Sunday, June 6, 2010

The Buyers’ Strike May Continue;
Was Friday a Clue?

On Friday, June 4, the Dow Jones Industrial Average declined 323.31 points or 3.15%, with most of the damage occurring early in the day. The volume of reported transactions was only marginally above what is now passing for normal. In the past, major declines brought out “buy on the dips” volume, however not this time. Was this a sign that something fundamental was happening that had longer term implications? Let’s look at three news items that came out on Friday (or after the close on Thursday) and their possible implications.


The new government of Hungary let it be known that the prior government’s statistics were so faulty that the country’s debt probably can not be supported without a devaluation of its currency, and therefore an induced inflation. The significance to investors in euros and US dollars was that this announcement might prompt us to raise a mirror to our own growth of government debt and a constrained economy. Hungary’s way out is its own currency. In effect Hungary, like Lehman and Bear Stearns, has access to capital markets. The countries collectively known as the “PIIGS” (Portugal, Italy, Ireland, Greece and Spain) do not have that option, at least for the moment they are trapped along with their richer neighbors in the single currency. The way out for the US (as the de facto world reserve currency) is induced inflation. Was this a wake-up call challenging those who feel that the problems in Greece, Portugal and Spain were being attended to, and the US would grow its way out of problems?


Also late on Thursday there were two unrelated news elements that brought additional concerns about the global financial community. The first was the rumor that Société Générale had suffered large derivative-related losses, which on Friday they denied. The key to the market was not that the French bank suffered trading losses, but rather that it and other banks could lose big. After the close in the US, it was announced that the president of Wilmington Trust unexpectedly announced his retirement. He is to be replaced as president by an internal candidate with corporate experience who has headed up Wilmington’s non-lending activities. Once again a bank is being led by a non-banker, similar to CEOs at JPMorgan Chase (a stockbroker), Bank of America (a lawyer) and Citigroup (a hedge fund manager). Tying these two elements together, are we projecting that banks will not make deposit gathering and lending their main source of future profits, but instead will rely on trading and other forms of investing to generate dividends for their various shareholders? Is this alternative being severely curtailed by the so-called reform measures in the conference committee of the US Congress which will put US financial institutions behind the less capitalized foreign universal banks? At this point in the cycle commercial banks and retail brokerage firms should be in a market leadership position and they are not today.


The third bit of bad news that hit on Friday was the extremely weak private sector jobs report. One could chalk the disappointment off to the “abysmal science” of the economists. Economists’ US estimates were way high and they were low in Canada, where job growth was twice what was expected and its unemployment rate dropped to 8.1%. There is a suspicion on my part that the economists and some analysts are not mall walkers, having under-estimated the Canadian market and over-estimated the US retail sector. The lack of confidence on the part of stores hiring retail sales people is palpable. There are still too many empty store fronts to support a growing economy. Part of the issue is that now with the bulk of the aggregate stimulus packages spent, our money supply is contracting. This is not a surprise to our government. Treasury Secretary Geithner has warned the other members of the G-20 that the “US can no longer absorb the world’s exports.”


How is all of this being translated into investment policies? There are additional inputs that might be useful in your own investment thinking,

The first is volatility. Notice that the press is full of stories about volatility primarily on down days. Few seem to worry about volatility on the upside. Part of this may be due to the harm that many financial academics have done to investing by equating volatility with risk. This is discussed more fully in my book Money Wise. The CBOE Volatility Index (VIX) is a popular measure of volatility (that few people really understand) which tracks the “bets” on the S&P500 contracts. When the number is high the “fear” indicator is high. The historic high on the index was approximately 80 and the low achieved a few months ago was about 15. On Friday the index rose 6.02 to 35.48, a one day gain of 20.43%. I believe that on May 6th the index was over 45. I would suggest in recognition of the fact that so many of the market participants are trading oriented that one needs to be prepared for volatility in today’s ranges. This translates that on most days we could see moves of 100-200 Dow Jones points. Expect this level of volatility as you manage your transactions.

As is often the case, the US bond market often is more sensitive to future trends than the stock market. Each week Barron’s publishes its confidence index which measures an index of high grade bonds divided by an index of intermediate grade bonds. A decline in the latter vs. the former generally points to higher stocks. In other words, as the yields on intermediate credit declines relative to high grade, their prices go up (which is often paralleled by more confidence in stocks). As an observer of this index for more than 40 years, I am used to seeing weekly moves of 1 point or less. For the week that just ended the reading was 79.0 up from the prior week reading of 75.2. A year ago the number was 68.7. While this indicator is far from infallible, it has produced winning judgments more often than not. I choose to be encouraged by this particular confidence indicator.


One has to have a strong contrarian point of view and a belief in institutional fallibility. The trend of leading pension plans to invest into commodities is growing. CALSTRS is joining CALPERS and the teacher plans in Texas and Illinois, as well BT from Britain and two Dutch pension plans in making specific allocations to commodities. I interpret these as long term bets on increased inflation caused by the deterioration of the value of money’s purchasing power. If these are more than a simple hedge, but a bet on institutionalized inflation, then one wonders whether long term bonds have any place in one’s investment portfolio. Stocks may not do well under these circumstances, but are clearly better than bonds. Many corporate pension plans are very much betting the other way, significantly switching equity money into corporate bonds. Both the government and corporate plans are reacting to their fears not to opportunities, which in the long run makes me bullish for our long horizon investment accounts.


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