Last week I wrote about the recent weakness in gold. So this week I was a little surprised to see an advertisement advising people to buy gold because it is up 30% for the year and should continue to go up because of a weak U.S. dollar. Gold is actually down about 11% since the beginning of the year and about 25% from its peak in March.

The information about weakness in the dollar was equally wrong. Over the past few weeks, the dollar is actually showing quite a bit of strength. Below is a chart that shows how the U.S. dollar (black line) has fared over the past six months compared to some other currencies. As you can see, over the past three months, the dollar has gained 15%.

Compare that to the Mexican peso (maroon line), the British pound (blue line) or the Euro (gold line). Over the same time span, these currency funds have declined from 18% to 42%. In recent weeks the only currency other than the dollar with a positive return is the Japanese yen. It is up 5%, but has weakened considerably in the past couple of weeks.

The middle section of the chart is a moving average convergence divergence (MACD) of the dollar. It remains positive, although it is indicating that the dollar might see more consolidation over the near term. The bottom portion of the chart is a relative strength index (RSI). It is trending solidly above the 50 level that indicates positive strength and momentum.

As long as this global economic crises continues, the U.S. dollar is likely to remain the top performing currency, because it will be in high demand. In spite of Europe’s attempt to make the euro the worldwide currency of choice, the dollar retains that position. During tough economic times, people worldwide try to hoard as many dollars as possible, because they know the U.S. will do whatever it can to maintain the dollar’s value.

In 1990, I was in the Soviet Union negotiating a contract to lease a cruise ship for a season. The communist government was still in control of pretty much everything, including the shipping company. We reached an agreement on price, the only catch was that money for the ship had to be paid in hard currency U.S. dollars. The irony of the situation was that at the time, it was illegal for someone to pay for any goods or services in the Soviet Union with anything other than rubles.

But communist officials knew their days were numbered. The best chance for their economic survival as individuals and as a country was to get hold of as much American cash as possible. For several years after, as the value of the Russian ruble collapsed, the unofficial currency of Eastern Europe was the U.S. dollar. I visited Russian banks that had no rubles to distribute, but had a back room with tables covered in stacks of U.S. currency.

Most of the world’s developed economies are dependent on spending by American consumers. Now with Americans cutting back on their worldwide purchases, there won’t be as many dollars floating around and the demand for them will increase. As a result, the dollar should remain strong as long as this situation remains critical.
F.S.

During the early part of my career as a financial writer, I worked for Howard Ruff, who had written a best-selling book called How to Prosper During the Coming Bad Years. The bad years he was referring to were the late 1980s and one thing he advised was for investors to hedge their market exposure and hedge against inflation by buying gold and silver.

His advice proved to be accurate. Precious metals prices soared and investors who listened to Ruff made a lot of money. He parlayed that successful call into the highest circulation investment newsletter of its era–The Ruff Times– with more than 250,000 subscribers.

Of course Ruff is not the only analyst who has advised that gold tends to be a solid investment during uncertain economic times. The yellow metal has long had ardent proponents who talk about how it holds its value unlike virtually any other investment. A gold buff once explained his passion for gold by noting that at the turn of the 20th century, a man with a one-ounce gold coin could buy himself a pretty nice suit. One hundred years later, that same ounce of gold could still purchase a quality suit.

While his reasoning was sound, I did not point out that if the same man had invested that amount of money into GE or AT&T stocks, he could have used the proceeds to buy dozens of suits through the years.

So given the fact that investors tend to flee to gold during times of economic turmoil, one might expect to see the price of gold soaring in recent weeks. In fact, gold is struggling along with every other sector of the markets.

The chart above shows the price of gold (black line) over the past year. The gold line is the S&P 500 and is included just for comparison. While gold has done quite a bit better than the S&P, an investor who bought gold a year ago has still lost money. And in the past few weeks, the decline in gold has been much steeper than in stocks. In March 2008 gold topped $1,000 an ounce, an all time peak. Gold is now trading at just over $700 an ounce. That is about the same rate of decline as the S&P 500 over the same period.

There is something called the Dow/Gold ratio that can explain part of the reason about why gold is declining along with stocks right now. But all you really need to understand is that contrary to many previous periods of market weakness when investors moved assets to gold, in this downturn, gold is also in a steep decline.

As we have indicated for many weeks, this correction is very unusual because every market sector is declining. For anyone looking for a safe haven for their investments, right now the only viable options appears to be money market funds.
F.S.

As professional money managers, we are also in the business of client recruitment. For the past couple of years, we have been particularly adept at making certain our clients were properly allocated. Our strategies were weighted toward international funds in the early part of 2007. During late summer in 2007 we switched assets to bonds, avoiding the October market downturn and capturing some nice gains in the early part of 2008. In May 2008, we moved virtually all assets to cash, sidestepping this severe downturn.

With that kind of recent performance, we have attracted the interest of many potential new clients. But some are hesitant to make the switch, because their current brokers or managers are telling them that this is the market bottom and they would be unwise to move now and miss the inevitable new bull market.

The problem with such reasoning is that while no one can predict exactly what the markets will do, most technical and fundamental indicators are still showing a market dominated by weakness. The current situation is unprecedented in many ways. Traditional Wall Street managers want investors to hang on because that is what is best for them, but not necessarily what is best for investors. These managers might want to keep in mind one of Wall Street’s oldest axioms: “don’t fight the trend.” And right now, the trend remains decidedly negative.

Below is a chart of the S&P 500 going back to the beginning of 1994. Notice that the current descent is much steeper than any experienced during the 2000-2002 bear market. The red line marks the lowest point of that decline, which happens to be the next level of technical support at about 780. That is about 13% below the current level. If the index were to drop below that level (and there is no technical or fundamental evidence that it can’t or won’t), then it is anyone’s guess about where the next support level would be. It could be near the 600 level marked by the blue line. That would be about a 33% drop from today’s level. If you think it can’t drop that much, think again. The Nasdaq lost even more during the 2000-2002 bear market.

On the bottom of this chart I have included two technical indicators. I could have included a dozen and they would all show essentially the same thing. Every technical indicator that I am aware of is currently negative. The middle portion of the chart with the squiggly blue and brown lines is a moving average convergence divergence (MACD). I added the horizontal green line to show that it is currently well below its lowest levels in 2001 or 2002. The MACD is a useful tool to help identify market extremes, but it cannot pinpoint exact tops or bottoms and I do not know of any tool that can.

The bottom portion of the chart is just a simple momentum indicator. Like the MACD, it is also at a level much lower than it reached in 2001 or 2002. But there is certainly nothing to indicate that it cannot go lower still.

The next chart below is the same as the one above, except it is just for a single year. I added the purple trendline just to show that the S&P 500 is definitely in a downtrend and I see nothing on the chart that would convince me that a bottom is near. The gold line is a 50-day moving average of the S&P 500. Notice that the currently price is well below that 50-day MA. Before a real bottom is reached, the gap between the gold line and the black line would have to get much narrower.

On this chart, the MACD is much clearer. Notice the separation between the blue line and the black line. A bottom will not be formed until those two line converge and the blue line crosses over the brown. Based on the current gap, that is several sessions from occurring. But even when that happens, it is no guarantee that a bottom is in place. All it means is that momentum has changed from negative to positive. That has happened several times in the past year but the bear market is still dominant.

One of the problems with technical tools is that they are virtually all lagging indicators. In other words, they do a poor job of identifying exact turning points in the financial markets. So how do we determine when the market has made a bottom? There is no one who can positively state when the exact bottom has occurred. But it is possible to identify some of the signs one might expect to see when a bottom is near or has formed.

The first indicators are usually economic fundamentals. There will be improvements in things like unemployment rates, retail sales, housing starts, durable goods orders, etc. When any one of these type of reports is better than anticipated, you might see the market react with a significant daily gain. But any subsequent bad news will send it plunging again. It will take several positive reports in a row to stabilize the daily volatility. So far that does not seem to have happened.

When the bias in economic reports turns from negative to positive, technical indicators will start to improve. The MACD will rise and cross above the zero line. Momentum will turn positive. Relative strength will rise above 50 and then stay above that level. On the equity exchanges, advancing issues will outnumber declining issues for several consecutive sessions. Again, so far that has not occurred.

Until we see confirmation from some of these signs, it does not make sense to remain invested in the markets or to jump back in in anticipation of a new bull market. These indicators all currently still show an equity market where risk outweighs the potential for reward.

When a new bull market is born, you do not need to worry about missing out. While it is possible that there will be individual market days with gains of 4%, 5% or even more, bull markets always rise much slower than bear markets fall. Look again at the top chart. It would have been tough to miss the bull market that began in 1995 and continued until 2000, or the one that began in 2003 and continued until 2007. Catching the exact bottom is far less important that missing the major declines like the one that is currently underway. Indexes normally consolidate in a sideways pattern before advancing out of a bottom. The pattern tends to be shaped somewhat like a bowl rather than a spike.

As I explained last week, Wall Street’s premise that the best investment strategy is merely to buy and then hang on until the day of retirement is not in an investor’s best interest. Brokers and advisors who are currently advising clients that they should remain invested and hope for the best could very easily be doing their clients more financial harm. Are you really going to continue to trust someone who has already advised you to sit by and take no action while your account declined 20%, or 30%, 40%, or even more?

Of course as mentioned above, the financial markets are in uncharted waters. Some analysts have compared the current situation to the start of the Great Depression, but many circumstances are completely different than ever before. I claim no special ability to be able to accurately forecast market movement and it is possible that the market could rally several hundred points tomorrow and never look back. But since I don’t profess to know what is going to happen, I will rely on the technical and fundamental tools referred to above, all of which are showing that the worst is not yet over.
F.S.

The carnage in the economy continues and so far more than $2 trillion has disappeared from the financial markets since the decline began in October 2007. While ordinary people have seen their retirement accounts and other investments plunge, this time the victims have also included some of the country’s oldest brokerages and financial institutions.

Somehow it seems fitting that these organizations have succumbed to their own greed. The primary reason some of these firms existed for so many decades is that their own survival has always been their highest priority. A common joke in the financial industry goes something like: “The broker makes money, the firm makes money; two out of three isn’t bad.” The implication being that the one who doesn’t make money is the client.

One truly sad aspect of this situation is that many of the losses by individuals could have been avoided. Unfortunately, through the years Wall Street convinced investors that stock market investments were secure and that any losses would be minimal and could quickly be made up once a bull market returned. Their argument was that because stocks historically always went up, the best practice for an investor who sustained losses was simply to hold on long enough and the losses would be recouped.

They taught investors that minimal asset diversification was enough to ensure the safety of one’s portfolio. Indeed, the implication was that as long as invested assets were diversified, investors rarely needed to pay any attention to their portfolios. Wall Street was so convincing with this lie that it has been adopted as an investment fundamental by everyone from brokers, to the financial media, to industry regulators, to economic academicians. The buzzwords were “asset allocation” and “buy and hold.”

The foundations of the lie came from research done in the 1950s. Harry Max Markowitz rightly recognized that most studies of the financial markets at that time paid very little attention to risk. Markowitz pointed out the significance of risk to a portfolio. He noted differences in correlation between asset classes and proposed that one could reduce overall risk and optimize returns by careful diversification among these asset classes. His concepts eventually became known as Modern Portfolio Theory or MPT.

Markowitz’s work was brilliant and went far beyond just diversification and MPT., but it is important to note that the investment world of the 1950s was dramatically different than today. Mutual funds were a fairly new creation. Most ordinary Americans did not have an investment portfolio and instead counted on employers to provide fixed retirement pensions.

Wall Street loved MPT because the basics of the theory were easy to explain, while the actual application was something difficult for individuals to accomplish on their own.

The world of investing changed dramatically with the advent of personal computers. Tools that were previously available only to mathematicians at the largest brokerage firms became available to smaller investment firms and really to anyone with a home computer. Trades that used to take days to execute and verify became almost instantaneous. But major Wall Street brokerages did not eagerly embrace these technological changes.

A good analogy comes from our own Revolutionary War. For a couple of hundred years previous, wars were fought on huge open fields primarily with infantrymen using muskets and bayonets. Blocks of men engaged each other at close quarters firing volleys because accuracy of the weapons was limited to 50 yards or so.

In the American colonies, gun makers perfected a weapon called a “long rifle.” Cutting grooves inside the barrel stabilized bullet flight. Instead of accuracy being limited to 50 yards, these new weapons made it possible to shoot accurately to 200 or even 300 yards.

American soldiers soon learned the folly of competing against the British in a traditional open field battle. Instead, they used the long rifles to their advantage by hiding behind cover and shooting from a distance. Brightly decorated officers made particularly tempting targets. This tactic was demoralizing to British soldiers who were not used to seeing their comrades killed by an unseen foe. British military leaders even complained to colonial leaders about the unfairness of such methods.

Just as the British clung stubbornly to an outmoded method of warfare, so did Wall Street firms stick with MPT and buy and hold, even when it became obvious that those strategies were not in the best interest of many clients. For example, the chart below shows performance of the S&P 500 over the past decade. The green line is merely to highlight that someone who invested in this index 10 years ago and held it until now has earned zero return. That is an average annual return of zero.

Unfortunately the S&P 500 is not the only index that has struggled. Few indices and few market sectors are showing significant gains over the past 10 years.

So much for buy and hold.

Wall Street might argue that a buy and hold strategy will work over a longer period–say 40 years. But that is not a realistic situation for most workers who accumulate the bulk of their investment assets in a 10- to 20-year period prior to retirement. In the example above, investors who began accumulating assets at a market top such as in 2000 or in 2007 could quickly find themselves with losses that might take decades to recoup. If those individuals were already retired and had no way to accumulate additional  assets, it might be impossible for them to recover from the impact of a bear market.

Or consider the case of an investor who is counting on retiring in three years. Those final three years happen to coincide with a downturn like the one that began in 2001. As a result he has significantly less money than he was counting on, so he delays retirement until he can catch up. If the ensuing years are like those we just experienced, seven years later he is no closer to retirement.

You might be wondering about the protection against risk afforded by diversification. Unfortunately, it rarely works as designed. The concept is that different asset classes perform differently. For example, when large cap U.S. stocks are doing poorly, bonds or international stocks might be doing better. Diversifying assets is theoretically designed to avoid having all of one’s assets decline at any given time.

Unfortunately, during recent bear markets different asset classes have shown high correlation. In other words, they have all gone down at the same time, negating the theoretical risk protection afforded by MPT and traditional asset allocation.

If MPT and a buy and hold approach are such fantastic concepts, one would imagine that they would be commonly used by Wall Street’s best managers. Ironically, Wall Street managers generally use an active management approach employing technical, fundamental and cyclical tools. And instead of traditional asset allocation for diversification, they tend to allocate more heavily to sectors they think are going to outperform and away from those they believe will underperform. And you can be sure none ever takes a position with the intent of holding it for 40 years.

At the same time, Wall Street firms have argued that ordinary investors and smaller institutions do not have expertise or ability to employ active management methods. For example, an October 9, 2008, article in The New York Times noted that investors who bail out of the stock market now will undoubtedly do long-term harm to their portfolios because they are not smart enough to know the proper time to get back in and might consequently miss some big up days.

Big Wall Street companies have been so successful with their lies that they have even been able to convince regulators to approve fees and penalties to punish investors for actively managing their own accounts!

The real truth is that diversification by traditional asset allocation combined with a buy and hold philosophy is very good for Wall Street and not so good for most investors. Consider a banking example: Your local bank would love for you to put all of your money in a savings account and leave it for 30 or 40 years. Would it be good for the customers? Sure, if they could afford to get by without using that money. The compounding effect would result in a tidy sum even at a fairly low rate of return. Of course we recognize the impracticality of such a situation. Yet somehow Wall Street convinced almost everyone that is exactly the best strategy to employ with their retirement accounts.

With the current crises, it is my hope that you have adhered to our recommendation to move your assets to the sidelines many months ago. If that is the case, you can feel a little better about watching the damage to our financial system. But many of us (my wife included) are counting on pension funds over which they have no control and which are undoubtedly still fully invested in the markets and suffering horrific losses. Managers of many public pensions eagerly embraced the lies from Wall Street and their accounts are showing the damage.

So as you watch these big Wall Street firms merge, reorganize or even disappear, there is no need to feel saddened. For the most part, they never cared what happened to you.

F.S.