How The Yield Curve Helps Banks.

A good article on the current positives for banks. I think it is a good illustration on how banks make their money which I think is helpful to many of my clients and readers. Whether their "fundies" are offset by all the dilution from the issued common remains to be seen.

Banks' Outlook Not as Dire as Stock Prices {excerpt}

By Matt Stichnoth5/29/2009 9:37 AM EDT

Link: http://www.thestreet.com/b/rmoney/financials/10506796.html {subscription may be required.}

Can we put aside for a minute all the jitters over this week's selloff in the 10-year Treasury note and what it all means for the global economy? Let's worry about that tomorrow. Whatever else the note's recent tankage portends, the associated 20-basis-point jump in the 10-year's yield created a milestone of its own: The yield curve is now steeper than it's ever been. For banks, that's really, really good.
I doubt I have to explain you why, either. Remember how the banking business works? Banks take in deposits that either pay no yield at all (in the case of checking accounts) or pay a yield tied to short-term interest rates (in the case of savings accounts). Then they turn around and lend those deposits at a longer-term interest rate. So when the yield curve steepens, as it is doing now, banks' net interest margins tend to go up. Which is to say, banks' profitability is expanding as you read this very sentence.
This yield-curve-steepening business isn't the only good thing going on with the banking business lately. Several other events are occurring that, prior to the industry being tossed into the investment community's doghouse, would have been considered bullish. For one, the financial system has come a long way toward recovering from its freeze-up in September following Lehman's collapse. Credit spreads have narrowed generally, on everything from corporate credits to junk.
And as Bloomberg reported on Thursday, the Federal Reserve is no longer the system's buyer of first, last and only resort....{C}redit the Fed has extended to financial institutions is off by 38% since the start of the year, to $701 billion. So increasingly, borrowing and lending is going on without the help of the federal government.
In the meantime, the "green shoots" in the economy that everybody seems to be talking about apparently aren't figments of anyone's imagination. Thursday morning, for example, unemployment claims came in better than expected (claims, a key leading economic indicator, have clearly passed their peak), while April durable-goods orders were notably strong. Consumer confidence, another leading indicator, is rising fast.
Put it all together -- widening net interest margins, a return to normalcy in the financial system and credible signs of an economic recovery -- and it's not hard to imagine a steady, rapid recovery in bank profitability in coming quarters. Yet the stocks seem to be priced as if the credit crisis is going to last more or less forever.....not only are the stocks not trading as if a fundamental recovery is visible; some are trading as if they face years and years of losses. Which they don't.
The steepening of the yield curve is only the most recent piece of encouraging news to hit the banking business lately. The pieces are in place for a broad industry recovery. It's just the stocks' valuations that have yet to catch up.

As an aside I used to work for the same company as Matt. He is very smart and understands banking very well.

GM-Cartoon

*Copyright 2008 Creators Syndicate.

Krugman On Inflation

Paul Krugman in a New York Times editorial weighs in on inflation. Excerpt with link at end:

The Big Inflation Scare
By PAUL KRUGMAN
Published: May 28, 2009

Suddenly it seems as if everyone is talking about inflation.....{a}nd markets may be heeding these warnings: Interest rates on long-term government bonds are up, with fear of future inflation one possible reason for the interest-rate spike.
But does the big inflation scare make any sense? Basically, no — with one caveat I’ll get to later. And I suspect that the scare is at least partly about politics rather than economics.
First things first. It’s important to realize that there’s no hint of inflationary pressures in the economy right now. Consumer prices are lower now than they were a year ago, and wage increases have stalled in the face of high unemployment. Deflation, not inflation, is the clear and present danger.
So if prices aren’t rising, why the inflation worries? Some claim that the Federal Reserve is printing lots of money, which must be inflationary, while others claim that budget deficits will eventually force the U.S. government to inflate away its debt.
The first story is just wrong. The second could be right, but isn’t.
Now, it’s true that the Fed has taken unprecedented actions lately. More specifically, it has been buying lots of debt both from the government and from the private sector, and paying for these purchases by crediting banks with extra reserves. And in ordinary times, this would be highly inflationary: banks, flush with reserves, would increase loans, which would drive up demand, which would push up prices.
But these aren’t ordinary times. Banks aren’t lending out their extra reserves. They’re just sitting on them — in effect, they’re sending the money right back to the Fed. So the Fed isn’t really printing money after all.....
.....The Bank of Japan, faced with economic difficulties not too different from those we face today, purchased debt on a huge scale between 1997 and 2003. What happened to consumer prices? They fell.
All in all, much of the current inflation discussion calls to mind what happened during the early years of the Great Depression when many influential people were warning about inflation even as prices plunged. As the British economist Ralph Hawtrey wrote, “.......It is after depression and unemployment have subsided that inflation becomes dangerous.”
Is there a risk that we’ll have inflation after the economy recovers? That’s the claim of those who look at projections that federal debt may rise to more than 100 percent of G.D.P. and say that America will eventually have to inflate away that debt — that is, drive up prices so that the real value of the debt is reduced.
Such things have happened in the past.....But more modern examples are lacking. Over the past two decades, Belgium, Canada and, of course, Japan have all gone through episodes when debt exceeded 100 percent of G.D.P. And the United States itself emerged from World War II with debt exceeding 120 percent of G.D.P. In none of these cases did governments resort to inflation to resolve their problems.
So is there any reason to think that inflation is coming? Some economists have argued for moderate inflation as a deliberate policy, as a way to encourage lending and reduce private debt burdens. I’m sympathetic to these arguments and made a similar case for Japan in the 1990s. But the case for inflation never made headway with Japanese policy makers then, and there’s no sign it’s getting traction with U.S. policy makers now.
All of this raises the question: If inflation isn’t a real risk, why all the claims that it is?
Well, as you may have noticed, economists sometimes disagree. And big disagreements are especially likely in weird times like the present, when many of the normal rules no longer apply.
But it’s hard to escape the sense that the current inflation fear-mongering is partly political, coming largely from economists who had no problem with deficits caused by tax cuts but suddenly became fiscal scolds when the government started spending money to rescue the economy. And their goal seems to be to bully the Obama administration into abandoning those rescue efforts.
Needless to say, the president should not let himself be bullied. The economy is still in deep trouble and needs continuing help.
Yes, we have a long-run budget problem, and we need to start laying the groundwork for a long-run solution. But when it comes to inflation, the only thing we have to fear is inflation fear itself.

Link: http://www.nytimes.com/2009/05/29/opinion/29krugman.html?_r=1&ref=opinion

Bank Stock Convert. Redemptions and Leveraged ETFs.

I'm printing an excerpt of this from 24/& Wall Street because this issue is out there and also for certain selected accounts I own postions in UYG which is a leveraged bank stock ETF. I think it is something of which to be award but I'm not exactly sure how it could affect this ETF postively or negatively. Actually I think it is a bigger negative for holders of bank preferreds.

"The triple-leverage financial ETFs of Direxion Daily Financial Bull 3X Shares (NYSE: FAS) and Direxion Daily Financial Bear 3X Shares (NYSE: FAZ) are getting to deal with yet another potential wrench in the machine: preferred share redemptions from major banks. This will also pose a potential issue for the Ultra Financials ProShares (NYSE: UYG) and the UltraShort Financials ProShares (NYSE: SKF) ETFs that trade at double-leverage of the Dow Jones U.S. Financials index......

...All of these index levels actually track just the common stock, so the dilution, the new issuances, and the potentially larger market caps of the common shares would be what matters to these ETF’s. These ETF’s are only full of the common stocks......The biggest issue out there for how this will affect the ETF’s which track banks, financials, and preferred shares is the overall weighting.....The incentive here is actually rather simple to retire these at lower prices than the traditional $25.00 PAR if possible. The yields on many of these preferred securities is close to 10%. Some yields are even higher. Bankers cannot make that much spread even if the credit card rules were not changing.
There is also the notion that these preferred share redemptions act as effective Tier-1 capital raising activities. Some consider this a balance sheet trick, but if it lowers current obligations and long-term debt then that is ultimately good for shareholders of common stock in today’s environment even if you consider the dilution that the common holders have to accept.

Link: http://247wallst.com/2009/05/28/leveraged-etfs-weigh-bank-preferred-redemptions-fas-faz-uyg-skf-pgf-bac-jpm-wfc-gs-c/#more-35916

*Long UYG in certain risk oriented accounts, certain bank stocks in legacy accounts and certain bank preferreds.

Crocuses Revisited!

Erin Burnett over on CNBC was discussing this morning how everybody uses the term "green shoots" when discussing signs that the economy is getting better. She said that she had thought about using the term "Crocuses" as she hadn't heard it as much. I'll remind Erin that we started using this way back in April when discussing a change in stocks' money flow characteristics. See the beginning of the series here: http://lumencapital.blogspot.com/2009/04/crocuses-in-spring.html. Don't think I could have copyrighted the phrase but it just goes to show that I'm a thinker ahead of my time! :-}

Oil Goes Boom!

Markets are beginning to notice that the price of oil is headed higher. We've discussed this for some time. It seems to me this must happen as world economies start to recover. More economic activity means higher demand for oil or at least it does according to how I learned the business. Here is what 24/7 said about yesterday about oil:

"Oil will post its largest one-month rise since 1999 in May. That does not seem possible given that it rocketed up to $147 in the middle of last year. The news is a sign that crude prices are on a march that may not end this month." Link: http://247wallst.com/2009/05/29/a-powerful-rise-in-oil-even-by-2008-standards/#more-36036.

Refinery usage is also up according to the US Department of Energy. It also reported yesterday that crude stockpiles & gasoline stockpiles declined in the past week. Oil inventories have now declined for three straight reports. We've all probably noticed that the price of gasoline has risen as well.

All of this is likely bullish for a higher price in oil commodities (which investors can own through the ETF USO) and is also bullish for higher share prices in oil services and exploration companies.

We've included a chart of USO above. Note these positives. 1. Oil has taken out its downward sloping trendline from last summer. 2. It has broken through resistance, the top end of its trading range which has been in place since December. 3. Money flow probability indicates that the price of oil per the USO should at some point be attracted to and test the $40 level. That $40 level nearly equates with a $75 dollar price in crude. That is a level that OPEC has argued is an ideal for oil prices. ^

^Link: http://247wallst.com/2009/05/28/oil-inventories-plummet-regardless-of-opec-production-targets-uso/#more-35909

USO is currently oversold. It could now flop around and consolidate its gains. Note as well I'm not arguing that oil is going anywhere near its old highs anytime soon. But I do think that the trade to oil and energy prices is now to the upside. I am an investor in these sectors and the commodity itself through the USO ETF for appropriate accounts and would like to buy these on weakness going forward.

*Long ETFs related to oil exploration companies and oil services companies. Long certain oil and oil services companies in legacy accounts. Long USO for risk appropriate accounts. Long certain leveraged energy ETFs for risk appropriate accounts.

Finally please consult your own investment advisor or do some homework on your own if you are not a client of our firm. This is simply to let you know what we are doing for clients and should in no circumstances be seen as a recommendation for you to follow our lead.

Volatile Markets!

Market Talk on this weeks volatile trading {excerpted}:

"US stocks continued the week’s erratic trading, rising after {Wednesday’s} sell off and after {Tuesday's} rally, as investors absorb a raft of economic data and GM edges closer to bankruptcy, although it might finally have the bondholders on board.
DJIA jumps 104 (1.3%) to 8404, S&P 500 gains 14 (1.5%) to 907, Nasdaq Comp rises 21 (1.2%) to 1752. Big Board volume’s weak. Again, Treasury's market is the big focus; 10-year yield hits key 3.75% mark, rising as high as 3.76% actually, but later falls to 3.64%.
So, let’s see. {Tuesday} the Dow surged ahead about 195 points (confidence looks great!) {Wednesday}, it slid 173 (government debt looks scary!) Yesterday it rose 104 (well, gosh, some things look good and some things look bad.) What it really looks like is the pros are just playing games here.
Durables orders rise sharply. Initial jobless claims slide, but continuing claims strike fresh record. MBA reports rising joblessness is pushing up mortgage defaults
Every sector rises except consumer discretionary. Financials lead, aided by late rise. Energy up smartly as crude crosses the $65/barrel mark, which should be a concern for everybody else."

Link: http://markettalk.newswires-americas.com/?p=2256#more-2256

Comment: I think most of this is market noise albeit with a bit more volatility. Market seems to be correcting by time instead of by price and could set the stage for another move up at some point between now and beginning of August. After that I think we could get dicey for a while. We continue to try to work on client allocations, invest in sectors we think will be attractive and find ways to repair positions ravaged by the bear market.

*Long ETFs related to the Dow, the S&P 500 and the Nasdaq Composite.

Housing Data.

24/7 Commented on Tuesday's release of the most recent housing data. Would have published this earlier but was too busy. Business conditions will start to get better I believe when the market becomes more confident that housing prices have bottomed.

Case-Shiller Housing Data May Not Be What It Seems
Posted: May 26, 2009 at 8:50 am

Subscribe Free Newsletter Follow us on Twitter

The S&P Case-Shiller US National Home Price Index dropped by another record. The March report was another drop of 2.2% for March. The Q1-2009 period does have a look-back to it that is older than more recent data, but the report showed a 19% drop. The drop for the 20-city report and the 10-city report showed 18.7% and 18.6% drops, respectively.This report did act against equity futures because it is knocking down the notion that the housing sector is coming back. The problem with this report is that despite the Q1 period being a record drop, this data is older than more recent data.
The numbers are still staggering. This is a drop of 32.2% from the peak of 2006 nationwide, and worse in some regions. We are also back to 2002 housing prices in aggregate.
We will not go so far as to call the housing market robust because it is not. It is far from that. But the new data with permits is mixed if you back out the multi-family projects. We are also starting to see a slight resurgence of activity. We have no hopes that the housing and construction activity will look anything at all like late 2004 through mid-2007. But this Case-Shiller data differs from other reports we have been seeing.
There is also a silver lining in the Case-Shiller data. The lower that index goes, the more and more affordable housing becomes. We would also note that while these prices were tanking the worst during the Q1 period also coincided with what was a foreclosure moratorium period where many quick sales and pre-foreclosure sales were commanding dirt cheap prices for qualified buyers. The lower prices are now driving the beginnings of what seems to be higher demand.
For the market to react this way makes the obvious even more obvious. Housing was grossly overpriced for years. Those part-time realtors who told you that housing always goes up, well you can call them and ask them about that now. They are easy to find. They are at home, or at their parents’ houses.

JON C. OGG

Link: http://247wallst.com/2009/05/26/case-shiller-housing-data-may-not-be-what-it-seems/#more-35592

GM In Bankruptcy: Grumpy Owes Me Dinner!

This today from 24/7 Wall Street:

GM’s (GM) creditors have rejected a program that would have swapped most of the auto company’s debt for equity, effectively driving the firm into Chapter 11. The century that began with the mass production of the Model T in 1909 and ended with the worst collapse of domestic vehicle demand in history is over. It was a one hundred year period when Detroit was considered the seat of global manufacturing prowess, a period when The Big Three were among the largest, and often the most profitable, companies in the world.
Fueled by abundant and cheap gas and the availability of rubber tire production, the US vehicle market grew to a 16 million unit a year business. This year that number will be under 10 million which will cause nearly every auto company doing business in America to show red ink in the region.
GM’s bankruptcy along with Chrysler’s will certainly help drive down the US market share of The Big Three and open the door further to nimble and more well-funded competitors including Toyota (TM), Honda (HMC), Nissan, and Hyundai. It would be surprising if Detroit has only a 30% share of the American car market by the time vehicle sales recover even modestly, probably in 2011.
Once GM comes out of Chapter 11, if it does, the US government, or more accurately the taxpayers, will own 70% of GM and the UAW will own almost 18%. GM will have become a ward of the state.
In Detroit, the last person to leave can turn out the lights.
Douglas A. McIntyre

Link: http://247wallst.com/2009/05/27/as-gm-gm-prepares-for-bankruptcy-the-detroit-century-draws-to-a-close/#more-35726

Comment: You might remember that I have a standing bet with Grumpy in which I took the side of GM going into bankruptcy. Grumpy has always been adamant that this would not happen. Grumpy is going to owe me dinner!

Fear Trade.

From "Market Watch" yesterday:

Does it seem like there was some kind of fundamental shift in investor perceptions last week, after S&P warned the UK about its finances (and, some felt, by extension, the US), or were investors just taking some profits off the table while the so-called fear trade was unwinding?
That’s the dilemma for investors right now. And given everything that’s happened the last two years, it’s not a question to be taken lightly. (We’re not financial advisers, but if you’re waiting to see how low rates will get before refinancing, now might not be the worst time to pull that trigger.)
Some are attributing the rise in bond yields and drop in the dollar as an unwinding of the risk trade, but something else might be at work.“That might have been the right spin in the past,” says market strategist Ed Yardeni. “However, could it be that the riskier assets have become the sovereign debts and currencies of Old World nations running excessively high government deficits?” (Yardeni includes the US in his definition of the “Old World,” which contrasts with the developing nations he calls the “New World.”)
He notes the administration may be getting the picture. White House budget director Peter Orszag told the FT the government will take steps to curb deficits and explore “policy adjustments.”
“They better start exploring faster,” Yardeni says. But, as with every question that crops up in the marketplace, there are other answers.
“I think a large portion of the rise in rates is result of the unwinding of the fear trade,” says Kent Engelke, chief economic strategist of Capitol Securities Management. Engelke doesn’t see the US losing its triple-A rating “for the simple it is not only the primary global benchmark but also the default benchmark. Competition or alternatives are nonexistent.”

Link: http://markettalk.newswires-americas.com/?p=2150#more-2150

an tSionna 5.26.09 Trading Range

Another chart of the SPY using some of our more proprietary indicators. Again double click on chart to make it bigger. Shorter term it is more of the same story. Pink lines show the trading range we've been in (and endlessly discussed) since last fall. One of our proprietary indicators of demand (# 1 above) flipped positive back in April and right now shows no signs of rolling over. This is an intermediate term indicator-measuring markets in increments of weeks and shows us that right now there are buyers willing to put money to work on pull backs of stocks.

Number 2 shows some more of our proprietary indicators. These measure whether markets are over bought or over sold. Currently these are showing declining trend lines. This indicates that stocks are beginning to work through their over bought condition. Remember we discussed over the weekend that stocks can work out being over bought by price (a declining market) or time (churning going nowhere). These indicators declining while stock prices essentially go nowhere indicates more of a churning market at this time.

*Long SPY and other ETFs related to the S&P 500.

an tSionna 5.26.09 S&P 50 & 200 Moving Averages

Here's a longer term chart of the S&P 500 represented above by one of its ETFs the SPY. You can double click on it to make it larger. Notice 3 things:

1. S&P trading above its 50 day moving average. {Green Line}

2. 200 day moving average {Red Line} has declined to the point that it has now become a legitimate focus of resistance. It has also flattened out and is not declining at this time.

3. Distance between the two moving averages has narrowed, making the likelihood of a positive (golden) cross possible sometime later this summer.

*Long SPY and other ETFs related to the S&P 500.

Happy Memorial Day

In our town of River Forest one of the highlights of our year is the Memorial Day parade which runs right down our street passing in front of Global HQ. We fly two American flags betwee now and the 4th of July.

The flag you see off to the side of HQ was carried by my brother-in-law who flew Harrier jets

jets for the marines in Afghanistan. We honor his service and all others who

are or have served in our armed forces.

Happy Memorial Day everybody. Hope its sunny!

Playbook: Market-Memorial Day Weekend

Playbook:

I wanted to elaborate on one point that I'm not sure was very clear in our latest letter. I stated that I think the most likely scenario will be that stocks remain mired in the same trading range we've been seeing since last fall. Memorial Day begins the summer season and there has been a traditional belief that stocks don't do well over the summer in terms of returns. There is conflicting data on that. I think the best way to characterize what we know is that stocks tend to hold their own throughout the early summer months. However August to Mid-October can be pretty dicey. I'll flesh this out with some data in a future post. The point is that I think this year we stand a very good possibility that stocks won't be much higher or lower {plus or minus 5-10%} from where we are right now.

I think that we have currently entered into some sort of corrective phase after the run up we've seen since March. Whether that is a correction of time {a market that essentially flops around and goes nowhere} or price (some sort of decline} is currently open to debate.

What we've done is to become somewhat more defensive in our posture. For appropriate accounts we have raised small amounts of cash. You should note that even if we have raised cash in your account than in many cases this is still at lower amounts than we have normally carried around this time. Some of the securities we sold were trades that we entered into on a more tactical basis during the spring and we have now sold out of some of these. We will look to re-enter these if the market pulls back at some point. We are also redeploying cash into areas that we think will be leading sectors going forward. We have discussed some of these in the past. Currently some of the sectors we favor include energy and materials, financials-in the belief that the worst of the banking crisis is behind us; and technology. In keeping with our energy and materials theme, in appropriate accounts we have also added some positions in gold and oil through ETFs.

We have also gone about the process of beginning to repair positions ravaged by last years bear market. I will describe how we are doing this in a future posting to you.

*Long ETFs related to energy, materials, financials technology, oil and gold for appropriate client accounts. Investors who are not clients of our firm should either do their own homework or consult with their own investment advisor to determine the appropriateness of these investments for their portfolios.

Chart Of The Day-PE's On Current Earnings

From Chart Of The Day.

This chart goes along with what they posted last week so I thought we should have a look at it as well. My one thought is that before much valuation work is done on this, we need to remember that not only are earnings impacted by the recession but they are also impacted by all of the reserves and charge offs corporations are currently taking. That should start to improve in 2010 and I believe the market will start to reflect that improving environment next year. However, if that isn't the case then stocks are expensive!

"Last week's chart illustrated the current plunge of S&P 500 earnings. Today's chart illustrates how this plunge in earnings has impacted the current valuation of the stock market as measured by the price to earnings ratio (PE ratio). Generally speaking, when the PE ratio is high, stocks are considered to be expensive. When the PE ratio is low, stocks are considered to be inexpensive. From 1936 into the late 1980s, the PE ratio tended to peak in the low 20s (red line) and trough somewhere around seven (green line). The price investors were willing to pay for a dollar of earnings increased during the dot-com boom (late 1990s) and the dot-com bust (early 2000s). As a result of the current plunge in earnings and the recent 2.5 month stock market rally, the PE ratio has spiked to the low 120s – a record high."

Link: https://www.chartoftheday.com/ {Subscription Required}.

*Long ETFs related to the S&P 500.

May Letter To Clients Part V

Equities Past 2009:

Stocks are certainly more expensive than they were in March but are still significantly below their previous highs. We are expecting sub par economic growth for at least the next 18th months. Both corporate and consumer balance sheets are still in the process of recovery. This should put a lid on consumer spending leading to that lower growth. Individuals are current savers of cash, rapidly reversing years where their savings rate was almost nothing. However, at some point that pent up economic demand should lead to a much better economy. We believe that stocks will begin to reflect that some time in 2010.

The S&P 500’s current P/E ratio (on a trailing basis) currently stands at 14.5, well below its 16.7 average since 1962. The trailing earnings yield (the inverse of the P/E ratio) is currently 6.9%.* Investors are being paid to own stocks right now, especially when viewed against the current anemic money market rates. Many ETFs also carry attractive dividend yields due to their depressed valuations. Even if one accepts that earnings will not soon significantly recover and that some dividend yields might still decline, investors can find many areas of the market where they can be paid good money to wait until better times.

Our chief scenario calls for an S&P 500 that could trade between 950-1,100 by year end and the potential to trade between 1,100 and 1,250 by year end 2010. This means stocks could potentially gain between 6-20% in 2009 and gain in excess of that 20% number by year end 2010. I’d also note that if the market traded at 1200 by next year it would simply be trading back at levels from last summer and would be trading around the same price where it first traded in 1998.

No investment thesis should be written in stone. There are many variables that could render our valuation scenario moot. We would then adapt them to current facts. However, we believe this is a plausible outcome and indicates that stocks are a better buy even after this most recent run up and certainly into any weakness that might occur this summer. As usual we will let our indicators be our guide.

Thank you for reading our letter and letting us serve your investment needs.

*Long ETFs related to the S&P 500

May Letter To Clients {Conclusion}

Christopher R. English is the President and founder of Lumen Capital Management, LLC.-a Registered Investment Advisor regulated by the State of Illinois. A copy of our ADV Part II is available upon request. We manage portfolios for private investors and also manage a private investment partnership. The information derived in these reports is taken from sources deemed reliable but cannot be guaranteed. Mr. English may, from time to time, write about stocks in which he has an investment. In such cases appropriate discloser is made. Lumen Capital Management, LLC provides investment advice or recommendations only for its clientele. As such the information contained herein is designed solely for the clients or contacts of Lumen Capital Management, LLC and is not meant to be considered general investment advice. Mr. English may be reached at Lumencapital@hotmail.com.

*Source Bespoke Investment Group, B.I.G Tips, 5.14.09 Long ETFs related to the S&P 500 at the time of this writing.

May Letter To Clients {Part IV}

Where Are We Going? {Mid-2009 Game Plan}

We manage portfolios based on clients’ personal criteria. This is influenced by factors such as a client’s risk profile, portfolio size; legacy positions held in accounts, tax considerations and targeted rates of return. What follows is therefore a broad statement of our thinking, a general statement of how portfolios are currently positioned and our investment posture at this time. Client portfolios may not exactly match our general analysis discussed below.

Many of our investment indicators have recently turned positive. This does not mean that an all clear is sounding but it does signal to us that conditions are improving. For much of this spring we have carried lower than normal cash positions in accounts. With the market’s recent advance we have where appropriate slightly trimmed certain investment positions. This is because we think stocks could pause in their advance for awhile. We could raise more cash if conditions warrant it in appropriate client accounts.

Our current strategy is similar to our last letter. That is: (1) Reposition into sectors that we think will benefit over the course of this year. (2) Reposition our core broad market ETFs. We have done this by splitting these sectors, one portion looking for longer term value while the other portion is utilizing in appropriate accounts some of our Targeted Investment Growth strategies to look for shorter term investment opportunities. (3) Take advantage of market dislocations which have given rise to attractive dividend yields. In general our investment focus has continued to be on ETFs.

While our crystal ball is cloudy even on its best days we do have three chief scenarios. Briefly here is their synopsis and our general strategy for each:

1) Market faces a serious decline taking us back to our recent lows. Given what we currently know we think this is unlikely. We believe that it would take an unexpected event {natural disaster, foreign crisis or a massive terrorist event} or an overlooked set of data points for this to occur. We have targeted levels where we would attempt to raise cash in risk appropriate accounts should this occur. Please note that an unlooked for event-something like 9.11.01, could lead to a sudden and severe market decline, making attempts to raise cash problematic.

2) Stocks continue to rally and move substantially higher over the summer. We also assign little likelihood to this given our current advance along with an anemic economy. However, our current investment posture would benefit if this should occur.

3) Market in a trading range. Stocks stay locked in this trading range through summer, evidence of economic improvement leads to a resumption of the advance later in the year. We think that this is the likeliest event. Again we have price points of where we would raise cash into any further decline for risk appropriate accounts and have ear marked certain sectors that we believe could do well in this kind of environment. These include commodity related investments, industrial and material sectors, agriculture and technology.

*Long ETFs related to the S&P 500

{Tomorrow Part V & Conclusion}

May Letter To Clients {Part III}

The Great Reset

We mentioned last year long before the Presidential election that 2008 would be viewed as a change year. Much like Kennedy’s win in 1960, FDR’s win in 1932 and Reagan’s win in 1980, we think investors will look back on this era and notice a fundamental break in many ways with the past. We also think for better or worse the world will be a much different place a decade from now.

Demographically and culturally the United States is changing. So are our views regarding a whole host of issues from energy to the environment to foreign affairs. Two areas that are currently seeing change are the role of governments and how securities markets function.

Governments at every level are becoming more assertive versus the private sector. Often this is simply motivated by the need for money. In case you haven’t noticed almost every institution and governmental entity is broke and screaming for cash. However the main thrust of this has come in response to the current economic crisis and a belief that there are many parts of the private sector that need more regulation or control.

From its response to the financial crisis to its firing of General Motors CEO and signaling of its intent to remake the healthcare sector, the new Obama Administration desires to revamp many Federal policies and bring the government into many sectors of private life. It is too soon to know how these policies will shake out. Usually too much governmental involvement in business leads to tepid economic growth and stock PE contractions. Such control usually brings about a higher tax burden which must be born by somebody at some point.

Securities markets are also changing. Not only are there many more types of instruments traded today such as Exchange Traded Funds {ETFs} but it is often unclear how some of these interact with trading. For example very few people had heard of Credit Default Swaps {financial instruments for swapping the risk of a debt default} until a year ago. Most cannot explain them even today. Fewer still could have predicted that these instruments would have the potential to wreck the financial system.

One thing that is clear is that markets now react instantaneously to information. As such we are forced to develop new tactics to these changes. Our development of our “Playbook" is a response to this. In it we constantly ask “What If….?”, we try to develop responses based on those results and then look for ways to tactically implement these ideas in client portfolios based on what we understand to be their unique risk/reward equation. We always have an investment game plan. We constantly evaluate our plan and stand ready to change it when conditions change.

*Long ETFs related to the S&P 500

{Tomorrow Part IV}

May Letter To Clients {Part I}

Like refugees, investors left their winter bomb shelters and finally took a look at the outside world and their investments again.

Emerging From The Rubble

Investors emerged from the rubble and tried to reconnect with their old lives. First came another mid-winter scare that sent stocks sliding on average another 25%. This last leg down came from missteps by the new Obama Administration, particularly in some early miscues regarding the banking crisis. The fact that corporate earnings were still falling off a cliff did not help either.

However, by mid-March, investors decided that stocks had become bargains. Share prices stabilized and then began a rally that trough to peak took the S&P 500 up close to 40%. Stocks are currently close to where they ended 2008. Recently, stocks have begun to exhibit traits that are characteristic of at least some pause in their current advance.

Where We Stand

I like pictures because I am a simple person. I have included below two charts showing what I believe is going on with the market.The chart pictured above shows a longer term view of the S&P 500 dating back to 2007. It puts this decline into perspective in terms of its length and depth. It also shows the current trading range we are in. We are still over 40% below the October 2007 highs and are still 25% below where we traded at the end of last summer.

May Letter To Clients {Part II}

The chart {above} is a more detailed version of events since August. I want to focus on the market’s trading range since then-which is roughly 200 S&P points or about a 30% swing from its bottom to its top.

Stocks have twice been turned back from the top of this range, the first time back in early November and then at the end of the year. The current evidence is indicating a likelihood that we are in the process of a third failure at this resistance line. Investors have been sellers into rallies recently and many companies have taken the opportunity to raise cash through stock offerings. This has the effect of bringing more supply to market than current demand seems to be able to support.

Under the surface are several positives which indicate that stocks are beginning to repair themselves. Stocks’ moving are now starting to exhibit upward as opposed to declining slopes. Moving averages show the average value of a security’s price over a set period. They are generally used to measure price momentum and define areas of possible support and resistance.

The second positive is that each time a security approaches a major line of support or resistance brings a higher probability that it will penetrate this next level. That is why any correction should provide clues as to market direction in the coming months. It is not unreasonable to expect a pause in the advance given how far stocks have traveled in a short period of time. Also stocks can correct in price (that is by declining) or by time (spending a certain period essentially going nowhere).

*Long ETFs related to the S&P 500.

{Tomorrow Part III}

Charts From Our Latest Investment Letter

Here are the charts from our latest investment letter. I didn't like how they came out when printed-a bit too blurry for my taste. You can double click on them to expand them!

Barrons: Bursting of Treasury's Bubble

Excerpt.



U.S. Blues
By ANDREW BARY T



The bear market in Treasuries will worsen, because of a glut of government bonds. Instead, consider high-yielding mortgage securities and certain munis.

THE BUBBLE HAS BURST.
We're talking about U.S. Treasury securities, not housing. At the end of 2008, risk-averse investors poured into Treasuries, driving down yields to the lowest levels in decades. The 30-year Treasury bond fetched less than 3%, and short-term T-bills carried yields of zero.

Since then, the economy has shown signs of bottoming, the credit markets are functioning more normally, and the stock market has roared back from its March lows. Treasuries now are in a bear market, while bullish enthusiasm has taken hold in other parts of the credit market, including corporate bonds, municipals and mortgage securities, all of which had fallen from favor late last year. The 30-year Treasury, for instance, has risen to a yield of 4.10% from 2.82% at the end of 2008, cutting its price by 20%.
Barron's called a top in Treasuries and a bottom in the rest of the bond market in an early 2009 cover story ("Get Out Now!" Jan. 5). We weren't alone in recognizing some of the nutty year-end developments. Warren Buffett highlighted the sale in late 2008 by his Berkshire Hathaway of a Treasury bill for a negative yield. Buffett wrote in Berkshire's annual letter in February that when "the financial history of this decade is written...the Treasury-bond bubble of late 2008" may rank up there with the housing bubble of the early to middle part of the decade. - How does the market look now? Treasuries still look unappealing for several reasons. Yields are very low by historical standards, the government is issuing huge amounts of debt to fund record budget deficits, and the massive federal stimulus program ultimately may lead to much higher inflation.
"There are better values elsewhere among high-quality bonds," says Steve Rodosky, an executive vice president at Pimco, which runs the giant Pimco Total Return fund (ticker: PTTAX).........Mohamed El-Erian, was blunt at year's end, saying, "Get out of Treasuries. They're very, very expensive."
While holders of Treasuries ultimately will get their money back, prices could fall sharply in the interim, and repayment could be in greatly depreciated dollars. Treasury yields may rise further in the coming year, meaning that prices will fall as the economy strengthens. The yield on the 30-year bond could top 5% and the 10-year note could rise to more than 4%, from a current 3.15%.........



......Treasury rates aren't apt to shoot up anytime soon, because so-called core inflation, which excludes food and energy costs, is likely to remain around 1% for the time being and because "the economy is turning slowly." Fresh concerns about the economy prompted a 4% sell off in the stock market last week, and a rally in the Treasury market, which tends to move inversely to stocks.
Looking out a few years.....the 10-year Treasury could hit 5.5% as investors seek a real, or inflation-adjusted, return of 3.5%, relative to what may be 2% inflation. It's no secret that the U.S. budget deficit is exploding this year from the combination of weak tax receipts and sharply increased spending. The Obama administration recently increased its deficit projection for the current fiscal year ending in September to $1.84 trillion, from the $1.75 trillion estimate made in February, and lifted its 2010 deficit estimate to $1.26 trillion, from $1.17 trillion. That compares with a $458 billion gap last year.
THE RESULT IS A LARGE INCREASE in the issuance of government bonds......The growth in bond supply is particularly pronounced in seven-year, 10-year and 30-year maturities. One sign of trouble was the poor reception in a recent sale by the government of 30-year bonds.
The government-bond glut is hardly confined to America. Combined issuance in the U.S., Europe, Japan, Canada and Australia could come to $4.2 trillion this year, according to British financial historian and author Niall Ferguson......
The U.S. Federal Reserve is trying to sop up part of the bond deluge with a program to buy $300 billion of government debt through the end of September......The Fed also has a program to buy $1.25 trillion of agency mortgage securities as part of an effort to depress mortgage rates, now averaging around 5%.
The Fed may succeed in artificially depressing Treasury rates for the time being, but the Fed program will end eventually, removing a key piece of support for the market. The Fed could get stuck with sizable losses if rates rise, since its holdings of bonds and mortgage securities, now $1 trillion, could double by the end of 2009....

...OVERSEAS DEMAND, PARTICULARLY from central banks, has supported the Treasury market in recent years, but that buying appears to be waning. China, for instance, sees sharply slowing growth in its foreign-currency reserves this year due to weakening exports, a development that reduces the country's demand for Treasuries. Chinese officials also are worried about the country's $1 trillion-plus holdings in Treasuries and other U.S. debt because of the risk of a weakening dollar and higher inflation......



Comment: As we have told clients, you can find many yield areas of the market today where you are paid to take risk. Treasuries and money market accounts are not currently in this category.



Link: (Subscription may be required) http://online.barrons.com/article/SB124242707254925309.html

One Of Our Newer Clients.

A Change In Short Term Sentiment.

Many of our shorter term indicators have moved into the negative column this week. So far what this represents is a loss of investor confidence that stocks are going to make another major move up soon. We do not believe at this juncture that it represents a longer term change in market trend. We have talked about this in several different postings in the past two weeks. We will also discuss this a bit more in our latest investment letter which will go out over the internet to clients Sunday night and will be mailed to others on Monday. If you are not a client or a contact of our firm, e-mail me and I will send you a copy. I can be reached at lumencapital@hotmail.com.

What I think is happening:

I think that the market's recovery since March is running into an inevitable pause. First stocks are up over 30% from their lows. Second, many investors that bought stocks recently may be looking for places to take profits. Finally people who might have wanted out a few months ago have a better price point at which to sell today.

A pause here is not necessarily a bad thing as it gives stocks time to consolidate their gains. Longer term I am bullish as I feel that absent some unlooked for event or some unconsidered economic turn that stocks have priced in most of their known negatives and have slowly started their long recovery phase.

Shorter term, that is the environment over the next several months, I think stocks will remain locked in the trading range we've discussed previously until there is further improvement in the economic picture. Currently we are near the top of that range and right now the evidence suggest that we have failed to break out to the upside for the third time in the past six months. Accordingly per the Playbook, we have begun to be a bit more defensive in our short term investment posture, actually doing some selling for risk appropriate accounts over the past week. We will likely continue in this manner should stocks remain weak in the following days. For certain risk appropriate accounts we may even try to hedge part of their portfolio's downside exposure.

Understand that our selling is more of a short term nature at this point and that cash raised would be redeployed either at more favorable prices later on or back into sectors that we think might be areas of out performance going forward. We have discussed some of these sectors in the past and will give an update on these going forward.

S& P 500 Earnings

Chart of the Day puts earnings into perspective today:

While the stock market is up sharply since early March, the economy as well as corporate earnings continue to suffer. Today's chart helps provide some perspective as to the magnitude of the current economic decline. Today's chart illustrates that 12-month, as-reported S&P 500 earnings have declined over 90% over the past 20 months (with over 90% of S&P 500 companies having reported for Q1 2009), making this by far the largest decline on record (the data goes back to 1936). In fact, real earnings have dropped to a record low and if current estimates hold, Q3 2009 will see the first 12-month period during which S&P 500 earnings are negative.

*Long ETFs related to the S&P 500.

Link to their website {subscription required. https://www.chartoftheday.com/

My comments: Earnings are in many cases being artificially lowered due to corporate write offs and charges. Earnings look different when financial companies are removed from this analysis. Still there is no denying that this recession is carving long and deep into corporate balance sheets and cash flows.

Was it a Sucker's Rally

I was pointed to this editorial in Tuesday's Wall Street Journal. I think its theme is similar (and better written than my earlier post) so I've excerpted it here with a link at the end.

Was It a Sucker's Rally?
{You can have a jobless recovery but you can't have a profitless one.}
By Andy Kessler

The Dow Jones Industrial Average has bounced an astounding 30% from its March 9 low of 6547........Only a fool predicts the stock market, so here I go. This sure smells to me like a sucker's rally. That's because there aren't sustainable, fundamental reasons for the market's continued rise. Here are three explanations for the short-term upswing:
- Armageddon is off the table. It has been clear for some time that the funds available from the federal government's Troubled Asset Relief Program (TARP) were not going to be enough to shore up bank balance sheets laced with toxic assets.....Nationalizations seemed inevitable as bears had their day.
Still, the Treasury bought time by announcing on the same day as Mr. Geithner's underwhelming rescue plan that it would conduct "stress tests" of 19 large U.S. banks. It also implied, over time, that no bank would fail the test (which was more a negotiation than an audit). And when White House Chief of Staff Rahm Emanuel clearly stated on April 19 that nationalization was "not the goal" of the administration, it became safe to own financial stocks again.
It doesn't matter if financial institution losses are $2 trillion or the pessimists' $3.6 trillion. "No more failures" is policy. While the U.S. government may end up owning maybe a third of the equity of Citi and Bank of America and a few others, none will be nationalized. And even though future bank profits will be held back by constant write downs of "legacy" assets (we don't call them toxic anymore), the bears have backed off and the market rallied......
- Zero yields. The Federal Reserve, by driving short-term rates to almost zero, has messed up asset allocation formulas. Money always seeks its highest risk-adjusted return. Thus in normal markets if bond yields rise they become more attractive than risky stocks, so money shifts. And vice versa. Well, have you looked at your bank statement lately?
Savings accounts pay a whopping 0.2% interest rate -- 20 basis points.....So money has shifted to stocks, some of it automatically, as bond returns are puny compared to potential stock returns. Meanwhile, both mutual funds and hedge funds that missed the market pop are playing catch-up -- rushing to buy stocks.
- Bernanke's printing press. On March 18, the Federal Reserve announced it would purchase up to $300 billion of long-term bonds as well as $750 billion of mortgage-backed securities. Of all the Fed's moves, this "quantitative easing" gets money into the economy the fastest -- basically by cranking the handle of the printing press and flooding the market with dollars....... Since these dollars are not going into home building, coal-fired electric plants or auto factories, they end up in the stock market.
A rising market means that banks are able to raise much-needed equity from private money funds instead of from the feds. And last Thursday, accompanying this flood of new money, came the reassuring results of the bank stress tests.
The next day Morgan Stanley raised $4 billion by selling stock at $24 in an oversubscribed deal. Wells Fargo also raised $8.6 billion that day by selling stock at $22 a share, up from $8 two months ago. And Bank of America registered 1.25 billion shares to sell this week. Citi is next. It's almost as if someone engineered a stock-market rally to entice private investors to fund the banks rather than taxpayers.
Can you see why I believe this is a sucker's rally?

The stock market still has big hurdles to clear. You can have a jobless recovery, but you can't have a profitless recovery. Consider: Earnings are subpar, Treasury's last auction was a bust because of weak demand, the dollar is suspect, the stimulus is pork, the latest budget projects a $1.84 trillion deficit, the administration is berating investment firms and hedge funds saying "I don't stand with them," California is dead broke, health care may be nationalized, cap and trade will bump electric bills by 30% . . . Shall I go on?
Until these issues are resolved, I don't see the stock market going much higher. I'm not disagreeing with the Fed's policies -- but I won't buy into a rising stock market based on them. I'm bullish when I see productivity driving wealth.
For now, the market appears dependent on a hand cranking out dollars to help fund banks. I'd rather see rising expectations for corporate profits.

Link: http://online.wsj.com/article/SB124208415028908497.html
Commentary: Much better written than my last piece. I think we are currently in a phase where things aren't as bad as the bears try to tell us and no where near as good as the bulls would have us believe. That's why we've been in this trading range and that's why it's likely now that we continue to have some sort of pullback.

*Long ETFs related to the Dow Jones Industrial Average. Long legacy positions in Wells Fargo and Bank of America. Certain accounts also own Citigroup.

That Sinking Feeling.

Well I have to take a couple of days away from writing @ Solas! and stocks swoon. Equities had their biggest one day drop in about 6 weeks yesterday. The S&P lost close to 3% as did the Nasdaq. We did a bit more trimming in appropriate accounts yesterday as it seems that the shorter term uptrends are at a minimum stalling out right now.

Whether the advance we've seen since early March is taking a breather or this period turns into just another bear market rally is too soon to access at this time. In any case we've dusted off the game plan pages that we've worked on for a market decline at this point. We've been discussing for at least a week that the market's were acting toppy. As we pointed out over the weekend sellers have been coming out during rallies and that is usually a negative sign. We'll see how stocks react in the next few days for more clues. We'll probably write up an "an-tSionna" on Friday-taking a look at where we stand then. One other point is that this is an options expiration week so volatility could move up a bit over the next couple of days.

Two last thoughts. We've been at the top end recently of the trading range we've discussed repeatedly over the past six months and with the rally we've had it is natural to see some profit taking at some point. Stocks can correct in one of two ways: by time or by price. So far it looks like we're in a bit of a price correction but we will have to see. What did move up today was the gold ETF which we own for appropriate accounts. It currently has very positive money flows.

*Long ETFs related to the Nasdaq Composite, the S&P 500 and for risk appropriate accounts ETFs related to gold.