Jason Kelly

Why The Middle Class Is Struggling

2009-11-03T20:10:00.000+09:00

I've received lots of email recently from people who are out of work, about to lose their homes, and unable to find new employment. One among them named Mike mentioned that times are hard now, but weren't easy before. He wondered if just getting back to the economy we had prior to the subprime meltdown would be sufficient. "Why," Mike wrote, "is it so darned hard to get ahead in the land of the American dream?"

The Washington Post ran last month an interview with Elizabeth Warren, Chairman of the Congressional Oversight Committee tasked with scrutinizing how the Treasury Department has spent the $700 billion to shore up America's failing financial institutions. The following excerpt from the article helps answer Mike's question:

When we compare middle-class families today with their parents a generation ago, we have basically flat earnings -- a fully employed male today earns on average about $800 less, adjusted for inflation, than a fully employed male earned a generation ago. The only way that houses could increase or families could increase their household income was to put a second earner into the workforce, and, of course that's now flattened out because there aren't any more people to put into the workforce.

So you've got, effectively, flat income in this time period -- with rising core expenses; housing; health insurance; child care; transportation, now that it takes two cars to get everywhere, two jobs to support; and taxes, because you've got two people in the workforce and we have a somewhat progressive taxation system. So, families are spending a lot more on the basic nut.

The third leg to the triangle, and that is families, to deal with this, stopped saving and started going into debt.

Why Bother Analyzing Companies?

2009-10-30T17:47:00.001+09:00

For more than a year now, fundamental analysis of companies has been a waste of time. Stocks have traded as a block, first plummeting in tandem a year ago to March as banks froze up the financial system, then soaring in tandem as the Federal Reserve expanded the monetary supply and made cash worthless as an asset with near zero interest. The latter sent liquidity flooding into stocks, lifting all of them together.

We've seen evidence of this recently. Last week, Apple delivered a superb earnings report that announced its most profitable quarter ever. It sold 10.2 million iPods, 7.4 million iPhones, and 3.1 million Macintosh computers in the quarter. Reports just don't get any better.

Since the March low, Apple's stock has risen nearly 150% and the easy explanation is its phenomenal business execution. Was it that bad before, though? No. Here's how Apple CEO Peter Oppenheimer began the earnings report conference call a year ago, on Oct. 21, 2008: "We are very pleased to report our September quarter results, which were record-breaking on a number of fronts. First, we sold more Macs than we have in any other quarter in Apple's history. Second, we sold more iPhones in the September quarter than in all previous quarters combined. Third, we sold more iPods than in any prior non-holiday quarter and finally, we generated more revenue and earnings than in any previous September quarter in Apple's history." Remember, that was a year ago. During that record-breaking quarter, Apple's stock declined 40%.

All Apple's recent stock price rise has done is return the stock to where it was in December 2007 before it dropped 59% to its low last March. It was a solid company with strong fundamentals all through the drop, and it's been a solid company with strong fundamentals in this year's rise. Those fundamentals didn't matter a wit. What mattered was the macro backdrop.

Also, since the March low, stocks of other companies -- both healthy and sick alike -- have risen remarkably, too. Citigroup is up 350% and Crocs is up 500%.

Judging by correspondence I've received from book readers and subscribers to my newsletter, the latest shenanigans from government, banks, and big business may have had a lasting impact on the character of the market. I sense that many individuals have finally had it. The ruse is over, the curtain is drawn back, and what's revealed is that Wall Street is no longer about companies using public markets to raise capital in an efficient way that allocates it to those with the best prospects.

Nope, it's a fraud in which you can spend all of your free time (or work time, as the case may be) analyzing product plans, marketing plans, management history, and so on just to be laid low by a bank that levers up too far or a single pen stroke from the Federal Reserve chairman. It finally became plain as day that individual investors are up against the Goldmans of the world, and the Goldmans own the casino via their connections to government and government's connections to the Fed. When the investment banks control the Treasury and the Federal Reserve, observing their actions alone is all that matters to the performance of a stock portfolio. Enough individual investors have seen that and realized that they stand little chance against such collusion that a crowd of former market participants would rather take their chances against inflation than the casino owners.

Sadly, those are the alternatives. Deciding to walk away from the stock market is barely an option for Americans because the money supply has been constantly inflating since the Fed's creation in 1913. Americans face two crummy choices: risk another cliff dive in stocks when the powers that be speculate the whole sham into another crisis, or try outpacing inflation in non-stock investments that are less vulnerable to Washington's whimsy. Lovely.

Individuals used to take solace in looking at fundamental factors, thinking they could find an edge with personal shopping experience as Peter Lynch taught, inside their own circle of competence as Philip Fisher taught, or culling the attributes of quality companies as Warren Buffett demonstrated. Now that even that impression has been rendered cock and bull, what's left?

About the best anybody can do is stick with broad index ETFs and try to sense the waves of pressure on the stock block. Good luck with that. Nobody can do it consistently, as has been widely demonstrated in the literature. Given the increasingly dice-like nature of stocks as the number of factors that individuals can analyze to make a difference dwindles, no wonder so many look to be placing their money elsewhere.

Trading is still alive and well. However, most stock market participants weren't in it for the slot machine aspect of speculating on stocks. They were in it for the steady average 10% per year growth they were told by the industry to expect, which is obviously not part of the bargain. It was made clear that past performance was no guarantee of future results. At last, it looks like people are paying attention to that. Instead of accepting the risk as they used to do, however, they're now concluding that they would like a few more guarantees in their financial future, and are more trusting of just about anything other than stocks.

The Fed Destroys Financial Freedom

2009-10-23T17:51:00.007+09:00

One reason so many Americans face personal financial difficulty is that they live in a culture of excess designed to discourage saving and encourage spending. At the root of that culture lies the Federal Reserve and its expansionist monetary policy, which has reduced the value of a dollar from $1.00 in 1913 when the Fed was created to just $0.05 today.

The following excerpts are from Texas Republican Congressman Ron Paul's new book, End The Fed.

Artificially low interest rates are achieved by inflating the money supply, and they penalize the thrifty and cheat those who save. They promote consumption and borrowing over saving and investing. Manipulating interest rates is an immoral act. It's economically destructive.

p. 133
___________________________________

The Fed encourages irresponsible accumulation of personal debt. People live beyond their means with the help of an expansionist monetary policy. They trade in their futures for the present. They neglect the need to save in order to consume more and more. In this sense, the Fed is the ultimate promoter of consumerism and living for the present. This amounts to a terrible cultural distortion in which short-term thinking wins out over long-term planning.

p. 151
___________________________________

Excessive debt of a country or a people, once it reaches a certain point, is unpayable and must be liquidated. That point is almost impossible to accurately predict, since it will vary from one situation or country to another. One thing certain is that we as a country, and probably the world, have reached that point.

Individuals and corporations can default and debt is liquidated. When the need arises, liquidation is necessary and beneficial. The market today is demanding this liquidation; the politicians and the Fed are doing everything conceivable to prevent it, but they are only prolonging the agony.

p. 184

Poker Lessons for Investors

2009-10-22T18:45:00.000+09:00

Today's somewhat whimsical article comes courtesy of frequent contributor Dave Van Knapp. His site, SensibleStocks.com, is chock full of clear-headed ways to pick stocks and explains the oft-unappreciated role of dividends.

Poker Strategy vs. Investment Strategy

by Dave Van Knapp
SensibleStocks.com

I enjoy playing poker, and there are many parallels between poker and investing. I play online on PokerStars.com. They have a tab called "Poker Strategy" for new players. I clicked on it, and I was struck by how much of their simple strategies and tactics apply equally to stock investing.

So I decided to translate their "Poker Strategy" into investment insights. While I have freely substituted investment terminology and added a few thoughts of my own, the basic structure of the following and most of its main points come directly from the PokerStars discussion.

Decisions for the New Stock Investor

To invest at a consistently winning level requires both time and effort. In other words, it takes work. To the extent you can, deciding which type of stock investor you want to be before you start will make your decisions easier. By "type of investor," I refer to such choices as investing for growth, investing for dividends, using fundamentals, using technical analysis, and the like. There is nothing wrong with combining disciplines into a hybrid approach, or using different portfolios to pursue different strategies. But getting your basic strategies down -- I recommend writing them out -- is important.

Make Good Decisions -- the Results Will Follow

Even the best investors in the world have losing periods. Don't make the mistake of expecting to win every time you invest. Your goal should be to make decisions to the best of of your ability at all times. If you do, the total return on your investing will take care of itself, and it will improve as you improve the quality of your decions. Many investors make the mistake of judging their ability based on the results of each decision. Your goal should be to make the best possible play every time. The closer you come to this, the better your results will be.

By "decisions," I refer to decisions to buy, hold, sell, or stay away entirely. Selling or staying away are investing's equivalents to folding a hand.

The Mathematics of Poker

Investing is a mathematical game, and it's a game of incomplete information. That may sound complicated, but it really isn't. On a very basic level, winning investing starts with the selection of which stocks or ETFs to buy or (more importantly) to avoid. This is called "stock selection." If you embark with the best decisions as well as you can determine them, you will increase your odds of overall investing success. In this context, stock selection includes not only identifying excellent companies or ETFs, but also determining favorable prices at which to buy them ("valuation").

Beyond Starting Hands

Stock selection is fundamentally important, but it's only one piece of the puzzle. Once you have mastered solid guidelines for purchase decisions, the next area you should work on is your play for the rest of the time. I call this "portfolio management." The area that separates better investors from the rest is that the better investors tend to play much better during the remainder of the process, after the starting stock or ETF selections are made. This is especially true concerning the decisions made about when to end the holding period for every stock or ETF purchased. These skills involve risk management, stop-loss techniques, deciding when a trend has played out, recognizing red flags, knowing what to do when a company cuts its dividend, and the like. Even small improvements in an investor's portfolio management can have a tremendous effect on that investor's lifetime success.

Avoiding Tilt

Another meta-skill that should be part of a winning investor's strategy is avoiding tilt. ("Tilt" is a poker term for someone who has gotten emotional -- perhaps because of a bad result -- and starts making bad decisions, perhaps in an effort to make it all back at once.) Your emotions can work against you, but only if you let them. Emotional play results in poor decisions and lost money. Tilting and steaming can happen to anyone, and sometimes the only cure is a break from the game. That's okay; the game will still be there tomorrow.

Higher Unemployment Could Bring More Trouble For Banks

2009-10-07T18:52:00.004+09:00

Unemployment hit 9.8% last month, and most analysts consider it all but guaranteed that it will exceed 10% by the end of the year. The following excerpt from Charles Gasparino's column yesterday shows how a rising unemployment rate could cause another banking crisis:

[Banks are] still holding trillions of dollars in ailing mortgage loans and commercial-real-estate debt that they have yet to fully write down. They're hoping they won't have to -- but continued joblessness is squeezing those portfolios.

The banks will tell you that they've written down a good chunk of their consumer loans. But the problem, according to banking analysts like Mike Mayo, becomes acute if unemployment passes 10% and nears 11%.

That's the point, according to many economic models, that American consumers start defaulting on loans in such a way that trillions of dollars in consumer-related loans and debt that haven't been written down start to implode.

And that doesn't account for the trillions in commercial-real-estate loans and bonds that have yet to take any significant hit at all -- but (most analysts predict) will be crashing in the months ahead even if unemployment stabilizes at 10%.

Bottom line: If unemployment goes higher than 10%, the banks' numbers get even worse. As losses begin to mount, the big banks may well find themselves back begging the government for more bailout money.

As one major Wall Street CEO told me: "If the consumer comes back, the banks will be safe -- but if the consumer begins to implode, so will the banks."

But will unemployment head toward 11%? Well, former Fed Chairman Alan Greenspan (whose lax monetary policy helped lead us into the financial crisis) warned last week that America should brace for it to cross the 10% level.

Prominent banking analyst Meredith Whitney, who all but predicted the banking crisis, recently laid out why unemployment is likely to keep rising: For all the talk of recovery, banks are cutting back on loans to small businesses, which make up nearly half of the country's workforce and a massive chunk of the GDP -- close to 40%.

Of course, President Obama and the stock market might be right -- unemployment isn't climbing as fast, so jobs will start coming back as business profits return. Problem is, President Herbert Hoover said just about the same thing back in 1932.

As the following chart from Econoday shows, the recent trends of rising unemployment and falling average hourly earnings aren't encouraging:

Market Says "No" To High Prices

2009-10-05T13:48:00.007+09:00

Last week saw a subtle but important shift in the way economic data were interpreted. During most of the rally, any improvement in data was heralded as proof that the worst was behind us and the future a ramp upwards with only the degree of incline in question. Merely an upward bias in economic data was enough to give stocks an upward bias as well. Last week, however, more attention was paid to the strength of the data instead of its direction alone. Finally, the market may be asking if the recovery is good enough to justify high stock prices. Over the past two weeks the answer has been, "No."

What could follow on the heels of such a shift is a further backing up from debating the incline of recovery to questioning whether an upward bias is guaranteed after all. With loan defaults rising, jobs about as common as sense in Congress, and central banks eager to pare back stimulus, more people appear to be wondering if another leg down is inevitable.

Let's look at the technical picture for the main stock indexes of the world's four financial centers: the S&P 500 in New York, the Nikkei 225 in Tokyo, the SSE Composite in Shanghai, and the FTSE 100 in London.

Here's New York:

Here's Tokyo:

Here's Shanghai:

Here's London:

Iran Nuclear Issue As An Oil Price Mover Has Been Postponed

2009-10-02T16:46:00.003+09:00

It looks like the Iran nuclear stand-off as an oil price mover has been pushed out a few weeks. I wrote on Tuesday that the risk of military action against Iran by either the US, Israel, or both is growing, and that such action would cause oil prices to spike.

The Geneva talks concluded yesterday. Iran will admit inspectors from the International Atomic Energy Agency (IAEA) to look at its previously secret enrichment facility near Qom by the middle of this month. While some are pointing to that as major progress, it's not too impressive when you consider that as a signatory to the Nuclear Nonproliferation Treaty (NPT) Iran was already obligated to allow such inspections.

Nonetheless, to get Iran to merely comply with the terms of the NPT that it signed, the P-5+1 nations (UN Security Council plus Germany) granted Iran the right to transfer low-enriched (about 4%) uranium to a third country for enrichment to the 20% level needed to make medical isotopes. That mixture will be shipped back to Iran for medical usage. Nuclear weapons require 90% enrichment levels, so the idea here is that the third party can guarantee that Iran is not using anything that would enable it to make a nuclear weapon.

Yet, the whole reason we came to this moment of truth is that Iran was not cooperating on inspections. Where's the guarantee that it will this time? Rather than having solved anything or put down any firm deadlines for progress, the talks appear to have just postponed the day of reckoning.

For countries far from the hot zone around Iran, ignoring the lack of real progress is a luxury that Israel does not share. It has said repeatedly that it can't survive a nuclear engagement of any kind because of its small size. It can't bear even a tiny risk of attack by nations that want it to disappear, so it cannot be as patient with Iran's maneuverings as other members of the UN can be. Thus, we need to see how Israel reacts to the situation. Remember, its decision to strike would cause Iran to disrupt shipping traffic in the Strait of Hormuz, thereby drawing in the US and bringing about the oil price spike previously discussed.

The granting of full IAEA access for inspection was one of Israel's requirements. That part should make it happy for now. Whether it believes the validity of the results of the inspections for a variety of reasons, such as whether Iran really showed all of its facilities, is another matter.

It all comes down to how Israel reacts. So far, it has said nothing, and that's worrisome. It might be willing to give diplomacy a chance, but probably not much of one.

You Call This Good News?

2009-10-01T18:59:00.001+09:00

The International Monetary Fund updated its Global Financial Stability Report yesterday. I received a barrage of emails from analyst cohorts telling me about the green lights provided by the report. I dove in, and came away with less an impression of green lights than a slight flickering of the red from being lit up so brightly for so long. I'll go through some highlights with you, and let you make up your own mind.

The GFSR thinks overall financial sector losses are less than it expected six months ago, but still staggering. "For both banks and other financial institutions, the GFSR calculates that actual and potential writedowns from bad assets such as loans and securities have fallen by some $600 billion over the past six months -- from about $4 trillion to $3.4 trillion, as a lessening in financial stress has narrowed spreads." When was the last time writedowns of $3.4 trillion were considered a pop-the-champagne moment in your experience? It expects US banks to lead the debtors list by incurring about $1 trillion of that sum.

It estimates that commercial banks have already written off $1.3 trillion so far in 2009, but still have another $1.5 trillion to go. In other words, we're not even halfway through this collapsing card house yet!

From the report: "Even though bank earnings are recovering, they are not expected to be big enough to offset fully the anticipated writedowns over the next 18 months. The insufficient earnings, combined with continuing deleveraging pressure, means banks will have to raise more capital." You think? Anybody running a spreadsheet through this crisis has been aware of that for about eighteen months, and wondering what all the stock market excitement has been about.

Despite being only halfway done, "Many private sector financial risks were transferred to the public sector during government rescue operations, leaving the governments vulnerable to future shocks. Countries with high debt-to-GDP ratios and large contingent liabilities (such as bank asset or liability guarantees) are particularly vulnerable." In other words, the United States. This means that if we do see a double-dip, there isn't a whole lot more left in the government tank to stimulate the economy into another false bubble. On the next leg down, we shouldn't expect another liquidity rescue like we got last time.

Those saying that the crisis is over and the economy on the mend will enjoy this next part: "Although banks' balance sheets have been stabilized, some of it because governments have injected capital, banks are not yet in a strong position to lend support to the economic recovery." No kidding, and maybe that's why we haven't seen lending tick up yet. Trillions into the black holes of banking, nothing out, sounds like just the recipe that created a two-decade recession in Japan -- so far.

If that's what passes for good news these days, brace yourself for the bad.

Cautious Commentary

2009-09-30T18:20:00.003+09:00

Today's reading is a collection of excerpts suggesting caution.

Doug Kass:

Despite the strong share price momentum and the aforementioned emerging optimistic economic/profit consensus, I continue to hold on to the variant view that the markets have likely peaked for the year based on the existence of nontraditional headwinds, an end to decades of aggressive credit expansion and financial inventiveness, a still-vulnerable housing recovery (in the form of outsized phantom inventory challenges) and a still-fragile consumer -- among other factors.

Full article here.

Ambrose Evans-Pritchard:

If you look at the sheer scale of global stimulus this year, what shocks is how little has been achieved. China's exports were down 23pc in August; Japan's were down 36pc; industrial production has dropped by 23pc in Japan, 18pc in Italy, 17pc in Germany, 13pc in France and Russia and 11pc in the US. Call this a "V-shaped" recovery if you want. Markets are pricing in economic growth that is not occurring.

Full article here.

Financial Times:

Banks round the world have still to reveal about half of their likely losses resulting from the financial and economic crisis, the International Monetary Fund said on Wednesday, warning that there was still a "significant" risk of another downward lurch in the global recession.

The IMF described credit risks as remaining "elevated" even though financial conditions have improved significantly since spring.

It said these risks, alongside weakened banks, were likely to depress the availability of new credit and damp the global economic recovery unless significant additional capital was raised to improve the health and lending capability of banking systems.

Full article here.

Finally, check out the bullish percent index for the Dow:

Risk Of An Oil Price Spike

2009-09-29T18:36:00.001+09:00

The biggest risk of higher oil prices looks to be the latest storm brewing in the Middle East. Our contention has been that oil prices are destined to slip back to their pre-stock-bounce range once economic reality sets in and demand remains persistently low. To that end, we own a hedge against falling oil prices.

However, the likelihood of military action against Iran by either the US, Israel, or both is growing, and such action would cause oil prices to spike. Let's look at the situation and chance of an attack, and why it would put upward pressure on oil prices.

In April, the Obama administration granted Iran until Sept. 24 to open talks with the five members of the UN Security Council plus Germany, a group referred to as P-5+1. The consequence of not doing so was to be harsh sanctions. Since then, Obama extended a fig leaf to the Islamic world with his friendly speech in Cairo, the appointments of special envoys George Mitchell for Israel/Palestine and Richard Holbrooke for Afghanistan/Pakistan, and soft-edged diplomacy intended to reverse harsh feelings left over from the Bush years.

The result of the fig leaf has been impressive when judged by the content of warm speeches all around, but not so great when judged by the list of concrete steps to improve upon America's interests in the region. Terrorist activity has not declined, Mitchell was unable to change the situation between Israel and the Palestinians on the settlement issue, Holbrooke hasn't improved the Afghanistan War situation at all, and, most vital to our discussion, Iran hasn't budged in its nuclear ambitions or even attitude toward the US and the P-5+1. It's now past the Sept. 24 deadline, and the situation technically calls for sanctions to be applied. Will they be?

Apparently not right away, because the talks have been rescheduled to start this Thursday, October 1. Few are holding their breath for the talks to mean anything, anyway, so attention is already turning to what will happen when Iran changes nothing.

If the sanctions are applied, they need the cooperation of China and Russia in order to work. Either country could supply Iran with all the fuel it needs, and both countries have expressed their disapproval of the sanctions. So, the sanctions are looking like a joke.

That leaves an attack as the most probable way of thwarting Iran's nuclear plans. It would likely involve both the US and Israel, because either country's initial entry into a fight with Iran would draw the other in. Israel can't go it alone against Iran and the US won't let Israel come out of a conflict worse off.

Besides, the first thing Iran would do in case of being attacked is close the Strait of Hormuz, which would bring the US immediately into the fight. In July, Iran's oil minister issued the threat and received the US response, as reported by Fox:

The US Navy and its Gulf allies will not allow Iran to seal off the strategic Strait of Hormuz if the country is attacked, the commander of US naval forces in the Gulf said Wednesday.

The warning comes as Iran's oil minister vows that any attack on his country by the United States or Israel would provoke an unimaginably fierce response.

The announcement by Vice Adm. Kevin Cosgriff, commander of the 5th Fleet, came as he was holding talks with naval commanders of Gulf countries at a conference in the United Arab Emirates capital of Abu Dhabi. The one-day meeting was to focus on the region's maritime and trade-route security and the threat of terrorism.

The 5th Fleet is based in Bahrain, across the Gulf from Iran. Cosgriff said that if Iran choked off the Strait of Hormuz, it would be "saying to the world that 40% of oil is now held hostage by a single country."

"We will not allow Iran to close it," he told reporters.

Cosgriff's comments follow Iranian threats that it could seal off the key passageway in case of a Western attack on Tehran. But Cosgriff said that if Iran moved to choke off Hormuz, the "international community would find its voice rapidly" against Iran.

Here, we run up against the risk of an oil price spike. Whenever 40% of the world's oil supply is perceived to be held hostage, prices will spike.

That's where we may be heading. Yesterday, Iran test-fired missiles that it claims can hit any regional target. That came on the heels of the US and its allies expressing concern that not only has Iran not slowed down its nuclear ambitions, but has in fact grown them by building a second uranium enrichment facility.

There is always the option of doing nothing, but that would make the US look unbelievably weak to sit by idly while Iran makes nuclear weapons. It would also force Israel to go it alone, which would cause Iran to close the Strait of Hormuz, which would draw the US into the fight anyway. Doing nothing would be about the worst option because the US would look weak and still end up in another military action.

Thus, as Iran moves ahead, the options before the US are sanctions that won't work, a military strike that will result in the Strait of Hormuz closing for a brief period, or doing nothing until forced into joining an Israeli military strike that causes the closing of the Strait of Hormuz for a while.

As you can see, the odds are pretty good that we'll see the Strait of Hormuz close in the near future, which will send oil prices higher. That's why we're watching this issue carefully, and may need to sell our oil hedge soon.

Disclosure: Long PowerShares DB Crude Oil Double Short (DTO)

Keep An Eye On Revenue

2009-09-28T18:29:00.002+09:00

Today's article comes courtesy of frequent contributor Dave Van Knapp. His site, SensibleStocks.com, is chock full of clear-headed ways to pick stocks and explains the oft-unappreciated role of dividends. You may find it useful to compare his market ideas in today's article with those he shared here on September 1, in Why The Rally Has Been Sustained.

Topped Out?

by Dave Van Knapp
SensibleStocks.com

As the market was plunging from October 2007 until March 2009, I ran occasional articles, usually titled Are We There Yet? The question, of course, was whether the bear market was over -- was it safe to come out of the woods and invest cash in the stock market again? A couple of these articles correctly identified false starts late last year as failing to demonstrate the end of the bear market. Finally, the bear market ended on March 9, 2009, replaced by a direct reversal and a strong bull market.

Now that bull market has lasted for more than six months and raised the S&P 500 by more than 50%. Some people are getting nervous about it. Is it sustainable? Therefore, I am going to write occasional articles asking the old question in reverse: Has the market topped out? Is it time to take some profits off the table, or to go completely back into the woods where the bears hang out? This is the first of those articles.

Frequent readers know that I already have my exit strategy in place for my public Capital Appreciation Portfolio. There are three holdings there: SPY (the ETF that tracks the S&P 500); QQQQ (the ETF that tracks the NASDAQ); and IBM, the only individual company. The first two holdings -- SPY and QQQQ -- are protected by 8% trailing sell-stops. I update the stops each weekend, sometimes in the middle of the week if the market makes a significant one-day jump. I have a 10% trailing sell-stop under IBM.

That's my approach to controlling risk. Others may be protecting their profits with hedging strategies, or by using sell-stops placed at different values...5%, 10%, the 20-day simple moving average (SMA), the 50-day SMA, or "support" lines they have drawn on a chart. There are an infinite number of ways to select the level of a sell-stop.

However you are protecting your profits, these occasional Topped Out? articles will be asking a different question: Are we back in a bear market? I will let that term be vaguely defined for now. Let's just say that I am asking whether we have entered a period where the market is likely to decline by 20% or more. That matches the rule-of-thumb definition of a bear market.

Of course, by definition, no one knows the future. So these articles will necessarily consist of conjecture. But I will base my conjecture on facts and sound reasoning to the best of my ability.

I have stated many times that this has been a sentiment-driven bull market. While it has been more powerful than most, in many ways it is a garden-variety recession bull. Of the previous nine recessions before the current one, the stock market has bottomed out and started back up several months in advance of the end of the recession. That's what has happened here since March. Why does that happen? Stock investors look forward -- the stock market is a leading indicator of the economy. So it often starts back up while the economy is still mired in recession, indeed while many elements of the recession are still getting worse.

But the market does not do that based on simple hope. I have coined the term "net news flow" to explain what positive-minded stock buyers have been reacting to during this bull market. They have been reacting to the so-called "green shoots"...signs that the economy might be pulling out of the recession. Early on (say, last March), most any sign that could be interpreted positively was a data point that was simply "less bad" than before. The perceived meaning of this was that the downward cycle of various indicators was slowing down and bottoming out -- a necessary precondition to the indicators actually turning back upward.

Currently, most indicators have slowed their descent significantly, some have clearly reached a trough, and some have turned upwards. For example the Conference Board's Index of Leading Economic Indicators has risen for four straight months. I track a few important indicators in my bi-weekly Timing Outlook reports.

One specific topic to end with: In the last earnings season, a majority of companies reported earnings that were "positive surprises," meaning they exceeded the consensus expectations of stock analysts. All of these positive surprises contributed greatly to the positive net news flow that helped the market along. In most cases, the quarterly reports did not reflect growing revenue or earnings compared to a year ago. They simply reflected better-than-expected earnings, which in most cases were well down from a year before. Most of those positive surprises were based on companies' fast cost-cutting, which meant layoffs and hiring freezes. That's why we have the high unemployment rate that we do right now.

However, it did not go unnoticed that, while earnings surprised positively, revenue often did not. Not only that, many companies' projections for revenue going forward were not encouraging. So here's my thought: Last earnings season was a "free pass" on the revenue front in terms of how forgiving the stock market was in interpreting the news. The market forgave revenue misses and rewarded earnings hits.

We have a new earnings season coming up in a couple of weeks. If many companies do not show sequential revenue jumps (that is, quarter-over-quarter), and/or do not project positive revenue expectations going forward, then positive earnings surprises will not be enough to count as "good news" this time around. This will not help the net news flow, will not add to positive investor sentiment, and may herald a new bear market.

The Long Malaise

2009-09-27T20:01:00.001+09:00

It's possible that stocks will not be worth their trouble for another many years. We could already be in a range that holds for so long that people simply move beyond stocks as a place they consider storing their money. The stock market could become a distant report for specialists only, much the way most people view esoteric investments like cattle futures. How much does the cattle report factor into the lives of most people you know?

It's already like that here in Japan. For the first five years of the lost decade of the 1990s, individual Japanese investors tried scooping up bargains on every minor bottom. The more nimble among them probably made a few yen in the bounces of 15% in autumn 1990, 40% from summer 1992 to summer 1993, 48% from summer 1995 to summer 1996, and so on. Each was heralded as the start of a new bull market, all proved false. The three bounces just mentioned were followed by respective drops of 45%, 21% then a spike followed by another 32%, and 43%. After eight years of fighting it out in the trenches, most stock investors saw their accounts worth less than half what they had been at the end of the initial drop.

Small wonder, then, that people gradually packed up and left. That was 11 years ago, and the Japanese stock market trades today at a level 20% lower than it did at the end of that example. When the news of plunging markets covered papers, magazines, and websites last year, few in Japan cared. Why would they? They hadn't had money in stocks for more than a decade and don't plan to ever put any in again. If anything, last year's headlines just confirmed that they'd made the right decision. "Gambling is fun," one engineer told me, "but it's not the right way to plan for the future."

Such a sentiment could take hold in America, too. The same factors that killed Japan's equity market are present. Banks blew up, government screwed citizens to bail out banks but didn't bail them out enough to actually get things moving again, the unresolved bank debt was moved from banks to the country's balance sheet and an increasing portion of tax revenue was siphoned off to service that debt, so a new normal took hold with a lower rate of growth and a much less enthusiastic population, most of whom never really understood what the hell happened. How did life go from golden bathtubs to goldfish for dinner because of some banker's mistake? It did, though, and it's happening in America, too.

During the savings and loan scandal of the late 1980s, a regulator named William K. Black exposed government connections to bank fraud when he accused then-house speaker Jim Wright and five US senators, including John Glenn and John McCain, of doing favors for the S&Ls in exchange for political contributions. Black wrote a book about the experience, aptly titled "The Best Way to Rob a Bank Is to Own One." Last April, he appeared on Bill Moyers Journal to discuss the subprime mortgage crisis. Among his many excellent observations, the following comment caught my attention:

In the savings and loan debacle, we developed excellent ways for dealing with the frauds, and for dealing with the failed institutions. And for 15 years after the savings and loan crisis -- didn't matter which party was in power -- the US Treasury Secretary would fly over to Tokyo and tell the Japanese, "You ought to do things the way we did in the savings and loan crisis, because it worked really well. Instead you're covering up the bank losses because, you know, you say you need confidence. And so, we have to lie to the people to create confidence. And it doesn't work. You will cause your recession to continue and continue." The Japanese call it the lost decade. That was the result. So, now we get in trouble, and what do we do? We adopt the Japanese approach of lying about the assets.

Yes, the bad assets are still there. The citizens of the United States unwillingly ponied up a national fortune via government's big bank connections such as former Goldmanoid Hank Paulson serving as Bush's Treasury Secretary. The Obama administration has employed many of the same people with banking industry connections, so the only thing that has changed is the name on the White House -- which matters little because it changes every four or eight years but the industry interests that control Washington never change. We have made a permanent growth impediment out of the ungodly sum of debt created by bank fraud. It is hanging over the United States the same way it has hung over Japan for two decades. The difference is, we're less than a year into our overhang.

This is treated as last year's story, but it's not. It's this year's story and, I'm afraid, next year's and the year's after that and so on possibly for a long enough time to remove stocks from the list of financial options in the mind of most individual investors. The problem is that few people ever grasped what had happened even when it was the hot news of the day. Now that it's already labelled history, fewer still will keep track of the long-term effects or why things just aren't quite as good as they used to be. As they say in Japan, "How long does a recession have to last before we stop calling it a recession and just call it the economy?"

Japan, too, had its periods of improvement over the last two decades. There were moments of good-times-are-here-again hope with this economic data growing more than expected, this company beating estimates, that bank getting squeaky clean, and so on. Overall, though, it's been a down trend across the board. The good news is that people adjusted. What else can you do when the new normal isn't just a slogan but is actually the new normal? If it's normal, you'd better get used to it, so that's what people did. People will do so in the US, too, but that doesn't necessarily mean good things for stocks.

You have every right to be angry. This is the biggest failure of American leadership we've seen in our lifetimes, though few see it that way yet. This is the culmination of a growing corporate ownership of America that began after World War II and spun out of control. About one-third of US tax revenues go toward a defense establishment strong enough to wipe out the Third Reich, but impotent against a bunch of box-cutter-carrying terrorists from our oil ally, Saudi Arabia. Our response? Launch an unrelated war in Iraq that's slated to cost $3 trillion before it winds down -- and it won't wind down until the new war in Afghanistan ramps up.

Even Robert Gates, Director of Central Intelligence under the first President Bush and Secretary of Defense under both the second President Bush and President Obama, pointed out the need for a more reasonable defense budget when he wrote last January, "As much as the US Navy has shrunk since the end of the Cold War, for example, in terms of tonnage, its battle fleet is still larger than the next 13 navies combined -- and 11 of those 13 navies are US allies or partners."

This is not a political discussion, it's an economic discussion. Notice how much of the opposition to health care reform has centered around the inability of the country to afford it. Why is there never such consideration for military expenditures? It's the same Treasury paying, and the same Treasury paying off banksters, too. There's an endless supply of money for meaningless wars and bank heists, but not enough for health care. You know how much the proposed health care reform would cost? About $100 billion per year for ten years. You know how much Paulson's Troubled Asset Relief Program (TARP) cost? $700 billion. Poof! Just like that, the banks got the dough. For health care's smaller cost, angry mobs turned up at town hall meetings to scream "socialism" at the very idea.

Is the country heading for bankruptcy? It sure looks that way. Is it because of social spending? No. It's not really because of military spending per se, either. The country is heading for bankruptcy because corporations control government and the nation's treasure is redirected to where it most benefits corporations, not citizens. Government military spending helps corporations because they want to sell the most expensive weapons systems to government. Government health care spending hurts corporations because it reduces profits at private insurers and lowers the price people pay for medicine and equipment. Lobbying by corporate interests in both cases has garnered more government military spending and less government health care spending. In these and other cases, corporations win and citizens lose.

This is not a discussion about the military or health care, though. It's a discussion about America's culture of corporate control. The same way government is manipulated to benefit corporations in those two sectors, it is also manipulated in the banking sector. There, the culture of corporate control has finally gone too far and made public the private debt disaster that bankers created. That overhang will crimp stocks for years.

Coming back to Japan, one reason people got tired of stocks is that none of the usual ways of analyzing them made sense anymore. It became a guessing game of what stimulus would come from government next, when it would peter out, what new shenanigan banks would try to prop up their balance sheets and how many people it would fool, when that would peter out, and so on. Gambling, indeed. Fundamentals? Please. Cash from government to banks to pour into the stocks they own to drive up those prices so the stocks could be dumped at a profit looks to the casual observer like a rigged game. Once the public sees the stock game as being rigged, it starts to pull out and leave the game to the big guys with government connections. Stock markets began as a way for companies to get financing to grow their business ideas. That's not what they are anymore. They're a competition of connections. If you have as many family members working at the Treasury as Goldman Sachs has, then you might just stand a fighting chance. If not, maybe other assets will prove better for you.

Are we there yet? No, and there's a chance the US will pull out of this funk the way it pulled out of the 1970s. For that, though, it took the vision and strength of Ronald Reagan. As popular as Obama may be, he's no Reagan. His first half-year in office has proved that, and his dropping poll numbers betray that even the political babes who fell for the hope gambit have realized that nothing's any different. Those who've been around longer knew from the get-go that the same people who ran things at the beginning of January would still be in charge at the end of January, and so it was. Having a Sunday morning celebrity for a president is good fun, but doesn't get much done.

Edward Lucas wrote in the Telegraph last Sunday:

Mr. Obama has tactics a plenty -- calm and patient engagement with unpleasant regimes, finding common interests, appealing to shared values -- but where is the strategy? What, exactly, did 'Change you can believe in' -- the hallmark slogan of his campaign -- actually mean? The President's domestic critics who accuse him of being the sinister wielder of a socialist master-plan are wide of the mark. The man who has run nothing more demanding than the Harvard Law Review is beginning to look out of his depth in the world's top job. His credibility is seeping away, and it will require concrete achievements rather than more soaring oratory to recover it.

Casholine On Equity Embers

2009-09-24T18:55:00.002+09:00

From last Sunday's Kelly Letter:

Cash is worthless with rates near zero, and there's a lot of cash out there needing somewhere to go after the many bailouts and injections into the banking system that have not been converted into new lending. Lots of money into the banks with none coming out indicates that banks have taken their free taxpayer money and put it into stocks, creating a self-fulfilling balance sheet improvement tactic. Toxicity on the accounting ledger has come down as stocks have gone up.

That's one way of saying that liquidity is driving the current market, lots of government liquidity. Gluskin Sheff's David Rosenberg, however, wrote on Friday that such talk "is usually a catch-all phrase for 'we have no clue' but it sounds good."

Apparently quite a few of us think it sounds good. For instance, Kopin Tan wrote in this weekend's Barron's, "Because the current rally is fueled not just by economic recovery but by the government-induced reflation of balance sheets, Michael Hartnett, Merrill Lynch's chief global equity strategist, thinks the risk of correction lies not with the widely feared double-dip recession, but with the withdrawal of monetary easing."

Add to that the following from Steven Pearlstein's column yesterday in The Washington Post:

So who is borrowing [all the money printed by the Fed]? By and large, it's not households and businesses, which are reluctant to borrow during a recession. Rather, it's hedge funds and other investors, who have been using the money to buy stocks, corporate bonds and commodities, driving prices to levels unsupported by the business and economic fundamentals.

The excess liquidity is even being used to finance a new "carry trade" in which global investors borrow at U.S. rates and buy government bonds in places like Australia, where prevailing rates are higher. Because the carry trade involves exchanging dollars for foreign currencies, it has been a major contributor to the recent decline in the dollar.

Naturally, this has been a blessing for Wall Street's biggest banks, whose trading desks have not only made big money executing and financing the investment strategies of others, but have also been trading actively for their own accounts. And with bubble profits come bubble bonuses.

Back at the Fed, the attitude has been to welcome anything that strengthens the balance sheets of banks, particularly while they continue to write off billions of dollars in soured loans each quarter. Nor is the central bank in any rush to begin pulling back from its current policies. Citing the mistakes made by their predecessors during the Great Depression and by the Bank of Japan during the "lost decade" of the 1990s, Fed officials are determined not to snuff out the economic recovery by moving too early to raise interest rates and reduce liquidity.

Rosenberg: Valuation Still Matters

2009-09-22T21:32:00.001+09:00

Gluskin Sheff's David Rosenberg on the market's overvaluation, sent to clients last Friday:

On one-year forward (operating) earning estimates, the P/E ratio is now 15.7x, the highest it has been in nearly five years. At the peak of the S&P 500 in the last cycle -- October 2007 -- the forward P/E was 14.3x, and the highest it ever got in the last cycle was 15.4x. So hello? In just six short months, we have managed to take the multiple above the peak of the last cycle when the economic expansion was five years old, not five weeks old (and we may be a tad charitable on that assessment).

As an aside, the forward multiple on the eve of the 1987 stock market collapse was 14x and one of the explanations for the steep correction was that equities were so overvalued and overbought that it was vulnerable to any shock (in that case, it came out of the US dollar market). It certainly was not the economy because that sharp 30% slide took place even with an economy that was humming along at a 4.5% clip.

In other words, valuation may not be the best timing device, but it still matters. If the S&P 500 was in a 700-750 range, de facto pricing in zero to 1% real GDP growth, we would certainly be interested in boosting our allocations towards equities. But at 1,060 and over 4.0% GDP growth effectively being discounted, we will be spectators as opposed to participants, understanding that the key to success is to NOT buy at the peaks.

So the strategy is to sit on the sidelines, be selective in our equity choices, and wait for the correction to come or for the fundamentals to catch up with this overvalued, overbought, overextended market. Remember, the reason why the tortoise won the race was because the hare got tired.

Economic Reality in Japan

2009-09-14T15:16:00.001+09:00

How about some news from the front lines of Japan's economic slump?

A new, young face recently showed up at one of my favorite restaurants in Sano, where I live. She waited on me a few times and the last time I asked her name and if she was a student. "Yes," she replied. "I'm 15, a high school student." That made sense, as I'd seen her only in the evening at the restaurant, never during lunch time.

"What clubs or teams are you on?" I asked.

"None."

That's unusual. Most students in Japan can't find enough hours in the day for their studying and many club and team memberships. "Why's that?" I asked.

"Because I'm working this job at night. I come here right after school."

"Are you saving to buy something?"

"No. I'm helping my family."

Her father lost his factory job and spends his days down at the government employment office, in line with former co-workers. The rest of the family members are doing what they can to help keep the lights on and the water running. For the first time in a long time, I wished the culture would allow me to tip somebody. Instead I told her she was a fine daughter, which made her smile.

That's how well the recovery is going here.

Gundlach: "You've made 90% of the money you're gonna make in this rally"

2009-09-11T18:12:00.003+09:00

TCW Group Chief Investment Officer Jeffrey Gundlach said at a June 2007 Morningstar conference, "The subprime market is a total unmitigated disaster and it's going to get worse. The delinquency rate is still climbing. At the same time, the ability of people to refinance is also going down. It's just not a very attractive situation." The S&P 500 traded at 1,500 back then.

On Wednesday, in a conference call titled Too Good to Be True, Gundlach said of the current market that it was about to lose momentum, and advised selling on strength when the S&P 500 is over 1,000.

"You've made 90% of the money you're gonna make in this rally," he said. He thinks much of the economic data that people are calling green shoots is just the temporary result of unsustainable government spending. "We're basically borrowing money and calling it economic growth. It's not real economic activity."

About the much-praised Cash-for-Clunkers program, he said, "Deflation is so strong that you can't even sell cars unless you slash prices 20% through government subsidies." He also thinks commodity deflation lies dead ahead, saying that "a turning point is close at hand in these markets."

He's also worried about debt defaults: "We're standing on the edge of a major default wave. Defaults are the elimination of dollars. You could eliminate so much actual wealth that this could be the source of a strong dollar rally."

To see the slides of his presentation in PDF format, click here.

Consumers Still Retrenching

2009-09-09T18:24:00.003+09:00

It was always said that come what may, you can count on U.S. consumers. Not these days. For nearly 20 years, consumer spending has outpaced income growth in America. Credit everywhere they turned, the wealth effect of the dot com stock market, and then the ATM-like appeal of rising house prices was enough to make the word "budget" foreign to most Americans. Shop 'til you drop was the rallying cry from coast to coast.

Too bad they did just that. We haven't seen this many dropped consumer corpses in the aisles since John Steinbeck was the contemporary chronicler of American culture.

The current financial crisis and attendant economy that grows nothing but joblessness has kicked consumers in the teeth. Finally giving up on government to limit the gimmicks of financial firms, households have ignored Washington's efforts to get the binge going again. Instead, Joe Sixpack and his wife are giving the finger to Goldman Sachs, the Treasury, and the Fed and taking care of some toxic assets closer to home. Yes, household balance sheets are getting fixed. People are buying less and saving more, which is catastrophic to the debt-based economy built by government, banks, and big business over the past fifty years or so. A full 70% of the economy depends on Joe buying trifles he doesn't need to keep trifle manufacturers in business so they can contribute to campaigns and lobbying efforts.

What's good for Joe, then, ain't good for the economy. At least not the fraud that the modern economy has become. Wall Street profits come from selling a lot of trifles, and if Joe ain't buying, earnings won't grow. The question then becomes: Is Joe buying?

Nope.

Consumer credit fell at an annual rate of 10.4% in July, erasing a record $21.5 billion. Revolving debt like that on credit cards dropped 8%, while non-revolving debt like auto loans dropped 11.7%. Those came to dollar amounts of $6.1 billion and $15.4 billion respectively. As of July, consumer credit has been shrinking for six months in a row.

Good for you, Joe! Keep up the good work. Cut up those credit cards and start paying cash. Read fine print. Don't borrow. Save. Send the government, bank, and big business scum back to the drawing board to figure out some new way to suck cash out of a different generation of suckers.

As for the economy, don't worry. Green shoots, remember? We'll do just fine on 30% firepower. Hey, it's better than nothing and in these new happy times, better than nothing is the same as fantastic.

Bill Gross On The New Normal

2009-09-08T19:14:00.003+09:00

From PIMCO Managing Director Bill Gross's September Investment Outlook:

It's time to recognize that things have changed and that they will continue to change for the next -- yes, the next 10 years and maybe even the next 20 years. We are heading into what we call the New Normal, which is a period of time in which economies grow very slowly as opposed to growing like weeds, the way children do; in which profits are relatively static; in which the government plays a significant role in terms of deficits and reregulation and control of the economy; in which the consumer stops shopping until he drops and begins, as they do in Japan (to be a little ghoulish), starts saving to the grave.

I could go on, reintroducing the negatives of an aging boomer society not just in the US, but worldwide. Increased health care may be GDP positive, but it's only a plus from a "broken window" point of view. Far better to have a younger, healthier society than to spend trillions fixing up an aging, increasingly overweight and diabetic one. . . . Our world, and the world's world, is changing significantly, leading to slower growth accompanied by a redefined public/private partnership.

Overspending, Not Credit Card Fine Print, Is The Problem

2009-09-03T18:00:00.004+09:00

Here's Megan McArdle at The Atlantic responding to an interview up with Nick Gillespie of Reason on the proposed Consumer Financial Protection Agency:

A consumer financial protection agency is not going to do much to help consumers. It is true that people don't always understand all the terms in their credit card contracts or mortgages.

The problem is, it is almost never the tricky hidden terms of those loans that get people into trouble. People get into trouble because hyperbolic discounting, or an insurmountable crisis, leads them to borrow more money than they can reasonably pay back. By the time a 5% increase in your credit card interest rate spells financial ruin, you've been in deep trouble for several years.

So if the CFPA confines itself to ensuring full disclosure, this will not much help consumers, because the terms that matter are already disclosed, i.e. that you are borrowing money and will have to pay it back with a high rate of interest.

Too many people look for somebody to blame for their inability to control their own spending. Yes, credit cards and banks maintain usurious policies to snag the unsuspecting. So, don't be unsuspecting. Get a no-fee card, limit your spending, and pay the full balance each month. If you do that, you get an interest-free loan each billing cycle, and the joke's on the bank.

Japan Still in Pain

2009-09-02T17:27:00.003+09:00

I wrote here a month ago that Japanese were wondering where talk of recovery was coming from. Japan had just reported its highest unemployment rate in six years at 5.4%, and its total number of jobless at 3.5 million. Credit Suisse Japan chief economist Hiromichi Shirakawa said, "Employment conditions are taking a turn for the worse."

A month later, they still are.

The unemployment rate reported last week rose to 5.7%, well above the 5.5% expected and, more to the point, the highest it's ever been. The total number of jobless is now 3.6 million. The ratio of job offers to job seekers fell to an all-time low of 0.42 in July, meaning every 100 job seekers must fight over just 42 offers. Fear of deflation persists, as consumer prices slipped 2.2% in July from the year prior, on top of a 1.7% dip in June. As in the US, Japan's families are cutting back. Average household spending in July declined 2% from a year earlier.

Toyota is slashing production capacity, and Japan Airlines is laying off 10% of its workforce. Companies in every sector are reducing hours worked per week, forcing many employees to find part-time jobs to support their families.

Unfortunately, forecasts for Japan's unemployment rate call for it to keep rising for some time yet. Barclays Capital in Tokyo, for instance, sees it reaching 5.9% in the first half of 2010.

The situation is eerily familiar to older Japanese. These conditions, particularly deflation, are what crippled the Japanese economy during the "lost decade" of the 1990s. As we close in on Japan having been in recession for 20 years, talk on the street is that it's silly to call it a recession anymore. It's just the way the economy is. The aberration isn't what people are calling bad times; the aberration was what they called good times.

"We see consumption as a major concern for the Japanese economy," said Chiwoong Lee, an economist at Goldman Sachs in Tokyo. "[Friday]'s labor market release revealed worse unemployment ... than the market expected ... and wages remain on a downtrend."

Daisuke Uno, chief strategist in Tokyo at Sumitomo Mitsui Banking Corp., isn't optimistic, either. "Jobs data and prices continue to deteriorate, indicating the economy has yet to hit the bottom," he said.

That's one reason Japan made a rare show of unity in "throwing the bums out" of political office last week. Almost 70% voter turnout -- the highest since the current electoral process took effect in 1996 -- put 308 of the Lower House's 480 seats under members of the Democratic Party of Japan (DPJ). Only 241 were needed for a simple majority, obviously, making this a notable landslide. It marks the first time since 1955 that the Liberal Democratic Party (LDP) has not controlled Tokyo.

The DPJ plans to work quickly with its army of new and young faces to restructure the government's economic stimulus package, and create a new policy writing board called the National Strategy Office to go through Japan's budget and re-set policies.

I like to consult with older people to see what to expect. The ones I spoke with said, "Not much." To them it looks like just another way of saying that change is coming, which has been said dozens of times over the past few decades, but nobody in office has any real power.

The last time Japan was this excited about its government was when Junichiro Koizumi became prime minister in 2001. His flowing hair and maverick ways were sure to shake up the system, went the refrain. Then, in 2005, he led his LDP party to one of the biggest majorities in recent Japanese history. Great! So, what came of it all?

A change in uniforms at the post office. Really.

The privatization of the nation's post office and its huge postal savings system was supposed to inject $3 trillion of private capital into the economy and get things moving again. To see how that went, re-read the first part of this article. Stamps cost the same, the post offices are all in the same places, the same people work at them, letters arrive as before, but instead of being called Japan Post it's now called Japan Post Holdings and abbreviated JP on signs and uniforms. Oh, and customers can now transfer assets from the post office to private banks at the ATM. Other than that, life goes on as before.

Just as in America, corporate interests are the real leaders. Elections and politicians are mainly for show so the electorate can get riled up over something, but those who fund politicians and pull their strings don't care who's name is on the door as long as he or she can vote, sign, and stamp as needed. As with Obama's enthusiastic base of six months ago that's already abandoned him once he turned out to be like his predecessors, so it will go with this supposedly significant election in Japan.

What do the old people here say about that? Something along the lines of, "Oh well, it's just about time for our lovely autumn colors. Where shall we view them this year?"

Figuring that out is a much better use of time than projecting what difference the DPJ will make.

Why The Rally Has Been Sustained

2009-09-01T17:53:00.004+09:00

Today's article comes courtesy of frequent contributor Dave Van Knapp. His site, SensibleStocks.com, is chock full of clear-headed ways to pick stocks and explains the oft-unappreciated role of dividends.

Why The Rally Has Been Sustained

by Dave Van Knapp
SensibleStocks.com

This article is a follow-up to my article, This Rally Is Sustainable, published in Jason's column on June 2, 2009. At that time, the market rally was almost three months old and the S&P 500 had risen from its March 9 closing low of 677 to 943, or 39%. It is fair to say that most commentators thought the rally was unjustified -- claiming it had no fundamentals to support it -- and that a backwards slide, or even a crash ("retest of the March lows") was both inevitable and probably imminent.

That's not what happened. Almost three more months have passed, and the index stands at 1029, or 9% higher, for a total gain of 52%. The rate of ascent has slowed, but overall the rally has been remarkably consistent: +9% in March, +9% in April, +5% in May, flat in June, +8% in July, and +4% in August. If you define "correction" as a 10% pullback, there has been no correction along the way.

The case I made for the sustainability of the rally has held up. Basically, I suggested that, (1) the stock market tends to rally significantly a few months before the ends of recessions, and, (2) various news items and data points could be interpreted by reasonable people as demonstrating that the recession was ending.

I'd like specifically to address those who say the rally is unsupported by fundamentals. I believe that this rally has been fully supported by fundamentals, although I suspect many will disagree with how I define "fundamentals." Here is my reasoning in three easy steps:

First, too many investors, while recognizing that both the stock market and the economy run in cycles, believe that the cycles are concurrent. That is, they think that the stock market's value and economic fundamental values are always directly proportionate. They are not. There are often stretches when the market's cycle and the economic cycle are out of phase. That has been consistently true in recessions. In eight of the last nine recessions, the stock market has anticipated the end of the recession by an average of about six months. The market displays its anticipation by going up. I simply postulated that this time it would happen again. It has, making it now nine out of the last ten recessions that the market has made a significant increase during the recession.

Second, then it is reasonable to define fundamental economic metrics as "improving" if they are getting worse at a slowing rate. Such fundamental economic measures as the GDP, employment rate, consumer confidence, the Conference Board's LEI (Index of Leading Economic Indicators), reports from ISM (Institute for Supply Management), housing prices, credit availability, and the like, do not have to be actually going up to be "improving." They may still be dropping toward their eventual trough -- the economy may still be contracting -- but the important observation is that the rate of contraction is slowing. If that is happening, then you can reasonably infer that the recession is in fact reaching its late stages. By definition from the National Bureau of Economic (NBER), which has quasi-official status in such matters, a recession ends when the economy stops contracting.

Third, what I call the "net news flow" has been kicking out many data points for months now that economic fundamentals were in fact getting worse at a slowing rate. In the past couple of months, a few of the fundamental economic measures have reached individual inflection points and actually started to rise. For example, the LEI have been going up for four months. More recently, housing prices (as measured by the Case-Shiller Index) have stopped falling and are rising in some metropolitan areas. Of course, the news is often lumpy and seemingly contradictory. That's life and is why I call it "net news flow." The point is that the "average" of all the economic news, taken as a whole, has been going in the right direction since this rally started.

That is why I believe that this rally has been fully supported by economic fundamentals. As you can guess, I disagree with the critics of "green shoots." The market runs on investor sentiment. It is the green shoots that have fueled this rally, giving hope to investors who have bid up stock prices in the belief that the economy first pulled back from the abyss and will begin getting better soon.

I invested based on this reasoning. I maintain a publicly published Capital Gains Portfolio, a demonstration portfolio for purchasers of my book, Sensible Stock Investing, that is also available for free viewing by the curious. The portfolio was entirely in cash for many months before this rally began. But in April, I began cautiously purchasing into the rally, mostly through a series of purchases of SPY (SPDRS, an ETF that tracks the S&P 500). At the time of the earlier article in June, the portfolio was 52% invested. Last week, I made my final purchase. The portfolio is now 100% invested.

In addition to the cautious, gradual re-entry into the market, I've helped manage risk by using tight 8% trailing sell-stops. None of the stops has been hit. All positions are in positive territory. Because of the gradual investments, the portfolio's performance this year is a bit behind the S&P 500's. That's OK. Because the portfolio was in cash for so long, it did not suffer from much of the crash that preceded the rally, so overall the portfolio is way ahead of the S&P 500 benchmark index since its inception. Risk management is very important; it helps you avoid "sucker's rallies," "dead-cat bounces," and just plain being wrong.

Where is the market going from here? I haven't given that much thought, to be honest. Now that I am fully invested (no new money goes into the portfolio other than dividends it generates), I have no more decisions to make for a while. My exit strategy is already in place via the sell-stops. Sure, I may play with the stops (tighten them, loosen them, or use a moving average rather than a flat percentage to set them), but I do not need to anticipate the market's next major move. Past readers of my articles may recall that I believe in "waiting for the turn" anyway.

That said, I think that strong arguments can be made for at least three scenarios:

The market will make a correction (that is, contract by more than 10%), then resume its expansion if the news warrants it.
The rally will continue for some more time, without a correction, anywhere from a few weeks to many months, depending on the news flow.
The rally will end and the market will reverse and begin to contract. This is what I think will happen if/when the net news flow turns negative. So if, as many believe, we are in for a double-dip recession, signs of that will show up in the news flow, and the market (again leading the economy) will anticipate that and go backwards.

Thoughts from Justin Mamis

2009-08-31T22:55:00.004+09:00

Pointed out by Kelly Letter subscriber Brian, the cash to assets ratio of equity funds has fallen to almost 4%. That's down from 5.1% in May, 4.4% in June, and 4.2% in July, according to the Investment Company Institute.

Brian was prompted to look into the current data after reading Justin Mamis' When to Sell, from which I share the following:

The Unites States itself has already become, in a manner of speaking, a mature company; what used to be growth pains and then middle-aged aches, now shows bureaucratic signs of arthritis. Were it a common stock, one wonders who would buy "America" (ticker symbol: USA; earnings: negative; management: questionable; long-term debt: enormous; potential for bankruptcy: increasing) on the grounds that it still merited a growth stock's price/earnings ratio.

Not to sell, therefore, is perhaps the riskiest investment approach of all. Nevertheless, it is surprising how many naive investors still venture their capital on the assumption that there's indiscriminate growth ahead. As growth itself becomes a struggle -- and for every company that flourishes, scores of others have the market equivalent of Andy Warhol's "fifteen minutes of fame" -- it will be all the more difficult to pick the few companies that will survive with their earlier promise intact. It is far better and easier to learn to sell at the sensible time, a time predicated not so much on earnings growth as on the market's and the stock's "natural" fluctuations.

He wrote the first edition of that book in 1977 and updated it in 1994. The more things change, eh?

Health Care's Inevitable Reality

2009-08-28T18:59:00.003+09:00

From the Kelly Letter research stream comes just one point today.

Washington Times columnist Tony Blankley said at time mark 18:30 on KCRW's Left, Right & Center a week ago:

Here's the fundamental problem for anybody who wants to go down the path that the president seems to be wanting to go down, and that is that the CBO [Congressional Budget Office] scored the various Democratic bills all indicating that even with their plan, even including the public thing, that the long-term process was going to increase costs, not bend the cost curve backward.

The problem is that we can't afford to pay for everybody's health care in this country, and the only way that we can subsidize it is by rationing the subsidy. But nobody wants to do that, understandably, and so you're stuck. But you can't have an honest discussion because the honest discussion is, of course if 80 percent of the cost of health care comes in the last couple of years and you want to cut health care costs by 30 percent, it's going to be 30 percent of 80 percent that's going to go, and so the old people are going to get rationed. That's what happens in every system where there's a rationality as opposed to a market place. But nobody wants to admit that, so everyone's got to pretend that the untruth is truth.

There are $40 trillion in unfunded liabilities in Medicare. It's going bust!

It's unavoidable. We are going to keep going down this path until the system completely fails, and then we'll scramble. And the scramble will be that we can't afford to subsidize everybody's health care. That's the inevitable reality.

Coupled with U.S. debt already on its way to $20 trillion by 2020, it makes you wonder when the pinball machine will just tilt.

Kass and Housing

2009-08-27T19:25:00.003+09:00

From the current Kelly Letter research stream come these two points.

Doug Kass has been the man of the year as far as market forecasts go because he confidently called a generational low in early March, as most of the herd fretted slipping into the abyss. From 666 on the S&P 500, Kass said we'd see 1050 by late summer or early fall, then take another trip lower. He still thinks so, and says the time frame is right on track. From an article he wrote yesterday at TheStreet.com:

Arguably, today investors face the polar opposite of conditions that existed only a few months ago, with economic optimism, improving valuations and positive sentiment.

To most investors, today the fear of being in has now been eclipsed by the fear of being out as the animal spirits are in full force. Bears are now scarce to nonexistent in the face of steady price gains in equity and credit prices.

The primary question to be asked is, Will the earnings cycle dominate the investment landscape and cause investors to overlook the chronic and secular challenges facing the world's economies, particularly as the public sector stimulus is eventually withdrawn and paid for and the economic consequences of the massive public sector intervention manifest themselves in the form of higher interest rates and marginal tax rates?

I expected a mini production boom and an asset allocation away from bonds and into stocks to be embraced and heralded by investors, who would only be disappointed again in the fall as it becomes clear that a self-sustaining economic recovery is unlikely to develop.

Just as I looked over the valley in March 2009 toward the positive effects of massive monetary/fiscal stimulation within the framework of a downside overshoot in valuations and remarkably negative sentiment, I now suggest another contrarian view is appropriate as I look over the visible green shoots of recovery toward a hostile assault of nonconventional factors that few business/credit cycles and even fewer investors have ever witnessed.

A double-dip outcome in 2010 represents my baseline expectation. When the stimulus provided by the public sector is finally abandoned, it seems unlikely to be replaced by meaningful strength or participation by any specific component of the private sector, and the burgeoning deficit (described above) will ultimately require a reversal of policy, leading to higher interest rates, rising marginal tax rates and a lower U.S. dollar. My forecast assumes that the market's focus will shortly shift from the productivity gains that have been yielding better-than-expected bottom-line results toward these chronic and secular worries.

Markets top during times of enthusiasm. I believe that the markets are now overshooting to the upside and that the U.S. stock market has likely peaked for the year.

That becomes all the more meaningful in light of the announcement earlier this week that the Obama administration underestimated the deficit by $2 trillion. Higher taxes and cutbacks in government programs are inevitable. Those will reduce consumer spending, the heart of the U.S. credit based economy, which will make the business environment far less hospitable than we're used to seeing.

Another point of concern is housing, which is by no means fine, as some already contend. Half of homeowners are destined to be under water on their mortgages next year, as explained by these excerpts taken from an article at MSNBC:

More than 13 percent of homeowners with a mortgage are either behind on their payments or in foreclosure, the Mortgage Bankers Association said Thursday. As of June, more than 4 percent of all borrowers were in foreclosure and about 9 percent had missed at least one payment. A separate report found that more than 272,000 borrowers were at some stage of foreclosure in July, up 8 percent from June and 55 percent from July 2007, according to RealtyTrac, which maintains a national database of foreclosure filings.

The continuing rise in foreclosures delays any meaningful recovery in the U.S. economy, in part because housing typically leads the economy out of recession. Every new foreclosed home increases the unsold inventory on the market and cuts into demand for new construction.

Foreclosed homes push nearby home prices lower. Unless the pace of foreclosures can be slowed, millions more homeowners will be forced "under water". Roughly half of all U.S. homeowners will be under water by 2011.

That notion is confirmed daily in the Kelly Letter email inbox, where subscribers and other readers tell me financial stories about the people in their lives. It's ugly out there. People are hunkering down, some by choice but others out of necessity.

Neither is good for the economy.

Banking, Health Care, and Inflation

2009-08-20T18:44:00.004+09:00

From the current Kelly Letter research stream come these four tidbits.

Ben Stein pointed out at Yahoo Finance that taxpayers are paying bank profits but getting no benefits. Admittedly, this is old news to those who've been paying attention but a lot of people haven't been paying attention, so it's worth putting out there again:

The government completed the circle of bank rescue by not only letting the banks borrow at almost zero, but then by allowing the banks to invest the money they borrowed in totally risk free Treasuries at roughly 3.6 percent. . . . The banks started making staggering profits again. So, what has the banking sector done with the profits and their new found health?

Bankers now -- again -- routinely take home $5 million to $10 million bonuses just for doing an ordinary job. . . . At Goldman Sachs, bailed out by the taxpayers a scant few months ago, secretaries and bookkeepers are making hundreds of thousands in bonus.

The taxpayers pay the interest on the trillions (yes, trillions) in Treasury bonds that allows the banks to make the lollapalooza profits they are making on their free money. . . . So, what do we have right now? A banking sector looking out entirely for itself, bailed out by all of us, at wild expense, and not lifting a finger to help end the mortgage and housing crises.

Onto the divisive health care discussion. The outcome of the reform proposal is important to us not just as Americans, but as investors. If runaway health costs are not brought under control, they will harm the long-term growth of the economy. However, if the federal deficit and debt are not managed properly in the creation of a new plan, they will swell to even more dangerous proportions which will threaten the viability of the dollar and the solvency of the Treasury. Finally, if taxes are seen as the way to provide everybody with health care, then consumer spending could be permanently impaired. Because it powers some 70% of the economy, damaging consumer spending even a little would bring big adjustments.

Princeton professor Uwe Reinhardt said at CNN that the central issue of too-expensive health care is being missed in the discussion:

Americans need to be taught a basic lesson on the economics of employment-based health insurance before they will feel as smugly secure with it as they do now and before they will stop nitpicking health-reform efforts to death over this or that detail.

If efforts at better cost containment fail once again, and health care costs rise to $36,000 on average for a typical American family of four under age 65 -- as almost surely it would -- that $36,000 will be borne entirely by the family.

Here it must be remembered that the wages and salaries of the solid American middle class have been relatively stagnant in recent years and are likely to remain so for the next decade.

This prospect -- relatively stagnant family incomes combined with family health-care costs that double every decade -- is what America's middle class should contemplate as it thinks about the imperative of health reform.

It is a pity that this central issue seems to have been shoved aside by mendacious distortions

Some in the medical industry have felt insulted at the comments about U.S. health care lagging behind the quality seen in other countries. I can tell you firsthand that that idea has always seemed odd to me, because even here in Japan the care is not as good as what I've received in the U.S. The health care system in America has not only saved my life from cancer at the age of 12, it also saved two other members of my family from life-threatening situations. I've always wondered, "If U.S. health care is so bad, why do people travel from so far away to get it?"

Part of the answer was provided by Steve Chapman at the Chicago Tribune, who found that U.S. health care is tops if you remove deaths caused by crime or accidents:

It's true that the United States spends more on health care than anyone else, and it's true that we rank below a lot of other advanced countries in life expectancy.

One big reason our life expectancy lags is that Americans have an unusual tendency to perish in homicides or accidents. We are 12 times more likely than the Japanese to be murdered and nearly twice as likely to be killed in auto wrecks.

In their 2006 book, "The Business of Health," economists Robert L. Ohsfeldt and John E. Schneider set out to determine where the U.S. would rank in life span among developed nations if homicides and accidents are factored out. Their answer? First place.

That discovery indicates our health-care system is doing a poor job of preventing shootouts and drunk driving but a good job of healing the sick. All those universal-care systems in Canada and Europe may sound like Health Heaven, but they fall short of our model when it comes to combating life-threatening diseases.

Finally, in case you need another reason to give up hope, Warren Buffett wrote in the New York Times that lawmakers are probably going to choose inflation as the way out of the mess their profligate spending has caused:

With government expenditures now running 185 percent of receipts, truly major changes in both taxes and outlays will be required.

Legislators will correctly perceive that either raising taxes or cutting expenditures will threaten their re-election. To avoid this fate, they can opt for high rates of inflation, which never require a recorded vote and cannot be attributed to a specific action that any elected official takes. In fact, John Maynard Keynes long ago laid out a road map for political survival amid an economic disaster of just this sort: "By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.... The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose."

Congress must end the rise in the debt-to-G.D.P. ratio and keep our growth in obligations in line with our growth in resources.

If you're still depending on government for a solution, you're a slow learner. Take control of your own finances under the assumption that you will never get a dime from government for retirement. Then, anything that ends up coming your way will be icing on the cake. As for the cake, better bake it yourself.