The combination of (1) slowing economic growth (with the possibility of a hard landing in the real estate market and a significant retrenchment in consumer spending), (2) elevated inflation pressures and (3) stiff monetary headwinds from central bank tightening and U.S. longer-term interest rates moving to their highest levels in four years presents a poor risk/return environment in the stock market and is the reason for our current defensive posture. There are additional reasons to be cautious.
The weakest seasonal period of the year is ahead in September and October, and we are also facing the most vulnerable stock market phase of the presidential cycle in the months preceding the mid-term elections. Despite the stock market’s weakness in May and June, the S&P 500 has yet to experience a 10% correction since the bull market commenced in March 2003. This is the second longest period in history without a 10% correction in the S&P 500.
Finally, as of the writing of this report, the technology sector has moved to a new 52-week low, which is not a good sign for the broader market. Technology is often a good leading indicator for the broader market, so relative weakness in the tech sector is usually a recipe for a weaker overall stock market. We view the downside risk as significantly greater than the upside potential and believe that the odds are high that the market will be lower in the early part of the 4th quarter than it is today.
Our view is that the recent decline is not merely a correction in an ongoing bull market, but rather the first leg down in a deeper downturn, which may turn out to be a cyclical bear market, whose eventual bottom will not be seen until later this year or in 2007. We view the downside risk in stocks as significantly greater than the upside potential. For the S&P 500, which is currently trading at 1260, the reward over the coming months is likely limited to 1300, while the risk extends down to 1150, with the possibility of a deeper decline if housing experiences a hard landing and recession looms in 2007. The downside risk in foreign and emerging markets stocks (the latter asset class already had a badly needed correction of excesses in May/June) is likely on par with the S&P 500, while small-caps are vulnerable to a larger decline because of their relatively high valuations.
As a result of the above, our portfolios are now the most conservative they have been since early 2003. There are few asset classes that stand out as being cheap or offering a lot of protection, so we have built our liquidity levels (defined as the sum of money markets plus short-term Treasury bond allocations) to 37% in our moderate growth portfolio. Cash is in a bull market with money market yields at their highest levels in over five years. Our objective in building these reserves is to defend bull market gains and to have the ability to take advantage of better buying opportunities that we believe will develop in the future.