Market retrospective - week of 9 October 2009

Contents: Overview; Tea leaf readings; Economic reports; Perspective, “What’s the deal with gold?”

"October. This is one of the peculiarly dangerous months to speculate in stocks. Others are November, December, January, February, March, April, May, June, July, August and September." – Mark Twain (1835 – 1910) American author and humorist (Speculate being the operative term here…)

Overview

Friday was the second anniversary of the Dow and S&P having hit their all-time highs. The NASDAQ hit its high back in the dot.com era in March, 2000. I don’t know how any of that played into the past week’s results but the week was outstanding on its own. It was up over 4% - the best week in over two years.

Alcoa did its bit, starting the official earnings season with much better than expected numbers and, on top of that, predicting an upturn in aluminum usage. That’s important n that aluminum is used in many sectors of the economy. We saw the service sector index – 80% of our economy today – reporting growth for the first time in a year. Initial unemployment claims continue to trend downward. While still showing a relatively weak labor demand, the gap between the business activity index component of the index and the employment index, is very similar to that in the early stages of the 2002 recovery.

As you can see in the Tea Leaf and Economic sections, there is a lot of positive data about the economy and the markets now. We are well past the so-called green shoots stage of the spring. And yet, Dr. Nourini Roubini, aka, Dr. Doom, and his ilk, are still beating the woe is me, sky is falling drum.

Due to the nature of the markets, I can’t say, for sure, that they’re wrong. However, even stopped clocks are right twice a day and I think their time has passed for now…

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.)

"Sustainable economic growth and low interest rates worldwide will spur a multi-year bull market in equities, led by developing nations. Low growth means low interest rates and actually that’s one of the best environments for stock-market investing. Anything that can show growth in this low-growth environment is going to be bid up by investors. It’s very pro the emerging-market world versus the developed world.” - Anthony Bolton, president of investments, Fidelity International

“The US economic rebound should support higher interest rates sooner rather than later and increases to the Fed’s target rate for overnight bank loans wouldn’t derail the U.S. recovery. I would not support a tight monetary policy in the current environment, but my experience tells me that we will need to remove our very accommodative policy sooner rather than later.” - Thomas Hoenig, President, Federal Reserve Bank of Kansas City

“In words, many see a need for ‘social justice’ to override ‘the dictates of the market.’ In reality, what is called ‘the market’ consists of human beings making their own choices at their own cost. What is called ‘social justice’ is government imposition of the notions of third parties, who pay no price for being wrong.” – Dr. Thomas Sowell, American economist, social commentator (I’m with him…)

“The stock rally should continue into the fourth quarter. We’re seeing an improvement in economic indicators. And Alcoa sent a very good indication for the overall earnings season. Commodities companies are early-cycle plays. That’s another indication that things are getting better.” - Tom Wirth, senior investment officer, Chemung Canal Trust Co.

"Accommodative policies will likely be warranted for an extended period. At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road. When the economic outlook has improved sufficiently, we will be prepared to tighten the stance of monetary policy and eventually return our balance sheet to a more normal configuration." - Ben Bernanke, Chairman, Federal Reserve Bank

“The market is only about halfway through what is historically typical of a bear-market recovery—and this time around, the rebound is likely to be even bigger. We’ve analyzed 14 past bear markets—ranging from gold to US stocks—and found that when markets dipped more than 40%, the average rally off the lows was about 72%.
Since the Dow is up only about 45% and the S&P about 52%, the market still has a lot of room to the upside. We've had a tremendous, an unbelievable decline in both the economy and the stock market and so I just think we're going to have a bigger than normal bounce. I just think we've got further to go." – Barton Biggs, CEO, Traxis Partners and former chief global strategist for Morgan Stanley

“Since 1871, the three worst ten-year returns for stocks have ended in the years 1974, 1920 and 1978. These were followed, respectively, by real, after-inflation stock returns of more than 8%, 13% and 9% over next ten years. In fact, for the 13 ten-year periods of negative returns stocks have suffered since 1871, the next ten years gave investors real returns that averaged over 10% per year. This return has far exceeded the average 6.66% return in all ten years periods and is twice the return offered by long-term government bonds. At the end of March of this year, the annual returns on long-term treasuries did outpace stocks over the last 40 years, 8.90% to 8.71%.

While the stock return was below its long-term average, the return on treasury bonds was well above average. Indeed to obtain those bond returns over the next 40 years, yields on long-term US treasury bonds would have to fall to about 2%, an exceedingly unlikely scenario. In fact, with the recent stock market recovery and bond market decline, stock returns now handily outpace bond returns over the past 30 and 40 years.

US stocks are cheap compared to forecast earnings. For the S&P 500 index, stocks are now selling for about 14 times projected operating earnings for 2010. Since 1955, stocks have sold at an average 18 to 20 times earnings when interest rates and inflation are low, such as now.

The recent behaviour of stock market prices sheds some light on a phenomenon which has long puzzled economists: why do stocks over the long run yield so much more than bonds? The pain that investors often suffer, such as in the recent bear market, forces many to forsake equities altogether. This drives stock prices down and enhances their future returns. Equities offer investors excellent returns to those willing to accept the market’s volatility.” - Jeremy J. Siegel, Russell E. Palmer professor of finance at the Wharton School, University of Pennsylvania, author of “Stocks for the Long Run”

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

The US service sector expanded for the first time in a year in September at a faster pace than expected. The Institute for Supply Management's services index rose to 50.9 last month from 48.4 in August. The dividing line between growth and contraction is 50. The services sector represents about 80% of U.S. economic activity, including businesses such as banks, airlines, hotels and restaurants.

Overseas markets rallied on Tuesday as Australia's central bank became the first major central bank to boost interest rates. The Australia Reserve Bank hiked its key lending rate by 25 basis points to 3.25%. Though the rate hike may strike some as an unlikely impetus for higher stock prices, global participants were encouraged by the symbolism of the act, since it suggests that the global economy has strengthened. Australia's central bank governor said it was time to begin reducing stimulus provided by low interest rates and that the risk of major economic contraction in the country was over.

Freddie Mac reported that the average rate on the 30-year mortgage dropped to 4.87% this week, down from 4.94% last week. Homebuilders rallied as analysts are growing more optimistic about the sector, citing the winning combination of rising home prices, falling mortgage rates and continued government intervention.
Congress is considering a possible extension of the $8,000 first-time homebuyer's tax credit, which is set to expire on Nov. 30. No word on how long the extension would be.

The US Commerce Department that the US trade deficit unexpectedly narrowed for the first time in four months in August, with exports rising to their highest level of the year and imports easing, despite higher oil prices. US exports in August rose 0.2% to $128.22 billion from $128.00 billion the previous month. Exports were at their highest level since last December.

“The basic fallacy of cash for clunkers is that you can somehow create wealth by destroying existing assets that are still productive, in this case cars that still work. Under the program, auto dealers were required to destroy the car engines of trade-ins with a sodium silicate solution, then smash them and send them to the junk yard. As the journalist Henry Hazlitt wrote in his classic, "Economics in One Lesson," you can't raise living standards by breaking windows so some people can get jobs repairing them.

In the category of all-time dumb ideas, cash for clunkers rivals the New Deal brainstorm to slaughter pigs to raise pork prices. The people who really belong in the junk yard are the wizards in Washington who peddled this economic malarkey.” – Wall Street Journal, 6 October

Perspective
“What’s the deal with gold?”

The gold bugs are finally enjoying their moment in the sun. After 20 horrible years, in which gold dropped from $800 to $250 an ounce, the sometimes-precious metal is now roaring to all-time nominal highs.

Even with the run over the past five years, gold is still trading well below its all-time peak, after adjusting for inflation. It hit its highest value in January 1980, when it reached a high of $873 per troy ounce. Inflation surged to a 14.8% annual rate in March 1980, after a four-year gain in gold that included that record. If you factor in inflation since then, that price of gold would stand at about $2,049 per troy ounce - about twice what current values are now. Given that gold is supposed to protect you from inflation, this performance is pretty horrible.

What's more, gold has actually performed poorly this year relative to other more boring metals like copper and silver because those metals are actually used for something. China's building houses again, which means they're scarfing up all the copper in the world. If history is an indicator, one thing is for certain. The higher gold prices go, the more people will be convinced it is a “great investment”. And the more people will fight each other out of the way to put it in their portfolios, moving prices artificially higher. Emotions will trump logic yet again.

However, since the media seemingly likes to look at these kinds of data only on a short-term basis, let’s look at this year.

On 15 January, gold closed at $807 per ounce. Since that time, gold is up about 30%. That’s great for those who bought in around then, but what about now?

The weak dollar is one of the keys to the recent rise in gold prices. A weak dollar can eventually lead to import-led inflation down the road inasmuch as a weaker dollar makes gold and dollar-priced assets cheaper for holders of other currencies. Gold has also gained on lack of faith in the administration and that increasing US debt will continue to drive down the value of the dollar. Obama has increased the nation’s marketable debt to an unprecedented $7.1 trillion as the government borrows to revive growth. Goldman Sachs predicts the US will sell about $2.9 trillion of debt in the two years ending next September.

Adding to the weakness is the fact that the Federal Reserve is keeping interest rates near zero percent. Other currencies offer higher rates so the dollar remains low/weak. The longer the US rates remain at these levels, the higher the likelihood of inflation, probably around 2011.

The slump will abate and the dollar will rebound to $1.46 against the euro by year-end and to $1.45 by March 31, according to the median forecast of 48 analysts surveyed by Bloomberg News. Forward rates suggest the dollar will be little changed in six months, at around $1.47.

Gold is appreciating along with other assets, from commodities to stocks, because money is so cheap. The dollar’s slump has prompted investors to buy commodities as a hedge against potential inflation.

A real conflict appears to be brewing in the financial markets. The Fed is fighting deflation with it’s near-zero interest-rate target, while gold, the dollar and commodity markets are signaling that inflation is the real problem.

Somebody is going to be very right here and somebody is going to be very wrong.

As is the case most times, I’m betting on the markets being right.

All my best,
Mike
509-747-3323

Closing values as of 9 October 2009 /
Dow Jones 9664 S&P500 1071 NASDAQ 2139 Oil $72.29/bbl Gold $1,048.60/oz