April 3, 2008

The Market May Be Turning Up

Two weeks ago the banking system was on the verge of collapse.  The Fed performed a shot-gun marriage with the bankrupt investment bank Bear Stearns, to a healthier JP Morgan.  Bear Stearns was in the “too-big to let fail” category.  A default by them would have too many waves in our economy and the entire world.  Big waves!  The Fed made a big statement when they stepped in and effectively showed that they had the resources and the leadership to keep the system functioning.

And, it seems like it is working.  Over the past two weeks, the markets have indicated approval of the Fed’s actions and are acting positively for the first time in almost 6 months.

For sure there will be more shoes dropping before this round of problems is over – more banks and investment firms will fail.  And we have heard nothing yet from the insurance companies which I find odd, since they reinvest your money similarly to banks.  Stay tuned on that one . . .

However, the stock market is finally showing signs of having hit bottom on March 10th after losing between 18-24% since October, depending upon which numbers you consider.  It is too early to throw caution to the wind, but it is not too early to note the improvement in the markets and begin making some adjustments.

True, the economy is in bad shape, but the stock market and the economy are two different animals.  The stock market normally bottoms and begins to move up long before the economic justification for the improvement is obvious.

As I have mentioned in recent newsletters the government is moving an unprecedented amount of cash into the economic system to combat the problems at hand and all that money will eventually have a positive effect.  The real question is when.

Conventional wisdom is that it takes 6-12 months for new money to have a measurable effect on the economy.  It has been 7 months since the Fed first intervened last August.  We are right on schedule for liftoff.

Another sign that it may be time to get invested again comes from “sentiment” indicators.  They are really bad.  Now, teenagers know that bad is really good.  For us older folks it gets confusing.  This seems like a crazy business sometimes because so many things, sentiment indicators among them, work just the opposite of how they appear on the surface.

Investing, whether in stocks, bonds, real estate or even CDs ultimately boils down to supply and demand.  How the number of sellers compares to the number of buyers.  Sentiment can tell us a lot about this.

Recently the American Association of Individual Investors’ survey of Investor Sentiment posted its longest stretch of negative sentiment in over 15 years.  A lot of those investors are “bearish”, expecting the stock market to go down.  Very few are “bullish”.

Consider the logic that those who are negative on the market are not invested in the market; therefore they are no longer potential sellers.  They are potential buyers.  And all we need for a market to bottom and begin moving up is the number of sellers to become smaller than the number buyers.

A simple way to put it is that everyone who was going to sell has already sold, so the balance of buyers and sellers is shifting.  That is what makes the stock market work

An FDIC Refresher

The FDIC, or Federal Deposit Insurance Corporation does a good job of allowing savers and investors to sleep well at night.  However, with each passing week we are finding out that another financial “Emperor has no clothes”, as the fable goes.  What about the FDIC?  Should we worry about it too?  Let’s see.

If you go to the FDIC’s Website, you learn the following:

“The Federal Deposit Insurance Corporation (FDIC) preserves and promotes public confidence in the U.S. financial system by insuring deposits in banks and thrift institutions for up to $100,000; by identifying, monitoring and addressing risks to the deposit insurance funds; and by limiting the effect on the economy and the financial system when a bank or thrift institution fails.”

This sounds pretty good. Depositors want someone to supervise banks. No one wants his bank to fail.  So the FDIC is one of three entities that can supervise national banks.  The Federal Reserve and the office of the Comptroller of the Currency are the other two.  If we don’t get a Keystone Cops moment and have these three entities stumbling over each other, three regulators should be better than one.

But here is another crucial question.  How solid is the FDIC?  How much money does it have?

The FDIC receives no money from Congress — it is funded by premiums that banks and thrift institutions pay for deposit insurance coverage and from earnings on investments in U.S. Treasury securities.  According to the FDIC, they hold insurance funds totaling more than $49 billion.  http://www.fdic.gov/about/learn/symbol/index.html

Perhaps a better question would be, what is the ratio of total insured deposits and FDIC reserves?

The FDIC insures more than $3 trillion of deposits in U.S. banks and thrifts — deposits in virtually every bank and thrift in the country.

Let’s see: $3 trillion divided by $49 billion. That tells us that the reserves are 1.63% of the money value of the insured accounts. For every dollar in an account, there is about a penny and a half in the FDIC.

Or is there? According to Gary North’s analysis of FDIC balance sheets (www.GaryNorth.com), they have only $12.3 billion of liquid holdings.  So, to insure $3 trillion in deposits, the FDIC has in ready reserve about $12 billion in government T-bills.  But how long would $12 billion, or even $49 billion last in a true banking panic?  Not long.

The bottom line is this: your bank accounts are insured up to $100,000 unless there is a banking crisis.  Then, you must hope for the best.  The best in this case is a political decision by Congress to give the FDIC money.  How safe do you feel with your financial well being in the hands of Congress?  I rest my case.

This is why wise investors should not become totally dependent on insured bank accounts.  They have other strategies: the kinds of strategies that are discussed in this newsletter.

Your bank deposits are protected up to $100,000 by the government.  But what exactly does this mean?  For example, if you have a $100,000 checking account and a $100,000 CD at the same bank, does that mean you’re protected up to $200,000?  The answer is no, actually – it’s $100,000 per depositor, PER BANK.

There is no protection for amounts over $100,000 in a CD (except for IRAs, at $200,000). Having more than $100,000 in any one bank is just taking on needless risk.  Ask yourself why you have your money in the bank.  Is it to take needless risk?

But please don’t jump to any “Chicken Little” conclusions here… I’m not predicting a string of bank failures…or the potential loss of your deposits above $100,000.  I just wanted to get to the bottom of what the logical extreme looked like, and what to do about it.

As the old saying goes, an ounce of prevention is worth a pound of cure.  The ounce of prevention is simply spreading your banking deposits around a bit to have them 100% FDIC insured.  While chances are good you’ll never need the prevention, it’s not hard to do.

Risks to Money Market Funds Have Subsided

Five months ago, before the credit and banking crisis was top-of-mind for most investors, I took the initiative to move your un-invested money from the traditional money market fund into a Treasury-only fund.  This effectively eliminated any default risk.  I had more than one client wonder if I was being a little too conservative because the rate of interest was a full percent lower on the new fund.

Now, a few months later, with banks and brokerage houses crumbling under the weight of defaulting or unsellable bonds, I’m not getting any more complaints, because our money has been ultra-safe in this anything-but-safe market environment.

In the next few weeks, however, I will be moving our managed accounts back to the traditional money market fund which holds top rated corporate bonds as well as government bonds.

If holdings in the traditional money market funds were going to default, they would have by now.  And with a current average maturity period of only 41 days, the vast majority of current holdings would have been bought after the issue of default risk became widely known, allowing the managers to easily avoid those risks.  Fidelity manages our money market funds, and they do a good job of it.  Now that the risk of being blindsided by defaults in money market funds is subsiding, it is time to move back and collect the extra interest for doing so.

Account Updates

You may have noticed some activity this past week as we move to be a little more in sync with the stock market.  Losses in growth model accounts¹ have been much smaller than the stock market indexes² have been, both for the year-to-date, and since the market began to decline back in October.  But we need to recognize the changes in the market direction and shift gears now if we want to get back in the black for the year.  That is what I have done in our growth accounts.

Although risk is now lower than it has been in the past 6 months or so, there is still risk, so we are still partially hedged to reduce that risk.  This has our growth model accounts¹behaving like they are 50% exposed to the stock market and 50% in the money market fund.

The Flexible Income model¹had a good month in March, and is now showing gains for the year.  In Flexible Income accounts we moved from inverse high yield bond funds into traditional high yield bond funds which have turned back up the past few weeks.

  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.

1. *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.