January 2008

January 22, 2008 02:10 p.m.The Big Sell Off

It seems I caused a substantial decline in world stock markets. Last week I posted the February 2008 issue of Retirement Watch in which I argued that today’s market environment is more like 2001 or early 2002, with more losses to come, than it was like late 2002 when the economy and markets were forming bottoms. Saturday morning I spoke to the Washington, D.C. chapter of the American Association of Individual Investors. There, I reiterated that it was not yet time to be a hero and go bottom fishing in the markets.

I’m just kidding. Ascribing the market sell off to my opinion is as rational as attributing it to investor reaction to the current fiscal stimulus proposal or disappointment over the Fed’s actions. Long time readers and readers of my recent book know that the markets have wide swings in price because investors move between extreme optimism to extreme pessimism. The moves are based on interpretations of news and market events. No one knows why investors worldwide began steadily selling stocks the few weeks. The risks in the credit markets and to the global economy have been well known since last summer. Yet, only now investors are fleeing risky assets for safety. No one can say why. That is why in our investing we practice risk management. We look at the risks in the markets and reduce or avoid the risks we don’t want to take. That is why I added some new sell signals in the February issue of Retirement Watch.

While the media focus on the panic and the extent of the sell off, there is some good news in the recent action.

• Much is made that recent days are the worst since August 2002. That was a bad time, but it also was near the bottom of the bull market that began October 2002 or March 2003. Perhaps we are forming another bottom now.

• The Federal Reserve and the federal government are responding to the problem.

• Commodity prices are retreating. That could keep inflation down and help businesses with stressed profit margins.

• Prices of many investments, except treasury bonds, are falling, resulting in much more attractive valuations than even a few weeks ago.

• Investor pessimism is rising, which increases the probability that we are closer to a market bottom than a top.

Market prices are low enough that we could be near a temporary oversold bottom. I don’t see this as a long-term buying opportunity yet. There is the potential for stocks to rise 10% or more in coming weeks as some investors are attracted by the recent declines. Yet, there still are unknowns in the credit markets and significant problems that need to be resolved. I think any rally will be temporary until there is a catalyst that will turn around the economy and bring a resolution to the credit market problems.

January 14, 2008 9:00 a.m. Reading the Market’s Action

It is getting difficult to find positive returns in the markets for 2008.

My database of mutual funds and ETFs is showing mostly negative signs for traditional investments. The winners are those that sell short a market index. The biggest losers sell short small cap U.S. stocks and Japanese stocks. A smattering of stock sector funds managed gains or to treat water: Biotechnology, health care, and utilities. Gold and commodities also have done well, though some commodities such as oil are below their peak levels.

Bond funds that focus on U.S. government bonds also have done well. Other types of bonds are starting to show signs of life, but so far government bonds have been the only safe bet in the credit markets.

Despite all the bad headlines, there is starting to be some good news. Regulators and government officials are focusing on the problems, which should lead to actions that improve liquidity and confidence. In addition, foreign investors including the sovereign wealth funds are showing a strong interest in shoring up the capital of financial firms by taking investment positions in them. The markets already have discounted substantial losses at financial losses, and the discounting might exceed the actual losses that will occur. Because of the price drops and low interest rates, stocks are not overvalued and some analysts think they are cheap.

I don’t think we are at a bottom just yet. There likely are more surprises out there, and we don’t know what is in many of the financial firms. I suspect the stock market will remain in the trading range it has been in for the last year or longer. Rallies will be temporary and precarious, much like the one in the last quarter of 2007.

January 7, 2008 11:45 a.m. New Year Hangover

As the New Year gets rolling, it looks like those who used caution to position their portfolios did the right things. Investors entered the year expecting the economy to stay strong, or at least steady, and inflation to be restrained.

The economic data of the first week caused investors to question that outlook and reposition their portfolios. As a result, stocks declined. The Dow lost 4.2% for the week, and the S&P 500 lost 4.5%. Barron’s reported that 2008 is the Dow’s worst three-day start to a year since 1932.

The outlook for the economy, if last week’s data is representative of the big picture, is a gradually deteriorating economy with steady or rising inflation. It isn’t clear yet if a recession is in the cards, but the economy is due to slow. Consumer confidence is declining. Bridgewater Associates reports that of the 27 statistics is tracks that are indicators of economic growth, 21 now are negative.

These are the big negative indicators. The labor market appears to be weakening. Job growth is slow, and unemployment claims are rising. In addition, mortgage applications still are very low. These factors indicate that consumer spending will continue to slow into the near year. Stocks appear to be reasonably valued by historic standards, but profit margins are at all time highs. Will these margins be sustained if consumer spending declines and commodity prices stay high? If not, then profit margins will decline. Stocks likely would follow.

Another problem is that the carry trade is reversing. The carry trade is when investors borrow in one low interest currency, such as the Japanese yen, to buy assets in a higher interest currency. Because of declining rates in the U.S., it is less attractive to borrow in yen to invest in the U.S.

A few more danger signs: The securities and lending markets still are weak from the credit crisis of last summer. Banks are accumulating assets instead of making loans. The dollar is weak. Foreign investors want the Fed to raise rates while U.S. investors want it to cut rates. Also, there are some initial signs that despite the weak dollar U.S. export growth is slowing. Export growth is the main factor holding up the stock market and the U.S. economy.

All in all, it is a good time to be cautious on U.S. stocks and bonds. Invest with a hedge in U.S. markets and look for opportunities in overseas markets.

January 7, 2008 11:50 a.m. Answer the Door…

The New York Times had an interesting article Sunday describing how Domino’s Pizza is a good microcosm of the economy.

The company’s stock is down considerably over the last year. The problems are the same ones affecting many consumer discretionary businesses. Higher commodity prices are pushing up costs rapidly. In Domino’s case, cheese is the big expense, and its price soared last year. At the same time, weak consumer spending due to higher gas prices and a softer labor market makes it difficult to maintain sales at current prices. Those factors make price increases almost unthinkable.

Domino’s complicated its situation back in the days when interest rates were low and credit plentiful. It borrowed heavily to pay a special dividend to shareholders. Now, it is strapped with a high debt level when profit margins are shrinking, and there is little or no opportunity to refinance the debt.

Yet, the company has a number of enthusiastic investors. They point out that international sales still are growing, a feature common to the U.S. economy as a whole. Also, the stock trades are a reasonable valuation.

For a very long term investor, the stock can be a smart purchase. If oil prices fall and other commodity prices stabilize or even fall, many of the company’s problems disappear. The U.S. economy might be going through a slow patch, but the only question is how long that will last. Eventually, the economy will be robust again, and consumer will again have spare cash to spend on discretionary items such as pizza delivery.

Overall, the Domino’s Pizza reflects the economy and many companies. Things are tough right now, but most of the negative factors are likely to be temporary. The big questions are how bad things will get before hitting bottom, and how long it will take for most of the negative trends to reverse.