Bi-polar Markets

Urban dictionary defines bipolar as “a disorder in which mood swings are so extreme that it can interrupt daily life. These mood swings can last for days, weeks, months, and even years.” I get a funny feeling of dejavu when reading this definition while reflecting on financial markets over the past few months.

The mood swings of the market over the past 3 months have reached levels only Howard Hughes could compete with. While attempting to create a forecast in the middle of wild swings from fear to greed can be treacherous we will attempt to do so anyhow. Before we embark on what may be in the future for financial markets let’s recap some of our more recent comments on markets from our last Quiver Quarterly.

You may recall the following graph that we published in our last quarterly.

S&P 500 – June 2007 to June 2010

In that issue we stated a case for the possibility that the equity market was working its way towards the red X where we feel a lower risk entry point exists to own equities.

Shortly after the time frame depicted in this graph the equity markets reached an extreme low in both price and sentiment with the S&P 500 reaching 1010 (according to Bloomberg), an approximate 17% decline from the April high of 1219.

Since that low the market has seen a quick snap back rebound as you can see in this chart below.

S&P 500 – October 2007 to October 2010

Sometimes pictures lack the ability to sum up all that has happened. In this short 3 month time difference reflected in these 2 graphs the equity market has swung from an extreme negative sentiment as economic reports showed a slowdown in the recovery of the economy, raising “double dip” recession fears.

This extreme negative sentiment has now been replaced with sighs of relief and reflex buying on the basis the Fed will provide Quantitative Easing to help light a spark under the economy. For those of you wondering what Quantitative Easing is, check our website for the December 2008 Quiver Quarterly. For those of you reading a paper version of this Quarterly feel free to contact our office and we will mail you a copy of this archived Quiver Quarterly.

In a nutshell, three months ago the economic numbers started to show signs of rolling over and employment has shown no signs of improvement. All this caused many investors to pull money out of stocks.

The quick 17% decline seen from April to June was the market detecting something the Fed has just now come out to confirm. The economic recovery is faltering and without some intervention there could be more pain to come.

The Fed obviously sees some additional slowing of the economy as they have recently reinforced recent statements that they stand ready to add more liquidity to markets if improvement isn’t seen soon.

How do they do this? Well, they begin printing money to buy treasury bonds as a way keep interest rates artificially low. The reasoning behind this logic is low rates will help support the borrowing needed to buy homes as well as for corporations to keep solid earnings by being able to borrow money at historically low rates.

Encouraging borrowing and debt accumulation is the Fed’s answer to getting the economy going.

The initial reaction to this is a drop in the dollar which then causes a push higher in commodities such as Gold, Silver and Oil. A weaker Dollar also provides a tail wind to profits in companies doing business overseas like Johnson and Johnson, McDonalds, Intel etc. In turn traders close out their short positions and some longer term investors decide to buy some stocks from the mindset that the Fed is here to save the day so it is ok to take more risk.

The result is the makings of a quick and vicious bounce back up in equity prices for the month of September and beginning of October while the fundamentals of the economy have not improved one bit.

The past month has been a perfect example of how at times a market can disconnect from the fundamentals. Regardless of what the economic news is the market has moved higher. If a report is good Wall Street says “Yeah the economy is ok” if a report is bad Wall Street says “Yeah, don’t worry the Fed will save us”. I don’t know about you but anytime someone has told me not to worry I find I should start worrying.

To that contrarian thought I offer you the subtle wisdom that if the FED has to be involved in your money then things aren’t good. In good times or at least when times look to be getting better the Fed doesn’t need to get involved. Even though the markets have responded well to the recent news of quantitative easing we still advise an extreme caution to getting overly invested in stocks at this time as there are other assets that may be able to provide you solid cash flow and growth potential with less risk.

All this usually leads us to look at past statements made in these Quarterlies to see if we are still on track with our previous thoughts. Let’s start with the two graphs shown earlier and the probabilities of the market reaching the red X we have so affectionately held onto.

With the recent rally in the market we are starting to feel the low of 1010 on the S&P 500 in June may have been the low of this year as the market would have to sell off pretty hard in November and December to reach our red X. Traditionally November and December are months where equity markets tend to have an upward bias, especially in front of mid-term elections. While it is possible the markets could reach that red X sometime this year it is starting to look less probable.

So what does that mean for those of you who are interested in owning stock? It means that you should consider adding some quality stocks that pay good dividends to your portfolio on any significant market dips with a firm decision to preserve capital if the market should break below 1050 on the S&P 500.

Our outlook is stocks are most likely stuck in a range where the S&P could move down to 1050 and up to 1200 over the next few months as the market waits to gather more data on the economy and jobs. For this reason we like stocks that pay you to wait with good dividends. Lower risk investors should sit tight for now and look for investments with less volatility than stocks such as structured notes or corporate bonds. We also advocate the use of money managers that are tactical in their allocation choices making changes as the market changes

As we often mention, there are other assets other than stocks that should be included in your portfolio.

Let’s cover a few of those now.

The US Dollar
The US Dollar has now taken first place in the most loved asset to sell. The reason behind all the pessimism towards the Dollar stems from the recent announcement by the Fed that it stands ready to print more dollars to provide support to the economy. The thought process works like this. If the Fed prints more money then it dilutes the currency therefore the value should go down which is exactly what has happened in recent weeks since the Fed’s announcement that it may begin Quantitative Easing. For a visual we offer you this 3 year graph the US Dollar against a basket of other currencies.

US Dollar- October 2007 to October 2010

A couple interesting notes should be made on this graph. In November of 2009 there was similar negative talk surrounding the Dollar and according to an AAII survey of investment managers only 6% of money managers believed the Dollar would increase in price. The subsequent 6 months we saw a rally in the Dollar. It is not uncommon that when sentiment reaches such a negative level like it did in November ’09 to see a turn in price. Seems counter-intuitive but it is what it is.

The price of the dollar is now approaching those price levels of November ’09 and the AAII surveys of money managers are showing only 3% of money managers believe the dollar will move higher. Based on this extreme negative sentiment reaching lower levels while price has not reached new lows may provide a clue that you could see a bounce in the price of the Dollar. If this were to be seen then it would increase the probability that other markets such as stocks and commodities could see a break in their recent increases in price. We have recently begun adding to investments related to the strength of the dollar as part of our contrarian pick for the next 3 to 6 months as we think you could see prices reverse course.

Interest Rates
In our last quarterly we stated “in the short term the likelihood of rising rates seems mute” which so far has been accurate as rates have declined significantly since our last writing. The interesting part about interest rates is that according to Bloomberg the rate of 2 yr 5 yr and 10 yr treasuries are roughly the same price as March of 09 when financial markets were in the midst of pandemonium. The difference now is we have rates as low as they were during the peak of crisis yet the stock market is roughly 40% higher in price. In our opinion one of these markets has the future predicted incorrectly and either stock prices need to move lower or interest rates need to rise. Only time will tell. For investors looking to buy treasuries we would caution that there may be other bond categories that can produce a healthier yield with less risk at this time.

With Gold making new highs the press has made this shiny mettle a no lose proposition. It does seem the longer term case for owning gold remains intact as more and more investors have a greater desire to own hard assets like Gold as their concern that paper money whether It is the Dollar or another currency will lose value as all countries will eventually begin printing money in order to devalue their currencies as a way to reduce debt loads.

In our last Quarterly we stated “a breakout above 1250 would create a target of 1380”, so far the high for gold has been near 1368. Moving forward we would not be surprised to see the price of Gold take a dip in the near term which we would be interested in buying depending upon the extremity of the next correction.

In regards to oil we recently stated that respecting the $70 a barrel price was necessary in order to keep oil as a holding in a portfolio. Since then the $70 price has held and price is currently near $82 a barrel. We don’t see any significant increases or decreases in the price of Oil in the near term.

As we enter the final Quarter for 2010 we feel the Dollar will most likely be the tell of where markets may go. A bounce in the Dollar will put a lid on the recent rally in equity and commodity markets where as a continued decline below the November 09 lows in the Dollar would accelerate the rise in stocks and commodities.

For our client accounts we continue to use experienced tactical managers which have been able to reposition accounts successfully as well as diversification into alternative assets like Absolute Returns and Structured Notes.

Until next time enjoy the beginning of Fall and the upcoming Holidays.

Colby McFadden

*The opinions expressed are those of Colby McFadden and Quiver Asset Management as of 10-15-10 and are subject to change due to market and other conditions
** Graphs provided are for illustration purposes only and do not reflect a specific investment recommendation
-There are risks inherent in investing in the stock market. Price value will fluctuate.
-Past performance is not a guarantee of future results
-The S&P 500 Index is a market-value weighted index consisting of 500 widely held U.S. stocks chosen for market size, liquidity, and industry group representation. Performance is compounded, distributions reinvested. An investment cannot be made directly in an index. Past performance does not guarantee future results.