2010Apr4 Week In Review

2010Apr4 Week In Review

The first quarter of 2010 has ended with major stock indices continuing last year’s positive trend after recovering from the January and February downturn. A recent Bloomberg poll indicated 70% of Americans claim to have not benefitted from the rise in stock prices. The flow of money out of stock mutual funds and into bond mutual funds suggests fear and safety remain dominant drivers of investor decisions. 

Bonds, traditionally viewed as safer than stocks, are likely to disappoint many investors. U.S. government bonds – the safest of them all – have provided negative returns over the past year. Our reference is the iShares Barclays 7-10 Year Treasury Bond exchange traded fund, IEF. Investors are ignoring several major risks.
 
Social Security tax collections have crossed below the amount needed for distribution to beneficiaries. The good news is that Congress cannot use those taxes to pay for unrelated expenditures. The bad news is that Congress will have to find the “lock box” where they have been “keeping” our taxes and start emptying it. Reality Check! Congress will have to borrow more money than previously anticipated and much sooner. Since the U.S. balance sheet is less attractive than Greece, lenders may soon demand higher interest rates. When that happens, bond investors will be sorely disappointed in the lack of “safety” in their principle.
 
Economic activity has been slowly increasing. While smaller businesses have fewer options during recessions, major companies have reduced expenses improving profitability. Better profits support higher stock prices. While the Administration and the mainstream media have pilloried profitable industries and companies, many investors have apparently assumed negative forecasts for their portfolios.
 
We assume economic growth can continue throughout the year and expect corporate borrowing to increase. Interest rates in longer term maturities have been rising which is generally viewed as an indicator of future growth. Interest rates can rise with increasing demand and bankers who will lend, cautiously, if the interest rate pays for the risk. Once again, when rates rise, bond investors will be sorely disappointed in the lack of “safety” in their principle.
 
The past three decades have been a bull market for bond investors. In 1981, one of my clients financed a home with a 21 ½% thirty year mortgage. Prime rate was 13%. Zero coupon government bonds were available at 12%. (Those were the “good old days”). Rates have consistently declined since then. That era has come to an end. Even Bill Gross, “The Bond King,” of PIMCO agrees that the bull market for bonds is over. Theoretically, bonds may reduce portfolio volatility, but they will no longer be a meaningful contributor to returns. 
 
Japan has been in economic contraction for two decades providing us with a laboratory of lessons. With interest rates at virtually zero, neither BOJ nor the Fed can lower rates to stimulate the economy. Raising rates to “reload” is quickly self defeating in a recession. The Bank of Japan has intervened with businesses “too big to fail” and extended an era of self deception. The Japanese stock market has intermittently surged only to fall back to new lows.
 
Unlike Japan, we have immigration and a positive replacement birth rate. It will be another decade before we have demographic support for sustainable growth in consumer spending similar to our experience in the 80s.
 
What are we supposed to do in the mean time? We must move outside the comfort of our “boxes” – the familiarity of recent history. Rule number one is that price does matter for investors. We cannot pay for retirement using long term averages. We cannot pay college expenses with the fundamental value of a company. Whether we need money for monthly living or a major purchase, the price of our investments at the time of need is all that we will get. Good averages or good fundamentals will not change the outcome.
 
The multi-decade averages of Modern Portfolio Theory are not meaningful for the decisions investors must make in a dynamic global market. Only traders can use headline news which is distracting by continually introducing new “rabbit trails.” “Buy and hold” is an exercise in faith that companies will never fail and that recessions will be shallow and short lived.
 
Price is the objective measure each day of global collective bargaining between buyers and sellers. Grouping prices into industry groups, sectors, asset classes and countries allows an investor to more easily identify trends. Rising trends support holding an investment while negative trends justify selling an investment to preserve capital. In a global market, it is easier to find opportunities than it is to make up lost capital.
 
As in team sports, there are times for offense and times for defense. We are used to ranking teams by their strengths. The Las Vegas odds makers and sports news anchors help us with processing data. They report the “relative strength” of each team or player.
 
With investing, we can use the same relative strength process. Collectively, prices identify which team is “has the ball.” Collectively, prices identify which asset is desired by investors, i.e., demand, which supports prices. Collectively, prices identify which assets are being liquidated, i.e., supply, where prices fall.
 
An investor’s portfolio must adapt to changing conditions. Asset allocation must be flexible to eliminate deteriorating assets or asset classes and add non-traditional ones not considered appropriate in the 1950s when Modern Portfolio Theory was conceived. Today, exchange traded funds provide liquidity and access to investments and markets previously limited to high net worth investors. Success with the future is not dependent on a good forecast as much as it is on identifying the here and now.

For information on how we have adapted our processes and what relative strength may mean for your portfolio, call us at 800-317-9119 or send us an email.