Light Fare-Understanding Last Years Crisis

A friend sent this joke to me.  I'll republish it for you as I think its a light hearted way of explaining what happened to our banking system these past several years.  Enjoy!

Subject: Instructive 101 Econ:  An Easily Understandable Explanation of Derivative Markets!

Heidi is the proprietor of a bar in Detroit . She realizes that virtually all of her customers are unemployed alcoholics, as such, can no longer afford to patronize her bar. To solve this problem, she comes up with new marketing plan that allows her customers to drink now, but pay later. She keeps track of the drinks consumed on a ledger (thereby granting the customers loans).

Word gets around about Heidi's "drink now, pay later" marketing strategy and, as a result, increasing numbers of customers flood into Heidi's bar.  Soon she has the largest sales volume for any bar in Detroit .

By providing her customers' freedom from immediate payment demands, Heidi gets no resistance when, at regular intervals, she substantially increases her prices for wine and beer, the most consumed beverages. Consequently, Heidi's gross sales volume increases massively.

A young and dynamic vice-president at the local bank recognizes that these customer debts constitute valuable future assets and increases Heidi's borrowing limit. He sees no reason for any undue concern, since he has the debts of the unemployed alcoholics as collateral.

At the bank's corporate headquarters, expert traders transform these customer loans into DRINKBONDS, ALKIBONDS and PUKEBONDS. These securities are then bundled and traded on international security markets. Naive investors don't really understand that the securities being sold to them as AAA secured bonds are really the debts of unemployed alcoholics. Nevertheless, the bond prices continuously climb, and the securities soon become the hottest-selling items for some of the nation's leading brokerage houses.

One day, even though the bond prices are still climbing, a risk manager at the original local bank decides that the time has come to demand payment on the debts incurred by the drinkers at Heidi's bar. He so informs Heidi and then demands payment from her alcoholic patrons, but being unemployed alcoholics they cannot pay back their drinking debts. Since, Heidi cannot fulfill her loan obligations she is forced into bankruptcy. The bar closes and the eleven employees lose their jobs.

Overnight, DRINKBONDS, ALKIBONDS and PUKEBONDS drop in price by 98%.

The collapsed bond asset value destroys the banks liquidity and prevents it from issuing new loans, thus freezing credit and economic activity in the community.

The suppliers of Heidi's bar had granted her generous payment extensions and had invested their firms' pension funds in the various BOND securities. They find they are now faced with having to write off her bad debt and with losing over 98% of the presumed value of the bonds. Her wine supplier also claims bankruptcy, closing the doors on a family business that had endured for three generations, her beer supplier is taken over by a competitor, who immediately closes the local plant and lays off 150 workers.

Fortunately though, the bank, the brokerage houses and their respective executives are saved and bailed out by a multi-billion dollar no-strings attached cash infusion from their cronies in Government. The funds required for this bailout are obtained by new taxes levied on employed, middle-class, non-drinkers who have never been in Heidi's bar.

Now, I understand.

*No postions in DRINKBONDS, ALKIBONDS and PUKEBONDS!

Something To Remember When Watching CNBC

I thought this was a pretty good post regarding portfolio managers and investment managers public statements. In our business nobody {including yours truly} speaks in a vacuum or for completely altruistic reasons. Part of the reason I publish here is to keep my clients informed. I also have found that putting ideas to paper forces me to focus and become a more disciplined investor. But I'd probably not put anything out here if I found this to be an unproductive use of my time. I've found Solas! to be a nice way to generate both new business and leads. Here's Abnormal Returns thoughts on the subject. {Excerpt}

Everybody talks their book, everybody. And no I am not talking about the “Talk Your Book” show on StockTwits TV. It is one thing to know that everybody talks their book. It is another thing altogether to know what to do about it.

First off, what exactly is “talking your book” mean? Talking your book is a phrase used to describe what portfolio managers are doing when they discuss their portfolio holdings. It is generally assumed that this discussion is to create interest (and buyers) of these securities. This will ultimately benefit the price of the security and the manager’s portfolio. The more cynical out there might see any sort of stock rise as an opportunity to exit a position as well.

Even that might be too simple an explanation. A manager might take the opposite tack and bad mouth a position hoping for a drop in price to allow further accumulation. Some are speculating that is exactly what happened when George Soros decried a growing gold bubble despite having increased his positions in the shiny metal.

As you can see there are no shortage of motivations involved here. A portfolio manager might also be giving interviews as a form of marketing for his or her business....

....The bottom line is that is difficult to take fund manager’s public security selections at face value. There are simply too many cross-currents at work to put much weight on their public pronouncements....

.....Portfolio managers talk their book. They talk their book for any number of reasons: some benign, some less so. But they are still talking their book. Thankfully there are some resources we can use to check what they say publicly against what they are actually doing, albeit with a lag.

Link: Everybody Talks Their Book

South Coast Swing

I'm off on the "South Coast Swing" to see clients. Posting may be light until I return next week.

Mutual Fund Money Flows

Today's chart comes from Marketwatch.com who derive their chart date courtesy of Bigcharts.com. It is the best I could come up with showing historic yields on the 2-year treasury going back to the late 70's.

Back in the late 70's and early 80's bond yields spiked to levels above 16% as fears of runaway inflation were rampant. The Reagan Administration with the help of Federal Reserve Chairman Paul Volcker chained inflation to manageable levels, interest rates started coming down and the stock market began in the early 80's a nearly 20 year rally.

Interest rates on the 2-year treasury are currently under 2%. They really have no room to go lower and last week's action by the Federal Reserve to raise the discount rate signals that rates at some point in the future will start to trend higher.

So what are investors doing with their money?

According to investor data that follows mutual fund money flows, funds continue to leave the stock market in favor of bond funds. Now I own certain bond & preferred ETFs for certain strategic reasons. But this mindless flow of capital into bond funds strikes me as another example of how the public is often wrong in how they invest their money. It is also a lesson why most individuals need help investing their assets but that is the subject for another post at another time.

Here's an excerpt from David Berman over at Seeking Alpha.com on the subject.

Dumb Money: What Mutual Fund Flows Say About Investment Trends: David Berman.

The next time you try to make a well-timed move into, or out of, a mutual fund, keep in mind that academics have a term for people like us: dumb money. That’s because evidence suggests that little investors like us have a tendency to get wrapped up in the news, pulling the plug on equities when the stock market has already bottomed out and jumping into stocks when they are near a peak, dooming ourselves to poor returns. But that’s why strategists remain interested in mutual fund flows – and what’s interesting is that, despite all the fretting over the steep rebound in the stock market over the past year, fund flows suggest that mutual fund investors remain in defensive mode, preferring bonds over stocks....

...{I}n...{t}he United States, {the}...Investment Company Institute reported last week that long-term mutual funds recorded their 47th straight week of net inflows in the first week of February – but bond funds enjoyed the biggest gains, while equity funds suffered net outflows of cash. This conforms to 2009 trends as well, suggesting that investors who were burned during the terrible stock market downturn of 2008 and early 2009 remain wary about joining this bull market....

The two largest inflows into equity mutual funds occurred in the fall of 1987 on the eve of a market crash and the first quarter of 2000 while the inklings of the first bear market of the 2000's began to stir. Two of the largest outflows from equity mutual funds came just prior to both of the Gulf Wars in January 1991 and March 2003 on the cusp of two great bull market rallies. Study after study shows further examples of how the mass psychosis of the public is often wrong when it comes to investing.

There may be good strategic reasons for investors to put some of their assets into fixed income securities at this time. Indeed investors looking for a more balanced approach to their portfolios will be invested in bonds at any given time. They however will do so likely with a laddered approach that attempts to take advantage of the yield curve.

But this mindless drive by investors to still scramble for yield will likely end poorly as I think stocks should out perform bonds substantially over the next decade. Time will tell but it often pays to lean against the public when they make such a substantive bet with their assets.

Link: Dumb-money!

*Long certain bond ETFs and preferred ETFs in portfolios seeking more of a balanced approach to their assets.

Earnings In Pictures

Chart of The Day has a pretty good graphic that shows the rebound in earnings we've seen since last spring.  They note that,

"With fourth-quarter earnings largely in the books (over 79% of S&P 500 companies have reported for Q4 2009), today's chart provides some long-term perspective to the current earnings environment by focusing on 12-month, as reported S&P 500 earnings. {Friday's} chart illustrates how earnings declined over 92% from its Q3 2007 peak to Q1 2009 low -- the largest decline on record (the data goes back to 1936). Since its Q1 2009 low, S&P 500 earnings have surged (up over 600%) and currently come in at a level that has only been exceeded during the latter years of the dot-com and credit bubbles."

This earnings recovery is the prime support underpinning last year's remarkable rally in stocks.  It's what I think will ultimately move stock prices higher by year end even though I think we may spend a few months going nowhere.

Link: Chart of the Day-Earnings.

an tSionna 2.22.10

Given the market's rise last week we are taking more of a market neutral stance shorter term {largely for some of our aggressive accounts who have somewhat of a trading bias for all or part of their assets}. There is a possibility that we may sell or become more defensive in regards to some of these shorter term trades this week depending on how the market acts.

We are still net market positive for assets we look to hold for a a longer time horizon. We reserve the right to change our market horizon depending on market conditions and we may do so without notice on this blog.

See here for a definition of these terms as it currently stands. Definitions

Rate Hikes

24/7's take on Thursday evening's suprise rate hike.

{I}n the FOMC meeting minutes from January, it was becoming painfully clear that the FOMC was getting closer to hiking rates. Most notable was that the discussions had revolved around whether changing the “extended period” and more importantly that the FOMC was considering raising the discount rate.

It is unusual to see the FOMC hike or cut the discount rate and not move the Fed Funds rate…. but that is what we are getting. The Fed has raised the discount rate by 0.25%. The FOMC raised the discount rate to 0.75% from 0.50%, effective {yesterday}. The FOMC noted that the policy outlook is effectively the same as during the January meeting. But it also noted that it will assess whether further discount rate hikes are needed.

The discount window borrowings as of last night were $87.77 billion and foreign central bank custody holdings were listed as $2.957 trillion. More important than that is that the Fed’s Mortgage-backed securities holdings crossed the $1 trillion mark.  The discount rate is the interest rate that depository institutions are charged to borrow short-term funds directly from the Federal Reserve. Today is not a full rate hike. But this is the beginning of the end of all that free money.

Link:  Fed Hikes Rates.

Stock Price Targets

We've stated that we think it is possible for the market as represented by the S&P 500 to trade up to a level between 1250-1350 by year's end.  Concurrent with that thinking,  we saw this piece from Bespoke Investment Group yesterday. 

Bespoke keeps track of many different sorts of market statistics.  One of these is keeping track of price targets of investment firm's market strategists.  According to Bespoke " At the start of the year, the average year-end price target for Wall Street strategists was 1,225. The year is only about 6 weeks old, but the average price target has now been upped to 1,232. The two firms that have already raised their year-end price targets are HSBC (1,225 to 1,300) and Bank of Montreal (1,175 to 1,200). The rest of them have kept their price targets the same. 1,232 is a gain of 16.07% from the S&P 500's current level. 

Note:  This piece was published on Feb 9, 2010.  The market is higher by 3% since then.  Also note that in the main strategists have been raising estimates for 2010.

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

Link:  Strategist Price Targets For 2010

Earnings Revisions

We discussed earnings estimates regarding the S&P 500 in this post back in January:  How We Value The Stock Market .  Earnings revisions continue to rise.  Here is briefing.com's take on what has now been four quarters of consecutive upwards earnings revisions. {Excerpt with My highlights and comment at the end.}

Cloudy with a Chance of Earnings Revisions-Last Update: 16-Feb-10 07:47 ET

Earnings are the most important driver of stock prices. Lately, though, it seems as if they have been relegated to an afterthought by the market, which has been grappling with headlines discussing sovereign debt in the eurozone, China's efforts to curtail bank lending, and some spotty economic data that have provided reason to question the pace of economic recovery.  All the while, company after company has posted better-than-expected earnings results for the fourth quarter.

The latest data compiled by Thomson Reuters indicates 73% of the S&P 500 companies that have reported fourth quarter results have exceeded consensus earnings estimates......As was the case a few weeks ago, S&P 500 companies are not just beating estimates, they are blowing them away......The ease with which corporate America is surpassing earnings estimates has revealed two things: (1) analysts used very conservative assumptions in their earnings models and (2) all of the cost-cutting throughout 2009 has created some tremendous operating leverage......

......Currently, four sectors -- energy, utilities, industrials, and health care -- are on pace to register year-over-year declines in earnings for the fourth quarter. Five sectors -- financials, materials, consumer discretionary, technology, and telecom services -- are essentially carrying the earnings load for the S&P 500 in the fourth quarter.....

{Briefing.com's} qualitative assessment of earnings guidance for the first quarter and calendar year 2010 is that companies have been sounding a cautiously optimistic note.  There has been almost universal acknowledgment that the worst is over. At the same time, business activity, while better, is still tracking below levels seen before the credit crisis.....

...Bottom-up earnings for the S&P 500 in calendar 2010 are estimated to be $78.92. That would be 29% above the estimate for calendar 2009, yet 11% below the calendar 2006 actual of $88.18.....

...Of  the 10 economic sectors, only two -- energy and technology -- have higher estimated earnings growth rates for calendar 2010 today than they did....just ahead of the start of the fourth quarter reporting period. Every other sector has seen a cut in its projected growth rate, though it would be remiss not to mention that all 10 sectors are still projected to deliver earnings growth for calendar 2010.....

...It may seem at times then that earnings news is taking a backseat to headlines of another nature. The fact of the matter, though, is headlines about sovereign debt, China's efforts to curtail bank lending, and/or weaker-than-expected economic data all feed into the outlook for earnings.  Accordingly, the earnings growth outlook for calendar 2010 is being called into question, which is why trading volatility has increased.

On that note, {briefing.com does} not believe the stock market has been disappointed with the fourth quarter results or even the guidance for that matter. Instead {their} belief is that the market has been transfixed by some unnerving headlines that have given it reason to doubt the achievability of guidance that has been offered....Until that doubt is extinguished, the flames of volatility will continue to burn in the market.

{My comment:  There is always some uncertainty in the market's earnings.  But if you take a $78.92 eps number for the S&P 500 and apply historical multiples  you get a range of 1,026 {at 13 times earnings} - to 1,260 {at about 16 times earnings}.  Based on Tuesday's close stocks are either slightly overvalued or between 15 to 20% undervalued.  This fits within our thesis that stocks have the potential to trade between 1250 and 1300 by year end.  Where they end up will largely be a matter of how earnings look going forward at that time.}

*Long ETF related to the S&P 500 in client & personal accounts.  Long ETFs related to technology, energy and finanacial sectors in client and personal accounts.  Long ETFS related to health care, industrial  and certain materials sectors in certain client accounts.

Link:  Earnings Revisions

an tSionna Gold an Update

We posted on gold back here in early January.  {See link: Gold.} Today is an update to that entry. We can be owners of gold via the gold ETF, GLD. We're back approaching GLD's old support level that has now become resistance. We'll be able to get some idea of where this ETF might be headed based on how it reacts to this resistance line. Today's breakout can be viewed as a positive however in that we have taken out the series of lower highs and lows that the metal has been locked into since January. No guarantees of course where GLD is going to trade going forward.

*Long GLD in certain client accounts.

Ash Wednesday.

Lent Begins.

pulvis es et in pulverem reverteris

Mystery Chart

Mystery ETF Chart:  I've hidden all references to its name because its not important.  This illustrated ETF is used solely for reverence as most of the charts I looked at today looked similar to this.   Like almost every stock and ETF I've been watching, we'll garner many clues about the coming months to how stocks respond when they ultimately reach their several overhead resistance points.  Most are still over sold as well.

*While I've not disclosed the name of this ETF I will let you know that I am long this in certain client accounts.

Definitions {Part II} Playbook & Game Plan

We often refer in our writings to the playbook and the game plan. Here is our current definition of both.

The Playbook: The playbook is situational and probabilistic analysis based on historical market results. We use our studies of money flows along with the disciplines of fundamental and valuation analysis to see how markets have responded to similar historical events that we might currently be facing. The playbook will give us different market scenarios to current market activity. From the playbook we formulate a game plan.

Game plan: A game plan is tactical and strategic allocation of our clients assets based on what the playbook tells us has historically occurred. It is further refined to the specific risk/reward parameters of our various client groups. In some cases portions of the game plan can be implemented across the board in all client accounts or in a specific investment category. At other times portions of the game plan can be specifically implemented in individual client accounts where events or certain client events may warrant such action.

an tSionna 2.15.10

An update to the Crossroads post from last week.  I've linked it here:   Crossroads?

Since the weight of our evidence is currently indicative of a rally we are currently Net Market Positive in our postioning.  We currently think this rally will be short term in nature given our view that stocks will spend some months working off last year's advance and positioning themselves for further movement later in the year.  We of course stand ready to change this thesis should events warrent a change to our stance.  Again please note this is a guess, an educated guess perhaps but not an event we can be certain about.  We have positioned ourselves accordingly to what we think might happen.  Casual readers should consult their own investment advisors or do their own homework before acting on anything you might read here.

*Long ETFs related to the S&P 500 in client and personal accounts.  Please see this link for a definition of this term. 

Link:  Definitions-Net Market Positive. 

Valentine's Day

A big Valentine's Day shout out to all the M. English's in my life!

-Cobh, Ireland 2008. 

Net Market Positive

As a post script to or Definitions article published below we are currently Net Market Positive. This is subject to change as events warrant. This has been our current market stance since we published our "Crossroads?" posting on February 10, 1010.


Link:  Crossroads?

Definitions - Overview.

We going to start an occasional series on definitions of certain terms we use.  I've long felt this is necessary so investors can understand some of the concepts we discuss.  In a perfect world with a web developer for instance there would probably be a definitions tab at the top of this page where I could constantly update our terms. The world isn't perfect and posting online is not my day job so we'll have to be content for now with a series that we can link and update.

I constantly struggle with how to explain what we might be doing on a general basis without being too specific about on our current investment posture in client accounts.  I also in general prefer not to discuss what we might be buying and selling in accounts. In general we refrain from discussing individual securities. While I might at times indicate why I like certain markets or sectors, for the most part I'll refrain from talking about our individual holdings.  Only rarely will you see me say something like "today we bought (or sold) XYZ and here's why." Even then it will be only for illustrative purposes.

Here's why we do it this way.  Lumen Capital Management, LLC is in a highly regulated business, particularly as to how we communicate with the public. In general the SEC and the State of Illinois discourages and in many cases bars statements with inflated claims. That's why you don't see us writing something like "Wow we sold XYZ today---made 40% on that investment! Call me so we can discuss our next big winner!"  Regulators frown on that sort of thing, especially if it can't be documented.  In any case it's just bad business so we try to avoid any appearence here of doing it.

We also want to avoid any appearance of front running. That is we don't want to be accused of buying a security for clients or ourselves and then writing about it in the hopes that we can influence a higher price for that security. {Believe me not enough people read Solas! for that to happen-but we'll try to avoid that appearance anyway.} This is also why we will disclose long {or short positions} in a security if we discuss it by name in a posting.

The other reasons have to do with the nature of our clients. Solas! is designed solely for our clients as well as friends and future clients of our firm. This blog is a way for us to communicate actively with these groups. We are not a tip sheet nor are we interested in turning this blog into an investment letter at this time.  We want our clients and friends to better understand our market stance and we want to provide them a forum so they can be kept informed of events that might interest them. Investors who want to know the specifics beyond what we provide here need to become a client of our firm.

Finally most of our clients are individuals or family groups. Because of this we manage accounts based on the unique risk/return profiles of our clients. In general we do this by placing clients into five different investment categories based on our understanding of their investment parameters. Within each group there is also permitted a certain amount of customization in each account. As such we are concerned with how to communicate our investment stance in a manner that most accurately reflects what we might be doing at a certain point in time.  For instance in a market decline, a defensive posture in our most aggressive category of investors can mean more aggressive selling than we might attend in some of our accounts that are designated  more passive investment category such as an account set up mostly for income.

Having said this we are going to try and use several broad definitions for market posture going forward. This is our first attempt at this and we stand ready to either redefine or change these definitions if they prove to be inadequate to our task.

Definitions {Part I}

Net Market Positive or Net Buyers of Stock:

Should be interpreted that we have over a certain period of time become net buyers of securities. That is on a net basis we have added more securities, {usually ETFs} to client accounts than we have sold. We may be both buyers and sellers during this given time but on balance we will have purchased more securities than we have sold. Such an action can be confined to one of our individual investment categories or it could possibly be something we have attended to across substantially all of our client accounts. We will not disclose what percentage of our client accounts such a positive bias accounts for except in extraordinary circumstances. We may also indicate whether we are Net Market Positive or Net Buyers of Stock in a shorter time frame or for a longer period of time but we will not be obligated to do so.

Net Market Negative or Net Sellers of Stock:

Should be interpreted that we have over a certain period of time become net sellers of securities. That is on a net basis we have sold more securities, {usually ETFs} in client accounts than we have bought. We may be both buyers and sellers during this given time but on balance we will have sold more securities than we have bought. Such an action can be confined to one of our individual investment categories or it could possibly be something we have attended to across substantially all of our client accounts. We will not disclose what percentage of our client accounts such a negative bias accounts for except in extraordinary circumstances. We may also indicate whether we are Net Market Negative or Net Sellers of Stock in a shorter time frame or for a longer period of time but we will not be obligated to do so.

Market Neutral:

In general we are neither net buyers or sellers of stock.

As I've previously stated these definitions are a work in progress. Such a system is not perfect, no generalization ever is. This is also not at this time meant to be seen as a market timing model nor as a blanket description of every portfolio. That is it will not be an audited event and we will not be in the business of grading its results. It is simply our attempt at giving our clients and friends a better grasp of our investment positioning at certain points in time. As I reserve the right to change these definitions should events warrant it.

First Quarter Letter To Clients {Conclusion}

Conclusion

Our crystal ball, cloudy on its best days, is saying that the markets will not be as easy a place this year as 2009. We believe there is a strong likelihood that the trends we experienced since last March are changing. We believe that a trading scenario similar to what we experience between 2004-2006 is a more likely place to review for profitable investment strategies. We also think that stocks still have the potential to experience attractive returns this year given what we currently know about the market and the economy.

Based on a current S&P 500 earnings estimate of $78 per share, its current P/E ratio currently stands around 14, well below its 16.7 average since 1962. The trailing earnings yield (the inverse of the P/E ratio) is currently near 7%.* Investors are still being paid to own stocks, especially when viewed against the current anemic money market rates and bond yields.

We have said before that 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 our analysis is plausible and indicates that stocks are a better buy once the parameters of this current correction are understood.

Investors have been through not only a lost decade as far as the equity markets but have experienced a roller coaster effect these past three years. We therefore understand their concern when stocks correct.

Thank you for reading our letter and letting us serve your investment needs. Please remember to check us out on the web! We have so much more timely content there. We try to post every day and it is designed to be read in less than five minutes each day. It is also the easiest way to give you an insight into our current thoughts. Again You can find us at: http://lumencapital.blogspot.com/ .

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.

*Long ETFs related to the S&P 500 at the time of this writing in client accounts.

First Quarter Letter To Clients {Part III}

The Playbook

Be that as it may, stocks have experienced a change of character this month. Irrespective of what we think might happen we must deal with the market as it is and not how we hope it might be. One of our primary market tools is to study money flows into and out of stocks. We believe that investors reward asset classes by injecting liquidity {more buyers than sellers} and punish by taking that liquidity away. Studying liquidity will not insure portfolios from all losses and it will almost certainly never prevent losses when we have a sudden unlooked for event such as a market crash. But understanding liquidity should in general raise cash in portfolios before a crisis hits and will help uncover clues on the current state of the market.

Equities today react almost instantaneously to information. Our development of the playbook is a response to this. The playbook is situational analysis based on historical market results. Using our studies of money flows along with the disciplines of fundamental and valuation analysis we formulate a game plan based on what the playbook tells us has historically occurred. This game plan attempts to take into account certain market outcomes and adjusts these to the investment profiles of our clients.

We know of no system that will totally inoculate a portfolio from market declines. What we attempt to do is to mitigate that risk based on a client’s comfort level. Thus we are constantly asking “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 the client’s risk/reward equation, We constantly evaluate our game plan and stand ready to change it when conditions change.

Please note we manage portfolios based on clients’ personal criteria. What follows is a broad statement of our thinking, a general statement of how portfolios are currently positioned and our current investment posture Client portfolios may therefore not exactly match the following general analysis. Factors influencing a client’s risk profile can include portfolio size, legacy positions, tax considerations and targeted rates of return.

We’ve chronicled over at our blog how we have become increasingly concerned since mid-January about the way stocks were trading. This has caused us to develop a more defensive posture at the moment. In some instances this has prompted us to raise cash. It has also prompted us to review every portfolio in order to identify what we might do in case this decline turns into something more serious. We do not know whether this current corrective phase will burn itself out soon or has further to go. Instead we find it prudent to let our indicators be our guide on what should be our next move. We recognize that we will likely never completely sell out of our holdings at market tops or be all in cash when markets trough. However, we would like to have cash to redeploy when stocks inevitably bottom out. We are in the process of trying to determine at this point what these amounts should be.

We think we will be able to better understand market direction over the next 3-6 months by how stocks react to any rally that we think should soon follow this decline. If stocks rally straight back to previous highs and manage to burst through those levels, they will act much like they did for most of 2009. That would be indicative of a market that wants to go higher in a shorter period of time than most investors currently anticipate. On the other hand a market that has trouble rallying from current levels or fails after a feeble attempt to move higher would be indicative of a situation that could lead to more downside or a certain period of consolidation. We’ll let our indicators be our guide at this point as to what to expect.

Our current strategy is to: (1) Reposition into what we believe to be attractive market sectors. (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 continues to be on ETFs.

{Tomorrow:  Conclusion}

Crossroads?

I've posted a rather busy chart today that I hope shows what we've been going through and our current thinking regarding the markets.{You can double click on this to make it larger}.

 

1. Volatility: Stocks are more volatile today. Here's why I think this is so.

• 
  
  Market is influenced more by short term traders and program trading than ever before.
• 
  
  Instant transmission of information
• 
  
  Cost an ease of which multiple trades and block trades can be put through the system
• 
  
  Lack of traditional market making by specialist firms and trading desks.

2. Volatility means that stock price gains and losses are compressed in time. What used to take a month or longer to occur now seems to happen in weeks or less.

3. We highlight in the chart above that stocks began to decline in earnest when President Obama went after the banks and financial sector in response to Scott Brown's win in Massachusetts. This decline has also been exacerbated by debt concerns within certain European Union countries. It is our opinion that the real reason that stocks started to decline was that they were so overbought from last year's rally that almost anything would have lead to some sort of sell off.

4. Money flow analysis is now indicative of a crossroad event. That is we will be able to garner certain clues about where stocks might be headed by their reaction to certain nearer term outcomes. For us, if stocks are able to rally through the downward sloping trendline {pictured as the thin blue line declining left to right in the chart above}, then we think there is a greater likelihood of a further short term advance for share prices. On the other side, a market that decisively takes out last Friday's lows would to us be indicative of a market that has further to go on the downside.

5. We think the evidence is indicating some sort of near term rally. As a result we have become slightly less defensive in our investment thinking in the shorter term. We of course stand ready to change this thesis should some of our money flow indicators continue to deteriorate.

6. However we also think that stocks will spend the next 4-7 months in some sort of trading range. If we had to guesstimate that range we think it would be between  1000-1120 on the S&P 500. Please understand that these prices should be considered simply our best guess as to what might occur. Events could warrant much higher or lower prices over time. We base these numbers simply on our current understanding of our different levels of market analysis. We will base our current investment posture in client accounts based on this analysis and the points we make below.

7. We believe that the retreat in prices have led to levels of valuation that are attractive in both the longer term and shorter term horizon based on what we perceive to be the current levels of economic growth. This is particularly true in certain sectors that we believe are showing attractive fundamental business prospects and seem to us to have been unfairly punished in this latest market decline.

8. We are currently publishing our end of the year investment letter to clients on this blog in serial form. Based on the economic evidence currently available to us we see no reason that those year end target levels for the S&P 500 mentioned in that letter cannot be reached.  More attractive levels of valuation married with positive business fundamentals in both the economy and individual sectors has moved us to a more positive assessment of stock prices longer term even though we expect stocks to be range bound for a certain period of time. We will marry this analysis with what we believe are appropriate account tactics for clients based on our understanding of their individual investment goals and risk/reward parameters. Once again we will change that thesis over the coming months if events warrant such a conclusion.

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

First Quarter Letter To Clients {Part II}

As January Goes….

Finally let’s address last month’s decline. Wall Street is full of old market proverb. One of these is “As January goes so goes the market”. This adage is not always true-last year’s nearly 9% slide proves that. But as Barron’s Magazine notes “there {seems to be} statistical significance in what January means for the rest of a year….When {January} is down, those years are on average flat over the following 11 months. The indicator really says an up January has very strong implications-but a down January pretty much just says, Don’t’ expect too much because anything could happen.” *Streetwise-January Puzzlement, Michael Santoli, Barron’s, February 1, 2010.

Our own cursory look at the data from the 2000’s shows there is no predictability to this adage. Six years between 2000-09 experienced a down January. Three of those years {2000, 02 and 08} also experienced down years. Three years saw January end down but stocks end up by year’s end. These were the years {2003, 05 & 09}.

We think we might be seeing a return to a pattern we first noticed back in the mid-2000’s where stocks show a strong tendency to run up prices during the last three months of the year and then spend some time adjusting to that gain at the beginning of the next. This pattern showed itself in 2001-02 and in 2004-06. This pattern may not repeat in 2010, but we do want to keep it in focus as we formulate our strategy for the rest of this year.**

{Part III Tomorrow}

**Note we  discussed this trend back in January.  You can see this post here:  Seasonal patterns.

an tSionna 2.08.10

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

First Quarter Letter To Clients {Part I}

Note this letter can also be summarized by reading our green highlights!

Stocks turned in one of their best years ever in 2009. Markets are currently showing signs of a change in trend.

Market Recap

Despite their gains, 2009 proved to be one of the most volatile investment years ever recorded. Stock prices collapsed nearly 30% through early March as fears of a global financial meltdown gripped investors. Stocks found their footing, stabilized and began a furious rally that saw share prices rise close to 40% from their lows.

From there shares languished until mid-July when another rally commenced that took equities in stair step fashion to their year-end gains. For the record the S&P 500 finished 2010 with a total return of 26.5%. The average pension plan returned 19.6%. Barron’s reports that a well noted hedge fund composite returned 20.12%.

We could spend pages discussing what went on last year. We believe our clients are more interested in what we think about the future. You can read our thoughts about last year by going to our archives at our blog: http://lumencapital.blogspot.com/

Looking Forward

Here are some of our bigger picture 2010 thoughts.

Stocks came back from the brink in 2009. Equities collapsed in 2008 on fears of systemic failure throughout the international financial system. One of the prime reasons for their recovery was the extraordinary efforts by world governments to avoid a repeat of the Great Depression. The rebound accelerated on evidence that these efforts were taking hold and of renewed signs of world-wide economic growth. We see no current evidence that these same governments are relaxing their vigilance on the system. Central banks have gone out of their way to continuously provide liquidity to the world banking system. Based on current policies we do not believe there will be a repeat of those events. Thus we think investors will continue to focus on the global economic environment and fears of systemic financial failure will continue to decline.

US Gross Domestic Product {GDP} surged in last year’s 4th quarter to a 5.7% advance. Traditionally, back-to-back quarters of GDP growth have marked a recession’s end. However, our economy faces many headwinds. Future economic growth will likely be less than what has traditionally been experienced at the end of a recession.

The economy is going through a massive deleveraging cycle. This is especially true for American consumers where the credit spigot has been turned off. They are also challenged by the depression in residential real estate. Governments at every level are broke. They are being forced into a combination of service cuts and raising taxes. They also have to cope with the staggering amounts of debt they have been forced to take on in order to mitigate the current economic crisis. Unemployment levels currently remain above 10% and will likely only slowly decline. Finally the Federal Government is not currently promoting policies that are pro economic growth.

We expect the economy to grow this year but that growth will be lower than historically experienced. The economy came to a standstill in 2008 and early 2009. The length of this recession leads us to believe that a combination of inventory rebuilds, replacement cycles in equipment-particularly as related to technology plus a slight pick-up in other economic activity will give us another year of economic growth. We believe these factors will be enough to grow the immediate post recession economy 3-6% in 2010. This is low by historical standards given the issues we highlighted earlier. Given the tepid nature of this recovery, the possibility of a shallow recovery or a double dip recession in 2011 cannot be ruled out.

3-6% economic growth, should it occur, would suggest possible S&P 500 valuation between 1,250 and 1,350 by year end. Current economic conditions would seem to favor the lower end of this range. That implies a possible total return for stocks of 10-15% based on closing values on December 31st. This return could be closer to 16-20% based on January’s decline. We base this analysis on what current data tells us. Events as they unfold could prove this either optimistic or pessimistic. We stand ready to change this thesis as events warrant.

We currently think that energy, technology, finance and certain health care sectors should outperform this year. We are also looking to find ways to up our client’s exposure to international markets. Our investment vehicle of choice is exchange traded funds {ETFs}. We continue to be interested in certain yield oriented securities and strategies. As of this writing it is still possible to find some ETFs that yield in excess of 4% with decent long term growth characteristics.

{Part II Tomorrow}

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

The Deindustrialization Of America

We've talked in the past about how the "Great Reset" is changing the nature of American jobs. This is a trend that has been going on since I started working some 20 years ago. I think it is being accelerated by this recession. Here is 24/7 take from an article last week. {Excerpt. Highlights mine.}

When Stocks No One Cares About Rise: The Deindustrialization Of America

By Douglas A. McIntyre:  24/7 Wall Street.

.....{Last Week} Eastman Kodak (NYSE:EK), once one of America’s great industrial firms but one that has been in ruins since the mid-1990s, had its shares trade up 25% to $5.92. Kodak was an $80 stock in 1995......Kodak has never been able to overcome the fact that people do not use film in cameras anymore and that few photographers print their pictures.

Kodak is an example of a company never truly dies if there is one shareholder who believes in it. Investment firm KKR put $700 million in debt into Kodak last year. Other investors were not happy with the arrangement because KKR can take control of 20% of the photo company’s shares by exercising favorably priced warrants.  The people who run KKR did not become billionaires without the possessing astonishing skills that help them to find value in something that appears valueless. KKR figured correctly that Kodak revenues would never go to zero, or even close. And, the company has gone through one of the most brutal series of cost cuts in the history of American corporations.....

....More important to KKR is that Kodak, which was started in 1892, is, like GM and other old industrial companies, an opportunity to make money on companies that can rapidly cutting costs to match swiftly falling revenue. If there is still a core set of customers to support some revenue at the end of the process, there is money to be made.  Kodak has fired more people over the years than most of the largest companies in the world will ever employ. The firm had over 145,000 workers in 1988. Today Kodak employs barely 20,000 people.

Unfortunately, Kodak’s story matches the employment trends in America over the last 30 years. In the mid-1980s, Kodak was one of the fifty largest companies in the country based on sales. GM, Chrysler, Xerox, and 3M were on that list as well. So were US Steel and Goodyear. It is academic now whether these firms could have kept their competitive positions in the world by more rapidly improving or changing the nature of the products that they sold. Their sales fell, for whatever reasons, precipitously over two decades and there was no choice than to fire huge portions of their workforces or go out of business.

             {Quarterly chart of Eastman Kodak dating back to July 1998.  EK has lost over 90% of its value since then.}

GM found an investor, an unlikely one, in the US government. The No.1 US car company had fired hundreds of thousands of workers and had a weak balance sheet. But, the cost cuts were not enough. Taxpayers own 70% of GM, and the company, with a fraction of its market share from the 1970s and 1980s, is likely to make money and perhaps even pay the government back through an initial public offering of shares in a company that was public for the better part of a century before it was pushed into Chapter 11.  GM will have cut its way to profitability and KKR gambled that Kodak could do the same.

 

                  

The process of dismantling large US industrial companies may occasionally be profitable for investors like taxpayers and private equity firms, but the American economy may never entirely recover from the trend. The majority of the jobs that Kodak and Goodyear and Chrysler have eliminated will not be replaced because the manufacturing base in the US has grown smaller and will not get much larger again. A Goodyear worker will have to work in a McDonald’s (MCD) for a fraction of his former wage, become permanently unemployed, or need to be re-educated in the hope of finding another line of work that pays well. Millions of Americans has gone through these processes in the past or are going through them now, and their prospects of having good jobs again is poor.

KKR may know how to make money from a floundering company that is prepared to put as many people on the unemployment line as is necessary to operate in the black. But, the economy can’t absorb those jobs. That is one of the reasons that high employment had become a chronic condition, and why KKR makes as much money as it does by finding survivors among the rubble.

Link:  The Deindustrialization of America

A Guesstimate!

If I had to make a guesstimate on the market's direction over the next 3-4 months it might be something like this.  Let's say up front I have no certain method of knowing which way stocks will trade.  For all I know we're going to turn right around at these levels and shoot much higher.  We study money flows in order to get some idea of market and equity direction.  From this analysis we derive certain probabilities of what might occur.  The chart above is simply a projection of what I think I'm beginning to see set up via money flows.  Not a prediction or a guarantee of course.  Consult your own advisor or do your own homework if you are not a client of Lumen Capital Management, LLC.  Or better yet hire us!

*Longe ETFs related to the S&P 500 for client accounts.

How We Value The Stock Market

I've been asked how we get a possible year end target of 1,250-1,350 on the S&P 500? Here's how we do that analysis. First off we have to ask a simple question at this point which is whether the economy is improving or listing back towards either stagnation or recession. Our analysis is that we are still improving although certain headwinds (Greece for example) have recently been added to the mix. An improving economy is likely an expanding multiple event. Current analysis indicates that the S&P 500 should earn somewhere between $75-79 per share this year and possibly $79-84 in 2011. {There however is a fear by some that the US economy could slip back into recession either later this year or in 2011. That however is not our current read of the economy}.

So let's take these numbers and apply some sort of PE multiple to them {Top Row}. Remember that at some point this year Wall Street will start focusing on 2011's numbers. I've highlighted in Green the range based on several of S&P's earnings estimates that I think its possible to see by year end based on what we know today. I apologize that this worksheet doesn't show up better on the blog. Folks who do this all day long can likely make this appear better, but it's not my day job!

PE Ratio 

        14     15      16     17 

75: 1050 1125 1200 1275

76: 1064 1140 1216 1292

77: 1078 1155 1232 1309

78: 1092 1170 1248 1326

79: 1106 1185 1264 1343

80: 1120 1200 1280 1360

81: 1134 1215 1296 1377

82: 1148 1230 1312 1394

83: 1162 1245 1328 1411

84: 1176 1260 1344 1428

A final note: Like the market's themselves this sort of analysis is always a work in progress and gets constantly revised. This is simply a snapshot of where I think we are today. If I had to guess today I would think we might trade at the lower level of that range by year end, say 1250-1275.  Obviously if we start revising these earnings numbers down then it is likely that our year end targets would have to be revised down for the markets as well. That of course works both ways! A market that looks to do substantially better than current analysis suggests could go even higher.

By the way, a market that trades say around 1,300 by year end would only take us back to where we traded in the summer months of 2008!

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

Gold vs. The Dow

This from Chart Of The Day:  The stock market has been rallying over the past 10 months. So, is the stock market performing well? It all depends on how you measure. When measured in US dollars, the Dow currently trades approximately 29% below its all-time record high. However, when measured with that other world currency (gold), the picture is even more bleak. To help illustrate the point, today's chart presents the Dow divided by the price of one ounce of gold. This results in what is referred to as the Dow / gold ratio or the cost of the Dow in ounces of gold. For example, it currently takes 9.3 ounces of gold to “buy the Dow.” This is considerably less that the 44.8 ounces back in the year 1999. When priced in gold, the US stock market has been in a bear market for the entire 21st century.

Link:Gold Chart.  {Subscription may be required}

Government Spending Freeze?

In last week's State of the Union address, President Obama discussed among other things freezing discretionary spending by the Federal Government for three years.  Ed Lazear in a Wall Street Journal editorial eplains why that is not going to happen.  {Excerpt with my highlights.}

The Spending 'Freeze' That Isn't  {Since 2008, the ratio of outlays-to-GDP has risen by about 14%}By EDWARD P. LAZEAR,  January 27, 2010.

In last {week's}State of the Union address President Obama proposed a three-year "spending freeze" on what amounts to one-sixth of the federal budget. Our biggest entitlement programs, Social Security and Medicare, would be excluded. These changes are optical rather than substantive. Given the spending agenda that is already in place, we can expect to see large increases in the proportion of GDP that is spent by our government for years to come.

Since 2008, the ratio of federal spending-to-GDP has risen by about 14%. From 2008 to 2009 we saw the greatest annual increase in spending in the last 30 years. In the name of stimulating job growth, the share of federal spending is now 24% of the economy, up from 21% in the last year of the Bush administration.

{Mr Lazear's}analysis of data from 1950 to the present shows that periods with high tax-to-GDP ratios exhibit much slower economic growth than lower tax ratio periods. The GDP growth in high tax years (defined as years during which the ratio of tax-to-GDP was above 18%, the 60-year average) was about 1.5 percentage points lower than the growth rate in low-tax years.

High taxes are clearly bad for the U.S. economy. For example, were we to tax above the 18% tax-to-GDP ratio over the next 25 years, GDP per capita in 2035 would be about 50% less than if we were to tax below the 18% ratio......

....The recent growth in spending has been camouflaged by a focus on deficits. Budgets and proposed legislation, like that on health care, are being judged not by their impact on spending and taxation, but by their projected effect on the deficit. Equal increases in spending and taxes reduce economic growth, even if they do not alter the deficit.

So the rhetoric surrounding the health-care bills misses this point. Were they to pass, it would mean more spending, more taxes and less growth.....The health legislation that looked likely until Massachusetts voted last week included about $1 trillion in new spending, $500 billion in promised Medicare cuts, and slightly more than $500 billion in increased taxes. If the Medicare cuts were to materialize, then the bill would reduce the deficit because tax increases exceed net new spending. But even if the Medicare cuts were realized, the policy would contribute to the growing size of federal spending and the budget, which, when financed, is the major impediment to economic growth. Arguments over whether the legislation would increase or decrease the deficit or whether it would bend the "cost curve" down or raise it are secondary as far as economic growth is concerned. The largest impact comes from levying over $500 billion of new taxes to pay for the increased spending.

Despite all the talk about deficits, the irony is that we are in little danger of eliminating or reducing the federal deficit. Mr. Obama's target is to lower the deficit to 4% of GDP by 2013. That is twice the level of the Bush deficit in the average year and larger than any Bush-year deficit. During President George W. Bush's term, the ratio of federal spending to GDP averaged 20%. Mr. Obama's budget aspires to reduce the spending ratio to 23% by 2013 from 24% today.

It is true that Mr. Obama inherited much from his predecessor, as the president and his surrogates are wont to remind us. There is no doubt that when the new team came in, the economy was in a deep recession and job losses were large. He inherited an unemployment rate that was over 7%. It now stands at 10%. The job growth that was the promised outcome of the $787 billion stimulus bill has not materialized. And when job growth returns and unemployment falls, it will owe little to the stimulus.

Consider the legacies Mr. Obama will leave his successor. He grew the deficit that he inherited. He grew the government spending ratio that he inherited. And he has already promised to repeal the low tax rates that he inherited. At this point, the question is how much and what form the tax increases will take. Part of the Bush legacy includes low personal tax rates, an average ratio of taxes-to-GDP of about 18%, low rates on capital gains, and a period of low estate taxes.

It will be virtually impossible for Mr. Obama to keep his promise not to raise taxes on the middle class while paying for an enormous increase in spending. Given the planned spending levels, taxes will have to rise substantially to get to the target 4% deficit figure that the White House wants.....Proposals that increase taxes and spending, even if they do not increase the deficit, will place a substantial burden on our recovering economy and on future economic growth.

Mr. Lazear, chairman of the President's Council of Economic Advisers from 2006-2009, is a professor at Stanford University's Graduate School of Business and a Hoover Institution fellow.

Comment-Given Mr. Lazear's role in the Bush Administration we should consider the fact that his analysis may be biased.  However, if Mr. Lazear's analysis is correct then we are looking at a substantial economic headwind and something that again if correct would likely lower the growth rate for equities in the years ahead.

Link: The Spending Freeze That Isn't