Libya… Like Egypt?

(Editor's Note: Paul Schatz, President of Heritage Capital, LLC, in Woodbridge, will be contributing to Fi$callyFit every Friday. Read his biography here)

For many, many weeks, I have discussed the stock market's need for a pullback. A short-term cleansing to refresh the rally. Unfortunately, far too many others have been talking about it as well, so the market decided not to accommodate, until it wanted to.

Several weeks ago, I offered that the pullback so many were looking for would probably come out of nowhere with some geopolitical event and would quickly lop 4-7% off the major indices. Tuesday was just that day, following more unrest in the Middle East. This time it was Libya with its big supply of oil. Since I have been writing about this pullback since late last year, I certainly deserve zero in the way of credit for it finally happening. I mean, even a broken clock is right twice a day! Call for something long enough and it's bound to happen at some point.

As I've mentioned before, it's still incredible that the Dow has not closed below its 20 day moving average (average price of the last 20 days) since 12/1 as you can see below. That's historic momentum! I am going to go out on a limb and say that the market will not respond the same way as it did with Egypt and this time it will close below the 20 day moving average in the coming week or so.

But at the same time, I also do not believe this is the start of a real correction (10%+ downside). Corrections typically do not start with a bang like we saw on Tuesday, just one day removed from the high. Instead, more significant declines usually start slow and small, building towards the large down days, like snowball rolling downhill and gathering momentum. When is a snowball and market going the fastest downhill? The second before it hits the bottom. In this case, we could (and should) see some more downside, but I don't think it's anything serious, yet.

I'll be watching for signs of sector rotation among leadership, both positive and negative, along with any indication that the emerging markets are ready to percolate again. As the major US indices have steadily marched higher since December, which you see from the above chart, emerging markets, chart below, weighted towards the big countries like China, India and Brazil, have totally lost their leadership role and unable to make upside headway.

Equally as important, the performance of the high yield (junk) bond market must be closely watched after the single most dramatic bull market run in history. For the most part, as long as the high yield market is confirming the rally and outperforming on the downside, the structural bull markets in stocks should continue, for now.


Feel free to email me with any questions or comments at Paul@investfortomorrow.com.

Until next time…

Paul Schatz

Heritage Capital LLC
http://www.investfortomorrow.com/
http://RetirementPlanningConnecticut.com/

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Bottoming Process Continues

(Editor's Note: Paul Schatz, President of Heritage Capital, LLC, in Woodbridge, will be contributing to Fi$callyFit every Friday. Read his biography here)

The stock market continues to build a bottom to launch another leg higher during the second quarter. As I mentioned the other week, the highest volatility and largest declines are often seen right before the low, like we saw on February 4 and 5, so further weakness this month cannot and should not be ruled out. But price is much closer to the end (and maybe we’ve seen it) than the beginning.

I won't be shocked if Dow 9800 is revisited or even breached, although that should be the final bout of selling and maybe the perfect buy point if you want to try and time the optimal entry, something that won’t be easy.

At this point there is plenty of technical and sentiment evidence to support the bottoming process, such as the usually wrong, mom and pop option traders, various sentiment surveys from A.A.I.I. and Investors Intelligence, showing a dramatic shift to bears and short-term mutual fund traders running away from risk. Additionally, last week's decline showed a small slowing of downside momentum that usually presages the final low.

More technical measurements like the number of stocks advancing and declining, the volume in those stocks, as well as the number of stocks making new 52 week highs and lows also points to a market that is building a foundation for another rally above the highs made in January. My target remains in the 11,500 to 13,000 range by Labor Day, but I will update that next month.

The fly in the ointment (isn’t there always?) a little longer-term is that the investment grade corporate bond market, which peaked in September, is in danger of making lower lows, turning the trend to down. The riskier junk bond market, which assumed a leadership role for all of 2009 and made a new high in early January, has collapsed in recent weeks.

Couple the bond market problems with the fact that most sectors I follow have rolled over to the downside, the stock market certainly has the smell of living on borrowed time this year. That fits in with my theme that the next rally, as large as it may be, should be the final one before a much more significant correction or worse sets in later in 2010. The sector behavior is important because the more sectors that are healthy, the longer a rally can last. Key leadership is vital and unless something changes dramatically, I just don't see where it will come from without a full fledged correction.

Please feel free to email me with any questions or comments at Paul@investfortomorrow.com.

Until next time…


Paul Schatz

Bond Market ABCs

(Editor's Note: Paul Schatz, President of Heritage Capital, LLC, in Woodbridge, will be contributing to Fi$callyFit every Friday. Read his biography here)

In the media, we often hear that the stock market was up or down a certain amount of points. By “the stock market,” reporters are usually referring to the Dow Jones Industrial Average, an index of 30 very large companies that are supposed to represent the economy. I’ve never believed that was an accurate representation of the market since 30 mega cap stocks often don’t tell the story beneath the surface.

As a professional investment manager, we often compare our returns to the S&P 500, which represents the 500 largest companies in the U.S. and the most widely used benchmark in the industry. There are plenty of other indices that investors watch, from the small cap Russell 2000 to the large cap Russell 1000 to the all inclusive Wilshire 5000. Just remember that the Dow Jones Industrials may not always be the most accurate.

When we hear about the bond market, people are usually referring to the treasury bond market, those instruments issued by the U.S. treasury and backed by the full faith and credit of the U.S. government. And they come in all maturities from 3 month treasury bills all the way out to 30 year treasury bonds. Over the past decade or so, the benchmark bond has become the 10 treasury note. We often hear that the bond market lost a certain amount, like ¼ point, forcing yields higher. Remember, and this is the most confusing part to understand, when bond prices rise (good if you own bonds), bond yields fall and vice versa.

Unlike stocks, where most of the indices generally trend in the same direction, but to different magnitudes, bonds are all over the place. Besides treasuries, there is the government and agency bond market, which includes issues from Fannie Mae, Freddie Mac, Ginnie Mae, Federal Farm Credit and so on.

Next we have the municipal bond market, which acts much differently than treasuries and govies. The muni market is more economically sensitive than the previous two as it relies on the financial stability of the issuing entity. If tax receipts are on the rise, the price of those munis will likely rise as well. When the local economy falters or collapses, muni bond prices will as well since that local issuer may have trouble paying interest or repaying principal.

The last major muni bond crisis occurred during the fourth quarter of 1994, known as the Orange County Crisis. Orange County California began investing their money in non traditional instruments that took on significantly more risk than what was generally accepted to increase return. It worked without a hitch until some of their cutting edge strategies began to fail miserably. Once that little snowball rolled over the edge, it grew and grew rapidly, leading to an early December 1994 bankruptcy filing that sent shockwaves through not only the muni bond market, but the entire financial system.

Beyond the municipal market, you may have heard about the investment grade corporate bond market. These are bonds issued by companies, from IBM to GE to Microsoft, and carry a credit rating of BBB- or better. This market typically does not behave like any of three bond markets already mentioned, but does have some similarities with the stock market.

At the end of the food chain, there is the high yield or junk bond market, which is made up of companies with credit rating worse than BBB-. These usually have the highest risk of default, but also tend to offer the greatest reward. Legendary financier and former Drexel Burnham Lambert superstar, Michael Milken, is credited with really creating the modern day junk market from almost nothing into trillion dollar machine. If you know the story, he also was convicted of insider trading, securities fraud and racketeering as Drexel collapsed in early 1990. After being released from prison, he continued his philanthropy through the Milken Foundation and Milken Family Institute and remains a huge supporter of medical research. (Sorry for the digression)

Junk bonds usually behave more like stocks than any of their fixed-income counterparts. During massive bull market rallies in stocks, like we’ve been seeing since March and again during 2003, junk bonds offered comparable returns to stocks with much less volatility and downside movement. In fact, in 2009, many of the popular junk bond funds have outpaced their equity brethren!

When trying to determine if investment grade and junk bonds are cheap or expensive, many people turn to what’s called spreads. Analysts measure the difference in yield between the bond and a treasury instrument like the two year, five year and 10 year note. The smaller the spread, the less an investor is being compensated for taking on the risk of a non treasury issue.

In early 2007, the spread between treasuries and junk fell to an all-time low, meaning that investors were not worried about the companies defaulting and just wanted to reach for the most yield possible, forcing junk bond prices higher and higher. As we know, those bubble investors were severely punished with prices falling 30, 40, 50 and as much as 80% in less than two years!

Conversely, earlier this year and in early 2003, with the financial markets and economy in collapse, junk bonds spreads widened to levels never before seen. Astute investors picked up bonds yielding 15-20% and have been immediately rewarded with prices rallying as much as 50%!
If you have any questions or comments about any of the equity or fixed income indices or markets mentioned, feel free to email me at Paul@investfortomorrow.com