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The Fog of War

Statistically and emotionally, the market action last week put to rest many investor fears, specifically those questioning whether the bull market in stocks was still alive.  Prices did not succumb to selling pressure after the enormous recovery in late October, but instead marched higher with broad support and enthusiasm.  Strangely, I found my inner contrarian flaring up again.  While I remain bullish and our portfolios are allocated as such in the short term, I am beginning to see the ingredients for our next major global financial dislocation taking shape.

Schwab Impact

The Schwab Impact conference was held in Denver this year and what a show!  It was apparently a grand event with the likes of Train, GW Bush, and Ben Bernanke there to entertain – in order of most to least entertaining.  I didn't go but spent quite of bit of brain matter reviewing the highlights and reading through the various presentation notes from Keynote speakers.  A few things raised my eyebrows.

1.  EVERYONE expects the bull market in US stocks to continue for roughly another 12 months (until after the 2nd rate hike by the Fed) but with higher levels of weekly and monthly volatility.   The market rarely (read never) does was EVERYONE expects.  Note to self – be ready for anything at any time.

2.  Ben Bernanke admitted that the Fed was operating in a “Fog of War” during the financial meltdown of 2008.  He said they had to improvise and work creatively to come up with solutions to massive forces.  He was pleased with the results of their grand experiment.  Note to self – Is the experiment over?  Sounds like a “mission accomplished” speech I heard once.

  1. 3.  Global headwinds to real and sustained growth are still with us.  They are first resource scarcity, especially arable land and food.  Second, poor demographics (like our own aging baby boomer population) in developed countries effectively creating a drag on our share of global GDP. Third, wealth inequality and massive poverty in emerging countries is not a solid foundation.  Forth, political systems with high turnover election cycles (like the US) force our leadership to only think and act on short term issues with high popular appeal rather than finding solutions to long term problems.  Finally, technology and robotics are still replacing wage earning jobs (although creating some as well) on a massive scale.  Note to self – These are big problems not easily solved.  Bear markets are not gone, nor will they be easy to tolerate. 

The rest of the topics were really industry related and I’m guessing not of interest to our readers. 

Good for Now But Problems Developing

The problems that I’m seeing develop are thankfully slow moving ones.  In the short term, I find little in the way of fundamental or technical evidence to warrant anything other than a fully invested position.  It will be important for certain sectors like energy, metals and materials to continue rebounding from recent lows.  Last week was all good with technology, industrials and financials receiving some of the love from the runaway advances in healthcare, utilities and consumer staples.  In fact, if this relative strength rotation continues, we may need to reallocate back toward the growth side of the market next week after sitting in the defense camp for several months now.  Even our bellwether names like GE (GE), Walmart (WMT) and Boeing (BA) are forming breakout patterns after trading flat to down all year.   On top of that, we are now right at the beginning of the best six months of the year in terms of productive gains and right on the front edge of the best three quarters of the entire four year presidential cycle.  In a nutshell, conditions are right for rather robust move higher if the market wants it. 


Looking out further into 2015, I see potential ingredients for the next bear market developing.  Of course, there are the widely announced prognostications of global credit market failures on the back of overly supportive stimulus measures by central banks.  Europe is a disaster and Japan is in worse shape than I thought with central bankers on high alert.  High yield bonds will let us know when these credit market risks move to the front burner.  But on top of that, there is some weakness in the economic numbers coming through the pipeline now.  Car sales, specifically in trucks, are now down year over year for the first time since the lows in 2009.  Employment numbers are healthy in absolute numbers but this month was a bit of a disappointment comparatively.  Wage pressure is also on the rise for the first time in several years (hinting at inflation to come) as are hours worked.  Housing continues to lag what we would expect for this stage of the cycle and we haven’t even seen borrowing rates move up meaningfully yet.  Technically, pricing structures are healthy but we’re obviously seeing an increase in weekly and monthly volatility.  As the market rises so too does sentiment and available cash is deployed.  Once everyone is in, who will buy?  I expect more looking forward as I mentioned at our annual meeting last month.  On the earnings front, the numbers have been good this quarter but stocks somehow seem vulnerable to anything that could be interpreted as a negative.  Financial engineering is clearly happening now to keep those earnings coming on strong but Wall Street has a good nose and seems to be punishing those that stink.   All in all, I see some deterioration in fundamentals, in real earnings, and in technical conditions albeit from very high and very favorable levels.  These are not show stopping events but slow moving changes that occur over months and quarters as we approach a more significant cyclical peak. 


When fear of the future creeps in, I fall back on our risk management system, knowing that it will sniff out weakness as it happens, tripping sell signals and moving us out of harms way hopefully early in the cycle.   The recent correction in October nearly pushed us over that line in a jerky and painful affair, but prices reversed just before we had to do much of anything.  It may have been a warning of sorts but clearly buyers are still waiting with cash in hand to pounce on any discounts. At some point, our current “buy the dip” mentality will give way and the markets will begin to reflect less favorable conditions.    We’ll be ready to act when the time comes.  In the meantime, we are glad to be breaking out of the summer slump and hope to add some real numbers before year end.

Sunny and 60 in Colorado this past weekend – Winter? 

Cheers

Sam Jones