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Market Data and Portfolio Management

For the week ending August 16th, the S&P 500 dropped 2.1%, and the second quarter of this year saw quite a bit of volatility. But, year-to-date, the S&P is still up 18% and since 2009, the bellwether index has been in the fourth longest bull market in history. Unfortunately, many nervous investors missed the long bull (others pulled out in July, only to see the market bounce back the first two weeks of August).

This is indicative of investors who insist on trying to time the market instead of realizing that the short-term volatility we experienced recently is simply the cost of earning long-term returns. Investing, like a successful career, can be a struggle; and to succeed you must take some risks and endure some pain.

Instead of searching for specific reasons for the decline (many pundits pointed to weakness in retail sales) in an attempt to avoid similar dips in the future is futile. That’s because volatile periods are typically random and thus very hard to predict. Stick to a globally diversified portfolio making tactical changes when necessary and you will be rewarded over time.

Dozens of economic reports are released each month by numerous sources. Market data relating to inflation, GDP and manufacturing is too short-term and too volatile to guide your portfolio decisions. Also, the data can be very confusing.

A good example of this is inflation vs. higher prices. While to two are certainly similar, they come from two very different sources. Inflation is a monetary phenomenon (too many dollars chasing too few goods) that causes a general rise in consumer prices across a large basket of goods. Inflation tends to be persistent and can last for longer periods of time.

Simple higher prices are usually associated with one or two goods (oil and food) that increase in price due to constriction of availability or simple supply and demand. Higher prices (price increases) tend to be short-term and can fluctuate quite a bit.

Another good example is housing, which continues to be weak overall, but real estate in some markets is very strong. Places like Houston and suburban Washington, DC, have experienced increases in home sales and prices. Other markets continue to struggle. As a result, banks in many places are still reluctant to lend.

Retail sales have been fluctuating dramatically and while prices on some goods have gone up, we haven’t seen the runaway inflation that many economists have been predicting. In fact, the CPI has remained fairly steady despite increases in the price of food and energy.

The key take-away here is not to react to every monthly economic report that comes out. Learn about them, understand them and use them as part of a larger examination of the current global economic situation. Don’t trade them like a hot-tip at a barbeque.

Don’t Trade On Economic Data

Recent economic data (especially short-term reports) has been quite volatile. Things like retail sales, housing starts and unemployment seem to change each month. This has caused a mixed reaction among investors, some of it very negative. But it shouldn’t affect your portfolio.

For example, housing continues to be weak overall, but real estate in some markets is very strong. Places like Houston and suburban Washington, DC have experienced increases in home sales and prices. Other markets continue to struggle. As a result, banks in many places are still reluctant to lend.

Retail sales have been fluctuating dramatically and while prices on some goods have gone up, we haven’t seen the runaway inflation that many economists have been predicting. In fact, the CPI has remained fairly steady despite increases in the price of food and energy.

Unemployment, while still not that great, has decreased in some places while other parts of the country continue to struggle. Applications for assistance go up and down like a roller coaster, but the overall unemployment rate has been slowly (very slowly) improving.

The point is that, due to their short-term cycle, monthly economic reports can be very volatile and you shouldn’t reallocate your portfolio every time one is released.

Don’t Overreact to Economic Data

Dozens of reports on economic data are released each month by numerous sources. Reports relating to inflation, CPI and manufacturing are too short-term and too volatile to guide your portfolio decisions. Also, the data can be very confusing.

A good example of this is inflation vs. higher prices. While to two are certainly similar, they come from two very different sources. Inflation is a monetary phenomenon (too many dollars chasing too few goods) that causes a general rise in consumer prices across a large basket of goods. Inflation tends to be persistent and can last for longer periods of time.

Simple higher prices are usually associated with one or two goods (oil and food) that increase in price due to constriction of availability or simple supply and demand. Higher prices (price increases) tend to be short-term and can fluctuate quite a bit.

Industrial production data—particularly when it comes to manufacturing—also causes quite a stir (good and bad) when it is released. When investors hear that manufacturing has increased in the U.S., many can become too optimistic. The truth is, manufacturing has been coming home in recent years and productivity has improved, but we are not going to replace Asia as the world’s factory floor any time soon.

The key take-away here is not to react to every monthly economic report that comes out. Learn about them, understand them and use them as part of a larger examination of the current global economic situation. Don’t trade them like a hot-tip at a barbecue.

Inflation 70s Style: Not Today

Is inflation inevitable? It depends on how you define inflation. True inflation is an economic phenomenon that represents a wholesale rise in prices across an entire economy.

Right now, the kind of insidious inflation we experienced in the 70s doesn’t appear likely. Why?

Because wages, home prices, bank credit and CPI—the four most reliable indicators of pending inflation—are not rising at the alarming rates they were in the 70s.

What’s Over the Fiscal Cliff?

Inflation is a monetary phenomenon. Periodic increases in gas, food and housing prices are typically related to supply and demand. True inflation is the wholesale rise in prices across the economy.

There are four major indicators we watch to determine whether the country is in an inflationary period:  (1) Disposable income, (2) Home price growth, (3) bank credit availability and (4) Headline CPI.

Right now, none of these indicators is pointing toward any serious inflation on the horizon.

The fiscal cliff (a combination of tax increases and spending cuts) is upon us. In terms of taxes, all income brackets will see their marginal tax rates go up.

This goes for low income earners and the “kings of the world” in the top one percent.

Investing In the Face Of Inflation

The sell off after the election and the subsequent recovery demonstrates once again that markets are unpredictable. That’s why trying to time the market is not a good idea.

One big reason why it’s a bad idea is the amount of information available to everyone around the world. So, unless you have information that is unavailable (not likely or illegal) to the vast majority of all other investors, you should stick with an investment philosophy that meets your risk tolerance.

The key is to stay diversified among asset classes, sectors and global regions.

Is inflation inevitable? It depends on how you define inflation. True inflation is an economic phenomenon that represents a wholesale rise in prices across an entire economy.

Right now, the kind of insidious inflation we experienced in the 70s doesn’t appear likely. Why?

Because wages, home prices, bank credit and CPI—the four most reliable indicators of pending inflation—are not rising at the alarming rates they were in the 70s.

Inflation is a monetary phenomenon. Periodic increases in gas, food and housing prices are typically related to supply and demand. True inflation is the wholesale rise in prices across the economy.

There are four major indicators we watch to determine whether the country is in an inflationary period:  (1) Disposable income, (2) Home price growth, (3) bank credit availability and (4) Headline CPI.

Right now, none of these indicators is pointing toward any serious inflation on the horizon.

The fiscal cliff (a combination of tax increases and spending cuts) is upon us. In terms of taxes, all income brackets will see their marginal tax rates go up.

This goes for low income earners and the “kings of the world” in the top one percent.

The Fed’s Mandate on CPI

David discusses the Fed’s mandate to control inflation and he defines CPI, the primary measure of inflation in the U.S.

College and Energy Lead the Way On Inflation

David discusses the continuing rise of college tuition then looks at the composition of core CPI (Consumer Price Index).

Inflation: The Silent Killer

David defines inflation and discusses the insidious effects it can have on an investment portfolio and what you can do to protect yourself.

What Government Statistics Really Report

-David sheds some light on government statistics by looking at what they actually report vs. what they are supposed to measure.

Theory and Practice in Government Statistics

David sheds some light on government statistics by looking at what they actually report vs. what they are supposed to measure.

Deflating Inflation Statistics

David explains government inflation statistics and why they tend to under report actual price inflation. He also begins a discussion about GDP.

2010 Midyear Update

By David L. Blain, CFA

In this publication, we are going to take a macro view of the domestic economy and the U.S. equities, bond and commodities markets. Then we’ll take a look at specific sectors and industries within the equities market that we feel bear watching.

The Economy

The economy, though still sluggish, continued along its square root recovery during the first half of the year. As you may recall, GDP fell off a cliff beginning in the first quarter of 2008, dropping from positive growth of 1.2% to a negative growth rate of 6.4% in the second quarter of 2009. Since then, it’s risen fairly steadily posting 3% growth at the end of the first quarter of 2010 (including a 5.4% jump in January), and we expect this upward trend to continue through the end of the third quarter. At that point, we expect GDP growth to level off and grow only modestly into 2011.

Of course we can’t talk about the economy without discussing unemployment. Sadly, the jobless recovery is a reality and we expect high unemployment to continue into 2011 and beyond. There are several reasons for this. First, we expect productivity (fewer workers needed to produce the same amount of goods or services) to improve during the recovery as businesses do more with less. Unfortunately, this increase in productivity will be accompanied by growth in the labor force which will aggravate the unemployment situation.

Also, slower economic growth coming out of the recent financial crisis means more part-time employees and a reduction in labor mobility (people can’t afford to move to find work). Additionally, there will continue to be a general reluctance among employers to hire more workers due to a variety of economic (trade deficit, restricted lending, reduced consumer spending, etc.) and geo-political factors (Euro-zone problems, tension with North Korea and Iran, the war in Afghanistan).

One important economic measure with which you may not be familiar is personal consumption expenditures or PCEs. Technically speaking, PCEs are a measure of actual and estimated expenditures by households on consumer goods and services. PCEs are important because they reflect (1) lower wage growth and increased compensation in the form of benefits; (2) low savings rates; (3) continued deleveraging (reduction of credit card debt and underwater mortgages) by consumers; and (4) changing demographics as the Baby Boom generation moves into retirement and the number of working age individuals goes down. During the second half of the year, we expect real PCEs to be in the 2.0% to 2.5% range, well below historical averages.

Another thing that will help the economy maintain a slow but steady growth track is the lack of inflation on the horizon. As of June 30, 2010, CPI was 1.1% and core CPI (CPI less food and energy) was 0.9%. So, prices in general should remain relatively low which means consumers are likely to continue spending even if it’s at deflated levels.

While inflation may not be an immediate issue, deflation does bear watching. Even though interest rates are at historical lows banks aren’t lending at the same rate they have in the past. As a result, companies are leery about expanding/hiring and consumers seem unwilling or unable to borrow money to expand their purchasing power. Less availability of credit, decreased spending and high unemployment—all of which we face now—are features of deflation.

So, with inflation on the distant horizon and deflation peaking around the corner, the time seems right for some sort of Fed action on interest rates. However, it doesn’t look like the Fed will raise rates until 2011. There are five main reasons for this including:  (1) high unemployment, (2) low inflation, (3) no asset bubble, (4) continued stress in the overall financial system (exacerbated by the European sovereign debt crisis), and (5) Bernanke has vowed not to repeat what he sees as mistake made in the 1930s.

U. S. Equities

Markets continue to be in the midst of a cyclical bull market (within a secular bear). In fact, despite a fairly steady decline in the S&P 500 since April, we believe the markets are poised for a rally. One reason for this is the 200-day moving average—a long-term look at the average daily price of the S&P 500. By averaging the value of the S&P, you “smooth out” daily price fluctuations making it easier to identify trends. When the moving average is rising, as it is now, the value of the S&P has gone up 7.5% on an annual basis 67% of the time.

Another reason we think the market is poised for a rally is the upward trend in trading volume (the number of shares bought and sold during the trading day). Since early 2009, trading volume on the S&P 500 has been rising steadily. An analysis of trends in trading volume using a 200-day smoothing analysis (similar to the 200-day moving average mentioned above) gives us a baseline of 105. When the deviation goes above 105, the S&P has gone up 16% on an annual basis 47% of the time. Recent deviation has been around 115.

In previous publications we’ve talked about investor sentiment as an evaluation tool for identifying trends in the market. The research we have shows that as investor sentiment reaches extremes in optimism, the S&P has traditionally declined. Alternatively, when investor sentiment reaches extremes in pessimism, the S&P typically goes up. As of June 30, 2010, our sentiment poll was at 50.1%. When investor sentiment dips below 57, the S&P has gone up 9.4% on an annual basis 47% of the time.

We continue to be in a favorable earnings environment as demonstrated by earnings per share for the S&P 500. So far, 178 (36%) S&P 500 companies have reported their second quarter results. Of these 78% beat estimates, 10% were in-line, and 12% were below estimates.

NOTE ON GLOBAL MARKETS:  Between April and June, the MSCI World Index (a global index similar to the S&P 500) dropped over 100 points. Within the 44 markets we track around the globe, only 45.2% were above their 200-day moving averages; however, 95% had RISING 200-moving averages. This means that global markets were oversold even though they were exhibiting upward mobility.

Bonds

At the beginning of the year, we believed the yield on the 10-year Treasury note would rise to the 4.0% to 4.25% range, but as of June 28, the yield was 3.05%. This was less than we anticipated and was due primarily to continued sluggish economic growth in the U.S. and the European sovereign debt crisis. At the end of the second quarter, the yield curve underwent a modest flattening; a bullish sign. But a true flattening of the curve probably won’t occur until the Fed considers raising interest rates which is unlikely until next year.

Yields in other countries also fell to near their multi-year lows. For example, the yield on Canadian bonds fell to their lowest level since May of 2009, and German bond yields fell to their lowest level since August of 2003. Of greater concern are the rising yields and spreads of French and Italian bonds because they provide a better picture of the continued viability of the euro. While rising yields can be good news, they can also drive up borrowing costs for governments, businesses and consumers which can lead to continued economic stagnation and disintegration in the value of the euro.

Commodities

Like stocks, commodities have been in their own bull market since 1999. For example, between 1999 and June 2010, the S&P/Goldman Sachs Commodity Index rose from the high 120s to 381, the Dow Jones/UBS Futures Index went from just under 75 to 98, and the Reuters Continuous Commodity Index rose from approximately 180 to 361. Another interesting aspect to recent trends in the commodity market is the impact of the dollar on commodities pricing.

If you compare the value of the dollar to the daily returns of the Reuters Continuous Commodity Index (CCI) you end up with an almost perfect negative correlation between the two. In other words, as the value of the dollar increases, the daily returns on the CCI go down. And as the dollar decreases in value, the daily returns on the CCI go up. Charts reflecting this relationship form an almost perfect mirror image. When evaluating the effect of the dollar on commodity prices, the most sensitive sub-industries are gold mining and coal & consumable fuels.

Perhaps the most obvious driver of commodity prices is China. When we compare the MSCI China Index to the NDR Basic Resource Sector Index and the Reuters Continuous Commodity Index, we see that though lagging slightly, these indexes closely follow the China index. Interestingly, during peaks, the indexes lag China by 24 to 36 weeks. During troughs the lag goes down to 4 to 6 weeks.

And now, a quick comment on gold. As you know, gold has been going up in dramatic fashion over the last five years. Since January of 2005, gold has risen from just over $400 an ounce to as high as $1,230. One of the reasons for this dramatic rise is a loss of trust in the ability of governments worldwide to manage their financial affairs.

Sectors

We’ll start our discussion by looking at so-called defensive sectors using Ned Davis Research’s SHUT (Staples, Health care, Utilities and Telecom) Index.

Defensive Leadership  When we compare the Index relative to the S&P 500, we see that the current level is virtually equal to the 200-day moving average for the Index itself. If the SHUT Index rises more than 50 basis points above its 200-day moving average (which it is close to crossing), it will be a signal that the defensive sectors will be in a leadership position as the cyclical bull market continues.

Interestingly, there have been five rallies since the market bottom in March 2009, and the only two sectors that have outperformed the S&P during these rallies are energy and materials. However, it’s important to note that within these sectors, sub-industries that have lower beta (volatility) relative to the market have lost less value during the recent downturn. As always, beta will play a key role in any continuation of the current cyclical bull market.

Consumer vs. Infrastructure  PCEs are important because they measure how much consumers are spending and as we know, the American consumer has been the driver of our economic growth over the last several years. But another important way we use PCEs is to compare them to capital expenditures or Capex; a measure of how much businesses are spending. When we compare recent consumer driven expenditures to business-driven expenditures we see that PCEs have continued to go up while Capex has come down slightly.

During the period 1Q2009 to 1Q2010, investment in industrial equipment rose only 0.9%, investment in information processing equipment and software was up 8.2%, and investment in transportation equipment was up 34.2%. And while these increases are encouraging, it’s important to remember that they are up off major bottoms and have a long way to go to return to levels prior to the financial crisis.

Retailing  The S&P retailing group typically goes up following a recession end and/or a PCE/Capex peak. Since 1975, there have been five PCE/Capex peaks and we seem poised to reach another one soon. Rising earnings expectations and beta played an important role in the consumer discretionary sector’s performance. (Sector earnings have also been aided by some of the highest margins in 10 years.) For example, as of June 4, 2010, the percentage of consumer discretionary companies that exceeded earnings expectations was 88.3%. Our beta research indicates that auto parts, hotels, advertising, home furnishings and department stores bear watching.

Industrials  PCE/Capex peaks also affect the industrials sector. In the months leading up to a peak, three of the top performing sectors were IT (+22.4%), consumer discretionary (+18.5%), and industrials (+16.6%). In the months following a peak, these sectors essentially reversed their leadership positions with industrials leading the way (+8.5%), followed by IT (+6.1%) and the consumer discretionary sector (+5.1%). As with the consumer discretionary sector, beta plays an important role in how we evaluate the industrial sector.

Among industrial sub-industries with beta above 1, we like industrial conglomerates though we anticipate switching from conglomerates to environmental services sometime in the second half of the year. For sub-industries with beta less than 1, we like aerospace and defense. We’ll also keep an eye on railroad stocks.

Technology  Among tech-related sub-industries with beta greater than 1, we like electronic equipment and instruments, and networking equipment. For those with beta less than 1, we prefer IT consulting and services. As we progress into the second half, we will likely hold on to the IT consulting and services, but we may take the opportunity to swap electronic equipment and instruments for office electronics and systems software. One final note on tech:  we believe that semiconductors are likely to underperform in the second half, but could rebound quickly if we have a year-end rally.

In summary, we believe the economy will continue to grow at a modest pace through the end of the year. This positive growth should keep us in a cyclical bull market into the first quarter of next year, though we will remain in secular bear market. We will be mindful however, that market performance tends to tail off in the second year of a bull market and the second year of an economic recovery (we are in both right now) so we could experience some volatility in the coming months. Regardless, we will be monitoring our portfolios carefully to help ensure we continue to meet the long-term financial needs of our clients.

What Drove Last Week’s Correction?

-David discusses what what behind last week’s market correction including investor sentiment, commodities (specifically oil), concerns about inflatin and other global economic issues.

Two Sides of the Same Coin

By David L. Blain, CFA

It’s almost impossible these days to open a newspaper, turn on the TV or visit a business-related website without seeing a story about inflation and/or deflation. Almost as impossible is to determine the prevailing wisdom on which one is worse for the economy, how best to guard against them, and which we are currently experiencing or will experience in the future. To understand the difference between inflation and deflation and their impact on the economy, it’s helpful to start with a definition of both.

Inflation is generally defined as a persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money; and deflation is commonly described as a general decline in prices, often caused by a reduction in the supply of money or credit. Both are typically measured using the Department of Labor’s Consumer Price Index (CPI) program which produces monthly data on changes in the prices paid by urban consumers for a representative basket of goods and services. Armed with this basic understanding of inflation and deflation, let’s look at some causes and potential effects of both beginning with inflation.

There are many underlying factors that can cause inflation. Among them are an increase in the money supply, a drop in the purchasing power of currency, a decrease in the production of consumer goods and a rise in the costs of production which are then passed on to consumers. Some of these factors are reflected in today’s economic realities; however, they aren’t always consistent in predicting the direction of inflation. For example, current monetary policy and the stimulus bill (increased money supply), the weaker dollar (drop in purchasing power), and higher commodity prices (higher production costs) are often considered inflationary. By contrast, the recent stabilization of factory orders (production of consumer goods) is not.

Like inflation, deflation has myriad causes. A decrease in the money supply, rising interest rates, lower consumer spending and falling consumer prices can all be indicative of deflation. But, like the inflationary factors discussed above, today’s economic realities possess some deflationary characteristics even if they don’t all point directly to deflation. Even though the money supply has increased under current monetary policy, credit has remained tight which is potentially deflationary. Recent Fed policy has kept interest rates flat over the last few months, but mortgage rates have actually gone down. Consumer spending has declined in part because of higher savings rates, but also because consumer prices—thanks in part to higher commodity prices—have been going up.

Inflation and deflation in small amounts are not necessarily harmful in and of themselves. But what can be done to prevent one or the other from taking root and causing real damage to the economy? Controlling the growth of inflation and/or the decaying effects of deflation is typically the job of the Federal Reserve. The Fed has several techniques in its repertoire for controlling both, most notably manipulating interest rates and controlling the money supply. For example, if inflationary indicators start to rise, the Fed can raise interest rates or decrease the money supply which would typically result in less spending and lower CPI. Conversely, if deflation begins to take hold within the economy, the Fed can increase the money supply and lower interest rates thus resulting in higher CPI. While this is somewhat simplistic, the basic concept of Fed policy as a tool for controlling inflation and deflation holds true.

As was mentioned in the July edition of The DLB Bulletin, I think that inflation will be a significant factor in the next several years, but my best estimate for the next six to twelve months is low or negligible inflation. Currently, the main inflationary pressures are coming from Federal Reserve monetary policy and the Obama Administration’s fiscal policy. Holding that in check are two main deflationary factors: 1) the output gap between potential GDP and actual GDP, and 2) the deleveraging of businesses and consumers.