I’d like to talk to you for a moment about my lawn. Back in 2003, my family purchased one of the great “old ladies” of Appleton, an 1893 Queen Anne Victorian complete with a wrap-around porch, a turret, and even the ghost of a former teacher (Mae Webster). Yes, the house was in need of much work and we’ve been diligent in attending to its needs over the years. The previous owners (knowing that they were going to sell) put down a wide array of lawn fertilizers, chemicals, pesticides, etc., which truly made the lawn look great.
But my wife and I have always avoided using chemicals on our lawn, mainly because we’ve got a lot of kids in the neighborhood, including our own. Eight years later, the lawn is admittedly a mess. We’ve got creeping charlie, chick weed, quack grass and other invaders too numerous to mention. It’s going to take a lot of effort and money to get back ahead of the weeds, especially if we decide to do it naturally. I actually believe that the chemical treatment of the lawn in previous years made its present condition worse as it became too dependent on artificial means rather than being allowed to grow naturally thick and lush and beautiful.
But It occurred to me a while ago that the U.S. (and probably the global economy for that matter) all are suffering today from the aftereffects of artificial stimulus that – for a time – made the global economy terrifically robust and vibrant. Back in 1998, both political parties created changes in the tax code that made it advantageous for real estate investors to flip investment properties by deferring capital gains tax, and to upsize their primary residence by avoiding capital gains tax altogether. In a word, the strategy was “brilliant.”
And I’m quite sure I know why it was done: some special interest group or analyst pointed out that real estate (primarily housing) drives approximately 60% of all economic activity, and that if you wanted to stimulate large-scale economic growth you should start by stimulating the housing market. The extra subdivisions and housing complexes and strip malls and apartment buildings (not to mention all of the municipal infrastructure needed to support them) probably wouldn’t have been created otherwise. The change in the tax code was just the “chemical additive” that was needed to get it all started. And boy did it boom, as we all know!
But over time, the real estate market (and the market as a whole) became vastly overbuilt due to this artificial stimulus. What didn’t occur to our leaders at the time that everything has a cost, and that if a growing housing market would lead to exponential economic growth, a shrinking market would have the potential to cause exponential economic contraction. In other words, take away the fertilizer and you’ll have a real mess.
We’ve got it. The bill that recently passed both chambers of congress and which President Obama signed is simply this: a bill that cuts economic stimulus (spending) at a time when it is most critically needed. The global economy is slowing – the evidence is clear (rising planned layoffs, plummeting durable goods orders, rising unemployment, and shrinking consumer spending). This is EXACTLY the environment trend-following strategies like ours are built for. We are once again at a tipping point, and I fear that most of society is no more prepared today for the ramifications than we were three years ago.
I wrote earlier this week that we’re close to several meaningful adjustments that would reduce or eliminate our exposure to the markets before the emerging downward trend gets to be much worse. That is true, as we are beginning to see several shifts in the optimal trends for which action will be required. Within the next few days, we will significantly reduce positions if the markets can’t find their footing. We’ve given up as much as is reasonable, and believe me when I say that there’s plenty of downside left to run for the markets. But for our portfolios, the line in the sand is close, just like it was in 2000 and 2007 when we reached past major turning points.
Our targets for the markets remain as they have for roughly the last seven years: Dow 14,000 at the top of the range and Dow 7,000 at the bottom. This is the range we’ve been stuck in since the turn of the century. Any sustained market decline would bring us dangerously close to 7,000 – we sit right now at around 11,800. This would represent approximately 41% downside from here that we have no interest in participating in.
The potentially crushing part of any economic weakness is the reality that our government’s hand has just been tied by the recent debt deal. Mandatory caps in spending mean that no additional stimulus would be possible. There’s no room for error in the current recovery, and if it falters we can’t expect any real government help.
But the vast majority of investors are in no way prepared for another economic slowdown. Foundations are investing exactly the same way they did in 2007. State-run investment boards still have massive economic risk that they haven’t taken steps to mitigate. College endowments have suffered massive losses time and time again over the past 11 years but still haven’t figured out that the market has changed. They say that time heals all wounds, but in the case of many of these important institutions time has been wasted. If a sustained downward trend emerges, time may have indeed run out because they still have no way to effectively manage the risk of another large, protracted decline.
The markets are at a critical juncture, and we’re ready to make meaningful adjustments to our investor’s portfolios if the advance that started back in September of last year really has run its course. We’ll know soon. I believe that the best values in the market may be in the “bear market” indexes that we employ in many of our portfolios as their current prices reflect a deep discount compared to where they traded the last time the markets were in the Dow 12,000 neighborhood. Any sustained decline and absence of additional stimulus could lead to a value “explosion” in these assets, a condition I would be eager to exploit for our clients’ benefit.