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A Look Back at 2009 and Outlook for 2010 (AA, GLD, DJIA, SPY)

January 11, 2010 Leave a comment

There has been much to celebrate during 2009 as the stock market ended its’ free-fall and set off on one of the biggest single year gains since the Great Depression. We have seen continued improvements in many economic indicators and their second derivatives such as temporary hires, corporate earnings, initial unemployment claims, and even the more comprehensive measure of U-6 unemployment registered a slight improvement in November. However, the improvements have been very slow coming and I do not anticipate any radical improvements in the near term that would justify additional sudden upside in equity markets.

Despite the improving flow of news, I remain cautious because of many structural issues  carried over from the last few years that remain to be dealt with and because of the significant caveats that apply to much of the good news we have had. For example, the big recent fall in initial unemployment is to be expected at the end of the year because companies usually try to avoid the bad PR of laying off employees going into the holidays. Also, the slight improvement in U-6 unemployment during November is more likely to be a statistical blip than the emergence of a new trend considering that it is still above the reading from September and December’s reading ticked higher as well.

At the end of the fourth quarter, the S&P 500 was sitting at the 50% Fibonacci retracement line from the July 2007 market highs to 2009 lows following more than a 64% move from the March bottom. At 19.9, the  projected 2010 price/earnings ratio of the market is certainly above the historical average of approximately 16 but it is still well within normal ranges during the beginning of a recovery.  Although I do not feel that the market is significantly over-valued at current levels, I see few catalysts for significant additional gains and after pouring over historical data, I believe there is a relatively high likelihood that the market will correct moderately to the downside as the previously mentioned issues play out and the following headwinds begin to manifest themselves:

  • Tepid Employment Outlook
  • Although the initial unemployment claims number has been declining recently, a disturbing trend in the data has been emerging in which continued unemployment has been rising in an almost inversely proportional way. This indicates that a growing number of people have been and are being disconnected from the labor market for almost a year. These people will lose their unemployment benefits soon, depressing their ability to contribute to the economy while also subtracting from the spending power of those people who remain employed because many people are now using discretionary income to support family members and friends who have fallen on hard times.

    To make matters worse, many of the jobs that have not yet come back (such as manufacturing, financial services, automotive, etc.) are not likely to return to pre-crash levels of employment and sectors that are growing such as health care are not hiring as much as they normally would be because of persisting uncertainty regarding regulation in the sector. Also, the longer someone stays out of the labor market, the more their skills become obsolete, diminishing their long term productivity and earnings potential. I’m also beginning to factor in a slight chance of a double dip recession similar to 1937 if the Government and Fed are forced to begin withdrawing stimulus and liquidity before the labor markets can fully stabilize.

  • Withdrawal of Monetary and Fiscal Support
  • A large part of the recent rally has been due to strong fiscal and monetary policies enacted over the past two years that I mentioned previously in my October 20th Buffett vs. Bullion post. However, these will be disappearing relatively soon as the Troubled Asset Relief Program (TARP) expires in 2010 and liquidity is withdrawn from the market by the Government and Fed to prevent inflationary pressures from building into another asset bubble. The U.S. Government hasn’t even come close to issuing all of the debt that is required to fund its’ growing deficits but now that a complete financial meltdown is off the table, investors are already demanding higher yields to make purchasing the treasuries worthwhile considering the balance sheet problems facing our country. If yields continue to rise, it will eventually put serious pressure on an already strained credit market and economy.

  • Hobbled Banks and Declining Credit
  • Commercial banks are the backbone of the worlds’ credit markets and they have been badly injured over the past few years by and are still being held together by unprecedented levels of legislative (termination of mark-to-market), monetary (lowering Federal Funds Rate below 0.25%) and fiscal (TARP) support. The banks are still being hobbled by a multi-year build up of toxic “assets” and unprecedentedly high default rates on a wide range of consumer and commercial loans which has significantly curtailed the ability of banks to loan out new funds in the market which would spur further economic growth.

    In recent past recoveries, credit has always continued to expand and the savings rate has continued its’ long term downward trend. However, the most recent recession seems to have fundamentally changed things. The weakened banks can no longer increase the credit they give (in fact, credit has been contracting), and Americans have begun rejecting their debt-loving nature sending the national savings rate average above 4.5% in 2009 for the first time since 1998. The markets rejoiced and rallied on the news that many of our nations’ major banking institutions had returned to profitability. Unfortunately, the opposite reaction could take place when/if investors realize that the return to profitability was heavily aided by taxpayer support and that normalized bank earnings will be lower in the near future because of the previously mentioned reasons and lower levels of lending.

  • Persistent Market Uncertainty
  • Certainty in and of itself is not necessarily a good or bad thing, however a lack of certainty is the breeding ground of volatility in the stock market which tends to reduce realized returns over shorter time frames. There continues to be a great deal of uncertainty concerning the Federal Funds Rate over the next several years and Government intervention in the market as we mentioned in our newsletter from the Third Quarter. There are also other issues which have been temporarily swept under the rug which could come back to haunt during 2010 such as health care reform, regulation of the financial industry, changes to the tax code and taxes on greenhouse gases. I feel that these are important issues which must be tackled comprehensively and in a timely manner. This will almost ikely continue to be a challenge for the current Congress and could become even worse following the 2010 midterm elections. Every day that goes by without there being solid laws on the books is another day that executives will delay hiring or expenditures because of uncertainty over what the business and economic landscapes of the U.S. will look like five years from now.

    For example, (1.) Should healthcare companies hire more people to meet growing demand from regulation that would increase the pool of customers, OR should they fire people because the industry might get regulated to death instead? (2.) Should financial institutions begin putting money back to work in the economy, OR should they be divesting certain assets because of a possible return of Glass-Steagal? The answer barely matters in this case; CEO’s just need to know what the rules of the game will be so they can plan for it. (3.) Should employers like General Electric continue to take advantage of our skilled labor force as well as our great technical and legal infrastructure, OR should they relocate to a more fiscally responsible country for fear of draconian tax rates being employed to sustain Congress’ out of control spending habits? (4.) Should companies continue investing in green and other sustainable technologies to improve our planet, OR should they shut down because they won’t be cost competitive with fossil fuels unless carbon emissions are taxed appropriately?

    Maybe Congress could answer these questions for us when they are done squabbling over who gets the most pork barrel money.

    All this being said, I continue to maintain a positive long term outlook because there are still many exciting areas which I feel offer favorable risk/reward fundamentals and will take advantage of longer term shifts in the global economy. I will continue to revisit my investment thesis regularly throughout the next quarter and I am very interested to hear what executives will have to say about their outlooks on the conference calls during the upcoming earnings season which Alcoa (AA) just kicked off.

    We have just emerged from one of the worst financial crises since the Great Depression and I use this comparison because of the great similarities between then and now. The Great Depression began in 1929 when the market fell steeply following years of greed and financial excess (sound familiar?). Market sentiment quickly recovered and stocks experienced one of their greatest runs in history over the next several months as investors covered short positions and began to anticipate a strong recovery (sound familiar?). The rally took the market all the way to the half-way back point (right about where we are now) but investors began taking profits as they waited for the projected fundamental economic improvements to materialize and the market proceeded to dive, not truly bottoming until almost four years later in 1933.

    Mark Twain once said “History doesn’t repeat itself, but it does rhyme” and with this in mind I plan on returning to a more defensive posture than I was in the beginning months of 2009 when prices as well as expectations were much lower.

    Words of Wisdom for 2010
    Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.”
    – Warren E. Buffett

    “The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities — that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future — will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.”
    – Warren E. Buffett

    Happy 2010 everyone!

    -MJB

    Follow-Up: Technical Trouble on the S&P 500 (SPY, GS, JPM, AAPL, CSCO, GOOG, F, GE, CAT, GLD, UUP)

    December 8, 2009 1 comment

    We have posted discussions about this in the past, most recently on November 25th and also on October 30th, where we looked at the charts and decided that the S&P 500 was possibly in for some trouble.  On November 25 the broad market index closed at 1111.18, and today it closed at 1091.94, for a loss of 1.7%.  Basically, the market has gone nowhere in that time.

    What has happened, however, is that the chart has given us some more signs that the market is running into trouble.  Here is a 1 yr daily chart of the SPX, similar to the one we showed in our previous posts, except with some updated lines.

    As you can see, we still remain unable to break above that 1120 line (yellow horizontal line), which is the long term 50% Fibonacci retracement line from the 2007 high to this years low.  It is likely that we are seeing heavy resistance at this level as traders anticipate this weakness and front run it to exit positions for the year.

    Additionally, this chart shows that we have broken the uptrend that was established since the March lows.  Keen observers will note that this also happened in October, but the break is much more definitive this time especially when combined with that price ceiling. However, we will need to take a look at where we close on the weekly chart because that should be much more indicative of future movements.

    For good measure, the same analysis applied to the E-Mini futures (/ES) yields similar results:

    The /ES is attempting, and thus far failing to break through its own ceiling which has been established at 1112.  As you can see, the E-Mini futures just broke below the upward trendline that has defined this rally since March.

    The root cause of this is, in our opinion, fund managers selling off risky assets to lock in the substantial gains some of them have been able to accumulate during this tumultuous year.  Obviously, this situation is not sustainable, as mutual fund managers often have a mandated maximum cash balance, and hedge fund managers generally do not like to have their end-of-year statements to clients say that they are in cash.  But there is a lot of money available to be taken off to the sidelines, so this situation may continue through the end of the year.  It will be important to watch leadership stocks over the next couple weeks such as Goldman Sachs & Co. (GS), JP Morgan Chase (JPM), Apple (AAPL), Cisco, (CSCO), Google, (GOOG), Ford (F), General Electric (GE), Caterpillar (CAT), etc. and of course gold (GLD) and the US Dollar (UUP). We’ll be making a follow up to this over the weekend.

    -Lucid Markets Team

    Disclosure: Long GS, CSCO, GOOG, GE, GLD, UUP, JPM and the stock market in general through various other positions.

    Why Warren Buffett Doesn’t Like Gold, and Why I Do (GLD, GDX)

    October 20, 2009 2 comments
    Warren Buffett

    Warren Buffett

    Warren Buffett is a strictly a long-term investor with a holding period of “forever”. The fact that he is an investor prevents him from investing in gold. Gold will never earn any money, nor will it ever pay out dividends to its holders.

    The only thing gold can do is precisely why I have been buying; it works extremely well as a store of value. An average automobile in 1950 would have cost the equivalent of approximately 30-40 ounces of gold. The same holds true today at the recent spot gold prices above $1000. Had you instead decided to hold cash, you would not even have enough money to pay for the down payment.

    The most common reason cited by people bullish on gold is inflation and although it is certainly a contributing factor, I do not feel that this is the most important issue affecting gold prices. Instead, I believe that there are three other overarching trends taking place right now that are exerting much more upward pressure on the price of gold.

    1.) Overall Depreciation of Currency
    Normally if one government prints a lot of money, the currency will drop relative to other currencies. However, in situations like we have today when many governments are printing money (and some are managing their currencies to subsidize exports like the Chinese), you get a situation where fiat currencies as a whole become worth less relative to other stores of value such as gold and other commodities. There is only so much gold on this planet and it is usually pretty hard to get to which helps fundamental elements of supply and demand.

    2.) Excess Liquidity and a Truly Damaged ‘Real Economy’
    Despite the recent stock market rally, the real economy is still hurting badly and even though unemployment has been improving, we are still a long long long… pause… long way from adding jobs. Governments are also intervening in the markets in very unprecedented ways in the form of legislative overhauls, a massive stimulus bill that served mostly pork-barrel interests and the new role of the Government/Federal Reserve as the biggest lending facility in the world.

    The poor state of the economy, along with the extreme uncertainty regarding the future business landscape and poor availability of lending facilities, it is not surprising that investors and entrepreneurs aren’t rushing into the real economy. They are instead putting their money into stocks, bonds, gold and commodities hoping to make at least modest return while also preserving the value of their money as central banks around the world flood the markets with liquidity.

    3.) There is no Price Ceiling on Gold Prices
    People in general don’t buy gold as an investment. They buy it because they feel they need to in order to avoid losing something; in this case, it is to protect investors and central banks from depreciating global currencies, inflation and political instability. The price they pay for this protection is simply whatever they can buy it for.

    David Goldman (ironic last name) pointed out in a piece from a few weeks ago that Central banks alone own about 4.8 million tons of gold. The world produces about 2,200 tons. If central banks were to increase their gold holdings by just one percent, it would require approximately 48,000 tons which is more than 20 times annual mining production.

    If the planet is about to be hit by a meteor and there is only enough room for 100 people in an underground bunker; the people who have the most cash (or the biggest guns unfortunately) are going to end up in the bunker.

    I don’t think gold will begin to fall again until we have incontrovertible evidence that the situation in the real economy is on the mend. Until then, I will try to have at three to eight percent of my portfolio in gold through the actual commodity (GLD, purchased @$99.65 on 10/5) and gold miners (GDX, purchased @$48.64 on 10/8). I hold a small legacy position in Barrick Gold Corp. (ABX) that I see no reason to sell, but I also see few reasons to buy it. I will be doing further research into gold mining stocks in the future.

    Gold is very volatile and I recommend gradually easing into positions on dips if you are going to play in this area.

    -MJB

    Disclosure: Long: GLD, GDX and ABX