Playbook: The Great Debate-Secular Bear Market

This composite chart courtesy of the Strategy desk of Morgan Stanley Europe shows what the average of the past 19 major Bear markets globally have looked like. The X marks the spot where we currently stand in their opinion. This is the long term secular Bear's argument. They think this bear market rally will be followed by another large correction and then stocks will essentially trade sideways for years. Fundamentally they would be in agreement with many of the points listed by Doug Kass in our post from Friday. They would argue that no new secular bull market will begin until we take out all the old market highs.

I have no way of knowing whether this chart will end up being an accurate forecast of future events, my crystal ball isn't that accurate. I'd be willing to bet though that the authors of this article have no better view of the future than me. This is however the Bear's view and it must be respected. I would note that even if they are correct my opinion is that there will be plenty of opportunities to make good quality investments along the way.

Tomorrow we will show the other side of this debate and let the Bulls have their say. We'll follow it up with my own views about the future. My views will come in two parts, the first is a attempt to look out longer term and then we'll follow up with what we think might happen in the short run.

Source: The Aftermath of Secular Bear Markets. Authors: Teun Draaisma, Ronan Carr, CFA & Graham Secker, Edmund Ng, CFA and Matthew Garman, Morgan Stanley European Strategy 10 August 2009:
Chart provided from The Big Picture.

Link: http://www.ritholtz.com/blog/2009/08/aftermath-of-secular-bear-markets/#more-36695

Q&A: The Great Debate.

I have been asked why are we going to spend time on both sides of the investment argument when my clients are mostly concerned about what I think and what I'm going to do regarding their accounts.

Answer: I believe that I can be of greatest service to my clients {for they are the sole reason I post on line} when I present to them a logical investment plan based on reasoning that takes into account many variables. One of these variables is to listen to all sides of the investment argument and then synthesize which parts of each side makes the most sense to me. We all come to this business with different viewpoints and different ways of looking at different things.

I believe that one is always learning in this business. Good investors have the ability to make decisions, formulate strategy and come up with investment ideas based on well-reasoned conclusions. They also have the flexibility to modify those conclusions based on changing conditions.

I want to hear all sides of the debate and I want you all to know what those arguments are. I particularly think this is important given how far we've climbed this year. I'm going to give my take on the markets and what I plan to do going forward after I've presented all sides of the argument.

Playbook: The Great Debate-The Bearish View.

Doug Kass of Seabreeze Partners correctly called the market bottom back in March. He penned an article Wednesday for The Street.com where he discussed why he has turned bearish and why he thinks the market has seen the high for the year. I am posting an excerpt of his article due to the conciseness of his argument. Highlights are mine.

"Back in early March, there were signs of a second derivative U.S. economic recovery,.....valuations were stretched to the downside and sentiment was negative to the extreme. These factors were ignored, however, and the S&P 500 sank to below 700.
To most investors, back in early March, the fear of being out was eclipsed by the fear of being in.......
It was at this point in time, on The Edge, in an appearance on CNBC's "Fast Money," on "Mad Money" and in multiple appearances on "The Kudlow Report," I confidently forecast the likelihood that a generational low had been reached.
I went on to audaciously predict that the S&P would rise to 1,050, a gain of nearly 400 points from the S&P low of 666 during the first week of March, by late summer/early fall........
Yesterday {Tuesday, August 25th} the SPDRs peaked at 104.20, within spitting range of my intrepid March forecast of 105......
Arguably, today investors face the polar opposite of conditions that existed only a few months ago, with economic optimism, improving valuations and positive sentiment.
To most investors, today the fear of being in has now been eclipsed by the fear of being out as the animal spirits are in full force.....
As if the movie is now being shown in reverse, the bull is persistent, stock corrections are remarkably shallow, cash reserves at mutual funds have been depleted, and hedge funds hold their highest net long positions in many moons........As I have written on these pages, the investment debate has morphed in a dramatic fashion from concerns as to whether U.S. economy was entering The Great Depression II to whether the current domestic recovery will be self-sustaining.
The primary question to be asked is, Will the earnings cycle dominate the investment landscape and cause investors to overlook the chronic and secular challenges facing the world's economies, particularly as the public sector stimulus is eventually withdrawn and paid for and the economic consequences of the massive public sector intervention manifest themselves in the form of higher interest rates and marginal tax rates?Most now have accepted the notion that due to the replenishment of historically low inventories, extraordinary fiscal/monetary stimulation and the productivity gains from draconian corporate cost-cutting, the earnings cycle is so strong that it will trump the consequences of policy. More accurately, most believe that they can get out of the market before the full effects of policy are felt.
I am less confident as a decade of hocus-pocus borrowing and lending and 35-to-1 leverage at almost every level in both private and public sectors cannot likely be relieved in the great debt unwind over the course of only12 months.
It is important to emphasize that when I made my variant March call, I expected many of the conditions that now exist -- namely, a resurgence of economic and investment optimism during the summer to be followed by a multiyear period of weak investment returns. Specifically, I expected a mini production boom and an asset allocation away from bonds and into stocks to be embraced and heralded by investors, who would only be disappointed again in the fall as it becomes clear that a self-sustaining economic recovery is unlikely to develop.
My view remains that it is different this time. Again (now for emphasis), the typical self-sustaining economic recovery of the past will not be repeated in the immediate future for 10 important reasons that will weigh on the economy and markets......

1. Cost cuts are a corporate lifeline and so is fiscal stimulus, but both have a defined and limited life.
2. Cost cuts (exacerbated by wage deflation) pose an enduring threat to the consumer, which is still the most significant contributor to domestic growth.
3. The consumer entered the current downcycle exposed and levered to the hilt, and net worths have been damaged and will need to be repaired through higher savings and lower consumption.
4. The credit aftershock will continue to haunt the economy.
5. The effect of the Fed's monetarist experiment and its impact on investing and spending still remain uncertain.
6. While the housing market has stabilized, its recovery will be muted, and there are few growth drivers to replace the important role taken by the real estate markets in the prior upturn.
7. Commercial real estate has only begun to enter a cyclical downturn.
8. While the public works component of public policy is a stimulant, the impact might be more muted than is generally recognized. There may be less than meets the eye as most of the current fiscal policy initiatives represent transfer payments that have a negative multiplier and create work disincentives.
9. Municipalities have historically provided economic stability -- no more.
10. Federal, state and local taxes will be rising as the deficit must eventually be funded, and high-tax health and energy bills also loom.

......I now suggest another contrarian view is appropriate as I look over the visible green shoots of recovery toward a hostile assault of nonconventional factors that few business/credit cycles and even fewer investors have ever witnessed.
Yesterday, the OMB/CBO .........forecast... an accumulated deficit of $9 trillion over the next decade (up $2 trillion from the previous forecast just two months ago), and public debt as a percentage of GDP is projected at an alarming 68% by 2019 (as compared to 54% today and only 33% in 2001). Thus far, the drop in the U.S. dollar (influenced, in part, by the mushrooming deficit) has been viewed favorably by the markets, but we must now be alert to a downside probe that becomes a threatening market factor. In other words, what has been viewed positively could shortly become negatively viewed.
A double-dip outcome in 2010 represents my baseline expectation. When the stimulus provided by the public sector is finally abandoned, it seems unlikely to be replaced by meaningful strength or participation by any specific component of the private sector, and the burgeoning deficit (described above) will ultimately require a reversal of policy, leading to higher interest rates, rising marginal tax rates and a lower U.S. dollar. My forecast assumes that the market's focus will shortly shift from the productivity gains that have been yielding better-than-expected bottom-line results toward these chronic and secular worries.
Even more important, my forecast of a 2010 market peak reflects that the aforementioned nontraditional influences (and the untoward policy ramifications) will, at the very least, yield a broad set of uncertain economic outcomes that (in consequence and in probability) tilt away from a self-sustaining economic scenario sometime in the following 12 months.
Stocks bottom during times of fear. With the benefit of hindsight, the March 2009 lows represented a dramatic overshoot to the downside.
Markets top during times of enthusiasm. I believe that the markets are now overshooting to the upside and that the U.S. stock market has likely peaked for the year."

Link: http://www.thestreet.com/story/10590765/1/kass-market-has-likely-topped.html

*Long ETFs releated to the S&P 500 in client accounts.

Playbook: The Great Debate.

There is a great debate going on right now in the investment community regarding both the current structure of the market and where we might be headed. I'm going to try and present all sides of this argument over the next several days. When we've looked at everybody's viewpoint I'm going to give my perspective on where I believe we stand and try to flesh out a bit on how we'll incorporate this thinking into the Playbook. Tomorrow we'll present the Bear's side of the debate.

Getting A Little Frothy!

Some signs of caution as we start the day.

-BeSpoke Investors is reporting that the percentage of stocks in the S&P 500 trading above their 50 day moving averages has currently reached 93% which is its highest level in three years.*
-Many of our indicators are similarly technically extended and have begun to show early signs that often presage some sort of correction. However, it is important to remember that a correction can be in time (duration indicating a churning market) instead of an actual price decline. The action this week is in our opinion "a shot across the bow"-a warning of some sort regarding the health of the markets. This "shot" is particularly evident in many our shorter term indicators.
-We have seen no significant consolidation in prices since early summer. This again is another warning that stocks are possibly somewhat ahead of where they ought to be right now.

-The past three days have seen stocks end weakly with very little gain and heavier volume near the close. This is often indicative of investors selling into the early day strength.
-Speculative action is heavy in single digit stocks. Names like AIG and Eastman Kodak have seen a lot of activity that likely bears little fundamental justification. This is typical of latter stage market rally action. Also sectors that are more defensive have begun to act better relative to the rest of the market. Take a look at sectors such as utilities and consumer staples recently.

Now this certainly does not mean that the market is going to roll over tomorrow or that we can tell at this point whether we're in for a correction or not. I've posted some recently why even with all of the seasonal worries regarding September and October we could possibly see little or no decline at all this fall. Yet I think given how far we've come since March it is prudent to be a wee bit more defensive minded at this point. I've raised small amounts of cash for certain accounts who have carried lower than normal reserves this summer. I've done this after considering where I think we might be in the short term. I have also continued to identify levels where I would be inclined to add to our other accounts' cash reserves if the market does decide to take a breather this fall. As always these decisions are made individually for clients based on our understanding of their unique risk/reward profiles. In particular these decisions will also be made vis-a-vis how much cash client accounts are currently carrying. Indeed some of our smaller sized investment accounts are already carrying cash levels we are comfortable with. It's possible we won't do any further selling in these accounts absent some change in the client's profile.

We may not get the correction that probability would indicate we should see. But I think it is prudent to update the Playbook in case we do start to go down. We'll still have in our opinion adequate exposure if stocks confound everybody and head higher. But I want to have a plan in case those seasonal patterns come into play which the weight of the evidence is beginning to suggest we could see.

*Source : B.I.G. Tips, BeSpoke Advisors, 8/26/09.

**Long ETFs related to the S&P 500 for client accounts.

We are sharing for general information purposes our current thinking when it comes to investing in certain markets. This information should in no way be construed as a blanket recommendation in the purchase or sale of securities or personal advice to anybody not connected with Lumen Capital Management, LLC. If you are not a client of our firm you should either do your own homework or consult with your own investment advisor. We cannot be responsible for any actions you might take when reading this or any of our posts unless you are a client of our firm.

God Speed Ted

http://www.youtube.com/watch?v=5C3UHiD29BI

Slan, Agus Beannacht de leath

Mexico.

"Poor Mexico. So far from God. So Close to the United States." Goes an old saying.

Mexico has quietly & slowly transferred itself from what many would have at one point considered a developing nation to a country on the verge of becoming a failed narco-state. Its not only me that thinks this is a possibility. So does the Pentagon. http://www.theweek.com/article/index/92337/Mexicos_failed_state_threat.

I think this is something that must be on our radar as investors due to its proximity to us. There have been some key events that have happened south of the border in the past four years. The most obvious is the Calderon Government's war with the drug cartels that has been spilling over into the United States into places like Phoenix and Los Angeles. Today I've decided to link a few stories that I've recently seen. We'll probably be coming back to this topic in the future. By-the-way there is a Mexico ETF, symbol EWW {No positions}. As of this writing it is up about 36% for the year.

Links:

From The Nation which is a left leaning US magazine is an article outlining some of the basic issues Mexico faces. I'd skip the parts that seem to blame us for the country's problems though. http://www.thenation.com/doc/20090803/faux

New York Times Article detailing the decriminalization of certain levels of drugs within the country. This cannot be a good thing given what's going on especially along our border with them. http://www.nytimes.com/2009/08/21/world/americas/21mexico.html

From Blogger Gregor.US comes an article detailing what ought to be a rapid decline in oil production coming from one of Mexico's biggest oil fields. If true this is perhaps the issue with the most strategic importance to us. Mexico receives most of its hard currency from the following sources: Drugs, tourism, remittances from abroad, and oil. Of the four, one is an illegal activity, the next two are largely tied to the US economy and the fourth is declining. This cannot be good for their economy and raises the specter of millions more people attempting to cross our borders looking for work. http://gregor.us/mexico/clarion-call-from-cantarell/

As an aside I lived in Mexico for a year as an exchange student. I don't pretend to be an expert on the place but I have a little more experience down there than the average fellow I think. Also don't think that this is a problem that's far far away. Mexican street gangs work in almost every major city in the United States and have taken over much of the drug trade here in recent years. http://news.bbc.co.uk/2/hi/americas/7785334.stm.

God Speed Becky!

"Ar dheis Dé go raibh a anam."

Investor Mistakes

This is a great article and while there are some points that I would take slight issue with, it is well worth a read. We're going to cover a lot of this when we begin our series on risk in the fall.

Excerpt & Link: {Note highlights are mine!}http://online.wsj.com/article/SB20001424052970204313604574326223160094150.html

"The Mistakes We Make—and Why We Make Them How investors think often gets in the way of their results."

Meir Statman looks into our heads and tells us what we're doing wrong.

What was I thinking?
If there's one question that investors have asked themselves over the past year and a half, it's that one. If only I had acted differently, they say. If only, if only, if only.
Yet here's the problem: While we know that we made investment mistakes, and vow not to repeat them, most people have only the vaguest sense of what those mistakes were, or, more important, why they made them.......This is where behavioral finance comes in. Most investors are intelligent people, neither irrational nor insane. But behavioral finance tells us we are also normal, with brains that are often full and emotions that are often overflowing. And that means we are normal smart at times, and normal stupid at others.
The trick, therefore, is to learn to increase our ratio of smart behavior to stupid. And since we cannot (thank goodness) turn ourselves into computer-like people, we need to find tools to help us act smart even when our thinking and feelings tempt us to be stupid.
Let me give you one example. Investors tend to think about each stock we purchase in a vacuum, distinct from other stocks in our portfolio. We are happy to realize "paper" gains in each stock quickly, but procrastinate when it comes to realizing losses. Why? Because while regret over a paper loss stings, we can console ourselves in the hope that, in time, the stock will roar back into a gain. By contrast, all hope would be extinguished if we sold the stock and realized our loss. We would feel the searing pain of regret. So we do pretty much anything to avoid that pain—including holding on to the stock long after we should have sold it.......
Successful professional traders are subject to the same emotions as the rest of us. But they counter it in two ways. First, they know their weakness, placing them on guard against it. Second, they establish "sell disciplines" that force them to realize losses even when they know that the pain of regret is sure to follow.
So in what other ways do our misguided thoughts and feelings get in the way of successful investing—not to mention increasing our stress levels? And what are the lessons we should learn, once we recognize those cognitive and emotional errors? Here are eight of them.
No. 1 Goldman Sachs is faster than you.
......The speed of the Goldman Sachses of the world has been boosted most recently by computerized high-frequency trading. Can you really outrun them? It is normal for us, the individual investors, to frame the market race as a race against the market. We hope to win by buying and selling investments at the right time. That doesn't seem so hard. But we are much too slow in our race with the Goldman Sachses.
So what does this mean in practical terms? The most obvious lesson is that individual investors should never enter a race against faster runners by trading frequently on every little bit of news (or rumors)......
No. 2 The future is not the past, and hindsight is not foresight.
Wasn't it obvious in 2007 that financial institutions and financial markets were about to collapse? Well, it was not obvious to me, and it was probably not obvious to you, either. Hindsight error leads us to think that we could have seen in foresight what we see only in hindsight. And it makes us overconfident in our certainty about what's going to happen.Want to check the quality of your foresight? Write down.....your forecast of tomorrow's stock prices. Do that each day for a year and check the accuracy of your predictions. You are likely to find that your foresight is not nearly as good as your hindsight.
Some prognosticators say that we are now in a new bull market and others say that this is only a bull bounce in a bear market. We will know in hindsight which prognostication was right, but we don't know it in foresight.......
No. 3 Take the pain of regret today and feel the joy of pride tomorrow.
Emotions are useful, even when they sting......{S]ometimes emotions mislead us into stupid behavior. We feel the pain of regret when we find, in hindsight, that our portfolios would have been overflowing if only we had sold all the stocks in 2007. The pain of regret is especially searing when we bear responsibility for the decision not to sell our stocks in 2007. We are tempted to alleviate our pain by shifting responsibility to our financial advisers. "I am not stupid," we say. "My financial adviser is stupid." Financial advisers are sorely tempted to reciprocate, as the adviser in the cartoon who says: "If we're being honest, it was your decision to follow my recommendation that cost you money."
In truth, responsibility belongs to bad luck. Follow your mother's good advice, "Don't cry over spilled milk."
Where am I leading you? Stop focusing on blame and regret and yesterday and start thinking about today and tomorrow. Don't let regret lead you to hold on to stocks you should be selling. Instead, consider getting rid of your 2007 losing stocks and using the money immediately to buy similar stocks. You'll feel the pain of regret today. But you'll feel the joy of pride next April when the realized losses turn into tax deductions. {As a note here, see our summer series on Tax loss selling-most of this can be found at this link.}
No. 4 Investment success stories are as misleading as lottery success stories.
Have you ever seen a lottery commercial showing a man muttering "lost again" as he tears his ticket in disgust? Of course not. What you see instead are smiling winners holding giant checks.
Lottery promoters tilt the scales by making the handful of winners available to our memory while obscuring the many millions of losers.........But we neglect to note evidence that hardly anybody ever wins the lottery, and that lottery numbers can go for decades without winning. This is the work of the "confirmation" error.
What is true for lottery tickets is true for investments as well. Investment companies tilt the scales by touting how well they have done over a pre-selected period. Then, confirmation error misleads us into focusing on investments that have done well in 2008.
Lottery players who overcome the confirmation error conclude that winning lottery numbers are random. Investors who overcome the confirmation error conclude that winning investments are almost as random. Don't chase last year's investment winners. Your ability to predict next year's investment winner is no better than your ability to predict next week's lottery winner. A diversified portfolio of many investments might make you a loser during a year or even a decade, but a concentrated portfolio of few investments might ruin you forever.
No. 5 Neither fear nor exuberance are good investment guides.
A Gallup Poll asked: "Do you think that now is a good time to invest in the financial markets?" February 2000 was a time of exuberance, and 78% of investors agreed that "now is a good time to invest." It turned out to be a bad time to invest. March 2003 was a time of fear, and only 41% agreed that "now is a good time to invest." It turned out to be a good time to invest. I would guess that few investors thought that March 2009, another time of great fear, was a good time to invest. So far, so wrong. It is good to learn the lesson of fear and exuberance, and use reason to resist their pull. {Another note: This is one of the reasons why we place so much emphasis on the study of money flows!}
No. 6 Wealth makes us happy, but wealth increases make us even happier.
John found out today that his wealth fell from $5 million to $3 million. Jane found out that her wealth increased from $1 million to $2 million. John has more wealth than Jane, but Jane is likely to be happier. This simple insight underlies Prospect Theory, developed by Daniel Kahneman and Amos Tversky. Happiness from wealth comes from gains of wealth more than it comes from levels of wealth. While gains of wealth bring happiness, losses of wealth bring misery.......
We'll have to wait a while before we recoup our recent investment losses, but we can recoup our loss of happiness much faster, simply by framing things differently......In other words, it's all relative, and it doesn't hurt to keep that in mind, for the sake of your mental well-being. Standing next to people who have lost more than you and counting your blessings would not add a penny to your portfolio, but it would remind you that you are not a loser.
No. 7 I’ve only lost my children’s inheritance.
Another lesson here in happiness. Mental accounting—the adding and subtracting you do in your head about your gains and losses—is a cognitive operation that regularly misleads us. But you can also use your mental accounting in a way that steers you right.....
........A stock-market crash is akin to an automobile crash. We check ourselves. Is anyone bleeding? Can we drive the car to a garage, or do we need a tow truck? We must check ourselves after a market crash as well. Suppose that you divide your portfolio into mental accounts: one for your retirement income, one for college education of your grandchildren, and one for bequests to your children. Now you can see that the terrible market has wrecked your bequest mental account and dented your education mental account, but left your retirement mental account without a scratch....... So here's my advice: Ask yourself whether the market damaged your retirement prospects or only deflated your ego. If the market has damaged your retirement prospects, then you'll have to save more, spend less or retire later. But don't worry about your ego. In time it will inflate to its former size.
No. 8 Dollar-cost averaging is not rational, but it is pretty smart.
Suppose that you were wise or lucky enough to sell all your stocks at the top of the market in October 2007. Now what? Today it seems so clear that you should not have missed the opportunity to get back into the market in mid-March, but you missed that opportunity. Hindsight messes with your mind and regret adds its sting. Perhaps you should get back in. But what if the market falls below its March lows as soon as you get back in? Won't the sting of regret be even more painful?
Dollar-cost averaging is a good way to reduce regret—and make your head clearer for smart investing. Say you have $100,000 that you want to put back into stocks. Divide it into 10 pieces of $10,000 each and invest each on the first Monday of each of the next 10 months. You'll minimize regret. If the stock market declined as soon as you have invested the first $10,000 you'll take comfort in the $90,000 you have not invested yet. If the market increases you'll take comfort in the $10,000 you have invested. Moreover, the strict "first Monday" rule removes responsibility, mitigating further the pain of regret. You did not make the decision to invest $10,000 in the sixth month, just before the big crash. You only followed a rule. The money is lost, but your mind is almost intact.
Things could be a lot worse.

High PE's

The folks at Chart Of The Day have taken a look at historical PE ratios. Link and comments at the end.

Today's chart { shown above} illustrates how the recent plunge in earnings has impacted the current valuation of the stock market as measured by the price to earnings ratio (PE ratio). Generally speaking, when the PE ratio is high, stocks are considered to be expensive. When the PE ratio is low, stocks are considered to be inexpensive. From 1936 into the late 1980s, the PE ratio tended to peak in the low 20s (red line) and trough somewhere around seven (green line). The price investors were willing to pay for a dollar of earnings increased during the dot-com boom (late 1990s) and the dot-com bust (early 2000s). As a result of the recent plunge in earnings and recent stock market rally, the PE ratio spiked and just peaked at 144 – a record high. Currently, with 97% of US corporations having reported for Q2 2009, the PE ratio now stands at a lofty 129!

Link to their main site {subscription required}: http://www.chartoftheday.com/Free_Chart.htm

Commentary: I thought it was important to post this chart because it shows one of the the opposing arguments to all the positive vibes the market is currently throwing out. However it is unclear to me whether this is looking at historical PEs or estimates going forward. Right now we are likely in the bottoming process of what should prove to be the steepest recession since the 1980s. We've also likely stepped back from the abyss that was Great Depression Part II so I'm not sure that these numbers have much value. If these are historical PE numbers we're looking at regarding 2008 and 2009 then the analysis is pretty meaningless. It may also be meaningless if they're using future estimates. These future eanings numbers are likely too low right now if the recession is ending. Still it is the opposing viewpoint currently being talked up in certain camps and I think you have a right to know what some of those viewpoints are.

an tSionna: While I'm Away-Part I

An update on the S&P 500 taking a look at a longer perspective with weekly charts (You can double click on it to make it larger). Hoping this and the next chart illustrates why I am currently concerned that stocks are vulnerable to a short term correction. I still think that there is a possibility however of higher markets by year end or early in the new year. That's because I think that gap between 110-120 on the SPY still needs to be filled. Again see the chart above. I'll outline my thinking more on this when I get back to writing next week.

*Long ETFs related to the S&P 500 in client accounts.

an tSionna: While I'm Away-Part II

Daily chart of same SPY. While probability would indicate that some sort of correction could occur during what is considered seasonally the weakest period of the year, stocks can correct either by time (that is by going essentially nowhere for a certain period) or by price (that is stocks decline). Since we don't know which this would be the Playbook indicates we should consider the following. 1. Raise some cash in certain accounts where we have carried lower than normal cash positions since last spring and 2. Identify stock price support levels which if breached would cause us to raise cash in more accounts per their specific risk-return parameters.

*Long ETFs related to the S&P 500 in client accounts.

an tSionna: Post Script.

One final thought on seasonal weakness. It is a well documented phenomena that stocks don't do well in the Autumn. However, this seems to also be the most common concern among the investment class right now. Thus we won't discount the possibility that stocks will do the exact opposite and continue their rally well into year end. Remember the old adage that stocks will do what they have to do to prove the most amount of investors wrong and inflict the most pain. From our perspective the most pain would be a sharp Autumn run up in prices. This could occur because many institutional managers are behind their benchmarks this year and there is something like a trillion dollars sitting in money market accounts earning essentially 0 return for investors. I have heard various estimates on how much money is actually on the sidelines. While the actual number may be up for debate, the number is historically much higher than average. Given this possibility, we prefer the Playbook strategy outlined above. If markets do the opposite of what the crowd thinks then we should be along for the ride. If we do indeed sell off then we have a plan for raising cash per our client risk return requirements.

Sand In The Shoes!

I'll be out until the week of August 24. Its time for the employees of Lumen Capital to take their yearly vacation on the sunny beaches of Rhode Island. There are a few business obligations that will keep me away as well during this time. Posting will be non-existent to infrequent.

We'll pick it up near the end of the month. August is usually a dead time in the world of finance. (Famous last words! Lot's of wars have been started in August!) Rest assured we'll chime in if anything of importance comes up.

Food For Thought On The Recession

A longer but thought provoking piece from 24/7 Wall Street. Link & thoughts @ the end.
The Recession America Needed {Excerpt with salient points highlighted.}

“It is probably well that we had the war when we did. We are better off now than we would have been without it, and have made more rapid progress than we otherwise should have made.”–Ulysses S. Grant, writing about the Civil War in his “Personal Memoirs”, 1885.

The human toll of the recession, reported to be the worst economic downturn since the 1930s, has been so searing that it could be considered cruel to evaluate this event for any benefits. More than six million people have lost their jobs since this financial catastrophe began and, according to The New York Times, well over one million of those will lose their unemployment insurance benefits between now and the end of the year.....
Many economists believe, or at least want to believe, that GDP will begin to stage a modest recovery near the end of this year.......All of this potential recovery takes place in the shadow of a national debt that, according to the CBO, could rise an average of $1 trillion a year for the next decade. The Heritage Foundation expects that the national debt will be $12.5 trillion ten years from now using inflation adjusted dollars. This number means that the debt would be 67% of GDP. The organization’s numbers could be off by a significant amount because they are thought to be somewhat pessimistic, but even a more sanguine view is likely to yield the conclusion that the deficit and the interest that will have to be paid on it are beyond the economy’s ability to support it, even if GDP growth is moderately good during the next few years. The recession came at the best time that it could because it has given the US a chance to make permanent adjustments to the government’s economic and regulatory policies and has offered businesses and individuals the opportunity to change decades-old habits. It has also allowed the nation to look at its place in the world, especially its best options to compete with China and other emerging countries, in a way that would have been forestalled if the recession had not happened in 2008 and 2009.The cause of the recession is often blamed on financial firms that took astonishingly large risks with the goal of multiplying their earnings at unprecedented levels and consumers who were willing to aggressively borrow against inflated home values that were not sustainable........Prescience, born of powerful deductive skills, could have caused regulators to sound alarm bells, but the collapse of the over-leveraged system was seen by very few experts until it was on top of the economy and in the process of ruining it.
Congress would like to regulate every corner of the financial system based on the idea that monitoring everything can prevent anything bad from happening. There may be a certain truth to that, but it is also true that a massive framework of regulation would serve to push almost all risk taking out of the market....... The trajectory of the economy might be improved for decades if financial firms were forced to disclose the risks they were taking without ceasing the process of taking those risks....... The government does not need to tell banks something that shareholders are certain to say with great force.The end of the recession may offer a much better balance between the risk that financial firms take and the potential harm it can do to them and the broader credit system.....
.....Another, and perhaps the most important by-product of the recession, is how it is remedied. The majority of Congress and the Administration believe that a growing national deficit can be maintained for a number of years. This supposition may be challenged, and challenged soon, if the world’s capital markets refuse to absorb hundreds of billions of dollars in US debt each year. The prevailing wisdom is that the largest holders of American paper, particularly the Chinese, cannot afford to stop funding the US government’s red ink because without capital to stimulate the world largest economy, it will fall back into a deep recession. An American economy facing a multi-year downturn is an economy that is no longer a huge market for importing Chinese goods.....China {however} has warned the US that its appetite for American debt is not insatiable. Its holdings of Treasuries are already nearly $800 billion.......
....China will never have rapid GDP growth without its huge export machine, but it may be able to slightly mitigate that risk by building a more consumer-based economy like the one that has been the mainstay of US GDP growth for decades.

An America faced with limits on it borrowing power is an America which will have to quickly find alternatives to government spending as the primary means of priming the pump of the economy. The Administration has already said that an increased manufacturing base in the US is critical to improving US exports which in turn would offset a less voracious American consumer. American businesses will need some form of credit from the government to invest in manufacturing. The cost of labor in the US is still too high to allow most businesses to compete with the cost of manufacturing overseas. Either US workers will have to agree to be paid less to have sustainable jobs, or manufacturing efficiency in America will have to take a great leap forward........
The government will also have to decide if it wants to use its limited resources to create programs like infrastructure improvements to produce jobs which may not last when the $787 billion stimulus program is over. Alternatively, the government may want to provide permanent incentives to keep manufacturing jobs in the US and to prevent professional jobs from moving off-shore. It pays GM to make cars in China and Microsoft and IBM to move work to India. The only practical way to get American businesses to stop sending jobs overseas is to provide them with tax incentives or financial subsidies to make the cost of US labor more competitive. It is a kind of employment socialism and would not be economically sustainable for a number of years but it could keep jobs in the US while the recovery has the time to take root for a longer period.
The recession will probably lead both American businesses and workers to the point where it is clear that the cost of labor in the United States has been too high, and it has been too high for twenty or thirty years....... The American worker is going to have to come to terms with the fact that an economy that supports 95% employment will be an economy where the incomes in many industries must decrease...... That will, in turn, reduce consumer spending, so the Administration’s plan to help improve the export portion of the economy as a key to GDP growth comes at the right time.
The US is going to have to be much more aggressive in defending the intellectual property rights of the companies that employ its workers and pay its taxes...... Microsoft, the world’s largest software company, says that it has all but given up on doing profitable business in China. Reuters reports that the movie, music, software, and book industries claim to have lost $3.5 billion to piracy in China in 2007. ........ This huge “leak” in American GDP is just as significant as large drops in consumer spending or losses of jobs that go overseas. Stimulating the economy has to be as much about the rights of American enterprise as it is about spending taxpayer dollars.
Publisher Henry Luce called the hundred years that began in 1900 “The American Century” in an editorial written for Life Magazine in 1941. A close reading of the article shows that he actually said “the first great American Century” implying that there would be more to follow. The United State is plagued by the idea that the 21st Century will be the Chinese Century and that, sometime around 2050, China will pass the US in total GDP. The recession may have actually gone a long way to make certain that this prediction is not a foregone conclusion. American business and industry and the fundamental operation of the US economy must change significantly so that this recession’s destruction of businesses and human lives will not have occurred for nothing. The country would then have the opportunity to take the path of greater efficiency, innovation, frugality, and recognition that a national debt in the trillions of dollars will increase taxes to unsustainable levels.
China has a number of advantages over the US economically and it can increase each of those. Its manufacturing base is its most important advantage. America can only take back initiatives in this arena if there is a permanent change in the expectations about compensation among US manufacturing workers and an extended improvement in manufacturing productivity. .....The only issue is whether the US blue collar population is willing to admit this today or live through a decade of high unemployment in order to be convinced.
One of the tremendous advantages that large Chinese companies have, especially those partially owned by the central government, is their access to capital from the treasury....... It is now a stated goal of the Chinese government that it will use its deposits to help companies in its strategic industries to buy assets from abroad.
The American system of putting capital into industry is well-illustrated by the bank and automotive crises. Banks and car companies received access to inexpensive capital when they were in deep trouble. This put taxpayer money at great risk no matter how necessary it was. The federal government has no systematic programs to provide money to American businesses that have reasonable chances for capital expansion......The current capital markets in the US make it very difficult for early stage or unprofitable firms in that sector to expand. The recession is actually making it impossible for many of them to stay in business.
The recession has made the government, and many of America’s largest industries, realize that China is coming closer to becoming the world’s dominant economy at a much faster pace than anyone could have expected just two years ago. The pressure to revive the US economy is intense, not just to save jobs and increase tax revenue, but also to prevent America from falling into a position where it begins to lose the leverage that being the world’s dominate economy gives it. The Chinese could withdraw their capital support from the US at any time. It is easy to say that is not in their short-term interests, but they may be willing to go through the unpleasantness that would come with thinking long term and cutting off funding to the country they are trying to best. .....
The devastation of the recession which may end early next year will not be forgotten as long as anyone who suffered through it is still alive. It is like the Great Depression that way. Some of these scars will be permanent. The opportunity America has at this point in the fragile recovery may not have existed before because of national arrogance and it may not exist again if the economy remains in a shambles long enough. The recession has given America a window, perhaps of only two or three years, to refresh its economic fortunes in a way they have not been refreshed since the core of the business strength of the US moved from the manufacturing to the service sector. The prosperity that went with that evolution may indeed have been a false promise. America may need both a powerful manufacturing and services sector with some reasonable access to capital, a credit and financial system that is reasonably transparent, protection of the intellectual property of the nation’s companies, and the realization that not everyone who can work gets a job simply because they live in the US.
Americans did not get the recession that they deserved but they did get the recession that they needed.
Douglas A. McIntyre

Link: http://247wallst.com/2009/08/04/the-recession-america-needed/#more-43052

My thoughts: I think this is a bit too alarmist for my taste regarding China. I remember when it was going to be the Japanese who ate our lunch and before that the Soviets. However, nobody can deny the rise of China and the symbiotic relationship we seem to currently have with them. The recession or the "Great Reset" as I call it is a wake up call for not just Americans but Westerners in general. We will need to substantially rethink much of how we operate and how we do business. Governments, individuals and businesses will have to rethink many of their basic principles. We can already see this as individual savings rates continue to increase. Market crashes as we've highlighted in the past signal the end of an era. Perhaps with articles such as this we are beginning to get an inkling of what the next turn of events will look like.

Unemployment

From Chart of the Day. Here is a link to their site. {Subscription required.} http://www.chartoftheday.com/

{On Friday}, the Labor Department reported that the unemployment rate actually decreased from 9.5% to 9.4% during July. This is the first decrease in the unemployment rate since April 2008. For some perspective on the current state of the labor market, today's chart illustrates the unemployment rate since 1948. Today's chart illustrates that despite this month's encouraging decline, there was only one general period in the post-World War II era during which the unemployment rate was higher than the current rate of 9.4% (i.e. June 1982 - June 1983). It is worth noting, however, that a one-month decline in the unemployment rate (even a small decline) after a significant spike (i.e. the unemployment rate spikes by 1.5 percentage points or more) has tended to occur slightly after a recession had ended.

My thoughts: Chart shows in pretty stark reality how tough this period has been. Remember that employment is a lagging indicator so the economy is going to turn likely as unemployment numbers continue to increase.

A Review Of Some Previous Posts.

As of this writing the S&P 500 is trading about 1000. You can see a good picture of this by taking a gander at yesterday's chart. This is a level that very few people thought possible last fall and last winter. I'd like to point out though that money flow analysis suggested this was a possibility even back then.

Back in November we laid out a possible scenario that has so far been pretty close to what we thought might happen although we were low on the unemployment level of 8%. Back then we said, "The 1st quarter of 2009 proves to be the the trough in corporate earnings. 2nd quarter numbers while still negative show a sequential improvement in results. By mid summer optimism that the economy has weathered the worst of it starts to seep into the investment community. Stocks which have spent about nine months trading between 850 and 1100 on the S&P 500 start to trade up as investors start to discount the possibility of a recovery by the end of the year." We said that the S&P 500 could end up around 1275 by the end of the year. We still think that is a possibility though we also think that probability suggests that we should see some pullback in stock prices as we enter what is usually a seasonally weak period for stock prices (late August-mid October).
Link: http://lumencapital.blogspot.com/2008/11/scenarios-mr-positive.html

Back in March we looked at one of our basic tenants which was "Markets will do what they have to do to prove the most amount of people wrong". We posed the question which way should the market go that would cause the most amount of pain for investors. We felt that direction was an explosive move to the upside. "The most unlooked for scenario would be a market that rockets considerably higher from here. There is a scenario that could get us to 1000-1100 on the S&P over the next year {or sooner} & 1300 by the end of 2010. This seems 'pie in the sky' but the first targets would get us only to where we were early in the fall and 1300 revisits the summer of 08." Link: http://lumencapital.blogspot.com/2009/03/variant-thought.html We felt that that 1,000-1,100 level was very possible on the S&P 500. We have reached the lower end of that level now.

If I ask the question today about which market direction would cause the most pain the answer is more mixed. Short to intermediate term the answer to what would cause the most pain would be a short and perhaps violent market correction. Longer term that answer is not so clear. There are trillions of dollars that have left the stock market that are sitting on the sidelines in money markets drawing little to no interest. I think the most pain would be for the market to not really give that money an opportunity to get reinvested in stocks.

One final note on this post. We study money flows because we feel that 1.) they are analysable and not subject to spin, that is charts don't lie. 2.) We feel that some of our proprietary studies gives us a longer and shorter term investment edge. 3.)We also believe that the study of money flows gives us an investment view that we can incorporate into the "game plan" and 4.) This discipline sets out certain probabilities that we can also incorporate into our investment approach. I would now like to make one important point. Probability is not certainty. That is there is no guarantee that probability as the most likely scenario is the one that will ultimately occur. Probability last summer led us to take defensive measures in client accounts in accordance to our understanding of their risk/reward parameters. Probability did not suggest that the markets would crash since it was impossible to know at that point that firms like AIG & Lehman Brothers would go bankrupt. We got hurt like everybody else. Similar to blackjack when you have a 19, (83% probability of winning-one deck) probability suggests that you have a higher percentage win rate than if you show a 14 (48% probability of winning-one deck). You can still lose with the 19 and win with the 14 but one is an easier path than the other. We therefore discuss probability and not predictability. We are not saying that we called the market in this post. We are saying that we believe that we have benefited this year by incorporating what probability teaches us by looking back at almost 90 years of stock market data and incorporating that knowledge into the investment management of our client accounts through the "game plan".

We will discuss money flows more extensively when we begin our study of risk in the fall. In the meantime, please let us know if you would like to have this concept explained to you further or if you are not a client of our firm and are interested in how we might apply our strategies to your current investment situation.

*Long ETFs related to the S&P 500 for client accounts.

S&P 500 A Review.

We published the lower chart back in early June. I'm republishing it now for reference. Here also is the link to that post: http://lumencapital.blogspot.com/2009/06/s-500-chart-iii-where-we-might-go.html

I've updated that same chart on top to show the current market situation. Very over bought right now. Probability would suggest some sort of pullback soon.

*Long ETFs related to the S&P 500 for client and personal accounts.

Thoughts On A Falling Dollar

What does it mean when the dollar falls, commodities and equities rise in thin volume, with lots of the program driven trading?

Perhaps Art Cashin’s comments yesterday might shed some light”
“Dollar Hits New Low For 2009. S&P Makes New High For 2009, Duh!
While economic data continues to come in “less bad”, many traders are pointing to the inverse relationship of the dollar to the market as the influence for movement.
Yesterday, the dollar fell and oil, stocks and commodities rose. Late in the day, oil pulled back as it hit chart resistance and recoiled.
There is speculation among brokers that a “dollar carry trade” may be evolving. For decades, arbitrageurs would borrow money in Tokyo at zero percent and short the yen. They would then take the “free money” and buy commodities, crude, high yielding bonds and even stocks. With U.S. rates held at zero for months, traders wonder if an American version of the “carry trade” is beginning to evolve.

Whatever the source, there is no denying the influence of dollar movements across asset classes. It is clearest against oil and commodities but quite evident versus stocks.

*Long ETFs related to the S&P 500 in client and personal accounts.

Source: The Big Picture. http://www.ritholtz.com/blog/2009/08/is-the-diving-dollar-driving-equities/

Minimum Wage

24/7 Wall Street on the minimum wage. {Excerpt}

Trading The Minimum Wage For Inflation

The federal minimum wage gets a boost to $7.25 an hour...., a move that may hurt the low-wage earners the Obama administration is trying to help. The result may help send us back 30 years to the era of stagflation.
The logic in raising the minimum wage is that it will help the people who need it most to keep up with the rising cost of basic life necessities.......Government stats such as the Chicago Fed’s National Activity Index say inflation is tame, for now. But where is it headed? The biggest reason to believe inflation will take hold is the high demand for gold, measured in both spot prices and TV informercials for you unwanted jewelery. It shows that the market is pricing in inflation expectations.....Rising commodities quoted in dollars, meanwhile, suggests some inflation is already here.....
No wonder people at the low-end of the economic food chain want higher wages. There is reason to think a rise in the minimum wage could provide some near-term economic stimulus. A study last year by the Federal Reserve Bank of Chicago confirmed that a minimum wage boost provided more economic benefit than a tax cut. The reason is elementary: Low wage-earners live paycheck to paycheck. Provide them with extra dollars, and they are very likely to spend them immediately. It all comes at a price down the road, though. Raising the minimum wage is by definition inflationary. It adds to the cost of most anything with a basic labor component; the price of thousands of consumer goods made in the U.S., the price of eating out at a low-priced restaurant, and the prices at most every struggling U.S. retailer that counts on low-wage earners to turn the lights on and run the checkout stands.
It’s the lowest wage-earners that can least afford long-term inflation.
The other big price of a higher minimum wage is the toll on small business owners, which are usually first to start hiring again in an economic upswing. If anything, forcing them to pay higher wages could lead to more layoffs — or at minimum, they will do less hiring .....
Put it all together, and the minimum wage hike provides a bit of near-term economic pickup in exchange for the likelihood of higher costs for most everything, and a further hit to the already weak jobs market. The word for that back in the day was stagflation.

Link: http://247wallst.com/2009/07/24/trading-the-minimum-wage-for-inflation/
Mike Tarsala

My thoughts: Might all be true but it is the political expedient thing for politicians to do. In the long run the easiest way for a politician to deal with all this debt is to inflate our way out of it.

an tSionna: Yesterday's Charts.

One thing I thought I'd mention from yesterday. Market rallies like this are subject to short term rapid corrections that will relieve the over bought condition. I've printed a chart from the last time we saw a trending summer bull market to illustrate. {Double click to enlarge). Markets don't have to relieve this condition this way but it becomes much more of a possibility when traders have made pretty decent money in the short term and start looking to protect their gains. Of course I'm not saying this is going to happen but it wouldn't surprise me to see us have a down 1 or 2% session one of these days.

*Long ETF's related to the S&P 500 in client and personal accounts.

Economic Recovery

BCA Research sees hope in some of the latest statistics that we may be in the first stages of an economic recovery.

The U.S. economy is transitioning to a recovery path, though it will be bumpy and subdued compared with past cycles.The ISM for the non-manufacturing sector reinforced that the economy is stabilizing following the "sudden stop" that occurred in the fourth quarter of last year. The new orders index rose to a post-Lehman high and is probing expansionary territory, indicating companies are regaining some confidence in final demand. This is corroborated by the continuing rise in the employment component, which shows that businesses are slowing the pace of job cuts, despite June's disappointing payroll figures. The ISM surveys signal that the economy is on the cusp of a recovery. Investor conviction, however, will only come with evidence that the U.S. consumer is beginning to spend a bit more freely, which we expect to see over the next several months.

Source: BCA Research 13:33:00, July 08, 2009 U.S. Economy: It Looks Like A Recovery.

Link:http://www.bcaresearch.com/public/story.asp?pre=PRE-20090708.GIF

an tSionna: Over Bought & Extended.

The market had a monster move in July. I'll have more to say about that in the next week or so. For now though we need to access what's happening. This kind of move just begs for the "smart money" to short it. That of course is a problem for them because they've been hurt recently and we've seen a lot of short covering over the past couple of weeks.
Today the market is bumping up against resistance that goes back to last fall within the trading range we've endlessly discussed these past 7 or so months. Such a move in a very short period of time has left stocks very extended. Stocks are also very over bought so logically one would expect stocks to correct. I'm still mindful of those seasonal patterns which by the way suggest that the weakest months for stocks are still in front of us. (late August-Mid-October.)
It may not be so easy this time for that to happen. There's trillions of dollars in money market accounts earning less than 1% that's missed out on one of the great stock market rallies in history. This money will likely want in at some point which could make pullbacks shallow and buying opportunities instead of places to lighten up equity exposure.

For now though we're very over bought and extended. Probability would indicate some sort of pullback given the extent of the move. We'll have to see!
*Long ETFs related to the S&P 500 for client and individual accounts.

On Land Phone Lines

I had a client ask me a couple of weeks ago what I thought about companies like AT &T or Verizon given the explosive growth in cell phones and given what I believe will be a technology curve changing event as smartphones become more developed. On the surface it would seem these companies have everything going for them plus nice dividend. Underneath I'm troubled that people under 25 don't use or even have landlines. Then there is that pesky US government that is beginning to make noises about anti-trust surrounding these companies cell phone plans. 24/7 Wall Street is out with a piece that shares some of my thinking. Here is an excerpt with link.

Sunset for Ma Bell: AT&T (T) appropriately makes the point that its earnings now are driven by its cellular business and its new fiber broadband. The company now has 79.6 million wireless subscribers. The Apple (AAPL) iPhone is winning the phone company new business. Perhaps most importantly, the revenue that AT&T gets from wireless data use is rising sharply, and in the second quarter was up $934 million from the same period a year ago.
......{However} the disconnect rate of AT&T’s old-time landline telephone service is high, very high. AT&T had 46.3 million total consumer connections at the end of the second quarter, compared with 48.4 million at the end of the second quarter last year. It is beginning to look like the ISP dial-up industry. That attrition rate is the single most acute problem facing the company.........The outlook for this part of AT&T’s business is extremely bleak. It is not clear that the growth of the firm’s wireless operations can make up for trouble in its legacy divisions.....AT&T’s two most promising businesses are both in increasingly competitive fields. The fiber broadband operation competes with cable and will compete with new 4G internet wireless companies. Some people may elect to drop fiber broadband if the next generation of wireless is fast enough.The American wireless industry is crowded and the market is essentially saturated......The cellular companies will have to fall back on data revenue and that business may not be big enough to keep earnings at firms like AT&T and Verizon (VZ) moving up rapidly.AT&T finds itself in one large business that is shrinking and two other large businesses that have profitable futures with uncertain revenue growth. The question for AT&T may be where it can find opportunities for diversification in related sectors of the economy, ones that could still have double-digit growth. That is a hard task but not one that is impossible.

Link: http://247wallst.com/2009/07/24/sunset-for-ma-bell/#more-41957