December 28, 2010
What We Should Expect from the Markets in 2011
There are many positives in the stock markets right now. We are entering the third year of the presidential election cycle, which is normally the strongest of the 4 years between elections, and we are in the colder months of the year which are often stronger than the warmer months, and the market has been confirming these strength cycles by posting 15 up days and only two losing days since December 1st.
Two weeks ago, my last newsletter mentioned my unease with the low volume of shares being traded and my unease has only deepened since then.
Sentiment polls of newsletter writers, individual investors and professional money managers are all at bullish extremes. That may sound good on the surface, but if you stop to think about it, these groups being so very positive really means that they are probably already invested.
In that case, they are no longer potential buyers but have become potential sellers. Prices are determined by the balance of buyers and sellers in a marketplace, and with this extremely bullish data we can see a rising tide of potential sellers that should be disturbing to experienced market watchers.
There are also other technical aspects of the market action that are in conflict with a rising market and with cycles that on average are very positive. This situation brings to mind the old adage about a person being able to drown in a pond that was only knee deep on average.
The recent rise in interest rates from their October lows is significant for more than just the 1% rise in 10 year Treasury rates. There is a fairly clear 60 year cycle in interest rates that was due to bottom in 2010, and the recent lows appear to be that long-term bottom. The Fed’s recent failure to control intermediate term interest rates–and the mortgage rates that are tied to them–underscore the significance of this issue.
History is now suggesting that we should expect about 30 years of generally rising interest rates. Ugh! Interest is an expense, meaning costs everywhere are going up, creating a serious headwind for the economy and the markets.
Another coming headwind is the rising price of oil which is currently at a 2 year high. Another big expense for all of us just got more expensive.
What concerns me is that both rising oil prices and rising interest rates have sent stronger markets than this one right into the tank. The double whammy (of both rising at the same time) could be very problematic.
A recent Citigroup study of similarities of the 3 Generational Bear Markets of the 20th century (early 1900s, the 1930s and the 1970s) compared to the 2007-2011 time period contradicts the suggestion of smooth sailing that the presidential and annual cycles suggest.
What makes me really pay attention to this study is that it focuses on the long, bear markets that I call Generational markets. Since we are in this type of market right now the study is really comparing apples to apples.
This study suggests a tough year in 2011, and although it flies in the face of popular cycle analysis, the burden of rising interest rates and higher commodity prices only needs a catalyst to become a problem, and bring the Citibank conclusion to reality. European credit problems, municipal bankruptcies, a rogue nation using a nuke; who knows what it might be, but the foundation for a major market decline is in place.
Despite a market that is currently setting new highs, the historical precedents concern me, and I feel the risk of stock investing is now higher than it has been in quite a while.
I sure like the comfort of being able to move quickly out of the market when needed.
The Big Mac Index
The Investment View from Prescott, Arizona
For many years The Economist magazine was my #1 choice in business magazines. Not only does it cover the world both economically and politically in great detail, it is published in London and brings a greater objectivity than purely American news outlets can.
The Economist has devised a marvelously simple method of currency valuation called the Big Mac Index. Since currency values are a concern to many Americans who are watching the Fed print more money each month, I thought I’d talk about the Big Mac Index, or more accurately, let The Economist talk about it. The following is from the October 14th print edition of The Economist.
“A WEAK currency, despite its appeal to exporters and politicians, is no free lunch. But it can provide a cheap one. In China, for example, a McDonald’s Big Mac costs just 14.5 yuan on average in Beijing and Shenzhen, the equivalent of $2.18 at market exchange rates. In America, in contrast, the same burger averages $3.71.
That makes China’s yuan one of the most undervalued currencies in the Big Mac index, our gratifyingly simple guide to currency misalignments, updated this week (see chart). The index is based on the idea of purchasing-power parity, which says that a currency’s price should reflect the amount of goods and services it can buy. Since 14.5 yuan can buy as much burger as $3.71, a yuan should be worth $0.26 on the foreign-exchange market. In fact, it costs just $0.15, suggesting that it is undervalued by about 40%.
The tensions caused by such misalignments prompted Brazil’s finance minister, Guido Mantega, to complain last month that his country was a potential casualty of a “currency war”. Perhaps it was something he ate. In Brazil a Big Mac costs the equivalent of $5.26, implying that the real is now overvalued by 42%. The index also suggests that the euro is overvalued by about 29%. And the Swiss, who avoid most wars, are in the thick of this one. Their franc is the most expensive currency on our list.”
Q: An old man wanted to leave all of his money to one of his three sons, but he didn’t know which one he should give it to. He gave each of them a few coins and told them to buy something that would be able to fill their living room. The first man bought straw, but there was not enough to fill the room. The second bought some sticks, but they still did not fill the room. The third man bought two things that filled the room, so he obtained his father’s fortune. What were the two things that the man bought?
What We Were Saying Back Then
IRA Deal of the Century.
I have written several times this year about converting traditional IRAs to Roths since conversions were available for the first time this year to earners with over $100,000 incomes.
For those IRA owners who chose to convert to Roths the tax bill passed by Congress on December 17th brings a gift much like a free loan.
2010 converters have the option to pay all of the taxes due on the conversion with their 2010 taxes or split it and pay half in each of 2011 and 2012. While the potential existed for tax rates in 2011-12 to change, this presented a risk of getting hit with higher tax rates if one opted to put off paying the taxes.
The tax bill that Congressed passed last week ensures that there will be no income tax increases for several more years. Whew! This also gives a gift to converters.
The decision of whether to split the income between 2011 and 2012 or paying it now becomes a no-brainer. If your other income will not increase in the next two years enough to push you into a higher tax bracket, opting to put off the taxes is like an interest free loan for the amount of the taxes due on the conversion.
As always, talk about this with your accountant, but this is one of the best deals Congress has given us in many years.
What’s Going On In Your Portfolio?
Careful Growth accounts are currently about 25% in cash and 75% invested in growth and energy stocks, gold, Latin American and Japanese country funds.
I always tell prospective clients that I really earn my fees in down markets, and that we often underperform in rising markets.
This is due to the fact that my Careful Growth strategy is designed to sell holdings at early signs of weakness. This is the “HCM Safety Net” I refer to occasionally.
To give you an idea of how well this works, through this writing on December 26, during 2010 the S&P 500 has experienced separate declines of 8.13% (Jan 19 to Feb 8), 15.99% (April 23 to July 2) and 7.14% (Aug 9-26), yet our Careful Growth model’s largest monthly losses were only 4.37%, and 4.25% a small fraction of the overall market’s loss.
The down side to this approach is the opportunity cost when the market quickly recovers and we are out of the market or hedged, and as a result miss the first part of the run up in prices. We may not be losing dollars, but we are losing the opportunity to make money each time this happens. The more zig zags in the market, the more ground we can lose and the 3 significant corrections this year, plus two minor ones, each cost us some opportunities.
This is the price we pay for being sure we are out of the market before a prolonged market decline can gather much momentum. Because all big declines start out as small declines, each small one gets my respect. To capture all of the return of the indexes, you take all of the risk of the big, crushing declines, too.
The stated goals for my money management are to first minimize the risk of being invested, and second, try to make money; so this approach fits with our goals. As of this writing on December 26th, my style of management leaves us a few percentage points from showing a profit for the year in our Careful Growth model due to many fits and spurts in the market this year. However, if you value smaller rather than larger waves in the value of your account as the market moves up and down, you are in the right place.
My strategies have out-performed the indexes over both full bull/bear market cycles since we began managing money like this in 1999, but our out-performance comes by avoiding downside risk, not by capturing all the upside of the indexes. Despite the appearance of this year’s under performance, I feel we are handling the choppiness in the market better than we ever have, and the long term out-performance that my work is noted for will continue.
In early 2010 we began including individual stocks in our investment selection with great success. Our six largest gainers of 2010 have been in our individual stocks rather than mutual funds or Exchange Traded Funds, so 2011 will see continued focus on individual stocks in accounts large enough to make them cost effective.
Also, at workshops over the past few months, I have picked up some new tools that I expect will increase the financial horsepower of the growth side of our work during 2011 and beyond.
The interest rate spike between November 4 and December 15 caused massive losses for some bondholders, but fortunately not my clients. An ETF that tracks the Barclay’s Aggregate Bond Index lost 3.47% and one that holds 7-10 year Treasury bonds lost 7.18%, while my Flexible Income clients saw losses about 1/10th of that amount during this period before their accounts stabilized.
Flexible Income accounts are poised to finish the year with decent gains despite recent upheavals in the bond markets.
Both Flexible Income and Municipal Income accounts are currently hedged to protect against the risk of further interest rate rises.
* The model accounts mentioned in this article are hypothetical examples of how the strategy may work as designed. Activity in client accounts may be different from that in the model in amount of each investment, specific timing of trades, and actual security used, which may vary from account to account. Not all trades are profitable. It should not be assumed that current or future holdings will be profitable. A list of all trades in these accounts for the past 12 months will be provided upon written request.
** The S&P 500 and Nasdaq Indexes are unmanaged lists of stocks considered representative of the broad stock market. Investors cannot invest directly in the S&P 500 Index.
This newsletter may contain forward-looking statements, including, but not limited to, statements as to future events that involve various risks and uncertainties. Forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause actual events or results to differ materially from those that were forecasted. Information in this newsletter may be derived from sources deemed to be reliable, however we cannot guarantee its accuracy. Please discuss any legal or tax matters with your advisors in those areas. Neither the information presented nor any opinions expressed herein constitute a solicitation for the purchase or sale of any security.