• Expect the Economy to Stay Sluggish
• Risk Now Better Understood 
• Valuations Suggest Opportunity 
• Conclusion 
• Recommendations

Buy The Dips

"If no one ever took risks, Michelangelo would have painted the Sistine floor."

- Playwright Neil Simon

In managing portfolio risk, there is always a balance between risk-taking and care-taking of assets. Taking risk is certainly laudable, but we believe taking calculated risks is a far preferable way to approach portfolio decisions and tactical asset allocation.

Over the past year, we have seen rising risks to the economy and markets have adjusted in response. Readers of our commentary know that we have been paying close attention to the supply and demand for credit in the economy; the rate of growth in private sector employment; the supply of unsold houses as a leading indicator of growth; and corporate profits and cash flow. Each of these indicators remains weak. 

However, we must weigh against these risks the prospects for returns over the horizon. Thus, even though the above mentioned trends remain negative, we now believe that investors should gradually seek to add riskier assets on "dips" because negative news on housing and the economy has become better understood and equity valuations have become far more attractive when compared to bonds and hard assets.

Expect The Economy To Stay Sluggish

Facts are stubborn things. Today, bank write-offs have exceeded $340 billion, while new assets raised have amounted to only $260 billion. Net new demand for credit throughout the economy, which once was growing at high double-digit rates, has slowed to a low-single-digit trickle. Private sector jobs are down 326,000 from November's peak and up only 0.2% over this time last year. The supply of homes for sale is 70% above normal, and further price erosion is expected. Corporate profits are expected to be down 16% for the first quarter – led by declines in financials and the consumer sector. Almost none of this was expected a year ago when forecasts for growth were high and risk was systematically priced out of many markets (see our March 19, 2007 and June 15, 2007 Market Comments for more on this).

Risks Now Better Understood

While this assessment of the economy is sobering, markets remain flexible and are forward-looking. Therefore, while current trends remain negative, we are adjusting our portfolio posture to allow for the gradual addition of riskier assets to portfolios on "dips" because negative news on housing and the economy has become commonly accepted.

The bad news on housing, rising energy costs, and employment can now be plainly seen in the data on consumer confidence. The most recent survey measure taken by the Conference Board shows that consumer confidence has dropped to levels that typically coincide with past recessions (see graph). The unrelenting and ongoing stream of negative economic news has become part of today’s landscape and the appreciation for downside risk is now much better understood than it was a year ago.

This adjustment in attitudes is a good proxy for profit expectations, which also are coming down, as earnings for the second quarter are now expected to be down 7% versus a +4.7% expected growth rate at the start of the year. We also know that the 34% underperformance by stocks (the S&P 500 index was down 16%) relative to bonds (long-term Treasury bonds were up 18%) between July 12, 2007 and March 17, 2008 represents a historic re-pricing of risk. This 34% relative adjustment is in the realm of magnitude of past re-pricing episodes including the 1973 OPEC oil embargo (a 40% relative adjustment); the 1980-81 credit shock (a 30% adjustment); the 1987 stock market correction (a 32% adjustment); and the bursting of the tech bubble in 1999 (a 61% adjustment). These pricing adjustments, while painful and generally accompanied by negative news, often yield to better times for investors.

To demonstrate this, we return to the Conference Board data on consumer confidence. Recently, we examined how equity markets have historically performed following major low points in confidence. Not surprisingly, we found that equity markets did well in the six, twelve, and twenty-four month periods following such lows (see table).

As the table above shows, from times of maximum distress in confidence, large-cap stocks returned 27.7% in the ensuing 12 months from the trough, on average. By contrast, investing during times of high confidence often led to disappointing results and produced an average -1.8% over the next 12 months following peak levels. The current low readings on confidence suggest that we may be nearing a turning point for equities.

Valuations Suggest Opportunity to Raise Risk Exposure

The most important reason investors should gradually add to riskier assets on "dips" is because equity valuations are currently cheap compared to bonds and hard assets.

Here, we consider the 20-year relationship between the performance of the S&P 500 index (representing stocks) to long-term Treasury bonds (representing bonds). On a total return basis, we see that stocks have only returned a modest 1% per-annum excess return over the U.S. Treasury asset. This may suggest that the "irrational exuberance" of the late-1990s that caused the boom (and bust) in equities has run full course and that we may be entering a new cycle of out-performance by equities. At a minimum, it is difficult to label the equity market as irrationally exuberant (although it could imply that bonds are).



Note: Indices are unmanaged. You cannot invest directly in an index.

But, U.S. financial assets seem to have quickly become far less expensive relative to hard assets. We see this across a variety of categories, including metals, energy, and agricultural commodities. Some of this is a function of rising global standards of living, but we believe that at least as much of the increase is caused by an underinvestment in the commodity supply chain (due to years of poor returns) coupled with portfolio shifts away from dollar-denominated financial assets. Since April 2000, for example, equities (S&P 500 index) have underperformed gold by 60%, with most of this underperformance occurring over the past three years. In the process, financial assets such as equities have arguably become more attractively valued by comparison.

Conclusion

So you can see that although employment, housing, credit, and profit trends remain negative, we believe portfolios should tactically add to riskier assets on "dips" for two main reasons. First, negative news on housing and the economy has become commonly accepted knowledge. But most importantly, equity valuations have improved materially compared to bonds and hard assets and the recent re-pricing of risk from July, 2007 through March, 2008 has been of historically significant proportions.

If we are right about our evaluation, investors − like the builders of the Sistine Chapel − will be rewarded for patience and prudent risk-taking by gradually modifying their portfolio posture to emphasize riskier assets over defensive ones during this difficult period, despite what will likely be negative ongoing headlines.

Current Recommended Tactical Asset Allocation

The information contained herein has been prepared from sources believed to be reliable but is not guaranteed by us and is not a complete summary or statement of all available data, nor is it considered an offer to buy or sell any securities referred to herein. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. There is no guarantee that the figures or opinions forecasted in this report will be realized or achieved. Employees of Stifel, Nicolaus & Company, Incorporated or its affiliates may, at times, release written or oral commentary, technical analysis, or trading strategies that differ from the opinions expressed within. Past performance is no guarantee of future results. There are special considerations associated with international investing, including the risk of currency fluctuations and political and economic events. Investing in emerging markets may involve greater risk and volatility than investing in more developed countries. Due to their narrow focus, sector-based investments typically exhibit greater volatility. Small company stocks are typically more volatile and carry additional risks, since smaller companies generally are not as well established as larger companies. Property values can fall due to environmental, economic, or other reasons, and changes in interest rates can negatively impact the performance of real estate companies. When investing in bonds, it is important to note that as interest rates rise, bond prices will fall. High-yield bonds have greater credit risk than higher quality bonds. The risk of loss in trading commodities and futures can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. The high degree of leverage that is often obtainable in commodity trading can work against you as well as for you. The use of leverage can lead to large losses as well as gains. Indices are unmanaged, and you cannot invest directly in an index.

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