Adviser trusts the bond market's signals, for now

Michael F. Absher has been a financial adviser with Wells Fargo Advisors for 13 years and works at the company's office in Chapel Hill. Absher, 35, lives in Raleigh and grew up in Wilkesboro.

It seems that many very intelligent and educated arguments have been made in the past few months supporting various economic forecasts. Each has centered on a letter of the alphabet, as a visual description of a gross domestic product, or GDP, chart.

The optimists defend a V-shape recovery, expecting the resilient American economy to rebound as sharply as it fell. Others forecast a W-shape recovery, where we will go down again before going back up sharply. Some cautious economists project a U-shape recovery where we improve, but at a much slower rate. Then you have the pessimists that describe an L-shape recovery, where we plummet to a bottom only to sit at that level for a long time. These people typically reference 1990s Japan as the model.

I will not pretend to know the correct answer, since these are all educated and fact-based arguments. Instead, I will fall back on two of my favorite quotes from two of the best known economists of the 20th century:

"One of the greatest pieces of economic wisdom is to know what you do not know." - John Kenneth Galbraith

"When the facts change, I change my mind." - John Maynard Keynes

Rather than get lost in the alphabet soup of economic forecasts where we have virtually no competitive advantage, I think it is critically important to own a portfolio of fairly valued investments that are attractive on their own merit regardless of which forecast proves accurate. It appears to me that the bond market is pricing in a stable economy with low GDP growth expectations, which I base on the tightening of credit spreads and the generally low interest rate environment. The stock market appears to be expecting a stronger recovery, which I am basing on the valuation levels of cyclical equities compared to more economically stable sectors including food and utilities. So even if an investor chooses to trust market prices more than an economic commentary, there are no clear conclusions.

So what does an investor do? I have chosen to rotate my model portfolio trusting the bond market more than the stock market. In the past four months, I have sold out of companies in my model portfolio that were highly correlated to the rebound of the American consumer. I replaced companies like Fortune Brands and Harley-Davidson with other companies such as Nike and McDonald's. Home renovations and motorcycles are more credit-driven purchases than sneakers and french fries.

More recently, I replaced General Electric with Deere, which gave me similar exposure to capital spending with less risk from credit losses. I felt the earnings news from J.P. Morgan was a good litmus test for future credit losses in the lending markets, and helped spur my decision to exit GE. Deere was an interesting way to add exposure to both stimulus spending and future food demand. I added two small insurance companies to the portfolio during the past few months, and both of those purchase decisions were based on the improvement in book value. Both stock and bond markets have significantly improved since their first-quarter lows, and those improved asset valuations will begin to be reflected in the underlying book value of companies like Mercury General and White Mountains. Both of these companies have high insider ownership, which I believe helps align management interests with shareholder interests.

As we approach the end of the year, many investment strategists will produce their annual outlooks. I am sure we will see optimistic projections from some and dour forecasts from others. I think the markets are currently trading at reasonable levels and that any bold forecast for 2010 is apt to be wrong. However, I also know that the stock market almost never returns 9 percent or 10 percent, even though that is the long-term average. In fact, the S&P 500 has returned between 8 percent and 11 percent only twice in the past 50 years. So it would seem a forecast of a return in that ballpark is both unlikely to happen and reflects a lack of conviction. I expect continuing credit losses and ongoing weak employment will keep markets subdued though. I believe the more probable outcome is for quality stocks to regain market leadership as the junk rally gets long in the tooth.

At the end of the day, any forecast is simply an opinion and is just noise. I will end with a favorite quote from the godfather of value investing:

"The investor's chief problem - and even his worst enemy - is likely to be himself." - Benjamin Graham

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