This week has provided a measure of relief from a bear market rally that was overextended. Of course it is too early to tell whether this week’s downward move will continue, but several technical indicators show that major indices are at a crossroads.

We’ve remained on the sidelines for the past three months while the market advanced, because we believe that risk of a renewed decline remains high. So far that has not occurred–perhaps because of the steps taken by the Federal Reserve and other government entities to try to stabilize the economy. But while there are some very slight glimmers of hope, such as a decline in the number of people filing for first-time jobless claims, there are also plenty of indications that the economy remains in peril.

In today’s Tech Ticker on Yahoo! Finance, Henry Blodget wrote:

“So far, the collapse of the world economy since April 2008 has actually been worse than the rate of collapse in the Great Depression. 

“The main difference between now and then is that most economists expect the world economy to recover more quickly than it did in the 1930s.

“The cause for this optimism has been that the government policy response this time around has been much more aggressive. Most major countries have cut rates and ramped up spending to unprecedented levels, which some economists believe will stop the pain.

“Of course, other economists disagree. In fact, we’re actually all now participating in a sort of lab experiment that will prove or disprove one of the major economic conclusions of the past 70 years: That the original Great Depression was not an inevitable outgrowth of the wild speculation of the 1920s but was caused by ‘policy errors’ after the collapse.

“If the 1930s was the result of policy mistakes, we should emerge from our current swoon relatively soon.  It if wasn’t, the new economic conclusion will be that there is simply no way to avoid economic catastrophes after a financial bubble the size of the one we just had.”

Blodget referenced some research by Professors Barry Eichengreen (Berkeley) and Kevin O’Rourke (Trinity) who compared the current economic downturn  with the Great Depression. You can see their charts at this link: http://www.businessinsider.com/henry-blodget-tracking-the-second-great-depression-2009-6/tracking-the-depressions-world-output-1

As indicated above, we do not know the direction the market will take in the next few weeks, but based on research like this and on our own analysis, we still believe caution is warranted when putting retirement assets at risk.

The chart below shows the price movement of the S&P 500 Index over the past six months. Right now, the index is nearly even for 2009. The gold line on the top portion of the chart is a simple 50-day moving average of the index. You can see that the index is resting almost on that line. Although I have not included it on this chart, the index is also right at its 200-day moving average. If the index bounces off of this level that would be a positive sign for additional upward momentum. If it breaks below this level, we could see it move quite a bit lower in coming weeks.

The next section of the chart shows a moving average convergence divergence (MACD). It is showing that the index has been trending at an overbought level for nearly three months. Under normal conditions, this indicator would be signaling that a downturn is imminent.

The next section below is a relative strength index. It has been trending above 50 for several weeks. This week it dipped back below the 50 level. Usually a drop below 50 is a sign that momentum is failing and additional weakness can be expected.

Finally, the bottom portion of the chart shows a stochastic oscillator. This tool is used to measure random cycles. It is currently negative and is forecasting additional downside weakness for the S&P 500. However, it is approaching an oversold extreme meaning the index could also rebound in a fairly short time.

The upshot of all this is that the technical indicators are reflecting mostly negative market conditions, but they are not definitive. For now, we must continue to err on the side of caution.

I will be out of town next week visiting family in Texas. As a result, there will not be an update until the following week on July 2.
F.S.

The current recession and its accompanying bear market have many investors looking for alternatives to investing in stocks. Often these investors turn to bonds, mistakenly believing that bonds are low-risk investments. While some bonds can be safer than some stocks, they are far from being a risk-free alternative. There are many types of bonds available to investors. Today I am only going to talk about long-term U.S. government bonds, because they are generally considered to have a very low risk level.

The government issues these bonds to generate money to pay its expenditures. In essence, the person who purchases the bond is loaning money to the government. In return, the government agrees to pay interest to that investor over the life of the bond. For example, if a $10,000 bond has a maturity of 20 years and a yield of 3.5%, the government agrees to pay the investor the yield each year for 20 years. At the end of 20 years the bond matures and the government pays back the original $10,000 investment. In other words, over the course of 20 years, the investor would receive about $7,000 in interest payments and then receive full return of the original principal.

These bonds are viewed as low risk because in the past, the U.S. government has always paid its obligations. Technically, the government can never default on its debts because it has the ability to print money to pay its bills. But there are risks other than default that investors must consider when investing in long-term Treasury bonds.

Liquidity risk–These bonds require a long-term obligation.  Maturities are generally 10, 20 or 30 years. During that period, the investor only has access to the annual yield–not to the original principal. If circumstances compel an investor to sell the bond before it matures, there is a secondary market of investors willing to purchase that bond. Sometimes it trades at a premium and sometimes at a discount. Right now long-term Treasury bonds are selling at a significant discount. That means instead of receiving the original $10,000 back, an investor forced to sell today might only receive $7,000.

Inflation risk–Here is how Dr. Jeremy Siegel, currently the Russell E. Palmer Professor of Finance at the Wharton School of the University of Pennsylvania, explains inflation risk: “Although under a fiat money standard government money must be accepted as a means of payment, there is no law that says what that money is worth when it is paid. If too many dollars are issued relative to demand, inflation must result. In that case the bondholder gets shortchanged not because of a government default on its bonds but because of the loss of purchasing power of the dollars paid.”

In more simple terms, if an investor is receiving a 3.5% annual yield on a long-term bond, but inflation is running at 7% annualized rate, the investor is effectively losing money each year because the amount of goods and services he can buy with that money is declining. The same is true of the $10,000 in original principal that he cannot access during the life of the bond.

While the rate of inflation in the United States is currently quite low, some experts believe that rising inflation is inevitable in the near future because of the huge amounts of money the government is creating in an attempt to end the recession. In a recent issue of the Financial Times, Niall Ferguson wrote: “the price of key commodities has surged since February. Monetary expansion in the U.S., where M2 is growing at an annual rate of 9 percent, well above its post-1960 average, seems likely to lead to inflation if not this year, then next.” Ferguson is a professor at Harvard who specializes in economic history.

Allowing hyperinflation for a brief time is a tempting method for a government to quickly free itself from financial obligations. The government simply prints as much money as it needs to pay all its debts and then everything starts over from scratch. It is kind of like a reset button for a financial system. There are many who believe the U.S. would never allow such a situation. I personally have seen that occur on several occasions in several different countries. So to think that it could never happen here might be naive.

Opportunity risk–The long-term obligation of government bonds means the principal is not available if an investor comes across a better investment opportunity during the life of the bond. For example, over the past three months the Nasdaq has risen more than 40%. An investor with long-term bond commitments would be unable to take advantage of short or even long-term moves in the stock market. One of the reasons these bonds frequently trade at steep discounts is because it is difficult to predict what the economic circumstance might be 15 or 20 years from now. Few investors are able to commit their assets for such an extended period because of the uncertainty of things like health care concerns, employment, deaths of family members, etc.

Market risk–Many investors choose mutual funds or exchange-traded funds (ETFs) that invest in long-term Treasury bonds. This avoids the long-term commitment of actually owning government bonds. Other investors have only small amounts of available capital and cannot buy actual Treasury bonds. Unfortunately, the daily value of these funds fluctuates like any other investment traded on the open markets and an investor is subject to the same risks. Some investors think that the volatility of a bond fund will be less than that of a fund that invests in stocks. Often that is not the case.

The chart below shows the daily price movement of iShares Lehman 20+ Yr Treasury Bond Index Fund (TLT) over the past two years. The gold line is the price movement of the S&P 500 Index for comparative purposes. While TLT has significantly better performance over this period, it has experienced similar volatility. And since the beginning of 2009, investors holding this fund have seen a decline of almost 40%. So even though this fund invests in long-term Treasury bonds, it would not be accurate to describe it as a low-risk investment vehicle.

Other risks– In addition to the risks described above, there can be many other risks specific to the circumstances of an individual investor. For example, an investor who hopes to pass his estate to his heirs upon death needs to carefully consider the implications of owning long-term bonds in that situation. Because these bonds are long-term obligations, tax laws might change significantly between the time the bond is purchased and the investor’s death. Knowing the exact long-term tax ramifications might not even be possible at the time the original investment is made.

In conclusion, while bonds can be a viable investment option, their suitability for an individual investor must still be carefully considered. And no investor should make the mistake of believing that bonds are a risk-free or even a lower-risk alternative than all stocks.
F.S.

Most investors are aware that since bottoming in March 2009, the financial markets have staged a strong rally. One sector at the forefront of that surge is energy. Like stocks in general, most of the rise in energy can be attributed to a hope or an expectation of an improving economy. Official reports, however, indicate that stockpiles of oil, gas and other liquid energy resources are more than sufficient to meet current demands.

The overview and consumption information below is taken directly from the U.S. Energy Information Association web site. http://www.eia.doe.gov/

“Overview.  EIA is currently projecting a weaker global oil market for 2009 than anticipated in last month’s assessment.  Expectations of global economic recovery and a resultant increase in demand were offset by initial data for the first quarter showing high oil inventories, weak consumption, and higher-than-expected production.  Price increases will likely be muted by the substantial surplus production capacity held by members of the Organization of the Petroleum Exporting Countries (OPEC), along with very high level of inventories among members of the Organization for Economic Cooperation and Development (OECD).  The expectation that prices should rise in 2009-2010 because of future economic growth will need to be tempered with the current market reality of this supply overhang.  The main downside risk to this Outlook’s oil price forecast remains a prolonged global economic slump, as well as the possibility of reduced compliance with OPEC production targets in the months ahead.

“Consumption. World oil consumption remains weak because of the global economic downturn.  Based on revised data and a re-estimation of the impact of the economic slowdown on oil consumption, EIA has reduced its forecast for world oil consumption from the fourth quarter of 2008 through the end of the forecast period. World oil consumption is now projected to fall by 1.8 million barrels per day (bbl/d) in 2009, a decline that is 0.4 million bbl/d larger than the decline projected in last month’s Outlook.  The forecasts for Asia and the Former Soviet Union (FSU) show the largest revisions.  In total, OECD oil consumption is expected to fall by nearly 2 million bbl/d in 2009, with oil consumption in Japan alone expected to fall by over 0.5 million bbl/d in 2009.  Partially offsetting declining OECD oil consumption is a growth of 0.2 million bbl/d in non-OECD consumption, particularly in the Middle East, China, and India.”

In other words, based on global supply and demand, there seems to be no real reason for the recent increase in oil prices or for continued increases in the near future.

Below is a chart showing the daily price movements of United States Oil Fund (USO) an exchanged-traded fund (ETF) that tracks U.S. oil prices. The gold line on the chart is the S&P 500, included for comparison. Notice that during a period when the S&P 500 has been especially volatile, the price of oil has been dramatically more so.

The middle portion of the chart shows the trading volume of USO. As the price of oil plunged, look how daily trading volume spiked, peaking in February. Although the volume has declined since then, as the price of oil has risen over the past three months, trading volume is still two to three times as high as during the latter part of 2007 and early 2008. The only real explanation for this increase is speculation by traders who are hoping for even higher prices if the economy rebounds.

The sharp spike in oil prices a year ago no doubt helped deepen the recession. Much of that rise was the result of speculation as traders anticipated growing demand from developing nations like China. As prices reached record highs, global demand waned and excess inventory piled up. As the chart shows, the resulting price decline was dramatic and provided welcome relief for consumers.

High energy prices create a tremendous drag on the economy. Energy costs are built into industry and service at every level and higher prices are generally quickly passed on to consumers, creating rising inflation. Rising oil prices could dampen or stall an economic recovery.

The bottom two sections of the chart provide a technical picture showing that oil prices can continue rising. The moving average convergence divergence (MACD) reflects that while oil prices are nearing an overbought level, there is still quite a bit of room before that overbought status would be considered extreme. Similarly, the relative strength index (RSI) is also at a high level, but based on price behavior over the past couple of year, tshe RSI can maintain this momentum for extended periods.

For decades, the oil market has been heavily manipulated. Obviously, oil producing nations want the price to remain high. But in recent years, many of those nations have gone on spending sprees in anticipation of high oil prices. Now they find themselves in a situation similar to that of American homeowners who borrowed all the equity from their homes and today realize they owe more than the home is worth. Those nations need oil prices to rise above current levels in order to meet their debt obligations.

It would not be surprising to see oil prices rise from these levels, even though supplies are plentiful and demand is weak. That creates a situation where volatility can be very high–something for which the energy sector already has a reputation. Investors who want to dabble in this sector should do so with full understanding that risk levels are always high and suitable only for the most aggressive investors who are risking money they can afford to lose.
F.S.