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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Have you noticed that in the midst of this heated presidential campaign the candidates never talk about the financial markets? They occasionally make a reference or two about the economy but Wall Street and the major stock indices never get a mention. I suppose that is because it is difficult for them to take credit when the markets move up and they certainly don’t want to take the blame when the markets move down.

This week the indices have continued to struggle, even with a better than anticipated GDP number and with lower oil prices. There is no immediate end in sight to the downturn that began in October and investors need to remain defensive.

Below is a chart showing the S&P 500 over the past three years. I’ve highlighted a couple of aspects of the chart to better illustrate the current situation. First I added a red trendline to show the general slope of this bear market. This shows that since October 2007, the S&P 500 has lost about 300 points or about 20%. But if the same slope and duration persists, the damage will be more severe. From this point another 300 points lower would be an additional 24% loss.

I’ve highlighted the steepest drawdowns with blue arrows. One common question from clients is why we do not take more short positions during bear markets to try to make money on the downside. Notice the steepness and severity of these drawdowns. Often the bulk of the damage occurs in just three or four days. Our trading strategies are based on mathematical models. Experience has shown that if we apply too tight a trigger to the models, investors get whipsawed in and out of trades and it is difficult to capture gains.

Sometimes we do use short funds but it is usually part of a risk management strategy rather than an attempt to create profits. For example, one strategy has held a position in Prudent Bear fund (BEARX) for several months. That position is being used to hedge the risk of offsetting long positions.

The gold line on the top portion of the chart is a 50-day simple moving average (MA) of the S&P 500. Currently the index is holding right at that line. Since October, the only two months it has been above its 50-day MA were April and May. While we could see it bounce above that line again here, the market does not seem to have enough momentum to reverse the overall bear trend.

Finally, the bottom portion of the chart is a moving average convergence divergence (MACD) of the S&P 500. It is showing that the slight upward move of the past few weeks is already faltering. Any significant economic news could send the index plunging on another of those steep downward spikes.

For the near future, staying on the sidelines remains the safest place for investors.
   
F.S.

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Early this spring I acquired 18 baby chicks and began the process of raising them to become fully fledged, egg-laying chickens–a process that normally takes about six months. I have had chickens before, so I knew there would be some casualties along the way. Prior chickens succumbed to neighbor’s dogs, drowning in horse troughs, and being so ornery that they became more appealing as soup than as egg producers.

I figured that if even half made it to adulthood, this fall I would have an abundant source of free-range chicken eggs. In the past with just three or four chickens it seemed like there were always more eggs than we could use.

I never counted on the fox. I live in an urban area where foxes are relatively uncommon. But it only takes one and this one has killed as many as five chickens in a single night. I am now down to two hens and one rooster. I’ll be lucky to have enough eggs to make pancakes for breakfast, let alone enough for scrambled eggs.

So far my efforts to hasten the fox’s entrance into the afterlife have been unsuccessful. But I am holding out hope that the remaining three chickens will survive because they have learned to fly into the barn rafters when the fox makes an appearance.

At some point I realized this experience has many parallels with what investors experience during bear markets.

When investors first put money into the markets, it is only natural that they start anticipating the gains they will make in the near future. If they happen to invest at the right time in a bull market, the money seems to grow quickly. But if their investment is followed by a bear market, they money they invest immediately starts to diminish.

As the account value declines, the reaction from investors is to assume that there is a serious problem. After all, the whole point of investing is to see one’s money grow. Unfortunately, bear markets are as much a part of the economic cycle as bull markets.

Like the fox that is killing my chickens, bear markets give their victims a sense of helplessness. There simply is no way to quickly and easily resolve the problem. Although there are several actions one can take, there is no assurance that any of them will work.

I started by trying to make sure my chickens were safe in their coop at night. But one night the fox figured out a way into the coop. Trapped inside with the fox, the chickens were easy pickings.

I have set traps for the fox, but so far he has not been cooperative about entering.

I have a shotgun by the back door, but the one time I saw him carrying off a chicken he was out of range.

I am now resigned to the fact that survival of the last three chickens is pretty much up to them and out of my control.

An investor trapped in a bear market can try to find an investment that is inversely correlated. During the 2000-2002 bear market many investors moved assets out of the financial markets and into real estate. While a few got lucky, it hasn’t worked out very well for many others. Right now it is very difficult to find any sector of the economy that is advancing. Chasing short-term moves in an attempt to make money often results in investors being caught in moves Wall Street calls “bear traps.”

Those who espouse a buy-and-hold approach would have investors stay in the market and ride out the downturn. There argument is that things will eventually improve and the market will bounce back. Unfortunately that is not a realistic option for investors who are retired or who are near retirement.

Some try to make money in a down market by shorting. In other words, they make a bet that the downturn will continue. But it is a risky gamble and really only suitable for very aggressive investors who can withstand significant losses if the market turns up quickly.

Although it is difficult to accept, during a bear market investors need to stop thinking “how can I make money?” and start thinking “how can I avoid losing money?”

During most bear markets the very best course of action is to move to the sidelines and wait for a new upward trend. By their nature, financial markets are cyclical and bear markets will always be followed by bull markets. That raises the obvious question: When can I get more chickens?

Unless the fox ends up in a trap or within range of the shotgun, buying more chickens right now would seem to be less than prudent.

Perhaps you were thinking of the other question: How does one know when it is safe to move back into the market?

That is when it helps to have a thorough understanding of fundamental and technical analysis. Or if you use the services of a professional money manager, that is why it might be worth paying a management fee even when your account is just sitting in a money market fund.
F.S.