Dightman Capital - Global Market Monitor

An Important Clue About Stocks In 2009

2009-01-05T18:52:00Z

For those of us interested in what 2009 holds for stocks the next few weeks may offer an important clue. December failed to produce a meaningful "Santa Claus Rally". Stocks did trend up most of the month but only closed up 0.8% above November's close. Not a bad feat considering the first trading day of December started with a nearly 9% decline on the S&P 500. The end of the year did see some impressive gains. From the 24^th - 31^st the S&P 500 advanced just over 4%. Unfortunately, most institutional investors were on vacation and trading volumes were very light. However, we did see an improvement in stock leadership with companies like Life Partners (LPHI), Tower Group (TWGP), and Gentiva Health Services (GTIV) breaking out and companies like McDonald's (MCD), Stanley (SXE) and Mantech (MANT) approaching good entry points. As a broad measure of stock leadership, however, the IBD 100 lagged the other broad indexes in last week's rally.

Despite a horrible retail sales season, deteriorating employment conditions, and continued weakness in residential real estate, the stock market is always looking forward and we should have a pretty good idea in the next few weeks if the market thinks the U.S. economy will be on better footing by this summer. With lower oil prices, a large economic stimulus package in the works, lower mortgage rates and resilient U.S. workers, perhaps we will be able to look back on November 2008 as the lows of the Credit Crisis Bear Market.

On the other hand, if stocks fail to rally meaningfully in January the likelihood that the November lows will be tested and potentially broken increases. If you are on the sidelines with cash, or in positions you would like to exit, it is a good time to pay close attention to market action.

Is A Santa Claus Rally Underway?

2008-12-18T01:06:00Z

The first trading day of December started off with the Grinch in control of stocks. Only a day later stocks rallied and accomplished a follow-through day and as the month progressed stocks continued the rally that was launched from lows hit in late November as shown in the chart below.

It is not surprising that stocks have advanced this month; December is historically a strong month for stocks and has often been associated with "Santa Claus Rallies". My job is to determine if this is more of a bear market rally or the start of a new bull market. With horrible economic news arriving every day only to be compounded by the biggest Wall Street scandal ever, it is hard to believe stocks can rise in this environment. Despite the headlines stocks are holding ground, even advancing. It helps to remember the stock market is forward looking by many months and should start a recovery in advance of any evidence of improved economics.

The current rally has been able to avoid distribution days, described as a day when prices fall but volume increases from the previous trading day. Unfortunately this cannot be said of foreign markets. While many of the Asian markets are up aggressively since this rally began in late November (iShares FTSE/Xinhua China 25 Index Fund is up 47% since November 20th), the Shanghai exchange has experienced three distribution days during the period, Hong Kong exchange four.

I believe this rally will ultimately fail for the several reasons. The start of a new bull market will involve more volume. Stock leadership is another component that is missing for the current rally. There have been some improvements but not enough to bank on. In the early stages of a new bull market many leading growth stocks break out into new price territory and that is scarce in the current rally.

From a fundamental perspective, I believe stocks are going to find it difficult to continue to appreciate until credit markets improve and the financial sector has completed the deleveraging process.

Another troubling development in the current rally is the price action in U.S. Treasury Bonds. They are soaring in price. This is a sign investors are still very uncertain about the future for stocks along with a deflation concern. During bull market rallies money leaves the safe haven of bonds and is invested in stocks, which does not appear to be happening in this market. Today we see so much money going into Treasuries that real yields have been pushed into negative territory (interest rate - inflation). 10 year Treasury bonds are yielding approximately 2.63% and inflation is currently listed at 3.66%, creating a yield of -1.03%. Take a look at the price action and pick-up in volume for the iShares 20+ Year Treasury Bond Fund.

We are not left completely void of opportunities in this market and selective entry into a few areas makes sense given the number of months and magnitude of declines in this bear market. The drop in crude oil has presented some unique opportunities and metals/mining stocks have performed very well over the last month. The ability for stocks to hold up in the face of some terrible economic news lately is impressive and it is possible stocks could move into a confirmed bull market from these levels. There are also some interesting opportunities in debt market and dividend stocks worth reviewing. For this reason I believe careful moves back into the market makes sense.

Important Week Ahead

2008-12-01T01:24:00Z

As the month of November came to a close stocks rallied and in the process gain 19% in the last 5 trading days to close down only 7.5% for the month. November 21st kicked the rally off but the day ended with Nasdaq volume falling 4%, generally not the way you want to start a new advance. Breadth was also light with winners beating losers by a modest 9-to-5 ratio on the Nasdaq, and less than 2-to-1 on the NYSE. The last 4 trading days took place during a holiday shortened week causing volume to taper off as the advance developed. While some individual stock leadership has appeared it is still very thin and combined with some of the previously mentioned shortcomings; the overall action leaves me skeptical this rally will be sustained.

In terms for the bond market, corporate junk bonds remain under price pressure and yield nearly 24%. As the stock market improves you would expect junk bond yields to decline as prices rise. On the other hand, 10 year treasury bonds continue to appreciate, sending their yields down to 2.94%. In response to the most recent government action to bring relief to the home market mortgage rates did see a drop with average 30 year fixed rates around 5.76%.

A series of cabinet and administration appointments by President-Elect Obama helped kick start the stock buying. He tapped New York Federal Reserve President Timothy Geithner to be the next Treasury Secretary. Mr. Geithner's intimate knowledge of NY based financial institutions and his direct involvement in several of the rescue deals already announced could prove to be helpful as the government continues to navigate the volatile credit crisis.

World economic data continues to be mostly weak and domestic leading economic indicators I follow indicate the worse may still in front of us. The residential housing market remains under pricing pressure base on the most recent data released by S&P/Case-Shiller. Inflation in the U.S. and many other places around the world appears to have cooled, but when I pay nearly $4 for a stock of celery I'm not so sure.

Next week will be an important test for U.S. stocks. After big price advances for the broad indexes, additional volume and wider participation would be a welcomed development in the days and weeks that follow if we expect recent lows to mark a bottom in the current bear market.

President Elect Obama & Investors

2008-11-06T16:58:00Z

With the elections over we can now turn our attention to how President Elect Obama is going to potentially affect our investments.

Given the magnitude of the economic challenges his administration will face, it will be interesting to see how President Obama handles taxes on dividends & capital gains, which are both set to expire on January 1st, 2009. If left alone dividend rates will rise to match standard income tax rates, while capital gains taxes will increase to 10 or 20%, depending on a filers' income level. Currently they are zero and 15% depending on the filers' income level.

In terms of investment themes, oil looks to be an attractive investment opportunity. Crude oil prices have come down substantially in the last year and Obama appears reluctant to aggressively develop our own oil resources, which may help drive prices back up. The opportunity is not without potential threats, specifically a possible windfall tax on oil companies that Obama has suggested. Fortunately there are many different ways to get exposure to crude oil prices and navigate an uncertain tax environment.

Another side of Obama's energy policy is likely to center on Alternative/Clean energy. Fortunately, here too there are many ways to gain exposure to solar, wind, nuclear and even technologies designed to make carbon based energy production and usage cleaner.

With less potential near term impact on capital gains than dividends, assuming he does not raise rates further, it may be more efficient to focus some taxable investing on growth versus income. That is unfortunate given the attractive dividend yields and uncertain growth opportunities found in today's market.

The more daunting challenge for investors is the unfolding credit crisis. The global economy is under tremendous pressure and government intervention so far appears to be coming up short. The research I have reviewed recently indicates we may have much further to go before a recovery can take hold.

Desmond Lachman of American Enterprise Institute presented data recently that suggests residential real estate inventories are still at record high levels (11 months) and more supply is coming on line as foreclosures surge and demand declines. He suggests prices could fall another 10-20% before the market stabilizes, sometime in the 2^nd half of 2009 as illustrated in the chart below.

Nouriel Roubini, professor of economics at New York University, founder of Roubini Global Economics and a respected international economist expects the total fallout from the credit crisis to total $1-2 trillion. He believes the problem has already spread to credit cards, automobile, and student loan sectors. Leveraged municipalities are also at risk and he expects corporate default rates to surge. He believes the next phase is already underway and involves credit and trade contraction spreading to emerging market countries, with a dozen or more in or headed to a state of crisis. He believes more downside surprises are in store from a variety of economic reports and corporate earnings will disappoint to the downside. His biggest concern is in the credit default swap (CDS) market where hedge funds and other participants still pose a financial crisis risk.

John Makin, a principal at New York based hedge fund Caxton Associates, and an advisor to the Federal Reserve System and Bank of Japan is considered an expert on central bank policies. He is concerned government policy decisions to date have not made much of a difference in addressing the credit crisis. While LIBOR rates have come down, there is still very little inter-bank lending taking place. He believes banks may be more inclined to use the cash infusions for mergers and acquisitions. He referred to the Taylor Rule, which is a guideline for targeting Fed interest rates based on GDP growth and inflation. The trouble is the Fed cannot lower rates below 0% and currently the Taylor Rule suggests a Fed target interest rate of -2%. It is currently at 1%.

Chris Whalen, co-founder and managing director of Institutional Risk Analytics, outlined what he is calling the three phases of the credit adjustment. He thinks we are about half way through the adjustment, having completed the loss recognition phase. We are now in the second phase where losses are realized and Q3 bank losses climbing rapidly. The final phase will involved credit losses broadening beyond mortgages. He also called out a concern with the CDS market, calling it the next financial crisis. The CDS market is magnitudes larger than anything that has been dealt with so far and it is not well understood. His concern is that corporate defaults could suck liquidity out of banks for years. He used the graph below to illustrate problems in the banking industry.

The IRA Banking Industry Stress Index combines standard measures of bank performance (profitability, default rates, capital adequacy, loan exposure, and operating efficiency) and is at its highest level in 20 years. He believes at least two of the largest remaining commercial banks will need additional liquidity injections. You will find many additional banking industry resources at the IRA website.

I believe the evidence suggests we have not seen the final chapter of the credit crisis and helps explain why markets have not been able to compose themselves. Volatility remains high and long-term technical indicators remain bearish.

President Elect Obama and his administration have a difficult task ahead. Decisions made early in the process will likely have a significant impact on this first term and the ability of the U.S. economy to recover; a result Americans would welcome.

Earnings & Elections

2008-11-03T20:31:00Z

After a dismal performance during the first part of the month, stocks tried to regain their footing last week and delivered a gain. Despite the final effort, which was not all that convincing, it did not prevent October of 2008 from delivering one of the worst monthly performances for the S&P 500, down nearly 17%.

By the close of the month approximately 65% of the S&P 500 companies reported 3rd quarter earnings and appear to be sending profits to an 11.7% decline. The net result has created a lower P/E ratio for the S&P 500 as a function of stock prices declining more than earnings.

P/E ratios may be in even better shape due to the effect of those companies reporting losses. As an example, a healthy company with a market value of $100 billion and earnings of $5 billion has a P/E of 20. Combined with an unhealthy company with a market cap of $5 billion and losses of $4 billion creates a market value of $105 billion, earnings of $1 billion, and a P/E of 105. This obviously does not make sense and is one of the pitfalls of looking at combined P/E ratios at a time when some companies are experiencing massive losses. While the S&P 500 P/E ratio has come down recently it is still well above the level that has historically been associated with new bull markets.

The stock market has historically led economic recoveries and the resilience of the U.S. economy has consistently demonstrated outstanding recovery capability in the last few recessions. It is still unclear, however, if we have complete visibility regarding the problems that remain in the off-balance sheet activities of commercial banks. In addition, consumer spending contraction appears to be in the early stages and if a more saving conscious (or debt reducing) consumer is part of the overall solution, the business sector is going to feel the pinch. Add to the mix state and local governments in financial trouble with more than 30 states faced with large deficits, and this recovery may take longer than expected.

Elections are tomorrow and the outcome may result in an increase in dividend and long-term gain tax treatment. The uncertainty around future tax rates has created an additional consideration in an already challenging investment environment. If the possibility of higher taxes does materialize, it may influence a change in the structure of our taxable portfolios. Regardless of who prevails in the Presidential and Congressional races, it is my hope that tax rates are not raised and our elected government representatives focus on spending cuts to balance the budget and reduce the deficit.

With P/E ratios a little higher than we would like, several economic headwinds still blowing strong, and a potential change in tax policy, we are maintaining our defensive bias.

Time To Buy?

2008-10-18T19:34:00Z

Many investors are wondering if we have found a market bottom. With Warren Buffett out buying stocks, shouldn’t all investors be doing the same? The risk of entering the stock market at this point has declined. However, the major bias is still down. During the last week we did have some constructive activity and if we see more in the near future it would help to signal an even lower risk entry point. We plan to deploy some capital in a newly created “opportunity fund” by one of our investment partners designed to take advantage of idiosyncratic opportunities the credit crisis has created. We have also identified two high yielding dividend investments, one of which is tied to the energy industry. With the decline in the price of oil, it may be a much better time to enter that market. The best thing an investor can be doing at this point is to scan the horizon for attractive opportunities, build watch list, and under some circumstances carefully deploy capital. We do not expect to reinvest our capital at the bottom, but we would prefer to do it after the bottom has passed versus watch our investments decline in value. That being said, we are willing to take some risks at this point, but are not yet ready to fully commit our cash.

There are several other reasons for caution. U.S. indexes have not witnessed a new group of strong individual stocks to lead the market. A few candidates have emerged, but the quality of any rally improves dramatically when strong stock leadership accompanies it. Stock markets internationally have also delivered little bullish conviction. While some markets are seeing price improvements, most remain muted and lack volume.

One way to take advantage of a depressed stock price is to use this opportunity for gifting. At current prices you are most likely able to gift a much larger number of shares, within the same dollar limitations, then you were a year ago. If transfer of wealth is on your radar, from concentrated stock or a large portfolio, now is a great time to consider action.

Part of our investment process involves an analysis of the business cycle. We are keenly aware the stock market usually improves ahead of evidence of an economic recovery. Our trusted provider of leading economic indicators, an institution with three generations of expertise, continues to indicate more trouble ahead. We prefer to see an improvement in the stock market coincide with a turn up in leading economic indicators for our investment strategy to become aggressive. Still, we are willing to take some risk ahead of data alignment, especially in asset classes with a unique characteristic.

On the economics front, the Cleveland Fed lowered the U.S. inflation rate to 4.94% from 5.37%. Our inflation outlook remains muted and asset prices sensitive to high future inflation have not signaled a reason for change. The government borrowing tied to the recovery program may be causing an unintended negative side effect, that of pushing some borrowing costs higher; the rate for 30 year mortgages jumped to 6.47%, up from 5.98% a week earlier. Short-term money rates have come down but the negative Ted Spread remains very wide. Housing starts are at 17-year low which could eventually reduce the supply glut of homes on the market, partially the result of an increase in foreclosures.

Failures at Fannie Mae & Freddie Mac

2008-10-13T19:30:00Z

In the midst of our current economic crisis it is natural for many people to lay the blame at the feet of the most convenient targets; perhaps as an emotionally driven response to an emotion filled situation, but as Americans we would be better served to dig deeper into the details and let the facts we uncover be our barometer. It is then we can root out the chief perpetrators of our Fannie Mae & Freddie Mac crisis and start holding those officials involved accountable for their part in this crisis.

This commentary is not an exhaustive review of everything that led up to the collapse of Fannie Mae and Freddie Mac, but it does highlight many aspects that have been underreported. This information comes from a summary of a five part series recently published by Investor's Business Daily as well as other sources.

We face big fiscal problems in this country and there is no shortage of political incompetence from our elected representatives on both sides of the isle. There were also irresponsible choices made on both Main Street and Wall Street. I believe it is going to take some critical thinking on the part of all Americans to get us out of this fiasco. I believe we live in a great country, enjoy tremendous freedoms and have opportunities available to us that can be found nowhere else on this planet. With our freedoms come responsibilities, both as an individual and a citizen, and I am encouraging you to examine how our government works and why it may not be taking your best interests into account.

$700 billion dollar problems rarely happen overnight and as you will learn, this problem has been in the making for decades. The current credit market problems came to roost at the government sponsored enterprises, Fannie Mae and Freddie Mac. To understand how they were able to operate in a manner that allowed them to cause so much damage to our economy, we need to go back in history to President Jimmy Carter and 1977.

It was during that year that some well meaning Democrats in congress brought the Community Reinvestment Act (CRA) into law. Democratic Senator William Proxmire described the intention of CRA from the Senate floor as "to eliminate the practice of redlining by lending institutions." During the 70's, "redlining" was the term used to describe the practice of taking deposits from a low-income part of town and loaning the funds to higher-income areas. The practice left minority communities starved of capital for housing and needed to be addressed.

Community activists viewed the law as a necessary step to bring the American dream to low-income families. Initially the CRA was supposed to extend lending to poor areas based on principals "consistent with safe and sound lending practices." So far so good, but the latter provision was ignored as CRA was implemented and, as you will learn, later modified.

Regulators largely left policing of CRA to community groups like ACORN (Association of Community Organizations for Reform Now) and NACA (Neighborhood Assistance Corporation of America). During the process those organizations diverted billions of dollars from banks and lent the money in poor communities. But the process was not entirely altruistic; these organizations took in thousands of dollars in fees for every loan. Some of the loans even required recipients to become active in questionable community causes.

In 1994, the CRA was rewritten under the Clinton administration through his National Homeownership Strategy. The changes to CRA broadened the CRA in ways Congress never intended. Instead of putting the changes before Congress, Clinton ordered Robert Rubin to rewrite the rules in 1995. The rules in effect made it harder for a bank to get a satisfactory "rating" by CRA. If you did not loan enough money to diverse borrowers, your ability to expand or merge became more difficult. A favorable CRA rating is important in the banking industry. Banking is a highly regulated industry and virtually every major action requires the approval of some government entity.

Howard Husock, a scholar at the Manhattan Institute wrote, "Bank examiners would use federal home-loan data, broken down by neighborhood, income group and race, to rate banks on performance." Yet, those rules were not enough. President Clinton persuaded the Department of Housing and Urban Development (HUD) to double-team the issue. Andrew Cuomo, Clinton's HUD secretary made a series of changes to Fannie Mae and Freddie Mac that allowed them to get into the subprime loan market in a big way. Other rule changes allowed the quasi-government agencies to hold just 2.5% of their capital to back investments versus 10% for banks. This single change allowed the bad loan problem at Fannie and Freddie to get much bigger. Since Fannie and Freddie can borrow funds at much lower rates due to their government-sponsored status, banks poured billions of dollars into loans that required no money down and no verification of income. From 1994 to 2007 subprime lending surged from $35 billion to $1 trillion.

One of the regulators of Fannie Mae and Freddie Mac emerged in the 1992 Federal Housing Enterprise Financial Safety and Soundness Act. The Office of Federal Housing Enterprise Oversight (OFHEO) was an arm of HUD. From the very beginning OFHEO was essentially a toothless regulator because each year Congress had to pass its budget; a unique characteristic among financial regulators. It was relatively easy for Fannie and Freddie to keep OFHEO off their backs; they funneled $200 million to various political causes and community activists while donating to 354 political candidates of both parties.

There were warnings. In 1992, Republican Jim Leach of Iowa was on the floor of the house talking about the potential danger Fannie Mae and Freddie Mac posed to our economy. The Washington Post reported Leach warned that Fannie and Freddie were changing "from being agencies of the public at large to money machines for the stockholding few."

As the Clinton Administration came to a close, Treasury officials under the new Secretary, Lawrence Summers, became increasingly concerned with Fannie and Freddie. Undersecretary Gary Gensler in 2000 made a request to Congress to end their special status. Democrats were in an uproar and so were Fannie and Freddie, who at that time were headed by politically connected CEOs. "We manage our political risk with the same intensity that we manage our credit and interest rate risk," Fannie CEO Franklin Raines, reported to investors in 1999. Mr. Raines was forced out of Fannie Mae after it was found to have engaged in fraudulent accounting practices. He passed the incident off as mistakes by subordinates and paid $24.7 million to settle the case. The former aid to President Clinton was compensated to the tune of $91.1 million between 1998 and 2004 by Fannie Mae. Given the questionable management that led to its eventual failure, why would any politician want to have direct links with the previous CEO's, Franklin Raines and Jim Johnson, of Fannie Mae?

There are some that would like to pin the crisis on the GOP led 1999 Gramm-Leach-Biley Act which repealed the 1933 Glass-Steagall Act. The new law allowed commercial banks to participate in a much broader assortment of financial services essentially expanding their customer base. Many experts believe this actually helped lessen the current crisis. A quick review of events helps us understand why. Investment banks Bear Stearns, Lehman Brothers and Merrill Lynch all got into such deep trouble they were either merged with a commercial bank or filed for bankruptcy protection. Bank of American and JP Morgan Chase could not have come to the rescue if Gramm-Leach-Biley had not passed. It is fairly obvious that investment banks suffered more severe consequences as a result of the credit crisis and commercial banks like Bank of America, JP Morgan Chase, Wells Fargo and Citi Group that were able to hold up better due to their broader business base.

A study of the record of the Bush Administration shows a consistent effort to address the problems at Fannie and Freddie. In 2003 President Bush proposed what the NY Times called "the most significant regulatory overhaul in the housing finance industry since the savings and loan crisis a decade ago." His plan included a new regulator for Fannie and Freddie, one that would boost capital mandates and examine how they managed risks. Even after schemes at Fannie and Freddie to boost earnings were uncovered, Democrats killed the reform. "Fannie Mae and Freddie Mac are not facing any kind of financial crisis," stated Rep. Barney Frank, then-ranking Democrat on the Financial Service Committee. North Carolina Democrat Melvin Watt accused the White House of "weakening the bargaining power of poorer families and their ability to get affordable housing." According to the White House, President Bush tried no fewer than 17 times this year to raise the issue of Freddie-Fannie Reform. In 2005, a bill cleared the Senate Banking panel, but stalled due to Democratic and some Republican opposition. In September of this year, former Democratic President Bill Clinton weighed in saying Democrats have been, "resisting any effort by Republicans in the Congress or by me...to put some standards and tighten up a little on Fannie Mae and Freddie Mac."

Alan Greenspan in 2005 told Congress, "We are placing the total financial system of the future at substantial risk." That year, Sen. John McCain, one of three sponsors of a Fannie-Freddie reform bill, said "If Congress does not act American Taxpayers will continue to be exposed to the enormous risk that Fannie Mae and Freddie Mac pose to the housing market, the overall financial system and the economy as a whole." Democratic Sen. Harry Reid, now the Majority Leader, accused the GOP of trying to "cripple the ability of Fannie Mae and Freddie Mac to carry out their mission of expanding home ownership." One determining factor in our elected official's fierce defense of Fannie and Freddie could be the huge sums of money donated for campaign funding. From 1989 through 2008, 384 politicians received funds from the two organizations. During that same period, the two government sponsored enterprises spent $200 million on lobbying and other political causes. In addition, their charitable foundations placed millions more with think tanks and questionable community groups. The two entities were also a favorite employer for out of work politicians. Regardless of what form (individual or corporate) taking large campaign contributions in recent years looks foolish for political candidates if they claim to have really knew the extent of the problems at Fannie and Freddie.

Throughout the crisis the media has been fairly successful in putting its own spin on the cause and effect of our current situation, often reporting what it wants us to hear rather than the facts we need to form our own opinion. I believe there is some corruption in both of our political parties. In the case of CRA, what started with good intentions ran amok by greed and objectives that were not realistic.

Credit Crisis Resolution

2008-10-01T04:51:00Z

I limited my commentary over the summer and as fall approached developments were moving at a rapid pace. There was not much of a point in posting since the defensive work in our portfolios had already been done. We spent most of the 3^rd quarter with 50-65% cash/bonds. The only equities we held were tied to metals and as the economic situation deteriorated further, we move out of those positions as well. In early September our portfolios held 70-85% cash/bonds with the remaining positions in long commodities, managed futures and hedged equities. I should return to a more normal post schedule of 3-4 a month. Some of which I will start to send out as emails. If you would like to get on the list, send an email to info@dightmancapital.com and put Global Market Monitor in the subject line.

A number of factors contributing to the credit crisis converged as we moved into September, forcing the U.S. government to structure a plan to stabilize markets. We have yet to see a proposal approved by congress, but in all likelihood we will see one shortly, perhaps as early as tomorrow with passage before the end of the week (it actuall passed on October 3rd) .

In a future post I plan to chronicle the series of actions taken by our elected officials over at least the last two administrations that led to the current situation. In my judgment, there are numerous policies and Politian’s responsible for this mess. But at the end of the day it is about individuals and poor choices, at the top of government and along main street.

I do not expect the downward bias in the stock market to change in the near term. The underpinning of the current problem is tied to our residential real estate market which so far shows little improvement. Prices are still declining and sales are sluggish. Until our real estate market stabilizes, it is going to be difficult for our economy to improve. It is possible a U.S. government rescue plan could shore up the housing market. At a minimum a rescue plan should restore confidence, reduce market volatility and prevent credit markets from locking up. If the latter scenario were allowed to happen it could send us into a deep recessionary environment.

Managing investments involves a certain amount of contradiction and one of the issues faced by investors today involves inflation. While consumers and business are feeling inflation pressure, in the form of higher prices for goods and services, prices for assets that are usually sensitive to inflation (like bonds) are not reflecting an expectation of future inflation. At the same time, we are seeing a deflationary environment in real estate and stocks. For this reason too, an overweight to cash and short term debt seems prudent right now.

Certainly, some terrific investment opportunities will come from the decline in global equities. For example, dividend yields are becoming much more attractive. For the time being, however, patience is the rule of the day. Even if a proposal passes congress and the market rallies hundreds of points, the general market trend is downward and it is going to take a little time for that to change.

Rally Reversed

2008-08-19T21:12:00Z

You may have noticed U.S. stock indexes moving higher over the last month, offering some hope we may have found a market bottom. Unfortunately, this does not appear to be the case as many indexes failed a major test in the last few days.

There were some promising elements in the rally. Small caps were a market leader, which is often associated with a bear market recovery. Lower oil and other commodities prices should be a boost to consumers which could prop up spending. Retailers were leaders at times during the rally and considered by some a necessary ingredient for a market bottom. But as the rally matured sector rotation never moved away from consumer staples and healthcare, two defensive sectors, indicating investors are still playing defensive.

Earlier this month I updated the Dightman Capital homepage with the following: “The U.S. stock market rally that started in the middle of July and continued in early August, in our analysis, lacks the components necessary to support sustained price appreciation. Trading volume continues to be light and we have yet to see an advance/decline ratio high enough to support the action. The stock leadership that has emerged is thin and inconsistent. Also, the S&P 500 P/E ratio, based on Q3 earnings estimates, is a little high at just above 20.”

Going forward, we face the recent development of a slowing global economy. Up until the spring, many foreign stocks were holding up better than U.S. stocks. Since July 15th through today’s close, the S&P 500 has rallied over 4% while emerging market stocks have declined over 7%, Japan is down over 5%, and European markets have fallen around 3%. Until recently, some analysis felt international stocks would be somewhat insulated from problems steaming from the largely U.S. credit crises, but that appears to be less likely. European stocks are down nearly 20% since the middle of May and slowing growth continues to be reported from many markets in the region.

As bear markets go, so far this one has been shallow. If we do suffer another down leg, there may still be time to raise cash. It could get a lot worse.

Market & Economic Brief

2008-07-11T22:05:00Z

WORLD MARKETS
Stocks around the world are feeling the effects of a troubled global credit market. The Dow dipped into bear market territory to end the first half of the year and both the Total Market (U.S.) and FTSI All-World Ex-U.S. indexes have served up big declines. We expect stocks to continue to feel pressure until credit markets stabilize and the U.S. housing market bottoms. Lower energy prices could also produce a boost to stocks. Investments related to natural resources have been one of the few areas delivering gains in the first half. Select opportunities based on a global infrastructure build-out, despite slowing economies, may be present. Defensive sectors like healthcare may also deserve consideration.WORLD ECONOMY
Slowing growth and higher inflation continue to make headlines in Europe and the U.S. Negative GDP growth has not yet been reported in the U.S. but unemployment has picked up. Participants in the credit markets, bond insurers and rating agencies continue to work through a host of problems related to lax lending policies and excessive risk taking. Lending between banks continues to be tight.INFLATION DATA
Core prices remain fairly well contained but food and energy prices have shot up dramatically in many countries. The U.S. inflation rate ended the first half of the year at 4.18%. Assets that are positively correlated with inflation (TIPS, Gold, Commodities) performed well in the first half of the year.

U.S. RESIDENTIAL HOUSING
Conditions in the residential housing market continue to deteriorate. Potential buyers are holding off due to falling prices. For those interested in making a purchase, rising mortgage rates combined with tougher lending standards are making it tougher to qualify.

Market Update

2008-06-30T20:21:00Z

Last week stock markets reacted to higher crude oil, weak earnings and inflation concerns which sent stocks down. The Dow lost 4.2% for the week. Several inflation protection assets (gold, TIPS, international bonds) performed well.

In terms of economic developments, tax rebates appear to have stimulated spending in May but rising food and energy prices are impacting consumer confidence. Factories appear to be holding up better than the 2001 recession; jobless claims have moved higher and durable goods were flat in May. The TED SPREAD declined to -1.14%, from -0.86% the week prior, a reminder of the ongoing credit market challenges.

The Fed's comments during the week included a hawkish note on inflation. Dow Chemical announced a second big price hike in less than a month. Some product prices will increase by as much as 25% in July. The move affects dozens of industries. They are also adding a freight surcharge in North America.

S&P/Case-Shiller reported April home prices experienced record declines. Existing-home sales fell in May; new home sales rose.

Stocks Under Increasing Pressure

2008-06-21T22:56:00Z

WORLD MARKETS
Both domestic and international stocks have started another leg down and appear headed for a test of the March lows. Unlike previous weeks of selling, current market leaders recently suffered sharp declines.

Commodities are one of the few areas advancing to higher levels.

Sectors performing well in the current environment include metals & mining, oil/gas exploration & production, agribusiness and basic materials.

Sectors to watch: water, clean energy, alternative energy.

WORLD ECONOMY
Renewed fears of big write downs and tight liquidity among financials continue to disrupt credit markets. More downgrades for credit rating agencies have been issued.

Factories continue to slow, the Philly Fed manufacturing index fell in June, the 4th sub-zero reading in a row.

INFLATION DATA
The Philly Fed manufacturing prices paid index shot up to the worst level since 1980, indicating costs are being passed on to customers.

U.S. RESIDENTIAL HOUSING
Home-builders at a recent conference indicated they are making progress clearing out excess inventory but warn that rising unemployment and a recession could hamper the progress being made.

The Buy & Hold Portfolio

2008-06-17T21:10:00Z

The following is a modified post I recently made on Marketwatch.com.

It is hard to argue with a buy and hold investment strategy, until you look at the numbers.

It took the S&P 500 7 YEARS to get back to even from the high hit in March of 2000. Now it is down around 13% from its new all time high hit in October of 2007.

Sure, if you held emerging markets, real estate investment trusts and commodities during the last 8+ years your total portfolio would be up. But how many buy and hold investors include asset classes outside of US & International Equities and Bonds? Some yes, but not as many as you would think. I look at portfolios of the average investor all the time. While we are at it, how many 401k plans include those asset classes? Very few.

One questions for investment advisors and the media that adopt the B&H strategy with clients, if the results are so spectacular why don’t you publish ACTUAL performance numbers? I am sure I have missed some examples, but the performance numbers I come across most often from B&H advisors and the media are based on back tested mutual fund performance, not actual client accounts. There is a VERY BIG difference.

Oh yeah, and Paul Farrell’s Lazy portfolio numbers, they only go back about 5 years. So the portfolios started just about at the bottom of the 2000-2002 bear market. It has not been terribly difficult to generate double digit returns from just about any asset class (except bonds) in the last 5 years.

Buy and hold can be fine if you have the right expectations. If you are too aggressive, it is going to be very painful to watch the declines roll in year after year (yes, bear markets can last longer than one year), especially if you are in retirement and now pulling income from your investments.

My advice, if you are going to use a B&H strategy, use a balanced allocation (approximately 40% in bonds) hold several equity and bond asset classes, keep expenses low, and expect your average long term return to be about 8%.

For the record, I use a hybrid model. I construct highly diversified but unique and focused portfolios. I over and underweight asset classes based on expectations of the future and right now I am focused on protecting and profiting from rising inflation.

200 Day Test

2008-06-10T21:02:00Z

For those that have read my GMM posts over the last few months, you may have picked up on my skepticism regarding the rally stocks embarked on since the middle of March. Yes, prices have moved up aggressively but without the volume characteristics generally associated with a recovery.

More recently I encouraged readers to watch the action of major indices around their 200 day moving average. Take a look at the charts below. You can see the S&P 500 (as represented by the exchange traded fund: SPY) has fallen well below its 200 day moving average (red line). The Nasdaq 100 (as represented by the exchange traded fund: QQQQ) has faired better only testing its 200 day moving average 3 times since the middle of May. It closed on that line today.

With the technical weakness of major U.S. stock indexes, combined with ongoing credit market issues (see April 29^th & May 23^rd posts) and deteriorating economic conditions (unemployment spiked up to 5.5% in May), the most natural path for U.S. stock indexes near term appears to be down.

Some sectors have weathered the current U.S. weakness better than others and I would not be surprised if it takes a more selective investment approach to make money in this market.

Credit Markets, Commodities, U.S. Factory Data & Stocks

2008-06-04T21:12:00Z

If you have been following the credit market mess you probably saw the news yesterday that Lehman Brothers may need to raise more cash. That is really no surprise to people following credit market developments. I posted on the subject May 23rd.

Strength in the dollar over the last week has pushed several commodity prices lower, especially oil, closing at just over $122 a barrel today from a high of $135 on May 22nd. I have recently read several commentaries on the price of oil with most writers' bullish long term. However, there are strong arguments that the price of oil will come down, potentially much further, in the near term. Many oil companies are using a price below $100 a barrel to determine if an extraction project is viable.

An interesting projection from the U.N. food summit was reported in Investor's Business Daily yesterday, estimating global food output will need to rise 50% by ’30 to meet global demand. After spiking around $43, the Powershares DB Agriculture Fund (DBA) is trading in the mid-30s. DBA is an agriculture commodity price play but I can think of at least two other risk managed ways to participate in the projected increase in global demand for agriculture commodities.

As we muddle through the credit mess it becomes more obvious with each round of economic reports that the U.S. economy has not fallen over a cliff. It still could, but the Commerce Department reported yesterday stronger-than-expected factory data up 1.1% for April, following March’s 1.5% gain.

U.S. stocks appear mixed on future economic prospects. I suggested back on May 10th the price action of major indices around their 200 day moving average might be a good proxy for the near term direction of stocks. I also mentioned back on May 2nd the performance of the Nasdaq 100 looked healthier than the S&P 500, Dow Jones 30 or New York Stock Exchange. Of the three, only the Nasdaq 100 is still trading above its 200 day moving average. Stocks are decidedly mixed, with the Nasdaq 100 outperforming in a market that started another correction on May 21st.