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Jim Welsh head shot

Q&As and Interviews

Q&A with Forward Funds Portfolio Manager Jim Welsh

Shauna O'Brien Oct 21, 2014


In the interview below, Jim gave us insights on several topics including the correction potential, key events to watch, and sectors to avoid.


Insights from Jim Welsh


Current valuations are in the top three of the highest valuations over the past 140 years, based on Shiller’s CAPE (“cyclically-adjusted price/earnings”) ratio, Tobin’s Q ratio and the market’s capitalization as a percentage of GDP, which is Warren Buffet’s favorite valuation metric. This does not mean that the market cannot continue to move higher. It does suggest, however, that returns over the next three to five years are more likely to be in the 4% to 6% range rather than the historical average of 10%. Should economic fundamentals deteriorate during the next 12 to 24 months the market could be vulnerable to a 15% to 25% correction since currently the market is somewhat expensive.

Over the next three to nine months there are a number of economic challenges that could pose a problem for the market. The stock market sold off after the Federal Reserve (Fed) ended QE1 and QE2, so the end of QE3 after October may induce some selling. More importantly, investors will be focused on and guessing when the Fed will begin raising rates. This will induce an element of uncertainty that has not been present since 2008, when the Fed adopted an extraordinary accommodative monetary policy.

The strength of the dollar and higher levels of volatility in the foreign exchange market have the potential to spill over into the global financial markets. A number of emerging market currencies could be especially vulnerable. Economic growth in Europe, Japan and China is not likely to pick up anytime soon, so global growth should remain muted in coming quarters. This could lead to concerns about growth in the U.S. Most economists and investment professionals expect the U.S. economy to perform well in the second half of 2014. If incoming data does not support this optimistic view, disappointment could cause an increase selling pressure. The overall technical health of the market deteriorated significantly during the third quarter, which means the market is more vulnerable to a larger decline should selling pressure rise. The level of volatility has been rising gradually since it bottomed in July. I expect the upward trend in volatility to accelerate in coming months. If volatility indeed rises, as I anticipate, the market could be vulnerable to a 15% correction or more in the first half of 2015.

As far as economic data is concerned, what key numbers are you paying attention to most these days?

I discuss key economic numbers for the U.S., eurozone, China, Japan and emerging markets in detail in my monthly Macro Strategy Review, available here.

My analytical approach is different than most strategists since I combine fundamental analysis with extensive technical analysis. This combination proved especially helpful during 2007-2009 in anticipating the financial crisis and its impact on the stock market. You can read more about how combining fundamental and technical analysis helped me identify the May top in the euro and bottom in the dollar index in my recent blog post.

Since consumer spending represents 70% of U.S. GDP, changes in personal income growth is the most important variable. Since 2010, incomes have grown about 2%—not much more than inflation has risen—so most workers are not getting ahead. Since the recovery began in June 2009, inflation-adjusted median income is actually down 3%. This why almost half of Americans believe the economy is still in a recession. The Fed hoped that by goosing the stock market, demand from the top 10% of wage earners would lift the economy and generate a self-sustaining expansion. Instead, it has only widened income inequality. Although GDP jumped 4.6% in the second quarter, income growth did not accelerate from the 2% it has averaged since 2010. This is why I expect the economy to gradually slow in the second half.

Specific to sectors, could you tell us what areas you are gravitating towards or remain bullish on, and where you may be avoiding?

I would avoid technology, biotechnology, semiconductors and industrials. These sectors are overbought and could be more vulnerable if the market declines, as I expect in the first half of 2015. Since I expect the dollar to continue to strengthen, Treasury yields may stay lower longer than expected, as international investors buy dollars and then Treasury bonds. If yields remain low, utilities could hold up better than most stocks during a correction, since they typically provide income. Since the market could be vulnerable to a 15% plus correction in the first half of 2015, I would suggest holding more cash. This is obviously a more defensive position, but it could work out well if the market declines, as I expect. As long as gold holds above $1,190, I think it can rally to $1,325-$1,350 over the next six months. After that, I expect gold to drop below $1,100.

In running several funds as you do, what would a normal work day be like?

Every day is a bit different. When it’s time to write the monthly Macro Strategy Review, everything else takes a backseat for the most part of a week. My research is reading the Wall Street Journal, New York Times and Investor’s Business Daily every day. I cut articles out on about 40 different topics ranging from basic economic data on the U.S., eurozone, China, Japan, etc., to regulations, federal budget data, and cool scientific stuff. When it’s time to write, I come up with a theme and select the folders that have the articles I’ve cut out during the month. I’ve been writing a monthly commentary for more than 25 years. Over time, I’ve learned how to connect the dots.

The funds I manage, Forward Tactical Enhanced Fund and Forward Equity Long/Short Fund, are primarily managed by quantitative models I’ve created over the years. Forward Dynamic Income Fund and Forward Equity Long/Short Fund are team-managed so there is a group of people involved that provide management. In the Forward Dynamic Income Fund, 75% of the assets are managed by Dave McGanney. In the Forward Equity Long/Short Fund about 30% of the assets are team managed, in addition to the quantitative processes.

Looking out, would you say investors should be prepared to expect more normalized returns compared to the recent 5-year span of gains?

As I mentioned previously, current valuations suggest returns during the next three to five years are likely to be lower than the historical average of 10%. In recent months, measures of investor sentiment (e.g., Investors Intelligence) showed the highest level of bulls in 27 years. For me this is a big yellow caution sign that indicates the odds are rising for a “surprise” to come along and rock the boat. As noted, the technical strength of the market has weakened considerably in the last three months. On July 3, 2014, 368 stocks made a new 52-week high when the S&P 500 Index was at 1,985. When the S&P 500 traded up to 2,019 on September 19, only 128 stocks made a new 52-week high. This shows that fewer stocks are participating in market highs, even though the S&P 500 made a new high. The Nasdaq Composite advance-decline (A/D) line actually peaked in early March. Historically, the A/D line has peaked about six months or so prior to important market tops. For example, the A/D line topped in June 2007, then the price topped in October 2007; A/D line topped in March 1987, price top was August 1987. That said, in order for the market to experience a bear market, there must be good reasons to sell. Most mutual fund managers and money managers are buy-and-hold investors who focus more on bottom-up strategies rather than macro issues. That’s why most did not see the financial crisis coming in 2008. Currently, most institutional investors are optimistic about the economy. Technical analysis is warning that the market would be vulnerable if a reason to sell materializes. My guess is that trouble is coming before 2014 ends.


The Bottom Line


Choosing areas of the market to invest in is a typical investor concern. Jim noted that technology, biotechnology, semiconductors and industrials may be areas to avoid, while utilities may be able to shield investors more from a correction.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of MutualFunds.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions.

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