When one examines the S&P 2-year chart, one sees the October 3, 2011 trough at 1099 lined up with the significant corrections that bottomed on June 4, 2012 and June 24, 2013. They intersect the 1630 area at which we recently had several touches. August 27 made a 4.67% retracement from 1710, the cyclical bull high hit August 2. May 21 - June 24 was a 5.75% drop. While 55.6% of years since 1950 have corrections of 10-20%, with a -14.4% average, 35.5% of those years sufficed with a 5-10% drop. We have had two of them: perhaps they will suffice and the markets push through 1710 toward 1800 by year's end. The 51 points added since August 29 is a sharp 3.02% rise in eight trading days.
Momentum, animal spirits and talking points are strong. While biking at the gym September 9, a major network ticker stated "2014 economy will be strong with low inflation and improving employment figures." That's great: perhaps problems are dissipating and can be finessed. But unease lingers from two sources: 1) bad economic basics like falling workforce participation and hours worked, rising yields and crashing mortgage applications and real inflation 6-10%. 2) More disturbing still is mainstream refusal to acknowledge problems, to spin them away. That may be lethal. It is a grating roar beneath gleaming narratives.
In 1851, Matthew Arnold wrote "Dover Beach" whose haunting verses on the gulf between enchanting appearances and life's harsh facts preview our era's discords.
The sea is calm tonight,
The tide is full, the moon lies fair
Upon the straits… the cliffs of England stand,
Glimmering and vast, out in the tranquil bay.
Come to the window, sweet is the night air!
Only… listen! You hear the grating roar…" (1851)
Arnold's poem, which he suppressed for sixteen years because of its bleakness, stressed the pervasive loss of trust and faith beneath gleaming narratives of progress. Amid a world extolled as "a land of dreams, so various, so beautiful, so new" he discerned an "eternal note of sadness." Modern culture to him was a period of panic and confusion "where ignorant armies clash by night." Long ago he described our era of dazzling virtual delights and distractions with precision.
In this context, should one keep adding to one's equity holdings and if so, how much? What allocation fits these uncertain times?
In a series of articles starting April 22, I have been describing a cohort of companies with strong revenues and cash flow / debt ratios, growing revenues, established market share and with a strong place in the evolving cultural structure. Consumer Discretionary and media-entertainment companies figure strongly in this grouping but damaged economic fundamentals could take the former down quickly, first those which like Home Depot (HD) reflect the vulnerable housing sector.
Let us review the snares that could make the racing markets quickly look overbought.
The Syria business easily could get out of hand, by chance or design. China's rising PMI could turn into more empty cities and over-sized ports, etc. The facts of sagging workforce participation and the rising ratio of those receiving benefits to those paying taxes could hollow out the recovery narrative. Japan's chaotic stock and currency markets and titanic 235% debt / GDP or the currency crises in India and ASEAN nations could cramp global commerce. The market for US T-Bills may shrink: who wants even 4% on a long term note in a depreciating currency of a nation flirting with demographic and socio-cultural crises? "Foreign investors might not be too keen on low-yielding assets in a depreciating currency" the Economist wrote about the pound and BoE bonds six months ago. The same holds true for us. However, if T-bills go even to 4% it will destroy the housing market and probably crash the rest of the economy. All these things could happen. Even a couple of them could hobble the indices.
Hindsight is 20-20: how great it would have been to go 80-90% equities in June or July 2012. But few of us did. Thus, while it is tempting to hurl oneself into the euphoric stream of the indices' rising trend lines, basic economic, fiscal and geopolitical facts warn against going all in. As for bonds, none of us are on the Fed's "call first" list. We do not know how the FOMC will play out next week. What happens there depends in turn on the deals the G20 forges on currency, trade and foreign policies. Even if the plans are sound and made in good faith, which is unlikely, "man proposes and G-d disposes." Or if you prefer, there's many a slip between the cup and the lip.
For most people then, overweight equities and cash and underweight bonds significantly. I would not exit them: things may transpire such that the Fed maintains or increases QE which would lift bond prices though the macro situation suggests they are into a rough stretch. Bob Johnson, knowledgeable, sensible and experienced suggests 80-85% stocks, 7% cash and the rest fixed income. The blend depends greatly on your net worth, income stream and risk tolerance. People with less room to err might be better at about 65% equities (including whatever precious metals holdings suit them), 20-25% cash and the rest bonds. The chances for a pullback or gasp, even if short, remain high.
Known for his emphasis on diversification, balance and indexing, John Bogle in April said he expects stocks to outperform bonds during this decade. He also said he expects two massive, 50% equity corrections. That would be horrible but there are many ways it could happen, less from transient crises than endemic socio-economic problems.
Here is a short list of low-debt, strong revenue companies to own: Starbucks (SBUX), TJX (TJX), Whole Food Markets (WFM), CBS (CBS), Fox (FOX), Disney (DIS), Time Warner (TWX), British Petroleum (BP), Shell (RDS.B), United Tech (UTX), Boeing (BA), Rio Tinto (RIO), First Majestic (AG), Endeavour Silver (EXK) and McEwen Mining, a growing, debt-free small cap. Freeport McMoRan (FCX), FOX, BP and the PMs (precious metals) have the most room to run.
As for the PMs named here, though they are superb, wait for the current sell-down to abate before buying. The sector will remain afflicted by volatility and irrational behavior. If the economy indeed is in even passable shape, silver should be up strongly. Purchases of American Eagles and Canadian Maple Leafs are having record years and tech applications for silver steadily grow. But even the most profitable companies frequently falter in risk-off and other trading trends.
Consider using relevant ETFs to cover the best sectors so you don't take on an unmanageable burden of individual equities to monitor. For international exposure, Bob Johnson made a strong, detailed case for Vanguard's Europe ETF (VGK) and ex-US Developed Markets (VEA). Note that like most equities they are at the top of this year's rise.
The PMs are a special case whose parameters and outlook I will address in my next piece. Note that September 10, the differential between SBUX and Goldcorp (GG) was 9.93% with SBUX +2.47% and GG - 6.46%. This may correct somewhat but bear in mind that there are few norms in the PM sector however sound a company is.
Whichever end of this allocation spectrum best suits your means and needs, be cautious about adding rapidly at current prices. The macro outlook is filled with risks and argues caution. The world is "swept with confused alarms of struggle and flight" and dazzling promises of joy that outstrip the economy's ability to fulfill. An eager wariness fits the times.