Archive for April, 2010

Bloomberg had an article posted today entitled – Bond Traders Declare Inflation Dead after Yields Fall!  The article surmises that interest rates are low and well contained.  One trader states that he is not concerned at all about rising interest rates.  He doesn’t think that rising interest rates will be a threat.

I believe that interest rates will rise for one simple reason.  Let me show you an illustration of something that ran in the Chicago Tribune.

(related image) 

Debt will probably be the reason that interest rates go up.  If you have been staying up on the news, you know that Greece and many of the other European Union countries are in financial trouble.  Greece, in particular, needs to borrow money or are seeking a bail-out just so they can make their debt payments to their creditors.   So if you are going to lend money to someone in trouble, shouldn’t you get rewarded with higher interest rates for taking the risk?  When Greece issues bonds (read: borrows money), they are forced to pay higher interest rates because they represent a risk.  I think that we will start to see the same thing in this country.  In fact, I think that we already are seeing this occur.  At some point, investors are going to demand much higher interest rates on US government bonds which forces interest rates to rise.  One other point to make about the article is that rising interest rates does not automatically equate to inflation.  We need prices to go up all across the board for inflation which brings me to the title of this piece.

Inflation would be a welcome sign.  The opposite of inflation is deflation.  That is what Japan has been mired in for decades and what the US went through in the 30’s.  I believe that is what we face today. Unusually high levels of debt create deflation.  So, once again, we come full circle to this enormous debt problem in America.  Our politicians can pretend it is not there.  We can also think of it as our children’s problems.  In reality, it is driving force behind all financial problems in this country.

Low Volume

Will Deener wrote an article in the Dallas Morning News this morning debunking the views of those of us who are bearish.  He quotes a trader that states the low volume in the stock market is actually a bullish indicator.  He says that you want to buy stocks when no one wants them.  I don’t think that I would go this far.  There is something else that usually occurs when the volume is this low.  You typically see low volume when you are getting to the end of a bull market run.  Further, investors are unusually spooked right now about the stock market.  I don’t think that this kind of fear is a good thing.

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What is the most difficult thing about managing money in this environment?  This is a question I get from time to time.  What separates this time period from any other is politics.  It is the most unpredictable risk out there.  The politicians are going to do whatever they need to pass their agenda.  Unfortunately, there is a great deal of agenda.  That agenda means that politics will influence the market positively or negatively.  Thus, you never know what actions Washington will take – either market friendly or unfriendly. 

Let me just get the obvious out of the way.  Wall Street needs to be reformed.  There is no question.  However, they don’t need to be reformed like the politicians want to reform.  There is reform and then there is control.  The financial regulation is all about giving the government more control.  That is the last thing that you want to do.

The politicians are having a tough time getting financial regulation and reform done because the Republicans see the power grab this legislation represents.  So, how do you fix that problem?  You shape public opinion by vilifying Wall Street.  Don’t even begin to think that Goldman Sachs is the only financial institution that the government pursues.  I will bet it is only the beginning. 

I was having a conversation with a close friend of mine who has been managing money for 20 plus years and made the comment that I don’t like the market at these levels as well in an environment with all of the indicators firing warning signs.  He replied that there is no catalyst.  Well, the catalyst is one thing that you don’t see in advance.  Politics has a great way of creating the catalyst. 

This does raise the stakes here at this level in the stock market.  It is too early to see if this is the start of a series of events that stops the bull market rally.  If anything, it welcomes a much needed correction.  For long-term investors, anything below 1081 on the S&P 500 creates a very large risk.  For the Dow, that level to watch is 9,234.  Those levels are a long way off.  Thus, the market could correct (which would be healthy) down to those levels.  That is roughly a 17% correction.  However, if the markets cannot rebound from that type of correction, this party might be over.

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You might want to put that Dow 11,000 party hat away for the time being.  Evidence of trouble ahead is getting much louder.   There are predictive indicators that would suggest that trouble is on the horizon.  These indicators simply suggest that risk levels are escalating.  They aren’t necessarily a great timing mechanism.   At the same time, as a stock market investor, you don’t want to ignore them.

They have been appearing throughout the first quarter. 

(1)               Percentage of Mutual Fund Managers in Cash Holdings

This has always been a great indicator.  When mutual fund managers hold low levels of cash, it has always been a sign that the market is headed for trouble. 

We are currently at the record level of low cash reserves held as in 2007 when the market turned into a bear market and in 1987 when we experienced the second greatest stock market crash of all time.

 (2)               The January Indicator

The old saying goes “so goes January so goes the rest of the year.”  During the last 59 years, January has had a negative return 23 times.  If you will recall, we had a negative January this year.  Of those years where there was a negative January, 56%  the stock market produced a negative result for the year.  

 (3)        P/E Ratios

I will resist getting into the mechanics of how a Price to Earnings Ratio works and its relation to the stock market.  You don’t need to understand how all of that works to get the point.   The bottom line is that new bull markets start when P/E ratios are low.  Bull markets end when the P/E ratio gets too high.

 The top of the bull market in 2007         P/E was 25.5

The top of the bull market in 2000         P/E was 44.2 (due to internet bubble)

The top of the bull market in 1966         P/E was 24.1

The top of the bull market in 1937         P/E was 22.2

The top of the bull market in 1929         P/E was 32.5

The top of the bull market in 1902         P/E was 25.1

 According to Robert Schuller’s valuation model, which looks at reality and makes no assumptions about the future, the current P/E ratio is 25! 

(4)               The December Low Indicator

 Lucien Hooper, a Forbes columnist and analyst, coined a stock market warning sign called the December Low Indicator.  If the stock market anytime during the first quarter goes below the lowest price level of the preceding December, a sell signal takes place.  This occurred during the first quarter. 

 The Stock Market Almanac further researched this sign and found that this has occurred 30 times since 1952.  If you get the combination of a negative January along with the December low indicator, the stock market has ended negative for the year 75% of the time. 

(5)               Decennial Cycle – 10th year of the decade

The 10th year of a decade has carried some significance.  Tenth years have the worst record within the Decennial Cycle and 2010 is a midterm election year, which has the second worst record of the 4 year presidential election cycle.  Of the last 12 occurrences dating back to 1890, the stock market lost money 8 out of the 12 times during the 10th year.  The average loss has been -7.2%.  

 Year                 % gain or loss

 1890                       -14.10

1900                       + 7.00

1910                       -17.09

1920                       -32.90

1930                       -33.80

1940                       -12.70

1950                      +17.60

1960                         -9.30

1970                          4.80

1980                        14.90

1990                         -4.30

2000                         -6.20

2010                        ?????

(6)  Low Volume

This is one thing that really perplexes the market pros.  If you have a strong rally, typically you have strong buying volume.  There are a lot of buyers stepping up to the plate.    A hallmark of market tops is a rising stock market on low rally.  If anything, it is a warning sign.  Today, we have very low volume on the way up. 

The number one job of Wall Street is to convince the world that risk doesn’t exist.  They would prefer if investors just go back to sleep and not pay attention.  The signs of risk are building.

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There is no question that seeing a positive sign in front of the employment numbers is an encouraging sign.  It has been a very long time since that has occurred.  On Friday of last week, the Department of Labor announced that 166,000 jobs were created last month.  As always, let’s drill down into the numbers and look at the real story.  In order to get on the road to strong economic recovery, we need to start seeing a creation of 250,000 to 300,000 jobs each month.  In fact, we need to see those numbers for a very long time just to get the millions of unemployed workers back into the workforce.

Of the 166,000 jobs created last month, 48,000 were temporary hires by the government in order to take care of the census.  Then there is my favorite government accounting methodology which is the birth/death ratio where the Government “estimates” the number of people who were hired and were not counted in the employment survey.  It is always dangerous to give politicians the license to estimate.  They “estimated” 81,000 jobs were created.  This leaves us with roughly 37,000 that were full time hires.  Temporary hiring is better than nothing at all.  Although any positive number is a welcome sight, this is not a solution to the longer term problem. 

There are a few other items worth noting.  I have written in weeks past that I felt we are in a strong deflationary environment.  Deflation, as you might recall, is an economic phenomenon that causes prices of almost everything to decrease.  Along with deflation, we do have some undesirable inflationary pressures.  Most people are not aware that the cost of oil is now $86.34 a barrel (as I write).  It continues to slowly creep up.  Of course, this ends up being reflected at the gas pump.  The other thing worth noting is the rise in interest rates.  Rising interest rates in a debt-plagued environment is not a good thing, especially when we still have an ongoing foreclosure crisis were people desperately need to refinance at lower interest rates. 

It has often been noted that 4% on the 10 year treasury bond yield is a level that you want to stay below because of its effects on mortgage rates.  As of this morning, we are dangerously close to hitting that level.  The current level is 3.98% as interest rates are soaring upwards this morning.  Yet, all of these issues face the stock market and it looks like no one will be satisfied until the Dow can hit 11,000.  So, once we arrive at that level (19 points away) do we break out the party hats?  We would only if it is sustainable.  The market would need super human powers to sustain these levels with these headwinds.

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