WEEKLY UPDATE

June 28, 2010

Talk of a Double Dip Permeates Financial News while Unemployment Benefits are Slashed

Economists for months have been warning of a possible dip in the economy as a year of federal stimulus programs begin to expire; the media is now picking up on the story. Before we talk about the markets let me talk briefly about unemployment benefits.

Congress Punishes the Unemployed

Congress's inaction last week to extend unemployment benefits means that nearly 2 million people will now lose this safety net of compensation. Here are a few numbers to think about:

- 10 million people receive unemployment benefits in our country today
- Of those 10 million people, 5.7 million receive long-term unemployment benefits (meaning beyond six months)
- 2 million of those people will now lose their unemployment benefits
- $309 is the average weekly payment for unemployment compensation

While it is true we have a huge deficit that needs to be cut, the money we spend to provide a safety net to the unemployed should be one of our highest budgetary priorities. We have spent over one trillion dollars to prop up the nation's banks, yet Congress chooses unemployment benefits as one of the first programs to cut in an attempt at fiscal discipline? This is hugely irresponsible considering that employment has not even begun to recover - it's merely stabilized at depressed levels. What are those two million folks going to do when their unemployment benefits end?

The Fed Tones Down Talk of a Recovery

The tone of the Federal Reserve Board's statement released after last week's FOMC meeting was decidedly less optimistic than a month earlier. Citing a slowdown in Europe, high unemployment levels here in the US, and a record drop in housing sales, the Fed decided to once again keep interest rates at "exceptionally low levels…for an extended period." This further fueled the recent rally in Treasury bonds and gave weakness to risky assets like stocks. Below is a chart of the S&P 500 Index showing the action since late March.



Bond Bubble?

I have had a number of calls as clients are hearing speculation about a possible bond bubble in U.S. Treasury prices. Most of these stories come from stock analysts or mutual fund companies hoping to get more money in the stock market; nevertheless the concern about a bubble in treasury prices is one to consider.

Because a picture is worth a thousand words, I will rely on a number of charts to tell a story. But for those of you like me who read the ending first, let me say that until the economy starts hiring the unemployed, interest rates are not likely to rise anytime soon.

Before we begin, remember bond prices move in the opposite direction as interest rates (i.e. if rates are falling, prices are rising, and vice versa).

This chart shows Treasury prices over the past year (revealing a strong rally since April):



This chart shows Treasury yields over the past year:



So far it looks like rates are at a bottom, but if we look out a little longer we get a better perspective. The next two charts show price and yield, respectively, over the past 5 years:







What we are seeing is that while prices are high today, they are still a long way away from record levels. Furthermore we see that we have been on a trend for lower interest rates and higher bond prices for 30 years by reviewing the two charts below, prices and yields, respectively:







Why are rates still falling and bond prices still rising?

The answer lies in the weakness of the economy, the slowdown in Europe, and a shift of investment funds flowing into Treasuries. One of the most successful bond managers around, Bill Gross of PIMCO, reversed his position weeks ago to begin shifting more money into Treasuries and out of other riskier bonds. For his move he cited many of the reasons I noted above. As long as the economy remains weak, unemployment remains high, and credit conditions fail to improve, a reversal to higher interests rates and lower bond prices is not likely.

Take care,
Greg

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June 22, 2010



Last week we saw a resilient stock market hold firmly in the face of disappointing economic news; today was different.

Existing home sales drop in May

Sales of existing homes in the U.S. fell 2.2% from April to May and disappointed analysts who were expecting a rise of 5%. This news, coupled with a report last week that home construction in May tumbled, suggests that the home-buyer tax credit scheduled to expire on June 30 is not enough to keep the housing market from slumping once again.

Mortgage rates remain low

A combination of low rate policy at the Fed and a flood of investors looking for safe returns in the government bond market are keeping mortgage rates at some of the lowest levels since the credit crisis began. The average 30-year mortgage rate was down to 4.89% in May which is down from 5.10% in April.

The Fed meets this week

The Federal Open Market Committee meets this week and will release a statement concerning the health of the economy and their current interest rate policy. Bond investors and analysts expect no change in interest rate policy right now but are paying close attention to the wording in the FOMC statement (which is due to be released after the meeting on Wednesday) for any clue to changes in the future.

Stock rally fades

The stock market fell today after failing to climb above several key levels of resistance. Normally technical analysis takes a back seat to economic analysis and the strength of each particular business, but today's market is different. With so many investors on the sidelines in cash or bonds, the stock market has been taken over by day traders. These traders are generally nervous about keeping stocks for the long term while the economy is so weak and our recovery is so vulnerable to a double-dip, so instead they look to several key technical indicators to signal when they should quickly buy or sell stock. What we have seen lately is a market that has recovered exactly 50% of what it lost since this correction began back on April 26, 2010. Once it retraced 50% of its April 26th to June 7th loss the market rolled over to the downside. Today traders saw the market fail to climb any higher so they then piled on and sold the market lower. The S&P 500 closed below the 200-day moving average; for the market to recover, it will now likely need a good dose of surprisingly positive economic news or perhaps news that Congress is white-washing the bank reform bill even further. The chart below reveals today's action in the market.



The bond rally continues

Weak economic news and a lower stock market usually translate to higher bond prices (and with it, lower bond yields). I placed a chart of the 2-Year U.S. Treasury Bond yields and the 5-Year Treasury Bond yields to illustrate our point that money continues to pour into the safety net of U.S. government bonds. Both of these charts cover the past year and illustrate that bond yields are the lowest they have been in over a year. The question that remains is now that bond prices have rallied so much over the past year, just how much higher can they go? It all depends on many factors not the least of which are concerns about the economic recovery, the budget crisis in Europe, and fiscal problems of our own state and local governments.

Here is a chart of the yield on the 2-Year Treasury Bond:



And here is a similar chart of the 5-Year Treasury Bond Yield:



Conclusion:

Bond investors are commonly known to be spot-on when reading the strength of the economy - the same cannot be said for stock investors. It appears that stock investors are beginning to price in a more realistic future for U.S. economic growth. While we would like to think we have a V-shaped recovery in the making, the evidence suggests that we simply do not. We continue to monitor and adjust our recommendations to suit our individual clients' needs and tolerances for risk and are pleased with the recent market action.

Take care,
Greg

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June 12, 2010

Nervous Stock Markets Remain Volatile

For the first time in weeks stock markets around the world found a footing late this week on news that China's economic growth may soften the blow of the European Union's possible collapse.

News was leaked on Thursday that China's economy was performing better than expected with exports rising on supposedly stronger worldwide demand. This caused a quick response with a jump of nearly 2% in stock markets around the globe. The news out of China came days ahead of the official government release of the data and the Chinese government has said it would launch an investigation into the source of the leak.

Our stock market jumped quickly on Thursday's news and caused an otherwise weak market to turn higher for the week. I place two arrows on the chart below to point out Thursday's jump in prices and the trade volume for the day. Most of the action took place in the first hour of trading on Thursday as traders quickly bought stocks. Unfortunately few investors followed traders into the market and in the end trading volume was very light, which is classic bear-style activity.



George Soros says, "We have just entered act II of the European crisis"

Billionaire hedge fund investor George Soros said this week that the budget woes affecting Europe is entering a new phase. "The collapse of the financial system as we know it is real, and the crisis is far from over." Soros said this week in a conference in Vienna. Soros has been a power player in the world for decades. He correctly called the collapse of Japan's economy in 1989 and the rise of Germany as an economic superpower in that same year following the fall of the Berlin Wall.

Soros said that the current situation in Europe is "eerily" reminiscent of the 1930s with governments under pressure to reduce spending and raise taxes at the very same time the economic recovery is very weak.

Can the European Union and International Monetary Fund Save Europe?

A $1 trillion aid package from the EU and IMF sounds like a lot of money and while it may help delay a Greek default and give Spain, Italy and possibly Portugal time to get their finances in shape, it would not likely be enough money to stop a wider contagion of the problem.

According to figures from the Bank for International Settlements in Basel, Switzerland, the amount of debt owed by Greece to European banks is very small when compared to the other countries that are also teetering on the edge. The chart below shows just how small a role Greece plays in the bigger picture and puts in perspective just how small the EU/IMF bailout fund really is when compared to the larger problem.



On the bright side, Moody's Investor Services said this week that after surveying more than 30 banks in 10 nations that EU banks could absorb losses on government and private debt in Greece, Portugal, Spain and Ireland without having to raise additional capital. One can only hope they are right.

Treasuries remain strong on weak U.S. economic news

On Friday the Commerce Department announced an unexpected drop in U.S. retail sales for the month of May. The decline of 1.2% was the biggest decline since last September. This coupled with a report from the Labor Department showing that U.S. consumer prices fell 0.2% for May bolstered treasury prices.

The chart below shows interest rates paid on U.S. Treasury bonds with maturities spanning from short to long-term maturities. This chart compares investor yields this week, last month and last year. Yields remain much lower than normal (which means prices are higher than normal) as investors continue to choose safer investments over risky alternatives.



Conclusion

We have been saying for months that the second act to the U.S. credit collapse is still unfolding. The EU and IMF are making a valiant effort to address the world's problem sitting in Europe, but we are far from out of the woods.

As I wrote last week, we are not "perma-bears" (those who always think that the stock market is going to fall), but neither do we believe a buy-and-hold approach is prudent in these times. Our macroeconomic thesis leads us to believe that a defensive position is appropriate. This is paying off right now. Once prices settle back to more rational levels, we will once again recommend re-balancing to take advantage of price volatility. For now, we are very happy to maintain our current allocations.

Take care,
Greg

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June 7, 2010



New speculation of a "Greek-style financial crisis" in Hungary combined with disappointing news on the US employment front was too much for stocks, sending the Dow and the S&P 500 sharply into correction territory.

The economic outlook softens

Job growth continues to languish at levels much lower than we normally see following recessions. Disappointing jobs data released on Friday shocked bullish investors, but it hardly came as a surprise to many analysts who recognize that the US economy is not yet positioned for sustainable job growth. The factors that are keeping our recovery subdued are many, including:

- higher taxes and the expectation of future tax hikes
- difficulty obtaining credit for individuals, investors, corporations and local governments
- falling home values
- uncertainty regarding the potential consequences of governmental credit crises, particularly in Europe
- an economic slowdown in Asia

These factors are making employers hesitant to hire more workers, and they are making consumers hesitant to spend money until these problems are more or less resolved.

The trend for stocks is clearly downward, but we are still likely to have some counter-trend rallies at times.



Meanwhile, US Treasury investors are benefiting from the market's flight to safety; the chart below shows the present upswing in bond prices.



The good news is that commodity prices are falling, which makes products cheaper for US consumers; the bad news is that commodity prices are dropping as a consequence of weak demand in our contracting economy. The chart below shows how an index of commodity prices peaked in early January, from which it has continued to trend lower. Whether this trend continues depends heavily on the US consumer.



Some have predicted that gold would soon reach above $2,000/oz., but that has not happened yet because gold is not immune to the deflationary headwinds of the other commodities. This chart shows that while gold's recent trend has been upward, there is resistance at the nominal high reached last year. For now the preferred safe-haven instrument remains Treasury bonds.



This is not news to everyone

Those in the business media tend to interview analysts associated with big Wall Street firms that profit when investors are more tolerant of risk; as such, these analysts usually give positive macroeconomic opinions to substantiate their claim that "risk is always good". The viewer rarely hears a gloomy outlook when one is due, yet there are many analysts and economists who have been touting a different story for some time. Bill Gross of PIMCO funds has been saying since last year that we should expect to see a period of subdued growth going forward because of the factors cited above. U.S. economist Nouriel Roubini, best known for predicting the U.S. housing crisis, said there is a risk of a second financial crisis, with countries and their banks becoming insolvent. Dr. Robert Prechter had accurately predicted the peak in stocks in late '07 and the bottom in '09; now he is looking for a retest of last March's low as we realize and address the numerous budgetary problems across the world. We follow these analysts (among others) to get a more balanced set of opinions, which has lead us to our relatively defensive posture.

We are not "perma-bears" (those who always think that the stock market is going to fall), but we do not believe a buy-and-hold approach is prudent in these times either. Our macroeconomic thesis leads us to believe that a defensive position is appropriate. This is paying off right now. Once prices settle back to more rational levels, we will once again re-balance to take advantage of price volatility. For now we are very happy to maintain our current allocations.

Take care,
Greg

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June 2, 2010

Stocks rally on home sales

For just the sixth day in the past month stocks closed higher today with the Dow posting a 225 point gain ending the day at 10,249. The market moved higher after hearing that the National Association of Realtors announced that their Pending Home Sales Index rose last month. Technical analysts could see today's action in the market as a counter-trend rally within a correction to lower stock prices.

Home sales were up last month

The good news is that the index rose higher than expected as buyers rushed in to take advantage of the home buyer tax credit. The bad news is that to receive the tax credit buyers had to sign escrow by April 30th and since then mortgage applications have plummeted. Four weeks after the expiration of the tax credit mortgage applications have fallen 40% from a month ago levels to their lowest level since April of 1997.

The bottom line is that today's real estate figures prove that tax credits can drive consumers to act but once the credit expires normal market forces quickly return.

Stocks post a counter-trend rally

The Dow drove back up to its 200-day moving average and could have the momentum to work a little higher before working to lower levels. Below is a chart of the Dow. The chart shows how the market has bounced slightly but the lower half of the chart shows that the number of trades (volume) is light which is a classic sign of weakness.

Treasury prices fade today

Treasury prices have been moving in the opposite direction as stock prices of late. The chart below shows the yield for the 30-Year Treasury Bond. This chart shows how yields have been falling for two months now; this means that the prices for these bonds have been going up for two months. While the trend is still for higher bond prices, bonds have pulled back a bit the past few days. One could expect this trend to continue for few more days but the duration and extent of this movement is largely dependent on the health of many European countries as they struggle to work out solutions to their debt crisis.

Bottom line

Today's bounce in stock prices and corresponding weakness in bond prices does not change our view that our economy is fundamentally weak and the markets are overly dependent on Federal stimulus just to keep stock prices reasonably stable. Our country cannot afford to support these markets indefinitely; otherwise we will soon find ourselves in the same kind of trouble that Europe is now dealing with. I believe our relatively defensive posture is working nicely for us.

Take care,
Greg