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Bob's Journal 
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May 30,
2007 10:30 a.m. I still do not see signs of a bear market, but there are some signs that a correction could be on the horizon. Today we are seeing a small decline, allegedly because China tripled the stock transaction tax in an effort to cool off its stock market. The Shanghai market is quite small compared to the U.S. market, and the rapid rise in Shanghai’s market the last year did not trigger a rise in U.S. equities. The only reason to be concerned about China’s efforts to dampen its stock market is that it might use reduced liquidity as a tool. I’ll have more about international liquidity and the stock markets in the July issue of Retirement Watch. One warning sign is interest rates. Over the last couple of years, U.S. stocks have undergone corrections whenever the yield on the 10-year treasury bond popped above 5%. In the last week the yield climbed, peaking between 4.8% and 4.9% this week. In the last couple of years, rises above 5% were accompanied by Japan’s efforts to raise its interest rates. The current rise in U.S. rates appears to be a fear of inflation, largely due to the rise in corn prices and how it is being passed through the to other products. There is no magic in economic theory to the 5% bond yield, but it has been an important trigger in the recent past and bears watching. Another warning sign is the 200-day moving average. The market indexes are well above this level. Traditionally, when a market surge lifts the indexes well above the 200-day moving average, the indexes fall to meet the average or even below it. There also is no magic in the 200-day moving average. But it is one of a number of signs that the surge since early March has pushed the stock markets into overbought territory. None of this is a sure sign that stocks are about to collapse. But they are good reasons to consider our policy of being invested to participate in rising markets but also maintain a margin of safety through some hedged investments and sell signals.
May 30,
2007 10:35 a.m. Medicare Advantage members need to keep an eye on Congress. The plans might be changing. The 2003 Medicare Reform law increased the amounts paid to managers of Medicare Advantage plans for each participant in the plans. This allowed the plans to dramatically improve their benefits and dramatically increase enrollment. Enrollment has increased about five-fold in the last year to 1.3 million members. Three years ago enrollment was neglible. But changes in Congress threaten this increasingly-popular option. The new majority in Congress is hinting that the higher payments to the plans are enriching the companies running the plans and that a cut in the fee might be in the works. Proponents of the plans point out that the Advantage plans provide more services at lower cost than traditional Medicare and that participants like the plans. It isn’t clear if Congress will take action or when. We went through this experience before. Medicare HMOs were very popular in the 1990s. Then, Congress reduced the amount paid to the HMOs for each participant. The HMOs reduced services, increased fees, or exited the Medicare market altogether. The Medicare HMO market virtually disappeared. The Medicare Advantage plans in the 2003 law were an attempt to revive the format and give Medicare members more choices. It would be a shame if Congress took away this option again.
May 24,
2007 11:50 a.m. This relatively quiet pre-holiday week is a good time to assess the stock markets. The market indexes haven’t done much for the last week. After a strong run since the February lows (and an even stronger run since last July), the Dow closed down three days in a row. The other indexes have been mixed. Today’s decline apparently was a response to some rather obvious remarks about the Chinese stock market from former Fed chairman Alan Greenspan (who has a rather poor record as a forecaster). Let’s look at the behavior of the market. The percentage point increases in the market indexes recently have been quite modest. There have been few explosive days, and those were not followed by follow-through explosive days. Instead, we have had a steady, almost-relentless rise in the indexes. In addition, trading volume has been low. Strong bull markets tend to be marked by rising volume on the days when the market indexes rise. We haven’t really had that. The days of the highest trading volume tend to be the days the indexes declined. But an interesting development is that the daily trading volume has been steadily rising since early April and has been higher than most days during the past year. That is a good sign for the markets. Another good sign probably is the high level of short interest on the exchanges. There are a lot of people who have sold short stocks. That could put a floor on the markets. As stock prices rise, the short sellers have to buy stocks to cover their short sales and cut their losses. It is possible that a portion of the recent rally has been due to short covering. But this data should be used cautiously. There are investors who use short sales as part of a long/short investment strategy or as part of an arbitrage strategy involving merger candidates. Both fundamental and technical factors regarding stocks look positive now. But the catalyst that reverses a bull rally cannot be known in advance. That is why we are continuing our portfolios that are partially participate in the bull rally and partially are hedged against it.
May 24,
2007 11:55 a.m. A few of the premier private equity firms are issuing shares to the public. Private equity firms invest in companies that are not publicly-traded. Most individuals cannot invest in the funds run by these firms. Only “qualified investors” who have minimum incomes or net worths can invest. Even then, investing is difficult because the good firms require hefty minimum investments and often are not open to new investors. That is why some people are saying that purchasing shares in the private equity firms is a way for many individual investors to participate in the hefty returns these firms have earned in the past. But the potential to buy shares in these companies should be a warning sign for several reasons. For one, it creates a potential conflict for the firms. One reason they have earned high returns in the past is that the managers have not had to worry about short-term performance and negative media attention. They could let a company’s management work through problems in private until they were solved. Then, the firm was sold to another firm or to the public. It didn’t matter if the firm had low profits or even losses for years as long as it eventually was profitable. As public companies, the private equity firm’s managers will receive a portion of their compensation based on stock performance. That could make them more short-term oriented than they were in the past. Or they might continue their past practices and ignore any short-term effect on the company’s stock. In either case, there is a potential conflict between the investors in the private equity funds run by these firms and between public shareholders of the firms.
May 15,
2007 02:20 p.m. The stock indexes have been meandering the last couple of weeks. Positive inflation reports Friday and today seem to have triggered more optimism among investors and set the stage for another rise. Yet, investors have been confused by the markets for the last year or so because they focus on the wrong data. Most of the analysis made today assumes that today we still are in a closed economy. Failure to recognize the global economy and how it affects markets makes so many forecasts incorrect. For example, the yield curve used to be an excellent tool for forecasting recessions. An inverted curve signaled a recession within 18 months. We have had an inverted curve for some time now with no sign of a recession. In the old days, an inverted yield curve indicated that the Federal Reserve tightened credit and raised interest rates. Those acts inevitably led to reduced business activity and a recession, unless the Fed reversed policies in time. Now, we have an inverted yield curve because developing countries with trade deficits are investing their surpluses primarily in the U.S. That keeps our long-term rates down. The Fed raised short-term rates the last few years, but that simply reversed the ultra-low rates following 2001. As long as developing countries run trade deficits with the U.S. and invest their surpluses back into the U.S., our interest rates will stay fairly low and the economy and markets will keep chugging along. This circle of trade and investment might be keeping a floor under U.S. markets. There are two real risks to U.S. markets. One risk is that the developing nations will shift their surpluses out of the U.S. This isn’t likely. Many of the countries will diversify their future surpluses into other investments. But they will not abandon the U.S. as an investment or sell existing holdings. The other risk, which is more immediate, is rising rates outside the U.S. These days, foreign rate hikes have more of an effect than domestic rate hikes. Higher rates overseas could slow their economies, and reduce exports by U.S. companies. Higher rates also could reduce the amount of money that is borrowed by hedge funds and other investors overseas to invest in U.S. assets. Higher overseas rates also make foreign bonds more attractive to international investors than U.S. bonds. Instead of watching the Fed, U.S. investors should be watching the Bank of England, Bank of Japan, and the European Central Bank.
May 4, 2007
9:50 a.m. The stock indexes have been on a roll. The media are full of the milestones: New highs on the Dow, impressive strings of closing highs, the S&P 500 closing above 1500 for the first time since 2000 and nearing its record high. The Nasdaq even inched up so that it finally is at half its peak value in 2000. The latest theory to explain all this exuberance is that the market is in a melt up. Some refer to this as a buying panic. The theory is that once the indexes hit the headlines again and investors saw that the bull market continues, they rushed to get back in the market. It is the old story of investors buying only after prices already have risen. If that is the case, this would be a good time to sell. The data, however, do not support the melt up theory. Unlike in the late 1990s and other pre-crash periods, the technical factors of the market do not support the theory. Trading volume has been relatively low during the recent surge. In a buying panic, volume should be high. Other factors also indicate a strong but steady market, not an irrational surge. There are fundamental factors to support rising stocks. Interest rates still are low. The economy is doing well. Earnings continue to result in positive surprises. Of course, there is a lot of liquidity in the world’s capital markets. Both corporations and private equity firms are taking stock out of the market, leaving fewer shares available to public equity investors. There also are few alternatives for investors. Fixed income investments do not pay enough to justify their potential risks. Commodities are high but also are volatile. Valuations in real estate trouble many investors. International equities are the only viable alternative to U.S. equities, and investors are pushing their prices up faster than those of U.S. stocks. What could be the catalyst for a decline? It is hard to say. There is not a lot of corporate debt, which usually precedes a downturn. I have concluded that the traditional inverted yield curve is not a good forecaster now, because factors have changed. The economy and markets have survived the subprime mortgage crash, which many analysts thought would be a catalyst. All we can say is that any catalyst for a decline would be a surprise. That is why we stay hedged and with a margin of safety. We are able to profit from the gains and have protected in case of a sudden reversal.
May 4, 2007
9:55 a.m. We spend a lot of time at Retirement Watch shattering myths about retirement. The most enduring myths seem to involve housing. The media image is that the typical retiree does one of two things. One route is to pack up and move to either Florida or Arizona. The other route is to keep the pre-retirement residence but spend at least a couple of months each winter in a sunny place such as Florida or Arizona. In truth, a minority of retirees take either route. Most retirees either stay in their pre-retirement home for at least five years or they downsize to a smaller home in the same area, often in the same ZIP code. I have offered statistics on these trends in the past, but a new set were published by Joel Kotkin, a housing scholar, in The Wall Street Journal. Kotkin was responding to recent forecasts that the Baby Boomers soon would be selling their suburban homes and moving to urban condos from which they could walk to everything. Kotkin says previous forecasts about the Boomers’ housing choices were wrong, and these are, too. Only about 2% of Boomers even cross state lines after retirement. The small percentage that move make their moves farther away from the cities, not into them. A 2000 survey showed that about two thirds of Boomers plan to stay in the suburbs. They want safety and access to outdoor recreational activities. Kotkin’s own studies of migration by those 55-64 shows that they move to sprawling suburban areas or to rural areas such as Idaho and Montana. Most Boomers want to be close to the grandkids, amenities, and open spaces. Investors and cities expecting affluent Boomers to floor into city condos probably should re-think their plans. Boomers who are considering a move to a city with the idea that they will be surrounded by like-minded, like-aged folk in safe enclaves also should reconsider. As I have said before, most people don’t move in retirement. Many that do discover they made a mistake and move back.
May 4, 2007
10:00 a.m. In my upcoming book, Invest Like a Fox…Not Like a Hedgehog, I spend some time explaining how many investors misunderstand and misuse data. This mistakes cost them a fair amount of capital. A new book addresses that aspect of investing in great details. Nassim Nicholas Taleb runs a hedge fund and a few years ago published Fooled by Randomness, a book I have mentioned. Taleb believes, as I do, that too many investors look at long-term averages and develop a false comfort. They do not realize that they averages are developed by events that differ wildly from the average. Most importantly, investment markets with some regularity have events that differ markedly from the averages. Statisticians, in fact, say that the markets do not behave in a “normal” manner. So what should an investor do with this information? First, recognize that markets will not appreciate at the long-term average rate each year and often have extended periods when returns are well above or below the average. Second, position your portfolio to protect yourself from a possible extremely bad event and to profit from an exceptionally good event. We have done just that in our Sector and Balanced Managed Portfolios. We are hedged against a swift downturn in the markets through Hussman Strategic Growth while being leveraged for good markets through ProFunds Ultra Bull. This is quite a distance from the traditional balanced, indexed portfolio. It also is a strategy that has served us well and will continue to do so no matter what today’s confusing markets deliver to us.
May 1, 2007
8:30 a.m. In the headlines almost every day recently has been a classic example of proving the error of a widely-held belief. Unfortunately, because most of the media are widely-invested in the conventional wisdom they either are refusing to report the contradiction or do not see it themselves. For many years we have been told that the U.S. trade deficit and federal budget deficit had to lead to a demise of the dollar against other currencies. I have written several times about why this is incorrect, including in a Platinum Club report a few years ago about economic and investment myths. We now have a contemporary, tangible refutation of this theory, and it largely is ignored. For some time now the trade deficit and the budget deficit have been shrinking. At the same time, the dollar’s value has been declining against most developed country currencies that are not fixed to the dollar. The recent surge in the Euro and the British pound have received the most attention, but there are other currencies doing well against the dollar. Even as inflation had an unexpected decline in the latest month, the dollar fell. Most likely, interest rates explain the flight from the dollar. A number of central banks around the globe raised rates in recent months. China is expected to keep raising rates because its economy is growing more rapidly than the government wants. Other central banks also have indicated they likely will raise rates a bit more. In the meantime, many investors are anticipating that the U.S. Fed will reduce rates as its next move. The economy is weakening, and they expect that the housing problems will weaken the economy further. I believe those investors and analysts are wrong. I think the economy is in good shape and likely to resume its growth. I suspect inflation is more of a problem than is generally recognized. If I am right, interest rates will remain stable or rise. Either move should help the dollar. That could be a problem for our international stock positions and also could hurt large U.S. companies that make a high percentage of their sales overseas. But it will most hurt investors who use futures or other investments to bet on a continuing slide in the dollar.
May 1, 2007
8:35 a.m. The trustees of the Social Security and Medicare Trust Funds issued their annual report recently, and as usual it was dismal. Buried within the report is some reasonably good news for those who want to see it. Medicare is in much worse shape than Social Security. This year the Medicare fund will pay out more in benefits than it receives in payroll taxes and other dedicated revenue. Its reserves will be exhausted in 2019 under current projections. Social Security will begin paying out more than it receives “soon” and will exhaust its reserves in 2041. The trustees estimate that Social Security could be brought into balance over 75 years with some combination of an immediate increase of 16% in the payroll taxes or a 13% reduction in benefits. Greater changes are required to ensure sustainability beyond 75 years. For Medicare some immediate combination of a 122% increase in the payroll tax and 51% reduction in outlays is needed. That is rather daunting. But, as I said, there is some good news. The first bit of good news is that the “days of reckoning” are farther away than they were a year ago and even farther than five years ago. That is because actual results have been better than the trustees’ assumed. Inflation is lower; economic growth is stronger; people are delaying retirement. More developments along this line could put the systems in better shape over the years. In addition, increased immigration and later retirements would do a lot of aid the systems. Even better news is that the tax revenues into Social Security will finance about 75% of scheduled benefits in 2041 and later. For Medicare, revenues will pay 79% of annual benefits after 2019. That means the programs can last indefinitely if layouts are trimmed to 75% and 79% of current levels. This can be done through some combination of means-testing and reducing either benefits or projected increases in benefits. Yet, as the trustees say, the longer Congress waits to take action the greater will be the required changes.
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E-mail: BCarlson@ Bob's Journal Archives January 2007
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