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2011Jan2 Week In Review: Will 2011 be happy?

HAPPY NEW YEAR!

The development of capitalism consists in everyone’s having the right to serve the customer better and/or more cheaply. And this method, this principle, has, within a comparatively short time, transformed the whole world.” Ludwig von Mises: Economic Policy, pg. 4

Stock Market:

Views of the stock market are often as disparate as political views, and we start a new year with no less division. Fourth quarter economic growth is viewed as confirmation that recovery is really under way. Reduced employee payroll tax starts this week as the only tax related stimulus occurring with the extension of current tax rates. Last minute Christmas shopping ramped up retail sales appearing to some analysts that consumers are back.

Alternatively, late shopping may have been a household budget strategy to see if discounting deepened. Generally, it didn’t. Recent years of cost cutting actually allowed for an increase in profit margins. As we covered in a previous update, Best Buy didn’t discount enough to match its competitors and lost holiday sales market share. Typically selling technology with a short shelf life, deeper discounts may arrive shortly.

Stock prices rise in response to the collective decisions of global investors. Some are rational and others emotional. It is not possible to know with any certainty what justifies price advance or decline. Retrospectively, we try to justify the direction and its cause. As prices change, valuations are deemed to be better or worse. Valuation of a stock, however, is not a science but a process of which there are many.

Since stocks have risen since March 2009 in the midst of financial turmoil, some valuations suggest the market is over priced. The market has risen as investors have withdrawn billions upon billions in favor of bonds. At current prices, some analysts view the market as over valued. Large company stocks have been under valued since March ’09 and remain so. Relative strength, however, is not an opinion. It is a math calculation which continues to rank small and mid-cap stocks well ahead of large and better known companies. Perhaps with their dividends as a magnet, large cap stocks will attract more investor attention this year and compete more effectively for investors’ capital. Time will tell.

Contrary to apparent assumptions made in Congress, taxes do affect behavior. Over the past decade millions have moved to states with low or no income tax. Keeping as much as possible of one’s income is a valued shared by all Americans since before the Boston Tea Party. We would expect that the extension of the current tax rates favoring stock dividends over bond interest will reinvigorate the search for dividend income and, possibly, supporting the recent increase in money flowing into equities.

Bond Market:

Bond funds have finally had money exiting in volume with tax free bonds leading the pack. Whether investors are responding to warnings from Meredith Whitney or to a recent segment on 60 Minutes about the dire financial condition of municipalities is just a guess. Either way, there is a cultural shift towards fiscal responsibility as long as your cow doesn’t get gored in the process.   

We continue to view the risk in bonds as real. The past few decades of rising tax revenues funded many projects not essential to local and state government services ( and more so at the federal level). Having behaved as though they were adolescents with their first credit card and seemingly unlimited credit, the day to pay has arrived along with insufficient income. OOOPS!

Some money managers and financial advisors regard bond default risks to be backstopped by the US government. (Here and Here). If the problems were limited in scope and the economy was strong, that assumption might be valid. We think the assumption may be weak when Texans, Floridians and others are told to pony-up for California’s (and other state’s) profligate habits.

Should bond investors be saved from the risk they assumed and have it transferred to US tax payers who never considered buying the bonds (or had the money to do so)? That will be a gross distortion to the capital markets and promote more fiscally irresponsible behavior by investors and budget committees.

Economy:

Chairman Bernanke’s goal of modest inflation has been achieved in emerging markets. China’s leadership announced inflation is “dire” and on Christmas announced that “inflation expectations are far more dire than inflation itself.” Commodities are rising and will soon impact the US consumer though official government numbers will not reflect it with food and energy excluded. Deflation remains dominant in employment, wages, benefits and real estate values.

The total US debt condition remains worse than the 1933 peak during the Great Depression. Foreclosures and proactive debt reduction by consumers and business is bringing it down slowly. It remains a major impediment to economic expansion as debt payments reduce funds previously used for consumption. If you are concerned about the national debt levels, see www.OweNo.com for more about the consequences of our growing debt level.

The Fed expects unemployment to drop but not below 9%. Even adding 2 ½ million new jobs, the unemployment rate will stay above the 9% level. The labor department will redefine “unemployed” to include up to five years instead of the previous two with a likely rise in the reported level of unemployment. With older workers staying on the job longer, there are fewer vacancies for the less experienced. Searching for jobs will be a long-term activity for those who do not reinvent themselves for contract work.

Real Estate:

Much of 2011 positive growth is based on having reached a floor in home prices. The guru of real estate prices, Robert Shiller, has given up on forecasting prices. The marketplace is facing increasing mortgage rates and delinquencies. Neither is supportive of the general economy or an end to declining prices.

If the current “bottom” in prices falls apart, Congress will likely panic and enact another home buyer’s credit which is unfortunate. If those who benefited from the prior credit lose their job and are foreclosed, they are liable for recalculating their return without the credit. They will face a higher tax with related penalties and interest.

A tax credit is the use of general revenues (or, in our case, borrowed money) to reward specific behavior assuming the federal government “knows what’s best.” A greater benefit would occur if tax rates were reduced to allow the marketplace to direct capital to the areas of greatest economic benefit determined by consumers and businesses. 

When the facts change, I change my mind. What do you do, sir?”  - John Maynard Keynes

Our plan is “the plan will change.” What is your plan?

Relative strength measures the price performance of a stock against a market average, a selected universe of stocks or a single alternative holding. Relative strength improves if it rises faster in an uptrend, or falls less in a downtrend. It is easily applied to individual positions in your portfolio and to sectors and asset classes.

If you would like a free relative strength analysis of your portfolio’s asset allocation, sectors and positions, call us at 800-317-9119. The call is free. The report is free.