Last week we saw the S&P 500 break through technical resistance to a new high for the year. But this week major market indices have been unable to add to those gains. In general, most sectors of the market remain overbought and the threat of a significant downturn is very real. In the meantime, Washington power brokers continue to do everything possible to maintain stability and keep the current market rally alive.

The obvious answer to the question about whether the market is being manipulated is yes. But this does not mean there is a secretive group that is part of a government conspiracy to profit from controlling market movements. Someone or some group is always trying to influence the markets to their personal advantage. That is why we have government agencies charged with overseeing the financial markets in an effort to ensure that no entity can gain an unfair advantage. The fact that we have both bull and bear markets is a testament that no single interest can control the markets on a continual basis.

Right now the Obama administration, the Federal Reserve, Congress, the banking system and anyone else who can is attempting to boost the entire economy, including indirectly the financial markets. No one wants to see a major market meltdown and no one wants to see the country endure an economic downturn that lasts for years.

The question dividing analysts, economists, politicians and investors is whether or not those who are trying to bolster the economy will be successful in ending the recession and in keeping the stock market from plunging. 

In an article published by Yahoo! Finance this week, best-selling author Robert Kiyosaki explained that he believes the worst is still ahead for investors. 

“1. I believe the stock market is being manipulated. I suspect the government, banks, and Wall Street are doing everything they can to keep the market from crashing. Our leaders know that nothing makes the world feel better than a raging bull market.

“Do I have any proof that the market is being manipulated? No. I just smell a rat, or a pack of rats. I believe greed, self-interest, arrogance, and fear control the financial markets. I suspect those in charge will do anything to keep us all from panicking… and I don’t blame them. A global panic would be ugly and dangerous.

“2. In my view, this global crisis has been caused by the Federal Reserve Bank, the U.S. Treasury, Wall Street, and the central banks of the world. They caused the problem, profited excessively in doing so, and now profit by being asked to fix the problem.

“Every time I hear a politician mention the word stimulus, my mind flashes back to high school biology class, when I touched battery wires to a dead frog to make it twitch. Today, you and I are the dead frogs. Pretty soon the dead frog will be fried frog.”

There are plenty of others who espouse the idea that current conditions have been artificially induced. Todd Harrison, CEO of financial web site Minyanville.com, said this week that he currently believes there is less risk in shorting the market than in holding long positions. “This is a Splenda market– because there’s so much artificial sweetener involved,” Harrison said.

“The government is showing its hand and what they want to do: They want to transfer our obligations to our children, which will inherently lower the standard of living to our children,” he said. … “That transfer of risk to future generations is in the hands of foreign holders of dollar-denominated assets,” he said. “A seismic currency readjustment is a legitimate risk.”

Of course there are plenty of experts who believe that government intervention in the economy and the markets will be successful and is necessary.

In a speech before the Chattanooga Area Chamber of Commerce this week, Federal Reserve Bank of Atlanta President Dennis Lockhart said, “My forecast for a slow recovery implies a protracted period of high unemployment. … The challenge my colleagues and I face is navigating between the risk that early removal of monetary stimulus snuffs out the recovery and the risk that protracted monetary accommodation stokes inflation expectations that could ultimately fuel unwelcome inflationary pressures,” he said.

In summary, there are conflicting opinions about whether or not the economy will stay propped up or whether it will succumb to negative fundamental factors and suffer another major correction. Regardless of what occurs, both sides seem to concur that right now market risk is very high.

I compare the economic situation to my flock of chickens. For the most part, the chickens need very little help from me. I give them a little feed and some fresh water and I collect eggs. Just before dark the chickens climb back into the coop. I come along and close the door to keep the foxes and raccoons from killing them. Everything works well until something interrupts the routine.

Sometimes the routine is interrupted because the chickens need to be put away early. I can try to facilitate this by getting their attention and then spreading some food inside their coop. Often that does not work. Next I can try to herd them toward the coop by chasing them and guiding them with a rake or something else to extend my reach. Usually this approach is successful on about half of the chickens.

I have a Brittany that loves to chase the chickens. Sometimes I try to enlist his help to chase them in the right direction or at least to help tire them out. Once the dog is chasing them the chickens’ behavior is unpredictable. Sometimes most will run into the coop. Sometimes only one or two will succumb and the rest will scatter over a couple of acres of brush. 

The last resort is to catch any and all stragglers by hand. This involves prolonged chases where the chickens normally have to be cornered in the barn or against a fence. It is a tiring process and carries the chance of injury for the chickens and for the elderly man (me) chasing them. Sometimes one or two cannot be caught and they are left overnight outside of the coop to fend for themselves. That is usually a death sentence because a predator will virtually always find and kill them during the night.

This reminds me of the current economic mess. The chickens are out of the coop and the various government and financial entities are trying to get them back in using any tactics they think might work. Some are easy and effective. Others are less so. Will they be able to get them all back before nightfall? Only time will tell, but so far we are still early in the process and while a hen or two might be headed toward the coop, the majority are still scattered in the fields.
F.S.

If you have been reading this blog for the past few weeks, it should be apparent that I believe the U.S. economy is still in bad shape. Based on weak economic fundamentals–high unemployment, poor corporate earnings, consumer spending declines, etc.–I think stocks should be falling. And yet major indices have risen about 50% since bottoming in March.

Right now technical indicators for most equity positions are positive. That includes things like relative strength indicators (RSI), short and long-term moving averages, advance/decline lines, and more. These are some of the tools we use to help us determine when to buy or sell specific positions.

I wrote recently that if technical market indicators remained positive, we would need to cautiously re-enter the market. We have reached that point. Even though we believe a significant correction is likely to occur sometime in the near future, it is time to test the waters.

In the Foundation Strategy at Strategis Financial Group, we have maintained a small position in Permanent Portfolio Fund (PRPFX) for a couple of years, including throughout this bear market. For much of last year, we hedged that long position with an offsetting position in a fund that shorts the market. We exited that short position several months ago.

In the same strategy we this week purchased an additional small position in Fidelity Intermediate Bond Fund (FTHRX). That brings the total invested portion of this strategy to about one-third, with the remaining two-thirds still in a money market fund. In the chart below, you can see that both of these funds have produced positive returns for 2009.

 
Because we believe market risk remains high, we have elected to adhere to a conservative approach for invested positions. FTHRX has low volatility and also carries no trading restrictions. If the market turns against us, we can quickly exit. We can also exit PRPFX at any times because we have held it for a long time and any trading restrictions have expired. But we can also hedge this position again using a short fund if needed.

If we are wrong and the market continues to advance, we would expect to eventually see improvement in economic fundamentals and we would add to our long positions. In the meantime, this toe-in-the-water approach allows us to participate in some of the gains if this rally continues.

Each of our strategies is managed separately, using a variety of criteria depending upon their objectives and risk levels. We are currently holding a couple of other small positions in specific strategies. Rest assured that we are watching the markets closely each day. Every investment decision is made with careful consideration for protecting client assets against additional major market corrections.
F.S.

Wednesday market watchers and traders spent the day eagerly awaiting comments from the Federal Reserve’s latest Open Market Committee meeting. Apparently they liked what they heard, because major indices closed the day with strong gains.

The actual Fed statement is quite brief, so I am going to include the full text here so you can judge for yourself how to interpret the committee’s comments.

“Information received since the Federal Open Market Committee met in June suggests that economic activity is leveling out. Conditions in financial markets have improved further in recent weeks. Household spending has continued to show signs of stabilizing but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit. Businesses are still cutting back on fixed investment and staffing but are making progress in bringing inventory stocks into better alignment with sales. Although economic activity is likely to remain weak for a time, the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability.

“The prices of energy and other commodities have risen of late. However, substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time.

“In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. As previously announced, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year. In addition, the Federal Reserve is in the process of buying $300 billion of Treasury securities. To promote a smooth transition in markets as these purchases of Treasury securities are completed, the Committee has decided to gradually slow the pace of these transactions and anticipates that the full amount will be purchased by the end of October. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.”

Although the Federal Reserve is trying to put a positive spin on the current economic situation, there is certainly nothing definitive in this statement to verify that the economy truly is improving. And comments like “ongoing job losses, sluggish income growth, lower housing wealth, and tight credit” might lead one to believe there is yet little reason for optimism. In fact, in some of the areas where the Fed statement cites improvement, there are substantive contrary indicators.

For example, the statement reads: “Household spending has continued to show signs of stabilizing.”  Yet today a new report from the Commerce Department showed that July retail sales fell 0.1 percent. Economists had expected a gain of 0.7 percent.

In spite of the Federal Reserve’s announced efforts to provide props for the housing markets and mortgage lending, the National Association of Realtors announced Wednesday that median home prices fell a record 15.6% during the three months ended June 30, compared to the same period in 2008. Median prices rose slightly from the first quarter of 2009, but that gain can be primarily attributed to season factors.

My personal impression is that most of the announcements that are being heralded as positive signs for an improving economy are really of the “less bad” variety: as in, the economy continues to lose ground but it is less bad than earlier. Or, jobless rates continue to rise, but it is less bad than expected.

Another thing that concerns me is an impression that most revisions to recent economic reports are negative. For instance, last week second quarter GDP was announced at -1%–better than expected. But first quarter GDP was revised downward from -6.4% from -5.5%–significantly worse than previously reported.

In my home state of Utah, the Department of Workforce Services Wednesday reported that job losses in the first quarter were 50,247 rather than the 26,000 that was reported earlier. That is almost double the previous number, in case someone is counting. The state’s senior economist blamed the data error on changes to the surveying method enacted by the U.S. Department of Labor Statistics.

The bottom line for our clients and friends is that while major indices seem to still want to go up, technical and cyclical indicators show that the current move is very extended. Virtually all economic fundamentals still reflect weakness and high risk for investors. We continue to anticipate that a sharp and severe market correction remains a possibility. It might not occur, but we must continue to follow a risk averse strategy under these conditions.
F.S.

An interesting article on YAHOO! Finance this week posed the question: “Is This Rally Out of Sync with the Economy?” Written by Simon Maierhofer, he explains that “For nearly five months, the major U. S. indexes … have been climbing higher and higher. Simultaneously, economic numbers continue to disappoint.”

When the current rally began in March, I warned investors to be cautious because surging advances during bear markets tend to become traps that quickly turn down and punish investors who jump in too soon. But the next leg of the bear market has so far failed to make an appearance. We saw a decline in June and it appeared our caution might be vindicated. But then stocks rose strongly again in July.

It is tough for a professional money manager to watch the market rise and realize that his clients are not participating. However, our foremost responsibility is to protect clients’ assets against unnecessary risk and during this entire advance, risk levels have been and remain high. 

In 2008 we were heroes because we anticipated the downturn and moved most client assets to money market funds. We sidestepped the major downturn and have largely watched from the sidelines ever since. Now in 2009 major indices have finally recouped their losses from earlier in the year and are showing some gains. With media reports from some analysts saying that the bear market is over, investors who have been waiting on the sidelines are beginning to feel left behind. But just because there are a few signs of economic improvement does not mean the danger is past.

As noted in last week’s blog, earnings on the S&P 500 are at an all-time low while valuation (as measured by the P/E ratio) is at a record high–far beyond any level ever recorded. Those are warning signals that would be irresponsible to ignore. Maierhofer’s article also mentioned the disappointing corporate earnings and the valuations that are out of whack. 

“Discerning the true value for stocks is actually quite simple, if you are humble enough to stick with a simple concept. During prior bear market bottoms of historic proportions, P/E levels, dividend yields, and mutual fund cash reserves have always reached levels indicative of a market bottom.

“Unless those indicators provide their stamp of approval, the market is overvalued and any rally will turn out to be short-lived. Based on those indicators, the market is grossly overvalued, still.”

I have spent about 20 years in the investment industry. Prior to that, I worked 10 years as a hard news journalist. I can never recall another period where negative economic news was so easily dismissed. Nor can I recall another time when the tiniest glimmers of positive news were so eagerly touted and embraced.

Again quoting from Maierhofer’s article: “The 9.5% unemployment rate does not reflect the 4.4 million people who’ve been unemployed for more than 27 weeks, or the employees who’ve been forced to work less and make less. As part of the above mentioned cost-cutting efforts, companies cut the hours worked by a record 2.3% to an all-time low 33 hours. The ‘all-inclusive’ unemployment rate published by the Bureau of Labor Statistics is 16.4%.”

Perhaps I am naive but I do not believe the stock market can continue to advance with unemployment above double-digit levels and with the S&P 500 at exceedingly high valuations. 

One final quote from Maierhofer: “During the Great Depression, the stock market declined in steps.  A 48% decline was followed by a 48% rally. The next 47% decline was followed by a 23% rally. This process continued until the Dow Jones lost over 89% of its value.

“Investors who jumped back in after the initial 48% decline saw their portfolios dwindle by yet another 60%. Investors who thought they were ‘bargain hunters’ after the second rally, found out that their bargains were a money pit. The cycle continued until the market had destroyed the financial existence of many.

“This rally is simply here to relieve investors’ pent-up urge to buy and recreate an environment that will drag the maximum amount of money back into the losing vortex.”

I do not profess to be able to predict what the markets will do. I can, however, compare past experience to current situations to help make decisions about what is likely to occur, based on similar historic events. During this current rally, the Nasdaq has been the strongest of the major indices. All technical indicators for this index are currently positive and if they remain so, at some point we will no longer be able to remain on the sidelines.

But we all know that markets are cyclical and right now, technical indictors are showing that a downward cycle might soon emerge. Below is a two-year daily price chart of the Nasdaq. The rally we have seen over the past few months is clearly visible. The middle portion of the chart is a Relative Strength Index (RSI). Notice that it recently approached 80. That is a very high level that is difficult to maintain. In fact, the only other time during the past two years that it neared this high level was in October 2007 and a significant downturn followed.

The bottom portion of the chart is a moving average convergence divergence (MACD). It is also at a highly overbought level, which normally would indicate that a downturn is immanent. But a closer look reveals that since April, the Nasdaq has spent most of its time at levels that would be considered overbought.

From a technical perspective, these indicators lead us to expect some sort of a market pullback, but it is impossible to know how much of a decline to expect. For several months major indices have resisted a significant drop, even though economic fundamentals show that the economy remains mired in recession.

If we see only a brief correction and then major indices rally again, we might cautiously enter a few long positions. But for the immediate future, the best course would seem to be to remain patient and wait for the right opportunity. 
F.S.