June 2009

June 26. 2009 10:00 a.m.
Highlighs from the Week

I don’t usually comment on Federal Reserve’s actions or the statements that go along with its policy announcements. But this week’s announcement is worth a note. While the statement is very similar to the last statement, it definitely is more cautious and even pessimistic about the economy. The Fed has pumped quite a bit of money and credit into the economy, and that brought an end to the crisis period. But it has not revived the economy. Consumer spending and business investment both are very weak. The economy still is very fragile with no sign of a return to robust growth. The Fed appears not to know what to do at this point and is taking a wait-and-see approach. If the economy improves, the Fed will continue or scale back its efforts. If the economy weakens, the Fed will have to step up. Right now, it doesn’t have a strong opinion which way the economy will go.

There were several items on the web this week that are worth your time.

Paul Volcker was touted as a leading advisor to Barack Obama before the election. Since then, others seem to have grabbed hold of policy. There is an excellent review of the events on Bloomberg here.

Vanity Faire’s Bryan Burrough has an excellent history of Allen Stanford and his apparent fraud here.

Last fall Warren Buffett advised investors to buy U.S. stocks and said they would do well over time. This week, he said the economy stinks, and he sees no turn around. See it here.

The head of Bank United agrees, saying that are few green shoots and no sign of a real estate recovery here.

Finally, the Financial Regulatory Association issued a warning on leveraged ETFs. While they can achieve close to their returns goals over a short term, over any period longer than a few days their returns can differ significantly from their goals. These ETFs definitely are not for buy and hold investors. Read the warning here.

June 22, 2009 12:45 p.m.
Another Turning Point

It appears that last week was a turning point in the stock markets. The last turning point was March 9, when the indexes hit their most recent bottom. Since then, investors have debated whether the ensuing rally was the end of the bear market or a bear market rally. We still don’t have a conclusion to debate, but whatever we were in is over. At a minimum a correction in the rally is occurring.

The rally was impressive. In the last 13 weeks, the iShares Emerging Markets ETF is up 32.85%. The Russell 2000 Growth ETF gained 30.95%, and the Nasdaq 100 ETF is up 23.92%. The Russell 2000 gained 28.34%, the S&P 500 19.98%, and the Dow 17.28%.

The only losers since March 9 have been gold and treasury bond funds and those that sell short the stock indexes.

Stock indexes began to flatten in the last few weeks, and the indexes turned decisively south last week. Bond funds did not change much last week, and gold lost less than a half percent.

Emerging market stock funds lost 5% and more for the week. The S&P 500 lost over 3%, and broader-based stock indexes such as the Vanguard Total Market lost just under 3%. The Dow lost 3.4%. The big losers were energy-related stocks, losing 8% and more. Real estate investment trusts lost over 6%.

Stocks were due for a pause in the rally, but investors also began to question the idea the economic downturn was ending. Initially there was optimism last Thursday when the unemployment claims report showed for the first time since January that the continuing claims did not set a new record high. But a little poking around the data reveals people did not start to find jobs. Instead, a number of people have been unemployed so long their benefits expired.

The declines in commodities and inflation hedges and the rise in treasury bonds indicate investors suddenly are not worried about inflation rising any time soon. Instead, they are worried about slow economic growth and perhaps continued deflation. Also, the positive signs some thought they were seeing in housing were interpreted far too optimistically.

We have been cautious this year, focusing on preserving capital. There remains a battle between the long-term deleveraging trend and the massive injections of money from the Federal Reserve. I suspect as these forces work against each other stocks will remain in a trading range and the economy will have an extended period of low growth. Investors who continue to follow the lessons they learned in the 1980s and 1990s will be disappointed as they expect quick recoveries for both the economy and markets.

June 16, 2009 08:30 p.m.
Weeds Among the Shoots

This week is only two days old, but already a couple of major weeks are cropping up among the green shoots so many investors have been straining to see.

The first bit of bad news involved credit card debt. Defaults on credit cards were reported at record highs on Monday. Bank of America said its default ratio rose to 12.5% in May to 10.47% in April. American Express had a lesser rise, from 8.56% to 9.41%. JPMorgan Chase’s default rate rose to 8.36% from 8.06%.

It already is looking like the credit card default rates used in the much-touted stress tests were too lenient. Unless things turn around sharply, the two-year default rate is likely to exceed that used in the tests.

The other bad news was industrial production, reported on Tuesday. It decreased another 1.1% in May. This puts overall industrial output at 13.4% below its level of a year ago. More importantly, only 68.3% of industrial capacity is being used. This is 12.6 percentage points below the long-term average and is the lowest level recorded since the data was first kept in 1967.

It is hard to see how the economy is going to grow much in the near term starting from this level. It will take a lot of hiring and ramping up of production to bring the use of industrial capacity near a normal level. Only sometime after that will manufacturers consider making new capital investments.

You also might have noticed that your access to credit is declining. Credit card firms are advertising for new card holders much less than they used to. In addition, anecdotally it appears that a lot of financial institutions are reducing or eliminating limits on credit cards and home equity loans. It doesn’t matter if your credit score is high and your payment record spotless. Credit is being canceled without warning.

The reason is banks need to improve their balance sheets. Your credit limit counts against the bank, even if you are not using any of the credit. So, if you are not using the credit and are an unprofitable customer, the bank might cancel your line of credit or credit card to make its balance sheet better.

That might be good management for a bank, but it is another sign that consumer spending is not likely to reach anywhere near its pre-crisis levels anytime soon.

June 11, 2009 04:45 p.m.
A Snapshot of American Wealth

In the past year we have discussed a couple of times the Federal Reserve’s quarterly Flow of Funds report. The name is a bit inappropriate, because the report tracks changes in the wealth of Americans.

The report for the end of the first quarter, released today, was another disturbing one. Household net worth as of the end of the quarter was $14 trillion less than at the peak in 2007. The Fed tracks real estate, financial assets (stocks, bonds, mutual funds, bank deposits, pension reserves, and more), and subtracts net liabilities. Most of the liabilities are mortgages. A share of government debt is not included in household liabilities. We should expect that net worth has increased a bit since the end of the first quarter, because the stock market has had a good run. But most families have more of their worth in their homes than in stocks, so the overall increase in net worth has not been great.

As a percentage of GDP, household net worth now is at about the same level as in the early 1990s and far below its peaks of over 450% of GDP reached in both 1999 and 2007.

The real news in the report is the continued deterioration of the housing market and how it affects household net worth. For many decades, homeowners’ equity in their homes held fairly steady between 65% and 70%. This declined beginning with the real estate crunch of the late 1980s. Though home prices recovered after that and soared in the early 2000s, the percentage of equity declined below 60% around 1992 and stayed below 60%. As home prices increased, Americans borrowed against the equity and spent it. Once home prices peaked, the percentage of equity Americans have in their homes declined sharply. It now is at an all-time low of 41%.

The situation actually is worse than the number shows, because about 31% of households do not have mortgages. So those that do have mortgages have very little equity in their homes.

Another compelling piece of data is mortgage debt as a percentage of GDP. While home values as a percentage of GDP has declined sharply (from 170% in 2007 to below 130% today), mortgage debt as a percentage of GDP has remained steady at around 75%.

What does this mean to you?

In the past I have discussed the wealth effect. When people feel wealthy, they spend more and save less. When they believe their wealth has declined, they spend less and save more. The shifts take a long time, since most people do not track their wealthy frequently and assume most changes are short-term. This data should give pause to those who are expecting a quick upward turn in the economy. Many Americans are likely to keep their spending low and savings increasing for a while, perhaps years. We won’t return to the heady days of 1996-2007 for some time. People do not have the income or equity to sustain much borrowing, and much of the spending during that period was made possible by borrowing against home equity.

This is one reason my expectation is for low economic growth, low profit margins, and below average stock market returns for the next few years.

June 3, 2009 07:15 p.m.
A Few Rays of Sunshine

It is a dreary, rainy couple of days here in Virginia, but a few pieces of economic data could be hopeful.

Today’s report on unemployment claims showed that new claims in the most recent week declined slightly from the previous week. Even more important, the number of people filing continuing claims declined a little for the first time since January.

The continuing claims figure is important because it indicates whether the previously unemployed are finding new jobs or the newly unemployed are joining the previously unemployed in an ever-growing pool of jobless. A steady decline in continuing claims would be the first reliable sign that employers actually are trying to expand. Ever-rising continuing claims mean employers continue to cut back. Until this week, the continuing claims have been setting a record each week since Jan. 24.

The 15,000 person reduction in continuing claims is the good news.

The bad news is the decline is small, and the continuing unemployed still is at 6.7 million. The initial claims still are quite high, at 605,000, and the four-week moving average rose to 631,250.

Reasons to continue to be concerned about the economy were well-stated in the Financial Times by Mohamed El-Erian of PIMCO here.

El-Erian makes two key points.

One is that the recent stabilization or growth in the economy is due primarily to two factors. One factor is a classic inventory cycle. Businesses reduced production in a panic such much in the last quarter of 2008 and first quarter of 2009 that inventories fell sharply. Consumer spending, while it fell sharply, did not decline as much as inventories. Businesses need to increase production to restore inventories to normal levels and to be able to meet today’s reduced demand. Once the inventory balance is restored, businesses might be content to maintain those levels and not seek to grow.

Another factor is the economic stimulus package has been providing some of the growth. The stimulus soon will pass its peak, and its effects will weaken. There are no signs the stimulus is having any follow-through effects.

The second point El-Erian makes is that even after growth returns, the normal or potential growth of the economy will be less than it was before the crisis. Debt levels will be lower. Businesses and consumers will be more conservative. Profit margins will be lower. All of this means that it could take a long time to put people back to work and restore the balance sheets of consumers and businesses.

That is why we remain cautious with our portfolios at Retirement Watch. Stocks and bonds have been strong for about three months. There is optimism that the worst is over and recovery is on the way.But too many people are treating this like a traditional economic cycle that ends shortly after the Fed starts cutting interest rates and increasing the money supply. This time, the Fed’s actions are barely enough to offset the deleveraging process. Low interest rates are not spurring new credit creation and borrowing. While the economic numbers are better than a few months ago, they still are dreary by normal standards. The economy still is very fragile. While traders can make money by moving in and out of risky investments at the ends of their trading ranges, investors need to be careful and focus primarily on capital preservation.