This week’s report is a day late and shorter than normal for a fairly good reason. Saturday I was hiking with my wife near Lake Mead in Nevada. I fell and broke my ankle coming down a treacherous slope covered with loose rocks and gravel.

I am fortunate because the injury could have been much more serious. Over the next several weeks my condition will be annoying and painful, but not critical.

Current market conditions are similar. Once again we’ve had a week of market activity that has been frustrating, but not critically damaging. Although major indices are still below their earlier levels, they appear to be setting a pattern of higher lows—a positive technical sign.

Perhaps the biggest wild card with the most potential to derail the markets now is the situation in Iran. Declining home values, falling GDP, and rising inflation can all cause problems for U.S. stocks. But if Britain takes military action against Iran to free its hostage sailors we could expect to see the world financial markets unravel in a hurry. It would be very easy for such a situation to escalate into all out war in which the U.S. would also become involved.

The price of oil has been rising and heightened tensions in the Middle East would send those prices skyrocketing again.

So keep your fingers crossed and hope that this situation can be resolved diplomatically.

Have a great weekend.

F.S.

For several weeks I’ve been looking to buy a horse. Yesterday I found one that was spectacular. It was a big, dark colored foxtrotter mare. She had a long mane and tail and would have looked right at home at a jousting tournament with an armored knight on her back. She’s had lots of training and work and responded to the slightest cue. Giving her the command to “whoa” and just the slightest lift of the reins was enough to bring her to an instantaneous dead stop. The price was much lower than I expected. I really wanted that horse.

Instead, I ended up paying more for an older, smaller horse that wasn’t nearly as pretty.

I needed a horse that anyone would feel comfortable riding, from a five-year-old child to a considerably older grandma. The big foxtotter would have been great for my athletic sons or my fearless wife, but a little intimidating for someone who had never been on a horse. The horse I purchased is completely calm. With dogs, other horses and people running around her, she paid no attention and focused all her attention on her rider. She might not be as beautiful, but she also isn’t the least intimidating.

Many investment purchases are similar. The glitzy, high performance fund is not always the right one to buy. Let me give an example. One of my favorite exchange-traded funds (ETFs) is iShares Latin America (ILF). It is the black line on the chart below.

Notice that over the past three years, this fund has gained more than 190%!. I’m sure we all wish we had that kind of gain over that period. In spite of that great return, I would not advise my retired parents to invest in this fund because it has a high level of volatility. Thos big gains are accompanied by some fairly significant downturns. For example, an investor who bought this fund in May 2006 would have seen his account decline by about 25% in the following month.

The blue line is another fund I like called Fairholme Fund (FAIRX). In contrast, this fund has gained just 46% over the same period. That’s still a great annualized return, but the volatility is much less. This is a fund that I have advised my parents to purchase. The gold line is the Nasdaq and it is included just for comparison. Notice that FAIRX has outperformed the Nasdaq over the past three years with lower volatility.

Now let’s get back to the horse analogy. If I’ve got a dozen older, calm horses in the barn that anyone can ride without fear, then perhaps I can take a chance and buy the spirited, spectacular foxtrotter. If I’ve only got room for two horses and the people that ride them most are a couple of elderly ladies with osteoporosis then I have no business owning that type of horse. Under the right conditions I would not hesitate to buy ILF for my own portfolio. But I would not put the majority of my assets in that fund.

This week the major indices continue to move mostly sideways. We’ve had about five weeks of instability so far. I expect we could see another week or two of uncertainty before stocks stage a breakout.

There is still a lot of overall weakness in the market as traders and investors wait for a move. So far this year basic materials, realty and international funds continue to be among the top sectors. Dow Jones U.S. Basic Materials Index Fund (IYM) is up 6.99%. iShares Cohen & Steers Realty Major Index Fund (ICF) is up 6.68%. The strongest international  funds are in the Far East with Malasia up 10.8%, Japan up 4.96%, and Singapore up 4.46%.

These numbers and sectors are generally indicative of a market that is in transition. During a bull market advance returns would be much higher and we would see virtually all sectors participating. I still believe that when a breakout occurs, we will see stocks advance rather than decline. But for now, we need to watch carefully and be prepared to take defensive actions if needed.
F.S.

The stock market continues to provide investors with plenty of volatility. For most investors, the past few weeks have been emotionally unsettling if not downright scary. Under these types of conditions, some investors start to look for profit opportunities that are more secure than the financial markets. Unfortunately, in an attempt to find good returns with less volatility some investors become victims of fraudulent investment schemes.

Variations of most of these schemes have exited for decades, but many have gained new life with the growth of technology and the internet. To help you recognize some of these schemes, here are a few that the Utah Department of Commerce have projected will be prominent in 2007.

Real Estate Investments. While real estate is generally considered a safe investment, there are plenty of deceptive practices. Specifically, the department warns consumers against scams that use your credit score to borrow money for real estate development or “flipping.”  Other schemes include lending money that will be used to finance high interest home loans that promise interest returns of 2% to 4% a month.

Free Meal Seminars for Seniors. These types of invitations are quite common in the financial industry. And while many are legitimate, the department warns that many of the promoters claim to be certified experts. In reality, “the certifications mean nothing more than the person has been trained on what sales pitches are most effective with seniors.”

Prime Banks. These schemes claim that money can deposited in special prime banks that finance transactions around the world. In one case a promoter claimed he had been appointed as a mediator by the International Monetary Fund. Investors were promised profits of more than 100% per week and that there was zero risk because the money always remained in their account at the prime bank. In reality, prime banks do not exist.

Hot Penny Stock E-mails. These try to convince investors of the urgency of buying a specific stock. Usually they will indicate that while the current price of the stock is less than $1 a share, the projected target is $3 to $5 and the price is expected to explode at any time. This is just a new version of the old pump and dump type scam.

Foreign Currency Trading. This type of trading is notoriously risky and dominated by large banks and professional traders. Promoters create the illusion of success by having an office with multiple computer screens tracking financial markets and by creating fictitious account statements showing huge returns. In cases the department prosecuted in 2006 the promoters all claimed special expertise but really used some or all of the investor money for personal expenses. The promoters are usually not licensed in securities.

Oil and Gas Investments. Beware of scams where you are invited to become an investor in a new oil well or a newly discovered oil reserve. Also expected are scams that promote new technology for extracting oil from tar sands or shale. Before making any investments in this highly technical arena, Investors should make certain the securities are state or federally registered.

Promissory Notes or Guarantees. These are commonly offered in a manner that creates the appearance that they are solid or are backed by collateral. In reality, a note is just a promise to pay and provides no protection of the company or person offering the note is in a precarious financial position.

While we all wish there were secure investments that provided high returns with no risk or volatility, such products do not exist. Every week we hear stories in our office about people who have lost significant amounts of money through schemes like those described above.

Protecting yourself from such scams is really fairly simple.

• First, you should always investigate a questionable investment by calling your state securities division and asking whether or not the offering is registered. ALL securities sold in any state must be registered. That includes hedge funds, private placement offerings, penny stocks, etc.
• Second, you need to find out if the person selling the product is licensed. Again, you can find out by calling your state securities division office.
• Finally, the person trying to sell you the investment should provide a written prospectus or memorandum.

Please don’t assume you are too smart to be taken in by one of these frauds. Many of those we see who succumb are savvy, seasoned investors. The lure of easy wealth is something that appeals to the greed in all of us.

I’ve purposely avoided talking about current market conditions this week because there really isn’t anything new to say. Just continue to hold tight because this correction should be over fairly soon. Have a great spring weekend.
F.S.

Perhaps the more important question is whether this latest market correction is the start of a new bear market or is just a dip in a continuing bull market. If this is the start of a new bear market, we face many more months of downward market action and we should take advantage of the recent upticks to bail out. But if this is just a correction in a bull market, then most of the damage is probably over and selling would insure buying back in at a higher price in a few weeks.

I strongly believe that what we are experiencing is a normal bull market downturn and that we will soon see the market return to its recent highs. I’ll explain some of my reasoning later, but I can illustrate the situation better with a chart.

This shows the daily price activity of the S&P 500 over the past two years. Although it was difficult to see at the time, the market bottomed in April of 2005 and has been in a pretty good uptrend since then. I’ve marked the major downturns with red arrows. Since spring of 2005, we’ve seen only two significant corrections until this latest decline. The first was in October 2005. It was a very sharp drop, much like we’ve just experienced. But it was a “V” bottom and within a month the S&P had recouped all of its losses.

The next decline began in May 2006. Once again the initial drop was very steep. Initially it appeared that it might be over quickly, because stocks rallied after the first steep fall. But then there was another decline and the S&P 500 ended up making a double bottom. This turned out to be the most significant correction since 2002. And while it was certainly unpleasant at the time, the second bottom occurred only about nine weeks after the initial fall. Then it took only about eight weeks for the index to climb back to its prior high.

By way of further dissection, I’ve marked a couple more spots during that correction. Let’s say an investor during last summer’s correction bailed out at Point A after the index recovered some of its losses. Then that investor bought back in at Point B when the S&P 500 crossed back above its 50-day moving average (the gold line). Even with such great timing, that investor gained very little. The additional decline experienced after Point A had been erased just a month later.

The point I’m trying to make is that after years of study, research and personally watching the markets, I’m convinced that the most powerful indicator that exists is a trend. And in spite of the recent correction, I believe the longer-term uptrend of stocks remains intact. In that case, the worst part of this correction is probably over. The chance that the market reached its 2007 peak in February is pretty low. So investors who hang tight and ride out this painful blemish should soon be rewarded with higher highs.

As for the question posed by the headline for this article, investors with money on the sidelines should probably get ready to buy on any down days. It is certainly a better time to buy than it was two weeks ago!

There are many reasons to believe that the bull market trend is intact. Foremost is the fact that the U.S. economy remains strong. Unemployment remains low. Long-term interest rates are low. Inflation is low. The housing market has declined, but the nationwide collapse that many predicted seems more and more unlikely. Oil prices seem to have achieved a measure of stability.

The bottom line: hold your long positions. There is little point in selling when most of the damage is done. And if you have un-invested cash, this could well prove to be a great time to put it to work in the market.
F.S.

For weeks the talking heads on financial news channels have been saying that the stock market was overdue for a correction. I’m not sure what that really means. It is easy to tell when my dog is overdue for a bath because he stinks. It is more challenging to know when stocks are going to correct.  There is no standard formula that says a rally can only last eight months or can only climb 15% before a serious pullback. Nevertheless, all the recent talk about a coming correction certainly had investors on edge.

When news of China’s market meltdown reached U.S. traders Tuesday, many were already looking for a reason to stampede to the exit.

I experienced a similar situation a couple of weeks ago. My wife and I went to the cinema and she reluctantly agreed to watch a scary movie. There were lots of young people in attendance–specifically teenage girls. To build suspense, the movie had ominous music and on screen cues meant to mislead the audience. Several times everyone was convinced that a scary scene was coming even though it did not. In each case, all the young girls would scream in anticipation.

My wife was doing quite well with the movie, but the audience screams convinced her that when something bad eventually did occur, it was going to be horrific. Whether that is true or not I will never know. The anticipation became too much for her to bear and we had to leave before the movie even got to the really scary part.

I think market activity and commentary over the past few weeks had pushed many investors to an emotional brink. The decline in the Chinese market was the event that forced them over the edge.

The chart below shows the daily price activity for the S&P 500 (black line) over the past year. The blue line is a simple 50-day moving average. (The gold line is the Nasdaq, included just for comparison). Notice that the S&P trended above its 50-day MA since July. Over the past couple of months it approached the blue line a couple of times, but in recent sessions it again traded well above that level. With Tuesday’s 5% decline, it broke well below that support level in a single session.

The same can be seen on the bottom portions of the chart. The moving average convergence divergence (MACD) and the relative strength index (RSI) both went from positive to negative in a single day.

I could expend quite a bit of time and effort explaining why the Chinese market sold off and the ensuring impact on U.S. stocks. But in fact there is no fundamental or technical economic change between Monday and Tuesday that should have caused a correction of this magnitude. This move was driven by investor emotion and not by economic or market fundamentals. Although there are some indicators that attempt to measure investor sentiment, I know of none that can accurately gauge the two major investor emotions: fear and greed.

The real question now becomes: how should one react to this event? Will stocks continue to slide or will this be the bottom?

While it is hard to say for certain, it seems likely that the worst of the damage is done. In the most serious correction since 2002, last spring we saw the S&P 500 drop about 7%. That downturn took several weeks to unravel. After Tuesday’s sharp move, stocks will need to build a news base and re-establish support. During that process we could see major indices drop another percent or two.

As long as that is the type of action we see, the best course from here is probably to hang on and ride it out. But if we see another major decline like we saw on Tuesday then all bets are off and the safest action will probably be to move to cash until the situation stabilizes.

F.S.

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