In the wake of the Bear Stearns (BSC) bail-out and the various related measures announced by the government, the view growing in popularity is that the credit crisis has finally been addressed adequately and "systemic risk" in the financial markets has been alleviated. A number of analysts have opined that, in light of the aggressive government policy responses now in place - (e.g. lending directly to broker-dealers in addition to banks; accepting non-agency mortgage collateral for direct Fed lending; expanding the lending capacity of Fannie Mae (FNM) and Freddie Mac (FRE) to help unclog mortgage markets; being willing to provide direct taxpayer financing to prevent large financial institutions from going bankrupt) - the "all-clear" has been sounded from a longer-term investment standpoint.
We think this view is premature. To us, the investment environment remains characterized by elevated risk, and the weight of the fundamental and technical evidence suggests continued caution. It remains to be seen how deep this recession will be, how much consumers will retrench in their spending, how much further home prices will fall alongside rising foreclosures, and how far along the financial system is in the process of de-leveraging and asset write-downs. It is entirely unclear how the aggressive actions of the Fed and the government will affect these forces. We have no doubt that they are having an effect, but it could turn out to be largely one of prolonging an inevitable corrective process and creating a number of undesirable side-effects, principally inflation, along the way. Thus far, the stock market itself has rendered a rather tepid verdict on the myriad plugs the government has inserted into the leaking dam. The S&P 500 is up only 3% since the recent lows of March 17.
Although the government has thus far been successful in arresting the stock market's decline when the S&P 500 reaches the 1250-1275 zone, which (not coincidentally?) coincides with a 20% decline from the October peaks, our sense is that the bear market lows are not yet in place. We suspect that another leg down below these support levels lies in store at some point in the months ahead, but the timing is impossible to judge. Based on the fundamental and technical tools at our disposal, we think for the foreseeable future the S&P 500 will fluctuate between 1175-1225 on the downside and 1400 - 1450 on the upside. Given today's price of 1315, and using the mid-points of the above ranges, this implies that upside and downside risks are roughly in balance at 8.5%.
In this volatile market climate, we think the best strategy is to err on the side of caution - focusing more on preserving capital than seeking gains - even if that means leaving some initial potential profits on the table if by chance the lows are already in place.
A Longer-Term Top in Commodities?
Barron's ran a cover story over the weekend about commodities entitled "Danger Lurks," suggesting that the price run-up in commodities is way overdone and that prices of commodity indexes "could eventually drop 30% as speculators retreat." The article posits that commodities are in a speculative bubble, as investors, both individual and institutional, have chased performance by pouring money into index-linked commodity funds and ETFs, while the "smart money" (defined as the producers and other owners of the commodities themselves) have been shorting (or hedging) commodities to lock in current prices.
The article is a worthwhile read, but we believe presents an overly bearish outlook. Clearly, in the recent run-up that began last summer, commodity indexes became very overbought and vulnerable to a sizable correction, but this in no way implies an end to the long-term bull market The article gives very short-shrift to two important factors in the longer-term bull case for commodities: (1) inflationary monetary policies of not just our central bank but a number of central banks around the world that in effect mimic our monetary policy to maintain pegs of some fashion to the U.S. dollar; and (2) the legitimate move by investors large and small to diversify a portion of their portfolios from "financial" assets to "hard" assets. The diversification value of hard assets and their lack of correlation to financial assets has been especially apparent over the past nine months, as confidence in the financial and monetary system has been shaken and investors have sought protection from inflationary government responses to the credit crisis.
We suspect that the commodity indexes will remain highly volatile, and (like equities and risky forms of debt), subject to periodic sharp price declines of 20% or more, but in light of favorable underlying fundamental and monetary forces, we don't believe the longer-term bullish trend in commodities is close to being over.