The market has moved to new highs for the year, but caution reigns supreme, with many concerned that the recent announcement of "QE2", or the second implementation of quantitative easing (which is about the only thing the Fed can do when rates are already zero), could lead to a bubble that will end badly. Brilliant minds will be debating the potential that this works or that it causes the end of the world as we know - I fall somewhere way in between. Having almost reached my near-term objective of 1250 on the S&P 500, I am short-term cautious, but I remain optimistic that we will reach 1500 in 2011 as I described recently. Essentially, we will get about 5-10% earnings growth projected for 2012 over 2011 and a 10-15% expansion in PE ratios.
The people who sell advertisements in financial publications or television networks as well as perma-bears and conspiracy theorists are alarmed by these charts:
Rumors of QE2 first hit in August. Note that from the very low that month until the recent high, commodities, as measured by the CRB index, have soared by 23%. Annualize that! The dollar has been somewhat weak, moving from $1.25 to a recent peak of $1.40 against the Euro, a 10%+ depreciation. The big fear is that the Fed is going to over-do it, holding Treasury yields below their fair value, stimulating the economy, killing our currency and leading to rampant inflation.
These are unprecedented times, so it's really unclear what the longer-term impact will be. It may not be enough! We just don't know. So, what's an investor to do?
To me, QE2 is just one of many moving parts. For now, clearly we have "easy" monetary policy, potentially helpful fiscal policies ahead (lower taxes, another round of targeted spending and several other options), very reasonable valuations, no excessive optimism and companies that are doing their best to manage (this I know, because I listen to lots of conference calls). It's a great time to own stocks!
With that said, we need to be careful: What if QE2 does turn us into Zimbabwe? Kidding aside, it pays attention to consider commodities, currency and interest rates in a longer-term perspective. I think that it makes sense to take some equity risk here until we approach certain "boundaries". At what point are commodity price changes, currency depreciation and rising rates a trigger for risk reduction? I think it helps to look at long-term charts:
The dollar has certainly weakened recently, but it doesn't look to be anywhere near the danger zone. The chart on the left, relative to the Euro, shows we are right in the middle of the range for the past few years. The big move there was coming out of the last recession and heading into this one (85-160). I also included the U.S. Dollar Index, which captures the weakening against all the other currencies. Again, this isn't too troubling. A 10% decline would leave us at the weakest levels, but not dramatically different from where we began the year. Against the Euro, I think 150 might be a level that would begin to cause some concern. This is good news - we can get away most likely with some more depreciation!
Again, it's nice to have this longer perspective. Like the cheapening of the dollar, commodities moved strongly from the depths of the last recession into this one. The rally has been sharp, but off of deeply depressed levels. Over the past 15 years, the CRB has appreciated 35%, which is less than inflation. Not exactly a problem. Here, I think that 360 would be the first sign of trouble. It's probably most important to watch Oil, which has a lot of resistance at $90 but even more at $100.
This is the most important chart to watch in my view. Actually, it may be second to the Corporate Bond yield chart, but this will make the point for now. In my view, the 10-year Treasury won't significantly concern investors until it hits 3.5%. While I imagine a move to 3% could lead to some initial reaction, let's face it: Rates are extremely low.
So, we have looked at three important indicators over a longer period of time in the context of trying to identify "how much is too much". I believe we have plenty of "slack" in each of these indicators before we have to worry about the proverbial rug being pulled out from under the stock market. Everything in moderation, but a little cheaper dollar, slightly higher commodities and gradually rising rates do not pose a problem.
I recently shared my high-level thinking regarding structuring portfolios as I turned over 16% of my Top 20 Model Portfolio and repositioned my Conservative Growth/Balanced Model Portfolio as well as I prepare for 2011. It probably makes some sense to lighten up in extended names and look for tax-loss selling impacted securities over the balance of the year. It probably makes sense to start to focus on more secular growth names too. As long as we stay in our boundaries, 2011 should be a good year.
Disclosure: No stocks mentioned