Wednesday, May 18, 2011

More a Stock Market than a Market of Stocks: Playing Defense or not Playing at All

Why begin a post on stocks by mentioning that I purchased a 5 year 'A' quality muni bond today yielding 4%?

Perhaps because I feel the risk-reward is better for this than for the stuff I've been buying lately in my stock accounts. And I hasten to add that in my retirement I am far from earning enough to even come close to the high tax brackets, so that I don't really need the tax-free nature of muni interest payments very much.

Nonetheless, having closed out almost all my weak dollar, growth-y financial assets except gold-related matters shortly after the hit on bin Laden, I have reviewed the 2007-8 investment scene as well as the 2000-3 post-bubble period and have found some asset classes that by those precedents look better than cash heading into what appears to be a cyclical industrial slowdown.

First, let's review what two conservative strategists think of the stock market as a whole. The Ph.D. economist and fund manager John Hussman has updated his views this week. He sees an average return for stocks over the rest of this decade as little better than 3% annually. So in his view one could just buy a 10-year Treasury for the same yield and wake up a decade later (the Rip van Winkle approach). He also refers to the more senior strategist Jeremy Grantham, who is famous for making uncannily accurate 7-year projections, and who is even more bearish about U. S. stocks than is Hussman.

Finally, there is the less well-known Andrew Smithers, who bravely published a book in 2000 calling out the stock market as a huge bubble. He soldiers on, every 3 months updating a chart valuing the stock averages both by his estimate of fair value based both on earnings (10-year average earnings) and asset value ("q"). According to his estimates, stocks are at least 75% over fair value, and are similar to their valuations at their mid-1960s and 2007 peaks.

But all these considerations are in the face of the seemingly permanent zero interest rate policy (ZIRP). So if cash is trash, and the powers that be have a somewhat illogical commitment to price inflation of pre-owned equities that is in aggregate called the stock market, then most portfolio theorists recommend some exposure to stocks, and I agree. And in truth, much as have been a proponent of gold investing since 2009 and was in and out of gold beginning in 2002, so long as I live in a "fiat" world where gold is not money in the transactional sense, and I have bills to pay, I need to think of fiat dollars and think that I can do a bit better than Hussman's 3+% with stocks for the short run.

Therefore, taking the Economic Cycle Institute's (ECRI) warnings about a major global industrial business cycle to heart, I have invested funds in the following stock groups: electric utility, health insurance, and defense. Admittedly I have primarily negative feelings toward the latter two groups of companies, but the only stocks that I have always refused to buy are cigarette stocks. (In fact, 30 years ago I refused to buy Bic stock because they made lighters in addition to pens; it soared without me on board.) I have also been buying into closed end muni bond funds, as these funds are able to use leverage to enhance yield with reasonable safety, and an individual cannot accomplish this.

On the other hand, interim kickback rallies notwithstanding, I look askance at the charts of energy, materials and even most tech stocks. Japan's history with ZIRP is that major bear markets can indeed occur without the central bank lifting interest rates. Cyclical industrial downturn such as that which may be approaching soon can teach a severe lesson to both veterans and noobs alike who trust in the central bank to prevent asset prices from falling in nominal terms.

If ECRI is correct, there will be continued important shifts in the pricing of different sectors of the stock market with more movement within the market than the averages will reflect, unless and until another systemic crisis a la late 2008 comes upon us and babies get tossed out with bathwater. One may need Biblical fortitude to resist the blandishment of tantalizing rallies in risk assets, however, to follow this cautious strategy through to its conclusion, which could very easily end (or not yet be ready to end) with the CNBC crew putting their Dow 10000 hats on backward.

Copyright (C) Long Lake LLC 2011

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