2010Aug22 Week In Review

After the negative adjustments to the past three years of GDP, the Fed remains concerned about further declines in inflation. Presumably, Tuesday’s decision to maintain the Fed’s balance sheet by investing its mortgage backed securities into Treasuries will provide some defense against deflation or a double-dip recession.

 

Chairman Bernanke is following a plan outlined in 2002 to stimulate consumer spending by keeping interest rates low. As a purchaser of Treasuries in the open market, the Fed can out-bid all others and force interest rates as low as deemed necessary to “stimulate” consumption.

 

However, in 2002, we were still had growing consumption within the demographic cohort of households with adolescents. Today, that demographic cohort has entered a new stage of life shifting its financial needs from educating children to saving for retirement. Even with generationally low interest rates, families intent on being debt free for retirement are not inclined to borrow more. Low rates can stimulate refinancing where equity has not evaporated, but it will not reactivate the consumption that has sustained us for nearly four decades.

 

The Morgan Stanley Business Confidence Index continues reporting general optimism for the coming year. However, growth expectations are muted when compared to recent decades. Normal culprits for restrained growth are uncertainties over regulations and taxes. Appropriately trained and skilled labor is increasingly hard to find, at least at the wages being offered.

 

We believe a major flaw in the government’s assumptions for returning to pre-2008 economic strength is not factoring in household and business deleveraging decisions. Previously, a $30,000 auto purchase with 10% down impacted the buyer’s financial condition by $3,000. The buyer borrowed the balance adding $27,000 to the economic growth of other businesses; car dealer, wholesaler, manufacturer, transporters and suppliers. Today, you opt to keep your $3,000. The positive impact of previously acceptable borrowing is absent. GDP must slow for a while until demographic needs change, which they will, as a new generation of children reprioritize family finances.

 

Whatever growth the economy can muster is going to be a result of adapting to the new reality of having less. That is less income, fewer choices and clearer priorities for household expenditures. On average, household incomes have been declining since 2007. The effect of lower paying work and shorter work weeks puts households at risk quickly, but it takes time to surface in economic data. By year’s end, we expect to see GDP reflect what is evident from discretionary spending trends tracked at www.ConsumerIndexes.com.

 

Stock Market:

 

Ignoring generally positive earnings reports and forecasts, the past two weeks market trend has been declining. However, it remains within the lateral trading band that we have witnessed this year. Investors’ uncertainties persist regarding various headwinds of tax changes, Fed policy and economic recovery. Lack of confidence in positive trends is evident in the lack of strong market leadership.

 

The market always has leaders and laggards whether examining individual stocks, sectors, asset classes or countries. Generally, the difference in returns between the top and bottom is quite significant. Sideways trending markets such as this year result in less distinction between the opposite ends. Academics and institutional investors continually examine processes to better understand changes and fallacies within the market.

 

Two more studies have been published confirming shortcomings of Modern Portfolio Theory. Neither study disregards the contribution of MPT since its development in the 50s. However, both studies conclude the need for momentum, or relative strength, as a necessary process for dealing with market risk.

 

Relative strength provided essential risk mitigation during down markets when, as in 2000 and 2008, MPT was ineffective. In addition, T.J. Moskowitz, Ph.D. at U. of Chicago published an article, “Momentum Investing.” Among the possible explanations for momentum, Moskowitz says:

 

“Several possible behavioral explanations have been put forth, many based on the Nobel memorial prize-winning work of Daniel Kahneman and Amos Tversky. One explanation posits that investors may be slow to react to new information: different investors (e.g., a trader vs. a casual investor) receive news from different sources and react to news over different time horizons and in different ways. This "anchoring and adjustment" is a behavioral phenomenon in which individuals update their views only partially when faced with new information, slowly accepting its full impact. Ample evidence supports slow-reaction-to-information theories ranging from market response to earnings and dividend announcements to analysts' reluctance to update their forecasts.”

 

We find this interesting in that it disclaims an essential foundation of the Efficient Market Theory: “All information is known to all investors simultaneously and they will all make rational decisions upon receipt.” Daily market prices and updated relative strength calculations force data into a decision process whether or not one’s belief’s can be justified.

 

“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?

 

If you would like a free relative strength analysis of your portfolio’s sectors and positions, call us at 800-317-9119 begin_of_the_skype_highlighting 800-317-9119 end_of_the_skype_highlighting.