Up, Up, and Away

March 17, 2012

So much for Greece and Europe’s imminent collapse. And inflation. And Mideast tensions. And banks having a Lehman 2.0 moment. And the housing mess. And the double-dip recession. And bankrupt states. And massive federal government indebtedness growing in an unending attempt to fix all of the above. 

Wall Street has a way of swinging from irrational fear to exuberance based on marginal changes in the underlying economy. With the news of the Dow back to its pre-Lehman high (but still off its all-time highs) and the Nasdaq back above 3,000 (but well below 5,000), you wonder if the only money to be made will be from trading on the exuberance and fear swings.

Fundamentally, stocks are good as long as we don’t have a major crisis on our hands. In fact, stocks are good for even a few mild, garden-variety crises. The yield on the S&P 500 is hanging in there at about 2%, thanks to some rising dividends to offset the rising stock market – most recently on the beleaguered bank front. Still , a low tax (for now) 2% yield is hard to come by in the world of income-producing investments, especially one that generally grows over time. P/E ratios are not astronomical at 16 times earnings, but future earnings growth may be a little sluggish as we near all-time high profit margins for corporate America. Revenue growth may also be tough.

I don’t want to underestimate the potential for the next pullback to be a doozy. The sum of all fears to investors may be a bad recession starting when we're already running deficits, near-zero interest rates, temporary tax cuts, and mortgage support programs, etc. to boost a troubled economy. It would be nice if the Fed would raise rates and the government would raise taxes, if only to give us some wiggle room. That way, if the next ball does drop, at least we wouldn't panic, because “Well, they can always lower rates and taxes again…” 

What about fund investors, our favorite barometer of what not to do? Recent stock market upward mobility hasn’t attracted many individual investors. At this point, the real action is in ETF and related exchange-traded products. 

Last year, ETFs brought in about $100 billion in new money, with about a 60/40 split to stocks and bonds. Open-end (traditional) mutual funds like those in your 401(k), lost about $130 billion in stock fund assets, and gained nearly as much in bond funds. The $30 billion or so that went into increasingly popular balanced funds that own stocks and bonds was the only net new money. Considering that ETF assets are not all individual investors, and much of it is just trading action that was going into stocks years ago, this is hardly a big move into stock funds. 

All in all, stock funds lost money in 2011, Year Three of a decent bull market that has seen stocks double. Recall that in the late 1990s and early 2000, $20 billion a month was going into stock funds ($10 billion into Janus alone). For 2012, outflows of U.S. stock funds more or less match inflows to ETF stock funds. The real area of stupid concern remains commodity funds, which are bringing in far more than they should be ($5 billion in 2012 so far,) considering that one class represents the earnings power of corporate America while the other is a mere ingredient of an economy. These ill-fated hard asset funds (and I use the term "asset" loosely) contain about 10% of all ETF assets.

And herein lies the most attractive aspect of the stock market: lack of mass popularity, at least for now. 

What will be the next problem? We tend to think it's the problems you least expect that lead to more-than-expected losses. No one saw tech collapsing in 2000, or homes sliding 25-50% across the nation in 2005. Everyone sees Europe coming, so it won’t cause a 50% slide in stocks. Our next crash may be emerging market growth hitting a wall and taking down all related parties investing in formerly hot markets. This could be one market (China) or all of them. 

We could see commodities slide 25-50% across the board as production growth eclipses demand, which in turn could take down entire hot economies built on resource development, even the likes of Canada. Perhaps commodity ETFs will be at the center of this problem. The next crisis may be only a moderate issue (10-25% slide) for the U.S. market, but far worse for the countries that are more directly involved. We’re sort of itching to get back into emerging markets on the cheap, so let the chips fall where they may.

We just hit the three-year anniversary of the post-financial crash bottom on March 9th 2009. (We increased our stock allocation at the end of February in 2009, but didn't keep it elevated long enough to catch the doubling of stocks over the past three years).

We increased our stock allocation slightly in September 2011. We may cut back soon, but we’d like to see bonds retreat a little. In general, there are plenty of investors sick and tired of 0% returns that don’t need much more reason than news of great returns over the last three years in order to jump back in. This is a reason for us to mostly stay in while the shift is taking place, but consider cutting back once stocks join bonds and cash at being overpriced.

Bottom line? This is a market to be allocated to, but not over-allocated to. Another 1,000- 2,000 or so on the Dow, depending on how soon it happens, and it'll be time to under-allocate to stocks again and wait for the next shoe to drop.