Years ago at Gordon Capital, Don Coxe, who was our research director, set out to prove you can run money by asset mix changes alone. At each quarter's end he sent our new portfolio weights of stocks, bonds, and cash to Royal Trust, which audited our performance. It proved superb. So when a year later Don moved to the U.S., yours truly, who became research director, continued the asset mix shifts for two and a half years, when the practice was discontinued.
Why discontinued? Because Gordon's asset mix outperformed almost all Canadian pension funds (they invest in all three asset classes), and several clients, who got paid for picking stocks, did not like being shown up by asset mix shifts alone.
Can this feat be repeated? Probably, though asset mixing is unlikely to match stock picking. But the relevant factors can sure help you decide when to be bold or cautious in stocks - or, if you run a hedge fund, when to be longer and when to be shorter.
But, which factors? And what do they show now?
Well, last column I mentioned the Fed. When it's in full money-printing panic, you can invest confidently - October of 1987, September, 2001, and March, 2009 - but it's hard to act then, because panic is catching. However, when central banks suck money out of the market - such as now - and you should reduce your exposure, it's often just as hard to act because it's tempting to think your brilliantly picked stocks will escape the general decline. But don't kid yourself. They likely won't.
Which other factors can help you identify long-friendly environments?
Doctor Copper Copper is said to have a PhD in economics because it has forecasted the economy better than any economist. Look at its chart: In 2008 it rolled over well before the economy and the market did, while in March, 2009, copper's moving averages rolled up as panicky Fed printing (see above) soon made even turkeys fly.
What of today? Dr. Copper is rolling over again (backed by copper's high inventory to sales ratio), so economic-sensitive earnings are likely to keep disappointing, as will copper.
Real interest rate "Real" interest rate? That's corporate triple-A rate less the 12 month change in the producer price index. When the real interest rate is high, it's (counter-intuitively) good for the market, because the economy is strong (hence high rates) yet raw materials inflation is low. The opposite is bad: On July, 2008, the real rate was a worrying negative 12 per cent, so the market tumbled. In March, 2009, it was very high (rising to 17 per cent, as producer prices plunged alongside commodities), so the market (helped by a panicked Fed) took off. Today's real rate is negative (minus 4 per cent) and getting more so. Be careful.
Future profit margins Take the one-year change in consumer price inflation and subtract the one-year change in producer price inflation and that will tell you where margins are likely heading. The first allows companies to boost prices, while the second means costlier inputs. When the difference is rising, margins (and profits) are about to rise. In July, 2008, the difference was negative 10 per cent, and the market tanked. In March, 2009, it was plus 11 per cent and the market soared. Today it's minus 7 per cent and falling. Again, be careful.
Unemployment insurance claims When unemployment insurance claims soar, the Fed panics and prints money, while investors panic and sell stocks. That's when you should be ready to buy stocks, because that's when they often come cheap. In contrast, when claims fall (and employment is high), the market often peaks. As they say on Wall Street, the market falls on full, rises on empty.
What of today? Unemployment insurance claims are falling (down 17 per cent year-to-year), so the Fed can complacently suck money out of the system. By comparison, in March 2009, when claims rose 100 per cent from the year ago level (i.e., the economy had tanked), the time to boldly buy was at hand. We are far from it now. Wait for Dr. Copper's forecast to come true first.
Commodity prices When these soar, input costs cut into earnings and suck money out of the market - such as in July, 2008, (when we saw a 17-per-cent gain versus the previous year). In March, 2009, however, commodity prices plunged (down 15 per cent year-over-year). This gave earnings scope and liberated cash to invest. It also panicked the Fed (see above), so the market soared.
What of now? Producer prices rose 9 per cent last month from where they were a year ago. That's almost like March, 2008: in a word, bad.
It's only if, or when, producer prices plunge (as the economy tanks - again, see Dr. Copper, above) that we could have a basis for going long boldly. We're not there yet.
What to do now Have more cash and short hedges. Then, if or when the economy follows Dr. Copper into a downturn and an international conflict erupts too, and everyone (including the Feds) hopefully lose their heads, remember Rudyard Kipling and keep yours. At such a time the above indicators (and of course individual values) would tell you to buck the crowd and buy - as this column did on Feb 28, 2009.
It may come sooner than you think.
By the way, all the data mentioned above can be obtained for free from FRED (Federal Reserve economic data), the U.S. Federal Reserve Board of St. Louis's database, at: http://research.stlouisfed.org/fred2/
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