In late April, I initiated my model portfolio. The portfolio is intended to represent the general construction of a long-only model portfolio with a six- to 12-month investment horizon. My hypothetical portfolio depicts an overall equity weighting and positioning relative to S&P 500 industry benchmarks and weightings.Successful investing is anticipating the anticipation of others. As discussed in the body of today's update, this morning's aggressive moves look beyond the current stock market vigor and the immediate strength of corporate profit cycle and more toward a confluence of factors that could lead to disappointing profit and economic growth next year. Today represents another major change in our model portfolio, with a further increase in the cash component of the portfolio from 43% to 54%. I am further reducing both recommended equity (to 41%) and credit exposure (5%) after a huge run in both asset classes. Over the balance of this year, I expect to further reduce the portfolio's recommended investment positions and raise cash weightings if there are (1) renewed signs that my baseline expectation of a double-dip in the economy is rising in probability; and (2) we witness a dissipation in the strong price momentum that has characterized the U.S. stock market over the past several months.
It's Different This Time
"Before all else, be armed." -- Niccolo MachiavelliIn the last several recessions, aggregate economic activity moved quickly back to peak levels. My view remains that it will be different this time -- just as the 2002-2006 cycle was unique in financial history. The enormity of the monetary and fiscal stimulation required to stabilize the U.S. economy speaks volumes to the depth of our economic woes and to where we might have been headed without government intervention. Those required policy efforts will have a long tail. Moreover, unbridled debt creation will no longer catalyze growth in a world where banks are reluctant to lend, the securitization markets are broken and the shadow banking system is nearly extinct.
The U.S. Government's Role Will Have Adverse Consequences
"It is dangerous to be right when the government is wrong." -- VoltaireWhile it is fortunate that our financials institutions have reduced the chance of systemic risk by decreasing their balance sheet debts, the U.S. government has taken the banking industry's place. And with that, comes challenges anew over the next decade.
The Bills of Massive Stimulation Will Come Due Sooner Than Later
"I, however, place economy among the first and most important republican virtues, and public debt as the greatest of the dangers to be feared." -- Thomas Jefferson
"The best way to destroy the capitalist system is to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens." -- John Maynard KeynesThe consensus view is that the replenishment of historically low inventories, the effects of recent and extraordinary fiscal/monetary stimulation, a recovery in residential housing activity and given the productivity gains from draconian corporate cost-cutting, the earnings cycle is so strong that it will trump the longer-term consequences of policy and will produce a self-sustaining recovery in 2010-2011. Even if the recovery does disappoint, most believe that they can get out of the market before the due bills and adverse effects of policy are felt. This might be wishful thinking as everybody, sooner or later, sits down to a banquet of consequences.
Nontraditional Headwinds Seem Likely to Dull Growth
"For everything you have missed, you have gained something else, and for everything you gain, you lose something else." -- Ralph Waldo EmersonMy variant view is that the strong short-term earnings cycle, which has dominated the investment landscape, captured investors' confidence and buoyed share prices over the past six months, will be short-lived as many of the aforementioned policy initiatives (e.g., one-time mortgage credits or the cash for clunkers program), while serving to pull forward sales, are borrowing from 2010. Moreover, numerous nontraditional headwinds ( highlighted in my last model portfolio update) will serve as a governor to economic growth. I see little incentive for businesses to get on the offensive and restock, especially in light of the continued deflationary trends in wages and in the absence of evidence of any sustainable advance in demand.
The Consumer Remains the Economy's Achilles' Heel
"Who gets the risks? The risks are given to the consumer, the unsuspecting consumer and the poor work force. And who gets the benefits? The benefits are only for the corporations, for the money makers." -- Cesar ChavezThe consumer is a victim of broad corporate cost cuts and remains particularly exposed in the period ahead. Private wages and salaries fell by a record 5.2% annualized rate in July. While some improvement from depressed levels can be expected, the labor market remains weak, and jobless claims are still elevated. I see the possibility of the consumer retreating from the decades-long aspirational spirit and turning back toward the legacy of the post-Depression mentality of maintaining the status quo. With this reset will come disappointing personal consumption expenditures and a higher level of savings that will likely match the post-World War II average savings rate of 7.5% and could even begin trending back toward the direction of double-digit savings rates that existed in the recession of the early 1980s.
Possible Outcomes Look More Problematic Than Expectations
"To be uncertain is to be uncomfortable, but to be certain is to be ridiculous." -- Chinese ProverbIn summary, there appears to be a wide range of corporate profit and economic outcomes possible in the year ahead. (It's important to note that not to be absolutely certain is one of the essential things in rationality.) Arguably, the market's recent advance is discounting the most favorable outcome and growing consensus view of a shallow but self-sustaining economic recovery. By contrast, I see the economy stalling in early 2010. If I am correct, the waning of optimism in a self-sustaining economic recovery coupled with the likely impact of numerous constraining secular influences will weigh on the credit and equity markets over the balance of the year.
- Technology: Microsoft (MSFT - Get Report) and Dell (DELL).
- Financials: I am eliminating Prudential (PRU - Get Report), MetLife (MET - Get Report), Hartford (HIG - Get Report), PNC Financial (PNC - Get Report), SL Green (SLG - Get Report) (convertibles) and National Financial Partners (NFP) (convertibles). Remaining are Bank of America (BAC - Get Report), Cohen & Steers (CNS - Get Report), Chubb (CB - Get Report), JPMorgan Chase (JPM - Get Report), Loews (L - Get Report) and SLM Corporation (SLM - Get Report).
- Energy: Transocean (RIG - Get Report).
- Health Care: Staying with selected HMOs.
- Consumer Staples: Dropping General Mills (GIS - Get Report) and Unilever (UN), adding PepsiCo (PEP - Get Report), remaining is Procter & Gamble (PG - Get Report).
- Industrials: Dropping 3M (MMM - Get Report), remaining are PPG Industries (PPG - Get Report)and Union Pacific (UNP - Get Report).
- Consumer Discretionary: Remaining are Home Depot (HD - Get Report), Lowe's (LOW - Get Report), Disney (DIS - Get Report) and eBay (EBAY - Get Report).
- Materials: Remaining is Freeport-McMoRan Copper & Gold (FCX - Get Report).
- Utilities: Duke Energy (DUK - Get Report), Dominion Resources (DRU) and PG&E (PCG - Get Report) remain.
- Telecom: Remaining are Verizon (VZ - Get Report) and AT&T (T - Get Report).
- Credit: Halving exposure by selling high-yield debt.