A Distilled Markets and Macroeconomic Letter: July 2006
Stocks - Short Term - Negative Outlook
After the broad sell off, the market seems week and the Nasdaq is below a key technical level (thatí s not good). I believe that there may be significant risk for U.S. and global stocks because of a continued high level of valuations. The VIX is at 14.02 (7/10/06).
Stocks - Medium Term - Negative Outlook
I believe that the risk is the market may have quite low returns for some time or potentially flat/negative returns when inflation is taken into account.
Bonds - I prefer to be in short duration (6 month)
Yields continue to be slightly inverted. I feel that the risk is on the side of higher rates and lower bond prices longer term, but in the near term I feel that bonds will rise in price if stocks continue their fall.
Gold - Leveling Out?
Gold seems to be stabilizing. I believe that gold is pricing in the risk that there is too much printed money in the financial system, which could increase inflation.
Oil - Oil stays high unless we see a global recession
Oil has stayed high and I believe that it will continue to do so unless we have a recession. Various risks to supply continue to cause concern. The world may be at the beginning of Peak Oil Production.
Fed funds rate is at 5.25%. The Fed tends to overshoot as they raise rates. John Mauldin feels that we will see another boost in August. I tend to agree. If the Fed pauses donít look for the market to outperform.
Consumers seem to be in a lot of debt and not saving. The Economy is largely running on consumer spending, which has been partially funded through the housing boom/bubble. It is my belief that this is unsustainable.
The Dollar has become a little weaker and may fall below a key level.
About two weeks ago I discovered this site. Itís excellent and Iím now reading it every week.
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More on Volatility
Last month I wrote about the VIX index, which is also known as the ďFear GaugeĒ of the market. Today the VIX is low again at 14. I thought I should write a little more about the VIX this month as it can be a contrary indicator. If the VIX is low then investors are not fearful. Maybe they should be fearful. When the market moves down quickly the VIX should shoot up at the same time. If you wait for the VIX to go up thereís a good chance that you are too late.
Richard Russell wrote recently that the recent volatility in price action (not the VIX, but pure price movement on the stock indexes) has been the highest in 50+ years. Thatís a long time! Russell feels that the market is boiling with volatility.
Mental Errors in Investing
John Mauldin does two fantastic letters each week. The first comes out on Friday or Saturday, which he writes. The second comes out on Monday and is usually written by a guest author. On July 3rd he had a letter by James Montier, who is the head of Global Strategy at Dresdner Kleinwort, about mental errors in investing.
The crux of this letter was that even MBA educated people tend to make these mental errors not just once or twice, but over and over again. Why did they do this? Because they didnít look past the surface of the issue at hand and then compound the error by not learning from their mistake.
Yikes! Maybe this gives some insight into why the typical investor only earns mediocre returns.
Hereís the link to the article.
In my opinion, the best way to avoid these kinds of mistakes is to diversify broadly into as many asset classes as possible and to rebalance at regular intervals. This should reduce the subjective element of the process.
Itís my opinion that the U.S. market is not fairing well and the Dow/S&P 500 are on the edge of key technical level. Going below that level as the Nasdaq has already done is a negative in the eyes of chart watchers.
I agree with Richard Russell that one should watch the fundamental valuations as well as the technical indicators. The fundamentals seem quite negative. The adventurous reader is directed to the excellent itulip.com site to look at a chart from Yale economist Robert Shiller: http://www.itulip.com/StocksvsInterestRates.htm.
The yield curve is slightly negative. Or, in other words, short duration bonds are higher in price when compared to longer duration bonds. If the yield curve stays inverted for 90 days it may signal a coming recession.
Not that much action in the bonds as of late, except that the curve is a little more negative than before.
Gold has come back up a bit. Seems like itís firming up in price.
Reminder: fiat currencies are not tied to anything of tangible value. They are only worth whatever the market, and the public, feels they are worth. As more fiat money is created the value of this paper money should go down. In my opinion, the U.S. is creating too much money and so are China, Japan, and Europe.
The Dollar has weakened again but has not broken out on the downside. Long term Iím still negative on the Dollar. I do think that the Dollar has now entered a new period of at least relative weakness vs other currencies. The real story is the Dollar against gold, where the Dollar has lost a huge amount of value.
Oil is over $73 (7/10/06). The risk here is that oil stays high. Much is being written about how the world is currently experiencing peak oil production. I find it interesting that the media gets very excited each time oil moves below $70, as if it will just keep going down. Each month I laugh at the people on TV who are so surprised that oil is still high. I wonder what they will say if it pops over $100?
There is continued instability in the Middle East. Do you think the Iraq situation is getting better? I donít. Iran is still a problem as well, not to mention Nigeria and Venezuela. All of these situations help to keep oil high along with the lack of new deposits being found and high demand. Oil will probably stay high unless the situations above improve or demand eases because of a broad global economic slowdown.
There is much speculation over a potential rate increase in August or a pause in this trend. Whatís the risk? That the Fed will go too far in raising rates, housing will come down harder than many expect and that will reduce consumer spending.
The home builder stocks are taking a beating. Housing looks weak in general. Condo projects are being canceled in some areas.
When adjustable mortgages reset to the higher current interest rates some people may have trouble making the higher payments. Richard Russell has reported $1.7 trillion of mortgages to reprice over the next two years.
Consumers tend to spend less when their homes are falling in value. I think consumer spending is keeping the economy going at the moment. If housing drops enough we could see a recession and a much cheaper stock market. Of course, this could happen even if housing just slows enough from the current high pace of sales and appreciation.
I believe that consumer spending is holding the U.S. Economy together. If one is concerned about the Economy, a great indicator to look at is the condition of the consumer.
I believe that many consumers have less home equity now than before because they have taken money out of their homes and spent those funds. Consumer savings rates are very low or negative. I believe that consumers are being gradually squeezed by high oil prices on one side and rising interest rates on another. Now the market could add another front.
My concept is to bring you a the most transparent look possible at the economy and markets via a quick read with plain language. This letter is geared toward the busy executive/business owner. If you are really short on time just look at the Snapshot section where I keep everything as brief as possible. In the Detail section I try to give a little more insight into my thinking without delving so deep that I stifle the reader.
When shaping portfolios, I take the client situation into consideration first and then combine that with the current economic/market situation.
Please note that I only change wording that needs to be changed from month to month, so the frequent reader needs to scan the detail section for changes. Also, unfortunately, there is a lag between the time that I finish the letter and when I am able to send it out due to compliance issues with my broker/dealer. This lag has now reached 8 days or so. If you have specific questions on where I see things, please email me or call me if itís urgent.
Stahlschmidt Financial Group
925 906 4600
500 Ygnacio Valley Road
Walnut Creek CA 94596
Disclaimer: The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. Investing involves risks including potential loss of principal.
The price of gold is subject to substantial price fluctuations over short periods of time and may be affected by unpredictable international monetary and political policies.
Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other factors. In General the bond market is volatile, bond prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
The price of commodities is subject to substantial price fluctuations in short periods of time and may be affected by unpredictable international monetary and political policies. The market for commodities is widely unregulated and concentrated investing may lead to higher price volatility.
Data contained here is obtained from what are considered reliable sources; however, its accuracy, completeness of reliability cannot be guaranteed. Registered Representative offering securities and advisory services through FSC Securities Corporation, a registered broker-dealer member NASD, SIPC & a SEC-registered investment advisor.
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