November Option Advisor Commentary

I usually use this space to comment on articles that catch my eye in the financial media. I'm always on the alert for suspect "conventional wisdom," because when the crowd heads off in one direction, my contrarian antennae become sensitive.

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"The sacred texts of investing need to be rewritten. It turns out that the so-called equity risk premium, the once-sacrosanct belief that stocks perform better than bonds over time, has been vastly overrated. Earlier this year, according to the Leuthold Group, a Minneapolis research firm, U.S. Treasury bonds had outperformed U.S. stocks over the preceding 10- and 20-year periods. And that was only the beginning. Bonds also beat stocks over the past 30 years. Even the 40-year returns were basically equal, a feat never before witnessed in the U.S. markets. Over other periods, of course, stocks performed far better. But for four decades they were a sucker's bet. If the bedrock principle of investing—that shareholders are compensated over the long term for the risk of buying equities—is a fallacy, then what, if anything, can investors believe in? ... The executives at Pacific Investment Management, or PIMCO, say they have the answer. The bond fund giant has adopted the phrase 'new normal' to describe the changes taking place. 'If you are a child of the bull market, it's time to grow up and become a chastened adult,' writes William H. Gross, manager of PIMCO Total Return (PTTRX), the world's largest bond fund, in his September dispatch to investors. 'It's time to recognize that things have changed and that they will continue to change for the next—yes, the next 10 years and maybe even the next 20' ... According to PIMCO's new normal, equities should make up just 30% to 54% of a portfolio, with no more than half in the U.S.—much less than the traditional 60% commitment to stocks and 40% to bonds. Of course, PIMCO, a bond shop, has an incentive to paint stocks as less attractive. But other asset managers are sounding a similar theme ... The California Public Employees' Retirement System (CalPERS), the nation's largest pension fund, is in a political dogfight. Its asset value in 2008 plunged a record 23.4%, worse than the performance of a basic 60/40 stock/bond portfolio. The $56.2 billion loss wiped out six years of earnings for CalPERS' 1.6 million working and retired clients, according to Bloomberg. 'We're still negotiating what's happening in the markets,' says a CalPERS spokesman. 'Like everyone else, we don't have a crystal ball.' Far from it. According to internal documents reviewed by BusinessWeek, CalPERS in 1999 was assuming it would generate annual returns of 8.25% over the following decade ... Amid the sharpest stock market rally in decades, CalPERS has cut its stock holdings from 56% to 49% and plans to devote much of its proceeds to illiquid investments."
(BusinessWeek – "Investing gauges are broken, market signals are mixed, and money managers don't know where to turn. What exactly is the 'new normal'"? – 10/5/09 issue)

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I recently discussed the anecdotal sentiment picture, concluding that this media-based gloom in the context of a powerful market uptrend had very bullish contrarian implications. Nothing has changed in the intervening 18 days. In fact, the skeptical crescendo may be accelerating, viz:

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The following is a reprint of the market commentary from the October edition of the Option Advisor, published on September 24. Prices and the chart are as of the close on September 24. For more information or to subscribe to the Option Advisor, click here.

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"As if they really knew, leading economists predict that recovery from our Great Recession will be plodding, gray and jobless. But they don't know, and can't. The future is unfathomable ... Though we can't see into the future, we can observe how people are preparing to meet it. Depleted inventories, bloated jobless rolls and rock-bottom interest rates suggest that people are preparing for to meet it from the inside of a bomb shelter ... But it has been a generation since a business cycle downturn exacted the collective pain that this one has done. Knocked for a loop, we forget a truism. With regard to the recession that precedes the recovery, worse is subsequently better. The deeper the slump, the zippier the recovery ... To the English economist Arthur C. Pigou is credited a bon mot that exactly frames the issue. 'The error of optimism dies in the crisis, but in dying it gives birth to an error of pessimism. This new error is born not an infant, but a giant.' So it is today ... The Fed's voice is among the saddest in the lugubrious choir of bearish forecasters, and for good reason. By instigating a debt boom, the Bank of Bernanke (and of his predecessor, Alan Greenspan) was instrumental in causing our troubles. You might have thought that it would therefore see them coming. Not at all. Belatedly grasping how bad was bad, it has thrown the kitchen sink at them ... In the meantime, ultra-low interest rates have lit a fire under the stock and debt markets. By rallying, equities and corporate bonds not only anticipate recovery, but they also help to bring it to fruition ... I promised to be bullish , and I am (for once)—bullish on the prospects for unscripted strength in business activity. So, too, is the Economic Cycle Research Institute, New York, which was founded by the late Geoffrey Moore and can trace its intellectual heritage back to the great business-cycle theorist Wesley C. Mitchell. The institute's long leading index of the U.S. economy, along with supporting sub-indices, are making 26-year highs and point to the strongest bounce-back since 1983 ... And that is my case, too. The world is positioned for disappointment. But, in economic and financial matters, the world rarely gets what it expects."
(The Wall Street Journal – James Grant – "From Bear to Bull" – 9/19/09)

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While most of us technical types love to dive into a wide swath of indicators in our attempts to divine market direction, keeping it very simple in your technical analysis can often yield huge benefits. Perhaps the most important of the benefits of simplicity is it can allow you to maintain a much higher level of objectivity, as you can't add yet another indicator to the mix to tilt your conclusion in favor of your biases.

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"Record low interest rates and vast amounts of money pumped into economies by central banks has translated into surging asset values across financial markets, raising the prospect of a new speculative bubble. 'Instead of getting consumer inflation from all this central bank liquidity, we are seeing asset price inflation and we all know that usually does not end well for investors,' according to Steven Ricchiuto, chief economist at Mizuho Securities ... In the US, the S&P 500 has risen nearly 60 per cent above its March low and the power of the rally has propelled the benchmark to its highest level above its 200-day moving average since May 1983. 'Not even during the great bull run of the 1990s did the S&P get this far above its 200-day,' says Justin Walters, co-founder of Bespoke Investment Group. The 200-day moving average is a closely watched indicator of long-term sentiment and currently is at 20 per cent below the S&P 500 – a divergence that shows how strongly equities have rallied ... With the S&P 500 up nearly 20 per cent for the year, the spectre of performance-chasing by investors who have been underweight stocks could propel the market a lot higher, stretching valuations further. 'A lot of people missed the start of the rally and have resisted joining in as the equity market has risen well beyond what the economic data have justified,' says Bill Strazzullo, chief market strategist at Bell Curve Trading. 'For the vast majority of people, stocks are the only game in town and we are seeing a lot of performance-chasing.' All of this could push markets well beyond fundamental values, setting up investors for a big fall, unless the economy grows much faster than bulls currently assume. 'Something will break the current trend and I'm worried about the risk of a 1987 style one-day correction,' says Mr. Ricchiuto."
(Financial Times – "Recovery prompts fear of bubble" – 9/18/09)

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