Weekly Market Recap

The U.S. markets rallied for their fourth week. We are now well up from the lows experienced in early March. Last week the S&P 500 rose 3.3% to 843 and the Nasdaq Composite advanced 5.0% to 1,622. Value stocks finally showed strength because the Financial Accounting Standards Board revised the mark-to-market rule giving bank stocks a boast. Value stocks however still lag growth stocks year-to-date. In fact, large to mid-cap growth stocks are now positive for the year.

Though the current rally has provided much needed relief, it does not mean the markets are only headed up. We have seen rallies galore since we started this ascent into hell last year. This is the fifth 10%-plus move we have seen in the past year and the previous rallies did not hold. For this rally to be sustainable the banks and the credit markets have to be functioning and stable.

The economy is still deteriorating. Last week, the official national unemployment rate reached 8.5% (an additional 660,000 jobs were lost in March). The real rate of unemployment is over 10% when you add in those that have been looking for a full time job for more than a year or those under employed (working part time but seeking full time). One out of every ten adults is unemployed and it will most probably only go get worse before it turns around.

This and other data suggest that the economy contracted in the first quarter by approximately 5%. Luckily some of the recent economic data related to housing sales, retail sales and consumer confidence is pointing to a moderation in the rate of decline. The Federal Reserve is also doing its best to pump money into the system and bolster up the banks. The economy is beginning to bottom out but the data is not pointing to a robust or steep US recovery. The economy will begin to stabilize the second half of the year but the going will be rough.

First Quarter 2009 Market Performance

I was quoted in yesturdays Contra Costa Times article on the First Quarter Performance.

Hope you enjoy!

Area stocks outperform market indexes

The stocks of Bay Area and East Bay public companies out-performed their counterparts on the national stock markets during the first quarter — but only by falling less than the Dow Jones 30, S&P 500, and Nasdaq Composite.
By the time the January-March period ended on Tuesday, the East Bay 50 index had fallen 2.7 percent and the Bay Area 100 index was down 0.2 percent. The Dow Jones Industrial Average plunged 13.3 percent, the S&P 500 slid 11.7 percent, and the Nasdaq fell 3.1 percent.
Those three-month losses came despite a general upswing in the stock markets towards the end of the first quarter.
"We seem to have gained some traction in the stock markets in March," said Libby Mihalka, president of Altamont Capital, a Livermore-based financial planning firm. "But we're not out of the woods yet."
The big problem now is financial gremlins continue to haunt broad stretches of the nation's economic landscape. And that has spooked investors.
"Short-term, there are so many things that are unknown," said Royce Charney, president of Oakland-based Trust Administrators, a financial company. "You still have all the bank and financial institution issues, and now we're dealing with the auto industry. But for long-term investors, the market still looks attractive."
Charney defined the long-term
"The collapsing financial system and the problems with the auto companies are hurting consumer psychology the most," said Richard Welty, president of Lafayette-based Welty Capital Management.
Among industry sectors during the quarter, the best-performing national index was the Morgan Stanley Retail Index, which rose 6.3 percent. The weakest sector was the Bloomberg Real Estate Index, which lost 33.7 percent of its value.
The best-performing East Bay companies during the quarter were primarily in the high-tech and biotech industries:
 Novabay Pharmaceuticals jumped 188 percent. Emeryville-based Novabay said a deal it struck to develop and commercialize one of its dermatological compounds could produce $50 million in milestone payments for Novabay.
 Zhone Technologies soared 130 percent higher. Oakland-based Zhone lost money in its fourth quarter, but the loss was in line with expectations. The wireless communications also landed some key deals and moved forward with plans to serve the rural United States.
 Neurobiological Technologies was up 116 percent. The Emeryville-based biotech company said it would seek the sale of the company or its assets.
 Socket Mobile was up 79 percent. The Newark-based maker of mobile-computing devices reported record annual sales in 2008, although the company lost money during the year and the fourth quarter.
 SYNNEX Corp. jumped 74 percent. Fremont-based SYNNEX, a technology services company, announced fourth-quarter profits that beat analysts expectations by a wide margin.
Walnut Creek-based PMI Group was the worst-performing East Bay stock, falling 68 percent. The mortgage insurer reported a smaller fourth-quarter loss. PMI also was jolted by a downgrade by Fitch, which warned that PMI faces more losses and reduced liquidity.
Concord-based Pacer International fell 66 percent. The freight logistics company's fourth-quarter results fell short of estimates for earnings and revenues.
The best-performing Bay Area company was XTENT Inc., a Menlo Park medical devices company whose stock rocketed 367 percent higher. But the improvement may have been due to XTENT's disclosure during the quarter that it had hired an advisor to help it sell some core assets, sell the entire company, or seek a merger partner. XTENT also decided to eliminate 115 jobs, or 94 percent of its workforce.
Investors should be prepared to confront more volatility during the second quarter of this year, financial planners said.
And even after the volatility fades, and the economy starts to look better, it's still quite possible that a rebound won't produce much to cheer about.
"We're going into a slow-growth economy," Mihalka said. "Things will stay slow. And then we may have inflation.

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.