Now that the elections are over and the political bickering is on hold for awhile we can take the time to look at where we have been and where we might be headed.
First the history. YTD the S&P500 is down almost 39%. All major indices are down to historic levels and there has been little to cheer about so far this year. The reasons for the historic drop are numerous. The collapse of the housing market and the liquidity crisis back in 2007 started the slide. More trouble followed on Wall Street as big name firms like Lehman Brothers, Bear Stearns, Fannie Mae and Freddie Mac soon realized how overvalued most of their assets were. Their highly leveraged balance sheets were filled with mortgage backed securities whose values were in a free fall as a result of the housing and liquidity problems. Commodity prices had reached historic highs brought on by speculators who also were able to convince the public that the high prices were the result of increased demand. The high prices and liquidity difficulties spawned the slowdown in business and rising unemployment resulted from layoffs and consolidations.
Our last line of defense was the consumer and, with less income, consumer confidence and spending followed the rest of the indicators to historic lows. Hopefully, the political machine will move away from the finger pointing and they will roll up their sleeves and get to work. It has been said that we deserve the government that we elect, and I can only hope we are deserving of the best administration this country has seen in several decades. It will take time to recover from this economic mess and we will be tested as a nation as we go forward.
Now to the future. What do we have to look forward to regarding the economy, the markets and investment performance? Suffice it to say the near term horizon is pretty cloudy. We know that long term our economy will recover and we will once again be on the road to growth and prosperity, but for the short term, and we don’t know how long the short term is going to be, we can expect much of what we have had over the last 4-6 weeks.
First, let’s look at some of the factors and issues we will be dealing with.
Market volatility has been the bugaboo virtually all year long with daily swings of 400 points on the Dow being a common occurrence. A measure of that volatility is the VIX (CBOE Volatility Index), often called the fear index, which tracks the ups and downs of the market. Volatility plays a significant role in the pricing of stock options and stock options are used by institutional investors as a way to protect portfolios. We are seeing some relief in this volatility which if this relief continues could calm investor fears and encourage them to return to the markets. Remember that the markets do not like uncertainty and when uncertainty reaches extreme levels investors stay away. We will need to see the VIX come down to normal levels.
A low inflation rate is a positive for the market. With falling commodity prices relieving pressure on corporate profits, this may be enough to offset rising unemployment. The Misery Index is seen as an indicator of a strong economy or a precursor of a slumping economy. We are currently seeing this index rise due to the prospects of more unemployment. In the short term, however, the lower costs of materials and expenses may be enough to keep unemployment in check as corporate profits rise and reduce the need to layoff workers. If we see the Misery Index moving up into the 10-12 range, it will likely be due to rising unemployment. If that happens, the recovery will be stalled.
A big unknown going forward is the new administration. Is it new or is it simply a return to the Clinton era? At this point it appears to be the latter as more and more of the appointees to key cabinet positions are connected to that administration. Fortunately, that time period was one of the more prosperous times we have seen in history. This time around, however, circumstances are different and the old ideas will not be well received, especially since the new administration was swept into office with the promise for new ideas. Some of the appointees such as former Fed Chair Paul Volcker are sure to generate controversy, but clearly there is a lack of confidence in our current political leaders and having a change take place will be a positive. How long that honeymoon period will last remains to be seen. It won’t be about the first 100 days of this administration that will make the difference, it will be the 200 – 500 day time frame that will determine our economic fate.
The recent $700 Billion Bailout Plan, also known as the Emergency Economic Stabilization Act of 2008 is a complicated plan that is just now being implemented. It has received plenty of criticism by many for its lack of transparency and accountability, but as time passes, the results and processes of the plan will become more apparent and easier to understand. With the availability of the internet, there is very little that now escapes the watchful eye of the investigative public. It will also take time for these steps to have an impact on the credit markets. Our economy is based on the availability of credit and when credit is free flowing, the economy grows. Unfortunately, there is still a lack of confidence among banks for them to allow credit to loosen. For the economies of the world to get back on track, that free flow of credit has to return to the markets. We will need to see LIBOR rates come down and Interbank activity pick up to signal the start of normal banking operations. The longer this takes, the longer our economy will stall.
Hand in hand with tight credit is the Yield Curve. This illustrates the all important relationship between short term and long term interest rates. In normal economic times the curve rises as it reflects higher interest rates for long term loans and lower rates for short term loans. One would expect to pay more interest for a long term obligation because the lender is taking the risk over a long period of time that interest rates can move against them. Recessions can often be predicted by the shape of the yield curve. An inverted curve signals a recession is not far away. Currently the yield curve is moving away from a slightly inverted curve towards a flatter curve. We may be seeing this return to an inverted curve again as the Feds eventually will be forced to raise short term rates to encourage consumer saving as well as regulate inflation which we expect to see down the road. Whichever way the curve is moving we will be watching it along with other technical indicators to provide market insight.
What does this all mean and how does it impact our investment strategies. Let’s take a look at the short term window.
First, quality is important. This will not be the time to look to untried fund managers to occupy our portfolio positions. We feel we are well positioned in this area and these fund managers make up the Beta portion of your portfolio.
Secondly, as market volatility continues to be a dominating force, cash will be an important component of both the Beta and Alpha portfolio portions. It is simply too difficult to be moving in and out of positions in the Alpha during volatile times. An important technical support level was set on November 20, when the S&P500 hit an eleven year low when it dropped to 741. It has since rebounded above 800 and is in the process of testing that support level. The longer we can hold above that the better. We will be monitoring this support closely and if we feel we are able to maintain that we will begin to reduce and eventually eliminate our URPIX hedge position.
In one of our numerous conference calls we have participated in, one fund manager (John Lekkas, Leader Capital), who has been very accurate with his comments, described the market going forward as a bouncing ball. When you drop a ball on a hard surface, it bounces up, then falls back down and bounces back up. Each bounce up however falls a little short of the previous bounce and eventually it settles down. Based on his interpretations and the markets that he follows, that is how he describes the market in 2009. He believes we will see a strong move up for year end as the visibility of the Treasury’s actions becomes clearer, then the ball will begin to bounce.
With that in mind, our strategy will be to convert more of the Beta and Alpha positions to cash on the bounces. We know that we will never be able to sell at the peak of the bounce, but we will be gauging this as best we can.
Comments from other managers, analysts and our research suggest that we are in for a long slow recovery. There will be no quick fix or overnight relief. During this time we expect to maintain a significant amount of the portfolio in cash and/or short term bonds. How we define significant will depend on your risk portfolio. Those portfolios with large allocations to Alpha will likely see much of that in cash and/or short term bonds. We will also likely have more of the Beta allocation in cash and/or short term bonds.
As we work through this recovery, there are a couple of sectors that we will be paying close attention to. The financial sector will have to be a key part of the recovery since businesses will need the fuel of funding to reinvest in their operations. Basic materials and manufacturing also could signal the rebound. President-elect Obama’s administration has made it clear they want to return jobs to America that have moved overseas. A key component will be the plan to rescue or resurrect our failing automobile industry. That industry employs thousands of workers who earn good wages and benefits. While that industry will take years to turn around, a workable plan to make that happen will instill a lot of confidence in the markets. Technology will also bear watching as we will need to continue to upgrade hardware and software to restore our flagging worker productivity.
To put things in a nutshell, we have a plan in place in the short term to create cash that can be repositioned for the long term recovery of our economy. During normal times we don’t carry much cash, but in uncertain times having cash is a good thing. The longer it takes to recover, the longer we will sit in cash.
Mark G. Neil, ChFC, CLU
Northwest Wealth Advisors, Inc.
Office: (503) 478-6632
Fax: (503) 296-5635
0605 SW Taylors Ferry Road
Portland, OR 97219
P.O. Box 82718
Portland, OR 97282-0718