The most surprising thing about the market this year is not that the S&P 500 had its best first quarter since 1998. It is that only two of the S&P sectors outperformed the broader index in the first quarter: energy and industrials. The last time this happened was in the first quarter of 2000, as the tech bubble was peaking. While the US stock market was strong in the first quarter of 2011, it was also quite narrow, not usually a healthy sign, especially when the leaders have by and large led the market for the past 10 years.
Professor Daniel Kahneman, who won the Nobel Prize for economics in 2002 for his work in prospect theory, visited our research team recently. He chose to talk about new work in cognitive psychology, specifically work on how the subconscious affects behaviour.
He said that while we live in a conscious world, much of our behaviour is automatic and driven by the subconscious. Psychologists call the subconscious System 1 and conscious behaviour System 2. System 1 is more or less automatic and System 2 involves attention, time, logic and analysis.
The work he described has implications for how markets function. If one is a contrarian value investor, one’s portfolio is a function of System 2. The time horizon is years. The market, though, is a real-time information processing mechanism and is almost entirely governed by System 1: a piece of news comes out and the market reacts almost instantaneously.
Last week’s sharp drop in the price of oil demonstrates how long oil markets have been governed by System 1. With the exception of last week’s sharp correction, it has been bullish for oil. If the dollar weakens, oil goes up, because oil is denominated in dollars and a weaker dollar leads to higher oil prices. If the US economy slows, that is bullish for oil, because it means the Fed will continue to pump liquidity into the economy and excess liquidity means higher oil prices. If the US economy strengthens, that is bullish, because it means more demand for oil. Emerging markets growth is bullish for oil, since it means more demand. Low per capita use of oil, such as in China, is bullish, since it is bound to go higher. High per capita use is bullish, because it means lots of demand.
The reaction of oil and other commodities to news flow is a largely automatic response to the market’s dominant theme, the dollar debasement trade, which we refer to as DDT. Just as that chemical was highly effective in the short run but poisonous over time, so too with the economic version.
There is, however, a price at which demand destruction will begin, and which will then reverse the price of oil. No one knows what that price is, but it is a lot closer with Brent crude, up 50 per cent since early November. This trend may have even started last week.
According to data compiled by Barry Bannister, equity analyst with Stifel Nicolaus, commodity returns relative to stock returns are at 200-year highs on a rolling 10-year basis. One thing is clear about long-term commodity returns: they are cyclical.
The nature of commodity cycles is that when prices are at lows, people believe they will go lower, and when they are at highs, people believe they will go higher. For the cycle to end, prices have to have been high enough for long enough to convince everyone that this time is different.
Have prices reached a level that fully reflects the concerns about supply and that may begin to destroy demand? I don’t know. What I do know is that there is a lot of price in these assets, a lot of momentum, a lot of belief, and not, in my opinion, a lot of value.
Where is the value in the market today? In the assets people do not want, that have no momentum, and that are cheap. Three broad sectors and two broad themes stand out. The S&P 500 sectors are; financials, technology and healthcare, which are in the bottom decile of their historical valuation ranges. This means they have been more expensive 90 per cent of the time over the past 60 years or so. The themes are US mega cap and deep value, meaning low price to book value and high free cash flow yield.
We began the year quite bullish on US equities. The Federal Reserve was providing ample liquidity, core inflation was subdued, interest rates were low, earnings growing, corporate balance sheets strong and valuations undemanding at about a 20 per cent discount to our assessment of fair value.
The market has been absorbing a lot of DDT without yet succumbing to its noxious long-term effects. From this point on, a lower dollar with concomitant higher oil and commodity prices, is bearish not bullish. We expect the Fed to end QE2 this summer. The System 1 reflexive view that Fed policy means higher commodities and a lower dollar will lose one of its pillars.
We believe now is a good time to buy what’s on sale, and a bad time to buy what’s been marked up, just as it was in 2000.
do your own due diligence