Market conditions have changed very little in the past week. Major indices remain overbought and overdue for a correction. Our assessment remains that the economy is very weak and market risk is at a high level.

There was an interesting article this week from The Wall Street Journal Online that referred to missing millionaires. Apparently, the state of Maryland decided to fix a budget shortfall by imposing a higher income tax on residents earning more than $1 million. There was plenty of support for the plan. After all, if anyone can afford to pay higher taxes it is those folks that most of us consider uber wealthy.

According to the report, by the end of April in 2008 approximately 3,000 Maryland residents filed tax returns showing more than $1 million in income. In 2009, that number dropped to about 2,000. Instead of the tax windfall legislators anticipated, the millionaires paid $100 million less in taxes in 2009 than in 2008, even with the higher tax rate.

This example raises important issues that need consideration during the current economic recession. First is the idea that somehow wealthy people are immune from the damage of a recession. In fact, that  group generally suffers right along with everyone else. It should not surprise Maryland legislators that there are significantly fewer millionaires than a year ago. Just like ordinary people have seen the value of their investments decline in 401K or other accounts, so have those that are considered most wealthy.

Millionaires in Maryland represented just 0.3% of the populace in 2008. Under the best circumstances that is too small a group to compensate for the economic challenges of the remaining 99.7%.

The problem on a national as well as regional basis is one of wealth creation rather than a simple redistribution of existing wealth. There currently is simply is not enough money to satisfy all of the wants and demands. After eliminating unnecessary expenses,  we must support economic growth, which will foster the creation of new sources of wealth.

This global recession impacts everyone. We all need to work together to make it as short and painless as possible.
F.S.

Www.chartoftheday.com is a free service that emails subscribers a daily chart covering some aspect of the financial markets. About a week ago, the daily chart showed the decline in earnings per share of the S&P 500 Index. What that chart shows is so significant it should probably be labeled as the chart of the century, rather than just the chart of the day.

Below is the chart to which I refer.

As the notation on the chart explains, in the past 20 months, earnings per share for the S&P 500 have declined by more than 90%–something that has never occurred before. As you can see, the chart goes back to 1935 during the midst of the Great Depression. At no time has there been another drop even close to the magnitude of the current event.

A few analysts and economists are now saying that the recession is over or that the worst part of this economic crisis has passed. This chart alone would seem to provide evidence that the worst might be just beginning. It will be difficult if not impossible for the stock market or the economy to sustain an advance if the companies that make up the S&P 500 have no significant earnings.

What can we reasonably expect in the coming months if there is a recovery? I’m not certain. But based on this chart, a move back to $21 per share–about the level experienced when I was born in 1957–would represent three times the current earnings level. Again based on this chart, similar moves occurred after World War II, in the 1990s, and from 2003-2008.

Another interesting bit of information that came to my attention this week was an article from Bloomberg.com about insider selling. According to the report, in the first three weeks of April, executives at NYSE-listed companies sold $8.32 worth of stock for every $1 of stock they purchased. That is the fastest rate of selling since October 2007, the peak prior to the start of the bear market that wiped out about half of the market value of U.S. companies.

On Wall Street, these insiders are often referred to as “smart money.” That is a reference to the fact that because of their positions they have access to information that ordinary investors do not. The implication of this recent insider selling is that perhaps they know something we don’t and if they believe this is a good time to head for the exits, perhaps we should be following.

According to the same article, the rally that began in mid-March is the steepest since the 1930s. So perhaps the insiders merely recognize that such a sharp advance is highly unusual and represents a good opportunity to cash in before a retracement.

For weeks we have maintained that market risk has risen right along with stock prices and is now at an unusually overbought level. Last week and this week we have seen some evidence that the current advance might be faltering. June tends to be one of the weakest months of the year for stocks, so we will soon know if this year will follow that pattern.

We hope you all have an enjoyable Memorial Day holiday.
F.S.

When making recommendations a financial advisor has much to consider. At the top of the list in virtually every situation is risk. The financial news media does not devote much time or effort to talking about risk. Their coverage is biased toward performance and to specific items that might be driving the market action of any given day.

Wise advisors worry about risk because they understand that portfolio losses are very difficult to recoup. And for investors who are near retirement or already retired, it might be impossible to completely recover from major losses. So while investors might become distracted by greed and focus their attention on potential profits, the advisor’s task is to first and foremost prevent losses.

Over the past eight weeks the markets have rallied strongly and there are a few analysts and economists saying that the recession is over. While we certainly all would like the economy to recover as quickly as possible, other technical and fundamental indicators are showing that market risk remains at a high level.

There are still plenty of analysts who warn that the bad days are not over. For example, Niels C. Jensen, of Absolute Return Partners in London, this week wrote: “The dangerous conclusion to draw from the experience of the past few weeks is that all is now well and dandy and it is time to load up on stocks again. I cannot emphasize it strongly enough: The bull market of March-April 2009 is almost certainly a bear market rally …”

David Rosenberg, Merrill Lynch’s chief North American economist, resigned last week. Upon his departure, he said that the bear market rally was over and he expects to see the markets correct.

The chart below includes a couple different indicators that help us determine the market’s likely direction and its risk level. I used the S&P 500 because it is currently performing better than the Dow Jones Industrials Average but not as good as the Nasdaq. The middle portion is a moving average convergence divergence (MACD). This tool is quite accurate at identifying market turning points. Right now it is showing that the S&P 500 index is very overbought and that a change in direction is almost certain.

Over the two-year period covered by this chart, the MACD has not previously reached the current high level. On two occasions when it came close to this level, significant corrections occurred. This indicator is showing that there is currently a high probability that a significant downturn is imminent.

If this were a typical retracement in a bull market, the most logical level of support for the index would be near 800–about 11% below the current level. Because this is still a bear market, the index could fall farther and retest the old low below 700. Or it could even decline more and establish a new low.

Of course, there is no guarantee that there will be a major correction. Certainly the government is doing all it can to bolster the markets at these levels. But even during powerful bull markets we could expect to see a prolonged sideways consolidation after a steep climb like the markets have experienced during the past several weeks.

The bottom portion of the chart is a relative strength index (RSI). Normally, the RSI must trend above 50 in order for an investment to have enough momentum to sustain an advance. In the current case, the RSI for this index has been above 50 since mid-March. But it is now falling and could drop below the 50 level. While it is certainly possible for the index to renew its advance and for the RSI to begin climbing again, right now the falling RSI is another indicator showing that market risk is currently increasing.

There are also many fundamental factors that continue to show the economy is in turmoil. Jobless claims rose again this week and the national unemployment level is approaching 9%. A report earlier in the week showed continued erosion in the value of homes. Retail sales numbers have fallen. The latest Producer Price Index showed a surge in food prices in April. And for two consecutive quarters, Gross Domestic Product (GDP) has declined by more than 6%.

We are all hoping for a quick end to this recession and we want to see a strong and healthy stock market. But based on the evidence available right now, the risk that the market will turn back down remains unacceptably high.
F.S.

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As you read this, I should be fishing. It is difficult to explain the market’s behavior over the past week or two. So rather than try, it is time for some relaxation. Actually, this is a trip I’ve had planned for quite a while. Check back again next week for an update on current economic conditions.

F.S.