January 17th, 2012
This is the investing analysis that is derived from the macroeconomic analysis posted on January 15. Readers of that analysis will understand why we see the risk that muddle through could change to rolling over in 2012. We will start the investment discussion with equities. Follow up:
Stocks - Wall Street loves to promote investment themes, which at their outset make sense and have value. But like all good things, they become over done, and then undone when things change. Over the last year the most dominant theme has been to buy stocks paying solid dividends of 3% or more. Compared to the 10-year Treasury yield of 2%, an increase of 50% or more in annual income has value. Since 1978, dividend paying stocks consistently underperformed non-dividend payers, which were more focused on growth than dividends. The period of relative weakness ended in 2000, at the peak of the dot.com mania. Since then, dividend paying stocks have been gaining in relative performance, and now sport the highest relative P/E ratio in more than 30 years.
Follow up:A recent study by AllianceBerstein ranked 650 large cap stocks by their dividends, and grouped them into quintiles. Currently, the premium of high-dividend payers over low-payers is the highest in 40 years. This fact alone does not mean this trade cannot continue to work, but a measure of caution is advised based on contrary opinion. We suspect this trade has attracted a lot of conservative money that is focused more on the income than the potential downside risk. If the stock market experiences another 20% decline in the next year, a dividend of 3% won't provide much solace if one's nest egg has shrunk by 17%.
Over the last 80 years the stock market has swung like a pendulum between undervaluation and over valuation on a 15 year rate of change based on returns. The total length of time between peaks and valleys is about 38-39 years. After peaking in 1929, the next peak occurred in 1968, and then again in 2007. The 15 year return valuation low in 1943 was repeated in 1982, and suggests the next secular bull market may not begin until 2020-2021. The next 8 to 10 years could be challenging.
Central banks will continue to inject liquidity every time their domestic or the global economy falters, due to the unwinding of financial leverage and over indebtedness of governments and consumers. If the central banks are successful, stock markets will fluctuate wildy, as periods of economic weakness or contraction cause sharp sell offs, and monetary accommodation ignites big rallies. Central bankers are confronting the largest credit bubble in history, and there is no guarantee they can prevent a tidal wave of defaults from sinking the global economy, no matter how much they expand their balance sheets.
As we noted in our December letter:
“As long as the S&P holds above 1190, there is still the potential for the S&P to push above the late October high at 1292. Investors should consider allocating a small portion of their portfolio to the Prudent Bear fund or the inverse S&P 500 ETF SH, especially if the S&P climbs above 1292. Both would rise in value as the market declines.”
The S&P did climb above 1292 this week when it exceeded 1296, so the market is at an interesting juncture for a number of reasons. Various measures of sentiment reflect a surge of bullishness, in response to better economic reports and market rally. Ironically, the S&P is no higher than it was at the October 28 peak, so the market's net progress has been nil. Internally, the market is overbought, and the rally has occurred on very light volume, aided by an absence of negative news. As we have discussed, low volume rallies are vulnerable should any negative news appear and cause a pick-up in selling pressure.
The S&P has approached resistance, as marked by the trend line connecting the lows in March and June, and the high last October. Pattern analysis suggests this could be an important high, since the A B C (Most Bearish) from the October low would suggest the market is poised to decline below the October low in the next few months, as a Greek default triggers another financial dislocation. We think it more likely that the current high will be followed by a decline to near or below 1158, and then be followed by a rally that would be equal in length to the 217 point rally from the October low at 1075, if the ECB becomes more aggressive in counteracting Europe's recession. (Less Bearish)
The least bearish scenario is for a modest decline that holds the wedge line of support between 1235 and 1248, which is followed by a dynamic push above 1320 on much higher volume. The 0.786 retracement of the decline from 1370-1075 is 1307. The initial rally from 1158 topped at 1267. Adding 109 points to the 1202 low targets 1311. Next week is option expiration, so the S&P may be able to grind up to 1307-1311. But the common thread in the above scenarios is that the market is near a high of some significance and vulnerable to a decline. Shorts established when the S&P exceeded 1292 should use a close above 1320 as a stop.
Bonds - In our November letter we suggested buying TLT, which is the ETF that mirrors the yield on the 20-year Treasury bond. It traded as high as $125.03 on October 4, just as the stock market was making its low. We think it will trade above $125.03. Use a close below $115.80 as a stop. Sell half if it trades above $125.03, and raise the stop to $117.50.
Dollar - In our May letter we recommended going long the Dollar via its ETF (UUP) at $21.56, and in our July 31 Special Update, we suggested adding to the UUP position below $20.91. A close above $22.62 should constitute a breakout, and set the stage for a rally above $24.00 in coming months. Use a close below $21.90 as a stop.
Gold - Since gold topped on September 6 at $1923, we have expected gold to decline below the September low of $1535.00, which it did on December 29. We recommend selling 65% of the position purchased at $154.00 on the opening on December 30, which was $155.48. We wanted to buy one-third of the GLD position back at $145.00, and another one-third below $140.00, but the low was $148.27. Sell on the opening of January 17, and repurchase one-third at $152.20, using $148.30 as a stop.
Is Decoupling Possible in a Global Economy? by Macrotides
Investing Blog articles by Macrotides
About the Author
Macrotides is a monthly subscription newsletter written by a wealth manager associated with a major Wall Street investment bank. The author’s firm has requested that he not use his name to avoid any incorrect implication that his views might reflect those of the bank. The author has written investment advisory subscription newsletters based on macroeconomic analysis and market technicals for more than 20 years. Enquiries can be made firstname.lastname@example.org.