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Investor’s Corner
By John Gudritz CFA
Principal
Front Street Investment Management LLC
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The decline in the stock market since April 23 has a lot of people concerned. This concern stems from a generalized anxiety that the nascent U.S. economic recovery is fading just as the government stimulus is tapering off. In my opinion, both the stock and bond markets are warning investors to become more defensive.
Besides the financial markets, there have been a number of pieces of data in recent weeks that point to a broad slowing of the economy. For example, auto sales in June were down about 5 percent from May and now rest at the same level posted at the start the year. The latest housing data has been ugly with both new and existing home sales posting disappointing numbers following the expiration of the government tax credits.
Retail sales, after stripping out the most volatile categories, have gone flat since March. This makes sense, given that we haven’t seen much job growth in this recovery. In fact, the number of employed workers in the U.S. fell in both May and June according to the government’s Household Survey conducted each month. The unemployment rate was 9.5 percent at the end of June and would have been over 10 percent if people had not given up on looking for a job and left the labor pool.
To back this up, initial claims for unemployment benefits were also falling to start the year, but in March the four-week average of new claims for benefits started to rise again. The figure now rests at about 450,000 new claims each week and normally you need to post sub-400,000 readings to see some real net job growth.
Further, while the ISM Purchasing Manager’s Survey Indexes for both the manufacturing and the service sector do still indicate economic growth, both ticked down in May and June. The Conference Board’s index of leading economic indicators fell in June. That was the second decline in three months. I tend to focus on inflection points in economic data to anticipate changes in trends.
Added to the above indications, the yield on 10-year U.S. Treasury’s has abruptly fallen from 4 percent to below 3 percent just since early April. This is not an inconsequential move in yields. It demonstrates investors’ desire for safety and could very well be indicating an oncoming slowdown or recession as well as deflation.
All of these things and more, taken one by one are simply forward-looking economic indicators of how things look in real-time. It’s important to note that the recent performance of the stock market is also one of these indicators.
As much as we like to dismiss the stock market as being all-knowing, its movements often contain actionable information. To consistently and reflexively dismiss other investors as behaving irrationally demonstrates a dangerous level of hubris. Balancing that reflex with the humility to show just a little bit of respect for their opposing views is an important challenge for conscientious investors.
Encapsulating the data points above, there has been a considerable amount of attention paid to a leading economic indicator called the “ECRI Weekly Leading Economic Indicator.” That is because the growth rate in the ECRI’s Weekly Leading Economic Indicator has an enviable record in forecasting past recessions.
Today, the growth rate on this index sits at a -9.8 percent. This was the tenth weekly decline in a row and it has posted a negative reading for the past six weeks. The speed of its descent has caught the attention of knowledgeable investors.
While this index’s forecasting record is not perfect, we have never before avoided a recession with recorded readings at these depths.
Putting this all together, I am concerned and feel justified in my continued conservative positioning for clients’ portfolios. In recent weeks, my firm took our caution to another level and, for all intents and purposes, we’ve once again completely hedged away our net exposure to the stock market.
While the portfolios are hedged, our clients do own some individual stocks with generally defensive and attractive attributes. They tend to be businesses with less economically sensitive revenues and/or provide ample dividend income. They are also businesses that have strong balance sheets and/or strong growth prospects at attractively low stock prices. Yes, these types of investments are designed to do better in tough markets. However, that relative-value argument rings hollow to me.
If left un-hedged in a double-dip recession or even with disappointingly slow economic growth, our portfolios would most certainly post losses.
Owning stocks that my firm thinks will do relatively better than the market while simultaneously betting against the entire market helps to hedge out the negative consequences of a slowdown.
As we reach the inflection point between a government-induced recovery and what will be at least a significant slowdown, I believe that our strategy to shield our clients from overall stock market risk and unsettling volatility is the right one.