Wednesday, June 3, 2009

Buy in May

Students of the Stock Traders Almanac will tell you that market returns over the best six month period of the year (November 1^st thru April 30^th) tend to trump those of the historically worst 6 month period of the year (May 1^st thru October 30^th.) On average for the DJIA, the November though April periods since 1950 returned more than 7% while the May through October periods remained flat.  Hence the saying “sell in May and go away!”  Just for fun, let’s look back at the six-month periods surrounding this crisis.

           Best 6:                        Nov 1, 2006- Apr 30, 2007:               8.1%

           Worst 6:                     May 1, 2007 - Oct 30, 2007:             6.6%

           Best 6:                        Nov 1, 2007 - Apr 30, 2008:            -8.0%

           Worst 6:                     May 1, 2008 - Oct 31, 2008:         -27.3%

           Best 6:                        Nov 1, 2008 - Apr 30, 2009:          -12.4%

           Start of Worst 6:       May 1, 2009 - May 29, 2009:         4.1%

So the pattern held until November of 2008…so far.  With May completed, we have now booked 1/6^th of the worst six-month period this year and have amassed a 4% gain.  While seasonality historically plays a role, I believe reversion to the mean tendencies trump seasonality.  Let’s look at the time periods of six-month losses in succession (since 1950) and the returns over the subsequent six-month periods:

                                                     Successive

                                                     Six-Month                   Next

            Beginning                  Loss  Periods           Six Months

            Nov 1, 1959                              2                          16.9%

            Nov 1, 1961                              2                           21.7%

            Nov 1, 1965                              2                           11.1%

            Nov 1, 1968                              3                             2.7%

            Nov 1, 1973                              2                           23.4%

            May 1, 1976                             3                             2.3%

            May 1, 1981                             2                           16.9%

            May 1, 1983                             2                             3.1%

            Nov 1, 2000                             2                             9.6%

So on average, over the last 60 years the first positive six-month period after a succession of negative six-month periods averages almost 12%.  Furthermore, there has not been a fourth consecutive negative six-month period to date.  So while the seasonality doctrine may suggest selling in May, the reversion to the mean doctrine tells you to buy.  This is not high finance by any means, but it makes me feel better.

The Other Markets

We spend a disproportionate amount of time in these weekly emails discussing the stock market. Now that corporate earnings season is behind us and the conviction around economic recovery has firmed, the stock market needs to look for inspiration elsewhere.  Moves in the stock market as of late have been reactionary to moves in the bond, currency and commodity markets, so for this week let’s turn our attention to these markets.

Bonds

Last year the only bonds worth owning were US Treasury bonds.  This year they have become toxic within portfolios.  The 10-year Treasury bond yield has risen rapidly from 2.25% at year end to 3.55% today.  Remember that prices fall when yields rise, so that amounts to large losses for Treasury bond holders.  Inversely, corporates and municipals have rallied strongly.  10-year municipal yields that were 4.46% are 3.45% now, while high yield corporate bonds were 19.5% at year-end and 14% now, serving up ample returns for holders.  (As an example, the high yield allocation in our bond model has appreciated 21% year-to-date).  This recovery in the risky sectors of the bond market reconciles with growing conviction in economic recovery.  However, the increase in the Treasury bond yield has raised eyebrows.  The speed and trajectory of the advance has stock market watchers concerned that key economic rates like mortgages will soon follow, choking off some of the oxygen to the economy.  The Fed has committed to purchasing Treasuries with $300 billion of their capital to suppress rising yields, but with Treasury issuance in the trillions, the $300 billion is nothing more than a gesture.  The most critical element of current market anxiety centers here.  Look for the 10-year yields to stabilize a bit, calming market fears.  The next 10-year Treasury auction occurs next week.  Light participation would validate concerns that foreigners are hesitant to hold longer-dated US debt.  This could have negative implications for the stock markets as worries persist about US solvency.  Heavy participation would pull this concern from the headlines and bolster stocks.  Either way, the US is funding all of its bailout initiatives with very cheap money historically.  I don’t believe the US will be a banana republic, but this is the wall of worry stocks must climb to move higher.

Currencies

The action in the US dollar has drawn vast attention.  Remember that currency prices are relative.  While the global economy is $48 trillion, the sum of all the financial assets equals $167 trillion.  This total moves with mouse clicks and can cross borders on command.  With all of this global money sloshing around, any shift in currents can have a huge impact on currencies.  Consistent with the move in Treasuries, when the global investor panicked in 2008, the dollar increased dramatically as Americans repatriated their foreign holdings and foreigners sought the safety of the dollar.  Between July 15^th, 2008 and March 9^th, 2009, the dollar rallied 23%.  Since March 9^th the currency has fallen 11%.  This slide contains elements of offshore risk-seeking activity, foreign repatriation and growing concern over the sanctity of US Treasuries.  As with the change in Treasuries, a measured move meets with expectations, while an exaggerated move raises concerns.  A decrease in confidence in the dollar will lead to foreign and domestic selling, seeking the relative safety of stronger currencies or commodities.  In my view, a dollar slowly drifting lower meets multiple agendas; a dollar falling precipitously would require intervention (either foreign or domestic).  As demonstrated, governments are no longer passive players.

Commodities

If you have real concerns about the quality of US debt or the soundness of the US dollar, buy oil!  Oil prices have rallied from below $40 a barrel in February to $67 today, a 70+% move.  Add to the concern the economic optimism trade, and you have powerful propulsion. Since gold does not benefit from economic expansion per se, but more from heightened anxiety and dollar concerns, the move in gold offers more insight into US solvency fears.  Gold has vaulted in the last six weeks from $870 to $978, or 12%.  These speculators have only one wish, the demise of the US dollar.  While that may not be patriotic, we do have bets alongside them.  Broader measures of US commodities such as the Dow Jones and Reuters commodity indices have advanced 5-8% year to date.  Commodities offer the double benefit of being offensive in an economic recovery and defensive in light of dollar declines.  We have been progressively moving more money here.

So there you have it.  At the risk of being redundant, the economic recovery trade is on, and the US insolvency trade has now begun.  The staggering advance off of the March 9^th low indicates that the stock market believes in earnings recovery.  Now the debate rages in the bond, currency and commodity markets over whether the US government can afford the clean-up bill.  The insolvency trade is short government bonds, short the US dollar and long commodities.  We currently have negligible Treasury bond exposure; we are overweight commodities and have more than 30% overseas.  Our most recent conversations have explored expanding our exposure to foreign and commodity-based holdings.  The issue is not whether this is prudent; the issue is how much exposure becomes imprudent.

Welcome to June!