Summer Doldrums. Somebody Agrees With Me.

IndexUniverse.Com posted last week a Sun Trust Robertson Humphrey Report on what they expect over the summer. Their conclusions are similar to mine. Which of course is why I'm giving you an excerpt! :-}
Excerpt with Green Highlights:
• The market’s momentum seems to have stalled over the past few weeks, as stocks continue to digest the roughly 40% rally from the March lows. Confidence that the Armageddon scenario is likely off the table supported much of these initial equity gains, but now investors are searching for tangible signs the economic recovery is under way, as opposed to merely a decline in the rate of change of disappointing data.
• With increased expectations versus what will likely continue to be a mixed bag on the economic front, at least in the short term, we suspect equities will be confined to a trading range in the near term as investors await the next catalyst. From a technical perspective, we see resistance for the S&P 500 at 956 (recent peak) and estimate downside support at 880, then 825.
• Indeed, the process of two steps forward, one step back is to be expected, as stocks almost never move up in a straight line...........
• That said, we believe the S&P 500 is likely to see higher levels later in the year, once investors gain greater confidence in an economic rebound and the corporate profit picture becomes clearer.
• Indeed, our SunTrust Chief Economist, Gregory Miller, is becoming more convinced that the economic recovery will prove to be stronger than the current consensus view. He estimates the economy will grow at an average annualized pace of 2.8% in the back half of this year, followed by average increase of 4.2% in 2010. His projections are stronger than the current consensus that calls for a 1.3% rebound in 2H09, and a 1.8% rise in 2010, according to the latest Bloomberg survey. Miller attributes much of his more optimistic projection to the roughly $400 billion, or about half, of the $787 billion of the fiscal stimulus package that the administration expects to deploy from October of this year through September 2010.
• From a stock market perspective, a better than expected economic environment could lead to upside earnings surprises later in the year, or at least stabilization of the negative revision trends that have been a regular occurrence during most of the recession.
• In fact, we are already seeing signs that earnings may be bottoming. One way we measure this is by tracking the percentage of S&P 500 companies that are seeing their current-year earning estimates raised. .....it appears they overshot to the downside, and in many cases they are now revising their projections higher. Over the past three months, 45% of companies within the S&P 500 have seen their earnings estimates increased, which is up substantially from just 9% in February.
This change is also being reflected in the Street’s aggregate S&P 500 earning estimates for 2009 and 2010, which appear to be bottoming (a portion, but not all, of the recent uptick was a result of the removal of General Motors from the index, which was projected to have a large loss). Also worth noting is that despite the substantial rise in crude oil from $45 at the end of last year to its current price above $70, analysts have only raised earnings estimates for 11 of the 40 companies in the energy sector. As long as oil prices do not collapse, we believe analysts will eventually have to adjust their numbers higher to reflect this new reality, helping to support the overall earnings outlook.
The reason we place so much emphasis on earnings trends is that at the end of they day, investors buy companies based on their profit potential. And when confidence in a company’s outlook increases, there is a secondary and important impact beyond the revised growth rate. That is, investors typically require less of a margin of safety when buying stocks since they have a better handle on the true earnings power, which can ultimately help to support higher P/E ratios.
Bottom Line:
Investor expectations have increased from the low levels seen earlier this year when fears of the next Great Depression were elevated, and now it appears it will take more than “less bad news” to move the needle forward on the stock market. In the near term, economic data will likely continue mixed, thus we suspect equities will be confined to a trading range as investors await the next catalyst. We believe that a stronger than expected economic recovery in the second half should help support earnings, which already are showing signs of bottoming, and will be a key factor that ultimately serves to drive equity prices above the recent range—but patience may be required.
http://www.indexuniverse.com/sections/research/6063-equities-set-for-summer-hibernation.html?Itemid=7

On Capital Gains & Losses Part IV

Dealing With Anger & Stock Losses.

{I am linking Parts I-III here. 1. http://lumencapital.blogspot.com/2009/06/on-capital-gains-losses-part-i.html 2. http://lumencapital.blogspot.com/2009/06/on-capital-gains-losses-part-ii.html 3. }

I'm very aware that individual investors are in general dissatisfied with stocks and likely the people who invest for them. I certainly understand why. Stocks have basically spent 13 years going nowhere and that sort of performance can take the wind out of the most ardent investor's sails. Perhaps you would expect me now to try and make a compelling case for equities and why you should remain or become invested.

I'll do no such thing. I'm assuming that if you are reading this then you already have decided to be involved with some portion of your money. I will simply point out what I said last week that I think because of their historical return potential that investors need some exposure to equities as a class but not necessarily to individual stocks. I'll leave it at that. I will however point out what I have stressed in other posts If you currently own stocks then for reasons we've already discussed you are likely already dealing with losses. Many investors aren't happy about that fact so today we'll discuss how investors are feeling and what to do about it.

First its OK to be angry right now. Much has come over the transom in the past year and there is plenty of blame to go around. . But anger without understanding what has happened and anger without having a plan going forward will not begin to dig any of us out of these circumstances.

Investors need to understand that stocks have and always will be volatile investments. Today's markets where information is instantly transmitted has brought about much higher levels of volatility. Most of us remember the 1994-2000 bull market where stocks did experience lower volatility at least to the downside and where stocks yearly posted double digit returns. History is likely to show that period as an anomaly, probably not to be repeated soon. That is not to say the market won't get better, but to expect us to revert to that sort of experience is I think a futile hope given our current economic problems.

Higher volatility brings a higher possibility of being on the wrong side of a trade at any given point at least in the short term. Investors often get angry at this when they buy a stock and find they are down 5-10% in a blink of an eye. Often that can be due to a lack of understanding about current market dynamics or a lack of tools to understand oversold or overbought markets. But often it is simply the market's internal noise. Investors need to understand that this is part of the natural order of things and develop tactics and strategies to deal with it.

Markets also crash more often than most investors think (Investment jargon for this is a rapid period of negative price adjustment!). I started in the business in 1987 right before my first crash. Besides then, stocks have experienced short term declines of 15% or more in 1990 (first Gulf War), 1998 (Long Term Capital Management), 2001 (World Trade Center), 2002 (run up to 2nd Gulf War), and last fall. I find it interesting that 4 of these events have occurred basically in this current poor period for stocks. It translates however in my 22 years to a rapid decline of 15% plus, once about every 3.5 years. Since 1998 that has been about once every 2.75 years. If we are going to invest in equities then we need to plan for this. That isn't to say we should be happy when it happens but we do need to expect that something will again come forward to cause stocks to violently correct and plan for it. There is probably no way to completely ever avoid such an event but investors can attempt to minimize its impact on their portfolios.

Also as we pointed out last week losses are part of the investment equation. Investors also often feel the pain of losses more keenly than the joy of gains. There is no holy grail that can keep losses from ever occurring even in the best of times! Investors have a right to be angry about what has happened. Yet anger without understanding the inevitable nature of certain losses or anger without developing future plans will not help your portfolio. There are ways to mitigate the impact of losses on portfolios just as there are certain ways to use them to your benefit in your long term investment planning. We'll begin looking at this next week.

{Next Week -Losses in the Investment Playbook }.

Wall Street's New Four Horsemen

Wall Street's new Four Horsement-Greed, Mendacity, Stupidity and Arrogance:

This is from the article "Wall Street’s Toxic Message", Joseph E. Stiglitz Vanity Fair, July 2009

You can read the article here: http://www.vanityfair.com/politics/features/2009/07/third-world-debt200907

Personal Savings Numbers

Personal savings numbers were out yesterday. Personal saving, as a percentage of disposable income grew 6.9% in May. From what I can tell that number is the highest its been in at least the past five years.
This is good news bad news. To get the economy back on track consumers need to open their wallets. For individuals and for investment in coming years savings is a net positive. Businesses would like to get folks back to the mall but economic uncertainty means those that can save are likely to continue doing so. Others are going to simply keep paying down debt. It's all part of the "Great Reset" and the economy in my opinion will likely not grown until everybody adjusts down to a new level of consumer demand.

The Problem With Home Appraisals.

Bogus Home Appraisals May Derail Real Estate Recovery {From 24/7 Wall Street: Excerpt} Douglas A. McIntyre
Posted: June 24, 2009 at 5:10 am 24/7 Wall Street.

A huge number of home value appraisals may be wrong, with most of them being much too high. That is causing banks to back away from mortgages. A house that has been appraised for $400,000 might support a $350,000 home loan. If the bank looks a the property and says it is only worth $300,000 the mortgage application gets put into the waste basket.
The over-valuing of homes could kill a turnaround in real estate and make the persistent and hard drop in property values continue longer than many economists predicted that it would.....
One of the by-products of the appraisal problem is that sellers often have to take less money for their homes than they had planned. This further depresses the value of real estate and often makes sellers take on debt to pay the difference between their mortgages and the amount that they get for their homes. People who take on new, large debt burdens are not likely to be consumers. Real estate values are directly linked to consumer spending.
The problem is hard to solve. ......If lenders believe that the information that they are getting is routinely inaccurate, they may sharply curtail their overall mortgage operations. Risk and leverage are not words that bankers want to hear right now......

Comment: Housing will not bottom all at once. It will vary by region and won't truly rebound until housing affordability levels come up. This can happen only two ways; home buyers need to make more money or the prices of homes still need to come down.

Kass On Yesterday's Trading

I thought this was a good quote describing yesterday's trading from Real Money's Doug Kass.

" All in all, I would not make too much of yesterday's market advance, which, as my friend/buddy/pal, Bill Fleckenstein, stated on CNBC's "The Kudlow Report" last night , simply "earned back" Monday's market schemeissing and occurred in front of a large Russell Rebalance and quarter-end mark ups!"

http://www.thestreet.com/b/dps/te/theedge1.html {subscription may be required.}

Q & A. Money Flow Analysis

Part of our occasional series of answers to questions posed by readers:

Question: You write often of money flow analysis. What do you mean by that?

Answer: Money flow analysis is a process we use to measure liquidity. It starts with the basic principle that investors reward positive economic development by injecting liquidity. They also punish negative economic events by removing that liquidity. Liquidity is defined by us as either cash or credit. We look at liquidity across three time :

-Short Term {Days-Weeks}

-Intermediate Term {Weeks to Months}

-Longer Term {Secular}

Liquidity can be measured. Simplistically bullish cycles show more buyers than sellers. Bearish cycles show more sellers than buyers. We have developed systems that measure this liquidity and we incorporate those measurements into our investment analysis. Money flow analysis is part of our overall investment matrix. The investment matrix is as follows.

-Market Structure
-Investment Paradigm {the disciplines listed below are incorporated into this.}
Fundamental Analysis
Valuation
Money Flow Analysis
-Portfolio Monitoring
-Sell Discipline

At some point possibly later in the summer I'll try to do a more in depth post or series of posts on this subject!

A Note On Disclosure

Just for clarification on disclosures of securities we own. In the past I have included my personal holdings disclosures as part of client disclosures as I am also a client of my firm. I am going to separate the two in the future in order to avoid any confusion. From now on I will indicate a distinction between client and personal disclosures. We apologise for any confusion in this regard.

an tSionna 6.25.09

Where do the markets currently stand? Above is a chart of the S&P 500. You can enlarge it by double clicking on it. We're still stuck in our trading range from last fall which is by our calculations roughly between 800 and 960 on the S&P 500. We touched the upper band of that in mid-June and have since backed off about 6%. Not only was the market repelled from this upper level it also failed to breach its 200 day moving average. It has since backed off from that level as well. {See point 1} This is consistent with what we were seeing mid month. {See these posts from 6.12.09: http://lumencapital.blogspot.com/2009/06/tsionna-61209-market-update.html and from 6.15.09: http://lumencapital.blogspot.com/2009/06/tsionna-61509.html }.

We've also come back to the 50 day moving average. You can also see this at point 1 on the chart. So far the market has found support at this average whenever it has traded lower since this rally has started. We could also find some support here as the market is currently short term oversold. {See points 2.}

We have said repeatedly for about 3 weeks that the market was due for a correction. So far we see nothing to indicate that this is anything besides a normal pullback within a rally. We'll continue to monitor our indicators and we'll try to alert you if we see anything that would make us deviate from our current thesis and where we stand with the playbook.

We are getting closer to levels where some short term tactical entries on the long side might make sense for risk appropriate accounts. But we are not quite there yet by our methodologies.

*Long ETFs related to the S&P 500 in client & personal accounts.

Going Postal?

The Postal System Becomes An Anachronism {Excerpt}

The US Postal System, which has been dying for years due to the advent of the fax, e-mail, and overnight delivery, may finally be close to its last act.
The agency lost nearly $2 billion in its last fiscal year and is faced with cuts of up to 3,100 offices potentially eliminating thousand of jobs. Media reports say that first class mail volumes are plunging.
What is killing and will probably eventually finish off the Post Office? In a word “broadband”, a system that the current Administration plans to build out quickly in the next two years. According to MarketWatch, the Post Office is already looking at stopping Saturday delivery. The next moves will probably cut the number of weekdays the mail is dropped off, particularly outside urban areas where the cost of reaching homes and businesses spread over a wide geography is enormous.
Broadband has taken away the need for sending letters and may large documents....Payment systems which wire transfer money have nearly eliminated the role of the check in paying bills. This will only increase as e-banking does.
Even the magazine and newspaper industries which relied on physical delivery systems for decades now use the Amazon (AMZN) Kindle as a way to get the printed word over the internet and downloaded onto the device. Almost every major print product also has an Internet version. Sending magazines via mail is expensive. Cutting back on that form of delivery would be a blessing. The modern postal system killed the pony express. The USPS could only last so long before it way itself replaced. That time has finally come.
Douglas A. McIntyre {24/7 Wall Street}

Link: http://247wallst.com/2009/06/15/the-postal-system-becomes-an-anacronysm/

Comment: Part of the problems with a modern economy is that technology improves efficiency and in the process human jobs are lost. Usually these are lower skill level positions. Let's face it. I like my mail lady a lot but walking & delivering mail is not a job requires much in the way of of intellectual thought. In my business I can do with myself and a part time assistant what I would have needed at least two people to do 10 years ago. This is going to be continue to be a hurdle to bringing down unemployment. Government's continued regulation of employment and the cost of employees simply means businesses will continue to do more with less. According to its own sources the USPS employs more people than any company other than Walmart. In 2003 that was 790,000 people. It's safe to say that this number is likely to shrink in the coming years as mail service is used less and less. These are good paying jobs that once gone will likely never come back.

*Long AMZN for one client account.

The Coming Re-regulation Of The Financial System.

From 24/7 Wall Street: {Excerpt & Comments}

Pause and consider for a moment the fact that no amount of regulation of financial markets can squeeze the effects of stupidity out of the system. The Administration plans a radical overhaul of how banks and financial trading are regulated.......One of the keystones of the new programs is an agency to help consumers from being preyed on by Wall St. Banks and brokers will be prevented from taking advantage of the average citizen who wants a mortgage or a credit card. This part of the structure of the new regulation has an aspect of protecting consumers from themselves. A bank may offer a customer a $500,000 mortgage on a $400,000 home. The government means to prevent that.
While a good deal of what happened in the mortgage and consumer credit markets resulted from institutions giving people the ability to take on financial leverage that was beyond their means, it was based on the desire of millions of Americans to borrow money instead of save it. A person with a $50,000 pretax salary who cannot figure out that he cannot afford $20,000 in credit car debt which carries an 18% interest rate is either a rank optimist or extraordinarily naive.
The new laws that the Administration and Congress mean to put in place spring from the concerns that investment banks and commercial banks created leverage that they system was unable to sustain. A large insurance company could buy a mortgage-backed security and perhaps double its money on the investment in 18 months. No actuary at the company asked whether that was possible or whether the instrument carried extraordinary risk........
.....The new laws that will allow the government to look into the heart of financial companies balance sheets and bank management decisions about investment and risk will keep both companies and individuals from betting too many assets in the most dangerous parts of the market. No amount of risk can keep a floor trader from trying to triple his firm’s money in a single trading day.
Douglas A. McIntyre

Link: http://247wallst.com/2009/06/17/the-regulation-of-financial-markets-to-improve-consumer-protection/#more-37961

Comment: Government has a long history of creating financial regulation after a market collapse. That's what gave us the SEC in the 1930's. I think that when the history of this era is written we'll book end a 10 year period between the collapse of Long Term Capital Management and last fall's fianacial meltdown. Both cost lots of money to clean up. Both nearly broke the banking system. I think government is tired of cleaning up these kind of messes and isn't going to let go of the reins on the financial industry for an awful long time. Financial firms I think will become much slower growth vehicles going forward. That's not good news for all those MBAs in the pipeline with Wall Street riches dancing in their heads.

On Capital Gains & Losses Part III

Today we'll clear the air on a few questions that I've been asked from our first two posts on capital gains & losses. I also want to point out a few things as well.

1. Last week's post could be interpreted as an attack on longer term or what is often called "Buy & Hold" investing. I don't want to take sides on its merits or whether long term investing still works. That is a subject for gurus, economists or perhaps another series of posts. It is currently a controversial area of debate and is beyond the ken of this current investment thread.

But I would note that most individual investors are in some way "Buy and Holders". For example many people have long term holdings in individual stocks at the company they have worked for. When companies are young and growing this is a wonderful way to accumulate assets. I have many clients who because they worked at one point for General Electric are long term holders of GE's common stock. Even if you don't own individual stocks you are likely averaging into mutual funds at work through your 401(k). Since this is statistically the case then we need to incorporate this thinking into our series on gains and losses.

My take on equities as it relates to "buy & hold" is that individuals need long term exposure to equities in general because they have historically provided superior returns to most other asset classes. However, with today's emergence of alternatives such as ETFs and even options , I don't believe individuals need the event risk of common stocks except in certain special situations. When it comes to "buy and hold", I prefer Jim Cramer of CNBC's definition which is "Buy and Homework". As we pointed out last week because this is how most individuals have traditionally invested then most long term investors are currently dealing with capital losses.

2. Individual investors as we have pointed out often have a hard time dealing with losses. So do money managers for that matter because we are human as well. However, anybody who invests money in the stock market will at some point be confronted with losing positions. It is part of the game. If you cannot deal with that then don't invest in equities. Professional traders will tell you that they lose money on almost half of their positions. Their difference is that their constant movement of money means that they will take these losses much more quickly than longer term investors are apt to do. I'm not suggesting that individuals all become day traders. I am suggesting that professionals understand that losses are part of the game and are part of what they must endure as part of the price of getting paid over time.

3. Investors also almost never see price movement from the market's point of view. Markets don't care whether your portfolio is making or losing money. Like "Ole Man River" markets just keep rolling along. Markets represent the collective decisions of millions of different participants with millions of different reasons for buying and selling. As such markets look out longer term and also take the shortest time frames into account. Markets don't care that humans break their investment time horizons down into units of measurement such as days, months and years. Markets exist to transfer risk and reward. Investments are rewarded by injections of liquidity (i.e. more buyers than sellers) and are punished by that same liquidity being taken away (more sellers than buyers). So markets don't care about capital gains or losses. But if they did and could talk they might do so through the following illustration:

Suppose you buy a stock at $10 per share. It moves up to 11.11 and then trades down to 10 whereby you sell it. From the investors perspective it's a wash- bought at $10.00 sold at same-nothing ventured nothing gained {forget the issue of commissions let's say they are 0 for this illustration}. Except from the market's point of view that's a 10% loss. That's right! From the market's perspective its the same as if you'd bought a stock at 10 and sold it at 9. Even so the market doesn't care if it's a gain or loss. Markets are forward looking mechanisms designed to assign a present value to a future event such as earnings. Because stocks are constantly looking ahead we need to do that as well. First though we need to deal with the emotional aspects of investing.

{Next week: Dealing with anger over losses.}

*Long General Electric in certain legacy accounts.

Happy Father's Day.

Happy Father's Day to all you Dads out there. In my house we've actually always had Mother's Month & Father's Hour!

Rest up Gents. The markets open sharply @ 8:30 AM Chicago time tomorrow. See you back here then.

The Dow-Inflation Adjusted.

From Chart of the Day:

"For some long-term perspective, today's chart illustrates the Dow adjusted for inflation since 1925. There are several points of interest. For one, when adjusted for inflation, the bear market that concluded in the early 1980s was almost as severe as the one that concluded in the early 1930s. Also, the inflation-adjusted Dow is now less than double where it was at its 1929 peak and trades a mere 30% above its 1966 peak – not that spectacular of a performance considering the time frames involved. It is also interesting to note that the Dow is up 30.7% from its March 9, 2009 low which is actually slightly more than what the inflation-adjusted Dow gained from its 1966 peak to today."

Link: http://www.chartoftheday.com/ {subscription required}.

Oil & Gas. Positive Technicals According To Barrons

More technical & seasonal pattern discussions, this time courtesy of Barrons. {Excerpt}

Link: http://online.barrons.com/article/SB124518909452620607.html#mod=BOL_hps_dc {Subscription may be required}.
Will Commodity Investors Have Summer Fun?
By MICHAEL KAHN

MOST INVESTORS ARE familiar with the phrase, "sell in May and go away." This refers to the tendency for stocks to have a strong winter and a weak summer. Asset classes, from soybeans to British pounds, demonstrate weakness over time in some months and strength in others. It looks like the odds favor a hot summer in oil and gold while Treasury bonds cool off.
John Kosar, director of research at Asbury Research, found that over the past 30 years, oil prices are exceptionally strong between April and September with May providing the best monthly return. Indeed, this May, crude oil gained a whopping 29%.
However, despite the strong spring and summer performance, the market does tend to take June off. The average loss for the month was 0.2% so it really serves as a rest stop for the bulls. Once June ends, however, the seasonal pattern points to three more months of solid gains.
We should step back for a moment to discuss what seasonal patterns really are. As with all market cycles, the seasonal, or intrayear cycle is an average performance over time. There are no guarantees that the market will rise or fall in any given month, but based on past performance we can at least stack the deck in our favor when deciding to invest.
For oil, the odds favor strength resuming in July. Gold tends to show seasonal strength in the latter part of the summer after a rather tepid June and July. According to the Commodity Trader's Almanac (John Wiley & Sons, 2009), buying gold the last week of July and holding into early September has resulted in winners 26 of the past 33 years.
To be sure, there are reasons behind seasonal tendencies. For gold, the fundamentals in late summer perk up as demand for gold jewelry surges.....But the greatest demand comes from the famed wedding season in India, the world's largest consumer of gold.
Technically, this shows up in the charts as rising gold prices during August and September. But no matter what the reasons may be, all we need to know is that this phenomenon happens so we can plan our investment strategies accordingly.
With strong summers ahead for oil and gold, it makes sense that talk of inflation would follow. The bond market typically does not do well under conditions of rising inflation, and as bond prices fall their corresponding interest rates rise.
Over the past 50 years, Kosar has found that the seasonal tendency for the 10-year U.S. Treasury note bears that out.....Again, seasonal tendencies are not guarantees, just averages of historical performances. But if you believe that the financial markets have returned to more normal behavior from last year's truly exceptional volatility, then a weak performance in the bond market can be expected starting in August.
If all these seasonal tendencies work as expected this summer -- rising oil, rising gold and falling bonds (meaning rising interest rates) -- it would present strong headwinds for the stock market. Remember, the seasonals for stocks point to weakness over the summer months and after a 40% rally from March, it would be quite a feat for stocks to keep rallying.
One final note -- the seasonal tendencies for bonds and stocks are based on decades of performance that does not include the effects, real or presumed, of the stimulus package and government efforts to increase liquidity in the financial markets. Theoretically, the flood of money coming into the economy will have inflationary effects and that would reinforce the seasonal tendencies in all markets covered in this column.

About the Author: Michael Kahn, mutual fund co-manager, author of three books on technical analysis, former Chief Technical Analyst for BridgeNews and former director for the Market Technicians.

One further comment from me. I think seasonal patterns need to be understood. Patterns however have a tendency to work, until they don't. There is no guarantee that we will see the same patterns this year as in the past. We do need to know about them, plan for them and develop strategies of how to use them in case they exert themselves again this year.

The Playbook: Money Management-Defense

Part of the confusion now is that investors are trying to determine if what we are seeing is a normal pullback resulting from profit taking after our big run up or a change in market trend. Right now commentators are all over the board on what is happening. Of course there's almost nobody arguing that stocks could streak higher this summer so I'm reminded one of the first lessons I learned form the Consigliere-"stocks will do what they have to do to prove the most amount of people wrong". The most pain I think would be if the market were for some reason to suddenly melt up and tack on a quick 5-10% from current prices. I think many investors-particularly institutions aren't positioned for that.

I also don't find that the most likely scenario. I've mentioned why in earlier posts {although I think we are correctly positioned if it were to occur}. I like most others think stocks have to rest or retrace some of their recent gains. If this transpires we must employ defensive money management techniques. Correctly identifying the difference between a pullback and a change of trend means the difference of buying into the dips and profiting from a subsequent advance or being stuck in losing positions as the market grinds down.

Studying money flows into and out of stocks can help identify the difference. Unfortunately it is not a foolproof method and it is usually impossible to know what we are exactly facing until a pullback or trend change is well established. Therefore the key is to be disciplined in your money management approach. These are the defensive tactics of the Playbook. The first thing you have to do is to try and have an adequate understanding of each client's risk reward profile. Frankly some people tolerate risk and volatility better than others. After that, develop a disciplined money management approach based on what you know about that client. If the client's risk reward profile tolerates buying for short term opportunities you still need to have a line in the sand where you take losses just in case you are wrong.

There is no perfect system of money management. The key function of defensive money management in the Playbook is to give you a client centric plan for what you should do when the market moves against you. It does not mean a portfolio won't ever have losses. If constructed properly it should mean that a portfolio loses less when the market inevitably goes through a period of profit taking. This is very important now. Stocks have gone straight up from their lows and have now started to show signs of running out of gas. The best one can do is to try and control the risk in the client's portfolio based on their profiles. For us this has meant incrementally raising cash positions in appropriate accounts, identifying signals that might give us further clues as to the next leg in market direction and identifying levels where we might make additional sells for appropriate accounts.

No system of money management will completely protect a portfolio from a market declines. Short of a system that moves portfolios completely to cash, no system will completely protect a portfolio from a collapse like we experienced last fall. However, a proper system does allow you to control some of the risk in the portfolio. It may often mean you might sell something at the wrong time or watch something you sold move higher in the short term.

Selling is often less an issue with ETFs. With them you are buying a security based on an index and they are unlikely to move away from you on the upside so substantially that you can't think about finding a level to buy the security back. Investors are often reluctant to almost immediately repurchase a stock or ETF they just sold, but it can be a good strategy particularly if the market moves lower short term. Modern spreads and modern brokerage commissions which are a tenth of what they were even a few years ago make buying and selling not the cost prohibitive factor it once was.

Nobody knows for certain what the future holds. We can develop tactics based on experience and what we are seeing right now. But proper defensive tactic can give us a leg up. If deployed correctly they should mean that portfolios are positioned with adequate cash positions to be used if the market retreats to lower levels this summer. If the market instead moves higher then we will capture an adequate portion of the gains with the ETF positions we currently hold.

Sell In June Avoid A Swoon?

"Sell in May and go away!" is an old Wall Street Maxim which basically means that stocks as a whole don't do much in the summer months. When I started in the business this was translated as "Out on Memorial Day, buy em back after Labor Day". We do know that statistically summer is often a weak period for stocks. We covered this in a post back in April {see: http://lumencapital.blogspot.com/2009/04/sell-in-may.html }.

I wanted to put a bit of meat on the bone so to speak so I ran some numbers over the weekend asking my systems to show results when looking for a seasonal market high between May 20 & July 31 and a subsequent seasonal market low between September 1 and November 1. We reviewed the period from 1990 until present or 19 years and used the S&P 500. We used the absolute high and the absolute low for each period in question and looked at weekly data for the S&P 500. We did not include dividends.
Results:
~Market declined in 17 of 19 years or almost 90% of the time.
~Stocks advanced in 1995 {1.03%} and in 2006 {2.50%}.
~The average loss = -7.97%
~The best year was 2006 with that 2.50% gain
~The worst year was 2008 with a -41.69% loss.
~Mean loss was -6.61%
~Period when stocks made made the majority of this period's seasonal highs: May 21-May 31. {6 years}
~Average date when seasonal peak in pricing took place: June 21-July 7
~Period when stocks made the majority of this period's seasonal lows: October 4-17 {12 years}
~Average date when seasonal low in pricing took place: September 28-October 17

Treating studies like this as dogma can be dangerous because there really is no predictive power in them. Nothing can stop this year from being the exception to the rule and posting a huge rally in the summer. Stocks did rally for much of the summer in 2006 before seeing a slight Autumn decline. Stocks have gone on to post great 4th quarter and yearly results in many of these years. Also people asking my question in a slightly different way may come up with slightly different results. But to me it is pretty decent evidence that we need to develop a more cautious stance in regards to the Playbook as we plan for the summer/early fall months. A river boat captain who knows that around a certain bend there is usually a sand bar prepares for that event long before he gets to that point. If this is the one year the river has shifted, then he is pleasantly surprised. If it's there as usual then he is ready to handle it as it will offer few surprises. It really is no different with the market. Historical patterns tend to have some reasoning behind them and it is best to respect what has happened in the past.

*Long ETFs related to the S&P 500.

California Dreaming?

24/7 Wall Street posted an interesting article last week on the current budget debacle in California. I'm going to excerpt it because California is often a trend setter and which ever way it goes you can expect other states to follow. If the Feds bail out California they will have to bail out every state. Every state and municipal authority seems to be broke these days.

{Excerpt below}

Aloha To California

The State of California, home to perpetual government turmoil, has warned the world again that it will self-destruct leaving its citizens without a single government service. Both taxpayers and the unemployed no longer believe the chatter. It comes from Sacramento too often.
The state’s controller has just announced that California will run out of money in fifty days. May revenue was down almost 18% from a year ago, dropping to $1.14 billion. Unemployment in California is high and real estate values have dropped more than 50% in some areas......
California’s government will collapse and it will either have to be saved by the US Congress and Administration or be forced into a form of receivership under which budget cuts will be mandated by accountants. The only ways that this might be avoided is if the politicians in the state agree to make deep cuts to state programs, which will force thousands of workers onto unemployment lines and diminish essential state services. The other alternative is to factor California’s receivables........ The problem with this solution is that it would mitigate the problem for a few months, at most. Revenue won’t pick up enough for the state to wean itself from a factoring program.
America has never seen the total financial collapse of a major state or municipality. It nearly happened in New York in 1975 when the city ran low on money and approached the federal government. Gerald Ford told New York that it could “drop dead.”
President Obama may love California and may want to do what he can to save the state. He is up against the fact that the most recent update of the federal budget shows that income is running well below the Administration’s plan and the Treasury’s need to raise money is beginning to put unanticipated, at least by the Treasury, pressure on interest rates.
No one is able to describe what will happen in California in August when the state does not have the money to pay its employees, its suppliers, and the expenses that are required to keep critical public services working. The mess will then be shoveled in the direction of Washington. The taxpayers will be asked to pay even more over the next decade. The only wild card is what the Chinese are willing to take on faith.
Douglas A. McIntyre

Link: http://247wallst.com/2009/06/11/aloha-to-california/

an tSionna: 6.15.09

Monthly chart of the S&P 500 showing different levels of support and resistance. You can double click on this to enlarge. Note points 1 & 2. These are very long term resistance levels that reach all the way back to 1998! Similar to our posting chart from the other day I think the market is now approaching a binary moment. {See http://lumencapital.blogspot.com/2009/06/tsionna-61209-market-update.html}

One scenario could be that we break through this long term resistance line and head higher. The other possibility is that we fail the first time at this level and back off a bit.

I of course don't know which way we're headed but I do know that after the move we've seen since early March, probability would indicate at least some sort of correction soon. Further supporting this are some very strong statistical numbers regarding market seasonality that are starting to come into play {more on this in an upcoming post}. For risk appropriate accounts I have sold a few positions in order to raise some cash. Not major amounts but enough to lower my exposure levels to stocks if things turn around and head south from here.

I think this is the most appropriate strategy for my clients at this time for the following reasons.

1. It can help us begin to repair certain core ETF positions. We will cover this in depth on how and why you would want to do this as we continue our series on capital gains and losses.

2. It will give us some cash to redeploy at lower levels if stocks do sell off.

3. We will still have enough exposure to the markets to participate in any further rallies if stocks instead break out and trade substantially higher from here.

*Long ETFs related to the S&P 500.

**Note this post is for informational purposes only. I am giving clients and friends of Lumen Capital Management some insight into our current portfolio management processes. That is I am giving you information for how I am managing money for clients of whom I know their current individual risk/return profiles. We make no comments that should be construed as a recommendation for individuals or institutions since we have no knowledge of their own investment profiles. As such, if you fall in this category you should consider that our thought processes might not fit into your own personal investment plans or philosophies. Please consult your own investment advisor or please do your own homework before considering any of the information presented in this posting! We cannot be responsible for any actions that you might take from reading this post.

On Capital Gains & Losses Part II

Last week we introduced the beginning of a series on what to do about capital losses. {You can see Part I here: http://lumencapital.blogspot.com/2009/06/on-capital-gains-losses-part-i.html }Today we continue by looking backward to see what's transpired. Hopefully we can illustrate the enormity of the capital losses that most investors must confront. We'll be using a monthly chart of the S&P 500 going back to the mid 1990's to illustrate these losses {double click to enlarge}.
Two pink trend lines extend across the chart. On one level they are simply a continuation of the trading range illustration we've repeatedly showed you since last fall. Notice though that this trading range extends backwards showing us that we have currently bottomed around the same level that we last touched in 2002-2003 and first breached in the late 1990s. This sets up a pretty easy illustration in terms of capital gains or losses.

If you purchased securities and have a holding date below the lower pink line then you currently have a long term capital gain on that investment. If you purchased securities that you still hold between the pink lines then you are likely break even to slightly ahead on your investments. Anything that you bought above the higher line and have held on to is a capital loss. To make these monthly losses easier to see, I've also highlighted them in yellow. Yellow periods indicate months where holders who purchased during that time will show losses. A cursory view shows this is many months.

This chart represents approximately 13 years of S&P monthly stock price movements. That equates to about 156 monthly bars. There are only 14 bars either fully underneath the lower line or partially underneath it. That represents less than 9% of months when long term investors could have bought securities in which they currently have gains. There are another 17 months in between these lines that can safely be said to be break even or slightly positive. That is about 11% of the possible months. This means that slightly more than 80% of investable months since 1997 are periods in which any purchases made and still held today have lost money.

That's simply the way it is. I don't care if I was managing your money, somebody else did if for you or you did it yourself. Anybody that has purchased securities in a portfolio and held on to them during most of this period has likely lost money. It has likely happened to you just as it has happened to sophisticated investors like Warren Buffett and to everybody else.

To look at this in years, if you bought securities in late 1997, 98, 99 or 2000 you likely lost money if you were a buy and hold investor. You likely lost money in 2000 through 2002 and are underwater for sure if you are still holding equities you bought in late 2003 until today. The fact of the matter is we are all likely dealing on our books with capital losses. How we deal with these losses going forward will likely determine how satisfied we become with our investment performance.

{Part III coming next week.}

*Long ETFs related to the S&P 500.

US Revenues Below Budget

24/7 Wall Street Comments on Budget Revenues {excerpt}.

Budget: The Revenue That Was Never There
Posted: June 11, 2009 at 5:00 am on their web site. Link to follow:


The Treasury said that the federal budget deficit in May was almost $190 billion bringing the total {deficit} for the government’s fiscal year to $992 billion......The first reaction to the news was that the government’s red ink for the year will exceed the forecast of $1.84 trillion. The smart money focused on the revenue shortfall. Tax receipts through May were less than $1.67 trillion, 18% lower than they were for the same period a year ago. Even relatively naive observers of the federal government’s financial difficulties understand the Congress and the Administration may be able to hold expenses to the level planned. Income is another matter. With corporate profits dropping and in many cases turning into losses, tax revenue from businesses will continue to drop. Unemployment and the drop in the average number of hours worked by Americans each month will insure that the tax income from individuals will keep dropping as well.
The fear among financiers and intelligent government servants is that the deficit has already reached a point of no return. Spending is set on a course that the Administration and Congress refuse to reverse. Receipts are not only dropping, they are dropping quickly and are not likely to recover for the next year. GDP growth may look good on paper, but employment is what pays the government’s rent.
Interest rates have already told the Treasury that the world knows it is borrowing too much money. It is odd that there is so little fear in the air in Washington. Congress may go home for the summer recess and return to the Capitol to find that a fiscal emergency has arisen that will require it to find a large number of cost cuts to keep China buying Treasuries.....The US government may find that the rate it has to pay to borrow capital has become so high that it has to turn to its citizens for the equivalent of a bailout.......
.....The government may inadvertently be killing the American dream of prosperity by burying its citizens under a mound of taxes just as they have reached the point when they know a growing number of neighbors and family members who are out of work. .......

Douglas A. McIntyre

Link: http://247wallst.com/2009/06/11/budget-the-revenue-that-was-never-there/#more-37386

Comment: I think this is a bit too alarmist of an article but I wanted to get it out there because the deficit is a concern. Deficits are currently way to high. Everybody knows that. For the sake of fiscal responsibility it's more important what percentage the total deficit remains relative to GDP longer term. As long as this new level of borrowing is not a permanent fixture every year I think we will be OK. One thing the US has going for it is that our population is still growing via births and immigration. As long as this remains the case we have a very good shot of ultimately growing our way out of these deficits versus inflating our way out of them. It's one of the main reasons that we will continue to encourage immigration.

Who Got Last Year's Financial Crisis Right?

I found a new investment blog over the weekend that posted an interesting article on the financial crisis. Since it dove tails into something about market crashes that I want to cover in the coming months, I thought I would excerpt it with a comment @ the end.

Being Right is Overrated:

Tadas Viskanta

06.06.09

Joe Weisenthal at Clusterstock points out today an interesting (long) piece by Holman Jenkins at Hoover.org on the financial crisis. The gist of the article is that the financial crisis was by and large a massive financial accident that was unforeseeable.
Jenkins notes that even investors like John Paulson, who many claim to have foreseen the meltdown of the global financial system, did not in fact foresee the crisis. If they had they would have invested quite differently:....
...those who bet successfully against subprime did so through elaborate, expensive, negotiated deals to purchase credit default swaps or buy “put contracts” on subprime indexes. Had they really seen what was coming, they would saved themselves a great deal of expense and bother by simply shorting Citigroup, Bank of America, Lehman, Bear Stearns, etc. Their profits would have been huger, their workload and hassle factor much less.
The point of the above quote is not whether the crisis was foreseeable, nor is it a criticism of Paulson.....If Paulson had foreseen the collapse of the global financial system there were much easier ways to profit from (and express) that viewpoint.....
Much too much is made in the media about who is right, and who is wrong. (Not that these thing are well tracked.)......The funny thing is that for investors, being right is greatly overrated.
Investors and traders need only worry about one thing: profitability. Are you generating requisite profits from your portfolio for the risks assumed? Everything else is just noise.
The need to be right is a common error for beginning investors. Any one who has ridden a stock down for a large loss can attest to this. Behavioral finance experts have a term for this: the disposition effect. Investors tend to sell winners too soon, and losers too late. You could even think of this as ‘get-even-it is.’ Investors do not want to admit that they made a mistake.
The fact of the matter is that all investors make mistakes. It is simply a part of doing business.....
Stated another way: For traders, {or I might add for investors} being right is overrated. It is far more important knowing when you are right, and when you are wrong, and acting accordingly.
In summary, being right may be a necessary component of trader profitability, but it is not sufficient. Proper money management techniques are required to turn trading decisions into trading profits.

*Long Citigroup and Bank of America in certain accounts.

Link: http://www.abnormalreturns.com/2009/06/being-right-is-overrated/

Comment: The beauty of ETFs is that the largest component that you need to get right is money flow analysis. Valuation and an overall fundamental approach are extremely necessary but it is also very important to know if liquidity is being added or taken away from a market or a stock. Money flow analysis helps spot trends and takes away much of the predictability aspects that many investors look to find. To put it another way. People might lie but charts never do!

an tSionna 6.12.09 Market Update.

Double click to enlarge.

*Long ETFs related to the S&P 500.

On Capital Gains & Losses. Part I

Barrons was out last week with an article on the treatment of Capital Gains & Losses. I've excerpted it below as I think it is good introduction to a subject that I will deal in a serial format over the next week or so. The article below deals with the basic rules on Capital Losses. Warning. Post is longer than normal!

"IT'S AN ILL WIND, AS THE SAYING GOES, THAT BLOWS NO GOOD. Consider, for example, the capital-gains tax. While Congress agonizes over the rate of tax on net long-term gains, the question is largely academic -- because in the downturn, most of us have accumulated mountains of capital losses, and many years, if not a lifetime, of immunity to this tax.
The basic rule, under no apparent threat of change, is that you can deduct only $3,000 of net capital loss against your ordinary income on any year's return; any excess can be carried over onto your returns for the following years, subject to the same annual $3,000 limit, until the loss is exhausted.
The value of excess losses (those not immediately deductible against ordinary income) as a reserve against future taxes isn't always appreciated. "What good," a friend complained, "is $3,000 a year? I hope to pick up lots more gains once the market improves." She overlooked the potential of the entire backlog of losses as an offset to future capital gains.
Thus, suppose you incur $70,000 of net capital losses in 2009; after applying $3,000 against your ordinary income, you carry over $67,000. If you have a $40,000 net capital gain in 2010, it will be completely wiped out by $43,000 of the $67,000 you carried over from 2009, $3,000 of which will be applied against your 2010 ordinary income. That in turn will leave a $24,000 backlog ($67,000 less $43,000) loss to be carried over to 2011......"

Link: http://online.barrons.com/article/SB124303130732448469.html {Subscription may be required}

The Barrons piece above has given me an opening to extensively cover the issues of capital losses. Investors often have a very hard time with these and usually is becuase in their minds these losses aren't permanent until taken. The stark reality of cashing in, of seeing those negative signs permanently etched in a blotter thrusts the finality upon them. The same thing can happen with investment gains but research into investor psychology has shown that most investors feel the pain of losses more than the joy of gains.

Most investors try to put off that pain as long as possible by either ignoring the losses or by holding onto investments with the hope that they ultimately will make back what they have lost. Certainly there are times to do this as there are also times to average down into positions. Many investors however think that the actual loss implications of a bad investment out weighs any sort of analysis as to the value of the actual stock they are holding. They often end up holding onto a bad investment longer than they might otherwise have done so and losing out on the opportunity to recoup some of that loss in an equity or ETF better suited to the current environment.

We will begin a series on dealing with capital losses in the coming days. The next piece in this series will be posted next week and will confront the stark reality of what has happened to portfolios since the late 1990's. We'll begin exploring why investors should not ignore this topic.