In the fall of 2005 I was listening to my doctor describe the land she had just bought to build her dream house. The land was purchased from the Rockefeller family. It sounded like the usual game of smart money picking off the peak of the market while picking the pocket of the uninitiated. “It is a good thing that commodities traders can make money in down markets,” I thought.
These suspicions were reinforced a month later when a press release from Sotheby’s auction house stated: “Sotheby’s will be selling a range of decorative arts and Impressionist paintings from the Collection of Mr. Laurence S. Rockefeller, the pioneering venture capitalist. The proceeds of the sale (are) estimated to bring in excess of $12 million.”
Playing both sides of the market lets us profit from other investors’ tendencies to overplay directional moves in each asset class. We can take advantage of the popular preference for hard assets at the expense of paper assets. Of course, doing so requires us to be aware of the dichotomy between hard assets (commodities) and paper assets (stocks, bonds and foreign currencies) and to be on the right side of each swing of the pendulum. It appears the pendulum may be starting to swing in a new direction.
By looking at the traditional movement of dollar investments through the major asset classes and then measuring three forces: employment, productivity and expectations for inflation, we can assess the likelihood that the U.S. stock market may be propelled into a new direction.
SOFT TO HARD
For six years, we have seen investors pile into gold and other hard assets. “They make it on Wall Street and bury it on Main Street,” is the old adage that warns of investors’ dumping paper assets to buy commodities.
The old wisdom refers to taking profits in the stock market and buying houses, grown-up toys and anything else people can literally put their hands on. We have been watching this transformation of wealth from paper to commodities during the recent cycle. The stock market peaked in 2000 when people started a long fire sale of equities. As the old saying goes, they spent their new cash on Main Street. The “store” with the most sales was the real estate broker’s office. Other stores that did well were home furnishings and mortgage bankers who offered refinancing as interest rates fell. Cash generated by stock sales financed hard assets. The question is now, when will investors move back into paper investments such as stocks? The short answer is: they already have. The U.S. Department of Housing and Urban Development announced that new housing starts declined at the end of 2005. From a peak of 2.2 million starts in February 2005, the agency reported a 13% drop in December to 1.9 million new starts. The regression line that slices off the top of this graph suggests the peak has passed. The trend in housing starts since 2003 appears to have waned. People may be starting their traditional move out of hard assets and back into paper investments. However, investors have not been moving into the U.S. stock market yet. The move out of hard assets back into paper investments often goes through the foreign equity market.
AND BACK AGAIN
Europe is usually the beneficiary of this switch, but Latin America, Canada and Australia may be the new favorites. This time around, our southern neighbors have attracted cash, while Europe has struggled with the legacy of decades of socialistic policies. The economies of developing countries, on the other hand, have flourished because they depend on providing commodities such as copper and tin that we use in construction.
To demonstrate this trend, look at the trend in the Latin America 40 Index iShares (symbol ILF) to the S&P 500 index. This situation may change as American housing starts level off and we need to fill those homes with fewer durable goods. The things we do put into our homes may be provided in a more productive manner. And those productivity gains, which rose toward the end of 2005, tend to have leverage for the consumers’ cash position. First, these gains strengthen the economy. Then, a stronger GDP usually leads to employment gains. An expanding economy that produces cheaper goods puts more money in the pockets of consumers. That cash can go into U.S. equities.
The increased employment from an expanding economy provides the additional income required for stock market investing. The long bull stock market began to attract the general public at the end of 1994. That is when employment increased and people had money to put into the market.
In 1994, near the bottom of “Stocks follow jobs” you can see that employment took a sharp turn for the better. People had more cash to invest and they had an IRA or a 401(k) to put it in. They had fewer corporate pension guarantees in the form of retirement pay and health insurance than they did in the 1980s, so there was an incentive to add to their own savings.
TIME HAS A ROLE
In addition to employment, expectations for inflation play a large part in asset allocation. Hard assets attract money when people expect higher inflation, while paper assets prosper when those worries recede. The yield curve is the traditional measure of inflation expectations.
A sharply positive curve, especially one in excess of 3% between the three-month Treasury bill and the 10-year T note says investors expect a major increase in inflation. Note that this is not saying they expect a high level of inflation, but that they think the rate of change will increase dramatically from the current level. Indeed, according to the Bureau of Labor Statistics, we saw a large increase in inflation, from 0.1% to 1.3% between 2002 and 2005. This rate of change, foretold by the steep yield curve in 2002, fueled commodities prices for several years.
By the middle of 2005 that curve had become so flat that many investors were concerned about a recession. Perhaps they should have worried more about what they were paying for their houses, oil futures and gold. They should have worried because the Fed had been taking cash out of the system for more than a year. There were fewer funds available to boost the prices of hard assets. At the same time, the supply of these commodities, most notably houses, was expanding. The definition of inflation as “too much money chasing too few goods” was reversed. Money supply decreased while homebuilders were building and gold miners were digging.
The investing public became enamored of gold and other hard assets and paper assets in the form of the U.S. stock market languished. “Gold glitters, stocks fade” (below) shows that gold more than doubled while the S&P 500 struggled between 2001 and 2006.
UP TO DATE
It was easy to watch the price of gold and miss the incipient shift back into paper assets. Only the most perceptive investors noticed the first tentative steps back into paper because they came in through the back door of a supplier of the commodities that built our new houses: Latin America. But the U.S. Department of Housing and Urban Development data suggest new housing starts are slowing. This slowing may reduce the demand for commodities and force the flow of funds back to the U.S. equity markets.
Productivity and employment gains may speed a move back into the S&P 500. Both of these factors put cash in the pocket of the consumer. The flat nature of the yield curve last winter suggests a major shift from hard assets to paper assets may be the next big thing in the markets. The curve, productivity and employment suggest investors’ next choice is likely to be U.S. equities. A 13% decline in housing starts and continued strong employment gains suggest a big change could be underway.
Deborah Weir is a CFA and author of Timing the Market (John Wiley & Sons, 2005). You can reach her at www.wealthstrategies.bz.