Investment Strategies for a Sluggish Market

The markets across the board have had corrections. The first quarter of 2005 was the worst quarter in two years for the S&P 500. Investors’ problems for the quarter did not end with the big company stocks that make up that index.

My database of mutual funds and exchange-traded funds showed negative returns in March for almost all funds. One group of funds that prospered is made up of funds that sold short stock market indexes, such as Rydex Ursa and Profunds Bear. A few other specialized funds that are in our Alternatives Portfolios prospered, such as Third Avenue Value, Hussman Strategic Growth, and Laudus Rosenberg Global Long/Short Value. There were no ETFs with positive returns for March.

The dollar staged a recovery in the last half of the quarter. That triggered sell signals for a number of our international stock and bond positions. These positions had boosted our returns earlier in the quarter. Real estate investment trusts, which we sold in January, continued to decline after a brief recovery in February. Bonds had modest losses.

The only investments that did well for the quarter were energy, commodity-related, and home builder stocks. Even these started to correct in March. The Nasdaq and technology-related stocks were the worst parts of the U.S. markets, losing about 10% from their peaks.

Some aspects of this correction might indicate an important change developing in the U.S. stock markets.

Small stocks have been beating the major stock indexes for about five years and held up well in recent corrections. In the latest correction, however, the small stock indexes lost more than the major market indexes.

In addition, financial stocks are suffering. Financial company stocks now make up about 30% of the S&P 500 and are the largest segment of the index. Low interest rates have been very profitable for many financial companies in recent years, and their performance essentially put a floor under the indexes. More recently, financials have been among the worst performers in the markets.

The decline in financial stocks indicates that investors are taking the threat of higher inflation seriously. They also believe that the Federal Reserve is likely to continue to increase interest rates, and those increases are going to hurt the financial companies as they have in the past. Until now, investors have ignored the interest rate increases. Another factor in the decline is the latest scandal at AIG and continuing scandals at other insurance companies.

We shouldn’t be surprised that the stock market sagged while the economy was doing well. I have explained in past visits that stocks and the economy frequently are disconnected. I believe today’s disconnection is due to valuations. Stocks remain above their long-term valuations, and after the bear market of 2000-2002 investors are hesitant to overpay for stocks. As I’ve said in the past, I believe we are in a long-term period in which the indexes essentially are flat – similar to 1966-1982.

We’ll earn more than the market indexes by carefully selecting from a wide range of investments, using money managers with unique and proven disciplines, and using sell signals to exit from investments that are in decline.

Sector and Balanced Managed Portfolios

Several sell signals have been triggered since our last visit.

The resurgence of the dollar finally triggered the sell signal for American Century International Bond. I remarked a few months ago that from the charts it appeared the dollar was near its low point for this cycle. The markets confirmed that as the dollar bounced off the lows.

Long-term the dollar could suffer further. The global trade imbalance and sluggish economies overseas need to be corrected. Either overseas governments must take steps to enhance their economies or the dollar is likely to fall. But for the year or so, higher interest rates and strong economic growth should continue to attract investors to the U.S. and stabilize the dollar. We made solid profits from BEGBX over the last couple of years, but I do not plan to reinvest in international bonds for a while.

A sell signal also was triggered for Driehaus Emerging Markets Growth. Emerging market stocks were among the hardest hit in the March correction. A combination of the dollar’s rise and a correction in commodity prices took a toll.

A significant share of these portfolios now is in money market funds because of the sale of these funds and the January sale of Cohen & Steers Realty Shares.

The Oakmark Fund has done its job during this period. It lost less than the market indexes and shows signs that it will recover strongly when the markets rally. Torray Fund has not done as well, losing more than the major indexes. Its concentrated portfolio contained a few stocks that reported bad news. We’ll hold these funds. Each is run by proven stock pickers and follows the focused, value-oriented strategy that can succeed in the current market. They look for great companies selling at good prices and concentrate their portfolios in their best ideas.

There are few opportunities with a margin of safety today. As I said, U.S. stocks overall are fairly valued to a little overvalued. There are few undervalued sectors in the U.S. market. Most of my favorite value managers continue to report difficult finding stocks that meet their standards.  Therefore, they are building cash. Income investments also are not yet appealing.

Hussman Strategic Growth continues its record of delivering strong returns with low risk. Going into the correction most of its portfolio was hedged against a market decline using futures. The fund’s indicators determined that the market environment was turning negative and that valuations were high. In addition, the stocks owned by the fund performed better than the indexes. The result is that the fund has gained about 2% for the year while the S&P 500 has declined more than 2%.

I’m recommending that we shift some of our recent sale proceeds from money market funds to Hussman Strategic Growth. It is the best fund in this uncertain environment. We’ll keep some of the portfolios in money market funds until next month’s visit. Details are in this month’s Investment Portfolio Supplement.

Income and Income Growth Portfolios

We’re in the most dangerous time for income investors. There was a great deal of complacency in the markets until recently. Longer-term interest rates declined as the Fed continued to raise short-term rates. The yield gap between treasury bonds and riskier investments declined. Investors were seeking higher yields, ignoring the traditional risks of those investments.

Many of them got hammered in March when longer-term rates reversed course. Rates declined a bit since then, but more increases are in store. Real interest rates continue to be extremely low. The Federal Reserve still has not reversed fully the moves it made to avoid deflation in the early 2000s. Unless the economy stalls, rates will continue rising until short-term rates are in the 3% to 4.5% range. We’re getting close to the bottom of that range, so we don’t yet have a margin of safety.

During this tough time for income investors, these portfolios have been in the safest shelter in the storm. Vanguard Short-Term Investment Grade Income lost a small amount of money, but it is among the top-performing bond funds in recent months. Income funds that take more risk tumble each time rates rise. Yields still are so low that the higher relative yields won’t make up for the likely losses as rates increase.
We won’t want to move out of our safe haven for at least a few more months. Stay invested in VFSTX and be content to preserve capital until the coast is clear.

Dodge & Cox Balanced provides some potential for capital gains with income to the Income Growth portfolio. To protect us from big losses from a steep stock decline, there is a sell signal in place for the fund. But it has not come close to triggering it. Hold the fund as long as it remains above the sell signal.