This blog is written weekly by Dock David Treece, a registered investment advisor with Treece Investment Advisory Corp. It is meant to share insight of investment professionals, including Dock David and his father, Dock, and brother, Ben, with the public at large. The hope is that the knowledge shared will help individuals to better navigate the investment world.

Monday, August 31, 2009

Recovery in the making but danger still abounds

Each week goes by and the same question remains: How much higher can this market go? After rallying nearly 50% from its bottom in March, the stock market must be nearly out of steam.

Despite economic numbers beginning to show what looks like the beginning of a mild recovery, we simply can’t believe that this market can go much higher. Especially since there isn’t as much money supporting prices as there was at the old highs. Not after so much leverage was wiped out of the system during the collapse.

And yet, with each passing week, the market continues higher.

Looking at the current economic situation and the fundamentals driving this market, we firmly believe that there is a correction on the way. One that may not take the market back to lows set in March, but undoubtedly one that will cause investors sufficient alarm to throw up their hands and walk away, turning instead to “safer” bonds.

These folks, the unfortunate few who lack necessary preparation and lose their heads (and a good portion of their portfolio), will without question be stepping out of the frying pan and into the fire. This is because bonds, those old bastions of safety, are set to decimate investors in coming years, for two reasons.

First, with interest rates so low right now, there is really only one direction they can go. Of course, readers who have a grasp of basic tenets of finance – or remember the 1970s – will remember that rising interest rates decrease the value of existing bonds.

Second, even those bondholders who are willing to ride out it out through rising interest rates and hold their bonds until maturity will not fair much better. In a time of rising interest rates, inflation tends to run like crazy because consumers take out loans to make purchases sooner rather than later, since they know it will be more expensive later.

Inflation is that tax for which none of us get a bill, but all of us pay. To holders of long-term bonds, it means a crushing blow to purchasing power.

When it comes to the possible dangers of bonds, take the following example. In December of 2008 we made our predictions for 2009. One of which was that the 30-year Treasury bond would be among the worst investments for 2009. At the time the bond was yielding about 2.6%. Now that same bond is yielding about 4.24%.

Therefore, that “safe” bond has caused anyone who bought in around New Years to lose more than 36% of their principal. In other words, if they tried to sell that bond in today’s market, they couldn’t even get 64 cents on the dollar for it.

The bottom line is that in this market, despite the volatility, bonds simply aren’t the answer. In fact, right now the stock market is just nearing the end of a 10-year bear secular market in equities, based on inflation-adjusted returns.

After the correction that we see coming in the near term, stocks will likely trade sideways for another four years or so while stagflation runs its ugly course in the United States economy (stagflation indicates a period of inflation that coincides with economic stagnation, and last appeared during the 1970s). After that, look for the start of something big. After the market moves sideways for awhile, a big bull run is on way in stocks.

Even while the market trades sideways in coming years that hardly means that there won’t be any money to be made. Even sideways markets have very trade-able rallies.

The long-term bull market that we see coming down the line in stocks is deeply rooted in fundamentals and may well lead the United States back to prominence as THE global economic power. The major sector that we see leading the economy back to glory will be – try not to laugh – manufacturing.

It’s no secret that manufacturing has been shifting abroad for the past 15 years or longer. Now companies are finding themselves unable to control the productivity of employees or the quality of their products; and while cheap labor is nice, they simply can’t sacrifice quality.

With technology, resources and labor becoming cheaper here due to high unemployment and lack of demand for raw materials, what we see coming is a very gradual shift over the next several decades that will bring a significant amount of global manufacturing from Mexico and China back to the United States.

The following are several examples of this trend already developing.

  • Several months ago a Chinese industrial company made a bid to buy Hummer from GM, with the intention of leaving manufacturing in the United States, and even expanding production by opening other plans, all within the U.S.
  • Carlisle Tire & Wheel is closing down its production plant in China and bringing it back state-side, and consolidating that plant with others from Pennsylvania and Georgia all under one roof in Tennessee.
  • Hair iron producer Farouk Systems is consolidating all foreign production in Houston, Texas, according to an article in the Wall Street Journal on August 24th (Coming Home: Appliance Maker Drops China to Produce in Texas, Aeppel). According to the article, the company spends about $500,000 each month battling counterfeit versions of its products, most of which come out of China.

While this trend is obviously beginning to form, it unquestionably has hurdles to overcome. Policies in Washington need to encourage cheap manufacturing and provide incentives to businesses that relocate here, either through tax abatements or government grants.

The attitude that Americans have towards foreign firms also needs to change. No longer can Americans consider the Chinese or Japanese the enemy. Instead, they need to be seen as collaborative business partners. Americans cannot maintain the current “us versus them” mentality if they want to see see jobs move back here.

Recovery doesn’t always come from the usual sources. Right now consumer spending is still extremely tight because of high unemployment. Meanwhile, according to Federal Reserve Data cited in a Wall Street Journal article on August 26th, American nonfinancial companies are sitting on $14 trillion in liquid assets (Where Consumers Fail, Can Businesses Lead?, Gongloff). That’s equal to about a year’s worth of GDP. A simple loosening of their purse-strings to invest a fraction of those funds in future growth is more than enough to cause a serious economic recovery in this country.

Monday, August 24, 2009

Market fizzle likely on lackluster data

For last three or four weeks, the stock market has been trading sideways, more or less, on economic news that has seen no substantial improvement. While obviously this has put many investors’ minds at ease, we may not be out of the woods just yet.

First off, at this point there are no economic fundamentals supporting this market. The numbers show no substantial improvement, and certainly not enough to warrant the kind of market recovery we’ve seen so far. At some point, the numbers we’re seeing on the economy need to improve, or else the market will turn, but for the worse.

This is especially true with unemployment. With the consumer-dominated economy of the US, there is really no possibility of any substantial recovery with unemployment so high. Americans simply don’t have the money to spend in order to turn this economy around.

Meanwhile, so far the new Administration and the Federal Reserve have released only a small fraction of the funds authorized through the stimulus bills. The government is also dragging its feet when it comes to paying back rebates auto dealers have accrued through Cash for Clunkers.

These issues make little since. Why did the government push through stimulus bills that were so unpopular, just to sit on the money? Why are they holding back money owed to car dealers, rather than making good on their promise and allowing that money to make its way through the economy? Finally, why does this White House seem to care so little about turning the economy around?

But, since economic numbers don’t show any signs of improving, a correction in stocks seems imminent. The question is how big it will be. While it certainly could put the Dow back around its previous lows, the chances seem higher than it could simply catch its breath after retreating to the 7500-8000 level.

To give some historical perspective, consider the recovery after the 1929 crash. After finally bottoming in July of 1932, the stock market rallied for just two months before topping out in early September. It then traded sideways for more than six months before it finally broke out in May of ’33.

Market action from the mid-1970s tells a similar story. After putting in a second and final bottom in December of 1974, stocks rallied for seven months, then went into a holding pattern through the end of the year.

As it stands, we’ve been rallying since March, and the market appears to be losing steam. In fact, it’s overbought according to multiple indicators. Not only that, but we are now nearing September and October, which historically tend to be the weakest months for stocks.

With all this in mind, chances are better than average that the market won’t move substantial higher in the next several months. And while an end of the year rally isn’t out of the question, I certainly wouldn’t hold my breath. Especially not after seeing the Dow Jones Industrials rally more than 40% off its bottom and tracing nearly 40% of its decline since October of 2007.

The real question for investors is whether they have a plan that will stand up to either a violent correction or a market fizzle. And while many Americans put that responsibility off on their broker, it’s important to understand that the financial industry is one of several that are still suffering, and it may have a largest impact on investment portfolios.

While the auto industry has suffered lately due to lower demand, increasing inventory, unemployment, and the like, and the slowdown in real estate over the past year or two has caused the cash flow for many to dry up, the turmoil in the financial industry impacts many Americans even more significantly.

Since last year, major brokerage houses have obviously taken a huge hit, and after a wave of failure and mergers, there has been a massive consolidation in the industry. This has left brokers worrying about their own jobs, and spending less time focusing on client portfolios. For this reason, as outlined in a Wall Street Journal article last week (Wall Street’s B-List Firms Trade on Bigger Rival’s Woes, August 11, 2009), smaller firms are growing to fill the void being left as the formerly-dominant firms struggle.

Americans need to understand that there is major shift occurring in this country, one very different from the changes we saw occurring for decades leading up to the collapse last year. We’re seeing it in politics, manufacturing and consuming; and the financial industry is no different.

Americans used to commit considerable time to researching their own investments, before they started delegating that responsibility to advisors. Of course, initially they wanted to get to know their advisor and understand the person’s strategy for managing money, as well as their personal character. Unfortunately, now we are seeing fewer and fewer people taking the time to do their due diligence and get to know what they are buying and who is selling it to them.

The bottom line is this: Investors need to know who they are entrusting with their life savings. If they can’t take the time to do their homework, they shouldn’t be surprised when they find they’ve been caught up in the next big swindle.

Monday, August 17, 2009

Real estate questions haunt economy

The last few weeks the markets have seen more questions than answers. Among the potentially most horrific questions is whether there will be a second downdraft in real estate. After everything that happened last year, real estate hasn’t exactly been an industry cast in the most positive light, but it is still a significant portion of the U.S. economy.

Lately there have been some big development projects that were started before the collapse that are nearing completion. And buyers who put down deposits in prefabrication stages are walking away from their deposits at an alarming rate. A good number have done the math and figured out that it’s cheaper for them to forfeit their deposit than to actually take possession of their units and try to flip them.

I heard about one company who recently got certificates of occupancy for finished projects in both New Jersey and South Florida. Immediately, prefab buyers walked away from both, leaving buildings totally vacant. The developer’s solution is to offer these condos at a two-for-one rate — buy a home in New Jersey, get the vacation spot in Florida for free!

Of course, residential real estate is only half the puzzle, and lately it’s probably been the better half. Inventory is finally starting to be absorbed, albeit at deep discounts. These discounts will ultimately have a negative effect on county tax receipts, which trickles down through funding for schools and other local projects.

But don’t forget about commercial real estate. Attempting to cut costs, many big corporations are trying to consolidate their real estate portfolios. Cited in a Wall Street Journal article Wednesday, JPMorgan is one such company trying to cut down on the overhead that comes along with real estate (Feeling Roomy, J.P. Morgan Shops Its Space).

Another sector of the market that is seeing its recent hope quickly fade is energy. After a relatively weak summer season that ended early due to lack of travel, the outlook for crude oil isn’t too good. Already OPEC is beginning to report inventory creeping back up, and lately the price has been sliding.

Aside from oil, there’s electricity, which was featured on the cover of Wednesday’s Wall Street Journal under the headline “Electricity Prices Plummet.” This is yet another HORRIBLE sign for the economy when electricity demand falls. This usually indicates that manufacturing plants, who are major consumers of electricity, aren’t running as much.

All of these signs should signal investors that, regardless of whether the market has bottomed, there will be no quick recovery for U.S. economy. That’s the story the economic numbers are telling, and it’s being backed up by the stock market, which doesn’t appear to be anticipating a major turnaround. In fact, the perception seems to be that the future of manufacturing in this country is remains questionable at best.

Of course, the financial industry isn’t exactly insulated from turmoil in the economy. Consider, for a moment, the world a broker lives in. The last twelve months have seen the death of Lehman Brothers and its partial-absorption into Barclays Capital, the sale of Bear Stearns to JPMorgan in an overnight deal, and the sale of Merrill Lynch to Bank of America, and many other deals.

It should come has no surprise that big brokerage houses are having trouble servicing clients because there’s so much turmoil within the companies. After all, most brokers, at least in a corporate setting, care far more about own jobs than their customers. With all the unrest within the major firms, smaller investment firms, where brokers are more independent are flourishing lately. With greater job security, brokers at these firms have much more ability, and inclination, to dedicate time and effort to doing what they do best — helping clients.

Back to the broader market, another big surprise this week is that the Fed remains the biggest buyer of Treasury bonds. Thankfully, at least someone is buying. With the Cash for Clunkers program expanding through additional funding and “rain-checks” and healthcare reform looking likely to be pushed through Congress, despite the public outcry, the big question is how the government intends to fund all its promises.

If there is anything positive that can be said about everything going on in Washington, it’s that that it seems to have finally woken the long-silent majority. And it’s about time the American people started caring. As much as our country is touted as the greatest country on Earth, with liberties and freedom that can’t be matched, for far too long we have seen far too much of the one thing worse than tyranny: apathy.

At this point it may be too late to make much difference on healthcare, so let’s assume that it’s going to pass. With a new mountain of expenses and tax receipts down, how can the government possibly come up with the funding?

The most likely solution, higher tax rates (a high probability) will only hurt our economy. Remember Reaganomics? Among other things, Reagan lowered the top income tax rate from 70 percent, where it had been since Kennedy, to 28 percent by the time he left office.

Contrarily, Obama has been quoted recently as saying that a tax hike on America’s middle class, the very people that got him elected, isn’t off the table. Talk about biting the hand that feeds you.

Monday, August 10, 2009

Watching the markets

During the last week, the stock market as continued to move surprisingly higher, despite the absence of good economic news. Each day that the market moves higher, further away from its base of support, we grow increasingly confident that a correction will occur in the near future. After all, markets cannot remain overbought or oversold forever.

Recent market activity as highlighted the growing division of investors that we have found since the precipitous decline of last year. In the post-panic investment world, individuals tend to fall into one of two distinct categories.

1. Those that are sure that the market is on its way back to pre-crisis levels, and perhaps even on to old highs. These investors wouldn’t think of selling today. Instead, most have set artificial numbers in their own heads as some kind of vague strategy. For example: “When the Dow gets back to 12,000, then I’ll get out or look at other alternatives. But until then I’m just going to sit tight.”

2. Those investors that, after being ravaged by the market last year (as we all were), have decided that they have had enough. They simply want to “cash out” to avoid any further losses. After the emotional toll taken last year, they sometimes have trouble sleeping, knowing that their money is still at risk. Typically these investors are a little closer to retirement, or perhaps already retired and living off their investment accounts. And while their concerns are legitimate, as I will demonstrate, there are some real problems with their solution.

Unfortunately for the people in these categories, which include the vast majority of individual investors today, they are both wrong, and both stand to pay a high price for their opinions.

First, for those stubborn investors in the frame of mind reminiscent of Cold War bomb shelters – just hang tight and wait it out. It pains me to say this, but the stock market will take years to get back to old highs. Investors with this mentality need to understand that they may have to wait for a very long time.

Consider the following example: In January of 1973 the Dow peaked and promptly crashed. By the fall of 1976 it was back near its new highs, but then traded sideways, more or less, until the fall of 1982. It took until October of 1982 for the stock market to finally break through its 1972 highs. On this timeline, that would mean that the Dow won’t set new highs until nearly 2014.

Is it really reasonable to wait another five years for investors to get their heads above water? While that may be a reasonable strategy for investors in their thirties, that may not be so for people closer to retirement. Secondly, remember inflation, which had huge effects on purchasing power through the ‘70s.

As for the second group, those wanting to cash out: In today’s market, and the way political and economic forces are playing out, it simply is not in anyone’s best financial interest to completely abandon equity investments. This is due to the inflation that is coming through the pipeline, and is set to sweep through the US economy like an economic twister, laying waste to any portfolios that aren’t properly prepared.

When it comes to investments, most people consider the absolute safest options to be either cash or bonds, particularly Treasury bonds. In an inflationary spike, both of these investments can prove toxic. When investors sit in cash, they earn little or no interest on their savings, even while their cost of living rises with prices (the main symptom of inflation).

Furthermore, once the government decides to halt inflation in its tracks, the usual course of action is to raise interest rates. This is bad for a couple reasons. First, investors holding bonds are receiving a lower coupon than new bonds being issued are paying. Second, if they try to sell their bonds in order to buy bonds paying higher coupons, they’ll find that the bonds they’re holding are worth much less in the market. It’s a lose-lose situation.

Since they first came about in 1997, Treasury Inflation-Protected Securities, or TIPS for short, have been an alternative used by many investors to help protect their portfolios, or at least a portion, from the threat of inflation. However, our advice to investors is simple: Forget TIPS, they’re utterly useless, for one simple reason.

TIPS increase their coupon rates as the inflation rate, based on Consumer Price Index (CPI), increases. But remember, CPI is a statistic that is released and even massaged by the US government. It has been proven in countless reports that this number simply can’t be trusted. So why do investors continue to stake money on an artificial number?

With all this in mind, investors need to find investments that will survive or even prosper in the coming inflation. These are mostly real assets, including precious metals, oil, and real estate, as well as the stocks tied to them, like those engaged in mining or drilling operations.

Let me leave you with some thoughts on Cash for Clunkers. Through this underfunded program, the federal government is giving away up to $4500 for old cars. While these cars are supposed to be in less favorable condition, they are, or were, assets for Americans, whether they run or not.

Through Cash for Clunkers, the government is taking those assets, perfectly good cars in some cases, and taking them off the road. In their place the government is helping to put a liability, a new “fuel-efficient” car that, more likely than not, isn’t paid off. In other words, by giving away $4,500 for old cars, the government is convincing (or fooling, depending on your perspective) hard-working Americans to borrow money for new cars that they may not even need.

The government is urging on this new debt under the auspices of both helping the environment by replacing gas-guzzlers with more fuel-efficient vehicles as well as saving the American auto industry. While the environmental impact may be true, it seems hard to argue the economic impact when four of the top five most popular cars sold through this rebate program are foreign-built Hondas and Toyotas.

What seems strange is the federal government’s approach to manufacturing in this country. In one hand there’s the olive branch, and a dagger in the other. While Congress publicly boasts their supposed saving of the US auto industry (which is hardly the case), the simultaneously work on legislation to ban energy derived from coal and natural gas, which are the only options that produce energy cheap enough as to make manufacturing economically feasible. Or is the government going to take that over, too?

Sunday, August 2, 2009

Exchange-Traded Funds

Last week’s blog exposed some of the underlying problems with Exchange-Traded Funds, or ETFs for short. Among these problems is the fact that many of them are essentially derivatives products. Many astute investors will recall that derivatives were large contributors to the market crash last year.

Also making a huge impact last year was excess leverage (debt) in the financial system, much of which was built-in to these glamorous derivatives products. That is the second problem that many are now noticing inherent with ETFs. Renowned investor Warren Buffett has a saying about leverage: “If you’re smart you don’t need it, and if you’re dumb, you got no business using it.”

Oddly enough, since I wrote my blog for last week, both UBS and Edward Jones have announced that they will be halting sales of leveraged ETFs, due to the problems built-in to these complex financial instruments (Bloomberg). While they may not be frequent readers of mine, it’s good to see that someone shares my opinion.

In other regulatory news, the SEC announced this week that it is putting a permanent end to “naked short selling.” This is a rather complex rule in the markets and I won’t bore readers with a lengthy explanation. However, I did feel the need to comment that so-called naked short selling has actually been illegal for years now. It seems the SEC is just now deciding to actually enforce the rule.

However, this news should prompt some personal thought for readers: Do you really know what it is that you own? And more importantly, do you understand how your investments will react to changes in the investment world?

In addition to his proverbs regarding debt, Warren Buffet also argues that investors shouldn’t buy anything that they don’t understand. This concept applies to both individual stocks for companies in strange industries, as well as complex financial instruments that are understood by only a few select minds on Wall Street.

In the markets this week, we continue to anticipate a violent correction in stocks. On Tuesday we saw what we believe was a sign that stocks may be running out of steam after several weeks of bullish trading.

This is not to say we aren’t still bullish on the market. As numbers continue to come out, it is becoming more and more evident that the economy has slowed its decline and now appears to be in a holding pattern.

While recovery is slow, at least things don’t seem to be getting much worse, with the exception of unemployment. In fact, some sectors of the market are actually improving, albeit at a much slower pace than their decline last year.

In light of recent market action, I feel obligated to reiterate a point that I have made repeatedly in previous articles: Investors today have a vital need to understand the role their financial advisor plays. In this industry, there are some professionals who conduct extensive economic research and endless analytical work in order to recommend investments that fit the circumstances.

There are other people in this business who essentially work from a corporate formula to build portfolios for clients that do not take any consideration for economic conditions. And while there is undoubtedly a place in the world for salesmen, investors need to be extremely careful in understanding where these salesmen fit in to their finances.

We can all be certain that the world has changed since this time last year. The long-held concept buy-and-hold simply doesn’t work anymore. Investors need to adjust to the circumstances that now exist, and their investments need to reflect this change in strategy. What investors need now is an active money manager who conducts their own economic research, invest client funds accordingly, and move them appropriately as circumstances change.