A Distilled Markets and Macroeconomic Letter: January 2007
Stocks - Short Term - Negative Outlook but Positive Mode
The market is still in a positive mode. I believe that caution is strongly warranted. The VIX (the “fear gauge”) is at 10.95 (12/28/06), which is very low and can be a contrary indicator. There seems to be little fear in the markets. On a valuation basis, I believe that the market is expensive. The housing downturn may weigh heavily on stocks.
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 are up a bit but the yield curve is still inverted. In the short run bonds may rise in price with a slowing economy but the longer-term bonds (5 year and longer) may eventually fall significantly.
Gold and gold stocks have been rising from early October. It will be interesting to see if gold will break above a key resistance level that it is near.
Oil - Probably Stays High
Oil has popped back up above $60. Middle East risk has been increasing recently, in case you missed it. More war(s) could raise the oil price even if we have a slowdown or recession. Oil could also fall significantly with an economic slowdown.
Housing continues to slow and new car sales are still off. Consumers are loaded with debt. Christmas spending by consumers was flat on an inflation adjusted basis. Is the consumer starting to significantly slow their spending?
The Dollar has pulled back a bit and has stayed above the key index level of 80 (stockcharts.com ticker: $USD). I feel that dollar based assets may be at risk in the medium to long-term.
Fed funds rate is at 5.25%. The Fed has continued to make comments that they are concerned about inflation. The risk is that the economy is slowing much faster than the major media pundits would have you believe.
Priced to Perfection
Once again, it seems that the market is priced to perfection. Markets can run in one direction a lot longer than many expect and the current market has done just that. So how long will it last? That’s hard to say, but as the market continues to move higher the risk to the downside only increases. Has the risk of international and domestic terrorism gone away? Is there now less risk of a wider Middle East conflict? Is housing now rebounding as recent news stories would lead many to believe? Could the current wave credit/debt for mergers and acquisitions be a bubble? Have you tried to take these risks into account in your portfolio?
Some Articles that Show Potential Risks
Eric Janszen has just released his Recession 2007 Part IV: The Year Ahead, which examines several large risks to the markets and the economy.
Mark Hulbert wrote an article in the New York Times that correlates high merger activity with market tops($).
The Big Picture reports that goods moved via trucks, measured in tons, is down significantly.
Nouriel Roubini’s blog takes an interesting look at current data points for housing and manufacturing (Dec. 27th and 28th blog entries).
This via John Mauldin: “Gary North has a good definition of being rich. You are rich when you have enough assets to live off the income (return) from the principal in the style you want to be accustomed to, taking into account inflation.”
Earn near-market, market, or better than market returns over your investment time horizon with less volatility and while avoiding large losses. Hopefully this will not be harder over the next 30 years than it was over the last.
Best wishes for a good 2007!
The Dow is near record highs. The Transports are still not confirming, which is not good for those betting that stocks are in a new bull market. I suggest reading Richard Russell’s excellent articles on this topic. Earnings are at record highs by about 100%. If earnings were at the historic median level, the market would then be judged to be very expensive. Most commentators are ignoring this. Take a look at John Hussman’s work.
The yield curve is still 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 a coming recession.
Gold has now been moving higher and may be close to breaching key technical levels on the upside. If gold now moves lower, I will be concerned that it is pricing in a recession.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 had a mild bounce up. Long-term I’m still negative on the Dollar. The real story is the Dollar against gold, where the Dollar has lost a huge amount of value and may lose much more.
Oil is at $60.40 (12/28/06). The risk is that oil stays high. If oil prices move downward substantially, they may be pricing in a recession. Much has been written about how the world is currently experiencing peak oil production. If we have a recession, especially a global recession, we might not have to worry about peak oil for a while. When the economy recovers from such a recession, oil prices could go much higher.
Will new sources of oil come firmly online in the interim?
The Fed is in pause mode and it seems that they will stay in pause mode for a while. If housing and the economy slow enough the Fed should start cutting rates again. Richard Russell thinks that there is risk that the Fed will not cut even in the face of a recession in order to support the Dollar.
I feel that the housing picture could become much worse.
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 along with well researched asset allocation strategies.
If you have specific questions on where I see things, or would like to discuss your portfolio, please feel free to contact me. Eric Hodges
Stahlschmidt Financial Group
925 906 4600
500 Ygnacio Valley Road
Walnut Creek CA 94596
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