Market retrospective - 15 May 2009

Contents: Overview; Tea leaf readings; Economic reports; Oil trends; Perspective; Conclusion

“I don't believe in circumstances. The people who get on in this world are the people who get up and look for the circumstances they want and, if they can't find them, make them.” – George Bernard Shaw (1856-1950)

Running in place

That’s what we may be doing for a while.

I mentioned last week that I thought the markets were looking tired. The results seemed to bear that out as the S&P 500 was off almost 5%, Friday to Friday. (We’re still up over 30% from March 9.) This coming week has little economic news or earnings reports to get this really jumping again. Until some catalyst comes along to spark things again, we’ll probably just chunk along. The odds are we could very well move somewhat lower near-term as profits from the recent run are taken. For reference, think around the 8,000 level for the Dow Jones Industrials and about the mid-800s for the S&P 500. A drop like that would provide another buying opportunity for those who missed the most recent rally.

This is totally normal.

This is referred to as base building and is typical as investors get a look at the new reality and start assessing how to participate. The longer the markets remain generally higher than we were in March, it’s more likely that the overall economy does better and helps to support the markets.

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.

“Analysts expecting the U.S. economy to rebound in the third and fourth quarter were too optimistic.” - Nouriel Roubini from NYU – “Dr. Doom”

“Some of the measures that have been taken to deal with the crisis seem to be predicated on the belief that this is going to be a short, short recession. Everything says that’s wrong, that this is going to be a sustained period of weakness.” – Paul Krugman, 2008 Nobel Prize for economics.

“The current global crisis is vastly worse than the 1930s.” – Nassim Nicholas Taleb, author of the “Black Swan.”

(These three guys are pretty smart. However, they’ve also been held up by the popular media as the omniscient ones all through the recent market unpleasantness. I don’t know that they would benefit them if the markets get better and nobody wants to call on them anymore…but, that’s just me talking.)

“The bull market is very sustainable. People are still frightened but they should take a look at high dividend paying stocks to inch their way into the markets. This is a once in a generation opportunity to get in at prices that haven’t been as good since 1982.” - Jim O’Shaughnessy, O’Shaughnessy Asset Management.

“The foreclosure crisis may be near its peak. Following a springtime burst of bank repossessions - mainly due to the expiration of government moratoriums – seizures are likely to begin tapering off in the summer. As bank fire sales slow, home prices should stabilize. Assuming that the economy begins to grow in the second half of the year, as many expect, we may be starting to see a leveling off. I believe the real estate recovery is mostly due to market forces. There is little evidence that this is a result of government actions." - Chris Mayer, senior vice dean at Columbia Business School, a chief architect of several Senate housing bills in the last year.

“The Standard & Poor's 500 could hit 1,050 within the next year even as the economy struggles to recover. As the stock market improves, gross domestic product probably will turn positive by the second half of the year, but only modestly as it registers gains of 1 to 2 percent. That incremental movement higher could result in a 15 percent gain for the S&P by mid-2010. The reality is that different sectors of the economy went into recession at different points." - Goldman Sachs analyst, Abby Joseph Cohen.

“This is not a bear market rally but a cyclical bull market. I don’t think it’s too late (to get into the market). We’re about half or 60 percent of the way through the upside. So we’ve still got significant room.” - Barton Biggs, managing partner, Traxis Partners.

“To expect this (market) to continue to move onward and upward from here would be unrealistic. It would be healthy for the market to take a breather and allow some of the fundamentals to catch up,” - Leo Grohowski, chief investment officer, Bank of New York Mellon Wealth Management.

“U.S. stocks could rise 20% and most Asian stock markets could gain 25% by the end of 2009 amid growing signs the global recession may be nearing an end. The global recession is almost over. June would mark an end of the U.S. recession. I know at this point money is flowing to risky assets. Momentum is significantly going to recovery types of trade such as stocks.” – Jan Loeys, head of JP Morgan global asset allocation.

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

Ford 300 million share offering ~ This first offering of common stock by Ford since 1956 was greeted as good news because it shows that the company doesn’t need Fed money and that they’ll be able to use the proceeds to fund their healthcare obligations to the UAW without giving the UAW an equity stake. If the money owed to the union health care trust had been made in stock instead of cash that could have given the union a 24% holding in the company.

US trade deficit ~ The US deficit in international trade of goods and services increased to $27.58 billion from February's revised $26.13 billion, the Commerce Department said Tuesday.
The overall U.S. trade deficit of $27.58 billion was smaller than expected on Wall Street. The trade deficit peaked in 2006 and has since been in a declining trend that will probably not change until 2011. That’s when the stronger dollar of the past year will start having an impact.

US small business survey ~ The National Federation of Independent Business said its monthly index of small business optimism broke a four-month pattern of declines. According to its survey, businesses grew more optimistic last month on the prospects for economic growth and stronger sales. The majority of survey respondents believed that conditions would improve over the next three to six months.

Bloomberg Professional Global Confidence Survey ~ For the first time since it began in 2007, investors are forecasting that the S&P 500 Index will climb this year.

Unemployment claims ~ Initial jobless claims rose slightly last week, primarily due to layoffs caused by Chrysler’s bankruptcy. While overall unemployment numbers will still be going up for a while, the number of initial jobless claims remains well below the peak of mid-March. The recovery in the number of jobless claims usually starts about eight weeks after the peak.

TARP money ~ The insurance companies of Hartford Financial, Prudential Financial, Lincoln National and Principal Financial have each received preliminary approval from the Treasury Department to receive funds from its Troubled Asset Relief Program.

Foreclosure rates ~ Proving the adage that real estate is definitely a locally-driven market, RealtyTrac, a realty company, reported national foreclosure figures for April. The raw numbers said that foreclosure filings of all types hit a record last month, up 32% over the year-earlier number -- putting one in every 374 U.S. households in danger of losing their home.

Not so fast.

Of the – currently - 342,038 nationwide foreclosures, nearly 60% of all the activity is in the four sand states of – in order – Nevada, Florida, California and Arizona. In my market, foreclosures are, maybe, 2%.

Retail sales ~ They declined in April but the drop was concentrated in only two sectors – gas stations and grocery stores. Weakness isn’t likely to persist in those sectors. Excluding those, sales were down only 0.1%. Overall, incomes are up after taxes and after making monthly debt/obligation payments. This will eventually translate into higher consumption. This leads to improving rates of the movement of money through the economy which will give us the legs we need to recover.

Producer Price Index ~ climbed 0.3% in April after declining 1.2% in March. Food prices, on a record jump in egg prices, along with higher prices for vegetables and meat, rose 1.5 percent in April, the biggest increase since January 2008. The increase in producer prices suggests that higher inflation numbers are to come.

Consumer Price Index ~ Compared to a year ago, this dropped by 0.7% in April. It was unchanged, compared with March. Energy and food prices brought consumer prices down by their fastest 12-month rate in over a half century. Still, data continue to suggest the risk of deflation remains very small, since the drops are still mostly centered in energy and energy-related products.

The “core” CPI, excluding food and energy, grew 0.3% in April. That’s the most in nine months and is up at a 2.5% annualized rate in the past three months. Real (inflation-adjusted) average hourly earnings are up 4.3% in the past year, helping support consumer demand even as job losses continue.

Renewable energy ~ (The following is a quote from David MacKay, professor of physics, University of Cambridge, from his book, “Sustainable Energy without the Hot Air.”)

“Let's express energy consumption and energy production using simple personal units, namely kilowatt-hours. One kilowatt-hour (kWh) is the energy used by leaving a 40-watt bulb on for 24 hours. The chemical energy in the food we eat to stay alive amounts to about 3 kWh per day. Taking one hot bath uses about 5 kWh of heat. Driving an average European car 100 kilometers (roughly 62 miles) uses 80 kWh of fuel. With a few of these numbers in mind, we can start to evaluate some of the recommendations that people make about energy. The average American uses 250 kWh per day: 250 light bulbs.

Let's imagine that technology switches and lifestyle changes manage to halve American energy consumption to 125 kWh per day per person. How big would the solar, wind and nuclear facilities need to be to supply this halved consumption? For simplicity, let's imagine getting one-third of the energy supply from each.

To supply 42 kWh per day per person from solar power requires roughly 80 square meters per person of solar panels.

To deliver 42 kWh per day per person from wind for everyone in the United States would require wind farms with a total area roughly equal to the area of California, a 200-fold increase in United States wind power.

To get 42 kWh per day per person from nuclear power would require 525 one-gigawatt nuclear power stations, a roughly five-fold increase over today's levels.

The sober message about wind and solar applies to all renewables: All renewables, much as I love them, deliver only a small power per unit area, so if we want renewable facilities to supply power on a scale at all comparable to our consumption, those facilities must be big.
If you don't want to build 1 million wind turbines, you can drill 1 million geothermal boreholes instead.

Before I close, I would like to say a few words about the idea that ‘the hydrogen economy’ can magically solve our energy problems. The truth is that, in energy terms, today's hydrogen-powered vehicles don't help at all. Most prototype hydrogen-powered vehicles use more energy than the fossil-fuel vehicles they replace. The BMW Hydrogen 7, for example, uses 254 kWh per 100 km, but the average fossil car in Europe uses 80 kWh per 100 km.”

Oil trends

I wrote briefly last week about oil prices. My contention is that the price today just doesn’t seem warranted by the economics. Based on the responses I got, I thought I’d do a bit more research to try and get a better handle on what’s going on.

Crude oil for June delivery on the New York Mercantile Exchange fell as much as 3.2 percent to $56.78 a barrel during the week as perceptions that the 10 percent rally of a week ago won’t last.

According to oil trader Daniel Cronin, senior commodities analyst at PitGuru, "unless we have a real rip-roaring equity market, I really don't see crude higher than $60. I don't see any kind of fundamental reason for it other than speculation like we saw last year. That's not the same game anymore." He’s definitely right about that.

Since February, crude prices have moved to the current levels, in spite of reduced demand. World oil demand will fall by 2.56 million barrels per day in 2009, the sharpest annual decline since 1981, the International Energy Agency said this week.

Commercial storage areas are overflowing, having increased in the first quarter, a period when they usually drop. Moreover, as oil prices have risen, OPEC's production discipline has started breaking down. OPEC actually increased output last month for the first time since August.
Even the folks at OPEC say that, “prices have remained above $50 per barrel due more to market sentiment than fundamentals. Considerable risks (downward) remain as oil market fundamentals are far from balanced due to the persistent contraction in demand and growing supply overhang."

OPEC also said in a monthly report that a rise in oil prices, which topped $60 a barrel for the first time in six months this week, was “due to sentiment rather than supply and demand fundamentals.”

Oil is really floating on cheap money. Investors in oil funds push up futures prices, making it profitable for others to store crude and sell it forward to be sold at, presumably, higher prices; another reason inventories are high.

Over time, supply and demand do set the oil prices. That's why it has little, to negative, correlation with equity markets over the long term. So far this quarter, however, correlation between the moves in the S&P 500 and crude-oil prices has leapt to 70%.

Bottom line. Unless the markets really rally strongly higher, I don’t see any continued upward move in the price. However, with money as cheap as it is, I can’t see it dropping significantly either.

Perspective

The way the media chooses to look at the markets has been a source of wonder to me ever since I started, back when the Wall Street Journal was hand written on papyrus. These past six months have proven to be no different.

I can assure you that this is not the worst economic crisis since the Great Depression. Let’s just go back to the 1980s and 1990s. The facts were then that agricultural loans, oil loans and lending to Latin America all went bad at once. To help combat inflation, Paul Volcker – chair of the Federal Reserve at the time - pushed short-term interest rates well above long-term rates, giving us what’s called n inverted yield curve. Very much unlike today, banks and savings and loans were paying more for deposits than they were earning on loans.

Eventually, between 1980 and 1995, more than 3,000 financial institutions went bankrupt. They did not destroy the economy. The government gave banks time to work out their bad loans. Meanwhile, the Reagan tax cuts got the economy going, eventually growing its way out of the worst of it. The Resolution Trust Corporation (RTC) was put into place in the late 80s to clean up the banks that just could not dig themselves out.

I have no reason to believe that capitalism is broken. It is still the best, self-correcting economic system. Allowing the market system to deal with the problems of the last few years would have been much better than having the government do it. The recent market movements are reflecting the fact that the capitalistic system is working its way into normalcy.

Conclusion

A number of experts are saying that bonds are still the place to be, using the past 40 years of performance by large company stocks (i.e., S&P 500) as proof of that theory. Over the past 10 years, that’s certainly true – if all you invested in was that Index. More to the point, using rear view mirrors is not how to invest for the future. Well, like Paul Harvey used to say, now, for the rest of the story.

Bonds are great for those chunks of money you must have available in a short period of time – say, three years or less. After that, they should only be a part of your asset allocation plan – not your main investment. Here’s why. There has never even been a 20-year period when real returns in stocks have been negative. In fact, the worst 30 year real return (after inflation and axes) for stocks is 2.6% per year, just slightly below the average real return investors earn with government bonds.

If you look at today's markets and going forward, the outlook for government bonds – and most bonds, in general - is not very good. Yields on 30-year TIPS (inflation-protected bonds) are 2.3%. Yields are only about 4 percent for a Treasury bond coming due in 30 years.

By comparison, in a time when stocks have fallen 50 percent from their previous high - as they had in March of this year - their subsequent 30 year real returns have always averaged 10% per year. In contrast – something the bond gurus seem to “overlook” - for the 40 year period from 1941 through 1981, government bond investors lost a whopping 62 percent of their value, after inflation and taxes. A loss in purchasing power over this long a period has never happened in stocks.

I believe outperformance of government bonds over large stocks has ended. Since the March 8 lows, stocks have rallied 30 percent, while government bonds prices have fallen sharply. As interest rates rise – both in response to a better economy and the impact of huge government spending – the bond prices will continue to drop.

It requires patience to stay with the stock market when things are rocky. It also requires a contrarian view and the strength of your convictions. For sure, it often also requires you to totally ignore the business media's sound bites. While they say that their intentions are honorable, with very few exceptions, they have no or little skin in the game. And it often requires you to ignore the delivery of the talking heads whose platform is the media and who are very general in their "advice".

Stay with your plan, based on your values, goals, desires and needs. Don’t let someone who doesn’t even know you prevent you from doing what’s best for you…

All my best,

Mike
509-747-3323

PS If you’d like to get together over coffee for a review of your current investment approach or have questions on any aspect of investing, please call this number or simply reply to this email.

Thank you.

Closing values as of 15 May 2009:
Dow Jones 8268 NASDAQ 1680 S&P500 882 Oil $56.47/bbl Gold $931.00/oz