Borrowing Money is Fun! Paying it back--Not so much.

Ben Bernanke (06/22/2011).......“We don’t have a precise read on why this slower pace of growth is persisting,” Bernanke said. Referring to “frustratingly” slow job growth and weakness in the financial and housing industries, Bernanke said “some of these headwinds may be stronger and more persistent than we thought.”

You have got to hand it to a man who is honest and straightforward, but markets get spooked when the man who “should know what to do” tells us that the Fed does not know why growth is so slow and that they underestimated the headwinds holding back the economy. Add this to continued worries about the fiasco in Greece and it is no wonder that markets trend down.  (Remember that markets are driven by fundamentals and sentiment.)  Mr. Bernanke is a good man and a great economist--perhaps he is not the best at inspiring confidence.

The chart above is one illustration of the biggest problem: Too much debt and the consequences of debt reduction. Borrowing money is fun—paying it back—not so much fun. (Sort of like gaining and losing weight.) Households in the US took on too much debt—in fact you might say we went on a debt binge from 1994 until 2008. Since then, we have been paying off debt—fast and furiously! The good news—we are rapidly approaching a “sustainable” level of 10-11% of our income.

Oil prices had been rising rapidly for a year. But, recently they changed direction and have been falling. Today, the US and other nations agreed to release a lot of oil from strategic storage reserves. This will tend to accelerate the drop in the price of oil and is a big stimulus to global economic growth.

The one thing out there that is not necessarily “about to turn the corner” with certainty is the debt problem in Europe. Banks lent too much money to homeowners in the US. In Europe, banks lent too much money to governments. When a homeowner can’t pay the loan back, there is at least some collateral that can be sold in a foreclosure. Lending to governments is like a signature only loan or credit card debt—you can’t exactly foreclose—your only collateral is government revenue from taxes. When governments continue to run deficits, spending more than they take in from taxes, there is no surplus left to pay back the loans.

So, the problem in Greece specifically and with European government debt in general is yet to be resolved. I have no sure idea what the final outcome will be, but my understanding of history (specifically in Latin America) tells me that a great deal of the debt in Greece, Ireland and Portugal will have to be written off and restructured. Will that hurt the stock market? In the short run—you are seeing it today as this scenario is being “priced in”. In the long run, reducing debt and getting back to being “fit and trim” economically is probably very good for the economy and the stock market.

This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.

Who Moved My Cheese?

Who Moved My Cheese? An Amazing Way to Deal with Change in Your Work and in Your Life, A best-selling motivational book by Spencer Johnson in 1998 was written as allegory. The moral: Change Happens (They Keep Moving the Cheese); and Anticipate Change (Get Ready for the Cheese to Move).

After many months of better than expected economic news, accompanied by a rising stock market, there has clearly been a recent spate of “disappointing” economic news. Over the past week, we have seen a significant reaction by stock markets to that “worse than expected” data. Somebody moved the cheese!

As most of my clients already know, I study and monitor certain economic data that I call Reasonably Reliable Leading Indicators. One of those indicators is particularly applicable to the present situation. It is known as the Citigroup Economic Surprise Index. It can be viewed at Bloomberg: http://www.bloomberg.com/apps/quote?ticker=CESIUSD:IND# (under the ticker CESIUSD:IND) A negative reading of the Economic Surprise Index suggests that economic releases have on balance failed to meet consensus expectations and have “disappointed”.

As I have indicated in the past, markets are determined by fundamentals and sentiment. When the Citigroup Economic Surprise Index falls, sentiment falls. When the Citigroup Economic Surprise Index is negative, sentiment is negative. When sentiment reaches an extreme (within it’s normal cyclical up/down range) it usually indicates a turning point. The Citigroup Economic Surprise Index reached an all time high (100+) around the first of March, and then fell like a rock to near an all time low (100-) this past week. The bottom line—in general, people had become too optimistic. Reality has returned. A quote from 2010 that we display on our website:

“Ever since Adam and Eve were cast out of Eden, Life has been uncertain, difficult and dangerous. Uncertainty, difficulty and danger will continue to exist. Some will be able to recognize opportunities despite such danger and difficulty and will prosper mightily. Others will simply adopt proven strategies to survive and prosper reasonably in a changing world where the future will always be uncertain. In the longer run, the future is seldom as bad as the pessimist believes, nor as good as the optimist predicts.”

Another Reasonably Reliable Indicator is the Investor Sentiment Survey published by the American Association of Individual Investors. http://www.aaii.com/sentimentsurvey  It is considered a contrarian indicator as the vast majority of individual investors misread the markets. (According to historical data.) The normal “bearish” prediction is 30%. Last week it was a much higher than normal 47.7%.

Again, markets are determined by fundamentals and sentiment. Fundamentals (corporate earnings) are strong. Sentiment (expectations about future earnings) is very negative. When sentiment reaches an extreme (within it’s normal cyclical up/down range) it usually indicates a turning point. It is impossible to predict market movements so it is possible that we could see continued market declines as sentiment falls further and fear begins to spread. On the other hand, fear and pessimism is pretty high and history teaches that we are most probably near a turning point. Or, at least a “treading water” period, waiting to see what the next round of earnings reports tell us about fundamentals.

 

Please remember that sentiment changes rapidly based on current news and information. What we don’t yet know, we don’t know. As I have stated “Life has been uncertain, difficult and dangerous. Uncertainty, difficulty and danger will continue to exist.” In times like these, it is important that any money invested is truly long term—then these short term up/down movements are much less important to you. It is also important to keep the emotions of fear and greed out of your thoughts as these emotions generally lead to bad decisions.

Although unemployment and housing information has been disappointing, other information is quite good, or at least not bad. A) According to a government advisory panel in Japan: “Spending to rebuild Japan's tsunami-hit northeast will spark an economic boom later this year”; B) The US Commerce Department reported: “American companies sold more computers, heavy machinery, and telecommunications equipment in foreign markets in April--exports have finally returned to pre-recession levels"; C) The Institute for Supply Management said its services sector index rose to 54.6 last month from 52.8 in April. The reading came in just above economists' forecasts for 54.0, according to a Reuters survey. (Service Sector employment according to ADP is much larger than the Good Producing Sector.); D) According to the Association of American Railroads: “U.S. Freight Rail Traffic: Not Seasonally Adjusted: intermodal in May 2011 up 7.5% over May 2010, Seasonally Adjusted: intermodal in May 2011 up 0.8% over April 2011.”

History teaches, and indicators tell us that there is a possibility of further declines; But, there is a higher probability that markets will turn back up or at least stabilize. One should always remember the moral: Anticipate Change (Get Ready for the Cheese to Move).

This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.

Is Silver (or Gold) a Safe Investment?

Silver was not a very good investment for one billionaire in 1980. Here’s the story...

Nelson Bunker Hunt is best known as a former billionaire whose fortune collapsed after he and his brother William Herbert Hunt tried, but failed to corner the world market in silver.

Beginning in the early 1970s, Hunt and his brother William Herbert Hunt began accumulating large amounts of silver. By 1979, they had nearly cornered the global market^. In the last nine months of 1979, the brothers profited, on paper, by an estimated $2 billion to $4 billion in silver speculation, with estimated silver holdings of 100 million ounces of silver.

During the Hunt brothers' accumulation of the precious metal, the price of silver during 1979 and 1980 rose from $11 an ounce in September 1979 to $50 an ounce in January 1980. Silver prices ultimately collapsed to below $11 an ounce two months later.

Hunt filed for bankruptcy under Chapter 11 Bankruptcy laws in September 1988, largely due to lawsuits incurred as a result of his silver speculation.

According to TV Investment Commentator, Jeff Macke, investing in Silver now is a strategy akin to “being reckless without getting killed… The fact is that charts like silver's 5-year (2006-2011) don't occur in nature. They are functions of a mob. Being part of a mob can be fun and lucrative as long as you don't get arrested or killed.”

It should always be remembered that during the last time the US had a bout with high inflation, the price of Gold fell by over 50% from 1980 to 1982. Precious metals are investments for people that are gambling or who are afraid. They have not done well in recent periods with high inflation and high interest rates.

Human nature is fascinating.  Some people will make a concentrated and speculative “high risk investment gamble” that they know has the potential of an almost permanent 50-78% loss in just a few months, yet a potential but temporary 10-15% drop in their diversified stock portfolio causes them to lose sleep at night.

Concentrated “investment gambles” like Silver (and Gold) sometimes pay off,  but the potential for sudden and great loss makes them an unwise choice for your serious money that you are saving for future income. There is no substitute for prudence and patience with a highly diversified portfolio.

 

This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.

Market’s Reaction to S&P Rating is probably Melodramatic

Three days ago I wrote: “Conservative and Liberal elements of our society are so diametrically opposed that the path forward regarding government’s role and spending are uncertain. What happens when government spending stimulus is withdrawn? What happens if government deficits continue?” 

Today, changing the outlook for US debt from stable to negative, Standard and Poors (S&P) said "We believe there is a material risk that U.S. policymakers might not reach an agreement on how to address medium- and long-term budgetary challenges by 2013; if an agreement is not reached and meaningful implementation is not begun by then, this would in our view render the U.S. fiscal profile meaningfully weaker than that of peer 'AAA' sovereigns”

Excerpt  from Bloomberg, August 31, 2007 :

“S&P and Moody's Investors Service failed to downgrade bonds backed by loans to borrowers with poor credit until July, when some had already lost more than 50 cents on the dollar. …U.S. Senate Banking Committee Chairman Christopher Dodd said yesterday credit rating companies must explain why they assigned ``AAA ratings to securities that never deserved them.''

The irony of S&P’s ratings today, warning about AAA rated US Treasuries, given Senator Dodd’s comment  3 ½ years ago,  is notable. Sort of in line with "be careful what you wish for".  

Given the track record of rating agencies and their own limitations/warnings regarding their comments, one must wonder why markets would react in any major way to anything they say.  Click on the below for warnings from S&P itself regarding what ratings are and are not.
           http://www2.standardandpoors.com/aboutcreditratings/

What we know after the S&P outlook change is the same as what we knew before.  We knew we had a deficit problem. We are expecting higher interest rates.  So why have world markets lost almost $600 billion in value, in one day, in reaction?

People act irrationally when they become fearful.  Sometimes being reminded about risks that they know already exist just makes people panic from fear.  

The value of the US $ in currency trading generally  rose after the S&P report today—exactly opposite the direction it should have gone if the US is less credit worthy—it went the direction you would expect during a general rise in the level of fear and uncertainty  in markets.

As I said on Friday, the Wall of Worry Gets Taller as potential risk and opportunity both grow.  

The important news will be what we don’t already know.

This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.

The Wall of Worry Gets Taller

The “correction” we expected as mentioned in our February 26, 2011 article did in fact occur in March.  Corrections can be likened to a room with gasoline spilt on the floor—the potential for fire exists—it only awaits the match.  In March, the “match” that lit the fire was a combination of a natural disaster in Japan, increasing tensions in the Middle East, and a new “limited” military adventure in Libya.  The correction did not last long.  After a 5% drop, the S&P500 ended March at the same level that it began.

The list of risks, any of which might derail our recovery seems to be growing.  European sovereign debt issues continue.  We are now engaged in three military conflicts in a Middle East that seems on the verge of revolution. Some believe the revolution is with the goal of democracy—others fear it is with the goal of radical theocracy.  Inflation caused by rising oil prices is threatening to permeate our entire economy. Unemployment is falling, but it is still very high. The residential real estate market continues to be weak, threatening a continuing problem of debt defaults and foreclosures.  Conservative and Liberal elements of our society are so diametrically opposed that the path forward regarding government’s role and spending are uncertain. What happens when government spending stimulus is withdrawn? What happens if government deficits continue? What happens after the world’s third largest economy experiences perhaps the most serious natural disaster in modern history? Fear regarding the future value of paper money seems to be creating a new bubble in the price of commodities and precious metals. As my title suggests: the Wall of Worry seems to have gotten taller.

As I have said in the past, a Wall of Worry is an absolute requirement for a continued bull market. It means that there is still a large bank of “potential” buyers.  While any of the risks mentioned could cause a fall in markets, it is important to remember that the values of equities depend on the psychological perception about corporate earnings in the long term as compared to interest rates, and a perception of the direction of corporate earnings in the short term.   

We are now just at the beginning of “Earnings Season”. Earnings and outlooks from Alcoa, Google, Bank of America and JP Morgan last week produced a bit of anxiety.   Be prepared for a great deal of volatility as the markets try to “read” the true meaning of the corporate announcements over the next few weeks.  What has been driving the markets up, despite worries, is the belief that the economy is recovering. This is supported by facts.  The fear is just about whether this trend and recovery continues.

I am most optimistic about one key indicator. CEO Confidence as measured by the Conference Board is quite high. Says Lynn Franco, Director of The Conference Board Consumer Research Center (April 7): “CEOs’ confidence has improved, yet again, and expectations are that the economy will continue to expand in the coming months. As for the employment outlook, CEOs are more bullish than last year, with half now saying they intend to ramp up hiring.”

Our advice is to remain cautious in the short term.  However, we are also convinced that tremendous opportunity exists for those with a long term view.  Stay the course, remain conservative and diversified—but keep your eyes peeled for trouble and opportunity—we are likely to see both.

This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.

Nuclear Situation in Japan and the Markets-Don't Join the Panic

Nuclear Situation in Japan and the Markets


News coverage from many sources has tended to exploit fear with sensational headlines and innuendo based on myth and rumor. Government officials have been pontificating, again with the goal of gaining attention to themselves, or perhaps an agenda that they support.

Here is an excellent source of factual information: http://www.nei.org/

The 50 heroes that are tending to the nuclear power plant did not abandon it like the press reported: They were evacuated for about an hour but returned to the site to continue efforts to restore safe conditions at the plant. A fire reignited at Tokyo Electric Power Co.’s Fukushima Daiichi 4 reactor. The fire was extinguished after about two hours and was not related to the spent fuel pool, but rather an oil leak.

Certainly the situation in Japan is serious. Pray for all of the Japanese people. (On behalf of our clients, we made a recent contribution to the Salvation Army who has a long term presence and tradition of helping people in Japan.) In regards to the nuclear power plant, a worst case scenario could be very bad. But, facts indicate that things are not quite as bad as is being reported.

The most recent stock market performance in Japan that closed today was UP 5.6%. A comment by European Energy Commissioner, Guenther Oettinger caused a big drop in US markets this morning when it was reported he told a European Parliament committee, according to news reports. “In coming hours there could be further catastrophic events which could pose a threat to the lives of people on the island.” He had no real knowledge about the subject, other than what he had read in the press. When a bureaucrat thousands of miles from the real picture can move markets with careless comments--you know the markets are spooked.

As an investor, it is important to remember that there is a big difference between a panic selloff and a crash related to a bubble deflating. As I mentioned in previous commentary, stock markets were a bit ahead of themselves. We were overdue for a normal correction. So far, the S&P500 is down 5.8% from the peak on February 18. We are essentially back to December 31 levels. Reasonably Reliable Leading Indicators are beginning to look positive. This is a simple panic selloff—and other than the stock of Tokyo Electric Power, the owner/operator of the troubled nuclear power plant , long term intrinsic values of well managed companies have not really changed. We may be closer to a buying opportunity than a selling one. Seems to me the biggest risk continues to be inflation and higher interest rates.

My advice is to never make major changes in reaction to a panic sell off. They can happen at any time. Your portfolio should already be prepared for them. You can see bubbles (2007-08) and therefore the resulting crashes that will come—making major changes to protect yourself. This does not appear to be a crash.

I am focused on the news in Japan to determine if any action is justified. So far, no major changes are recommended. If circumstances deteriorate—not based on hyperbole, but real facts, then you should give me a call for further discussion.

This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.

Climbing the Wall of Worry-Managing Risk

In our last “post” we shared a video with an interview of Goldman Sach’s, Abby Joseph Cohen, titled “The Drought is Over”. Stock market performance in January and February sure seems consistent with that assessment! The S&P500 has risen 4.95% and the MSCI World Index is up 3.52% for January-February. On the other hand, fixed income did not provide very good returns, with the DJ CBOT Weighted Treasury Index actually declining 0.15%.

Reversing an eight month trend of outflows totaling more than $61 billion, money started returning to US Stock Mutual and Exchange Traded Funds with $26 billion inflows in January. Optimism on the part of many has returned, BUT many worries remain.

While paper earnings appear solid, many believe that banks are hiding skeletons in their closets. House prices continue to fall. Federal stimulus designed to reverse this fall in housing prices has resulted in higher prices in other areas. Inflation, particularly in food prices seems to be one spark, among many causes for uprisings in the Arab world where the average family spends more than 40% of their income on food. Unemployment is still a problem in the US. Sovereign debt in Europe is still a great concern. And, high energy prices threaten to choke off the fragile recovery. Finally, no one is sure of the long term effects of US debt and deficits; and no one is sure of the short term effects of austerity measures to reduce this debt and deficit. To a great extent, the stock market in the US is underestimating these risks.

Investors always have three choices: Buy, Sell or Hold. Clear “Sell” signals were present in 2007. By mid to late 2009, we saw clear “Buy” signals. Since November 2010, our cautious view has been somewhere in between Buy and Hold. Global markets appear fairly valued and the US stock market as a whole appears a bit overvalued. One caution is that markets can continue to be overvalued for quite some time.

For the long term we are bullish and, we like what Warren Buffet had to say in his recent letter to shareholders of Berkshire Hathaway…. http://www.berkshirehathaway.com/2010ar/2010ar.pdf

 

“Money will always flow toward opportunity, and there is an abundance of that in America. Commentators today often talk of “great uncertainty.” But think back, for example, to December 6,1941, October 18, 1987 and September 10, 2001. No matter how serene today may be, tomorrow is always uncertain.

Don’t let that reality spook you. Throughout my lifetime, politicians and pundits have constantly moaned about terrifying problems facing America. Yet our citizens now live an astonishing six times better than when I was born. The prophets of doom have overlooked the all-important factor that is certain: Human potential is far from exhausted, and the American system for unleashing that potential – a system that has worked wonders for over two centuries despite frequent interruptions for recessions and even a Civil War – remains alive and effective. We are not natively smarter than we were when our country was founded nor do we work harder. But look around you and see a world beyond the dreams of any colonial citizen. Now, as in 1776, 1861, 1932 and 1941, America’s best days lie ahead.”

 

“It’s easy to identify many investment managers with great recent records. But past results, though important, do not suffice when prospective performance is being judged. How the record has been achieved is crucial, as is the manager’s understanding of – and sensitivity to – risk (which in no way should be measured by beta, the choice of too many academics). In respect to the risk criterion, we were looking for someone (to replace Mr. Buffett over time) with a hard-to-evaluate skill: the ability to anticipate the effects of economic scenarios not previously observed.”

                      …Warren E. Buffett, February 26, 2011

                       (BERKSHIRE HATHAWAY INC. 2010 ANNUAL REPORT)

In the short term however, we advise caution and draw your attention to Mr. Buffet’s comments about investment managers needing an “understanding of – and sensitivity to – risk” and “the ability to anticipate the effects of economic scenarios not previously observed”.

I believe that in the short term, there is considerable risk of a correction. Not a 100% probability, but higher than 50%. So, particularly for new money, continued caution is advised. For existing investments, particular attention to quality is important. Attention to individual securities that are possibly overvalued is appropriate.

In addition, I am always careful when the statement “this time is different” is made. This statement is often very dangerous, particularly when it breeds overconfidence. However, I believe that we are presently in one of those “economic scenarios not previously observed” that Mr. Buffett writes about. This is a time when an “understanding of – and sensitivity to – risk” is even more important than it is normally.

Managing risk in the short term may result in a conservative position with higher than average cash positions---and to the average investor, may appear to result in missed opportunity as the “market” rises more than their portfolio does.

In an upward moving market, it is important to recognize “the trend is your friend”. But the trend is a fair-weather friend and can turn at any given time. The trend doesn't announce its intention to change direction. It switches back and worth as it pleases without your permission.

It is important to remember that bull markets climb a “wall of worry” and as Mr. Buffett has said, “Be Greedy when others are fearful..be fearful when others are greedy”. Perhaps today, too many are greedy and not enough are fearful. As soon as that situation reverses, great opportunity for long term gains returns.

This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.