WEEKLY UPDATE

March 26, 2010



A bear-market rally is a strong, unsustainable rally that follows a major drop in stock market levels before fundamental economic improvement is reasonably expected. A chart of a typical bear-market rally, which occurred in the U.S. during 2000 - 2003, is below:


source: www.safehaven.com

Is this a bear-market rally?
Yes, we are in the midst of a strong bear-market rally that is fueled by artificial means, i.e. economic stimulus from the Federal Reserve.

How long will this rally last?
Many analysts are surprised that the rally has lasted this long. My view is that as long as the Fed keeps supporting the market, it will stay pumped up at these general levels.

Is the market overvalued?
I believe that it is. If you consider the Price-to-Earnings ratio of the broader market, you see that the market is priced too high given its earnings. A normal range for the PE ratio of a stock market is a low of 10 (meaning the market is somewhat cheap) and a high of 20 (meaning the market is somewhat overvalued).

A close look at Standard and Poor's estimate of the S&P500 PE ratio shows that on a trailing 12 months earnings basis the market is trading at a PE ratio above 90!

On a forward earnings basis, Standard and Poor's is estimating that corporate earnings will grow more than 35% higher this year and based on that the PE ratio is above 15. I personally cannot see how one can reasonably expect a 35% increase in earnings when consumers remain largely tapped out.

Over the past year corporations surprised everyone by cutting expenses to the bone with massive lay-offs. By cutting costs, earnings growth has been strong, but earnings cannot sustainably grow unless the economy and the American consumer recover.

According to Robert Shiller, a widely respected economics professor at Yale, the market is about 25% overvalued based on his very long-term study of corporate earnings.

Is the market overdue for a correction?
I believe it is. The chart below shows recent action on the S&P500 - upside momentum is stalling out with trading volume lighter on up days and stronger on down days. These are signs that investors' purchasing power is exhausting, but until the market breaks below its 50 and 200 day moving averages the market trend must be respected.



What is the long-term outlook for stocks?
The long-term outlook for U.S stocks is positive but before we get to sustainable conditions we need to muddle through what Bill Gross from PIMCO describes as the "new normal". The new normal is the situation that for as long as we delay refinancing our residential, commercial, and government debt we will have a very flat economy, high unemployment, and low inflation.

Eventually we can emerge from these obstacles (in the next couple of years), but until then economic growth will be muted. Until we get past these issues we run the risk of falling deeper into an economic malaise similar to the Great Depression. Here are some of the obstacles we still face:

- Unemployment ranges from 9.5% to more than 20% depending on which measure you prefer - without a turnaround in unemployment, the economy will remain soft.

- Mortgages remain a problem. 1 out of 4 mortgages in this country now have negative equity. With more ARMs and Jumbo ARMs ready to reset this year, we don't see a recovery in housing for at least another year.

- Commercial debt is a time bomb. The Congressional Oversight Panel for the TARP program warns that losses originating from underwater commercial loans will exceed $300 billion starting in 2011. Almost half of these loans are concentrated in smaller banks and it stands to cripple them. This is a problem that has yet to be addressed.

- Bank closures. In spite of closing 140 banks last year the FDIC has increased the number of banks on its problem list from 400 to over 700 during the past six months. The FDIC has run out of money and is running out of good banks to use to buy the assets of bad banks. The FDIC came out a couple of weeks ago urging public pensions to consider buying bad banks (which is a terrible idea!).

- $2 Trillion public pension hole. The Pew Center, a non-partisan research group, reviewed the health of California's public pensions. What they discovered is that even before the markets fell in 2008 there was a $500 billion shortfall in our public pension accounts. Since then the losses have grown by an estimated $1-$2 trillion more. If our states do not find a way to fill this gap we will find ourselves in the same predicament that Greece, Spain, Portugal and others are now in.

- Greece, Portugal, Spain, UK, etc. suffer from too much debt. While Greece is in the news today, all of these countries and more are suffering from excessive debts. Excessive debt lowers a country's creditworthiness, raising yields demanded by lenders, making it more difficult for the country to issue the debt necessary to finance the debt that country already has outstanding; this cycle can lead to default. Greece is currently hoping for a bailout from the European Union and/or the International Monetary Fund but how many countries can these institutions afford to bail out?

Conclusion:

It really boils down to this: the world (homeowners; state, local, and national governments; private equity firms; pension plans) has too much debt on its hands - the world is overleveraged. When the credit bubble burst it wiped out trillions of dollars of wealth so folks everywhere are finding it quite difficult to refinance the debt they built up during the good years. We have to muddle through this. The Fed knows that the only way to keep things upright is to inflate the world with cheap dollars. The Fed has begun to pull the plug on their money pumping machine and end some of the stimulus programs they have been running this past year. Once these programs are ended we will begin to see truer valuations in the stock market and this bear-market rally may have finally run its course.

Take Care,
Greg

---

March 23, 2010

Bear Market Rally Pushes Higher. U.S. stocks have quietly risen in 10 of the last 11 trading sessions and have worked their way just above the mid-January recovery high, yet the market is not going anywhere fast. Trading volume is very light, signaling that many investors remain on the sidelines. Buyers continue to slightly outnumber sellers in this unusually light market so sellers are unable to wrest control of this market from the buyers. Meanwhile, complacency continues to seep into the markets as the VIX index (a.k.a. the volatility or "fear index") continues to fall to lower levels, signaling that traders are comfortable with the market at these levels; the problem with this is that a low VIX index is a very good contrarian indicator that the market is overdue for a pullback of increasing amounts.

Phillippe Gijsels, head of research at BNP Paribas Fortis Global Markets was quoted on CNBC yesterday saying that, "we have always labeled the move from the March (2009) lows as the mother of all bear market rallies and we stick to this view, even thought it has already moved quite a bit further than we expected."

In any event the market is overbought and overdue for a much deeper correction than that which occurred some weeks ago, but with trading volume still well below historical averages, the market continues to float along until an unexpected news development triggers a correction to lower levels.

Bond Funds Hold on to Gains. In spite of concerns about how the bond market will react to the ending of the FED's year-long support program, bond funds continue to hold on to price gains. Below is a chart for the past week of some selected bond funds that are indicative of the broader government bond fund marketplace. We are keeping a close eye on this sector as we approach the end of the FED program, which is just two weeks away.



The next couple of weeks should be quite interesting. We have a showdown forming in Europe over Greece's fiscal problems, we have a war of words brewing between Washington and China over currency values, and we have a variety of economic reports coming our way. I look forward to sharing the results of these events with you as they develop.

Take care,
Greg

---

March 16, 2010



Stocks were slightly higher last week as were bond fund prices. Here are some highlights:

The FED leaves interest rates unchanged. After the conclusion of today's FOMC meeting they announced that they are not making any changes to interest rates or the various stimulus programs they currently have in place. Stock and bond prices rose following the Fed's announcement.

Stocks ended slightly higher last week with a slim gain of 12 points on the DJIA. The stock market ended slightly higher for the second week in a row on very light trading volume. There has not been much news to direct the markets so the focus was on today's Fed meeting.

Our bond funds were slightly up for the last two weeks despite rising Treasury yields. The last two weeks have seen rises in Treasury yields (for instance, the 2-year Treasury rose from 0.82% to 0.94%); however our bond funds have risen slightly higher in price over this period. On an otherwise quiet week, the most notable change in bond prices has been the price change of Ginnie Mae, Fannie Mae and Freddie Mac mortgage-backed bonds which were much higher this week and are now at levels similar to their treasury counterparts. This is important because many of our bond funds hold mortgage-backed bonds issued by these government entities. Some of the strength in these bonds can be attributed to comments from Bill Gross (of PIMCO) last week that the U.S. Government should support the mortgage market by continuing their purchases of mortgaged-backed bonds. Today's comments from the Federal Reserve did not support Bill Gross's view that mortgage-backed bonds should continue to receive their support; nevertheless, the prices of these bonds rose following the Fed's comments. The chart below shows the price change in many of our bond indexes following the Fed's announcement.



Mortgage Rates Fall slightly. Thirty-year mortgage rates fell slightly to 4.95% this week while fifteen-year mortgage rates declined to 4.32%. At least part of these drops could be attributed to less demand for new mortgages and better pricing in the mortgage-backed bond market.

In 2009, U.S. banks posted their sharpest decline in lending since 1942! If you want to see if real estate is getting better, look for an expansion in lending. Total residential mortgage debt actually declined in 2009 by 2.1%, and the trend is getting worse. The rate of decline accelerated to 3.2% in the fourth quarter while commercial mortgage borrowings fell at a whopping 7.4%. This is a clear sign that despite flooding our banks with capital, this money is not making its way to borrowers.



38% of all home sales in January were distressed sales. Distressed sales, such as foreclosures, accounted for 38% of sales in January, up from 32% in December. People continue to lose their homes at an increasing rate.

Consumer Sentiment Dips in March. According to Thomson Reuters/University of Michigan's Surveys of Consumers, Americans are less optimistic about jobs and the economy. Early March results were lower from February and below analysts' forecasts.

On the bright side, employment should improve over the next few weeks! The good news is that the government is planning to hire 1.5 million part-time workers to complete the 2010 Census. While this is a short-term improvement in employment, any progress in this area is appreciated by the millions of displaced workers looking for employment. Aside from job growth in November we have yet to see more jobs created than the number of workers who file for first time unemployment benefits. We need roughly 100,000 net new jobs each month just to keep pace with young folks entering the workforce. We have not seen this for two years so any improvement (even temporary) is welcome. We expect that the media will tout this as a recovery and bond prices may react negatively as bonds are a haven of safety, but we do not see this as a sign of long-term sustainable job growth.

Take care,
Greg

---

March 8, 2010

Don't Worry about a Double-dip in the Economy - If/When it Arrives, We're Ready for It

Some of TV's more popular talking heads are now giving airtime to the question, "Is the economy headed for a double-dip?" We have been talking about a double-dip in the economy for some months now. It doesn't take too much effort to see why a double-dip could be in the cards: banks are still too unhealthy to lend, we are still losing jobs, and the government is pulling away many of the stimulus plans it enacted a year ago to prop up the economy. Each of these alone puts the economy on shaky ground. I wrote about the Fed's three-year outlook for subdued growth just a couple of weeks ago, but today we will take a closer look at what one private group is saying about the economy.

The Consumer Metrics Institute Forecasts a Decline in the Economy

The chart below comes from the Consumer Metrics Institute, a private economic forecasting firm. The CMI uses a data collection method that gathers U.S. economic information on a real-time basis - a much timelier approach than that of the Commerce Department, which is notoriously slow at revealing turns in the economy.

This chart (Figure 1) compares the CMI's real-time economic growth index to the U.S. Department of Commerce's quarterly GDP growth rates for the past four years. The CMI's data suggests that a downturn in consumer activity started last August, and because there has been a four-month lag time between consumer activity and activity in factory production, we are only now starting to see weakness re-emerge in factory output and employment. The employment chart (Figure 2) below shows a peak in job growth in November followed by more declines; this supports the CMI's view that the economy peaked in November.





Meanwhile the Commerce Department Index of Leading Economic Indicators dropped significantly on January 15th and reached a net annualized "growth" rate of -1.5% by the end of February. Further making the case, the Commerce Department announced the results of the Consumer Confidence Survey on February 23rd which dropped 10.5 points from the January reading. They went on to report that "current business conditions and the job market pushed the Present Situation Index down to its lowest level in 27 years." All of this is pointing to a slowdown of reported economic activity over the next few months.

The Official Unemployment Rate Stays Steady at 9.7% with 36,000 Jobs lost in February

The Bureau of Labor Statistics (BLS) reported that non-farm payroll employment was down 36,000 jobs in February. Employment fell most in construction and information services, while temporary help services added jobs to the economy. Among the highlights:

- 36,000 jobs were lost vs. 26,000 lost in January.
- 64,000 construction jobs were lost vs. 77,000 last month.
- 51,000 (50,000 were part-time) professional and business service jobs were added vs. 30,000 added last month.
- 48,000 temporary help jobs were added vs. 50,000 added in January.
- Average weekly hours slipped from 33.9 hours worked each week to 33.8 hours.


People Not Included in the Numbers

About 2.5 million people have lost their jobs but are not included in the unemployment rate because they have not actively looked for work in the past 4 weeks; this figure is up 476,000 from a year ago. Among these 2.5 million people, 1.2 million of these folks are "discouraged workers" because they believe that no jobs are available for them.

The chart below (Figure 3) shows the offical unemployment rate (U-3, 9.7%) and the broader (U-6, 16.8%) unemployment rate which is the offical unemployment rate plus those folks who gave up looking for a job, those whose unemployment benefits ran out, and those working part-time but desire a full-time job. The SGS alternate figure is based on the way unemployment was calculated before it was changed in the mid-1990's.



The key takeaway from all this is that there are 8.8 million people who are looking for work today and countless more working part-time. Part-time jobs will have to begin turning into full-time jobs before the unemployment rates decline and the economy begins a sustained recovery.

Our Outlook for Next Week

U.S. stocks had a good week. Most of the gains in the stock market could be attributed to favorable news concerning Greece (i.e. a successful Greek bond auction and further talks of a bailout from the European Commission) and the better-than-expected U.S. unemployment figures released on Friday. Technical analysis points to a little more strength in the stock market.

Bond yields (Figure 4) for 2 and 5-year U.S. Treasuries have been trending lower (with prices trending higher) since January 1st, but the unemployment figures sparked a mild pullback in some sectors of the bond market. Those of you who were under-allocated in bonds saw us take advantage of these weaker prices by buying some selected bond funds. For now the trend in interest rates is neutral. Signs of economic growth may cause rates to rise, but as I indicated at the top of this week's update, time will tell if and when a double-dip of economic weakeness surfaces. If it does, it will be bullish for our credit-worthy bonds.



All in all our positions are squared up to endure the economic conditions we now face. A double-dip economy may be in our future, but we are prepared for it.

Take care,
Greg

---

March 1, 2010



It was a tough week for economists to find bright spots. Fed chief Ben Bernanke set the tone on Wednesday when testifying before the House Financial Services Committee. He told the committee that the U.S. economy is in a "nascent" recovery and that interest rates near zero are still required. This was followed by the release of some troublesome economic data that was consistent with his outlook.

Unemployment claims come in higher than expected for the second week in a row
This week's new unemployment claims report showed nearly 40,000 more people had filed for first time unemployment support. The Labor Department said new claims for unemployment insurance rose to a three-month high and this was the second week in a row that new claims of unemployment came in higher than expected. Economists thought new claims would be down to nearly 400,000 by now, instead new claims are currently at 496,000.

New orders for durable goods unexpectedly drops
Orders for durable goods excluding transportation unexpectedly fell 0.6%, the biggest drop since August, while a measure of bookings for business equipment showed its largest decrease in nine months, the Commerce Department said this week. What makes these figures even more disheartening is that defense spending by the Federal government is holding up the durable goods figures more than ever before. On average defense spending has made up 4.4% of overall durable goods spending but since December 2007 defense spending has been increasing to a level today of more than 8% of durable goods spending. If we took away the defense department durable goods spending, we could see just how weak the private sector really is.

New and existing home sales plunge
Sales of new homes in the U.S. unexpectedly fell in January to the lowest level on record, a sign that an extension of government tax credits may not be enough to rekindle demand for housing. Folks on the business networks began to discount this information saying who wants to buy a new home with so many cheap existing homes on the market. That may be true but their argument that buyers were avoiding new homes to favor existing homes fell apart when it was reported that existing home sales also plunged. Existing home sales fell an unexpected 7.2% in January showing that this housing recovery is a lot shakier than most had anticipated.

So… with all this weak economic news, how did stocks and bonds perform?
As the chart below shows, stocks were lower for the week. Much of the weakness in stocks came naturally as a result of the weak economic data, but recent moves in stock prices also have a lot to do with the strength of the dollar. From Monday through Thursday morning the dollar held firm against the Euro and lately a stronger dollar means lower stock prices. But after reaching an eight-month high against the Euro, the dollar started to weaken on Thursday morning and this put a floor under stock prices. As we start next week any further signs of Euro strength will likely put a boost into the stock market which I doubt will last long as a bailout of Greece will only delay the decline in the Euro against the greenback.

Meanwhile treasuries had one of the best weekly gains since last August
Yields on 2-year Treasury notes closed the week at 0.82% down from 0.92% a week earlier. "The fundamental picture is supportive of Treasuries as the recent housing data highlight how the U.S. economy may be unable to move down the road without government training wheels," said Bill O'Donnell, head of Treasury Strategy at RBS Securities.

The chart below shows the past week in trading for the Dow compared to the dollar index (UUP) and the mortgage-backed bond market (MBB).



The bottom line is that we need to keep our jackets on while this snowstorm of economic weakness continues to dampen the hopes for a quick economic recovery. Talk of economic green shoots may soon be replaced with concerns that we are in the beginning of a double-dip. Our approach remains cautious.

Take care,
Greg