Market Update

3^rdQUARTER 2011

“DOWNGRADE IGNITES A GLOBAL SELLOFF,” Wall Street Journal, August 9, 2011, a headline we never imagined.  Well, you can tell your grandchildren you were there.  The base problem is the West in general, and the U.S. in particular, has been spending more than they’ve taken in for many years.  Quoting S&P, “The downgrade reflects our opinion that the effectiveness and stability of American policy making and political institutions have weakened at a time of fiscal and economic challenges to a degree more than we had envisioned when we assigned a negative outlook on April 18, 2011.”  Actions do have consequences.  “Everybody, sooner or later, sits down to a banquet of consequences,” Robert Louis Stevenson, as quoted in The Wall Street Journal, September 10, 2011.  From less than $6 trillion in 2000 to $14 trillion in 2011, our prolific ways have caught up with us.

The markets continue to demonstrate investor concern.  The DJIA closed the quarter at 10913.38, down YTD 5.73%, the S&P 500 1131.42, down YTD 10.03%, and the NASDAQ 2415.40, down YTD 8.95%.  Mutual funds, in addition to experiencing large outflows, fared no better.  Barron’s, October 10, 2011, reports results according to LIPPER:  Large Cap Core ?14.76; Mid Cap Core ?20.84; Small Cap Core ?20.82 (for fund definitions please see Google, Lipper Fund Classification Definitions).  There was no place to hide, not a positive number on the page.

Unemployment remains stuck in the 9% area according to government reporting.  Using 1980 calculation methods, the number is probably closer to 20%.  Bank of America announced on September 9, 2011, that they would be restructuring due to economic conditions, to which by the way, they were a major contributor.  The process will eliminate 40,000 jobs.  Thanks BAC, we needed that.  The political debate continues.  Throw more money at the system to create jobs?  With 2.3 trillions of dollars already committed, TARP, cash for clunkers, QE I and QE II have come and gone with questionable results.  And one, we recently discovered.  From The New York Times, Gretchen Morgenstern, November 14, 2009, “Home Builders (you heard that right) Get a Gift.”  Major homebuilders Pulte ($3.95) and D.R. Horton ($9.04) by way of example, were allowed to go back as far as five years and use current losses 2008, 2009, to offset previously declared profits and taxes paid on those profits.  This generated substantial tax rebates, reportedly $1.3 billion by D.R. Horton in 2009 and 2010.  Given the state of new home construction in 2010 and 2011, it’s very unlikely those rebates were used for new hires.  Some argue the money wasn’t spent to create jobs with new infrastructure projects, but rather to fund government jobs that would have been lost otherwise.  Or, as in the case above, to refurbish corporate balance sheets.

The recently announced $447 billion American Jobs Act has met with mixed reviews, mostly along political party lines.  Bloomberg Businessweek, September 19, 2011, notes “For the stimulus to work, Obama must first make the public believe it will,” and “sentiment can be so harmed that a gloomy outlook becomes a self-fulfilling prophecy.”  The Bloomberg Consumer Comfort Index is at -41, down from +33 on January 2000, and has hovered there since 2008.  The NFIB Small Business Optimism is 88.1, down from 103.6 in January of 2000.

“Fed Launches New Stimulus,” Wall Street Journal, September 22, 2011, the effort will be to reshape the Fed’s Treasury’s $2.65 trillion portfolio so as to lengthen the average maturity.  Operation “Twist.”  This will entail buying $400 billion of longer maturities and paying for them by selling a like amount of shorter maturities.  The goal, to lower longer term interest rates so as to encourage home buying and business investment.  The ten year Treasury dropped in yield to 1.87%, the lowest on record since 1977.  At the announcement of the new effort, the Fed issued an unusually strong statement, “There are significant downside risks to the economic outlook, including strains in global financial markets.”  Moves, such as this, are becoming more controversial.  Three of ten voting Fed members opposed the action.  There is an inherent floor for mortgages, maybe 3 to 4%.  Keep in mind someone must be willing to lend the money, looking for a return on investment and normal business operating costs.  So even if the Fed lowered long rates to zero, mortgages would not follow.  Markets responded by losing 6.3% in two days, September 22 and 23.  “Insanity,” according to Einstein, is “doing the same thing over and over and expecting different results.”

The importance of housing in the economy cannot be overstated, existing home sales, new home sales, foreclosures, and short sales.  For those who have not kept up with the jargon, a “short sale” occurs when an owner sells for less than the balance due on his mortgage.  Wall Street Journal, September 22, 2011, “A speck of good news, existing home sales rose 7.7% in August to the highest level in five months and to a seasonally adjusted rate of 5.03 million.  Short sales accounted for 31% of total July sales.”  The longer term plus in this is, the recognition and the dealing with a problem.  Selling a house for far less than you paid and working out the consequences.  On a larger scale, this is the situation which the country at large must address.  Sadly, the article also reports home prices continue to drop, and are expected to be down 2.5% this year and rise only 1.1% through 2015, according to Macro Markets LLC.  Recently released data indicates sales of new homes slipped to 295,000, seasonally adjusted rate in August from 302,000 the previous month, the lowest level on record since 1963.  Competition from existing homes is too tough.  In sum, an AGORA Financial Services writer, Chris Mayer, notes five years into the housing bubble, 28% of mortgages are underwater, 7% are delinquent and 10% have been foreclosed.  Barron’s, September 19, 2011, Jim Grant, Editor, Grant’s Interest Rate Observer (please Google) “capitalism is not just about success… that’s the easy part.  It’s also about failure, recognizing it, dealing with it, liquidating it, and properly pricing it.”

In 1965, Charles De Gaulle predicted that with the Dollar as the world’s sole reserve currency, the U.S. would eventually fall victim to the ease with which it could borrow.  The following is from Barron’s, David Rocker, September 19, 2011, “The markets have shown that we have reached our limits.  The S&P’s lowered ratings and the Tea Party are not responsible for the recent market meltdown.  Years of irresponsible fiscal policy, in both Republican and Democratic administrations are the cause.  We have brought this on ourselves and we must fix it ourselves with hard work and sacrifice.  Austerity is no longer an option.  We must get used to limits, and focus to a greater degree on what we need rather than what we want.  The establishment of priorities when resources are limited is what budgeting is all about.”  This, of course, was what the “debt ceiling” debate was about all this summer.  From all we read and hear, this debate will not be resolved until the general election of 2012, when the country decides the direction it would like to pursue.  Wall Street’s “old saying” number 1, “markets hate uncertainty.”

Looking due east to Euroland does not bring much comfort.  As Barron’s notes in the October 10, 2011, issue, “Europe’s Comedy Hurtles Toward Tragic End.”  To say that situation is precarious is an understatement of epic proportion.  No one knows how and when it will end, but a happy ending seems remote.

These two situations, the U.S. and European economies, inevitably lead to a discussion of Gold, the Dollar, currency wars and the race to the bottom—lots to digest.  It’s appropriate here to review what Aristotle laid out in 300 BC as the four pillars of good money; divisibility, durability, portability, and scarcity, or intrinsic value.  With gold around $1800/oz. there is a lot of talk of the “gold bubble,” Jim Grant again, “you can think of gold as a stock that went from 2? to 18 in a dozen years.  I’m not sure that’s a bubble.  Gold is simply the reciprocal of the world’s faith in the institutions of managed currencies.”  There will be more chapters to this story.  Meanwhile, keep Mr. Grant’s statement in mind.

As usual we need to keep current on Chinese activities.  On September 15, 2011, in an article from the Telegraph, of London, “China to Liquidate U.S. Treasuries, not dollars” by Ambrose Evans-Pritchard, well known economist and financial reporter (see Google).  Li Daokui, a top advisor to China’s Central Bank said at the World Economic Forum, “The incremental part of our foreign reserve holdings should be invested in physical assets.  We would like to buy Boeing ($60.51), Intel ($21.34), and Apple ($381.32),and maybe we should invest in these companies on in a proactive way.”  Knowledgeable observers note this is an unusually direct comment from a high profile Chinese official.

A major investment theme, on which we will devote considerably more time in coming letters, is the universal growth of the middle class.  Poor people by necessity subsist on grains and other plant-based foods.  The first thing they do as soon as their income covers more than the bare essentials is to add meat, protein, to their diet.  This is a worldwide trend, the proof of which is evidenced by the following news item; “Chinese Hunger for Corn Stretches Corn Belt,” Wall Street Journal, August 24, 2011.  In July China ordered 24 million bushels of corn, exceeding what the government thought they would buy for all of 2011.  In August they bought another 2.2 million bushels.  Not surprisingly, corn prices which have doubled over the last year, traded at that time around $7.275/ bushel.

Addressing another worldwide trend, the desire to own physical gold, we note from the Taipei Times, September 26, 2011, “China launches its first gold vending machine.”  China, already the world’s second largest bullion consumer (India is first), has installed the country’s first gold vending machine in a busy shopping district in Beijing.  Each withdrawal is capped at 1 million yuan or $156,500.  Chinese demand has soared 27% year over year according to the World Gold Council.  Gold vending machines exist in Britain, the U.S., the Middle East and in Europe.  Please review the pillars of money above.

Oil has fallen to the $79/bbl range in the last several weeks, gasoline at the pumps near $3.85, much to buyers delight.  Who enjoys $75 fill-ups?  The coming global slow-down is being credited with the decline.  Do not reduce your budget planning for fuel oil and gasoline, just yet.  “TOTAL, Optimistic on Oil, Gas Output,” Wall Street Journal, September 27, 2011, French oil giant is raising its outlook for production and consumption.  They expect normal long term consumption growth to continue and predict that spare capacity now around 6% will decline to 3%.  China and India this year will consume about 25% of the global energy supply, which is up from 13% in 2000.  According to a report by the International Energy Administration on September 26, 2011, China and India will account for about 35% of the world’s available energy by 2035.  The growth of the middleclass theme, noted above, contributes to this growing demand.  Think bicycle, to moped, to automobile, to travel.  China currently has about 500 commercial jet airliners.  There are estimates of 5000 required by 2030.  In 2010, 267 million Chinese bought airline tickets, up 15.8% year over year.  Energy prices are not going to stay down.

As The Wall Street Journal notes on September 23, 2011, “It isn’t easy to find a bright spot amid the market carnage, but contrarians would say sentiment is so negative that it could actually be supportive of stocks.”  Some sentiment readings were already as low as they were at the end of the last bear market in 2009.  A survey of professional investors recorded 32% bearish.  Additionally, the American Association of Individual Investors recently notes 48% of their members in the bear camp.  If the majority is always wrong, maybe we are nearing a turn.  Still, it is hard to see a meaningful change in direction until we know where the country is going, after November 2012.

As always we invite your comments and questions. 

Warmest regards,

The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material.  The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete.  Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation.  Any opinions are those of Professional Planning Group and not necessarily those of RJFS or Raymond James.  Expressions of opinion are as of this date and are subject to change without notice.  This information is not intended as solicitation or an offer to buy or sell any security referred to herein.  Investments mentioned may not be suitable for all investors.  Past performance does not guarantee future results.  You should discuss any tax or legal matters with the appropriate professional.  Please note that international investing involves special risks, including currency fluctuations, differing financial accounting standards, and possible political and economic volatility.  Commodities and currencies investing are generally considered speculative because of the significant potential for investment loss.  Their markets are likely to be volatile and there may be sharp price fluctuations, even during periods when prices overall are rising.  Diversification does not assure a profit or protect against loss.  Gold is subject to the special risks associated with investing in precious metals, including but not limited to:  price may be subject to wide fluctuation; the market is relatively limited; the sources are concentrated in countries that have the potential for instability; and the market is unregulated.

 Inclusion of these indexes is for illustrative purposes only.  Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance.  Individual investor’s results will vary.  Past performance does not guarantee future results.  The S&P 500 is an unmanaged index of 500 widely held stocks that’s generally considered representative of the U.S. stock market.  The NASDAQ is an unmanaged index of securities traded on the NASDAQ system.  The DJIA is a price-weighted average of 30 actively traded blue chip stocks, primarily industrials.

MARKET, ECONOMIC AND INTEREST DATA 9/30/11

Source:  The Wall Street Journal

Inclusion of these indexes is for illustrative purposes only.  Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance.  Individual investor’s results will vary.  Past performance does not guarantee future results.  The Dow Jones Industrial Average (DJIA), commonly known as “The Dow”, is an index representing 30 stock companies maintained and reviewed by the editors of The Wall Street Journal.  The S&P Midcap 400 Index is an unmanaged index that tracks 400 stocks of medium-sized U.S. firms with a market capitalization ranging from $1.5-$5.5 billion and chosen by capitalization, liquidity, and industry group representation.  The S&P Smallcap 600 is an unmanaged index that tracks 600 stocks of small-sized U.S. firms with a market capitalization ranging from $300 million-$2 billion and chosen by capitalization, liquidity, and industry group representation.  The CRB Bridge Index represents unweighted geometric average of commodity futures prices of 17 major commodity futures markets and viewed as a broad measure of overall commodity price trends.   The S&P 500 is an unmanaged index of 500 widely held stocks that’s generally considered representative of the U.S. stock market.  The NASDAQ composite is an unmanaged index of securities traded on the NASDAQ system.  This is not a recommendation to buy or sell any investment.