January 2007

January 31, 2007 05:10 p.m. The Fed Boosts the Markets

It was a good day all around for the stock markets.

The day got off to a good start with the GDP report. It revealed stronger-than-expected growth and declining inflation. Consumer spending was high. The only negatives in the report were a sharp declining in the housing market and a jump in government spending. This report was in line with our recent forecasts in Retirement Watch and also in line with the Fed’s expectations. Initially the report caused stocks to decline. Apparently investors believed that the Fed would want to raise interest rates soon and slow the economy. (Quite a change from expectations of only a few months ago.)

But the Fed’s statement later in the day indicated that inflation was starting to decline. While the Fed indicated it still might have to raise rates at some point, the optimism about inflation was what investors wanted to hear. Stocks surged upward. Though the indexes finished below their highs for the day, the gains were strong. Volume also was fairly strong. It was not among the highest-volume days, but volume was among the highs for the last two months. Since investors did not do much trading until the Fed’s announcement, it should be considered a strong volume day.

Before the Fed announcement, there were other items of interest that investors were ignoring. Consider the following:

• Chinese stocks declined 5% overnight. A Chinese official stated that the market was in a bubble (with more than a 130% gain in 2006), and that it would have to decline. This statement produced losses in the Asian markets.
• The web site Tickersense has been producing charts showing the price-earnigns ratios of key Dow Stocks over the recent past. The bottom line: Most of the stocks are selling for lower valuations than they were a few years ago, though the stock prices have increased.
• The best-performing stocks in the last year have been in the auto, resources, retail, and construction industries. These generally are economically-sensitive industries and are considered to indicate the future direction of the economy. Strong gains in these stocks mean investors think the economy will do well.
• Earnings for the fourth quarter of 2006 are looking stronger. A week or so ago, the earnings reported to date indicated that S&P 500 earnings would increase less than 10% for the first quarter in over three years. Now that most of the companies have reported, double-digit growth seems a lock for another quarter. In addition, the number of companies missing their targets or reporting cuts in forecasts for the next quarter are down.

January 29, 2007 09:55 p.m. Big Week for the Markets

The Federal Reserve Board meets this week. It was only a few months ago that investors were convinced that at this meeting the Board would be in a rush to reduce interest rates. That sentiment caused a big part of the surge in stocks during the last half of 2006. But, as we expected, the economy has been stronger than most investors anticipated and inflation is under control. A rate cut is off the table for now and perhaps for many months. We might even see a rate increase before the next cut.

The economy has been quite resilient the last six years. It withstood terrorist attacks, two wars, oil price shocks, rising inflation, corporate scandals, mutual fund scandals, a declining dollar, and a series of interest rate increases. This week a great deal of economic data will be reported, along with the end of earnings season. We could see a rise in volatility. Remember the stock indexes have gone about 140 days without a daily change of more than 2%. Stocks have had a good run since last July, and there is a lot of optimism among investors. Don’t be surprised by a correction of 5% or more in coming weeks. That is why we have sell signals in place and part of our Sector and Balanced Managed Portfolios are hedged against market declines.

January 29, 2007 10:15 p.m. Some Leisure Reading

I don’t subscribe to the Sunday New York Times, but I usually check out the Business section online. (Free registration is required.) Yesterday, there were several interesting articles.

The lead article revealed that Saudi Arabia want to keep the price of oil at around $50 per barrel. The Kingdom, of course, wants high oil prices to keep its economy humming. But prices that are too high cause problems. High prices spur interest in alternative sources of energy, make previously uneconomic oil wells profitable, reduce economic growth in the U.S. and other countries, and cause reductions in the use of oil. High prices also create political problems. Oil money funds disruptive forces in the Middle East, such as Iran, and revolutionaries such as Hugo Chavez in Venezuela. The article reminded me of one I read about five years ago in which an oil analyst said that Saudi Arabia’s main goal is to keep the world oil price volatile. Volatility makes it difficult to justify investments in alternative energy or energy-saving technologies, leaving the world dependent on oil.

Another article discussed how ordinary individual investors can make use of hedge fund-like strategies, which the article referred to as “007 Finance.” The article discussed exchange-traded funds. Investors can use them to invest in tiny slices of the market, such as water company stocks. ETFs also can be sold short or hedged through options on the ETFs. But the article did not talk about our portfolio of “hedge fund” mutual funds or discuss many of the funds that we use in Retirement Watch.

The third article is one we will discuss in more detail in a future issue of Retirement Watch. It addresses the theory that people are being encouraged to save too much for retirement. The article blames the financial services industry (which benefits from having more assets under management) for overstating retirement savings needs. The critics join us in attacking the use of rules of thumb instead of individual projections. It also discusses a few research articles you won’t see discussed much in the media that reveal most people are saving adequately for retirement. We’ll address these issues in more detail in a future visit.

January 24, 2007 1:55 p.m. Oil and Interest Rates

The equity markets have been fairly quiet in the New Year, but interesting things are happening in the oil and bond markets, and the developments are being widely discussed.

Recall a few years ago when all the talk was about the conundrum of long-term interest rates remaining low while inflation and short-term interest rates rose. Now, we have long-term interest rates rising while inflation and short-term rates remain stable. Oil appears to be the key.

It appears that the recycling of petrodollars is a major factor. The cycle seems to work like this. Oil prices rise, so more money flows to the oil exporting countries. They invest a large portion of this money in U.S. assets, especially bonds. These investments keep long-term interest rates low (and other asset prices high). Some analysts believe they have traced increased buying of U.S. bonds to U.K. accounts, which is where key oil producers base their investment accounts.

Now, with oil prices falling, interest rates are rising. The oil producing countries have less cash to invest. Interest rates are rising. But that could also mean that there will be less money flowing into stock and real estate markets. We’ll have to be alert to the potential for declines in those markets.

Perhaps another influence on interest rates is that the economy is showing no signs of sliding into a recession. The money that is not going to oil producing countries is back in consumers’ pockets. They are spending some of that at restaurants, retailers, and other places.

The fall in oil prices also is a lesson in how markets operate. In 2005 and 2006, oil prices were rising. Most forecasts were that the price of a barrel of crude would not stop below $100. The proponents of the Peak Oil Theory were dominating the discussions and arguing that oil supplies had peaked. In this journal, in Retirement Watch, and in a series of radio appearances I argued that it was prices that were nearing a peak. Higher prices soon would rise, and people would change their habits and consume less. That appears to be what has happened. There are some conspiracy theorists who point out that Goldman Sachs altered its commodity index twice, each time reducing the allocation to oil. After each re-allocation, oil future prices dropped. It is an interesting theory, but numbers show that oil inventories are high; the mild winter and other factors have caused demand to decline. Simple supply and demand explain the oil price changes.

January 11, 2007 2:45 p.m. News for the Markets

A few news and commentary items this week do a good job of identifying the key issues facing the markets as the new year unfolds.

Today’s “Ahead of the Tape” column in The Wall Street Journal (subscription required) raises the issue of what will replace earnings from energy companies in the market indexes. Throughout 2006, earnings growth was strong overall primarily because of the profits from oil and other energy companies. Without those earnings, profit growth among the S&P 500 would have been in the single digits. The price of a barrel of oil is below $55 and perhaps on its way to $45. That won’t be good for oil company earnings. Without that growth, the price-earnings ratio of the index will rise and make the index more expensive. Will technology, financial, and other companies make up the difference? Or will earnings growth tank?

Fed Governor Donald Kohn made a speech that says what I’ve been saying for some time: interest rate cuts probably aren’t in the cards for a while. Economic growth is stronger than most people believe, and there are few signs that the economy possibly is headed for a recession. Inflation has to decline further before the Fed considers rate cuts. This caused stocks to stumble in the first trading days of 2007. But investors seem to be recognizing that economic growth is a good thing for stocks.

Monday’s Journal had a good discussion of the inverted yield curve. The traditional view, which I held for a long time, is that the yield curve is the best predictor of the economy. A yield curve that stays inverted for a while is a strong indicator of recession. We have had an inverted yield curve for much of the last half of 2006 through today.

But most inverted yield curves of the past were caused by credit crunches and by the Fed shrinking the money supply. Other factors are at work here. International money continues to be drawn to U.S. bonds, keeping longer-term rates low. Pension funds also are shifting their portfolios into bonds, and individual investors hold a lower percentage of stocks than they did in the 1990s. These factors also distinguish this yield curve inversion from those that forecast recessions in the past. I’m inclined to think that, while economic growth will be lower than in 2003 and 2004, it still will be positive. I could be wrong, and that is why our portfolios are hedged a bit. But I expect growth of the economy and earnings to be positive, and that stock market returns also will be positive in 2007.

January 5, 2007 1:45 p.m. Changes Coming to the Site

I started this web blog about a year ago. I’ve learned a lot and will be rolling out some changes through January. Software and other changes will allow more frequent updates that include links, charts, and perhaps some other features. I’m also planning to give updates on our portfolios, especially the Invest with the Winners portfolios. It also looks like we will be able to get the RSS system working properly in coming weeks.

As part of the changes, more of these features will be moving to the subscribers’-only section of the Retirement Watch web site. I will have regular updates to this public-access site, but I’m planning the offerings for subscribers to be more robust and frequent. These changes will be phased in over coming weeks, and I hope to have them complete before the end of January. I also have initiated and plan more improvements in the subscribers’ web site that will roll out in stages.

January 5, 2007 1:45 p.m. New Year’s New Market

Investors pay a lot of attention to how the stock indexes perform during January, especially the first half of January. Conventional wisdom has it that the market’s performance in January dictates its performance for the year. That isn’t quite true, as recent on Ticker Sense makes clear. A positive January means there is a high probability of positive returns for the year (but most years have positive returns anyway). But a negative January foretells a negative year only 47% of the time. So, don’t fret too much over January’s results. Even if the conventional wisdom is right, it matters only to investors who buy and hold index funds the entire year.

As I indicated in December, there was a possibility that investors might wake on January 2 itching to sell stocks. We already had four straight years of positive returns and no correction of 10% or more during that time – very rare occurrences. Plus, indexes have been on a roll since July. This itch to sell is the main explanation I have for the sharp declines we saw during most of Thursday and for Friday.

The economic news has been good, and that seems to bother investors. Today’s employment report had a lot of good news. It indicates the economy is doing well and is not near a recession (though employment is a lagging indicator). Investors apparently decided this mean the Fed is not likely to cut interest rates anytime soon, because inflation might be on the rise. That is a reason to sell stocks. On the other hand, commodity prices are falling. Oil was at $78 per barrel July 14 and all reported indicated $100 was the next stop. Instead, it is at $55 today. Other commodities also have had steep declines. Investors say that means the economy is slipping into a recession. So that is a reason to sell stocks. The bond market is voting with the recession crowd, bringing interest rates lower today. But the dollar is rising, which normally happens only when growth is strong.

The bottom line is that investors have split interpretations over the latest news. Ignore the headlines and short-term market changes and focus on longer-term trends. Of course, investors might simply notice the leadership changes in Washington and wonder how that will affect policies.

I have maintained for some time that the economy is stronger than most investors recognize. My main concern through 2006 was that inflation would continue rising, and interest rates would have to rise further. That fear so far has proven to be unfounded. Investors and corporations have a lot of cash, and there are numerous opportunities throughout the world. I do not anticipate that stock markets will rise without pause, but they should be good investments for at least a while. We balance this forecast with sell signals and diversification. Some positive news comes from the manager of the Hussman Strategic Growth fund. John Hussman’s indicators have been bearish for more than a year, and the fund has been more or less fully hedged against a market decline. But in his recent weekly reports, Hussman has said that if the indexes decline 2% to 4%, he probably will shift his options positions to capture gains from a rebound.