MUSINGS

While I have not altered my equity exposure, now 30% of financial assets, I wanted to bring you up to date on my thinking. There will be two parts: my current views on the economy and stock market; and a reiteration of how I manage my family's assets.

The latter may not be of interest to many of you. After all, there are many ways to manage money successfully, and mine may not appeal to you. However, the raison d'etre of this blog was to teach my family one person's approach to money management.

CURRENT VIEWS

My views remain the same: 1) deleveraging takes a very long time to unwind; 2) now, three years from the trough of the business cycle, the economy still seems mired in a sub-par real growth mode of 2% plus or minus one percentage point; 3) such low growth raises the probability of lapsing back into a recession, especially upon any exogenous event, such as a flareup in the Mideast, a sustained severe U.S. drought, etc.; 4) The EU's ongoing deleveraging continues to exacerbate recessions among several important members; 5) significant progress in Europe will only be triggered by some financial crisis there; 6) There is some question whether China will achieve a "soft landing," or something worse, in its attempt to quell inflation, particularly in food and housing; 7) The U.S. economy, probably soon after the election, must undergo its own austerity to stabilize debt as a percentage of GDP ( the so called "fiscal cliff"), which will dampen growth; and 8) on the brighter side, the passage of time has benefited the auto and housing industries due to the buildup of demand for those products. The housing slump has been an important inhibiting factor to resuming normal GDP growth (what I call achieving "escape velocity"), and its recent upturn may set the stage for significantly better employment numbers. If that were to occur, the stock market would stage a breathtaking rally.

My conclusion remains that, currently, most probably the U.S. economy will continue to muddle through, with recession next most probable, albeit still a low probability, and escape velocity the least probable.

The S&P 500 Index at 1360 is roughly 15% overvalued based on my normalized price to earnings ratio of 15 and normalized earnings of less than 80 (compared to estimates of 100 this year). For some time now, I have opined that, over the next ten years, the S&P 500 Index will easily outperform, on a risk adjusted basis, the 1.5% yield to maturity of the 10 year U.S. Treasury note.
However, over the next six to twelve months, the outlook for the stock market is quite murky. The rapid growth in earnings from the 2009 trough has slowed considerably. A return to normal profit margins may be starting. Economic indicators have weakened recently, and some economists feel that a recession in the U.S. may have already started.

This year, the S&P 500 Index has outperformed some European indices, the emerging markets as a whole (especially China), and Japan. However, volume has been quite low. It appears that high frequency traders/hedge funds have constituted a disproportionate share of total trading. When there appears to be progress in Europe, signs of faster growth in China, or imminent additional easing by the Federal Reserve ("QE3"), the stock market rallies. Subsequent negative news on these fronts then snuffs out the rallies.

I have a contrary view on the Fed's QE3. Conventional wisdom is that enactment of QE3 will spark a rousing and lasting rally in our stock market. In my judgment, the positive effect on our economy of each successive easing has been less than the preceding one. The Federal Reserve is running out of bullets. When QE3 is announced, there may be a one to three day rally; but, in my opinion, it will peter out much sooner than expected. It will be an example of "Buy on the rumor; sell on the news." At that time, mostly all of the good news will have been out.

REITERATION OF MONEY MANAGEMENT METHODOLOGY

My approach to managing the family's financial assets is to assign a core equity position to each family member based on how the stock market's valuation compares to its fair value, each person's age, financial needs, and other asset categories such as property. In my case, the relevant differential variables are my age, 73, and the value of the East Hampton property. That property's value correlates highly with the stock market's level because potential buyers, including Wall Street executives, will likely pay more when they are wealthier. On Wall Street, incremental wealth is primarily a function of yearly bonuses. So, to me, the East Hampton property has a greater stock market content than, say, a property in Kentucky, where I spent my youth. I currently have a core equity exposure of 30%.

To those who have read most of my previous posts, it must be apparent that I place great emphasis on a single sentiment indicator and on the relationship of the stock market's current value to what I consider "fair value." This sentiment indicator, which measures bullishness and bearishness among writers of financial newsletters, is a contrary one in that extremes of bullishness are considered a bearish signal. This sentiment indicator is only useful at extreme readings; thus, it is usually neutral, as it is now. The fair valuation measure is based on a dividend discount model. I use normalized, or trendline, earnings and earnings growth, rather than current earnings and growth in order to adjust for cyclical variations around the secular trend.

Were both an extreme level of bearishness and a significant undervaluation of the stock market to occur, then I would increase my equity exposure above the core level. For example, during the first decade of the millennium I had a zero equity exposure except on two occasions, in the 2001-2003 period and 2008 to the present. For most of that decade I believed that U.S. Treasury 10 year notes would outperform the S&P 500 Index, which, at the beginning of the decade, was a rare 100% overvalued. If we were to experience a bear market from here, I would probably double my exposure and sell that new incremental position when the stock market became significantly overvalued and the sentiment indicator reached a bullish extreme.

Once the equity exposure is determined, I then select how that exposure should be allocated among countries. After that, I decide which types of equities within a given country, such as large capitalization growth or value, small cap growth or value, etc. are the most attractive. Then I choose which no-load mutual funds best represent that category. (I do not select individual equities myself because that requires constant vigilance, which I don't want to do during my retirement.)