Market retrospective - week of 30 October 2009

Contents: Overview; Tea leaf readings; Economic reports; Perspective, “The dollar and commodities”

“The very liquidity of stock markets causes people to focus on price action. If you buy an apartment house, if you buy a farm, if you buy a McDonald’s franchise, you don’t think about what it’s going sell for tomorrow or next week, or next month - you think about how this business is going to do. But stocks, with this huge liquidity, suck people in and they turn what should be an advantage into a disadvantage. You are focusing on the right thing if you look at the stream of income that a stock asset is going to produce over time.”– Warren Buffett (1930 - ) investor

Overview

Last week, we hit 10,000 again. This week, we had the 80th anniversary of the start of the stock market crash in 1929. It was the start because it really didn’t happen all in one day – the real low wasn’t hit until almost three years later.

I thought it was interesting that on that same day, the third quarter GDP numbers were released, which were much higher than that ever popular consensus had expected. Kind of the yin and the yang, especially in view of so many having claimed that this is the worst time since then. As opposed to what happened after that 80 year ago date, it seems that we are on our way higher.

One other interesting note – you can see that I don’t get out much – is that after all the sound and fury of the past week, it did, in fact, signify nothing as the averages were just about exactly unchanged from last week’s close. Matter of fact, the month of October ended almost unchanged from the end of September.

Don’t get too focused on short-term data. As Mr. Buffett suggests, the stream of income – which comes over time – is your key to success. Go with trends – not sound bites.

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.)

"My own view is that this will be a business-led recovery, not only in terms of capital-spending investment, but also business-to-business transactions. Corporate cash flows are very strong and profits are improving. Economy-wide productivity is very high. And let’s not forget the Fed’s highly expansionary policies, with a zero target rate, a steep Treasury curve, and a growing balance sheet.” – Larry Kudlow, economist, Kudlow & Company (I think he is spot on with this one…)

“I believe equities will outperform corporate credit. People are underestimating the strength of the recovery. Growth will continue in the US as the unemployment rate is seen trending down by end 2009.” - Larry Kantor, global head of research, Barclays Capital

“For some investors, there still is a case of once bitten, twice shy. We do see a reluctance of people to get back into the market and people are tending to buy certainty of cash flow over uncertainty of equities. The rewards are wearing thin. The cost of certainty has become very high; with interest rates effectively at zero and the returns offered by Treasurys are not enough to live on. Unless you can’t afford to lose a dime, do not allocate a disproportionate amount of assets to this area.

I believe the economy has been in recovery mode since the first quarter. While there is still negativity out there, we think leaning against the skepticism is the right thing to do and recommend being modestly overweighted in equities.” - Paul Zemsky, head of the Multi-Asset Strategies and Solutions Group, ING Investment Management

“With our government continuing to provide cheap money to the market place to help finance the recovery, commodities are going to outperform other asset classes going forward. That said, the biggest risk factor for commodities over the next few months is the reallocation of money back into the dollar. If there is a major correction in the stock market, investors will look for safety in the dollar and that would be a caveat for the whole complex.Without that big switch in sentiment, the trends that we have seen over the six months will continue to play themselves out going forward.” - Adam Klopfenstein, senior market strategist at Lind-Waldock, division of MF Global

“The GDP broadly fits in the small positive sweet spot for risk. The figures are not too strong to bring forward rate hike expectations or too weak to encourage thoughts of the recovery faltering." - Alan Ruskin, international strategist, RBS

“The recovery has just started. The Dow’s move from 6,600 to 10,000 is giving us back what we should have had in the first place. I expect the Dow Industrials to hit 11,000 by the end of 2009 and 13,000 by the end of 2010. Through the next 14 months, there are a couple of sectors that are going to lead us through this recovery.

Financial services is one. Because it has been so beaten down with investors overreacting to the economic fallout, financials are better positioned than any other industry.
I also think the tech sector will be even better in 2010 than in 2009. Technology tends to do well when the global economy is doing well.” – Dr. Bob Froehlich, senior managing director, The Hartford

“Don’t focus on the housing and unemployment numbers. Those two things are lagging indicators and unfortunately, investors focus on those headline topics. This economy is starting to improve, things look a lot better than a lot of people anticipated and I think the market has quite a bit on the upside.” - Greg Merlino, president/founder, Ameriway Financial Services

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

More US industries are experiencing an increase in demand and profits, a survey showed, further proof the economy started growing again in the third quarter. “The survey provides new evidence that the US recovery is under way," said William Strauss, a senior economist at the Federal Reserve Bank of Chicago and chairman of the NABE's industry survey committee.

In its latest industry survey, the National Association for Business Economics said the improved optimism had pushed its net rising index (NRI) for demand to 23 in the July-September quarter, the first time it had risen in five quarters.

Home prices in the 20 largest US cities rose in August for a third consecutive month, bolstering the case that an economic recovery is at hand. The S&P/Case-Shiller home-price index climbed 1% from the prior month on a seasonally adjusted basis after a 1.2% increase in July.

“After increasing for five months in a row, new home sales declined in September, coming in below consensus expectations. More aggressive pricing by sellers – a bullish sign –may have played a role in the slower pace of sales. The median price of new homes increased 2.5% in September, an unusually strong gain for this time of year. The average price of new homes increased 10.2%, the largest increase for any September on record, going back to 1975.

We believe the pace of sales will renew its upward trend very soon, regardless of whether Congress renews the homebuyer tax credit, as the fundamentals in the housing market are much improved. Prices on a national average basis are back near fair value and interest rates remain low by historical standards. Given demographic trends, we anticipate that over the next few years the annual pace of new home sales will climb from 402,000 in September to roughly 950,000.” – Brian S. Wesbury, chief economist, First Trust

In its first estimate of third-quarter economic activity, US gross domestic product (GDP) rose by a seasonally adjusted 3.5% annual rate from July through September. – Department of Commerce (This was the first growth in GDP since the second quarter of 2008 and is an “unofficial” confirmation that the recession has ended. The reason for the delay is that The National Bureau of Economic Research is responsible for determining when contractions “officially” begin and end. The head of the committee charged with making the call, said in August it may take more than a year for the group to reach a conclusion. (Don’t kill the job, I guess.)

The number of US workers filing new claims for jobless benefits dipped last week, while the number collecting long-term aid fell to the lowest reading in seven months as the job market steadied. – Department of Labor

Deutsche Bank AG boosted its estimates for US economic growth in the second half of 2009 and 2010, citing a “noticeable pickup in demand” following yesterday’s third-quarter report.
Gross domestic product growth estimates were raised to 4% in the fourth quarter, 4.5% in the first quarter of 2010, 3.5% in the second quarter, 3.7% in the third quarter and 3.8% in the fourth quarter. The previous forecasts were 2.5 %, 2.6%, 3.1%, 3.3% and 3.8%.

Perspective
“The dollar and commodities”

The dollar dropping forever is not a good thing. However, for now, it’s not altogether terrible. If nothing else, it’s helping US companies of all types and sizes do business overseas. Let’s look at some of the mechanics of what’s going on.

Whether a currency – anybody’s – is considered weak or strong is directly related to what return that currency provides compared with other currencies. So, since the prevailing interest rate here is, effectively, zero – the dollar is considered to be weak. Further, the dollar has a great influence on commodity prices since ALL commodities are priced in dollars.

We have the risk trade. Today, that means you sell (short) the dollar and buy commodities and companies in emerging markets. That’s done because with the dollar being weak, commodity prices keep rising and because the traders believe that the emerging markets are where the major growth will come from.

Then there’s something called the carry trade. This is a popular strategy in the foreign exchange markets. The traders buy the higher interest rate currencies while selling the ones with lower rates, i.e., the dollar.

Let’s consider a few specific commodities.

How about gold? According to Bill Gary, president of Commodity Information Systems Inc., “gold is particularly affected by the weakness of the dollar because it has always been viewed as a safe haven for catastrophes and depreciation of currencies.” Over time, it has provided a marginal return at best. Since it offers no dividends or interest, the only way you benefit is to “buy low, sell high.”

Oil is the prime example of how the dollar being weak has benefited commodity prices. There are still huge inventories globally and demand continues moderate, at best. The weak dollar and increasing demand from Asia and India can help keep prices high, even when the dollar strengthens.

Supply and demand is impacting soybeans more than the dollar. The crop has been a strong performer the last few months. However, huge yields are expected from both South America and the US next year. Even though that magic bean has many uses and Asian demand will likely remain high, seems that production looks bigger than demand.

Commodities are considered to be non-correlative to the stock market. In American, that means that, for the most part, if stocks are up, commods are down and vice versa, so it can be a great way to get your asset allocation in balance.

You can invest through stock in a commodity company, or one that has something to do with the production of a commodity, exchange traded funds or commodities (ETFs or ETCs), individual commodity futures, commodity mutual funds and managed futures funds. All have varying degrees of risk and investment requirements.The biggest risk factor for all commodities over the next few months is the reallocation of money back into the dollar. That can occur for two reasons.

First, if there is a major correction in the stock market, investors will look for safety in the dollar and that would be a caveat for the whole complex. I don’t think that’s hardly likely. The other is that the Fed actually increases our interest rates. That doesn’t look likely now until late 2010 at the earliest.

The bottom line…find what you’re most comfortable doing. Do your homework and understand that fluctuation can have a whole new meaning when it comes to commodity type investments.

All my best,

Mike
509-747-3323

Closing values as of 30 October 2009 /
Dow Jones 9712 S&P500 1036 NASDAQ 2045 Oil $77.12/bbl Gold $1,046.60/oz