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, September 28, 2009

Bull market set to buck investors

Lately I’ve been watching a little more CNBC than usual, trying to keep my finger on the pulse of this market. In doing so, I’ve noticed a recent trend, one that, sadly, isn’t all too unusual. As guests and commentators discuss market action, prices continue to climb, particularly for stocks and commodities, especially gold.

And yet, predictions and price targets keep moving higher and higher. It occurs to me, after having been raised to be a contrarian investor, that when absolutely no one thinks there’s a top in sight, quite often they’re standing frighteningly close to the edge of a cliff.

My point is this: lately the general public has been getting increasingly excited about where this market might be headed, and all the “dumb money” — those funds not managed by professional investors — has been piling onto the long side of the market

Meanwhile, the smart money has gone in exactly the opposite direction. Wednesday morning we saw the OEX put/call ratio hit the highest levels we can recall. That means that the professionals – fund managers, investment advisors, on down – are all betting that the market is poised for a major correction, one worth hedging against in a big, big way.

So, to recap: Dumb money, which is almost always wrong, depending on time horizon, is decidedly long the stock market, despite its gains year to date. Smart money, which has a much better batting average, is short, and short BIG.

The question for investors is what to do now. After seeing portfolios, on average, cut in half during 2008, most investors have made back at least some of their money, as typically growth funds are up anywhere between 15-30% on the year.

Despite their gains, many investors are happy to sit tight and “let it ride.” There seems to be some sort of sense of entitlement on the part of individual investors that they are still owed the remainder of what they lost. It would appear that a large number of investors have forgotten one of the most important tenets of investing: the market doesn’t care about you.

The sad fact is that the market could care less how much John Q. Public lost in his IRA last year. So if John thinks making it all back is as simple as sitting tight and waiting, he likely has another thing coming.

While most stock funds have made strong gains so far this year, they have done so mostly on blind luck. Recent economic numbers simply do not support current price levels in stocks. So with the S&P 500 P/E ratio currently well over 100, and no truly positive economic news in recent memory, investors need to think long and hard about what to do now.

If you haven’t guessed it, we are currently pushing investors to take their gains and step out of the market for a breather. The coming correction will likely allow investors to buy back into choice sectors at much lower levels, rather than having to ride the market down.

While many investors might protest this argument, the simple fact is that most have taken a beating over the past two years, and need to book their gains and take a little time to regroup. Even rodeo riders get off the bull when their eight seconds are up.

In our view, anyone who sticks around now is just a glutton for pain. They’re more than welcome to ride the market through the storm ahead. But as for us, we’ll be on the sidelines where it’s warm and dry.

Monday, September 21, 2009

Market poised for dive as deflation odds rise

Sometimes life is a waiting game, and such is certainly the case with the coming correction in the stock market. Day after day, week after week, this market continues higher in a trend built entirely on thin air.

With few fundamentals to support this market recovery, investor sentiment is nearing levels of bullishness, typically associated with bubbles. In the late 1990s, sentiment reached all-time highs for tech stocks, and surged late last year for 30-year Treasury bonds as investors fled stocks. The global real estate market saw unprecedented positive sentiment for years as the housing market boomed, finally coming to a peak about two years ago.

Investor sentiment essentially measures the popularity of a given investment. The higher it trends, the more likely the investment is near a major peak. Investments can’t go up forever; at some point, they simply have to correct. The further an investment gets away from rational levels, the more likely it is to snap back in the other direction. This is reflected in market sentiment.

Today, we can see this not just in most of the stock market, but also in several commodities, particularly precious metals. Gold, which we typically love, has lately enjoyed a run that is extremely overdone on the upside, and it is poised to see a major correction within the next two to six weeks.

Likewise, silver is also overpriced given current conditions. Unlike gold, silver is much more closely linked to manufacturing – that’s where it’s most commonly used — and the economy simply has not recovered sufficiently to support the current price.

While we have been on the path for high inflation for a long time — we still haven’t seen the consequences of the trillions of dollars created in government bailouts — the sad reality is that it is becoming increasingly likely that the United States may enter a deflationary environment in the near future.

Deflation hasn’t been a major issue since the Great Depression, but it is typically characterized by falling prices that result from the slowing of credit, a general deleveraging (e.g. American paying off debt) and, unfortunately, rising unemployment.

These characteristics describe the current situation in the United States frighteningly well. What that means is that Fed Chairman Ben Bernanke, the self-proclaimed expert on the Great Depression — and avoiding a repeat — is looking at the real possibility of a double-dip recession that would cause massive unemployment and nasty deflation.

The problem now, and the reason that deflation is becoming feasible, is even though the Fed, in conjunction with the Treasury, created trillions of dollars last year out of thin air, all that new money simply isn’t circulating because the economy is so terribly slow.

The challenge facing the Fed is how to get all of that new money, currently held by banks as excess reserves in the Federal Reserve System accumulating minute interest, into the hands of American citizens and companies for spending.

At this point, with banks fearing losses from defaults, most banking institutions are happy to leave all that bailout money in the Federal Reserve System earning interest — no matter how small — rather than take the risk of lending.

Just as significantly, there simply isn’t demand for loans on the part of American consumers. The Fed seems to be expecting the consumer to turn around and create demand for credit which will get all their new money circulating. Unfortunately, this is unlikely.

During the past year, the United States has seen a drastic increase in the savings rate, which indicates that most Americans are much more interested in saving as opposed to consuming, much less taking on debt in order to make major purchases.

For years this rate was negative, meaning that Americans borrowed more than they saved. Now, it seems that trend has changed, and with unemployment moving higher and no truly positive economic news to be found (less bad will not suffice), Americans are cutting back on spending and building up reserves of their own.

When it comes to consuming, at this point, companies are much more likely to have any kind of demand for credit. In fact, right now they’re sitting on record cash reserves that could be used to service such debt.

The government’s best course of action would be to offer corporations incentives to loosen their purse strings to invest in expansion projects. This would most likely be done through tax credits for corporations. The current political climate makes this highly unlikely.

Instead, with its outdated fixation on the U.S. consumer, the government is much more likely to try everything in its power to stimulate American citizens into taking on additional debt to make unnecessary purchases. This would most likely be achieved through the expansion of homebuyer tax credits as well as rebate programs like cash for clunkers.

What the government fails to realize is that at this point trying to stimulate American citizens to take on debt and buy things they don’t need is akin to beating a dead horse.

The balance sheets of most Americans have been decimated during the past two years and it should be abundantly clear that the demand for new debt simply does not exist. It’s time the Fed realized this, and looked for another way to rescue the American economy from the brink of disaster.

Monday, September 14, 2009

Gold hits $1,000 an ounce – but can it last?

It recently has been relatively quiet in the markets, with the biggest news being gold’s fifth test of the $1,000 mark in the past year and a half.

While gold’s recent strength is certainly no surprise — we have been singing its praises for a decade — it is worth noting that this most recent advance towards $1,000 has taken place as money supply numbers released by the Federal Reserve (especially M2 and MZM) have actually been falling.

What this seems to indicate is that the Fed has taken action the past month to begin removing excess liquidity from the system that it injected last fall. It is doing so with the hopes of avoiding massive inflation once credit begins to loosen again and all that new money starts making its way through the global financial system.

So far, the Fed’s efforts to remove excess liquidity have not been totally successful, as gold has marched higher since this time last year, nearing $1,000 for the third time since then. It has done so as the dollar has fallen sharply on worries that the international community will make good on its promise to abandon the U.S. dollar as the world reserve currency.

This concept has been picking up steam since the financial crisis erupted in the United States last year, with the rest of the world being dragged into the pit thanks in large part to their substantial reserves in dollar-denominated holdings. During the past year, the reserve currency status of the dollar has been called into question by the likes of the G-8, the International Monetary Fund and, most recently, the United Nations.

The varying dynamics of this year and last have sparked an interesting debate about whether gold or United States Treasury bonds provide a better “disaster hedge.” In a Sept. 9 Wall Street Journal article (“Is Gold the Right Recipe for Disaster”), Peter Eavis addresses both sides of this argument.

Frequent readers will undoubtedly guess where we tend to stand on this issue. And for those who call us fatalists for preferring gold, I’ll point to the 38 percent decline in the value of 30-year Treasury bonds year-to-date, versus the 14 percent advance in the price of gold bullion.

Strangely, other commodities seem to lack the luster in gold’s recent performance. Crude oil has been trading at $70/barrel lately after dipping briefly into the upper 60s.

This is likely because of the relatively slow summer travel season this year, as well as decreased speculation, which played a major role in oil trading more than $120 a barrel this time last year.

Even more significantly, natural gas remains very cheap, trading at slightly more than a third of its price this time last year. This is even more remarkable considering that we are heading into what has been predicted by “Farmers’ Almanac” to be an extremely cold winter. Some may remember that even last year, which was not as bad as this year has been forecasted, saw Russia cut off the flow of natural gas into the Ukraine due to shortages in Eastern Europe.

As we head into fall, a historically weak period of stocks and strong time for gold bullion, all of these developments have set the stage for what should be an exciting six months.

Between now and Christmas, the world markets will reveal a lot in the way of collective expectations about where our global economy is headed, and how it intends to get there.

Tuesday, September 8, 2009

Recession’s impact magnified by credit crunch

Debt. The very word by now should make your eyes water and the hair on the back of your neck stand on end.

We all know how it works; buying something today and paying for it tomorrow rather than saving today to buy tomorrow. And, most importantly, we know the disastrous effects it can have on a nation and a global economy.

For years leading up to the financial crisis of 2008, the United States’ consumer savings rate had been negative. That means that, in aggregate, more money was borrowed by Americans than was saved. It means that our country, from sea to shining sea, was running completely and totally on borrowed money — and borrowed time, as the saying goes.

The bill for all that debt finally came due in 2008, and in the blink of an eye credit tightened up tighter than a snare drum. When that happened, when the system couldn’t even get the credit to run on a day-to-day basis, the whole thing came crashing down.

Depressed yet? Well, don’t be. Despite the double-digit unemployment and daily headlines about protest after protest, topped off with a wave of bankruptcies, the truth is that this recession hasn’t been all that bad. Unfortunately, it has been magnified immensely by the credit crunch we experienced in the fall, and the ensuing financial crisis.

Now, months later, with the market having staged an excellent rally and the economic numbers starting to turn up, it has become apparent that the system is stabilizing.

After such a sharp decline, the U.S. economy and stock market are simply resetting, but at lower levels, since there isn’t enough debt left in the system to support the old highs in the market. The destruction of all that debt over the past year has just proven extremely … messy.

Living on a prayer

But have ye faith. The economy and the stock market — and your 401(k) — will return to their old highs. It may not happen for some time, so if you’re waiting for the Dow to get back to 12,000 so you can sell everything and move to Tanzania, you might not want to hold your breath.

The economy will recover — in time. And we can add a third line to that short list of things we know in life that are absolutely certain, right under death and taxes. That is this recovery will most definitely not be built on credit.

It may not even be consumer-led. With American consumers still in the process of getting back on their feet, it’s quite likely that, in this economy, consumers are going to take a backseat for a while, and let business drive. As discussed in the article, “Recovery in the making but danger still abounds,” nonfinancial U.S. companies are sitting on (hoarding) and unprecedented $14 trillion in liquid assets.

With a year’s worth of U.S. Gross Domestic Product in cash, this economy could be turned around in remarkably little time. Of course, that turnaround would be predicated on the right policies coming out of Washington and providing the necessary incentives – not penalties – for companies to invest some of that cash in expansion projects.

Those policies would include tax cuts (abatements at the local level simply won’t cut it), general deregulation (e.g. employment rules) and cheaper energy. Cheaper energy is a hot issue, especially with cap and trade coming up for a vote.


Focusing for a moment on the economic climate, the most important objective in Washington should be making the United States self-sufficient for all its energy needs. This would contribute to the ultimate goal of keeping energy affordable, since energy dependence leaves this country at the mercy of energy providers, OPEC and the like.

Lately, it seems nearly impossible to check the headlines without noticing political turmoil, especially within this country. Between cap and trade and now health care reform, there seems to be a growing tension that there is somehow a battle waging between good and evil in this country. That President Barack Obama and Speaker of the House Nancy Pelosi want to bankrupt America, or that Rush Limbaugh and Glenn Beck want to burn down D.C. Neither of these could be further from the truth.

The bottom line is that liberal or conservative, Republican or Democrat, no group cares any more about America than the other. It’s just that when it comes to this country, each has a totally different vision of what the finished product looks like.

Conservatives want to save the economy through pro-business policies. The general feeling is that in order to allow the American working man to pull himself up by his bootstraps; the government needs to kindly step off his back.

Likewise, liberals tend to want desperately to help out the less fortunate, who have been made even more so by the current economy. They hope to capitalize on this opportunity to radically reform the role of U.S. government; to put systems in place to keep the little guy well-stocked on fish, rather than lifting regulations that make a rod and reel overly expensive.

Bottom line

The fact is that after the events of the last year, the current landscape — political, economic, and investment — is totally different from before. As an investment adviser, I can tell you with complete confidence that there are certain ideas, previously accepted truths that have been completely discredited over the past year.

First and foremost, the theory of buy and hold simply doesn’t work anymore. Today’s world sees major changes on a daily basis in both domestic and international politics, various sectors of the economy on various scales and with conditions constantly changing, the market is simply too dynamic for this system to work.

If that doesn’t throw enough of a wrench into your portfolio, the second change finally being acknowledged by the financial community is that diversification doesn’t work. Why this is a surprise, I simply will never know. Even the academics who conceived the idea of diversification stated that it was never meant for real-world implementation (Markowitz, Portfolio Selection: Efficient Diversification of Investments, page 275). As Warren Buffett once said, “Diversification is a hedge against ignorance.”

As you are undoubtedly aware, the world we live in today is vastly different from what it was a year ago. If you don’t understand how this impacts your investments, you better make sure your adviser does.