May 2011

May 25, 2011 10:00 a.m.
It’s Not All About Europe

The stock indexes are set up for a fourth consecutive day of losses, and gold is trading at a multi-year high. The headlines say this is all caused by the latest episode in the long-running European debt crisis. That debt crisis certainly is a problem, and I’ll have a more detailed view of that in an upcoming post, but that’s not what’s causing the stock market’s problems. I want you to understand that, because your view on this issue will affect how you respond with your portfolio. The recent decline in stocks would be happening without a new phase of the European debt crisis in the headlines.

The stock market is declining because of the following factors:

* The economic data are turning in negative surprises. Markets aren’t moved by the economic data, they are moved by the data relative to expectations. In other words, when investors are surprised by data, they start to re-evaluate their forecasts and outlooks. The economy clearly is slowing, and slowing faster than expected. It’s slowing before the Fed even is done with its quantitative easing.

* Emerging markets are trying to reduce their overheated economies, and they’re succeeding. We’ve discussed this a number of times recently. Emerging markets with free-floating currencies and their own central banks are raising interest rates. Others, including China, are raising bank reserve requirements and taking other measures to throttle back growth. Much of the recovery in the U.S. economy and corporate profits is derived from sales to emerging markets, so this will have a major effect on the U.S. economy.

* High commodity prices are having an effect. Consumers shifted spending from other areas to spend more on energy and food. We can see this is in recent retail sales data, showing lower sales growth in non-food and ?energy retailers.

* The employment picture is not improving. Businesses aren’t going to expand unless they anticipate buyers for their goods and services. The prospect of a large block of unemployed adults and the lid that places on wage growth for employed Americans are factors that make businesses cautious about expanding.

* The stock market has a number of technical measures indicating it is over-extended and weak. Financial stocks are down more than 3.5% this year and below its 200-day moving average. They make up a large percentage of most indexes and normally lead the market and economy. The advance/decline line (or breadth) of the markets is turning down. For smaller company stocks (which led the indexes up), the breadth clearly is negative. For larger stocks, the breadth is weak but hasn’t yet on a clear downtrend. All major indexes are below their 50-day moving averages, which is a sell signal in many technical trading programs. Commodity prices are falling. Companies that benefited from rising commodity prices were market leaders, so these stocks are falling with commodity prices. The earnings season was weaker than in recent quarters. According to Bespoke Investment Group, 59.5% of companies beat the estimates. While that may seem high, it’s the lowest percentage since the depths of the crisis in 2008 and seven percentage points lower than last quarter.

Don’t believe the analysts who say the recent decline is due to the European headlines. They’re also saying stocks will rise again once the crisis fades from the headlines again. I’m more concerned that stocks and the economy were being kept afloat by quantitative easing and fiscal stimulus and won’t be able to sustain themselves as those efforts fade. That’s why we have modest stock positions in our portfolios and have sell signals on them.

May 3, 2011 12:30 p.m.
Accelerating Into the Turning Point

Last week I told you the economy and markets were nearing a turning point, but that most investors didn’t realize it. Now, it seems more investors are seeing the turning point and they don’t like the direction things seem to be turning.

One sign investors see things turning is silver’s price. We held silver in our Invest With the Winners portfolio since mid-February through iShares Silver Trust (SLV). The ETF’s been on a meteoric rise since last fall. Yet, it’s stumbled recently. The sell signal was triggered on Monday’s close, so we sold from the model portfolio on Tuesday. The price continues to fall today.

I’ve pointed out a couple of times that silver’s recent rise wasn’t based on fundamentals and seemed to be at odd with demand and supply. The rise seemed to be fueled entirely by investors seeking an inflation hedge or chasing higher commodity prices. It’s always hard to know what will trigger the reversal of such a trend. For silver, the reversal was triggered by the futures exchange increasing the reserves required to invest. This was followed by reports that prominent gold investors, such as George Soros, already sold their positions.

Stocks also are telling us that investors see the turning point coming. While stock indexes have been rising steadily, there were some tips that underneath the indexes all was not sanguine. Trading volume was low in recent months. The gains in the indexes were fueled largely by strong gains in a few stocks. Valuations were starting to get stretched. Investors seemed to be projecting strong economic growth indefinitely.

The economy isn’t going to support those sentiments. Much of the earnings growth the last couple of years was derived from increased sales to the red hot emerging economies. The governments and central banks in those countries are trying to reduce economic growth. That would lead to a reduction in sales by U.S. companies into those countries. You can see signs of the emerging economy slow down in recent losses in Chinese stocks.

On top of that, the latest GDP report and some other data indicate the U.S. economy is slowing.

We might be seeing only a pause or a correction in the bull rallies in stocks and commodities, but I remain cautious. I’ve been warning for some time that the economy is supported by stimulus and other artificial means. It doesn’t appear to have achieved a sustainable growth rate on its own. Sustainable growth would be indicated by rising personal income that’s not supported by government spending and by private credit growth. So far, I don’t see these signs.

Instead, I see the fiscal and monetary stimulus nearing their peaks and starting to decline in influence. I suspect the economy has enough momentum and stimulus to keep growing at least through the end of 2011. But the growth isn’t going to be strong or increasing. Sometime late in 2011 or early in 2012 growth will be weaker. There doesn’t seem to be a lot of public demand for the Fed and the government to start a new round of stimulus.

That’s why I’m remaining cautious in the portfolios. We’re well-diversified and balanced. Our returns don’t depend on one economic outcome. And our riskier assets have sell signals in place. If the economy and markets do well, so will we. More importantly, we’ll preserve more capital and might even generate profits if economic growth stalls and markets reverse course.