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November 11, 2008

The past does not repeat itself, but it rhymes. ~ Mark Twain

State of the Market
Given the precipitous drop in stocks this year, investors and clients are wondering if we're at or near the bottom. I would usually have written this newsletter a month ago and included everyone's year to date returns. However, October became so brutally ugly, so fast, that I decided instead to write after month's end and include 10/31 returns. The following points represent my view of where the markets stand currently:

The S&P 500 has dropped 46% from its peak in October 2007 to its 10/27 low point; 34% from 12/31 to 10/31. This is in line with the worst bear markets going back sixty years. Based on historical perspective, we would expect the worst to be over. Still, while history offers guidance, it offers no assurances.

Stocks have reached levels that offer real value, given current and future earnings expectations. This means that today's prices should translate to good returns for patient investors. If and as prices drop further, stocks only become more attractive long term investments.
 
Unfortunately, a fair or compelling valuation does not mean that the market will not make further lows. In a bear market, final lows are not reached until the desire to sell has been thoroughly exhausted, usually through emotional, panic selling. We won't know it's over until we observe broad, enthusiastic buying. The bottoming process could continue for months. We could see further declines, a frustrating sideways pattern or the bottom could have been reached already. The markets may also be awaiting further clarity on the Obama presidency.

Aggressive accounts have been partly in cash since summer (moderate and conservative accounts proportionately more), meaning we have not borne 100% of the decline. My plan is to return to fully invested as the market statistics begin to show the enthusiastic buying typical of a new bull market cycle.

Future Plan
I believe that the mainstream market averages and stocks may offer mediocre returns in the next bull market cycle. I don't anticipate a rah-rah bull market where every stock tip makes money and everyone is an expert. We can look to past periods where the market averages made very little money for years - such as 1968 to 1982. Just the same, during those periods, there were selected industry sectors and regions which made healthy gains. I am optimistic that Kay Investments' active, targeted strategies will prove profitable during the next bull market cycle. I am already looking ahead to sectors that may outperform, such as energy services, infrastructure, certain foreign regions, medical equipment and yes, financial and banking.

If you would like to discuss your risk orientation or investment model, please contact me by reply email or phone. I will be publishing 10/31 year to date returns very soon.

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September 11, 2008

If stupidity got us into this mess, then why can't it get us out? ~ Will Rogers.

The Ongoing Bear Market
Having already written several newsletters on this topic, I would prefer a cheerier topic. People want to know how and when the market will stop falling and what to expect. Beyond the usual (very true) disclaimers about no one knowing the market's short term direction, I can offer some historical facts for insight:

Bear markets happen on average approximately every 6 years. The timing, severity and duration all differ but they are inevitable. We rely on the other 4 - 5 years of the cycle to recoup losses and make money.

Bear markets historically do not end until we observe panic, desperation and emotional selling, resulting in very oversold stock prices. Human nature will be demanding that we sell rather than buy. Based on certain measures, it does not appear that we've reached that low yet. As a result you must be prepared for further losses.

Historically, the September and October months are often when the final lows are made. The final declines, while precipitous, can also be cathartic. However, the market is too unpredictable to "bank" on this or other scenario.

Keep in mind that the stock market looks ahead 6 to 8 months. It contemplates the status of credit problems, recessionary factors, global slowdowns, etc. out in the future, not where they are today, however dismal. The market may also be waiting for a resolution to the presidential race.

Generally, the larger profits of the new bull market come at the beginning of it. The first full year often recovers the lion's share of the losses. In 2002 the S&P 500 lost 23%. In 2003 it gained 26%. Significant gains will likely occur before we are able to confirm that the bear market has ended, just as significant losses (approximately 16% from the peak) had occurred by mid January when the bear market was confirmed.

My perspective of the bear market is that there is simply no region and no industry sector where we can find good performance. In other periods, even mediocre mainstream market performance has not stopped us from finding specific sectors and regions that were providing good returns. Our accounts are positioned today where we are likely to see early gains after the bottom occurs. I was in agreement with the view that energy would be an effective hedge for stock prices - i.e. if energy stayed high we would make some money in energy, if energy fell this would bring recovery to our stocks. Unfortunately, since May - June, BOTH have fallen.

I am watching for the quantitative measures that will confirm an end to the bear market. It is impossible to know if that point will be higher or lower than today's stock prices. If I could know that, of course, I would be able to recommend confidently whether to sell or to hold. HOWEVER, if anyone would prefer to convert their account further or entirely to cash, I promise my BEST effort to identify the day when quantitative measures present confirming signals. I understand the sleep factor.

Please contact me if you would like to discuss the above further.

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July 21, 2008

Lord, the money we do spend on Government and it's not one bit better than the government we got for one third the money twenty years ago. ~ Will Rogers.

Mid-term Report Card and the Ugly Month of July
As of June 30, things didn't look all that terrible as we were not down all that much for the year (approximately 7% for the most aggressive accounts versus approximately 13% for the market averages). We actually made money for the months April, May and June combined, all owing to the fact that there have been places to hide. Our sector investments helped our cause greatly, specifically energy services, natural gas and medical equipment, along with the materials-oriented Fidelity Independence fund.

A number of things have changed in the last few weeks. For one thing, energy prices finally hit the choke point, meaning levels that threaten the health of the global economy - and then finally retreated. The other thing is that the market decline became broad based, exhibiting weakness in practically every sector and region. There has been practically nowhere to hide. We made the transition to full-fledged bear market.

Perspective, Outlook and Strategy
From its highest peak early last October through its recent low point, the S&P 500 dropped over 20%. It hovered not far from its value on 12/31/04, meaning the averages gave back over 3 years of gains. Fortunately (known as good news/bad news), our client accounts have retraced toward values from 2007.

Bear markets happen around three times every 20 years. Our last one bottomed in the fall of 2002. I note that they often reach bottom in the fall months. Historically, it would be quite common to witness a drop of 30% from peak to trough. Typically, the bottom represents a final "capitulation" meaning that selling pressure becomes utterly exhausted as investor sentiment and emotions reach a riot point. Are we near that point? Some of my sources feel that we are, while others don't. My opinion is that the current rally will eventually hold and we will resume a downward track for somewhat longer.

I have taken converted a portion of the accounts cash, but it is also risky business for an advisor to decide that an aggressive investor with a long term time horizon should be out of the markets. If you feel that your "sleep factor" requires a more conservative approach for a while, then I need to hear from you.

Future Opportunities
For the last few years, the larger gains have come from energy, natural resources and foreign markets. I believe there will be a shift coming out of this decline and I expect financial and banking stocks to be a big part of it. Those stocks, which are currently a gagging, retching mess, will provide the opportunity for outsized gains eventually. I feel that today is too early but one can be assured that the Federal Reserve will do whatever is necessary to protect the its franchises, the country's banks.

What Am I Doing?
Aside from contemplating doomsday scenarios, I am occupied with keeping the portfolios invested in the sectors I believe will be strongest in this period. In particular, despite the likelihood of a nearer term pull back in energy prices, I'm staying somewhat invested in energy funds for the long term. Aside from energy, I'm focused in information technology, biotech, medical equipment and healthcare. I have greatly reduced international holdings. I intend to stay invested within the risk profile you provide.

What Should You Do?
You should be at peace with your investment orientation. Given the short term uncertainties, it is not a given that I would be able to sell your positions today and reinvest at a lower price later after the market bottoms. Therefore, I am more comfortable with you changing your risk profile only if the change is intended to be long term, but I will respect your wishes. Should we discuss this? I am available by phone and email. Remember that my opinions regarding the future are just opinions. My preference is not to give opinions on market timing - it is to identify sectors, funds and regions that are likely to be strongest at any given time.

 

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June 3, 2008

In the distance, I see a frightful storm brewing in the form of untethered government debt. ...... Unless we take steps to deal with it, the long-term fiscal situation of the federal government will be unimaginably more devastating to our economic prosperity than the subprime debacle and the recent debauching of credit markets that we are now working so hard to correct. - Federal Reserve Bank of Dallas President, Richard Fisher

What About the Recession and the Bear Market?
Interestingly, it looks now like there may be no recession. Several factors seem to be at work. First, as noted in my earlier newsletters, the economic woes seem fairly concentrated in certain consumer discretionary, financial and real estate sectors. Other areas of the economy, such as technology, industrials, staples, transportation and healthcare have been relatively stronger. Second, the aggressive Fed actions lowering interest rates are definitely working (whether you agree with the philosophy). And third, we are reminded once again that recessions cannot be predicted, confirmed or influenced by what certain 'experts' say or the number of times the word appears in print or on the web.

Another similar outcome may be shaping up with the bear market, i.e. we may not really be in a bear market but we may have actually experienced a severe correction within the late stages of the ongoing bull market. What is the difference? True cyclical bear markets drop much lower than what we've seen and last much longer.

For all the talk about subprime mortgages, the freeze-up in the credit markets, home prices tanking and banks being on the ropes, the far greater threat to the global bull market is the developing mania in energy prices. Fortunately, there is evidence that we may be about to see a pause and correction.

2008 has been characterized by high volatility and sudden steep declines, before nearly returning to breakeven as of the end of May. The most difficult thing about investing in periods such as this is that the strongest investments generally correct the most, i.e. appear the weakest. Examples this year are technology and many foreign markets (China foremost). Technology stocks have been considered good value but, being inherently more volatile, dropped well more than the averages in January and March.

So What is Ahead?
I still believe, as I wrote in January, that 2008 will be a positive year for stocks (more or less depending on the sector and region). There is a wall of worry to climb (as is always the case with the stock market), especially given that energy prices are not terribly far from the choke point. However there are positives, including the low interest rate environment, relatively strong global markets and the positive earnings outlook in many industry sectors.

A true, deeper cyclical bear market lurks somewhere in our future but my thinking is that it may more likely occur late in 2009 or even 2010. It's all just speculation, but I suspect that a certain combination of inflation, ever higher energy costs, higher interest rates and surprises (especially political) may bring the recession and major stock market decline that have been much anticipated for 2008. Historically, recessions correlate more typically with the start of a new decade. Also, the first and second years of a new presidential term are far less kind to the markets - due to the inevitable surprises. When and if that happens I will be doing my best to position the stock models accordingly - just as I am today.

What Am I Doing?
I am keeping the portfolios invested in the sectors that should be strong. In particular, despite the possibility of a short term pull back in energy prices, I'm staying invested in energy stocks for the long term. The energy market is in what we call a secular uptrend and that is not likely to change as long as global demand keeps increasing while supply decreases. In addition to energy, I'm focused in technology, medical and industrial equipment and international stocks, with special emphasis on Latin America. I intend to stay invested within the risk profile you provide.

What Should You Do?
We are not far from breakeven for 2008, following a very good year in 2007. I would suggest that now is a good time to rethink your investment orientation and make sure you are happy with how you are positioned. You've experienced high volatility. Are you comfortable with your risk profile or should we discuss it? I am available by phone and email. Remember that my opinions regarding the future are just opinions. My day job is not to give opinions - it is to look for sectors, funds and regions that are likely to outperform when the markets resume their ascent.

I agree with changing your risk profile if the change is intended to be long term. Those few of you who instructed me to sell out of the markets in January or February succumbed regrettably to human nature, which is seldom a faithful guide in investing. Why didn't anyone think about calling me in October when the markets where cresting?

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