Signs of Caution

During the last week of May, the Bloomberg strategist survey put the consensus equity allocation at 66%. At the end of June, it had dropped to 62.5%. That may not strike you as much of a change, but it’s a big move for the slow-moving strategist crowd. In the last ten years, their equity allocations have fluctuated in a narrow band between about 50% in 1997 to about 70% in 2001. Since that high, they’ve been on a gradual slope downward, bouncing off a low of about 60% at the beginning of 2006. In the last few years, they’ve been pretty good at increasing their allocation ahead of a market rise and vice versa.

In London last Tuesday, private equity firm executives said that runaway leverage in financial markets should make investors cautious, and serve as a signal that the market is “somewhere near its top.” Indeed, some deals have been withdrawn while others are struggling to get funding, according to Alchemy managing partner Jon Moulton. Each hardship is considered evidence of a market peak.

Mr. Moulton went on to compare the leveraged buyout business with America’s sub-prime lending business, warning that the LBO market could be hit with “the same sort of problems” that come from “overenthusiastic markets” that lose their enthusiasm when the bill comes due. Rising leverage amounts raise the specter of a company being unable to make its interest payments, just as a low-income borrower on an adjustable-rate mortgage can become unable to make housing payments.

Lest you think such talk was just a case of jolly old England getting edgy, know that the same conversation happened back in the U.S.

TIAA-CREF, a firm that manages some $415 billion in retirement accounts for teachers and professors, is pulling out of debt offers intended to back LBOs. Fidelity and Lehman Brothers said they’re steering clear of buyout debt, too.

Kevin Lorenz, a managing director at TIAA-CREF’s New York office, said he’s found “some very scary analogies between high yield and the mortgage market. You cannot do fundamental analysis and believe that those are creditworthy companies.”

In the past two weeks, more than $8 billion in borrowed funding was cancelled or reduced by the likes of U.S. Foodservice, Kia Motors, Brazil-based Banco Schahin, and Germany’s Mittal. The latter is the world’s largest steelmaker, clear evidence that funding is drying up not just for small fry, but for all borrowers.

Meanwhile, the sub-prime fiasco is not over. Worries about collateralized debt obligations, or CDOs, are growing.

Jonathan Laing wrote in Barron’s this weekend:

“Far greater troubles await the sub-prime market in the next two years, when homeowners will face increases of as much as 50% in their monthly payments after their two-year teaser rates expire and convert to materially higher floating interest rates. The period will see some $800 billion in sub-prime loans reset, according to Deutsche Bank. . . . The coming crisis in sub-prime CDOs is reminiscent of the S&L; collapse of the early 1990s; both involved imprudent lending and will be enormously costly.”

Over in tiny Monaco, Fidelity International fund manager Anthony Bolton, who turned $2k into $325k in the last 28 years, said he finally sees what will humble the rising stock market. “For the first time I can see what may be the catalyst. We have started to see it with the sub-prime and the CDOs. It has started to percolate out.”

To protect his fund, Mr. Bolton is moving more of his portfolio into larger companies, which he believes will hold up better in a broad market decline. A year ago, 20% of his fund was in large companies; today that portion has risen to 50%.

Jim Rogers, co-founder of the Quantum Fund with George Soros and author of Investment Biker, told Bloomberg, “I’ve sold out of nearly all the emerging markets. Right now, there are probably 10,000 young MBAs on airplanes flying around from one emerging market to another. The only one I didn’t sell was China. I don’t ever want to sell China, but if China doubles again this year, then it’s a full-fledged bubble and I’ll have to sell.”

Perhaps they all read The Kelly Letter and noticed that I remain cautious over the medium term.

Tomorrow: more heated follow-up on my doubts about Apple’s iPhone forecasts. If you want to join the conversation, just email me.

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