April 2010 Market Update

April 2010 Market Update

The Dow Jones has broken through 11,000 and I can just hear the mental wheels turning; “Have we missed out?”

The answer to that question is yes, we have missed out on the gains we could have made but we have also missed out on a great deal of risk.

Would I repeat our strategy knowing what I have of the risks along the way?  Absolutely!  And remember, the Dow is still 22% below the level at which we removed the bulk of your portfolio from the stock market.

Why are we not in the stock market?  (I’ve only gotten this question a few times so most of you must be “getting” it)

What I need to communicate to you is the drastic change in the evaluation of risk that has taken place on Wall Street and which directly affects the value of your investments. Risk levels that 10 years ago would have been unthinkable are now considered safe.

Leverage of 30 to 1 is now commonplace. In other words, borrowing $30 for every one dollar you invest.  If the investment fails the damage is magnified and you have to get the money to repay your creditors from your other investments or you default.  This is just one example of what has been rocking the markets.

Investment products have been invented that even their developers don’t understand but they make so much selling them, they don’t care. Goldman Sachs reported first quarter earnings of $3.5 billion or a 91% increase in profit selling just these products (derivatives).

 It is as if we are telling this generation of children that it is o.k. to play with matches, because our computer models say it is safe. Also, if the house burns down the insurance company or the government will build us a new one, so not to worry. As long as your neighbor thinks this way; your house, neighborhood, and city are at great risk. As long as Wall Street and its counterparts around the world think this way; the world markets are at great risk of more melt downs.

 TAKING “A LITTLE RISK”

 How do you take “a little risk” when you live next to someone who plays with fire.  I am being asked about taking “a little risk” in the stock market? You can’t.  You either risk your house burning down every day or you move. In the market, moving equates to investing in high quality bonds with maturity dates.

Who are these investors that are driving stock prices up despite the risks?

They are traders on the desks of the 5 largest banks who are not investing their own money but that of the bank with leverage. They receive commissions on each trade so they are basically selling stock back and forth to one another. There is no sign of any other buyer out there.

 “Individual investors aren’t driving the gains, according to analysts who track their behavior. Instead, the rise is led by hedge funds and other professionals.  Purchases of US stock mutual funds has been anemic, dwarfed by demand for bond funds.”  

Wall Street Journal, April 13, 2010

One indicator of this is the low volume that has characterized this rally. Should it matter to us though, if we are watching our portfolios grow? It matters a great deal. Lack of participation means that stocks are in the hands of fewer owners. There is no buffer against adverse news; when they decide to head for the exits and there are no buyers. Do you want to get caught in the downdraft?

A recommended book for these turbulent times is “The Great Depression: A Diary”.  It is the only detailed personal account of the 1930’s that has been published. It is the story of Benjamin Rush, a Youngstown, Ohio lawyer.  On July 31, 1931 he writes in his journal:  “Magazines and newspapers are full of articles telling people to buy stocks, real estate etc… at bargain prices” This was during the market rebound from the first crash. The market still had 35% to go on the downside before the triple waterfall bear market ended in 1941.

I understand that we all want to get back to the old neighborhood to start making money again but until the Homeowners Association can get rid of the firebugs we are better off living in Bondville.

THE ECONOMY

 The most telling news from the economy is that Wal-Mart, the king of the entire retail sector, announced price cuts on 10,000 items.  This folks, is the definition of DEFLATION.  The gravity of this announcement is evident when you realize that the entire CPI (Consumer Price Index) only contains 8,018 items.

A number of clients have asked me to explain deflation . Most of us have experienced its’ opposite, inflation in the 1970’s.  Inflation is “too much money chasing too few goods”.  When there is too much money in circulation because of high employment, low interest rates, or the Treasury printing money; the dollar becomes worth less. During the 1970’s the dollar lost 75% of its’ purchasing power.  What cost 25 cents in 1970 cost $1.00 in 1979.

The effect on consumers is that they buy NOW because items will cost more tomorrow.  For investors hard assets like real estate do well because they are not paper denominated which becomes worth less and less.

Turn that on its’ head and you have deflation.  Deflation is “Too little money chasing too many goods”.  When banks are not loaning money; paychecks are disappearing and debt must be repaid, there is less and less money to buy products.  So items become cheaper, or in other words the dollar increases in purchasing power.

The danger is how far prices spiral down before they hit bottom. The consumer tends to put off buying because the items will be cheaper tomorrow. But the producer can’t wait forever or he goes out of business.

For investors, safety is foremost because no one knows how bad things will get.  Cash and high quality bonds are king.  Cash because it becomes more and more valuable and quality bonds because the interest received and principal returned are worth more and more and they are less likely to default as things get worse.

What is so dangerous about these times is that the economy could go either way. The government is printing more money to shore up the economy. This could prove too much money in circulation and become inflationary.  As businesses close and jobs are permanently lost, less money is available to buy.  This is deflationary.

I have your portfolios poised for either eventuality it’s just that the returns are nothing to write home about.  That, however, is the price of safety.

 SOME HELP IS ON THE WAY

I knew it would take some time before we would see high profile legal charges against the Masters of the Universe on Wall Street. Civil cases take much longer to prepare than criminal cases but we are now seeing the first of what should be a long list of revelations of outrageous activity at the expense of the investor and taxpayer.

CASE #1

Last week, according to the Federal Reserve Bank of New York, 18 major banks including Goldman Sachs, Morgan Stanley, Bank of America and CITI Group (you know, the ones you and I as tax payers own) were charged with understating the level of debt they were taking on by an average 42% to fund securities trades for the last five quarters!!!

By understating debt, they are lowering the amount of reserves they must hold in case these investments fail.  This is exactly what took them down in the first place and what I was referring to earlier as an example of the new definition of acceptable risk.  If the investments succeed they get the profit.  If they fail, we bail them out because we need the banking industry functioning.  How long is the taxpayer going to put up with this.  I wonder.

CASE #2

 “AS BAD AS THEY COME”
(headline, Wall Street Journal, April 20,2010)

The SEC accuses Goldman Sachs of fraud when it sold investors a Collateralized Debt Obligation (CDO) of 90 bonds in 2007.  Goldman knew the bonds to be of the lowest quality yet allowed Moody’s, the well respected rating agency, to give them its highest AAA rating.  Goldman then proceeded to buy credit default swaps (derivatives) betting against the CDO so it would profit when the bonds defaulted.  In just nine months 99% of the bonds were downgraded and investors lost billions.

Again, you may ask how any of this affects you?  It affects you by setting the markets into turmoil so that even the safest of investments you may own lose value.

The good news is that the Obama administration is forging legislation to combat all of this abuse.  IF it passes, investors may have a level playing field again, but that is a very big IF.  And then it must be implemented; another big IF.

I leave you with this thought; I just got off the phone with a friend of mine who is an air traffic controller here in Denver.  He was telling me that he just put a little money back in the stock market because he “couldn’t afford to not make anything on his principal”.  I asked him if he couldn’t afford to not make money on his principal, them how could he afford to lose it?  “Oh”, he said, “It’s only in safe stocks”.

I reminded him that earlier in our conversation he insisted that the airlines in Europe were doing the right thing by not allowing any flights until the volcanic ash clouds dissipated. “Safety first”, he said.  I asked him if he thought there was any way to just take the “safe” planes through the lava cloud.  He got the message as I hope you do too.  Have patience. Things are changing every day.

Happy Spring and call with any questions, comments or otherwise.

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