Is the Market in a Sweet Spot, or What?

Readers of this blog know I'm not a market forecaster.  They know I don't have a crystal ball.  They know that I subscribe to the low-cost, well-diversified index fund investment philosophy touted by Warren Buffett, Burton Malkiel, Dan Solin, and Andrew Hallam.  What some may not know is that I follow the markets closely and have been following and investing for over 30 years.

And,  just because you're an indexer doesn't mean you can't have a bit in the market seeking to outperform the market.  I recommend this be kept to 10% or less of total assets.  This is the "fun" account.

Anyway, having said all of this, I have to say I've been amused by the constant long-time parade of talking heads on CNBC predicting a market correction.  I understand the guru status meter and how predicting a downturn in the market that actually occurs causes the needle to go crazy.  I've been around so long I remember Gazarelli's call in 1987 before the market crash that saw a 24% drop in one day.  I watched as her notoriety ramped up big time.  And as it ramped down.

Like a broken clock, some of these guru wanabees will eventually be right and garner followers who reward them for their correct market call.  Most of these gurus emphasize that their favorite valuation measures are high (above some critical level) on an historical basis.

Anyway, since everybody and their brother seems to want to offer a view, I thought I would offer mine.  First off, I believe the backdrop in today's market is important, maybe more so than at any time in history.  The notion that "this time is different" is nonsense is nonsense.  Every market is different! Today interest rates are at historically low levels in the U.S. but higher than important rates elsewhere in the world, namely Germany.  The yield on the 10-year U.S. Treasury stands at 2.59%, a full 1.24% (124 basis points) above the similar offering in Germany.  For Europeans, the U.S. Treasury note is extremely attractive given their year-over-year inflation rate of 0.5%!  Throw in U.S. dollar strength, and it is a terrific investment for European investors.

Another huge part of the investment scene that makes the present different is the gray tsunami of the baby boomers retiring and scrambling to live off their retirement funds.  Many are stretching, for an extra 1% to 2% is important for their standard of living.

It is no secret that looking in the rear view mirror, although extremely costly at times, is the prevalent way of investing; and today that rear view mirror shows that dividend stocks have pulled up many income investors by the bootstraps.  Like the guests at the party passing around the secret message, gray-haired investors are noting the higher-than-Treasury-yield dividend payouts by the likes of Johnson and Johnson and are jumping on the bandwagon.

I look at all this in economic terms.  The safe dividend payers with rates above 3% are substitutes for fixed income.  Go back to your Econ 101 notes.  Remember how an increase in the price of apples resulted in an increase in demand for oranges?  Make the price of fixed income too high (i.e., keep Fed policy focused on low rates) and investors demand for  dividend stocks increases.  Especially attractive, when inflation is under consideration, is the potential for dividends to increase versus locked-in Treasury payments for the life of the bond!

Of course, other factors are in play as well.  The Fed is systematically reducing its Quantitative Easing by $10 billion per month at each session, and the Federal Deficit is narrowing.

I don't have a research assistant to run down a bunch of fund flow and Treasury foreign fund investment data for you, but I believe this behavior by marginal investors is an important part of the market that a lot of the gurus don't get.  That huge pockets of investors, both domestic and foreign, have driven spreads on junk bonds (and even junkier Euro zone members) to eye-popping tight levels and, consequently, now see the dividend payers as the way to go trumps the old "P/E ratios are above historical averages and therefore it is time to lighten up on stocks" message.

To the extent that this thinking is correct, a big threat to stocks is, in fact, rising rates that approach dividend yields.  In the absence of rising rates, stocks could continue chugging higher, despite higher valuations on an historical basis.  This is not to say other threats are not out there, including nut jobs heading up major countries.  It is to say that the odds favor continuing to exploit downturns in the market, as long as Treasury yields remain significantly below dividend yields on high quality stocks.

Just my 2 cents.

Cisco's Message?

Cisco earnings disappointed, big time, this past week and the stock got hammered in the process. So what's the message? CEO Chambers put the blame on governments cutting back spending - not just in the U.S. but in Europe and Asia as well. But we knew this. Apparently what we didn't know was the extent of the cutbacks and the timing.

Cisco is a bell-weather. Chambers said "We believe the public sector business will continue to be challenging for at least several quarters."

In the bond market, the Treasury struggled through another week of heavy issuance as yields pushed higher, especially at the longer end.

The S&P 500 is up a bit more than 9% year-to-date and bonds have also done well. To me, this adds up to a time to be a bit cautious and take some profits.

Disclosure: Commentary here is not intended as advice for any specific investor. Individuals should do their own research or consult an advisor as to their specific circumstances.

"Beggar Thy Neighbor"

"Beggar Thy Neighbor." Ever heard the phrase? If you've studied the Great Depression, you have. "Beggar Thy Neighbor" is an action on the part of countries that is said to have exacerbated the Great Depression. It is when countries devalue their currency, thereby lowering prices to sell their goods more easily on world markets and, at the same time, not buying the goods of their neighbors. It is a modern version of mercantilist policy.

To understand currencies, picture the situation near to where I live. There is a circle and catercorner to each other are a High's and a Royal Farms (convenience stores for you Canadian readers), and each sell gasoline with their prices posted prominently on billboards. If one has regular gasoline at $.02/gallon less than the other, then it has a line of cars at the pumps and gets the bulk of the business for the day. In the same way, if the dollar drops versus the Euro, say, then all goods and services in the U.S. are thereby cheaper. This occurs naturally with the ebb and flow of demand and supply in the course of global trading. The problem is when currencies are aggressively manipulated by the world's largest economies. After all, isn't this what we are aggressively hammering China about?

All of this is, of course, well known by Federal Reserve Chairman Bernanke because, after all, he is a recognized expert on the Great Depression. This begs the question, therefore, of why he is pursuing a "Beggar Thy Neighbor" policy with his Quantitative Easing II program - especially given the fragile state of the world economy. He fully understands that lowering longer-term interest rates by buying bonds will cause the dollar to drop and U.S. goods to be more easily sold on global markets etc. He gets that pressuring the Chinese to increase the value of the Yuan will result in the U.S. buying less Chinese goods. He hopefully comprehends that all of this increases the odds of a trade war and is poor timing, given the state of the global economy. Even some of the Fed governors understand this.

At the same time, we have Treasury Secretary Geithner, like a parrot over in the corner, repeating the refrain that "the U.S. supports a strong dollar."

All of this has the G-20 in a tizzy and is leading to a possible confrontation at this weekend's meetings.

My prediction (going out on a limb here) is that global pressure will get the Fed to back off or at least lessen its policy and, thereby, cause the dollar to push higher, taking interest rates with it. I believe the rise in the dollar over the past couple of days reflects this expectation. Sadly, the actions of our policy makers continually make it difficult for business to operate. Who can be willing to hire workers in this environment?

Investor Psychology

Where are investors in this cycle? Some think investors are moving out of the caution phase and the market has higher to go. Others think we are over the hump and in the area of indifference. For the negative view, take a look at Phillip Davis - Gives a pretty good overview of the bearish case.