The Year in Review and Looking Ahead

At the end of every year, we like to look back at the year and share some thoughts on what worked, what didn't, and how the next year is shaping up.  While there are still a handful of trading days left this year, the markets are looking like they will post another up year.    

As we began 2010, we believed most of the stock market's cyclical gains were probably behind us and it would be important to try to generate income from dividends and interest in order to achieve a positive absolute return as we expected the markets to be volatile and news driven.  In general, having a more defensive bent would make sense if this were to occur.  This forecast turned out to be correct for most of the year with the S&P 500 dropping over (6%) into February, rising 16% from that low until end of April, dropping (17%) from April into July, rallying 10% from July into beginning of August, falling roughly (7%) into the end of August, and finally rallying over 18% from August to put us where we are today.   All of the return this year has happened since September.  

We had some trouble trying to get our heads around a post-credit-bubble environment in which global central banks have charted much different courses, with the net effect being a muddle-through, erratic, global recovery. Every time it looked like there would be trouble, the capital markets suffered, and Chairman Ben Bernanke rode to the rescue with his quantitative easing. The Bank of England and the Bank of Japan have also been quite active in priming the liquidity pump, and the jury is out on their level of success and how long it will continue.

We turned more positive on the markets in October believing the time for being bearish had past and we said volatility in the markets should be used as a opportunity to increase exposure to those areas expected to perform well in 2011.  We expected the volatility to continue into the fourth quarter as it did all year, allowing some low risk entry points to increase exposure to stocks, but it didn't materialize as we believe investors began to realize the US government is going to permanently backstop risky assets and markets in order to bring about the wealth effect per the Fed Op-Ed several weeks ago.  This will have unintended consequences, but we will save that discussion for another day.

So, while there were more fits and starts for the economy than we expected, we would say we got the market volatility correct for the most part; however, the appreciation of US markets in the last quarter turned out to be much greater than we expected with no downside volatility. 

As the stock market continued to move higher in the fourth quarter, interest rates also began to move higher, putting downward pressure on bond prices as investors shifted funds from bonds to stocks, especially dividend paying stocks.  Many income producing equities did in fact perform well in the fourth quarter, something we probably suspect will continue as market participants continue to look for yield, particularly if the pain of declining bond prices becomes more pronounced.  Ever since the second round of quantitative easing (QE2), interest rates have spiked to the upside, exactly the opposite of what most had expected would be the case. 

For 2011, we believe this trend of bond outflows and equity inflows will likely continue, overwhelming any concerns about valuations or fundamentals.  In the short run, we've come to realize that fund flows, or investor desires for specific asset classes - tends to exacerbate price movements in both directions, often for much longer than most expect.   For anyone that doubts this tendency, just take a look at tech stocks ten years ago, housing prices five years ago, commodities prices three years ago, and Government bonds recently.

We believe with the Federal Reserve "having the stock markets back" and corporate earnings continuing to meet expectations, the markets can continue higher.  In addition, the added liquidity of investors pulling funds from bonds should help fuel higher prices.  Although volatility has been non-existent the past few months, we don't expect it to disappear completely.  Given how everyone is positive on the markets for 2011, we expect volatility will return in the first quarter of next year, if only to keep everyone honest.

As we see it, several factors play into a positive stock market environment in 2011.  First and most important, is a more politically friendly environment for business.  Given the historic changing of the guard in Washington D.C., it appears as though President Obama is going to take a more centrist approach as Clinton ultimately did following his first two, difficult years in office.   

One of the biggest strengths of the economy in the past year has been the level of corporate profits and cash balances, but most executives have remained cautious with their actual spending given recent memories, the prevailing anti-business sentiment, and tax and regulatory policy uncertainty.  The good news is that these headwinds may now prove to be tailwinds, turning the ability to invest capital into actual action.

Another positive for stocks may very well be the state of the bond market.   Rising interest rates may actually be a positive to the extent it signals an improvement in the economy, which we suspect is the case today.  Bernanke, like him or not, appears willing and ready to do whatever it takes to keep the economy and specifically the stock market moving in a positive direction.    

Higher interest rates, of course, also means tougher times for bond investors as bond prices decline.  While the back up in yields may not matter much for investors intent on holding until maturity, we would suspect that a large percentage of recent bond buyers has been investing on the basis of total return and the allure of rising prices than simply their yields, even if unknowingly so.     

As history has it, the third year in a President's term tends to be positive for the markets as the current administration is likely to find ways to stimulate the economy and spur economic growth and stock prices; to be sure they are re-elected the following year.  We hope that 2011 follows this tradition.

US National Debt

Here's a new way to think about the U.S. government's epic borrowing problem: by as early as 2015, the estimated interest due on US government outstanding debt will be $533 billion - which is equal to a third of the annual federal income tax revenue expected to be paid that year. 

Fortunately or looking on the bright side, the record levels of debt issued in the past few years have paid for stimulus and other rescue programs that prevented the economy from falling off a cliff; and the money was issued at very low interest rates.  But low interest rates won't be around forever.

As interest rates rise and the economy improves, the private sector borrowers will likely return to the debt market and compete with the US government for capital. At that point, the country's interest payments could increase dramatically.

The Congressional Budget Office, which makes the debt and interest payment forecasts, already baked some increase in rates into the numbers.  Of course, there is always a chance those estimates may prove too conservative.

Below is a table showing our outstanding gross debt and the percentage of GDP the debt represents (in billions of dollars). It is projected to be over $14 trillion at the end of this year and represent 94% of our GDP.

2000 5,628.7 58.0
2001 5,769.9 57.4
2002 6,198.4 59.7
2003 6,760.0 62.6
2004 7,354.7 63.9
2005 7,905.3 64.6
2006 8,451.4 65.0
2007 8,950.7 65.6
2008 9,985.8 70.2
2009 12,311.4 86.1


Below is a link to the Treasury's website which posts the monthly as well as annual interest payments on the debt.  Click on the link to be taken to the website.

http://www.treasurydirect.gov/govt/reports/ir/ir_expense.htm

Equity Risk Premium Explained

Equity Risk Premium can be defined as the excess return that the overall stock market provides for an investor over the risk-free rate of US Treasury bonds. This excess return compensates investors for taking on the relatively higher risk of the equity market. The way to think about equity risk premium is to define it as the difference between the expected total return of the S&P 500 and the expected yield on Treasury bonds over a period of time.

As an example at the basic level, if 10-year Treasury bonds are yielding 3% annually and the expected 10-year annualized return of the S& P 500 is 5%, the equity risk premium is 2%.  In other words, investors are expected to achieve a 2% higher annualized return in the stock market versus the Treasury bond market.  The equity risk premium has historically averaged around 4%, which means a 4% better annualized return by investing in stocks over bonds on average.  Equity risk premiums in general tend to be higher in recessions and lower in recoveries.

At present, based on calculations of forward earnings, normalized historical earnings, and market valuation models, the average 10-year return projection for the S&P 500 is 4.00% annually.  Currently, the 10-year Treasury is yielding 3.25%, making the current equity risk premium .75%; one of the lowest readings in recent years.  Of course, we should expect a lower reading in a recovery.

However, the likely premium for equity risk is at the low end of the typical range.  Why does this matter?  Based on the current assumptions, for a return of roughly .75% over the expected return on Treasury bonds, equity investors are accepting risk that is approximately 3 times greater than that of US Treasury bonds - the risk/reward scenario doesn't seem favorable.  The last time the equity risk premium was really low was in the late 1990's, as investors believed stocks would continue to go higher and didn't feel the need to be compensated for the additional risk.

Of course, the expected 10-year annualized return for the S&P 500 is an assumption based on models and could increase from current levels, especially if economic growth improves.  If economic growth expands at a faster rate in the future, we should see the expected S&P 500 annualized return percent move higher as well.  However, it will need to increase to approximately 7.25%, based on interest rate of 10-year Treasury yield of 3.25%, to reach the historical equity risk premium average of 4.0%.  Also, if the 10-year yield continues to rise, the expected annualized return of the S&P 500 will need to increase even more than 7.25% in order to keep pace and move toward the long-term average of 4.0%.  Unless economic growth begins to pick up significantly, we should expect the equity risk premium to remain at the lower levels of the range as the economy continues to recover.

Equity risk premiums can also be applied to sectors of the market and there are certain sectors whose equity risk premium is higher than the equity risk premium of the broad market; meaning a better valuation of that sector and the likelihood of out performance versus the broad market in the future.

While investment decisions can't be made on one indicator or valuation model alone, it does help to use various market and risk valuation metrics to assist in the decision making process.

Smart Money / Dumb Money Update

The latest results from the Smart Money / Dumb Money index show that retail investors (dumb money) are very confident in a rally while institutional investors (smart money) are not as confident in the markets continuing to rally.  These numbers don't mean the market can't continue to work higher in the short-term, but typically any short-term gains are quickly erased by a larger correction, especially when readings reach these extreme levels.

 

 

Smart / Dumb Money Confidence

 

The Smart Money is 33% confident in a rally.
The Dumb Money is 71% confident in a rally.

Jobs Report and QE2

Surprisingly the BLS reported today that jobs gained 39,000 and the unemployment rate moved up to 9.8%, the highest rate since April.  Private payrolls gained a mere 50,000 compared to expectations of upwards of 160,000.  Both jobs and the unemployment rate were worse than every single economist estimate, which has us noting that economists and forecasters as a group are an optimistic group.

Here are the details of the jobs report this morning:

• Payrolls increased 39,000, less than the most pessimistic projection of economists surveyed by Bloomberg News, after a revised 172,000 increase the prior month, Labor Department figures showed today in Washington.
• The jobless rate rose to 9.8 percent, the highest since April, while hours worked and earnings stagnated.
• The unemployment rate was forecast to hold at 9.6 percent, according to the median prediction of 83 economists surveyed by Bloomberg. Estimates ranged from 9.4 percent to 9.7 percent.
• Overall payrolls were forecast to climb by 150,000, according to the survey median, with estimates ranging from 75,000 to 200,000.
• The report also showed an increase in the number of long-term unemployed Americans. The number of people unemployed for 27 weeks or more increased as a percentage of all jobless, to 41.9 percent, the highest since August.

Keep in mind, were it not for millions of people allegedly dropping out of the labor force over the last year as their benefits ran out, the unemployment rate could be over 12%.

So with this poor jobs report shouldn't the markets be declining in reaction?  Shouldn't the market sell off on the bad news?  The answer would normally be yes - however, with the Federal Reserve providing QE2, market participants believe lower employment growth means more QE (maybe even QE3), which adds a underlying layer of support to the market and keeps investors confident in the economy and capital markets.

While adding some confidence to the capital markets, QE2 has not helped the interest rate picture.  Interest rates, across the board, have actually been spiking since the announcement of the QE2 program on November 3.  See chart below.



It turns out (as many believe) the Federal Reserve is more or less powerless to lower rates from prevailing levels.  QE2 was likely not really designed to drive rates down from current levels but merely to try to prevent a dramatic rise in interest rates and to promote more stability in the capital markets.

So the paradox we discussed in October regarding interest rates is beginning to be resolved.  Excess liquidity provided by the Fed is now starting to create expectations of future inflation and causing bond yields to rise (prices drop), whether or not this is the beginning of a new trend remains to be seen.

ISM Non-Manufacturing Report

This morning saw another good report from the ISM Non-Manufacturing Index, with the overall index rising to 55 and strong readings in Business activity (57) and New Orders (57.7) and an improvement in employment to 52.7.  We are still happy to see a continuation of growth in the US service sector.

Sentiment Reaching Extremes Again

In order to improve decision making, we incorporate sentiment readings into the process.  This is an area which is sometimes overlooked, but we think is extremely important.  We believe this is one of the key metrics to use as it helps remove emotion from the overall thought process.  Today we are looking at sentiment readings because they are reaching extremes again.

Now that QE2 has started, corporate earnings have for the most part been better than expected, and the market has rallied - everything seems to be fine, at least according to the latest Investor Intelligence sentiment figures.

Each week the service Investors Intelligence surveys some 140 financial newsletter writers to determine whether they are bullish or bearish in their opinions to subscribers. The resulting Investors Intelligence Survey compiles the data to arrive at a weekly percentage of bulls vs. bears. The Survey is considered a contrarian indicator, since extremes in either direction have historically signaled a reversal of the market’s current trend.

Currently, the readings are just as bullish as they were back at the end of April 2010, right before the flash crash in May and the subsequent drop into July.  While there is no guarantee the markets will decline, given the history of the sentiment readings as a contrarian indicator, it makes sense to be more cautious at this juncture and patiently wait for sentiment to turn more bearish and less bullish.

Below are the most recent charts for bullish sentiment and bearish sentiment along with recent commentary from Investors Intelligence.

Overview 

The election is over and the latest quantitative easing has commenced, with indexes showing remarkable gains since the end of August. That was when the Fed action was first announced and polls forecast the change in Washington, which occurred. Despite the already solid gains near 20% in about 2½ months the latest readings show a lot of advisors apparently “buying the news” as the percentage of bulls soared over 8% the last week. The jump came within a hair of the levels shown in December 2007, which were just below their high of 62% from October 2007. That was the all-time stock market high.

Impact of Quantitative Easing

It continues to seem likely that QE2 will unfold against a backdrop of steadily rising treasury and investment grade bonds yields in the coming months. In a sense the second round of quantitative easing is just the monetary version of “cash for clunkers”, which effectively shifted car sales that would have occurred later in 2008 to the summer months. QE2 may lower yields in the short term but it is unclear that there will be any lasting effect.

The build-up to QE2 has also been characterized by a rapid sell-off in the US dollar, but this is merely a reflection of powerful investment flows rather than a genuine or deliberate debasement of the currency by the Federal Reserve Board. Nobody wants to own an investment that decreases in value. Ironically the US dollar has been notably more robust since the official launch of the QE policy and it is certainly possible that it has marked its lows for the time-being, particularly against major currencies.

The great winner in the QE2 sweepstakes thus far has been the commodity complex with money chasing virtually the entire spectrum. Agricultural commodities have been particularly strong with multi-decade highs recorded in sugar, coffee and spices. In terms of the commodities gold has managed to establish a series of new all time highs over the past few weeks and crude oil has finally managed to break above its multi-month range as it moves toward $90 per barrel.

We would not bet against any portion of the commodity complex at the moment, but are also not particularly tempted to jump aboard a runaway train either.

The Federal Reserve's Explanation

Federal Reserve Chairman Ben Bernanke wrote an article for the Washington Post that was printed in the paper Thursday morning. Below is the link to the article. Very interesting read.

http://www.washingtonpost.com/wp-dyn/content/article/2010/11/03/AR2010110307372_pf.html

Economic Growth Rises 2% in Third Quarter

U.S. economic growth edged up as expected in the third quarter. Gross domestic product expanded at a 2% annual rate as consumer spending rose at its fastest pace since 2006, the Commerce Department reported in its most recent data release.

While consumer spending increased and business investment continued to expand, much of the rise in demand was met by overseas production and domestic goods continued to pile up in warehouses. This may lead to more tepid growth in the fourth quarter.

However, the economy is definitely recovering, it is just doing so at a very slow pace. The economy expanded at a 1.7% rate in the second quarter and third-quarter growth matched most economists' expectations.

The GDP report showed the Fed's preferred inflation measure, the personal consumption expenditures (PCE) index, excluding food and energy, rose at an annual rate of 0.8 percent in the third quarter. According to reports, this was the smallest increase since the fourth quarter of 2008 and well below the Fed's comfort zone for inflation.

A pick-up in consumer spending gave the economy a lift in the last quarter. Third-quarter growth in consumer spending, which accounts for 70 percent of U.S. economic activity, increased at a 2.6 percent rate after rising 2.2 percent in the prior period.

Analysts expect the Fed to announce treasury bond purchases of at least $100 billion a month on Wednesday. Bond prices rose on the premise of more "quantitative easing" from the Fed, while the dollar extended losses against the yen on the prospect the Fed will need to print more money.

Small Business Credit Easing

Below is an excerpt from an article referring to the fact that the contraction of credit for small corporations has ended. After two years of very restrictive lending standards, credit is becoming more available. This is a positive for the economy as many new jobs are created by small businesses.


Credit Eases 'My Pain' as U.S. Bank Lending Buoys Small Business

Khalique Rehman, who runs My Pain Clinic in McDonough, Georgia, got a $1.8 million loan this month from Atlanta-based Private Bank of Buckhead to purchase a new building and construct offices.

“I was surprised because everyone said it would be so difficult,” said the 46-year-old physician, who plans to double the space of his eight-employee practice and hire another doctor and possibly a nurse. “I am really happy.”

The freeze in bank credit is beginning to thaw after two years, signaling more support for the U.S. recovery.

American banks increased credit in July, August and September, the first consecutive gains since October 2008, according to Federal Reserve data released Oct. 15. Commercial and industrial loans rose in July and August after dropping 25 percent, the data showed. Banks eased lending standards in the second quarter for the first time since the credit crisis began, the Fed reported Aug. 16.

The stabilization may help reduce the odds of a relapse into recession next year to less than 10 percent, said Neal Soss, chief economist at Credit Suisse Holdings USA Inc. in New York. That compares with a median estimate of 20 percent during the next 12 months among 48 economists surveyed by Bloomberg News this month.

“Lending is no longer collapsing,” Soss said. “That is a very good thing compared to where we were. When you are in a hole, the first thing is to stop digging deeper. That is where we are: The credit system is not getting weaker.”

Regional bank stocks are likely to benefit from any increase in lending, including Wells Fargo & Co. of San Francisco, PNC Financial Services Group Inc. of Pittsburgh and Fifth Third Bancorp of Cincinnati, said Richard Bove, an analyst at Rochdale Securities in Lutz, Florida.

The pick-up in lending also may boost yields on U.S. Treasury 10-year notes to 4% by the end of 2011, said Mark Zandi, chief economist at Moody’s Analytics. The yield fell to 2.33 percent on Oct. 8 from 4 percent in April as the economy slowed.

“This is a very positive sign for future growth,” the West Chester, Pennsylvania-based economist said. “Non financial corporations are no longer deleveraging. Increasingly it is no longer a question of whether businesses can invest and hire, but whether they are willing. This is a good reason for optimism.”

An increase in bank lending may help the economy expand 2.5 percent next year, he estimates. Growth stalled to an annualized 1.7 percent pace in the second quarter from 5 percent in the last three months of 2009.

Rehman said his 4 1/2-year-old clinic, which specializes in pain, sports medicine and rehabilitation, will move to its new location in Stockbridge, Georgia, after the interior is rebuilt. Processing the loan through closing took about two months.

“Banks are definitely eager,” he said. “Everything went very smoothly. I am quite satisfied.”

Pat Carroll, 31, received a $300,000 loan from Wells Fargo in August to expand his Atlanta apartment-management company with additional properties in Georgia, North Carolina, Tennessee, Texas, Maryland, Virginia and Florida.

“You couldn’t get a loan two years ago,” he said. “Banks are back in business and lending again. Things are starting to loosen up.”

Some borrowers still aren’t seeing much change. Brian Rist, who runs a Fort Myers, Florida-based hurricane-protection company, said he’s disappointed that a loan he’s negotiating may require him to put up family assets as collateral, even though his business is profitable and has $13 million in revenue. He wants to hire another 20 to 25 people to diversify into energy audits for companies and individuals.

Fed data show that most of the credit growth so far comes from banks buying securities including mortgage-backed bonds rather than making loans, as demand, especially among consumers, is still weak. Commercial and industrial loans rose at an annual rate of 1.6 percent in July and 0.4 percent in August after 20 consecutive months of declines and fell 3.5 percent in September, as businesses slowly begin to reverse efforts to shed debt and hoard cash.

Purchases of securities other than Treasury and agency bonds have risen at an annual rate of more than 10 percent for three months, according to the Fed. That indicates lenders are willing to take risks and feel more comfortable about their capital levels, said Paul Kasriel, chief economist at Northern Trust Corp. in Chicago.

“When bank credit reaccelerates, it usually starts with the securities and then moves with a lag to the loan portfolio,” said Kasriel, who worked as a research economist at the Federal Reserve Bank of Chicago. “This appears to be the first sign that banks are willing to commit risk-based capital. We are early in the game.”

Banks also are loosening standards on lending to businesses of all sizes, according to the Fed’s most recent survey of senior loan officers, released Aug. 16.

“The good news is that the tightening of credit standards has passed,” New York Fed President William Dudley said Oct. 10 in Washington. “As time passes, we’ll see a further improvement in credit availability, and as that happens, that will actually support economic activity going forward.”

Zions Bancorporation’s loan business is starting to stabilize, and the Salt Lake City-based bank’s commercial portfolio may be “even growing a little bit,” Chief Executive Officer Harris H. Simmons said Sept. 13 at a Barclays Capital investor conference in New York. “We are very much focused on increasing lending activity.”

S&P 500 Earnings Forecast

Our current assessment is that the US stock market averages (based on S&P 500 index) are slightly undervalued, yes undervalued, taking into account the most recent expectations for future earnings growth and Federal Reserve interest rate policy. This is a change from previous forecasts where the expectation was for earnings to decline given a slowdown in economic growth, thus causing the US markets to decline. While a slowdown in economic growth did occur and markets did decline over the summer on the expectation of a decrease in corporate earnings, the slowdown apparently didn't impact corporate profits, as earnings estimates have not declined since the end of last quarter.

Surprisingly, earnings estimates have continued to move higher over the past few weeks, an indication from analysts that despite a slowdown in growth companies are still able to produce an increase in profits, most likely do to operating efficiencies and continued cost cutting.

As of October 1, earnings estimates have increased from $81.73 at the end of last quarter to $82.69 for the 2010 calendar year. Earnings estimates for 2011 decreased a few percent to $93.93, which assumes growth of 13.5% over 2010 numbers. Using a price-earnings multiple of 15 (long-term average valuation proxy), we calculate valuations of roughly 1,240 for the S&P 500 Index for 2010 and approximately 1,400 for 2011, above current index levels of roughly 1175. Remember, the markets tend to follow earnings and not economic growth. So even though economic growth may be weak, it seems corporations have been able to sustain and even increase earnings through continued cost cutting in conjunction with productivity gains.

In the first few weeks of the third quarter earnings season, corporate profits are coming in better than expected so it is possible earnings estimates are not inflated as originally thought. As long as reported earnings are generally positive during the quarter and future guidance is upbeat, we should expect the markets to continue to move higher, at least in the intermediate term.

The Feds Next Move

Is the Federal Reserve, with its zero percent interest rates and promises of more quantitative easing (read printing more dollars) responsible for the markets rallying? It's hard to say for sure because much of the data doesn't really support the view that excess liquidity provided by the Federal Reserve has been finding its way into equity markets.

However, it could be that the possibility the Federal Reserve may provide additional levels of liquidity in the future that is driving equity prices higher.

We do have a bit of a paradox at the present time, however. If excess liquidity, or its future prospect, are driving stock prices higher, why is it that bond yields continue to move lower? To the extent that excess liquidity from the Federal Reserve may cause future inflation, bond yields should be rising, not falling. We tend to believe that institutional bond investors are the smartest players in the room, so we always pay attention to their actions.

So there is the paradox. Excess liquidity should create expectations of future inflation and cause bond yields to rise (prices drop), yet bond yields continue to move lower (prices rise). This is a paradox that is not easily resolved or explained. To find the answer, we may just have to wait until the Fed's next move.

ISM Release

Back in July we stated in a special update that we expected the manufacturing sector to slow down heading into the fourth quarter. In a press release today, The Institute for Supply Management (ISM)said the manufacturing sector expanded for the 14th consecutive month, although at a slower pace (54.4 in September versus 56.4 in August).

While the headline number shows relative strength this month as the PMI reading of 54.4 percent is still quite positive (anything above 50 shows expansion) the overall picture is less encouraging. The growth of new orders continued to slow, as the index is down significantly from its high this year of 65.9% back in January 2010. Production is currently growing at a faster rate than new orders, but it typically lags and would be expected to possibly weaken further in the fourth quarter of this year. Manufacturing has enjoyed a stronger recovery than other sectors of the economy, but it appears that weaker growth is the expectation for the fourth quarter. Both the Inventories and Backlog of Orders Indexes are sending strong negative signals of weakening performance in the sector. It seems like the summer slowdown in the economy is likely carrying over to the fourth quarter.


See table below for details: (Double click for larger image)

S&P 500 Breaks Above Resistance

The S&P 500 Index has continued to track sideways at just below well established resistance at 1135 level during the remainder of last week. On Monday the index opened higher and accelerated through resistance to close at 1142.71. This marked the highest level the index has reached in 4 months. Although the staying power of the recent breakout is yet to be established in the short term, it is significant.

Although volatility could return at any time, with quarter end next week and hopes for more Federal Reserve intervention via QE2, we would not be surprised to see the market make a run to 1175 or the "flash crash" high of several months ago.

With the majority of economic data now surprising to the upside, fears of a double dip have decreased dramatically and the unwinding of this negativity has had a powerful effect on the markets.

National Net Wealth

Below is a 20 year chart of the national net wealth in the USA. It is essentially Housing Equity + Stock market Value and is compliments of Fusion Analytics.

The value of US stock and housing equity fell 25.7% from the pre-crash peak (June 2007) to the recent low – $65.8 trillion down to $48.8 trillion — a destruction of value of nearly $17 trillion dollars. This is a very large amount of wealth destruction and will take time for it to return to peak levels. Perhaps this explains some of the negative sentiment on Main Street...

Continuing Claims Holding Steady

As we discussed back in June of 2009, possibly one of the best predictors future growth in the US economy is a moderation in continuing unemployment claims. Continuing unemployment claims are those who are receiving benefits on a weekly basis.

To obtain a better perspective on unemployment during past recessions, below is a chart of continuing claims (those who continue to receive weekly benefits) dating back to 1971. (Click on chart for larger image)





Looking at the chart, the line shows continuing claims as reported each week. You can see that the last several months have been clustered in the 4.5 million range after spiking to over 6 million in 2009. Let's take a look back at the last three recessions to gain a better understanding of past cycles.

The early 1980's recession officially lasted from January 1980 until November 1982. As you can see on the chart the peak in continuing claims came in November 1982. The continuing claims dropped significantly over the next two years as the economy experienced a robust recovery. Economic growth was spurred by the Fed lowering interest rates and Congress reducing tax rates.

The early 1990's recession officially lasted from July 1990 until March 1991. Reviewing the chart we can see that the peak in continuing claims occurred in the first quarter of 1991. Although the recession ended in the beginning of 1991, it wasn't until the second half of 1992 (when continuing claims dropped) that the economy began a recovery.

The early 2000's recession lasted from March 2001 until November 2001; again the recession ended as the continuing claims figured reached a peak. Unfortunately, the ensuing recovery was rather anemic and job creation was below past recovery levels. The economy didn't really gain meaningful traction until the end of first quarter of 2003, many months after the recession officially ended.

While we hope we begin to experience job creation and an improved employment picture, we believe it is possible the recovery may be very similar to the most recent recessions in the early 90's and 2000's; where continuing claims remain elevated or clustered for several quarters (in this case around the 4.5 million level) and economic growth experiences rather anemic trends until continuing claims begin to steadily decline. This statistic will be important to watch in the coming quarters.

Less Bearish, More Opportunistic

During August I spoke with a investment manager who happens to be a friend of mine. He told me he couldn't remember a time when he was so right about the overall macroeconomic data yet couldn't figure out the direction of stocks and bonds. We talked for some time and I told him that it is important to remember that you typically can't make sound investment decisions strictly based on economic data. In the real economy, things are bad and will likely get worse for the foreseeable future. However, stocks don't always move with the economy.

Stocks move up or down based on current earnings and (this is important) the future expectation of earnings growth. While the economy can be mired in a slow down for many months, the stock market can move higher, seemingly defying forecasters as the economic data points remain weak, while earnings continue to grow.

The time for being overly negative about the economy has likely passed. It's time to adjust to the new reality and prepare for the future environment.

The reality is that no one knows for sure when companies will begin hiring again or when the housing market will turn around or when consumers will begin spending again. However, we have endured a terrible domestic stock market over the past decade and everyone in the media, as well as economists and strategists continue to paint a bleak picture. It is at times like these, when everyone is very pessimistic, to begin thinking from a contrarian perspective - emphasis on "thinking."

Make no mistake, we are not advocating allocating 100% into stocks. We believe the domestic economy has a lot of issues and there are still concerns about government debt in Europe. Of course, one negative news event and we could see lower prices in the markets.

However, most people have adjusted to this and are either completely out of financial markets or are completely in bonds.

What we are experiencing now is the polar opposite of the bullishness and euphoria prior to the debt crisis and real estate collapse. Only time will tell, but the pessimism seems to be deep and entrenched. While this negative sentiment could continue for some time, eventually it will break, the economy will improve, and markets will move higher. The key is in the timing - will this happen next month, sometime next year, or a few years from now?

Our prediction is it could be the latter, but that doesn't mean there will not be opportunities. We expect certain stocks, sectors, and overseas markets to outperform the broad US market indices over the next several years. From a big picture perspective, we want to think about the right time to begin deploying capital into these areas over the next few years, taking an opportunistic approach, and taking advantage of any volatility in the markets. Big opportunities come from acting against the crowd, not with them.

We still want to err on the side of protecting capital, but as time goes on we want to be less bearish and more opportunistic.

August Hiatus

With only a few weeks left of summer (hard to believe) and many taking vacations, we will be taking a short hiatus from the BAM weekly updates during the month of August. Please be sure to read today's updates.

BAM weekly updates will resume in September. Please be sure to contact us if you have any questions and enjoy the rest of your summer!

Cutting Through The Noise

How does one cut through the economic, political, and market noise to arrive at intelligent decisions about how to allocate capital? We believe it comes down to price, research, discipline, and patience. One must take the time to assess underlying value and remain highly disciplined about how much should be paid for a particular investment. We must look for value and opportunities within a framework of big picture macro economic trends.

To begin, an investor must follow economic statistics such as non-farm payroll and employment figures, consumer confidence, the dollar, Federal Reserve policy, as well as consumer confidence. The statistics, and statistical trends (moving up or moving down over time), can give one a good framework from a macro economic perspective.

While in theory this makes sense, investing more aggressively when macro trends are positive and investing more conservatively when trends are negative, the current difficulty with this endeavor is that we have never before experienced our current economic situation. Statistics have been moving from positive to negative to neutral to really negative to fairly positive and back again. There are a lot a fits and starts in the data, but no clear trend. Even the Federal Reserve is having a difficult time interpreting the data as they continue to maintain a 0% target interest rate policy. Some economists even believe the rate could stay low for a few years.

With so much conflicting macroeconomic data, bulls and bears are both out in full force with their respective arguments. Both camps have good data points, reasonable arguments, and even some historical precedents that serve to support their thesis. The battle between the bulls and bears has added to volatility in the markets over the past year.

Given the uncertainty of the macro economic trends along with price volatility, investing in today's capital markets can by a trying proposition.

In trying times, investing is about patience, discipline, being price conscious, protecting capital, and more patience. We have to remember that opportunities are usually always present in the capital markets, if you look hard enough. We continue to seek out those opportunities while protecting capital, remaining disciplined, and staying patient.

Eventually the dust will settle, the clouds will blow through, and brighter days will appear - it's just going to take time.

Employment Report Disappoints

The Bureau of Labor Statistics (BLS) reported that nonfarm payrolls declined by 131,000 in July. The unemployment rate was unchanged at 9.5 percent.

The contracting payrolls figure is due to the fact that 143,000 temporary 2010 Census workers were let go by the federal government. Excluding government jobs, private payrolls rose by 71,000. The increase in private payrolls was weaker than the 100,000 increase that had been expected by Wall Street economists surveyed.

The report suggests that businesses remain cautious in the wake of the financial markets' recent turmoil. Adding to the sense of weakness in employment, private payrolls in May and June were revised lower by a cumulative 34,000. Private job growth has averaged 51,000 over the past three months. This is down from an average growth of 154,000 in February-April. Job growth has taken a step back after fairly strong gains since this time frame, putting in question the strength of the economy's recovery from its worst downturn in the post-war era.

Profits Good - Economy Not So Much

It is often difficult to determine why the markets rise or fall based on either good or bad economic news. Sometimes markets fall on good economic news and sometimes markets rise when poor economic data is reported. Recently, the market has seemingly defied logic over the past few weeks by rising in the face of poor economic data. The recent rise can probably be attributed to the fact that earnings (for the most part) are meeting or beating expectations. While main street is still hampered by job losses, it is a boon for corporate profits.

As of yesterday, roughly 80% of reporting companies have beat earnings estimates, but only approximately 65% have been beating top-line revenue growth estimates. In other words, companies are making their numbers by continuing to cut costs. This outcome is not how to build a foundation for solid long term growth and is likely not good news for longer term earnings growth (beyond next quarter).

Jacob Hacker of Yale recently presented a study sponsored by Yale University in conjunction with the Rockefeller Foundation on economic security and income. The study argues that in the past year, one in five households suffered income losses greater than 25%. It typically takes several years for households to recoup the lost income. In addition, household budgets are stretched and have little in savings.

So while the markets rise in the face of good earnings (remember, markets will follow earnings, not the economy), these results are unfortunately coming at the cost of future consumption which still constitutes roughly 70% of GDP.

Watch the Transportation Index

The Dow Jones Transportation Average (DJTA) hit a high in May of this year and seems to be steadily declining; registering lower highs and lower lows. (see chart below)




Over the past few months, the DJTA has declined along with the broad market averages. Usually, the transportation index can give us a good indication of growth in the economy. Transportation companies charge freight rates based on demand. If demand is strong, higher rates can be charged, improving transportation companies' earnings. When demand is soft, the opposite occurs. While so far the DJTA has declined along with the broader market, the index and company earnings (such as Fedex, UPS, & CSX Corp) should be watched carefully. A continued decline in the index could be a precursor of slower growth, while a rebound in the index and transportation stocks should point to at least stable demand in the intermediate term.

S&P 500 Earnings Update

Our current assessment is that the US stock market averages (based on S&P 500 index) are priced at fair valuation, taking into account the recent decline in the index and our expectation that earnings estimates will be adjusted in the coming months. Surprisingly, earnings estimates have continued to move higher over the past several weeks, despite expectations for a possible global slowdown in growth. As of April 1, 2010, earnings estimates were $78.15 for 2010, a 37% increase over final 2009 numbers ($56.86). As of June 30, 2010, earnings estimates increased to $81.73 for 2010 and $94.84 for the 2011 calendar year, increases of 44% and 16% year over year respectively – still too optimistic in our opinion.

If we make a reasonable yet optimistic assumption of 20% earnings growth this year and 16% earnings growth next year – earnings estimates would be roughly $68.23 for 2010 and $79.15 for 2011, below current expectations. Using a price-earnings multiple of 15 (long-term average valuation), we calculate valuations of roughly 1,023 for the S&P 500 Index for 2010 (near end of June levels) and approximately 1,187 for 2011. We believe markets are adjusting to this new fundamental reality and this is likely why the markets have declined in recent weeks. Currently, second quarter earnings releases are in full swing and company comments will give us a good indication of earnings prospects for the second half of the year.

Consumer Credit Declines Again

A report yesterday by the Federal Reserve showed that U.S. consumers shed some of their debt for the fourth month in a row in May. Total seasonally adjusted consumer debt fell $9.15 billion, or at a 4.5% annualized rate, in May to $2.42 trillion. Economists expected a decline but of only $3 billion. Of course, this data series tends to be very volatile from month to month. For example, the April consumer credit was revised sharply lower to a decline of $14.86 billion compared with the initial estimate of a gain of $1 billion. The decline in May was led by revolving credit-card debt, which fell $7.32 billion or 10.5%. This is the 20th straight monthly decline in credit card balances. Non-revolving debt such as auto loans, personal loans and student loans, fell $1.82 billion or 1.4%. Since the collapse of Lehman Brothers in September 2008, consumer credit has declined in 18 out of the past 20 months.

While consumers reducing debt is a long-term positive for the economy, it reduces short-term consumer spending and impacts economic growth.

Special Update

The recent report from the Institute for Supply Management, which measures productions of goods in the manufacturing sector, showed slower growth in the month of June. Almost of all the components of the report showed declines from May. Of particular concern was the deceleration of new orders (dropping by 7.2%) and prices paid (dropping 20%).

Going forward, we expect further deceleration in manufacturing. The combination of a stronger dollar and slower demand coming from Europe should hit export orders moving forward. The overall level of ISM readings are consistent with GDP growth of 3%-plus. However, further declines in the data in the coming months could bring down growth in the second half of this year.

In order to the economy to have enough momentum going into 2011, economic growth needs to be humming along by the end of the year, including job gains of roughly 200,000 per month by the end of the third quarter. With today's payroll number showing a loss of jobs for last month, it is becoming more unlikely we will see significant job growth in the next few months.

At this point, the prospects for the economy are moving between a worst-case scenario of a relapse into recession (which is a low probability) to a best-case of sluggish, sporadic growth in 2011. Thus, the current decline in the markets is expected given this fundamental change. We have stated earlier this year that earnings expectations were probably too high and adjustments would be made in the second half of this year; which would could see in the coming months. It is likely the markets will remain in a trading range until signs are clearer as to where to economy and earnings growth is headed. Until there is further confirmation of the data, we should expect volatility to continue, with a good news/bad news driven market.

In the meantime, it is best to continue our defensive-minded approach as we have since the beginning of the year - holding more fixed income, income producing investments (utilities), and cash as we wait for the dust to settle and less cloudy days to appear.

Enjoy the long weekend!

End of Quantitative Easing?

If we take a minute and set aside weekly jobless claims, retail sales numbers, housing starts, and other economic data; probably one of the most important factors to focus on is that the Federal Reserve seems to be quietly tightening up on credit. Tom McClellan of the McClellan Market Report believes this is likely the largest single contributor to the recent market volatility.

While the Fed did leave its policy rate unchanged when it concluded its two-day meeting this past week, that hasn't stopped the central bank from quietly removing cash from the financial system.

One measure of money is the system is known as "money w/zero maturity" or MZM, is now contracting for the first time since 1995. MZM represents currency in circulation as well as deposits that could be withdrawn at anytime, such as checking accounts, savings accounts, and money market funds. After growing over the past decade and by over 4% during the first quarter of 2009, MZM started contracting in March at the rate of 2% per year.

It is possible the Fed has ended quantitative easing and is in the beginning stages of tightening monetary policy while leaving interest rates at zero. We could be entering a period where the Fed has decided that days of easy money are over. This, just as the global economy seems to be slowing down from the growth experienced in the second half of last year and first few months of 2010.
The global markets are becoming more volatile as traders react to the stealth tightening of credit by the Fed and possible impact on the the global economy. In addition, with less money to borrow at cheap rates, hedge funds have been caught flatfooted as borrowing costs may begin to increase; which would cause them to raise more cash by selling investments, since they won't be able to borrow at zero percent in the future.

Over the next few months, we will know whether this is just a blip in the monthly data or if quantitative tightening has begun.

Voluntold

If you are not familiar with the word “voluntold”; here is the definition per the Urban dictionary:

Voluntold: The exact opposite of volunteering. Always used in reference to an unpleasant task to which you have been assigned by your boss.

Example 1:

Co-worker A: I hear you got a transfer to another division.
Co-worker B: Yes. I didn't want to take the job, but I was voluntold.

Example 2:

Co-worker A: Hey, do you want to go to the baseball game on Saturday?
Co-worker B: Unfortunately, I can't. I got voluntold I have to work this weekend.


But “voluntold” doesn’t apply to just the workplace. Husbands are often voluntold to do a variety of tasks, myself included. Some of these tasks may be tolerable but most are not as none of the activities were my idea. Most of us are voluntold to do X and in the interest of marital harmony, we do them.

But watching BP CEO Tony Hayward leaving the White House yesterday, I couldn’t help but notice he looked very similar to our largest banks CEOs after their November 2008 meeting with the Bush administration when they agreed to accept TARP. Like the bank CEOs before him, Hayward had been voluntold to turn over $20 billion in assets to the US Government.

Don’t get me wrong, I believe BP, like anyone who does something wrong, should be held accountable. In addition, the more negligent or egregious the action, the more severe the punishment should be.

Still, being voluntold feels very unsettling, particularly as it seems like it's becoming more the norm than the exception.

About a week ago, Governor Mitch Daniels of Indiana marked the one-year anniversary of the bankruptcy of GM and Chrysler with an op-ed in the Wall Street Journal in which he shared that “It was June 10, 2009 when the government tossed aside the option of proven, workable bankruptcy procedures in order to nationalize Chrysler on behalf of its union allies.” In other words, the bondholders of GM and Chrysler were voluntold to accept less than historical precedent would have suggested.

But I would note the pattern. In all of the voluntold situations to date (our largest banks, GM, Chrysler, and BP) we’ve had enormous organizations with staggeringly large liabilities.

It looks to me like companies with large liabilities or those which are considered “too big to whatever” entities; public policy outcomes can trump capital markets precedent?

But if Washington believes this, I believe that investors must too. And I'd offer that the bondholders and shareholders of the world’s largest companies now face a substantial risk of being “voluntold” should something negative happen.

When it comes to big corporations, the public policy outcome now matters most and will take precedent. But we'd be wise to consider the long-term implications, particularly as the global nature of our largest corporations and financial institutions makes the public policy outcome far more complicated than I believe most people currently appreciate.

The Upside of the Financial Crisis

Below is an excerpt of an article written by Todd Harrison, founder of Minyanville and former hedge fund trader. The article is posted on the Minyanville website. We believe it decribes the process of discovery we are experiencing as a result of the financial crisis.


"The unfortunate capital market destruction is an inevitable comeuppance, the cumulative result of risk gone awry. It’s been percolating under the seemingly calm surface for several years, magnified by financial engineering and consumed by an immediate gratification society.

The socioeconomic consequences will be pervasive as we enter the other side of the business cycle, an unenviable retrenchment that politicians and policymakers have tried so hard to avoid. It’s certainly scary as new beginnings always are.

Therein lies the opportunity.

The media portrays the Great Depression as one where everyone in America stood on street corners or waited in a bread line. A closer look shows that similar to today, economic hardship for the middle class began well before 1929.

We’ve got a few lean years ahead but that’s nothing to fear. In fact, it’s a healthy and positive progression.

To get through this, we need to go through this. As painful as the process is, it takes us one step closer to an eventual recovery.

I view the Great Depression as the framework for optimism. Most of society worked, great discoveries were made and formidable franchises were established.

Indeed, if the greatest opportunities are bred from the most formidable obstacles, we’re about to enter a most auspicious era.

The 90’s were about wealth, accumulation and consumption and we’ve now entered a period that is entirely more austere, if not more sensible.

Debt reduction and the rejection of materialism will continue to manifest as we come to terms with doing more with less.

Flashy rides and big-ticket items that were once badges of honor now serve as hollow reminders of misplaced priorities.

Humility, once viewed as weakness, will be embraced.

Doing for others -- rather than asking what others can do for you -- will become more commonplace as people learn to appreciate what they have rather than constantly keeping up with the Dow Joneses.

This mess is a bitter pill to swallow, particularly for the mainstream American who doesn’t know a derivative from a dividend. We can point fingers and wallow in the “why” or take a deep breath and begin the process of recovery.

Something good comes from all things bad and the greatest wisdom is bred as a function of pain.

It’s unfortunate that the structural foundation of the global capital market system had to shake before people -- and policymakers -- paid attention but it is what it is and we’ll do what we must.

Surround yourself with people you trust. Practice risk management over reward chasing.

It won’t be an easy road but it won’t be impossible either."

Deflation versus Inflation

Back in October 2009, we talked about the possible deflation and inflation scenarios that could play out. See link below -

http://brightassetmgmt.blogspot.com/2009/10/puzzle-pieces.html

In this piece there were two scenarios that were likely -

Scenario 1: Dollar decline, lower bond prices, higher stock prices, higher commodity prices, higher gold

Scenario 2: Dollar rises (as of function of deleveraging), higher bond prices, lower stock prices, lower commodity prices (as a function of a reduction in global demand.)

While Scenario 1 dominated during the second half of 2009 and into the beginning of 2010, Scenario 2 has been playing out over the past few months as debt and financial concerns in the Eurozone are creating expectations for deflation.

Remember, deflation is the contraction (reduction) of money and credit. It occurs when an economic system is carrying too much debt to be supported by the level of income generated by economic activity - both in private and public sectors. It occurs because too much debt has been incurred to create unproductive assets that don’t generate income. Deflation is a corrective process, it’s simply the market not being able to service debt, so the debt must be forfeited.

Inflation is just the opposite involving the expansion (creating) of money and credit. Since the 1950's, central banks and accepted economic theory are all about creating debt to grow economies (artificially), so periods of inflation (creating money-debt and credit) last a very long time. Debt is accumulated slowly and incrementally during periods of economic expansion until there is just too much of it.

The current job of global central banks is to fight deflation. Hidden behind the bailouts, stimulus packages, zero interest rate policies, mortgage workouts, housing credits, and working groups are politicians attempting to engineer a business and economic recovery while fighting off the forces of deflation.

While these plans seemingly worked over the past year, none of these plans will affect the larger deflationary credit contraction. Debt deflation is occurring outside of the Fed’s control at many of the world’s money center banks. This process will probably take several years to work out but will ultimately yield positive results. The destruction of debt will allow world economies to build a solid foundation for future expansion that is entirely more secure than what we currently have in place at the present time.

There are no easy answers but there are certainly simple truths - truths that don't get politicians re-elected, however.

S&P 500 Index P/E Ratio

The current sell-off over the past several weeks in US stocks has reached the point at which smart money investors are starting to see value appear. This is by itself no guarantee that further lows will not be reached, but it suggests that we have entered the part of the selling in which an increasing proportion of sales are involuntary liquidations (driven by mutual fund redemptions, margin calls, or a need to cut risk exposure). Of course this is the major reason that the maximum pace of price decline typically takes place right at the end of a correction, which we saw at the beginning of this week.

Below is a chart of the S&P 500 index showing index price (white line), current P/E (green, right side) and Bloomberg Estimated P/E (red, right side). While the price level of the index is no lower than it was for much of Q4 2009, the significant recovery in both the level of US corporate earnings means that the index is trading at an estimated P/E of just under 13. To put this in perspective, the 13 level was only breached during the period of October 2008 to March 2009. Furthermore, during that period of crisis, estimated earnings were being cut at a rapid pace, making a low estimated P/E a much less reliable guide that value was being established than at the current time.

If we couple this P/E ratio decline with the increase in mutual fund redemptions over the past two weeks, increase in bearish sentiment, the decrease in dumb money confidence, and the increase in smart money confidence, we are reaching an attractive valuation point for a good risk/reward opportunity. We are not saying the end of this correction has definitely occurred and it is possible that even deeper value may be created by the time the downturn has run its course; but we are likely closer to the end of the move than the beginning.

Volatility is Back!

Back on April 16, we discussed how sentiment was reaching extremes with dumb money very confident in the markets, while smart money was not confident. See link to article below:

http://brightassetmgmt.blogspot.com/2010/04/sentiment-going-parabolic.html

Now sentiment has turned 180 degrees. Volatility has increased as fear now dominates where just a few short weeks ago, greed took center stage. See chart below courtesy of sentimentrader.com:

Dumb Money Sentiment has declined to 33% confidence, while Smart Money Sentiment has climbed to 50% confidence; one of the highest readings since March 2009.

As we discussed in the April 16th update, we believed any correction or decline in the markets as a result of extreme sentiment readings would likely translate into an opportunity in undervalued areas of the markets' given the improved economic picture. While we expect volatility could continue in the short-term and markets move lower, the increase in smart money confidence to 50% coupled with a decline in the markets of over 10%, and the fact the dumb money is becoming more fearful, makes us confident that a decent rally could be coming in the weeks/months ahead.

The key is having patience as well as the courage to act against the crowd...

The Deadly Web of Debt

We thought the easiest way to understand the debt issues in Europe is with a picture. Below is a graph that was posted in the NY Times several days ago. It is a fairly accurate depiction of the debt issues facing the Euro Zone. (Double click on picture for larger image)

Something Wrong with the System

Apparently, the markets dropped 10% in a matter of minutes yesterday because a "fat finger" trader mistakenly hit the "b' key instead of the "m" key. Fortunately orders don't trade that way and our sense is that the stock exchanges needed a "reason" for the media. Our feeling is that the system broke yesterday and we started to crash until the powers that be stepped in to keep the markets from imploding. Case in point, while we were looking to purchase various positions during the craziness, there were large spreads between the bid (sell price) and ask (buy price) one minute and all of a sudden there was no market. No bid, No ask, nothing. Stocks just don't trade like that even under heavy amounts of selling. Something happened yesterday that is not normal and shows that something is wrong with the system. We hope someone figures out what happened.

Why does this matter? Because our system is built on credibility, trust, and confidence - confidence in the process. Credibility and loss of confidence was at the heart of the financial crisis in 2008 and could become an issue once again. Psychology is a delicate animal and can turn vicious when the "real" comes to the surface.

Now from where we sit the last thing we want is for the market to crash as it wouldn't be good for anyone. However, it is within the probability spectrum and an outcome we must respect. Yesterday was a great example of "expect the unexpected".

So what does one do? The key is not to panic, but to act rationally. The worst of the downside may have already happened - emphasis on the word "may". According to reports, all of the unusual trades on the major exchanges that happened between 2:30 and 3:00 yesterday will be cancelled. This could add some stability to trading today but also means that people that panicked and sold positions yesterday will have the trade cancelled, so they could decide to sell at some point in the near future.

It's highly likely that markets will remain volatile over the coming weeks as news from Europe and currency markets take center stage.

In times of crisis and high levels of uncertainty it's better to error on the side of conservatism and position accordingly. Cash can be the great neutralizer in volatile times. While it doesn't help you when the market goes up, it doesn't hurt you when the market goes down. Plus, it's always good to have capital on hand to take advantage of opportunities. We have to remember that the capital markets will be here tomorrow and there will always be opportunities.

The good news from yesterday's free fall is that dumb money sentiment is beginning to turn more negative after several weeks of europhic numbers; while smart money sentiment is beginning to turn more positive (see recent weekly updates). This sentiment shift could be setting the markets up for a decent multi-month rally.

Senators versus Goldman

While watching the Goldman Sachs hearings during lunch earlier this week, I couldn't help but feel like it was a political setup. People are upset about the financial crisis (rightfully so) and many senators are feeling the heat from constituents. While there were many companies involved in trading the mortgage securities market, it seems like Goldman has become the target - likely because Hank Paulson the former Treasury Secretary was the CEO for Goldman and many believe the bailout was a direct attempt to help Goldman survive. Given all the discussion this week, I thought it would be helpful to look at some of the issues surrounding the case. We will don't believe Goldman acted in the best interest of clients at all times, based on the current information available, Goldman Sachs likely didn't do anything illegal - however, Goldman acted in a way that was socially unacceptable and improper.

First, we have to go back to the late 1990's and the passage of the Commodity Futures Modernization Act, which exempted swaps and derivatives from regulation. All the big problems in the country seem to stem from something the government does or in this case didn't do. Below is a link to the BAM Weekly Bulletin article from last year.


http://brightassetmgmt.blogspot.com/2009/04/blame-commodity-futures-modernization.html


Second, Goldman didn't cause the financial crisis. They participated in trading and creating swaps and derivatives in the mortgage backed securities market, but they single handily didn't cause the collapse. It was a combination of several events happening at the same time. Remember, nothing Goldman or any other firm did with respect to creating or trading derivative products was illegal - the products were unregulated so technically there were no rules.

The word "synthetic" is the word that is important in this discussion. It's not a real asset, like the peanut butter and jelly you might find on a peanut butter and jelly sandwich. When an asset is "synthetic", every buyer for the product creates a seller who is effectively short the asset. Since the asset doesn't actually exist, there needs to be a buyer and a seller; it can't be one-sided. So, if a customer wants to buy a "synthetic" asset from Goldman Sachs that would make either Goldman or a third party the seller.

One of the reasons Goldman Sachs created the synthetic products was because there was strong demand from its customer base and this is an important point. Customers wanted to purchase assets that were tied to sub-prime mortgage back securities (and other mortgage related securities) either directly or synthetically, in order to increase risk or reduce exposure to risk, because they believed the underlying position would be very profitable or wanted to hedge an existing position. Because there was such positive sentiment about the mortgage market at the time, there weren't many investors interested in taking a negative view. Goldman and some other seemingly smart investors had an idea that the mortgage market may unravel at some point and were comfortable with betting against the mortgage market, or taking the other side of the trade in this example. We also have to remember that the average investor doesn't have access to a "synthetic CDO". Most sophisticated investors (hedge funds, pension funds, endowments) who were buying the synthetic products from Goldman and other firms for that matter were smart enough to understand what they were involved in. Goldman Sachs basically created products that were demanded by its customers and took, with other third parties, the other side of the trade.

We will have to wait and see what happens next...

S&P 500 Earnings Update

Our assessment is that the US market averages (based on S&P 500) are still at the higher end of fair valuation, if not slightly overvalued, based on final earnings estimates for 2009 ($56.86) and current estimates for 2010. However, valuations don’t seem to matter as the markets continue to power higher on expectations of a stronger economic recovery and increased corporate profitability.

As of January 1, 2010 earnings estimates for the S&P 500 stood at $75.27 for 2010, representing a 32% increase over finalized 2009 results. As of April 1st, earnings estimates have increased to $78.15, a 37% increase over 2009. A 15 price-earnings multiple (long-term average valuation) on the $78.15 estimate translates to a 1,172 value for the S&P 500 Index. Given the abundant liquidity in the markets, low interest rates, and expected low inflation, market participants could put a premium on future corporate earnings and be willing to pay more for those earnings; pushing markets significantly higher. For example, placing price-earnings multiple of 18 on earnings of $78.15 translates to a 1,406 value for the S&P 500; while a multiple of 20 would put us back to the old market highs reached in 2007. We can’t rule out the possibility, if economic conditions remain favorable, of the markets moving back to new highs over the next couple of years.

However, as we have stated previously, while we do believe earnings will increase in 2010, a 37% increase is probably a bit optimistic. We will likely need to see double digit GDP expansion in order to see such an increase in earnings. While this type of increase in earnings may not happen; it’s the perception of what may happen that matters. Right now the perception is that earnings will increase significantly and the economy will continue to accelerate with or without job creation. As long as this perception holds weight with market participants, the markets will likely continue to climb as this outcome is priced into stock valuations.

Sentiment Going Parabolic

We usually never cover a specific topic two weeks in a row but the sentiment numbers have gone off the charts. See the chart below from Jason Goepfert at Sentimentrader.com.





Dumb Money Sentiment has reached 75% confidence level, while Smart Money confidence is currently at 29% confidence. The spread has widened to 46%. The last time the spread reached this kind of extreme was in May of 2008. The markets didn't fair to well after those extreme readings.

Back in January of 2010, the Dumb Money Sentiment reached 75%, while the Smart Money Confidence was at 38%; right before the markets declined roughly 9% in about 3 weeks due to concern over economic growth; so caution is warranted.

However, economic numbers have greatly improved since the reports at the beginning of the year and we are in a recovery as opposed to heading into a recession as was the case in May 2008. Any correction or decline in the markets as a result of extreme sentiment readings we are currently seeing will likely translate into an opportunity in undervalued areas of the markets.

Sentiment Reaching Extreme - Again

The Smart/Dumb Money Confidence indicator is reaching an extreme reading again and at one of the widest spreads on record.

As a refresher, the Confidence indices are presented on a scale of 0% to 100%. When the Smart Money Confidence is at 100%, it means that those most correct on market direction are 100% confident of a rising market, and we want to follow their direction. When it is at 0%, it means that the Smart Money are 0% confident in a rally, and we want to be more defensive and hold more cash.

We can use the Dumb Money Confidence in a similar, but opposite, manner. For example, if the Dumb Money Confidence is at 100%, then that means that the Dumb Money investors are supremely confident in a market rally. And history suggests that when these investors are most confident, we should exercise extreme caution. When the Dumb Money Confidence is at 0%, then from a contrary perspective we should be concentrating on the long side, expecting these traders to be wrong again and the market to rally.

In practice, the Confidence Index numbers rarely get below 30% or above 70%. Usually, they stay between 40% and 60%. When they move outside of these levels, it’s usually time to take notice.

As of this morning, the Smart Money confidence has recently dropped to 29%; the lowest level this year. The Dumb Money confidence has just risen to 71%; making the spread between the two 42 points! These readings are each above and below the respective extreme bands of 70% and 30%.

Again, this doesn't mean that markets will decline immediately and the markets could actually continue to move higher in the short-term. However, the risk/reward equation is not favorable and the probability of an increase in volatility rises with each passing day.

Manufacturing Index improves

March's ISM Manufacturing survey delivered better than expected results and this key data point continues to suggest that the economic recovery is gaining more momentum and a solid rebound in manufacturing is taking place than has been broadly recognized. The overall index improved to 59.6 (from 56.5 last month) which is the best reading since July 2004 (interestingly this was one month after the first Federal Reserve Board interest rate hike in the 2004-06 hike cycle). The most important data is supplied by New Orders which improved to 61.5 (59.5 previously), indicating that orders continue to grow rapidly. This new order figure will require greater production which in turn requires re-employment of labor. We are finally seeing the sort of rush to re-build inventories that we typically see when an economic recovery really takes hold. All in all this is a very positive data set and one that suggests that the manufacturing employment cycle is likely about to turn strongly positive.

Economy adds jobs in March

The American economy added 162,000 jobs in March, the biggest burst of hiring in three years, the Labor Department said Friday. The unemployment rate held steady at 9.7%, the level it has been at for the last three months.

The March job gains, which were boosted by temporary hiring for census work, marked the biggest one-month increase since 239,000 jobs were generated in March 2007, roughly 3 years ago. The latest gain was slightly lower than what many economists had been forecasting, but the government also revised upward the payroll count for the first two months of the year. It revised the January payroll date to a creation of 14,000 jobs, instead of losing 26,000 as previously reported. And the losses in February were shaved by more than half, to 14,000.

The news of the hiring last month will be welcomed news to the 15 million jobless American workers. But the latest report somewhat overstated the strength of a slowly recovering labor market. About 30% of the payroll increases last month, or 48,000 jobs, were positions created by the Census Bureau, which is expecting to hire hundreds of thousands more workers in the next couple of months to knock on doors and collect data for the decennial count of the nation's population. Many of these jobs are part-time and will last only several weeks.

However, this jobs report shows that the economic recovery seems to be gaining some momentum as we head into the second quarter of the year.

Healthcare Reform - Pros and Cons

Now that healthcare reform legislation has passed, we thought it would be helpful to take a quick overview of the pros and cons.


New Health Care Bill – Pros:

1. Everybody can have health insurance if they want it.
2. Insurers will not be able to stop paying for people who are sick, even if they lose their jobs.
3. People who cannot afford health insurance won’t have to pay as much money.
4. People who are already sick will be eligible for healthcare.
5. In the long run it will (hopefully) reduce medical costs significantly. Rising medical costs are the main reason the long-term budget projections are so alarming. Unfortunately, this bill might not do enough. While there will definitely be some savings, it’s not clear that they will be as great as hoped.
6. Health insurers can no longer cap coverage. In other words, they will no longer say that they have spent enough on you and you’re on your own for the next hundred thousand dollars. This should reduce medical bankruptcy.
7. There will be increased competition in the insurance market. This might push the healthcare companies to lower costs and provide better service.


New Health Care Bill – Cons:

1. For the first ten years, it will cost about $100 billion a year. This is about the yearly cost of the Iraq War.
2. The bill might increase the cost of health insurance. This depends on whether the gains from increased efficiencies and increased competition are outweighed by the cost of providing additional benefits.
3. The Individual Mandate. You will have to either buy health insurance if you don’t have it or have a 2% tax increase. This insurance will be subsidized—but there is no guarantee that the subsidy will suffice for your specific situation.
4. There will be a tax increase on very high income people. If you are making more than half a million you will have about a 1% tax increase.
5. Increased government involvement in healthcare. Government already pays for huge amounts of healthcare—so this won’t be anything new.
6. Additional regulation on insurance companies. This might increase costs. It will increase quality.
7. Physicians will have increased access to information about what treatments are most effective for their cost. If two treatments work equally well and one is cheaper, doctors can recommend that one. This was almost universally considered a good thing until a few years ago, but some people have started criticizing it lately.

Here are some more facts about this new Health Care Bill on government extractions:

1. The US government will extract a fee of $2.3 billion annually from the pharmaceutical industry. If you are a pharmaceutical company what you will pay depends on the ratio of the number of brand-name drugs you sell to the total number of brand-name drugs sold in the U.S. So, if you sell 10% of the brand-name drugs in the U.S., what you pay will be 10% multiplied by $2.3 billion, or $230,000,000. (Under reconciliation, it starts at $2.55 billion, jumps to $3 billion in 2012, then to $3.5 billion in 2017 and $4.2 billion in 2018, before settling at $2.8 billion in 2019.

2. The US government will extract a fee of $2 billion annually from medical device makers. If you are a medical device maker what you will pay depends on your share of medical device sales in the U.S. So, if you sell 10% of the medical devices in the U.S., what you pay will be 10% multiplied by $2 billion, or $200,000,000.

3. The US government will extract a fee of $6.7 billion annually from insurance companies. If you are an insurer, what you will pay depends on your share of net premiums plus 200% of your administrative costs. So, if your net premiums and administrative costs are equal to 10% of the total, you will pay 10% of $6.7 billion, or $670,000,000. In the reconciliation bill, the fee will start at $8 billion in 2014, $11.3 billion in 2015, $1.9 billion in 2017, and $14.3 billion in 2018.

Many of the provisions of the reform don't go into effect until 2014, so depending on what happens in the November elections, it's possible it could be amended or changed. It is unlikely this will happen but it is possible.

Markets continue to rally

The S&P 500 Index has closed in positive territory 24 of the past 28 sessions and has risen to new highs for the year. If you think that is breathtaking, the Russell 2000 Index has rallied 20 of the past 23 days. A near-term corrective phase would be totally natural at this point and as long as the indices don't give back too much of the gain; that would be a constructive development for possible future gains.

The equity market at any given moment in time is basically one part reality to three parts perception. The perception part (and the reason behind the continued rally) is that 0% interest rates are good news for stock prices. With rates expected to stay low for an "extended period of time", the perception is that is good news all around.

Question we ponder is if 0% interest rates were a cure-all for all that ails the economy then we suspect Japan’s Nikkei Index (where zero percent interest rates have existed for years) would still not be 70% lower than it was in 1989? As we look back to 2009, didn’t the S&P 500 slide 30% in the opening months of the year with the same interest rate policy we have today? It was only when the Federal Reserve began quantitative easing, the government bought shares in the banks and injected stimulus, FASB made changes to accounting rules and the shorting community was sufficiently ostracized that the market made a bottom. Perceptions changed.

Perception is OK as long as the future reality matches up to the at the moment perception. And so far that has happened. Perception continues to match future reality and the market has rallied accordingly. The stock market perceives a robust recovery, which actually may happen. Economic numbers and earnings continue to come in above expectations. So far so good. Of course, there is always a twist.

The bond market's perception is vastly different from the stock market's. If the bond market (which is actually several times bigger than the stock market) is perceiving a recovery as robust as the stock market, intermediate and longer term interest rates should move higher, as they have in every post war recovery; in anticipation of the Federal Reserve raising rates due to strong economic growth. The 10 year treasury rate is the benchmark for the markets as many other lending rates, such as mortgages, are tied to this rate. In June of 2008, the 10 year treasury rate was 3.79%. In June of 2009, the 10 year treasury rate was 3.71%. Where is it today? As of this morning, the rate is 3.66%. At this point, the bond market doesn't expect the economic recovery to be as robust as the stock market perceives. So who has the correct perception - the bond market or the stock market?

If the economy is recovering at more than just a tepid pace, we should begin to see interest rates move higher as smart bond market investors begin to sell bonds anticipating higher rates. At first, the stock market will likely decline as higher rates tend to be a precursor to an allocation move out of stocks and into bonds as yields rise. However, longer term a rising interest rate environment is good for stocks because it signals stronger economic growth and in increase in pricing power for companies; requiring the Federal Reserve to raise rates to slow growth and tame inflation. If interest rates continue to remain steady or move lower, we should except a continued slow recovery and more muted expectations for earnings growth this year. Economic numbers over the next several weeks should give us a better idea of who is right.