Market retrospective - weeek of 22 May

Contents: Overview; Tea leaf readings; Economic reports; UK credit rating mess; GM again; Perspective; Conclusion, “Regrets may cost you money”

"Like weather forecasters, economic forecasters must deal with a system that is extraordinarily complex, that is subject to random shocks and about which our data and understanding will always be imperfect. In some ways, predicting the economy is even more difficult than forecasting the weather, because an economy is not made up of molecules whose behavior is subject to the laws of physics, but rather of human beings who are themselves thinking about the future and whose behavior may be influenced by the forecasts that they or others make." – Federal Reserve Chairman Ben Bernancke

Overview

I suggested last week that we might be running in place in terms of market direction. I didn’t realize the clout I have with the markets.

On a week over week basis, the Dow was up 9 points this week, the NASDAQ up 12 and the S&P 500 added 5. With a holiday shortened week coming up and no economic reports of substance scheduled, I won’t be surprised if we get more of the same smoke and little fire.

A lot of people are still looking for some sort of major drop, (euphemistically referred to on Wall Street as a correction), before committing even a small amount of money to the equity markets. It’s important to be aware that sideways movements – as we’re doing now – can also be considered a correction. They could be disappointed by waiting for a downdraft that never really comes and then watching the market train continuing to pick up speed as it pulls out of this recession station.

In order to support the growth of the averages, we do need to increase the volume of shares being traded daily on the various exchanges. Volume is the friend of the bull, so goes the market saying. Our upward move since March has been on relatively light volume – I think due to the continued lack of conviction by many. And now, coming into the summer doldrums, volume is usually slow anyway.

The good news about that is that the markets aren’t getting ahead of themselves either. We don’t have everybody “in the pool” by any stretch. That, together with the gigantic pools of money lying fallow on the sidelines is another reason why the move up is likely to continue.

Tea leaf readings

I use this term to describe quotes from a number of opinion leaders about current market and economic events – what they see happening now and their expectations.

Americans grow happier as they age and the tendency is holding up even as the economy has performed poorly. Happiness is a complex thing. Past studies have found that happiness is partly inherited, that Republicans are happier than Democrats and that old men tend to be happier than old women. - Pew Research Center survey

Confused by market-related terms? Check out Investorwords.com /glossary

The Chicago Board Options Exchange Volatility Index, (VIX) Wall Street's favorite measure of investor concern, pierced the psychological 30 level Tuesday for the first time in eight months, indicating the perceived need for portfolio insurance is diminishing.

"Its apparent investors believe this market is headed higher at least in the short term, albeit with days that you're going to see the market sell off with a little bit of profit-taking. Every bit of data, every announcement, every piece of guidance both here and overseas is important to assess how the global economy is faring and we're beginning to see the possibility of actual growth. That's what you're looking for - you're looking for traction, you're looking for demand to pick up." - Quincy Krosby, chief investment strategist, The Hartford.

"Investors are tip-toeing back into risky assets. It's classic in what has occurred in the sense that volatility and risk aversion tend to spike over very short time periods and are only repaired over longer time periods." - Lawrence Creatura, equity market strategist and portfolio manager, Federated Clover Capital Advisers.

“33.7 percent of the financial newsletter writers surveyed were bearish, the lowest level of bearishness since January 2008.” - Investors Intelligence

“The demand for commercial lending in small businesses has grown dramatically…I see that as a generally positive sign.” - Jeff Immelt, CEO, General Electric

“Stock markets are just at the beginning of a larger rally which could see the major indexes jump another 20 to 30 percent. We are going to see an earnings rise from 2009 to 2010. We are very much at the early stage of this rally.” - Michael Browne, portfolio manager, Sofaer Global Research

“Prices may rise 2.5% in 2011, a rate well above central bankers’ preferred range. The economy may be at greater risk of inflation than the conventional wisdom indicates.” - Charles Plosser, President, Federal Reserve Bank of Philadelphia

“This rally is absolutely, positively, unquestionably, fundamental; it is not due to some sort of moronic liquidity.” - Paul Schulte, Managing Director, Nomura International

“A market pullback will be smaller than expected as many see this as a buying opportunity.” - Andrew Sullivan, sales trader at MainFirst Securities.

The S&P 500 seems to enjoy the summer most, going up historically an average of 3.7% from Memorial Day to Labor Day. The Dow Jones Industrials average gain is 2.9%. The NASDAQ average gain is 1.8%.

Economic reports from the past week (along with occasional translations…)

New Credit Card Law ~ Key provisions: It takes effect in 9 months. Once it does, credit card companies can’t raise interest rates until a balance is 60 days past due. These increases due to non-payment can be reversed with six consecutive months of on-time payments. The trade-off is that credit will likely be less widely available and will come at a higher price, i.e., fewer rewards programs, higher annual fees, etc.

Federal Reserve comments ~ According to the Wall Street Journal, some of the Fed officials are open to raising the amounts of mortgage and Treasury securities purchase programs beyond the $1.75 trillion that they've already committed to buying.

Additionally, they projected an even deeper recession than they expected three months earlier and a more sluggish recovery over the next two years as labor markets remain under pressure. They expect unemployment to end 2009 between 9.2% and 9.6% and stay above 9% in 2010.
(Some have suggested the Fed is “jawboning” and trying to talk the economy slower. In any case, the unemployment numbers are always the last to turn in a recovery…)

Leading Economic Indicators ~ The Conference Board says its index of leading economic indicators, designed to forecast economic activity in the next three to six months, rose 1 percent last month, better than expected.

State unemployment claims ~ The number of workers filing new claims for state unemployment benefits fell more than expected last week. Due to the auto sector, workers collecting benefits for more than a week rose to record highs.

Michigan's jobless rate was the highest at 12.9%, followed by Oregon at 12%, South Carolina at 11.5%, Rhode Island at 11.1% and California's unemployment rate dropped to 11% last month. Here in Washington, we’re at 9.1%.

Drug company R&D ~ According to the Pharmaceutical Research and Manufacturers of America, drug companies invested an estimated $65.2 billion (worldwide) in R&D last year. Only two out of 10 marketed drugs ever produce revenues that match or exceed R&D costs. Prescription drugs account for just 10¢ out of every dollar spent on health care, according to the Centers for Medicare and Medicaid Services. The two biggest components of spending are hospital care (31%) and physician/clinical care (21%).

Stock market size ~ Since the March 9th low, the total global market capitalization has risen to just over $35 Trillion. The US is, by far, the largest market in the world with an almost 31% share of the total market cap. Japan and China are the next largest markets at 8.7% and 7.6%, respectively. The BRIC countries - Brazil, Russia, India and China - now account for 13.5% of the total market cap, topping the combined 13.4% from the UK, France and Germany. - Bespoke Investment Group

India's elections ~ With 700 million people voting, the Congress Party of Prime Minister Manmohan Singh was unexpectedly given a full mandate to stay on the free-market path that party has been pursuing since 1991.

India's stock market rocketed 17% in the aftermath of the election. The rally was a vote of confidence for an economy that has had 8% to 9% growth almost every year since Singh, who had been finance minister, opened India to investment in 1991. It also showed that even in a downturn, Indians' belief in the future and free markets has been strengthened, not weakened. – Investors Business Daily

Home builders ~ The National Association of Home Builders reported that its housing market index increased for the second month in a row in May, reflecting growing optimism on the part of the 733 residential developers it surveyed nationwide.

According to NAHB chief economist David Crowe, the increase is due to "the best home buying conditions of a lifetime" and that “home prices are at their most affordable in nearly two decades.” He added that, “this continued increase indicates that home builders feel we're at or near the bottom of the market.”

Housing starts ~ It was reported that home building had hit a record low in April - but the reports missed the crux of the story.

The reason housing starts hit the low was that multi-family starts dropped by 46.1%. This is the most volatile segment of the industry. A big downward move this month could become a big jump up next.

Single family starts are up for the second month in a row. Due to the continued excess inventories of homes, the recovery in starts will be gradual at first. Many feel that fewer starts and permits are good things as that will help reduce the housing inventory more quickly.

Canadian oil ~ In 2000, Canada's oil sands produced just 600,000 barrels of oil a day. Today, those sands produce 1.3 million barrels. By 2030, they could be producing as much as 6 million. Probably a good thing to be and remain buddies with the folks up the road…

Effect of high state income taxes ~ Arthur Laffer, working with Richard Vedder of Ohio University, found that from 1998 to 2007, more than 1,100 people moved every day - including Sundays and holidays - from the nine highest income-tax states.

These include California, New Jersey, New York and Ohio. They moved mostly to the nine tax-haven states with no state income tax, including Florida, Nevada, New Hampshire and Texas.

And, no surprise, they found that over these same years the no-income tax states created 89% more jobs and had 32% faster personal income growth than their high-tax counterparts. The problem for states that want to pry more money out of the wallets of people is that it never works. People, investment capital and businesses are mobile. They can – and seemingly do - leave tax-unfriendly states and move to tax-friendly states. Why don’t politicians see that?

UK credit rating mess

Standard & Poor's gave the markets a jolt last Thursday when it announced that it had changed its outlook for the UK's credit rating to negative. This is considered to be a formal warning that the Brits must get their national finances in order or lose their AAA credit rating. Not only would that raise their overall cost of governmental borrowing, it would have huge political ramifications as well.

While its AAA outlook was affirmed, there was a 33 percent chance they would get downgraded. The UK now joins Portugal, Spain, Greece and Ireland with negative credit outlooks.
S&P analyst David Beers said that, “we have revised the outlook on the UK to negative due to our view that, even assuming additional fiscal tightening, the net general government debt burden could approach 100 percent of gross domestic product and remain near that level in the medium term." Yipes!

They got into this mess to some extent because the budget the government put out in April combined some very creative borrowing forecasts along with a refusal to say exactly how the growing deficit might be controlled.

The UK Treasury’s own forecasts in the budget conveniently showed debt peaking at 79% of GDP, just under the 80% level that would usually trigger a downgrade – adding to the suspicion that the forecasts were “politically influenced.” But S&P doesn't buy their numbers.
Our market tanked on Thursday as some extrapolated that we were next. Wrong.

First, as noted in the Tea Leaf section, our economy – as represented just by the stock market – is WAY bigger than that of the UK. More important, the dollar is considered a reserve
currency. That means many different governments hold it in large numbers as a portion of their foreign exchange reserves. It’s also the major pricing money for the global markets in most things. In short, it’s the asset of choice in the world.

We also still have a great deal of flexibility with our economy as a whole. We can – and, likely, will – continue to grow as things become more normalized. And that too is a major strength.
Bottom line. Whether the Brits or us are subject to a ratings downgrade is not likely to happen over the next couple years – if then. Things can change for the better too.

GM - again

Speaking of messes. There are so many moving parts to this disaster that it’s very hard to keep up. I’ll attempt to give you some degree of insight into where we are now.

On Friday, GM announced it had borrowed another $4 billion from the US Treasury, taking its total federal funding to $19.4 billion. What began as an emergency batch of loans to GM, Chrysler and GMAC in December, 2008, now looks likely to balloon well beyond $50 billion and could approach $100 billion by the end of the year. I personally don’t know why we do it.

To help GMAC raise additional funds, the FDIC took the rare step Thursday of allowing the junk-rated company to gain access to its debt guarantee program. GMAC will be allowed to issue as much as $7.4 billion in debt, guaranteed by the FDIC in case the company defaults on payment -- marking the second time the government has stepped in to prop up GMAC. The injection is designed to support their balance sheet and allow it to continue making loans for car purchases at GM and Chrysler LLC.

In addition, the Federal Reserve waived rules to give GMAC's new bank, called Ally Bank, more leeway to make loans to GM customers.

According to the Washington Post, the US is preparing to steer GM into bankruptcy, but other sources say they have no plan to do so. General Motors restructuring efforts are likely to go right up to the June 1 deadline set by the administration, but not beyond, a White House economic adviser said Friday.

For perspective, as recently as 1985, GM had 40% of the US market. Today, they have less than half that, only about 19%. How much market share will the “new” GM have? GM's current projections say they will emerge from all of this with an 18% share - after they sell or discontinue their Hummer, Saab, Saturn and Pontiac brands. According to Soleil Research, these four brands only made up 3.8% of the US market. (Looks like GM must be using some of the Brits who came up with their national budget to work their numbers.) Soleil says 16% is a closer estimate for market share.

One thing's for sure, this will be a huge opportunity for Asian car makers - and a few large European makers - to pick up significant US market share over the next few years.

Right now, GM is engaged in negotiating a reorganization that would increase vehicle imports from its plants in Mexico and Asia, while closing factories and cutting the work force in the United States. The UAW doesn’t like that idea. In a letter to each member of Congress, the UAW argued that to qualify for more government assistance, the auto giant should be required “to maintain the maximum number of jobs in the United States.” Never happen.

Why? Even as very friendly this administration seems to be to big labor, even they understand that GM must import a significant percentage of cars from their plants in low-wage countries, like Mexico and China, or low-cost countries, like Japan, to offset fewer imports from Canada and Europe. GM already imports a third of the vehicles that go to showrooms.

What about the current stock and bondholders?

Under the highly unlikely, non-bankruptcy restructuring plan proposed by GM, the government (you and me) would get 50% of the company, the United Auto Workers would get 39%, the unsecured bondholders would get 10% and the equity (stock) holders would get 1%.

To accomplish this goal, GM would increase the number of shares from approximately 600 million to approximately 60 billion, distribute new shares and conduct a reverse split back to 600 million shares.

What that means in American for existing shareholders is that their shares, valued Friday at about $1.40, would theoretically be worth 1.4 cents - each. Whether or not bankruptcy occurs, shareholders are busted. They now have lottery tickets.

For stock holders, bankruptcy court is a not a good place to be because shares typically go to zero once the case is settled. The current shares can continue to trade through the court process. It is, however, remotely possible that GM can avoid bankruptcy over the next few days, and that is why the stock is trading.

The real focus is now on GM bondholders who are being asked to forgive debt in exchange for that 10 percent stake in the “new” company. Representatives of the bondholders have rejected that offer as insufficient – a response I totally agree with. The Feds have, to use the current euphemism, thrown them under the bus…

Perspective

In the overview, I talk about how recoveries can start from these sideways markets. I’ve found some historical market data to help give you additional reason to either start or increase your allocation into stocks.

One important consideration that’s happening right now is that we’re seeing the onset of a potentially meaningful asset reallocation by many large pension plans in the US out of fixed income and into equities. The risk/return tradeoff doesn’t justify a large exposure to bonds in this environment.

A company named Ibbotson, renowned for their charts and graphs of the market and its segments, says the S&P 500 shows historic rallies after historic downturns. The biggest decline - from August 1929 to June 1932 – led to a 163% total return in the 12 months after the June 1932 bottom. More recently, after the June 1970 bottom, the S&P put up a recovery of 42% in the following 12 months.

We’re now up about 30% from our low and, I believe, there’s more to come. Check this out.
According to money managers Navellier & Associates, in the 12 to 21 months following the market bottoms after the previous five recessions, the Dow - on average - gained 55%.

Further, as we’ve seen in the past few weeks, recoveries come fast and with no real advance notice. My close, personal friend – not really - Ken Winans of Winans International says that, in the five years after the bear markets ending in 1974 and 2002, nearly half of stocks' ultimate gains came during the first calendar year after the bottom.

There are still tons of values in this market – be sure you benefit from them.

Conclusion

My comments about not hesitating to get into the markets all come together in a study I came across this week that says, in effect, worrying about regrets may cost you money.

Mr. Bruce Alan Carlin of the Anderson Graduate School of Management at UCLA, along with Mr. David T. Robinson of the Fuqua School of Business at Duke University, has studied how regret affects economic actions in market settings.

These two gentlemen tracked bets made by players at black jack tables without the player’s knowledge. Interestingly – to me anyway – they found that more money was lost by playing too conservatively than too aggressively. Hmmm.

Apparently, this is in line with psychologists' theories about regret. The psychologists say that people tend to act more conservatively if there is a chance they will regret their actions. Here is an example.

Take these two investors. One who loses money because he failed to sell his shares and another who loses money because he sold his shares. Even if the losses are the same, the second investor feels more regret because he took direct action. The other investor can blame forces beyond his control and doesn't have to take direct responsibility, i.e., “the market”.

According to Mr. Carlin, “a lot of older people should have seen the risk of volatility earlier and should have rebalanced their portfolio. But they worried that if they sold and market rebounded they would feel more awful than if market just went down.”

Mr. Carlin also points out the problem may even be more severe in the general population. By definition, black jack players are gamblers. “This is the behavior among risk seekers. Imagine what it looks like among the risk averse,” he said.

Don’t regret – carpe diem!

All my best,

Mike
509-747-3323

PS If you know someone who has suffered the death of a spouse, has been divorced or has changed jobs and has a retirement plan they’re not sure what to do with, please let them know I can be of help. Thank you.

Closing values as of 22 May 2009:
Dow Jones 8277 NASDAQ 1692 S&P500 887 Oil $61.48/bbl Gold $957.00/oz