A couple of weeks ago, I wrote that investors should expect the market to rally going into the last month of the year. For several days after my forecast appeared way off base as the major indices dropped. Now the market has rallied for three straight days and the major indices are higher than when I made that forecast. But the amount of weakness shown by stocks in the past couple of weeks makes me nervous.

I still think it is likely that this rally will continue and the highest market levels of the year will probably be seen in December. But I also think investors and traders are very nervous and there is likely to be serious downward volatility on days when economic news is bad. I also would not be surprised to see a significant sell off in January.

For now I would continue to hold onto long positions, but caution is warranted. If major indices struggle in the early part of December, the best course might be to start taking defensive positions.

Understanding your self-directed retirement plan

Prior to the Employee Retirement Income Security Act of 1974 (ERISA), companies that offered pensions to their employees were usually in charge of how those pension assets were invested.  That didn’t always turn out well. Corruption and defaults prompted Congress to make some changes. The result included several types of defined contribution plans where the employer, employee or both contribute to an employee’s individual retirement account. These plans include 401Ks, Simple IRAs, SEP IRAs, profit sharing plans, and more. 

At first, most companies that offered these plans still made the decisions about how they would be invested. The assumption was that employees weren’t smart enough to make sound investment decisions. As things turned out, many of the people overseeing the plans did not make great decisions, either. As a result, today most companies have adopted defined contribution plans that allow the employees to choose how their plan assets will be invested. 

If you work full time, chances are you are participating in some type of defined contribution plan or at least have the choice to participate. From plan to plan there is a wide variation in the types of investment options available to plan participants. Obviously, this will have a direct impact in how the plan assets perform over time.

For example, my wife is an educator. In addition to her state sponsored retirement, the school district she works for offers her the opportunity to contribute to a 401K plan. The district contributes an amount equal to .25% of her salary each year. That doesn’t amount to much, but anything is better than nothing. My wife also makes a tax-deferred contribution to this account each month. That means the money comes out of her check before taxes are withheld.

Her 401K plan is totally self directed. In other words, she decides where the money will be invested and how it will be allocated. She is restricted, however, to the investment selection offered by the plan. In this case, she has about 20 investment options. She is allowed to change her allocation once per month.

You might be wondering where the plan comes from and who decides what investment choices will be included. In this case, the plan itself is actually a variable annuity created and offered by an insurance company. The investment offerings are determined by the insurance company and are variable annuity sub-accounts. The best way to describe a sub-account is that it is essentially a clone of a mutual fund offered through the insurance company.

To obtain these sub-accounts, the insurance company contracts with a mutual fund company to create clones of some of its existing funds. The sub-account might even have the same name as the fund it is replicating. But because it is a duplicate and not the original, there will be differences in performance. Even though it is the same manager, execution times might be slightly different, the amount of money the manager has to work with will be different, and there could be differences in trading restrictions. So when someone owns Fund A in his 401K account and he checks the year-to-date performance on Yahoo!, it is likely to be different that what is reflected on his account statement.

In contrast, the defined contribution plan offered by my employer is a Simple IRA. In this case, instead of coming from an insurance company, my plan is set up through Fidelity, a brokerage firm. I can choose virtually any investment option available through Fidelity for my plan. I can purchase stocks, Exchange-Traded Funds (ETFs), regular mutual funds, and more. In this case, the mutual funds I buy are the real funds, not clones. I can change allocations any time I want, but I am subject to fees and penalties imposed by the investment vehicles and by Fidelity.

Most defined contribution plans are going to fall between these extremes when it comes to the number of investment choices that are offered.

The real challenge is deciding where to allocate the assets that are in the account and how often to change those allocations. I’ll provide some advice on that subject in next week’s blog. 
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 me, Flint, at 800-279-3377.

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For most children, the days before Christmas are some of the longest of each year. Anticipation builds as they wait for the night when Santa Claus will make his appearance and deliver presents. Investors don’t look forward to Santa’s visit with the same anticipation is children, but perhaps they should. Because most years, December turns out to be quite rewarding.

This year, with the month half over November has brutalized the stock market. The Nasdaq is off about 8% since peaking the last week of October and other major indices have also been hammered. With all the negative news about sub-prime mortgages and weakness in the housing market, many investors are worried that this might be just the start of a major correction.

As I’ve admitted many times, I don’t have a financial market crystal ball and I don’t believe anyone else does, either. But although it is certainly possible that the market could continue to decline from this point, I’m more inclined to believe that we will see a typical end-of-the-year rally with major indices reaching their annual peaks sometime in December. If that occurs, then the next six weeks offer one of the best profit opportunities in 2007.

If you wonder how I can take such a position in view of the market’s current weakness, let me remind you of some recent market history. In the past 16 years, the Nasdaq peaked in December in 1991, 1992, 1993, 1995, 1996, 1998, 1999, 2003, 2004, 2005 and 2006.

I’m sure you remember the three most recent  years when it did not peak in December. In 2000, 2001 and 2002, the economy  suffered from the collapse of technology stocks, the impact of 9-11, and was working through a recession. The Nasdaq still has not fully recovered from the damage of those years.

Of the other two years, I don’t remember much about 1994 because I was in Russia and Ukraine, teaching principles of free enterprise to aspiring businessmen and introducing them to U.S. citizens who were eager to share the American Dream. I know part of the reason it was a bad year for the markets is because the Federal Reserve raised interest rates multiple times. Although the market sold off at the end of 1997, overall it was a good year for stocks with the Nasdaq gaining nearly 22%.

That totals 11 years when the market peaked in December versus five years when it did not. I believe that 2000-2002 were abnormal because of the unusual circumstances. If we disregard those years, then there are 11 of 13 recent years when the Nasdaq reached its annual high in December.

So what does all this mean for 2006? First, let’s look at a chart to assess the current situation. Below we see the Nadaq over the past couple of years. The gold line is a 50-day moving average. You can see that during the current correction, the Nasdaq broke below its 50-day MA, something it has done twice before in 2006. I added the green trendline because that is where there is strong technical support for the Nasdaq. You can see that the index is currently resting near that support level.

The bottom portion of the chart is a moving average convergence divergence (MACD). Right now the MACD is somewhere around -30. During the two previous corrections in 2006 when the Nasdaq broke below its 50-day MA, the MACD has also been negative.

After both of those previous corrections, the Nasdaq rebounded and the losses were quickly erased. If the current correction adheres to that pattern, then the Nasdaq should be on the verge of a sharp upturn–especially when we include the seasonal pattern of a December peak.

There are strong economic and fundamental reasons for stocks to peak in December. The most obvious is that because of holiday spending, December is a huge revenue month for many businesses. Consumer spending makes up two-thirds of the U.S. economy and December is the peak month for consumer spending.

Another reason the market peaks in December is because every fund manager, Wall Street trader, hedge fund manager, or neighborhood broker wants it to. For many of these folks, there are significant bonuses and financial incentives connected to how they finish out the year. So they will do everything they can to make certain that when some guy in Des Moines checks his 401k statement in January that it shows his account reached a new high in December.

Of course there are those who will argue that the problems in the housing market are similar to what the technology market saw in 2000. In reality, the two instances are quite dissimilar. The tech bubble was much bigger than the sub-prime mortgage market and it experienced far more speculation in the preceding months. And there was the impact of the Y2K concerns. People were afraid their computers would not work in the new millennium so individuals and businesses all upgraded their systems in 1999. That meant many did not need new upgrades or software for three or four years–about the time it took for the markets to get back on track.

Anytime the market is correcting, caution is warranted. But so far the overall uptrend is intact and perhaps the best advance any investor can get is to stick with the trend. So unless something dramatic happens between now and Christmas, expect Santa to make his annual appearance and the stock market to have a seasonal rally.

We won’t be publishing a market update next week because of the Thanksgiving holiday. I hope you all have a wonderful time counting your blessings with friends and loved ones.
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 me, Flint, 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.

A few weeks ago (Sept. 27), I wrote that the rising price of gold was an indication that inflation remains a major concern. Since then, the situation continues to escalate and the price of gold has risen dramatically.

My first introduction to this phenomenon  came back in the late 1980s when I went to work for Howard Ruff. Ruff was more or less an economic doomsday guru who in the course of events advised his followers to buy gold to protect themselves from the impending economic disasters. Many of Ruff’s predictions never came to pass, but he was right about rising gold prices. As gold climbed to more than $800 an ounce, a number of his followers who had purchased large quantities of gold ended up becoming very rich.

Of course there were other folks who made lots of money by buying gold 20 years ago. One of the things that makes gold such a volatile investment is that many remember the past price spikes and they have a tendency to jump in and out, each time hoping for another big score.

Below is a chart that shows how the price of gold (black line) has risen over the past two years. Notice that the price of gold turned up in August about the same time as the major market indices rebounded. But unlike the other indices such as the Nasdaq (gold line) gold has not seen a pull back in recent sessions. In fact, the angle of its advance is even steeper.

Under normal conditions, this steep of an advance would be difficult to maintain for more than a few weeks, but with everything else that is going on in the economy, apparently there are lots of investors right now who are willing to place a bet on gold. Given the circumstances, this advance could have some serious staying power. The bottom portion of this chart shows a moving average convergence divergence (MACD) for gold. The MACD is still in positive ground and is moving up, meaning that gold still has the momentum to keep advancing.

Right now precious metals and oil are about the only sectors moving up. So there are plenty of speculators that will continue to jump in if this trend continues.

At Strategis Financial Group, we recently purchased a position in gold for investors holding our Sector Rewards Strategy.

A couple of weeks ago I wrote about the dilemma currently facing members of the Federal Reserve Open Market Committee–the group that sets interest rates and determines economic policy. Normally the FOMC is primarily concerned with keeping inflation under control. Right now there are many experts and analysts who argue that inflation is becoming a significant problem, but the Fed is still lowering interest rates to stave off a recession that could be brought on by the sub-prime mortgage fiasco.

In its latest statement, the FOMC indicated that the inflation situation remains under control. But this spike in gold prices is an indication that there are many would do not believe the Fed can both cut rates and prevent inflation.
F.S.

You have probably noticed the increased cost of gasoline in recent weeks. I drive a diesel pickup, and the cost of diesel fuel here in central Utah is running about $3.60 a gallon–as much as 80 cents a gallon more than regular gasoline. When it comes to higher fuel prices most Americans have no options other than to grimace and fork over the money.  Mass transit, carpools, or even just driving less are not legitimate alternatives for many.

While most people know the price of oil not many can explain why, including experts. The increased cost is not related to a decline or disruption in supplies, which are holding steady. The higher cost is also not explained by increased demand or to rising political tensions in oil-producing areas.

Instead, some oil industry experts blame the current price increase on speculators.

For example, In an article in the Ft. Worth Star Telegram, Fadel Gheit, an energy analyst for Oppenheimer & Co. in New York is quoted as saying he is convinced based on supply and demand the current price of crude oil should be no more than $55 a barrel–about $40 lower than current levels.

Gheit was quoted as saying that commodities trading in oil is the world’s largest unregulated gambling hall. “This is like a highway with no cops and no speed limit, and everybody’s going 120 miles per hour.”

Trading oil futures gives speculators tremendous leverage. Each contract generally controls 1,000 barrels of crude oil and contracts can be purchased on margin, meaning the investor does not have to put up all the money. Margins can be as low as 5% of the contract value.

The impact of this speculation can be seen on the chart below. The black line is iPath Crude Oil Exchange Traded Note (OIL). Notice that over the past 10 weeks, OIL has risen about 40%. The blue line is Oil Services HOLDRS (OIH). The difference between these two vehicles is that the OIL reflects the price of crude oil while OIH is reflective of the oil services industry. Over the same period, OIH has risen just 20% and has really gone sideways for the past six weeks while OIL continued to rise. That means in spite of rising oil prices, oil companies and other oil-related businesses are seeing declining profits.

The gold line is the S&P 500 and is included just for comparison purposes. Notice that it has risen about 8% since mid-August.

Like most speculative investments, this run-up in oil prices carries a high degree of risk. Those who are bidding the price up are betting that something is going to increase the demand for oil or decrease the supply. That could be an escalation of the war in the Middle East to include Iran. It could just be a seasonally higher demand because of cold weather. Eventually a day of reckoning will come and if those or other events have not happened, those speculating on higher prices will be forced to sell their positions at a loss and we will see the price of oil start to come down.

In the meantime, everyone who has to use oil or gas is going to be paying higher prices. Since that means virtually every consumer and supplier in the country, that will increase inflationary pressures on the economy. Under normal circumstances, when inflation becomes a threat the Federal Reserve increases interest rates and tightens the money supply. Wednesday the Fed did exactly the opposite and lowered rates. Here is how the Fed explained this apparent contradiction in the release announcing the rate cut:

“Economic growth was solid in the third quarter, and strains in financial markets have eased somewhat on balance.  However, the pace of economic expansion will likely slow in the near term, partly reflecting the intensification of the housing correction. Today’s action, combined with the policy action taken in September, should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time.

“Readings on core inflation have improved modestly this year, but recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation.  In this context, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully. 

“The Committee judges that, after this action, the upside risks to inflation roughly balance the downside risks to growth.”

The combined effect of these factors is that investors are starting to get nervous about the economy–not the economy today, but the economy in the near future. Remember that consumer spending accounts for two-thirds of U.S. economic activity. From now until the end of the year is the most important time for consumer spending because of the Christmas holiday season. If consumers are spending more money on gas, heating oil, milk, eggs, and other essential items, that means they will spend less on other things. That is why we saw a sharp sell off today and why it is likely that in coming weeks, the down days are probably going to be volatile and more frequent.

That doesn’t mean investors need to be in a panic mode. After all, this is traditionally one of the strongest periods for stocks and so far the market’s uptrend is still intact. However, given the combination of a weak housing market, record high oil prices and rising inflation, investors need to watch market activity closely and be prepared to react quickly if an emotion-driven sell-off ensues.

F.S.