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Investment Commentary

Printed below is the Investment Commentary that is being sent to clients next week as a part of their quarter-end statements. I thought you might want to read what our clients receive from us that explains the impact of our investment activities on their portfolios.

Over-bought, Over-extended, Over-hyped

A bit over a year ago, the stock market made an important bottom in its post-crash movements. Readers of this Investment Commentary know that we moved from a heavily cash position to an over-weight equity position at that time based upon the valuation and technical indicators that we follow. It proved to be the right move since the market has recovered over half of its crash-induced losses.

Now, we have the opposite situation: those same valuation and technical indicators show that the big move off that bottom has gotten ahead of itself as the market is over-bought, over-extended and over-hyped. Don’t get me wrong, I still believe we are in a bullish cyclical move up and that equity exposure is the right thing for the intermediate term. However, near-term the market needs to pull back to a technical level that supports earnings and economic expectations so that the next leg higher can occur.

Because of this analysis, we have used trailing stop losses and price target sales to generate cash and reinvest it in a collection of short-intermediate term bond funds. Given the Federal Reserve’s policy to keep short-term interest rates low, keeping the sales proceeds in a money market fund earning a fraction of a percent makes no sense – it’s easier on us to do that, but not in your best interest. That is why we are utilizing the bond fund strategy so that you can get a return on your invested assets.

So, what specifically are the valuation issues?

Rising Interest Rates: the bond market has reacted negatively to signs of a strengthening economy and lack of demand from buyers of treasury bonds. That has driven yields up in the past week to levels that, if surpassed, can make 10-year treasury bonds a viable alternative to equity securities in a portfolio – that level has historically been in the 4% to 4.5% range, and we have moved up to 3.9% as I write this. Higher yields historically have reduced P/E values on stocks.

A Growing Deficit: growth in government spending at a time of falling tax revenues has called into question the creditworthiness and AAA rating of the United States, which could raise interest rates across the board for government borrowings. A lack of faith in the US Government leads to higher rates on its debt, and higher yields reduce P/E values.

An Increasing National Debt: as the deficit grows, the government needs to borrow at increasing amounts in order to fund the deficit and to rollover their current debt. Supply and demand fundamentals show us that as the supply of treasuries increases the demand for higher yields increases. Higher yields, lower P/E’s.

Forecasts of Higher Inflation: the current concensus is that inflation is not present. However, if you look at some of the underlying components of the Producer Price Index, for example, you can see that the crude goods component is showing signs of rising prices in the basic materials used to produce durable goods. The crude goods component of the calculation has a good track record of predicting increases in inflation because producers ultimately raise the prices of their finished goods as the components of their production increase in cost. Higher inflation historically translated into lower P/E’s.

Unemployment Will Remain High: we are still in the 9.7% range, and most economist forecast that we will be well above 8% for the foreseeable future. Our own forecast is for 9% to be the new 5% – the level we enjoyed from the mid-80’s, 90’s, and 00’s that was brought about by pro-economic growth policies of those various presidencies. Unfortunately, those pro-growth policies (low taxes, reduced government size, spending caps) were high jacked first by one political party then the next to geometrically increase spending beyond reasonable increases in revenue. Now, it will be exceedingly difficult to reasonably increase tax revenues to fund increasing levels of spending given the sustained high unemployment levels. Rising taxes reduce money available for consumer spending → consumer spending is 70% of our economy → economic growth is reduced due to reduced consumer spending → reduced economic growth sustains high unemployment and limits corporate earnings growth → limited corporate earnings growth means equities have less comparative value for investors.

There are other issues that concern me, but this list gives you a feel for many of the important ones. I mentioned P/E values several times above and I wanted to make sure that you understood what I am writing about: the P/E is a ratio of the stock Prices to Earnings. It is just a way to tell us how much investors are valuing the earnings of a company. At times when the economy is good or stocks are in a bull market, investors value a company’s earnings higher, and stock prices move up accordingly. At times when the economy is bad or stocks are in a bear market, investors value a company’s earnings lower, and stock prices move down accordingly. In the various issues above, all of them historically have caused investors to value a company’s earnings lower and stock prices have moved lower.

So what specifically are the technical issues?

The technical indicators we follow are really just a proxy for investor sentiment. We can fairly easily determine the fundamentals of a company or of the broader market by looking at earnings, earnings growth, sales, market share, debt, and all the other components of their financial reporting. This is called the fundamental aspects of investing. There is, however, an equally important component that represents the sentiment aspects of investing. You can’t find investor sentiment in financial statements, so we need another way to gauge how excited, fearful, or complacent the investing public is relative to the market. For that we use various technical indicators – some related to the overall market and some related to specific companies. Here, we are discussing those related to the overall market. I’ll apologize in advance if the following is confusing or boring – I know I have some readers that enjoy these sorts of discussions, so if you are not one, feel free to skip past it.

mcclellan

McClellan Oscillator: a momentum indicator that is applied to the advance/decline line. It indicates to us short-term investor sentiment relative to the number of stocks advancing or declining in the current market move. Statistically, there are certain levels on the graph that have proven to be good indicators of investor sentiment (that investors have gotten too complacent or too fearful) and a change in market direction is likely once those levels are reached. You can see that this indicator has already moved below the zero line indicating that there is a significant loss of investor momentum and the likelihood of a pullback is near. We began to reduce exposure to equities when the indicator peaked in March.

summation

Summation Index: a momentum indicator that is applied to the McClellan Oscillator. It indicates to us intermediate-term investor sentiment and gives us a broader view of the current market movement. There can be short-term changes in the market’s direction that are contained within longer-term moves in either an upward or downward move in the market. The concerning thing here is that the index has reached a top and has curled down. It is still in bullish territory on an intermediate basis, but could be indicating a more than short-term move lower the closer it moves toward zero. If it were to move below zero, that would provide an intermediate bear market signal.

breadth

Breadth Oscillator: an important characteristic of stock market performance is whether a small number of stocks with large capitalizations are dominating the index readings or whether the movement in the index is representative of most of the companies in the market (or in other words, is the movement broad-based or showing good breadth). The important thing to see here is that the blue line is below the red line, that the red line is moving down, and that the blue line is making a series of lower highs and lower lows. This is indicative of a market that has fewer and fewer of its participants moving higher in price.

vix

VIX Volatility Index: fear and complacnecy in the market are generally contrary indicators. Investors adopt a herd mentality, so historically the safest thing to do is do the opposite of the herd. If fear is rampant and the VIX is giving a high reading, that generally means it is a good time to be invested in stocks as the market is likely to make a move higher. If complacency is prevalent, the VIX gives a low reading, and the market is likely due for a correction. With the VIX currently below the important level of 20, there is much complacency in the market and a move lower is possible. Note that we plot the S&P 500 Index on this chart so you can see the generally inverse relationship of the two.

Our tactic of using trailing stop losses and price target sales has been effective. As we have moved toward the top of the current price range for the S&P 500 (you might recall from our 2010 Forecast that we said the S&P 500 would be stuck in a range between the 200-day moving average and 1,250 until more signs of economic recovery have materialized) we have been moving up the price of the trailing stops to protect the hard won gains since the crash. We have also used target price sales to generate cash in companies that have reached or were near the targets we set, also to protect those hard won gains. The proceeds from those sales will stay in the short-term bond funds until our indicators tell us that momentum, breadth, and volatility – as well as earnings growth fundamentals – are supportive of the next move higher in the market. Until then, sitting back and earning some interest while the market finds direction makes sense to me.

For clients in our mutual fund program, stop losses are not available so we have been rebalancing to increase the fixed income allocation in those portfolios in order to accomplish our goal. For clients in our ETF program, we have trailing stop losses set, but due to the index-like nature of ETF’s very few have hit at this point.

For those of you reading this that are in 401k’s and you manage your own portfolios, market movements are a good thing for you relative to your elective deferrals. When markets pull back, you are able to buy more shares of the funds you select. However, it’s not so good for the balances you have already accumulated. If you are overly aggressive in your investment allocation you may be assuming too much risk, and conversely, if you are overly conservative, you may not be assuming enough risk. You should feel free to contact Charlie Osborne at (217) 351-2877 if you have questions about your investment selections.

As always, we want to thank you for being our client during these tumultuous times in the economy and investment markets. We work to provide you with professional investment management services and communicate our strategies and analysis to you through this Investment Commentary with your periodic statements, through our blog on a multiple-times-per-week basis, and though our Investment Strategies newsletter three to five times per year. If you have any questions or would like us to assist you with other investment needs, please do not hesitate to call us.