We have been cautiously optimistic since mid-summer. Despite a springtime bounce, stocks were undervalued given the combination of unprecedented Fed stimulus and the absence of any risk of inflation. The money had to go somewhere. If it didn’t boost the economy, it had to boost the market. We steadfastly repeated that the S&P would rally to (our 2009 forecast level of) 1050.
About six weeks ago the market had risen 50% from the March lows, creating the risk of a minor 3-5% correction. Had that correction transpired, we would still be bullish. Instead prices continued to rise, modestly exceeding our 2009 target.
Battered retail investors did not suddenly move back into stocks. Instead, fund managers and traders drove prices up as they adopted our view that any correction would be mild and short-lived. Call me anti-social, but when it comes to investing, I hate company. Twice burned retail investors aren’t coming back to equities any time soon, and the professionals who supported this market when they repeatedly bought on the dips have covered their shorts and are now fully invested. Retail investors may still be shell shocked, but financial advisors are more bullish than any time since the 2007 market highs. Without the return of greedy individual investors, there is no way stock prices can sustain a rise above fair value (we estimate as S&P 1100 is the market ceiling for the foreseeable future).
Bullish advisers argue the trillions of dollars in money market funds earning near zero interest will force investors into stocks, driving prices higher (interestingly there is no more money in money market funds than there was at the Oct 2007 stock market high). Following huge stock & real estate losses, money market investors are looking for better returns knowing they will never recover earning zero. However, they have little appetite for stock market risk. Instead money is flooding into bonds from treasuries to high yield corporate bonds.
Overall, bonds are just as richly valued as stocks. Unlike stocks, bonds can go a lot higher. We are in a new bubble. I call it the emerging “bubble of safety”. Investors only want to put their portfolios where they have confidence they will get it all back and make a little money. In the short term this strategy is not only painless but profitable; which is why I believe the flood of money will continue to drive bond prices higher for at least a few months.
By locking up their money in low yielding T-Bonds and CDs, investors ignore the long term risk that inflation will devour their principal. With the Fed (aggressively and artificially) supporting the TBond and mortgage market, a few savvy investors have followed our lead into better quality municipal and lower rated corporate bonds (BBB to BB). This investment trend is likely to continue. These bonds offer better risk adjusted returns than TBonds, stocks, or money market funds. However, by themselves and on an historical basis, bonds are no longer cheap. They are simply the best house in a marginal neighborhood. In the short term they are likely to continue to appreciate (until the Fed raises interest rates).
This provides a road map for our portfolios. We have reduced stock market exposure to near minimum (the smallest it has been since late 2007). Conversely, we have maintained or increased our exposure to the corporate and municipal bond markets, taking advantage of what we believe to be further modest appreciation and acceptable current yields. If the double digit stock market decline unfolds as we anticipate, it will overinflate the “bubble of safety”. We plan to use that opportunity to take profits on our bond positions and add those proceeds to the cash we already generated through recent stock sales. That cash will be used to rebuild a large position in stocks at lower prices. Of course we could be wrong; stocks could continue to rally, leaving us underinvested. This would reduce the huge gap between our 2009 portfolio gains and the market. It would however push our Diversified Portfolio up close to 30% for the year. We hope to keep making mistakes like that.