I am still sticking with my original forecast for 2007, though the timing has changed a little. I always disclaim any timing calls because there is no way even the most educated, smart people get this right every year. There are just too many variables, especially now that we are in a world economy. But my general thesis is based on history repeating in some ways. Value is value, so that remains constant and is the basis for all other decisions. I had suggested that the first half of the year (through the summer) would see declines, followed by a rally at the end of the year into 2008 leading up to the elections. The year before presidential elections is almost always good for the stock market.
When the market corrected by 6% on Feb. 27, I thought I had this call nailed. But then the market came roaring back to new alltime highs on the Dow 30 the past month. I still think this summer will be weak and the decline could start any day. However there is a big BUT and that is global liquidity (many years of good profits in raw materials) and the China expansion prior to the Beijing Olympics. Our economy is now global and what worked in the past for American markets, is now influenced by global markets. So, maybe the Melt-Up continues. Here are the arguments for both directions, up and down:
1. The market is neither cheap nor expensive at around a P/E of 16 for the Dow and around 20 for the S&P (which has smaller cap companies). This makes direction difficult to choose. It is why my own portfolio is somewhere in the middle with about 67% equity and 33% cash and almost no bonds, since it is possible interest rates will go up from here as the dollar devalues (to attract money back to the dollar, the Fed can raise interest rates). Of the equity portion of the portfolio, most is in "value" or low P/E stocks like Health Care/Pharma (now historically cheap), Energy or Basic Materials. You know I am heavily in the CanRoy oil trusts both for their value and their large dividends. The big dividends provide the income and diversity that bonds would otherwise provide. Dividends provide a cushion against a potential market downturn.
While attractive from a fundamental, world growth, point of view, materials stocks like FCX and BHP have become more expensive on an absolute historical basis. But, their profits are growing almost as fast as their stock price, keeping relative value almost constant. The potential demand from China and Asia for infrastructure development has the potential to dwarf anything the world has ever seen. Materials companies with operations in that part of the world (both FCX and BHP have big operations in Australia and/or Indonesia) will benefit for years to come. That is unless the China economy were suddenly to come to a halt or collapse. This is possible over the next 12 months as the big push for the 2008 Olympics in Beijing comes to a close. There is a lot of risk in the China economy right now as it is growing at historically unsustainable rates (for a national economy) of over 10% a year for the past 5 years. It makes sense that once the artificial, government led push for the Olympics is done, that the Chinese market will cool off, and maybe cool off the entire world economy.
2. Other than the Olympics thesis, it is not possible to know for sure what might change the current global synchronized economic expansion. Various war scenarios are speculative, they may but probably won't happen. There really is no precedence for this global economy. There was a 20 year period before World War 1 that saw global peace and prosperity with lots of free trade. And again in the 1950s, during the reconstruction after World War 2, there was a 20 year period of the same (Korea in the 50s notwithstanding). But during those periods, there was no internet or global communications. It was also before the era of global air freight and the fast movement of goods and people around the world. So, the expansionary period since the last big recession from 1990-1992 is exceptional. The current environment that favors industrial goods and basic materials is also without precedent (the construction of industrial infrastructure in the USA took 100 years and America is only 20% the size of China by population). High demand and short supply for raw goods could continue for another decade or more, until global infrastructure development slows, or materials production facilities dramatically increase supply.
3. We are now officially in a bull market from the lows in 2003. We did not know this for sure until earlier this year when the Dow went past 11,700 surpassing the previous high from 2000 (the S&P500 has not yet confirmed with a new all-time high, but is only about 2% away at 1510). Bull markets tend to have 5 distinct segments: up for several months to a year, then a 10-15% correction; up for another several months, then another 10-15% correction, and then a final up move which can have a big "melt-up" at the end before it collapses from its own prosperity and exuberance. This was the pattern from 1992 into 2000.
It could again be the pattern, with the correction last summer of 10%, now followed by the up leg which may be "melting up" right now. Note that the every day public investor like you or me is typically the last to get into a bull market (even though we all probably have mutual funds investing on our behalf all along the way). People who follow such data professionally say that the public is still on the sideline and never got back into the market after the 2001-2002 collapse. Until that money comes in, the market can't make a true bull market top. By definition, tops in stocks or in stock markets happen when everyone who ever will buy has already bought. Then, there is no one left to buy at a higher price, so all that can be done is to sell, driving the market lower (into a bear market).
The way we can know a major market turn as average people without access to industry data that shows this action conclusively, is to watch major magazines and newspapers. When the media headlines start talking about a New Era and featuring great riches earned (or lost), we know we have either a market top or bottom. You may have noticed a year ago that all the talk was about how EVERYONE was making money flipping real estate. That was the sign that the top had been reached in that market. Same thing was true in 2000 with all the talk of the Internet changing the world and creating a new era and people day-trading tech stocks that had no earnings.
So, if in the next few months, everyone gets in, then that will spell the top of the market. Since that time is hard to see until it has passed, it is probably good to have one foot in and one foot out of the pool. At this stage of the cycle, investments should be defensive (lower P/E and non-cyclical necessities of life) with a lot of dividends to provide a foundation for the stock should there be a correction.
4. The dollar continues to weaken against world currencies. Fewer nations are using the dollar as a benchmark. Japan still does, but says it may not in the future. China is gradually moving away from the dollar as its standard, slow enough not to hurt its export economy. As the world moves to other currency standards (or "baskets of currencies"), and the US goverment continues to run big deficits, the dollar MUST continue to devalue. This will move the price of all world raw goods, especially precious goods like gold and silver, higher in dollar terms, even if the prices stay constant in other currencies. Gold, then, is a good hedge against devaluation, as are energy plays like the Canroys or the other Materials stocks like BHP or FCX. In fact, the first quarter's supposed "earning surprises" to the upside were mostly a result of currency translation by the big multi-national companies issuing those earnings reports. When the dollar goes down against the Euro, then all profits from Europe earned in that currency will appreciate by the amount of the decrease in the dollar. The dollar decreased by about 8% in Q1. That was about the same as the "earnings increase" reported on average. So, on a weighted basis, profits in real dollar terms may have only increased by 2-3%, not the 8% reported. This will eventually catch up as year over year comparisons do not benefit from currency translations in the future (if the dollar stops sinking).
If you are looking for an idea, other than precious metals / gold (VGPMX) or the CanRoys I recommended in January that you bought, I am now buying and recommending BDJ and DHG. BDJ is a twist on "Dogs of the Dow" investing. It buys the highest dividend Dow 30 stocks and does so with borrowed money which leverages the return. It also uses a Covered Call options strategy to further enhance payouts. Covered Calls are a good defensive strategy and easier to execute on large cap Dow stocks when working with big money in a fund like this (options fees are high compared to the available returns on these big name stocks for average investors). The return is currently around 8.3% with a monthly payment. The payment has been steady for a couple years at a little over 10 cents a share per month. Share price is right around $15. If the Dow goes up, so will the price of BDJ, as its portfolio appreciates. But it is a closed-end fund, so underlying value (NAV) and the market price can be and usually are different. Make sure you don't buy at a premium to NAV. It is a small discount right now, so a good time to buy.
Another closed end that I have started buying is DHG with a dividend return around 7.8%. This is more of a commercial paper (short term loans to companies with high interest rates) and a high dividend fund specializing in deep value stocks (including some CanRoys). It is run by Dan Dreman's fund company. Dreman is a renowned value investor. This one is brand new and so has had a pretty spastic market price as a closed-end can, even though the NAV has hardly changed at all.
Both the above benefit from a lot of diversity. It is unlikely either will get hammered in a market selloff on NAV (market price MIGHT get hurt, but would quickly rebound. The payout probably won't change, so the yield would provide some drag on the selloff: as price goes lower, the dividend yield goes higher if payout is constant). As long as high yielding investments are in tax deferred accounts, there is no tax impact from the payments and they will continue to compound if reinvested in the CE funds.
www.etfconnect.com is a good place to research closed end funds and see the history of discount versus premiums
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