As indicated in last week’s report, major market indexes continued building support. The latest Commerce Department report showed that second quarter GDP was much stronger than initially believed. The annual rate of 4% compared to earlier estimates of a 3.4% rate. That is the highest GDP rate since a 4.8% rate in the first quarter of 2006 and it provides more evidence that economic fundamentals remain strong.

Analysts are forecasting that GDP for the third quarter could fall to an annualized rate of 2% because of the mortgage industry problems and the resulting market turmoil. Others believe that the Federal Reserve will take whatever action it must to avert any threat of recession by cutting interest rates or adding more liquidity to the markets.

Several times over the past couple of years I’ve written that concerns about the problems in the housing markets are being exaggerated and needlessly hyped. This week  I got some support for that view in the latest column from Tobin Smith.

Allow me to quote from his Aug. 29 WaveWire newsletter:

First, we have 75 million homeowners in the United States, and about 65 million have seen 100% gains in their homes from 2001 to 2005 — that’s a 25-year gain in just five years.Almost 40% of homeowners own their houses free and clear. (I know that might be hard for the East and West coasters to believe, but it’s true.)

Of the 60% of homeowners who have mortgages, 80% are prime mortgages, and 97% of those people are making their payments just fine.

About 14% of the 60% of mortgages in the United States are sub-prime or alt-A, and we are going to have to assume that a lot of those will go bad.There is around $150 billion worth of mortgages at risk, so for argument’s sake, let’s say that $75 billion of that gets foreclosed.

It’s not as though that money vanishes into thin air. About two thirds of it will come back to the banks. So, I figure less than $50 billion will have gone to money heaven when this is all said and done.

And we have a $10 trillion –with a “T” — mortgage market to absorb that $50 billion.

Furthermore, we have $18 trillion in major stock value and $30 trillion in bonds. So, while sub-prime mortgages are a problem, they are a relatively minute one.

This panic was about fear, not reality.

This is not like the Internet bubble bursting, which wiped out $7 trillion in 18 months. And, remember that we only witnessed a mild recession following the historic attack of the United States on 9/11, and we bounced right back.

You can subscribe to Tobin Smith’s newsletter at www.changewave.com

I have not had the time to verify these numbers, but the point he is making is sound. The overall impact to our economy because of these problems will not be significant. However, the effect can be much more pronounced if investors get caught up in the fear and frenzy and start reacting emotionally to reports that are hyped by the mainstream media.

As a former member of the mainstream media, I can assure you that most reporters do not understand the mortgage industry or the financial markets. I doubt that even 5% could correctly define a mutual fund, let alone explain a P/E ratio. So when you are hearing reports about how problems in the sub-prime mortgage market are going to cause the collapse of Wall Street and usher in the next Great Depression, don’t believe it.

Let me leave you today with an interesting chart. The black line is the Nasdaq over the past two years. The gold line is streetTRACKS Wilshire REIT (RWR) a real estate ETF. You can clearly see that this fund corrected sharply beginning in February. But notice that over the past two years, it has a total return of about 16%–slightly less than the Nasdaq over the same period.

Real estate is not exempt from the laws of risk and reward. Over the past few years, real estate has been the strongest sector of the market, posting some impressive and unusual returns. It is a sector that was overdue for a correction, just like technology in 2001.

Here is one more tidbit from Tobin Smith’s column for you to mull over. During the past 30 years, the United State economy has endured 14 months of recession. Remember, about the only stock market variable shown to have and predictive ability is trends. Given that trend of 30 years, do you want to be an optimist right now, or a pessimist? I’ll choose the best case outlook nearly every time.

Have a great Labor Day weekend.

F.S.

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Those are pretty much the questions traders and investors are all wondering. Knowing the right answers or at least guessing correctly could be very profitable over the next several weeks. The Nasdaq, S&P 500 and the Dow are all currently at levels where they have solid technical support. That doesn’t mean there won’t be another market downturn. But as we saw last week, the Federal Reserve certainly doesn’t appear willing to submit to a market meltdown. So it seems unlikely that stocks will fall much below these levels. I think it is more probable that major indices will regain some momentum and then possibly retest this level in the coming weeks.

As the chart below shows, these indices are currently at the same levels as in February and April. I added a red line to the chart to show this technically important level. If indices can advance past this level over the next few sessions, it will become an area of very strong technical support. The bottom portion of the chart is a moving average convergence divergence (MACD) of the Nasdaq. This indicator has turned upward from a very overbought level. That would seem to forecast that market momentum has shifted back to the positive side.

The mainstream financial media continues to overemphasize and even sensationalize difficulties in the mortgage and housing markets. Certainly problems are going to persist in these areas for some time–perhaps even three or four years. But the impact on the daily lives of most Americans will be minimal. 

Most of the people who will be hurt by the problems with sub-prime mortgages are those who took speculative positions. A speculative real estate position entails a high level of risk, just like a speculative stock position or any other type of speculative investment. These types of positions should only be taken by those who can accept the higher level of risk and handle the losses that could occur.

In the late 1990s and in 2000, many people foolishly allocated IRAs, 401Ks and other investment accounts into exclusively technology positions. They did this because they were greedy. They saw the big gains in the technology sectors and they put too much of their assets at risk in those positions. When the technology sector collapsed in 2001, many lost huge amounts of money they could not afford to lose. There are some investors who still have not fully recouped those losses and probably never will.

In the past few years, many people used gimmicks like interest-only loans or super-low adjustable rate mortgages to buy property that they really could not afford. Others took equity from their homes or cashed out retirement accounts to invest in real estate in areas where speculation was fueling rapid increases in property values. People in these types of situations are going to get hurt by this current crisis. 

Where is the money going?

When one sector of the market declines that usually means another sector rises. So far that hasn’t seemed to be the case with this correction. Major indices are down, but no other portion of the market seems ready to rise and take up the slack.

A ranking of the ETF universe shows that over the past three months, five of the top 10 performing funds are short funds. In other words, they are funds designed to make a profit when the market or a segment of the market is going down. The top fund over that time is Ultra Short Real Estate ProShares (SRS), up 43%. The other five include three Asian international funds and two energy funds.

Normally when running this type of ranking one or two market sectors really stand out as having the best performance. It might be technology funds, or emerging markets, energy funds, etc. Right now that is not the case. In fact, over the past three months, there are cases where short funds and long funds for the same market segments have essentially the same return.

This kind of directionless pattern usually occurs when the market is in transition. Certainly that seems to define our current situation. It is likely to take at least a few more weeks before we know whether the bull run is continuing for the stock market or whether we a going to see a more prolonged downward move. In the meantime, our best advice is to be defensive and to hold tight until a direction becomes more clear.
F.S.
If you would like an investment strategy that attempts to minimize risk but still provides the opportunity for solid growth, check out the Foundation Strategy from Strategis Financial Group.  This actively managed strategy is designed to take advantage of the experience and expertise of some of the nation’s best mutual fund managers. To learn more, call Flint Stephens, Mark Sumsion or Scott Garbutt at 800-279-3377.

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The past week’s market activity has done a lot of technical damage to the major indices. The long-term uptrend is at risk and investors need to be taking steps to protect their portfolios. 

For example, I am a primary consultant for the Foundation Strategy at Strategis Financial Group, Inc. This strategy normally holds six mutual fund positions. The objective is to hold high quality funds with low betas that are in long-term advances. As a defensive strategy, this week we sold the two funds that had shown the most recent weakness. One of those positions will remain in cash and the other was replaced with a short fund called Prudent Bear (BEARX).

So the composition of the strategy is now 66% long, 17% short and 17% cash. But the short position effectively neutralizes an equal portion of the long position, meaning the strategy effectively has a long exposure of less than 50%. In the financial world, protecting a long or short position with an offsetting investment is called hedging. 

The chart below illustrates how hedging works. The black line is the daily price movement of the Nasdaq over the past two years. The gold line is BEARX, a fund that shorts the stock market. Notice how the two positions are inversely correlated. By purchasing BEARX right how, our objective is to offset losses that might occur in our long positions if the market continues to decline.

With the market headed down, one might wonder why we don’t either move all of the positions to cash or to short funds. The simple answer is that when this correction ends, stocks can move up very quickly. We don’t want to be sitting on the sidelines when that occurs. This correction still looks like a downturn in a bull market rather than the start of a new bear market. And there are signs that the market is oversold and could experience a significant bounce fairly soon.

The bottom portion of this chart shows a moving average convergence divergence (MACD) for the Nasdaq. Notice it turned negative a few days ago and has quickly reached a level that indicates oversold market conditions. Compare the current situation to the correction that occurred in the summer of 2006. The MACD is already at the level where that recovery took place. Someone using the MACD (or RSI or a moving average) as a trigger to get back into the market would miss some substantial gains as the market headed back up.

Of course, there is no guarantee that this is the bottom. That is why we are taking defensive action.

Federal Reserve trying to calm markets

The irony is that there does not appear to be a substantive reason for a correction of this magnitude. Corporate earnings are strong. Unemployment is low. Interest rates are low by historical standards. Major indices are not at irrational valuations. The driving force of this correction is fear and uncertainty about the sub-prime mortgage market.

Wednesday St. Louis Federal Reserve Bank President William Poole said the U.S. economy remains strong and there is no need for the central bank to stimulate the economy with an emergency rate cut. Poole acknowledged the problems in the housing market and said the slump would likely continue. But Poole said there is no evidence that the housing problems are spreading into the business fixed investment or the consumer segments.The next regularly scheduled meeting of the Federal Open Market Committee is September 18. Poole said that barring a “calamity,” there is no need to consider cutting interest rates before then.

So far in the past week, the Federal Reserve has added $71 billion in liquidity to the financial markets. Today the central bank released a statement saying it is prepared to do more, if needed. The Fed can add liquidity in a variety of ways. It can increase the amount of money available to member banks at the federal funds rate. It can repurchase government debt instruments like government backed mortgage securities. It can also increase the money supply. All of these actions have a similar impact of making more money available for banks to lend. In essence, the effect is the same as an unofficial rate cut.

So you might be wondering why the Fed doesn’t just go ahead and cut interest rates. The Fed’s number one enemy is always inflation. Right now rising inflation remains a very real threat. Last week the Fed stated that “a sustained moderation in inflation pressures has yet to be convincingly demonstrated.” The latest report from the Labor Department showed that core inflation remained at a 2.2% rate in July, exactly the same as May and June.

Interestingly, it is quite possible that the Fed’s injection of money into the financial system might very well undermine its own attempts to curb inflation. The U.S. money supply (M2) has been increasing steadily for many months. Below is a chart from the Federal Reserve showing the money supply growth rate.

M2 includes currency and demand deposits (the components of M1) plus time deposits, savings deposits, and non-institutional money market funds.

A growing money supply means more money available for spending, which contributes to inflationary pressures. Below is a link to a speech given by current Federal Reserve Chairman Ben Bernanke where he gives an historical account of the Federal Reserve and its attempt to accurately monitor money supply and the impact on the economy.http://www.federalreserve.gov/boarddocs/speeches/2006/20061110/default.htm

For now, the Fed is walking a tightrope of trying to keep inflation in check by avoiding an interest rate cut, while trying to convince the public that there is no reason to be worried about the overall health of the financial markets. Whether or not it can pull it off remains to be seen, but in the meantime, it makes sense for investors to take some preventative action.
F.S.

If you would like an investment strategy that attempts to minimize risk but still provides the opportunity for solid growth, check out the Foundation Strategy from Strategis Financial Group.  This actively managed strategy is designed to take advantage of the experience and expertise of some of the nation’s best mutual fund managers. To learn more, call Flint Stephens, Mark Sumsion or Scott Garbutt at 800-279-3377.

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In a newly released song, country singer Brad Paisley reveals his true nature. Titled “I’m Still a Guy,” the song’s lyrics note that while he might occasionally walk his wife’s sissy dog or hold her purse at the mall, eventually he will revert to behavior more typical of a male.

In the past few weeks, we’ve seen the major stock indices revert to more typical market behavior.

In mid-July 2006, major market indices began a powerful advance. One of the unique features of this rally is that with the exception of a small pullback in February 2007, it has been a smooth, sustained rise. Much of the volatility that normally accompanies market movement was absent. Intraday trading ranges were tight as the markets marched steadily upward.

Fast forward to mid-July 2007, Not only does the market endure a correction, but daily volatility increases dramatically.

It is uncomfortable for many investors when major indices have daily swings of 1%, 2% or even more. This most recent episode has seemed particularly difficult because we haven’t seen this kind of volatility for more than a year.

The chart below makes it easy to see how market behavior has changed.

The black vertical lines show the daily price activity of the Nasdaq over the past six months. On the left side of each line is a tick that marks where the index opened on that day. The line itself shows the trading range during the session. A tick on the right side of each line shows where the index closed. Notice that everything appears pretty even and regular until the Nasdaq peaked in July. Then those black vertical lines start growing longer, signaling much greater intraday trading volatility.

Most ordinary investors do not like volatility because it makes them uncomfortable. But it is important to understand that volatility is an inherent feature of the financial markets. We like volatility when it works in our favor. Most of us would be thrilled to own an investment that gained 5% in a single session. But when an investment we own loses 5% in a day, our feelings are totally different.

Volatility, risk, and reward are inseparably connected, even though most investors wish that were not the case.

As I write this, the Nasdaq is about 50 points (2%) higher than the prior week. But that isn’t necessarily comforting, because it is also 30 points lower than its close yesterday.

It is still too early to know whether this correction has reached its lowest point. But we can forecast with a high level of confidence that the markets’ are likely to maintain their increased volatility for several more weeks.

Enjoy the ride.
F.S.

If you would like an investment strategy that attempts to minimize risk but still provides the opportunity for solid growth, check out the Foundation Strategy from Strategis Financial Group.  This actively managed strategy is designed to take advantage of the experience and expertise of some of the nation’s best mutual fund managers. To learn more, call Mark Sumsion or Scott Garbutt at 800-279-3377.

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Once again because of some family obligations tomorrow, I am writing this report a day earlier than usual.

After today’s market action, the Nasdaq is still holding above its 200-day moving average. As I indicated last week, if the index drops below that level then the long-term upward trend will be in jeopardy. At that point investors will need to watch market movement much more closely. Already though there are industry sectors that are doing much worse than the major market indices and investors who have held on to these positions have experienced substantial losses.

Recent market weakness has primarily been attributed to problems in the U.S. housing market. There is plenty of concern that slumping home sales and mortgage defaults will have a disastrous impact on the overall economy. For several years, real estate has been among the market’s strongest sectors. But as the chart below shows, that situation started to unravel earlier this year.

The gold line on the chart is DJ Wilshire REIT (RWR), a real estate ETF. The black line for comparison is the Nasdaq. Notice that since peaking in February, RWR has fallen about 28%. When the Nasdaq regrouped and began advancing again in March, the best RWR could manage was some sideways consolidation. Since April, its trend has been downward with sharp acceleration in the beginning of June.

Other funds in the real estate sector have seen similar declines. IShares Dow Jones US Home Construction (ITB) is down more than 25% so far in 2007. IShares Cohen & Steers Realty Majors (ICF) has dropped 12% in the past three months. Ultra Real Estate ProShares (URE) has lost more than 21% in that same time period.

I anticipate that we’ve seen the majority of the decline for the major market indexes, but not necessarily for the real estate sector. And as the correction in real estate deepens, it will begin to spill over into other areas. The building and construction stocks have already seen steep declines. Home improvement stocks will also suffer. In the financial sector, stocks of companies that invest heavily in real estate or in home mortgages are also likely to see some declines.

There are also some market sectors that continue to do well. High oil prices mean that the natural resource sector is going strong. Oil Services HOLDRs (OIH) is up nearly 20% over the past three months and there are many other natural resource ETFs showing gains of 15% to 20% over that same time.

In spite of market weakness, a number of technology funds are holding up well. Internet Architecture HOLDRs (IAH) is still up 14% over the past three months. Ultra Semiconductor ProShares (USD) is up more than 27%.

In the international arena, Pacific Rim and emerging markets funds still show solid gains, led by PowerShares Golden Dragon Halter USX China (PGJ) with a three-month return of 26%.

All of this points out the value of an active approach to investment management. Investors in the right sectors are feeling very little pain from this current market downturn, while those in the wrong sectors have already amassed some very damaging losses. At the same time, investors using a traditional asset allocation approach for diversification are likely seeing very little benefit because most asset classes remain highly correlated.
F.S.

If you would like an investment strategy that attempts to minimize risk but still provides the opportunity for solid growth, check out the Foundation Strategy from Strategis Financial Group.  This actively managed strategy is designed to take advantage of the experience and expertise of some of the nation’s best mutual fund managers. To learn more, call Flint Stephens, Mark Sumsion or Scott Garbutt at 800-279-3377.

You requested this MarketOwl free e-newsletter. Please add support@marketowl.com to your e-mail address book to ensure prompt delivery.