BAM Weekly Bulletin

2012 Annual Limits and Tax Information

2012-02-10T11:26:00.006-05:00

The latest update to the annual limits as well as relevant tax information is now available. The link below will take you to a PDF file with all the updates, including info on 401k deductions, Medicare, tax brackets, social security, as well as the latest estate tax exemptions.

http://www.cffpinfo.com/pdfs/2012_AnnualLimits.pdf

The January Effect

2012-02-03T08:00:00.003-05:00

Here is an interesting article by Steven Russolillo from the Wall Street Journal. It focuses on the January effect and some of the correlations between the first month of the new year vs. what we might expect for the rest of 2012.

The Dow Jones Industrial Average surged 415.35 points, or 3.4%, last month. It was the biggest January point gain in the Dow’s history and best percentage surge since 1997. The numbers look even better for the S&P 500 and Nasdaq
Composite. The S&P 500 jumped 4.4% last month, its biggest gain since 1997. And the tech-heavy Nasdaq advanced 8%, registering its best performance since 2001.

A majority of the January gains were accomplished in the first three weeks of the month, as stocks have leveled off during the past week. Skeptics say there’s not much justification for following the “January effect.” Just because the market moves a certain way in the first month of a calendar year shouldn’t necessary translate into future direction over the next 11 months. But for whatever reason, it’s hard to deny the pattern. The blue-chip Dow has matched the direction of the January performance in 85 of 114 years of the Dow’s history, according to WSJ Market Data Group, good for a 75% success rate. On top of that, when the Dow finished January with a gain, it ended the full year higher 82% of the time, according to WSJ data. When the Dow has risen in January during the years dating back to 1970, the rest of the year has followed suit 92% of the time.

Now that we’ve laid out all the bullish arguments, there are several caveats to consider. History isn’t always an accurate assessment of future performance. And this theory fails to take into account current market fundamentals. While 2012 has started strong, the rally has also shown signs of vulnerability. The Dow’s four-day losing streak is the longest skid since the end of November. About 1/3 of the price-weighted Dow’s monthly gain was concentrated in only one stock: Caterpillar. And Bank of America swiftly shifted from the Dow’s worst performer in 2011 to its top gainer last month, jumping 28%. Corporate earnings continue to be lackluster and Europe’s sovereign-debt crisis has the potential of flaring up at any given moment.

There are lots for investors to chew over in the coming days. And its worth noting that February is typically one of the worst months of the year for stocks. Investors will have to fight the seasonal tide if they want to push the market even higher. Since this post was heavily focused on the “January effect,” we’ll leave you with one final seasonal trend.

The Stock Trader’s Alamanc’s early 2012 indicators are a perfect three-for-three. The Santa Claus rally came to fruition. The “first five day” theory — which states the S&P 500 has never fallen in a year when the first five days see gains of 1.8% or more — was intact (the S&P 500 rose 1.8% in 2012′s first five trading days). And now the January barometer suggests future gains for the broad market. “Since 1950 this trifecta has occurred 27 times in 62 years,” according to the Almanac. “Full-year gains followed in 24 of the 26 previous occurrences, 92.3% of the time.”

Fourth Quarter GDP Breakdown

2012-01-27T11:13:00.005-05:00

After three quarters in a row that averaged roughly 1.2%, the fourth quarter real GDP grew 2.8%, a bit below expectations of 3.0%. Since the price deflator was up just .4% versus the estimate of 1.9%, nominal GDP (measure of growth not adjusted for inflation) was up 3.2% versus the estimate of 4.9%.

Personal consumption rose 2.0%; fixed investment rose 3.3%, helped by a 5.2% increase in equipment spending and residential construction rose by 10.9%. Government spending was a drag on GDP growth lead by a 12.5% decline in national defense spending. State and Local government spending fell by 2.6%. Inventories added roughly 2% to GDP growth, but final sales rose just .8% versus 3.2% in the third quarter. This shows that inventory rebuild played a large part in the fourth quarter GDP increase.

Bottom line is the economic environment continues to be mixed, but positive. We have to watch the European slowdown for potential impact on our domestic recovery.

Existing Home Sales Increase

2012-01-20T16:28:00.001-05:00

The latest monthly data shows total existing-home sales rose 5.0 percent to a seasonally adjusted annual rate of 4.61 million in December from a downwardly revised 4.39 million in November, and are 3.6 percent higher than the 4.45 millionunit level in December 2010.

Total housing inventory at the end of December dropped 9.2 percent to 2.38 million existing homes available for sale, which represents a 6.2-month supply at the current sales pace, down from a 7.2-month supply in November.

This graph shows existing home sales, on a Seasonally Adjusted Annual Rate

(SAAR) basis since 1993. Sales in December 2011 (4.61 million SAAR) were 5.0% higher than last month, and were 3.6% above the December 2010 rate.

Expect the Unexpected

2012-01-13T10:27:00.006-05:00

It is always interesting to see a tremendous amount of advice the New Year brings, an exercise which requires a considerable investment of time and attention by writers, despite the fact that markets tend to be indifferent to what month or year is on the on a calendar. Our view of 2012 is that it will likely be marked by a continuation of the trends that were so obviously in place at the end of 2011 – mainly uncertainty.

The interesting thing about the latter portion of 2011 and now the start of 2012 is that it witnessed one of the clearest dispersion of returns in asset classes that we have seen in over a decade. In addition, the US economy seems to be involved in a weak recovery as evidenced in the latest round of economic data. Although this contradicts leading economic indicators which show the economy could be slowing down dramatically as we move through 2012. We suspect that in this post crisis era economic recoveries which gain no real traction, such as the one we are in, will likely display a constant conflict in the data between recovery and possible recession, until one or the other becomes more obvious.

If at some point this year this recovery gains more momentum it will provoke a reconsideration of the Federal Reserve’s very accommodative stance. This could be the greatest risk in 2012 simply because no one believes it. We don’t believe the Fed will change its stance, mainly because this is an election year, but we want to be aware of the possibility of a surprise move. We can follow the bond market for clues. Right now bond investors don't expect rates to rise anytime soon.

Indeed the effect of the Federal Reserve’s promise not to raise rates prior to 2013 has been to encourage investors to take more risk than would otherwise be prudent and build portfolios around this premise. However, we should be aware that the Fed has a dual mandate which concerns employment and inflation (not yet problematic but hardly non-existent). We would imagine that if US economic data continues its recent path then pressure will grow within the divided FOMC to reconsider its accommodative stance.

As we head into 2012, we believe this could prove to be another interesting year. In a world filled with uncertainty, one thing is probably certain – the markets have never experienced two flat years in a row. This could be the year to expect the unexpected.

Happy Holidays!

2011-12-23T10:37:00.002-05:00

We want to wish you and your family a very happy holiday season and a prosperous and healthy New Year!

Enjoy the year end review by the guys at Jib Jab - very funny!

Year End Tax Planning Tips

2011-12-09T10:30:00.006-05:00

While there's not a lot of time left before the end of the year, there are things you can still do to reduce your tax liability. A number of tax provisions end on December 31st of this year, so this will be your last chance to take advantage of them.

Tax Planning For Individuals

The election to deduct either state and local income or sales taxes as itemized deductions expires this year. If you are contemplating buying a large item, such as a car, you may benefit by making the purchase in 2011.

You can convert a traditional IRA to a Roth; this may make sense if you expect your 2011 income to be lower than in the future.

If you reached age 70 1/2 during 2011 you must begin taking a distribution from your traditional IRA by April 1, 2012. If you wait until 2012 to withdraw it, you will need to take a second distribution during 2012. It may be better for you to take that first distribution in 2011 and avoid doubling up in 2012.

If you have a health savings account (HSA) you should consider making the maximum contribution you can, even if you need to withdraw it right away to pay for qualified medical expenses. Since this is an "above the line" deduction, it has the added benefit of reducing your AGI, which could make you eligible for other tax benefits.

Making charitable contributions not only helps others, but can save you taxes.

The "American Opportunity Education Tax Credit" runs through 2012. To get the full $2,500 credit in 2011, you must pay at least $4,000 for qualifying expenses by December 31st. If you have already paid this much, you may want to wait until 2012 to pay for the spring semester to be sure you are eligible for the credit next year. This credit does have an income phase-out, so not everyone will qualify.

If you need cash to pay for qualified education expenses, you should consider withdrawing the funds from your IRA. While the amount will be subject to income taxes, you will avoid the 10% early distribution penalty. Just be sure to pay the expenses in the same year that you take the distribution, otherwise the penalty will apply.

The alternative minimum tax "patch" is scheduled to expire this year. Those taxpayers who will be subject to the AMT in the future may find it advantageous to pay property and state income taxes in 2011 rather than waiting until 2012 when the taxes are due.

The adoption credit was increased to $13,360 for 2011 and made refundable, meaning that you will benefit even if your federal income tax is not high enough to absorb the entire credit. However, you must finalize the adoption by December 31, 2011 to be eligible for the credit in 2011. The credit will be reduced and no longer be refundable after this year.

Smartest Guys In The Room

2011-12-02T11:31:00.005-05:00

Many believe bond traders understand the economy better than equity traders and therefore are considered the smartest guys in the room. Large institutional bond investors pay very close attention to the economy and any factor that might affect interest rates. Equity investors also recognize that changes in bond prices provide a good indication of what bond investors think of the economy.

Since the global bond market is more than twice the size of the world' stock markets, stock investors pay attention to what bond traders see. Bond prices tend to rise and interest rates fall when there is greater perceived risk. Many portfolio managers will move money from stocks to bonds if they see greater risk in the future. Transferring cash from stocks to bonds adds to the downward pressure on stock prices and upward pressure on bond prices.

Below is a chart of the 20-year US Treasury Bond Fund. You can see in this chart that both the price of the bond fund and the trading volume moved higher in the first few weeks of August at the same time the Euro zone issues started to become more pronounced. It will be important to watch Treasury bond prices in the future for clues. If bonds continue to move higher in the coming weeks/months, bonds investors could be forecasting an economic slowdown or possible crisis in Europe. Conversely, if bonds prices decline in the coming weeks/months, it could be a good indication that both an economic slowdown and Euro zone crisis are much less of a worry - at least in the near to intermediate term.

Home Equity Line of Credit as First Mortgage

2011-11-18T11:30:00.001-05:00

With the Federal Reserve stating that interest rates are expected to remain low until 2013 and possibly longer, there is an opportunity available to homeowners with a higher rate first mortgage. A homeowner could consider paying off their first mortgage (amortized loan) with a home equity line of credit (HELOC) or simple interest loan. Over the life of the HELOC one may save thousands in mortgage interest and pay off the balance of the loan much sooner.

First it is important to understand a HELOC. The term home equity line of credit is not interchangeable with the term "second mortgage." A "first" or "second" mortgage only refers to the loan's claim position, not its terms. HELOCs are often referred to as "second" mortgages because there is usually another mortgage against the property when they are taken out. If one were to default, the lender in second position would not see any money until after the lender in first position had been repaid. However, it is possible to have a HELOC in first position if there is no other mortgage on your home when you open a HELOC or you use the HELOC to pay off your first mortgage.

Let's take a look at how a HELOC could work as a first mortgage. For our example, let's take a $200,000 30-year conventional loan at a fixed interest rate of 5.50%. For this loan the payment would be approximately $1,130 per month (roughly $900 interest and $230 principal in initial years). Total interest paid over the 30 year life of the loan would be roughly $208,000; more than the original loan. As we know, an amortized loan is mostly interest paid in the early years and mostly principal paid in the later years.

Currently interest rates on HELOCs are 3.00% or less in some cases. The interest rate of a HELOC is a simple interest calculation and is not amortized over a set period of time. Therefore, each payment toward principal reduces the next month’s interest expense. The interest rate is variable so if interest rates rise, the interest charged will increase and vice versa.

For example, a $200,000 home equity line of credit at 3.00% would require a minimum interest payment of roughly $500 per month; almost half of the interest paid on the convential 30-year loan. If one continues to make the same $1,130 payment each month toward a HELOC, which would result in a $630 payment to principal each month. If we assume the interest rate stays at 3.00%, the loan could be paid off in roughly 19 years and total interest paid would be $65,000; much less than the total interest paid on the same convential loan.

Even if interest rates increased by .25% each year (HELOCs have variable interest rates), the loan could be paid off in approximately 23 years with total interest paid of roughly $143,000; still much less than the original total interest amount on a conventional mortgage.

While converting a first mortgage to a HELOC may not be the best option for everyone because of the variability of interest rates; in an environment of low, steady interest rates a HELOC could be a great opportunity to pay down a mortgage more quickly versus a coventional 30-year mortgage. A HELOC is most attractive if a homeowner makes extra payments toward principal, which in turn reduces the monthly interest expense.

Super Committee Update

2011-11-11T11:11:00.011-05:00

Below is an LA times article which came out today regarding the latest on the "super committee."

"With time and compromise slipping out of reach, the congressional "super committee" may punt its toughest deficit decisions to next year rather than strike a deal that would enrage both parties' political bases heading into the 2012 election. The Joint Select Committee on Deficit Reduction has until Nov. 23 to agree to a package that would reduce deficits by $1.5 trillion over the next decade.

Achieving that goal would require painful compromise — both parties would have to give up political weapons they have hoped to wield over the next year. But failure could roil the financial markets as the holiday shopping season begins and further trash the already record-low approval ratings for Congress.

In an effort to avoid stark failure, a fallback plan is emerging that would push tough decisions on taxes to next year, perhaps into a lame-duck session after the election, according to officials familiar with the panel's discussions.

Under this scenario, the two sides would agree now to a level of revenue from new taxes. They would direct the congressional tax-writing committees to revamp the tax code with fixed dates and goals. The object would be to generate new revenue while lowering corporate rates and keeping the top individual bracket no higher than the current 35%.

The move would allow the two sides to reach the outlines of the deal now, while deferring the most difficult issues until both see who wins the 2012 election. Currently, election politics makes an agreement difficult — each side has used the budget stalemate as a rallying cry and each believes it stands a chance of winning next November and thereby being able to strike a better deal. If voters deliver a clear verdict in November, Congress might be in a better position to come to terms.

"By kicking it into next year you're basically saying you're going to have this litigated in the next election," said R. Bruce Josten, executive vice president for government affairs at the U.S. Chamber of Commerce.

Even a limited deal, however, as it is being envisioned by those close to the secretive panel, would require substantial political give on the tax and spending issues that have come to define the modern political parties.

Democrats would have to allow sizable cuts to Medicare, Medicaid and other cherished domestic programs, and Republicans would need to loosen their signature anti-tax stance. Any discussion of an overall increase in revenues would probably violate the "no new taxes" pledge that most Republican members of Congress have signed, although a deal might be able to fuzz up the line enough that Republicans would not have to acknowledge having done so.

In proposals that have been exchanged so far, Democrats offered a package that would be made up of equal parts spending cuts and new tax revenues — but would push the tax component to next year.

Under that plan, a new set of "triggers" would be put in place that would be designed to automatically force tax-law changes if Congress failed to act.

No changes in Medicare or other entitlement programs would take effect until the tax changes were adopted.

The proposal was rejected by Republicans, who said the Democrats' insistence on $1 trillion in new revenue was a level they could not accept. They also said the proposed triggers would not be strong enough incentive to reach a deal. The GOP's own proposal offered $250 billion in new tax revenues, along with lower rates.

A deal presumably would have to fall between those two amounts.

Just as in the summer, getting to yes will require substantial give — particularly on the ratio of taxes to spending cuts — that could prove out of reach in the current political climate.

A compromise would assuredly result in an uproar on the political left and right, signs of which have already emerged. AARP is running ads warning lawmakers not to dare cut Medicare or Social Security. Top conservatives have made it clear that compromise on new taxes would be politically unforgivable.

Alienating so many important constituencies just as the 2012 campaign season is underway would be a tall order, even if the result could be followed by a grand political bargain. But with time running short, many in Congress are loath to walk away from the possibility of a history-making achievement. Never before, experts say, has one group of lawmakers been given as much power as the super committee wields. Any proposal the committee members agree to has a guarantee of an up or down vote in both houses of Congress, bypassing the Senate's ability to filibuster."

Risks Remain Elevated

2011-11-04T10:14:00.165-04:00

Along with the news of an apparent final and comprehensive European solution last week was the the report that US GDP rose at an annual rate of 2.5% in the third quarter; higher than expected. Unfortunately, investors continued to follow the results of coincident and lagging indicators rather than leading indicators, so the positive GDP figure was taken as evidence that an oncoming economic downturn or slowdown was now "off the table."

We will emphasize that leading indicators are in fact leading evidence of the economy. As we know, past performance is not indicative of future results. For example, the ECRI Weekly Leading Index, which we discussed a few weeks ago, is continuing to point to a slowdown in growth. Of course, it's not a perfect indicator by itself, but its leading properties are useful. If you go back over the past few decades and look at the points where the index growth rate fell below zero, you'll find that weekly unemployment claims (a coincident indicator) were generally below the five-year average at that time and took 3 to 4 months before unemployment claims climbed over the long-term average.

So the tendency for investors to make predictions from data such as this current data can be dangerous. It allows investors to be sucked in by temporary reprieves in periods where very negative conditions persist. Despite the variability in short-term outcomes, and the tendency for the market to advance as the economy declines, the overall implications are usually negative in terms of risk/reward.

The same can be said here of economic prospects. Investors have almost entirely abandoned any concern about recession risk based on a few weeks of benign economic figures. Yet on the basis of indicators that have strong leading characteristics, a broad ensemble of evidence continues to suggest that recession risks still remain, and combinations of such indicators provide a basis for concern.

For example, since the early 1960's, when the ECRI Weekly Leading Index growth rate has been below -5, the economy has already been in recession approximately 80% of the time. If in addition, the S&P 500 Index was below its level of 6 months earlier, the economy was already in recession 87% of the time.  Interestingly, when the index was below -7, and the S&P 500 was below its level from 6 months earlier, the U.S economy has been in a recession within 6 months, 100% of the time.

Now, we certainly don't base our economic expectations solely on these data points, as a broad array of other economic data points are mixed at the current time; however we want to be very aware of the data and historical statistical evidence.  Therefore, we would view the sheer abandonment of a recession by the media, economists, as well as investors to be a bit misleading.  Wall Street economists will quickly point to the summer of 2010, when the ECRI's Weekly Leading Index dropped below -10 without a subsequent recession, thanks we believe to the brief stimulative effect produced by QE2.  Although the ECRI itself did not officially observe enough deterioration in its indicators to project a recession last summer.  As we know it is currently projecting a U.S. recession in 2012 based on its leading indicators. To what degree is unknown at this time - it could be mild or more severe depending on outside shocks; or non-existent if the Federal Reserve steps in with another round of quantitative easing.

Given that nothing in economics is entirely certain, it's possible that this time will be different. We have seen a lot of firsts over the past few years.  But that possibility is not one that has support in the data. To avoid a recession, we have to hope for an outcome other than the one that has historically occurred 100% of the time; given the current indicators.  While we can't predict the future, it would seem prudent not to ignore this fact.

Quarterly Summary

2011-10-28T09:52:00.014-04:00

The Federal Reserve's efforts to jump start the struggling U.S. economy dominated the quarter's headlines. In early August, the Fed announced it would hold short-term interest rates near 0% until at least mid-2013. The Fed's move accompanied a downbeat forecast in which it noted a depressed housing sector and deteriorating jobs market. The Fed acted again in September when it announced plans to sell $400 billion in short-term Treasury bonds in its portfolio by June 2012 and buy longer-term debt, a move aimed at further driving down long-term borrowing costs. The Fed also said it would maintain its investments in mortgage-backed debt at current levels, instead of paring its mortgage holdings as it has done over the past year, in an attempt to boost the ailing housing market. On a more negative note, the central bank noted "significant downside risks to the economic outlook, including strains in global financial markets."

At the end of August, the Commerce Department reported the U.S. economy grew at a 1.3% pace in the second quarter of 2011. However, other indicators continue to point to a sluggish economy. Job creation stalled in August, when the unemployment rate was stuck at 9.1% for the second straight month. Consumer confidence fell to multi year lows, as consumer worries about the weak jobs market and falling stock prices escalated.

Investor uncertainty has increased markedly in recent weeks, but we see reasons to be cautiously optimistic. We believe odds of an outright recession are around 50%, despite growing talk that the U.S. is sliding into another downturn; although the ECRI has officially called for a US recession in 2012. A more probable scenario is a "stealth growth recession" characterized by extremely low economic growth and high unemployment.

The situation in Europe remains a bit troublesome, as economic growth is slowing across the Eurozone, loan losses continue to pile up, and the risks of a banking crisis are growing. A Greek default looks increasingly likely; it seems to be just a matter of when. However, European policymakers appear to have finally grasped the gravity of the crisis, and we believe the odds are favorable that they will take sufficient action to prevent it from spreading.

While the news over the past several weeks has been fairly negative, the one thing missing from the constant cascade of worrying headlines is any hint of deterioration in US corporate earnings, at least at this point. Earnings estimates will need to be watched carefully in the coming weeks/months for signs of a slowdown. So far this month most earnings reports have come in better than expectations, which is a good sign for continued profitability by corporations. S&P 500 earnings estimates for 2011 are still hovering around $98.00 (up slightly from the first quarter); with continued expectations for roughly $108.00 in 2012.

Headline Risk

2011-10-14T10:12:00.020-04:00

Over the past few months, there has been an abundance of negative press regarding the credit concerns over in Europe. These concerns triggered a nasty spillover effect here in the United States, leading to increased pessimism and greater negative sentiment within the markets. As a result, we’ve seen stock prices decline from late July/early August and have since been trapped in a volatile trading range. Meanwhile, more news continues to spread. Last week Fitch downgraded both Italy and Spain. We saw domestic activity similar to this back on August 5th when S&P downgraded the United States. Though it was a trivial act, the broad market sold off sharply. Over the next few days, we witnessed some of the most pronounced swings in market history which spawned even higher levels of uncertainty and negative sentiment among investors.

This is a classic example of headline risk that investors will inevitably face, (especially during volatile times like this). What investors need to be reminded of is the fact that nothing fundamental changed from one day to the next, and still the market went into a tailspin. This pertains to both the United States and Europe. A rating agency came out and offered their new “opinion” about a nation’s ability to deal with their current debt level. Keep in mind these are the same rating agencies that triple stamped mortgages for the majority of an entire decade only to help spawn the housing and financial meltdowns.

The point is that in situations like these, the cooler heads will often prevail. The “sell everything” mentality is nerve wracking and often shows up at just the wrong time. Emotions tend to get the best of us and acting on them, especially when it comes to investing, is never a prudent strategy. If a slight change or adjustment to your account is in order, keep it simple. Remember, it’s good to pay attention to what’s going on in the markets, but don’t let too many front page articles get the best of you or your investments.

Anti Wall Street Protests

2011-10-07T11:25:00.001-04:00

Over the past few weeks, large numbers of young Americans have been gathering at Wall Street in NYC in an OccupyWallStreet movement. Caroline Baum from Bloomberg News wrote a very interesting column this morning about the movement. I think the movement addresses a number of concerns and the article is insightful is showing what we could expect in the coming weeks and months. Link to article is below -

http://www.bloomberg.com/news/2011-10-07/anti-wall-street-protests-ignore-legitimate-gripe-caroline-baum.html#disqus_thread

What Is Happening?

2011-09-30T10:01:00.075-04:00

The number one question we usually get asked (at least lately) is "what is going on with the markets?" Although a simple question, it's actually a really good question. In an environment where we continue to see massive upside moves followed by massive downside moves as well as very large intraday swings - both in domestic markets and those around the globe.

We believe there is a simple answer. Right now there are just too many outside influences and external factors playing on the collective emotions of market participants. Here is what the last month or so has sounded like:

We will default on our debt if the debt ceiling isn't raised.
Greece is saved...no it's not...it's saved...maybe not...
Germany is going to leave the Euro.
Italian banks are in big financial trouble.
The Fed is going to do this...the Fed is going to do that...
The US economy is slowing down.

In over 20 years in the business, I have never seen such market interference and involvement by governments on a day to day basis. One government leader states one thing, another government leader says another, and then our government leaders say something completely different. Until this dynamic changes, we should expect more of the same. The longer the dynamic continues the worse it is for the capital markets and world economies.

The good news is that eventually, when all is said and done, the global markets will eventually move in the direction they intended to go - which unfortunately in our opinion may be lower, as the increase in volatility is making investors more nervous and economic data continues to show a slowdown in global growth. Just this morning the ECRI stated on CNBC that its indicators were saying the US is heading into another recession. And this group has been very accurate in the past. The video clip can be viewed by clicking on the link below.

http://www.businesscycle.com/#

It our opinion it is best to continue to be defensive oriented and wait until there is more clarity on both the government involvement as well as economic front.

Weekly Update

2011-09-23T11:13:00.006-04:00

Below is excerpt from recent market commentary from the managers of the Marketfield fund.

US economic data remains squishy, but not as straightforwardly weak as consensus imagines. Perhaps most importantly non-financial earnings continue to produce positive surprises with a number retail and technology stocks reporting better than expected earnings in recent days. The Federal Reserve Board however seems to have capitulated to the fears of downside pressure issuing a decidedly downbeat statement on Wednesday that unnerved the US equity market.

As to their decision to intervene in the long end of the treasury curve this was expected but is unlikely to have a significant effect other than possibly collapsing the wide spread between the 10 and 30 year bond. As we have stated before, US monetary policy is already extremely stimulative and further embroilment of the Federal Reserve into the yield curve was an unnecessary complication. No doubt the well meaning members of the FOMC felt the need to be seen to be doing something, and at least have chosen a path that is unlikely to make matters worse.

Even after the abrupt decline on Wednesday afternoon the SPX remains in the middle of its trading range and with the exception of financial stocks, a large number of which made new post 2009 lows, most sectors remain well above key support although some may end up testing this during what looks to be a difficult week for stocks. The Nasdaq Index continues to look much better and actually broke above its 200 day ma before being pulled lower on Wednesday.

Even so the index remains in positive territory for 2011, and is the only large global index to be able to make this claim. The out performance by the NDX remains the most interesting aspect of the long corrective phase and we would be building positions in this index during the current pullback. The small cap Russell 2000 index has shown none of the defensive qualities of the larger cap indexes and we would be avoiding this area of the US equity market.

This takes us to Europe, where a hurried announcement regarding the provision of emergency US Dollar auctions last Thursday at least bought some time for the beleaguered institutions that were at risk of being choked out of funding markets. Unfortunately the first week has been frittered away without other progress being made other than a widening of collateral accepted by the ECB. The danger of a further sharp dislocation by the market has not been averted by either of these moves and a far more radical change of tack is still urgently required. The only question in our minds is whether a narrow portion of the US equity market can start to detach itself from Europe's woes and start to make steady progress in the absence of a solution being hammered out across the Atlantic Ocean. This seems unlikely if things are allowed to proceed to a full-blown crisis, but a longer process of muddling through could potentially create some great opportunities in a number of US sectors.

Unemployment Rate Shows No Improvement

2011-09-16T11:43:00.008-04:00

State unemployment rates were generally little changed in August. Twenty-six states and the District of Columbia reported unemployment rate increases, 12 states recorded rate decreases, and 12 states had no rate change, the U.S. Bureau of Labor Statistics reported.

Nevada continued to report the highest unemployment rate among the states, 13.4 percent in August. California posted the next highest rate, 12.1 percent. North Dakota registered the lowest jobless rate, 3.5 percent, followed by Nebraska, 4.2 percent.

New Mexico registered the largest jobless rate decrease from August 2010 (-1.9 percentage points). Four additional states reported smaller but also statistically significant decreases over the year: Oklahoma (-1.4 percentage points), Indiana (-1.3 points), Oregon (-1.1 points), and Florida (-0.9 point). Forty-five states recorded unemployment rates that were not appreciably different from those of a year earlier.

The fact that 45 states and the District of Columbia have seen little or no improvement over the last year is a reminder that the unemployment crisis is ongoing and could be for some time.

In related news, the Department of Labor stated that in the week ending September 10, the advance figure for seasonally adjusted initial claims was 428,000, an increase of 11,000 from the previous week's figure of 417,000. The 4-week moving average was 419,500, an increase of 4,000 from the previous week's revised average of 415,500. See chart below -

Bubble Comparison Chart

2011-09-09T10:44:00.044-04:00

Over the course of the past 30 years, the world has seen several "bubbles" emerge. Below is a chart we call a "bubble comparsion" chart. The chart compares Japan's stock market bubble in the 1980's, the technology stock bubble in the US in the late 1990's, China's stock market bubble of 2007, crude oil bubble of 2008, and the current state of gold in 2011. We offer this chart so you can see what happens on the other side of euphoria.

Ironically, a recent Gallup poll shows that over 35% of Americans believe gold is the single best long term investment for the next decade; higher than real estate, stocks, bonds, and savings accounts. Although not referenced on this bubble chart, would you like to guess what 38% of Americans believed was the best long term investment in April of 2007?

Real Estate. It is truly amazing how often history repeats - just never in the exact same way.

Market Decline Wipes Out E-Trade Baby

2011-08-11T10:45:00.000-04:00

http://biggeekdad.com/2011/08/e-trade-baby-loses-everything/

Second Quarter Update

2011-07-22T11:30:00.000-04:00

After another three months of volatility, the major market averages didn’t move much in the second quarter, ending right about the same levels as the end of March. If it weren't for the last three days of the quarter, the markets would have been down a few percent. The Dow Jones Industrial Average declined (0.77%) for the quarter; the Nasdaq Composite declined (0.27%); the Russell 3000 Index was unchanged; and the S&P 500 declined (0.39%), excluding dividends. International markets, as measured by the MSCI EAFE Index, actually rose 1.83% during the quarter. The Barclays Capital Aggregate Bond Index was the big standout, increasing 2.29% during the quarter.

While the news over the past several weeks has been fairly negative, the one thing missing from the constant cascade of worrying headlines is any hint of deterioration in US corporate earnings, outside of the financial sector which has a separate set of problems. This doesn’t insulate the US stock market from the possibility of increased volatility in in the short term in reaction to news, but the overall recovery is likely to remain positive. So far this month most earnings reports have come in a bit better than expectations, which is a good sign.

Earnings estimates have remained steady over the past several weeks. As of July 1, 2011, earnings estimates were $98.39 for the year ending in December, an increase over the $97.00 estimates as of April 1, 2011. Economists and analysts are currently posting estimates of $111.00 for 2012, a 13% increase over the current 2011 estimate, and probably consistent with 2 - 3% overall economic growth.

The Debt Ceiling - A historical look back

2011-07-15T10:15:00.003-04:00

The current debt ceiling battle is the topic du jour in Washington. The Republicans, influenced by the Tea Party, argue that simply raising the debt ceiling over and over again is an unsustainable policy, so they're insisting on budget cuts or no deal will get done. Many Democrats agree that the U.S. has a deficit problem, but they stress the necessity of raising the debt ceiling promptly in order to prevent default or problems funding other U.S. obligations. With all this arguing about “to raise or not to raise” we thought it might be informative to take a look at the past.

The debt ceiling was first set in September 1917. At that time, Congress authorized the issuance of about $7.5 billion in U.S. bonds and another $4 billion in certificates of indebtedness, under the Second Liberty Bond Act. How much was $11.5 billion dollars back then adjusted for inflation? In March 2011 dollars, it would be roughly $193 billion. Currently, the debt limit is set at $14.3 trillion -- so inflation doesn't tell the whole story! To be sure, Washington's love affair with debt has grown tremendously over the past 25 years.

So first, here's the debt limit throughout history, charted along with actual U.S. debt outstanding:

The chart shows that the debt ceiling (thick red line) didn't even hit $1 trillion until 1982 -- less than 30 years ago. Since then, it's increased exponentially. Of course actual debt outstanding (thin green line) moves right in sync with the actual debt ceiling, as it generally only rises when the government decides to issue more debt.

You can see the ceiling is a sort of step function, as it increases based on Washington's whims, not a natural mechanism. This chart also shows that increases in the debt ceiling are quite common. Over the 94-year period, the debt ceiling has been revised 102 times.

Depending how high Congress raises the ceiling in coming months, it could potentially surpass 100% of our nation’s GDP. It would take at least a $700 billion increase: currently the ceiling is set at $14.3 trillion and would have to be a little greater than $15 trillion to move past the annualized GDP estimate. The last time Congress raised the debt ceiling, in February 2010, it increased the limit by almost $2 trillion.

In the end, a decision comes down to a determination of whether the potential harm of the budgetary cuts necessary to avoid raising the ceiling are worth the risk they pose to the U.S. economic recovery. But history does help show that longer-term fiscal reform is needed to cure Congress of its addiction to debt.

"Twinkie Market"

2011-07-08T11:15:00.019-04:00

In an interview with Jason Zweig at the end of last year, Seth Klarman, a legendary Boston-based hedge fund manager known for his astute investment management skills, called this "a Twinkie market." He went on to say that “It is fun and tasty, but all the ingredients are artificial.” We would add that Twinkies aren't really good for you either. We believe this analogy rings even more true today than it did at the end of 2010. The simple truth is that by holding interest rates at an effective 0% level, the Federal Reserve has executed a forced asset allocation liquidity trade. To earn a return on your cash and keep pace with inflation an investor has to increase his/her risk levels by moving into riskier assets. Money that was in savings accounts or other fixed-rate investments like CD’s, has found its way to the stock market or other investments looking for some rate of return.

Mr. Klarman went on to say that he was more worried about the world than he had ever been in his career. He stated that the global and domestic risks keep increasing with each passing month. European sovereign debt is the most obvious problem as it has dominated the recent headlines. Europe is trying to “kick the can down the road” with the current Greek situation, but other countries, including Italy, Portugal and Spain, also face potential debt problems. In recent weeks, we have seen the protests in Greece on television, and perhaps we will see them repeated in other nations as they must face difficult choices to deal with their own financial conditions.

Here at home, the risks include political posturing surrounding the debt ceiling for the federal government and severe funding problems for many state and local governments. We recently read an article about the U.S. needing to take its own austerity measures at some point in the future. We believe this is entirely possible in the years ahead.

So with a renowned hedge fund manager worried, the prospect of a further debt crisis in Europe, and debt issues here in the U.S., shouldn’t the global markets be reacting to this bad news and moving significantly lower? The simple answer is yes. But the reality is that these concerns/issues don’t matter until they do matter. As long as the current problems don’t prevent companies from increasing revenues and earnings (which hasn’t happened yet) the problems don’t matter. At some point they probably will matter, but at the moment they don’t.

This doesn’t mean one should totally disregard the news entirely because understanding the macro economic trends are important; but the global markets, while subject to news-based volatility, will tend to follow the underlying trend of economic activity and earnings rather than the headline news. And so far the trend of economic activity and earnings has been positive, albeit at a slow rate.

Widgets for the Weekend

2011-07-01T10:25:00.054-04:00

Happy Fourth of July! Please enjoy the weekend -

With all of the talk of austerity in Greece (and other European countries), congress dealing with our own debt ceiling limit, and the grumblings about the high price of gas, we want to share some interesting widgets we found. The data updates in real-time (or close to it). The numbers speak for themselves!

More of the same?

2011-06-24T11:41:00.006-04:00

As we conclude an interesting week in the market, we will point out that so far, this year has some resemblance to what happened in the beginning of last year. The stock market began both years in a steady uptrend. 2010 slipped a little in late January and early Feb with about a 10% correction, but then went on to rally for two months straight, (up to the late April highs). From that point on in 2010, we saw a lot of “chop” in the market through the summer until September when energy stocks finally pulled the market into the next leg up after August and through the rest of the year. This year, the uptrend continued straight though until mid-February, before slipping from roughly 1340 to 1250 on the S&P. The earthquake in Japan was part to blame for this. Since then, we have seen decent earnings reports accompanied with some very disappointing macro-economic data. The housing market took another step back and further dragged on hopes for better US GDP Growth. At the same time, unemployment data came in weaker than expected. The Greece/European debt turmoil hasn’t helped things either. Then just out this morning, orders for U.S.-made durable goods partially rebounded in May after a steep decline in April. Durable-goods orders rose 1.9% in May after a downwardly revised 2.7% fall in April. The increase in May was slightly stronger than expected. Transportation orders had the biggest increase last month. Excluding transportation, orders rose 0.6%. Shipments rose 0.3% in May. Orders for core capital goods rose 1.6% in May after a 0.8% fall in April. Could it be that we are in for some more of the same “chop” through the summer? Hard to tell at this point, but so far it looks like things are shaping up that way.

Jan-Jun 2010

Jan -June 2011

Earnings Estimates Remain Intact

2011-06-17T11:43:00.065-04:00

While continued concern in the Middle East, worries over debt crisis in Greece and greater Europe, and underwhelming economic numbers are giving investors cause for concern, it is important, from time to time, to take a step back from the news headlines. Ultimately, the markets, both foreign and domestic, will follow the trend of corporate earnings. If earnings are growing, markets tend to rise over time. If earnings are declining, markets tends to fall over time. Also, markets tend to discount future earnings by either moving up or down in anticipation of what may happen. Therefore, we want to periodically review earnings to see if earnings estimates are being adjusted upward or downward by analysts who follow the companies. Of course, analysts tend to often be late in making adjustments either up or down, so what we really want to follow is the trend of earnings estimates - are they trending higher, trending lower, or staying roughly the same.

Given the domestic markets have declined since the beginning of May, we would expect to see earnings estimates start to trend downward over the past month and moving forward. Let's take a look at earnings estimates for the S&P 500 as a whole and broken out by sector since the end of last quarter. The aggregate top line number (first line) doesn't equal the total of the numbers below that number because companies can be in multiple sectors.

	1-Jun	1-May	1-Apr
S&P 500	97.88	97.21	96.99
S&P 500 Consumer Discretionary (Sector)	20.48	20.31	20.10
S&P 500 Consumer Staples (Sector)	21.53	21.43	21.30
S&P 500 Energy (Sector)	48.78	43.05	43.04
S&P 500 Financials (Sector)	16.65	17.73	18.21
S&P 500 Health Care (Sector)	32.47	32.92	32.77
S&P 500 Industrials (Sector)	20.87	20.83	20.52
S&P 500 Information Technology (Sector)	30.90	31.10	30.65
S&P 500 Materials (Sector)	17.89	17.33	16.92
S&P 500 Telecommunication Services (Sector)	7.81	7.69	7.75
S&P 500 Utilities (Sector)	12.78	12.86	12.85

As you can see with the list above, with the exception of Financials most sectors have seen earnings estimates increase since last quarter or in some cases, like utilities and healthcare, revised slightly lower. As of June 1st, only a few sectors have seen a decrease from May 1st estimates. So while the markets have declined, earnings have not in aggregate. The overall number for the S&P 500 (top line) has continued to move higher for 2011 and also 2012 (estimates not shown but currently stand at $111.82 for the index, up from $110.29 in April).

If estimates trend lower in the coming weeks, the recent downturn in the markets is most likely adjusting to the probability of slower earnings growth this year and that adjustment would be considered normal. However, if estimates continue to stay roughly the same and not trend lower (which we believe is likely), we could have a divergence from market expectations and actual earnings, which could send the markets into undervalued territory and create opportunities in certain sectors. Earnings will be the key focus in the weeks ahead, especially in July when actual earnings for the second quarter are released.

Smart Money More Confident

2011-06-10T11:03:00.015-04:00

We haven't looked at sentiment data since earlier this year when dumb money sentiment was very high and smart money sentiment was low. At that time we said the risk/reward setup was not favorable based on historical precedent.

The most recent sentiment data from our friend Jason Goepfert at SentimenTrader.com shows just the opposite occurring today. The smart money is becoming more confident as the market moves lower while dumb money is becoming less confident.

While markets can continue to move lower in the near term, when smart money confidence rises close to or above 70 (which it rarely does), the risk/reward setup is extremely favorable for investors in the short to intermediate term.  And of course, one wants to act in concert with smart money investors, even when emotionally it doesn't "feel" right. We believe more downside action in the indices, coupled with higher smart money confidence readings will likely provide solid, low risk, opportunities.

Weekly Update

2011-06-03T09:24:00.029-04:00

This week's update is courtesy of our friends at Oscar Grouss Management.

"Our contention that the second leg of the corrective phase is underway certainly looks to be more reasonable after a very ugly session on Wednesday took the SPX index back down to key short term support. As we had explained, the combination of month end allocations and a late Memorial Day holiday were likely to obscure matters for a period of time but a very poor start to the May data cycle saw confidence crack in the US equity market and the largest one day decline recorded since the start of the strong rally last August.

As has been the case for several weeks, the brunt of the sell off was borne by financial stocks. It is our belief that these losses will not be quickly recovered and that large cap financials are being re-rated following an appreciation that recent legislative changes are likely to meaningfully downgrade their profitability going forward. This is particularly true of large, diversified institutions that have mixed principal and customer businesses under one conflict-ridden roof.

These we expect to see centered on the financial and commodity related sectors in the US and the emerging market complex outside. We would also be concerned about any individual issues that have become particularly linked with emerging market growth.

Within the core US equity market we still expect losses to be relatively contained and it is quite possible that the low point will be at or above that reached in mid March when the SPX traded just below 1250. A breach of this level would imply a deeper corrective move (1180 being the next clear support level) but as we always say, the least important number in a corrective move is its low point, the most important is the probability that the losses incurred will be recovered reasonably quickly. It is really this understanding that leads us to be patient with US equity exposure as opposed to emerging markets that we believe may be tracing out a terminal top to their ten year economic cycle. It should therefore be noted that the end of May saw much less sign of investor flows into the emerging market equity complex than recent months.

May’s overall losses were trimmed but this remains a very challenging start to 2011 for most equity markets. However, thus far investors seem to merely be switching their attention from equity to corporate credit. This is important since it has neutralized the effect of equity outflows on the currencies of many emerging markets. We doubt whether this balancing act will be able to stay in place much longer, and would look for one or more emerging market currencies (our favorite candidate being the Turkish Lira) to break down during the current cycle.

We would also expect to see continued strength for both US treasuries and the US Dollar. The former area is starting to look a little expensive, with the 10 year yield now well below 3.00%, but we would be patient with any long positions for the time being. As we have seen before, long dated treasury yields can fall well below any fundamentally justified level in a corrective move and both the 10 and 30 year yield would seem to have further to run. The US Dollar on the other hand continues to look remarkably cheap. At the very least the DXY (dollar index) should be able to rally up to its declining 200 day ma (77.87) with a more ambitious target being the December 2010 high just above 81."

Currencies As A Hedge

2011-05-20T10:05:00.015-04:00

In the aftermath of the global credit crisis, it has been hard to find truly uncorrelated asset classes in the capital markets. Uncorrelated investments are a way to protect against downside risk. However, since many asset classes continue to move in the same direction simultaneously, it has become increasingly difficult to find those assets that exhibit such uncorrelated behavior. The hard currency asset class may fill this void. The currency asset class has historically displayed low correlations to traditional asset classes, such as stocks, bonds, and commodities, and offers potential profit opportunities given its unique market structure. Therefore, the addition of a currency component to a portfolio may deeply enhance the risk/return profile over time.

During the run-up to the credit crisis in 2008, asset classes became increasingly correlated, and that phenomenon has continued to this day. Most asset classes generally moved up in tandem approaching the credit crisis; most asset classes moved down together as the credit crisis unfolded; and, broadly speaking, most asset classes have continued to move in lock-step ever since. In order to truly diversify and hedge downside risk, it is important to add uncorrelated assets to a portfolio whenever possible. It is within this framework of portfolio construction that the addition of the currency asset class may provide excellent potential. Currency investments have historically exhibited very low correlation to many other asset classes.

The effect of many non-profit seeking participants in the currency market may enhance the uncorrelated attribute of the asset class. For example, multi-national corporations might contract to buy or sell certain currencies for the primary reason of hedging against currency risk on future earnings or expenses in a certain country; governments and central banks are active in managing foreign currency reserves; even tourists are active currency market participants – when tourists spend money on souvenirs, food or any travel related expense in a foreign currency they influence the price of that currency, even if they are unaware of it. Such non-profit seekers can have substantial influence on currency price movements and valuations. The effect of these entities’ actions can cause currency prices to move in directions that are largely uncorrelated with most other asset classes.

Additionally, many currency investment strategies are aimed at profiting from trends that are completely unrelated to other asset classes, and therefore also generate return series that are uncorrelated to other asset class returns. An often overlooked attribute of the currency asset class is that when an investor purchases one currency, the investor is also, by implication, selling another currency, as currencies always trade in pairs. Therefore, the return generated from a currency pair is likely to differ from, and be uncorrelated to, returns of the broad stock market; which is turn adds an effective hedge to a portfolio.

Return vs. Yield

2011-05-13T14:23:00.002-04:00

A year or so ago, I remember having a discussion with a former colleague about the performance on a certain mutual fund. As we were going over the numbers on the fund’s fact sheet, he finally asked me, “So what is the difference between annual return and yield?” Being that he had worked as an advisor for a major brokerage firm for many years, I initially thought he was kidding. But by the puzzled look on his face afterwards, I quickly realized that he truly had no idea. Without poking any fun, I explained it to him as simply as I could.

Since then, I have had other clients ask me the same question. As advisors, we use the two terms often and I think people sometimes believe that a portfolio’s annual return and a portfolio’s yield are both one and the same thing. This is not the case. Although each can be used to describe the overall performance of an investment or portfolio, the two terms differ in regards to specific time periods, (the past and the future).

“Return” expresses what an investor has actually earned on an investment in the past. This includes capital gain, interest, and dividends combined. “Yield”, on the other hand, just focuses on what the investment will pay the investor in the future. So, if you own a portfolio of stocks and bonds that is yielding 3%, but earned you 8%/year over the last decade, you know two things.

1. the total of all capital gains, interest, and dividends over the past decade averaged out to 8%.

2. if you continued to hold the portfolio unchanged for one year, you will earn 3% of interest and/or dividends of what the overall portfolio value is at that moment in time.

In looking backwards, the yield the portfolio generated in the past has already been calculated into the 8% return the investor has seen. But in looking forward, you can only calculate what the yield will be, (based on the current value of the portfolio and the amount of income the portfolio is expected to pay). We have no idea what the value of the holdings in the portfolio will be in the future. But we do know what those holdings will pay us if we continue to hold them. If we end up holding that same portfolio for another year and the price of the securities goes up another 10%, the return would end up being 13% on the year, (10% gain + 3% yield = 13%). Understanding this concept becomes important when looking at certain investments, (stocks, bonds, mutual funds, exchange–traded funds, etc). Knowing what a portfolio has earned in the past and knowing what the portfolio will yield in the future can certainly help investors make smarter, and more informed decisions.

The Sky is Falling...

2011-05-06T10:25:00.005-04:00

As it has been said, what goes up must come down…this past week silver experienced a free fall as the precious metal dropped from almost $48.50 to roughly $34 in one week – a drop of over 30%. The silver market witnessed “parabolic downside turbulence”. This dynamic happens when a sharp rise in a short period for no reason other than investors falling over each other to buy; is followed by a swift and sharp sell off as investors fall over each other to sell.

Much of the sell-off in silver was attributed to tougher margin requirements for speculative traders. The Comex exchange had raised trading margins on silver contracts for the third time in two weeks. Comex said this week that the minimum amount of cash that must be deposited when borrowing from brokers to trade silver futures will rise to $16,200 per contract at the close of business yesterday, from $14,513. A year ago, the margin was just $4,250. There was also news that one of the biggest silver bulls in the world, Eric Sprott of Sprott Asset Management, had started selling 35 million shares of Sprott Physical Silver Trust (PSLV), a silver-based ETF.

Back in the 1970’s the Hunt brothers of Texas tried to corner the market in silver. Back then, after futures rallied to a record $50.35 an ounce in January 1980, prices dropped 78 percent in four months and wasn’t until this past week that prices got even close to that level.

Overall, silver has gained more than 145% in the past year, and 20% in April alone. Unlike gold, which is typically bought and held by large investors and central banks, silver is dominated by individual investors and hedge funds looking to capitalize on the hot play du jour. It will be very interesting to see if silver follows the same path that it did after the peak in 1980.

Quarterly Update

2011-04-29T09:40:00.026-04:00

The market volatility which was missing back in the last quarter of 2010 into the first few months of 2011 came to visit in March as an unexpected earthquake and devastating tsunami in Japan, along with continued tensions and unrest in the Middle East sent global markets lower. In just two and one half weeks, the S&P 500 lost 7%, while global markets declined even more. In the subsequent two weeks the markets surprisingly recovered fueled by in-line or better than expected economic data. The Federal Reserve continued its quantitative easing program increasing liquidity into the system; which has been finding its way into commodities; as the price of oil and soft commodities continued to rise during the quarter.

Amidst the natural disasters and geopolitical unrest, the S&P 500 ended the first quarter up 5.4%, excluding dividends. Within the market, small caps outperformed large caps and the US Energy sector led with an impressive 16.8% rise amid political tensions in the Middle East. Energy stocks have now gained almost 40% in the past year. Developed markets outperformed emerging markets and Europe finished up 4.5%. Fixed Income underperformed equities due to fears of inflation and rising interest rates. Treasuries were basically flat, while high yield, (+3.9%), preferreds, (+3.6%), and TIPS , (+2.1%), did the best.

The Federal Reserve Board continues a very aggressive monetary policy. At some point in 2011 this will likely change and recently there has been a growing minority of those on the board that QE2 should be halted on schedule at the end of June of this year. With the exception of Thomas Hoenig, no calls for an actual interest rate hike have been made. If the Federal Reserve does end QE2 on schedule (which it indicated it plans to do), it is possible the end to this policy could bring increased volatility to the markets as investors try to understand the implications to the economy moving forward; given the Fed has provided ongoing liquidity and support to the monetary system for well over 2 years and to the tune of almost $2 trillion.

Our current assessment is that the US stock market averages (based on S&P 500 index) are priced close to fair valuation given current earnings estimates and the possibility of future interest rate hikes, which lowers the amount investors are willing to pay for future corporate earnings. Earnings estimates have remained steady over the past several weeks, despite the earthquake in Japan and issues in the Middle East. As of April 1, 2011, earnings estimates were $97.00 for the full year ending December 2011, a 15.8% increase over final 2010 earnings of $83.77. Applying a price-earnings ratio of 13 and 14 to expected earnings for 2011 translates into a value of 1261 (based on 13) and 1358 (based on 14) for the S&P 500. The S&P 500 ended the first quarter at 1326, right in the range of fairly valued. If expectations for higher interest rates don’t materialize, it is possible the markets could trade higher (higher price-earnings ratio) as investors will be willing to pay more for future corporate earnings.

Tax Saving Tips for 2011

2011-04-15T10:40:00.001-04:00

The filing deadline for 2010 tax returns is upon us, with tax returns due this Monday April 18th. In order to help you be better prepared for 2011, below is a list ot tax tips to help you maximize deductions and minimize taxes. Please be sure to send us a copy of your 2010 tax returns for our records in order to assist us in tax planning for 2011.

Know the tax system - We know this is easy to say but far too many people do their taxes without fully knowing what they are doing. Read the entire guide, read up on yearly 2011 changes and make sure you understand why you are putting a certain number in a box. If you don't want to complete your return yourself, hire an accountant to file your return. Mistakes can cost you money.
Use software - Software is great for helping you file your taxes efficiently online. The extra help and clear instructions give you a better chance of ticking the right boxes and inputting the right figures.
Claim the extra work expenses - If you work for someone else it is unlikely that you ever claim expenses. However you are entitled to some deductions and you can check with the IRS to see what is eligible. Examples may be expenses you have had to pay out of pocket while attending meetings or business trips.
Find out if you are eligible for any tax credits – There are lots of tax credits available with new ones every year. Read through the requirements and see if you qualify for any of them.
Give to charity – If you plan to make any donations remember these are tax deductible. If you want to save from donations without spending actual cash you can donate old goods to Goodwill or Salvation army and receive a tax deduction. Just make sure to get a receipt.
Max out your 401k account – Maximizing contributions to your 401(k) will ensure that you maximize tax savings. The maximum remains unchanged at $16,500.
Check out health care deductions - There are lots of changes in health care deductions as a result of the Affordable Care Act Tax Provisions. For instance, the cost of an over-the-counter medicine or drug cannot be reimbursed from a flexible spending account unless it’s for insulin or you have a prescription.
Keep track of mileage — The mileage allowance changes again in 2011 to 51 cents-per-mile for business miles driven; 19 cents-per-mile for medical or moving purposes, and 14-cents-per-mile for driving for charitable organizations. Be sure to keep accurate records, seriously. :)

Have a wonderful weekend and be sure to contact us or your tax advisor if you have any questions.

Definition of Hedging

2011-04-08T10:05:00.011-04:00

People sometimes ask me, “What exactly is a hedge fund? And what do they do that separates them from the other, more traditional investment companies?” According to Wikipedia, a hedge fund is defined as: “a private investment fund which may invest in a diverse range of assets and may employ a variety of investment strategies to maintain a hedged portfolio intended to protect the fund's investors from downturns in the market while maximizing returns on market upswings.” Okay, but what does the “hedged” part mean? Here we will attempt to explain one of the most simple and basic strategies a hedge fund uses in order to “hedge” the fund from a downturn in the price of a stock.

Hedging is what an investor does in order to offset some of the risk on a certain investment or position within a portfolio. We will use a single stock position as an example. So, if you owned 100 shares of ABC stock and were afraid that its value might depreciate in the near term, you could employ a basic strategy designed to protect your investment in case that were to happen. In most cases, you’d pay a premium for this protection much like the premiums one pays for an insurance policy. It’s basically the same concept. Investors are able to buy this “coverage” simply through the use of option contracts. Options are contracts that allow investors to buy or sell a certain stock at a certain price within a certain period of time. Options to buy stock are known as calls and options to sell stock are known as puts. The price or premium for these contracts fluctuates based on the movement of the stock and the amount of time left on the calendar before the option expires. So when the price of a stock declines, put contracts typically appreciate while call contracts would typically depreciate. In getting back to the original example, if an investor thinks that the price of ABC stock is going down, a put contract, (option to sell) would work well here. Assuming the stock price depreciates, the put contract for that stock is actually going to appreciate and in result cover or offset some of the risk of owning the stock outright.

Now there are several types of option strategies that hedge fund managers can use, but this one here is probably the most basic and a good way to understand how these options are used to “hedge” a specific position. Now should the stock go in the other direction, (that being up), the value of that put contract is going to depreciate and possibly expire with little to no value. So in that scenario, the investor would lose on the principal paid for the owning the contract. However, they still own the stock and therefore would be getting appreciation for holding it. Therefore, owning the put option is the “hedge” against the stock.

The hedging activity by "smart money" or institutional investors is available to us via our friends at Sentimentrader. As you can see in the chart below, the "smart money" is currently hedging at a rate similar to that reached at various times in 2007. The higher the number above 1.00, the more hedging by institutions. After dramatically reducing hedging activity at the end of 2010, hedging activity has increased significantly since the beginning of this year. While the markets can obviously continue higher, this increased hedging activity by the "smart money" should be watched as it indicates a more cautious posture by large institutions; or at least a desire to "hedge" their bets.

Monetary Base Explodes Higher

2011-04-01T09:52:00.006-04:00

The monetary base is defined as all currency in circulation outside of the central bank and Treasury including those deposits held by financial institutions (banks) at the central bank.

The chart below is a chart of the US monetary base. In simple terms, it charts how much money the Fed has pumped into the system. So it’s a kind of visual of when the Fed is really pouring money into the system. Given the events of the past few years, we can assume when the monetary base explodes higher, the Fed is concerned about stability in the system and therefore pumps liquidity into circulation.

You can see that during the financial crisis the Fed didn't do much until the autumn of 2008 when it pumped nearly $1 trillion into the system - the first vertical spike. Through various Federal Reserve programs the monetary base continued to grow during 2009. Now, after the monetary base actually declined during much of 2010, it has recently jumped another $450 billion to roughly $2.45 trillion. While some of this can be attributed to QE2, most of it is beyond QE2.

It could be the Federal Reserve just wants to keep liquidity in the system to be sure economic growth continues. Or, it may be the Federal Reserve is worried about the stability of the system and is adding liquidity. We will monitor this monetary expansion to see if it continues over the next few months. Either way, going from less than $1 trillion in the monetary base to over $2.4 trillion in a little over 2 years is concerning and can't continue at this rate without consequences. Stay tuned...

Asset Allocation, Volatility, and Returns

2011-03-25T10:33:00.040-04:00

Much of the conventional wisdom about investing has been predicated around the notion that purchasing indices of risky asset classes are optimal and provide the best way to generate a return over the long term. Such wisdom became common place and moved mainstream during the 1980's and 1990's and was further supported by academic theories. The widely held belief was that markets are efficient and indexing to benchmarks always provide the greatest return for a given amount of risk. The other notion has been that over the long term, risky assets will always perform better than safe assets like government bonds. Therefore, simple diversification and occasional rebalancing would be the way to manage risk in an otherwise passive portfolio. If it worked in the past, we can extrapolate into the future, so the theory goes.

These days, there is much discussion about the implications of such conventional wisdom. The new reality in today's markets and economy can be stated as anything but conventional. A series of bubbles and crashes have generated high volatility in both the markets and economy, with little or no gains for well over a decade. At the same time, safe investments have outperformed riskier ones. The ultimate question is whether the financial crisis was just a perfect storm of events and eventually the markets will revert back to expected long-term return rates, or if we are entering a cycle where high volatility, high asset class correlation, and lower expected returns will be the norm. And if we have entered a new cycle, how long may it last? What will be the impact on the conventional wisdom should this new reality prove to be true?

If we look back in history there are long periods of time with high volatility and sub par returns - 1930's into early 40's, mid 1960's into late 70's, and the year 2000 until now. The bursting of asset bubbles, especially when induced via credit expansion, are usually followed by periods of higher volatility and sub par returns until the excesses are out of the system. In addition, the negative societal mood after such events usually impacts and shapes the way people feel about the economy, government, and the markets. In result, post-bubble market scenarios create serious challenges to the traditional asset allocation framework and expected returns associated with these models. A lesson from history shows us that asset classes can go through multi-year periods where the risks of holding the asset is not adequately compensated via the actual return achieved.

So what is an investor to do? One lesson we can take away is that allocation must rely on a top-down macro approach (what is happening from an economic, political, societal standpoint) in selecting asset classes which are most undervalued. Identifying undervalued investments requires experience and the ability to look beyond conventional market wisdom at the moment. Detailed analysis of market cycles and human behavior can be used effectively in determining the tactical asset allocation. The levels of entry and inevitable exit of an investment will be critical, although it shouldn't be confused with market timing. The process should be viewed as an essential component of risk management in a high volatility period where it could be more warranted than in decades past.

Weekly Update

2011-03-18T09:48:00.002-04:00

With the recent market volatility in wake of the news from Japan, stocks were fittingly green yesterday on St. Patrick’s Day. Technically speaking, we have noticed an increased level of put (bets on market going down) vs. call (bets on market going up) activity since the end of 2010. The Chicago Board Options Exchange 5-day put/call ratio has shown an increase in put volume relative to call volume. This would suggest that investors are becoming more cautious as the US equity market reached new recovery highs earlier this year. With recent global uncertainties leading to a deeper correction for US equities in the past few weeks, the 5-day put/call ratio has already begun to move even higher indicating an increasing amount of pessimism about US markets. An higher number indicates higher put volumes relative to call volumes. From a contrarian point of view, the put/call ratio is becoming more bullish. However, based on recent history, increased volatility, as well as uncertainty in Japan and Middle East, deeper oversold levels for this indicator shouldn’t be ruled out. If stock prices continue to move lower along with the put/call ratio rising and investment sentiment becoming more negative, it could set the stage for higher stock prices.

On the economic data front, new applications for unemployment benefits fell by 16,000 last week to 385,000, keeping initial claims at a level usually associated with a modest pace of hiring. Continuing claims also decreased as the unemployed either found jobs or are no longer receiving benefits. At the same time, the Labor Department reported that U.S. consumer prices, (inflation) rose 0.5% in February, mostly fueled by higher gasoline costs. So-called core prices, which strip out the volatile food and energy categories, rose a lesser 0.2%. A variety of economists had forecast this figure to rise 0.5% overall, with a 0.1% increase in the core rate. Consumer prices have risen an unadjusted 2.1% over the last 12 months, though a smaller 1.1% on a core basis. So all things considered, if you strip out the cost of gas and food, things don’t appear to be so bad. Unfortunately, those two things alone weigh heavy on the consumers’ pockets and their ability to spend. We shall see soon enough.

Weekly Update

2011-03-11T09:51:00.042-05:00

This week's update has a recap of various tidbits of news from the past week.

Well, what a difference a week (or two) makes. With yesterday's decline in the markets, we have retraced back to the levels from mid-January - in just two weeks time. When volatility increases in the markets (as we expected would happen during the first quarter) owning income producing investments are a great option as one continues to accrue interest and dividend income, regardless of market direction. The good news is that volatility creates opportunities across various asset classes. Patience will be the key in the coming weeks as investor sentiment is still very bullish (negative for markets).

These days you rarely hear reports of big mutual funds selling anything when stocks are going up and bond yields are low, like today. Most mutual fund managers will tell you what they are buying but don't tell you what they are selling. Considering the average stock is held an average of 6 months, there is more selling occurring then big fund managers are admitting. That being said, when the biggest mutual fund in the world sells out completely of U.S. Treasury securities because the manager believes they're not a good investment, it's a big deal. Bill Gross, manager of the $236 billion PIMCO Total Return Fund, is outspoken in his dislike of quantitative easing. In his latest letter to investors, Gross said – the day the government will end its second round of quantitative easing (QE2) – will be "like D-Day". Gross believes stock and bond prices are artificially inflated by the government stimulus. With the Federal Reserve currently purchasing 70% of government bonds issued since QE2 began, Gross wonders, "Who will buy Treasuries when the Fed doesn't?" Gross concluded his letter saying, "PIMCO's not sticking around" to see the result. Gross proved he's more than just talk. This week news came out that he sold ALL Treasury securities in the Total Return Fund (the fund was 12% in Treasuries in January). He also raised cash levels to 23% from 5% in January. Gross thinks bond yields will rise 1.5% without government intervention.

In other news, Carl Icahn is giving his investors' money back. Icahn filed a letter informing limited partners in his hedge funds that he'll be returning their capital. Icahn said the losses incurred by investors in 2008 bothered him "a great deal more, in many respects," than his own losses. He says maybe it's because he's used to dealing with large paper losses for himself. He didn't prevent investors from withdrawing funds during the crisis, and many chose to do so. Carl Icahn, for all his ego and swagger, is apparently a bit of a softy when it comes to other people's money. He acknowledged it in the letter, realizing "it may sound 'corny' to some" that he felt bad about his limited partners' losses. The reason for returning investors money he states - "While we are not forecasting renewed market dislocation, this possibility cannot be dismissed. Given the rapid run up over the past 2 years, and our ongoing concerns about the economic outlook, and recent political tensions in the Middle East, I do not wish to be responsible to limited partners through another possible market crisis."

This is similar to last November when hedge-fund manager Seth Klarman said he'd return 5% of the $23 billion he had under management at the time to investors. Last summer, Klarman said he was more worried than at any time in his career and he's not sure what will happen over the next decade. In December Klarman said his "opportunity list" was smaller now in relation to its growing cash balances.

According to the Fed, household net worth is now off $8.8 Trillion from the peak in 2007, but up $8.1 trillion from the trough in Q1 2009. Household net worth peaked at $65.7 trillion in Q2 2007. Net worth fell to $48.7 trillion in Q1 2009 (a loss of almost $17 trillion), and net worth was at $56.8 trillion in Q4 2010 (up $8.1 trillion from the trough). The Fed estimated that the value of household real estate fell $260 billion to $16.37 trillion in Q4 2010. The value of household real estate has fallen $6.3 trillion from the peak.

Possible QE3 by the Fed - recent comments from Atlanta Federal Reserve President Dennis Lockhart this past week, combined with spiking oil prices, have led to speculation regarding future rounds of quantitative easing by the Federal Reserve. Lockhart spoke recently at the National Association of Business Economics conference, commenting on rising oil prices and the potential for spikes to affect the economic recovery. “I would take a position we would respond with more accommodation” Lockhart said, regarding the potential onset of recession as a result of oil price increases. While current – or even slightly elevated – prices are manageable, said Lockhart, “around $150 it becomes a much more serious concern.”

Q Ratio Explained

2011-03-04T09:04:00.036-05:00

The Q ratio was devised by James Tobin of Yale University, Nobel laureate in economics, who hypothesized that the market value of a company on the stock market should be about equal to its replacement cost. The Q ratio is calculated as the market value of a company divided by the replacement value of the firm's assets:

For example, a low Q (between 0 and 1) means that the cost to replace a firm's assets is greater than the value of its stock. This implies that the stock is undervalued. Conversely, a high Q (greater than 1) implies that a firm's stock is more expensive than the replacement cost of its assets, which implies that the stock is overvalued. This measure of stock valuation is the driving factor behind investment decisions in Tobin's model.

This method can also be applied to the stock market as a whole. It's a fairly simple concept, but time consuming to calculate for the whole market. The Q Ratio is the total price of the market divided by the replacement cost of all its companies in the market. Fortunately, the government does the work of accumulating the valuation data for the calculation. The numbers are supplied in the Federal Reserve Flow of Funds Accounts of the United States, which is released quarterly.

Below is historical chart of Q ratio using the data:

The average Q ratio for the stock market is about 0.71. The all-time Q Ratio high at the peak of the Tech Bubble was 1.82 - which suggests the stock market price was 158% above the historic average replacement cost of 0.71. The all-time lows in 1921, 1932 and 1982 were around 0.30, which is about 57% below replacement cost. Interesting how the extremes in the Q Ratio (highs and lows) have corresponded closely to high and lows in the stock market. Of even greater interest is the reading of 0.69, which is right around the historical average of 0.71, occurred after the tremendous stock market decline in 2008/2009. One would think this number would have been much lower than 0.69 given the severity of the downturn in the market.

Ripple Effect

2011-02-25T10:22:00.020-05:00

The ripple effect from the successful ouster of a 30-year dictator Egypt is being felt all over the globe, as Libya, Bahrain, and maybe even Saudi Arabia take center stage and attempt their own versions of civil unrest. Even in the United States, union protesters are battling various Governors over state budget deficits – right now Wisconsin is in focus, but soon it could be all around the country. All of these issues are a systematic ripple effect from the financial crisis over 2 ½ years ago.

Now everyone is focused on oil, commodities, inflation, and what happens next in the Middle East. However, the focus should really be concentrated on Asia as the ripple effect is being felt in many Asian nations. Asia is very important to the United States. Middle East countries tend to be poor and uneducated, repressed, and un-democratic. These countries are not the marginal buyer of copper, steel, cotton, or US treasuries. Asia is the world’s power buyer.

Now while there is not yet civil unrest in Asia, interesting events are happening which are being completely ignored by the mainstream media: there has been a run on the banks in South Korea over the past week. The eighth bank just closed yesterday because of insufficient capital and none of the banking officials are sure what to do to stem the flow of funds out of the banks. No one is sure why it is happening.

So what’s the issue? We should be sure we don’t let the latest news story in the Middle East distract us from the main attraction - Asia. China is beginning to face increasing social unrest. It is only one of many un-democratic regimes in the region, with a poor, uneducated class that is now facing rising food prices (actually all countries are facing rising food prices). If China’s economic growth begins to slow due to social unrest, look for industrial commodities, such as copper, to fall sharply and a ripple effect to come out of China and impact the rest of the world.

Liquidity and QE2

2011-02-18T10:25:00.060-05:00

With liquidity abound, QE2 has been a positive factor in igniting the current stock market rally. As the Federal Reserve purchases bonds, the cash is being reinvested into the stock market via hedge funds, mutual funds, pension plans, and large institutions.

However, QE2 has also precipitated both a rise in interest rates as well as a spike in commodity speculation (most commodities are priced in dollars), likely hurting many more than a stock rally helps. Also, as raw material input costs rise, companies must raise prices or cut costs to preserve margins as it is difficult to pass on these costs to consumers.

So one of two things will likely happen:

businesses try to increase prices, they are not able to, and see their profit margins cut
businesses do raise prices, people buy less because of wage constraints, and revenue gets hit.

In both instances, companies will likely need to reduce costs to improve profit margins. While this isn't an issue at the moment, it will be important to monitor moving forward as most commodities have seen prices rise dramatically in the past six months. And it takes about 6 months or so for these price increases to work into the system.

See charts below:

Valentine's Day Humor

2011-02-11T10:05:00.004-05:00

Happy Valentine's Day! Below are some quotes about love and a couple of funny Valentine videos...

"Valentine’s Day is when a lot of married men are reminded what a poor shot Cupid really is.” ~Unknown

"I wanted to make it really special on Valentine's Day, so I tied my boyfriend up. And for three solid hours I watched whatever I wanted on TV.” ~Tracy Smith

"If love is blind, why is lingerie so popular?" ~Unknown

"One should always be in love. That is the reason one should never marry." ~Oscar Wilde

"Gravitation can not be held responsible for people falling in love." ~Albert Einstein

“Sales ad at a store: ‘You are my one and only’ Valentine's cards, now on sale: 4 for $5.” ~Unknown

"Never go to bed mad -- stay up and fight." ~Phyllis Diller

"No matter how love sick a woman is, she shouldn't take the first pill that comes along." ~Joyce Brothers

"Love is like playing the piano. First you must learn to play by the rules, then you must forget the rules and play from your heart." ~Unknown

"If love is the answer, could you rephrase the question?" ~Lily Tomlin

"Behind every successful man is a woman, behind her is his wife." ~Groucho Marx

Global Markets Diverging

2011-02-04T11:00:00.002-05:00

Below is a graph of the S&P 500 Index, along with a China Index, India Index, Brazil Index, and Emerging Market Index. At the very top of the chart is the S&P 500 Index; the blue line represents emerging markets; the brown line represents Brazil; the orange line represents China; and the reddish line India. The right scale is the percentage return over the past three months.

While markets don't always move in tandem, there is usually a general correlation with respect to global markets as global economies are very interconnected. While some economies perform better than others and market returns will vary from one market to the next, it is interesting to observe the recent divergence over the past few months. While the US markets are moving higher, the markets in the fastest growing global economies are moving lower. The markets could be saying something or it could be nothing, but an interesting development none the less.

Institutional Manager's Comments

2011-02-04T10:25:00.100-05:00

For our current weekly update, we decided to share some of the insights we receive from the institutional managers we follow by paraphrasing their thoughts in short commentaries. Collectively they represent many of the thoughts we have shared from time to time in our weekly updates, but we feel as we start the new year, it would be helpful to hear things "directly from the horse's mouth."

Specifically, these institutional managers judge security selection, valuation, and patience as key determinants for risk/reward decisions and long-term success, while the markets in general have become more herd oriented whose behavior swings wildly from "risk-on" to "risk-off" and back again - hence the volatility. We believe this is mainly due to the increasing amount of capital controlled by people who are incentivized to take large risks with other people's money; this is caused by massive moral hazard (bailouts, free money), and not being held accountable (blame the markets or government policies).

We point this out because we believe while we don't always get it right, we make real judgments about risk with respect to our clients' assets and understand we have a duty to intellectual integrity and prudent decision making - in a world where private and public money is largely controlled by those who have proven to be some of the most inefficient allocators of capital. It is often difficult to go against the herd mentality, but history shows it has resulted in long term success.

Commentaries

#1
Despite hearing different prognosticators claim that equity investors now face no possibility of near-term losses, and that the coast is once again clear to ramp up risk, we remain unconvinced. Our skepticism is based in part on the Fed's poor track record over the course of our careers, particularly during the past decade-plus, during which short-term stimulative policy often proved short-sighted and resulted in severe unintended consequences later on. The LTCM bailout emboldened risk-takers and inflated the tech stock boom. The multi-year negative real rates implemented to counteract the ensuing bust caused a far greater and far more insidious problem, a housing bubble. One needs only to compare what percentage of Americans own houses to that which speculated meaningfully in stocks, or how housing is inextricably linked to credit, while tech investments were primarily equity-driven, to understand how much worse it was to trade one problem for the other.

Quantitative easing may feel good in the short-term, but the long-term risks seem substantial. A weaker dollar increases energy and other commodity costs for Americans -- essentially a highly regressive tax on the middle and lower classes, who are already grappling with sustained high unemployment and negative home equity. Also, it seems likely that a steadily depreciating dollar will provoke a meaningful response from both our trading partners and foreign holders of USD-denominated assets. These fears seem already to be reflected in the bond market, where long rates have risen quite sharply since late August (from 3.5% to 4.3%) -- not exactly the lower long-term interest rates the Fed claims quantitative easing will engender to stimulate the economy.

#2
Looking ahead, there is certainly room for optimism. Corporate earnings could rise to record levels. Valuations in some areas of the market remain attractive. The economy appears to be gaining strength. Business confidence coupled with healthy balance sheets could lead to increased merger and acquisition activity. An increase in investor sentiment could lead to further multiple expansions on corporate earnings, leading to further gains in the equity markets. The tax package will almost certainly stimulate further consumer spending. On the monetary side, the Federal Reserve continues its efforts to further ease credit markets with unconventional Treasury purchases, hoping that low interest rates spur more borrowing and force investors, perhaps unwillingly, into riskier assets to improve returns.

#3
On the other hand, going into 2011 we wonder just how much of this optimism has already been discounted. Three straight years of positive performance in the equity markets has only occurred twice since World War II. In both cases, the third year saw average returns of just 1.7%. Will 2011 follow suit? We have no idea-the year 2010 was a difficult year in which to handicap the financial markets. Despite what we see as an extremely disappointing economic recovery, the equity and fixed income markets performed extremely well. Looking forward to 2011, we do not know if the S&P 500's return to the level it held before Lehman Brothers collapsed is a confirmation of the market's strength or if the last marginal buyer has arrived and signals a temporary or perhaps longer term lasting market peak.

We have no desire to make any predictions for 2011 other than to expect a certain amount of the unexpected which will lead to at least some volatility in stock prices. At this moment, there are few desirable companies that can be bought with a decent margin of safety. This isn't to say that there aren't a lot of good companies whose stocks are worth continuing to own. But the unforeseen potholes that certainly lie ahead will once again give us opportunities to put fresh capital to work on more favorable terms."

Weekly Update

2011-01-28T10:20:00.032-05:00

For the first time in several weeks there was a whiff of turbulence in the air in January. First the first time since last summer, volatility crept back into the markets, although only slightly. We expected this could happen as the sort of effortless advance that we have seen in over the past few months typically gives way to a more difficult market environment moving forward - lots of up and downs with limited direction. What usually happens is we now enter a cross-roads or a turning point for how best to approach the markets and tactically allocate. Changes of market leadership rarely take place outside of a corrective phase or decline. A period of weeks in which US markets, as well as international markets were volatile but where downside was limited to 5 to 10%, combined with sharper losses in a number of certain overvalued asset classes, would likely go a long way to encouraging investors to reconsider their current bullish stance and become more defensive. This type of action is healthy and normal in the context of capital markets - straight up moves, or down moves for that matter, are not.

It is still far from clear whether or not this process has begun in earnest, but as the monetary tightening continues to be heard across emerging market economies, we believe this will eventually impact the US markets. Just a few weeks ago, there was an increase in interest rates in Brazil, which raised its domestic interest rates by 1/2% to 11.25%, while signaling that further hikes are forthcoming. Contrary to the US markets, most emerging market countries like Brazil, China, and India have seen their respective markets decline significantly over the past three months due to rising inflation as well as economic growth concerns. Also, social unrest in several countries like Egypt and Tunisia are adding pressure in overseas markets.

Back here in the United States, with plenty of positive economic data as well as good news coming from US companies in the past month, we believe that while markets could be volatile, there should be a strong level of support below current prices, unless fundamental data changes. Unlike last April/May, not only earnings have been better than consensus estimates, guidance has also been fairly upbeat as opposed to last summer when most corporate management were still looking over their shoulders fearing a relapse of conditions back to the dark days of 2008.

While there are likely going to be surprises this year (there usually always are), which could derail the markets in the short-term, unless the fundamental data or economic conditions change significantly, the Federal Reserve juiced capital markets should continue to perform well.

Risk versus Reward

2011-01-21T10:33:00.023-05:00

This continues to be and will always remain the $64,000 question when it comes to investing as there are plausible arguments for both the bulls and the bears, especially in the current environment. The bears will argue that geopolitical risks in Europe still exist, inflation is starting to accelerate, and bullish sentiment is running high. Bulls will counter that there are more skeptics about the markets and economy, the economy is finally gaining traction, and earnings will likely continue to improve over the year.

The hard part is deciphering which opinion is correct as we can see validity in both arguments. Thus the current market environment creates a double edged sword.

So how does one play this market, given the confusing but equally valid messages being sent by the market? We suggest a more cautious approach as we do believe eventually there is going to be a decrease in price momentum and markets will enter a corrective phase. It is important to be extremely selective and wait for opportunities to arise.

Bottom line is there are always varying degrees of risks and rewards. Sometimes but very rarely the decision is easy. However, most of the time, such as the present, it's not as clear. Right now we believe there is a higher level of risk.

Investing in the "new normal" of markets and government backed economies requires a great deal of patience - knowing when to pounce an an opportunity and when to conserve energy and wait. The time to pounce is when the likelihood of reward is the greatest and stacked in your favor.

However as we all know things change very rapidly in our technology driven society and information moves at the speed of light. It is important to keep an eye on the data (both positive and negative) looking for clues that will help tip the risk/reward scale to favor more reward and less risk.

Sentiment Data Suggests Caution?

2011-01-14T10:37:00.008-05:00

The most recent sentiment data from our friend Jason Goepfert at SentimenTrader.com shows that the retail investor is most confident in a market rally while the smart money or institutional investor is least confident. While markets can continue to move higher, it is typically times like now when the risk/reward setup is least favorable for investors, at least as it relates to past market history. However, what is really interesting is that the S&P 500 Index is on its longing winning streak without a signficiant pullback (to its 50-day average price) in the 82 year history of the index - over 93 days and counting.

Risk level: HIGH

The Smart Money is 38% confident in a rally.

The Dumb Money is 75% confident in a rally.

WEF's Global Risks Report

2011-01-14T10:22:00.008-05:00

Just recently, the World Economic Forum published its Global Risks Report for 2011. The World Economic forum is an independent international organization committed to improving the state of the world by engaging business, political, academic and other leaders of society to shape global, regional and industry agendas.

Sometimes it is helpful to obtain information regarding the global economy from people outside of the U.S., who tend to view the world and global economics in a much different way.

The link to the report is below - click on "download PDF" to view the report.

www.weforum.org/reports/global-risks-report-2011

Employment Numbers Still Low

2011-01-07T09:45:00.030-05:00

The best news was the decline in the unemployment rate to 9.4% from 9.8% in November. However this was partially because the participation rate declined to 64.3% - a new cycle low, and the lowest level since the early '80s (Note: This is the percentage of the working age population in the labor force).

The 103,000 payroll jobs added was below expectations of 150,000 jobs, however payroll for November was revised up 70,000 and the October payroll was revised up 38,000, both good trends.

The increase in the long term unemployed is an ongoing concern. The average workweek was steady at 34.3 hours, and average hourly earnings ticked up 3 cents.

The following graph shows the employment population ratio, the participation rate, and the unemployment rate.
Click on graph for larger image.

The unemployment rate decreased to 9.4% (red line).

The Labor Force Participation Rate declined to 64.3% in December (blue line). This is the lowest level since the early '80s. (This is the percentage of the working age population in the labor force. The participation rate is well below the 66% to 67% rate that was normal over the last 20 years.)

The Employment-Population ratio increased to 58.3% in December (black line).

Hopefully, the employment pictures begins to improve as we progress through the year. Employment growth of 250,000 to 300,000 will be needed to really begin to bring the unemployment rate down.

The Year in Review and Looking Ahead

2010-12-23T15:30:00.000-05:00

At the end of every year, we like to look back at the year and share some thoughts on what worked, what didn't, and how the next year is shaping up. While there are still a handful of trading days left this year, the markets are looking like they will post another up year.

As we began 2010, we believed most of the stock market's cyclical gains were probably behind us and it would be important to try to generate income from dividends and interest in order to achieve a positive absolute return as we expected the markets to be volatile and news driven. In general, having a more defensive bent would make sense if this were to occur. This forecast turned out to be correct for most of the year with the S&P 500 dropping over (6%) into February, rising 16% from that low until end of April, dropping (17%) from April into July, rallying 10% from July into beginning of August, falling roughly (7%) into the end of August, and finally rallying over 18% from August to put us where we are today. All of the return this year has happened since September.

We had some trouble trying to get our heads around a post-credit-bubble environment in which global central banks have charted much different courses, with the net effect being a muddle-through, erratic, global recovery. Every time it looked like there would be trouble, the capital markets suffered, and Chairman Ben Bernanke rode to the rescue with his quantitative easing. The Bank of England and the Bank of Japan have also been quite active in priming the liquidity pump, and the jury is out on their level of success and how long it will continue.

We turned more positive on the markets in October believing the time for being bearish had past and we said volatility in the markets should be used as a opportunity to increase exposure to those areas expected to perform well in 2011. We expected the volatility to continue into the fourth quarter as it did all year, allowing some low risk entry points to increase exposure to stocks, but it didn't materialize as we believe investors began to realize the US government is going to permanently backstop risky assets and markets in order to bring about the wealth effect per the Fed Op-Ed several weeks ago. This will have unintended consequences, but we will save that discussion for another day.

So, while there were more fits and starts for the economy than we expected, we would say we got the market volatility correct for the most part; however, the appreciation of US markets in the last quarter turned out to be much greater than we expected with no downside volatility.

As the stock market continued to move higher in the fourth quarter, interest rates also began to move higher, putting downward pressure on bond prices as investors shifted funds from bonds to stocks, especially dividend paying stocks. Many income producing equities did in fact perform well in the fourth quarter, something we probably suspect will continue as market participants continue to look for yield, particularly if the pain of declining bond prices becomes more pronounced. Ever since the second round of quantitative easing (QE2), interest rates have spiked to the upside, exactly the opposite of what most had expected would be the case.

For 2011, we believe this trend of bond outflows and equity inflows will likely continue, overwhelming any concerns about valuations or fundamentals. In the short run, we've come to realize that fund flows, or investor desires for specific asset classes - tends to exacerbate price movements in both directions, often for much longer than most expect. For anyone that doubts this tendency, just take a look at tech stocks ten years ago, housing prices five years ago, commodities prices three years ago, and Government bonds recently.

We believe with the Federal Reserve "having the stock markets back" and corporate earnings continuing to meet expectations, the markets can continue higher. In addition, the added liquidity of investors pulling funds from bonds should help fuel higher prices. Although volatility has been non-existent the past few months, we don't expect it to disappear completely. Given how everyone is positive on the markets for 2011, we expect volatility will return in the first quarter of next year, if only to keep everyone honest.

As we see it, several factors play into a positive stock market environment in 2011. First and most important, is a more politically friendly environment for business. Given the historic changing of the guard in Washington D.C., it appears as though President Obama is going to take a more centrist approach as Clinton ultimately did following his first two, difficult years in office.

One of the biggest strengths of the economy in the past year has been the level of corporate profits and cash balances, but most executives have remained cautious with their actual spending given recent memories, the prevailing anti-business sentiment, and tax and regulatory policy uncertainty. The good news is that these headwinds may now prove to be tailwinds, turning the ability to invest capital into actual action.

Another positive for stocks may very well be the state of the bond market. Rising interest rates may actually be a positive to the extent it signals an improvement in the economy, which we suspect is the case today. Bernanke, like him or not, appears willing and ready to do whatever it takes to keep the economy and specifically the stock market moving in a positive direction.

Higher interest rates, of course, also means tougher times for bond investors as bond prices decline. While the back up in yields may not matter much for investors intent on holding until maturity, we would suspect that a large percentage of recent bond buyers has been investing on the basis of total return and the allure of rising prices than simply their yields, even if unknowingly so.

As history has it, the third year in a President's term tends to be positive for the markets as the current administration is likely to find ways to stimulate the economy and spur economic growth and stock prices; to be sure they are re-elected the following year. We hope that 2011 follows this tradition.

US National Debt

2010-12-17T10:21:00.063-05:00

Here's a new way to think about the U.S. government's epic borrowing problem: by as early as 2015, the estimated interest due on US government outstanding debt will be $533 billion - which is equal to a third of the annual federal income tax revenue expected to be paid that year.

Fortunately or looking on the bright side, the record levels of debt issued in the past few years have paid for stimulus and other rescue programs that prevented the economy from falling off a cliff; and the money was issued at very low interest rates. But low interest rates won't be around forever.

As interest rates rise and the economy improves, the private sector borrowers will likely return to the debt market and compete with the US government for capital. At that point, the country's interest payments could increase dramatically.

The Congressional Budget Office, which makes the debt and interest payment forecasts, already baked some increase in rates into the numbers. Of course, there is always a chance those estimates may prove too conservative.

Below is a table showing our outstanding gross debt and the percentage of GDP the debt represents (in billions of dollars). It is projected to be over $14 trillion at the end of this year and represent 94% of our GDP.

2000 5,628.7 58.0
2001 5,769.9 57.4
2002 6,198.4 59.7
2003 6,760.0 62.6
2004 7,354.7 63.9
2005 7,905.3 64.6
2006 8,451.4 65.0
2007 8,950.7 65.6
2008 9,985.8 70.2
2009 12,311.4 86.1

Below is a link to the Treasury's website which posts the monthly as well as annual interest payments on the debt. Click on the link to be taken to the website.

http://www.treasurydirect.gov/govt/reports/ir/ir_expense.htm

Equity Risk Premium Explained

2010-12-10T09:45:00.000-05:00

Equity Risk Premium can be defined as the excess return that the overall stock market provides for an investor over the risk-free rate of US Treasury bonds. This excess return compensates investors for taking on the relatively higher risk of the equity market. The way to think about equity risk premium is to define it as the difference between the expected total return of the S&P 500 and the expected yield on Treasury bonds over a period of time.

As an example at the basic level, if 10-year Treasury bonds are yielding 3% annually and the expected 10-year annualized return of the S& P 500 is 5%, the equity risk premium is 2%. In other words, investors are expected to achieve a 2% higher annualized return in the stock market versus the Treasury bond market. The equity risk premium has historically averaged around 4%, which means a 4% better annualized return by investing in stocks over bonds on average. Equity risk premiums in general tend to be higher in recessions and lower in recoveries.

At present, based on calculations of forward earnings, normalized historical earnings, and market valuation models, the average 10-year return projection for the S&P 500 is 4.00% annually. Currently, the 10-year Treasury is yielding 3.25%, making the current equity risk premium .75%; one of the lowest readings in recent years. Of course, we should expect a lower reading in a recovery.

However, the likely premium for equity risk is at the low end of the typical range. Why does this matter? Based on the current assumptions, for a return of roughly .75% over the expected return on Treasury bonds, equity investors are accepting risk that is approximately 3 times greater than that of US Treasury bonds - the risk/reward scenario doesn't seem favorable. The last time the equity risk premium was really low was in the late 1990's, as investors believed stocks would continue to go higher and didn't feel the need to be compensated for the additional risk.

Of course, the expected 10-year annualized return for the S&P 500 is an assumption based on models and could increase from current levels, especially if economic growth improves. If economic growth expands at a faster rate in the future, we should see the expected S&P 500 annualized return percent move higher as well. However, it will need to increase to approximately 7.25%, based on interest rate of 10-year Treasury yield of 3.25%, to reach the historical equity risk premium average of 4.0%. Also, if the 10-year yield continues to rise, the expected annualized return of the S&P 500 will need to increase even more than 7.25% in order to keep pace and move toward the long-term average of 4.0%. Unless economic growth begins to pick up significantly, we should expect the equity risk premium to remain at the lower levels of the range as the economy continues to recover.

Equity risk premiums can also be applied to sectors of the market and there are certain sectors whose equity risk premium is higher than the equity risk premium of the broad market; meaning a better valuation of that sector and the likelihood of out performance versus the broad market in the future.

While investment decisions can't be made on one indicator or valuation model alone, it does help to use various market and risk valuation metrics to assist in the decision making process.

Smart Money / Dumb Money Update

2010-12-10T09:30:00.011-05:00

The latest results from the Smart Money / Dumb Money index show that retail investors (dumb money) are very confident in a rally while institutional investors (smart money) are not as confident in the markets continuing to rally. These numbers don't mean the market can't continue to work higher in the short-term, but typically any short-term gains are quickly erased by a larger correction, especially when readings reach these extreme levels.

Smart / Dumb Money Confidence

The Smart Money is 33% confident in a rally.
The Dumb Money is 71% confident in a rally.

Jobs Report and QE2

2010-12-03T10:51:00.038-05:00

Surprisingly the BLS reported today that jobs gained 39,000 and the unemployment rate moved up to 9.8%, the highest rate since April. Private payrolls gained a mere 50,000 compared to expectations of upwards of 160,000. Both jobs and the unemployment rate were worse than every single economist estimate, which has us noting that economists and forecasters as a group are an optimistic group.

Here are the details of the jobs report this morning:

Payrolls increased 39,000, less than the most pessimistic projection of economists surveyed by Bloomberg News, after a revised 172,000 increase the prior month, Labor Department figures showed today in Washington.
The jobless rate rose to 9.8 percent, the highest since April, while hours worked and earnings stagnated.
The unemployment rate was forecast to hold at 9.6 percent, according to the median prediction of 83 economists surveyed by Bloomberg. Estimates ranged from 9.4 percent to 9.7 percent.
Overall payrolls were forecast to climb by 150,000, according to the survey median, with estimates ranging from 75,000 to 200,000.
The report also showed an increase in the number of long-term unemployed Americans. The number of people unemployed for 27 weeks or more increased as a percentage of all jobless, to 41.9 percent, the highest since August.

Keep in mind, were it not for millions of people allegedly dropping out of the labor force over the last year as their benefits ran out, the unemployment rate could be over 12%.

So with this poor jobs report shouldn't the markets be declining in reaction? Shouldn't the market sell off on the bad news? The answer would normally be yes - however, with the Federal Reserve providing QE2, market participants believe lower employment growth means more QE (maybe even QE3), which adds a underlying layer of support to the market and keeps investors confident in the economy and capital markets.

While adding some confidence to the capital markets, QE2 has not helped the interest rate picture. Interest rates, across the board, have actually been spiking since the announcement of the QE2 program on November 3. See chart below.

It turns out (as many believe) the Federal Reserve is more or less powerless to lower rates from prevailing levels. QE2 was likely not really designed to drive rates down from current levels but merely to try to prevent a dramatic rise in interest rates and to promote more stability in the capital markets.

So the paradox we discussed in October regarding interest rates is beginning to be resolved. Excess liquidity provided by the Fed is now starting to create expectations of future inflation and causing bond yields to rise (prices drop), whether or not this is the beginning of a new trend remains to be seen.

ISM Non-Manufacturing Report

2010-12-03T09:22:00.002-05:00

This morning saw another good report from the ISM Non-Manufacturing Index, with the overall index rising to 55 and strong readings in Business activity (57) and New Orders (57.7) and an improvement in employment to 52.7. We are still happy to see a continuation of growth in the US service sector.

Sentiment Reaching Extremes Again

2010-11-19T09:21:00.006-05:00

In order to improve decision making, we incorporate sentiment readings into the process. This is an area which is sometimes overlooked, but we think is extremely important. We believe this is one of the key metrics to use as it helps remove emotion from the overall thought process. Today we are looking at sentiment readings because they are reaching extremes again.

Now that QE2 has started, corporate earnings have for the most part been better than expected, and the market has rallied - everything seems to be fine, at least according to the latest Investor Intelligence sentiment figures.

Each week the service Investors Intelligence surveys some 140 financial newsletter writers to determine whether they are bullish or bearish in their opinions to subscribers. The resulting Investors Intelligence Survey compiles the data to arrive at a weekly percentage of bulls vs. bears. The Survey is considered a contrarian indicator, since extremes in either direction have historically signaled a reversal of the market’s current trend.

Currently, the readings are just as bullish as they were back at the end of April 2010, right before the flash crash in May and the subsequent drop into July. While there is no guarantee the markets will decline, given the history of the sentiment readings as a contrarian indicator, it makes sense to be more cautious at this juncture and patiently wait for sentiment to turn more bearish and less bullish.

Below are the most recent charts for bullish sentiment and bearish sentiment along with recent commentary from Investors Intelligence.

Overview

The election is over and the latest quantitative easing has commenced, with indexes showing remarkable gains since the end of August. That was when the Fed action was first announced and polls forecast the change in Washington, which occurred. Despite the already solid gains near 20% in about 2½ months the latest readings show a lot of advisors apparently “buying the news” as the percentage of bulls soared over 8% the last week. The jump came within a hair of the levels shown in December 2007, which were just below their high of 62% from October 2007. That was the all-time stock market high.

Impact of Quantitative Easing

2010-11-12T09:43:00.011-05:00

It continues to seem likely that QE2 will unfold against a backdrop of steadily rising treasury and investment grade bonds yields in the coming months. In a sense the second round of quantitative easing is just the monetary version of “cash for clunkers”, which effectively shifted car sales that would have occurred later in 2008 to the summer months. QE2 may lower yields in the short term but it is unclear that there will be any lasting effect.

The build-up to QE2 has also been characterized by a rapid sell-off in the US dollar, but this is merely a reflection of powerful investment flows rather than a genuine or deliberate debasement of the currency by the Federal Reserve Board. Nobody wants to own an investment that decreases in value. Ironically the US dollar has been notably more robust since the official launch of the QE policy and it is certainly possible that it has marked its lows for the time-being, particularly against major currencies.

The great winner in the QE2 sweepstakes thus far has been the commodity complex with money chasing virtually the entire spectrum. Agricultural commodities have been particularly strong with multi-decade highs recorded in sugar, coffee and spices. In terms of the commodities gold has managed to establish a series of new all time highs over the past few weeks and crude oil has finally managed to break above its multi-month range as it moves toward $90 per barrel.

We would not bet against any portion of the commodity complex at the moment, but are also not particularly tempted to jump aboard a runaway train either.

The Federal Reserve's Explanation

2010-11-05T09:51:00.016-04:00

Federal Reserve Chairman Ben Bernanke wrote an article for the Washington Post that was printed in the paper Thursday morning. Below is the link to the article. Very interesting read.

http://www.washingtonpost.com/wp-dyn/content/article/2010/11/03/AR2010110307372_pf.html

Economic Growth Rises 2% in Third Quarter

2010-10-29T10:34:00.003-04:00

U.S. economic growth edged up as expected in the third quarter. Gross domestic product expanded at a 2% annual rate as consumer spending rose at its fastest pace since 2006, the Commerce Department reported in its most recent data release.

While consumer spending increased and business investment continued to expand, much of the rise in demand was met by overseas production and domestic goods continued to pile up in warehouses. This may lead to more tepid growth in the fourth quarter.

However, the economy is definitely recovering, it is just doing so at a very slow pace. The economy expanded at a 1.7% rate in the second quarter and third-quarter growth matched most economists' expectations.

The GDP report showed the Fed's preferred inflation measure, the personal consumption expenditures (PCE) index, excluding food and energy, rose at an annual rate of 0.8 percent in the third quarter. According to reports, this was the smallest increase since the fourth quarter of 2008 and well below the Fed's comfort zone for inflation.

A pick-up in consumer spending gave the economy a lift in the last quarter. Third-quarter growth in consumer spending, which accounts for 70 percent of U.S. economic activity, increased at a 2.6 percent rate after rising 2.2 percent in the prior period.

Analysts expect the Fed to announce treasury bond purchases of at least $100 billion a month on Wednesday. Bond prices rose on the premise of more "quantitative easing" from the Fed, while the dollar extended losses against the yen on the prospect the Fed will need to print more money.

Small Business Credit Easing

2010-10-22T10:08:00.009-04:00

Below is an excerpt from an article referring to the fact that the contraction of credit for small corporations has ended. After two years of very restrictive lending standards, credit is becoming more available. This is a positive for the economy as many new jobs are created by small businesses.

Credit Eases 'My Pain' as U.S. Bank Lending Buoys Small Business

Khalique Rehman, who runs My Pain Clinic in McDonough, Georgia, got a $1.8 million loan this month from Atlanta-based Private Bank of Buckhead to purchase a new building and construct offices.

“I was surprised because everyone said it would be so difficult,” said the 46-year-old physician, who plans to double the space of his eight-employee practice and hire another doctor and possibly a nurse. “I am really happy.”

The freeze in bank credit is beginning to thaw after two years, signaling more support for the U.S. recovery.

American banks increased credit in July, August and September, the first consecutive gains since October 2008, according to Federal Reserve data released Oct. 15. Commercial and industrial loans rose in July and August after dropping 25 percent, the data showed. Banks eased lending standards in the second quarter for the first time since the credit crisis began, the Fed reported Aug. 16.

The stabilization may help reduce the odds of a relapse into recession next year to less than 10 percent, said Neal Soss, chief economist at Credit Suisse Holdings USA Inc. in New York. That compares with a median estimate of 20 percent during the next 12 months among 48 economists surveyed by Bloomberg News this month.

“Lending is no longer collapsing,” Soss said. “That is a very good thing compared to where we were. When you are in a hole, the first thing is to stop digging deeper. That is where we are: The credit system is not getting weaker.”

Regional bank stocks are likely to benefit from any increase in lending, including Wells Fargo & Co. of San Francisco, PNC Financial Services Group Inc. of Pittsburgh and Fifth Third Bancorp of Cincinnati, said Richard Bove, an analyst at Rochdale Securities in Lutz, Florida.

The pick-up in lending also may boost yields on U.S. Treasury 10-year notes to 4% by the end of 2011, said Mark Zandi, chief economist at Moody’s Analytics. The yield fell to 2.33 percent on Oct. 8 from 4 percent in April as the economy slowed.

“This is a very positive sign for future growth,” the West Chester, Pennsylvania-based economist said. “Non financial corporations are no longer deleveraging. Increasingly it is no longer a question of whether businesses can invest and hire, but whether they are willing. This is a good reason for optimism.”

An increase in bank lending may help the economy expand 2.5 percent next year, he estimates. Growth stalled to an annualized 1.7 percent pace in the second quarter from 5 percent in the last three months of 2009.

Rehman said his 4 1/2-year-old clinic, which specializes in pain, sports medicine and rehabilitation, will move to its new location in Stockbridge, Georgia, after the interior is rebuilt. Processing the loan through closing took about two months.

“Banks are definitely eager,” he said. “Everything went very smoothly. I am quite satisfied.”

Pat Carroll, 31, received a $300,000 loan from Wells Fargo in August to expand his Atlanta apartment-management company with additional properties in Georgia, North Carolina, Tennessee, Texas, Maryland, Virginia and Florida.

“You couldn’t get a loan two years ago,” he said. “Banks are back in business and lending again. Things are starting to loosen up.”

Some borrowers still aren’t seeing much change. Brian Rist, who runs a Fort Myers, Florida-based hurricane-protection company, said he’s disappointed that a loan he’s negotiating may require him to put up family assets as collateral, even though his business is profitable and has $13 million in revenue. He wants to hire another 20 to 25 people to diversify into energy audits for companies and individuals.

Fed data show that most of the credit growth so far comes from banks buying securities including mortgage-backed bonds rather than making loans, as demand, especially among consumers, is still weak. Commercial and industrial loans rose at an annual rate of 1.6 percent in July and 0.4 percent in August after 20 consecutive months of declines and fell 3.5 percent in September, as businesses slowly begin to reverse efforts to shed debt and hoard cash.

Purchases of securities other than Treasury and agency bonds have risen at an annual rate of more than 10 percent for three months, according to the Fed. That indicates lenders are willing to take risks and feel more comfortable about their capital levels, said Paul Kasriel, chief economist at Northern Trust Corp. in Chicago.

“When bank credit reaccelerates, it usually starts with the securities and then moves with a lag to the loan portfolio,” said Kasriel, who worked as a research economist at the Federal Reserve Bank of Chicago. “This appears to be the first sign that banks are willing to commit risk-based capital. We are early in the game.”

Banks also are loosening standards on lending to businesses of all sizes, according to the Fed’s most recent survey of senior loan officers, released Aug. 16.

“The good news is that the tightening of credit standards has passed,” New York Fed President William Dudley said Oct. 10 in Washington. “As time passes, we’ll see a further improvement in credit availability, and as that happens, that will actually support economic activity going forward.”

Zions Bancorporation’s loan business is starting to stabilize, and the Salt Lake City-based bank’s commercial portfolio may be “even growing a little bit,” Chief Executive Officer Harris H. Simmons said Sept. 13 at a Barclays Capital investor conference in New York. “We are very much focused on increasing lending activity.”

S&P 500 Earnings Forecast

2010-10-15T10:06:00.002-04:00

Our current assessment is that the US stock market averages (based on S&P 500 index) are slightly undervalued, yes undervalued, taking into account the most recent expectations for future earnings growth and Federal Reserve interest rate policy. This is a change from previous forecasts where the expectation was for earnings to decline given a slowdown in economic growth, thus causing the US markets to decline. While a slowdown in economic growth did occur and markets did decline over the summer on the expectation of a decrease in corporate earnings, the slowdown apparently didn't impact corporate profits, as earnings estimates have not declined since the end of last quarter.

Surprisingly, earnings estimates have continued to move higher over the past few weeks, an indication from analysts that despite a slowdown in growth companies are still able to produce an increase in profits, most likely do to operating efficiencies and continued cost cutting.

As of October 1, earnings estimates have increased from $81.73 at the end of last quarter to $82.69 for the 2010 calendar year. Earnings estimates for 2011 decreased a few percent to $93.93, which assumes growth of 13.5% over 2010 numbers. Using a price-earnings multiple of 15 (long-term average valuation proxy), we calculate valuations of roughly 1,240 for the S&P 500 Index for 2010 and approximately 1,400 for 2011, above current index levels of roughly 1175. Remember, the markets tend to follow earnings and not economic growth. So even though economic growth may be weak, it seems corporations have been able to sustain and even increase earnings through continued cost cutting in conjunction with productivity gains.

In the first few weeks of the third quarter earnings season, corporate profits are coming in better than expected so it is possible earnings estimates are not inflated as originally thought. As long as reported earnings are generally positive during the quarter and future guidance is upbeat, we should expect the markets to continue to move higher, at least in the intermediate term.

The Feds Next Move

2010-10-08T09:15:00.007-04:00

Is the Federal Reserve, with its zero percent interest rates and promises of more quantitative easing (read printing more dollars) responsible for the markets rallying? It's hard to say for sure because much of the data doesn't really support the view that excess liquidity provided by the Federal Reserve has been finding its way into equity markets.

However, it could be that the possibility the Federal Reserve may provide additional levels of liquidity in the future that is driving equity prices higher.

We do have a bit of a paradox at the present time, however. If excess liquidity, or its future prospect, are driving stock prices higher, why is it that bond yields continue to move lower? To the extent that excess liquidity from the Federal Reserve may cause future inflation, bond yields should be rising, not falling. We tend to believe that institutional bond investors are the smartest players in the room, so we always pay attention to their actions.

So there is the paradox. Excess liquidity should create expectations of future inflation and cause bond yields to rise (prices drop), yet bond yields continue to move lower (prices rise). This is a paradox that is not easily resolved or explained. To find the answer, we may just have to wait until the Fed's next move.

ISM Release

2010-10-01T13:52:00.011-04:00

Back in July we stated in a special update that we expected the manufacturing sector to slow down heading into the fourth quarter. In a press release today, The Institute for Supply Management (ISM)said the manufacturing sector expanded for the 14th consecutive month, although at a slower pace (54.4 in September versus 56.4 in August).

While the headline number shows relative strength this month as the PMI reading of 54.4 percent is still quite positive (anything above 50 shows expansion) the overall picture is less encouraging. The growth of new orders continued to slow, as the index is down significantly from its high this year of 65.9% back in January 2010. Production is currently growing at a faster rate than new orders, but it typically lags and would be expected to possibly weaken further in the fourth quarter of this year. Manufacturing has enjoyed a stronger recovery than other sectors of the economy, but it appears that weaker growth is the expectation for the fourth quarter. Both the Inventories and Backlog of Orders Indexes are sending strong negative signals of weakening performance in the sector. It seems like the summer slowdown in the economy is likely carrying over to the fourth quarter.

See table below for details: (Double click for larger image)

S&P 500 Breaks Above Resistance

2010-09-24T10:08:00.007-04:00

The S&P 500 Index has continued to track sideways at just below well established resistance at 1135 level during the remainder of last week. On Monday the index opened higher and accelerated through resistance to close at 1142.71. This marked the highest level the index has reached in 4 months. Although the staying power of the recent breakout is yet to be established in the short term, it is significant.

Although volatility could return at any time, with quarter end next week and hopes for more Federal Reserve intervention via QE2, we would not be surprised to see the market make a run to 1175 or the "flash crash" high of several months ago.

With the majority of economic data now surprising to the upside, fears of a double dip have decreased dramatically and the unwinding of this negativity has had a powerful effect on the markets.

National Net Wealth

2010-09-24T10:02:00.008-04:00

Below is a 20 year chart of the national net wealth in the USA. It is essentially Housing Equity + Stock market Value and is compliments of Fusion Analytics.

The value of US stock and housing equity fell 25.7% from the pre-crash peak (June 2007) to the recent low – $65.8 trillion down to $48.8 trillion — a destruction of value of nearly $17 trillion dollars. This is a very large amount of wealth destruction and will take time for it to return to peak levels. Perhaps this explains some of the negative sentiment on Main Street...

Continuing Claims Holding Steady

2010-09-17T10:15:00.003-04:00

As we discussed back in June of 2009, possibly one of the best predictors future growth in the US economy is a moderation in continuing unemployment claims. Continuing unemployment claims are those who are receiving benefits on a weekly basis.

To obtain a better perspective on unemployment during past recessions, below is a chart of continuing claims (those who continue to receive weekly benefits) dating back to 1971. (Click on chart for larger image)

Looking at the chart, the line shows continuing claims as reported each week. You can see that the last several months have been clustered in the 4.5 million range after spiking to over 6 million in 2009. Let's take a look back at the last three recessions to gain a better understanding of past cycles.

The early 1980's recession officially lasted from January 1980 until November 1982. As you can see on the chart the peak in continuing claims came in November 1982. The continuing claims dropped significantly over the next two years as the economy experienced a robust recovery. Economic growth was spurred by the Fed lowering interest rates and Congress reducing tax rates.

The early 1990's recession officially lasted from July 1990 until March 1991. Reviewing the chart we can see that the peak in continuing claims occurred in the first quarter of 1991. Although the recession ended in the beginning of 1991, it wasn't until the second half of 1992 (when continuing claims dropped) that the economy began a recovery.

The early 2000's recession lasted from March 2001 until November 2001; again the recession ended as the continuing claims figured reached a peak. Unfortunately, the ensuing recovery was rather anemic and job creation was below past recovery levels. The economy didn't really gain meaningful traction until the end of first quarter of 2003, many months after the recession officially ended.

While we hope we begin to experience job creation and an improved employment picture, we believe it is possible the recovery may be very similar to the most recent recessions in the early 90's and 2000's; where continuing claims remain elevated or clustered for several quarters (in this case around the 4.5 million level) and economic growth experiences rather anemic trends until continuing claims begin to steadily decline. This statistic will be important to watch in the coming quarters.

Less Bearish, More Opportunistic

2010-09-10T09:44:00.007-04:00

During August I spoke with a investment manager who happens to be a friend of mine. He told me he couldn't remember a time when he was so right about the overall macroeconomic data yet couldn't figure out the direction of stocks and bonds. We talked for some time and I told him that it is important to remember that you typically can't make sound investment decisions strictly based on economic data. In the real economy, things are bad and will likely get worse for the foreseeable future. However, stocks don't always move with the economy.

Stocks move up or down based on current earnings and (this is important) the future expectation of earnings growth. While the economy can be mired in a slow down for many months, the stock market can move higher, seemingly defying forecasters as the economic data points remain weak, while earnings continue to grow.

The time for being overly negative about the economy has likely passed. It's time to adjust to the new reality and prepare for the future environment.

The reality is that no one knows for sure when companies will begin hiring again or when the housing market will turn around or when consumers will begin spending again. However, we have endured a terrible domestic stock market over the past decade and everyone in the media, as well as economists and strategists continue to paint a bleak picture. It is at times like these, when everyone is very pessimistic, to begin thinking from a contrarian perspective - emphasis on "thinking."

Make no mistake, we are not advocating allocating 100% into stocks. We believe the domestic economy has a lot of issues and there are still concerns about government debt in Europe. Of course, one negative news event and we could see lower prices in the markets.

However, most people have adjusted to this and are either completely out of financial markets or are completely in bonds.

What we are experiencing now is the polar opposite of the bullishness and euphoria prior to the debt crisis and real estate collapse. Only time will tell, but the pessimism seems to be deep and entrenched. While this negative sentiment could continue for some time, eventually it will break, the economy will improve, and markets will move higher. The key is in the timing - will this happen next month, sometime next year, or a few years from now?

Our prediction is it could be the latter, but that doesn't mean there will not be opportunities. We expect certain stocks, sectors, and overseas markets to outperform the broad US market indices over the next several years. From a big picture perspective, we want to think about the right time to begin deploying capital into these areas over the next few years, taking an opportunistic approach, and taking advantage of any volatility in the markets. Big opportunities come from acting against the crowd, not with them.

We still want to err on the side of protecting capital, but as time goes on we want to be less bearish and more opportunistic.

August Hiatus

2010-08-06T10:14:00.004-04:00

With only a few weeks left of summer (hard to believe) and many taking vacations, we will be taking a short hiatus from the BAM weekly updates during the month of August. Please be sure to read today's updates.

BAM weekly updates will resume in September. Please be sure to contact us if you have any questions and enjoy the rest of your summer!

Cutting Through The Noise

2010-08-06T09:55:00.007-04:00

How does one cut through the economic, political, and market noise to arrive at intelligent decisions about how to allocate capital? We believe it comes down to price, research, discipline, and patience. One must take the time to assess underlying value and remain highly disciplined about how much should be paid for a particular investment. We must look for value and opportunities within a framework of big picture macro economic trends.

To begin, an investor must follow economic statistics such as non-farm payroll and employment figures, consumer confidence, the dollar, Federal Reserve policy, as well as consumer confidence. The statistics, and statistical trends (moving up or moving down over time), can give one a good framework from a macro economic perspective.

While in theory this makes sense, investing more aggressively when macro trends are positive and investing more conservatively when trends are negative, the current difficulty with this endeavor is that we have never before experienced our current economic situation. Statistics have been moving from positive to negative to neutral to really negative to fairly positive and back again. There are a lot a fits and starts in the data, but no clear trend. Even the Federal Reserve is having a difficult time interpreting the data as they continue to maintain a 0% target interest rate policy. Some economists even believe the rate could stay low for a few years.

With so much conflicting macroeconomic data, bulls and bears are both out in full force with their respective arguments. Both camps have good data points, reasonable arguments, and even some historical precedents that serve to support their thesis. The battle between the bulls and bears has added to volatility in the markets over the past year.

Given the uncertainty of the macro economic trends along with price volatility, investing in today's capital markets can by a trying proposition.

In trying times, investing is about patience, discipline, being price conscious, protecting capital, and more patience. We have to remember that opportunities are usually always present in the capital markets, if you look hard enough. We continue to seek out those opportunities while protecting capital, remaining disciplined, and staying patient.

Eventually the dust will settle, the clouds will blow through, and brighter days will appear - it's just going to take time.

Employment Report Disappoints

2010-08-06T09:45:00.004-04:00

The Bureau of Labor Statistics (BLS) reported that nonfarm payrolls declined by 131,000 in July. The unemployment rate was unchanged at 9.5 percent.

The contracting payrolls figure is due to the fact that 143,000 temporary 2010 Census workers were let go by the federal government. Excluding government jobs, private payrolls rose by 71,000. The increase in private payrolls was weaker than the 100,000 increase that had been expected by Wall Street economists surveyed.

The report suggests that businesses remain cautious in the wake of the financial markets' recent turmoil. Adding to the sense of weakness in employment, private payrolls in May and June were revised lower by a cumulative 34,000. Private job growth has averaged 51,000 over the past three months. This is down from an average growth of 154,000 in February-April. Job growth has taken a step back after fairly strong gains since this time frame, putting in question the strength of the economy's recovery from its worst downturn in the post-war era.

Profits Good - Economy Not So Much

2010-07-30T10:37:00.008-04:00

It is often difficult to determine why the markets rise or fall based on either good or bad economic news. Sometimes markets fall on good economic news and sometimes markets rise when poor economic data is reported. Recently, the market has seemingly defied logic over the past few weeks by rising in the face of poor economic data. The recent rise can probably be attributed to the fact that earnings (for the most part) are meeting or beating expectations. While main street is still hampered by job losses, it is a boon for corporate profits.

As of yesterday, roughly 80% of reporting companies have beat earnings estimates, but only approximately 65% have been beating top-line revenue growth estimates. In other words, companies are making their numbers by continuing to cut costs. This outcome is not how to build a foundation for solid long term growth and is likely not good news for longer term earnings growth (beyond next quarter).

Jacob Hacker of Yale recently presented a study sponsored by Yale University in conjunction with the Rockefeller Foundation on economic security and income. The study argues that in the past year, one in five households suffered income losses greater than 25%. It typically takes several years for households to recoup the lost income. In addition, household budgets are stretched and have little in savings.

So while the markets rise in the face of good earnings (remember, markets will follow earnings, not the economy), these results are unfortunately coming at the cost of future consumption which still constitutes roughly 70% of GDP.

Watch the Transportation Index

2010-07-23T09:13:00.000-04:00

The Dow Jones Transportation Average (DJTA) hit a high in May of this year and seems to be steadily declining; registering lower highs and lower lows. (see chart below)

Over the past few months, the DJTA has declined along with the broad market averages. Usually, the transportation index can give us a good indication of growth in the economy. Transportation companies charge freight rates based on demand. If demand is strong, higher rates can be charged, improving transportation companies' earnings. When demand is soft, the opposite occurs. While so far the DJTA has declined along with the broader market, the index and company earnings (such as Fedex, UPS, & CSX Corp) should be watched carefully. A continued decline in the index could be a precursor of slower growth, while a rebound in the index and transportation stocks should point to at least stable demand in the intermediate term.

S&P 500 Earnings Update

2010-07-16T10:22:00.003-04:00

Our current assessment is that the US stock market averages (based on S&P 500 index) are priced at fair valuation, taking into account the recent decline in the index and our expectation that earnings estimates will be adjusted in the coming months. Surprisingly, earnings estimates have continued to move higher over the past several weeks, despite expectations for a possible global slowdown in growth. As of April 1, 2010, earnings estimates were $78.15 for 2010, a 37% increase over final 2009 numbers ($56.86). As of June 30, 2010, earnings estimates increased to $81.73 for 2010 and $94.84 for the 2011 calendar year, increases of 44% and 16% year over year respectively – still too optimistic in our opinion.

If we make a reasonable yet optimistic assumption of 20% earnings growth this year and 16% earnings growth next year – earnings estimates would be roughly $68.23 for 2010 and $79.15 for 2011, below current expectations. Using a price-earnings multiple of 15 (long-term average valuation), we calculate valuations of roughly 1,023 for the S&P 500 Index for 2010 (near end of June levels) and approximately 1,187 for 2011. We believe markets are adjusting to this new fundamental reality and this is likely why the markets have declined in recent weeks. Currently, second quarter earnings releases are in full swing and company comments will give us a good indication of earnings prospects for the second half of the year.

Consumer Credit Declines Again

2010-07-09T08:33:00.002-04:00

A report yesterday by the Federal Reserve showed that U.S. consumers shed some of their debt for the fourth month in a row in May. Total seasonally adjusted consumer debt fell $9.15 billion, or at a 4.5% annualized rate, in May to $2.42 trillion. Economists expected a decline but of only $3 billion. Of course, this data series tends to be very volatile from month to month. For example, the April consumer credit was revised sharply lower to a decline of $14.86 billion compared with the initial estimate of a gain of $1 billion. The decline in May was led by revolving credit-card debt, which fell $7.32 billion or 10.5%. This is the 20th straight monthly decline in credit card balances. Non-revolving debt such as auto loans, personal loans and student loans, fell $1.82 billion or 1.4%. Since the collapse of Lehman Brothers in September 2008, consumer credit has declined in 18 out of the past 20 months.

While consumers reducing debt is a long-term positive for the economy, it reduces short-term consumer spending and impacts economic growth.

Special Update

2010-07-02T10:14:00.002-04:00

The recent report from the Institute for Supply Management, which measures productions of goods in the manufacturing sector, showed slower growth in the month of June. Almost of all the components of the report showed declines from May. Of particular concern was the deceleration of new orders (dropping by 7.2%) and prices paid (dropping 20%).

Going forward, we expect further deceleration in manufacturing. The combination of a stronger dollar and slower demand coming from Europe should hit export orders moving forward. The overall level of ISM readings are consistent with GDP growth of 3%-plus. However, further declines in the data in the coming months could bring down growth in the second half of this year.

In order to the economy to have enough momentum going into 2011, economic growth needs to be humming along by the end of the year, including job gains of roughly 200,000 per month by the end of the third quarter. With today's payroll number showing a loss of jobs for last month, it is becoming more unlikely we will see significant job growth in the next few months.

At this point, the prospects for the economy are moving between a worst-case scenario of a relapse into recession (which is a low probability) to a best-case of sluggish, sporadic growth in 2011. Thus, the current decline in the markets is expected given this fundamental change. We have stated earlier this year that earnings expectations were probably too high and adjustments would be made in the second half of this year; which would could see in the coming months. It is likely the markets will remain in a trading range until signs are clearer as to where to economy and earnings growth is headed. Until there is further confirmation of the data, we should expect volatility to continue, with a good news/bad news driven market.

In the meantime, it is best to continue our defensive-minded approach as we have since the beginning of the year - holding more fixed income, income producing investments (utilities), and cash as we wait for the dust to settle and less cloudy days to appear.

Enjoy the long weekend!

End of Quantitative Easing?

2010-06-25T09:32:00.001-04:00

If we take a minute and set aside weekly jobless claims, retail sales numbers, housing starts, and other economic data; probably one of the most important factors to focus on is that the Federal Reserve seems to be quietly tightening up on credit. Tom McClellan of the McClellan Market Report believes this is likely the largest single contributor to the recent market volatility.

While the Fed did leave its policy rate unchanged when it concluded its two-day meeting this past week, that hasn't stopped the central bank from quietly removing cash from the financial system.

One measure of money is the system is known as "money w/zero maturity" or MZM, is now contracting for the first time since 1995. MZM represents currency in circulation as well as deposits that could be withdrawn at anytime, such as checking accounts, savings accounts, and money market funds. After growing over the past decade and by over 4% during the first quarter of 2009, MZM started contracting in March at the rate of 2% per year.

It is possible the Fed has ended quantitative easing and is in the beginning stages of tightening monetary policy while leaving interest rates at zero. We could be entering a period where the Fed has decided that days of easy money are over. This, just as the global economy seems to be slowing down from the growth experienced in the second half of last year and first few months of 2010.
The global markets are becoming more volatile as traders react to the stealth tightening of credit by the Fed and possible impact on the the global economy. In addition, with less money to borrow at cheap rates, hedge funds have been caught flatfooted as borrowing costs may begin to increase; which would cause them to raise more cash by selling investments, since they won't be able to borrow at zero percent in the future.

Over the next few months, we will know whether this is just a blip in the monthly data or if quantitative tightening has begun.

Voluntold

2010-06-18T09:37:00.004-04:00

If you are not familiar with the word “voluntold”; here is the definition per the Urban dictionary:

Voluntold: The exact opposite of volunteering. Always used in reference to an unpleasant task to which you have been assigned by your boss.

Example 1:

Co-worker A: I hear you got a transfer to another division.
Co-worker B: Yes. I didn't want to take the job, but I was voluntold.

Example 2:

Co-worker A: Hey, do you want to go to the baseball game on Saturday?
Co-worker B: Unfortunately, I can't. I got voluntold I have to work this weekend.

But “voluntold” doesn’t apply to just the workplace. Husbands are often voluntold to do a variety of tasks, myself included. Some of these tasks may be tolerable but most are not as none of the activities were my idea. Most of us are voluntold to do X and in the interest of marital harmony, we do them.

But watching BP CEO Tony Hayward leaving the White House yesterday, I couldn’t help but notice he looked very similar to our largest banks CEOs after their November 2008 meeting with the Bush administration when they agreed to accept TARP. Like the bank CEOs before him, Hayward had been voluntold to turn over $20 billion in assets to the US Government.

Don’t get me wrong, I believe BP, like anyone who does something wrong, should be held accountable. In addition, the more negligent or egregious the action, the more severe the punishment should be.

Still, being voluntold feels very unsettling, particularly as it seems like it's becoming more the norm than the exception.

About a week ago, Governor Mitch Daniels of Indiana marked the one-year anniversary of the bankruptcy of GM and Chrysler with an op-ed in the Wall Street Journal in which he shared that “It was June 10, 2009 when the government tossed aside the option of proven, workable bankruptcy procedures in order to nationalize Chrysler on behalf of its union allies.” In other words, the bondholders of GM and Chrysler were voluntold to accept less than historical precedent would have suggested.

But I would note the pattern. In all of the voluntold situations to date (our largest banks, GM, Chrysler, and BP) we’ve had enormous organizations with staggeringly large liabilities.

It looks to me like companies with large liabilities or those which are considered “too big to whatever” entities; public policy outcomes can trump capital markets precedent?

But if Washington believes this, I believe that investors must too. And I'd offer that the bondholders and shareholders of the world’s largest companies now face a substantial risk of being “voluntold” should something negative happen.

When it comes to big corporations, the public policy outcome now matters most and will take precedent. But we'd be wise to consider the long-term implications, particularly as the global nature of our largest corporations and financial institutions makes the public policy outcome far more complicated than I believe most people currently appreciate.

The Upside of the Financial Crisis

2010-06-11T11:01:00.004-04:00

Below is an excerpt of an article written by Todd Harrison, founder of Minyanville and former hedge fund trader. The article is posted on the Minyanville website. We believe it decribes the process of discovery we are experiencing as a result of the financial crisis.

"The unfortunate capital market destruction is an inevitable comeuppance, the cumulative result of risk gone awry. It’s been percolating under the seemingly calm surface for several years, magnified by financial engineering and consumed by an immediate gratification society.

The socioeconomic consequences will be pervasive as we enter the other side of the business cycle, an unenviable retrenchment that politicians and policymakers have tried so hard to avoid. It’s certainly scary as new beginnings always are.

Therein lies the opportunity.

The media portrays the Great Depression as one where everyone in America stood on street corners or waited in a bread line. A closer look shows that similar to today, economic hardship for the middle class began well before 1929.

We’ve got a few lean years ahead but that’s nothing to fear. In fact, it’s a healthy and positive progression.

To get through this, we need to go through this. As painful as the process is, it takes us one step closer to an eventual recovery.

I view the Great Depression as the framework for optimism. Most of society worked, great discoveries were made and formidable franchises were established.

Indeed, if the greatest opportunities are bred from the most formidable obstacles, we’re about to enter a most auspicious era.

The 90’s were about wealth, accumulation and consumption and we’ve now entered a period that is entirely more austere, if not more sensible.

Debt reduction and the rejection of materialism will continue to manifest as we come to terms with doing more with less.

Flashy rides and big-ticket items that were once badges of honor now serve as hollow reminders of misplaced priorities.

Humility, once viewed as weakness, will be embraced.

Doing for others -- rather than asking what others can do for you -- will become more commonplace as people learn to appreciate what they have rather than constantly keeping up with the Dow Joneses.

This mess is a bitter pill to swallow, particularly for the mainstream American who doesn’t know a derivative from a dividend. We can point fingers and wallow in the “why” or take a deep breath and begin the process of recovery.

Something good comes from all things bad and the greatest wisdom is bred as a function of pain.

It’s unfortunate that the structural foundation of the global capital market system had to shake before people -- and policymakers -- paid attention but it is what it is and we’ll do what we must.

Surround yourself with people you trust. Practice risk management over reward chasing.

It won’t be an easy road but it won’t be impossible either."

Deflation versus Inflation

2010-06-04T11:13:00.003-04:00

Back in October 2009, we talked about the possible deflation and inflation scenarios that could play out. See link below -

http://brightassetmgmt.blogspot.com/2009/10/puzzle-pieces.html

In this piece there were two scenarios that were likely -

Scenario 1: Dollar decline, lower bond prices, higher stock prices, higher commodity prices, higher gold

Scenario 2: Dollar rises (as of function of deleveraging), higher bond prices, lower stock prices, lower commodity prices (as a function of a reduction in global demand.)

While Scenario 1 dominated during the second half of 2009 and into the beginning of 2010, Scenario 2 has been playing out over the past few months as debt and financial concerns in the Eurozone are creating expectations for deflation.

Remember, deflation is the contraction (reduction) of money and credit. It occurs when an economic system is carrying too much debt to be supported by the level of income generated by economic activity - both in private and public sectors. It occurs because too much debt has been incurred to create unproductive assets that don’t generate income. Deflation is a corrective process, it’s simply the market not being able to service debt, so the debt must be forfeited.

Inflation is just the opposite involving the expansion (creating) of money and credit. Since the 1950's, central banks and accepted economic theory are all about creating debt to grow economies (artificially), so periods of inflation (creating money-debt and credit) last a very long time. Debt is accumulated slowly and incrementally during periods of economic expansion until there is just too much of it.

The current job of global central banks is to fight deflation. Hidden behind the bailouts, stimulus packages, zero interest rate policies, mortgage workouts, housing credits, and working groups are politicians attempting to engineer a business and economic recovery while fighting off the forces of deflation.

While these plans seemingly worked over the past year, none of these plans will affect the larger deflationary credit contraction. Debt deflation is occurring outside of the Fed’s control at many of the world’s money center banks. This process will probably take several years to work out but will ultimately yield positive results. The destruction of debt will allow world economies to build a solid foundation for future expansion that is entirely more secure than what we currently have in place at the present time.

There are no easy answers but there are certainly simple truths - truths that don't get politicians re-elected, however.

S&P 500 Index P/E Ratio

2010-05-28T09:25:00.001-04:00

The current sell-off over the past several weeks in US stocks has reached the point at which smart money investors are starting to see value appear. This is by itself no guarantee that further lows will not be reached, but it suggests that we have entered the part of the selling in which an increasing proportion of sales are involuntary liquidations (driven by mutual fund redemptions, margin calls, or a need to cut risk exposure). Of course this is the major reason that the maximum pace of price decline typically takes place right at the end of a correction, which we saw at the beginning of this week.

Below is a chart of the S&P 500 index showing index price (white line), current P/E (green, right side) and Bloomberg Estimated P/E (red, right side). While the price level of the index is no lower than it was for much of Q4 2009, the significant recovery in both the level of US corporate earnings means that the index is trading at an estimated P/E of just under 13. To put this in perspective, the 13 level was only breached during the period of October 2008 to March 2009. Furthermore, during that period of crisis, estimated earnings were being cut at a rapid pace, making a low estimated P/E a much less reliable guide that value was being established than at the current time.

If we couple this P/E ratio decline with the increase in mutual fund redemptions over the past two weeks, increase in bearish sentiment, the decrease in dumb money confidence, and the increase in smart money confidence, we are reaching an attractive valuation point for a good risk/reward opportunity. We are not saying the end of this correction has definitely occurred and it is possible that even deeper value may be created by the time the downturn has run its course; but we are likely closer to the end of the move than the beginning.

Volatility is Back!

2010-05-21T09:51:00.001-04:00

Back on April 16, we discussed how sentiment was reaching extremes with dumb money very confident in the markets, while smart money was not confident. See link to article below:

http://brightassetmgmt.blogspot.com/2010/04/sentiment-going-parabolic.html

Now sentiment has turned 180 degrees. Volatility has increased as fear now dominates where just a few short weeks ago, greed took center stage. See chart below courtesy of sentimentrader.com:

Dumb Money Sentiment has declined to 33% confidence, while Smart Money Sentiment has climbed to 50% confidence; one of the highest readings since March 2009.

As we discussed in the April 16th update, we believed any correction or decline in the markets as a result of extreme sentiment readings would likely translate into an opportunity in undervalued areas of the markets' given the improved economic picture. While we expect volatility could continue in the short-term and markets move lower, the increase in smart money confidence to 50% coupled with a decline in the markets of over 10%, and the fact the dumb money is becoming more fearful, makes us confident that a decent rally could be coming in the weeks/months ahead.

The key is having patience as well as the courage to act against the crowd...

The Deadly Web of Debt

2010-05-14T09:44:00.001-04:00

We thought the easiest way to understand the debt issues in Europe is with a picture. Below is a graph that was posted in the NY Times several days ago. It is a fairly accurate depiction of the debt issues facing the Euro Zone. (Double click on picture for larger image)

Something Wrong with the System

2010-05-07T08:56:00.001-04:00

Apparently, the markets dropped 10% in a matter of minutes yesterday because a "fat finger" trader mistakenly hit the "b' key instead of the "m" key. Fortunately orders don't trade that way and our sense is that the stock exchanges needed a "reason" for the media. Our feeling is that the system broke yesterday and we started to crash until the powers that be stepped in to keep the markets from imploding. Case in point, while we were looking to purchase various positions during the craziness, there were large spreads between the bid (sell price) and ask (buy price) one minute and all of a sudden there was no market. No bid, No ask, nothing. Stocks just don't trade like that even under heavy amounts of selling. Something happened yesterday that is not normal and shows that something is wrong with the system. We hope someone figures out what happened.

Why does this matter? Because our system is built on credibility, trust, and confidence - confidence in the process. Credibility and loss of confidence was at the heart of the financial crisis in 2008 and could become an issue once again. Psychology is a delicate animal and can turn vicious when the "real" comes to the surface.

Now from where we sit the last thing we want is for the market to crash as it wouldn't be good for anyone. However, it is within the probability spectrum and an outcome we must respect. Yesterday was a great example of "expect the unexpected".

So what does one do? The key is not to panic, but to act rationally. The worst of the downside may have already happened - emphasis on the word "may". According to reports, all of the unusual trades on the major exchanges that happened between 2:30 and 3:00 yesterday will be cancelled. This could add some stability to trading today but also means that people that panicked and sold positions yesterday will have the trade cancelled, so they could decide to sell at some point in the near future.

It's highly likely that markets will remain volatile over the coming weeks as news from Europe and currency markets take center stage.

In times of crisis and high levels of uncertainty it's better to error on the side of conservatism and position accordingly. Cash can be the great neutralizer in volatile times. While it doesn't help you when the market goes up, it doesn't hurt you when the market goes down. Plus, it's always good to have capital on hand to take advantage of opportunities. We have to remember that the capital markets will be here tomorrow and there will always be opportunities.

The good news from yesterday's free fall is that dumb money sentiment is beginning to turn more negative after several weeks of europhic numbers; while smart money sentiment is beginning to turn more positive (see recent weekly updates). This sentiment shift could be setting the markets up for a decent multi-month rally.

Senators versus Goldman

2010-04-30T09:58:00.009-04:00

While watching the Goldman Sachs hearings during lunch earlier this week, I couldn't help but feel like it was a political setup. People are upset about the financial crisis (rightfully so) and many senators are feeling the heat from constituents. While there were many companies involved in trading the mortgage securities market, it seems like Goldman has become the target - likely because Hank Paulson the former Treasury Secretary was the CEO for Goldman and many believe the bailout was a direct attempt to help Goldman survive. Given all the discussion this week, I thought it would be helpful to look at some of the issues surrounding the case. We will don't believe Goldman acted in the best interest of clients at all times, based on the current information available, Goldman Sachs likely didn't do anything illegal - however, Goldman acted in a way that was socially unacceptable and improper.

First, we have to go back to the late 1990's and the passage of the Commodity Futures Modernization Act, which exempted swaps and derivatives from regulation. All the big problems in the country seem to stem from something the government does or in this case didn't do. Below is a link to the BAM Weekly Bulletin article from last year.

http://brightassetmgmt.blogspot.com/2009/04/blame-commodity-futures-modernization.html

Second, Goldman didn't cause the financial crisis. They participated in trading and creating swaps and derivatives in the mortgage backed securities market, but they single handily didn't cause the collapse. It was a combination of several events happening at the same time. Remember, nothing Goldman or any other firm did with respect to creating or trading derivative products was illegal - the products were unregulated so technically there were no rules.

The word "synthetic" is the word that is important in this discussion. It's not a real asset, like the peanut butter and jelly you might find on a peanut butter and jelly sandwich. When an asset is "synthetic", every buyer for the product creates a seller who is effectively short the asset. Since the asset doesn't actually exist, there needs to be a buyer and a seller; it can't be one-sided. So, if a customer wants to buy a "synthetic" asset from Goldman Sachs that would make either Goldman or a third party the seller.

One of the reasons Goldman Sachs created the synthetic products was because there was strong demand from its customer base and this is an important point. Customers wanted to purchase assets that were tied to sub-prime mortgage back securities (and other mortgage related securities) either directly or synthetically, in order to increase risk or reduce exposure to risk, because they believed the underlying position would be very profitable or wanted to hedge an existing position. Because there was such positive sentiment about the mortgage market at the time, there weren't many investors interested in taking a negative view. Goldman and some other seemingly smart investors had an idea that the mortgage market may unravel at some point and were comfortable with betting against the mortgage market, or taking the other side of the trade in this example. We also have to remember that the average investor doesn't have access to a "synthetic CDO". Most sophisticated investors (hedge funds, pension funds, endowments) who were buying the synthetic products from Goldman and other firms for that matter were smart enough to understand what they were involved in. Goldman Sachs basically created products that were demanded by its customers and took, with other third parties, the other side of the trade.

We will have to wait and see what happens next...

S&P 500 Earnings Update

2010-04-23T11:06:00.003-04:00

Our assessment is that the US market averages (based on S&P 500) are still at the higher end of fair valuation, if not slightly overvalued, based on final earnings estimates for 2009 ($56.86) and current estimates for 2010. However, valuations don’t seem to matter as the markets continue to power higher on expectations of a stronger economic recovery and increased corporate profitability.

As of January 1, 2010 earnings estimates for the S&P 500 stood at $75.27 for 2010, representing a 32% increase over finalized 2009 results. As of April 1st, earnings estimates have increased to $78.15, a 37% increase over 2009. A 15 price-earnings multiple (long-term average valuation) on the $78.15 estimate translates to a 1,172 value for the S&P 500 Index. Given the abundant liquidity in the markets, low interest rates, and expected low inflation, market participants could put a premium on future corporate earnings and be willing to pay more for those earnings; pushing markets significantly higher. For example, placing price-earnings multiple of 18 on earnings of $78.15 translates to a 1,406 value for the S&P 500; while a multiple of 20 would put us back to the old market highs reached in 2007. We can’t rule out the possibility, if economic conditions remain favorable, of the markets moving back to new highs over the next couple of years.

However, as we have stated previously, while we do believe earnings will increase in 2010, a 37% increase is probably a bit optimistic. We will likely need to see double digit GDP expansion in order to see such an increase in earnings. While this type of increase in earnings may not happen; it’s the perception of what may happen that matters. Right now the perception is that earnings will increase significantly and the economy will continue to accelerate with or without job creation. As long as this perception holds weight with market participants, the markets will likely continue to climb as this outcome is priced into stock valuations.

Sentiment Going Parabolic

2010-04-16T11:09:00.003-04:00

We usually never cover a specific topic two weeks in a row but the sentiment numbers have gone off the charts. See the chart below from Jason Goepfert at Sentimentrader.com.

Dumb Money Sentiment has reached 75% confidence level, while Smart Money confidence is currently at 29% confidence. The spread has widened to 46%. The last time the spread reached this kind of extreme was in May of 2008. The markets didn't fair to well after those extreme readings.

Back in January of 2010, the Dumb Money Sentiment reached 75%, while the Smart Money Confidence was at 38%; right before the markets declined roughly 9% in about 3 weeks due to concern over economic growth; so caution is warranted.

However, economic numbers have greatly improved since the reports at the beginning of the year and we are in a recovery as opposed to heading into a recession as was the case in May 2008. Any correction or decline in the markets as a result of extreme sentiment readings we are currently seeing will likely translate into an opportunity in undervalued areas of the markets.

Sentiment Reaching Extreme - Again

2010-04-09T10:16:00.005-04:00

The Smart/Dumb Money Confidence indicator is reaching an extreme reading again and at one of the widest spreads on record.

As a refresher, the Confidence indices are presented on a scale of 0% to 100%. When the Smart Money Confidence is at 100%, it means that those most correct on market direction are 100% confident of a rising market, and we want to follow their direction. When it is at 0%, it means that the Smart Money are 0% confident in a rally, and we want to be more defensive and hold more cash.

We can use the Dumb Money Confidence in a similar, but opposite, manner. For example, if the Dumb Money Confidence is at 100%, then that means that the Dumb Money investors are supremely confident in a market rally. And history suggests that when these investors are most confident, we should exercise extreme caution. When the Dumb Money Confidence is at 0%, then from a contrary perspective we should be concentrating on the long side, expecting these traders to be wrong again and the market to rally.

In practice, the Confidence Index numbers rarely get below 30% or above 70%. Usually, they stay between 40% and 60%. When they move outside of these levels, it’s usually time to take notice.

As of this morning, the Smart Money confidence has recently dropped to 29%; the lowest level this year. The Dumb Money confidence has just risen to 71%; making the spread between the two 42 points! These readings are each above and below the respective extreme bands of 70% and 30%.

Again, this doesn't mean that markets will decline immediately and the markets could actually continue to move higher in the short-term. However, the risk/reward equation is not favorable and the probability of an increase in volatility rises with each passing day.

Manufacturing Index improves

2010-04-02T10:29:00.005-04:00

March's ISM Manufacturing survey delivered better than expected results and this key data point continues to suggest that the economic recovery is gaining more momentum and a solid rebound in manufacturing is taking place than has been broadly recognized. The overall index improved to 59.6 (from 56.5 last month) which is the best reading since July 2004 (interestingly this was one month after the first Federal Reserve Board interest rate hike in the 2004-06 hike cycle). The most important data is supplied by New Orders which improved to 61.5 (59.5 previously), indicating that orders continue to grow rapidly. This new order figure will require greater production which in turn requires re-employment of labor. We are finally seeing the sort of rush to re-build inventories that we typically see when an economic recovery really takes hold. All in all this is a very positive data set and one that suggests that the manufacturing employment cycle is likely about to turn strongly positive.

Economy adds jobs in March

2010-04-02T10:21:00.004-04:00

The American economy added 162,000 jobs in March, the biggest burst of hiring in three years, the Labor Department said Friday. The unemployment rate held steady at 9.7%, the level it has been at for the last three months.

The March job gains, which were boosted by temporary hiring for census work, marked the biggest one-month increase since 239,000 jobs were generated in March 2007, roughly 3 years ago. The latest gain was slightly lower than what many economists had been forecasting, but the government also revised upward the payroll count for the first two months of the year. It revised the January payroll date to a creation of 14,000 jobs, instead of losing 26,000 as previously reported. And the losses in February were shaved by more than half, to 14,000.

The news of the hiring last month will be welcomed news to the 15 million jobless American workers. But the latest report somewhat overstated the strength of a slowly recovering labor market. About 30% of the payroll increases last month, or 48,000 jobs, were positions created by the Census Bureau, which is expecting to hire hundreds of thousands more workers in the next couple of months to knock on doors and collect data for the decennial count of the nation's population. Many of these jobs are part-time and will last only several weeks.

However, this jobs report shows that the economic recovery seems to be gaining some momentum as we head into the second quarter of the year.

Healthcare Reform - Pros and Cons

2010-03-26T10:10:00.001-04:00

Now that healthcare reform legislation has passed, we thought it would be helpful to take a quick overview of the pros and cons.

New Health Care Bill – Pros:

1. Everybody can have health insurance if they want it.
2. Insurers will not be able to stop paying for people who are sick, even if they lose their jobs.
3. People who cannot afford health insurance won’t have to pay as much money.
4. People who are already sick will be eligible for healthcare.
5. In the long run it will (hopefully) reduce medical costs significantly. Rising medical costs are the main reason the long-term budget projections are so alarming. Unfortunately, this bill might not do enough. While there will definitely be some savings, it’s not clear that they will be as great as hoped.
6. Health insurers can no longer cap coverage. In other words, they will no longer say that they have spent enough on you and you’re on your own for the next hundred thousand dollars. This should reduce medical bankruptcy.
7. There will be increased competition in the insurance market. This might push the healthcare companies to lower costs and provide better service.

New Health Care Bill – Cons:

1. For the first ten years, it will cost about $100 billion a year. This is about the yearly cost of the Iraq War.
2. The bill might increase the cost of health insurance. This depends on whether the gains from increased efficiencies and increased competition are outweighed by the cost of providing additional benefits.
3. The Individual Mandate. You will have to either buy health insurance if you don’t have it or have a 2% tax increase. This insurance will be subsidized—but there is no guarantee that the subsidy will suffice for your specific situation.
4. There will be a tax increase on very high income people. If you are making more than half a million you will have about a 1% tax increase.
5. Increased government involvement in healthcare. Government already pays for huge amounts of healthcare—so this won’t be anything new.
6. Additional regulation on insurance companies. This might increase costs. It will increase quality.
7. Physicians will have increased access to information about what treatments are most effective for their cost. If two treatments work equally well and one is cheaper, doctors can recommend that one. This was almost universally considered a good thing until a few years ago, but some people have started criticizing it lately.

Here are some more facts about this new Health Care Bill on government extractions:

1. The US government will extract a fee of $2.3 billion annually from the pharmaceutical industry. If you are a pharmaceutical company what you will pay depends on the ratio of the number of brand-name drugs you sell to the total number of brand-name drugs sold in the U.S. So, if you sell 10% of the brand-name drugs in the U.S., what you pay will be 10% multiplied by $2.3 billion, or $230,000,000. (Under reconciliation, it starts at $2.55 billion, jumps to $3 billion in 2012, then to $3.5 billion in 2017 and $4.2 billion in 2018, before settling at $2.8 billion in 2019.

2. The US government will extract a fee of $2 billion annually from medical device makers. If you are a medical device maker what you will pay depends on your share of medical device sales in the U.S. So, if you sell 10% of the medical devices in the U.S., what you pay will be 10% multiplied by $2 billion, or $200,000,000.

3. The US government will extract a fee of $6.7 billion annually from insurance companies. If you are an insurer, what you will pay depends on your share of net premiums plus 200% of your administrative costs. So, if your net premiums and administrative costs are equal to 10% of the total, you will pay 10% of $6.7 billion, or $670,000,000. In the reconciliation bill, the fee will start at $8 billion in 2014, $11.3 billion in 2015, $1.9 billion in 2017, and $14.3 billion in 2018.

Many of the provisions of the reform don't go into effect until 2014, so depending on what happens in the November elections, it's possible it could be amended or changed. It is unlikely this will happen but it is possible.

Markets continue to rally

2010-03-19T10:38:00.001-04:00

The S&P 500 Index has closed in positive territory 24 of the past 28 sessions and has risen to new highs for the year. If you think that is breathtaking, the Russell 2000 Index has rallied 20 of the past 23 days. A near-term corrective phase would be totally natural at this point and as long as the indices don't give back too much of the gain; that would be a constructive development for possible future gains.

The equity market at any given moment in time is basically one part reality to three parts perception. The perception part (and the reason behind the continued rally) is that 0% interest rates are good news for stock prices. With rates expected to stay low for an "extended period of time", the perception is that is good news all around.

Question we ponder is if 0% interest rates were a cure-all for all that ails the economy then we suspect Japan’s Nikkei Index (where zero percent interest rates have existed for years) would still not be 70% lower than it was in 1989? As we look back to 2009, didn’t the S&P 500 slide 30% in the opening months of the year with the same interest rate policy we have today? It was only when the Federal Reserve began quantitative easing, the government bought shares in the banks and injected stimulus, FASB made changes to accounting rules and the shorting community was sufficiently ostracized that the market made a bottom. Perceptions changed.

Perception is OK as long as the future reality matches up to the at the moment perception. And so far that has happened. Perception continues to match future reality and the market has rallied accordingly. The stock market perceives a robust recovery, which actually may happen. Economic numbers and earnings continue to come in above expectations. So far so good. Of course, there is always a twist.

The bond market's perception is vastly different from the stock market's. If the bond market (which is actually several times bigger than the stock market) is perceiving a recovery as robust as the stock market, intermediate and longer term interest rates should move higher, as they have in every post war recovery; in anticipation of the Federal Reserve raising rates due to strong economic growth. The 10 year treasury rate is the benchmark for the markets as many other lending rates, such as mortgages, are tied to this rate. In June of 2008, the 10 year treasury rate was 3.79%. In June of 2009, the 10 year treasury rate was 3.71%. Where is it today? As of this morning, the rate is 3.66%. At this point, the bond market doesn't expect the economic recovery to be as robust as the stock market perceives. So who has the correct perception - the bond market or the stock market?

If the economy is recovering at more than just a tepid pace, we should begin to see interest rates move higher as smart bond market investors begin to sell bonds anticipating higher rates. At first, the stock market will likely decline as higher rates tend to be a precursor to an allocation move out of stocks and into bonds as yields rise. However, longer term a rising interest rate environment is good for stocks because it signals stronger economic growth and in increase in pricing power for companies; requiring the Federal Reserve to raise rates to slow growth and tame inflation. If interest rates continue to remain steady or move lower, we should except a continued slow recovery and more muted expectations for earnings growth this year. Economic numbers over the next several weeks should give us a better idea of who is right.

Consumer Credit Expands in January

2010-03-12T10:15:00.001-05:00

Total consumer credit outstanding expanded by $5 billion in January after contracting 15 of the previous 17 months. Hopefully this trend will continue as 60% of the US economy relies on consumers.

Consumer credit outstanding includes revolving and non revolving credit. Revolving credit is mostly credit card debt, and non revolving credit includes loans for items such as autos and boats. Even with the slight increase in January, total consumer credit (after adjusting for inflation) has contracted roughly 6 percent since the recession began in December 2007. This number might seem like a huge contraction but compared with three of the past four recessions, it actually looks rather typical, if not mild. Consumer credit contracted 9 percent in the 1973–75 recession, 11 percent in the 1980–82 recessions, and 8 percent in the 1990–91 recession.

Then, just when you think this recession is just like the others, in comes a curve ball - the report shows that if we the current recession is separated into revolving and non revolving credit, the relationship to past recessions changes. Typically in a recession, non revolving credit shrinks considerably while revolving credit shrinks little if at all. The trend so far in this recession has been the exact opposite; non revolving credit essentially has remained unchanged while revolving credit has shrunk 11 percent.

It is interesting to note that the surprise blip “up” in the most recent consumer credit report came entirely from non-revolving debt. Credit card debt continued to contract. Most likely this change in debt is due to the fact that interest rates for auto and boat loans are exceptionally low, while interest rates for credit cards are typically much higher.

Tax Law Update for 2010

2010-03-05T10:22:00.006-05:00

No phaseouts on itemized deductions & exemptions in 2010
This may provide an opportunity for some notable tax savings. Historically, high-income taxpayers have been subject to a reduction in the value of itemized deductions and personal exemptions after a certain income threshold. In 2010, the phaseouts are gone entirely. In 2011, they are poised to return.

As IRS standard deduction and personal exemption amounts are indexed to inflation, you’ll see very little change there for 2010. The standard deduction for heads of household will rise by $50 to $8,400 for the 2010 tax year. Other standard deductions will stay put, and the personal exemption amount will remain at $3,650 for 2010.

Lower long-term capital gains rates through 2010
Unless Congress decides to extend these Bush-era cuts, capital gains tax rates will revert to pre-2003 levels in 2011. For 2010, the long-term capital gains rate for those in the 10% and 15% tax brackets is 0%. In 2011, it is set to go to 10%. If you fall into the 25%, 28%, 33% or 35% tax brackets, the capital gains rate is 15% in 2010 and 20% in 2011.

The dreaded estate tax to be revised in 2010
Zero percent estate taxes in 2010? That was the plan … but the reality is that estate taxes are likely to remain at current levels in 2010 with some retroactive lawmaking. In early December, the House voted to restore the estate tax for 2010; a week later, the Senate voted against temporarily extending 2009 estate tax levels into the coming year. The Senate will almost certainly take up the issue again this year. However, to prevent a complete repeal of the estate tax, any new legislation is expected to contain a retroactive provision. So instead of taking effect upon passage, any new estate tax law would likely be made retroactive to January 1, 2010.
In other words, don't plan on a sudden demise in 2010 in order to pass your estate on to your heirs without estate tax.

Don't forget the homebuyer tax credit
The homebuyer tax credit appeared a couple of years ago. In 2009, lawmakers improved upon the original tax break. Now the homebuyer tax credit is a true credit. That means it reduces your tax bill dollar-for-dollar and in this case, could get you a refund if your IRS bill is zero.

The credit amount was increased to an $8,000 maximum and it's not limited to strictly first-time buyers. Homeowners who've lived in their residences for a while and want to buy another one can get a $6,500 maximum credit.

Under the Worker, Home ownership and Business Assistance Act of 2009, signed into law on Nov. 6, 2009, you have until this April 30 to buy or sign a contract to buy a principal residence. You then get two more months, until June 30, to close on the property. If you're a first-time buyer, you also get the option of claiming the credit on either your 2009 tax return or waiting until you file your 2010 taxes next year.

News of the Week

2010-03-05T09:57:00.001-05:00

Euro-Zone GDP growth slows
WSJ reported this week that economic growth in the 16 countries that use the euro slowed as expected in the fourth quarter, with the fragile recovery entirely dependant on exports, revised official data showed. Quarterly gross domestic product growth slowed to 0.1% in the final quarter of last year, down from 0.4% in the three months to the end of September, the European Union's Eurostat statistics agency stated. The figures are in line with the first estimate of euro-zone GDP published last month and the market consensus estimate from a Dow Jones survey of economists.

Monster Employment Index rises sharply in February
The Monster Employment Index rose by ten points in February, as employers resumed hiring activity after January's seasonal lull. The long-term growth rate turned positive, with the Index up 2 percent year-on-year, for the first time since December 2007 suggesting some improvement in the underlying demand for labor. During February, online job availability rose in 15 of the Index's 20 industry sectors and in 19 of the 23 occupational categories monitored... "Although some of the increase in the February Index can be attributed to seasonality, a rise in hiring for sectors like manufacturing, transportation and wholesale trade offers an encouraging sign of increased investment and business activity," said Jesse Harriott, senior vice president and chief knowledge officer at Monster Worldwide.

Weather Conditions Play No Role on Employment Data
Nonfarm payrolls fell by 36,000 in February after declining by 26,000 in January. The consensus expected payrolls to decline by 68,000. It seems forecasters overestimated the effects of the severe winter weather on the payrolls data. The consensus estimate included a decline of 100,000 in payrolls due to inclement weather. As the bureau stated in its press release, the estimate turned out to be bogus and weather conditions played almost no role in moving the payroll numbers. The unemployment rate held at 9.7% in February. The consensus expected it to increase to 9.8%. Importantly, the unemployment rate did not hold at 9.7% due to statistical manipulations. Instead, the data provide evidence of an influx in job creation. The number of employed increased by 308,000 while the labor force rose by 342,000. There is a strong caveat to the unemployment data. The increase in employment is not coming from full-time/high-wage positions. Employment growth was caused by workers taking part-time jobs because poor business conditions made it difficult to find full-time work. These new part-time hires topped the entire aggregate increase in employment.

News of the Week

2010-02-26T08:45:00.000-05:00

Initial Claims Report Suggests a Much Weaker Labor Sector
The initial claims data weakened for the week ending Feb. 20 as the claims figure increased from 474,000 to 496,000. The consensus expected claims to decline to 460,000. Many analysts, including us, believed that inclement weather conditions across the U.S. would prevent many workers from filing new claims. If this scenario is true, then the actual initial claims figure would be much closer to 550,000... Continuing claims rose a modest 6,000 to 4.617 mln for the week ending Feb. 13. The figure for the week ending Feb. 6 was revised up from 4.570 mln, and the consensus expected claims to remain at that previous level. The decline in original claims is mostly due to workers running out of benefits and it seems the weather made it difficult to process extended benefit applications.

Durable Goods Orders Headline Data Deceiving
Durable goods orders rose 3.0% in January after increasing 1.9% in December. The consensus expected a more modest 1.5% gain. The headline data is very misleading. Transportation orders jumped 15.6% in January on the back of a 126% increase in orders for nondefense aircraft. Strangely, even though auto assemblies rocketed higher in January, motor vehicle orders fell 2.2%. The drop may correspond with higher motor vehicle inventories in the coming months. Excluding transportation, orders slipped 0.6% after increasing 2.0% in December. The consensus estimate called for a 1.0% increase. After a strong Q4 2009, growth in business investment seems to have slowed. Orders for nondefense capital goods excluding aircraft fell 2.9% after increasing roughly 3.3% in both November and December.

China's banks in cash-call rush to lift balance sheets
FT reports China's state-controlled banks are rushing to raise money from public markets to shore up their balance sheets after a year of unprecedented loan growth and the introduction of stricter capital requirements by regulators. This week alone, Chinese lenders have announced plans to raise up to 76 bln through equity and bond sales, with at least 150 bln of bank fundraising in the pipeline, analysts say. The cash calls come as Beijing tries to limit new lending to the white-hot property market and the investment vehicles of local governments.

Latest truck tonnage reading indicates economic recovery
Truckline reports the American Trucking Associations’ advance seasonally adjusted For-Hire Truck Tonnage Index jumped 3.1% in January, following a revised 1.3% increase in December 2009. Compared with January 2009, SA tonnage surged 5.7% which was the best year-over-year reading since January 2005 and the second consecutive increase. ATA Chief Economist Bob Costello said that the latest tonnage reading, coupled with anecdotal reports from carriers, indicates that both the industry and the economy are clearly in recovery mode, although at a slow pace.

Mortgage Delinquencies Continue to Rise

2010-02-26T08:35:00.000-05:00

While the most broad measures of publicized economic data have showed positive readings over the past few months, indicating the massive stimulus and liquidity injections are likely working, we also want to keep an eye out for imbalances in those less reported pieces of fundamental data on the economy. For example, in a recent report, mortgage delinquencies of 60 or more days rose for the 12th straight quarter, hitting a record high 6.89% in Q4 2009, according to credit bureau TransUnion. Year-over-year, the delinquency rate is up about 50% from 4.58% delinquent in Q4 2008. When we are talking several trillion dollars in outstanding mortgage debt, 6.89% becomes a fairly large number.

TransUnion, one of the major US credit bureaus, conducts a survey of roughly 27 million all of its credit files from its total consumer base, or about one in every nine consumer files in its database of 250 million consumer files each quarter. States with the highest delinquency rates in Q4 2009 were led by Nevada with 16.19% and Florida with 14.93% delinquent.

Ironically, the bureau in December projected that delinquencies will drop nearly 3% by year-end 2010 to 6.39%; but that was when the year-end delinquency rate was expected to come in around 6.56% rather than 6.89%.

Part of the rise in delinquencies may come from a trend of more borrowers than ever choosing to pay down credit card debt before making mortgage payments. TransUnion found the share of borrowers who were delinquent on their mortgages but current on their credit cards rose to 6.6% in Q3 2009 from 4.3% in Q1 2008. At the same time, the share of borrowers that were delinquent on credit cards but current on mortgages slipped to 3.6% from 4.1%. It seems like more people are willing to default on mortgage debt than credit card debt.

In addition, the delinquency rate on commercial mortgage-backed securities (CMBS) loans posted the largest single monthly increase on record. US CMBS loans are also transferring to special servicing status faster and greater than ever before.

The delinquency rate on CMBS loans rose by 1/2% in January, driving the total rate to 5.42% in February, according to a report by Moody’s Investors Service. The new rate marks the largest increase in the delinquency rate, by dollars and basis points, as recorded in the current downturn by Moody’s. (See chart below)

So while the broadest measures of economic statistics are showing better numbers and economic improvement, there are many cross currents. The economy does have some underlying fundamental weakness in certain areas, such as mortgages delinquencies, which, if the trend continues, could impact the degree and pace of economic recovery.

30 Year Bond Yields

2010-02-19T09:52:00.011-05:00

We are currently paying very close attention to the 30-year bond yield which is testing key resistance at the 4.75% level. The highest closing yield since the 2008 collapse was 4.76% on June 10, 2009 and over the last 2 years 4.79% on June 16, 2008; meaning that this is potentially a crucial level to be aware of for bonds. Should the long bond go on to establish a higher range (higher interest rates), this would be one of the first signs of the bonds markets adjusting to positive economic date and the likelihood of the Federal Reserve raising interest rates in the near future. It should be noted that the bond market will adjust market interest rates in anticipation of the Federal Reserve moving interest rates higher. If Treasury bond yields move higher (price lower) this will push all other bond yields - such as corporate bonds - higher even if credit spreads continue to stay tight.

The 30-year bond seems likeliest to be a leading indicator of this change (the short end of the curve is too tied to the Federal Reserve's expectations) but it is highly likely to drag the benchmark 10-year note yield higher as well. As the chart below shows, the spread between these 2 yields is at the wide end of its historic range at 96 basis points (100 basis points is equal to 1%) and we doubt whether it would widen more than another 15 basis points. Should the 30-year bond yields move higher, we should expect to see the 10-year note yield move up to test key resistance at the 4.00% level. A move higher in the 10 year yield will cause lending rates - such as mortgages - to move higher as well; which could have some impact on future economic growth.

(Double click on image for larger view)

Economic Indicators 101

2010-02-12T10:18:00.001-05:00

Almost everyday, there is some economic statistic or number that media pundits discuss as either good for the markets or bad for the markets. It makes sense for investors to have a basic understanding of how the economy works and how economic activity is measured. While we focus and monitor the numbers from month to month, we thought it would be informative to give you a breakdown of the key economic indicators for your reference:

Business Inventories: A monthly running total of how well companies are selling their products, business inventories are a signal to economists. The business inventory data is collected from three sources: the manufacturing, merchant wholesalers, and retail reports. Retail inventories are the most volatile component of inventories and can cause major swings. A sudden fall in inventories may show the onset of expansion and a sudden accumulation of inventories may signify falling demand and hence onset of recession.

Gross Domestic Product: The gross domestic product (GDP) is the most important economic indicator published. Providing the broadest measure of economic activity, the GDP is considered the nation's report card.

The four major components of the GDP are: consumption, investment, government purchases, and net exports. As the barometer of the nation's total output of goods and services, GDP is the broadest of the nation's economic measures.

Consumer Price Index (CPI): The consumer price index (CPI) is considered the most important measure of inflation. It compares prices for a fixed-list of goods and services to a base period.

Unlike other measures of inflation, which only cover domestically-produced goods, the CPI covers imported goods, which are becoming increasingly important to the U.S. economy.

Job Growth: Except for the GDP, the government's employment report is the most significant economic indicator reported, setting the tone for the entire month, providing information on employment, the average workweek, hourly earnings, and the unemployment rate.

Consumers feel more at ease and more confident when the job market is expanding. But when job growth contracts to 100,000 or less month to month, it typically means a recession or slow growth for the economy.

Consumer Confidence: The Conference Board maintains this index of consumer sentiment based on monthly interviews with 5,000 households.

In bad times or good, consumer confidence serves as a reflection of the nation’s financial health. Sometimes the consumer worries about inflation more than unemployment, and at other times the reverse is true. Consumer confidence is far more important to the financial markets during times of national crisis or panic and recessions.

As might be expected, consumer confidence is the weakest during recessions, slightly better on average during recoveries, and highest during expansions (like the decade long bull market of the 1990’s.

Unemployment Index: The government's employment report covers information on payroll jobs, including employment, average workweek, hourly earnings, and unemployment. Unlike the jobs data, which is a coincident indicator of economic activity (it changes direction at the same time as the economy), the unemployment rate is a lagging indicator. It increases or falls following a change in economic activity.

Housing Starts: This indicator tracks how many new single-family homes or buildings were constructed throughout the month. For the survey each house and each single apartment are counted as one housing start, (a building with 200 apartments would be counted as 200 housing starts). The figures include all private and publicly owned units, with the only exception being mobile homes which are not counted.

Most of the housing start data is collected through applications and permits for building homes. The housing start data is offered in an unadjusted and a seasonally adjusted format. Declining housing starts show a slowing economy, while increases in housing activity can pull an economy out of a downturn.

Index of Leading Economic Indicators: The index of leading economic indicators (LEI) is intended to predict future economic activity. Typically, three consecutive monthly LEI changes in the same direction suggest a turning point in the economy. For example, consecutive negative readings would indicate a possible recession.

S&P 500 Index Update

2010-02-05T09:11:00.010-05:00

Over the past five or six months, the broad markets have continued to climb higher, surprising many pundits and economists. When the markets slowly grind higher and bullish sentiment becomes somewhat euphoric (as we saw in the sentiment readings in January), there is a setup for a pickup in volatility. When markets correct to the downside and volatility intensifies, as we have experienced over the past few weeks, the selling pressure can quickly wipe out months of appreciation in the markets; which is why we have been more defensive and cautious since last Fall.

Below is a six month chart of the S&P 500 Index as of yesterday's close. As you can see, we are essentially back to mid September levels in the index, virtually eliminating all gains from the 4th quarter of last year and beginning of this year in just a few weeks - dropping over 8% from this year's high.

Fortunately, there is some good news. First, reported earnings have been fairly positive so far and the economy is improving, albeit at a slow pace; and it's much better than it was last year at this time. Second, this market decline has caused an 180 degree turn in sentiment for both dumb money confidence and smart money confidence. Below is a chart showing dumb money confidence dropping to 46 down from a high of 75, while smart money confidence has risen from a low of 38 to 50; indicating the smart money is becoming more confident in the markets as prices decline. The smart money readings are moving close to the levels from March of 2009. If the markets continue to fall and smart money confidence continues to rise, we will look to become less defensive and more opportunistic, so when the pendulum swings back, we will be on the right side of the market, along with the smart money.

Lessons of the Past Decade

2010-01-29T09:30:00.004-05:00

As we enter a new decade and prepare to navigate the financial markets, it would be helpful and prudent to list the lessons we have learned from the past 10 years so we may be better prepared for the next 10. Below is a brief but important list of those lessons which have taught us the most.

1) The Federal Reserve has more power and influence on capital markets than we ever thought possible.

2) The Federal Reserve is capable of being out of touch with reality for extended periods of time - "what housing bubble" or "the sub-prime crisis is contained."

3) Poor political leadership and decision making can have an adverse impact on an economy in a relativity short period of time.

4) Members of Congress are more dysfunctional and partisan than ever and have lost perspective of what is important to the American people.

5) Non-traditional asset classes can be great investments for extended periods of time - think gold, commodities, and high yielding currencies.

6) Volatile markets can last longer and can be more violent than previously observed in market history. The past decade saw two multi-year declines leading to a negative 10 year cumulative return in stocks.

7) Developed countries, such as the U.S. are well past their prime compared to developing markets.

We believe the next decade will have its own share of ups and downs. Taking into account the lessons from the past decade, we believe there will be many opportunities in non-traditional asset classes as well as non-standard tactical allocation strategies.

China Growth Beats Expectations

2010-01-22T09:28:00.001-05:00

Gross domestic product in China rose 10.7% from a year before, according to a statistics bureau report from Beijing. For the full year, GDP gained 8.7%.

The report has stoked speculation the central bank will begin a interest rate campaign on its benchmark interest rate and tighten restrictions on the nation’s lenders. According to reports, minutes after the release, the People’s Bank of China guided three-month bill yields higher, essentially raising interest rates.

The world may again this year count on China as the biggest engine of growth, with the International Monetary Fund projecting it to expand 9 percent, compared with 1.3 percent for developed economies.

Retail sales in China rose 16.9 percent after adjusting for consumer price changes, the bureau said. The government stated the gain was the biggest since 1986.

Fourth-quarter economic growth was driven by an unprecedented $586 billion stimulus package, subsidies for consumer purchases and a credit-fueled investment boom. The property market has rebounded and a 13-month slump in exports ended last month.

China’s 2009 GDP growth rate was down from 9.6% in 2008. The statistics bureau revised its estimate of growth in the third quarter of 2009 to 9.1 percent from 8.9 percent. It changed the first-quarter figure to 6.2 percent from 6.1 percent.