With the stock market floundering for almost two years, there is a good chance someone advised you to consider gold as an alternative. Gold prices are near an all-time high. And there are valid arguments for holding a limited amount of gold in a diversified investment portfolio. But those who are considering gold as an option need to understand that it can be a highly volatile and risky investment choice.

There are several ways to invest in gold. They range from owning gold bullion, to gold coins, to gold mining stocks, to gold mutual funds or gold ETFs. Many investors prefer gold funds or ETFs because they offer trading convenience and easy liquidity.

The chart below shows performance of an ETF, SPDR Gold Shares, over the past year. The gold line on the top portion of the chart is a 50-day moving average of the price. Currently the fund is well above its 50-day MA, but the price appears to be rolling over instead of continuing its recent break out.

The middle portion of the chart shows trading volume and you can clearly see that trading volume has been falling off and is well below February and March peaks. Below the volume section is a moving average convergence divergence (MACD). This indicator is showing that gold has reached an overbought status and a correction of some sort is likely. The bottom section of the chart is a simple momentum indicator and it is also showing that momentum is falling and could quickly turn negative.

What all this indicates is that for an investor looking to buy gold, a better opportunity is likely to occur after what appears to be an impending correction. Merely looking at the price fluctuation of the past year one can see that gold is volatile. Even if it maintains its uptrend, it is likely to fall back to its 50-day moving average–something it has done many times over the past year.

Historically, gold has been considered as a hedge against inflation. That relationship has not proved true for many years, however. While rising inflation is a strong future possibility, for now the Federal Reserve continues to issue statements indicating that inflation is not an immediate threat.

Buying gold simply because the stock market has not performed well carries high risk–particularly for conservative and moderate investors.

So for now perhaps the best rationale for buying gold would be as a speculative investment suitable primarily for the most aggressive investors and then for only a small portion of their total portfolio.
F.S.

Looking at the financial markets over a short period is kind of like looking at a small portion of a very large painting. Sometimes that small glimpse is enough to give you a clue about how the rest of the painting looks. Other times, that small portion might not provide enough information to have any idea about what the rest of the picture holds.

In recent weeks, short-term views of the major market indices have not been sufficient to help us decipher the big picture. Today I thought it might be enlightening to take a longer view so we can look back at where we came from to help us gain a better appreciation of where we are today.

Below are charts from 1995 to present of the S&P 500, the Dow Jones Industrials Average, and the Nasdaq. On each I have added a blue line that marks the current level of the index and I have extended the line backwards to make it easier to see the ensuing progress.

Although there have been some dramatic differences in how each of these indices has behaved over the past 11 or 12 years, all three are at about the same level as they were in 1998. In other words, a buy-and- hold investor who has been in the market for that entire period has endured a great deal of volatility for very little gain.

If an investor entered and exited the market since 1998, he could have experienced significant gains or substantial losses, depending upon the exact entry and exit dates.

If I look at these charts as an investor, my attention is immediately focused on the rally of the past six months. Looking back over the period covered by these charts, I see that in most cases, a rally of this amplitude and duration has usually been followed by a fairly substantive correction or consolidation. So while it is tempting to jump into the rising market, at these levels the long-term risk is probably greater than the possibility of short-term returns.

Tuesday, Henry Blodget wrote the following on Yahoo! Finance.

“The early 1930 rally came after the market had fallen nearly 50% in the fall of 1929. The spring rally took the market up nearly 50% again, to a level that was only about 20% below the previous peak.

“That rally, of course, was also the biggest sucker’s rally in history.  After the market peaked in April 1930, it crashed again, eventually ending up down 89% from the 1929 high and more than 80% from the 1930 high.  The market did not reach the 1930 high again for another quarter of a century.

“Our current rally came after a crash that was actually slightly more severe than the 1929 crash (53% versus 48%).  It has taken the market up more than 50% from the low.  Our current rally has also lasted slightly longer than the 1930 rally did.

“Today’s rally, of course, may actually be the start of a great new bull market, one that will climb the ‘wall of worry’ back toward the previous record highs.  On the other hand, it may yet also be another version of what happened in 1930.”

One of my biggest worries about the current rally has been the overall lack of corporate earnings and Wall Street’s apparent lack of concern. So I found this interesting quote from the April 16, 1930 New York Times:

“On the whole, Wall Street has discounted the effect of smaller earning during the first quarter of this year, it is contended, while an increase in the earning of certain companies would be decidedly encouraging in view of the slower trade this year.  The fact that several of the most important corporations have been able to show an increase in share earning in the face of these conditions has been reassuring to a large section of the financial community.”

In other words, Wall Street was willing to overlook the lack of corporate earnings because a few companies were able to buck the trend and there was anticipation that conditions for other firms would improve. To me that sound very similar to the current situation. It is just one more reason to view the current market rally with suspicion and to continue to follow a risk averse investment approach.
F.S.

Wednesday the Federal Reserve released its latest “beige book,” a report on economic conditions from the 12 Federal Reserve Districts. There was muted reaction from the financial markets, even though the report stated that “most Districts noted that the outlook for economic activity among their business contacts remained cautiously positive.”

Perhaps the lack of enthusiasm from traders and investors was because even though Fed officials are cautiously optimistic that the economy is stabilizing, there are still plenty of signs of weakness. One of the biggest negatives was the uptick in unemployment last week to 9.7%. Of course the real number could be as much as double that level when the long-term unemployed and those who have taken part-time jobs are included.

Many investors were caught off guard by the strength and duration of this rally that began in March. Normally bear market rallies last about six to 10 weeks and stocks rise 15% to 30% before the downtrend resumes. But never before has a bear market been treated with the kind of economic stimulus that we have seen this time.

Traditionally, September is one of the weakest periods for the financial markets. That is also undoubtedly on the minds of many traders who are worried that this rally might be near the end of its run.

The chart below shows that the S&P 500 remains in an uptrend, but momentum appears to be failing.

The middle portion of the chart is a moving average convergence divergence (MACD). It has spent most of the past six months at overbought levels. Normally that would indicate that a downturn is overdue. The bottom portion of the chart is a relative strength index. Although it remains above the 50 mark, notice that is seems to be losing strength in recent weeks, another indication that a downturn could be on the horizon.

I’m sounding like a broken record, but at this time there is still too much risk in these markets to jump in with both feet. For now the best course of action is to keep most of our assets on the sidelines until there is a clearer indication about which direction the markets and the economy are headed.

F.S.

I have several acquaintances who are in the financial industry. Most are friendly, honest and sincere. I would trust them to take care of my children anytime. However, I would not allow them to manage my investment assets. That’s because they have been trained in the culture of Modern Portfolio Theory (MPT). In other words, they believe that diversification alone is sufficient protection from market risk.

The combination of market downturns that began in 2001 and in 2007 finally prompted many economists and financial experts to admit that MPT does not work. In past commentaries, we have highlighted numerous quotes and comments from such people. http://www.marketowl.com/2009/03/26/proponents-of-buy-and-hold-are-disappearing-fast/ In spite of agreement among these experts that MPT is flawed, most of the local financial professionals I know stubbornly cling to the idea that asset allocation and buy-and-hold investing is valid. I suspect that is because they do not have any other method to offer.

Unfortunately, by sticking to methods that don’t work, they are risking the financial futures of their clients. It’s kind of like a local physician 150 years ago who continues to bleed his patients in an attempt to cure them because he doesn’t understand recent discoveries linking illnesses to viruses and bacteria.

Given the volatility and performance history of the financial markets over the past decade, there are some important questions that investors who use the services of a professional advisor should consider. These are especially critical for investors who are nearing or at retirement age.

1. If you use the services of a financial advisors, does that person provide competent advice and service?
2. Has he or she explained how your investment assets are protected against market risk?
3. Do you think something or anything could have been done to protect your assets from losses that might have occurred?
4. If you thought there might be another 40% market downturn sometime in the next four or five years, do you trust your advisor to protect your investments from possible double-digit losses?

The recent stock market rally has caused many investors (and advisors) to breathe a sigh of relief and to believe that stocks are making another long-term bull market run. And while I do not profess to be able to predict what the market will do, it seems prudent to assume that there could be significant market corrections still to come. It might be several years before we see another major decline or it could occur next month.

The important question investors must answer is whether they have a plan for effectively dealing with the next major downturn, whenever that might be. And investors who are paying a financial professional to manage their portfolios need to ask their advisors about their plans for dealing with market risk.

As the chart above shows, in the past decade there have already been two powerful bear markets. Major indices are currently at about the same levels as they were 11 years ago.

Given the current economic situation, it seems likely that major swings in the market are likely to continue into the future. All investors, but especially those who are near or at retirement age, need to carefully consider how they can protect their investment assets from future market downturns.

F.S.