Stop Losing Money

Election Day 2008 and the markets roar. Guest analysts on radio and tv brazenly state that we are surely turning the corner. After all, the economic news was dismal. September Factory Orders dropped sharply, more than three times what analysts had been predicting. Other economic news was just as troubling. But what did the market do? Up over 300 points to 9,625 on the Dow. This proves, some said, that the market has bottomed!

Also rallying sharply were bond prices. Yields on the ten-year notes (TNX) fell nearly 0.25% to 3.765. Rates appeared to be in a free-fall during the afternoon while stock prices surged higher. Rates were not shrugging off the bad news. As my earlier posts have indicated, this kind of market action spells trouble for normal investors who rely on their asset managers to help them reach their goals. While investors are thrilled at times to see their monthly statement show all aspects of their diversified portfolio going up, they should be questioning the value of their money managers who rely strictly on traditional diversification.

One important feature of diversification is that gains in some instruments offset losses in others thus smoothing out returns over time. To achieve diversification, money managers strive to find assets that are not correlated with each other. Normally, stocks and bonds are negatively correlated meaning the when stocks go up, bonds generally go down. When markets are operating normally, the one can expect to get pretty good portfolio returns in up markets as stocks provide growth and dividends. Bonds generally do not perform as well but because they generally pay out interest periodically, the interest return helps temper any losses on the bond funds. And if the interest is reinvested, because the bond prices are lower, one can build up a larger position in this asset class and can reap higher rewards when bonds finally rally.

Prior to recent months, the last down market occurred from 2000 to 2003. Markets were acting normally then in that stock prices and bond prices were negatively correlated. When stocks went down, bonds went up. To validate my idea, I looked at the Vanguard S&P Index Fund (VFINX) and the Vanguard Long Term Bond Fund (VBLTX) as my proxies for stock and bond markets. Any interest and dividends were reinvested for the sake of the study.

A correlation study for these two funds from the beginning of 2000 to the end of 2002 showed a -94 correlation. During that period, the S&P Fund fell nearly 38% but bonds rose 44%. A 50/50 mix of stocks and bonds (not rebalanced over time) showed a net gain of 3.2% during those three dismal years. Those who had such a diversification, while not especially pleased with such a small return, were more than grateful that their portfolios weren't devasted like portfolios of their friends. Here, stock and bond diversification worked!

In 2005, this important negative correlation between stocks and bonds stopped. In fact, it was common for stocks to rally even on bad news. The whole investor mindset was totally distorted. I'll never forgot the big grins on the faces of the stock market commentators as negative economic news resulted in skyrocketing stock prices. 'Home owners can now refinance at lower rates, helping to further stimulate the economy' was the logic. Eventually markets must return to reality. Weak economic news means lower corporate profits, less employment, less spending and an eventual market meltdown.

From the period of 2005 to the end of 2007, stocks and bonds, based on the two Vanguard proxies, had a positive 77 correlation! For this period, stocks returned 27.7%, bonds returned 15.4% and the 50/50 mix returned 19.7%. NICE!! They called it the "Goldilocks Economy." Not too hot, not too cold, just right. Everyone was happy except a handful of renegades who saw through this charade. The high correlation between stocks and bonds continued on and so far this year, the correlation is a positive 92 but now, stocks and bonds are both falling. All of the traditional diversification is totally useless in this environment until stocks and bonds have a negative correlation.

But is this ANY EXCUSE for you losing money??? Why have others made millions, even billions in the recent market action and you, my dear friend, must delay your retirement. I won't go as far as to suggest that your money managers might be incompetent. I am sure that they are seeped in modern portfolio theory and are struggling to maintain their composure. The truth is, they don't have a clue. They don't know why the markets are acting like they are acting, nor do they have any idea on how to make you money. Nope, they stand firm telling you that the market will come back. You have to be patient. After all, the market has always come back, hasn't it? Those who sold during the bottoms of the last market meltdowns can only kick themselves for not being patient. But in the end, the market is a tricky devil my friend. The market knows how to take all of your money.

The dark clouds continue to gather overhead. Our Federal Reserve and Treasury Department know no other way to solve a crisis other than throwing money at it. This is one of the reasons we are where we are today. The causes of the problem were never solved. Only the symptoms were treated with lower interest rates and additional liquidity. For years, the government has tried hard to keep interest rates low to keep their debt servicing payments low. But how long will this be possible? How long can the US be the world's safe haven? At what point will foreign governments stop buying and holding US debt? Hopefully forever but there is anger out there over the recent financial crisis. When demand for government bonds and the US Dollar wane, interest rates will rise. Rise they will. It will snowball. As rates rise, it will cost the government more to service their debt, causing them to incur even more debt. Or, they just print more money (as they have been doing). Somewhere though I read that this could cause inflation. Too many dollars chasing too few products (or investments). Will interest rates rise? (Causing bond prices to fall). Will this high positive correlation continue to exist (stock prices fall along with bonds)? Where can one run for cover? What will your asset manager say then? Stay the course? Things will get better??????? (at Dow 5,000??).

Who can say what market reforms will occur now that Barack Obama will be the new president. With control over the House and Senate, he might be able to act quickly to stop utter financial devastation from occurring. But he's got himself quite a mess to fix. Will we get through the next two months? What new bailouts and giveaways will the Republicans pull off before Obama takes control?

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What can you, a normal investor do to profit, even in times of chaos? Unfortunately, unless you take control over your investments, you are left to traditional money managers who only know the basics: mutual funds, individual stocks, cash. But the investment world is much more dynamic and those who fail to get up to speed with other products and instruments will soon find themselves out of business.

(To be continued)

WHO COULD HAVE SEEN THIS COMING????

“Who could have ever seen this coming?, many are commenting. Certainly even the highly esteemed Alan Greenspan, one of the chief contributors of our current economic situation, admitted to Congress this week that he could never believe that corporate executives would not act in the best interests of corporate shareholders. In essense, he suggested that capitalism really doesn’t work. Corporate execs can’t be trusted and that more regulation is needed.

Unfortunately, no amount of regulation can restrain the basic human emotion of greed. So many are guilty of this, not just the ultra rich who have amassed huge fortunes over the past few years at the expense of the rest of us. Both the stock and housing markets witnessed huge explosions in value over the past few years as eager investors (people like you and me) piled into these “get rich quick” opportunities. Manias have been and will continue to be with us forever.


LOOKING BACK

Several years ago, I found myself so confused with the market actions. In my newsletters, I described it as The Tale of Two Markets. It was the best of times (Stock market makes new highs) and the worst of times (Bond market makes new highs). It’s a horrible position to be in if you are a conservative investor. After all, one diversifies using stocks and bonds in order to get a moderate return over time. The theory is that if the economy is strong, the stock market will go up and so will the demand for money. This tends to increase interest rates and lower bond prices. Just the opposite should occur in a weak market. Stock prices and business activity will fall, reducing the demand for money and as a result, lower interest rates and higher bond prices. It’s ideal to have investments that are not correlated to smooth out your investment return over time.

In 2005, I pointed out in the initial blog, how stock prices were not following expected patterns. One could expect to see correlation between stock prices, interest rates and the dollar. It did not make sense that with bond prices hitting higher and higher highs that stocks would continue to rise. Many said that in reality, lower interest rates were not reflecting a weak economy and that there were other causes of demand that led to lower interest rates. And for sure, I could see some logic in that considering that we now purchase everything from China, India or other places abroad. Where else can these countries put their US Dollars other than back in the US, with government guaranteed debt? I cringe at the thought that keeping your money with the US Government, a country with what $10 trillion in debt now? is the safest bet.

The other day, I was discussing current economic analysis with an associate and I remembered that I had written this blog some time ago and yes, things were starting to play out as I had envisioned. It led me to review my idea that the interest rates and stock market should be correlated.

If you were to review a ten year weekly chart of the 10 year note (TNX) compared to the S&P Index, you could see that in the period from 1999 through 2004, interest rates and the S&P moved quite nicely in a similar pattern. But then, the S&P started moving well ahead of interest rates. What is most surprising is to see where the S&P is now in relation to the interest rates. Right back in line. Does this mean that perhaps markets are starting to align and that the massive stock market fall is near to an end?




In 2005, my projection of 6,500 was based on the failure of the Dow to make new highs. When stock prices ultimately advanced to new highs, the next logical pattern to consider was the Head and Shoulders. With such a solid neckline building below the 8,000 level, it’s been obvious to see that there should be considerable support here.




In times of normal markets, one could expect a somewhat symetrical pattern to unfold and after some support in the 7,600 – 8,000 range, a rally would occur moving the Dow back to the 11,000+ levels. But these are no ordinary “Normal” times. The “powers that be” have managed to prevent market meltdowns after the Asian Contagion, the Long Term Capital debacle, the Dot Com collapse and other bubbles. And while the markets were able to avoid dramatic corrections, it’s possible that the corrective actions taken by the Fed and other elements of government have only delayed the inevitable. It’s always possible that the market will blow through support, really stunning everyone.

While I expect the market to find support at the Head and Shoulders formation neckline, around 7,600 or so; the financial situation is really quite ugly and still, few are willing to admit it. Has the US yet acknowledged that we are in a recession? I do believe that the mere mention of the term by a Fed official recently sent the stock market into a tizzy. What will happen when the government finally admits that things are really as grim as many are beginning to perceive????

Another point of concern is the complacency of investors. No one appears to be really “bailing out.” So many have said that “I’m in it for the long-term.” Or, “it will come back, it always has.” It also seems that each day, a key stock market television station interviews a prominent floor trader who is continually looking for the “blow off” – Capitulation! The grim looking floor trader appeared to be in dismay on Friday when, although pre-market futures went limit down and stopped trading, that the Major indices, once the equity market opened, did not follow suit. He may be waiting for a long time for capitulation. It seems that many are just closing their eyes, expecting things to normalize and the stock market to rebound. Hasn’t it always done so? Bit what if it keeps going down? Will there be some point when the market “capitulates?” Will it be at 5,000? 3,500? Or as one bloggist who correlates the market based on the price of gold writes - 770?


WHAT’S IN STORE FOR US?
I am convinced that the government’s attempt to bail out companies that have made massive mistakes further compounds the inevitable catastrophe. Although the Fed has managed to “save us” from other potential disasters in the past, the extent of the problem has yet to be seen. In the end, they are just delaying the inevitable. The banking system may possibly collapse and the government will have to nationalize.

Just look at the AIG situation. Already, they have run through the $90 billion that the government put up to save them. They need much more. It appears that other insurance companies are in a precarious position. How will they possibly be able to support their guaranteed annuity products if the market fails to recover? I’ve got to believe that a chart that look like this could be telling us that there is danger ahead.

WHERE IS THERE OPPORTUNITY

In my previous writings, I’ve mentioned the futures market as a prime market to protect yourself from market catastrophe. If I were a person of significant wealth, I would hedge off my stock market positions, reducing or eliminating any further risk I might have. Once the dust settles, I would reevaluate market conditions and lift my hedges.

I’ve also been a long time fan of Jim Rogers. Rogers identified, well in advance, the huge opportunity that commodities offered. He still advocates agriculture products as well as precious metals despite their current weakness.

It’s really important to work with an advisor who has knowledge and experience in all kinds of markets: stocks, bonds, options, futures and others. The world is too complex now and those holding significant wealth need to employ all investment and risk management tools available.