Temporarily Conflicted

As an investment manager, I am constantly monitoring multiple data points in my decision making process. There is no such thing as a perfect investment environment. When risk management is a good part of your job, there is always some piece of information to sway your decision. I remember when Operation Iraqi Freedom launched in the middle of March, 2003. U.S. markets had seen 3 years of bear market declines and many investors were in no mood to talk about stocks, still suffering from brutal declines in their wealth. The stock market, however, had been rallying for months and combined with other economic develops underway at the time, I encouraged clients to get into stocks. 2003 turned out to be a great year for stock investors.

I believe in highly diversified portfolios. There’s a never ending set of variables to consider when managing portfolios and diversification helps you maintain exposure in an often conflicting environment. Investors can't afford to go completely to cash when the environment gets ugly. But I do think you can over and underweight different asset classes to create a more offensive and defensive position to accommodate market conditions. At present, I have incorporated a defensive bias in many portfolios, which has worked well in the most recent market downturn.

Since mid-March the markets have rallied and I must now re-evaluate my exposure to U.S. stocks. After yesterdays big run I considered adding the NASDAQ 100 to some portfolios. Compared to the S&P 500 and DJ 30, the NASDAQ 100 has seen more trading above its average volume on up days and very little increased selling on down days since the rally started over a month ago. It includes many global companies, (Apple, Microsoft, Google, Cisco, Intel, and Oracle). Outside of information technology, which represents around 64% of the index, it includes health care (14%), consumer discretionary (13%), Industrials (5%), and a small allocation to a few other industries. The NASDAQ 100 has also performed on par with emerging market stocks since the rally kicked off in March.

The challenge is determining if the current rally is sustainable or simply a rally within a market headed for more declines. To finalize my decision I reviewed the current climate and what do you know, the Fed came out with a brand new liquidity program to help banks (you mean they need more help? Isn't everything all rosy now that they have written down some debt and raised liquidity with new financing?). The Fed is now willing to take credit card and auto loans as collateral for Treasuries in an effort to expand liquidity. The Fed even convinced the European Central Bank and the Swiss National Bank to joint in. Sounds like a party, but it points to a very serious problem facing world markets. For more details see the following MarketWatch article. Banks are still holding troubled debt and as a result they are unwilling to make loans to each other. I have posted on the trouble with the TED Spread previously and the latest action by world monetary authorities is targeted at that specific problem. A low interest rate environment by itself does little to stimulate the economy. The economy needs a vibrant loan market so businesses and consumers (mostly consumers) can spend money (isn’t that what got us into this problem to begin with?) which helps drive corporate profits. Which brings me to another important concern: corporate profits (as measured by Y/Y % change) have been very strong over the last 5 years and are considered by many analysts to be at unsustainable levels. Q1 '08 earnings were far from a disaster and international strength helped many companies turn in reasonably good numbers, but profit growth remains in negative territory, a trend started in Q3 ’07. At current valuations, the expectations for profit growth are considered by some to be lofty. If the current profit slowdown in financials spreads to other industries, it is going to be hard for stocks to maintain current valuations. Of course, globalization may help U.S. corporations deliver positive profit growth later in ’08, as many expect. Even so, it is not uncommon for stock prices to lag profit increases, as we saw 2002-2003 for 5 straight quarters. In 2006-2007, we saw the exact opposite: growth in stock prices exceed profit growth for 5 straight quarters.

It is hard to watch the NASDAQ 100 move over 18% (since March 10th through today’s close) and not feel like better days are right around the corner for U.S. stocks. After my review, however, I feel as through there are more obstacles to over come then sustainable drivers that can push stocks higher. I would not be surprised if short covering has helped facilitate the current rally and I continue to remain cautious on U.S. stocks.