Let’s try not to ascribe too great a significance to the market’s current rally since April. However, for all the right reasons, everyone loves an uptick and portfolio valuation increases. Bear in mind, though, that markets are cyclical, not linear, and nothing goes straight up without pause or capitulation.
To start, too much of these rallies are paid for with borrowed funds. And as we all know, but conveniently tend to forget, borrowed money needs to be paid back at some point. By avoiding any thought about payback, and hoping instead for the “big score”, individual investors and hedge funds, alike, are playing fast and loose with incontrovertible truths, and ruining the market in the process.
Secondly, if earnings are the lifeblood of economics, then there are too few success stories to support the kind of massive rotation of all stocks into a never-ending upswing. In truth, only two sectors (Technology and Consumer Non Cyclicals) have shown any kind of near-term staying power.
To be sure, the moves in Energy and Basic Materials can be justified on a secular (generational) basis. These two sectors have/have had the highest product demand and the greatest pricing power, which drives bottom-line profit margins. But even the strongest of secular trends experiences intermediate topping, and that is the case for commodities currently.
Just behind their exhaustion follows the always volatile Industrials, which has been in a short cycle advance for the past 3 months, but with little acceleration in earnings advances.
The least attractive, and worst performing sectors are the Cyclicals and Financials, for obvious reasons. The consumer is simply not in a position to boost discretionary spending, and those who are lending investment capital have the most to lose if demand does not pick up, as has happened to the once-burgeoning real estate market.
One might think from this diatribe that I don’t favor stocks, currently. I respond by saying that the subtlety of the message is more complex than that.
Stocks will do better than bonds because rising rates hurt bonds more than all sectors in the equity market. As I wrote last week, tumbling bond prices are certainly enough of a disincentive not to buy bonds. Although my work does indicate a rough road ahead for stocks (because of declining earnings acceleration patterns) there always is the opportunity to be properly “sector-allocated” and “sector weighted”.
Unfortunately the yield projections in my analysis do not lend the same type of buoyancy to the bond market. I predict more defaults on outstanding long term debt, and more portfolio devaluation in the face of rising interest rates.
The same macro fundamentals that drive the economy have negative influences upon categories of financial instruments. Many global banks and most consumer pocketbooks are two of those potential casualties of the current climate in world finance.
Couple the “cost of money” with the “cost of goods” (inflation) and you have a potential shift in economic momentum.
All is not doom and gloom. I see investment opportunity in the emerging markets, which require telecommunications and brick-and-mortar development, alternative fuel sources, bio-pharmaceuticals and healthcare, as well as computer periphery and software.
The question to ponder today is “where are we on the social and economic paradigm” and in which phase is the momentum moving?
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