Rally Not Sustainable Without Bank Recovery

The U.S. stock markets rallied for a third week. The S&P 500 index was up 6.2% last week. Stocks have now rallied approximately 25% up from their lows of less than three weeks ago. The rally has pushed the S&P 500 index into single digit losses for the year (down 9%) and for a few days moved the Nasdaq briefly into positive territory until it fell on Friday.

The market loved all the positive economic news it received last week starting with the 5.1% increase in existing home sales followed by a 4.7% increase in new home sales. Durable goods orders rebounded 3.4% and consumer spending rose 0.2%. All these indicators came in at better-than-expected levels. These could be signs that the economic recession may be moving past its peak but it is still too early to tell.

The market also rose last week because investors enthusiastically embraced the Obama’s Administration bank recapitalization plan. The Treasury Department outlined the Public-Private Investment Plan (PPIP) which gives banks the means to remove toxic assets from their books freeing up capital to make new loans. This plan should help the banks and the credit markets to recover and begin lending. Nonetheless, these market rallies cannot be sustained over the long run until the banks are on sound footing. This is not to say that the success of the PPIP is guaranteed. There are numerous details and glitches that need to still be worked out if the PPIP is to be successful. There are, however, numerous reasons to be optimistic about the prospects of this program. The PPIP combined with all the government fiscal programs should eventually bring about a resolution to the credit crisis.

The recent rallies have been encouraging from a technical perspective. Trading volume has been increasing on upward moves and declining on pullbacks. This is crucial to building a bottom, but it creates painful volatility as the markets over shoot on the latest news. There is still much negative news out there, including high levels of unemployment, a very troubled auto industry and an extremely fragile financial system that could still be subject to negative shocks. A market like this will create exciting rallies and sickening declines. These market gyrations are an important part of the bottom building process as the market challenges asset pricing over and over again. So it is important for investors to keep a long term perspective despite the excessive level of volatility.

Forget the Sideshow: Just Resuscitate the Credit Markets

For the second week in a row, equities managed to post a positive gain despite heavy profit-taking at the end of the week. The S&P 500 gained 1.6% to close at 769. From the early March lows the market is up 20%.

The big news is the Federal Reserve’s announcement to institute a program to buy $1 trillion worth of mortgage-backed and Treasury securities in an effort to boost economic growth. The market for mortgage-backed securities has been frozen for months. The Feds attempt to thaw this market has been well received. The move is designed to lower mortgage rates so many homeowners (that are not under water and have jobs) can refinance. This should increase homeowners' cash flow and reduce foreclosures. In addition, this may induce prospective buyers to begin purchasing homes, thus bolstering the battered housing market.

Unfortunately while the Fed is doing its best to prop up the markets, save the banks and jump start the economy, Washington is too busy with its own sideshows. This one comes complete with a freak show of politicians berating AIG bonus recipients. While the outrage engendered by these bonuses is understandable, the grandstanding and legislative response is not productive.

If this proposed tax on bonuses received by TARP recipients is enacted, it will surely hurt the Fed's efforts to prop up the banking system. The bonuses are egregious but it is more important to get the economy jump started than to pursue a witch hunt. Stabilizing the banks should be our first and last priority. If we cannot stabilize the banks the economy will get much worse and the credit markets will freeze up further. Stabilizing the banks and greasing the gears of the credit markets should remain the government’s focus, not sideshows and witch hunts. Punishing these bonus recipients isn’t necessary because in the end the markets will extract its own retribution in the form of reduced pay or no job at all. Sooner or later these kings of finance will find that their industry has changed and the pickings are slim to none.

I anticipate the markets will be a little choppy but the rally will continue at a slow pace. If you are not in the stock market, I highly recommend that you start dollar cost averaging back in.

Turnaround or Bounce? Look To The Banks

Last week’s positive move in the stock market was overdue, but it is unclear whether this is the beginning of a turnaround or merely a bounce from oversold conditions. There is some evidence that market conditions are improving. Last week’s rally was broad-based and volume was heavy, which are strong technical factors. Additionally, lower-quality stocks have been outperforming, which typically happens as markets turn around. However, it is very possible that we are still bottoming-out.

There was good economic news last week. Retail sales figures were surprisingly positive. January’s data was revised to show that sales actually rose, and February’s numbers were down only slightly. All told, it appears possible that overall first-quarter retail sales growth will net out to around zero, a much better scenario than was widely anticipated only a few weeks ago.

Today more good news. An unexpected rise in housing starts and a more moderate increase in wholesale prices point toward a brighter economic outlook. Another plus, the market appears to have leveled off before the recently passed stimulus package has started to have any effect.

That said, the overall economic environment remains troubled, and as Federal Reserve Chairman Ben Bernanke said last week, “Until we stabilize the financial system, a sustainable economic recovery will remain out of reach. In particular, the continued viability of systemically important financial institutions is vital to this effort.” The banking system needs to stabilize before we see a full recovery.

Housing Prices Plunge in December

The Case-Shiller index showed accelerating price declines in December. Every city experienced declines. Denver and Dallas held up the best declining approximately 4% in value from sales of existing homes in December of 2007. Sun Belt cities continued to post the worst declines with Las Vegas and Phoenix sliding 33% and 34%, respectively. San Francisco posted the worst monthly drop ever, a 31% decline. The rest of California fared no better with San Diego and Los Angeles both falling 25% and 25%, respectively.

The S&P/Case-Shiller home-price index is a closely watched gauge of U.S. home prices in 20 major metropolitan areas. The housing market will continue to deteriorate at least through the summer and probably through the rest of the year.

Deteriorating housing prices cause buyers to sit on the sidelines thus causing housing prices to fall further. This is a deflationary spiral that is hurting the economy. Consumer confidence dropped to an all time low of 25 in February. This is the lowest reading since the index's inception in 1967. This new reading shows consumers do not expect economic conditions (i.e. employment and business conditions) to improve in the next six months. In fact, 40% of respondents said they expect economic conditions to instead worsen. Under these conditions, few consumers are willing to buy a new home especially if they expect the housing market and economy to worsen. So the spiral continues …..

The only glimmer on the horizon is the new Obama housing stimulus plan. It is an elegant plan but it may not be enough. The plan is expected to help 9 million families refinance their mortgages to avoid foreclosure by using incentives and subsidies. Unfortunately, the plan is structured to offer the least help to homeowners in markets that have receded the most (the Sun Belt States, California, Florida and Michigan). It is a start and will help shore the housing market up in some parts of the country but it will not completely bolster the collapsing housing market.

Interactive Housing Market Graph Link

It is not likely that the economy will turn around in 2009.

Inflation, Deflation, Reflation or Stagflation???

In the short term, the world’s economies will not have to worry about inflation. The drop in demand for goods and services is causing prices to actually drop. This disinflation will not last long since the supply is still constrained. As demand picks up again, especially in the emerging economies, inflationary forces will emerge. The U.S. government’s stimulus programs will actually add to the inflationary forces in the future. In the short term these forces will lead to reflation, which is the reappearance of a rising inflation rate. Reflation is not undesirable since a low level of inflation has always led to a stable economy. However, if reflation leads to high inflation (above 2%) then it is considered destructive to the general economy, and our Federal Reserve usually steps in to extinguish inflationary pressures. Except this time the Fed may not be able to combat inflation. (If it fights inflation then it causes growth to further stagnate; if the government encourages economic growth it sparks rising inflation).
Inflation is usually driven by strong economic growth. As we discussed before, it is unlikely that we will experience a high growth rate for quite a few years. But inflation can occur during periods of stagnant growth if there are constraints on supplies. We are facing numerous future constraints. Our growing trade deficit, aging population, rising cost of labor around the world, and supply-constrained commodities are all contributors to inflation. Inflation with stagnant growth is called stagflation and it looks like this is where we are heading in the long run (probably a year from now). Stagflation requires a completely different investment mindset. For instance, in a world prone to inflation and slow growth, fixed rate securities like Treasuries are really not “risk free” or safe since a rising inflation rate can eat up the wipe out any real return.
Since the early 1980’s inflation, also known as the Consumer Price Index or CPI, has been steadily falling in virtually every economy from double digits down to 2% (see chart below). So inflation has not been a factor on which investors have had to focus. As inflationary pressures reappear, it will become important to reach back to the investment strategies that worked thirty years ago and update them to meet the changing securities markets. For instance, strategies that emphasize inflation-linked bonds and commodities will probably do well in this environment while stocks may under perform.
In the near term, we will be experiencing reflationary pressures coupled with a stagnant or low growth economy. In this environment, high quality corporate bonds and municipal bonds will perform the best when mixed with stocks and the slow introduction of inflation-linked securities. Commodities in the near term will not perform well but will shine when inflation takes off. Your portfolio rebalancing recommendations will reflect the realities of this new investment landscape. Please review your rebalancing recommendations and return them to us as soon as possible.
The new administration certainly has an amazing number of wild fires to deal with. It will be impossible for them to put them all out and put things to right quickly. It will take massive government intervention in the form of both tax cuts and spending on infrastructure to stop the consequences of the sudden de-leveraging of financial markets, consumers and businesses. This will be a protracted recovery. Over the last few weeks the credit markets have begun to thaw. High quality corporate and municipal bonds will recover first as yield spreads to Treasuries narrow. The stock market will hold steady and may begin to slowly recover in late 2009 but will face massive head winds in the near term.
It is important to adjust to the economic headwinds we face and shift your portfolio to reap any strategic advantage the markets offer. The markets always recover in the long term but each time it is different. The key is not to panic. Instead, focus on identifying these differences and shift your portfolio to take advantage of them. Hiding in Treasuries will not repair your portfolio but may in fact garner you further losses. Short term volatility always yields opportunities if you know where to look.

Is Your Financial Advisor A Smooth Talking Con Artist?

Both the Stanford and Madoff scams have something in common. These advisors used simple techniques to separate investors from their money by promising high returns and no risk (greed). If something is too good to be true - Well It Is!!!!!!!

So here are the warning signs:

If you receive statements from only your Advisor's firm you could be in trouble. An Advisor should custodian your funds at a separate and independent company. I custodian my client's portfolios at Charles Schwab & Co. The client receives a separate statement directly from Schwab verifying their holdings. Madoff would never have been able to steal his client's money if custody of the funds had been held at another firm. Many advisers avoided the Madoff ponzi scheme because when they asked simple questions. When they found out that Madoff managed funds were not held by an independent third party brokerage firm they didn't invest. Never hand over custodian ship of your portfolio to your advisor.

If your advisor has you write a check or transfer your assets to them, you are probably never going to see your money again. I know I said it before but Never hand over custodianship to your advisor. The check should be made out to your custodian (i.e. Schwab, Vanguard, Fidelity).

Be wary of the promise of unreasonably high return with virtually no risk. There is no such thing as a free ride. This tripped up both the Madoff and Stanford investors. Stanford promised huge returns on risk less CDs. In addition, most investors assume that all CDs are FDIC insured up to $250,000. They are not. An advisor may say or promise that their CDs are insured or guaranteed but by whom? If ii is not FDIC insured don't invest. Be sure to ask alot of questions.

Do Not Invest in Anything You Do Not Understand. If your advisor can't explain it to you simply then they do not understand it or they are trying to take your money. Bottom line, it is your money so there is no such thing as a simple or stupid question. If your advisor becomes annoyed then find a new one. Do not invest in a fancy catch phrases (Stanford Investment Model or SIM) or a black box (Madoff's supposedly winner options trading strategy).

Finally, Listen to your gut. If you are uncomfortable and feel under pressure to sign with an advisor, then leave. It is alright to look foolish. In fact, it might be the smartest thing you have ever done. If after additional research and thought you change your mind, I guarantee that the advisor will still be happy to help you with your portfolio.

A smooth talking con artist is always happy to separate you from your money so stay alert!

The Economy Ain’t Hummin’ Along

Banks, consumers and businesses are rapidly deleveraging. The process was so abrupt that it was though someone slammed the brakes on the global economy. (Please note if you cannot read a graph or insert double click on it and it will appear larger and less fuzzy on your computer). First, the housing market began to deleverage in 2006 sparking the financial sector to begin to deleverage in 2007 causing the consumer to deleverage in 2008 and in September the rest of the world followed. When so much liquidity is pulled from the markets and economy so rapidly the dislocations and shock waves are massive. Now only one entity is large enough to get the economy moving again, the U.S. government. The government is now moving forward rapidly to stimulate the economy as unemployment soars and economic growth stalls.
The unemployment rate is approaching the levels reached in the early 1980s. Given the recent severe declines in retail sales, business spending and employment, it is highly unlikely that the economy will improve anytime soon. It is clear that the job market will continue to deteriorate for most of 2009. It is entirely possible that we will reach the levels of unemployment experienced in 1982. Even if the much-needed stimulus bill passes soon, the economy is likely to end 2009 in roughly as bad a shape as 1982.

Currently, the unemployment rate was 7.6% in December 2008 if you include discouraged workers. In addition, another 5.2% of the labor force was involuntarily working part time. Combined the rate approaches 13%. However, this still understates the unemployment rate, because the Labor Department’s definition of discouraged workers is too narrow. If everyone looking for a full time job were counted, the rate could reach over 14%. It is estimated that unemployment reached over 30% during the Great Depression and it is doubtful we would approach this level given the size of the government’s proposed stimulus package. It is possible that we could come close to the 1982 peak rate of unemployment of 16%.
Almost half of the current work force is too young to have any real memory of how tough it was to navigate through the early 1980s recession. They only remember the mild recessions of 1990-91 and 2001. Many are unprepared for layoffs and tough times. It is a generation that spends and does not save, a generation that has systematically borrowed from future income to finance today’s wants. Now the bill has just come due and the delinquency rates on Consumer Loans and Residential mortgages are climbing rapidly. Consumers are leveraged to the hilt, and as they lose their jobs they begin to default on their car, home and credit card debt. There is no buffer, no savings since they have not prepared for the end of the leveraging party.