Confusing Crosscurrents

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The greatest rescue effort in history bailed out the world’s largest financial institutions, pulled the global economy from the brink of recession or depression and fueled a two-year surge in stock and commodity prices.  When initial efforts proved insufficient, governments and central banks stepped up with additional rounds of stimulus.  In this country, equities declined in the spring of 2010 by almost 20%.  With the economy improving but still at recession levels, the Federal Reserve determined that even more stimulus was needed to prevent a complete failure of the initial rescue effort.  That was the “all clear” signal to Wall Street, and investors determined that Fed Chairman Bernanke was unwilling to let market prices or the economy decline meaningfully. 

From the August 2010 announcement of a second round of quantitative easing (money creation), stocks took off again on another 30% up leg into the beginning of May 2011.  Fueled by new money, the economy continued to grow, although at the slowest rate of any post-recession recovery since World War II.

From the early-May high, the U.S. stock market began to retreat, gradually but persistently. For the first time since 2004, equity prices have declined for five consecutive weeks.  Economic statistics are slowing globally, even in the emerging economies.  That has put nary a dent in the Wall Street community’s confidence.  Since economic expansions typically last longer than two years, confidence remains high that the current advance will continue.  The recent slowdown is seen merely as a soft patch to be followed by new stock market highs.

That view of another temporary pullback followed by at least one more stock market high is supported by Lowry Research Corporation, one of the oldest and most respected technically-oriented data analysis firms.  In business since the 1930s, Lowry’s specializes in the analysis of market supply and demand forces.  They maintain that in nearly 80 years the stock market has never made a major top without their measures of supply having first increased substantially.  In the present instance, that has not yet occurred.

While I am a great believer in paying close attention to consistent long-term precedent, there are some extraordinary factors at play in the current market.  This is not a “business as usual” environment.  What cannot be accurately assessed until it disappears is the artificial effect of massive central bank interference in the markets and the economy.  Will normal patterns unfold when government stimulus ends, much less is withdrawn?  It is certainly possible that the greatest-ever creation of liquidity has distorted normal cause and effect relationships in the economy and the markets.

People want certainty.  There is never certainty in markets.  Today, however, even short-term probabilities are hard to discern.  Will the Fed determine that a third round of quantitative easing would be the best approach if economic fundamentals continue to deteriorate?  Should they make that determination, would there be so much political opposition that implementation would become unlikely?  If they did implement some form of QE III, would investors react as they did after QE I and QE II?  Or would investors begin to focus on the inevitable impossibility of repaying the debt created in the rescue efforts?

To add to the confusion, the message of the market itself is conflicted depending upon one’s time frame.  As indicated earlier, Lowry’s figures point to a probable new high prior to any new bear market.  Over the intermediate term, the weakness off the early-May high would point to a probable continuation of this pullback before any meaningful attempt at a new high.  In the very immediate time frame, five weeks of persistent price decline have produced a significant short-term oversold condition.  Most such conditions are worked off by at least a multi-day rally.  There haven’t been six consecutive weeks of decline since 2002.  On the other hand, the market’s tenor appeared to change last week.  Whereas buyers have materialized consistently over the past two years when prices retreated, buyers were noticeably absent last week at points where they would otherwise have appeared.  And Friday’s close was very soft after weak attempts to rally.

With countries on the verge of default, this clearly is not business as usual.  The risk of unraveling debt is huge despite government rescue promises.  We will continue to monitor the message of the market but recognize that crosscurrents are severe.  Rewards are still possible–at least for a while longer–if the government rescue succeeds.  Penalties, however, are potentially even larger should confidence in the government rescue wane. In determining their willingness to accept exposure to risk-bearing assets, investors must assess their own individual ability to withstand the risk of significant loss.

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Another Yellow Flag Waving

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Long term clients and readers of our work know that we pay close attention to the alternating long strong and weak cycles that have characterized the U.S. stock market for more than two centuries. These cycles vary in length, but each phase has averaged just under a decade and a half since the beginning of the nineteenth century. Long weak cycles begin at excessively high equity valuations with investors extremely optimistic about the outlook for stocks. Conversely, long strong cycles begin at extremely low equity valuations with most investors licking their wounds from prior market declines and swearing off stock market participation for the foreseeable future.

The nearly two-decade-long cycle that closed the twentieth century was the strongest ever when combining both return and duration. The current long weak cycle began in 2000 and has encompassed two stunning market collapses and two powerful rallies. Even at the two market troughs of this century’s first decade, however, equity valuations never approached levels that characterized the inception of past long strong cycles. Today’s valuations are more similar to major market tops than to bottoms.

In his May 16 publication, the always-informative John Hussman examined the components of the long weak cycles since the beginning of the twentieth century. With long cycles averaging almost a decade and a half in length, there are inevitably several “cyclical” mini-bull and mini-bear markets within the longer “secular” bull or bear cycle. The following table, which Hussman attributes to Nautilus Capital, delineates all the cyclical bull markets that took place within the four secular bear markets since the early 1900s.

There were four cyclical bulls in the secular bear that covered most of the twentieth century’s first two decades. Three cyclical bulls unfolded in the troubled 1930s, with four more through the secular bear that extended from the mid-1960s into the early-1980s. So far only two cyclical bulls have provided the upside strength in the secular bear that began in 2000. While the average long cycle lasts almost a decade and a half, there is reason to expect that this long weak cycle might exceed that average. The excesses of the powerful strong cycle that covered almost all of the 1980s and 1990s and ended with the explosion of the dot.com bubble will eventually demand correction. Never had valuations nor debt loads been greater.

The table’s second and third columns show the duration and return of each cyclical bull. Columns four and five show the decline and duration of the bear market immediately following each cyclical bull. The average cyclical bull has lasted for 26 months and provided an 85% return. It is interesting to note that no cyclical bull had exceeded 33 months prior to the 63-month marathon extending from 2002 to 2007. I suspect that the Fed’s unwillingness to accept a normal corrective recession and the investing public’s confidence in the “Greenspan put” unnaturally prolonged that cyclical bull. In any case, the current cyclical bull that began in March 2009 is now 26 months long, the average length of its twelve predecessors. The 102% gain in this rally is a bit above the 85% norm.

These patterns are certainly not precise, and many factors can override expected outcomes, not least among them current confidence in the “Bernanke put.” At a minimum, however, investors should recognize that few cyclical bulls extend much beyond the 26 months of the current rally.

Should our assumption that the secular bear market remains intact prove true, an average decline would bring stock prices well under 8,000 on the Dow Jones Industrial Average if the May 2 high is not exceeded. In many respects, this is not just a normal cyclical bull market advance. This rally has been supported by the greatest infusion of new money in history. That money production is scheduled to end next month. It’s noteworthy that the Fed’s prior loose money escapade resulted in a housing bubble and a far greater than average 57% collapse, when the market gave up the Fed-sponsored gains.

Perhaps the Fed will get it right this time, although the stock market and commodity prices are so far the major beneficiaries of the Fed’s largesse. As the QE2 program is coming to its scheduled end, economic growth is slowing perceptibly, both here and abroad. Major corporations have improved their balance sheets, but the average household is still hurting. Overwhelming debt burdens have become commonplace around the world. The caution added by a study of cyclical bulls within secular bear markets is just one more yellow flag waving.

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Are Stock Charts
Pointing To A Global Slowdown?

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It was a pleasure welcoming a number of Tucson friends to our spring seminar on Tuesday evening. We analyzed massive debts and deficits, unprecedented money creation and the implications for inflation or deflation. We also broadly examined global factors that would likely affect the progress of stocks and bonds in the quarters and years ahead. The following is a small portion from Tuesday night’s presentation.

Looking at the long-term stock market charts and analyzing the underlying conditions of the world’s three largest economic powers makes one question the staying power of the current global economic expansion.

S&P500(Source: Decision Point)

Nasdaq(Source: Decision Point)

The graphs of the U.S.’s Standard & Poor’s 500 and Nasdaq Composite demonstrate clearly the rocky road our markets have endured since the turn of the century. At the end of the 1990s, the confluence of excessive debt and absurd stock market valuations led us to forecast the beginning of a long weak cycle that would span a decade and a half or so, give or take a few years. We’re now more than a decade into that long weak cycle, and valuations remain extremely high, although down from the nosebleed levels at their most extreme. The debt crisis, however, is far worse. We’ve made no price progress in more than a decade, and the problems continue.

Nikkei(Source: Decision Point)

Japan’s troubles with excessive debts and extreme valuations began a decade before ours. Thus they’ve had many more years of strong rallies and big declines. While we’ve had two market collapses and two roughly 100% rallies, prices remain below where they started more than a decade ago. Japan’s had more rallies–the biggest of which exceeded 150%–and many more declines. Their prices remain 75% below the level at which their problems began more than two decades ago.

Japan tried to resolve its dilemma by not recognizing the bad loans in its financial system, by bailing out its banks and by dropping its interest rates essentially to zero. They remain in a deflationary, recessionary condition today.

The sad thing is that we in the United States are trying to solve similar problems caused by excessive indebtedness with the same policies: don’t recognize bad debts, rescue the banking system and drop interest rates to zero. The 100% stock market rally over the past two years is testimony to the widespread belief that we will successfully solve these problems with the same tools that have failed badly for Japan and that failed in this country just three years ago.

Nikkei(Source: Decision Point)

It is unfair to directly compare China, an emerging nation, with the U.S. and Japan, the two largest developed economies in the world. It is curious, however, that despite China’s phenomenal growth story, its stock market is selling for less than 50% of what it was 3½ years ago. Clearly there are fears that something will disrupt that Chinese growth story.

There are ample fundamental reasons to justify a slowing global economy. The preceding graphs demonstrate prices beginning to roll over in the U.S., a two-decade-long decline in Japan and a halving of stock prices in China since 2007. These pictures hardly instill confidence in the sustainability of the global recovery as government stimulus recedes.

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Preparing For The Seminar

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Most of my time this week has been occupied preparing for our May 17 seminar. Local readers who have not registered and would like to attend can call or email Steve Pentland at 577-5559 or Steve@missiontrust.com for details.

This week’s blog post is a lightly edited reprint of an entry from August 24, 2009.

The Silliness of 20% Bull and Bear Markets

This is hardly about a critical investment issue, just one of my market-related pet peeves.

In recent years readers of either the financial press or wider circulation papers have regularly read that 20% is the threshold for identifying bull or bear markets. To their credit, some writers acknowledge 20% as merely an “unofficial” bull or bear market determinant, as if there were an official definition. That financial writers and commentators have taken to using the definition regularly shows, at the very least, a lack of thoughtfulness.

The absurdity of using a 20% definition should have been apparent from the market gyrations of late 2008 and early 2009. In the final six months of the market collapse from October 2007 to March 2009, the simplistic 20% measure identified two “bull markets” interspersed among three “bear markets.” After the 33% decline in September and October 2008, the market skyrocketed by 24% from Friday morning, October 10 to Tuesday morning, October 14. Voila! A “bull market” in two market days. Unfortunately, that dramatic spurt didn’t last, and we suffered another 24% “bear market” over the next five weeks. But not to worry, another 22% “bull market” to the rescue in the next month and a half before the final “bear market” into the March bottom. Such a definition of bull or bear markets can make sense only to a statistician.

Perhaps the most obvious refutation of the purely quantitative definition comes from the experience of the greatest stock market collapse in U.S. history. The U.S. stock market plummeted by 89% in less than three years from 1929 through mid-1932. It would be difficult to imagine a bull market mixed into such carnage.

After the initial 48% crash in late 1929, the market bounced by a similar 48% in the five months from November 1929 to April 1930. One could argue that this rally constituted a bull market. I would prefer to categorize it as a substantial rally in a much longer bear market. What is far less open to question, however, is the designation applied to four subsequent rallies, ranging from 20% to 35%, in the 15 months from December 1930 to March 1932. The claim that the market experienced four separate bull markets in just a year and a quarter during the greatest market decline in this country’s history simply makes no sense.

There is no official definition of bull or bear markets. Logic demands, however, that it include some time factor at the very least.

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Investors Are Herd Animals

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Anyone who has taken Econ 101 has studied supply and demand curves. They teach us that when prices are high, we are willing to sell more and buy less. Conversely, when prices are low, we are willing to sell less and buy more. In the world of commerce, a transaction occurs where the supply and demand curves intersect. In the investment world, those curves look different. Take stock prices, for example. After a significant decline, when prices are low, few want to buy. Only after prices have risen does demand grow. And when prices rise persistently for an extended period of time, it is common to see demand grow significantly.

Psychologically, few of us appreciate being called herd animals, but that’s how most of us invest. We get our courage up and become willing to take risks when everybody else is doing it. The more markets rise without meaningful corrections, the more we abandon fundamental considerations and become momentum investors. Almost always, there is a plausible story to justify the advance. Even if investors were previously unenthusiastic about that story, the farther markets rise, the more compelling it becomes. After all, rising prices are confirming it. Today, after TARP, TALF, QE1 and QE2, confidence is solid that the government, especially the Federal Reserve, will not allow the economy and the investment markets to stumble and fall again as they have twice so far in this short century-to-date. Investment insiders now refer to this support phenomenon as the “Bernanke put.” It succeeds the “Greenspan put,” which was widely believed for years until it was eventually debunked by weak economic fundamentals overwhelming loose money.

Sentiment surveys measure the degree to which we investors as a group believe the price of a particular asset will continue to rise or fall. At their extremes of bullish or bearish enthusiasm, the surveys tend to be excellent contrary indicators. Like all other technical indicators, however, they’re not perfect. While bullish or bearish sentiment can, from time to time, remain extreme far longer than normal, the sharpest changes in price direction most often occur from points of extreme sentiment.

In recent months, common stocks, precious metals and various other commodities have gained followings that admit of no realistic potential for substantial, long-lasting declines. On the flip side, virtually all investors expect the U.S. dollar to continue its year-long decline. It’s rare that lopsided majorities remain right for long. At the very least, investors should recognize that for purchases made at current levels to be profitable, confidence must remain high and momentum strong.

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The National Inflation Association Contends That Hyperinflation Is Imminent

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A friend emailed me a wideranging article from the National Inflation Association and asked whether I believe the currency situation to be as serious and imminent as the author contends.  Click here to read the article. I found the subject interesting enough to offer my response as the basis for this week’s blog entry.

The article from the National Inflation Association (NIA) makes a number of interesting arguments.  While I agree with the conclusion that we could potentially face hyperinflation, I see it as just one of a few possible outcomes.  I wrote a blog entry titled “The Danger of Hyperinflation” on December 23, 2010.  My views have not changed.  Let me comment on the specific points in the NIA article.

I concur that the United States has already sunk below a AAA credit rating, but disagree that we should be accorded junk status.  Barring a possible temporary disruption caused by an inability to increase the debt ceiling, the U.S. will continue to pay its debts for years to come.  For the foreseeable future, we are capable of printing our way out of our problems.  While that action precipitates its own deleterious consequences, hyperinflation need not be one of them in the near term.

I do not agree that “the credit ratings agencies have absolutely no credibility left and will be out of business in a few years.”  They certainly deserve condemnation for their role in the recent financial crisis.  Because of very obvious conflicts of interest, they may have been complicit in the deceptions foisted on the investing public.  That notwithstanding, they have largely escaped anything worse than moral outrage, and they have been forced under the microscope of public scrutiny to clean up their acts.  They are still widely used and are unlikely to fail unless successful suits are brought that could wipe them out.

I do agree that Treasury Security Tim Geithner has lost credibility.  He is a government spokesman with a vested agenda to maintain public confidence in the U.S. as a creditworthy borrower.  There is, in fact, no realistic chance that the U.S. will ever satisfy its long-term financial promises in dollars worth anything resembling their current value.  That eventuality, however, could be far short of hyperinflation as last experienced in a major industrial country in the Germany of the 1920s, where the currency became essentially worthless.

The article clearly gets into the realm of hyperbole when it contends “There is no chance of the U.S. ever balancing its budget, without eliminating the so-called untouchable entitlement programs like Social Security, Medicare, and Medicaid.”  These programs have been looming problems for years, despite the fact that we’re only a bit more than a decade removed from our last balanced budget.  Serious modification is certainly necessary, but “elimination” is not required and won’t happen.  Furthermore, the magnitude of the long-term problem with these programs has been recognized for years, and hyperinflation has yet to occur.  In spite of our profligate money creation, we have still been able to borrow at extremely low rates.  So far our creditors have chosen not to concentrate on future payment problems. While there is no certainty that those future concerns will factor into their present considerations, with each year that passes, the risk increases.

The article makes a sound point that a current major defense against U.S. default is our status as the world’s reserve currency.  It is also true that, as the author points out, the world is diversifying away from the dollar.  Diversifying away from and abandoning the dollar as the reserve currency, however, are two very different things.  There is obviously a growing global impatience with U.S. monetary policy, but there is no readily available substitute for the U.S. dollar.  The euro, the yen, the yuan, a basket of currencies or a new gold-backed currency all have been discussed, but each has major drawbacks, and a transition would not be easy or rapid.

The author opines that, “China is likely to begin selling their U.S. dollar reserves and accumulating real assets like gold and silver with this money.  The biggest ever rally in precious metals is just around the corner, which means the U.S. dollar’s purchasing power is about to plummet.”  The article’s forecast could be spot-on.  On the other hand, even if the premise is correct, the predicted conclusions need not follow.  China has frequently voiced its concern with the stability of the U.S. dollar. It has been on a concerted program of buying real assets such as strategic real estate and other resources around the world.  They may continue to concentrate on that type of asset purchase rather than on precious metals.  There have already been huge rallies in gold and silver.  While that doesn’t rule out a continuation of such rallies, one always has to question the extent to which future expectations have already been taken into account by current prices.  While a continuation of the rallies in precious metals could well be accompanied by further drops in the dollar’s purchasing power, that isn’t a necessary consequence.  Purchasing power is more closely related to the dollar’s value relative to other currencies, rather than to the precious metals.  Without doubt, one of the Fed’s goals has been to decrease the value of the dollar relative to other currencies.  Recently they have been eminently successful.  It is unlikely, however, that the other central banks of the world will simply let our Fed devalue the dollar and gain economic advantage.  At some point, currency wars are likely and competitive devaluations could become a fact of life.  Such actions would promote inflation but would also destabilize world commerce, which could in turn lead to recession, which would tend to offset inflation.  What condition would dominate and to what degree would be subject to innumerable unpredictable details and political decisions.

The article argues that both the Paul Ryan budget and the Barack Obama budget “…are simply being used to distract Americans from the real issue, the Federal Reserve’s monetization of our debt…”  I agree that neither budget sufficiently addresses our debt and deficit problems, leaving us with massive deficits even a decade or more from now.  They are just different degrees of bad.

The article offers the opinion that the Fed will likely soon stop paying interest on excess reserves banks have parked at the Fed, in an effort to push this colossal monetary reserve out into the economy.  The author suggests that this massive infusion of new money could “…cause a run on the dollar, with the world rushing to dump their U.S. dollar reserves for just about any real asset they can get for them.”  First, the Fed’s terminating interest payments on excess reserves will only mildly increase the willingness of banks to lend those funds into the economy.  The credit worthiness of interested borrowers is still a major hurdle.  Such a Fed action will have no effect on demand for the funds.  Even at historically low interest rates, there is very little demand for already abundant funds.  The suggested run on the dollar will not occur simply because of an increase in money supply.  There must be an increase in demand and in turn an increase in the turnover velocity of the money in the economy.  These will occur only if the stimulus-fueled economic recovery continues to grow in the absence of the current level of Fed pump priming.

The article suggests a growing danger from accelerating inflationary readings over the past few months.  Much of the CPI surge is related to the jump in oil prices, the demand for which could fall markedly unless the recovery becomes self-sustaining.  The author attributes the oil price rise to the Fed’s loose monetary policies.  Such policies are certainly contributors to inflationary growth. It’s overly simplistic, however, not to recognize worries about the instability in the Middle East and Northern Africa as additional significant factors.  The price increases for oil and gas, while inflationary, contribute to self-correction.  As energy prices rise, use will decline, which will in turn slow economic growth, which will dampen inflationary tendencies.

The author assumes that the Fed will pump even more money into the economy to maintain consumption as gas and food prices rise.  With political attitudes having turned increasingly intolerant of unfettered monetary stimulation, that assumption becomes less likely.

With respect to the potential for spiraling food price inflation, you know far better than I what happens in the agricultural cycle when prices rise.  It won’t take long before lots more supply hits the market.

My devil’s advocate response to the article’s contentions and urgency is not to deny the possibility that they could be right.  I still believe hyperinflation to be unlikely, however, especially in the near term.  The debt excesses throughout most of the world are ultimately an ongoing deflationary force.  They won’t be quickly resolved.  Most of the developed world is still suffering from extreme weakness in residential and commercial real estate.  Add to that the worst unemployment situation in this country since the Great Depression of the 1930s, and it will be very difficult for inflation to take hold.  Strong inflationary and strong deflationary factors may interact violently to create all sorts of economic dislocations with unpredictable outcomes.

Carmen Reinhart and Ken Rogoff have written a magnificent analysis of 800 years of financial crises and their aftermath – This Time Is Different: Eight Centuries of Financial Folly.  Examining hundreds of financial crises throughout the world, of which our recent crisis is the most current, the authors identify several common themes.  Inflation is the most common path back to stability, although hyperinflation is rare.  Such a process, however, usually unfolds over many years typically encompassing a few recessionary episodes.  While inflation may be the normal longer-term outlook, the path to that result is littered with hurdles which may include deflationary periods.  Investments that may benefit from inflation normally are very different from those that benefit from deflation.  The risk of losing money is especially severe during such unpredictable periods.  Flexibility and preservation of capital are critically important until economic stability is restored and values are again historically attractive.

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QUARTERLY COMMENTARY
First Quarter 2011

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Since our year-end commentary, interest rates have risen, Japan has suffered terribly from earthquakes, a tsunami and radiation exposure, and violent unrest has spread throughout the Middle East and Northern Africa.  On a positive note, corporate earnings continued strong, and the flood of money from QE2 has led to additional growth in most areas of our economy. As measured by the S&P 500, stocks advanced by 5.9% in the first quarter.  Treasury bonds were flat to down moderately.  Corporate bonds were slightly positive except for junk bonds, which continued their powerful advance with a 3.9% jump.  Safe short-term investments provided essentially no return.  The Fed succeeded again in “forcing” (their word) investors to assume risk to earn a return.  In general, the more risk one assumed, the more return one earned.

At year end, I wrote a very detailed commentary addressing the many pros and cons facing the domestic and global economies.  I have just reread that document, and it remains entirely current.  While I will not repeat that analysis here, I encourage you to review it on the Mission website.  It presents the many variables that could prove critical in determining the course of the economy and the securities markets in the months ahead.

Headlines assail us daily with reasons why the domestic and global economies could suffer.  European countries are in increasing danger of default.  A growing number of Mid-East countries are involved in armed conflicts.  The giant economic power of Japan has been severely compromised by ecological disasters and their aftermath.  Domestically, employment remains near its weakest levels since the Great Depression of the 1930s.  Housing prices continue to fall, and a huge inventory of homes for sale argues against any near-term price improvement.  Unprecedented and monumental debt levels have become a flashpoint of disagreement between differing political ideologies about the role and scope of government in the years ahead.

Notwithstanding the litany of problems, the liquidity-induced global economic recovery has propelled most world stock markets to three-year highs.  Government willingness to rescue almost all failing countries and essential institutions has promoted widespread confidence that governments will not permit the kind of systemic failure that threatened the world financial system just over two years ago.  The eagerness of most world central banks to fuel the still unfolding recovery with a copious supply of new money has built a firm foundation for investor confidence.

In recent weeks, however, some cracks in that wall of confidence have materialized.  The bodies politic in such countries as Ireland, Iceland and Germany have been less than unanimously willing to bail out all who have been harmed by prior financial misadventures.  On April 15 the yield on two-year Greek debt skyrocketed to 18.5%, demonstrating a very high degree of skepticism that such government debt will escape default in one form or another.

Similar debt has experienced intermittent rallies and declines through the past year as levels of confidence in the probable success of government bailouts ebbs and flows.  This latest manifestation of concern, however, demonstrates that even the most reassuring words of government officials do not prevent confidence from dissipating.

We believe that risks remain greater than potential rewards for both stocks and bonds.  What materializes in markets in the months ahead will depend on whether or not investors remain confident in favorable outcomes.  Governments and central bankers will certainly continue to offer reassurances of the ultimate success of their efforts.  Their job, however, may become increasingly difficult if current trends persist.

Global growth rates are slowing, and inflation in emerging countries is forcing more restrictive monetary policies.  Domestically, QE2 is coming to its scheduled end, and political opposition is growing to any continuation of bailout policies.  Analyst after analyst is dropping current quarter GDP estimates from the 4% level to about 1.5%.  The economy is running the risk of falling again to stall speed despite the greatest infusion of rescue money in human history.  This is testimony to the depth of the hole we have dug for ourselves over the past three decades with our borrow and spend approach to economic life.  There is no easy way out.  There is significant risk, however, that all we have accomplished with our massive rescue efforts is bail out the most egregious perpetrators of financial malfeasance, defer the pain for ourselves and send the bill to our grandchildren.

As recent European events demonstrate, confidence can be a fragile and fleeting commodity.  Investors quickly convert from bulls to bears.  In recent weeks, equity buyers have become scarce, but market averages have not declined by much, because sellers are virtually non-existent.  Any number of events could create an urgency to sell that would propel prices lower.  Our concern is not about a normal correction of the powerful advance of the past two years.  We fear, rather, that the underlying problems of excessive indebtedness have been exacerbated, not solved, leaving our entire financial system in grave danger.  Most of the bad loans remain on somebody’s books.  If the growth of the world economy slows, servicing that debt will become increasingly onerous, especially if interest rates rise.

While there is no certainty that the worst will unfold, that potential is very real.  It would be folly for investors to believe that the government rescue has eliminated the risks that pushed stock prices to 50% losses twice in the past decade.  In such an environment we will continue to look for value in equities or fixed income securities on significant price declines and add as much safe yield to the portfolio as possible from assets not committed to longer term securities.

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Preparing The Commentary

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Preparation of our quarterly commentary has filled most of my writing time this week.  That report should go out to our clients Monday and be posted here next week.

The following is a “Golden Oldie” from August 10, 2009.  It’s a theme that I have emphasized for years to Thomas J. Feeney & Co. consulting clients.

 

Past Performance May Be Misleading

The vast majority of investors view past performance as the quality measure of investment managers.  Of course, they’ve read the caveat on all performance reports: “Past performance is not necessarily indicative of future results.”  Most ignore that completely, especially if a strong track record extends to a decade or more.

Implicit in the confidence born from observing an extended strong track record is the assumption that the manager understood market prospects better than did his/her peers.  That manager foresaw what was coming with greater clarity than did other managers.  Of course, that assumption could be true in any single instance, but I would argue that it is highly flawed. 

Every investment management decision plays itself out over a particular set of future circumstances, a great many of which are unforeseeable in advance.  If we had the luxury of viewing a given decision’s result 100 times instead of just one, we would have a far clearer understanding of that manager’s actual foresight.  Would that decision prove right 70% of the time or, perhaps, just 30%?  Did the manager get lucky this time, despite the probability that the same decision would prove wrong more often than not?

It is critically important for investors to fully understand this as a probability business, not a certainty business.  Managers make decisions based on a long list of assumptions.  Some will prove correct, some incorrect, largely derived from the psychological reactions of households, businesses and governments.  Under either similar or dissimilar circumstances, those entities may react differently leading to a different conclusion.

Investment decisions made in the last dozen or so years have taken place during a unique era in U.S. history.  Leverage amounts and equity valuation levels have reached unprecedented heights.  These conditions may prove to be long-term precedent or they may provoke “What were we thinking?” reactions in future years.  We can’t know, but probabilities would suggest that what appears unsustainable today will not be sustained.  In all likelihood, excessive leverage will continue to be unwound, and levels of equity valuation common before the debt bubble era will again prevail.

Investors should evaluate carefully whether investment manager performance earned through the era of runaway debt is likely to be predictive or whether it is the fortuitous result of a phenomenon unlikely to be repeated.

Selecting tomorrow’s best managers is problematic at best.  You will strongly elevate your potential for success if the managers you examine explore the full spectrum of possible investment outcomes and structure portfolios fully conscious, not just of the rewards for being right, but of the penalties should the market prove them wrong.

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A Very Quiet Week

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There was very little movement in the equity markets this week.  The Dow Jones Industrial Avenue was essentially flat, its price range a mere 130 points from the high of the week to the low.  The other major equity indexes were down by just small fractions of one percent.  Volume continues to be surprisingly low, despite strong corporate profits and a growing economy offset by threatened national bankruptcies, attempted government coups, spiking oil prices and burgeoning debt loads.  These factors would normally be expected to stimulate trading volume, but not now.  Buyers are scarce; sellers have virtually disappeared.  Typically, extended periods of calm precede sharp changes, but the price move could be in either direction.  With high-frequency traders accounting for about 60% of the weak daily trading volume, the potential for short-term manipulation in either direction is high. Short-term traders don’t care about investment fundamentals.  They just want market movement.  This was not their favorite week.

The real action for the week was away from the equity market.  Oil and other commodity prices surged.  The U.S. dollar fell to its lowest level since late-2009.  Gold spiked to all-time highs, and silver was even stronger than gold.  Bond prices broke below support this week as yields approach their highest levels of the past three years.

As I write, the nation waits to learn whether or not the government will shut down at midnight tonight.  At the very least, the political dance being done by the two parties presents the sobering prospect that many more problems lie ahead in the quest for agreement on the debt limit and future budgets.

While the week was calm for stocks, the ingredients for far more excitement are readily at hand.  Short-term traders should not stray far from their computers if they have either long or short positions.

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Does The Stock Market Rally Make Sense?

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I attended the funeral of a friend yesterday. At the reception afterward a newly-made acquaintance asked whether I thought the rising stock market made any sense in light of peripheral European countries wrestling with default, the earthquake, tsunami and threatened nuclear meltdown in Japan and numerous Middle Eastern and North African nations in revolt. It’s a question being asked consistently on financial news stations, in the press and on the cocktail circuit. His follow-up question was whether he should remain in a highly risk-averse position, which he adopted when the bad news hit, or whether he should reestablish equity positions and take a chance that stocks will continue their upward climb in the face of news that would normally push prices down.

While it did not fit the questioner’s actual situation, his questions reminded me of the old adage that the market can remain irrational longer than you can stay solvent. In other words, from time to time the market can and will do the improbable–even the irrational–far longer than people anticipate. This puts a premium on risk control. In the current situation, the long list of negatives is countered by world monetary authorities flooding economies with liquidity. So far, that liquidity as well as investor confidence that it will continue has trumped all the negatives. It is conceivable that the Federal Reserve and other world central banks will succeed in re-energizing the global economy without kindling destructive inflationary fires. That beneficent outcome, however, is not the norm when governments try to bail out economies after banking crises. Almost universally, as pointed out in copious detail in This Time Is Different by Reinhart and Rogoff, economies struggle for several years before returning to some semblance of normalcy.

Owners of equities today should evaluate the landscape carefully. The major stock indexes have doubled in price over the past two years but still are at prices first reached in 1999, the start of the decade of no return. While the economy has grown vigorously off the recession’s severely depressed trough, most economic measures are still at levels typical of weak, not strong economies. Corporate profits have surged higher, but ratios of valuation such as price-to-earnings, dividends, book value, sales and cash flow are all above historical norms. In fact, all but price-to-earnings are at or near all-time highs but for the recent bubble years that produced essentially no stock market return. On a historical basis, stocks are extremely expensive.

Equity buyers today will profit only if the Fed’s liquidity flood succeeds in overcoming the long list of negatives, and if this time truly is different and the economy and markets don’t suffer their normal fate following banking crises. Alternately, the successful trader can make money if the market continues higher, and that trader is astute enough to recognize telling signs of the ultimate market top. Unfortunately, nobody rings a bell at such tops. Few traders successfully lightened their equity positions before the disastrous market declines that began in 2000 and 2007. Compounding the danger today is the near-unanimity of bullish conviction. As a result, equity allocations are near their upper limits. The exit doors are not very wide if many decide to leave at the same time. With the flash-crash peril of last May still fresh in our minds, the danger of a repetition creates the potential for a large gap down, should something shake investors’ confidence suddenly.

We have chosen to remain highly risk-averse until we find more stocks at historically attractive levels of valuation. This approach is especially important for any investors with largely irreplaceable capital.

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