As a young man, I lived in Iceland from 1976 to 1978. It was my first time abroad and my first prolonged exposure to a foreign culture. I learned a lot about environment, society, economics, language and faith.

This week the government of Iceland collapsed. That means the governing coalition agreed upon by the political parties fell apart and the prime minister and several cabinet members resigned. There will be new elections and a new political structure. The catalyst for this political catastrophe was the bankruptcy of the country’s economy and the failure of its banking system in 2008.

With the current worldwide economic turmoil, this situation has prompted me to wonder if other nations–including the U.S.–are in jeopardy. If the U.S. banking system were to fail, is our government and our Constitution at risk?

After considerable pondering, I believe the answer to each of the preceding concerns is yes. While such a drastic scenario still seems unlikely at this point, the possibility exists.

It really boils down to a simple question: Will people continue to get paid? If the money keeps flowing, people are willing to live with inflation, corruption, shortages, deception, and a host of other bad circumstances. Once the money is cut off, the government almost instantly loses power and control over the populace.

From 1989 until 1995 my work focused on Russia and Eastern Europe. I witnessed firsthand the collapse of communism and the break up of the Soviet Union. The change from communism to democracy did not occur because the people wanted freedom from political oppression. It occurred because the economies of communist nations ceased to function.

As the communist governments ran into economic troubles, they stopped paying workers. Using military and police force, they could make people report to their jobs at the mines, banks, schools, hospitals and factories, but they could not make them do the work. Before long, nothing was being produced and shelves everywhere were empty. In spite of its scarcity, money became almost worthless, because there was nothing to buy. When the police and military stopped getting paid, they refused to work as well. In a relatively short time, the old Soviet system came to a complete standstill.

The Icelandic government went bankrupt trying to bail out its banking system. With nationalized health care, education, banking, and government subsidies to hosts of other industries, there was no way a bankrupt government could pay all its obligations. Instead of getting paid, workers started getting government IOUs. Soon there were riots in the streets and now the country will have to start over.

The economic collapse of communism was mitigated somewhat because of the economic strength of other countries–primarily the U.S. I experienced times when it was difficult to obtain Russian rubles from Russian banks. At the same time, those banks had stacks of U.S. dollars, British pounds, and Swiss francs. I personally negotiated contracts with Russian government entities that required payment in U.S. dollars. The strength of other currencies served as a crutch to give Russia time to resolve the problems with its own currency.

In recent months the U.S. dollar has risen in value when compared to most other currencies. The dollar is winning by default–not because of its strength, but because it is the least objectionable choice. 

The chart below shows how the U.S. dollar (black line) has fared against some other countries and currencies. These include: China (maroon line), Brazil (blue line), and Europe (gold line). The bottom portion of the chart is a relative strength index (RSI) for the dollar. An investment that can maintain an RSI above 50 shows good strength. Since the middle of summer 2008, global investors are choosing the dollar over virtually any other currency.

In some ways, one could consider this akin to a wager on the United States. Investors are essentially betting that there is a greater chance that the U.S. will be able to solve its economic problems than other countries will be able to resolve theirs. Or perhaps they just understand that the U.S. economy is the lynchpin to the entire global financial system. 

The world can survive bankruptcies and government collapses in places like Iceland– or even large countries like the former Soviet Union–as long as the rest of the world remains stable. 

Right now the United States is seeing a changing of the guard with a new Presidential administration and significant changes in both parties of Congress. Some people are euphoric and believe that the economic situation will rapidly improve. Of course there are also those who believe exactly the opposite. 

The financial sector rose strongly this week on news that the House had passed President Obama’s economic stimulus bill. Today the equity markets are down sharply over renewed concerns about rising unemployment and falling home values. Obviously the situation remains volatile and the direction of the financial markets over the next few weeks remains uncertain. Under those conditions, it is prudent for investors to remain on the sidelines.

In six months the situation could be much improved, significantly worse, or about the same. Fortunately we believe that our tools and methodology will help us properly allocate assets regardless of what transpires.
F.S.

I keep seeing articles in the financial media about what a great buying opportunity this is for investors because the markets have lost so much value since peaking in October 2007. One article I read this week encouraged investors to increase their 401K participation levels because of the great discount they are getting by investing today compared to a year ago.

Here is an illustration from that article: “It’s like walking into a retailer and you’ve got a nice plasma TV up there, and six months ago you’d have had to pay 100% of retail, and today you get to pick it up at a 40% or 50% discount. That’s a pretty good deal, and it’s the identical piece of merchandise.”

While that sounds good, it is not a completely accurate portrayal of the current situation. Most of these articles ignore the real possibility that market values could still go much lower. Although many investments have declined by 40% or even 50%, there is no guarantee that this is the bottom. 

In other words, to continue with the hypothetical illustration above, what if you purchased that plasma TV today at a 40% discount only to discover that the price dropped another 40% the day after your purchase? You might still be glad you did not pay full price, but you would undoubtedly wish that you had waited a little longer and obtained the additional discount.

As I write this, Bank of America stock (BAC) is trading at $5.78 a share. Is that share a better deal today than it was a year ago at $50? Not necessarily. That represents a loss of about 89%. If Bank of America were to drop another 89%, the share price would be 63 cents. Is it possible that BAC could drop to that level? Given the current economic situation, it is quite conceivable. 

On the bottom line of an investor’s balance sheet, there is no difference between an investor who starts with a share price of $5.78 and loses 89% or one that starts with a share price of $50 and loses 89%. 

I have a feeling that many investors are hearing comments from their brokers or advisors that go something like this: “The Dow lost 34% in 2008. The last time that happened was during the Great Depression. You don’t want to pull your money out of the market now. You’ll miss out on the rebound. What are the odds that the Dow is going to fall another 34%? Sure we’ve seen some individual positions with those kinds of losses, but a major index is more diversified.”

In case you have forgotten, after peaking in spring of 2000, the NASDAQ lost almost 75% of its value before bottoming in the fall of 2002. Not only is it possible for a major index to lose more than 30% in consecutive years, it has already occurred once less than a decade ago.

Please don’t mistake my caution at this juncture for a market forecast. I hope that the market does not fall another 30% from this level. But right now it certainly seems possible. Economic fundamentals are too weak to say that additional downside risk is insignificant.

The mere fact that the price of something has gone down–even significantly–does not mean it has become a better buy. A couple of years from now, it is possible that we could look back and identify this point in time as the bottom of the financial and economic crises. For now, however, we cannot determine where the bottom lies and it is irresponsible for advisors to tell investors that this is a good time to buy simply because stocks have suffered a significant downturn.
F.S.

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The 2008 Santa Claus rally was weak to begin with. Wednesday a disappointing report on retail sales from the U.S. Commerce Department seemed to erode any positive momentum that remained for the stock market.

The Commerce Department reported that retail sales dropped 2.7 percent in December. That was more than double the 1.2 percent decline that Wall Street expected. The December decline followed a November fall revised downward to 2.1 percent. The reported decline confirmed earlier reports that this was the worst holiday shopping season since at least 1969.

Major market indices rose in a gradual advance from the third week of November through December. Since the beginning of 2009, those indices saw consolidation of those gains but many investors were hoping that there would be a rebound this week. Unfortunately, the downward slide has quickened instead. Today that slide continued as the market opened significantly lower on weakness in the financial markets.

In a separate report Wednesday, the Commerce Department said businesses slashed inventories by 0.7 percent in November. That was the largest decline in seven years and it marked the third straight month that stockpiles were reduced as companies try to cope with huge declines in sales. Total business sales fell by a record 5.1 percent in November, according to the report.

This is all very significant because consumer spending accounts for two-thirds of U.S. economic activity. And U.S. consumers dominate world consumption. So when people cut back on expenditures, the ripples keep going for a long time.

Below is a price chart of the Dow Jones Industrial Average over the past year. I added the two red lines. The top one shows that the long-term downtrend continues, although the slope might have moderated somewhat. The bottom red line shows a technical support level that was violated on this downturn.

The bottom portion of the chart is a moving average convergence divergence (MACD). It rolled over at the start of the year and is on the verge of going negative again. This would indicate that there is still plenty of downward momentum in the market and it is quite possible that indices could reach or exceed the lows of November 2008.

We continue to hear reports of advisors who are telling their clients to hang on because the market is bottoming at this level. Others are saying that this is a good time to buy because most stocks are priced at least 40 percent lower than they were a year ago.

All technical and fundamental indicators we follow show that market risk remains very high. While it is possible that stocks could be near a bottom at this level, it is also possible that they could fall significantly lower. At this point, we believe that the most prudent course of action is to keep the majority of all assets allocated to a money market position.
F.S.

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I trust all who are reading this had an enjoyable holiday season. Unfortunately, now it is back to the real world and for the most part, the economic picture remains ugly. In fact, early this week minutes from the December meeting of the Federal Open Market Committee of the Federal Reserve revealed that an economic recovery is not likely until 2010. Interestingly, there was no real negative market reaction to that comment.

Major market indices have been trending upward since late November. It seems the Santa Claus rally occurred, in spite of dismal sales reports and spiking unemployment.

Over the past couple of weeks I’ve watched and read opinions from numerous experts advising investors on the best way to recover from the significant losses most incurred in 2008. Most of these supposed experts told investors to simply hang on and wait for the market to rebound. In other words, they offered no genuine, specific plan to help investors recoup their losses.

It is possible that some of these experts are not offering any new insights because they don’t have any. The strategies and philosophies that worked for them in the past have failed and they do not have an alternative. Some comments from a column by market analyst Ben Stein called “Lessons from a very bad year” are appropriate:

“…Efficient market theory is sunk. The problem is that we have nothing else to replace it except the predictions of many different analysts.”

“Buy and hold as a strategy is very questionable…. It’s worked in the past, but in times of severe market stress it just doesn’t work. We’ve now gone 10 years–many of which were banner years for profits–without a gain in the broad indices.”

In the end Mr. Stein acknowledged that while these accepted methods had failed, he knew of no better alternatives available. That isn’t very reassuring for investors who find themselves with portfolio losses of 30% to 50% or even more.

Here are some tidbits from an article in the latest Consumer Reports magazine on rebuilding your nest egg: “Work longer, keep saving. Reset your retirement clock. Stay in the market. Start early and diversify.”

Correct me if I am wrong, but except for the part about delaying your retirement, the rest of that advice sounds exactly like what most financial advisors have been saying all along. In other words, it is the same advice that many people have followed which led them to the current losses in their portfolios.

Ali Veshi, a CNN analyst, has written a book about recovering from this downturn called Gimme My Money Back. His advice includes: “…The strategy you should follow should be a function of your investment time horizon–how many years you’ll be contributing to your portfolio before you start taking money out of it–and your ability to tolerate volatility.” What is then described is a system focused primarily on asset allocation. Once again, nothing he advocates would have protected investors from this recent major market correction or from significant losses in future downturns.

Many economic experts quoted in the media continue to state their belief that the worst is over and investors who are out of the market now are in danger of missing out on a recovery. Often these are the same experts who failed to warn investors about the current economic crisis. Continuing to follow their advice seems imprudent, particularly when members of the Federal Reserve seem to believe that the economic downturn is likely to worsen in 2009 and continue into 2010. 

Because of the failure of most widely accepted market theories to protect investors from this economic onslaught, we again state our belief that the best investment strategy is one that utilizes active risk management and active allocation. Active allocation means overweighting portfolios toward stronger market sectors. We believe this combination is also the method that offers investors the best hope for recovery in the current situation.

There could be rallies during this bear market that offer investors opportunities for shorter-term gains. But for right now, risk continues to outweigh the possibility of reward. The safest place for investments is on the sidelines in a money market fund.
 
F.S.

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