High Risk Market

The S&P 500 fell almost 10% from its January 19th high to its February low. We wrote about the overbought market in our 2010 forecast and the likelihood of a 20% plus pullback sometime in 2010; the question is, has the expected decline already begun or is the market working off its overbought state by trading sideways for a few months (markets can correct in time instead of price, chopping sideways until earnings catch up with price). There is no question that the up trend from the March 2009 low is broken. Furthermore, with the 20-day moving average now below both the 50 and 100-day moving average, additional market weakness is a distinct possibility. Add in half a dozen distribution days (down days on heavy volume) since the January 19 high, and the case builds that the rally is on wobbly legs and will need to regain momentum in fairly short order if further profit taking is to be avoided (many institutional investors rely on charts to trigger buy and sell decisions, which is why charts are useful in the first place - circular reasoning I know, but very much a reality in the casino that passes for today's stock market). Further deterioration in the chart - in particular a breach of the recent 1042 low - will likely cause additional profit taking that could lead to our predicted 20%-30% 2010 decline.

As well, it is easy to build a fundamental case for further declines in the market. The S&P 500 is still about 20% over valued using $60 for earnings and 15x for a trailing multiple. (The S&P 500 has traded on average at 14 to 15x trailing reported earnings historically). Also, reported economic growth is mostly smoke and mirrors at the moment. The reported 5.7% Q4 GDP growth is likely to give way to Q2 and Q3 2010 growth in the 1% to 2% range, given the weak final demand components of the Q4 number. As you will recall, Q4 GDP got a huge assist from inventories declining at a slower rate, adding an estimated 4.4% to the final number. History indicates that subsequent quarters show punk growth when over half of GDP growth is coming from inventories.

In fact, there have been 9 quarters since 1970 in which GDP grew by at least 3 percent and at least half of the growth was due to inventories. While inventory spikes make for big growth numbers (average growth in the 9 quarters was 6.6%), average growth in the subsequent quarter averaged only 0.9% and only 1.6% in the second quarter following the blowout number. Weak growth numbers in the next few quarters will likely make current earnings forecasts overly optimistic, which will, in turn, pressure the stock market (It is possible that Q1 will come in fairly strong if the inventory swing hasn't quite played out).

One last indicator that the market is due for a further decline, or at least a relatively long period of sideways chop - the "we-can't-find-many-good-companies-at-great-prices" indicator is flashing at us. As many of you know by now, we do not do market timing. Rather, we look at risk levels in the market as context for our bottoms up, one-company-at-a-time, portfolio construction. It is currently taking us quite a bit longer to put new money to work in our client portfolios because we are just not finding that many good companies at great prices at the moment. Our price discipline held us in good stead in 2000-2001 and again in 2007-2008; we would expect it to prove beneficial once again in 2010. Meanwhile, we recommend continuing to treat the market as high risk, and plan accordingly...

Bogus GDP Report Revision

We wrote recently about the bogus Q4 GDP number which was reported initially at 5.7% last month. We believe the final number will come in somewhere between 2.0% and 3.0% when all is said and done - although we won't likely see that admission from our clever government bean counters for a year or so. Meanwhile, it looks as if there could actually be an upward revision in the GDP number as the December inventory number was likely flat, while the BEA assumed a sharp inventory liquidation in December. It is possible that the GDP number might temporarily be revised as high as 6.7% for Q4 2009, leading people to assume that a strong economic recovery is in place. Given that over 4% of the Q4 number would be due to a decline in the rate of decline of inventory liquidation and that personal income took a bigger hit than previously thought (based on Friday's downward revision in payrolls and hours worked) we are unable to get on board with the idea that the U.S. economy is powering strongly ahead. Rather, given continued weak end demand, we see an economy poised to decelerate back into recession sometime in 2010 - likely in the third quarter. Our confidence in that forecast is only increased by the continued and increasing contraction in real M3 (the broadest measure of money supply). As previously mentioned, contraction in real M3 is historically a 100% predictor of economic contraction in the following two to three quarters. We think it unlikely that it will be different this time.

And, of course, a renewal of the recession means a continuing rise in unemployment and decline in home prices among other (bad) things. A double dip recession is also unlikely to be a positive for the U.S. stock market....

Diversification Revisited

Proper diversification is one of the single most important tools for any investor. Properly diversified investment portfolios are the best means of protecting and growing wealth. There are two main levels of diversification, at the asset level, and at the individual security level. Most people ought to own both stocks and bonds, as well as real estate, commodities, and cash. As well, folks ought to own some international stocks and bonds since a good portion of the world economy is outside the U.S. and investors can miss out on quite a few attractive investment opportunities by limiting themselves primarily to home country investments. (Home bias is a well known investor mistake that leads investors to put too much of their money in domestic assets and not enough elsewhere). And well-diversified portfolios should also have diversification within asset classes. Too much exposure to any one company, through its stock or bonds, is an unnecessary risk that is unjustified in most cases. A couple of real life examples can help investors to understand how risky it can be to invest too much in one single asset class or one security.

The first example is a case in which an individual sold his business and retired. His fee-based advisor (stockbroker) built a portfolio consisting of $2 million in stock mutual funds and $400k in private real estate investment trusts. The $2 million in stock mutual funds consisted of a large cap growth fund, large cap value fund, small cap fund, and an international fund (a pretty common allocation for the many sales guys passing themselves off as qualified investment advisors). Of course, all of the funds were front loaded and paid the sales guy a hefty 5.75% commission along with a 0.30% yearly trailing commission, and of course our poor investor was also paying 0.60% annually to the mutual fund to actually do the investing. The $400k in private REITs was split into two investments with the same company, with basically the same commercial real estate exposure in both.

So what kind of diversification did our poor investor get for all those commissions paid? Very little is the answer. The three U.S. stock mutual funds all performed equally badly during the 2007-2009 bear market and the international fund did even worse. The illiquid private REITS can't really be valued since our investor can't get out of those particular roach motels at the moment - the REITs are husbanding their capital and have suspended redemptions for the time being. The bottom line is our retired investor is busily looking to unretire now that his portfolio has dropped from $2.4 million to $1.2 million. Oh, and in case you are wondering why the sales guy put our investor in illiquid private rather than liquid public REITS the answer is.... BIGGER COMMISSIONS!

Our second case study highlights both types of unwarranted concentration. The fee-based advisor had put an older couple 100% in bonds (at the older couple's request), using both mutual funds and individual bonds. Additionally, the advisor had placed the majority of the money allocated to individual bonds in GE Capital bonds and California muni bonds. In fact, the GE capital bonds alone made up approximately 50% of the entire portfolio. Yikes!

There are a few observations worth making here. First, commission based advisors must sell something in order to make money. Like any good salesman they will keep trying until they find something their customer likes. Don't want mutual fund A? How about mutual fund B? Don't really want to own stocks? No problem, I'll sell you bonds (and take a juicy slice of the mark up). The moral of this story is that commission based advisors often sell what's easiest to sell rather than providing actual investment advice to the client (and risk losing the sale). There is no way a couple in their mid-60s with a 25 to 30 year planning horizon should be allowed to put 100% of their money in bonds - unless they have so much wealth that purchasing power risk (inflation) isn't going to bite them in the budget in the out years. And after Enron, WorldCom, Bear Stearns, Lehman Brothers, AIG, GM, Fannie Mae, and Freddie Mac, do I even need to talk about the incredible risk assumed by having some 50% of your bond portfolio in just one company? The fact is that our couple did dodge a bullet as the Federal Government did have to (quietly) bail out GE last year when the commercial paper market seized up.

Building properly diversified, low-cost, portfolios that will both preserve and grow an investor's wealth is a critical step in planning for retirement. Appropriate portfolios are not static in nature as they must change as an investor's needs change. Unfortunately, most financial advisors are paid to sell products and do not actually make their money from giving advice or investing on a client's behalf. Consequently, their motivation to sell frequently gets in the way of sound investment advice. It is no coincidence that both of our poorly constructed portfolios were put together by fee-based advisors. The fact is that it is a huge conflict of interest, which investors would be well advised to take into consideration when dealing with "the sales guy".

The Bogus Q4 GDP Number!

Whoopee! The economy is in a strong recovery and all is well with the world. The huge stock market advance of last year is justified after all and it's clear sailing from here on out! Or is it?

The short answer is that we aren't buying what the numbers are selling. Q4 GDP was reported at 5.7% but that number is much less than meets the eye. Inventory build accounted for about 3.7% of that growth and will likely reverse in subsequent quarters given the weak consumption component (the consumer spending growth rate actually declined in the quarter from 2.3% in Q3 to 1.7% in Q4). Approximately 90% of the preliminary GDP number is composed of guesstimates since most of the inputs aren't finalized yet; the government has had a tendency to report overly optimistic initial numbers and then revise down those initial estimates in later quarters... when people aren't paying as much attention. One likely source of a coming downward revision is the trade deficit, which worsened in October and November (December hasn't been reported yet), but, nevertheless, is credited with adding 0.5% to the GDP number in Q4. Other problems with the GDP number were falling imports and declining aggregate private hours worked, which contracted at a 0.5% annual rate. Neither number indicates any kind of strong recovery taking place. All in all, we think the GDP data point toward a slow growth to no growth economy in coming quarters and quite likely an outright resumption of the recession sometime in 2010.

Further evidence that we are heading back into recession in the next few quarters lies with the money supply data. Money supply growth is currently negative as M2 and M3 continue to contract. We have never had an outright contraction in M3 (the broadest measure of money supply) without an accompanying recession! The bottom line for the public is to take the currently reported economic numbers with a HUGE grain of salt, and to act appropriately in positioning their investment portfolios.