January 21, 2011

On this week’s Consuelo Mack WealthTrack, Consuelo talks to one of Wall Street’s top investment strategists, Francois Trahan about why he believes the dollar is key to understanding stock market performance this year. Learn how to take advantage of the dollar, in weakness and in strength, with Wolfe Trahan’s Chief Investment Strategist.

CONSUELO MACK: This week on WealthTrack: “All American” team strategist Francois Trahan discusses his playbook for 2011 and why the dollar is key to stock market performance. Investment strategist Francois Trahan’s best offense and defense recommendations are next on Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack. I’m Consuelo Mack. Whenever asked for his market forecast, legendary financier J.P. Morgan would famously quip: “the market will fluctuate.” As we all know, Warren Buffet subscribes to the J.P. Morgan school of market forecasting. However, there are market practitioners who have a better grasp than most of market behavior. One of them is our guest on WealthTrack this week. He is Francois Trahan, the head of portfolio strategy and quantitative research at research boutique Wolfe Trahan, who has been voted the Street’s top portfolio strategist by Institutional Investor magazine for the past three years.

Deciphering the mysteries of market behavior requires a potent mix of science, art, skill, luck, and in this day and age, massive amounts of data and computing power. It also requires an understanding of global economic, business, and political events and trends. If investors have learned anything through the financial ups and downs of the last couple of years it is that “macro matters”, now more than ever. One of the most fascinating charts that Trahan has produced recently shows just how much macro matters. This chart shows “macro explaining a record-high 90% of equity returns”- major forces such as the European debt crisis, leading economic indicators, Bernanke’s speeches, the U.S. election and the extension of Bush’s tax cuts heavily influenced stock market behavior last year- 90% versus a long term average of 71%- whereas stock-specific influences only accounted for 10% of stock returns versus 28% historically.

The other thought provoking chart which Trahan says is key to understanding stock market behavior this year shows the close correlation that has emerged between the dollar, the U.S. stock market, and oil prices. But it’s a negative correlation so the dollar line here is inverted. The pattern shows that when the dollar declines, the stock market and oil prices go up; when the dollar rises, stock market and oil prices fall. I asked Trahan why this correlation has become so tight, as high as he has ever seen it, and why it is so important to investors.

FRANCOIS TRAHAN: Well, first off, the correlation rate between the dollar and the S&P is as high as we’ve ever seen it, so I think it’s impossible to have a view on the market here and not have a view on the dollar – at least an informed judgment on the dollar. So I’m just acknowledging that this relationship exists. We’ve never seen it this tight before.

CONSUELO MACK: So why is the correlation so tight? What’s happened, going on that that’s occurred?

FRANCOIS TRAHAN: Well, I think it’s something that started, you know, a long time ago. It started with the free trade agreements that were put in place almost 20 years. So we know that trade as a percentage of world GDP is now as high as its ever been. We know the percentage of S&P revenues derived abroad is now as high as it’s ever been. It’s about 42%. So the S&P is becoming a global index. We know, you know, that the percentage of GDP of countries that are pegged to the U.S. dollar – you know, that’s also risen a lot largely because of China.

So all those things, you know, explain kind of the secular influence. And cyclically, if you think about what’s taking place in the U.S. – the Fed Fund’s rate is at zero. So there’s not a whole lot of room for monetary policy to have a big impact. The Federal Government is running a huge deficit. There’s not room for additional fiscal stimulus, but the dollar has become the policy tool of last resort, if you will. Dollar goes down is a form of stimulus to the U.S. economy. So it sends the stock market higher. So I think those are kind of all the ingredients, if you will, that explain why this relationship exists.

CONSUELO MACK: So what do we do with that information? I mean, you know, you’re a strategist, you follow macro trends. So as an investor, what should I be following therefore?

FRANCOIS TRAHAN: You have to, first of all, you have to figure out where the dollar is going to go. So knowing this relationship exists, you want to avoid scenarios that are dollar bullish because what they imply is a lower stock market.


FRANCOIS TRAHAN: And there are a lot of developments taking place around the world, you know, that are really- some of them outside of our control at least- that can lead to a dollar bullish scenario.


FRANCOIS TRAHAN: Well, you think of what’s taking place in Europe. You know, if the rolling crisis that you’ve seen in Europe continues to escalate and all of a sudden starts to impact countries like Spain, Belgium – you know, bigger components of the Euro area.


FRANCOIS TRAHAN: Italy. That would be a dollar friendly development. I think it would be very negative for markets. You know, similar – we saw a mild version of this last year. You know, it started around the month of May so we could see something like that in 2012. And there’s still a lot of stresses, in my opinion, in Europe. I can’t get myself to say the crisis is over.

CONSUELO MACK: So the European crisis- the reason that the dollar, it’s bullish for the dollar, it’s basically- is that a flight to quality? Is that essentially why it works that way?

FRANCOIS TRAHAN: Yeah. So because trade is so large and the world economies are so intertwined nowadays, what you’ve seen, you know, the asset classes have also become very, very correlated. It’s a binary world. It’s risk on, risk off. You know, it all works at the same time and then it doesn’t. So the dollar, of course, is a defensive asset class. It tends to go up when the world economy is slowing, when there are stresses in the world. So I think it’s as simple as that. So the dollar is going to work when the defensive sectors are working, when bond yields are working, when all things that are considered to be defensive in the world are working. Right now, we have a lower trend in the dollar. So we have a stock market that’s had a pretty good run here. But I would say it’s had a run, you know, on the back of the declining dollar. I’m not convinced that it’s a sustainable dynamic – that it will work forever. It didn’t in the 2006 to 2008 episode.

CONSUELO MACK: So let’s talk about kind of what your view of the stock market is. There are a lot of things that you see in the U.S. stock market that are actually positive.


CONSUELO MACK: And yet you’re pretty cautious about the U.S. stock market. So let’s talk about some of the positives: corporate earnings, for instance.

FRANCOIS TRAHAN: Sure. Absolutely. So it’s tempting to be bullish here because the stock market is not that cheap from an historical perspective. Earnings are high. So earnings are high, you know, multiples are low is usually a pretty good combo. Corporate balance sheets are very healthy. I think there is a long list of things that are very supportive, but unfortunately, with the greater trade and the greater integration of the world economy, we’ve diffused risk around the world, but at the same time we’ve become susceptible and vulnerable to developments taking place elsewhere. So Europe runs into problems, we’re going to feel it here in our index. Asia slows because they’ve been tightening policy. You know, we’re going to feel it in our index. So those to me are the two biggest possible dollar bullish developments this year and I think two things that would give a big hiccup to the S&P 500.

CONSUELO MACK: So, but overall, the dollar has been declining which is, therefore, bullish for stocks.



FRANCOIS TRAHAN: Has been so far.

CONSUELO MACK: Right, exactly. And just those two elements, so those two possible events that could basically turn it the other way.


CONSUELO MACK: But how high are you putting the probability of those two occurring? Of a crisis in Europe that’s significant enough that it’s going to actually help the dollar? Or Asia slowing and that too will help the dollar?

FRANCOIS TRAHAN: It’s hard to say, but there are barometers that you can watch I think both in Asia and in Europe. But I want to give you a third scenario for the stock market. Dollar keeps going down. Dollar keeps going down, it helps the stock market until a certain point. So if you look back to ’06,’07 the dollar went down, the stock market went up. It was great. It worked, it worked, it worked and then one day the dollar went down, the stock market went down. It didn’t work anymore. It didn’t work anymore because you got to a point where the lower dollar led to such high commodity prices that all of a sudden U.S. consumers, you know, were putting so much money in their gas tanks that they started to change their spending behaviors. So it works until it doesn’t, until it has an impact on the middle class. And what we know from the 2006-2008 episode is that the breaking point, if you will, was somewhere around $95 in oil.

CONSUELO MACK: Which we are very close to at this –

FRANCOIS TRAHAN: We’re at about $90 roughly.

CONSUELO MACK: Right, right.

FRANCOIS TRAHAN: In the range now so there’s a little bit of a margin for the market to work here. Can it go up, can the S&P go up another 50 points? Of course it can. Can it go up tremendously from here? It’s difficult for that to happen because for the S&P to go up to 1,500, you know, which some folks are clamoring, you’d have to get oil at 150. And of course, you know, that would just crush consumption in the U.S. So it’s not a sustainable dynamic, unfortunately. I don’t think this will be a big year for the market. I think at best it’s a flat year for the market and I think there are a lot of risks.

CONSUELO MACK: You know, another interesting piece of research of that you’ve done is looking at the correlation between the markets and what’s happening on a macro level. So looking at the economic cycles and how much impact they have on stock market behavior versus the impact that our looking at individual companies might have that make up a portfolio.

FRANCOIS TRAHAN: Right, right.

CONSUELO MACK: Can you tell us a little bit about that?


CONSUELO MACK: And that strikes me as something very significant for investors to know.

FRANCOIS TRAHAN: Right. So essentially, what we’re trying to figure out is of a stock’s price, what percentage of a move in its price is explained by the market, by its sector, by its industry, and by company fundamentals? So it’s a way for us to know how much time do we need to spend figuring out where the market is going to go, how the sector is doing, and how much time do we need to spend understanding the company itself? And what you find right now is that macro has never been this important. You know, that north of 80% of an average stock price performance is explained by macro events. So you know, you can have the best analyst in the world, unless they’re getting some sort of understanding of what is taking place, you know, on a macro level, on a broader basis, they’re going to have a hard time picking stocks.

CONSUELO MACK: So given that fact, you know, is that something new or is that something that’s been growing or, you know, is this something that you think is going to last? That macro is going to continue to matter a great deal to your portfolio?

FRANCOIS TRAHAN: Yeah. Well, macro has always been important. I think when you have a big recession as we did in ’08, its importance gets magnified so all of a sudden everybody wants to become, you know, a macro economist, a macro strategist, but you know, I think it is here to stay. I really do. I think in a world that’s intertwined, you know, now we’re not just dealing with U.S. parameters, you have to figure out what’s happening in Europe, you have to figure out what’s happening in Asia. A tightening cycle taking place in China is very key. And all these things are intertwined. The Chinese are tightening because we’re doing QE2, you know, so none of this is happening in a vacuum anymore. So I think it’s very important to have a macro view of the world even for people that are fundamental analysts, bottom up stock pickers.

CONSUELO MACK: So apply your view of the world to my portfolio. To your clients’ portfolios. So explain, so your view of the world is what?

FRANCOIS TRAHAN: Yeah. So right now what you have is a weaker dollar trend, right? The dollar is weakening so the best performing asset classes that you’re seeing right now, everything that does well when the dollar goes down: gold, commodities, in the S&P the best performing sectors, energy, materials. These are all what I would call dollar hedges. The best performing stocks in each sector are the ones that have that foreign exposure. So that, to me, is how you want to be positioned at the beginning of the year. That’s what I call the dollar hedge. If you believe, like me, that there’s probably some sort of tipping point this year and it’s either that the dollar changes course because of the development taking place in Europe or in Asia–

CONSUELO MACK: And again, changes course – in other words, appreciates.


CONSUELO MACK: Versus major trading partners.

FRANCOIS TRAHAN: Correct. Or that the relationship simply breaks down because commodity prices rise too much. Then you’re going to want to have what I call a growth hedge and you’re going to want to have much more defensive assets. So assets that do better when growth is about to slow. It doesn’t mean that we’re staring at a recession necessarily, but I think those are the ones that will do best. So you know, it is a binary type of event. Of course, if you’re a portfolio manager, you know, you start to think about that and you start to position for that, you know, somewhat slowly. But that’s how I’m thinking about the year.

CONSUELO MACK: Remind us again, what are the defensive sectors?

FRANCOIS TRAHAN: Healthcare, staples, utilities, some of the telecom names- everything that offers earning stability to people.

CONSUELO MACK: Your native Canada. Investing in Canada at this point. I mean, the Canadian dollar has been very strong versus the U.S. dollar. You know, everybody is talking – as you have when you’ve been on WealthTrack before about how Canada really had gotten its act together; that that was now the more business friendly environment versus the U.S. What’s your view of Canada today, vis a vis the U.S.?

FRANCOIS TRAHAN: So secularly that is kind of amazing, but cyclically, you know, when you look at the Canadian dollar, honestly, it looks exactly like an emerging market, you know, which is pretty interesting. So to me, when you talk about a dollar hedge, you know, that’s a dollar hedge. So buy gold stocks in Canadian dollars, then you’re going to get the double benefit for the declining dollar. That’s one way to participate in that trade. But I think you’re going to see an inflection point in world growth later this year. I think the Canadian dollar is probably vulnerable under that kind of scenario.

CONSUELO MACK: And the inflection point in world growth means that the world growth which has actually been relatively strong at least from the emerging markets point of view –


CONSUELO MACK: It’s going to get weaker. Is that what you’re –?

FRANCOIS TRAHAN: Well, that we’re going to price in slower growth. Correct.

CONSUELO MACK: Okay. And so slower global growth. So what about the emerging markets? Which, of course, has been most people’s favorite investment.

FRANCOIS TRAHAN: Correct. It’s been a very rewarding investment.


FRANCOIS TRAHAN: It’s a dollar hedge. It has done well. The dollar has come down. And unfortunately, what’s taking place in that part of the world is that when we do QE in the U.S., you know, there are consequences to this. And there are consequences not just, I would say, domestically in the U.S., but also in other parts of the world. So countries that are pegged with the U.S. dollar like China- when the dollar goes down inflation in China goes up. CPI in China now –

CONSUELO MACK: And that’s what’s happening.

FRANCOIS TRAHAN: That’s what’s happening.


FRANCOIS TRAHAN: So CPI in China now, 5% in change. And China is very pragmatic about monetary policy. CPI goes up, they tighten. It’s as simple as that. So we’re forcing them in a way to tighten policy. We’re taking them one step closer to, you know, a big domestic slow down and potentially imploding their own real estate bubble. So they’ve tightened a lot. You know, like I said earlier, we’re not doing this in a vacuum, you know, there are going to be consequences to quantitative easing and I think a slow down in the developing world is going to be one of them.

CONSUELO MACK: So if you were running a global portfolio then, so where would you be emphasizing your, that portfolio right now, you know, where would you be overweighting it and where would you be underweighting it?

FRANCOIS TRAHAN: Okay, so I’d begin the year overweighting the emerging markets, overweighting gold, commodities, energy materials, all these things. But what I would be doing in the coming months is transitioning to what I call the growth hedge. So I would be selling all these things on strength and I would be buying counter cyclicals on weakness. I would be buying government bonds of countries that are fiscally responsible.

CONSUELO MACK: Such as Canada?

FRANCOIS TRAHAN: Well, that would be a good example. That would be one on the list. I think probably Treasuries will do well just because they are deep –

CONSUELO MACK: In the latter half of the year?

FRANCOIS TRAHAN: Yes, yeah, well, I might start earlier, but something like that. I would be starting to build positions now. So I think that’s –

CONSUELO MACK: In U.S. treasuries?

FRANCOIS TRAHAN: Sure, absolutely.

CONSUELO MACK: That is definitely a contrary call, you know that.

FRANCOIS TRAHAN: Well, they’re the defensive, you know, asset class.


FRANCOIS TRAHAN: If you think back to the events that took place in April/May of last year, you know, when all of a sudden, you know, we had problems brewing in Europe- that was basically a great entry point into Treasuries. Money piled into a defensive investment. And treasuries started their run, you know, all the way to two and change. So I think that they probably do well in that backdrop. I can tell you sentiment right now in Treasuries – pretty bearish.

CONSUELO MACK: Very bearish.

FRANCOIS TRAHAN: You know, the opposite on stocks, of course. We begin 2011 with, I think, sentiment is euphoric with regards to equities.

CONSUELO MACK: And so is sentiment something that you pay a lot of attention to as well? I mean, you know, do you really believe that wherever sentiment is strong is kind of you should take the opposite position? Do you think that’s an important market analysis?

FRANCOIS TRAHAN: Yeah, you know, we tend to focus more on trends than anything else. Everybody always asks me to predict the stock market the next month. You know, I don’t have a magic formula to do that, but sentiment, I would say, is useless to me 90% of the time, but when it is at major extremes, as we are now, I think it gives you a sense of what the odds are going forward. We’re beginning the year with sentiment that’s very bullish on stocks so would it be surprising to have some sort of correction here? Absolutely not.

CONSUELO MACK: So, Francois, what would change your, you know, your view that you’ve just laid out and your strategy that you’ve just laid out in a longer term way? Is there some dynamic that would change the longer term trend of the dollar decline?

FRANCOIS TRAHAN: Yeah, I don’t know that that dynamic is going to change, to be quite honest, because it’s just a function of world trade. Maybe, you know, it could change over a generation if the U.S. decided to pursue protectionist policies. You know, it’s the reversal of free trade that would unwind these relationships and other things that would make me constructive on stocks. You know, consumers are deleveraging. It’s factual. It’s taking place. It’s been taking place for two years.

CONSUELO MACK: And that’s actually a positive long term, right?

FRANCOIS TRAHAN: Well, you know, living through it is not fun.


FRANCOIS TRAHAN: But coming out of this, I think it will set the backdrop for something that will be pretty darned good. States, obviously, what you’re hearing in the news is not encouraging, but they are right-sizing government. So coming out of this, I think you’re going to have states that will have the ability to cut taxes, to stimulate growth. Federal government at some point will probably, you know, be forced to do that too. So I can see how three years, fours years down the road, who knows. We have a pretty phenomenal set of conditions for stocks. You know, unfortunately, deleveraging takes time. It’s not fun. You can’t really accelerate the process and what it means is sub par growth and lots of hiccups.

CONSUELO MACK: So in the meantime, if that’s, you think that’s probably going to be, this is the reality that we’re facing, what will you have all of us own in a long term diversified portfolio? What would your One Investment recommendation be?

FRANCOIS TRAHAN: Well, in a long term diversified portfolio- let’s define “long term” in today’s world. You know, I would tell you this year, I think you want the transition from dollar to growth hedge. If I had to tell you about one screen that would probably do well- I don’t believe the stock market this year does a whole lot. I think income is going to be very important. So I like dividends, not all dividends, but dividends of companies that have the ability to sustain them. Last year that was a screen that did very, very well, particularly when we had the hiccups in Europe and so on. So to me that is one, the first screen that would look at to pick a stock this year, to be quite honest. So I think there are opportunities in the market. You know, it’s just not the tidal wave of ’09 where everything went up. You could throw a dart, you were going to make a lot of money. You know, it’s not like that anymore. This is much more challenging.

CONSUELO MACK: You know, we’ve had a number of portfolio managers on who have basically been looking at the, you know, U.S. multinationals, for instance. U.S.- based large cap stocks that have a – just like you described the S&P 500 with 40% of their earnings overseas– as the most undervalued equity class or asset class just basically in the world. I mean, how do you feel about U.S. large cap stocks?

FRANCOIS TRAHAN: I like them. I think if you have to pick a corner of the style size box, large cap growth is what you want to go with.

CONSUELO MACK: Large cap growth as opposed to large cap value?

FRANCOIS TRAHAN: Correct. Because growth tends to be what does best when you’re staring at a slow down. And the reason for that is that when economic prospects begin to decelerate, portfolio managers gravitate toward growth where they can find it and it’s not a big slice of the market, but that’s where they find it. So in my opinion, large cap growth, I think, would be what is most consistent with our theme. With both our themes, to be quite honest.

CONSUELO MACK: And large cap growth, but with dividends.

FRANCOIS TRAHAN: Well, you know, usually they go hand in hand. To be quite honest. So, absolutely, with sustainable dividends.

CONSUELO MACK: So Francois, what is it that your clients are asking you about or you’re telling clients that you don’t think is necessarily out there?

FRANCOIS TRAHAN: Yeah. What I find interesting right now- there’s a debate amongst clients as to whether the Fed will actually continue with QE2. We think they will. We think if Bernanke–


FRANCOIS TRAHAN: Well, beyond – no, I mean, through June. Some people believe that we might, you know, bring an end to the program because we’ve seen better economic data points. So we’re not convinced that that’s going to take place at all in light, of course, CPI being at its lowest reading in history and the unemployment rate being where it is. So I don’t see that happening. I think if you give Bernanke some credit. He’s been consistent. He’s doing exactly what he told us he would do. I mean, I’m concerned by some of the statements that he’s made. You know, this fall he talked, he said inflation concerns were overstated. I find that difficult to reconcile with commodity prices hitting all time highs. So there are consequences to quantitative easing. I think we have to be honest about that. And the ultimate consequence is a tax hike on the U.S. consumers, you know, who are the folks that get impacted the most by a decline in the U.S. dollar.

CONSUELO MACK: Which is bearish.

FRANCOIS TRAHAN: Which is bearish. Which is difficult for the U.S. economy.


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