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May 17, 2009

A DOWNTURN, BUT HOW FAR DOWN?

Although it seems that everyone is saying that the market has goon too far, too fast, I am dubious about the likelihood of a deep pullback, given the important information I am going to share with you in a moment. But it is certainly possible that these sectors/indices could pull back a bit more, then resume the coming bull market I have been discussing for several weeks now. That means that we could have a couple of days (at most) of further market weakness before bargain-hunting buyers step in and boost the market sharply higher.

By Christopher Michaels IntelligentValue.com

Although we moved to cash as the market topped out this last week, we're going to ease into the long side of the market with our Model Portfolio this week and begin to ease out of our short positions in the Aggressive Portfolio in the next coming days as the market dictates. In this market environment, which is still trading based on technicals, not fundamentals, anything can happen, but the goal of intelligent investment behooves us to carefully analyze all available technical indicators.

To support my thesis that we are at the start of a major, 4-year bull market, I'm going to discuss some of the top-down economic indicators that affect the market the most. This section includes one of the most profound charts I have ever seen. Read on, I think you'll be amazed, too:

IMPORTANT LEADING INDICATORS

Many commentators in both print and television have been talking about 'green shoots' in the economy. Obviously, the market was ahead of them as there was still talk about the end of the world while the market was commencing its strong rally in early March. Some commentators are still talking up dire predictions for the economy: even 'Dr. Doom' himself, Nouriel Roubini, who appeared on CNBC with Maria on Friday. Mr. Roubini predicted many more problems, but actually said that he thought the recovery could begin by the end of the year. My analysis shows that its already begun.

I'm no utopian idealist when it comes to the economy. I think we still have a lot of hard work and tough times ahead of us. But the economy has already improved immensely if you can recall how bad it was last Fall. Many people even stopped purchasing groceries for a while there. President Bush, Treasury Sec. Paulson and company had the country (and world) scared to death with warnings of an economic meltdown within 48 hours if congress didn't give $850 billion to the banks. Where'd it go? Nobody knows.

But the doomsayers can't argue about these facts, which are already having an immediate affect on commerce and the stock market:

1) Weekly Jobless Claims appear to have leveled off and are dropping somewhat since the high in late March. Post WWII, this has been a two-month leading indicator of a recovery.

2) The ECRI Leading Index, one of the most watched and accurate of all leading indicators (it's a proprietary composite of seven other indicators), has been in a cyclical upturn for five months now. According to ECRI, "Those who dismiss this development don't understand its implications for a business cycle recovery. In fact, over the last 75 years, growth rate cycle upturns during every recession were followed zero to four months later by the end of the recession itself. No exceptions."

What's really important now is that the level of the ECRI Leading Index has been rising for three straight months in a manner that signals the end of the recession. Along with the rest of ECRI's leading indexes, these developments are pointing to a business cycle recovery this year, probably by the middle or end of the summer.

3) The Baltic Dry Index (BDI), a measure of the cost of international shipping, has risen dramatically since its bottom in December 2008. Because shipping activity is so symbiotically related to the movement of raw materials, the BDI is considered a leading indicator of global demand for raw materials. This index is a daily quote of the cost of shipping various products, such as iron ore, grain or oil, on various routes, not an estimate or a forecast.

The Baltic Dry Index closed above 2300 for the first time since October 10, and reached a 7-month high on Friday of 2544. Over the last ten days, the BDI has increased by 772 points (44%), and over the last 25 days the index has increased by 1081 points (74%). Although this is a highly positive harbinger for the world economy, I would expect to see a pullback soon from those sky-high gains. But that doesn't mean the upward rise won't resume.

Other leading economic indicators — which serve as the foundation of important political and economic decisions - are often massaged to serve narrow interests, and subjected to adjustments or revisions. Payroll or employment numbers are often estimates; consumer confidence appears to measure nothing more than sentiment, often with no link to actual consumer behavior; gross national product figures are consistently revised, and so forth. Unlike stock and bond markets, the BDI "is totally devoid of speculative content," says Howard Simons, an economist and columnist at TheStreet.com. "People don't book freighters unless they have cargo to move."

Shipping stocks have surged recently based on the increase in shipping rates. However, one thing we need to keep in mind with this index is that many shippers have currently pulled their ships off the seas to reduce supply and increase prices. It is estimated that 750 cargo ships are sitting off the coast of Singapore.

4) According to a Chicago Sun Times article on Saturday, "Consumer Prices were flat in April, the Labor Department said Friday, as recent price declines mirrored 1950s levels. The April performance met economists' expectations and followed a 0.1 percent dip in March. The docile inflation performance reflected a second monthly drop in energy costs and a third straight decline in food prices. Over the last year, consumer prices have fallen 0.7 percent, the largest 12-month decline since a similar drop for the 12 months ending in June 1957."

Stable prices are an excellent platform upon which to build an economic recovery. Although the expectation of inflation as well as deflation in the future is passionately argued every day in the media, it's not time to worry about it now. Enjoy the currently stable price environment.

5) According to the University of Michigan, Consumer Confidence is at its highest since September at 67.9, a rise from 65.1 in April. Of note is the fact that when Consumer Confidence spikes, it's typically a short-term signal for a market pullback - in other words, a contrarian indicator. This coincides nicely with the current pullback we are seeing, but over the longer term, rising consumer confidence bodes well for future economic and market gains. We need consumer confidence in order to get people shopping and business owners buying inventory.

Of course, there are just as many points that could be made to support a recession that continues on for years. Some are even still forecasting a depression. Therefore, this next point deserves its own section, as it may be the most profound support for an upward trending market (over the long term) I have ever seen in my investment-related life:

Money Market Funds - THE REAL DRIVER OF THE COMING FOUR-YEAR BULL MARKET

According to Ned Davis Research in Venice, Fla., a record $3.8 trillion is invested in money-market mutual funds, equal to 43% of the stock market's $8.9 trillion capitalization as of March 31. With the Federal Reserve pumping in liquidity and buying up Treasuries to keep rates low, these accounts are collecting an average return of just 1.2% annualized.

Eighty-nine percent of the time when money-market funds exceeded 10.8% of total stock-market capitalization, the stock market returned an average of 9.9% above average over the following year. However, those records could be skewed by the current reading. Never before has the level been as high as 43%. In 2002, the level was about 8% and in 1982, the start of the last 17-year secular bull market, the level was about 16%. The level of money market funds compared to the stock market capitalization normally averages just 1.5%.

What's never been seen before is what happens to the stock market when the Federal Reserve is on a mission to lower the return of low-risk assets such as Treasuries and money market funds and push investors outward on the risk curve towards stocks. There's an estimated $11 trillion in money market funds earning next to nothing, and another $9 trillion sitting in FDIC-insured checking accounts.

In addition, according to the American Association of Individual Investors (AAII), the average individual investor currently has more money in bonds than stocks. What all that means is that the amount of capital allocated to stocks is at the lowest point in the history of keeping these records.

The frightening, cascading downward stock market we saw last Fall was the result of forced selling as investors demanded that their brokers/fund managers get out of the market. As usual, the average amateur investor was buying like crazy in 2007, then sold at the bottom of the market in late 2008 - early 2009.

Now is the time for intelligent investors to BUY, just as Warren Buffett has been buying. By all accounts, Mr. Buffett has spent all of his available investment funds after having more than $20 billion sitting in cash in early 2008. Does it make sense to be like Mr. Buffett and ignore the 'Wall of Worry?' I think so.

MORE EVIDENCE

There's more evidence that money is moving into the stock market. According to data provided by Trimtabs, the amount of money flowing into Equity Mutual Funds has increased dramatically in May. In the last four months, the trend has gone from outflows of $14.3 billion in February to projected total inflows in May of $17.8 billion. Extrapolated through the end of the month, projected total inflows are about $40 billion. Here's the amount of inflow/outflow the last four months:

You can argue all day about green shoots or brown weeds, but the evidence above shows that an almost unbelievable amount of money is sitting in the sidelines, and it is now beginning to pour into the equity markets seeking a higher return. This is a case of simple supply and demand. Last Fall, equities were sold in a panic, forcing their prices to drop precipitously. Today, the proceeds of those sales are beginning to pour back into the stock market and the prices of equities will climb just as rapidly as that money comes in - and this next point is IMPORTANT: The stock market will climb in value REGARDLESS OF WHAT THE ECONOMY DOES.

This money pouring into the market will force prices higher, which will result in more confidence in the economy (regardless of its actual state), which will result in increased buying and increased economic activity, which will result in a better economy. Although it's still early and we need to see how the Fed manages cooling things off over the next few years, it appears that the Federal Reserve under Ben Bernanke may have pulled off the perfect 'save' of the world's economies and markets.

THE ERROR OF OPTIMISM  - AND THE ERROR OF PESSIMISM

More than 80 years ago, Mitchell described how the error of optimism at the heart of every boom “grows in scope and magnitude... But since the prosperity has been built largely upon error, a day of reckoning must come… Then the past miscalculation becomes patent – patent to creditors as well as to debtors, and the creditors apply pressure for repayment. Thus prosperity ends in a crisis.”

A. C. Pigou writing in 1920 said, “The error of optimism dies in the crisis but in dying it ‘gives birth to an error of pessimism. This new error is born, not an infant, but a giant; for (the) boom has necessarily been a period of strong emotional excitement, and an excited man passes from one form of excitement to another more rapidly than he passes to quiescence.”

In my article entitled, "The Lizard Brain that Sabotages Your Investing," I discussed how Behavioral Finance is now helping investors learn to set aside their emotions and not extrapolate past conditions into the future.

Over the last two months, we have seen stocks that were of lower quality - those beaten down to a price below $5 - being bought the most. High quality companies are still selling at values that are excellent bargains relative to their earnings potential. The case can be made that the U.S. economy will never return to its prior heights, but that significantly ignores the human creative potential.

Just because you can't see the wonderful developments of the future doesn't mean they won't come. In 1975, could you have predicted that someday you would have a computer with the power of a mainframe that would fit in the palm of your hand and could also be used as a telephone to make wireless calls to and from anywhere in the world?

Innovations of the recent past, such as computers and the internet, will be replaced in the future by biotechnology and other medical innovations, transportation advances, environmental advances, and creations we can't even conceive of yet. These will be the drivers of future economic strength from the source of all economic innovation - the human mind. As Dale Carnegie said, "Whatever the mind of man can conceive and believe, man can achieve."

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