Bermuda: LOM Weekly Perspectives

Bear Hug on Wall Street

Investors are in a disagreeable mood, and this shows up in the general trend of the major indices over the past few weeks. Even the best-performing big-cap index this year, namely the Dow, has given up ground - - despite positive talk about big multinationals being helped by the falling dollar. It appears that some investors’ patience may have run out. After waiting for a long time to see a solid earnings-growth turnaround, and trying hard to ignore accounting flimflam and management misdemeanour, they may have decided that they have had enough of it. However, let’s not generalise too soon because there are still some stalwarts willing to step up to the plate.

Some of the corporate managers appear to be in a selling mood as well. Insiders have continued to unload stocks, over and above what would normally be expected due to options expiration and portfolio diversification. Meanwhile, any sniff of trouble leads to severe punishment of the stock in question, which may then extend to the whole sector. This is what happened to Merck recently. Part of the reason is that fund managers have been burned badly in the recent past by the likes of Enron and Tyco and do not want to be caught with potential disaster cases in their portfolios.

They are very keen to have relatively safe "good-looking" stocks in their portfolios when they are preparing for quarterly reviews. However, eventually, the beaten-down stocks are rediscovered. In passing, we should note that even active managers are careful not to drift too far from benchmark allocations and weightings because of the risk of greater tracking error. The result is that they will buy issues that are heavily weighted in the index, despite poor prospects for such stocks.

We have said before that this is not a "normal" economic recovery and consequently we did not get the "normal" up-and-away rise in stock market indices this year. Nor has "normality" been witnessed in sectoral performance behaviour. There has been rapid rotation in and out of sectors, with quick switches in favouritism. Investors who initially latched on to sectors that traditionally do well as recovery unfolds have been disappointed and have been forced to rethink their strategy. We have, at times, observed the anomaly of consumer staples and cyclicals rising simultaneously.

Notably, the consumer discretionary sector made a run for it, early on, based on the usual argument that it was due for a rebound in concert with rising economic activity. It has since retreated substantially. As for the technology sector - a traditional growth play - we know the punishment that it has been receiving. At the same time, there have been a few fairly consistent winners – among them: consumer staples, defence industries and managed healthcare. However, even in lousy sectors it has been possible to pick winners by focussing on quality factors -- consistent performance and no fluff.

At the beginning of the year too many advisers were eager to recommend higher weighting in asset-class allocation towards equities, based on the usual cyclical recovery story. They had mistakenly looked for a strong rebound in stock markets, based on historical precedent. In fact, so far this year, both bonds and cash have outperformed equities. Low-yielding cash may have looked like trash, but some people forget that its principal role is not to give the investor competitive returns, compared with other asset classes, but to preserve capital. Needless to say, holding large cash balances is not an adequate long-term strategy.

Sentiment swings

Naturally, investors would like to see the bear hug eventually transformed into a bear rug. But that outcome doesn't appear to be just around the corner. Currently, there is no obvious spark that can signal a sustained turnaround in the market. Sentiment has soured regarding U.S. equities and it may not sweeten in a hurry. Of course we should not expect investor psychology to work symmetrically. Just because, for years, there was an overshooting to the upside in assessing American assets it does not mean that we have to get many years of negativity on the downside. However, there is no reason to expect a rapid positive turn in sentiment either. For that to happen, we need a quick readjustment of the imbalances in the United States. Meanwhile, the dollar is sliding but, fortunately, not collapsing. The reason is that while things haven’t turned out as rosily as expected Stateside, the situation is not shiningly bright in Europe and Japan. The balance of good news relative to bad news is just enough to make the latter attractive destinations.

The word "capitulation" is back in a many peoples' vocabulary again. Some analysts are looking for it -- to signal the end of bearishness. For that to happen, folks who have been hanging in the market expecting a strong recovery would have to give up all hope. This would lead to a significant sell-off, increase pessimism, flush out any remaining doubters and create bargains. However, it appears that there are still too many residual optimists left in the market for this scenario to occur. So, while some good values are appearing, the market as a whole is not super-cheap.