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Overview of the Capital Markets
By William Parmenter, editor
Frank Barbera, CMT, editor of the Gold Stock Technician, spoke on the outlook for 2010 and beyond at the Feb. 20, 2010meeting of the Los Angeles chapter of AAII at the SkirballCenter.
The title of Barbera’s talk was “What’s Ahead: An Overview of the Capital Markets and the Global Economy.” He gave an update on the economy and world markets.
The Fed is funding 92 percent of the mortgage market, a statistic that does not auger well for the housing market.
The most important thing now is risk control, said Barbera.
Debt levels are still very high. Consumers are de-leveraging their balance sheets. Spending is still about 70 percent of the GDP.
Upward wage pressure is nonexistent. That indicates a longer period of recovery and of household de-leveraging.
Wages and benefits are under pressure and near historic lows. At the same time medical and other costs are up.
The situation in the U.S. is similar to that of Japan in the 1990s, where unemployment and lower incomes were correlated with a weak economic recovery.
There needs to be a more organic base for an economic recovery. Although the domestic economy had a nice bounce, the situation is still negative. There is an epic disparity between consumer expectations and the economic situation.
The consumer is in a very defensive mind set. He is saving and not taking on big expenses. Sales of appliances, cars and homes are all down.
Jobs are hard to get. Unemployment is still making all time highs, while people are exhausting their unemployment benefits.
What are the odds of a double-dip recession? There is a very high probability of a double dip, of around 30 to 40 percent. There may be another slide down in the third or fourth quarter.
What end to the recession? By the highest measure unemployment is over 20 percent. The employment to population ratio at 58 percent is the lowest since 1983. The market needs job creation in small businesses, and new technology, not in government.
The money supply has been contracting in the U.S. and the world. Bank lending is the lowest since the Great Depression.
The money multiplier has fallen to negative and for the first time is below one. That means for each dollar the Fed pushes out, less than one dollar is borrowed. Basically there has been a shutdown of lending in the economy.
The economy has become bipolar.
Table of ContentsOverview of Global Markets……..Frank Barbera….. p.1
Building a Portfolio……….Dr. Somnath Basu……….p.3
Investor Education…………Dr. Don Gimpel...………p.4
Large corporations have improved quite a bit. Small businesses are not doing well.
Autos and housing sales historically have led economic recoveries. Neither is doing well.
Automakers sold 10.4 million vehicles last year, down 21.2 percent from 2008. Vehicle sales are projected to grow about 10 percent this year to about 11.5 million, far below the 16 to 17 million sold annually from 1999 to 2007.
New home sales dropped 11.2 percent in January, the third month in a row of decline. New home sales in January were 309,000, far below the 1.4 million sold in July, 2005.
A plunge in mortgage applications to the lowest level in nearly 13 years have renewed fears of another decline in housing prices.
Housing prices have a couple of more years of moving lower, according to Barbera. Mortgage delinquencies are still increasing. Even after a 40 percent decline, the price of houses is still high, still in bubble land.
Homebuilding has declined since November. The shadow inventory is high and exacerbates the housing problem.
Tax revenues are not picking up. State and local tax revenues are collapsing. Municipalities are in terrible shape. Looking ahead to May and June Barbera expects real tension in trying to hammer out a state budget, with possible strikes on the horizon.
The oil tanker glut shows a decline of global demand for oil.
Watch China for signs of weakness. The Shanghai stock exchange is teetering on the verge of breaking down. The question of concern, isChina facing an overcapacity bust?
Equity markets are in trouble. Greece and Spain have major debt problems that pose a risk to the stability of the Euro. They are joined by Italy, Ireland and Portugal with serious debt problems. The debt problems of southern Europe are not remotely close to a solution.
Greece could possibly exit the European Union and then devalue its currency. That could affect Spain, which has a far larger economy, and could destabilize markets more than Greece.
How does that affect the U.S? Bank portfolios are interconnected, for example, UBS Corp., Credit Suisse, and Barclays Bank. The banking world is tightly interconnected.
There was a 61 percent recovery of the initial decline of the stock market.
The best case for the stock market would be that it would stay in a trading range and then go up. If there is no traction in fundamentals, the market could move back into bear territory. In Barbera’s view a resumption of the bear market is more probable. The market may take back its gains.
Investors could be in cash, Ginney Mae funds, or short-correction bond funds. On the short side, one could invest in Pimco Bear Fund (PSSDX), a no-load, low-expense ratio fund. It could be used as a hedge or as an investment.
In the question and answer session, Barbera said he expected the price of gold to come down to $850 to $950, with the low about the end of the year. Then he thinks gold will
Los AngelesCountyMeeting ScheduleWestside Computer Group – Don Gimpel, 310/276-9875 Veterans of Foreign Wars Memorial Bldg. Culver Blvd. & Overland Avenue, Culver City, at 10:30 a.m. Saturday, April 3.
Pasadena Group– Meets at 7 p.m., third Tuesday of the month, except for August and December, at the Main Library in the David Wright Auditorium, 285 E. Walnut St., Pasadena.
Mutual Fund Group – Gunter Hagen 310/457-7404, . at 10:30 a.m. Saturday, March 6, with John Kang, of Fidelity Investments, on Fidelity Market Update with Investment Strategies,at FairviewLibrary, 2101 Ocean Park Blvd., Santa Monica. The meeting is free to the public
Options Special Interest Group – Robert Morgen, meets at the Westside Pavilion Community Room A, 10800 W. Pico Blvd, Los Angeles. Date TBD.
Stock Selection/CAN SLIM Group—Norm Langhout, 310/391-6430, . Fourth Wednesday of the month at 7 p.m. Fairview Library, 2101 Ocean Park Blvd., Santa Monica.
San Fernando Valley Group – Mid Valley Library Community Room, 16244 Nordhoff St. North Hills, Date and topic, TBA
Los AngelesChapter SkirballCenter at 9 a.m, Sat. March 20. Dr. Mark Skousen, on Adam Smith v. John Maynard Keynes: Who’s On Top? And Robert Morgan, president of MPS, on Using Covered Calls to Control Risk and Enhance Returns.
move up for three to five years to the $3,000 to $5,000 range. The driver will be deflation and contagion of currency value declines.
Sovereign debt default is the big issue moving forward. Think of gold as insurance for your portfolio.
Barbera can be reached through his email address at: .
Sound Portfolios and the Future
By William Parmenter, editor
Dr. Somnath Basu talked on the topic of “How to Build a Sound Retirement Portfolio” at the February, 20th meeting of the Los Angeles chapter of AAII at the SkirballCenter.
Basu is a professor of finance at the CaliforniaLutheranUniversity, and director of the California Institute of Finance. In his talk, Basu talked about constructing a sound portfolio, and the economic outlook.
Now, of necessity, one needs to have a global portfolio more than ever before. With U.S. stocks only in the portfolio, investors are taking on a larger risk.
The U.S. share of the world market declined from 47 percent in 2000 to 40 percent in 2005. Europe’s share is about 25 percent and Asia and the rest of the world are the other 25 percent. The emerging markets amount to about 10 percent of the global capitalization.
Few U.S. investors are proportionally invested with only 40 percent of their portfolio invested in the U.S.
Typically U.S. investors have 80 percent of their portfolio invested in the U.S., reflecting their bias toward the U.S. economy. Professional money managers follow the pattern of the U.S. public.
The risk of the global market is a lot lower than for the U.S. market alone.
For most investors stocks and bonds are enough. If you want a return of 6 to 10 percent it is fairly straight-forward and mechanical. Select bond funds and balanced funds.
It is hard to find low-correlation investments. The correlation between the U.S. markets and those of other developed countries is high. Giving U.S. a number of one, there is a correlation of .85 with Germany, .83 with United Kingdom, .45 with Japan and .74 with Australia.
Country risk rating is variable. Least risky is Norway with a 92.3 rating, number 14 is Japan with an 84.5 rating; number 15 is United Kingdom rated at 84; number 42 is the U.S. with a rating of 77.5 and number 44 is China with a risk rating of 76.8. The riskiest at number 140 was Zimbabwe, with a rating of 36.3.
Aside from country risk, investors have to take into account political risk, economic risk financial risk, and foreign exchange risk.
About 50 percent of foreign return is due to change in currency values. That is not something a small investor can protect against. Currency value changes can really swamp the investor.
Currency is a measure of a country’s economic and financial health. The dollar has been going down and is expected to continue to go down, due to globalization and other countries coming up.
Some considerations involved in constructing the optimal portfolio include: portfolio horizon and asset allocation; elementary asset pool; and the need to subjectively customize the portfolio for each customer.
Some of the assets to consider putting into the elementary asset pool are: stocks, bonds, real estate, commodities and cash.
A retirement portfolio could look like this: 60 percent domestic AA/AAA bonds; 25 percent international AAA bonds and 15 percent domestic large cap stocks. This portfolio would have foreign exposure, and an overall weighting of 85 percent bonds.
Fine tune the portfolio in three to five years. In retirement the issue of risk to the income stream is paramount. Bonds return 3 to 4 percent, are very safe, are not volatile and provide a low return.
An alternative portfolio, with a longer-term time horizon, would look like this: 40 percent domestic AA/AAA bonds; 25 percent international AAA bonds (65 percent of the total in bonds); 20 percent in domestic large cap stocks; and the last 15 percent in international large cap stocks.
The last segment of Basu’s talk was directed to forecasting and reflecting on the next ten years. Given the time constraint he was under, he had to rush the presentation and barely had time to finish.
The great recession started in the U.S. with the burst of the real estate bubble in 2007. Mortgages had been given to borrowers with no job, and no assets. Then defaults spread to the financial sector.
The increase of unemployment affected retail industry and the consumer goods market. Unemployment swelled until it became about 18 percent of the workforce.
U.S. citizens are addicted to a range of consumption, from shopping to eating out. Going forward, what kind of jobs can we produce in the U.S.?—doing dog shampoos at home? The U.S. labor market cannot compete with China and Taiwan and their $2 an hour jobs.
Most of China’s growth has come from the U.S. buying; if the U.S. curbs its consumption that would hurtChina.
China has a savings rate of 25 percent. It will take a generation to reduce it to 5 percent. Currently China is buying companies and resources. That is better than investing in the U.S. dollar. When the U.S. goes down, it takes China down too, as China depends on U.S. consumption.
The U.S. government should get out of owning companies, because the government is not a good manager. Basu does not foresee the U.S. going back to the economic glory days of ten or twenty years ago.
The economic recovery will be slow, and it will be relatively jobless. Look for a steady state around 2012 to 2014.
The ominous cloud of inflation is on the horizon, what with the huge federal deficits and the lack of domestic production.
Expect the price of commodities and basic material prices to go up. Expect regulation and reform of the financial markets.
Other issues on the horizon include: world market energy conditions; wars and political turmoil; chance of a double-dip recession; changes in the world economic order (the ascendance of China); globalization versus protectionism; the role of technology in raising the U.S. economy (for example fusion technology); the BRICs; and the strong Asian economies of China, Japan, South Korea and Taiwan.
In his closing remarks Basu touched on many interesting topics, any of which could change the global economic setting, but he ran out of time to explore any of them in detail.
Education Nuggets
By William Parmenter, editor
Dr. Don Gimpel’s entertaining and informative five minutes of investor education and announcements stretched out a little longer than usual, due to the delay in arrival of the first speaker to the Feb. 20 meeting of the Los Angeles chapter of the AAII at the SkirballCenter.
Gimpel asked the audience to follow him in a thought experiment, using known facts to test a hypothetical situation, in the vein that Dr. Albert Einstein used.
Imagine that you have a net worth of $1.2 million, you live in Beverly Hills south of Olympic Boulevard and you earn $150,000 per year. Given that situation, your wife obtains a bid to remodel the kitchen for $16,000.
The price looks good, until you find out on further questioning that $16,000 was only the amount you would pay in the first year. The second year you have to pay $14,000, and the third year you have to pay $12,000. At this point, it is not known how much you would have to pay in subsequent years.
The problem of successive, unstated large future bills is analogous to the federal government’s deficit, stretching out into the future.
Some numbers: the total net worth of the nation, including everything, is estimated at $110 trillion. About $52 trillion of that is household net worth, according to Google, where Gimpel got the figures.
The government is running a deficit of $1.6 trillion. Does that bother you? Next year the deficit is estimated at $1.4 trillion. The estimate is for a $1.2 trillion deficit in the year after that. Does all of this bother you?
Gimpel showed the audience a demonstration of what is available on the website WorlframAlpha.com. It was developed by a mathematical genius, named Wolfram, who decided people need factual answers to financial questions.
Once on the homepage, you can enter the name of a stock or an index. You can get a price history chart and a chart of performance comparisons. You can also get a chart of return measured against risk. Also, you can get a chart to peek into the future under different conditions.
You can put in the names of various companies. For example Gimpel put in Apple, Microsoft and Google and compared their performance against each other and the S&P 500.
Another question you could test on the Wolfram site is to find out what would be the optimum allocation of five or six different items under Modern Portfolio Theory.
Gimpel recommended looking at the website as it has scholarly articles, and less junk than Google.
Orange CountyAAII Announcements
Mark Skousen, editor of Forecast and Strategies, will talk on The Best of Both Worlds: My Five Favorite Stocks to Earn Income and Capital Gains in 2010” on Friday, March 12 at the BalearicCommunity Center, 1975 Balearic Drive, Costa Mesa, contact phone number 714-754-5158.
Ron Muhlenkamp, CFA, founder, president and portfolio manager of Muhlenkamp and Co. Inc. will talk at 1 p.m., Saturday, May 15 on The Signposts of Change: Economics, Rules, Markets: at the BalearicCommunity Center, 1975 Balearic Drive, Costa Mesa, contact phone number is 714-754-5158.
For more information about the OrangeCounty chapter of AAII and their meetings, go to .
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Please have your copy emailed to the editor by the fifth of the month. Letters and comments are welcome. If you want to email anarticle about the fragile financial system, the status of the economic recovery, or some other financial issue, you will have a chance to appear in print and inform Pro Forma readers.
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90802, or use email to send copy to the editor at .
My home phone is (562) 437-2412.
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Pro FormaPro Forma Editor William Parmenter
Pro Forma Editor, Emeritus Orvis Adams
SIG GROUPCHAIRMEN
IBD Meet-up/ AAII CANSLIM Norman Langhout
Mutual Fund Group Gunter Hagen
Options Group Robert Morgan
Pasadena Group Ivan Wong
Palm Springs Group Patti Gammino
San Fernando Valley Group Evan Press
Westside Computer Group Don Gimpel
Pro Forma is offered free of charge exclusively via email and is also available for downloading from the Los Angeles Chapter web site at: .
The American Association of Individual Investors is an independent nonprofit corporation formed for the purpose of assisting individuals in becoming effective managers of their own assets through programs of education, information and research.
Pro Forma is published for advising members of the groups' activities and for sharing information. All material compiled without verification of accuracy to a specific task or computer system. All material provided in the ewsletter is for educational and illustrative purposes only. Comments are the views of their author and no other person or organization. Investing is an inherently risky business. Investors may loose their entire investment or more. Past performance is not a guide to future return.
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