By Jim Wiandt
It's still early days for us contrarians, but the market is starting to make some sense and it feels like opportunities are beginning to appear.
I guess I should say "Time to rebalance?" because as people who know me will understand, I'm mostly a by-the-book asset allocator, possibly a bit more daring than most, but with a plan I stick to. That doesn't mean there are not times I feel better about the market than others. And now, ironically, is one of them.
Frankly, markets just have not made much sense to me for a long while, and I'm much more comfortable when there's some strong correlation benefit in the market and a bit of downward volatility. And we're certainly seeing that now. Oh boy, are we. And it's about time is all I have to say. I've got a LOT to say about the current market situation and where opportunities are, so let me try to consolidate some of my thoughts here.
First, I think the whipsaw effect, particularly in some sectors of the economy, has swung back wildly enough that there may be some opportunities on the rebound. U.S. financials (which international investors are buying up like crazy right now) and homebuilders leap to mind.
First, why is this?
On homebuilders, the sheer magnitude of a sector that is clearly not going to disappear from the economy always makes me look twice. At various times, I've been a buyer on the margins of airlines and energy for this reason. I'm feeling a bit that way about homebuilders (though it's a wild ride, and you certainly wouldn't want to put grandma's house on it, but a 50% 2007 drop and p/e of less than 10 makes you wonder about the segment being oversold.
A much larger issue is the U.S. Financial sector. It seems like there could still be more room to go down or that the crisis could be pretty much priced in. It depends who you talk to. I lean slightly toward the latter, but am very alert to the opportunity that financials seem like they could be presenting. Add in a strengthening dollar, and I think it only adds to this dynamic. BTW, XLF was down around 20% in 2007 and p/e in the Financial sector is now just OVER 10. The S&P 500 has a p/e of 16.7 and returned over 15% last year.
I'm speaking in sectors I know. It always makes more sense to me than the more academic discussion of "growth" and "value." There is almost always one sector driving the upward or downward dynamic of growth and value (which in 2006 had a return divergence reminiscent of what we saw in the late 1990s, explaining the hit all these new effectively value strategies took in the second half of the year).
Value as a buying opportunity? Yeah, definitely maybe, though read Larry Swedroe's article on the difficulty of trying to do that (though his timing for running that article certainly jibes nicely with gathering consensus that we might be entering a value-favored environment). Again, the trick is in the timing it right. And experience tells me that this is so hard to do that it's practically worthless to try to game the market, when all the gaming is priced in—IN REAL TIME. Heck, I was a value buyer in 1995, so you may not want to listen too closely to me.
With that, let's talk a little macros. Medium term, I'm definitely bullish on a Financials recovery there once we're clear of subprime. I also think the U.S. monetary guys are more on top of things. The big news recently in the currency arena points to the global/U.S. macro picture. The dollar has refused to drop to new lows, though Bernanke is taking a big drop and consensus is around 75 basis point lowering of fed funds rate.
What this all points to is that maybe we are headed for a recession, but that the U.S. will be better positioned to recover—always the U.S. seems more resilient than Europe, which never experiences a big boom and seems to be in a 50-year civilized slump. Still, the big bang is East of here, but I like the U.S. for a turnaround after a downturn, and I like the homebuilders as a medium-term contrarian play ...
You may notice that I've eased off on talking so much about gold (which Matt pointed out has dropped even as markets are dropping). We've seen a LOT of run there recently, though there are plenty of bulls still out there—and I'm still among them, just not as vocally.
In terms of my personal investing philosophy, in addition to being incredibly cheap, and looking at things relatively simply, I'm almost always cynical about market exuberance, and when I'm not on the cautious side, I'm certainly on the contrarian side. I'm such a contrarian, in fact, that I'm like one of those annoying guys who plays the "don't pass" line (bets with the house) in craps.
I'll wrap up here with some interesting things I'd like to share.
I picked up this gem of an overview (from a Credit Suisse report put out by Graham Ewen that is one of my favorite market reviews) of the current bloodbath in Europe:
[Monday] was the largest down gap on the SX5E (Dow Jones EuroSTOXX 50) index since 1987. However, here are a few reasons why you may not want to entirely give up on 2008: according to Credit Suisse Strategy, tactical indicators are at buy territory. Also, we believe the Fed is targeting growth and will cut rates aggressively, and Bush/Congress have shown at least the willingness to help. Lastly, the T-bill/LIBOR spread has improved and CDS for commercial/investment banks have stabilised, with some $79bn of capital raised to finance more than $100bn of write-offs.
Reasons why you may remain bearish in the short term: lead indictors are slowing everywhere and likely to lead to postponement of investment growth. Earnings momentum is very bad. Banks are still over-leveraged, particularly in UK and Europe. We see that the main problem will actually be timing: the US equity market tends to trough 2 to 7 months after the trough in ISM New Orders. Additionally, a renewed bull market normally happens only after the ECB/MPC have started cutting rates, which may happen only after the German wage round in April. Overall equity markets may continue to fall until H2 2008.
We continue to look at barrier options, this time to play a v-shaped scenario on the SX5E index. The price of the Dec08 at-the-money call is 9.4% (indicative). We would suggest investing in a 90% down-and-in, 90% strike call (a call option that will be activated at-the-money if the SX5E index falls to 90% of its current level - or willl expire worthless otherwise) at a price of 6.6% only. Investors could further cheapen the option by adding a knock-out feature that would make the option worthless if the SX5E index falls more than 20% from here - a relatively unlikely scenario given that it would imply a cumulative fall in the index of almost 40%: price of t he option would then be only 5%.
Well, I'm not real likely to do all of that with the options. But I've got my views. I'm certainly wary of Europe now, particularly with a currency that is not holding its ground despite the U.S. fed signaling aggressive action.
Finally—Don Friedman is talking about going long again. That right there should be enough to frighten you into caution (Don's shorts have largely gotten hammered the last 2 or 3 years, though he's covered his Intel recently just before it REALLY plunged, he told me). Here's what I told Don:
It's been a while since I've been this bullish. And I'm still bearish about the market probably for the next year or two, but then like our (U.S.) chances of coming out. There are now some opportunities out there. One thing is that I would scale back on international generally, and make bets on the dollar, which finally seems to have (I believe) hit the bottom. At around $1.50 last week, the dollar held steady despite threats of a huge rate decrease. My instincts on that were right, because the dollar has now busted up in the last 2 or 3 days. And I think that trend will hold generally.
In terms of contrarian bets, there are finally some decent options on the market. The obvious ones would be the homebuilders funds and financials, and perhaps value generally—though we may not quite yet be out of the woods there (the devil is always in the timing—and like I said, my guess is that we may have a year or two to play out the cycle on equity prices.
So on the margins of my account, playing on larger potential upside, I like Financials and Homebuilders; I'd scale back on Europe, EM and international generally; and look to tilt back a bit toward value and small. All of this fits within the context of broad, sensible asset allocation across the U.S. total market and total international market (where I'm generally weighted 50/50 or so with U.S., way more than most Americans.
OK—now that's GOT to be just about enough market timing nonsense for an "index investor" for one day. Good luck.