Jubak's Journal - A portfolio for pessimists
6/16/2006 12:00 AM ET
If you're a true pessimist -- and the number of those has swelled recently -- you know a rally like that which began on June 13 doesn't really change anything.
It's just a trap, a fake to get you feeling good about stocks, so that the market can slam your portfolio again. Sure, now stocks rally, now that the financial markets have decided that the odds of the Federal Reserve interest-rate hike at the end of June are 100%. But what about an August increase? Aren't worries about that just around the corner?
If you're feeling pessimistic about stocks right now, you're certainly not alone. A drop of 8% in the Dow Jones Industrial Average ($INDU, news, msgs)and 11% in the Nasdaq Composite ($COMPX, news, msgs) from May 9 through June 13 has turned plenty of us into pessimists. Watching the even bigger declines in the small-company Russell 2000 Index ($RUT.X, news, msgs) -- 14% -- or in foreign indexes, such as the 20% drop in Japan's Nikkei 225 ($US:N225, news, msgs), doesn't help the mood any.
It will take more than a two-day rally to turn that mood around for many investors. And feeling pessimistic at a time like this is understandable and perfectly appropriate.
But just as getting too optimistic is likely to cost you at market tops, getting too pessimistic will exact its pound of performance flesh at market bottoms.
At a time like this, when thoughts turn to the dark side, it's good to think about exactly how pessimistic you are -- and should be. Pessimism, like optimism, comes in all kinds of flavors and degrees. Do you belong to the "It's nasty but normal" school or to the "Bury the gold, Martha, and pass the ammo" camp?
In this column, I'm going to lay the "big picture" groundwork for developing what I call The Pessimist's Portfolio. In my next column, I'll give you some individual stock picks for building The Pessimist's Portfolio. It's a relatively short-term portfolio, designed to take you through the next 12 months. It begins with an attempt to gauge exactly how pessimistic you are -- and then to examine if your worst nightmares hold up in the light of day. I'll then show you, in my next column, how to construct a portfolio that's the best way to navigate the market, even if your pessimistic vision turns out to be accurate.
When it comes to developing an investment strategy, your degree of pessimism matters. And the easiest way I know of to measure that pessimism is to build a scale of pessimistic scenarios from best-of-the-worst to worst-of-the-worst.
Pessimist's Scenario No. 1
Not much has changed. Despite all its saber-rattling, the Federal Reserve isn't really all that committed to fighting inflation to the death. In fact, all the tough talk about fighting inflation is a prelude to a pause after a June or maybe an August hike in the Fed's series of interest-rate increases.
(And, yes, for the record, it looks like my May 12 column, "The Fed is done hiking rates (for now)," is going to turn out to be dead wrong. The Fed funds futures market has priced in the odds of a June 29 interest-rate increase at 100%.)
The world's other central banks, after getting strong political opposition, also decide enough is enough by the end of 2006. This would lay the foundation for a fourth-quarter rally in stocks and a drop in prices at the long end of the bond market as investors become convinced that inflation isn't dead. But it wouldn't be good news for stocks in 2007.
This policy shift would leave the world awash in relatively cheap capital (although more expensive than in early 2006) and leave inflation to continue its recent climb. The central banks and the financial markets would have to fight the cheap-money battle all over again on less favorable terms (and with another stock market tumble) in 2007. The U.S. dollar would fall with the end of Fed interest-rate hikes, adding to inflation, but economic growth ends the year stronger than now expected.
Pessimist's Scenario No. 2
The central banks raise interest rates until inflation cries uncle. But they overshoot and crush economic growth, too. Emerging markets sink further as money gets more expensive and competing yields in developed markets climb.
The higher energy and commodity costs now finally creeping into consumer prices may leave the central banks no choice. The U.S. consumer price index (CPI) announced on June 14 was very bad news in this context. For May, the core (that's inflation without energy and food) consumer price index climbed 0.3% to an annualized rate of 2.4%. That's matches the February 2005 rate, which was also a four-year high. (The core consumer price index hit a 40-year low of 1.1% in 2004.)
But the Federal Reserve's quarterly report on the economy, the Beige Book, released on June 14, also reveals a slowing economy with housing starts and home sales, job growth and retail sales all showing signs of moderating. Economists currently believe that higher energy prices, higher interest rates and a slowing housing market are finally taking a toll on the U.S. economy.
If the banks are too focused on fighting inflation, this scenario goes, they could wind up stepping on the brakes too hard, turning a gentle slowing into a hard crash. The combination of higher interest rates and less growth would be bad for stocks.
Knowing how central banks work, an unexpectedly fast economic slowdown would lead the Federal Reserve to at least cut interest rates in 2007. By that time, the damage to the stock market would be done, of course, with cyclical stocks -- everything from oil services to copper miners to heavy equipment makers -- taking the brunt of the punishment on the U.S. markets.
Pessimist's Scenario No. 3
The Federal Reserve raises rates a couple more times but then stops while the central banks of Japan and the European Union keep going. The rate increases are enough to slow U.S. economic growth. But they're not enough to bring U.S. inflation under "control."
With the yield difference between U.S. bonds and Japanese and European equivalents narrowing, the dollar starts to fall. A stumbling U.S. economy keeps stocks from appreciating, and that makes U.S. dollar-denominated assets even less attractive to overseas investors. Some investors start to shift out of dollars, causing the dollar to fall even further, which produces an even bigger dip in the dollar.
To stop the slide, the Federal Reserve has to raise interest rates, sending the U.S. economy further into a tailspin. The result: the worst of all worlds with higher interest rates, a weaker dollar (meaning less buying power for U.S. consumers) and slower economic growth.
A 12-month time frame
Maybe you're pessimistic enough that you want to add even more nightmarish scenarios at the end of the list. Be my guest. But remember that this is a list for the short term. I just don't see the worse fears of total economic collapse or financial collapse that I know lurk out there among my readers coming about in the 12-month time period that I'm addressing in this column.
The immediate effect for me of spelling out these three scenarios is to demonstrate how much more likely the first two are than the third. The third requires a number of conditions to work out exactly right -- or actually, exactly wrong -- for this disaster to occur. Pessimist's Scenarios 1 and 2 are comparatively straightforward in their engineering.
Unfortunately for the investor, these two scenarios lead to almost exactly opposite investment strategies.
In the first, growth remains solid, interest rates remain relatively low and inflation remains relatively high. In these circumstances, you'd want a portfolio loaded with cyclical stocks -- oil services, for example, heavy equipment, commodity metal producers, coal miners -- to take advantage of continued growth. With inflation fears rising toward the end of the year you'd want to own gold stocks and other inflation hedges. An increase in yields at the long end of the bond yield curve would be good for bank stocks. A falling dollar would work to the benefit of gold (again) and argue for exposure to Japanese and European stocks.
That's a pretty decent description of the composition of the Jubak's Picks portfolio right now.
That second scenario
But what if it's Pessimist's Scenario No. 2 that dominates the next 12 months? Well, on the evidence of the performance of Jubak's Picks since May 9 -- down roughly 15% through June 14 -- the results would be, how shall we put it, somewhat disappointing.
That's because higher U.S. interest rates would lead to a stronger dollar and lower prices for gold stocks.
That's because slower U.S. economic growth would lead to slower sales and a declining rate of sales growth for cyclical stocks and commodity producers.
That's because higher interest rates plus slower economic growth would take a bite out of bank revenues as lending slowed and more weak borrowers wound up in default on their loans.
On the other hand, some kinds of stocks did absolutely or relatively well in the downturn: Pure growth stocks. Highly predictable big-company stocks, such as General Electric (GE, news, msgs), and financials such as local bank stocks.
Exquisite torture
The pessimist in me appreciates the exquisite torture of this position as investors are caught between two very different pessimistic scenarios that demand very different strategies and that will impose very different penalties on investors who get it wrong.
How to get out of this pickle?
I think there is a way to prepare your portfolio for a reasonable chance at success in either of my first two pessimistic scenarios. Despite their differences, each of these scenarios does have one similarity: Under both scenarios, the stock market will be starved for predictable, relatively high earnings growth. Uncertainty about Federal Reserve policy and the speed of economic growth won't get resolved any time soon. Given lags in the economy, we won't know about the effects of any Federal Reserve action until a good six months after the bank's move.
Scenarios 1 and 2 have more in common from this perspective than concentrating on Federal Reserve moves and likely GDP growth rates suggest. Both scenarios describe what I'd call a Growth Famine, a period where stocks that deliver promised earnings -- and a little bit more -- will be very rare.
And in the stock market, like any market, things that are rare are very valuable indeed.
Next column: Part 2 of the Pessimist's Portfolio -- 5 stocks for a growth famine.
Updates
Sell Copart
On June 9, two insiders sold shares of Copart (CPRT, news, msgs). In other markets, I'd be inclined to overlook the sale by a director and a senior vice president of 26,000 and 5,500 shares, respectively. Insiders sell for lots of reasons that have nothing to do with their perception of a company's future and I, therefore, give them much less weight that insider buying. But coming on the heels of the company's miss on earnings and revenue in its May 31 earnings report, I'd give this selling more weight. The last thing any stock needs in the current market, which I see drifting lower over the summer, is a combination of insider selling and an earnings shortfall -- a result in this case of a huge backlog of damaged vehicles as a result of hurricanes Katrina and Rita that has depressed prices. (Copart sells salvage vehicles.) The effect of that inventory on prices is likely to last for at least another quarter or two. So I'm selling Copart out of Jubak's Picks with a 2% gain since I added it to the portfolio in January 2006. The sell will also give me cash to use in the better buying opportunities I anticipate in late July and August.
New developments on past columns
Can bankers save the world? Investors say no: Russia has decided to diversify away from U.S. dollars for the moment. The country, which thanks to soaring energy prices now has the world's fourth-largest gold and foreign currency reserves, has announced that it will increase the allocation to euros and away from U.S. dollars in its $72 billion budget stabilization fund. The new mix of 45% euros, 45% U.S. dollars and 10% sterling represents a big swing toward the euro, which had represented 25% to 30% of the fund in the past. The direct effect of a shift in allocation in the $72 billion fund when global foreign exchange reserves total $4 trillion in likely to be negligible. But the move is psychologically important since it confirms fears of a gradual drift by central banks away from the U.S. dollar. That perception is a major factor in driving the dollar lower in the long run.
Editor's Note: A new Jubak's Journal is posted every Tuesday, Wednesday and Friday. Please note that Jubak's Picks recommendations are for a 12- to 18-month time horizon. See Jubak's CNBC Picks for shorter six-month recommendations. For picks with a truly long-term perspective, see Jubak's 50 best stocks in the world or Future Fantastic 50 Portfolio.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak did not own or control shares in any of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.
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