For the last three months I have been urging caution, and recommending you hedge your longs with shorts; then came May's plunge - which was the worst May performance for the Dow since 1940. Have stocks reached their buying point? And is the time for caution over?
Not in my view - if anything, conditions may be getting dicier - for at least three reasons. First, the stimulus money is about to be mopped up worldwide, and drying liquidity is bad for stocks generally, no matter how attractive a particular stock is individually. Second, worldwide conflicts are rising and there's a chance of one or two deteriorating into wide-scale wars, which would further raise risk. Third, the U.S. is going through one of its periodic bouts of meekness, which always causes the U.S. dollar to fall. None of these factors on its own is good for stocks. Taken together, they call for extra caution.
Let's take them in order.
First, the stimulus. When the Fed is your friend you can invest confidently - such as in the depth of March, 2009's market plunge, when all central banks were printing money with abandon. You could then invest heavily, since the central banks were all on your side. Indeed, many stocks have doubled since. Now, unfortunately, it's the opposite - central banks everywhere are beginning to suck money out of the markets, to prevent inflation from rising. So whereas in 2009 stocks had the wind at their back, now they have the wind in their faces.
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Second, conflicts worldwide are growing. For the last year I've been noting that the huge capital destruction that took place worldwide would magnify all conflicts, raising the chance that some would become all-out wars. This is coming to pass: whereas the war in Afghanistan and Pakistan is ongoing, North Korea is a hot new trouble spot that may blow up, Iran is getting hotter and may blow up as well, and now Turkey, too, seems to be keen to join the fray, wishing to become an empire again. I hope I am wrong on this, but we may be due for another Mideast war - they erupt every seven to 10 years or so, like clockwork: 1956, 1967, 1973, 1982, 1991, 2003. Is another on the way?
The third worry is the weakness of the U.S. dollar. All through 2009 it fell against the Canadian dollar, and those who did not hedge their U.S. investments, probably lost on the currency some of what they've earned on their stock picks. Such U.S. dollar weakness should continue and perhaps accelerate, since we are in one of the periods when the U.S. inexplicably turns meek and tells the world it really doesn't like being the strongest, and promises to consult and accommodate its competitors and global adversaries. "Like it or not we remain a superpower," President Barack Obama said.
To convey the full absurdity of it, imagine the chief executive officer of Apple, for example, saying, "Like it or not, we're No. 1, but in future we'll listen to Microsoft and Adobe more, and take their interests and views into consideration."
What sort of behaviour do you think this would engender in Apple's competitors? And what do you think would happen to Apple's stock price?
It is the same with countries. When they are strong and confident, their currency strengthens. But when they or their political leaders weaken, the currency weakens, too. History proves this. In the mid '70s when the U.S. was losing the Vietnam war and its Watergate-weakened president, Richard Nixon, was on the verge of being impeached, the U.S. dollar weakened also, and American tourists in Paris saw hotels refuse to take their currency. Similarly, under Jimmy Carter, another apologetic U.S. president, the greenback weakened. However, once President Ronald Reagan came to power, he spelled out his Cold War strategy simply as this: "We win, they lose." The U.S. dollar began ascending.
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Now, on the other hand, in the midst of drying liquidity worldwide and rising probability of hot conflicts, the U.S. is again acting meek. This, on top of the rising U.S. debt burden, means the U.S. dollar will likely continue to weaken.
The investment implications are simple and twofold: first, continue to hedge your U.S. currency positions - do not endanger your stock profits by risking currency losses.
(Please note: I don't mean to take a directional punt against the U.S. dollar, but rather to hedge it out, for example, to have a short U.S. dollar position in the same amount as your long U.S. dollar investments, either via a short U.S. cash position - as we do at Venator - or, if you know how to do this and deal with large amounts, via futures.)
Second, keep your stock short hedges on, while you wait for the U.S. attitude to change - it always had in the past, after such periods of meekness. Once the U.S. starts flexing its muscles again, both the U.S. dollar and U.S. markets will likely strengthen. It will come.
Avner Mandelman is a director of Venator Capital Management and author of The Sleuth Investor. Amandelman@venator.ca