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Did you ever wonder why mortgage rates have been so low this year?  Well, let me take you on a journey.  Mortgage rates are influenced by government bond interest rates.  Government bond interest rates are influenced by the price of Government bonds.  If bond prices go up, then interest rates go down.  In order to raise the money to pay for all of the irresponsible spending of the Government, the Treasury sells Government Bonds.  Institutions, other countries, investment firms, etc. buy the bonds from the Government.  That money then goes to work to pay for all of the spending created by the Government.

The Government has a lot riding on those government bond sales or auctions.  If they go well, the Government sells the bonds and gets the money, bond prices go up, and interest rates stay low.  Since most people don’t want to lend the US money because we are in so much debt as it is, someone had to step in and help buy those bonds.  Yes, the Federal Reserve Board has been buying bonds all year creating more debt and keeping bond prices higher and interest rates lower.  I will not even go into how incredibly irresponsible it is for the US to buy its own bonds.  That goes without saying – the problem is that program is coming to a grinding halt at the end of this week following the largest bond auction on record this week – 123 billion dollars worth of government bonds to be issued.  The Fed will get out of the way and the bond markets will be allowed to function freely again.  That might not be so good.

Interest rates started going up today and are at a 2 month high.  What happens when you suppress something that should be going up and then stop?  It is like compressing a spring.  If you let go of the spring, it takes off.  I think that the same thing could happen with interest rates.  If this happens it could disrupt the credit markets, consumer interest rates will go up, businesses will have even more trouble borrowing money, and homeowners will now have trouble getting low cost mortgages. 

The stock market would have a tough time with raising rates.  However, the rising interest rates should help the dollar. If the dollar is going up, the price of gold should take a hit.  Welcome to Deflation!  The economy might start the debt detox process that should have started when this crisis started. 

If you are looking for a catalyst, this could be it.  Interest rate risk is not something that the stock market is ready to face.  However, China and others would certainly like to see the value of our dollar go back up.

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Those of you who have been reading my analysis are probably wondering when I am going to throw in the towel and just admit that the bear market is over and start talking about buying stocks again.  Well, I hate to disappoint you.  It is not going to happen yet.  Let’s take a much bigger picture look at what is occurring.  First, we are in a financial crisis produced by the bear market and those don’t just go away without a strong fight. 

Second, how could a 40% plus rise in stocks not mean the bear market is over?  Well, let’s take a look at history for that answer.  In 1929, a bear market started as a result of a credit/debt crisis.  There are many similarities between that period and today.  The big difference is the type of debt crisis.  The bear market eventually bottomed in 1932 after an 86% decline.  The first “crisis” decline in 1929 saw the market drop -44%.  Following that -44% decline, the stock market went up 46% over the next 147 days.  If you compare that to today, we are going through a similar experience.  The crisis of last year resulted in a -48% decline.  Thus far we are a little over a 40% increase in the stock market over 137 days.   This is not in any way unprecedented.  The problem for stock market investors in 1929 was what followed the 46% increase.  Following that incredible stock market rally was an -82% loss over the next 3 years. 

Third, the market has been rising over the past two weeks as a result of earnings season reports.  Over 70% of the companies of the S&P 500 have reported better than expected profits.  However, a closer look would reveal that the vast majority of these “profits” were due to cost cutting and not real growth.  These are clearly not sustainable. 

Fourth, Wall Street is beating the drum that the recession is just about over.  The index of leading indicators came out last week “and is rising at a rate that has accurately indicated the end of every other recession since the index began being compiled in 1959” (Dallas Morning News).  Is that really valid when we are dealing with the worst recession since 1929 when no leading indicator index was even around? It is important to compare apples to apples.  Wall Street has a history of claiming the recession over prematurely many times before.

Finally, unemployment is a major crisis and there is nothing in the works to fix it.  Of course, you can always get a job working an Obama induced construction job. 

Let’s not get to ahead of ourselves.  I was premature to write that the stock market rally was nearing the end.  Obviously it still has more to go.  I don’t think that I am wrong to suggest the bear market is over.

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 As an investment manager, I am constantly looking into the future and evaluating indicators to determine which investments make the most sense.  Since originally warning of the risk in stocks back in 2007, my indicators have not given any signs that the risk for being in the stock market has changed.  As long as the bear market is around, investors really need to be careful regarding the amount of money that is invested in stocks and stock-based mutual funds.

 

What has to change for stocks to be a prudent choice again?  Although there is a laundry list of reasons for investors to be cautious, one risk remains at the top of the list.  It has been the driving factor for the credit crisis.  Until we get past the foreclosure crisis, I believe this bear market will remain in control.

 

In the simplest of explanations, the foreclosure problem can be explained this way.  For years, the mortgage industry gave loans to people who could not afford them.  For example, Joe wants to buy a home.  He goes to the mortgage company and finds out he can qualify for up to a $100,000 home.  The mortgage company determines that loan amount by looking at Joe’s income and expenses.  Joe can afford the $1,000 a month mortgage. 

 

The mortgage industry thought that it would be a good idea to come up with loans other than a 30-year or 15-year mortgage.  With these new loans, that $1,000 a month payment would purchase a much bigger house.  In fact, it is possible that the $1,000 a month payment could buy a house valued at as much as $400,000.

 

In order to accomplish that magic number, the mortgage company had to make a few adjustments to the traditional loan.  First, they arranged it to where Joe just paid the interest for that month versus interest and principle.  This one little change made a big reduction in the amount that he had to pay. 

 

Second, they were able to give him an adjustable rate feature.  This gives Joe a much lower payment the first 3 years or so.  However, that rate adjusts after the first 3 years and the $1,000 goes up to $2,500 a month.  By then, the mortgage company rationalizes with Joe that he can simply refinance the mortgage and get the payment more manageable.

 

So, imagine millions of people just like Joe taking out adjustable rate mortgages and facing a higher mortgage payment in the future.  This is what has happened.  Millions of adjustable rate mortgages had a payment change and the consumer couldn’t afford the mortgage anymore.  They couldn’t refinance the home because the home was now “under water” or worth less than the mortgage.  This is what led to the foreclosure crisis. 

 

So, if we had hundreds of thousands of people facing higher payments in the year ahead, would it be reasonable to assume that we could have a high number of foreclosures? 

 

Well, this is what I wrote to my clients in 2007.  I showed the following graph which pointed out the billions of dollars of mortgages that were about to have higher monthly payments. You can see by this graph that during the first quarter of last year, the largest number of mortgages changed.  As a result, we had the beginning of the worst of the foreclosure crisis last year. 

   

 

Unfortunately, that was round 1 of the foreclosure crisis.  That graph only represented sub-prime mortgages.  Now, we have all of the other types of mortgages whose monthly payments will change coming due this year and into next year.

 

  

This graph shows that we are at the beginning of payment changes for mortgages that will not peak until 2011.  It looks like we will not be out of this problem until 2012. 

 

When you have waves of foreclosures, you have problems with the banking system and everything that is tied to those mortgages.  It gets much more complicated.  To make the problem more challenging, a good percentage of these homeowners owe more than the house is worth.  Look at the following percentages of homeowners with the various types of mortgages:

 

73% homeowners with Option Adjustable Rate Mortgages owe more than the value of the house.

50% homeowners with Sub-prime Mortgages owe more than the value of the house.

45% homeowners with Alt-A Mortgages owe more than the value of the house.

25% of Prime Mortgages owe more than the value of the house. 

 

Contrary to what the Government and Wall Street want you to believe, the risk is still extremely high for the economy and the stock market.  What has plagued the stock market is still the problem. 

 

So what is the bottom line for investors?  There are two things to consider.  First, make sure you understand the amount of risk that you are taking in your company 401(k) plans.  Remember the easiest way to define risk is by looking at the overall percentage of your plan that is invested in stock-based mutual funds or individual stocks.  Second, if your money is with a financial advisor, find out what their strategy is in the event that the bear market is not over.  If they have no strategy and instruct you to just “ride it out,” move your money to an advisor that can manage money in a bear market. 

 

It has never been more important to understand risk than today.

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Brand New Prudent Money Blog – May 12 -Could the Government be Under-reporting the Jobless by 50%?

There is an old saying in the stock market that you should sell (stocks) in May. It is based on the notion that stocks perform better the 6 months leading up to May (November to April) than the 6 months following May.  There are some interesting statistics that support that notion.

John Mauldin’s newsletter is something every investor should be reading.  He writes a weekly newsletter that he publishes for free.  The content is excellent and he should be charging for this newsletter.  For more information, go to www.frontlinethoughts.com.   He had an excellent newsletter that highlighted this same notion but looked at it when the stock market was in a bear market.  First he took a look at the average returns since 1950 in the S&P 500.

You can see the big difference in returns when looking at separate 6 month periods.

Now take a look at these same numbers but looking at it when the stock market was in a bear market.

The numbers on average are much lower.  It illustrates to me that we could be heading for a rough period, for the market, if historical norms hold up.  If you see what history has to say, you look at the warning signs, the indicators are flashing and considering that we are in the worst bear market since the Great Depression, the risk level is getting higher

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Well, yesterday continues a strong performance for the stock market.  Remember we are still focusing on one question.  Was the low in the stock market in March the bottom of the bear market and the start of a new bull market or was the stock market rally that started in March nothing more than a bear market rally?  This is one of the most important questions to continue exploring at this juncture. There are huge risks for either answer. 

If you are not properly invested and this is the new bull market, then you are really missing out on recouping your losses.  If this is nothing more than a bear market rally, then the potential for extreme losses for stock market investors still lie ahead. 

For those of you who read my daily outlook blog, you know that I believe this is a bear market rally and a great opportunity for those who are heavily invested in stock to take advantage of this big move in the market and reduce your risk by selling stocks or stock mutual funds. 

As I started writing last week, my indicators are flashing caution right now and suggest that the risk continues to climb for anyone invested in stocks.  The market is truly ignoring some negative items.  Growth for the economy was announced yesterday much worse than expected.  We had -6.1% growth last quarter and the growth numbers for the first quarter were revised and reflect a worse first quarter than originally reported.  The last 6 months were the worst since 1958.

Foreclosures are climbing.  Swine flu should now be on every investor’s radar as this is just about to be classified as a pandemic.  The first of what I believe will be two automakers declared bankruptcy this morning.  The Government is going to be selling 71 billion dollars worth of government securities next week (read: printing money).  Finally, unemployment continues to weaken as evidenced in this morning’s new weekly jobless claim numbers (another record). 

All of this is occurring, and the consumer confidence number increased by 50% with the highest read since November 2005?  Are you kidding me?  As I have written many times, there is a great deal of evidence that exists that economic numbers are doctored.  There is just no plausible explanation for a rise by that much during a time with this much negativity.  However, keep in mind, we just “celebrated” (it certainly seems that way) President Obama’s 100th day in office.  It sure would be fitting for the stock market to have made money in his first 100 days as well as a huge rise in consumer confidence due to everything he has done in office.  HMMMMM…I follow this data very closely and it doesn’t add up.  It looks more and more like an organized PR campaign.  Let’s just all hold hands and believe there is no risk and the government will take care of everything.  If you are not paying attention to what is occurring out in front and behind the scenes please start doing so. 

Agree or disagree and think I am a conspiracy nut, things don’t add up.  I am just writing what I am seeing and staying away from the kool-aid that is being consumed in mass quantities.  For now, be careful with your risk.

with your risk.

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Part 1 of a series on how to use this daily stock market outlook

I won’t deny it, last week was a big week for the bulls.  Last week finished the best 4 week rally in the stock market since 1933.  Typically when markets go through these big rallies, the stock market will go through a period of selling.  The key is whether the rally will resume after investors take a break for a while.  At least in the short-term, this is the last chance for the bears to take back control of the stock market.  If the bears cannot send this market back into a decline, this market rally might be with us for a while.  The golden opportunity for the bears is earnings season.  Earnings season kicks off tomorrow morning. This is the time of the year where companies give the good and the bad news. It has been a rough time for the stock market lately.  If the bulls can get through this period, that would be a positive sign for the stock market.

This morning the market is declining after a big 4 weeks.  Nothing has changed in my overall assessment of the stock market.  I still think that we are in a long-term bear market and experiencing what is referred to as a bear market rally. 

The big question is how long will this rally last and how big will it be?  I could also be very wrong and the worst could be behind us, signaling the start of the next great bull market.  The answer to these questions is key, no matter what type of investor you are today.  Whether you are a 401(k) plan investor, have accounts with a financial advisor, or invest your own money, this is a key question.

Over the next few days I will be introducing a new way to use this daily market outlook.  Yes, it will be written in such a way that even the most novice investor can understand it.   The key is – You need to know when to increase or decrease risk in your investment.  You increase or decrease risk by increasing or decreasing the percentage of money that you have invested in stocks, stock based mutual funds, or investment accounts. 

Yes, stock market investing gets more complicated than just looking at risk as the percentage invested in stocks or stock funds.  However, just understanding some key strategies can make a HUGE difference in your success as an investor.  So, before tomorrow, determine which category describes you at the moment:

1)  Want to reduce or increase risk

2)  Want to invest new money

3)  Want to trade and time your investing

 

 

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This is not to be taken as advice.  This is a discussion on price levels and for educational purposes only.  There is no sure fire way to manage risk.  It is a process.

Bob,
You’ve given us 3 price levels to watch. What should an investor’s reaction be with their portfolios given this information? Perhaps you can give a few examples?

This is a great question. I appreciate all of the questions that I have received both through e-mail and on the blog.  This is how we can learn this information together as a community. 

I want to add another layer to the discussion of price levels.  Let’s think short-term, medium-term, and long-term.  In other words, what direction is the market going in these three time periods?  Is it going up, down, or is it just moving sideways? 

Always think of the direction of the market as the direction of the value of your account. For the past 17 months, most investors’ accounts have been moving down with the long-term direction of the market.

I am only going to answer this from the standpoint of when you increase stock exposure through a stock index fund or ETF and when you decrease it.   If you are fully invested in the stock market and the stock market continues to stay above the 800 to 825 price levels, then you watch carefully.  Remember, we are looking for the market to go above 825 for things to start looking positive in the short-term. 

If the stock market were to get above the price level of 825 and stay there, then you might start to either increase your exposure (gradually) to the stock market or simply maintain what you have already invested.  As we see this morning, the stock market is already back below the 825 price level on the S&P 500.  Thus, yesterday’s close at the end of the day above 825 was not yet the positive sign that we are looking for.  

If the stock market falls below the price level of 800, that is a warning and, given the nature of the environment, might be a signal to you that it makes sense to reduce the exposure (sell) to your stock investment.  If the stock market continues to fall and goes down to 741 and closes below that level, you are taking extreme risk.  Remember the next price level down is between 575 and 600. 

It is in the short-term that investing is the trickiest.  If the market is really going to go up in value over maybe the next few months, you would want to participate and stay invested.   However, we are still in a dangerous environment, making the risk level even greater.  It truly is high risk for high reward. 

Now, for most investors, you want to look at the medium-term time period.  When the market starts to look positive in the medium-term, the risk level for investing in stocks starts to really diminish.  What would I call the medium-term?  In my opinion, the S&P 500 would have to get all the way back up to between 1200 and 1300 for the medium-term period to look good. 

The ideal time to be fully invested in stocks is when the short-term, medium-term, and the long-term are all positive.  Right now, the short-term is slightly positive, and the medium-term and long-term are both negative.

I know that this gets confusing.  However, you have to remember the objective right now.  As an investor, you always want to know what the risk and reward looks like for stocks.  The overriding principle is that you don’t want to be taking a ton of risk if there is a big possibility of you losing a lot of money.

 

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