Taking the Temperature

The S&P500 inched up 0.88% in another low volume week, despite a scary final session, when many of the eurozone’s leading nations were downgraded by Standard & Poor’s rating agency. Volatility, interestingly, moved slightly against the price rise and moved up slightly, about 1.4%.

US economic news took a turn for the worse, disappointing on multiple fronts, starting with wholesale trade, which barely grew, instead of rising at a strong 0.5% rate. Initial jobless claims roared back to the 400,000 level associated with economic recessions. Retail sales were horrible. Instead of rising 0.4% as expected, they managed to creep up only 0.1%. What’s worse, the more important retail sales ex-autos results collapsed. Instead of rising 0.4%, they fell 0.2%. Business inventories (a key driver of GDP growth) rose far less than predicted. International trade was far more negative than expected, and export prices were far weaker than consensus estimates. Both of these results suggest that the economy was growing more slowly in the fourth quarter of 2011.

Technically, the S&P is very overbought on the daily charts. And it’s showing signs of losing momentum.  It seems that it wouldn’t take much for the upside momentum to stop completely and reverse to the downside. Greek default, anyone?

Last week, we reviewed the insightful investment advice that was provided by Howard Marks in his new book, “The Most Important Thing: Uncommon Sense for the Thoughtful Investor”.

The key insight noted here was the need to take the market’s temperature periodically, to assess if the markets were too optimistic, too pessimistic, or somewhere in-between (or neutral). This type of analysis is much easier to do, and it’s far more accurate, that what almost every professional investor does instead–forecast the near future, place his bets, and hope that the actual outcomes match the predicted future. Because in the predicted future comes to be, then the bets should pay off handsomely. But if the predicted future fails to arrive, then the bets will not pay off.

Marks noted that most professional investors and even most professional economic forecasters have a horrible track record with their forecasts.

So instead of betting on consistently inaccurate forecasts, investors would be better off if instead they focused on reading the present, on taking the temperature of today’s markets.

And today, we can easily rule out that idea that markets are pessimistic. After rebounding smartly off their 2009 lows, equity and credit markets are certainly not running scared today as they were back then.

In fact, by several measures that Marks uses, markets are more optimistic than they are neutral. Equity investor surveys are decidedly more bullish than they are bearish. In the credit markets, interest rates are very low; money is eager to lend at tight spreads, especially for investment grade bonds. Corporate profits aren’t just high, they are near record high levels (as a percent of sales). Asset owners are happy to hold; certainly they’re not rushing to sell. Asset prices are on the high end of multi-year ranges.

As a result, Marks would conclude that since, today, prices are on the high side, that risk is also on the high side. Therefore prospective returns are on the low side.

It bears repeating that “taking the temperature” today is not a forecast for tomorrow.  Instead, it is a determination that being fully invested today raised the odds of lower future returns.

So what’s a professional investor to do….with this type of temperature reading?

Marks would offer several pieces of actionable advice. First, don’t take on much more risk when it’s so high today. In fact, consider reducing risk, by selling it down. And certainly don’t break the golden rule of value investing (of buying assets below their intrinsic values) by overpaying for assets. Another related part of this advice would be to increase the percentage of your portfolio that’s held in cash, to be ready for times when prices (and risks) are lower, and to lessen the damage that could result from market corrections, corrections that are more likely to occur in overly optimistic markets (than in overly pessimistic markets).

Again, without knowing anything about the near future—and without making any attempts to forecast it—our temperature reading of TODAY’S markets is flashing a caution sign. It’s telling us to be careful about higher risks today, but also to be prepared to accumulate assets, at lower prices and lower risk levels in the future, should they become available.

Words of wisdom indeed.

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