March 2009

Short-Term vs. Long-Term March 26, 2009 12:00 p.m.

The stock market indexes have been on a tear since March 9. It is quite a turnaround.

January and February were among the worst months on record for the indexes. The decline finally ended with new 12-year lows on March 9. The markets were oversold at that point and due for some kind of a rebound. At the time I wrote that the reversal was prompted by little more than positive comments from a few banking leaders and rumors about forthcoming government programs. Since then, the indexes clocked returns of around 20%, with much more significant gains in financial stocks. The indexes have had their first two consecutive weeks of positive returns in a while and are on their way to a third week.

The biggest day was this past Monday after the Treasury announced its plan to for the government to form partnerships with the private sector to purchase debt (toxic assets) from banks and other holders. Also helping stocks were economic data that were “not as bad as expected.” The question for investors is whether we are in the early stages of a new bull market or another bear market rally.

As you know, I believe if a new bull market is beginning there is no rush to try to catch the bottom. If it is a new bull, there are years of gains to come. It is better to be sure the tide has turned to avoid catching the top of another bear market rally.

Here are my reasons to be suspicious of this rally:

? As mentioned, there were reasons to expect a rally after the steep, unrelenting losses of January and February.

? We shouldn’t confuse economic data that are not as bad as expected with positive data. The best that can be said about the data is the economy is not deteriorating as fast as it was.

? The government programs continue to pump liquidity and leverage into the economy instead of dealing with the fundamental problem of there being too much debt. The programs seem determined to delay dealing with the debt overhang instead of fixing the problem.

? The private partnership program does not deal with the basic issue of the prices to put on the toxic assets on bank balance sheets. Contrary to public statements, there are buyers ready and willing to buy these assets. The problem is they are willing to pay prices much lower than what the owners are willing to accept. The partnership program hopes to solve this problem by providing a lot of essentially free debt to buy the assets and absorbing most but not all of any losses. The hope is the private investors will “overpay” for the assets because less of their own money is at risk. As I said in the April issue of Retirement Watch this essentially is another subsidy for bondholders and other creditors of the sellers.

? Taxpayers won’t be too happy if they learn details of the partnership program. It applies to far more firms than just the banks. Apparently, it is possible for a firm that owns bad debts on its own books or those of a partnership it formed to become a manager of one of the new partnerships. Then, the new partnership can buy the bad debts from the firm’s older partnerships. Or firms with bad assets on their books can form partnerships to buy each other’s bad assets.

? Despite the potential benefits, the most likely buyers have not been falling over each other to join the program. One reason is that not all the details are clear. Another is the difficulty of being a partner with the government. The bonuses paid to a few people at AIG were chickenfeed compared to the potential profits from the partnership program. If the public was mad about the AIG bonuses, it is hard to imagine the reaction to double-digit profits from the partnerships (though the government will share in profits).

? A plateau in the economy was to be expected. The monetary expansion and fiscal stimulus are starting to have some effects, cushioning the effects of the debt crisis. Also, the economy could not continue declining at the rate it did in late 2008. But the stimulus measures are not enough to offset the negative effects of reduced consumer spending, lower home values, falling incomes and employment, and excess capacity in the economy. Stimulus will cushion the effects somewhat but is not enough to overcome them. In addition, the stimulus will wear off over time.

? Other assets, especially bonds, did not have the same enthusiastic response as stocks. Since the problems are in the credit markets, their response is more important than the response in stocks.

? Monday’s market rise was one of the top 50 in U.S. market history. Unfortunately, according to Bridgewater Associates, most of the top 50 stock market days occurred in bear market rallies, not in the early stages of bull markets.

For now I conclude that it still is best to maintain a capital preservation strategy with your portfolios. The financial news is not as dire as it was from September through February, but it is not positive yet. We can expect some decent news in the short-term, but the longer-term picture still is cloud. I’m still making my shopping list but am not ready to increase the risk in our portfolios yet.

The Fed, Goals, and Diversions March 19, 2009 11:30 a.m.

The Federal Reserve announced some big moves yesterday. They had powerful, positive effects on our portfolios. The announcement of major infusions of cash into the system caused treasury yields to plummet. Inflation hedges soared, including gold, foreign currencies, and TIPS. DB International Government Inflation-Protected Bond rose almost 5%. Price International Bond gained almost 3%. iShares Comex Gold also gained almost 5%. Vanguard Inflation-Protected Securities returned 3.71% for the day. TCW Total Return Bond gained 1.28%. Hussman Strategic Growth had a modest gain, but Hussman Total Return gained almost 3%.

The big  moves by the Fed have two goals. One is to help banks make more money in two ways. By announcing it will purchase more treasury bonds and other debt, the Fed drives down interest rates on them. That enables banks to pay less interest on their deposits and perhaps earn more income on the spread between what they pay on deposits and what they earn on loans. Lower interest rates also might generate more mortgage and lending business, from which the banks will earn fees.

The other goal of the moves is to reduce interest rates to consumers and businesses. Through the crisis, while treasury yields have plummeted, interest rates charged by lenders have not declined much. This is especially true of rates charged to consumers, which have increased on many types of credit. Yields on mortgages are most likely to decrease, and that should spur refinancing fees to banks if not fees on many new mortgages. Rates on credit cards and other debt have been stickier.

Will these moves push the crisis to a close?

I doubt it. Lower rates and more credit do not deal with the issue of there being too much debt. Those who still have income and asset values to qualify for loans will refinance existing loans. But many people with too much debt won’t be able to refinance. The surge of money into inflation hedges after the Fed’s announcement was not a positive sign, though it is good for our portfolios. The Fed’s moves do not deal with the basic problem of too much debt.

The other big news this week was the incentive compensation paid to employees of AIG. I find this to be a diversion and misdirection. The bonuses are a small portion of the company’s revenues and of the government money shipped to the firm.

The real issue should be what the firm did with the rest of the money. It was sent to foreign banks, hedge funds, and firms such as Goldman Sachs. These firms had contracts with AIG or made loans to the firm and did not check out its financial position. The taxpayer money is used to bail out their bad deals. As I write at length in the April 2009 issue of Retirement Watch (now on the web site), there might be good reasons for using taxpayer money this way. But it should be debated openly. I do not think it is a coincidence the bonuses became a big issue a day after the recipients of the rest of AIG’s money were made public. The shock and anger over the bonuses seems to be a diversion of attention from what happened to the rest of the money.

Reading the Rally March 13, 2009 4:15 p.m.

We have had eight daily rallies of 5% or more since the market peak in Oct. 2008, and several extended bear market rallies since the crisis began in 2007. This one looks to me like another bear market rally. It could be a significant one. But too many “ifs” must be fulfilled for this to be a market and economic bottom.

The beginnings of this rally are suspicious. They are based on statements and announcements rather than data. The triggers also appear to be coordinated attempts to manipulate the market. The triggers were:

A leaked e-mail from the head of Citigroup saying the bank was profitable in the first two months of 2009.

A statement from Congressman Barney Frank that he thought the mark-to-market rule would be changed in a few weeks.

A suggestion by an unnamed source that the SEC would reinstate the uptick rule on short sales.

Anonymous leaks about the long-awaited Treasury Department plan to buy bad assets from bank in partnership with private investors, including hedge funds.

This looks very much like the big rally that began just before Thanksgiving 2008. The markets were oversold and pessimism was high going into this week. But the fundamental problems are not closer to resolution. There still is too much debt accompanied by falling incomes and asset values.

Government is not addressing the fundamental problems. Instead, officials seem to believe we have a “confidence problem” and that positive announcements will trigger a market rally and restore confidence and stop the downward spiral. I think the problem is households and businesses have more debt than their incomes and assets can support. Until I see progress on that front, or firm evidence I am wrong about that being the problem, I recommend maintaining a capital preservation mode in your portfolios.

Following the Smart Money and Other Thoughts March 2, 2009 11:00 a.m.

Here in Virginia and most of the East Coast we are blanketed in snow. Let’s sift through some recent headlines and news.

Should you be investing with the “smart money.” That has been a policy of any people for decades. There even are mutual funds established on this foundation. It hasn’t worked out well recently. Sam Zell and Bruce Sherman bought into newspapers just before the advertising market crashed and severely damaged them. Michael Dell made a big purchase of Dell stock that at this point looks like terrible timing. Wilbur Ross made a big purchase of mortgage servicing companies in 2007 that at least some believe he is regretting. Warren Buffett invested in General Electric and Goldman Sachs at prices that looked like bargains at the time but now look expensive. Buffett wrote an op-ed piece for the New York Times in the fall of 2008 encouraging investors to buy stocks.

Don’t feel bad for any of these investors. They have a lot of money and are well-diversified. They can wait for years for these investments to pay off, and won’t be hurting much if they do not work out. But investors who tried to follow their leads are suffering. It is not a good idea to blindly follow the “smart money.” They have different circumstances and time frames than the rest of us, and they are able to structure deals in ways the average investor cannot.

Buffett’s annual report to Berkshire Hathaway shareholders, released this past Saturday, highlights the important differences. The annual report always is worth reading. You can find many of them here.

Buffett highly publicized his purchases in General Electric and Goldman Sachs last fall. He said the companies would be around for a long time, and investors could be comfortable investing in them. But it turns out he did not do much portfolio reallocation with these investments. News reports implied Buffett put his large hoard of cash to work with these purchases. It turns out he sold other stocks to buy these and used only a small amount of his cash. While he was writing that investors should be adding to stock positions in the fall of 2008, he apparently did not change his own or his company’s portfolio allocation much.

Buffett’s market and economic comments were highly negative and in line with the rest of the headlines last weekend. On the front page of the weekend’s Wall Street Journal were Economy in Worst Fall Since ?82″ and “GE Joins Parade of Deep Dividend Cuts.” Other papers and pages highlighted that the major stock indexes are trading at levels not seen since 1997, and the indexes are down sharply again today. The biggest news is the indexes have declined about 50% since their peaks in October 2007. Buffett’s Berkshire Hathaway had its worst year ever in 2008, though it did better than the indexes.

Let’s close with some good news. Our move to more conservative, capital preservation portfolios in late 2008 was a good one. They lost only a percent or two in both January and February while the stock indexes had their worst January ever and a bad February. March is off to a poor start.

Other good news is there are some winners in the stock markets. Gun sells such as Sturm Ruger and Smith & Wesson have doubled since November. This is attributed partly to fear over the current economic climate and partly to worries gun purchases could be made more restrictive in the future. A few Internet retailers such as Amazon.com are soaring. Best Buy benefited from the demise of Circuit City, rising 65% recently. Technology stocks also are holding up, though there is some doubt how long that will continue if the economy continues to decline.