Posted by: Steve | June 24, 2009

Market Commentary: 6/24/09

A Trip Down Scenario Lane

 

All investors are compelled to guess the future direction of the economy and the stock market. Whether by gut feeling or the use of sophisticated mathematical algorithms, the future is not predictable and any attempt to forecast it is a futile enterprise. Past performance will give us no more insight into the future than crystal balls or astrology. Warren Buffett quips that if past performance were all that was required to be successful, all of the rich people would be librarians.  Furthermore, Wall Street types who forecast the market really have no more clue than you or me; however they compound their problem by giving pin-pointed forecasts which are wrong most of the time.

The Four Most Likely Scenarios

It is far better to approach this question by coming up with a list of reasonably valid scenarios that include the full range of economic outcomes and then try to attribute a rate of return for the market over the next 5 years. While not perfect, this can be done with some accuracy, due to the fact that we are forecasting a range of returns over a longer time horizon (5 years).

Scenario 1: “Muddle Through”

This suggests an economic recovery in late 2009 or early 2010 continuing with a less than normal recovery for several years. Also Inflation gradually rises.
 
Scenario 2: “Stagflation”

This also suggests an economic recovery in late 2009 or early 2010 and a less that normal recovery for several years. However it is followed by STRONG INFLATION in the 5-8% range near the end of the five year period.

Scenario 3: “Severe Recession Accompanied by Deflation”

This is a bitter scenario because it forecasts an extended and deep recession causing prices to spiral downward through 2010. The recession does end but the following economic growth is very anemic.

Scenario 4: “Goldilocks”

Everything is just right because the Government’s “kick-start” gets the economy growing in late 2009, followed by average growth with moderate inflation.

Since these are the four scenarios most likely to occur, the next question we need to ask is: What are the possible returns of the stock market under each scenario?

Before examining the chart, let’s get a little knowledge about a few of the numbers that appear in the first two rows.

First we want to add up all of the companies’ earnings that make up the S&P 500 and compare them to the price of the S&P. In 2008 the S&P’s earnings added up to about $501.  As of this writing the index of the S&P stands at just under 900, therefore a simple math calculation puts the price as a multiple of earnings to (PE) around 17. Just to reiterate, this means the average company in the S&P 500 sells at 17 times its earnings.

Now this PE multiple thing is not a static number. A lot of things like interest rates and inflation among other things can affect it, but our research forecasts the following earnings and PE ratios under each of the four scenarios. The chart below organizes all of this and forecasts possible returns based on a given price level of the S&P 500.
  Blog Chart.6.24.09
 
 
Look at the left hand column under “Starting S&P 500″. Go down to the number of 900 which is where the S&P 500 is at the current time. Following across, one can see the possible returns under each scenario. Under the Muddle Through scenario, the possible future annual return of the S&P 500 over the next five years is 5.2%. Under the Stagflation scenario it’s 2.7% For Deflation it is between -3.5% and .5% and under Goldilocks; 13.9%. (Hurray for Goldilocks).
 
Realistically, we don’t know which scenario is going to work out so to be extra careful, we would want to buy the S&P 500 at a lower price just to build in a margin of safety.
 
Move up to 800 on the left hand column and the numbers start to look better, but not ideal.

During the latest  sell-off which occurred in March of ‘09, the S&P 500 dipped to 680. I don’t think we will see the 680 lows again but I do think 750 is a good possibility, so let’s look at that.

The possible future returns at 750 range from .05 to 18.5%. If we eliminate the extremes of deep painful recession and a goldilocks economy, we are left with returns in the 7% to 12% area. This is a decent return and one that will create real wealth for those with the patience and fortitude to stay invested. This return won’t come easy, however. Remember I’m forecasting an average annual return. The word average sounds safe, but it is one of the most dangerous words in the investment vocabulary.
 
“You know it don’t come easy…”  
– George Harrison
 
For example, it can be said that if you have your head in the oven and your feet in the icebox, your average temperature could be 98.6o, but of course you will probably not be around to measure it.

The same is true for investing. To get an average rate of return of 10% you will probably have to experience annual volatility of 20% and maybe more. That means that the range of returns in any one year could swing by 40%. This is not for the faint of heart and as we saw last year, many were not able to stomach it and keep their faith about the future.

There we have it; an idea of possible future returns under four economic scenario at numerous price levels of the S&P 500. This is not crystal balling, nor is it wild guessing. In my opinion, since one of these four events will actually occur, we can choose our entry back into the market accordingly. We can control our investing destiny rather than having the market or our emotions control us.

This is the essence of successful investing and the essence of wealth creation.

Steve…
 
1Source: Standard and Poors

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Posted by: Steve | May 28, 2009

Market Commentary: 5/27/09

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I am always searching around for good ideas, and when I find them I send them along to you. This one was written in 2006, by “JLP” and it’s quite good. The title of this post was inspired by Stephen Covey’s best-seller: the 7 Habits of Highly Effective people. 
  Steve……
 

 The 7 Habits of Highly Defective Investors 

1. They don’t have an asset allocation plan

We’re all familiar with the common wisdom that says that 90% of a portfolio’s performance is determined by the portfolio’s allocation. I don’t know if that is true or not, but the fact remains that having an asset allocation plan and sticking with it through rebalancing, makes a lot of sense. Why, because it brings discipline to the investing process. When a portfolio has an asset class that performs extremely well compared to the other asset classes in the portfolio, human nature tells us to the sell the poorer-performing asset classes and buy MORE of the asset class that just performed well. In reality, we probably should do the opposite and sell some of the appreciated asset class and buy more of the underperforming asset classes.

2. They invest for the short term, using long-term investments

Stocks, a long-term investment, should only be used for goals that are more than 5 years away. Although it may be tempting to meet a short-term goal with a hot stock, it is never wise to do so.
 
3. They check their portfolio’s value too often
 
The reason this is a bad habit is that constantly thinking about one’s portfolio tends to give the portfolio a short-term feel, which can lead to short-term decision-making.
 
4. They get stock advice at cocktail parties
 
Although it might be fun to trade hot stock tales at parties, it can be hazardous to a portfolio unless the tip is followed-up with lots of research.
 
5. They are envious of other’s successes

This ties in with the last point. Listening to a person brag about their 60% return can make anyone envious. However, keep in mind that they probably are leaving out some important details such as the fact that all their other stocks are in the toilet. In other words, congratulate them and change the subject.

6. They watch too much CNBC

I’m not saying CNBC is a bad thing. However, I am saying that too much CNBC can turn a long-term investor into a short-term trader. Consider changing the channel or cutting back on the business news.

7. They pay TOO MUCH in fees

I cannot stress enough the importance of keeping costs down when investing. For the most part, the more an investor spends in fees, the less they will have at retirement.

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Posted by: Steve | April 17, 2009

Market Commentary: 4/6/09

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Been Down so Long it Looks Like Up to Me
                                           –Richard Farina

The Current Dilemma.
 
Now that the stock market has rallied, investors are in a quandary. Should they continue to hold stocks and hope to recoup more of their money back, or should they sell into the rally in the hope of avoiding more carnage if the market falls once again? They ask themselves: “What if this is just a rally in a continued bear market? They would be right to think so, just look at the chart below.

Chart 1

 chart2
 
Every single market rally was followed by a decline, some benign and some quite vicious (August 2008 -December 2008). The same thing happened between 2000 and 2003.

Chart 2

 chart

 However, instead of continuing its downward slide like most experts forecasted, the market entered a new bull phase lasting until November 2007. Chart 3 shows the rise starting in 2003.

Chart 3

 another chart
Putting It Into Real Dollars

If the value of your 401k or IRA stood at $500,000 on October, 2007, it would have declined to $225,000 by February 2009. One month later, the value of your investments would have been grown back to $275,000 (Using the S&P 500 as our proxy).

Therefore any rally as represented in Chart 1, would have represented a selling opportunity. For example, by March 10th 2008 your $500,000 would have declined to $415,000. By November 17th, it was valued at $254,000.
Just like the 2003 period, we never know if the previous bottom is the final bottom. Unfortunately, looking at the past does not give us enough information to predict the future. Like driving, looking only in your rear view mirror, the past may give clues, but its ability to forecast is limited.

Is There Any Way To Cope With This Uncertainty?

Yes, but the first thing to do is take a fresh look at today’s environment. Put the past behind you and look forward. Ask yourself if the economic landscape has changed since those dark days of 2008?

I would have to say that compared to the terrible events in October and November 2008, we have seen positive changes in financial markets. It is just a flicker of change, but change nevertheless.  I know, a flicker is not a flame and a few drops of water do not make your glass half full, but notable changes are taking place. Here is a short list:

1) The Government has stepped in and backed nearly everything.
2) Banks now have new rules regarding the pricing of their bad assets.
3) Banks are starting to lend again. As a matter of fact, Bank America just announced they are re-entering the jumbo mortgage market.
4) GMAC, the financing arm of General Motors, also said Wednesday that it would resume making loans to subprime borrowers in order to spur sales.
5) The decline in orders for a number of companies is beginning to flatten out; suggesting the rate of decline is slowing in many cases.
6) Production in increasing in China.
7) The stimulus has not even started yet.
8) Interest rates are at historic lows.
9) The price of oil is showing signs of life.

The jury is still out and many economic challenges remain and many smart people continue to predict the economy will get worse before it gets better.  However, there is a sense on my part, of an end to the free-falling economy and stock market.

How Does One Make A Decision Under These Stressful Conditions?

One way is to try and determine if the stock market is “under-valued”, “over-valued” or “fairly-valued”. A person I respect, who has studied valuation successfully for many years is Jeremy Grantham, head of GMO. (Click on the link to find out more about him). Grantham uses a simple investment idea in a sophisticated way to determine “fair-value”. He also understands there will be times when the markets will go too high and too low relative to “fair-value” and he knows that what goes up will eventually come down and vice versa. He calls it “regression to the mean”.

The chart below shows the performance of the “DOW” from 1965 to 2007. The straight line going up the middle is the trendline or average. The tech bubble is the area above the trendline between 1998-2001. Interestingly, after the big decline in 2002, markets did not go below the trend line, indicating a move back to fair-value. The market rose again until 2007, declining dramatically bringing the market to what  appears to be a significantly “under-valued”. This is a simplistic picture and not meant to directly reflect Grantham’s calculations, but it does illustrate the point.

its the last chart 
 
Grantham thinks fair-value is currently around 900 on the S&P 500 (The DOW is not a very good measure of the market anymore). Today the S&P 500 stands in the lower 800’s, having sunk to a low of 675 on March 9th, 2009.

This is information we can use. We can be more assured of success buying below the trendline than either at it or above it. The only problem, as Grantham has experienced on more than one occasion, is the curse of being TOO early. These trends of over and under valuation do not change overnight. Sometimes they can last for years and be quite frustrating.  If the market is over-valued and you sell, it can continue higher and make you feel you are losing opportunity. If the market is under-valued and you buy, it can become even more under-valued making you feel you have made a big mistake. During the period between 1995-2000, Grantham shouted loudly that the market was severely over-valued and was deemed dead wrong for 3 years. He stuck to his guns however, and even in the face of losing many accounts, he was eventually validated. (Warren Buffett often suffers the same fate).

Today, while everyone is screaming the “sky is falling”, Grantham is buying stocks during the deepest of the market declines. He can do this because he is willing to be wrong for periods of time thinking he will eventually be proven right.
My job is a bit different. I must take a more exacting course because my first concern is to preserve capital.  Instead of grabbing the extreme bottom or top of the market, my philosophy is to grab the middle two-thirds thinking that it should be enough to create wealth over the long term.

To this effect I remain cautious but poised at the trigger to enter at the “right” time.

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Posted by: Steve | March 6, 2009

Market Commentary: 3/2/09

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The Doom and Gloom of it all…

Many investors are now asking when their stocks will get back to even.  My response is always; “What do you mean by even? Is it the amount of money you initially invested, or is it the amount that your investments were worth on the day the Dow hit its high on October of 2007?” Human nature, being what it is, the answer is usually the latter: the value at its high. We all tend to anchor on the highest number we can remember.

Think of your house, for example. You probably remember the price your neighbor’s house was sold for during the very good times. I know I do. My house was originally purchased for $215,000 in 1996, and I remember seeing it worth over $500k as other homes sold in my neighborhood at that price. (Of course, they didn’t have the extra features my home had). When I looked up the value of my home on Zillow.com the $500,000 value was further reinforced.

I understand my home is now worth somewhere in the neighborhood of $300-$350,000 which is a decline of 30-40%. Yet, from my initial purchase, my home is still higher in value by 40-60%. If  I’m not selling, how important are these numbers to me?  Important in mainly one respect. What we all want financially from owning our own home is for the value of the home to keep pace with the cost of housing in general. In other words, in order for me to have enough flexibility to move to another home, I would need the capital from my first home to be close to the capital needed for my new home. If prices are rising, I will have more money to pay for a new house whose price has also risen. If I was renting, I would not have the money to pay for the higher cost of a new house. Fundamentally, home ownership enables us to keep pace with the rising (over time) cost of housing in the United States.

You might say: “Fine Steve, but that’s your house, what does this have to do with my investments?” I suggest it’s very much the same thing.

Think of your 401k or IRA for example. Values were much higher 16 months ago (I’m sure you remember THAT number) and yes, today’s value is lower, but are you spending any or all of that money right now?  If you’re not using all the money today, it’s like staying in your home. It doesn’t really matter what its worth this day or this year. It will only matter when you are ready to spend it all.

You may reply: “But, I came into the market late and the current value of my 401k is LOWER than all of my monthly contributions combined! I don’t have the satisfaction of seeing the value of my 401k worth more like you do with your house.”

True, but what is the real effect on you? In hindsight we know now that the values 16 months ago were high and perhaps the future rate of return from those high numbers will not increase much for the next 5 years or so, but the future rate of return from today’s prices, should be MUCH higher.

Let’s look at the stock market. The Dow reached approximately 14,000 in November, 2007 and let’s say from that point, stock prices rise at a rate of only 3% per annum on average. (Not a very good return from the 14,000 level.) If this is true, the level of the Dow will be 17,734 in 10 years. With the Dow now around 7,000, the annual rate of return from 7,000 is 9.75%. This is far better than 3% you would earn if you did nothing, so you can see the benefit of continuing to invest when prices are low.

Of course nothing is ever this simple and there certainly are unknowns. Maybe the market won’t appreciate 3% over the next 10 years from the 14,000 level (even though history suggests a high probability that it will earn more.)  Nevertheless, right now you only have to beat the 2.5% return you earn on your risk free investments like CD’s or Treasuries to be successful. That, I think should be relatively easy to accomplish.

How then, do you weather this awful downturn? 1) Turn off financial TV. (…except when I’m on, of course.) 2) Suck in your belt and get your emotions under control. Think past this recessionary cycle. Investigate the downturns of 1973-75, 1980-82, 1990-91, and 2000-2002. You’ll discover each one of those periods felt scary and different from the previous recessionary period. Experts lectured about the end of capitalism or the irreparable damage to America’s position in the world. These lectures and conjectures continue today.

Remember though, if you didn’t buy into their negativity back then, you likely would have profited very well, and chances are, doing the same in these days of uncertainty will profit you very well indeed.

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Posted by: Steve | February 19, 2009

Market Commentary: 2/16/09

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The Cycle of Market Emotions

There is a psychological “sea-change” taking place before my eyes and I am beginning to recognize a sense of fear I haven’t seen so far in this cycle. Many I talk with, think the stock market is headed for a huge fall and absolutely want no part of it. I can understand their fear, but this is starting to feel like the beginning of one of the big mistakes people make when the news is at its dreariest. Allow me to explain.

There is a natural cycle to any “risk” type of investment. Whether we are talking about Gold, Real Estate, Foreign Securities, -even the bond market. As markets rise, people become hopeful and encouraged. They may start to buy-in as they notice the economy and the stock markets improving. This is natural and healthy. As the markets continue to rise, hope turns into optimism and excitement as their earlier decision is reinforced by the rising market. Every new investment is rewarded with a higher value a few weeks or months later. Investors are feeling very smart while being constantly reinforced by the news of improving fundamentals. Companies are hiring and expanding and profits are rising. They are also growing domestically and internationally and Countries, which historically have had impoverished financial systems, start improving bringing wealth to many of their people who once had little hope of a decent material life. All is good. So good, in fact, that now new people are entering the market trying to get in on the action.

Let’s examine Real Estate as a recent example. As interest rates declined and home prices rose, more and more buyers entered the market with sound fundamental reasons behind their purchases. Homes were affordable and rising prices reinforced their decision that the home purchase was a good idea. This continued for many years reaching a point where prices rose well past reasonable fundamental value.  By the time speculators entered the market, people were predicting ever higher prices, due a rising economy as far as the eye can see. This had real estate investors stirred up to the point of euphoria and hysteria.

It continued for a relatively long time, well past the point of rationality and reason. Investors just continued to focus on rosy news reports and rising prices until just when everyone involved reached the maximum point of euphoria, the music stopped. This point of maximum euphoria is the point of maximum financial risk. In other words, when you are feeling that investing is easy and low risk, and you are feeling most secure and assured, investing is at its riskiest point and the probability of high future returns are low.

What has this got to do with today’s investing environment? You might be wondering why I’m talking about rising markets when we are in a completely different part of the economic cycle. Prices are low and seemingly continuing lower. Nothing good is being reported by the media and now, even the White House is forecasting doom unless they get their money. In addition, I am starting to get panicked calls from clients and others who think they should be out of the market at any cost.

This is the cycle I just described turned on its head. Let’s see how we got here.

In early 2008, prices began to weaken and the market became more volatile. Investors felt a little anxious, especially as volatility picked up, but the experience of the last few years had demonstrated to them that holding on would be the best thing. This was not unreasonable. Stock prices were nowhere near their highs, relative to earnings, as observed before the dot com crash of 2000. The economic news was still pretty good and while there were some difficulties in the mortgage sector, the FDIC, the Federal Reserve and the Treasury Department seemed to handling things in an orderly manner.

But the news began to get worse and fear rose amongst investors when in October and November Wall Street began to unravel. Banks were in need of huge infusions of cash, brokerage firms were crumbling under the weight of bad investments and too much leverage and access to credit became so restricted that borrowing virtually ceased. The Stock Market had a heart attack.

Fear rose to desperation and panic as the news started to get pretty bad regarding the economy and everyone finally opened their statements and gasped. So now investors’ fear factor started rising but no one really wanted to sell into that great decline. Now, a few months later, clients tell me about so-called sophisticated investors who are saying they are pulling out of the market. I am hearing from liberal radio that the Bush administration didn’t tell Obama how bad it really was and conditions are much worse than they appear. CNBC is full of experts making prognostications about the rest of the year and, day after day, the front page news tells the facts about a deteriorating economy. This feels bad and people are discovering that successful investing is hard to do and can be high risk.

I am suggesting that while this condition can go on for a while, we might be near the flip side of the cycle I described earlier-the opposite of euphoria. Remember I just said the following: “When you are feeling that investing is easy and low risk, and you are feeling most assured, this is the time when investing is at its most risky!

Now I am saying that in these times when investing is hard and seems very risky and you are most fearful about your money, it is the time when investing is actually safer and more rewarding in the future.

That is why Buffett and others are buying today.

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Posted by: Steve | February 2, 2009

Market Commentary: 2/2/09

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Introducing Your New Partner, Mr. Market

Let me tell you a story about two partners that went to work together every single day. The first partner, you could say, was the operating partner; let’s call him “Mr. Operator”. He toiled a full day, growing and managing his business in a very diligent manner. The second partner did not operate the company, but he was the guy with the money. He was the investor; let’s call him “Mr. Market”. Mr. Market would talk to his partner, Mr Operator, every day without fail, since the very first day of the business. Each day Mr. Market would offer to buy the business at a price he thought represented the future value of the company.

However, there was one caveat. Mr. Market suffered from manic depression, and like most manic depressives, he was elated for periods of time and hugely depressed for others. On the days he was feeling most positive and optimistic, he would offer a sky high price assuming the future prospects were unlimited. On the days he was depressed, he would offer a very low price, afraid that Mr. Operator would unload the company at too high a price.

This went on day after day after day. Even though Mr. Market was the money guy, Mr. Operator was a smart guy too. He really understood his business and had a good idea of what is was really worth. He never took Mr. Market’s offer price as an indication of the value of the company. He knew that one day he would sell to Mr. Market, but it would only be at a time when Mr. Market was in his overly optimistic, manic phase. You see, he knew what the business was worth, so he could choose the price at which to sell. He knew that Mr. Market’s price was based more on emotional factors than on facts.

All investors who buy and sell securities in the stock and bonds markets have Mr. Market as a partner too. As the operator of your investments, you may choose to buy-from or sell-to him at his stated price, always aware that the choice is yours. You see, it’s up to you to know the value of your business, never confusing the price that is offered with the real value of your investment. It may or may not be the true value, but it is up to you to know.

Since the beginning of 2009, Mr. Market has been quite manic. As expected, Mr. Market was feeling pretty good. A new President, a new congress, the promise of change lifted his spirits and his view of the future. This is a common occurrence at the beginning of most new years, and in true form he offered higher and higher prices for a few weeks—just a few weeks, because soon his mood began to darken once again. He started concentrating on the negative. Yes the economy was bad, and the media was sighting statistics that described it in detail, but Mr. Market acted confused, and couldn’t make up his mind from day to day. One day, he would push up the price for companies and the next day he would push them back down like a see-saw. Day in and day out he has been acting this way for the entire month. If news hits the screen about the fall of “New Housing Starts”, prices go way down. If another report surfaces about a rise in the number of houses sold, the market zooms higher.

If you are an active trader, you have to decide whether you are willing to trade with this manic depressive, not knowing what mood he will be in- on any given day. Or you can sit on the sidelines and wait for him to present an offer to you to buy something at a low, low price. If you do decide to buy from him at a low price, you can now wait for the return of Mr. Market’s overly optimistic periods. You have to know what your business is really worth and you can choose to sell to him on your own terms.

Right now, I choose to wait on the sidelines until Mr. Market gives me an offer I can’t refuse.

Looking at January

Concerning January’s performance, I will share with you some thoughts and insights from Sam Stovall, Chief Investment Strategist, Standard & Poor’s Equity Research:

The S&P 500 fell 6.4% month to date through January 29. This would be the second consecutive year in which the S&P 500 declined during the opening month of the year. Since 1929, there have been five other times that the “500” tripped up in two successive Januarys (1956-57, 1973-74, 1977-18, 1981-82 and 2002-03). In the remaining 11 months of the second year of these “double-dips,” the S&P 500 gained an average 3.0% and rose three of five times. But don’t get your hopes up too quickly. Twice the market fell in January three years in a row (1939-41 and 1968-70).

Why should we care if the S&P 500 rises or falls in January? Because of an old Wall Street adage, first observed by The Stock Trader’s Almanac that states: “As goes January, so goes the year.” A positive performance by the equity markets in January has typically led to a gain for the full year, while a negative performance in the first month usually signaled a decline for the entire year. Of course, past performance is no guarantee of future results.–Sam Stovall, Global Equity Strategy, January 29, 2009

What to do now.

What am I doing? I’m culling the herd, so to speak, getting rid of the weakest investments. I am buying bonds at 6+% and dabbling in the preferred stock and junk bond arena, getting yields of 11 and 15%. These investments are riskier, so consult your advisor before doing this on your own.

Stock wise, I’m still on the sidelines having ended my “phasing in’ strategy earlier in the month due to negative technical readings.

At this moment, there are no signs pointing to a rising stock market, which leads me to the conclusion that the next few quarters might be rough.  However, many stocks remain at historic lows and any sign of a bottoming out of the economy will, in my opinion, send these stocks soaring once more.  Patience will be needed and patience will be rewarded.  In the words of a better philosopher: “Patience is bitter, but its fruit is sweet.”–Rousseau.

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Posted by: Steve | January 22, 2009

Market Commentary: 1/19/09

Three Important Questions

 

• What to do now in 2009
• How to get a decent return without so much risk!
• What to hold and what to sell

 

Before answering these three questions please allow me to recount how we got to this point in the first place.

2008 began like any normal year. The economic outlook was good as was the health of the stock and bond markets. I felt there would be some economic slowing throughout the year and bumpier ride in the stock market so I raised cash in advance. It was like the mood you’re in on a beautiful day 20 minutes before your house disappears in a Tornado.

The tornado that comes out of the blue then bam! all hell breaks loose.

First, oil rises to $148 per barrel, and everyone’s paying 4 bucks and over for a gallon of gas. Experts start predicting a rise to $200 per barrel and most other commodity prices start going up dramatically causing inflation to rise with no end in sight. (We start seeing videos of masses of people from China and India switching from bikes to cars). Then, as fast as oil prices rise, the price drops to $40 and gas at the pump is $1.80 again.

Now we hear that housing prices are declining faster than expected and many homeowners are unable to make their payments and foreclosing, so the banks start losing billions and the economy experiences a credit panic not seen in 75 years. This scares the heck out of everyone causing the stock market to unravel which is followed by a huge government bailout as banks continue to weaken. Then, established investment companies start merging or going out of business and interest rates rise dramatically on everything but Treasury obligations. The final icing on the cake for 2008 is the uncovering of the most diabolical Ponzi scheme in history. What a mess.

But just as seems it could get no worse, the panic subsides, and credit markets start to improve. (See my commentary: The Great Thaw, week of January 12, 2009)

Here we are today, bewitched and bewildered, sitting on a pile of uncertainty wondering if the storm has passed, wondering if this hellish ride is over. Hoping it is safe to come out of the bunker to assess the damage.

In order to know if it is safe, let’s look at the current state of affairs and the important numbers to ponder:

Interest Rates:

• Rates are falling. Mortgage rates are 5+% but they want to go even lower.
• T-bills are at .2% and you would only get 3% if you loaned the Government money for 30 years!
• Prime is at 3.25% so if you have a home equity line of credit you are only paying a pittance.
• CDs are at 2-3%
• Many stocks are paying higher dividends than Treasury bonds which we haven’t seen since the 50’s.

This is good news.

Inflation:

Declining, and expected to stay low for a while.

Good news.

Unemployment:

Rising and rising fast. The economy basically shut down in November and December and companies are adjusting to the situation.

A strong negative, especially since consumer spending makes up 70% of our GDP.

Real Estate:

Still declining but at a slower rate. Housing is affordable once again and low interest rates will help too. Homebuilder stocks are up 40% in the last 2 months. Maybe the market sees something new brewing

Look for some positives later this year.

Oil:

Low and likely to stay low as the economy remains weak. A lot of the banks and hedge funds are no longer driving prices wildly up and down. Typical supply and demand dynamics have returned putting some sanity back into pricing.

This is good.

Banks:

Still reeling and not ready to come out of the woods for a while.

A big negative.

Corporate Earnings:

Corporate earnings are soft and won’t move until credit becomes available once again to the consumer. We need the banks to improve dramatically before that happens.

Not good.

Government Spending:

A trillion is the new billion. A lot of stimulus and economic support is coming our way and our new president is committed to getting the economy back on track by investing in infrastructure and public works programs. It will be interesting to see how well this works, but the old saying: “don’t fight the fed” means you don’t want to bet against this huge amount of stimulus.

For the economy this is good right now. For the future????

Stock Prices:

Stocks are valued as a function of future earnings and current interest rates. Low rates make stocks more valuable. So this is a positive. Future earnings are also important. With rates this low and earnings expected to grow, on average, 6-8% per year, stocks are currently a good investment and will probably yield double digit returns in the next 10 years.

Prices are attractive

Bonds:

• Investment Quality Bonds yield over 6%
• Preferred Stocks yield over10%
• Low quality (junk) bonds are yielding 15-20%. This is a risky category but you are, in my opinion, getting paid to take the risk.

Bonds are very attractive.

Three Important Questions Answered

• What to do now in 2009

Keep a decent amount of cash in your accounts but don’t sell out of your stocks entirely. Get rid of the weakest companies and replace them with high quality companies. Look for so-called “fat-pitches”. These are the pitches you get in a game of softball that you just know you can hit out of the park. Wait patiently to buy any stock and then “swing” when ready. That is what we’re doing.

• How to get a decent return without so much risk!

Bonds are a very good way to do this. Picking individual corporate bonds is getting trickier, so for the time being buying mutual funds or index funds is a better way to go. Let the manager decide on which bonds to buy.

• What to hold and what to sell.

Today, picking the right individual stocks is more risky than ever so I would invest in either larger index funds that invest in the S&P 500, RUSSELL 2000, overseas markets and the like. This will help you get broad access to the market without the risk associated with owning just a few stocks. When this market turns, these funds will do very well.

Add some gold to the mix and some funds which can hedge against market downturns.

Summary:

All in all, I’m not entirely negative right now. The news will continue to be mixed with a negative slant, and it may get scary once again, but stock prices are reflecting most of what is already known. If there are any positive surprises, the market may rise strongly, if the surprises are worse than expected, be ready for more turmoil. Hopefully you have planned for this and you will survive to fight another day.

Finally, regarding very short-term market conditions:

We did get a cautious buy signal about four weeks ago and started to invest some sideline cash on a stepped-in basis adding 20% at a time. That signal has failed to follow through so I am currently in a holding pattern waiting to see what we will do next. I will keep you informed.

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Posted by: Steve | January 15, 2009

Market Commentary: 1/12/09

Click here to listen…

The Great Thaw

We are now going through a period which I am calling the Great Thaw and in order to have a great thaw you need a very deep freeze, and boy did we ever get one in 2008. It was the greatest economic freeze we have seen in a long time.  It occurred in October and November and created a panic so furious that practically every investment around the world fell sharply in value. In those few short months, the world financial system nearly came to a crashing halt mostly caused by a deep freeze in the credit markets. 

Like a river which flows when temperatures are moderate, but stops flowing as temperatures decline, the flow of money can also stop circulating under extreme conditions.  These conditions occur because banks lose confidence in the value of their own investments. In a tizzy about the loss of their own capital, banks become less confident about lending to other enterprises as well.  You see, if banks aren’t sure they will get their own money back from the loans they provide, they will stop lending money to others.  When banks can’t trust their best clients to pay them back, lending stops; hence, the deep freeze.  One way to tell the extent of the freeze is to follow the rate of interest banks charge on loans.  If money is tight, interest rates will rise, and rise they did in 2008. Commercial paper rates reached 7% (which means that no money was really available) and LIBOR, the rate banks charge each other, rose to such extreme heights that capital became literally unavailable to companies in need. Once money no longer flows, the financial system can seize up and bad things will happen.  I don’t want to think what this may have meant for the rest of us.
 
To the rescue came the Federal Reserve and the Treasury. They rushed to get billions of dollars released to the banks in an effort to shore up their capital, and prevent the economy from grinding to a halt.  The government tried a number of different strategies, some of which did not work or worked too slowly.  The strategies’ degree of failure or success, as measured by the reaction of interest rates and the stock market, proved discouraging. As a result, the Federal Reserve decided to insure everything the banks owned and every investment the banks had made, without discrimination.  The scope of this governmental intervention surpassed anything seen before.
 
The Federal Reserve even reached out to private companies who asked for help. These companies have been in the news all through this crisis; AIG, General Motors, GMAC, Fannie Mae and so many others.  The government allowed investment companies like Goldman Sachs to become bank holding companies affording them the same privileges and protections as Citicorp, BankAmerica and Wells Fargo.  From my perspective, having been in the business for so long, conditions must have been very, very bad for a top-notch firm like Goldman Sachs to give away their Golden Goose in order to survive.  Companies like Goldman Sachs hearken back to the industrial age and have always been fiercely independent risk takers.  These are the companies that have survived trying times before and earned fortunes for their partners and shareholders.  Watching these companies turn into banks, boring and highly regulated, is an astonishing event to experienced investors. I wrote during that time that I had seen “the mountains move”, and as I continue to view the investment landscape from my office every day, I still see those tectonic shifts taking place right in front of me.  However——-I have some good news.
 
The Panic of 2008 is over.
 
Companies are starting to enter the market again and issue bonds to raise capital.  Important interest rate levels have returned to normal and investors are starting to come out from their hiding places and invest once again. This is the beginning of the Great Thaw (at least in the bond market). This thaw will trickle down to the rest of the economy in due time. Like a person who has experienced any serious trauma, it will take some time for the economy to shake off the shock. As interest rates come down for mortgages, and housing becomes much more affordable, buyers will return and the housing market will improve once again. The cycle will swing up as it always does. This is just one example of the benefits from the Great Thaw and I look forward to many others as the years’ progress.
 
Therefore, I am optimistic about the next few years and I am inclined to begin adding to riskier investments as I see these benefits of the Great Thaw.  Am I saying the economy is getter better right now? No, I am not.  Am I saying the bear market in stocks is over?  No, because it’s probably not.  Right now I am only saying one thing; the deep credit freeze is over and the Spring Thaw is upon us.
 
I look forward to a glorious summer.

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Posted by: Steve | December 22, 2008

Market Commentary: 12/22/08

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Fratricide?  Patricide? Genocide?

Investicide

Somewhere among the moneyed elite, you may have heard the following conversations:

“I hear you want to invest in the fund, so tell me about yourself (Let me see if you are worthy)

Where do you live? Oh, there? Check.

Gobs of money, Check., (nice Bentley in the driveway, by the way).

Charitably inclined, Check.

Okay, so who do you know? No kidding…Check.

Well, I’ll tell you what. You got a million to invest? Why don’t you start with $200,000 and we’ll go from there. See if we get along, okay? Yes, yes, yes, you’re welcome–don’t mention it.  I’m happy to do a favor for one of our kind.”

From all accounts, these were the conversations going on in exclusive hotels and country clubs around the world. The person talking is Bernard Madoff (Bernie to his friends) and his minions. This is a small part of the story that is unfolding as the days pass by. The story of the largest Ponzi scheme in history. $50 billion dollars of history.

It is said that Steven Spielberg was an investor with Madoff. It would seem that he had a close encounter of the 3rd kind, which, by definition, is direct contact. I, on the other hand, had a close encounter of the 1st kind, which is a sighting of odd lights and objects not attributable to human technology. My sighting came 10 years ago, when a CPA asked me to comment and review the returns of a very successful money manager. One of his clients was very excited by the possibility of investing with this manager. What bothered the CPA and subsequently bothered me, was the questionable consistency of the returns. Records showed gains of 10-15% per year; year in and year out. Not a single year of negative returns. I looked over the material and stated bluntly that this was not possible, and I advised him to pass on this. Luckily, he did.

This, for me, was a simple observation. I had never seen or heard of anyone who could invest like this, and having read many books about the world’s greatest investors, I knew the basic rules of the stock market, one of which can be explained by the following metaphor: “If you’re in a boat, and the boat is in the water, when the tide goes out, you have to go out with it”. In other words, if you are invested in the Stock Market, it is impossible to get in and out of the market consistently and successfully over any long period of time. Because of the laws of financial physics, it is impossible. Like gravity, what goes up must come down.

How did so many people get fooled? Everyone is asking themselves the same question. How could so many people entrust their entire savings to one person? Even a few professionals were fooled and they should have known better. Professionals know how to diversify appropriately. They know that one manager, even with very good investment results; will lose money at some time. It takes a well diversified portfolio to protect you from this fact. Diversification prevents these types of devastating events. Interestingly, Madoff made no pretentions to diversification. He had one strategy, and that was his secret. It is reported that he freely told investors that he would reveal how he invested the money and it seemed a matter of pride. No one could do it like him and because he did it for so long, everyone believed him.

What can we learn from this? Madoff’s strategy could have been considered hypnotic. According to Laurence Leamer, author of “Madness Under the Royal Palms”; if Madoff handled your account, you could boast about having the largest financial gains to your friends. It was an honor if Madoff managed your money. He had the Midas touch. Madoff was a God.

How did he succeed for so long? How did he pull this off? To answer this, let’s examine the psychological reasons he succeeded. I’m not a psychologist, but I have my own ideas.

First, he was smart enough not to publish or pretend he had made the highest returns. If his fund was rising 28% per year for 10 years everyone would have been suspicious. He just promised 10%, a very reasonable return. After all, hasn’t the stock market risen at an average rate of 10% for the last 80 years? Most people don’t realize that the term: “average return of 10%” is very misleading. Here’s why. It is said, “If you have your head in the freezer and your feet in the oven, you’re average temperature is 98.6 –but you’re dead”. Or “The average temperature in Dallas, Texas is 78 degrees, but it’s 110 in the summer and 25 in the winter”. You see, it’s misleading. Some years the market can rise by 10 and 20% and in other years it may fall by 30%. The average may be 10%, but the sequence of these returns can really hurt you if you’re not prepared. Madoff’s trick was to use consistency as his lure. This is an old sales technique called the “Puppy Dog “close and I want to thank my friend Bob Irish for this one.

The “Puppy Dog “close is used by pet stores to “help” you make a decision to buy a puppy while you’re already in the store. The salesperson knows the decision to buy a dog is a big one. It’s a big commitment to care for a puppy for many years, and it may give you pause. To make the decision easier, the salesperson breaks the purchase down into smaller increments. This allows you to make a small decision instead of a large one. Instead of just buying the puppy, the salesperson suggests you just take it home for a little while and if you don’t like it, bring it back. He knows that once this dog licks your face and starts playing with you, you’re probably NOT bringing the dog back! It’s the “Puppy Dog” close.

Once Madoff’s new investors became involved and got a taste for those steady returns, they were not going back!

Madoff’s club was an exclusive club. You may remember how it felt to be excluded from cliques in high school and how good it always feels to be a part of something special. That is how it felt to invest with Madoff. You were a part of something special. If you had Madoff, you were special. Investors didn’t investigate Madoff before they invested, he investigated you! What a brilliant switch!

He took advantage of our love of celebrity culture. We love and admire our celebrities and endow them with major powers and gifts of insight. If it was good enough for Steven Spielberg, it’s surely good enough for me. Steven Spielberg is a movie making genius, but does that make him a savvy investor?

Finally, Madoff was using what is now referred to as viral marketing. This is the same as word of mouth, only stronger. Viral marketing is a technique that uses pre-existing social networks to produce increases in brand awareness. You know, you tell two friends and they tell two friends etc. This is very powerful stuff and very hard to resist.

So what should you do if you are presented with one of these too-good-to-be-true investment schemes?

Use your good sense. YOU do the due diligence–it’s your money. Do your homework. Don’t take someone else’s word for it. Try to keep your emotions out of it, and remember Groucho Marx’ famous saying: “I won’t belong to any club that would have me as a member”.

If you give your money to a manager, make sure he is not holding the money in his own brokerage account, or that your money is not comingled with others unless it is a registered security. If it’s not registered, have a securities attorney look over the documents. Also, it is preferable that the money sit at an independent firm, a firm that is separate from the manager.

Finally, know what you own. Look for diversification. Diversification will protect you from a lot of serious mistakes made by investors. Stay vigilant. You have worked very hard for your money, so make sure the person managing it, respects it as much as you do.

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Posted by: Steve | December 15, 2008

Market Commentary: 12/15/08

A Year-End Synopsis and a Not-So-Close Call with

Mr. Ponzi.

 

We are approaching the end of 2008 so it’s time to look back and make sense of what happened. It is also time to look ahead to possible opportunities on the horizon.

Before I begin, however, I want to relate a personal experience to you that has become news this week. In 2000, I received a call from someone looking for help in investing a friend’s money. Then, like now, the market was declining and his friend had experienced some significant losses. I took the portfolio and fashioned it, as usual, for growth and asset preservation.  

 

The person referring his friend was using a money manager that showed consistent returns year in and year out. I’m talking 10% returns, no matter which way the market was moving. Every year his portfolio would rise by about 10% with never a down year. I knew this couldn’t be true, so I asked for the statements and trading reports to see what was going on. I spent the good part of the week studying the material, but couldn’t find anything suspicious. The manager was trading in and out of positions on very specific days, making regular profits but there was nothing incriminating on the reports.

 

This manager, by the way, was very well known on Wall Street as a major Market Maker for many important stocks. A market maker is a company whose function is to aid in the market, by making bids and offers for his own account in the absence of public buy or sell orders. In other words, it’s a company that is very involved in the order flow from investors around the world. I chalked his performance up to the fact that he was so involved; he could get in between the flow of buy and sell orders.

Of course, I couldn’t come anywhere close to these types of smooth consistent returns and eventually the client left as he was able to convince this money manager to take his friend’s account. 

 

Last week it was revealed that this manager’s name is Bernard Madoff and he is accused of running a $50 billion Ponzi scheme. This is the largest fraud I know of using a Ponzi or pyramid scheme. The scheme involves using new investors’ capital to give old investors a return on their investment. This pyramid works well until there are no new investors to entice, or old investors start asking for their money back. This seems to be exactly what happened. Investors, spooked by the market asked for $7 billion of their money back and the manager was unable to pay. Madoff confided to senior people ( his sons, apparently) that he had been running the Ponzi scheme for many years and he was broke. I heard about this from a CPA whose client has $12,000,000 in the fund. The CPA’s client was the person who had come to me 10 years ago. He lost it all, I understand.

 

I think you all know the lesson here. If it’s too good to be true then it’s probably a scam. I feel very bad for anyone involved in this type of scheme and any “I told you so’s” don’t help anyone, but I have seen this so many times in my years, that each time it happens I’m still surprised. These schemes ALWAYS lose in the end. They have to. It’s a law of financial physics. There is always a trade off. It’s important to note, if you are looking for higher returns and have placed your money in the stock market, real estate market, gold, currency, oil etc.; you are always assuming some risk. If the risk has been abated, then the return has to adjust as well. There is no free lunch.

 

Let’s continue with my commentary, and look at the numbers through December 12, 2008   For the month through December 11th, the Dow is down 2.99%. For the year, the Dow has decreased 35.43%.From the high reached on October 9th, 2007, the decline has been 39.53%. The S&P 500 has decreased 44.18%.  

 

These are horrific numbers. It took the S&P almost 3 years to lose 40% between 2000 and 2002. This time it has taken less than one year. From the high on October 9th, 2007 to the low on 11/20/08 the market declined 52% which was the third worst ever. The number 1 and number 2 declines took place in 1932 and 1938, down 62% and 54%, respectively. There were 5 other declines greater than 40%, 4 took place in the 30’s and 1 in 1974.

 

Bespoke Investment Group, provided these numbers, and they feel we are now in a bull market, as hard as that is to imagine. They define a bull market as one in which there is a 20% rally after a 20% decline. They believe the bottom of the market was the November 9th, at the 7,500 level on the Dow.

 

Whether we are in a bull market or not, the technical reading for the market still shows no signs of an imminent recovery just around the corner.

 

Finally, are there any opportunities for high returns in 2009? The answer is yes, a few good ones are taking shape. Two are in the bond market and one is a complete surprise.

Bonds

 

The two opportunities in the bond market are associated with good quality and low quality corporate bonds. 

 

Normally, to measure corporate bonds’ risk/reward, you look at the difference in the yields as compared to treasuries. This difference or spread is currently well above normal due to the credit crisis. A normal spread is 2-3%, today the spread is 5-7%. This means you are getting paid a lot of money for the risk you are taking.

 

High Yield bonds are yielding even more. The spread between “junk” bonds and treasury bonds is at a historic high of 12%; i.e. high yield bonds are currently paying 15 to 20% while treasuries are at 2.5%. This spread pays you very handsomely for the risk you are taking.

 

Now the surprise. An asset class that is currently undervalued is Real Estate. As a matter of fact, the shares of home builders have increased 30% from their November 20th lows, so something is going on here. Real Estate Investment Trusts, which invest in all types of Real Estate, from residential to commercial properties are now paying dividends of 6-9%, as investors worry about office building vacancies in 2009. It is obvious that commercial real estate is under pressure from the slowing economy, but once again, you may be getting paid for the risk. There is no hurry to act on any of these items so I will be buying these investments discriminately as the opportunity arises.

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