Alan Moore Commentary 5-1-2011   alanmoorecommentary.blogspot.com

    Its spring and most investors have heard the old saying, “Sell in May and go away.” That phrase was first coined in 1937 by my Uncle Walter who sold out of the stock market that year, just before it went down 35%. He didn’t go back in, choosing instead to invest in a franchise to distribute milking machines to dairy farmers (the first automatic milking machine had just been invented).  It turned out he was a great salesman; one time he sold two machines to a farmer with only one cow, and when the farmer couldn’t come up with the down payment, he took the cow as collateral. Milking it for all it was worth, in May of 1947 he sold that franchise for a big profit and retired; then he went fishing every clear day thereafter, until he died at 88. On my tenth birthday he took me on a fishing trip and I had the opportunity to ask him what he thought his greatest success was, and he said: “Sell in May and go away.” Sell what? I asked. He replied: “anything sells better in  May---- buying right is a numbers game, but selling is an art, and I was an artist………. May was my canvas.”(Uncle Walter was also an investment poet.) Being in the same boat that day, I questioned him further about his art with: “How do you know when to sell?” After a long pause, he held up the thermos bottle by his side and said: “it is like this bottle, you put something hot in it and it keeps it hot; you put something cold in it and it keeps it cold; it just knows what to do and when.  How does it know?” I was overwhelmed by his wisdom.

   Forty years went by before I understood what he meant, when I read an academic study going back to 1885 that said 66% of the time the market goes lower after May and doesn’t pick up until winter comes. Somehow, Uncle Walter knew that before the PHDs did. He also didn’t worry about the other 34% happening: “No sense crying over spilt milk,” he would say; “there is still enough milk in the jar to feed the baby.” (Uncle Walter was a master of metaphor)

      Last month The Wall Street Journal quoted a 70-yr-old retired guy about where he was invested and he’s keeping 80% of his money in the stock market. He said: “That’s why most of us are in stocks, because there is no place to go;” noting he would happily move into safer CDs if he could get a better rate. “I hope my assets don’t run out before I die.” In other words, my words, the stock market is rising because everyone is doing it, even the retirees who can’t afford the risk, driven to such lengths by the Federal Reserve Bank’s effort to support GDP growth with low interest rates. That about sums up the market’s mental state, culminating in the VIX volatility index which is down to 15 indicating that investors are complacent, as they huddle together in their ETF funds. The only thing that I can see that will stampede them out is rising interest rates, and I am betting on it by shorting long-term Treasury bonds, thereby exposing some of my portfolio to the risk that interest rates may go down suddenly due to a default scare out of Spain---and Spain is going to go viral sometime this year. The only difference between me and that 70-yr-old guy is that I had an Uncle Walter who taught me that it wasn’t such a bad thing to take money off the table and put it under the mattress……at least you can sleep on it. (Uncle Walter never had regrets)

     Not crying uncle yet, the old guy that is 80% in the market is putting his faith in decision-makers to see the cliff coming------ and there is no cliff, only a series of decision points centered on taking the path of least pain at the time of crisis. In a democracy, the right decision will always be obviated by compromise, so the voters won’t become riled. Hence, we have quantitative easing to accommodate our current spending binge versus just balancing the budget and bearing the pain now. After all, the budget deficit is $1,6 trillion and the Tea-Party-Republicans were only proposing cutting it by 3.8% ($61B), since watered down by compromise to $31B; has anything been solved? No, but supposedly, Congress sent a message that the decision-makers are on the job and see the cliff coming. In reality, the politicians are desperately trying to push the deficit problem into the future. For example, Obama’s health care provisions don’t kick in until 2014; Paul Ryan’s proposed Medicare cuts only apply to those less than age 56: both parties now propose cutting the deficits………… a decade out; and we know how that will go. Lee Iacocca once said, “I could cut anything 10%.” Where are the cuts? 

     Plagued with that bias, I am convinced the government will take the inflation solution to decrease the value of the national debt, versus actually controlling the deficits. It is the path of least pain which can be spread over many years. If that happens, Treasury bonds will not hold their value, nor will TIPS--- the inflation protected ones. The question becomes the timing, because there is money to be made in shorting bonds when the Fed reverses course. Most economists think our interest rates will stay about where they are until next winter, predicated on the unemployment number coming down very slowly-------- with that thinking, bonds should be safe until then. However, barring another European debt collapse, the end to QE-2 in June should be a turning point, and I think bond prices will drift downward starting in May anticipating a change in Fed policy; the European Central Bank already started raising rates last month and if US core inflation goes over 2% (and it will if oil stays high), the Fed will have to go to 3% to curb expectations. Such a move would affect short term rates at first resulting in a flattening yield curve. If they are not aggressive enough in raising rates, eventually long-term bonds will also be negatively affected. Believing that scenario will indeed happen, I recently doubled my short position of long-term treasuries, buying more of “TBT”, the ETF fund selling them short; accordingly, a portion of my money is where my thinking is, which may not be right of course. I doubled the short now because of Uncle Walter’s advice: “Anything sells better in May.” I just assumed that meant selling short.    

   The tail wagging the inflation that dogs us is, of course, “food and energy”.   Instead of letting the markets take care of those things, Obama is promoting the use of wind power which really can’t compete with carbon price-wise, just like  ethanol can’t compete with pure gasoline running a car. The difference between Obama and Don Quixote is that Obama talks-up wind mills while Don Quixote tried to fight them---both endeavors are losing battles. In the mean time, China is exporting their inflation to us which will add to the food and energy push on the CPI. For example, five years ago Chinese manufacturers paid the average worker $50 per month and now they are paying $250 to find qualified people. China has a labor problem and must raise prices for everything they produce, not to mention their currency: India also has a shortage of skilled workers.  Walmart, the biggest single importer of Asian textile products, will have to increase prices as a result, even as same-store sales declined 1.8% last quarter. Outsourcing production is at a standstill, but Asia’s labor is still a lot cheaper than our labor, therefore US workers will not be able to fill the vacuum-------- Inflation will, and bonds prices will suffer. I am not implying hyperinflation, just a modest single digit rise of 3 to 4% will occur; how can inflation surge a great deal (even with oil so high) when GDP for the first quarter came in at 1.8%:  the economy was forecasted to grow 3.6% by Obama & company  just three months ago----that is a 50% mistake. Obviously, the economy continues to remain weak and will remain that way the rest of the year. Stagflation is here and I am preparing for the consequences. 

   As to turning to stocks to find yield, I resist that temptation because of several factors that worry me: first, the Q ratio hit a 110-year high and, second, the dividend/price ratio on the S&P index is 1.8%, the lowest since it fell to 1.76% at the peak of the market in 2007.  Both indicate to me that the market is hugely overvalued, if not under-invested by the bullish crowd following the momentum. The Q ratio was developed by James Tobin, an economist who measured the price of the market divided by the replacement value of the assets of corporations. Banks for example, sell for 3 times tangible book value today; when I worked for a bank in the late 1970s, they routinely went for 1 ½ times book.  Being very low, the current dividend yield reflects the inclination of businesses to hold on to cash and not pay it out in dividends or invest it; obviously management is not so confident in the recovery. An overvalued market can go on for a long time, and the timing as to a change gravitating back to the mean is very difficult to assess; I certainly don’t know anything special, except that the market is risky and I don’t like it. Optimistically, I sometimes try to guess when stocks will go down------- and I did last month by buying the “VXX” ETF fund, which is essentially a short on the stock market, because it is tied to the VIX (volatility index). Volatility goes up when stocks drop and vice versa.  With this buy, I have officially shifted from a neutral position to a slightly negative one: 10% of my portfolio is short bonds and stocks, 4% in RWE and 86% is in cash. I also recently purchased real estate on a short sale and will probably buy more. Please don’t take this information as a recommendation to follow suit. I am more risk intolerant than most and too distrustful of government policy to be a long term investor, which doesn’t leave me much room to invest. (Uncle Walter only needed a mattress)

   The major risks that remain are housing and jobs; neither is doing well. In fact, home prices are set to take another dive with all the foreclosures coming down the pike. Here is what I mean:

(MarketWatch 4-26-2011) —“ U.S. home prices fell in February for the seventh straight month, according to a closely followed index released Tuesday, as the beleaguered market approaches a double-dip recession. Home prices in 20 major U.S. cities fell 1.1% in February, according to the Case-Shiller home-price index released Tuesday by Standard & Poor’s. Prices fell 3.3% year-over-year in February, compared with a 3.1% year-over-year drop in January. “

   Despite the bigger problems of housing and jobs, all attention is now focused on raising the debt limit, it appears Congress must raise the debt before it can begin to cut the debt-----however, it is the lack of jobs and housing-bust that is driving the economy sideways at 2% growth; the national debt is but a mounting headwind. At the end of June, when the Fed quits buying bonds, we will be left to face $4+-a-gallon gasoline at the pump……………. alone, with a credit card and a gas-guzzling car. If interest rates also rise, it will be too much for the consumer to bear; and the month of May could be as good as it gets for the stock market this year. Despite the looming doom, I am only willing to risk 10% of my portfolio on that scenario, which is not a lot of conviction. I sleep well though, on the cash------ My investment strategy can be summed up in a few words: sell May and buy October, and sleep on it in between. (I’ll blame Uncle Walter if it doesn’t work)  

Alan