Trading for our strategies at Dightman Capital has picked up the over the past several weeks and an enhancement to our approach has been the emphasis of client communications recently. We also sent a note to clients about deteriorating forward looking economic indicators. Overall strategies at Dightman Capital have been preparing for a deteriorating environment for weeks and now consist of primarily defensive positions.
While there has been some strength in select economic data, overall activity has not been able to bring unemployment below the elevated level of 9%. Adam Smith described Land, Labor and Capital as the factors of production that produce utility and wealth. I believe our political leaders are going to have to address how each area is being handled and propose more productive solutions.
Perhaps we will avoid a sustained move down, but the risks we won't are high. I know some readers may wonder how the market could go so low when stocks are considered by some to be so cheap. What investors often forget is many P/E calculations are based on FORECASTED earnings, which are often revised down, sometimes dramatically, as economic conditions deteriorate. Be on the lookout for this development as we enter earnings season in October.
I prefer to use adjusted historical earnings based on Shiller and Crestmont methods to gauge whether stocks are cheap or expenses. The most recent data show they are a little more than fairly valued. The most recent update from Crestmont puts the average Crestmont adjusted P/E ratio at 13.7. As of September 30th the Crestmont P/E ratio was 16.8, above its historical average (arithmetic mean). The trouble is many other factors like the price of S&P 500 and Corporate Earnings Growth are also above their historical averages. Is the perfect fundamental storm about to unleash capital destruction on investors? I sure hope not but here again is reason for investors to be cautions.
So what is an investor to do now? If you believe we are about to enter a period of a sustained downward move in U.S. stocks, investment grade bonds are a logical choice. I know some commentators consider bonds in a bubble and risks in the asset class high. With the U.S, economy heading into recessionary territory, inflation and interest rates are likely to be held at bay. Japan is a current day example of a developed economy that has been able to keep interest rates low for a prolonged period.
I do expect U.S. stimulus measures will eventually catch up to us in the form of inflation and higher interest rates which would push bond prices down. That is why investors might consider using bond ETFs for exposure to the asset class. There are several bond ETFs with better liquidity than some individual bonds which may allow an investor to trade the investment more efficiently. You also get the benefit of diversification. With just a few bond ETFs you can cover several different classes of bonds across the yield curve. That is more difficult to do with individual bonds.
Another strategy for dealing with rising interest rates, when the day arrives, involves shorting the bond market. There are several ETFs available today that would allow an investor to hedge their bond portfolio should rates start to rise.
If you believe bond interest rates can move lower bonds are a reasonable place to invest during a downward move in stocks. You have the potential for capital gain and you also collect income along the way. With money markets not paying investors, there are few viable places to park cash while you wait for the current situation to stabilize and recover.
There are a lot of mixed signals in the economy right now. When the message gets muddy, that is when it pays to play more defense. Regardless of what happens over the next few weeks or months, the economies of developed countries are in serious trouble and likely to keep markets volatile for years. Sure, we can issue trillions in additional debt to prevent defaults, but the debt has to be repaid. The simple fact of the matter is some economies are not growing fast enough to make payments on their EXISTING debt. How do we expect they will be able to make payments on additional debt? So far budget cuts and austerity measures have not been enough, especially with the low growth economy.
Michael Lewis has a new book, Boomerang, which surveys some of the world's most financially challenged countries. He recently provided a nice overview of how several countries created their debt trap and how they are responding. The contrast between the Icelandic, Irish and the Greeks reveals how difficult it can be to bring different cultures together and helps explain some of the challenges Eurozone policy makers face. You can listen and read the story here.
Back in the U.S. we have our own set of challenges. We find ourselves at the convergence of both systemic economic issues (aging populations and high debt levels) and mixed policy effectiveness from our elected officials. The economy is facing multiple challenges that are not often experienced or understood completely and standard Keynesian economic policy appears to have fallen short of what is needed.
The bearish tone of the market has been augmented by a recent announcement from the leading economic indicator firm, Economic Cycle Research Institute (ECRI). They have made a recession call for the U.S. which is explained further in this video clip.
This is not the economy of the 80's and 90's which is why I have been urging investors investors to use a different investment approach. An approach that is more nimble and active. We recently enhanced our strategy after a period of backtesting and implemented the change at the end of September. It will take a couple of quarters to confirm our expectations. We believe we will be able to maintain our current risk management element, which is simply the goal of avoiding sustained downward moves, with the enhanced characteristic of positive annual returns. It is a tall order but our experience with this economy and new backtested data we are ready to take on the challenge.