An Appel a Day...
07/29/2005 12:00 am EST
With the multitude of variables impacting the outlook for financial assets, market timing is at best an inexact science. Not surprisingly, few have stood the test of time. One who has is Gerald Appel, who has focused on marketing timing since 1973. Here's his latest.
"From 2001-2004 the dollar fell, but so far this year the dollar is up 10% despite persistent trade deficits. The question for investors is whether this year’s rally in the dollar is just a short-lived advance, or whether a long term rebound in our currency has begun. Since 1971 there have been eight rallies of 10% or more, six of at least 15%, but only three of 20% or more. There have been only two major long-term advances: 1978-1985 and 1995- 2001. Is the current rally the start of another multi-year uptrend such as these two? Or is it more likely a shorter-term move of the sort that has occurred much more frequently?
"Clearly, a smaller move is more likely based on the frequency of past occurrences. An analysis of fundamentals also suggests that the current rally in the US dollar is not likely to develop into a long-term uptrend. The two major historical rallies in the US dollar occurred in the setting of high real US interest rates compared to those of our trading partners. The higher the real interest rate, the more attractive a country’s bonds should be (creditworthiness being equal), and therefore the more actively sought out its currency should become.
"Fed chairman Alan Greenspan has commented on the conundrum of low interest rates. With the bond market confounding predictions of higher interest rates for the past two years, it appears unlikely interest rates will rise much faster than inflation in this country. US bonds (and by extension the US dollar) could also become more attractive on a relative basis if real yields fall elsewhere. In order to accept this a basis for predicting further appreciation in our currency, one would have to project that economic growth in our major trading partners should slow considerably.
"However, economic growth in other developed countries (particularly Western Europe) is already quite slow. It is hard to conceive of their economies getting so much worse as to depress their already low levels of inflation and of interest rates. The implication is that although it is reassuring to see that our currency has found support rather than tumbling to new lows in concert with our burgeoning trade deficit, the action in the US dollar this year is unlikely to be the start of a long term uptrend. This means that international stocks, even in Europe (the foreign stock markets with the poorest results this year when translated into US dollars), could become more attractive later this year or next.
"The stock market seem to be forecasting an ideal economic scenario of continuing growth with low inflation. Oil prices have backed off a bit from their highs, which would be good news if it continues. Nevertheless, I continue to believe that upside potential for stocks remains limited in the near term. Small company stocks have been leading the way higher during the second quarter, perhaps marking the last gasp of their six year reign of supremacy over large caps. They have been helped by falling interest rates and by a strong US dollar. Both of these favorable trends have begun to be challenged this month. Based on trailing earnings, small caps are more expensive than large caps by a wider margin than normal, which is another reason to expect that this market-leading sector will face headwinds in the months to come.
"Moreover, seasonality is unfavorable on two counts. The May 1-October 31 period has historically been far less favorable than the November 1-April 30 period. The presidential election cycle has helped the stock market achieve above average returns during the election year and especially during the pre-election year. Conversely, the mid-term and post-election years have been below average. From the technical analysis viewpoint, the S&P 500 now seems to be in a situation similar to where it was back in March, when it closed at 1225. Certainly there is room to go higher, but that does not mean the market will. Market breadth may give a clue as to whether or not the investment climate is changing, and if breadth remains weak, watch out below.
"During the second quarter of 2005, both of these factors turned favorable for small companies, perhaps explaining the outperformance of small caps during the second quarter. The Russell 2000 index started off poorly in 2005, but recovered strongly during May and June. Now, in July, small caps have faltered. At the same time, investment grade bond prices have pulled back, and the 10% advance in the US dollar index has stalled. The implications are that small caps remain stronger than large caps over the intermediate term, and may therefore remain the best trading vehicles. However, just as the long term prospects for a higher US dollar and lower US interest rates are far from certain, so too are the prospects for continued outperformance of small caps over large caps. Despite their strong showing in the second quarter, I caution against making a long term commitment to small caps."
Meanwhile, based on his relative strength system, here are the four funds in his "low volatility" portfolio: Third Avenue Value All Cap (TAVFX); Fairholme Fund All Cap (FAIRX); Artisan Mid Cap Value Mid Cap Value (ARTQX); and RS:Partners/A Small Cap Value (RSPFX). In his bond portfolio, Appel holds Northeast Investor Trust Corporate High-Yield Bonds (NTHEX) and the iShares Lehman Aggregate Bond Index Fund Int-Term Corporate Bonds (AGG ASE), both ETFs.