I’m writing this week’s commentary early because I will be attending a regulatory workshop later in the week. It should be an interesting time to visit Washington D.C., because the entire make-up of the financial industry is currently in a state of flux.

This week I’ve had a couple of calls from investors who still have money invested in the equity markets and they wanted to know if they should sell. I told them they should have sold months ago and moved to a money market fund as we advised. Since they did not, it is now very difficult to forecast whether the equity markets will lose another 10% or whether this is the bottom.

I’ve also spoken to a couple of investors who plan to liquidate their accounts and suffer any associated penalties for early withdrawal so they can have the security of possession of the actual cash. That is obviously an extreme action and one that is difficult to endorse because if we all did it, the entire banking and investment system would collapse.

The situation is dire, but nothing will be accomplished if everyone panics.

To help put the situation in perspective, let me include some quotes from John Mauldin, a widely respected economist and analyst. These come from a weekly column he writes. You can subscribe to it for free at:

http://www.frontlinethoughts.com/subscribe.asp

“We all know about the sub-prime crisis. That’s part of the problem, as banks and institutions are now having to write off a lot of bad loans. The second part of the problem is a little more complex. Because we were running a huge trade deficit, countries all over the world were selling us goods and taking our dollars. They in turn invested those excess dollars in US bonds, helping to drive down interest rates. It became easy to borrow money at low rates. Banks, and what Paul McCulley properly called the Shadow Banking System, used that ability to borrow and dramatically leverage up those bad loans (when everyone thought they were good), as it seemed like easy money. They created off-balance-sheet vehicles called Structured Investment Vehicles (SIVs) and put loans and other debt into them. They then borrowed money on the short-term commercial paper market to fund the SIVs and made as profit the difference between the low short-term rates of commercial paper and the higher long-term rates on the loans in the SIV. And if a little leverage was good, why not use a lot of leverage and make even more money? Everyone knew these were AAA-rated securities.

“And then the music stopped. It became evident that some of these SIVs contained sub-prime debt and other risky loans. Investors stopped buying the commercial paper of these SIVs. Large banks were basically forced to take the loans and other debt in the SIVs back onto their balance sheets last summer as the credit crisis started. Because of a new accounting rule (called FASB 157), banks had to mark their illiquid investments to the most recent market price of a similar security that actually had a trade. Over $500 billion has been written off so far, with credible estimates that there might be another $500 billion to go. That means these large banks have to get more capital, and it also means they have less to lend. (More on the nature of these investments in a few paragraphs.)

“Banks can lend to consumers and investors about 12 times their capital base. If they have to write off 20% of their capital because of losses, that means they either have to sell more equity or reduce their loan portfolios. As an example, for every $1,000 of capital, a bank can loan $12,000 (more or less). If they have to write off 20% ($200), they either have to sell stock to raise their capital back to $1,000 or reduce their loan portfolio by $2,400. Add some zeroes to that number and it gets to be huge.

“And that is what is happening. At first, banks were able to raise new capital. But now, many banks are finding it very difficult to raise money, and that means they have to reduce their loan portfolios. We’ll come back to this later. But now, let’s look at what is happening today. Basically, the credit markets have stopped functioning. Because banks and investors and institutions are having to de-leverage, that means they need to sell assets at whatever prices they can get in order to create capital to keep their loan-to-capital ratios within the regulatory limits.

“Remember, part of this started when banks and investors and funds used leverage (borrowed money) to buy more assets. Now, the opposite is happening. They are having to sell assets into a market that does not have the ability to borrow money to buy them. And because the regulators require them to sell whatever they can, the prices for some of these assets are ridiculously low. …”

Mr. Mauldin goes into much more detail and I would encourage you to read his entire column. But one of the main concepts to understand is that without some type of government intervention, this situation cannot be corrected. Much of it was undoubtedly created by greedy executives on Wall Street and poor government oversight. But if the credit and banking systems are allowed to fail, the resulting chaos will impact virtually every person in this country and many in the rest of the world, too.

For now the best action investors can take is to hunker down on the sidelines and wait. If you are really worried, a little prayer might not hurt either.
F.S.

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When the president, the chairman of the Federal Reserve, and the U.S. Treasury secretary are all talking about the prospect of an economic meltdown, it is a safe assumption that the situation is very dire.

As we all should understand by now, the United States has a credit-based economy. A credit economy can only function as long as there is honesty and trust by the vast majority of parties involved. A bank is willing to loan me money in exchange for my promise that I will repay that loan. My ability to pay is based on the promise of my employer that I will be paid for the work that I do. My employer’s payment to me depends on clients who have promised to pay for the services they receive.

There is an interconnecting chain of promises and the current economic trouble is a result of breaks in that chain. Right now the banks have born the brunt of the damage because they are the ones who have lent money that is not being repaid. If enough banks fail, then there is a danger that the entire system could break down.

It is important to note that not all banks have been equally hurt. For example, the chart below shows the stocks of three different banks. The black line is Wells Fargo, which is considered by many to be the strongest major U.S. bank. Notice that for the year, the stock price is actually showing a gain of almost 20%. Compare that to Citigroup (gold line), which is down almost 40%, or with Downey Savings and Loan (blue line), which is currently off about 80% in 2008.

It is far too early to know what impact today’s announced government bailout will have on the banking industry. Certainly Wall Street is pleased that some action is being taken, as evidenced by today’s rise in major indices.

Over the short term–in spite of today’s stock market advance–the bailout is likely to change very little. The trust that is the foundation of our economic system has been compromised. Trust is something that will need to be rebuilt over a period of weeks and months. In the meantime, expect to see credit remain very tight and stock market volatility to continue.

For now, investors following our advice should be safely on the sidelines or in assets that do not correlate to daily market movements. At some point in the not too distant future, this situation will turn around and investors are going to be presented with a great opportunity to re-enter the markets. 
F.S.

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Wow! Nothing I can write will compare to or explain the show that major market indices have given this week–and we still have one more day to go. For those who enjoy thrill rides, the market has offered up plenty of excitement.

By now most of the world understands that the United States has significant economic problems. By association, that means virtually every other economy in the world is also at risk. I do not want to be too dramatic, because even if the economy as we know it collapsed, a new alternative would arise and day-to-day life for most of us would continue pretty much unchanged. I say this with some degree of knowledge and confidence because I have seen it occur more than once with several different countries.

Right now some of the brightest economic minds in the world are trying to figure out how to prevent an economic free fall. (These minds do not include either Obama or McCain.) My fear is that in spite of their best efforts, they might be unsuccessful. One reason is that other supposedly smart economic and financial experts are largely responsible for the current mess. They created a dizzying array of financial derivatives and convinced everyone that the risk that this house of cards would fall was relatively small.

Let me use an analogy to explain my concern. When I was 19, I had a friend who was mechanically gifted. He had a knack for being able to fix virtually anything that broke. He even got a job at an electronics repair shop even though he had no formal training.

As a hobby, this friend liked to take photographs. One day his camera quit working and he decided he would fix it, just like he had repaired so many other broken things. Once he got the camera apart, he was surprised by the number of miniscule parts. He forged ahead and eventually discovered what he thought was the problem and fixed it. Then he discovered that he was unable to put the camera back together.

One of our other mutual acquaintances happened to own the same model of camera. So my fix-it friend borrowed the other camera. He reasoned that by using the complete and working camera as a model, he would be able to correctly reassemble his own camera. Unfortunately, he was again stymied by the number of tiny parts and the intricacies of the instrument. After a couple of days, he had two separate boxes, each containing all the parts of a disassembled camera.

He underestimated the complexity of the camera and he was overconfident in his ability to repair something he did not fully understand.

I see many similarities to the current economic situation. The world’s financial systems are vast, intricate, and connected in ways I am not certain it is possible for anyone to fully comprehend. In spite of the best efforts of the folks at the Federal Reserve and the U.S. Treasury, they could end up with a box of parts that no one can reassemble.

For months we have been warning investors that market risk was very high and the safest place assets was on the sidelines in a money market fund or something similar. Nothing has changed. Expect to see more extreme volatility in the future as Wall Street reacts to every rumor and announcement that impacts the financial markets.

Have a great weekend.
 
F.S.

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It is one of those rare days one can never forget. The first I can recall is the day President Kennedy was shot. Next is probably the day Neil Armstrong walked on the moon. Then there was the day we lost the Challenger space shuttle. But 9-11-2001 easily surpasses all the rest.

It was a day that shattered our illusions of security. It was the first time many of us recognized that people in other nations hate us simply for being Americans.

With regard to the financial markets, in September 2001 the U.S. had already endured an 18-month bear market. By that time many analysts believed the worst was over and a quick recovery was right around the corner. All that changed when the towers fell. Trading was halted or curtailed for several days and when the markets reopened, major indices quickly slid.

The chart below shows how the Dow (black line) and the S&P 500 (gold line) fared in the months preceding and after the 9-11 attacks.

While there were ups and downs in the markets in the ensuing months, there is little argument that the 9-11 events deepened and prolonged the bear market. In fact, it is easy to argue that 9-11 is still significantly impacting the economy when one considers the cost of the ongoing war, changes in security procedures, and the effect of a politically unsettled Middle East. Of course one cnot forget the increased cost of oil as well.

The chart below shows how the same indices have performed through the current day. The blue line and the green line help show the current levels compared to the levels on 9-11-2001. Although both indexes are slightly above where they were on that fateful day, they are well below the highs of 2001.

In other words, thanks at least in part to the attacks of 9-11, buy-and-hold investors who purchased a Dow or S&P 500 index fund in the spring of 2001 have seen zero return on their money in the past seven years. That is a perfect argument against a buy-and-hold approach to investing. There were significant market moves in 2003, 2006 and 2007. Through active management an investor could hope to take advantage of those up markets while stepping to the sidelines during the downtimes.

Currently the financial markets remain in a downturn. From an economic perspective, the situation is much the same as it was prior to 9-11. The current bear market is about to mark a full year. A turnaround could be just a few months away. But an unforeseen event like we saw in 2001 could send the markets plunging from these already low levels.

It is possible, though unlikely, that before this correction is over the indices could retest the lows they made in 2002. We just need to cross our fingers and hope that they can find a bottom before reaching those lows.
F.S.

For most of the early part of this year, I emphasized that there were not many market sectors that were advancing. While that remains true, two of the year’s early leaders have reversed course. We are all undoubtedly aware that oil prices have been falling, because the media gives a report on energy costs several times a day. There have also been price declines at the gasoline pumps–more in some states than in others. (Here in Utah we currently have the highest gas prices in the continental U.S.)

The decline in the energy sector has been disastrous for energy investors. The chart below gives a good image of how severe the downturn is. The black line is United States Natural Gas ETF  (UNG). This fund was the top performer for much of the year. But since turning down in July, the price has dropped so far and fast that this fund is now down about 10% from the start of 2008.

The blue line is United States Oil ETF (USO). It has also fallen on hard times after being a profit leader for much of the year. While it is still up more than 10% since the start of 2008, that is a significant decline from the more than 50% gain it enjoyed at its peak in July. Six months of gains vanished in only six weeks!

The gold line is the S&P 500 and was included just for comparison.

 
Just about the same time the energy sector started its plunge, a couple of other sectors were starting to improve. During bear markets, bonds have traditionally been an alternative for many investors. Buying bond funds is different than buying the actual bonds. Bond funds fluctuate in value as the demand for bond yields ebbs and flows. The black line on the chart below is iShares Lehman 20+ Year Treasury  Bond Fund (TLT). For the past four weeks, this fund has made a nice upward move. You can see that this fund has shown significant volatility this year and it is probably still too early to take a position in this fund, but at least the bond sector is showing some strength again.

The gold line on the chart is PowerShares DB US Dollar Index Bullish Fund (UUP). After languishing for most of the year, it has had a nice upward slope since mid-July. At Strategis Financial Group we have take limited positions in this fund in some of our strategies.
   

In spite of the improvement in these two sectors, overall the financial markets remain very weak and the current risk far outweighs the potential rewards. The advice we have been giving for several weeks remains: the best place to be right now is on the sidelines waiting for an improvement in economic fundamentals.

Staying out of the markets can be challenging. Many investors seem to feel a need to jump back into the market whenever there is an upturn. But risk at this level remains a very real concern as demonstrated by days like today. Even though the major indices have suffered significant losses so far this year they can still experience more declines.

Investor patience will eventually be rewarded. Avoiding a 15% loss us just as profitable as capturing a 15% gain.
F.S.

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