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“Wake Me Up When September Ends”

Below is the Investment Commentary that I sent today to clients in their August 31st statement. You get to see it here first.

I am headed to St Louis for the Illinois V Missouri game with lots of friends so I won’t be posting updates for a couple of days. Have a great holiday weekend and I’ll be back at it next week.

Mark

“Wake Me Up When September Ends”

Historically, September and October have been difficult months for the stock market. We all remember how last September brought us the Lehman Brothers bankruptcy which was the catalyst for the stock market crash. That was not fun.

sp-bear-mkt-view1

We have come a long way since the crash, having recovered 50% of that downward move (you can see the graph of the S&P 500 above). Given that the market moved above that 50% retracement level, and our clients on average have enjoyed double the return of S&P 500, we decided to step back from the recovery euphoria and analyze the current situation.

The recovery, in my opinion, is solely related to the monetary stimulus unleashed by the Federal Reserve. The combination of:
· near-zero percent interest rates;
· the implementation of Quantitative Easing (creating dollars to buy treasury securities);
· purchasing and accepting as collateral non-treasury debt instruments (including sub-prime mortgages, a.k.a., toxic assets in the news); and
· purchasing Fannie Mae and Freddie Mac debt from foreign central banks so that they can buy treasury securities to fund our deficit;
the economy is flooded with cash.

The cash is being invested in the stock market, the bond market, oil, industrial metals, and precious metals, driving the prices of all of these way above where current economic fundamentals would justify.

All of these markets are very forward looking and seem to be saying that we are on the verge of an economic recovery that will increase industrial production, bring down unemployment, and end the housing crisis that precipitated the entire financial crisis.

However, our job is to look at whether the picture the market is forecasting has a likelihood of becoming reality. There are a number of headwinds that make this economic recovery different than the past. Current forecasts are for the economy to come out of recession in the 3rd or 4th quarter of 2009 (basically where we are right now). The headwinds make it likely that the economic growth, once in positive territory, will not be at levels of past recoveries:
· the US economy is 70% consumer based;
· unemployment is at the highest level in 27 years and is still rising, although at a slower rate than previous months;
· access to credit has been diminished with the destruction of equity in consumers’ homes;
· home foreclosures continue to rise;
· gasoline prices have nearly doubled from their levels in early 2009;
· bank lending to businesses by the money center and regional banks is still at below-normal levels, which does not indicate employment will advance anytime soon;
· many states, much like Illinois, are in serious financial trouble; and
· the current year’s deficit will be nearly $2 Trillion with a $10 Trillion projection over the next decade.

All of this has me very wary of those pundits on television that are saying this is the start of a new bull market in stocks based upon the coming economic recovery. My opinion is that, at best, the recovery will be a very slow growth recovery (1% to 2% GDP growth compared to normalized 4% to 6% GDP growth during the recovery phase of the economic cycle).

This means that having a well thought out strategy of active investment management will provide far superior results than a passive strategy that relies on the broader market to increase in value in order for your portfolio to increase in value. In every market there is generally some component of it that moves higher – except of course when we have a wholesale liquidation of all risk-asset classes as we had starting a year ago.

Currently, our strategy continues to have portfolios positioned for a global economic recovery. We have allocations to growth-style companies, emerging markets with better economic fundamentals than our own, the cyclical area of the market as well as the commodity-oriented areas, all of which historically outperform the broader market during a recovery. This rally has been no different and has allowed us to double the return on the S&P 500 Index for our equity clients.

However, given the headwinds described above and the fact that we have a strange situation vis-à-vis gold and treasury bonds (see the graph below) that seems to be providing a warning sign of some undercurrent in the market indicating some level of increased risk, we have implemented what was described on our blog as a Profit Protection Plan.

ust-v-gold

We have reviewed all holdings of individual equities and ETF’s department-wide and any that have a >40% return year-to-date are subject to:

1. sell 10% of the position immediately, and
2. set a stop loss on 10% to 15% of the remaining position below one of the following technical support levels (13 day EMA, 34 day EMA, 20 day SMA, or two standard deviations below the 20 day SMA trend)

This whole market reminds me of the 1999 NASDAQ which continued to go up in the face of overly bullish sentiment. We sold technology companies early in that process and missed a lot of the ultimate upside – something I’d like to avoid in this market if it continues to move higher. But we also avoided much of the big downward move as prices corrected and we were able to have cash on-hand to identify and participate in the next big market mega-trend: oil and base metals.

So, to summarize what we have going on:
· we have ridden a major rally up to a 50% recovery of the losses experienced during the crash that started with the Lehman Brothers bankruptcy and proceeded into the March lows;
· we have identified some concerning macroeconomic headwinds that will likely make the anticipated recovery less robust than many pundits project;
· we have noticed a strange relationship developing where both gold and treasury bonds are rallying concurrently, generally a sign of a flight to quality from risk-assets; and
· we have taken some profits on positions that have moved up significantly in order to raise some cash, but we have maintained a healthy allocation to equities to continue to participate in the upward trend of the market.
There is every chance that we will make it through September and enter the 3rd quarter earnings reporting season in October with companies reporting earnings that are well ahead of expectations, leading to a market that rallies into a next leg up. That is exactly the situation we had in July with the 2nd quarter earnings reporting season. However, given the discussion above, we believe our cautiously balanced approach is justified where we book some profits, protect some profits, and remain invested in the upward trend.

If the upward trend in the stock market starts to break down (we will see it based upon the various technical indicators we follow and from the fact that the shorter-term trend lines start to cross downward over the longer-term trend lines), we will utilize additional stop loss orders to protect our hard-earned profits.

The title of this Investment Commentary comes from a song by the band Green Day. In this ballad, the lead singer revisits his painful childhood and thinks about the day he lost his innocence when his father died. Like many faced with such a traumatic event, he never truly recovered, and he can’t believe that twenty years have passed since that September day.

Even though sad and painful as that September day was when Lehman Brothers declared bankruptcy and the stock market crash commenced, I think we all need to step back to gain get perspective. There is more to life than money (although money helps – a lot) and by employing an active management strategy we will retrace the other 50% and return to pre-crash levels in the market. We will know more when September ends.

As always, we appreciate your business and want to thank you for allowing us to help you with your financial situation. If you even have any questions or if we can assist you with other investment management needs, please do not hesitate to contact us.