WEEKLY UPDATE

September 28, 2010



The Conference Board's consumer research center released weaker than expected results of a survey of consumer confidence today. Economists had anticipated some weakness in today's survey but the results showed a much more pessimistic outlook was looming in the minds of U.S. consumers. The survey shows that consumers are concerned about jobs and housing prices. Such concerns as these are understandable given the post-stimulus weakness surfacing in housing prices and an unemployment rate that is expected to stay in the 9-10% range for the next year.

Weakness in consumer confidence is re-igniting expectations that the Fed may announce another round of stimulus for our economy. This is referred to as "quantitative easing" (QE).

What is QE? It is essentially the process of flooding the economy with newly printed money. The Fed will print money and use it to buy government-backed bonds. Over the short-term this keeps interest rates low and indirectly weakens our dollar which can boost the value of our exports. However, over the long-term it can destabilize the economy.

Is QE inflationary? Yes it is. Whenever the Fed puts more money into the economy than is commensurate with economic growth, it results in inflationary. Proponents of QE point out that we are in danger of having a deflationary economy. Home values are falling, banks are failing, loan values are dropping, people are out of work and those with jobs are not spending; these all create deflationary pressures on the economy so the Fed is using QE in an attempt to re-inflate a deflating economy. Think of a child blowing up last summer's pool toy while at the same time the toy is leaking air at the seams - that little boy is the Fed and that pool toy is our economy.

Does everyone agree that QE is good for our economy? No. Many people believe that too much Fed stimulus fueled the housing bubble, so they believe another round would only create another bubble. Many of these folks believed that the first round of QE that was implemented in April 2009 was necessary to steer the world's economy away from an abyss, but resorting to another round of QE today will create more problems than it solves.

Does QE affect our financial planning outlook? Yes it does. Quantitative easing is a risky tool. Using QE forces the Fed to walk a tightrope. Without QE we are making the choice to let our economy heal naturally but slowly. We allow housing prices to reach a natural price level, we let the banks slowly absorb their losses and we let the stock market correct to historically supported levels. Deciding not to use another round of QE gives us a better shot at cleaning up our debt mess without jeopardizing the future of our country any further.

If instead the Fed decides to apply more QE to the economy they are in a sense giving a powerful drug to the economy that may work in the short-term (by boosting the economy) but in the long-term leave us with problems such as a weaker dollar, artificially supported markets, and higher inflation.

Did the first round of QE (April '09) work? It did little to help the economy directly but it did help the economy indirectly. It saved large banks from collapse, it helped boost the stock market and it indirectly helped us all sleep at night. Sixteen months have since passed and after spending more than $2 trillion in stimulus money we still suffer from record high foreclosures, lower property values and unemployment rates that have hardly budged.

If QE was ineffective last year, why consider it again? With an economy teetering on the edge of a double-dip and interest rates already reduced to nearly zero, the Fed has virtually nothing left it can do to stimulate the economy. Many argue that the Fed should allow the economy to heal on its own (and the Fed may in fact do just that), but the Fed cannot very well face the public and tell them there is little else they can do without risking a backlash.

What impact does QE have on stock and bond prices? QE has a direct (short-term) positive impact on government bond prices because the Fed is using QE to buy bonds. QE has an indirect and less positive impact on stock prices because QE reduces the value of the dollar which makes our stocks more attractive to overseas investors.

Below is a chart of the S&P 500 stock index and it illustrates how the prospects of QE are causing the dollar to fall, the Euro in turn to rise, and in the end boost stock prices. This relationship is not a long-term indicator for stock prices but it explains much of why September has been a good month for stocks. QE however runs the risk of causing a bubble in stock prices and that is precisely one of the issues we face today.



QE helps fuel bond prices too.

As mentioned above QE is a short-term boon for bond prices. QE helps reduce bond rates over the short-term and that boosts prices. Too much QE however can also cause a bubble in bond prices if the Fed goes too far with their purchases. In the meantime bonds are also rallying because of the weakness in the economy.

Yesterday the government auctioned off two-year treasuries and today auctioned off five-year treasury notes. Both auctions went very well and fueled a rally in bond prices. Many factors can be attributed to this continuing rally in bond prices: the Fed's decision in August to invest money from maturing mortgage-backed bonds into treasuries, the public's aversion to stock market risk, and an economy that is trending very closely to the post-credit collapse economy of Japan's. All of these factors continue to heavily support a rally in bond prices.

The chart below shows several exchange-traded bond indexes and how they have rallied in price.



So what does this mean for us? It means that as investors we are benefiting from a solid bond rally that is fundamentally supported by a weaker economy. Stocks on the other hand remain in an elevated risk/return environment. Our current portfolio allocations reflect today's risk/return opportunities in stocks, bonds, cash and funds. All in all things are going very well. Over the long-term however we have to remain cognizant of the fact that the economy is only part-way through the recovery process following the greatest credit collapse since the Great Depression. Where the economy goes from here lies in the hands of politicians and central bankers. I expect that we will be performing further updates to all of your financial plans as we discover if the cloud on the horizon is one filled with deflation or inflation. Either way we will deal with it.

Take care,
Greg

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September 22, 2010



Back on August 27 Ben Bernanke said that the Fed would do whatever it takes to support the economic recovery if it continued to lose strength. The Fed repeated the same statement yesterday following their one-day FOMC meeting - although they expressed an increased disappointment in the economic recovery, they made no changes to combat the slowdown. They reiterated maintaining interest rates at their current levels for an "extended period". Stocks bounced briefly on the hope that the Fed would announce another round of quantitative easing (i.e. buying bonds to keep interest rates down), the dollar fell against foreign currencies, and government bond prices spiked higher.

Is the economy getting weaker?

If a picture paints a thousand words then the chart below says them all. The Consumer Metrics Institute charts US GDP, the same economic data the government does, but with one very important difference - the Institute releases this data on a real-time basis while the government releases the data quarterly (thus the punctuated government line). The Institute's data (the blue line) shows an ever-weakening economic environment:



So why didn't the Fed offer any new changes to boost the economy?

Frankly there is little the Fed can do. Bond interest rates are already at their lowest levels since the height of the crisis, the interest rate for inter-bank borrowing (the primary tool for Fed policy) is at zero and thus no longer a tool with further potential for effect, and the banking system is flooded with excess cash that no one is eager to borrow. Increasing liquidity will not solve the problem of low business confidence, which is the real cause of our high unemployment. Such a solution can only come from the Executive Office: we need a deficit reduction plan, and we need to know what taxes are in our future.



What's ahead for the markets?

The stock market is in its own little world right now, disconnected from the economy, the bond market, and the gold market. Stocks are caught in a trading range as day traders move the market up and down hoping to obain quick trading profits while long-term investors are still on the sidelines. The chart below shows the market at the top of its trading range but is in overbought territory and has reached this level on very light trading volume. The market is trading on thin air.



Bonds on the other hand are trading on economic fundamentals. Bond prices have rallied all year long and if this were a normal year one would have to expect that prices would pull back to lower levels. This will eventually happen but because of the uncertainty surrounding the economy, bonds remain a highly popular risk-and-return play for investors. The chart below shows bond prices this past year. The spike in prices on the right of the chart shows the bond market's reaction to the Fed's meeting yesterday.



Have a good week,
Greg

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September 3, 2010

The Hindenburg Omen

One technical indicator that has been getting a lot of buzz lately is the Hindenburg Omen, which was activated in late August. Apparently it was given the name Hindenburg because "Titanic" was already taken! The name alone is so scary to some that I thought it wise to discuss it.

The indicator professes to signal an imminent stock market crash, but it has only had 25% accuracy since 1987.

The Hindenburg is quite technical in nature. It is a concurrence of several requirements on a single trading day:

The requirements:

1. More than 2.5% of NYSE stocks must hit a 52-week high and more than 2.5% must hit a 52-week low on the same day
2. The number of new 52-week highs cannot be more than double the number of new 52-week lows
3. The NYSE 10-week moving average must be rising
4. The McClellan Oscillator (a NYSE measure indicating overbought or oversold conditions) must be negative

The logic is that the stock market must have some internal uniformity of direction, otherwise stock investors will become too confused and leave the market altogether. Investors hate uncertainty.

Once the Hindenburg Omen flashes, it must flash again within 40 days to confirm the signal. It first hit on August 12 and was confirmed by another signal on August 20. It flashed a third time again in late August.

This indicator has gone off before every stock market crash since 1987; however, it has also signaled many times without an ensuing crash.

Based on historical occurrences of the Omen, the probability of a stock market crash (>20% decline) is now 25% for the near future. Although that also means there is a 75% chance of no such decline, a one-in-four probability is something that must be considered, especially at a time when:

1) The bond market is also predicting a huge sell-off
2) Elliot Wave theorists also predict a huge sell-off
3) The housing market may already be in a double dip
4) The service sector is near recession, again
5) US GDP growth declined almost 60% from Q1 to Q2 of 2010
6) Unemployment continues to rise
7) Fed Chairman Bernanke feels the need to assure the markets that the Fed will do whatever is necessary to support a continued recovery, despite being unable to lower interest rates any further

The Bottom Line:

We understand that the Hindenburg Omen has been triggered, but we also realize that the markets are complicated in nature. We use many different sources of information, i.e. fundamental economic data and direction, technical market indicators, stock valuations, investor sentiment and our clients own individual investment goals and tolerances for risk when recommending various investment positions. The Hindenburg is just one indicator that we keep an eye on when assisting our clients to meet their goals.

Take care,
Greg

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September 2, 2010



Happy Labor Day Weekend!

- Manufacturing is a bright spot - The ISM Manufacturing Index showed a slight improvement for August when the opposite was expected. Manufacturing in the U.S. is a fraction of what it used to be, but while U.S. consumers continue to cut back on spending, foreign interest in our goods still exists. Manufacturing is, in fact, the only part of our economy that has shown consistent signs of recovery.

- Construction spending has fallen again - Construction spending fell 1% in July and is down nearly 11% from year-ago levels. With today's high inventory of houses and commercial properties on the market, it is no wonder construction spending is falling.

- Consumers are not spending - Automakers are reporting horrible sales for August. GM said sales plummeted 25% in August from year-ago levels; Toyota's U.S. sales were down 34%, and Honda's were down 33%.

- Job outlook remains bleak - This week's ADP employment report for August showed that the job market is continuing to deteriorate, with the private sector losing 10,000 jobs - the first monthly loss since last December. New jobless claims were 472,000 for the latest week, significantly higher than that which can sustain job growth.

Bond funds remain strong

Below is a chart of several bond funds and how they have traded this year. Bonds rallied strongly in August, but if there were any soft spots in August they were in Ginnie Mae-type bonds, but they did grow stronger during the second half of August. All in all it was a strong month for bond investors.



Stocks

It seems that many stock traders started their holiday early this week. Trading volume was very light, and this usually increases volatility, which was illustrated on Wednesday when the Dow jumped 254 points. Economics was not a factor in the move as much as the bears simply were exhausted after making August a terrible month for stock investors. This created a perfect opportunity for the bulls to defend a key level of support that the market has had for the past year.

I have drawn a white line on the chart below to show where a battleground has been playing out between the bulls and the bears. This trend line is at the 1,040 level on the S&P 500 Index and marks a key area that bulls have defended many times since last summer. I have placed a green arrow on the chart every time the market has fallen to or below the 1,040 level.

Recently the bears had pushed the market down to the 1,040 level but could not go further. Finally on very thin trading the bulls won the battle and pushed the market higher. Wednesday's rally pushed the market up far enough to re-trace 50% of the previous decline. Now the market is back at a key resistance level and will need a new positive incentive upward if the bulls are to have any hope of going higher. The odds are against the market going much higher without a spurt of stronger-than-expected economic news. Look for tomorrow's non-farm payroll data.



What does this mean for investors? Well if you're a long-term investor, you are likely still bearish and if you are a short-term trader, you went from a bear to a bull and back to a bear in one day!

Have a happy and safe Labor Day!
Greg