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.

Wednesday, May 26, 2010

Market Skids on Skittishness, Uncertainty Remains

Last week in Bracing for a Breakdown we wrote that the market seemed to be hinting that its correction was not yet over, and that investors might be wise to approach equities with caution. Since then the Dow is down about 400 points after trading down four of the past five days.

While this correction may not be over yet, as the market moves lower the chances of prices continuing lower will diminish. In other words, since the market is lower than it was last week, the chances of it continuing down over the next week are relatively lower.

After all, between the Flash Crash earlier this month and the market’s recent correction, market prices have come down significantly. Investors need to remember that corrections, like bubbles, don’t last forever.

Even more importantly in looking forward, the market has not declined in uniform fashion. Some sectors have experienced declines far more dramatic than others. As an example, oil stocks have been hit far harder than those of companies which mine precious metals. Whichever of these two sectors seems better, given the circumstances, is a matter of basic investing philosophy.

Given current price and earnings levels, equities in aggregate are certainly not cheap – hence the calls for a correction. However, there are some sectors of the economy whose prices may represent buying opportunities. Money managers with a sector-orientation spend considerable time looking for such opportunities and take advantage of them whenever possible.

Since the correction began, there has been a growing level of uncertainty in the market. Before the market started down, sentiment among professional money managers was approximately 80% bullish. It took just 13 trading days for that number to fall to 45% BEARISH. What this means is that advisors began by recommending that their clients be 80% invested in the market, to recommending 13 days later that clients use 45% of their portfolios to short the market (bet that it will go down)(The Bearish Bandwagon, Hulbert,

During the same time the S&P 500 Volatility Index (VIX) experienced a sharp rally, indicative of increasing worries about the market’s prospects going forward. Granted, of course, the VIX had declined before the crash, to pre-2008 levels, revealing a great deal of complacency in the market. Since its recent rally, the VIX has reached levels only attained four times in the past ten years, each of which represented relative buying opportunities.

Also contributing to growing uncertainty are geopolitical circumstances currently emerging around the world. While the troubles facing Europe, the potential breakdown of the European Union, the oil spill in the Gulf of Mexico and the prospects of sweeping financial reform legislation coming out of Washington are becoming old news, there are new stories developing every day.

Case in point: Tensions between North and South Korea are flaring up again in spectacular fashion. Of course, let’s also not forget the recent violence in Jamaica or recent political turmoil as election season approaches. Included therein are the accusations Pennsylvania Democratic Congressman Joe Sestak has leveled against the Obama Administration, whose approval rating continues to fall (charge which could prove to be an impeachable offense, if substantiated).

While the markets are obviously facing considerable obstacles going forward, there have also some great developments that shouldn’t be underestimated. First and foremost, the manufacturing sector appears to be continuing its recent improvement, particularly in the United States as the recent trend of “on-shoring,” which we first mentioned a year or so ago, begins to pick up steam.

In fact, there have been several stories lately of Chinese businesses opening plants HERE because they are more economical. Who would’ve thought they’d ever live to see the day when the Chinese turned to Americans for our cheap manufacturing?

The world in which we now find ourselves is most certainly an interesting place. Whether from an economic, financial, geopolitical, or industrial perspective, the world is constantly changing. Although it’s certainly difficult to assemble the ever-changing pieces of a faded puzzle, the task remains necessary none-the-less.

Wednesday, May 19, 2010

Bracing for a Breakdown

Investors beware: The smell of a correction is heavy in the air. Even after the “Flash Crash” on May 6th, there are serious signs that the market is just beginning to recognize the current weakness in economies around the world, including that of the US.

Considering that we may very well be standing on the precipice of a substantial market correction, investors would be wise to consider this time to take earnings out of the market and begin accumulating cash positions.

After all, we’ve had a very nice run since the stock market bottomed in March of 2009. Fourteen months and more than 70% later, the market appears to be recognizing that there has been little or no real economic recovery to justify current prices – a fact we have reminded readers of for nearly a year.

Among other indicators, commodity prices are especially insightful about current economic weakness. The prices of oil and base metals have proven weak, and gold, despite hitting all-time highs earlier this month, has shown weakness since, as have gold stocks. [For more on this subject, see last week’s article: Buying the Bull.] Even Jim Sinclair, a precious metals specialist and perhaps the authority on gold, has admitted in recent commentaries that gold may be in for some tough times ahead.

Proving particularly troublesome for commodities are the recent worries about ETFs. In many cases, investors are beginning to study ETFs closer, and are finding that, in many cases, they did not own what they thought. In some cases, they own nothing at all – except the promise of some unknown counterparty.

Exchange Traded Funds have been getting significant attention – and not the good kind – since the Flash Crash, as they were among the biggest losers. Of all the trades that were nullified by exchange officials following the May 6th turmoil, ETF trades accounted for more than 70%.

The basic concept having to be relearned following the Flash Crash is that technology (e.g.: computerized trading) and derivatives (e.g.: ETFs) simply do not mix. [Note: ETFs fall in the category of derivatives because share prices in ETFs are derived from the prices of underlying securities. However, shares in ETFs do not represent actual ownership of a portion of the fund’s holdings.]

Oddly enough, this mix of derivatives and technology comprised the essence of portfolio insurance (a product that has since gone by the wayside) in 1987. For those who don’t remember, portfolio insurance played a HUGE role in the 22% single-day decline on Black Monday in October of ’87.

When it comes to investments, it is our opinion that there is only one computer with the capacity to make sound decisions, and it is found between the ears. After all, financial markets are NOT the study of mathematics, on which all complex trading algorithms are based. The financial markets are a study of behavioral psychology, and must be treated as such.

Over a year ago we wrote, but feel obligated to remind readers, that the only people who benefit from exotic new financial products (e.g.: ETFs, CDOs, CMOs) are the financial engineers who get paid to design them and the brokers who sell them. Quite frequently, even the designers fail to understand the implications of their inventions, as do most of the reps getting paid to push these products on the unsuspecting public.

We continue to feel that this will come out as a result of the SEC’s investigations into major Wall Street firms including Goldman Sachs, UBS, Deutsche Bank, JP Morgan Chase, Citigroup (which owns Smith Barney along with Morgan Stanley), Credit Suisse, Merrill Lynch, and Morgan Stanley. When the dust finally settles, the public will also be keenly aware of these firms’ [lack of] fiduciary responsibility that allowed them to get rich at the expense of their clients.

Obviously Goldman Sachs seems to be an especially strong focus of attention from regulators, and the firm will probably fare far worse than many of its peers. Judging by everything that has come out so far about this major Wall Street player, it seems they brought it on themselves. According to a recent Bloomberg article, in the first quarter of this year Goldman was able to make trading profits every single day, while its clients have lost money in seven of Goldman’s nine “recommended top trades for 2010” (Xie, Goldman Sachs Hands Clients Losses…).

Wednesday, May 12, 2010

Buying the Bull

This week we’d like to educate investors on a frequently overlooked and little-understood topic in finance: The life cycle of an investment. The example we’d like to use, because of its current place in its own life cycle, is Gold.

Tracing Gold from 1998 to present provides a fantastic illustration for investors of how an investment progresses through stages over time, rising out of relative obscurity to become the focus on national headlines.

In 1998 and 1999, Gold, as an investment class, was absolutely dead. Prices for the metal had gone nowhere but down for an entire generation, and Gold was hovering around 20-year lows. In short, Gold was cheap, very cheap. This relative “cheapness” led some investors – not many, but some – to begin accumulating holdings in both the metal and companies that mine it.

Through the year 2000, gold remained relatively unattractive (and still extremely cheap) as the tech bubble, then peaking, dominated headlines and commanded the attention of investors around the world.

After the tech bubble burst in late 2000, the government began cutting interest rates in order to stimulate the floundering economy. Thus, in 2002-03 Gold became a buying opportunity as a hedge for investors against the impacts of inflation.

After interest rates set by the Fed bottomed Gold ceased to be an inflation hedge and became an anti-dollar investment from a foreign exchange standpoint between 2003 and 2007. At that time, as the offshore bandwagon picked up steam and significant business moved out of the US – or sprang up elsewhere – the dollar began to suffer. Since Gold maintained its inherent value, the price in dollars increased.

The dollar, relative to other currencies, bottomed in late 2007, yet Gold remained a great investment option. From 2007 through 2009 Gold maintained its popularity, not as an inflation hedge or an anti-dollar play, but as a source of a relative safety in the market, a store of value.

Since 1999, as you can see, the reasons for owning Gold have changed, but the result has been the same: the price of Gold has increased. Now, after progressing through each of these stages, we continue to find ads for Gold on TV, radio, and in print. As I write this the commentators on CNBC are singing Gold’s praises.

Unfortunately, none of the reasons for owning Gold exist any longer. Gold is not cheap; in fact, quite the contrary, it just set its all-time highs. It is not, in our view, a good currency play, since the dollar is likely to increase over the next several years, as we have discussed in previous articles regarding the coming wave of on-shoring.

Finally, Gold is not necessary at present as an inflation hedge. The reason is simple: Currently inflation is not a concern. Prices have not been increasing, and real money supply growth as measured by M3 is actually negative, and by no small figure.

Instead, the only remaining reason to buy Gold is as a momentum play; in other words, to buy it because it has been going up. Unfortunately, that is the birth of a bubble, by definition. That doesn’t mean that the price of Gold can’t continue to rise, it will likely continue to do so until something bursts the bubble.

However, at this point any further gain in Gold’s price is totally unsupported by fundamentals. For investors, when the price of an investment ceases to be tethered to value, that investment becomes nothing more than a bet.

Wednesday, May 5, 2010

Greece’s Achilles’ Heel

The financial difficulties facing Greece have been very well documented over the past few months, and until recently it appeared that the powers that be were preparing to bailout the country, which has been plagued with riots.

However, it is now coming to light that the prospects of a bailout are quickly fading, at least in part because such a bailout was contingent on concessions for Greece’s union-organized work force. It seems now that those concessions will not be made, and hence the bailout will not occur.

To show the world just how convoluted a financial situation Europe currently faces, the New York Times recently published a chart constructed by Bill Marsh that displays Europe’s so-called “Web of Debt.”

While this map certainly shows just how confusing the situation has become across the pond, both its architect and its believers are operating under a very danger assumption: that the debt will paid. As we’ve mentioned before, all too often people forget that governments do in fact go broke.

For evidence, just look at Russia, Argentina (twice), the City of New York, and California. Add to that a good deal of near-misses, like in the early ‘90s when Mexico had to devalue the peso in order to keep from going broke. In fact, between the mid ‘80s and the mid ‘90s there was a wave of debt defaults – excuse me: restructurings – among Latin American countries that almost sent Citigroup under.

When it comes to debt, people and corporations have only two options: either pay it off, or default. Since they own the printing presses, governments have the convenient third option of inflating their debt away (paying it off with currency hot off the presses, and subsequently worth less).

Unfortunately for those of us subject to the whims of our governments, even when our fearless leaders DO decide to pay debt off, they very rarely do so responsibly. More often they incorporate their inflation option to some degree.

Why, you may ask, would they do such a thing? The better question is why not. The answer, dear Watson, is that their creditors have no recourse, no way of stopping them. The holders of government debt, when that debt goes sour, have only two options. They can either take what the issuer offers them, or they can walk away.

The basic concept that needs to be understood from all this is that governments do not act ethically or responsibly. They have nothing to do with responsibility, much less intelligence, but with feelings. Elections are predicated on pain, and who has caused the least in voters’ short memories. Therefore, governments choose the path of least resistance – and least pain.

Consider the following: Recently minutes that were released from a 2004 meeting of the Federal Reserve Board of Directors (such minutes are not released for several years after meetings occur) reveal that then-Chairman of the Fed Board Alan Greenspan was actually aware of a possible bubble forming in the real estate sector all the way back in ’04, more than two YEARS before the real estate market crashed!

In fact, that this meeting in 2004, several of his subordinates, including Jack Guynn (then-President of Federal Reserve Bank of Atlanta) and Cathy Minehan (then-President of Federal Reserve Bank of Boston) expressed significant concern about ‘overbuilding’ that was occurring at the time. As history tells us, Greenspan obviously ignored this advice, and allowed the real estate market to continue its trend of increasing-prices and overbuilding. We all see how that turned out.

Mark my words, events in Greece will not play out in totally dissimilar fashion. Remember that this little invention called the Eurozone is little more than a decade-old experiment, in which almost every member country regrets participating. It will come as no surprise to us if the Eurozone collapses in the next five years.

Likewise, the offshore trend that has lasted nearly 20 years is just about to end, and like dot-com and tech stocks before it, investors will soon find that off-shoring is not the wave of the future. After years of investors hearing that they need to be putting money in gold and foreign securities – far away from US dollars – the party is quickly coming to an end; and the last one to leave gets to pay the tab.