Thursday, April 8, 2010

March 28, 2010 Weekly update

The US stock markets were up for the fourth week in a row and six of the past eight weeks. The Dow Jones Industrial Average closed up 1.01% last week, is up 5.09% for the month and 4.05% for the year. The S&P 500 was up 0.58% for the week and is now up 5.62% for the month and 4.62% for the year. US Treasuries had a lackluster issuance and the Euro closed lower for the second consecutive week falling just over a penny to $1.3421. The Euro did rally Thursday and Friday following an announcement that a general agreement of a Greek bailout had been reached by the European Union.

March Madness

Those of us who consider the NCAA Men’s Basketball Tournament, affectionately referred to as “March Madness,” the greatest sporting event annually in the United States have been reminded again of the difficulty in making predictions. ESPN reported March 20th that 98% of the approximately 4.8 million bracket predictions made by fans had Kansas reaching the Sweet Sixteen, 59% had the team reaching the Final Four, and 42% had them winning the championship. Only problem, Kansas lost to Northern Iowa in the second round shocking most serious and casual fans and wrecking their chances of winning the $10,000 first prize at ESPN.

What if all of those fans who picked Kansas had a chance to adjust their bracket selections after the Kansas loss or after each round, do you think their chances of picking the ultimate winner would be improved? Of course it would.

This is a timely example of the concept of relative strength analysis and trend-following that I use in building portfolios. Systematic trend-following analysis eliminates our dependency on the need to predict what is going to happen in the future. Relative strength identifies the strongest assets (just as the head-to-head competition in March Madness identifies the strongest teams currently playing) and allows me to stay with the asset/trend as long as long as it stays strong. When an asset weakens, it is kicked out of the portfolio and replaced with something stronger. This kind of casting-out methodology allows the portfolio to adapt to the market environment and is constantly being refreshed with new, strong assets. We all like to know what the future may bring, however, we rarely get it right. So do not base your asset selection on predicitions.

Mixed Signals

The GDP was revised downward slightly last week from 5.9% to 5.6% and the markets took little notice. Fed Chairman Bernanke continued to show support of an accommodative money policy, but has made it clear that he intends to stop purchasing mortgages as the previously stated $1.25 trillion ceiling is reached. Terminating this program will reduce money supply as banks and other institutions retain the loans they have issued making less money available for other lending. Mortgage rates have ticked up slightly in anticipation of this move. In another moved designed to pull money out of the economy, the Fed is considering selling some of its stake in high profile companies like Citigroup. All of this is healthy for the markets in the long term by reducing the risk of inflation in the future.

Jobs will continue to draw the attention of economists and investors. The general consensus for the March job numbers (released this Friday, April 2nd) is for nonfarm jobs to increase by 200,000. The headline will be good, but like so much of economics, the real story will be in the fine print. Much of the gains are expected to be attributed to hiring by the government for temporary census jobs, and for delayed hiring in March due to the terrible February weather in much of the country. I believe it will be important to see private sector job growth expand at 50,000 to 100,000 per month for a period of months before you can assume a real jobs recovery is under way.

Additionally, the US Treasury saw lackluster demand for the $118 billion in various notes issued last week. Interest rates were up slightly with the all important 10-year treasury yield closing the week at 3.8545% compared to 3.6930% the week before. Supply is clearly a factor, but the late week success in achieving an apparent deal for a Greek bailout has made investors a little more risk tolerant and also plays a role in the weakening demand.

The passage of health care reform did not have a negative impact on the markets early in the week. I believe that the jury is still out as companies assess the impact on their bottom lines. AT&T announced that they would have to take a $1 billion charge for the loss of tax breaks related to drug prescription plans for retirees. John Deere also announced restatement of $150 million and Caterpillar will restate $100 billion. These actions are being taken in accordance with tax rules requiring corporations to state changes to retiree liabilities when they are learned, not when they actually occur.

Greek Bailout

Germany, France and the other members of the EU reached agreement on the basic outline of a bailout plan for Greece. Germany had been the holding out for a demand that the International Monetary Fund be part of the bailout, lessening the potential liability of German taxpayers who have been opposed to any aid to Greece. The Euro rallied Thursday and Friday on the news. The next test will be Greece’s planned bond offering this week or next. The Greek government must replace about €11 billion ($14.7 billion) in April and another €11.6 billion ($15.6 billion) in May. Credit markets will be watching how much more Greece will pay compared to equivalent German bonds as a gauge of risk. Skeptics abound but the fact that agreements have been reached and credit markets are functioning can be seen as good news. International stocks remain unfavored in my analysis.

Looking Ahead

If the Euro begins to strengthen, you can anticipate a rise in general commodity prices due to exchange rate factors and also a return for greater risk taking in general. Oil is especially sensitive to these fluctuations, and look for gold to rally if interest rates continue to creep upward.

US equities remain favored. Small and Mid Cap stocks continue to show greater relative strength than the larger cap stocks and Growth favors Value. There has been no change in my favored sectors and they include Real Estate, Consumer Discretionary, Information Technology, and Materials. US Corporate and International bonds are favored. I am less optimistic about US treasuries. If the trend continues upward for interest rates, valuations will begin to slide.