A Distilled Markets and Macroeconomic Letter: September 2006
Stocks - Short Term - Negative Outlook
With the recent run up, the market is in a positive mode. I believe that caution is strongly warranted. The VIX (the “fear gauge”) is at 12.19 (8/22/06), which is very low and can be a contrary indicator. There seems to be little fear in the markets.
Stocks - Medium Term - Negative Outlook
I believe that the risk is the market averages may have quite low returns for some time or potentially flat/negative returns when inflation is taken into account.
Bonds - Inverted yields pointing towards recession?
Yields continue to be inverted. Bill Gross, of Pimco, says that bonds will go higher in price. I feel that there is a fair amount of risk that this may not happen and a longer duration bond portfolio might suffer.
Gold - Consolidating?
Gold is looking good on the charts recently but it’s nearing a point where the direction should become more clear. I believe that gold is pricing in the risk that there will be too much money in the financial system in the future, which might greatly 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. This means that we may be starting to run out of oil just as China and India are greatly increasing the demand for oil.
Fed funds rate is at 5.25%. The Fed paused at the last meeting. I feel that the market has over reacted to this pause. Just today (8/22/06), Fed leaders made statements that they may need to raise rates further.
Consumers seem to be in a lot of debt and not saving. In my opinion 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 and will end badly. In some areas, housing seems to be in meltdown mode.
The Dollar is still holding up. I feel that dollar based assets are at risk.
Will the Middle East truce survive? I’m skeptical. Iran seems to be running the show and just today they chose to not suspend uranium enrichment. So the U.S. will do what next? Sanctions? What if Iran decides to put less oil on the international market?
Interest Rates vs a Slowing Economy
Reuters reported that Michael Moskow, from the Fed, said “The risk of inflation remaining too high is greater than the risk of growth being too low.” In other words, they may need to raise rates again. A slowing economy and higher rates might cause real pain in the stock and bond markets as well as housing.
Roubini’s Contrarian Recession/Market Call
Nouriel Roubini has written several posts to his blog calling for a recession in early 2007. You can read him at his excellent site: http://www.rgemonitor.com/blog/roubini/. I feel that his reasoning is very well thought out and it is a good complement to the content at iTulip.com. Additionally, I wanted to mention him in light of a recent interview he had on CNBC. After Roubini gave his negative views on the market/economy, the host of the program said “I guess this is probably a buying opportunity!” I would say that the average investor watching the show would probably just disregard everything that Roubini had just said.
Ok, on to Roubini’s main points: consumer confidence is down sharply, housing is in a strong downturn, demand for loans is sharply slowing, car sales are falling and business indicators are signaling weakness. Additional points from Roubini: the economy will have a hard landing, the Fed will cut rates but 10 year and 30 year Treasury bonds may not rise in price, there is significant risk of the dollar falling a large amount, and the global economy/markets will not do well when the U.S. goes through the above. In other words, your international investments might be at a significant risk in Roubini’s scenario. I tend to agree.
A great compliment to the Roubini work is the article on iTulip.com by Aaron Krowne: “What (Really) Happened in 1995?” Aaron convincingly notes that the Fed, in 1995, reduced bank reserve requirements to ~0%, which injected a huge amount of money into our economy and created the Nasdaq bubble. This money then trickled over to the housing bubble. This may, along with other factors, create the eventual strong inflation that I, and many others, are concerned about. These low reserve requirements are still in place today.
The market has rallied higher and I don’t trust it. The Dow needs to go above 11,722 for things to get interesting and the Dow Transports would need to go to a new high as well. Go to www.dowtheoryletters.com for details by Richard Russell. I read him every day.
The yield curve is inverted. Or, in other words, short duration bonds are higher in price when compared to longer duration bonds. This inversion along with other indicators point to a higher likelihood of recession.
Not that much action in the bonds as of late, except that the curve is a little more negative than before. I feel that, near term, medium duration bonds may perform well. The risk here is that with any slowdown or recession the Fed will probably be aggressive in cutting rates, which may lead to a sustained inflationary trend and lower bond prices.
Gold has been off again as of late but is holding above $600. It could move to the mid $500 range and still be in a positive mode.
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.
Dollar | Currencies
The Dollar has not moved too much in the last few weeks. Long term I’m 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 at $72.83 (8/22/06). The risk is that oil stays high. Much is being written about how the world is currently experiencing peak oil production.
There is continued instability in the Middle East. Do you think the Iraq situation is getting better? I don’t. Iran is becoming a huge 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 and/or demand eases because of a global economic slowdown.
As stated above, the Fed may feel the need to raise rates again. Roubini thinks that the worsening housing picture will force the Fed to cut rates this fall. I feel that the Fed may raise and then start cutting rates soon after. Take away: Inflation may be enough of a problem to hurt the value of your home and your stock market investments.
A report today (8/2306), from the New York Times, says that home prices are now only rising in the South and all others areas are falling, on average, by a small amount. The market did not expect this, but I’m not surprised at all and feel that this trend will accelerate.
Barron’s reported (8/21/06) some interesting statistics on housing: 10% of all home owners with mortgages have no equity in their homes and $2.7 trillion dollars in loans will adjust to higher rates in 2006 and 2007.
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.
My concept is to bring you a the most transparent look possible on the economy/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 constructing portfolios, I take the client situation into consideration first and then combine that with the current economic/market factors presented in this letter.
If you have specific questions on where I see things, or would like to discuss your portfolio, please feel free to contact me.
Stahlschmidt Financial Group
925 906 4600
500 Ygnacio Valley Road
Walnut Creek CA 94596
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