As the latest versions of Windows and Office get their first updates, more and more businesses will feel it's safe to take the plunge. Data storage and virtualization have also experienced rising demand, so firms in those areas can expect rising revenues and share prices. As suggested above, financials may offer the greatest appreciation potential if for no other reason that because they've fallen so far so fast. But at best, they're longer-term plays. They won't reassert their market leadership until there's clear and tangible evidence that the subprime crisis has truly been put to rest. That's at least a year off. Smart investors realize these things and will adjust their thinking accordingly. This year doesn't promise to be one of the market's best, but it could be paving the way for a great 2009. Investors should stop believing the past two months' turbulence is just a speed bump along the way to another double-digit annual gain and start thinking ahead to how they want to position their portfolios for the months and years ahead. This doesn't change if the U.S. economy's in a recession or not. Semantics don't matter, profits do. Investors who realize this and act on it will be the ones who will flourish in the coming 12 months. Search this site! Just enter you key word or words:
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HETHER OR NOT THE U.S. economy has entered recession, it sure feels like it has. Corporate earnings have fallen off, the dollar is down, and so are stocks. It will take months for the government to determine if this is a textbook "recession", but savvy investors need to act like it is.
