Still Cautious, Despite Soaring Stocks

Stocks enjoyed their fourth straight weekly gain, and the senior U.S. stock averages all moved to new bull market highs. The rally broadened out last week to include formerly lagging sectors (e.g. financials, consumer discretionary, real estate, and small caps) that hadn’t yet gotten involved in the bullish action.

The Russell 2000 small cap index surged 4.7% and is now only 2% from joining the large cap U.S. equity indexes in record territory.

Emerging markets continued their parabolic ascent, as investors chase performance and pile into this asset class now universally regarded as the ideal beneficiary of the global growth theme and the renewed global inflation/liquidity paradigm. Emerging markets are as overbought as we have seen the asset class, having rallied 28% in less than two months. We reiterate our comment from last week that this is not the time to add to emerging markets exposure.

Clearly our cautious posture in recent weeks has been out of step with a soaring stock market. We were perhaps premature in concluding that the credit bubble had been pierced. Moreover, we misjudged the Federal Reserve, which surprised the markets on September 18^th with a larger than expected rate cut and in the process did considerable damage to whatever inflation-fighting credibility the Bernanke Fed may have garnered.

This Fed, like its predecessor, has demonstrated to Wall Street that it is willing to aggressively promote inflation to combat bursting bubbles, and markets have quickly responded to the "Bernanke Put," convinced that expansionary monetary policies will succeed in supporting asset prices and sustaining the bloated credit structures that looked so fragile just a few weeks ago.

It is no fun being defensive when the markets are soaring. We must confess, however, that we are much more comfortable with stocks when they are rising because of favorable fundamentals, rather than the ultimately counterproductive stimulus of inflation and dollar devaluation. Broad U.S. dollar money supply (formerly known as M3) is up 12.9% in the past year, which goes a long way towards explaining why so many commodity prices are at record highs and why the U.S. dollar is trading at a record low.

With the Fed now obviously favoring the financial markets, we likely need to adapt our thinking and assume that an easy money/weak dollar policy will be successful in supporting stocks, commodities and real estate prices until some countervailing force emerges (e.g. rising bond yields due to the outright recognition of inflation). One would hope that the Fed would refrain from any further rate cuts (the next FOMC meeting is on October 31 and the markets are currently giving 50/50 odds to another cut) to defend the dollar and regain a modicum of inflation fighting credibility. We must confess, however, that at this point we have no confidence that the Bernanke Fed won’t cut rates further in an effort to support home prices that are being pulled lower by a massive and still-rising supply of housing inventory.

Our portfolios currently carry a sizable cash cushion as a result of our concerns about the risks of stagflation. We recognize that cash rapidly loses its luster when asset prices are reflating and money market yields are declining as a result of Fed rate cutting. We are open to moving some cash reserves back into higher returning assets, but we are going to stay cautious and skeptical a while longer. We have never piled onto an overbought market, and are not about to start now.

Our defensive posture has not exacted a significant penalty on our model portfolios, whose year to date performance is only slightly below our benchmarks. Our exposure to foreign stocks and commodities (energy and gold) has compensated for our overweight position in cash. With the markets marching to new highs, it is hard to be patient and wait for stagflation risks to subside and more favorable entry points, but that is exactly what we are going to do.

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