Addition by the Elimination of Subtraction

Last week I heard the Chief Executive Officer of Pimco funds explain the current market environment with this thought provoking phrase “We are experiencing the addition by the elimination of subtraction”. A clever way of saying that things are better because they are not getting worse.

A very true statement considering that it was only roughly 90 days ago the level of fear and negativity reached a crescendo with markets down over 60% from their October 07 highs and over 20% from just the beginning of the year.

Since those bleak March days there have been dramatic improvements in the financial markets while economic improvements have been anemic at best. This disconnect between financial market performance and economic recovery is very common for bear markets. “Bear Market Rallies” have been witnessed in every past secular bear market. Here is a little history of past bear market rallies.

– November 1929 –April 1930: +49%
– March 1938 – November 1938: +60%
– December 1974 – August 1975: +51%
(info provided by CMG Funds 6/09)

History has shown the average bear market rally from low to high has been approximately 7.5 months with an increase of roughly 50% from the lows. Also, in each occasion the markets reversed course to give up all the gains to either touch the previous lows or surpass them before the bear market ended for good.

These bear market rallies are sparked first by technical factors created from short covering, a subject discussed in our last two market updates. And then reinforced with economic news that shows the rate of decline in the economy has slowed from a 100 mile an hour pace to 30 miles an hour. This slowing pace of negativity is enough to give investors the feel that Armageddon is off the table and that at some point in the future there will be a turn towards improvement. Essentially, the sentiment changes from fear and worry to hope and cautious optimism. As a result we have seen improvements in credit markets and as we have said in past letters the credit markets are the source of all pain or pleasure when it comes to the recovery of markets.

Digesting a Ten Course Meal
Since the gloomy days of March the markets have digested a ten course meal – Bank Stress tests, Swine Flu, GM and Chrysler bankruptcies, Rising Unemployment – not to mention the death of many icons – Ed McMahon, Michael Jackson, Farah Faucet and the pitch man himself Billy Mayes. Oh and let’s not forget a Lakers victory. With all this to swallow – credit spreads have improved, interest rates have declined, consumer confidence has improved, housing starts have bounced off the flat line and industrial production has improved slightly over previous months.

I offer words of caution to the improvements in industrial production, housing and confidence as these were improvements over March’s dismal numbers but still significantly below last year’s numbers and even further from the year before. None the less the market has liked the fact the numbers have ceased to be negative from one month to the next, after all we have to start somewhere.

From Somewhere to the Future
Since somewhere has come it now leads us to tomorrow and what may happen next. Using history as our guide we find that market rallies based on the “elimination of subtraction” are treading on thin ice.

In our past market updates we have stated we anticipate a near term decline in the equities markets. We believe we have seen the beginning of this in June with the markets seeing 2 days of trading where volume increased as 90% of stocks traded lower. These 2 days were within 7 days of each other and is usually a very large sign that the trend is reversing and additional selling should be seen in weeks to come. Patience is needed with June being both month end and quarter end it is not uncommon to see large institutions do what is called “window dressing”. This is where they purchase stocks towards the month end in order to list those stocks in their quarterly and yearly reports to share holders so it looks like they owned these stocks throughout the whole quarter. This window dressing can cause markets to stay elevated in the last week of the month.

Beyond window dressing, the internals of the market show that there has been expanding volume on days the market has gone down and contracting volume on days the market has gone up. In simple terms this means there have been more sellers in recent weeks than buyers. There are additional technical indicators that lead us to the belief we will see markets decline in July and August that we won’t bore you with at this time.

As a side note it is important to realize that markets move in two directions and the indicators noted can change causing us to change our outlook. In addition, there is still a slight probability the markets could move one step higher in the first two weeks of July as some cycles work themselves out. However, for now the signs point to weakness in the near term.

While the indicators are giving us the impression of a near term decline in equity markets this decline may not be as large as we originally spoke of back in the beginning of May. As we have done additional homework there is a greater possibility that this near term decline if seen will be one step back in a larger two steps forward dance as this bear market rally may move higher after the summer.

If this bear market rally were to fall within the averages of previous bear market rallies – lasting 7.5 months and up approximately 50% – it would give us a target of 999 to 1050 on the S&P500 (currently at 920), so at this moment any decline that may be seen could be temporary. We will know more on this as July unfolds.

Longer term, looking out over the next year the market moves will be dependent upon earnings and economic news. Without a significant change towards the positive in economic news we feel the equity markets will then begin another decline which will lead us back towards the March lows as we deal with the structural issues that are residing within the economy.

Earnings will provide us the next direction
The recent rally and any subsequent increase in this rally if seen will eventually need to be supported by increased earnings from companies. In following the research of Larry Tomlinson the publisher of Market Charts Advisory, the following analysis of market valuations can give us a guide in understanding whether markets are fairly valued, overvalued or undervalued based on earnings from the last reported quarter. According to this research The Dow Jones is expensive at 8900, fair price at 7400 and a bargain at 5700. Currently the Dow is near 8500, neighboring the expensive realm and at the March lows near 6500 it was close to a bargain.

Earnings have consistently declined since September 07 and will most likely continue to be challenged with rising unemployment and consumers spending less as they save more and pay down their debt in the face of an uncertain future and credit markets that are reducing individual credit lines.

Without a doubt we are moving into a new era that some have said will create a “new normal”. An environment of higher taxes, more regulation and greater emphases on savings. We are already seeing a shift towards Eisenhower era principles of spending less and saving more with the savings rate moving from 0% a year ago to over 5% today. While this will be good for the longer term picture as we rebuild our financial houses on firmer ground, the process of getting there will cause some pain as the consumer will continue to pull back. This pull back in consumption is what will prevent companies from experiencing expansion in their earnings at any significant pace and without expansion in earnings it is difficult to see sustainable growth within markets.

History has shown us that in the face of these deflationary forces we may see a slow down in economic deterioration as we have in the last few months but not a significant rebound until earnings begin to recover. Markets will always revert to the mean or find the middle road by going to low then to high. It is these transitions that provide us the opportunity to prosper.

Inflation Vs. Deflation
This brings us to the conversation of inflation vs. deflation. Over the past few weeks the financial media has been on an inflation kick. The main argument has centered on the recent expansion of the Feds balance sheet, otherwise known as the Fed printing dollars. The argument is that the Feds activities will lead to hyperinflation. While I do believe inflation is in our future I disagree that it will happen in the near term.

The obstacles that are in front of our economy with a depressed housing market, auto industry in disarray, increased availability in square footage of retail and office space, capacity utilization running at decade lows, rising unemployment and continued reduction of credit lines to individuals and businesses will continue to be powerful deflationary forces for the foreseeable future.

In addition, the socioeconomic shift of saving as opposed to spending is something that will take time to change. This is at the core of the definition of deflation, when money changes hands at a much slower pace than it did in the past as people hoard their cash and pronounce cash is king.

This deflation phenomenon will most likely continue for the next year which increases the probability that markets can decline after this bear market rally goes back into hibernation as we head towards 2010.

Don’t allow this to discourage you as this could possibly be setting up the best buying opportunity investors have seen in over 80 years. Remember, many people got rich following the Great Depression as they bought up assets that were priced extremely low and appreciated in the years to come. Not to mention the money that can be made within the transitions that will be happening in currencies, interest rates and other asset classes.

What this means for us as investors is in order to earn money from investments over the next few years we will need to become comfortable working within a new norm where the traditional advice of buying mutual funds or stocks with the intention to diversify between large cap, small cap, mid cap, etc. – won’t work. Investors will need to be more tactical or find managers that are tactical and have a skill set that allows them to make money in both rising and falling markets. Sir John Templeton’s well known statement “Buy when everyone else is selling and sell when everyone else is buying” will be the order of the day.

This is easily accomplished in today’s market place as there are investments which allow for active management as well as managers which specialize in doing so.

Third Quarter Possibilities
Now that we have covered what has happened and what we expect to happen in markets let’s turn our focus to certain asset classes which may give us an opportunity to make some money. Since we have already covered the equities markets I will cover a few of the more popular alternative assets.

Gold – Gold has been a hot topic this year. Many are predicting we could see gold reach the $1200 an ounce price range (currently at 935) due to fears of inflation. While ultimately these people may be right we feel there are lower prices in Gold’s near term future. The 940 price seems to be the line in the sand. If we see continued trading below 940 over the next few days to weeks then the probabilities increase significantly that Gold will reach below 900 an ounce before any move higher is seen. A move above 940 in the next few weeks would remove this possibility. For those of you interested you can check out DZZ an exchange traded fund which appreciates in price as Gold declines.

The US Dollar – The dollar and commodity prices such as gold and oil typically have an inverse correlation, which means as the dollar moves lower commodity prices tend to move higher and vice versa. The Dollar has had its name in the press time and time again in the last few months with most of the press not being so positive. As of last month the negative sentiment surrounding the dollar reached epic heights as prediction after prediction came out that with inflation in our future the dollar was doomed to decline. Amazingly right at the height of this negativity the dollar has seemed to catch a break with prices reversing upward in recent weeks. We feel this move may be the first move in a rally in the dollar which could last for a few months. The next few days will tell us as the dollar will need to stay above 80 for this to be true. Any move below 79 increases the probability the dollar will move lower to 77 before finding any strength to move higher. For those interested in watching these markets check out UUP an exchange traded fund that tracks the dollar or UDN which is an exchange traded fund which increases in value if the dollar were to decline.

Oil – In the face of deteriorating fundamentals (increase in inventories and decrease in demand) oil has been able to move from 35 to 70 dollars a barrel in 3 months. These kinds of moves are not uncommon for oil, remember it wasn’t too long ago we were looking at $140 a barrel. I sometimes feel with all the speculators playing in the oil markets that predicting oil prices is a fool’s game. Regardless, I’ll make an attempt and base the analysis on price. It seems that the $72 dollar range has a lot of resistance for every time oil comes into that price area the price drops back down to $68 which makes the analysis fairly simple. If we see prices get above 72 then we could see 75 then 80, however if prices fail to do so in the next few weeks and we see strength in the dollar we could see oil prices head to $55-$60.

Interest rates – When the Fed announced their plans to buy treasuries in December of 08 we witnessed interest rates plummet as bond prices rose. Exactly what the Fed was planning on. For more info on how the Fed works see our website. Back then we wrote that inevitably we would see interest rates rise. Well they didn’t just rise in May and June they soared moving an investment like TBT from $45 to $60 (now at 51). Looking out over the next few month’s rates will most likely be stuck in a sideways range as the markets try to figure out what the longer term aspects for the economy look like. The probabilities support a slight upward bias in rates but we don’t think we will see the dramatic price moves that we have seen in the last 6 months in the next 6 months.

In closing, I would like to remind our clients that we sit at the edge of one of the greatest investment opportunities in history and the fact that we have preserved our assets by missing most of the market declines in 08 and the beginning of 09 we are positioned well to take advantage of the opportunities that will present themselves. Patience will be required as some of these opportunities will take months to develop but they are out there and the horizon looks much better than it did just 3 months ago. The investors that will profit the most will have a tactical approach to their portfolios as opposed to the traditional buy and hold strategy that hasn’t produced any profit or protection over the past 10 years.

We have recently reviewed all accounts and have either been in touch with you or are in the process of reaching out to you to discuss your portfolio and what you may specifically expect for your situation in the second half of the year. Until next month enjoy the 4th of July and know we are wishing you healthy days ahead.

Colby McFadden


**The opinions expressed are those of Colby McFadden and Quiver Asset Management as of 7/1/09. These opinions are subject to change due to market and other conditions.