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

Fed Can’t Resuscitate Economy without Tax Relief

With stocks and the economy now adjusting to a recessionary environment this month amid a never-ending blitz of bearish developments in the credit markets, the Federal Reserve will cut lending rates again on January 30th. Markets have priced in at least a 50 basis point cut (0.5%) and some participants are even calling for at least 0.75% or a full point off the Federal Funds rate. The current Fed Funds sits at 4.25%.

But Ben Bernanke can’t fix the American economy alone. The country is facing its worst housing deflation in history with a massive $23 trillion dollars tied to consumer balance sheets in mortgages that in many cases are worth more than underlying property values. That’s especially the case in California, Florida, Ohio, Michigan and several other states where recession has already gripped local economies since last year. It’s estimated that about a third of the U.S. economy is already in recession.

Bernanke, who testified on Capitol Hill yesterday, basically argued for a major government-led spending plan to boost consumer spending. The proposal, about $150 billion dollars’ worth of relief, will alleviate some of the stress in the financial markets but is unlikely to give the economy a significant boost. That’s because housing deflation takes years to form a bottom; a $500 cash rebate from the government isn’t exactly going to turn consumers into spendthrifts again.

Bernanke needs the government to inject fiscal stimulus because the dollar can’t handle aggressive interest rate cuts. The Fed Chairman knows he can’t slice another 200 basis points off the Fed Funds rate without inviting a dollar crash. The Fed needs the government to enact fiscal stimulus in concert with rate cuts—and now.

I admit being too sanguine about the credit crunch last summer. Most investors would probably admit they’re shocked over the alarming reach of this crisis, spreading from mortgage-backed securities to bond insurers and now consumer credit loans. Junk bond defaults are starting rise, commercial real estate loans are becoming clogged and banks have grown wary to lend. Though I still think large-cap stocks will post a gain later this year once a barrage of bank credit (a.k.a. Fed printing) and tax relief is poured over the markets, we’re going to have some rough treading over the next several months.

I’ve turned bearish this month. I’m pretty comfortable with my portfolios now and will look for a market rebound to unload another 5-8% of my equity portfolios – but not amid panic selling.

Don’t sell into market weakness. If you want to bail or reduce risky positions, do so when stocks are rallying or in the midst of a dead-cat bounce. It looks like you’ll have a chance to unload stocks today as U.S. stock futures look considerably higher.

Have a good weekend. See you Monday.

Anchor Portfolios with Diversified Global Funds in 2008-2009

For the first time in more than eight years, my equity exposure has been reduced in favor of alternative investments, the Japanese yen, agricultural commodities and bear market funds. But just because I’ve grown very cautious about the next 24 months doesn’t mean I’ve exited from the market entirely. And neither should you.

Market-timing is largely a mug’s game. I don’t know too many professionals who have successfully timed the market; in fact, I think it’s almost impossible. However, asset allocation is an investor’s best defense in all markets, and that’s what will determine your long-term returns.

Over the last six months I’ve reduced or liquidated most of my sector and country fund bets in favor of diversified global stock funds employing a value bias. Yes, these funds are getting hit hard this month as stocks take a bruising, but at least I’m covered with a hefty sum of cash, the yen, gold and alternative investments with a negative correlation to the market. The latter strategy is really shining this month in the worst January since 1991 for global equities. With markets down 6% in January, my portfolios are about flat – and I’ll take flat in this muck.

When the going gets tough and markets are poised to change direction in a big way, I sell the riskiest equity funds in my portfolio and beef-up my global equity fund positions.

Global mutual funds are diversified behemoths that invest worldwide across currencies and asset classes, mostly in large-cap stocks; what’s great about this strategy is that it allows me to concentrate on the big macro picture without adding speculative positions in a bad environment for most common stocks. In other words, I want to maintain some broad equity exposure in all markets, yet I don’t want to be subjected to the extraordinary volatility associated with emerging markets or small-caps at this stage of the economic cycle. Right now, I don’t want exposure to China or any other single-country market directly. Instead, I prefer to own many of these markets through a diversified global fund where the risk is much less.

The biggest challenge over the next 24 months will be how to protect capital ahead of the worst bear market since 2000-2002 and possibly, 1973-1974. A major profits recession is underway. But Wall Street hasn’t noticed as earnings estimates remain extremely too bullish in an economy mired by a major credit crisis, shrinking profit margins as commodities prices skyrocket, surging energy prices and slower domestic consumption. Plus, another brick is about to fall as securitization woes in auto loans and other consumer credit securities start to come under pressure this year.

The good news? I don’t think the market has much more to fall in this correction or bear market; a rally will ensue eventually and then we could see new lows again later this spring or summer. That’ll be the opportunity to “get out of Dodge” and unload risky securities as stocks post an intermittent advance. Basically, I think most bull markets around the world are either dead or dieing a slow death in 2008 and won’t reignite until 2010, at the earliest following dramatic interest rate cuts by global central banks.

The Retirement Crisis of 2008

Bear Market Arrives for Small-Caps as Claws Dig into Broader Market and Global Stocks

Smaller companies are the first segment of the market to enter the den of a bear market in 2008. After yesterday’s big global slide, U.S. and foreign small-caps are now firmly in the basement this year as the global economy gradually slows along with its primary locomotive – the United States. Small-caps are highly cyclical and sensitive to the global economic cycle. Like copper prices, also sliding since last fall, it’s considered a reliable growth barometer.

Historically, small-cap stocks have outpaced the returns generated by larger companies and have far exceeded the returns logged by the S&P 500 Index since the bull market began in 2003. But smaller stocks as defined by the Russell 2000 Index, is now down 20% from its all-time high – a bear market by definition. I also expect the S&P 500 Index, or American broader market, to follow south and match or exceed that decline. The S&P 500 Index has now declined 12% from its high.

The worst-performing Dow average since last year, preceding the broader market’s decline, is the Dow Jones Transportation Average. The Transports have plummeted a cumulative 22.6% -- a major bear market by definition. Everything from trucking stocks, railroads and airlines have tanked over the last six months.

With financial stocks representing nearly 30% of total global stock market opportunities, it’s no surprise that the MSCI World Index continues to struggle since November. The banks have not stabilized this month, despite billions invested by state sponsored investment companies and other vulture investors in distressed American financial behemoths. Global benchmarks remain hostage to bank stocks.

Like I wrote Monday, stocks are extremely oversold at these levels. I would not dump stocks at these low levels and instead, would wait for a rebound to unload the riskiest growth stocks in your portfolio. The worst thing an investor can do is sell stocks amid market weakness. Don’t do any major shopping in this market, unless you’re getting paid to own quality companies at low prices that yield fat dividends. This is no time to aggressively put new money to work.

Global Central Bank Intervention a Growing Possibility; Avoid Overbought Gold at these Levels

Prior to the Fed’s first in a series of interest rate cuts in mid-September, spot gold prices traded just south of $700 an ounce. Four months later and in the absence of any serious decline or correction spot prices now fetch north of $900 for the first time in history. Since September 1st, spot prices have surged $224 an ounce, or a cumulative 33%.

In the commodities world, a major up-crash like we’re seeing now for gold is usually a harbinger for a huge correction. It would not surprise me to see gold pull back to the $750-$700 level before making its next historical blast towards $1,000 an ounce. If a correction of that magnitude occurs, gold stocks will get trashed and plunge 25% or more in a very short period of time. That’s why I’d avoid buying gold or the gold stocks now.

Don’t get me wrong; I’ve been extremely bullish on gold since 2000 and continue to forecast at least $2,000 an ounce over the next few years and probably higher before this bull lays to rest. But corrections are a normal occurrence in a bull market and gold prices are too high right now in a world that’s fed-up with U.S. dollars and lower interest rates in America.

At some point, I’m expecting a massive, short-term dollar rally that will flush-out speculators. The trigger might be concerted global central bank intervention supporting the dollar or news of a major bottom in the sub-prime crisis or real estate in the United States. I’d count the odds of the latter sparking a dollar rally as very low, and instead, believe central banks are very close to intervening on behalf of the dollar. Intervention is a futile exercise over the long-term as markets ultimately take a currency to its proper level, regardless of central bank intervention. But if you want to put a psychological floor on the dollar’s decline, then intervention will do the job. I’d also expect the dollar-heavy Asian and Pan-Arabian central banks to join the Fed, and the Europeans to support the buck. The decline has been too severe for too long and another major decline in 2008 might trigger a dollar freefall. Since peaking in 2001,the dollar has plunged a cumulative 53.8% versus the euro.

Gold is in a secular long-term bull market. Like other commodities, this bull is mainly predicated on a combination of supply disruptions in South Africa and chronic dollar weakness. The buck’s reversal, which is coming, won’t last long. But for now, don’t add or build new positions in the precious metals ahead of a major counter-cyclical dollar rally.

Sub-Prime, Consumer and Commercial Debt will weigh on Markets in 2008; The Piper Comes Calling by 2009

With U.S. and global stock markets now 10% off their all-time highs and heavily oversold since late October, the odds of a major counter-cyclical rally occurring has increased markedly. Global stocks are now down 5% this year – the worst start since 1991. Only high-grade government bonds and commodities are up sharply this month.

But before getting too excited about the bull’s return, I’d use any intermittent strength in world stocks as an opportunity to sell your weakest positions and reduce market exposure. The only exception to this rule is the bank stocks.

I’ve been delving into distressed bank stocks since last September. Admittedly, I was too early like many other value investors. Yet I’m still dollar-cost-averaging my positions several months later because these prices are simply too cheap to ignore. In the United States, Canada and Europe, major banks are trading anywhere from 25% to 50% below their highs and still pay hefty dividends. I’m especially interested in those companies that have little or no sub-prime exposure, pay 5%-plus dividend yields and have insider buying. Three such names have made my Dogs of the World roster in 2008 and will be introduced to members tomorrow.

The sub-prime crisis is spreading to other sectors of the U.S. economy and threatens to push the country into recession this year.

And another threat lurks for investors this year outside of the sub-prime fiasco.

Consumer credit debt and commercial real estate debt is the next house of cards to fall in 2008. Virtually all banks have mountains of commercial and consumer-backed debt packaged and securitized the same way as sub-prime securities – Wall Street’s fabricated garbage of the decade.

In addition to more sub-prime resets later this spring, consumer installment debt is probably the next shoe to drop in 2008 as delinquency rates climb. In 2007, personal bankruptcies surged 40% from a year earlier and will certainly rise to new heights in 2008 as deflation continues to attack the consumer, mainly in plunging home values, soaring gas and food prices and eventually, rising unemployment.

The name of the game in 2008 is global asset allocation. Investors should hold only the best global brand name stocks paying dividends, value-based stock mutual funds, commodities, gold stocks, foreign currencies and high quality short-term government bonds or ETFs. Bear market funds and other alternative investments with a negative correlation to equities are essential to mitigate market risk.

I’m pretty confident that over the next 24 months investors will suffer the tribulations of the worst bear market since the 1973-1974 wreckage as the Dow plunged more than 50% in two years amid rising inflation, a bull market in commodities and soaring military expenditures resulting from a protracted conflict in Vietnam. The Fed and the White House will do all they can to keep this economy from tanking in an election year in 2008. But 2009 is another story altogether as the piper comes calling.

I’ll be discussing these and other defensive strategies for 2008 and beyond at The Sovereign Society’s Emergency Money Summit in St. Kitts next month.

Why the Dogs of the World Strategy Represents the Highest Margin of Safety in Rough Markets

The Dogs of the Dow and other income-oriented investment strategies predicated on value investing logged negative returns in 2007. In fact, many high-yield multinational financial services stocks suffered hefty double-digit losses last year amid sub-prime woes and a generally weak market in the post-July period. Even stodgy companies with reliable earnings in the consumer discretionary sector posted uninspiring returns or even losses.

In 2007, the Dogs of the Dow declined 1.4%, mainly because of Citigroup, trashed under the weight of its massive sub-prime and SIV (Structured Investment Vehicles) losses.

The Dogs of the Dow strategy involves selecting the top ten highest-yielding stocks in the Dow 30 index and equally-weighting a portfolio for 12 months. At the end of the year, an investor simply rotates into the next top ten high-yielding stocks. This formula has effectively outpaced the market over the last 35 years, takes only several minutes a year to execute and pays cash dividends every month.

Value Investing Hammered in 2007

The Dogs of the Dow had some company in 2007 as other value strategies suffered losses.

Value investing, as defined by the Russell 3000 Value Index of America’s broadest collection of value-based stocks, fell 3.6% last year versus a 10.6% rise for the Russell 3000 Growth Index. That’s a huge discrepancy in return and marked the first time since 2002 that value posted a calendar year loss. Value stocks typically harbor high free cash-flow, low stock-market multiples and solid balance-sheets that are typically unrecognized by the investment herd. Many of these stocks also pay cash dividends.

In 2007, benchmark indices fared much better than value investments. The MSCI World Index gained 7% while the S&P 500 Index rose 3.5%. The Dow Jones Industrials Index gained 6.4% and the Russell 2000 Index of smaller companies fell 2.7%.

Overall, 2007 was a terrible year for value investors as above-average dividends and cheap stock values failed to produce a positive return in a bizarre environment of volatility combined with new highs for stocks.

Introducing the Dogs of the World in 2008!

Last summer, I began to research a strategy based on the Dogs of the Dow formula. But instead of focusing on the top ten highest-yielding Dow 30 companies, I decided to twist that strategy a bit and expand the universe to 500 global multinationals. The end result was a massive study conducted over eight weeks costing thousands of dollars, including paying for index-based research.

The end result is a global strategy combining large-cap multinationals accompanied by big dividends and foreign currency diversification. In 2007, my Dogs of the World strategy gained an eye-popping 19.8% in U.S. dollars. That return outpaced most global averages, except the high-flying emerging markets, which largely don’t pay big dividends.

Next week, I’ll be introducing my Dogs of the World investment strategy to TSI members for 2008 – and the Dogs have never looked better!

Banking on Dividends, not Sub-prime

However, because many banks made the list in 2008 following a huge price decline in 2007, I’ve pruned my recommendations to exclude most institutions with sub-prime exposure.

From of a universe of ten Dogs of the World in 2008, only three stocks are banks and two of those three issues have zero sub-prime exposure yet pay dividends in excess of 5.5% per annum. And the single bank that does have sub-prime exposure is also home to the most significant corporate insider buying in the sector with over $19 million dollars in cash purchased by several directors since late November.

What matters most to me amid the ongoing sub-prime fiasco is to find those high-yielding bank stocks around the world with little or no sub-prime exposure that ultimately won’t chop their dividend payments. I’m not sure I can say that about Citigroup or Regions Bank. That’s why I’m not so sure the Dogs of the Dow strategy will post impressive returns this year because of its overweight in money-center banks.

An Optimal Dollar Hedge

My Dogs of the World strategy is also a boon for dollar-based investors. That’s because seven out of ten Dogs are international stocks traded in countries like Sweden, Italy, Australia and Norway – currencies that have pounded the wounded U.S. dollar since 2002. In addition to regular dividend checks and hopefully, capital gains, you also get foreign currency appreciation as the Fed desperately tries to revive a sluggish economy through lower interest rates and competitive currency devaluation.

As global market volatility accelerates this year, the Dogs of the World promises to provide investors with a higher margin of safety than most indexed-based strategies, including the Dogs of the Dow – still vulnerable to sub-prime losses.

In 2008, the Dogs of the World will invest in safe, high-yielding large-cap banks, telecommunication stocks, healthcare and natural resource companies. The effective yield of this portfolio was 6.61% on January 1.

In 2008, I’ll bet the Dogs of the World beats the Dogs of the Dow.

I will be away for the rest of this week, but will be back and posting my next blog on Monday, January 14th. Until then, have a nice week!

If Oil Prices Decline, buy Airline Stocks

Historically, one of the worst businesses in the world is the airline industry. With the exception of only a few really successful business models (Singapore Airlines, Virgin Atlantic, Ryanair, Southwest), the majority of carriers have lost hundreds of billions of dollars over the last 30 years. That’s especially the case since Reagan deregulated the industry in the 1980s resulting in the eventual demise of Eastern Airlines, National, TWA, Braniff, Pan Am and many other smaller carriers.

Running an airline is usually a one-way ticket to bankruptcy. That’s because surging energy prices (jet fuel), labor costs and rising prices for everything from blankets to food have stripped margins down to the bone for most carriers, especially the legacy carriers like Delta, United, American, Northwest and USAir. Plus, competition is intense with low-cost operators ripping into legacy carriers’ market share. It’s just a bad business model.

But if oil prices (and jet fuel) decline in 2008, which I expect amid a slowing global economy, then investors might see some big short-term gains in a very smashed-out sector. I also can’t find an airline-dedicated exchange-traded-fund in the market, which tells me the service-providers have no commercial interest in launching a product handcuffed by a secular bear market. That’s bullish for contrarians.

But if there was an airline ETF, the index would have crashed over 40% since January 2007. Stocks like AMR or American Airlines’ parent, has plunged over 50% while Delta is down over 35%, to name only a few casualties. Many other stocks in this sector, and not just in the United States, have crumbled since 2006.

Obviously, I can’t find a reason to be a long-term airline industry bull. But a dead-cat bounce is highly likely over the next several months if jet fuel prices decline. If that happens, look to buy a basket of the legacy carriers for a profitable trade.

Global Benchmarks Unplugged: Study Indices before Drawing Final Conclusions in 2007 Returns

Unless you were over-weighted in the high-flying emerging markets in 2007, major economy markets were largely a disappointment. The MSCI World Index, the leading global benchmark for investors and money-managers since 1969, gained 7.1% in 2007 versus a whopping 36.5% for its MSCI Emerging Markets Free Index.

But below the surface of diversified equity market returns lies a distortion in performance attribution last year.

Based in local currency terms, which strips away currency considerations for global indices, the MSCI World Index gained just 2.8% in 2007. And if we omit the performance of U.S. stocks in that equation, the MSCI EAFE Index of foreign equities rose a miserly 1.2%. Worse, euro-based investors suffered a 3.4% decline in global stocks in 2007.

What the above data confirms is that broadly-based major economy markets did not post generous returns last year. Indeed, in U.S. dollar terms, the MSCI World Index captured the bulk of its total returns in 2007 from currency gains vis-à-vis the euro and to a lesser extent, the yen, pound, Canadian dollar, Australian and New Zealand dollars, which comprise smaller market-cap weightings than the euro-zone in the MSCI World Index.

Japan, which ranks as the second-largest stock-market in the world behind the United States, logged its worst year since 2002 as the Nikkei fell 6% in dollars. That acted as a major drag on not only the MSCI World Index but especially, MSCI EAFE Index.

For the record, the MSCI Emerging Markets Free Index measured in local currency terms gained 30.4% in 2007. That tells investors that most of the indexes’ returns last year were organic, unlike the MSCI World Index and EAFE, measured in dollar terms. By “organic” I mean returns were generated from underlying stock-market returns, not foreign currency considerations.

Over the last five years, the MSCI Emerging Markets Free Index has surged 33.6% per annum versus just 14.9% per year for the MSCI World Index, in dollars. In local currency terms, the bull market has served investors well, however, with emerging markets up 28.3% per year compared to a not-too-shabby 12.3% for the World Index.

Indeed, 2007 once again benefited emerging market investors with stunning gains recorded in Brazil (+76%), India (+75%), Turkey (+66%) and Chinese stocks (+63%), to name just a few. The best-performing major market bourse in 2007 belonged to Finland, up 50% in dollars followed by a 49% gain in Hong Kong.
Over the next five years, I think the New Emerging Frontier Markets will outpace the Emerging Markets while U.S. stocks beat European equities. And Japan, badly lagging all benchmarks since 1990, will outpace all major markets.

But that’s just a forecast…

Election Year Stock Market Cycles: 2008 Looks Challenging

One of the more accurate gauges for forecasting stock-market performance is the U.S. presidential election cycle. And in 2008, the bulls will probably struggle to maintain the upper hand, if history proves correct.

Since 1888, the S&P 500 Index has advanced in 23 of the past 30 U.S. presidential election years. The average gain for the broader market in that period was 8.4%; however, upon closer examination the data confirms that returns were muted when the incumbent Republican candidate lost the presidency to a Democrat. In that case, a scenario that’s highly likely later in November, the S&P 500 Index gained just 1.7%.

In the first Presidential cycle of the new millennium in 2000, the stock-market suffered a bruising dot.com bust starting in March of that year, resulting in a 9% loss for the S&P 500 Index. That was the market’s first calendar year loss since 1990. In 2004, stocks struggled to stay above water for most of the year as the Federal Reserve began raising interest rates, logging most of its calendar year gains in November – after George W. Bush won his second term. In 2004, the S&P 500 Index gained 11%.

With Democrats now likely to tone down their tax hike rhetoric amid a slowing American economy since September, the market might record a healthy return this year. That assumes the Fed continues to cut lending rates, the housing market finds a bottom and lenders extend credit in an environment of what’s still largely defined as a capital shortage.

In 2008, the odds are better than 50-50 that equities will post a gain. Stay invested in quality large-cap stocks, ETFs, mutual funds and most of all make sure you have a diversified portfolio including currencies, commodities and alternative investments to hedge your market exposure.