Eric Roseman's Eruptions: Stocks, Global Markets and Commodities BLOG

Sunshine State turns Cloudy for Conservative Investors

The state of Florida froze withdrawals from a $15 billion dollar state-managed investment fund yesterday, confirming the sub-prime credit squeeze continues to spread. And in Norway, several municipalities also reported mortgage-related liquidity issues. In Germany, two state-sponsored banks or Landesbanks are also on the verge of failure.

Florida’s State Board of Administration imposed a moratorium on withdrawals, a clear signal that sub-prime has spread to state coffers. The action also strongly suggests that other states probably have sub-prime exposure and related losses but have yet to fess-up to mortgage-backed exposure.

Florida’s State Board took hits in asset-backed commercial paper tied to sub-prime issuers, a popular vehicle for many institutions seeking higher inflation-adjusted cash yields this decade. The fund, with $2.3 billion dollars in assets, was marketed as a money-market fund; two weeks ago, the fund held more than $12 billion in assets ahead of a redemption scramble by local governments and school districts.

At this point, it’s quite obvious to even the most casual observer that money-market mutual funds are not safe havens amid a credit crunch. Any products marketed and sold as an alternative to money-markets are suspect.

If you hold a money-market mutual fund, consider selling out now and depositing those assets directly into Treasury bills or short-term Treasury bonds instead. The only exception to this rule is if you own “Treasury Bill” mutual funds, which are safe.

If you don’t want to own T-bills directly, you can also trade Treasury securities through online discount brokers and buy SHV (iShares Lehman Brothers Short Treasury ETF) or SHY (iShares Lehman Brothers 1-3 YearT-Bond ETF).

I’ve been recommending alternatives to money-market funds over the last few months as the credit crunch deepens. Review your cash and cash-equivalent positions in your portfolio and sell anything that’s not in T-bills or Treasury bonds. It’s not worth the headache.

I’m off to Vienna, Milan and London next week. I’ll report from Europe on Wednesday. Have a good weekend.

What’s in Your Global Equity Fund?

Most Global Equity Funds invest in major industrialized economies around the world with sprinkles of advanced emerging markets exposure in places like Brazil, China and Russia. For the most part these funds invest according to benchmarks with about half of their assets in the United States and the balance spread out across Western Europe and Japan, including Hong Kong and Australia.

But increasingly, more funds are deviating from their diversified advance economy mandates and investing in emerging market stocks. The result is greater returns but with accompanied risk that most shareholders don’t understand or never discovered when they made their initial investment.

For example, some funds coined “Global Equity Funds” have soared over 30% this year while the benchmark, the MSCI World Index, has risen just 8% in dollars. Obviously, something is wrong with this picture. To their amazement, investors might find their mutual funds stuffed with high-risk stocks like China Mobile, China Life, Baidu.com or Brazil’s CVRD.

The Global Equity sector in the United States and offshore is home to the single largest category of traditional mutual fund assets. That’s because with one investment, an investor can gain instant global diversification across hundreds of stocks in foreign currency-denominated markets. Investing in these funds takes the guess work out of global investing since you don’t have to time the next big foreign market or sector; and lower portfolio turnover means higher net returns since you’re not busy trading all the time. That’s the good news.

The problem facing investors ahead of the next bear market is “how much” emerging markets exposure do they really have? People forget that emerging markets investing is a two-way street. Yes, the returns have been truly spectacular this decade; but in the past, when financial “bubbles” burst, investors lose a pile of money in a very short period of time.

If you own Global Equity Funds, make sure you don’t have more than 10% in emerging markets, preferably even less. Although the major market economies have inherited all the risk this year amid a major financial services bear market tied mostly to sub-prime, the emerging markets are not immune to a recession in the West. Buyer beware.

Copper Price Decline Signals Slowdown

Dr. Copper continues to strongly suggest a global economic slowdown is now underway.

More than any other commodity, copper prices are a leading economic indicator since the metal is heavily tied to the growth cycle. Since January 2002, copper prices have skyrocketed 348% on a combination of surging demand from emerging markets (mainly China), historically low inventories and a falling dollar – all bullish developments that have supported the boom. But that party is coming to an end as the United States flirts with recession and other economies start slowing down in 2008.

Unlike previous global stock market declines or corrections since 2003, copper prices this year are clearly in a downtrend and have peaked. Since hitting a high of $3.75 per pound in September, spot copper has tanked 21% (see enclosed chart) while prices have severely broken support crossing important 50-day and 200-day moving averages.

The Chinese, however, have long supported long-term copper prices this decade and take advantage of any short-term price decline to build inventories. But that’s not happening this fall. Inventories held at the London Metals Exchange (LME) remain high, further depressing prices.

The world economy, excluding the United States, will continue to grow briskly in 2008. But a significant American slowdown or a recession next year will hurt foreign economies to some extent as exports slow. Copper trends now suggest that global growth has peaked. Bond yields, the dollar, small-caps and cyclical stocks also confirm a major slowdown is now underway in the world’s largest economy in late 2007.

Central Banks Misguided on Monetary Policy

The credit markets are now clearly in a major freeze across the United States, Canada, Europe and parts of Asia. And last week, Europe took the booby-prize as bond insurers scrapped two offerings on the heels of poor demand.

Once again, short-term lending rates like Euribor (€) and Libor (US$) are trading way above central bank targets as bankers remain reluctant to lend for extended periods in a growing credit crunch. The chart below shows the big spike in Libor rates since August 9 when signs of the credit squeeze first erupted.

The big theme among global investors is what sort of policy response can we expect going forward from the world’s leading central banks? Thus far, the Fed has cut rates and will continue to aggressively reduce borrowing costs as recession fears escalate. But the Europeans are reluctant to cut interest rates, despite pumping billions into the European inter-bank market.

Some central banks, like the Federal Reserve, are late coming to the rate-cut party.

As recently as March 28, Fed Chairman, Ben Bernanke, claimed “the impact on the broader economy and financial markets of the problems in the sub-prime market seems likely to be contained.” Then on June 5, he exclaimed “Fundamental factors – including solid growth in incomes and relatively low mortgage rates – should ultimately support the demand for housing, and at this point the troubles in the sub-prime sector seem unlikely to seriously spill over to the broader economy or the financial system.”

Bernanke, no doubt, is not a stupid man. But the above quotes depict a misguided monetary policy response, poor economic forecasts and a certain naivete on the part of the world’s most influential central bank. I’ve also got to believe the Europeans are thinking the same way.

The renewed credit freeze two weeks ago is not about to calm down any time soon unless the Europeans start aggressively cutting interest rates, especially the Bank of England, which literally “lives on another planet” believing inflation is still a primary concern. It is possible that one or two of England’s smaller banks will collapse in this squeeze.

The same “out of touch mentality” is also true for the European Central Bank (ECB) and the Federal Reserve; with housing clearly in a massive bear market and credit haemorrhaging, the threat of deflation, not inflation, has surfaced for the first time since 2000.

Would a series of European interest rate cuts alleviate pressure on credit markets? That’s an academic question because since August the world’s largest central banks have pumped the financial system with over $600 billion dollars’ worth of liquidity. But emergency rate cuts now from London and Brussels would throw the markets a tidal wave of liquidity, jacking-up government bond yields and finally injecting a dose of confidence to credit markets. It would also take some air out of the euro versus the dollar.

Central banks usually act in concert on monetary policy, especially amid a financial panic. This time won’t be any different. The sooner the Bank of England and the ECB abandon rear-view mirror inflation-fighting and tackle deflation in credit and housing, the sooner this bear market in financial assets will end.

Dow Theory Triggers Bear Market Alert

A major bear market signal was triggered on November 21st.

Developed by Dow Jones co-founder Charles Dow and perfected by investment writer Richard Russell, the Dow Theory is a popular technical indicator among market participants dating back to the late 19th century. When major averages such as the Dow Jones Industrials and the Dow Jones Transportation Average move in the same direction, the markets’ long-term trend is identified. And starting last week, the Dow Jones Industrials Average (DJIA) finally confirmed the Dow Jones Transportation Averages (DJTA) previous bear market signal earlier this summer.

If correct, the current bear market signal could imply the DJIA and other U.S. and international averages are heading at least 10% lower over the next several weeks – the first bear market since March 2000.

Economy Sluggish in late 2007

Since hitting an all-time high on July 19th, the DJTA has tumbled 20.4% as signs continue to point to a broad-based U.S. economic slowdown.

The Transports are a reliable indicator of the economy’s direction because they include cyclical companies tied to the movement of goods, including railroads, truckers, airlines and freight companies; when the economy stumbles, this average usually feels the pain first as shipping orders decline and freight volume decreases. But until last week, the mother of all global indexes, the DJIA had defied the Transports’ weakness hitting all-time highs until October 9th.

From its high last month, the Dow now sits 9.8% off its best level and marks the second time since August that it has tested previous lows. Since March 2003, the Dow has not declined more than 11% from its highs amid a period of unusually low volatility until earlier this year when signs of sub-prime stress first struck the market.

Other Averages Also Deteriorating

Along with the Transports, smaller company stocks have also been hit hard this year and trail the broader market for the first time this decade.

Since hitting all-time highs last summer, the Russell 2000 Index has plunged 13.6% as investors continue to bail-out of risky small stocks and swap exposure for the more defensive large-caps in the S&P 500 Index and the Dow 30. But even these larger companies are taking a beating lately as investors flee just about everything, except gold stocks.

Overseas Markets No Safe-Haven

Despite its declining influence and smaller share of total global stock-market capitalization, the United States still sets the short-term trend for the majority of world markets.

And the old adage remains true: “When Wall Street sneezes, the rest of the world catches a cold.”

Market pundits have been quick to claim that Asia and other emerging markets are now “decoupled” from the United States’ economic cycle. Nothing could be further from the truth. Despite losing pre-eminence to financial centers in London, Frankfurt, Shanghai and Hong Kong this decade, New York still radiates loud and clear on any given trading day. Asian markets follow Wall Street’s trend overnight and European bourses open the next day on the heels of New York’s closing trend. If you need proof, market returns in November rank as the worst month for investors since September 2002; the MSCI World Index has tanked 8% while the MSCI Emerging Markets Index has stumbled 11.4%. Even with a weaker dollar again this month, foreign currency denominated stocks have declined in-synch with U.S. averages offering no safe-haven.

Recipe for a U.S. Rally in 2008

I’m probably a lone wolf on this forecast, but I want to reiterate why I think American large-cap stocks, including the financials, will rebound in 2008 along with the majority of foreign markets.

Think lower interest rates, an extremely competitive U.S. dollar, decent corporate earnings and at some point, sharply lower oil prices in 2008.

A secular bear market is unlikely to develop because the classic signs of a monetary squeeze are simply not in the cards. Previous recessions and bear markets were the result of Federal Reserve monetary tightening; the Fed is now on course to cut interest rates even further into 2008 to halt the deepening mortgage-backed crisis and the severe bear market in housing. Lower rates will put on a floor on earnings and the stock market. Provided employment doesn’t fall off a cliff, the economy will recover by mid-year.

The best way to play that imminent recovery is to buy large-cap multinationals, including the beaten-up banks. Though I expect more sub-prime related write-downs in 2008, the market is getting very close to discounting a tidal wave of bad news. Also, with U.S. equity mutual fund sales at a negative $19.9 billion this year, a major contrarian signal has surfaced for the bulls. Individual investors are notoriously wrong at market-timing.

Finally, as oil pushes through $100 per barrel and beyond over the next several weeks, I expect a major correction in the primary trend. Too many speculators are riding this bull and a major shakeout is looming.

Lower Oil would be Bullish for Stocks

Oil prices are undoubtedly in a secular bull market this decade as supplies remain historically tight, OPEC can’t boost production further and tensions remain in the Middle East. But the market is placing too much faith on China’s consumption; crude oil prices do not reflect a weakening American economy this quarter and over the next six months. At some point, a vicious correction looms. A major decline in crude prices would boost consumer sentiment and jolt the stock market higher. I remind investors that even in a bull market, commodities can suffer a bad year. Oil declined in 2005, despite commencing a secular bull run in late 2001. Also, in a Presidential election year, I suspect the government will do all it can do influence lower crude prices, including releasing supplies from the Strategic Petroleum Reserve.

We might be in a bear market in late 2007. But I think it’ll be a short-term decline, however painful, that will eventually lay the groundwork for another big rally over the next several months as the Europeans, Canadians and Asian central banks join the Fed and start cutting lending rates to boost economic growth. Stay invested.

New Frontier Markets in “Bubble” Zone

The hottest thing in global investing since 2003 might be the BRICs, or investing in Brazil, Russia, India and China. “Chindia” funds are also the rage lately, or funds and indices that invest in China and India. But even hotter is the New Frontier markets, mostly small and opaque markets of Vietnam, Bangladesh, Bahrain, Oman and Romania, to name just a few from a universe of 31 countries according to Morgan Stanley Capital International (MSCI) and Standard & Poor’s (S&P). These markets are blasting ahead of China, India and Russia over the last seven years by a country mile!

The S&P Frontier Markets Index has surged 23.75% per annum from January 2000 to September 2007 compared to 12.42% from the MSCI Emerging Markets Index and just 1.18% annually for the S&P 500 Index in the United States. That’s an impressive figure. Many markets only recently surpassed their pre-2002 bear market highs, including the S&P 500 Index last summer. But even amid a plunge in most global stock-market values from 2000 to 2002, the Frontier markets continued to roar.

The New Frontier Markets are special because they’re mostly small and highly illiquid.

Most of these countries have limited stock-market floatation with only a handful of big companies dominating daily trading. Naturally, that makes investing in places like Ghana or Kazakhstan exciting, but equally, dangerous if the tide turns.

The largest and most liquid New Frontier bourse is Vietnam (see chart above), an amazing economy I visited last winter for a few days. But like Vietnam, up more than fivefold over the last few years, the majority of these high-flying markets are severely overheated and now in the “bubble” zone as more institutions look to diversify away from traditional emerging markets like China and India.

Here’s why you should avoid these markets right now…

Investors are recklessly lunging from one financial bubble to the next, markedly increasing portfolio risk. The trailing 12-month P/E for the S&P New Frontier Markets Index is a not-so-cheap 19 times versus 17.3 times earnings for the MSCI Emerging Markets Index. While U.S., European and Canadian bank stocks continue to get dumped, hitting multi-year lows, investors are still racing for emerging markets. But that’s typical rear-view mirror investing among the herd. I’ve already started to buy some banks, admittedly early, amid total chaos.

Call me conservative, but I like buying these markets “after” a major stock-market crash, not in the middle or tail-end of a massive speculative bubble.

There’s a new Frontiers ETF coming soon, so watch for it. It’ll be worth tracking and hopefully, investing following a major crash.

Good Calls, Bad Calls in 2007

With five weeks left of trading in 2007, it’s time to tally my main investment recommendations this year. Following dozens of investment editorials, interviews and several investment conferences and seminars, I’ve certainly had my share of picks and pans like all advisors in this business.

This hasn’t been a bad year for my investors. Though, it was looking much better heading into November – the worst month for global stocks since September 2002. In November, the MSCI World Index is down an ugly 8.3% in U.S. dollars or 10.5% in euro terms.

Suck it up

What matters most to me in this business, and to my investors, is to fess-up to losses when they occur.

Wall Street, on the other hand, doesn’t fess-up to losses; rather, they hide their trading misfortunes and let other suckers absorb the costs of their ineptitude. When I’m wrong, and I tend to be hard on myself, I admit it. And when I’m right, I always like to brag just a bit.

I’d have more respect for investment advisers and newsletter editors if they would publish a list of “winner and losers” every year and let the public scrutinize the bottom line. Too many advisors like to focus on their winners and rarely discuss why they lost money on selective trades.

My favourite lame excuse lies with money-managers. These guys justify losing money in a declining market by pointing to the benchmark, which declined far worse. What a joke. That’s not the way to manage money and explains, in great part, why the majority of actively-managed products continue to trail the benchmarks.

British Land

My absolute worst call in 2007 was to buy the already smashed-out British REITs in August following a huge 35% drop accompanied by insider buying and high-profile Middle East institutional interest.

The booby-prize goes to British Land (London-BLND), down more than 20% in just a few months – despite trading at a fat 30% discount to book-value when I first recommended the REIT. But the entire financial services sector and the FTSE index went into a swan-dive again recently with all sorts of fears plaguing the banking and mortgage sector. My timing was just dead-wrong on British property.

Also, I ill-timed Japanese smaller companies (the cheapest index worldwide) and French blue-chip stocks.

Gold and Commodities

On the plus side, the majority of my recommendations in 2007 are in the plus column led by big gains in natural resources. My advice was consistent in both TSI and Commodity Trend Alert: Stick to gold and energy stocks in 2007.

Last summer, ahead of gold’s latest rally, I heavily plugged gold stocks. I’ve also liked the oil drillers since January – also in the double-digits. In late December, I recommended BHP Billiton (NYSE-BHP) in my CTA – now almost a double. We’ve also played the grains, junior gold’s and other resource stocks.

I’ve also loved the Canadian dollar, which since 2002, I predicted would ultimately hit par-value versus the American dollar. Many of my resource picks this year in Toronto, when converted back to U.S. dollars, have posted big gains in just a few months.

As we shortly conclude another year of investing, my advice is to protect your downside as markets remain highly volatile. I suggest placing a trailing-stop on all your stocks. If you own mutual funds, don’t bother with stops. More importantly, look carefully at your long-term asset allocation goals, restrict trading fees and buy good companies for the long haul.

If you want to learn how to effectively hedge a portfolio, I urge you to read next month’s TSI, which features our new “Chaos Market Hedge Investments Portfolio.”

Have a Happy Thanksgiving.

Insurance Companies Join Financial Services Bear Market

Why are some insurance companies invested in mortgage-backed securities? Why did E*Trade pile into sub-prime lending and mortgage-backed securities?

Increasingly, we’re learning that non-bank companies have delved into the opaque world of mortgage derivatives and CDOs, or collateralized debt obligations.

In an effort to boost their earnings, these and many other companies in the financial sector have lunged after mortgage securities. The irony is that most of these institutions don’t really understand what they own and since late July, can’t even get a decent bid to sell these securities. That puts more pressure on the mortgage-backed market, causing more selling and broad-based panic.

Swiss Re (RUKN.VX), the world’s largest insurance company, just announced a $1 billion dollar loss on mortgage-backed securities yesterday – a shock to many investors because only a few months ago, the Swiss carrier claimed its books were clean. Surprise! Markets took Swiss Re’s shares 10% lower in Zurich on Monday and now sit at a 52-week low. The sub-prime shock spilled over to all insurance companies yesterday with the good, the bad and the ugly all going down hard.

Like I stated yesterday in my blog, previous financial crises in Japanese banking and the Latin debt crisis took years to materialize before actually peaking. The sub-prime mess, which began in earnest last February and resurfaced like a bad dream in July, will probably stay with us for at least another six months. Financial companies have not been honest with shareholders and should fess-up to their mortgage-backed losses. But part of the problem here is that many banks and now, insurance carriers, can’t sell these illiquid securities because the market is literally mostly frozen.

Financial services are a big chunk of the global stock index. The protracted selling is still quite severe and won’t end until the market has a real handle on the cumulative amount of losses. And I don’t see companies reporting their total losses until they can figure out what these securities are worth. It’s not over, yet.

Avoid Excessive Overseas Credit Card Conversion Fees

If there’s one thing I just hate, it’s getting fleeced by the credit card companies when I’m traveling overseas. If you travel to Europe or abroad, then you know exactly what I’m talking about.

The credit card companies have made a very profitable market for themselves all these years charging excessive foreign exchange conversion fees on cardholders. Although consumer protection groups are applying pressure on these companies to reduce these excessive charges, most cardholders still pay too much for foreign goods and services.

For example, if you buy something in London and the current pound spot rate (wholesale) is 2.05 per U.S. dollar, the credit cards will charge roughly 3 points more for that privilege.

Travelers have a few avenues available to avoid these excessive fees.

One way to limit the huge fleecing is to convert your entire foreign currency amount at home before you leave through an American Express or AAA office. These companies charge among the lowest retail foreign currency spreads and allow you to take euro or Japanese yen traveller’s checks with you; all you have to do is simply cash them in as you need the money. Also, traveller’s checks are great because you can get a refund if you lose them. Just be sure to write down the serial codes for each check and place them in a separate place while travelling.

Also, Capital One Corporation (www.capitalone.com) doesn’t charge currency conversion fees for overseas purchases. Many other issuers levy as much as 3% above spot currency rates. Capital One is simply a great alternative to other credit cards.

The next time you’re heading overseas, take your regular credit card (s) in case of an emergency, but cut your expenses dramatically with a Capital One card and foreign currency traveler’s checks.

Signs Increasingly Point to U.S. Slowdown as Housing, Employment and Bank Lending Contract

Treasury bond yields are sitting at a two-year low, housing prices are deflating at an alarming rate, employment growth is peaking and the banking industry is suffering its worst bear market since the Savings & Loans crisis in 1991.

The bull market for stocks, which began in late 2002, is now facing its toughest challenge in more than seven years as a rising tide of bearish developments attack the bull by its horns since July.

Although stocks continue to offer some of the best inflation-adjusted returns over the next 12 months amid lower Federal Reserve interest rates and generally strong non-financial sector corporate earnings, especially overseas, the party is gradually winding down. The rising weight of housing deflation, soaring energy prices and the relentless tidal-wave of sub-prime credit losses will subdue the consumer in 2008.

U.S. Consumers still Very Influential

Housing, employment growth and consumption are the main threats to U.S. and therefore global economic growth in 2008.

Consumer spending in the United States represents approximately 75% of GDP, or gross domestic product.

And make no mistake about it -- American consumption continues to drive global economic growth. The rapid ascent of emerging markets this decade and the boom in consumption in places like China and Russia, won’t supplement the loss in U.S. demand for imports. If the consumer hibernates next year, foreign economies will feel the brunt of slower exports to the world’s largest economy.

With employment growth stalling and wages now declining, the grand bull market for the consumer is about to slow, and possibly, contract. Indeed, imports have slowed this year while U.S. exports are rising as a cheap dollar continues to make American goods extremely competitive abroad at the expense of soaring foreign currencies.

Housing Deflation a Major Threat

In addition to discretionary spending, housing is also a major player driving U.S. economic growth. According to some measures, the bear market in residential real estate is now the worst since the Great Depression.

September was a watershed in the housing industry as builders cut housing starts to a decade-low of 1.19 million units while 4.4 million homes remain unsold – 16% more than a just 12 months ago. Housing deflation, or a period of protracted price declines, is the single largest threat to U.S. domestic consumption; the era of reverse mortgages has ended with a thud since mid-2006 as more homeowners retrench from discretionary spending and look to the stock-market as their wealth savior.

Adding insult to injury for homeowners is the credit crunch.

Mortgage Resets a Major Hurdle in 2008

With banks and investment banks saddled with several hundred billion dollars’ worth of mortgage-backed losses that continue to mount by the week, the credit crunch is not about to end any time soon. The housing market will face another enormous test next year when over $500 billion dollars of mortgage resets come due at higher interest rates. If employment growth continues to stall, housing values deteriorate further and the stock market declines, it’s hard to imagine the consumer will continue to service credit installment without delays or defaults.

Remember Japan?

Previous banking crises worldwide over the last 30 years usually morphed into greater losses following the initial shock or blow. This was the case with Latin America’s debt crisis in the 1980s, Japan in the 1990s and the S&L crisis starting in 1989. Each episode resulted in far greater losses for investors as banks only grudgingly revealed the extent of financial bleeding.

Just how bad is the current sub-prime crisis affecting the U.S. economy and money-center banks? Almost daily, one institution after the next is dropping a financial bomb on shareholders; markets are unsettled because the majority of these companies seemingly can’t clean their books. Considering financial services represent a hefty 18.5% of the S&P 500 Index’s total stock-market capitalization, it’s pretty amazing that stocks are in positive territory at all in 2007 and even hit new highs earlier in October.

Stick with Global Stocks, but Get Defensive

The Federal Reserve will cut interest rates aggressively into 2008 to boost the economy in a Presidential election year. Money-supply growth worldwide remains buoyant, supporting equities and most commodities, and interest rates in Europe will decline over the next several months to give those economies a lift. But risk is rising. The threat of deflation, not inflation, is my primary concern as the enormous weight of housing continues to impact U.S. consumption and ultimately, economic growth in 2008. With employment trends now looking weak combined with high energy prices and no end in sight for housing woes, the consumer faces his biggest test since 1990-1991.

I’m still invested in global stocks (only large-caps), commodities, foreign currencies and increasingly, cash. Also, I’m not adding to stocks at these levels with the exception of hedged products that can mitigate market risk and earn profits in a bear market.

In 2008, asset allocation will determine whether investors earn a profit or lose their shirt in an increasingly fragile bull market.