April 14, 2009
What to Expect from the Stock Market Recovery
What a difference 5 weeks can make. On March 9th there were long faces on many investors as the S&P 500 Index** closed at 676.53, a price not seen since 1996. But after 5 straight weeks of rising stock prices, many investors are beginning to notice the light at the end of the tunnel.
But how much farther can the stock market rally go? My work leads to several key insights. This is the same work that caused me to begin moving back into the stock market just 3 days after the March bottom.
Even if the major trend in the stock markets were to continue down, the market never goes in a straight line for long. There are always zigs and zags along the way and these movements have patterns that often repeat. The current patterns point to a significant uptrend that I believe is now underway. Two most commonly indicated levels that stocks may be expected to move back to as they zig and zag are currently at 1120 and 1018 on the S&P 500**, which closed on Thursday April 9th at 856.56. The smallest of these price targets, 1018, is still 19% above where we are right now.
The character of trends can be measured by comparing the strength (or weakness) of up legs and down legs as the market zigs and zags along on its primary trend. Currently the up legs are stronger than the down legs, with more trading volume on up days, another positive indicator. This is markedly different than most periods since the market topped out in October 2007 and tells me that we are in a different market environment.
One reason for the new strength in the market may be that money market fund assets now equal 45% of the value of the entire S&P 500 Index**. At the last bear market low, in 2002, cash on the sidelines was only about half of today’s level. This means investors have been hording cash, and with bank rates so low, the bond markets already so high, and real estate so scary, having stocks at steep discounts makes them look more and more attractive to investors wanting to put cash to work. This means that a huge amount of cash is available to be the rocket fuel for the market’s liftoff. (data from www.sentimentrader.com)
I firmly expect some short-term declines along the way to keep the faint of heart from investing in stocks, and after Thursday’s big rally the market is overextended and due for another zag (or is it a zig?). But, I do expect significant gains before this rally is really over and it becomes time to be defensive again.
Insurance Company Ratings Now Available
With the broad financial crises over the past year, one would expect insurance companies to be feeling the heat, too, and some are. The largest insurer in the world, AIG, has become the poster child for defaulting insurers. If the biggest can fail, how about the others?
Since I am not an expert on analyzing insurance company financials, I rely on rating services for this. To help keep tabs on default risk of insurance companies, Hepburn Capital has just subscribed to a new rating service that provides all of the ratings in one spot for over 500 insurance companies.
Significantly, this new database is updated twice a month to better stay on top of things.
With so many different ratings that may sound similar but mean different things, a new composite rating indicator called Comdex is now available for many of the larger companies. Comdex factors in all available ratings and tells you in one simple percentile rank how your insurance company ratings compare to all others. For example, is your insurance company rated higher than 95% of all insurers or only better than 50%? Comdex rankings are a pretty simple yardstick that anyone can understand.
Variable annuities do not have default risk since your investments are not held by the insurance company so you don’t need to call about them. Fixed rate policies are all you need to worry about when thinking of default risk.
The Kids Fund Update
We have been very quiet about the happenings with our new mutual fund, The Kids Fund since its announcement last Fall. Part of the reason was the oddities of security regulations which prohibited me from selling the fund I managed (yes, this is a crazy business) and any mention of the fund by me required prospectus-like disclosures and a regulatory review that would have clashed with the informal nature of this newsletter and the timeliness of its news being distributed just a day or two after it is written.
As it turns out, we successfully launched The Kids Fund in November, and had market beating performance for much of the time since then. However the brutal market conditions made it difficult to get investors interested in anything new, especially if it was in any way related to the stock market. My timing for a start-up could hardly have been any worse.
Mutual funds are very expensive to run until assets get up to $25 to $50 million and I was well below those levels. So, in light of the economic realities, a few weeks ago I made the painful decision to shut down The Kids Fund. The decision felt similar to having to put a pet down. It was a sad day.
That is the bad news. The good news is that I learned a lot in the process, and it makes me a better money manager for the accounts I run for Hepburn Capital clients. I would not trade the experience for anything.
Thanks for all of your support in this exciting project and the kind wishes you have extended to me and to The Kids Fund over the past year.
The stock market uptrend has been good to our Careful Growth accounts* with the model now showing small gains for the year through April 9th. If we get the follow through in the rally that my research suggests, I’m hoping that we may be able to recover last year’s losses, too, before the rally is done.
Strong performances from our holdings in emerging markets and strangely enough, banking, lead the way. Technology and retail are also strong. Our one investment that is planned to protect us if the value of the dollar falls, commodities, is the only laggard.
Growth accounts* have been 80-90% invested since March 19th, with 10-20% in cash.
Flexible Income* accounts are now fully invested in high yield bonds which are enjoying a relatively steady uptrend. High yield bonds (sometimes called junk bonds) are great investments when they trend up as they tend to do so with relatively low volatility compared to other bonds and especially stocks. They might have a lousy name, but they are great investments when they are working right. The stock market tends to also do well when high yield bonds do well, so this is doubly good news.
Balanced accounts should also see nice gains since both the growth and income components are doing well at the same time.
It sure seems like a long time since I was able to write this positive an account update. Sure feels nice.
It may seem crazy to have the markets trending up in the face of all the economic problems, but keep in mind that the financial markets and the economy are two different things. We invest in the markets, not the economy, and the markets normally turn up six months before the economy shows visible signs of recovery. Right now, jobless numbers are rising, and getting a lot of press. They will be the last thing to improve after an economic recession, so focusing on them to the exclusion of other factors will cause you to miss what is really going on, which is a robust stock market rally.
The rally will eventually run out of steam, just as certainly as I knew the winter’s decline would eventually find a bottom and rebound. Rest assured that I will be watching it to move your money back out of harm’s way as quickly as possible if a change of trend becomes evident.
In the meantime, sit back and enjoy the rally. And please tell your friends about my work if you get the chance. Thank you.
What about the value of the dollar?
The dollar keeps trending up despite many investor’s expectations that mounting government debt will cause it to decline. This reasoning makes sense on the surface, but ignores the fact that currencies can only be valued relative to one another.
The fact is that the US Dollar Index, which ranks the dollar against a basket of world currencies, is higher than it was 3 months ago, 6 months ago and a year ago and confirms that things are much worse in other countries than they are here.
In my mind there are three things that are necessary for one currency to be more sought after than others, and for it to be what other countries want to hold in reserve as a store of wealth.
1. Political stability.
2. Economic strength.
3. Military might.
If you can name one country that has more of these three factors than the US, buy their currency. If not, continue to hold dollars.
* 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.