We continue to believe for the time being, that the best approach right now is to remain cautious and prudent. The biggest mistake most investors make is they always feel like they need to be doing something.
Geopolitical events aside, the economy and the stock market runs in cycles. We are not as focused on what is happening geopolitically as we are with what is occurring within the business cycle. Don't get me wrong, geopolitical events are important, but the maturity or end of a business cycle is the first thing we are focused on.
The Business Cycle
Economics teaches us to look for certain signals during a business cycle. Basically there are two that we would like to address;
1) A business-cycle peak-Typically, earnings are high and unemployment is low at a peak. When prices for raw materials rise and inventories start to increase, look for a downturn to follow.
We believe the business cycle has peaked. The stock market usually anticipates the end of a business cycle, and it may begin to slide even as good earnings are still being reported.
Once the economy begins to contract a bear market usually follows. A bear market is characterized by rising yields, falling P/E ratios, and sharp declines in stock prices with heavy trading volumes.
It is a toss up as to how long a bear market will last. The bear market that begun in January 2000 did not reach its finally lows until September 2002. Of course, the economy took a number of hits during that timeframe. In fact, it had to contend with;
1) A business- cycle peak.
2) A Presidential election that took weeks to resolve.
3) The attacks of September 11th, 2001.
Historically, bear markets have last on average 9-12 months.
Bear markets usually end when the stock market becomes indifferent to bad news. The market will tend to look beyond the widespread pessimism, and you will begin to see a gradual upturn in stocks.
It is during this period when the business-cycle begins to bottom out.
2) A business-cycle trough- The trough is usually characterized by low earnings and high unemployment. When investors start to become widely pessimistic, an upturn in the economy and stock market will not be far behind.
The Federal Reserve usually helps to light a fire under the economy by lowering interest rates.
Despite what we are hearing today, the end of the tightening cycle does not signal the beginning of a new bull market. An economic downturn usually ends after the Fed has made of series of rate cuts.
Summary
I believe we are in the early stages of an economic downturn. A well balanced portfolio of fixed income and cash will be of use to investors in the weeks and months ahead.
Here is a series of events that we think will unfold;
1) The housing bubble is deflating, and consumers who have borrowed on the equity in their homes will begin to feel some pain and curb their spending. Already, consumers with adjustable rate mortgages have seen 20%-40% increases in their monthly due to interest rate resets.
2) As the consumer pulls back, earnings estimates will come down, and stock prices will follow.
3) Energy prices have acted like a tax on the consumer, and will continue to do so until the U.S., Chinese, and world economies contract.
4) Consumer spending has driven the savings rate to the lowest level since before the depression. As real estate prices fall, foreclosures will rise since many consumers do not have enough savings to get them through a rough patch.
5) As the U.S. economy teeters on recession, Chinaç—´ economy will come in for a hard landing. After both economies contract, the rest of the world will follow which will cause a major correction in energy and commodity prices. This correction will ease inflationary pressures.
6) Interest rates will decline, and bonds will rally.
7) During periods of maximum pessimism, investors should increase their exposure to stocks.
