May 13, 2008

Market Update

The stock market continues the two steps forward one step backward dance it has been doing for almost two months, now.  As frustrating as that can be, this is a much better rhythm to be in than last winter’s 3 steps down and one up, 3 down one up. 

The fact that the markets have moved modestly higher despite the continuing bad news for the economy is encouraging.  We have to remember that the markets and the economy are two separate things.  You earn and spend your paychecks in the economy.  Your savings are at work in the financial markets. Wall Street often mixes up the two for their own ends, but the stock markets and economy can go up and down at different times.

Two of the key investment themes of the year are the elections and the money supply.  Both give positive support to the markets for the rest of the year.

Presidential election years tend to be positive years for the stock markets.  The fact that this one started off with sharp losses suggests that sharp gains are needed to get us back up to an average return for an election year.  Even if the climb out of the deep hole the market dug for itself keeps us from getting all the way back up to average, the return from now to the end of the year could still be a very good one.

In my work I try to focus on what lies ahead, not what has just happened.  Last year does not make us any money this year.  So, looking ahead, theme #1 looks positive for the rest of the year.

The other key theme of the year is liquidity.  How much money is available to buy stocks, bonds, mortgages, etc.  The Federal Reserve has impressed me with its creative approaches to getting cash into the system to avoid bigger problems in the economy.

For the past few months the Fed has been making “loans” to troubled banks at semi-monthly auctions.  They announced that in May they would triple the amount of money being auctioned off to banks.  This tells us two things.  One, the problems in the banking system are far from over, and two, the Federal Reserve is heavily committed to righting this floundering ship – regardless of how much money it takes.

This money the Fed is injecting into the economy has to go somewhere.  Some of it will find it’s way into the stock, bond and mortgage markets, providing the fuel to drive prices higher as the year goes on.  This importance of this second theme for the year cannot be underestimated.  Money is the raw material of healthy markets, further suggesting a sustainable recovery is underway in the financial markets.

A Follow Up

I mentioned a few weeks back that the financial crisis was not over because we still had not heard from the insurers, which faced many of the same problems as banks and mortgage firms.  Friday May 9th, Insurance giant AIG, a member of the Dow Jones Industrial Average pulled the stock market down with a whopping 8.77% loss in one day when they announced a $12 billion loss for the first quarter of 2008, with reports of more losses and bad news to come.

 So the other shoe is finally falling.  That is the bad news, especially for AIG shareholders who have seen 50% losses over the past year.  The good news is that we need to get these events out of the way before a sustained uptrend in the stock market can resume.  With AIG’s report behind us, we are one step closer to a healthy market.

Is Real Estate About Done?

A common discussion I have with folks as I travel around is about real estate.  Everyone has either owned or wanted to own real estate, so everyone has opinions, and I hear them all.  Many aggressive real estate investors are ready to begin buying.  I would recommend waiting.

I still believe that real estate has a long way to go before it hits bottom.  As I have mentioned in past articles, futures prices are pointing to 15-20% lower home prices before we are done.  But the key piece of my thinking is the absense of a Resolution Trust type entity on the horizon.

You may remember from the early 1990’s when many Savings and Loans had gone under, and the FSLIC, fore runner to the FDIC, ended up with a lot of foreclosed real estate on their hands.  Today we hear a lot about foreclosure rates being sky high, but where are the ton of foreclosed properties we should be seeing on the market?  Right now they are just a trickle when they ought to be a torrent.

Remember the money the Fed is “loaning” off to distressed banks with their “auctions” mentioned earlier in this newsletter?  What do you think the collateral is that the Fed is taking for these?  My guess is that they are a bunch of distressed loans that were dragging the banks down, and this is the off-loading mechanism enacted to keep the banks afloat.  But the bottom line is that even if the banks are kept from closing, a big chunk of the foreclosed properties end up being held by the government.

So, until you see the modern day version of Resolution Trust taking property from the government to get it back into the private sector we won’t be at the end of this real estate downturn.  Even when that occurs it may be a long time before home prices begin to go up again.

If you think a real estate deal you see is just too good to pass up, I would encourage you to take the time to pencil out what will happen if the price drops some more before it stabilizes and goes back up.  And also pencil out what will happen to you if it takes many years for prices to begin to turn up.   That is a real possibility.

The big risk in real estate is lack of liquidity.  If things don’t work out the way you expected you may not be able to sell except at fire sale prices.  Make sure you have the cash reserves to hold your real estate for a long time if you buy now.  The alternative is to become another statistic in real estate’s bear market.

Account updates 

Our growth model^₁accounts are now 80-95% invested in the stock market, our highest levels since early last summer.  That statement probably summarizes my outlook better than anything else that I can say.  We are invested in a mix of US and International stock funds. Emerging markets are the strongest segment of the international stock markets so we have investments there whenever possible.

Our growth models¹ continue to make money slowly, and through May 9th have outperformed the S&P 500 index2 over all periods, month to date, quarter to date, year to date, the past 12 months and from inception.  Our stated goal in growth accounts is to exceed the returns of the S&P 500 with less than half the risk, and  we are delivering that for sure.

Our Flexible income model¹ holds a mix of high yield bond funds and a fund that will take advantage of rising interest rates.  As you know I am concerned that the Fed’s actions to solve the banking crisis will end up causing inflation and interest rates to rise, and this investment is our hedge against inflation.

International stock investments, denominated in foreign currencies are held by design in growth accounts to protect us from inflation and the declining value of the dollar.  Regardless of which strategy I use in your account, please know that I am keeping a close eye on inflation for you.

  On a Personal Note

I still have a few clients who were in my very first Yavapai College class back on June 21, 1990, on my son Matt’s birthday.  Regularly, although less frequently as Matt got older, I have commented in my newsletters on his milestones. 

Matt graduates from high school next week, so I thought it was time for one more update.  I could not be more proud of Matt.  His grades are good and he stays out of trouble.  He is an accomplished drummer, having won several state competitions and has already played for the Yavapai College big band for two years now.  After a year at Yavapai, Matt plans to attend a music school, yet to be named.  Cathy and I are both proud that Matt volunteered to be a D.A.R.E. representative and a good example for younger students in the area of drug and alcohol abuse prevention. 

And he hits the softball farther than any other 140 pounder that I know.

Congratulations, Matt.  I love you.  -Dad.