Market Outperform

Global Macro Investing with ETFs Part I: Currencies

2007-11-03T15:07:00.000-04:00

For the average investor, trading in currencies can be dangerous business. But diversification through non-US currencies as part of a long-term diversified portfolio can be quite beneficial.

Rydex offers 8 foreign currencies in ETF form:

1) Australian Dollar (FXA): 5.88% interest
2) British Pound Sterling (FXB): 5.38% interest
3) Canadian Dollar (FXC): 4.20% interest
4) Euro (FXE): 3.79% interest
5) Japanese Yen (FXY): .24% interest
6) Mexican Peso (FXM): 5.81% interest
7) Swedish Krona (FXS): 3.63% interest
8) Swiss Franc (FXF): 1.58% interest

Therefore, the return for a currency ETF is based on two components:

1) Carry (interest rate)
2) Capital gain/loss - appreciation or depreciation of the currency vs. the US dollar.

Finally, Full Inversion

2006-02-17T21:22:00.000-05:00

The yield curve is fully inverted as of today's bond market close with the 3-month t-bill trading at a yield of 4.54% and the 30-year t-bond trading at 4.51%.

We've been waiting for this inversion since the fed began raising rates in 2004 as the 30-year bond stubbornly refused to sell off. Inversion is a rare, unnatural occurrence, where investors are not being compensated via higher rates for the lack of liquidity of tying their money up in longer term instruments.

There are various explanations floating around for the current inversion: 1) Increased demand from China to increase the value of the dollar and keep those Chinese imports cheap, 2) A lack of future inflation expectations, and 3) A lack of interest rate competition worldwide of similar instruments.

As we know, inversion in the past has been a highly predictive leading indicator of economic slowdown (recessions). Will this time be any different? Most pundits believe so; to them it's always different. The release of the next GDP report will give us a better clue, but if the fed raises to 4.75% on March 28th, a steeper inversion could result.

With stocks at 4 1/2 year highs and money market rates hitting 4.8% at HSBC, cash is starting to look pretty attractive in the short-run.

The Greenspan Legacy

2006-02-05T01:18:00.000-05:00

After 18 years, 2 recessions, a stock market crash (87), a stock market bubble and ensuing deflation (2000-02), and the greatest housing boom in US history (2000-2005), Alan Greenspan has finally stepped aside.

Many have argued that no other public figure in the past twenty years has influenced the world economy more than Greenspan, who along with his federal reserve compatriots, directly influence the money supply, which in turn effects interest rates and inflation rates.

Examining the US stock market performance under his tenure, the 87 crash occurred within months of Greenspan taking control, but the longer-term performance of the S&P 500 since he took office has been nothing short of spectacular, with 11.22% annualized returns.

So if we can blame Greenspan for allowing and in many respects perpetuating the stock market bubble of the late 90's and the housing bubble which exists today, we must acknowledge the strong performance of the US economy and US equities since he took office. What would the performance have been if Greenspan had taken a more stable and less secretive approach to monetary policy is anyone's guess.

But I'm of the belief that although the media is forever fascinated with the federal reserve and its supposed power, markets will eventually reach a state of equilibrium in spite of federal reserve actions. The recent performance of the 10-year bond proves this to be this case, as Greenspan's 14-straight rate hikes have had no effect on long-term rates.

Worldwide supply and demand, investor appetite for risk, and investor expectations about future interest rates and inflation will over the long-term win-out over any short-term actions by the fed. But in the short-run, dramatic declines or increases in the federal funds target rate can undoubtedly have a significant influence on investor's attitudes.

The burning question that remains today is whether Greenspan took rates far too low (from 6.50% to 1.00%), creating a speculative housing bubble that will leave the state of the US economy in disarray should it come crashing down. Bernanke inherits a 4.5% federal funds target rate, and 14 straight .25% increases since June of 2004. The expectation today is that Bernanke will raise to 4.75% in the March 28th meeting, and that will be the end of the .25% hikes. After that, stocks will supposedly start another bull run.

I don't buy it. It's never that simple. Inflation and housing speculation continue to be problematic, so I still think we'll see 5.00% by May, and probably 5.25% by June. What that means for the equity market is anyone's guess. But it should be good news for those stashing money away in short-term savings vehicles.

(Fed Funds Rate Under Greenspan, Click to Enlarge)

2006 Year-End Forecasting

2006-01-08T09:05:00.000-05:00

At the start of each year, hundreds of self-proclaimed wall street "gurus" weigh in with their year-end predictions. More often than not, their predictions for the new year are bullish. The reason for this bullishness is quite simple: Since 1900, the S&P 500 (including dividends) has had 30 down years and 76 up years. Therefore, in one-year periods, up years have occurred 71.7% of the time vs. 28.3% for down years. Clearly, if you were a guru and you had to make a bet based on those odds, you would predict an up year as well.

But more important than the prediction itself is the reasoning behind the prediction. While this part of the analysis is rarely given in a satisfactory manner, I often develop my own scenarios to justify their forecasts.

While the gurus will confuse you with talk about the fed, interest rates, inflation, etc., it is important to get back to basics in developing forecasts.

Simply, an index's (such as the S&P 500) return is merely a function of two variables: 1) Price Appreciation, and 2) Dividend Yield.

I'll assume a Dividend Yield of 1.95% for the S&P 500 (=($6.07 4th Quarter 2005 Dividend on the S&P 500 * 4) / (Year-End S&P 500 Value of 1248.29).

That leaves us with Price Appreciation. Price Appreciation will be dependent on two factors: 1) Year-End P/E Multiple, and 2) Earnings Growth.

The P/E multiple at year-end 2005 was 17.91. 2005 Earnings for the S&P 500, if 4th Quarter estimates hold, will be 69.69 (a 19.03% increase over 2004).

The current estimate for earnings growth in 2006 is 10.2%, taking 2006 earnings to yet another all-time high of 76.8.

Assuming that forecast of 76.8 is accurate, we can begin to develop our year-end forecasts by assigning a P/E multiple to that value. If we believe that P/E multiples would remain the same at year-end 2006 as year-end 2005, we would have an ending value on the S&P 500 of 1375.49, which is simply 76.8 in earnings multiplied by a P/E of 17.91. This would leave us with a 2006 Price Appreciation of 10.2% (equal to the estimated increase in earnings). Add in 1.95% for dividends and you have a total return of 12.15%. Not too shabby.

However, what is the likelihood of the year-end P/E multiple remaining at 17.91? That is the key question to answer. Remember, since 1871, the historical average P/E ratio on the S&P has been 15.01. Over time, then, we would probably suspect a "mean reversion" to this value. That is in fact what we have been observing in the market as P/E multiples over the past few years have been steadily declining as follows:

2001: 46.50 P/E
2002: 31.89 P/E
2003: 22.81 P/E
2004: 20.70 P/E
2005: 17.91 P/E

Additional evidence in favor of the assumption of a declining P/E is observed when looking at periods in the past when the S&P began the year with a P/E multiple within 1 of the current multiple of 17.91. Going back to 1871, there have 19 such occurrences, and the following year P/E has declined by an average of 1.41%.

A similar decline in P/E in 2006 would take the year end P/E to 17.66, and assuming yearly earnings of 76.8, a year-end value of 1356.29, or an 8.65% Price Appreciation. Add in a dividend yield of 1.95% and you would have a total return of 10.6% under this scenario.

When 76 gurus were polled in the latest edition of Business Week, their average forecast was a gain of 7.0% for the S&P 500. That tells me that on average they either expect 1) P/E multiples to decline more than 1.41% in 2006, 2) Earnings to grow slower than the current estimate of 10.2%.

The most bullish guru was the predictable perma-bull Elaine "the stock market never declines" Garzarelli, with a year-end forecast on the S&P 500 of 1635, or 30.97% price appreciation. The most bearish guru was Barry Ritholtz, with a year-end forecast of 880, or a decline of 29.50%.

This data tells me that Mr. Ritholtz either sees 1) a recession occurring at some point in 2006, causing S&P earnings to decline, or 2) a dramatic decrease in P/E multiples. Conversely, Ms. Garzarelli's prediction implies either 1) a greater than expected increase in S&P earnings, or 2) a dramatic increase in P/E multiples.

It is important to note that Ms. Garzarelli predicted a year-end value of 1420 for the S&P 500 in 2005, a 17.17% increase. Similarly, Mr. Ritholtz predicted a year-end value of 950 for the S&P in 2005, a 23.9% decline. Neither came close as the S&P had actual price appreciation of 3.0% in 2005, closing at 1248.29.

As always, the lessons to be learned by this analysis is to do your own thinking and reasoning and to always question forecasts thrown out by experts. It is far more important to understand the underlying analysis behind a forecast than to just accept a gurus prediction as gospel. After all, you shouldn't be relying on predictions and forecasts to make money. If you haven't figured it out by now, no one can accurately forecast exactly what is going to happen in the financial markets. That is what makes them so interesting and why we keep coming back for more: their inherent unpredictability.

The best we can do is come up with a range of expectations based on various assumptions of underlying variables, and to put our money to work where probability theory works in our favor giving us the best chance of succeeding. With that said, I will leave you with a range of possible ending S&P 500 returns, based on differences in underlying variables. Which one will prove correct? I really haven't the slightest idea. But based on market history, I will say this: stocks have a 71.7% chance of producing a positive return in 2006.

Take a Bow, Diversified Investor...

2006-01-07T02:01:00.000-05:00

Delayed gratification, that is the secret to profitable long-term investing. Do you have the patience and fortitude to let passive gains come to you. If you do not, put your money elsewhere; enjoy that 4% risk-free return because you're unlikely to beat that 4% playing with stocks. But if you do have the patience, and you have at least a 10 year time horizon, you are more often than not handsomely rewarded. Since 2003, when the current bull market began, these are the annual and cumulative returns of various index ETFs (including dividends): see chart (click to enlarge)

If your own returns don't quite measure up, do not despair. Remember, over 90% of the professional mutual fund managers fail to beat the indexes over the long haul. As the saying goes, if you can't beat em, join em. So if your annual statements over the past 3 years aren't showing cumulative gains in the range of 50-70%, you might want to take another look at index funds and ETFs. At the very least, if you are not a full time investor or trader, you must question your ability to beat those that are.

The above chart not only shows the benefits of increased diversification through using index ETFs, but also the benefits of increased diversification among ETFs. As I've said many times on this blog, the DIA (or "Diamonds") are an inferior product to VTI and SPY, mainly due the fact that with only 30 holdings a few of the those holdings can and will drag down the entire index (see GM in 2005). This is exactly the reason why you invest in ETFs in the first place: to not let any one stock hurt your portfolio's return. That is why we laugh each week when Cramer blesses 5-stock portfolios as "diversified." Only a Harvard lawyer could sell that nonsense to 300,000 viewers a night.

The chart also makes a strong case for international diversification via EFA, which contains securities from Europe, Australia, and Far Eastern markets, and is considered the global equivalent of the American S&P 500. Unless you have a damn good reason why U.S. stocks will outperform international stocks in the long-run, you should have some international exposure in your portfolio. As you can see, over the past three years having this exposure would have greatly boosted your overall return, as EFA nearly doubled over that period of time. EFA also serves as a hedge against a falling dollar, which would have worked against you in 2005 (when the dollar advanced against the Euro), but for you in 2004 (when the dollar declined against the Euro).

Wagons East...

2005-12-14T23:53:00.000-05:00

"A surge of Chinese shipments of televisions, toys and computers delivered to U.S. stores for holiday shoppers pushed the U.S. deficit with China to a new monthly record of $20.5 billion. So far this year, the deficit with China is running at an annual rate of $200 billion, far above last year's record deficit of $162 billion." -- AP

Santa Claus has officially relocated: his new digs are in Beijing, where the elves don't demand benefits, pensions and 15-minute breaks. And so it goes, month after month, billions of dollars in capital flows east, as the Americans are fed the lies of "free trade" and "open markets." Americans will soon ask themselves: was all that cheap, materialistic junk worth it?

Millions of high-paying manufacturing jobs have already been lost, and are never coming back to these shores. The new jobs added to the U.S. economy are largely in service (i.e. restaurant, bars) industries and retail (i.e. walmart), and these jobs don't pay nearly as much as the manufacturing jobs being lost. Capital investment is flowing out of the U.S. in search of slave labor, and we Americans are eating it up.

When will it end, you ask? When U.S. politicians finally start putting the interest of their constituents (American workers) above the gods of the "Global Economy." But by then it may be too late. We are fast becoming a country dependent on foreign nations for our basic needs. We were once the most self-sufficient country on the face of the earth, and that status propelled us to victory in World War II.

If America is to face a similar enemy in the years to come, where would the industrial might come from? We'd have to import that might. America is a nation, not an economy. We have to look beyond GDP growth to measure the strength of a nation. As a nation, the triplet deficits (negative savings rate, current account (trade) deficit, and national debt), if uncorrected, will bring us to ruin.

Every empire has a rise, decline, and eventual fall. If America continues on its quest of being a global empire, it will suffer a similar fate. But there is hope. If America fights to regain its status as a self-sufficient republic, it may once again become that shining city on a hill.

A Sirius Joke...

2005-12-13T22:21:00.000-05:00

Sirius Satellite (Nasdaq: SIRI) has been in the news lately as the degenerate clown (Howard Stern) who abuses the mentally retarded for laughs is finally switching over from FM radio. People often ask me for feedback on SIRI as an investment, as if I would ever recommend an individual stock to anyone, let alone a neophyte investor. I've said it before but I'll say it again: if you let someone tell you what stock to buy, you had better be sure to have them tell you when to sell.

But back to Sirius as an investment. First, I point out, often to the eager individual's amazement, that Sirius has yet to make a dime as a public company (click here for income statement data). Next, I point out that SIRI has been a public company since 1996. That's right, almost ten years without ever seeing the black. Next, I'll point to analyst estimates for the next fiscal year (Dec-2006, click here), -.59 per share. Lastly, if they're still interested in buying SIRI, I'll point to Stern's contract with SIRI (click here), which totals an astounding $500 million over five years, or $100 million per year. SIRI had revenue in the current year of $237 million, so Stern's salary alone would account for 42.2% of SIRI's current revenue.

If the person is still interested in buying SIRI, that's fine. You should never let anyone, including myself, dissuade you pursuing an investment or trading idea that your research and analysis has told you to buy. Just don't tell me you're buying it because Cramer said it would go up or because of Howard Stern. Give me a solid fundamental, technical, or quantitative reason. And if you're buying it because of the "fundamentals," I'd be really interested in how you as a neophyte investor can put a valuation on a company like Sirius that has never earned a dime and isn't expected to in the near future.

But that's just my two cents on SIRI. I'm interested to hear yours.

--Market Professor

13 Straight...4.75% Money Market Yields

2005-12-13T17:28:00.000-05:00

The Groundhog Day fed marches on, raising the federal funds target rate once again to 4.25% (13th straight .25% increase). The Equity Bulls are saying the fed is nearly done, and will raise perhaps once more to 4.5%. For the moment, the 3-month yield seems to back up this assumption, as it languishes at 3.9%. The 3-month has almost perfect positive correlation with the fed funds rate historically, and as such we shall closely monitor the 3-month in the coming weeks.

On the other hand, Banks don't seem to concur with the fed being done at 4.5%, as jumbo money market yields have reached 4.75% (New Century Bank, click here). As you know, I believe the fed has to go to at least 5.00% to be close to a "neutral" policy and to stop the endless flow of easy money. That means at least 3 more quarter point hikes.

For Related Posts, See Blog Entries On:

9/18/05: "The Fed Funds Target Rate Under Greenspan";

6/30/05: "Groundhog Day Fed";

6/2/05: "Fed Funds 4.25%, Year End 2005"

The Ultimate Form of Inflation...One that Forces You to Move

2005-12-09T12:27:00.000-05:00

Each month, with the release of the CPI data, so-called economists roam the financial media channels extolling the lack of inflation in the U.S. Always citing "core" inflation (which excludes food and energy), they argue that the 1.96% year-over-year (yoy) core inflation rate is an accurate depiction of rising prices in the U.S.

But those of us who actually eat and drive cars know better. And those that actually have to live in a home, know that the even the CPI which includes food and energy (4.15% YOY) actually understates the true inflation.

Look no further than the growing problem among communities in which the average home price has appreciated over 100% in the past five years. With that home price appreciation has come much higher property taxes and increased homeowners insurance.

"On Long Island (click here for story), the once bucolic suburb but now heavily developed region next to New York City, about 70 percent of residents are at least somewhat concerned that high housing costs will drive their families from the region. And this is not a far-off issue -- 45 percent said it was at least somewhat likely that they would move out during the next five years."

When 45% of a residents of a highly populated area are contemplating moving due to inflation in the housing market, I'd say the true cost of living is rising greater than 4% per year. What do you think?

Investing Words of Wisdom...

2005-12-08T23:29:00.000-05:00

"We have certain things in common. We both hate to have too many forward commitments in our schedules. We both insist on a lot of time being available almost every day to just sit and think. That is very uncommon in American business. We read and think. So Warren and I do more reading and thinking and less doing than most people in business. We do that because we like that kind of a life. But we've turned that quirk into a positive outcome for ourselves." -- Charlie Munger, describing himself and his long-time partner, Warren Buffett.

If I had to sum up my investing philosophy in one paragraph, to a word, that would be it. Unfortunately, with the advent of circus shows like "Mad Money," the hyperactive pump and dump, buy and sell attitude has become in vogue once again. But the great investors and traders know that 99% of the game is planning and strategizing, preparing oneself for the other 1%, the optimal time to pull the trigger. Trading and investing, while appealing to our innermost gambling addictions, are truly intellectual endeavors.

Reading and thinking, says Charlie. Most would rather have CNBC's many pundits tell them what to do. They don't want to read; they don't want to think. For them, making money in the markets is as easy as perma-bull Joe Battipaglia always claims it is.

If you don't love to read and think, find another vocation; trading and investing are not for you. But if you do love to read and think, there are few vocations in which you will be in a perpetual state of learning as you will be if you study the financial markets for a living.

If you're still reading this, you're ready to read and ready to think. Where should you begin? Begin by learning from the very best, and reading Buffett's annual shareholder letters from 1977-2004 (click here). Enjoy.

--MP

Watch the 3-Month T-Bill...

2005-12-08T00:28:00.000-05:00

When the fed meets next tuesday (12/13/05), the federal funds target rate will undoubtedly be raised to 4.25%, marking the 13th straight .25% increase since June of 2004.

While the overall yield curve (30-year minus the 3-month) has already flattened from 2.60% on 1/1/05 to .69% today, within the next week we should see a further decline in the spread.

There is over a 99% correlation between the fed funds target rate and the 3-month t-bill (see the following article). Therefore, as the 3-month bill currently stands at 4.02%, it should push towards 4.25% within the next two weeks. If the 30-year bond remains at current levels (4.71%), this would flatten the overall yield curve to just .46%.

And as the fed will likely raise to 4.5% in its first meeting of 2006, we will finally have our interest rate showdown. The long bond has no place to run: either we see an inversion or higher long-term rates. Neither scenario will be favorable to equity investors.

The long run of excessive easy money is finally coming to an end. With it came the greatest housing bubble the world has ever seen, fueled by creative lending and a gold rush mentality.

But for now, enjoy the santa claus rally, and we'll revisit these questions as the inevitable showdown approaches.

For Related Posts, See Blog Entries On:

11/18/05: "The Conundrum Continues";

8/12/05: "All Eyes on The Yield Curve";

5/28/05: "Yield Curve Continues to Flatten"; and

4/26/05: "Inverted Yield Curve and Recession"

The Conundrum Continues...

2005-11-18T01:33:00.000-05:00

As all three of the major indices are now firmly in positive territory for the year, the average, diversified investor is naturally relieved. The dog days of October are long forgotten; the dependable end of the year rally is upon us.

There is much to be euphoric about of late, and that is beginning to worry me. Fearful when others are greedy, remember that always. The easy money from the October buying opportunity has been made, and now the pigs will enter to attempt to sell to the greater fool.

Invincible Google has been a true leader, crashing through $400 with no end in sight. $100 points and 33% in 24 trading days. And they added Amazon to the S&P 500, with a market cap of merely $19 billion, vs. $112 billion for Google. Something doesn't add up there.

But I digress. Don't fight the tape. The trend is up; don't be a hero and bank on a reversal. But profits must be taken when desperate buyers jump in with the fear of "missing out." I sense that fear in the past week.

What I'm most concerned about, though, is the interest rate picture. The Financials (XLF) and Tech (XLK), the two most important sectors, are both trading near 52-week highs, ignoring the narrowing spread between short-term and long-term rates. Have interest rates become meaningless? Will an inverted yield curve be shrugged off?

I think not. Remember, in the short term anything can and often will happen in the markets. But with the spread between the 10-year (4.46%) and 2-year (4.37%) at 9 basis points (.09%), we're sure to see fireworks in the next two months.

With the fed funds target rate currently at 4.0%, after 12 straight .25% hikes, the December 13th fed meeting will be here before you know it. That means another .25% hike, bringing the target rate to 4.25%.

At that point, there are three possible outcomes: 1) the fed changes from its current course of .25% hikes (currently, 4.5% is all but guaranteed after the next two meetings), 2) long-term interest rates finally rise above 5%, increasing the spread between long-term and short-term rates, or 3) we see a yield curve inversion, with short-term bills offering a higher yield than long-term bonds.

We've been spoiled with record low interest rates for two years now, but the party is soon coming to an end. Those low interest rates have induced increased inflation (4.2% over the past year) and created a speculative bubble in the housing market. Unless the new fed chairman Bernanke wishes to perpetuate this bubble, he will have to continue raising rates to at least 5%.

I don't believe equity investors are expecting to see 5% after the next four meetings, or anticipating the consequences such a move would have on the interest rate picture and U.S. economy. They could be in for a rude awakening.

--Market Professor

For Related Posts, See Blog Entries On:

8/12/05: "All Eyes on The Yield Curve";

5/28/05: "Yield Curve Continues to Flatten"; and

4/26/05: "Inverted Yield Curve and Recession"

Homebuilders Fall Below Key 200-day MA

2005-10-07T00:30:00.000-04:00

For almost a year, the U.S. Construction Index has traded above it's 200-day moving average, a key technical point in the markets. Yesterday, the 200-day line was broken (see chart).

For a U.S. economy that has become increasingly dependent upon the housing industry, this is no small event. If housing goes bust, we will all feel effects. The seven major homebuilders on my trading screen, the darlings of the housing bull market, are in dangerous technical shape. They have all sold off over 17% from their all-time highs set in July (see chart), and all are trading below their 200-day moving averages.

As for the index as a whole ($DJUSHB), it has yet to breach the upward trendline from March of 2003, but it should be only a matter of time before this line is tested (see chart).

With interest rates on the rise, the ongoing scandals at Fannie Mae, and year-over-year growth in housing appreciation slowing, the housing bulls have a long wall of worry to climb. I wouldn't count out the bulls just yet for one final dead-cat bounce, but I won't be catching any of these falling knives anytime soon.

We'll continue to monitor the technicals and fundamentals on individual stocks in the housing sector, and for the time being, look for opportunities only on the short end.

--Market Professor

For Related Posts, See Blog Entries On:

9/21/05: "Breaking Down the Homebuilders";

8/15/05: "A Housing Pause...Or Something More";

6/14/05: "Introducing the Market Outperform Housing Bubble Index (MOHBI)..."

Understanding Volatility

2005-10-05T23:35:00.000-04:00

Why do most "investors" lose money in the stock market? The answer is simple. They fail to understand that the road to riches is not a single, upward hill, but a series of hills and valleys, with the next hill more often than not higher than the previous one.

While investors covet the 10% long-term returns that the equity markets provide, they expect that 10% per year in a neat .83% monthly installment. But the equity markets will never provide this type of return, and if they did their returns would resemble that of CDs and money market accounts. That is, the reason why equity markets deliver a higher return than risk-free investments is because you are being compensated for risk.

In layman terms, risk is is volatility. Broken down further, risk is the likelihood that your monthly investment statement will fluctuate a great deal during the year. And if you're the type of investor who checks his account value each day, the volatility will drive you crazy if you aren't the type of person who can handle it and understand it.

By studying the monthly range of values for the S&P 500 since 1950, you'll notice that the average range between high and low values for each month is 6.58%. Starting with a $100,000 stock portfolio, then, your account values during the month will on average fluctuate by $6,580.

If the month starts off with heavy selling, that $100,000 opening balance could be the month's high point, and your account could dip to $93,420. If the month starts off with heavy buying, that $100,000 opening balance could be the month's low point, and your account could rise to $106,580.

As the average monthly return for the S&P since 1950 is .68%, your ending monthly balance will more often than not be higher than your beginning balance. However, history has taught us that you should not expect volatility to always be in your favor. In fact, many of the most volatile months in history have been to the downside.

The most volatile month since 1950 occurred in October of 1987, with a range of 51.96% from high to low. The S&P declined 21.76% that month. But if you gave in to fear instead of viewing the decline as one of the great buying opportunities in history, you would have missed out on the 35% rise over the following two years.

Another two volatile months in the past few years occurred in September of 2001 and July of 2002. During these months, the S&P declined 8.17% and 7.9% respectively. But had you bought the S&P at the close of each of those months and held until today, you would have gains of 15% (from 9/01) and 31.1% (from 7/02).

Intuitively, initiating long-term buys after a crash makes sense. All else equal, would you rather buy after the market has risen 15% or declined 15%? I know it is much easier said than done, but successful investing requires moxie and knowledge.

You must have the moxie to be greedy when everyone else is fearful and you must have the knowledge that equity markets are inherently volatile and that the volatility is what makes them rewarding in the long-term.

Recently, those weak-kneed among us have been spoiled by the lack of volatility in the markets. The average monthly volatility during 2004 was 4.45% (vs. 6.58% long-term average), and 4.13% thus far in 2005. Compare these numbers to 2001 and 2002, when monthly volatility measured 10.87% and 11.76%.

Eventually, we should expect the markets to revert to the mean and increase in volatility. But, regardless, that is not the purpose of this exercise. The purpose is for you to understand that the fluctuations you see in your monthly statements are natural occurrences of markets, and if anything, should only be used as buying opportunities.

With the S&P down 2.42% in the past two days, it is only natural to be alarmed when you see your $100,000 portfolio decline $2,420. But what makes a successful investor is how you react to negative volatility. That's what separates the Warren Buffett investors from the Jim Cramer investors.

Jim Cramer investors are gamblers, tracking their portfolio values each minute, and turning over their portfolios at least once a week. Like casino gamblers, Jim Cramer investors lose money.

On the other hand, Warren Buffett investors are true investors, and they ride the coattails of the market for 10% returns over the long-haul. They know the only proven road to investment success has ups and downs, and that the path to outperformance requires buying at the bottom of the hill.

Which type of investor are you?

(S&P 500 Monthly % Range (High to Low), last 20 years)

For related posts, see blog entries on:

3/26/05: "Risk: Can You Handle It?";

3/27/05: "Better Things Come to Those Who Wait"

Breakdown: Fannie Down 36.8% YTD

2005-09-28T15:11:00.000-04:00

"Fannie Mae, the largest U.S. home funding company, said on Wednesday its mortgage portfolio slumped by an annualized 27.1 percent in August, to $768.3 billion, its tenth consecutive monthly decline. That followed a 25.3 percent decline in July."

(Absolutely No Support)

For related posts, see blog entries on:

8/15/05: A Housing Pause...or Something More?;

4/27/05: "More Trouble at Fannie"; and

4/25/05: US Government Fueling Housing Bubble.

Housing in 2005...Something for Nothing?

2005-09-26T18:37:00.000-04:00

These types of articles are becoming commonplace and rather comical when you think about it. Either we're in the 9th inning of one of the most spectacular examples of "irrational exuberance" this country has ever seen or centuries of economic and financial theory will have to be rewritten.

Simply put, there seems to be a lack of any expectation of risk in the housing market. From lenders who will lend to just about anyone with a pulse to buyers purchasing on the belief of 20% annual returns into eternity without any decline, there is never any talk of risk.

"It felt kind of weird buying it because in our bank accounts we didn’t have any reserves," said Hupton, 34. "We definitely would never have been able to afford it without 100 percent financing."

Weird indeed. I suppose in the new economy banks don't care about risk of default. Down payments? That's so 1980's. But Chris Thornberg, a senior economist with the UCLA Anderson Forecast, poses an interesting question.

"What happens when you run out of people who could even qualify to buy a house with an interest-only, (zero-down), variable-rate mortgage?" Thornberg asked. "The answer is ... there are no more shills to enter the bottom of this pyramid and, therefore, the pyramid scheme will have collapsed into itself. We are in the midst of the biggest bubble we’ve ever seen."

September Slump = Buying Opportunity?

2005-09-22T23:51:00.000-04:00

As a long-term investor, you should always be looking for optimal points to add new money to your index portfolio. September usually provides such a time. Since 1982, September has historically been the worst month for the S&P 500, declining an average of 1.22% for the month (see chart).

Currently, at 1,207, the S&P is down 1.09% in September, following a decline of 1.12% in August. Year-to-date, the S&P, which started the year at 1211.92, is down .4%, and up .5% including dividends.

To be a successful investor, you must differentiate between trading and investing, which often require opposite skill sets. Investing requires being greedy when others are are fearful and fearful when others are greedy.

Entering 2000, when the S&P 500 traded at 1469.25 with a trailing P/E of 30.5, you should have been fearful. The annualized return of those who bought the S&P entering 2000 is -2.15% (including reinvested dividends). Entering 1979, when the S&P 500 traded at 96.11 with a trailing P/E of 7.79, you should have been greedy. The annualized return of those who bought the S&P entering 1979 is 12.4%.

So where does that leave us today? Currently, with a trailing P/E of 17.97, the S&P is neither extremely overvalued (as it was in 2000) or undervalued (as it was in 1979). That does not mean you won't make money investing in stocks going forward, just that you have to lower your expectations. But even with returns of 8-9% going forward on average, stocks still offer the best "real" (inflation-adjusted) return opportunities.

And with an average historical P/E of 15.01 (since 1871), the S&P's current P/E of 17.97 is relatively low, given the current state of long-term interest rates (higher long-term interest rates, usually measured by the 10-year bond, generally result in a lower P/E ratio on equities). In fact, on a monthly basis, we haven't seen P/E ratios this low since July of 1996 (P/E of 17.78).

From a fundamental standpoint, that is good news for beginning equity investors and investors who are looking to increase their allocation to stocks. A buying opportunity? I would argue almost every day is a buying opportunity for the long-term investor (read this post to see why). But certainly buying after short periods of sharp declines (when others are fearful) will increase your long-term return, and allow you to outperform your peers.

--Market Professor

Hello 4.0%...

2005-09-21T22:25:00.000-04:00

Last year, when money market rates averaged under 1%, you probably never thought you'd see the day when savings rates reached 4%.

Well, 11 quarter point rate hikes later (from 1.0% to 3.75%) and 4% is finally here, courtesy of emigrant direct. With no fees or minimums and a direct link to your checking account, there is no excuse to keep idle cash in your checking account or low-yield savings account.

After years of paltry yields, savings rates are finally giving stocks and bonds a run for their money. As I wrote here in August, I believe that money market accounts are the best way to earn income this rising rate environment. Bond ETFs still don't offer high enough yields to compensate for the risk of price depreciation (as bond prices move inversely to interest rates).

Additionally, whereas the dividend of 1.9% on the S&P looked great in comparison to 1% money market yields last year, they no longer offer this appeal. For sure, the S&P offers capital appreciation in addition to the tax-advantaged dividend (dividends are currently taxed at a maximum of 15%), but for investors who need the money in a short period of time (liquidity) and cannot withstand the risk of a decline in equities (low risk tolerance), money market funds provide the best alternative.

By setting its yield at 4% (.25% above the current federal funds target rate of 3.75%), emigrant apparently believes the fed will raise rates once again at the November 1st meeting, for the 12th consecutive time. If this occurs, we could see 4.5% money market rates in the not too distant future. While that's great news for the "cash is king" crowd, stocks, bonds and especially real estate could be in for a rough ride in 2006.

--Market Professor

Breaking Down The Homebuilders

2005-09-21T02:03:00.000-04:00

It is no secret that wall street has become enamored with the homebuilders over the past five years. Fundamentally speaking, though (unlike the internet bubble of 2000), the meteoric rise in homebuilding stocks is not an aberration.

Like the energy sector, these companies have experienced tremendous growth in profits over the past five years, and yet they still trade at less than half of the overall market's multiple. With an average P/E of 8.93 for the homebuilders vs. 18.19 for the S&P 500, you would would suspect that analysts are projecting a slow-down in earnings going forwards for the housing sector.

This is far from the case. The seven major homebuilders that I track have an average expected growth rate in EPS of 16.85% (see chart). Comparatively, current expectations for the S&P earnings as a whole
are at 2.62% for 2006. Therefore, with a substantially higher expected growth rate and strong outperformance over the past five years, you would expect the homebuilders to trade at a premium, not a discount.

The argument to buy these stocks, then, goes as follows: if the homebuilders are able to hit these target EPS numbers next year, and their present P/E multiples remain at current levels, we could see yet another year of lofty gains (approximately 17%). Theoretically, this argument works wonders.

But the prudent investor must understand the risk of analysts over-hyping future earnings expectations. That is, either the homebuilders are grossly undervalued at current levels or their future earnings expectations are too high. We'll monitor these expectations in the coming months, and look for any sign of lower expectations.

Given the recent weakness in the housing bubble index, hitting an all-time low on tuesday (inception: 6/7/05), the market participants are sending a message. The message to the believers in technical analysis is simple: those lofty earnings expectations for 2006 are anything but a sure thing.

The Fed Funds Target Rate Under Greenspan

2005-09-18T22:40:00.000-04:00

This Tuesday, the fed will meet once again to determine the fate of short term rates via the fed funds target rate. Lets examine the history of rate changes since Greenspan came to power on August 11th, 1987.

As you can see, it has been difficult to predict the performance of equities based on changes in the fed funds target rate. While the general consensus is that a rise in the target rate is a negative for equities and vice versa, this certainly hasn't been true of late.

As Greenspan brought rates down from 6.5% to 1.0% from January of 2001 to June of 2004, the Equity markets still experienced a net decline over that period of time. And conversely, as Greenspan has raised rates 10 consecutive times since June 2004, the equity markets have still managed to gain 8.95% over that period (excluding dividends).

Greenspan's critics argue that he takes rates too far in either direction, having gone too far in bringing rates down to 1.0% (causing a speculative housing bubble), and now raising too fast in an effort to slow the growth of housing and speculation (and the accompanying inflation).

These are legitimate gripes from the review mirror economists among us, but as traders and investors we must always narrow our focus to how these rates effect our investments.

From a long-term investors standpoint, these individual rate meetings are meaningless and should be ignored for the most part. At a certain point, if short-term rates continue to climb, the investor must grapple with the decision to increase their allocation to cash.

From a traders perspective, tuesday's meeting will likely set the tone for the remainder of September, and possibly the rest of the year. Once again, I believe Greenspan will raise by 25 basis points to 3.75%. If the number of traders expecting Greenspan to hold at 3.5% in the wake of Katrina is greater than I suspect, we could see a nasty sell-off, especially if the language in the statement doesn't indicate a hold in the rate hikes at the November 1st meeting.

Could we see 4.25% by year-end? I for one wouldn't be surprised.

Hope you had a great, well-rested weekend and are ready to make money in the week ahead.

--Market Professor

Housing Continues to Crumble...

2005-08-19T14:07:00.000-04:00

If the current numbers hold up, the Market Outperform Housing Bubble Index (click on link to the right for components and quotes) will close down for the 6th straight trading day, bringing the index to a new low (inception: 6/7/05).

All 15 components of the index are now technically short-term bearish, with the 10-day moving average having crossed below the 40-day. I've been watching the homebuilders closely, as they have had the largest run-up in the index (particularly TOL, KBH, and PHM), and they will have the largest run-down in any extended decline.

The Homebuilders Index ($DJUSHB) has already given back 14% from its recent high, and a key level to watch here is support at 950 (last quote at 965.10). If that level doesn't hold, we should see a further free-fall.

Energy...Buy the Dip?

2005-08-18T23:15:00.000-04:00

That is the question on every trader's mind. Buying the pullback has worked well over the past two years, as each dip was neatly followed by a breakout to a new high. As you can see by the chart below, the energy ETF (XLE) has held its 200 day moving average over the past two years, and would clearly warrant at least a starter position at that level (currently 41.06). But do you buy the support at the 50-day moving average (46.65), which held up today?

I think you do. Trading is not an exact science, and in the end success invariably comes down to understanding probability, discipline, and money management. Clearly, XLE is short-term oversold, has support at the 50-day moving average, and is still in a solid two-year uptrend. That puts the odds in your favor.

Additionally, Crude is up 46.51% in 2005, vs. 31.24% for XLE. XLE has given back 6.29% from its recent high of 50.55, while crude is down 5.13% from its recent high of 67.1. Now, I do not mean to suggest that Crude and XLE are perfectly correlated, but I do believe that the market is pricing into XLE a future decline in Crude, and that the performance of Crude and XLE should be more closely aligned than the current state.

For instance, in 2004, Crude was up 33.6%, and XLE up 33.7%. If you believe that the performances of Crude and XLE for 2005 will converge, one strategy would be to go long XLE and short Crude. But understandably, without a Crude ETF (that is surely needed), this would be a difficult strategy to carry out for the average investor.

So back to the pure XLE trade. Perhaps the most compelling argument in its favor is Jim Cramer's latest call recommending you dump oil in favor of "stocks that can make money even if the economy's in a pinch, such as Google and Yahoo!"

Really, so tech and the QQQQ's will do well in an economic downturn? Is it possible that Cramer has already forgotten the last economic downturn (2000, 2001, and 2002), when the tech-heavy Nasdaq suffered consecutive losses of 39%, 21%, and 31%?

No, Cramer hasn't forgotten; he simply needs to push tech because he's likely overweight tech in his portfolio (and tech has underperformed the S&P YTD by 4%). Yes, one of the oldest tricks on the Street and the main reason why you have to be fiercely independent to succeed in this business.

Have a good night,

-Market Professor

What Dreams May Come...Baidu's 1,830 P/E

2005-08-16T22:45:00.000-04:00

With net income last quarter of $1.5 Million, Baidu.com (BIDU) sports a nifty market cap of $2.96 Billion. If you bought some BIDU on day 2 last week (after kicking yourself for missing out on the day 1 party) without a stop loss and you're hoping and praying to get even, you better hope the greater fool is willing to push BIDU's P/E back over 2,000.

This may well happen, but it's unlikely given the recent market weakness, as the leaders index has broken down after a three-month run. Google (GOOG), Chicago Merc (CME), and Sears Holding (SHLD), the darlings of the recent upswing, have all broken down technically, with their 10-day moving averages crossing below the 40-day moving average.

That tells me it is not the time to be long growth names, until the situation reverses. Simple, I know, but I find it effective nonetheless. If the leaders continue to weaken, and the QQQQ's break down, I will begin exploring short opportunities in the growth area. But given the thin trading of these final weeks of August, this is not the time to be aggressive, on either side of the trade.

And it is never the time to be buying and holding stocks with P/E's in the thousands. The only way to play these animals is for a trade. If you think a hot IPO can't tank, recall the story of VA Linux (LNUX), now called VA Software. Linux opened for trading on December 9th of 1999, and hit an intra-day high of $320 that day. It would never see $300 again, and it now trades at $1.59.

But don't tell that story to your friend who bought BIDU last week. Your friend doesn't want to hear it. He wants you to tell him BIDU is the next Google, and is soon headed for 300. Not because of technical or fundamental analysis, but because he owns it. He doesn't need you to tell him to average down, all the way to zero -- he's already doing it. After all, if he liked it at $150, its surely a buy at $90.

A Housing Pause...or Something More?

2005-08-15T18:03:00.000-04:00

Last week, for the first time in months, the Housing Bubble Index declined for four straight trading days (-6.94%). Two months of steady gains and almost daily all-time highs in the Homebuilders and REITs have been wiped away in an instant. The market humbles us all, especially those who average down and trade without stops. If you held the homebuilders (TOL, CTX, PHM, KBH, HOV, LEN, or DHI) during the past two months and haven't taken profits and raised your stops along the way, you've learned the best lesson the market has to offer: one that costs you money.

The individual charts within the index are breaking down. For 13 out of the 15 names within the index, the 10 day moving average has crossed below the 40 day moving average, a clear indication that the rally is fading fast. SPG and PHM are the final holdouts, but both are days away from joining the rest of the pack.

The worst stock in the index: Fannie Mae (FNM), which has now experienced 4 straight high down volume selloffs. Of all the stocks in the housing bubble index, FNM presented the best shorting opportunity, and I've spoke at length of Fannie's accounting problems in the past. If Fannie takes out its 52-week low of 49.75, watch out. It could get ugly for those knife catchers who think anything housing-related can do no wrong.

FNM is now down 28% year to date, and 13% since June 7th, when I began monitoring the housing bubble index. As I've said in the past, no one knows when the tide in housing will turn, but the mortgage companies will likely give us the earliest indication. With Fannie (FNM), Freddie (FRE), and Countrywide (CFC) all down on the year, clearly a signal is being sent.

Is that signal the beginning of the end for housing? I'll leave that one to the many pundits on CNBC. In the meantime, there's money to be made.

Seeking a Safe Yield...Stay Clear of Bond Funds and Bond ETFs

2005-08-14T20:04:00.000-04:00

Entering 2005, Americans were starving for yield. The best money market rates yielded just over 2%, producing a negative real rate of return (adjusted for inflation). Naturally, many investors turned to bond funds and ETFs, enticed by the higher yields.

But unlike bonds with a fixed maturity, bond funds and ETFs have two components of total return: coupon and price appreciation/depreciation. The second component, which moves inversely to interest rates, has been a blessing to bond fund investors over the past 20 years, as interest rates have experienced a dramatic decline over that period of time.

But all trends must come to an end at some point in time. For short term interest rates, that point was last year, when the fed began raising rates. SHY, the short term bond ETF (1-3 years maturity), returned a paltry .66% in 2004, and is up .62% year to date in 2005. As you can see in the table below, the average yield for SHY in 2005 is 1.57%, but because short term interest rates have risen, the price of SHY has declined from 81.43 on 12/31/04 to the present 80.66, bringing the total return to .62%. Clearly, investors seeking yield would have been better off with money market funds than short term bond funds or SHY.

With the exception of TLT, the long-term bond ETF, all off the Bond ETFs have lower total % returns than average yields, indicating a decline in the price of the bond. With an average maturity of 23.05 years, TLT has benefited from the "conundrum" decline in the 30-year bond rates (from 4.82% on 12/31/04 to 4.45% on 8/12/05), and is up 7.99% year-to-date.

So what is an investor seeking a safe yield to do? Given that interest rates are at historic lows with the short end moving higher, money market accounts provide the best option. Unless you expect interest rates to decline from this point and wish to speculate on this belief, bond funds and ETFs do not promise a high enough yield to compensate for the risk of higher interest rates cutting into total returns.

Where do you find the best money market rates? Bankrate.com is a great resource. Currently, Key Direct (click on money market savings account) is offering the best rate, at 3.66%. By the end of 2005, if the fed continues raising short rates as expected, the highest money market rates should be well over 4%.

Yes, 4% is nothing to go crazy about and if you have a longer time horizon (see earlier post on time horizons) and any tolerance for risk (see earlier post on risk tolerance) I would certainly suggest indexing the stock market, but for those who want a guaranteed yield or are holding cash in an emergency fund or funds that will be used shortly (i.e. saving for a house), money market accounts are the best alternative.

Don't be seduced by the higher yields of bond funds. Those higher yields, in my opinion, are not enough to compensate you for the risk of higher interest rates. It's total return we care about at Market Outperform. If a stock pays a dividend of 5%, but declines 20% for the year, what good is that 5% dividend. Similarly, if a bond yields 5%, but its price declines 10% for the year, you still have a net loss.

All Eyes on The Yield Curve

2005-08-12T20:17:00.000-04:00

On April 26th and May 28th of this year, I wrote about the flattening of the yield curve (the spread between the 3-month bill and the 30-year bond). As I write today, the yield curve is reaching dangerous levels.

On April 26th, the spread between the 10-year and 2-year was 62 basis points (.62%). On May 28th, the spread had declined to 43 basis points (.42%). Today, the spread stands at 21 basis points (.21%).

While the fed has raised rates 10 times in a row, bringing up the short end of the curve from 1% to 3.5%, the long end (10-year and 30-year) has not risen in tandem. As shown in the above chart, the 30-year has actually declined 37 basis points thus far this year, bringing the total-yield curve spread to 94 basis points (30-year: 4.45%, 3-month: 3.51%).

That is, by investing your money for 30-years, you are now gaining less than 1% more than investing for 3-months.

As Greenspan is now fully expected to raise rates by a quarter point at each of the next 3 meetings (9/20/05, 11/1/05, and 12/13/05), something has to give. We're either going to see a yield curve inversion for the first time since 2000, or long rates will rise.

As all past yield curve inversions have preceded recessions, the equity market will not react favorably to such an event. In addition, the financial sector, representing the bulk of the S&P 500 as its leading sector (at 20.2%), will likely take a large hit if such an event were to occur.

In the alternative, if long rates finally rise, the long-awaited decline in housing demand could result, bringing down the housing market and the American consumer with it.

The second half of the year will certainly be eventful. If the 21 basis point spread between the 10-year and 2-year reaches 5-10 basis points, watch out.

It's Never Too Late...Cut Those Losers

2005-07-29T07:17:00.000-04:00

With the Major Market Indices (excluding the Dow) hitting 4-year highs, it is once again a time for portfolio reflection. Don't ignore those monthly statements, putting off for another day what could be done today. If the market is hitting new highs, so should your portfolios. I don't want to hear any excuses. If your portfolio is down for the year, you had better cut out the culprit of that underperformance: almost always an over-weighting of individual stocks.

While the Harvard lawyer Jim Cramer gives his blessing each week to 5-stock portfolios as being "diversified", we at Market Outperform know better. A 20% weighting in a stock is a sure recipe for disaster, and almost always underperformance. If you want to see the negative effects of a lack of diversification, look no further than the Dow vs. the S&P 500 the past few years. Many academics would argue that the Dow, with 30 stocks, is sufficiently diversified to represent the overall market. I fervently disagree.

Looking at 2003-05, during this the latest bull market, we can observe following yearly performances:

Dow: 2003: up 27.13%; 2004: up 4.92%; 2005: up .55%
S&P: 2003: up 28.19%; 2004: up 10.59%; 2005: up 3.85%

Starting with $100,000 in both the Dow and S&P in the beginning of 2003, you would have $134,118 if you invested in the Dow (DIA), and $147,223 if you invested in the S&P 500 (SPY). That is a 34.12% gain for the Dow vs. a 47.22% gain for the S&P 500.

Clearly, even with a portfolio of 30 stocks, individual names can drag down your performance. For instance, this year, Verizon (down 15%), IBM (down 14.3%), GM (down 10%), and JP Morgan (down 9%) have all been a drag on the Dow.

In my long-term investing portfolio, I never want an individual stock to cause me to underperform. Neither should you. Cut those losers out of your portfolio today. It's never too late.

The Nasdaq 2100 Close...Will It Finally Happen?

2005-07-08T14:15:00.000-04:00

We're currently at 2103 and rising for the Nasdaq intraday, the third time during this two-month uptrend that we've crossed the 2100 mark intraday. The other two times, on June 22nd and June 23rd, we failed to close above this mark and the Nasdaq subsequently sold off, reaching a low of 2039.69 on June 27th, down 2.87% from the 2100 mark.

Let's see where this one closes. Markets all looking strong at the moment, many new highs being hit, 28/30 dow stocks higher, and all of this with oil over $60.

Prayers for London...

2005-07-07T23:50:00.000-04:00

On a day like today, who can think of making money. Not me. It is a day of reflection, thoughts, and prayers for the innocent victims of the London attacks.

Whatever your political leanings, after September 11th, there was no better friend and greater ally to America than England. As an American and a New Yorker, I will never forget that fact. Again, my prayers for the innocent victims and their families, and my support for Tony Blair in enacting swift revenge on the Al Qaeda members responsible for these murders.

Pulte Homes Testing June 17th High...

2005-07-06T10:08:00.000-04:00

In the 12th trading day since the blowout opening high on June 17th for the Housing Bubble Index, Pulte Homes (PHM) finally broke out to hit a new high this morning. An an encouraging sign for the index: all 15 stocks are currently higher (see "Market Outperform Housing Bubble Index" link to the right for current quote info).

But given the index's recent history: sell on strength, buy on weakness. Too much euphoria out of the open today. Always a good time to take some profits.

(PHM, Click to Enlarge...)

The Leaders Aren't Giving Up Just Yet...

2005-07-06T00:03:00.000-04:00

Just last Monday, the bears were rejoicing: $60 oil, yet another fed rate hike (9 times in a row), and the Nasdaq falling below the key level of 2050.

But as I mentioned back then, a strange thing was happening among the leaders of this two-month rally: they were continuing to hit new all-time highs. If we were ready to drop back to 1900 on the Nasdaq, why were so many stocks continuing to hit new all-time highs? If we could just get back above 2050, as we did one day later (and haven't closed below this level since), maybe there would be one more attempt at 2100.

That brings us to yesterday (7/5/05), when the market outperform leaders index closed higher by 1.68%, to another new all-time high of 985.94 (inception 6/7). 8 out 10 stocks in the index closed higher, with Southwestern Energy (SWN) and Orckit Communications (ORCT) hitting new all-time highs. Since June 7th, when I began tracking these 10 stocks (click on the link to the right entitled "Market Outperform Leaders Index" for the complete list and current quote information), they are up 8.72% on an equal-weighted basis, and 9.48% on a price-weighted basis.

Comparatively, the Nasdaq 100 ETF (QQQQ) is down 1.79% since June 7th. A changing of the guard, so to speak?

I've long argued that the Microsofts (MSFT), Ciscos (CSCO) and Intels (INTC) have had their big run in the 90's. While I expect them to rise along with a rising market, I no longer expect these behemoths to lead the next bull/bear market phase. And leading is what we're looking for, as our goal is outperformance.

Who will lead, then, should there be another 10-15% leg upward (or downward, for that matter)? Well, we can start with the two stocks that recently broke $300 in the leaders index, Google (GOOG) and Chicago Merc (CME).

But beyond these two names, there are many signs of strength at the current time. Looking at my screen of ETFs yesterday, I noticed more than a few key all-time highs being hit: 1) Energy (XLE, IGE), 2) REITs (IYR), 3) S&P Small-Cap 600 (IJR), 4) Midcaps (MDY), 5) Small-Cap Value (IWN), 6) Utilities (XLU).

Yes, Tuesday July 5th, was not an ordinary trading day. These are key indices hitting all-time highs. True, the old large caps represented by the ETFs for the Dow (DIA), S&P 500 (SPY), and Nasdaq 100 (QQQQ) are still well off their all-time highs of 2000, but there is clearly substantial money being made elsewhere.

So as long as the Leaders and these indices continue to hit new highs, I will continue to look for growth stock opportunities on the long side within the index and elsewhere. To do otherwise, and fight these powerful movements upward, would be foolish and futile. The leaders, or more specifically, their charts, will tell us when to stop buying.

Clearly, though, with so much strength yesterday, the prudent speculator will be protecting profits and raising stops. Remember, the longer Mr. Market giveth, the faster he taketh away.

See you back tomorrow.

--MP

S&P Sector Performance, Strategies...

2005-07-03T21:09:00.000-04:00

This is a table (below) of the performance of the 10 ETFs which represent the ten sectors in the S&P 500. As a speculator or investor, you should always be cognizant of what sectors are performing well in terms of performance, and the relative valuation of the various sectors. As you can see, Energy (up 22.78%) and Utilities (up 14.12%) have led the way thus far this year. Overall, the S&P 500 was down .6% through June 30th.

(Table 1, S&P 500 Sector ETFs, Performance through 6/30/05)

Notice the weights of the various sectors in parentheses. Financials (at 20.2%), Technology (at 14.8%), and Health Care (at 13.7%) have much more of an effect on the overall return of the S&P 500 than Telecom (at 3.2%) , Utilities (at 3.4%) , and Materials (at 3.1%). One strategy that has outperformed thus far this investing in the sectors on an equal weighted basis. That is, if you simply invest in SPY (the S&P 500 ETF), you are effectively buying all of the stocks in the S&P 500, which necessarily will result in you owning 20.2% Financials, 14.8% Technology, 13.7% Healthcare, etc.

If instead you wished to invest on an equal weighted basis in all 10 sectors, you could simply allocate 10% of your portfolio to each of the 10 Sector ETFs (ex: In a $100,000 portfolio, put $10,000 in each). This strategy would have netted you a gain of .68% vs. a loss of .60% under the traditionally weighted S&P 500 (SPY), for an outperformance of 1.28%.

(Table 2, Equal Weighted Sector ETF Strategy)

Another strategy that has outperformed thus far was overweighting Energy (XLE) in anticipation of higher oil prices. Under this strategy, you could have allocated 19% of your portfolio to energy, while reducing the allocation to the remaining sectors to 9% each. This strategy has returned 2.89% through June 30th, vs. -.6% for the S&P, for an outperformance of 3.49%.

(Table 3, Overweight Energy (XLE) Strategy)

My purpose in displaying these strategies and results is not to suggest that they will continue to outperform, but to (1) display a lower-risk means of attempting to achieve outperformance, and (2) emphasize the importance of tracking the performance of the various sectors.

If you are new to speculation, I encourage you to use sector ETFs before venturing into individual securities. For instance, if you think XYZ Energy company will be the next big thing (hopefully based on fundamental/technical analysis and not merely a hunch or a tip), your risk will be greatly reduced by overweighting XLE instead of overweighting an individual stock. If the energy sector moves higher, a majority of the stocks within that sector will be rising also. That is, most of the performance of individual energy stocks can be attributed to the performance of the sector as a whole. This is a difficult lesson to learn, as you're inclined to believe that your stock pick will go up no matter what the Energy sector does and no matter what the overall stock market does.

But the exact opposite has been proven time and again. Most stocks move with their sectors and with the overall market. Tell me how many stocks in the S&P 500 had positive returns during 2000-2002? Conversely, how many stocks have had negative returns from 2003-present? Understanding the answer to this question will make you a better trader and investor.

Have a Great 4th of July!

--MP

Fed Funds 4.25%, Year End 2005?

2005-07-02T19:08:00.000-04:00

4 More Fed Meetings to go in 2005...

8/9/05
9/20/05
11/1/05
12/13/05

If the fed raises a quarter point at each meeting (as it has done 9 times in a row already), what will be effect on the yield curve and the economy? I'll be raising these issues in the coming months.

Groundhog Day Fed...

2005-06-30T22:57:00.000-04:00

For the ninth consecutive meeting, the fed raised rates by a quarter point (25 basis points), from a low of 1.00% last year to the current 3.25%. With the language in the statement left virtually unchanged (the now famous "measured pace" increases), these 2:15pm announcements remind me of that Groundhog Day movie. Most of the talking heads on the street are predicting one or two more quarter point increases, and then an end to the rate hikes.

I'm not so sure Greenspan will comply with this wishful thinking. I'm more inclined to believe that we'll see at least 4% (3 more hikes), and most likely 4.25% by year end. As long as real GDP remains relatively strong (above 3.2%) and the jobs numbers keep coming in above 100,000, Greenspan will see no reason to stop at 3.5% or 3.75%.

The real question is what effect will a year-end 4.25% have on the markets, especially if the street is discounting the market based on an assumption that the Fed will stop at 3.75%. As always, we'll have to wait and see for that one, but if the stock market manages to eke out gains for the second year in a row in spite of the rate hikes, perhaps that axiomatic warning not to "fight the fed" will have to revised somewhat.

In the other economic releases this week, first quarter GDP came in stronger than expected, with the GDP deflator (a measure of inflation) lower than expected.

But the most surprising release of the past two months, in my opinion, is personal income finally outpacing consumer spending. Are Americans finally starting to save (the American savings rate is at an all-time low)? I wouldn't bet on it, but if this trend continues, you can bet the world will take notice.

Leaders Poised to Hit Another All-Time High...

2005-06-29T08:21:00.000-04:00

The Market Outperform Leaders Index hit another all-time high on Tuesday, gaining 2.62% on the day. On a price-weighted basis, the index is up a healthy 5.9% since inception (6/7).

On Tuesday, 7 out of 10 Leaders closed higher, with 3 stocks in the index hitting all-time highs: GOOG, NTRI, and CME.

CME was once again the stock of the day, closing up $15.50 to $271.00. What's driving the incredible move in this stock, which is up 19% Year-to-date? A possible acquisition of CBOT Holdings, its cross-town rival.

In pre-market action, CME is up another 7 points (2.58%) to 278. Will CME soon become the next member of the $300 club?

Speaking of that other member, everyone's wondering about the late day sell-off in GOOG, which closed down after hitting another all-time high. But after closing higher for 8 straight trading days, I believe a pullback is not only excusable but healthy. Watch the 10-day moving average (288.94) for support and a lower risk entry point for those of you who have missed this juggernaut of a stock.

Nasdaq futures up, QQQQ up .3% premarket (37.26)...see you after the open. -MP

Declining Earnings Estimates...

2005-06-29T00:39:00.000-04:00

In an April 13 post, I introduced the concept of the Price/Earnings (P/E) Ratio of the S&P 500 and its importance to the long-term (read this post for what I consider long-term) investor.

In the post, I stated that the trailing P/E on the S&P 500 (at 18.44) at that time was at its lowest point since October 1996. Since that point, the S&P has gained 2.38%, pushing up the numerator (P), and raising the trailing P/E to the current 19.43. This is still higher than the long-term average of 16, but low given recent history and record low interest rates.

What irked me back then, and still does today, were the lofty earnings expectations analyst had for the current year (2005) and next year (2006). I wrote:

"If earnings for 2005 [of 19.39% YOY growth] do meet expectations, I expect the S&P to extend its bull-market phase and end the year in the green. However, I would not bet on these lofty expectations being met. Even if they are met, current estimates of 15.59% earnings growth in 2006 will likely have to be cut down to reality."

Indeed, they both have since been cut down to reality. Current year estimates have been lowered from $69.9 to $65.5, or a 6.29% decline. But even at $65.5, this represents an 11.87% increase (down from the projected 19.39% on April 13th) from last years record earnings (of $58.55). Calendar Year 2006 earnings, which I warned were even harder to predict, have since been lowered from $80.8 to the current $72.5, or a 10.27% decline. $72.5 represents a 10.69% increase from 2005 estimates, down from the projected 15.59% on April 13th.

But as you saw by the 2.38% increase in the S&P since April 13th, these downward revisions have largely been ignored by Wall Street. Anything can happen (and often does) in the short run, but in the long-run you can bet that if these downward revisions continue the street will take notice.

As a long-term investor, you'll sign up for 11.87% earnings growth at the start of any year. I'll sign up for it right now. Let's see where we end up, and just how reliable these "estimates" really are. In the mean time, I'll remain highly skeptical of the perma-bull analysts.

--Market Professor

Crude Correlations...

2005-06-28T03:02:00.000-04:00

Interesting article out of barrons discussing the crude-equities relationship, or lack thereof. As the article points out, "since the interim crude oil bottom in May the correlation between crude and stocks has been 83%."

So maybe the pundits are making too much of $60 oil and its affect on stocks. Only in the past few days, as the markets have sold off, has an inverse relationship between equities and crude played out. Looking at 2004, a year when Crude finished higher by 33.6%, the S&P 500 also finished higher by 10.59%.

So clearly stocks can do well in spite of rising crude. The real question, as the article addresses, is what sectors have performed the best in the face of rising crude. The top three: Energy, Industrials, and Financials. The worse performing sector: Technology, with a -62% "correlation between its relative performance and rising energy prices."

How can the individual investor trade on this? If you believe $70-$100 oil is a real possibility, simply overweight the energy (XLE, up 26.03% Year-To-Date), Industrial (XLI, down 5.51% YTD), and Financial (XLF, down 3.52% YTD) ETFs in your portfolio, and avoid or go short the Technology ETF (XLK, down 6.06% YTD) or Nasdaq 100 (QQQQ, down 7.8% YTD).

(Two Year Chart, Crude (up 140%) vs. S&P (up 20%)...Click to Enlarge)

Homebuilders Mount Comeback

2005-06-27T13:33:00.000-04:00

After a sickly decline last week, the Housing Bubble Index is showing signs of strength today, with 13 out of 15 issues trading higher, and 6 issues up more than 2%.

As a trader, you have to like the volatility in this group, and after a dramatic sell-off last week (12 out of 15 down more than 2%), an opportunity for a bounceback trade was created. See you after the close...

(Housing Bubble Index, 6/27 Intraday % Change)

Nasdaq 2050 or Bust...

2005-06-27T10:09:00.000-04:00

I'm watching the Nasdaq action, and it isn't pretty. Support at 2050 didn't hold this morning. We'll see what happens on a closing basis, but I wouldn't be buying non-energy stocks at these levels.

Oil surged above $60 this morning, and it looks at though we're finally going to see that close above this level.

Stocks in my buy screen in the energy space:

XLE (up 1.58%)
APC (up 2.51%)
VLO (up 2.61%)
OXY (up 2.01%)

What a Difference 2 Days Makes...

2005-06-27T02:00:00.000-04:00

The rally lasted for over a month and a half, and in two trading days (last Thursday and Friday), it was over. That's how quick you can lose your shirt in this business. As a speculator, this is precisely the reason for instituting an emotionally neutral stop-loss program: to protect your profits and limit your losses so that you can live to trade another day.

After last week, the markets are in limbo, and it is a risky time to initiate positions on the long or short side. Cash is king in times like these. Let the market play itself out and give us a clearer indication of where it is going.

As for last week (6/20-6/24), both the Leaders Index and Housing Bubble Index declined, with the exception of "the juggernaut": Google (GOOG). 7 straight higher closes has put GOOG within striking distance of $300. Given its strength on Friday, I think we'd all be shocked if GOOG didn't take out $300 at some point this week. But will GOOG suffer the same fate as the Nasdaq at 2100? We'll have to wait and see...

As for the rest of the leaders, BOOM (-5.11%) and CRYP (-11.04%) were hit hard last week, but the other leaders held up relatively well considering the decline in the Nasdaq.

(Leaders Index, Week of 6/20)

The housing bubble index didn't fare as well as the leaders, with 14 out of 15 issues trading down for the week. The single gainer was the long-bond (TLT), which saw its price rise 2.18% as the 10-year yield fell below 4% once again (the "conundrum" continues). The homebuilders were hit particularly hard, reinforcing the technicals showing the 6/17 blowout open to be a potential top for the group. I'll wait for another five days of weakness before considering some of these stocks as short candidates.

(Housing Bubble Index, Week of 6/20)

Hope you rested up this weekend. With the fed meeting on Thursday and the indices in limbo, it's going to be quite an interesting week.

See you in the AM,

--MP

Weakness Abounds...

2005-06-24T14:04:00.000-04:00

As Crude trades at 59.75, all the major sectors are down, including energy (XLE). The worst performers on my ETF screen:

Small-Caps (IJR): Down 1.59%
Materials (XLB): Down 1.41%
Retail (RTH): Down 1.31%
Technology (XLK): Down 1.04%
Mid Caps (MDY): Down .93%

Best Performers: Bonds

20-Year (TLT): Up .31%
7-10 Year (IEF): Up .22%
Corporate (LQD): Up .22%

Still waiting for that rally in the Nasdaq, but it doesn't look like it's coming today. If we can rally past 2062 (currently at 2054.5), I might get interested. Until then, I'm just a spectator.

See you back tonight,

Has the Downtrend Begun? Leaders Saying Otherwise...

2005-06-24T11:07:00.000-04:00

I'm watching the Nasdaq continue to sell-off (now down more than 2% from yesterday's high), but I'm seeing some strange activity in the Leaders Index.

6 out of the 10 leaders are trading to the upside this morning (GOOG, CME, CRYP, NDAQ, BOOM, and NTRI), and GOOG continues to show tremendous strength. If the Nasdaq is done, and the two-month rally is over, why are these stocks that have lead this market higher not going down with it?

With Crude still under $60 (at 59.72), it makes me think that if Crude could find a way back under $59 (showing a possible double top at $60), we could see one more push toward 2100.

As long as a majority of the leaders are trading higher today, I'll be looking to jump in on the long side for a trade if the opportunity presents itself.

Hope you're trading well,

Market Professor

When Crude Ruled the World...

2005-06-24T01:16:00.000-04:00

You could see it coming, all those failed attempts at a close above 2100, and Crude rising all the while. Still, that was some sell-off today, taking down all the leading sectors of late (Homebuilders, Techs, and Retail). Even the energy stocks (XLE) were only up .09%.

Closing at 59.85 and hitting 60 intraday, Crude is now up a staggering 37.74% year-to-date (from $43.45/barrel to the present 59.85). What makes this even more remarkable is that this gain follows 2004's gains, when Crude finished up 33.6% for the year (from $32.52 to $43.45). The hope for the equity bulls? A double top at $60 (see chart). But I certainly wouldn't bet on Crude stopping at $60, and neither is most of wall street (hence the sell-off).

Crude Oil...click to enlarge

For the past month, buyers have been ignoring the rise in crude, but that ended with a bang today. Not only did the Nasdaq fail to close above 2100 once again, but it closed near the low for the day, at 2070.66. This, after hitting a high of 2106.57 just before noon.

That downward spiral of over 35 points on the Nasdaq from noon to 4pm took most of market with it.

I say most because GOOG somehow managed to stay in positive territory for the day, closing up 41 cents to 289.71, its 6th straight higher close.

Now, onto the Market Outperform Indices:

First, The Leaders Index:

Down 2% on the day. Worst Performer: BOOM (down 6.01%); Best Performer: GOOG (up .14%).
Only 1 out of the 10 stocks in the index closed higher (the lowest reading since inception on 6/7/05), that being GOOG.
1 new all-time high hit intraday (CME), which then sold off to finish down over 9 points (shows you the importance of a stop loss in speculating).
What to watch for tomorrow: weakness at the open. These 10 stocks haven't experienced 2 straight days of heavy selling in quite some time. I'll be watching to see if they can hold off another sell-off tomorrow and take back some of the losses from today.

Next, in the Housing Bubble Index:

Down .88% on the day. 0 stocks out of 15 closed higher (first time since inception that we saw that).
No new all-time highs.
In the news: (1) DHI added to S&P 500 , but still couldn't manage to finish in positive territory. (2) Existing home sales -- second highest in history (at 7.13 million), but below consensus estimates (of 7.2 million).
Question remains: was friday's (6/17) blowout open and subsequent sell-off a near-term or long-term top?
What to Watch for on Friday: New Homes Sales Report (consensus estimate: 1,320,000).

Homebuilders 5-day chart...Click to enlarge (notice the volume spike at the open last Friday)

Goodnight,

--Market Professor

GOOG showing strength, leaders index enters day at new highs...

2005-06-23T10:47:00.000-04:00

The Leaders Index closed up another 1.22% on Wednesday, and entered the day at an all-time high (inception: 6/7/05), up 4.48% since 6/7. 6 out of 10 stocks in the index closed higher, with 3 stocks hitting new all-time highs: SWN, NSI, CME.

If you've been reading this blog on a regular basis, you've noticed SWN coming up a lot. In fact, it has hit a new all-time high 10 days in a row. Will it make it 11 today? We'll have to wait and see....

In the early going this morning (Thursday), the indices are selling off, but the Nasdaq is only down .06% and is poised to make another run at 2100 during the day.

GOOG continues to show strength this morning, up .92% (while the Nasdaq was down .06%) and will attempt to make it six straight higher closes today. Yesterday's stock of the day, CME, is cooling off in the early going, but a pullback is to be expected after it rallied over 10 points to a new all-time high yesterday.

Back to the market...

MP

Opening Bell: 2100 Broken...But Will It Hold Up?

2005-06-22T10:08:00.000-04:00

The Nasdaq opened up 6 points higher this morning (to 2097), and quickly jumped over 2100. Eight times was a charm but will the Nasdaq close above 2100? That is the more important question.

We've sold off since the open, and currently sit at 2095.12, with the intraday high being 2102.75. Before the close, I'd like to see a rally past this point.

Bullish Indicator: All ten stocks in the Leaders Index positive, for the first time in a while. SWN leads the index, up 2.83% thus far, as the energy play are advancing once again after yesterday's pullback.

Nasdaq 2100...Eight Times a Charm?

2005-06-21T23:33:00.000-04:00

While growth stocks continue to hit new highs, the Nasdaq Index is facing fierce resistance at its old friend, 2100.

On seven occasions over the past three weeks the Nasdaq has come within 5 points or less of hitting 2100 intraday, only to be turned away by the powerful sell orders at 2100.

The Nasdaq first flirted with 2100 back on June 1st, hitting an intra-day high of 2095.54. On Tuesday (June 21), the Nasdaq again came within striking distance, hit an intraday high of 2095.69.

As I've been (and everyone else, which is why it is such an important level) saying, 2100 is now a key technical point for the Market as a whole, and I'll be looking for a short-term target of 2150 if we can close above this level.

Now, to the Market Outperform Indices:

First, in the Leaders Index:

Up .18% on Tuesday, up 3.78% since June 7th (inception). 5 stocks in the index closed higher, 5 lower. There were 2 all-time highs hit in the index: SWN, and NSI.
Strong Action out of GOOG in the past 2 sessions, especially on Monday when rallied 15 points from a low of 271.73 to close at 286.7. GOOG also broke through its 10-day moving average, currently at 281.65.
Year-to-date, the Leaders Index is up 120.55%, led by NSI (up 387.37%), BOOM (up 239.62%), and ORCT (up 214.73%).
News in the Index: (1) GOOG apparently won't be competing with pay pal after all.

Next, in the Housing Bubble Index:

Up .15% on the day, 3.43% since June 7th. 8 Stocks Closed Higher, 7 Lower.
Of note, there were 0 all-time highs hit on Tuesday, after 11 out of 15 stocks in the index hit all-time highs last Friday (the blow-out open day after KBH's earnings).
Question Remains: Was the Friday, June 17th open the homebuilders last hurrah? We'll have to wait to see if the homies can rally above Friday's open in the next week or two.
News of Note in the Index: LEN's strong number and increased profit outlook. LEN close up 2.16%, but could not rise above Friday's open.

Growth Stock of the Day: HANS, which continues to impress and deserves a spot in the Leaders Index.

All Eyes on the Housing Bubble Stocks...

2005-06-20T01:02:00.000-04:00

To the rational man, Friday's euphoric open in housing stocks was the top of the mountain. After all, a top will be set at some point (as nothing rises in perpetuity), so why not Friday? Friday showed all the signs of a last, desperate buy in at the open by the johnny-come-lately investor who couldn't stand on the sidelines and watch fortunes being made in housing any longer.

Ahh, but if only the markets were rational. Housing stocks are overbought by any technical measure (Williams %R, ROC, etc.), but that doesn't mean they cannot become even more so.

All I can do is observe and report what I see, and what I see is nothing short of incredible.

The Market Outperform Housing Bubble Index continues to march upward, finishing 2.18% higher on Friday to a new all-time high. The index is now up 4.46% since June 7th (8 trading days), and 17.77% on the year. 14 out of the 15 stocks in the index closed higher on Friday, with 11 stocks hitting new all-time highs.

These 11 included all of the homebuilders in the index (TOL, CTX, PHM, KBH, HOV, LEN, DHI), and all of the REITs (IYR, SPG, EOP, EQR).

But while the REITs rallied during the session on Friday to close above their higher opens, the homebuilders fell during much of the session to close below their opens. Is this a sign of future weakness?

Not sure, but it will be interesting to see if the homebuilders can rally past Friday's open this week (TOL = 106.65, CTX = 71.25, PHM = 86.5, KBH = 81.53, HOV = 67.34, LEN = 65.1, and DHI = 38.25).

I'll be watching the action in these stocks closely tomorrow, along with the REITs...

5-day Chart of KBH. Notice the Volume Spike at Friday's Open...
(Click to Enlarge)

5-Year Chart, Small Caps (IJR) vs. Large Caps (SPY)

2005-06-20T00:54:00.000-04:00

+60% for IJR, -10% for SPY. Will the trend reverse in the next five years or continue?
(Click to Enlarge)

Small-Cap Rally Latest Failed Prediction of "Experts"

2005-06-19T23:22:00.000-04:00

Can it get any worse for the so-called wall street "experts?" I've already written about the following failed consensus predictions of wall-street experts, but let me summarize them again:

1. Expert Prediction #1: A Fall in Long-Term Treasury Prices, Rise in 10-Year Yield at 5% by first half of the year. Today: 10-year at 4.08%, down 14 basis points from the start of the year (start: 4.22%). TLT (the long-bond ETF) up 8.37% (bond prices move inversely to yields).

2. Expert Prediction #2: Fall in Crude back to the low 40's, and an end to the run in energy stocks. Today: Crude closed at a 52-week high at 58.75, up 35.74% Year-to-date. XLE (the major energy ETF) up 26.61% Year to Date.

3. Expert Prediction #3: Continued fall in the dollar vs. the Yen, Euro, and Pound. Today: Year-to-date, Dollar up 10.52% against the Euro, 5.59% against the Yen, and 4.26% against the Pound.

And in the past few weeks, the fierce rally in small-caps has ruined yet another expert opinion. The expert consensus coming into the year was that the multi-year small-cap outperformance over large-caps would come to an end this year. While this proved true during the first few months of the year, Small Caps have rallied sharply and now are outperforming large caps year-to-date. I use the S&P Small Cap 600 ETF (Symbol: IJR) to measure small-cap performance, and the S&P 500 ETF (SPY) to measure large-cap performance.

Year to date, IJR is up 2.96% while SPY is up 1.2%.

There are many lessons to be learned by these results. First, the fact that the so-called experts have gotten it wrong does not mean they're stupid, but that it is extremely difficult to predict the short-term fluctuations of markets. Be wary of all gurus, but especially those who are bombastically prognosticating about near-term future events as if what they say is assured to occur.

Second, we learn that you have to be an independent thinker in this business. While there is much more comfort in trading with the consensus, it is better to be profitable than comfortable.

April 29th was not that long ago, when the Nasdaq hit a low of 1889, and the world was coming to an end. But as I wrote back in that time period, for the truly long-term investor (see my post on what I consider long-term) you should always be rooting for short-term price declines, so that you can buy in at lower prices. If you're a long-term investor adding money each year (or month), far better for an index to stay unchanged for 9 years and then go up 100% in year 10 than go up 100% in year 1 and then stay flat for the next 9 years.

On friday, the Nasdaq closed at 2090, up 10.64% from April 29th. Will the next month and half be as profitable as the last, stay tuned...

Housing, Leaders Hit New HIghs

2005-06-17T00:18:00.000-04:00

Here are Thursday's Stats on the two Market Outperform Indices...

The Leaders Index:

Up .37% to 917.27, a new all-time high (inception 6/7/05)
On an Equal-Weighted Basis, the index is up 3.97% since 6/7, led by SWN (up 20.82%).
2 New All-Time Highs Hit Intraday Within the Index: SWN, CME
5 stocks closed higher on the day, 5 closed lower.
News Story of the Day: Bear Sterns Initiates Coverage on SHLD (click for story), setting a year-end price target of $169. SHLD closed up 2.64% to 151.35, and is again within striking distance of its all-time high of 158.9 (set on 6/3/05).
Positive for the group: Nasdaq (up .69%) again outperformed the S&P (up .36%) and the Dow (up .12%)
Overall Sentiment: Bullish, eagerly awaiting the Nasdaq 2100 test, which may come tomorrow. A close above 2100 might really ignite this Nasdaq Bull.

The Housing Bubble Index:

Up 1.12% to 954.66, new all-time high for 3rd day in a row.
On an Equal-Weighted Basis, the index is up 2.27% since 6/7, led by TOL (up 7.27%).
7 Stocks Hit New All-Time Highs Intraday: TOL, CTX, PHM, KBH, HOV, DHI, SPG. Five of these stocks hit new all-time highs yesterday as well (TOL, CTX, PHM, KBH, DHI).
All 15 stocks in the index closed higher, with TOL being the largest % gainer at 2.47%.
News Story of the Day: KB Home's Earnings report: profits up 78% and beating wall-street estimates.
Overall Sentiment: Bullish Disbelief, awaiting tomorrow's action as the homebuilders were flying in after-hours (TOL up 1.44%, CTX up 2.56%, PHM up 2.13%, KBH up 6.57%, HOV up 2.15%, LEN up 4.52%, DHI up 3.42%). Incredible. That means there will again be a number of new all-time highs tomorrow.

Until then,

-MP

Rich Get Richer...Housing Stocks Continue to Hit New Highs

2005-06-16T11:23:00.000-04:00

Inspired by yet another strong housing starts report, a number of stocks in the Housing Bubble Index are hitting new all-time highs. Four stocks hitting all time highs yesterday again reached an all-time high today (TOL, KBH, DHI, and PHM). In addition, HOV has joined the party, hitting an all-time high of 63.80.

Notice the spike on this chart at 10:00 AM, after the housing starts release.

Hope you're trading well,

-- MP

Housing Bubble Index Hits All-Time High...

2005-06-15T23:43:00.000-04:00

As I wrote on these pages on June 8th, there seems to be no stopping the real estate bull market. I also pointed out the futility of trying to get short some of the "bubble stocks" in the midst of such a powerful uptrend. It was far better to look to go long some of the names that you thought couldn't possibly go any higher (stocks trading at their all-time highs).

Indeed, since I began tracking my Housing Bubble Index last Tuesday, we have seen nice gains in TOL (up 4.68%), LEN (up 3.23%), KBH (up 2.96%), and PHM (up 2.67%).

As for Wednesday's performance, the index closed at 944.1, up .87% for the day. 9 out of 15 of the stocks in the index closed higher on the day, with 5 of those stocks hitting all-time highs intraday (TOL, CTX, PHM, KBH, DHI). As I mentioned yesterday in my post on the Leaders Index, as long as stocks in these indices continue to hit all-time highs, I will continue to aggressively seek out trading opportunities within the group.

Chart of the one-year performance of the 5 stocks hitting an all-time today (click to enlarge)

Google's Weakness...Consolidation or Something More?

2005-06-15T00:29:00.000-04:00

The Market Outperform Leaders Index (MOLI) continues to set new highs on an equal-weighted basis (up 2.19% since inception on 6/7/05). On a price-weighted basis, the index closed at 897.89, up .49% on Tuesday but still down .48% since inception.

The reason for the disparity: Google, which is down over 14 points (or 5%) since last Tuesday. The question is whether google's weakness is merely consolidation or an indication of an end to the Nasdaq rally. For now, I will believe it is the former, but if Google continues to underperform as the Nasdaq marches towards 2100, I will become more suspicious of the rally.

One stock does not make a market, but to continue my overall bullish stance I'd feel much better if GOOG holds the line at 269.43. In stocks that were extended as GOOG, it is normal for a pullback to occur to the 10 and sometimes 50-day moving averages. The 10-day is already broken (currently at 284.97), but the 50-day remains at 234.04 and the 200-day at 185.71. That should give you an idea of how fast GOOG has risen in the past month (generally, the further a stock trades from its moving average, the more likely it will experience a quick pullback).

For those GOOG bulls, you may take some comfort in GOOG's recent history. Remember that after experiencing a previous all-time high on February 2nd of this year at 215.55, GOOG pulled back to a low of 172.57 on March 14th (a 19.9% decline).

For those patient enough to stomach this decline, GOOG would trade back above 215.55 on April 22, when it closed at 215.81 (up 25.1% from the March 14th low). From that point it rallied to a high of 299.59 on June 7th (or 38.8% from the prior peak set on February 2nd). And since June 7th, it has declined to 278.35 (or down 7.09% from the June 7th high).

Therefore, if GOOG follows a similar pattern to February and March, it could decline as much as 19.9%, taking it down to a low of 242.67 before it resumes its longer-term uptrend. I'm not suggesting that this is going to happen by any means, but those taking a gamble on GOOG thinking it will only go straight up to the moon should be familiar with GOOG's recent history, and the inherent volatility of a stock that has more than doubled since it began trading last August 19th.

As for the other members of the leaders index, 6 out of 10 closed to the positive side on Tuesday with SWN and ORCT hitting all-time highs. As long as stocks in this index continue to hit all-time highs, I know there is still money to be made in momentum stocks and I'll continue to look for opportunities in this area.

Until Tomorrow,

--MP

Introducing the Market Outperform Housing Bubble Index (MOHBI)...

2005-06-14T17:46:00.000-04:00

To measure the seemingly never-ending rise (and eventual fall) in the housing market, I have created an index of 15 securities that will henceforth be known as the "Housing Bubble Index."

The index is broken down into four components: 1) Homebuilders, 2) Mortgage Lenders, 3) REITs, and 4) the Long-Bond ETF.

The Homebuilders in the index are TOL, CTX, PHM, KBH, HOV, LEN, and DHI. All of these stocks are at or near all-time highs.

The Mortgage Lenders in the index are FNM, FRE, and CFC. While FNM and FRE are trading off their highs, CFC is trading at an all-time high.

The REITs in the index are IYR, SPG, EOP, and EQR. All of these REITs are trading at or near all-time highs.

The Long-Bond ETF is TLT, which will signify the direction of long-term interest rates and corresponding mortgage rates. Like all bonds, a decline in TLT's price indicates an increase in rates, and an increase in TLT's price indicates a decrease in yield. The idea is that a decrease in TLT signaling an increase in long-term interest rates should eventually have a negative impact on the Housing Market. TLT hit a 52-week high on June 3rd, when the 10-year bottomed out at 3.8%.

The index closed today at 935.93 (cumulative closing prices of the 15 securities), up 1.25% from yesterday. Out of the 15 securities in the index, 14 closed higher today, the exception being TLT, as interest rates continued to rise.

There is unbelievable relative strength in many of these 15 stocks, as they continue to set or push towards all-time highs. Stocks in the index breaking through all-time highs today included: CTX, PHM, KBH, and SPG. All of these stocks are up at least 200% in the past 5 years (see graph).

Monday's Developments...

2005-06-14T01:53:00.000-04:00

While the major indices closed nearly unchanged, there were more than a few interesting developments on Monday...

First, Morgan Stanley's 2% rise after CEO Purcell announced his retirement. While the S&P is up 20% over the past 2 years, MWD sits nearly unchanged (click for chart).

Second, glancing at my watchlist of 41 ETFs, I noticed that SPY (the S&P 500 ETF) has quietly moved back into positive territory for the year, up .15% (including dividends). The leading ETFs on my watchlist year-to-date are XLE (Energy, up 21.05%), IGE (Natural Resources, up 14.12%), and XLU (Utilities, up 11.57%). The rationale here is simple: Crude is up 27.64% on the year, from 43.45 on January 1st to 55.46 as of Monday.

Third, there has been a sharp pullback in Treasuries in the past week, with the ten-year back up to 4.08% after hitting a low of 3.8% on June 3rd. TLT (the long-bond ETF) has sold off, but is still up 8.36% year-to-date.

Fourth, the US Dollar continues its totally unexpected rise thus far this year, now up 11.21% against the Euro, 6.14% against the Yen, and 5.37% against the pound. I'm anxiously awaiting the day when we see currency ETFs.

Finally, the Market Outperform Leaders Index closed up .37%, with 6 out of ten stocks in the green (GOOG, NSI, SWN, NDAQ, CRYP, and CME). Out of this group, SWN and NDAQ hit all-time highs intraday. Since 6/7/05, the leaders index is Down .95% on a price-weighted basis (Due to the weak performance of GOOG and SHLD over the past week), but up .70% on an equal-weighted basis.

Overall, I'm still waiting for another 2100 test for the Nasdaq. On the economic front for tomorrow we have retail sales and PPI.

Nasdaq Lags, GM Breaks Out...

2005-06-10T10:52:00.000-04:00

In the early going, the Nasdaq is lagging (-.56% vs. +.17% for the Dow and -.16% for the S&P). The Dow is being pushed higher mainly because of GM, which is rising because of the report that the auto union (UAW) is willing to allow national leaders to negotiate healthcare with GM. As healthcare costs have been a major impediment to American automakers, any possibility of a renegotiation to lower healthcare costs will help the big three.

GM is currently up 10.66% to 35.20 (up 3.44 points), providing a nice trade as it broke through key resistance earlier in the session at 33.54. Ford (F) is trading up 7.2% in sympathy. Back to the Market...

Nasdaq 2100 and NDAQ...

2005-06-10T02:37:00.000-04:00

As the Market resumed its upward climb on Thursday, we eagerly await Nasdaq 2100. As a speculator, I have no general preference for how the market reacts at another 2100 test, but I do want to see that test. I'll be prepared at that point to go long/short based on my indicators.

In the mean time, as 8 out of the 10 stocks in the market outperform leaders index showed early strength, and as the Nasdaq was leading the S&P and Dow, it was a good day to go long some of the familiar names. In the leaders index, NSI and NDAQ reached all-time highs intra-day, and only CRYP and MW closed to the downside. The index closed at 896.84, up from 881.69 yesterday, or +1.72%. On an equal-weighted basis, the index is now up .04% since inception (6/7/05 close).

Momentum plays that I am considering adding to the index include GEOI (set an all-time high today), HANS, and UNH. My goal is to fine-tune this index to include the leading stocks with the most clout, so as to provide advanced indications of a continued uptrend or a reversal.

Leaders Index, Nasdaq Showing Strength

2005-06-09T12:45:00.000-04:00

A lot of positive signs developed this morning, with 8 out of 10 stocks in the leaders index showing strength right out of the gate (Only CRYP and MW are trading to the downside). This gave me confidence to put some money to work on the long side. I also like that the Nasdaq is once again leading the market indices, up .73% vs. .50% for the S&P 500 and .37% for the Dow.

We'll see if we can hold this strength into the close...

Leaders Index Down, Nasdaq Resistance in Place

2005-06-09T01:06:00.000-04:00

As I introduced in my last post, I am closely following the stocks that have led this rally, and have created a "leaders index" to measure their cumulative (stocks in the index: GOOG, CME, SHLD, MW, BOOM, SWN, CRYP, ORCT, NDAQ, and NSI) prices.

Today was not a good day for the leaders index, as it closed down 20.42 to 881.69 (the cumulative closing price of the 10 stocks, representing a price-weighted index, similar to the Dow Jones Industrial Average), or -1.41%. On an equal weighted basis, the leaders index was down 2.26%. 8 out of the 10 stocks in the index closed down, with only NSI and NDAQ advancing. For me to be a net buyer of these stocks in the coming days, I would like to see at least 80% of the stocks trading to the upside. That would signify to me that the uptrend still has legs.

I will also be watching the Nasdaq, which has led this market rally but is now down 1.81% from its high of 2097 reached on June 2nd. There is clearly strong resistance at 2100 and I see support at the 2050 level. A push above 2100 would be provide a strong incentive to add to long positions, and a close below 2050 may be an opportunity to take some profits as 2000 (a stronger support point) may not be far off.

As for Google, at 279.56, it managed to close above its 10-day moving average (278.31), but when gurus start writing articles advising you not to short GOOG, that may give you some indication that a short-term top is in place.

So we have 2100 on the Nasdaq and $300 on Google. If these points are taken out in the coming weeks, I have no doubt there will be substantial money to be made on the long side. In the mean time, be patient and let Mr. Market's price action tell you where he is going.

Until Tomorrow,

Market Professor

Shifting Leadership? The Market Outperform Leaders Index (MOLI)...

2005-06-08T11:05:00.000-04:00

With the Nasdaq closing down yesterday, and the Dow higher, perhaps we're seeing a change in leadership. Today, the Dow is up .4%, while the Nasdaq is up only .16%.

If there is a shift out of Tech, we might see some weakness in the names that have brought us to this point. Currently, I am watching 10 stocks, looking for a change in sentiment: GOOG, CME, SHLD, MW, BOOM, SWN, CRYP, ORCT, NDAQ, and NSI. We'll call these stocks the "Market Outperform Leaders Index (MOLI)." In a rising market, we should expect these stocks to continue to lead.

Today, 6 out of these 10 stocks are trading on the downside (on a day when all three major indices are positive), with BOOM down 6.73%, GOOG down 4.03%, and ORCT down 2.55%. Coming into today, the Leaders Index had a cumulative price total (adding together the closing price of all ten stocks) of 902.11, and currently the price total stands at 885.69, down 16.42 or 1.82%. On an equal weighted basis, the Leaders Index is down .84% today.

It remains to be seen whether this is a one-day blip or a true rotation out of the leaders. I'll report back tonight with closing numbers...

Real Estate Bulls Take Control...

2005-06-08T01:36:00.000-04:00

While I continue to believe that we are already deep into real estate bubble territory, I cannot ignore what Mr. Market is telling me. So while in March the prudent trade on these bubble stocks was on the short side, for the past month and a half it would have been foolish to resist the strong upward trend in real-estate related stocks. The lesson to be learned is that stop loss orders need to be extremely tight when timing a reversal in a bubbling industry due to the confounding nature of all bubbles: that they often last far longer than anyone deems possible.

Left for dead on April 4th at 110.70, IYR, the most liquid REIT ETF, has made a valiant comeback, currently up 3.32% year to date, and closing at an all-time high today (June 7th) at 126.00. The Homebuilders ("homies") have followed suit, led by TOL (setting an all-time high on June 3rd), KBH (setting an all-time on June 7th), and DHI (setting an all-time high on June 3rd).

These stocks have undoubtedly been buoyed by the sharp decline in the 10-year (the "conundrum") and the corresponding unexpected decline in mortgage rates. But this isn't the only explanation. With the housing boom in full force, the homies are still making money hand over fist, and continue to have their already lofty earnings expectations revised upward.

So maybe each person in America will own 3 homes afterall, and we can all live happily ever after trading homes to each other at forever inflated prices.

Sarcasm aside, I hope my message is clear: never get married to an idea, and never let your beliefs cost you money in the market. While simple economics tells us that the real estate bubble cannot persist indefinitely (as the ratio of median home prices to personal income is at an all-time high), the stock market does not care about economic theory in the short run.

In the short run, from a trading perspective, it is better to have the belief that "anything is possible," that Google can go to $500, that the 10-year can go down to 3.5%, that Crude can go to $100. Having an open mind about where markets can go will allow you to trade instruments that you would otherwise avoid, and will prevent you from losing money trading against instruments in the belief that they cannot possibly go higher/lower.

And so, while I still think there will be fortunes made on the collapse of the real estate bubble, now is not the time for that type of trade. The time will come, rest assured, but it is not today. You don't need to go short at the peak to show that you were the smartest man in the room. Be patient, wait for weakness, and the time will come.

In the mean time, the long trade is presenting some great opportunities....

Portfolio Examination Time...

2005-06-02T23:52:00.000-04:00

It's been a great past month for stocks, and if your portfolio isn't significantly higher (at least 5%) than it was a month ago, you had better reexamine your positions.

Since the April 29th low, the QQQQ's are up 12.5%, SPY is up 5.96%, and DIA is up 5.00%. During an uptrend, you want to be long the leaders, in this case technology. Forget valuation, forget P/E's, the trader's paramount concern must be price action.

If I were investing for the next ten years (the minimum time-period I believe is required for a true "investment"), I would not even look at QQQQ. But for a trade, QQQQ is at the top of the list to obtain instant Tech diversification and liquidity.

My top ETF holding for the long-haul is still the boring DVY, a dividend-concentrated portfolio comprised one hundred of the highest dividend-yielding securities (more info here). DVY is up 1.43% YTD, yielded 3.5% last year, and has widely outperformed the dow, s&p, and nasdaq since its inception.

Back to the trading room. Google clearly has been the story stock of this rally, up 32.67% since the market lows of April 29th (from 217.82 to 287.9), and 49.33% year to date. In the 23 trading days since April 29th, Google has closed higher in 18 of those days (78.3%), and at one point closing at a new all-time high an astounding 9 consecutive days. Google now sports a market cap of $80 billion, greater than that of Merck (MRK). Yes, a company with $400 million in net income last year (GOOG) is worth more than a company with $5.8 billion in net income (MRK).

But valuation means next to nothing in the short term. This is a hard lesson to learn for beginning traders. Almost as hard as the concept that buying a $2 stock does not present a better opportunity to make money than a $200 stock. Faced with the choice on May 16th of buying GOOG at $230 or Lucent (LU) at $2.90 (two of Jim Cramer's picks), I hope you went with GOOG.

While I often knock Cramer for recommending what seems like thousands of stocks each day on his "Mad Money" program, I have to give him credit for his GOOG call (of $320 when GOOG last reported earnings). It remains to be seen if GOOG will hit this once unbelievable number, but it becomes more likely each day.

The market is clicking on all cylinders going into the jobs report tomorrow. No worries, euphoria abounds, everybody making money. That has to worry you. Remember, greedy when others are fearful, and fearful when others are greedy. 190,000 new jobs is the expected number. How will the market react to a number above/below 190k?

Will a low number (below 190k) once again be construed as good (indicating a slowing economy and an end to the fed rate hikes)? A good number can propel this nasdaq bull into the green for the year and over 2100, while a bad number will no doubt cause some profit taking after a nice run.

Another interesting friday awaits us...

Yield Curve Continues to Flatten

2005-05-28T16:20:00.000-04:00

On April 26th, I wrote of the increasing danger of an inverted yield curve. On that date, the spread between the 10-year (4.25%) and the 2-year (3.63%) was 62 basis points.

Today, the 10-year stands at 4.07%, and the two-year at 3.64%, for a spread of 43 basis points. Thus, the continued flattening of the yield curve and increasing risk of an inverted yield curve.

The unexpected price gains in long-term treasuries has been the story of the year thus far. TLT, the long-bond ETF with an average maturity of 23.05 years, is up 7.43% year-to-date, compared with losses in the Dow (-1.83%) , S&P 500 (-.13%) , and Nasdaq (-4.27%).

Going forward, there is support on the yield of the 10-year at 3.95-4.0%, and Resistance on the price of TLT at 94.50.
(Click to Enlarge, 10-year)

(Click to Enlarge, TLT)

For the stubborn bond bears, a short TLT or IEF (7.98 average maturity) trade can be initialized here, with a stop just above the 52-week highs of 94.65 for TLT and 86.87 for IEF.

In the meantime, we await the next fed meeting, on June 30th, and the continued expectation of another 25 basis point hike. That increase will bring us to 3.25%, with many expecting at least a pause in the tightening at 3.5% after the August 9th meeting. With the CPI averaging 3.6% year-to-date, I don't see Greenspan stopping at 3.5%.

Have a great weekend

The Calm Before the Storm...

2005-05-03T11:44:00.000-04:00

Awaiting the fed at 2:15pm, we're in a tight range and keep bumping up against that 1163 on the S&P. For the moment, the bears are winning that battle, but I don't know how much longer they can keep up the resistance.

The word on the street is a sharp up move after the announcement, and that makes me nervous. Perhaps the street is expecting too much from the fed today and will be disappointed if they don't get what they want.

So the contrarian play is to keep shorting at 1163, and to short any immediate rally after the announcement, looking for a continuation of the 1140-1163 trading range. Don't be fooled by the first move after the announcement, as we often see sharp reversals soon after the news is digested.

So, while there is money to be made or lost by the gambler, the smart move by the speculator here is to stay in cash and wait for a better risk/reward entry. Let the gamblers fight it out after the announcement and be ready to jump in only when it's in your best interests.

Should be an interesting afternoon...

(S&P Daily, Click to Enlarge)

Reversal at 1163? Imagine that...

2005-05-02T13:53:00.000-04:00

Playing the range, which I wrote about last week, continues to be the best strategy in this sideways market. This morning we saw once again that 1163 for the S&P is more than just a number, and the obvious trade was to go short with a tight stop (above the highest resistance point).

But remember, we have two major news events this week (the fed meeting tomorrow and job report on friday) with a very good chance of taking us out of this range, so be very cautious and always have your eye on the market.

The fed will raise by 25 basis points tomorrow (captain obvious reporting), but it is all about the language these days as Greenspan has eliminated the risk in the number itself. Will they scare the market enough (portending continuing future increases indefinitely or speeding up the pace of increase or continued concern about inflation or concern over growth) to break 1140 on the downside, or will they give comfort to the market and allow it to make a strong breakthrough to the upside (above 1165).

That is the question on every trader's mind. Should be an exciting week.

The Amazing Bull Market of 1978-1999, Part I

2005-04-30T00:09:00.000-04:00

The terms "Bull" and "Bear" Market have many different meanings on the street. Personally, I like to take a longer-term view when using these terms, and define Bull and Bear on a yearly basis using the S&P 500 as the index of choice.

My definition of a Bull Market dictates that a Bull Market continues until there is annual decline in the S&P 500 of 7% or more. Alternatively, a Bear Market continues until there is an annual gain in the S&P of 7% or more.

Using this definition, far and away the greatest (in % terms) and longest (in years) Bull Market in U.S. history occurred between 1978-1999. During this 22-year period, the S&P 500 produced an astounding 2,982.79% cumulative return. In 20 of the 22 years the S&P finished in positive territory, with the two small down years of -5.19% in 1981 and -3.43% in 1990.

A $100,000 investment in an S&P 500 index fund in beginning of 1978 would be worth $3,082,790 at the end of 1999. Buy and Hold index fund investing was clearly the best strategy during this period, and would have produced 16.86% annual returns for those with enough restraint to resist the urge to play their hand at market-timing and individual stock picking. While most investors surely made some money in the stock market during this period (remember the monkey with darts experiment), I'd venture to guess that less than 20% of stock investors approached 10% annual returns, and less than 5% of investors held onto passive index mutual funds to achieve the 16.86% per year.

We can learn many things from observing this unbelievable bull market. First, the unfortunate fact that it is unlikely to be repeated in our lifetimes. A twenty-two year trend is a rarity to say the least. After 1978-1999, the three longest bull markets by my definition are as follows:

10 years, from 1947-1956, with a cumulative return of 393.84%.
9 years. from 1894-1902, with a cumulative return of 160.94%
8 years, from 1921-1928, with a cumulative return of 429.8%.

Since 1871, the average bull market has lasted 4.75 years, while the average bear market lasts 1.5 years.

Second, we must learn how a bull market such as this is possible in the first place. Going into 1978, stocks were extremely out of favor, with a P/E ratio on the S&P of 8.73. At the end of 1999, the P/E ratio on the S&P was 30.5. As you can see, people were willing to pay a lot more for a $1 of earnings in 1999 than they were in 1978.

Why is this so? Since 1931, the worst 20-year period for the S&P was from 1959-1978, at 6.23% per year. During the 5 years leading up to 1978, the S&P experienced negative returns of -.44% per year. Due to this historically low period of growth in stocks, people became overly pessimistic about stocks and P/E ratios contracted down to 8.73, making stocks a compelling value for long-term investors. Remember, the average long-term P/E ratio for the S&P is approximately 15.

Thus, we have learned the most important lesson of investing: when stocks (or any asset class) appear to be at their worst (as you project negative past returns into the future), that is often the best time to buy.

(S&P 500, 1978-1999, Click to Enlarge)

Playing the Range (1145-1163)

2005-04-27T15:23:00.000-04:00

Rarely is trading this effortless, but the S&P 500 made a classic bounce off its 1145 short-term support this morning. What's next? According to the recent script, we'll eventually challenge the 1160-65 range once again. Take some profits there, and look for a turn to go short once again or for that long-awaited high-volume breakout to the upside.

Not the most exciting strategy, but in this environment the speculator will take any opportunity the market avails him.
Last Five Days:
Long @ 1145, sell at 1163: 1.57% gain;
Short @ 1163, cover at 1145: 1.55% gain;
Long @ 1145, sell at 1163: 1.57% gain

(Click to Enlarge 5-day Chart)

Will we stay in this range for too much longer? Your guess is as good as mine. When we finally do breakout of it, though, expect a strong move either to the upside or downside.

Where will that impetus for a breakout come from? 4 Possibilities: (1) Tomorrow's GDP report, (2) Microsoft's Earnings Report tomorrow (4/28), (3) The FOMC Meeting next tuesday (5/3), and (4) Next week's jobs report (5/6).

If the fed gives clues that the rate hikes are coming to an end, look for an upside breakout. If the fed hints that stronger tightening (50 basis points) is needed, look for a downside breakout.

To say the least, it should be an interesting week in the markets.

"More Trouble at Fannie"

2005-04-27T00:37:00.000-04:00

"Uncertainty created by the accounting scandal at the biggest U.S. buyer of home mortgages has the potential of spilling into the housing industry and making mortgages less available for homebuyers." -- Armando Falcon, Agency Director of the Office of Federal Housing Enterprise Oversight.

Falcon now says that her office very well might "find more problems as [they] continue to review the company's accounting."

Why is this a problem for the housing market? As Falcon states, should Fannie or Freddie fall, "there would be less money for (consumers) to borrow in order to get a mortgage."

As we know, mortgage mania and creative lending to unqualified applicants has been fueling the housing market to unprecedented highs. The decline in supply of easy money would finally put an end to 100% leveraged buying, and rampant, speculative demand would dry up.

Interestingly, Falcon has taken heat in exposing Fannie's fraud from "Democratic lawmakers who benefited from housing investments by Fannie Mae and Freddie Mac in their districts."

Yet another example of politicians putting their self-interests over the interests of all Americans. Instead of commending Falcon for his efforts, they lambaste him because it might hurt their chances of re-election.

But as the article mentions, the game is coming to an end for Fannie and Freddie, as Congress (with endorsement from Bush) is looking "to tighten the government's hand over Fannie Mae and Freddie Mac and create a new regulator with broader powers, including reducing their combined $1.5 trillion mortgage porfolios."

Stock News:
Fannie (FNM) Down 1.66% to $52.64.
Freddie (FRE) Down .21% to $60.82.

Read my earlier post on the subject HERE.

Inverted Yield Curve and Recession...

2005-04-26T00:05:00.000-04:00

We began 2005 with the following treasury yields:

3 Month: 2.23%
6 Month: 2.58%
2-Year: 3.07%
5-Year: 3.61%
10-Year: 4.22%
30-Year: 4.80%

This is where we stand today:

3 Month: 2.88% (up 65 basis points; where 1 basis point =.01%)
6 Month: 3.14% (up 56 basis points)
2-Year: 3.63% (up 56 basis points)
5-Year: 3.94% (up 33 basis points)
10-Year: 4.25% (up 3 basis points)
30-Year: 4.55% (down 27 basis points)

As you can see, short-term treasuries have been rising and long-term treasuries have been flat (10-year) to falling (30-year).

Of particular importance on the street is the spread between the 10-year and the 2-year, which began the year at 115 basis points (4.22% - 3.07%). Currently, that spread sits at 62 basis points. Thus, the continued flattening of the yield curve, where long-term bonds do not demand as much of a yield premium over shorter term instruments as they did previously.

As bond prices move inversely to yields, long-term bonds have dramatically outperformed their shorter-term counterparts in the past two years, as long-term rates have held steady or declined while short term rates have increased with the fed's tightening.

TLT, the Bond ETF with an average maturity of 23.05 years, is currently up 4.73% this year, while SHY (with an average maturity of 1.77 years) is up only .19%. In 2004, TLT increased 8.48% while SHY returned only .66%.

For the speculator who anticipated a flattening yield curve two years ago, the strategy of going long TLT and short SHY has proved superior.

But what is the move going forward? Will the 62 basis point spread between the 10-year and 2-year continue to flatten, or will the 10-year finally move upward in tandem? This question will likely be answered by actions of the fed. If the fed continues its predictability in increasing the short-end, little premium will be placed on the long end. But when this "measured pace" language is finally removed, the 10-year should plummet, driving yields up and steepening the yield curve.

If the measured pace language isn't removed by the end of the year, we'll be dangerously close to the financial paradox that is the inverted yield curve. Why should bulls be afraid of this yield curve inversion? It has preceded the last five US recessions, most recently the inverted yield curve in 2000 which preceded the 2001 recession.

1163, 1163, 1163

2005-04-25T14:43:00.000-04:00

Yes, I know that virtually everyone is focused on this number for the S&P 500. But that is all the more reason why it's of importance to the speculator. If the bears are in control, the next move will be a bounce down off 1163. If bulls are truly in control, we should see a breakthrough accompanied by higher volume.

Sometimes it pays to keep things simple. Do not overanalyze. Just take what the market gives you.

As the trend is still down, you have to give the odds to the bears and a sell-off at 1163. But if we see that breakthrough and a close above 1163, be ready go in for a trade on the upside.

If you're a long-term investor, adding money to a fund each month, all these short-term technicals are meaningless. You should always be rooting for the market to tank in the short-run so that you can buy in at lower prices.

See you after the close.

US Government Fueling Housing Bubble

2005-04-25T02:30:00.000-04:00

Fannie Mae and Freddie Mac to go private?

The Congressional Budget Office (CBO) sees that as a possibility (READ), with the CBO director saying such a move would "reduce the risks and costs to the federal government."

Risks? You mean to tell me all those interest-only loans and no-money-down purchases from unemployed individuals with bad credit are risky?

And what is this about costs to the federal government? Fannie's own website says that it receives "no government funding or backing." You mean to tell me that Fannie, who misstated earnings by an estimated $11 billion going back to 2001, could be misleading us?

Well, the CBO director says that Fannie and Freddie received $23 billion in federal subsidies in 2003, passing on "$13.6 billion to borrowers as reduced mortgage rates."

In plain English, Fannie and Freddie have become just another entitlement arm of the US government. We, the taxpayers, are subsidizing loan rates (which are already at historical lows) to the tune of $13.6 billion per year. Who knows what they are doing with the other $9.4 billion.

In the new "ownership society" of George W. Bush, you don't have to work hard and qualify for a loan that you will one day be able to pay back. If you're part of the 40,000 "low-income families" that Bush has singled out, the government will provide "down-payment" assistance. All this in the name of "affordable housing."

Affordable? To whom? Home prices that have more than doubled in the past five years while incomes have risen a paltry 10% are affordable?

I know Dubya has a Harvard MBA, but has he forgotten the lessons of Economics 101? Doesn't he realize what socialized stimulus does to the "affordability" of an asset class? Has he ever looked at New York City's failed rent-control and rent-subsidized housing policies. All these programs do is drive up the cost of housing for everyone else. Sure, the person who is getting the house or apartment for free is loving that type of affordability, but what about the people who actually have to pay their own money towards the monthly rent?

The effect of decreased supply and government-induced demand is evident in every rent-controlled city in the nation. Instead of people living in a place where they can afford the housing (Brooklyn, Queens, Bronx, Staten Island), they live in a place where they cannot afford(Manhattan). While it sounds great to have "affordable housing" for everyone on Park Avenue, the costs to society are tremendous.

The same argument holds in the home-buying market, where people who should be saving to buy a home in future years are jumping in early due to 1) government subsidies, 2) loose lending standards, 3) low interest rates through the fed's loose monetary policy, and 4) the fear of missing out on the great housing boom and the expectation of home prices increasing 20% per year ad infinitum.

Under the socialist "ownership society," everyone must own a home. If someone cannot afford one, one will be provided, either through subsidized rates, loose lending standards, or tax incentives.

As Fannie says, "their business is the American dream." Yes, the new American dream is to have the government subsidize the purchase of your home, and have the rest of America pay for it through higher taxes and increased home prices due to a government-induced increase in demand and decrease in supply.

This will end badly, my friends. There is no other way for it to end. Fannie has already declined 32% from its 9/04 high, but in my humble opinion it has a ways to go.

I contend that shorting Fannie (FNM) and Freddie (FRE) is the American thing to do. Fannie needs to collapse to end the socialist system that is currently in place. A return to free market prices awaits us. Be patient, close your ears to all the "instant fortunes" being made in real estate, and be ready to jump in and clean up when you're the only buyer with cash in his pockets at the end of the downfall.

(Click to enlarge)

Get Shorty...

2005-04-22T15:10:00.000-04:00

The indices are giving back yesterday's gains in a hurry. Despite yesterday's historic swing, the trend is still down and the S&P could not break through the key 1163 resistance level (the previous support level). During bear markets, there are often violent swings to the upside, only to be following by lower lows. As a speculator, you have to be nimble here and short on the first sign of weakness.

We'll see where this one takes us. Don't be surprised to see 9750 on the dow and 1100 on the S&P as further downward tests.

As for Google, so far the professionals who faded today's higher open at $221 are in the green for 2.33%, as google now trades at $215.83. Let's see how this plays out...

Goggly for Google...

2005-04-22T02:17:00.000-04:00

Yesterday was officially Google day on wall street. After running up on monday, tuesday, and wednesday, the technical signs were there if you were looking. Google was about to report a blowout earnings number, and it delivered as promised after the close. First quarter profits came in at $1.29 per share vs. $.24 a year ago, and 40% above analyst estimates of $.92.

The stock closed at $223.69 in after hours trading, up 12.9% on the session. More importantly, it surged past its February 2nd (2005) all-time high of $216.80, and for the moment lacks any upward resistance. Later today google will go wherever the traders want to take it.

Thinking about joining the party? Jim Cramer, bandwagon master, doesn't think it's too late. He forecasts Google going to $319, but didn't give a time horizon on that call. He could mean tomorrow, he could mean in 2030, but by not giving a time horizon he may eventually be right. In the bubble era, $319 could be reached in a matter of days (I have fond memories of YHOO's $100 2-day climb back in December of 99' (from 253 to 353)), but those were the good old days when anything could happen in any given day.

If you do choose to play GOOG later today, be sure to understand that you are speculating, not investing. Why do I say that? Valuation. I don't consider stocks with a P/E of over 50 investments under Warren Buffett's definition of "buying a company and holding it forever." Using today's close, Google still has a trailing twelve month (TTM) P/E of 64.47, with past twelve months earnings at $3.49. Analysts are currently expecting a long-term growth rate of 30% per year going forward. Thus, assuming GOOG stays at $223.69 going forward and annual 30% growth in EPS, the accompanying P/E ratios in the coming years will be as follows:

1Q 2006: $4.54 TTM EPS, 49.30 P/E (223.69/4.54)
1Q 2007: $5.90 TTM EPS, 37.90 P/E (223.69/5.90)
1Q 2008: $7.67 TTM EPS, 29.16 P/E (223.69/7.67)
1Q 2009: $9.97 TTM EPS, 22.43 P/E (223.69/9.97)
1Q 2010: $12.96 TTM EPS, 17.26 P/E (223.69/12.96)

Therefore, it will take 5 years of unbelievable growth (30% per year) for Google to have a multiple comparable to the market. This assumes no price appreciation in GOOG stock. That is, while google may be a spectacular company, it should prove to be, if my numbers hold up, a lousy investment.

In five years, Google's growth will have slowed as it continues to mature, and it will no longer command the insanely high P/E ratio that it does currently. Just look at MSFT, CSCO, and INTC if you don't believe me. Check their valuations five years ago when "projected" annual growth was in the same range as google. Compare those expected numbers with their actual growth rates. Then take a look at their current P/E ratios: 27 for MSFT, 19 for INTC, and 22 for CSCO. Now notice their 5-year charts (HERE). All of them great companies, but as an "investment" five years ago, they leave much to be desired.

The fact that MSFT, CSCO, and INTC are even around at all are a testament to the strength and innovation of their underlying businesses. Many of the high P/E darlings of 5-years ago are no longer with us. All those fancy projections of 50% year over year growth for 10 years are worthless today.

The marketplace is an amazing thing. It is incredibly hard to consistently grow at 30% for five straight years. Competition has a way of eating away at the profits of successful businesses. There are only a handful of large-cap companies that have achieved such growth in the past. With a $61 billion market cap, google is already enormous. When Google opens for trading tomorrow, it will be worth more than many American icons: Disney, Boeing, AT&T, General Motors, Ford, Gillette, Goldman Sachs, Morgan Stanley, Merrill Lynch, and on and on.

The power of a search engine, indeed. But how powerful will GOOG be as an investment? That is the question. Not whether it is a good company, but whether it is a good stock. You must make the final decision upon your own analysis in the end. Don't let my opinions sway you. If you think 30% growth will be seen in GOOG for the next ten years, by all means invest.

But don't be surprised to see it at $223.69 or below five years from now.

Thinking of Investing in China..."Forget About It"

2005-04-21T03:00:00.000-04:00

Another great article from Henry Blodget (yes, that Henry Blodget) over at slate (READ HERE). Blodget has been doing a series about the China Gold rush, and in this piece discusses the pitfalls of investing in Chinese stocks.

I certainly agree with Blodget's last point, that if you "can't stand" not investing in China, you had better do so through a diversified country fund.

Personally, I would go with Ishares China 25 Index fund (FXI).

Bond ETFs...How Can They Benefit You?

2005-04-21T00:42:00.000-04:00

A central tenant of modern portfolio theory is asset class diversification, where you allocate your investment portfolio among stocks, bonds, real estate and commodities. Pairing assets with low (or even more ideal, negative) correlations will reduce the volatility (standard deviation) of your portfolio without making a significant dent in your overall, long-term return.

In a bull market, the average investor has no need for diversification of this kind. He only sees the effects volatility and risk on the upside. It isn't until the volatility is seen on the downside (the last few months are a prime example) that investors start appreciating having assets other than stocks to lighten the blow of a bear market.

From 1995-1999, having 100% of your assets in the S&P 500 was a fun place to be. But in the bear market of 2000-2002, having 100% of your assets in the S&P would have seen consecutive declines of 9%, 12%, and 22% (including dividends). If you had owned 10-50% bonds in your portfolio during this period, your yearly losses would have been significantly lower.

In an article from CBS Market Watch (Read Here), the author does a nice job of explaining the diversification benefits of bond ETFs. In a nutshell, "over the 10 years through March 31 (2005), splitting money evenly between the S&P 500 and Lehman Aggregate Bond indexes -- and rebalanced monthly -- would have earned 86% of the return of an all-stock portfolio with 50% of the volatility."

How is this split best achieved? Today, thanks to a variety of bond ETFs from ishares, you can purchase bonds from your discount broker in the same manner of stocks, buying shares of these bond ETFs that trade throughout the day. The Bond ETFs range from short-term (SHY, 1.68 yrs duration), intermediate term (IEF, with a 6.6 yrs duration), and long-term (TLT, with a 13.05 yrs duration).

The S&P 500 of the bond world is the Lehman Aggregate Index, which trades under the symbol AGG, with a duration of 4.55 years. There is also a corporate bond ETF (LQD, 6.42 yrs duration), and an inflation-protected ETF (TIP, 6.1 yrs duration).

Thus, a basic Stock-Bond portfolio can be achieved with 50% in the S&P 500 (SPY) and 50% in the Lehman Aggregate ETF (AGG).

But what is this duration thing I keep mentioning? I won't go into all the nasty details in this post, but basically the longer the duration, the greater the % change in the bond for a given change in interest rates. Thus, TLT, with a duration of 13.05 years, is much more sensitive to interest rate changes than SHY, with a duration of 1.68 years.

Who should own these vehicles? Many different classes of investors can use bond ETFs in a variety of ways to suit their individual needs.

First and foremost, the long-term investor who cannot emotionally handle the inherent volatility of equities can reduce the potential annual declines by adding Bond ETFs to their portfolio. In an earlier post, I spoke about the important concept of risk (Read Here), explaining that if you cannot handle the risk of the S&P 500 declining 10-20% in any given year, you should stay away from stocks because you will be inclined to sell at the lows (when stocks are at their worst) and buy at the highs (when stocks can do no wrong). For this extremely risk-averse investor, adding bond ETFs will enable them to invest in stocks and not react with emotion as they would with an all-stock portfolio because the potential annual declines (and rises)will be lower.

Secondly, the shorter-term investor who is looking for higher yields might look to Bond ETFs. Last year TLT yielded 4.76%, significantly higher than comparable money market rates at that time. However, this higher yield comes with increased risk, namely the risk of rising interest rates. If interest rates increase, your principal will decline, cutting into that 4.76% yield. Conversely if interest rates confound everyone and manage to decrease yet again this year, the price of your bond will increase, adding to your 4.76% yield.

However, with money market rates currently at 3.25% and climbing, I would hesitate to take the risk of investing in TLT for the extra 1.5% yield, unless you know something about a future decline in interest rates that I don't know about. I'd like to see the yield curve steepen and TLT yields rise before investing in these instruments for their yield alone.

Lastly, as the price of Bond ETFs move inversely to interest rates, the speculator can go long or short TLT based on his expectations for future long-term interest rates. Certainly this is a risky trade, and those shorting TLT expecting higher interest rates this year have been severely burned, as long-term interest rates have actually gone lower year to date. However, should 10-year rates unexpectedly rise to 6% in the next year, a short TLT trade would likely outperform both equity and fixed income instruments.

I'll talk more about bond ETFs in the coming days and months, discussing where you should own them (Retirement Accounts vs. Taxable Accounts) and in what percentage.

Get your housing short list ready...

2005-04-20T00:45:00.000-04:00

If you haven't already done so, get your housing short list ready. Housing starts came in 13% below expectations at 1.837 million, and posted their largest monthly decline in 14 years, with a decline of 17.6% from February.

The homebuilders ("homies") took the news in stride, and traded higher on the session along with the overall market. But it is my belief that their time is running short, and when they decline, it's gonna be a huge move, and you better be there to profit from it. This is a once in a decade opportunity for the patient speculator.

A short list of the top homebuilders is a good start. You've all heard the names by now. They are the stars of the new market, just like JDSU and ARBA were in the internet bubble. Remember these names if you haven't heard them already: Lennar (LEN), Toll Brothers (TOL), KB Home (KBH), Pulte Homes (PHM), and D R Horton (DHI).

Examine the accompanying chart below, with these homies all up between 400% and 800% over the past five years. This is unsustainable, bubbly growth. Notice the downturn at the end of the graph. This very well could be the beginning of the end for the homies. They may make a final rally to that previous top, but that will set up a beautiful double top scenario.

Could I be dead wrong and housing will continue to rise at 20% per year forever, as people are expecting? Well, we do know that markets can remain irrational far longer than you can remain solvent, and that bubbles persist far longer than people expect. But we have already seen ARMs, Interest-only loans, and loose lending standards to the max. Where is the new demand going to come from?

The only thing sustaining the bubble is the consensus belief from the "greater fool" that future appreciation will be 15-20% per year for housing going forward. Therefore, while rising mortgage rates may contribute to the downfall, they will not be the proximate cause. Just as the tech investor's gung ho expectations turned on a dime in 2000, when housing prices start to decline modestly expectations will come back to reality, and sellers will flood the market. All of the sudden, the supply of housing won't be as low as the real estate bulls are contending.

Knowing what we do about the nature of bubbles, how should the speculator play this trade? Start with small positions and tight stops. It is the long trend we're looking for here, and a few 2% stop losses are acceptable. Also, don't try to short the very top or bottom; all you want to do is catch the major move and stay on for the ride.

For most, shorting the homies is more than just a trade, but also a hedge against the wild appreciation you've been experiencing in your own home, in many areas doubling over the past five years. This type of hedge is certainly not for everyone, but may be useful for those expecting to sell their homes is the next 3-5 years, and who don't want to take the chance of a housing crash before they sell. Sell short and at least you won't be totally exposed in a downfall. But of course you will be giving up some of the upside appreciation, if the bubble continues to grow.

If you're in the crowd that believes your house will rise 15-20% per year forever, you'd be crazy to employ a hedging strategy. 100% leverage and interest-only loans are the only way to play that game. I wish you the best of luck in this strategy.

I'll talk more about housing short candidates in the coming weeks and shift the focus to mortgage lenders, REITs, and other industries that will be affected by a decline in housing.

(Homies 5-year Chart, Click to Enlarge)

What a Relief...Stocks, Bonds, Crude Rise

2005-04-19T18:53:00.000-04:00

As expected, a mild PPI and strong earnings reports have led to a nice relief rally in stocks during the past two days.

It is also interesting to see stocks and crude now declining and rising in tandem. At this point, $50-$55 oil seems to be already priced into stocks, and a rise in energy stocks has certainly been helping the indices in the past two days. As long as GDP remains strong and PPI/CPI remain low, perhaps the equity markets will continue to shrug of higher oil as they did in 2004.

An in-line PPI also helped long-term bonds. The rise in these bonds (and decline in yield), if maintained, will become troubling in the coming months, as the fed continues to raise short-term rates and the threat of an inverted yield curve arises.

Also, a decline to normalcy in the volatility index ($VIX) after last week's spike has been a positive sign for the bulls.

Let's see if stocks can continue their run with CPI and earnings tomorrow. So, far, it looks like that run will continue, as YHOO (up 4.88%), GOOG (up 4.02%), and INTC (up 3.76%) are all up big in after-hours trading.

(click to enlarge)

(click to enlarge)

"I Still Love Lucent"...Jim Cramer

2005-04-18T15:41:00.000-04:00

Jim Cramer used to do a segment on his radio show called "I love lucent," where he would play the theme song from "I Love Lucy" and talk about what a wonderful company lucent was and how the market was getting it wrong. That was when lucent was trading at $4/share, back in November of 2004. Cramer was saying back then that it could easily trade at $5-6 in the near future. Today it trades at $2.37, down 40.75% from its $4 level.

Needless to say, he doesn't play the song anymore. But he still loves lucent, writing an article about his continued optimism on April 5th. Why does he love it? In a nutshell, because it is a "profitable company." I can't argue with that. It is profitable, but by that logic most companies would be a buy. As we know, though, profitable companies can be terrible investments. Just look to GM and Ford, who have been profitable in the last 12 months, but awful investments.

But who needs logic when you have love: Cramer loved LU at $3.75, $3.50, $3.25, $3.00, $2.75, $2.50, and he'll probably love it at $.01. His love affair with lucent is a beautiful thing, but I sincerely hope it didn't cost you any money. Cramer never tells you that he owns lucent as part of a diversified portfolio of over 30 stocks. He merely says "I love lucent" when asked about it, and to keep buying it on the way down. He has no need for portfolio management; just love it and buy it.

This may be fine strategy for the truly long-term investor who has hundreds of other stocks, but it is not the strategy for the average investor who will put 50% of his funds in lucent on Cramer's advice, and continue to average down, all the way to $0. Because this investor is not diversified, and really had no intention of holding lucent "forever" (a la Warren Buffett) but just wanted a quick trade, he will inevitably feel the pain more than Cramer (Cramer, after all, will still be a multi-millionaire, even if LU goes to $0) and will finally sell his position close to the low.

In short, I know I've warned you in the past, but be very wary of investment gurus, especially a guru like Cramer who gives a thumbs up to 10-20 stocks each day on his show. By the sheer amount of stocks he recommends, he will inevitably be right now and then, just like a broken clock is right twice a day. But don't fall for his act. The only way to make money in this game is fierce independence. If you use Cramer for anything, use him as a contrary indicator.

Afterall, if you had merely shorted Lucent when Cramer started pumping it, you would be up 40% instead of down that amount. And if you shorted after his latest April 5th recommendation (at 2.53), you'd be up 6.3%.

Lucent reports earnings tomorrow. They may be good, they may be bad: I don't play the beat/meet wall street earnings game. The stock may rally a great deal on good news. But if you currently own this garbage stock, this shouldn't factor into keeping it. As always, to own any investment you must have a legitimate reason of why lucent will not only go up, but will outperform the market. If you don't have a legitimate reason ("it's profitable" does not count), you have no justification for taking on the increased risk of an individual stock, and you should buy the indexes or keep your money in cash. Anything else is just gambling.

After the Mini-Crash: The Week Ahead...

2005-04-18T02:09:00.000-04:00

What I'll be watching in the coming week:

Possibility of heavy selling at the open on Monday, with a lower close continuing the down trend and a rally with a close above last Thursday's close as a major sign of strength.
Look for a strong relief rally (led by tech on positive earnings news) at some point in the week. But will that relief rally hold, or will we see subsequent lower lows?
Oil under $50 and its effect on the markets (recently, the inverse relationship between oil and the markets has broken down, with stocks and oil both declining dramatically). On a similar note, continued weakness in the CRB index is significant.
Bonds continuing their "conundrum" rally: 10-year closed at 4.24% on Friday (began year at 4.22%), down from a high of 4.69% earlier in the year.
Bull's Last Hope: Earnings. After IBM's disappointment sent the market plummeting on Friday, any positive news on the earnings front should produce a nice relief rally. Key reports this week in tech sector: YHOO, GOOG, EBAY, INTC, TXN, NOK, LU. Non-Tech Reports: JNJ, F, GM, KO, JPM.
Economic Data, Tuesday: Housing Starts (2.1 million consensus)-- Signs of weakness in the housing market? Look for continued weakness in the homebuilders (which got crushed last week) on a bad number. Stocks to watch here: KBH, LEN, PHM, DHI, TOL.
Economic Data, Tuesday: Producer Price Index (.7% consensus, .2% less food/energy) -- Any sign of increases over consensus will not positive news for stocks, as it will signal inflation, and give credence to continuing with the rate increases. Likewise for bonds, any sign of unanticipated inflation should send yields back up.
Economic Data, Wednesday: Consumer Price Index (.5% expected, .2% less food/energy) -- Same concerns as PPI.
ETF's to watch:
Continued strength in health care (XLV), Continued freefall decline in Energy (XLE, IGE) and Materials (XLB).
Internets (HHH) giving back all of last years 42% gain with a close below 50.19 (Closed at 51.4 on Friday).
Continued strength in the long-bond ETF (TLT), up 3.95% YTD.
And of course, Technology (XLK), down 12.51% YTD and Financials (XLF), down 8.66% YTD, without whom the bull market cannot continue.

Carnage

2005-04-15T12:32:00.000-04:00

Year to Date: Dow down 5.03%, Nasdaq Down 12.19%. With the exception of Health Care, weakness across the board.

Happy Income Tax Day

2005-04-15T02:01:00.000-04:00

I know, I know. You don't get excited on Income Tax Day. It's not fun filing those ridiculously complicated tax returns and paying a third of your income in federal and state taxes.

So let's focus, instead, on tax freedom day, the day after which you will finally be pocketing some of that money you work so hard for. Each year, the tax foundation calculates how long you are working for the various government agencies (federal, state, local, etc.), instead of for yourself and for your family. This year year, Tax Freedom day falls on April 17th. This means the average American's earnings from January 1st to April 17th all go to taxes. On April 18th, you finally begin to start keeping some of the money you work for.

In states with high state and local taxes like our wonderful New York, Tax Freedom Day occurs even later, on April 29, 2005. New York is second only to Connecticut, whose Tax Freedom Day is May 3, 2005. This is one contest you don't want your home state to be winning. Essentially, in New York and Connecticut, you are working for four months before you start earning a dime you can keep.

There is some good news on the tax front, though. On the national level, Tax Freedom Day has been occurring earlier in recent years due in large part to the Bush tax cuts. As shown in this graph, tax freedom day was as late as May 3rd under the Clinton administration.

But I yearn for the days of 1910, when tax freedom day occurred on January 20th, and only 5% of your income went to taxes. Will we ever get back down to these reasonable levels? A guy can dream, can't he.

Tax Freedom Website (click here)

Growling Bear...

2005-04-14T18:47:00.000-04:00

The Dow, S&P, and Nasdaq all closed at their lows for the year.

Of particular significance was S&P's failure to hold the line at 1164, closing at 1162, down 3.83% year to date. As I've said before, the next solid level of support is at 1100, or 5.33% below current levels. Tomorrow will be an important day for the S&P, to see if this this breakout will be confirmed or we'll see a rally back into the trading range. As there is so much pessimism floating around these days, don't be surprised to see a dead cat bounce tomorrow.

The technical trader here will be playing it both ways, either long in anticipation of a relief rally or short following the trend and breakthrough of resistance.

The Dow also set new lows for the year, with GM proving the old adage "never catch a failing knife", declining another 6% and setting another multi-year low. The story of GM should be taught in every business school as an example of the perils of buying and holding individual stocks. GM now trades for about half of what it traded for in 1965 (not including dividends). 1965! Over that period, had you simply invested in the S&P 500, your $10,000 initial investment would be worth $319,000 today. A similar $10,000 investment in GM would be worth $5,000 today.

Stocks vs. Bonds...

Year to date, contrary to wall street consensus, bond have outpaced stocks. The 10-year remains stubbornly low at 4.32%, and TLT (popular long-term bond ETF) is up 2.59% for the year, compared to a decline of 3.83% for the S&P. Thus far, those predicting 6.0% on the 10-year by years end have some explaining to do. If Greenspan continues raising rates as expected an the ten-year refuses to budge, we might see an inverted yield curve.

I'll be back later tonight with some more thoughts on the current state of the markets.

And There Goes The Support...

2005-04-14T11:59:00.000-04:00

What the street is watching today:

Crude dipping below $50 early in the session.
The Nasdaq (at 1961) trading below its recent low of 1968 on 3/29, and below its 200 day moving average. QQQQ (Nasdaq 100 ETF) is now down over 10% on the year.
The Dow (at 10,350) trading below its January low of 10,368, down 3.5% on the year.
The S&P (at 1169) still holding above its January low of 1163, down 2.82% on the year.

See you after the close.

S&P 500 Bargain Hunting?

2005-04-13T23:30:00.000-04:00

If you're a long-haul investor, there is no more important market variable than earnings. If I'm investing for a period of at least 10 years (see post), I don't care about the day-to-day chatter on interest rates, oil, inflation, geopolitical risks; it all comes down to earnings in the end.

Earnings are foundation of your investment. If your chosen stock cannot make money, your investment will eventually be worthless. When you invest in a broad index such as the S&P 500 (through SPY or an index mutual fund), as a whole the 500 stocks that represent that index will always be making some amount of money.

That is a good thing, and one of the major benefits of diversification that cannot be overlooked; your investment in the S&P 500 will never go bankrupt. It can go down substantially in the short run, but unlike an individual stock (Enron, etc.), you will never lose your entire investment.

But the stock market is not merely content with making x amount of money year after year; it wants growth. Theoretically, the market should rise because (1) it is undervalued compared to historical metrics, or (2) it is currently overvalued but there is positive anticipated earnings growth.

While there are thousands of valuation metrics used in the investment industry, the most popular and long-standing is the Price to Earnings (or P/E) ratio. Simply, it represents the price of a stock per share divided by the earnings per share. For example, Microsoft (MSFT) is currently trading at $25.04 per share (buying 1 share will cost you $25.04), and its trailing 12 month earnings are $1.21 per share, giving it a trailing P/E ratio of 20.69.

What does this number mean? Basically, you are willing to pay 20.69 times past earnings for a single share of Microsoft at the current price. Comparatively, high-flyer Google (GOOG) has a trailing P/E of 133.79, whereas the decimated General Motors (GM) has a trailing P/E of 5.73.

Why the large disparity? Growth. Investors are predicting that Google will grow at a much faster pace than Microsoft and GM, and that growth will eventually raise the E in the P/E ratio, causing the P/E to decline to a more reasonable level. Similarly, investors are expecting negative growth in General Motors, which will lower the E in the P/E ratio, and thus raise the future P/E ratio. If Google fails to deliver on that expected growth, its P will decline dramatically, bringing the P/E ratio down. You get the picture.

To get a broader view, the P/E ratio of the S&P 500 is used. Here, we take the total value of the S&P 500 (1173) divided by the trailing 12 month earnings for the 500 companies in the S&P (63.62), giving us a P/E ratio of 18.44. You can find excellent S&P 500 data at the standard and poor's website.

Now, how does this number, 18.44, measure up historically. The S&P 500's average P/E ratio is roughly 16 times earnings (from 1881-present). Thus, one could argue that the S&P is currently overvalued and will eventually revert to its mean of 16.

Does the S&P 500 have to decline to reach this 16 P/E? No. Given the formula, prices can decline or earnings can increase to reach 16. This is assuming that, over time, people will pay roughly the same amount for a $1 of of earnings.

Given recent history, however, a P/E of 18.44 is extremely low, and we haven't seen a P/E this low since October of 1996. To give you some perspective, in March of 2002 the S&P 500 P/E reached an all-time high of 46.45. The P/E ratio has been declining ever since, mainly due to increases in the denominator (E). Year over year Earnings (E) growth for the S&P clocked in at 11.75% in 2002, 76.66% in 2003, and 20.13% in 2004.

Impressive growth, indeed, and the main force behind the bull market of the past two years. But back to the question of the S&P's current valuation. It is here where we must introduce the concept of a forward P/E ratio, or Current Price per Share divided by Expected Future Earnings.

Currently, analysts are projecting a whopping 19.39% year over year earnings growth for 2005. Thus, based on full-year 2005 expected earnings, the S&P has a forward P/E of 16.78.

And that, my friends, is the name of the game on wall street. Predicting and giving advice based on those predictions. But the truth is that predicting earnings a year from now is nearly impossible. No one was expecting the 50% decline S&P earnings in 2000, just as no one was expecting the 76.66% increase in S&P earnings in 2003. Accordingly, the S&P was down 9% in 2000 and up 28% in 2003.

So where does that leave us today? If analyst estimates for future S&P earnings are correct (and they rarely are), at current values the S&P will have a very reasonable P/E of 16.78 come December. Also, on a yearly basis, S&P earnings will hit another all-time high in 2005 (of 69.9).

If earnings are at an all-time high, you ask, why is the stock market not at an all-time high? Well, in 2000, expecting exploding future growth (30-40% year over year), the market was trading a much higher multiple (30's) than today. If the S&P were to trade at a multiple of 35 times earnings today, it would be valued at 2,205, or 88% higher than where it currently trades. But don't expect to see these bubble-era valuations again anytime soon.

If earnings for 2005 do meet expectations, I expect the S&P to extend its bull-market phase and end the year in the green. However, I would not bet on these lofty expectations being met. Even if they are met, current estimates of 15.59% earnings growth in 2006 will likely have to be cut down to reality.

Let's summarize what we know to be true today:

With an 18.45 current trailing P/E patio, the S&P has not been this cheap since October of 1996. Wall street is always talking about "bargain hunting" and we haven't seen these "bargains" in quite some time.
The current P/E of 18.45 is relatively low as compared to the 15-year moving average P/E of 25, but is still above the historical average P/E of 16.
An entry into SPY or an S&P index fund is significantly less risky today than in December of 1999, when the S&P had a P/E ratio of 30.
The markets are anticipating significant earnings growth going forward (19.39% in 2005, and 15.59% in 2006). As S&P earnings have already already doubled since 2002, these may be lofty expectations.
If you are a long-term passive investor (10 years +), this may be interesting subject matter, but it should not effect your investing strategy. As a long-term index investor, you will make your 8-10% annually without ever having to calculate a P/E ratio.
Trailing P/E ratios are just that, trailing. If there is another recession and earnings were to decline 50% as they did in 2000, the S&P's P/E would double to 36. As such, the P/E ratio only holds so much power, and should be used in combination with a variety of other metrics in making investment decisions.

Giddy About Your Tax Refund?

2005-04-11T18:17:00.000-04:00

There's nothing more amusing than the yearly response of the typical American to their tax refund. Treating it as found money, they rush to spend it at the nearest mall or trinket shop.

Why bother to understand the tax system? What's to understand, anyway? The bigger the "refund" check from the government, the better. Right?

Well, perhaps in an alternative tax universe. But the American tax system is its own greedy animal. In the American system, the government makes you pay as you go. That is, instead of paying tax after you make the money (in 2005 for 2004 income), you pay income taxes all year long, either through income tax withheld from your paycheck (if you work for another) or through estimated payments (if you're self-employed or have substantial investment income). On April 15th of the following year, your tax return merely calculates how much you paid all year versus how much you should have paid.

Next time you get your paycheck, look to see how much you would have received if not for taxes. Look to see how much was "withheld" on at the federal and state level. These are your tax payments for the current year, all paid in advance.

This is also the reason why so many Americans are complacent about higher taxes: they don't know how much they are paying in tax because they never write a check to the government; they simply receive less money in each paycheck, never bothering to understand why they are receiving less.

But come April 15th of the following year (2005), these same fools, when filing their taxes, hope for the largest refund imaginable. After all, when they get their refund they must be "making money" because they never had to write a check to pay taxes. What a wonderful country this America is.

Naturally, the more money withheld (pre-paid to the government all year), the more refund money you will receive come April 15th of the following year when you file your income taxes.

The higher that refund, the more your overpaid all year long, and the more you lost on interest on that money. You were giving the government an interest-free loan all year long, and now they are merely giving it back to you. Thus, the most optimal financial outcome is to OWE tax on April 15th of the following year. If you owe taxes, not only did you not give the government an interest-free loan all year, but you made additional interest on the underpayment of taxes for the entire year.

I know, but you still want your refund. It makes you feel all warm and fuzzy inside. If you love getting a refund of your own money so much, I have a proposal. Next year, give me $100,000 at the beginning of the year and I'll give you a nice $100,000 check the following April 15th.

E-mail all requests to marketoutperform@gmail.com

Weekly Recap: Crude/Equity Relationship Breaks Down

2005-04-08T11:14:00.000-04:00

After four straight up days for the dow, Friday brought the bulls back to reality. The low volume advances from Monday through Thursday could not be sustained, despite a sharp decline in crude, which finished down 7% for the week.

For days the market has been be trading in an inverse relationship with crude, but not on Friday. Crude fell another 79 cents on Friday (to $53.32), but the indices were all down close to 1% for the day.

Encouraging news: the dow broke its 4-week streak of declines, 3 more sectors entered the green, inflation fears were ameliorated with the decline in crude, and the 10-year trades under 4.5%.

Discouraging news: light volume advances, continued weakness in dow components AIG and GM, continuing failure of Nasdaq to hold above 2000.

What to look for next week: Important international trade number on Tuesday, retail sales on Wednesday, and Import/Export prices on Friday. Also, I believe a continuing decline in crude (especially a decline under $50.00) should spark a nice rally in the markets, despite the lack of correlation on Friday.

Have a great weekend.

Sector Watch: Move to the Green for Materials, Consumer Staples, and Health Care

2005-04-06T02:12:00.000-04:00

As the markets advanced for the second straight day after last friday's pullback, we're seeing some encouraging signs for the bulls. First, as mentioned in a post on 3/29/05, the S&P has managed to make a stand and rally off its 1163 bottom, closing at 1181 yesterday. Similarly, the Dow has not broken its January low of 10,368, closing at 10,458.

Also of note are some new signs of life in the non-energy sectors. Whereas at the lows of last week we only had energy (XLE) and utilities (XLU) in the green for the year, we are now seeing some strength in other sectors. Materials (XLB), Consumer Staples (XLP), and Health Care (XLV) have pushed into positive territory, with year-to-date gains of 1.06%, .46%, and .77%.

If technology (XLK) and the financials (XLF) would join the party, we could see a nice rally here. The internets (HHH) have rallied just over 7.0% from their recent lows, a sign of a potential turning point for the oversold Nasdaq.

Again, we're watching crude for any sign of weakness, as any pullback is pushing the markets higher.

See you at the open.

Retirement Watch: Time Running out for 2004 Roth IRA

2005-04-05T00:59:00.000-04:00

For most Americans the Roth IRA is the best savings tool for retirement, and the most flexible tool for inheritance and early withdrawal issues.

So naturally, the Roth IRA comes with certain government-imposed limitations on adjusted gross income, dollar amounts, and time.

Adjusted Gross Income...

Before discussing the benefits of the Roth and how much you can put in each year, lets see if you qualify in the first place. If you file a single return, you may only invest the maximum amount in a Roth IRA if you have an AGI (adjusted gross income) of less than $95,000. From $95,000 to $110,000, the amount you can invest in a Roth IRA is gradually reduced to $0 (click here for the exact amount). For married couples filing jointly, you can invest the maximum if your AGI is less than $150,000, with the amount you can invest gradually reduced to $0 when your AGI hits $160,000.

Persons with incomes this high, whom socialists call "the rich," must look elsewhere for their retirement savings. They can often invest in a traditional IRA or a 401(k) plan, which I will discuss in a subsequent post.

How much...

Assuming you meet the income limitations (earn less than $95,000 if single or $150,000 if Married filing jointly), you may invest the maximum amount of $3,000 for 2004, and $4,000 in 2005.

For investors age 50 or older, you may invest up to $3,500 in 2004, and $4,500 in 2005.

Time...

Basically, if you don't use it each year, you lose it. For Example, you have until April 15th of this year (10 days) to contribute towards your 2004 Roth IRA, up to $3,000 (or $3,500 if you are 50 or older).

You have until April 15th of 2006 to contribute toward your 2005 Roth IRA, up to $4,000 (or $4,500 if you are age 50 or older).

If you do not invest in your 2004 Roth IRA by this April 15th, you will lose the chance to contribute that $3,000. You may not, in the following year, invest $7,000, for example. You are limited to that particular amount for each year, and if you do not make the deadline, you lose it forever.

Benefits of the Roth: Deferral, Tax-Free Withdrawal, Early Withdrawal...

Unlike 401(k) plans and the traditional IRA, the roth IRA is invested with after-tax dollars. That is, if you have an income of $50,000 in 2005, and contribute the maximum $4,000 to your 2005 roth IRA, you will receive no tax deduction for this contribution. You must invest with funds left over after taxes and expenses.

Like any retirement vehicle (401(k), traditional IRA, etc.), the roth IRA growth each year tax-free. Say you invest your $4,000 in a 5-year CD at 5%, with first year interest income of $200. If this $4,000 was not in an IRA, the $200 would be added to your taxable income for that year. But in a Roth IRA, not only is that $200 not taxable in that year, it is tax-deferred forever. That is, you never pay tax on your roth's appreciation, even when you make a withdrawal.

This last part is what separates the roth from the other retirement vehicles which are taxable on withdrawal because you received an up-front deduction. Since much of what you withdraw is likely going to be appreciation, the roth ira has the clear advantage. That is, the up-front deduction is not worth as much as the tax-free withdrawal later on.

Early Withdrawal...

The roth also gives you the unique opportunity to withdraw your principal contributions (what you put in, not the income on what you put in) at any time without a penalty. While I don't recommended taking early withdrawals, this is yet another reason to contribute as much as possible to your roth. If you ever need the money, you can take out what you put in without being penalized.

Additionally, interest and principal can be withdrawn (up to $10,000) when used to purchase your first home.

No minimum distribution requirement...

An added benefit of the roth IRA for estate planning is that there is no required minimum distribution at age 70 1/2 (that the traditional IRA and 401(k) plans require). If you have enough money to live on outside your roth IRA, you need not ever make a distribution from your roth IRA and you can leave the roth to your heirs. I'll discuss the benefits of inheriting a roth IRA vs. a traditional IRA further in an upcoming post.

Conclusion: If you're lucky enough to meet the roth IRA income requirements, get out there and start investing. You have 10 more days to put money towards your 2004 roth IRA. Remember, putting just $3,000 in a roth each year for 40 years, starting at age 25 ($120,000 total contributions) will leave you with $1,327,777 at age 65 assuming a 10% annual return. The $1,207,777 of income you made on your $120,000 investment is completely tax-free.

In the next financial planning segment, I will compare roth IRA outcomes assuming various levels of annual appreciation and ages of initial contributions.

Jobs, Jobs, Jobs

2005-04-01T01:35:00.000-05:00

You have to love the myriad of possible reactions to the monthly jobs report later this morning. Ok, maybe you don't have to love it, but I certainly do.

To the average American, the more jobs the better. After all, the economic recovery has been anemic at best, and disastrous at worst. We're barely adding enough jobs to keep pace with population and illegal immigration growth, and the jobs we are adding are not the high paying manufacturing or IT jobs that we've been losing for years.

That said, I have to back up my pessimistic view with an expectation that the number will be below the 225,000 that the street is expecting.

But as for the market's reaction, that is the trickiest thing of all, much more difficult than predicting the number itself.

Remember the twin market fears of late: Crude and Rates. Crude saw a nice rally yesterday (to $55.82) on a report from Goldman saying prices could hit a ridiculous $105/barrel. Already up 28.42% on the year, a sustained rise into the 60's or 70's would likely prevent any market rally for 2005.

The markets did manage to maintain much of their gains from Wednesday, as higher crude prices were balanced out by rising treasuries and lower interest rates. The 10-year finished at 4.49%, down from a high of 4.69% hit on 3/23/05.

But back to the jobs report, and the markets reaction.

A stronger than expected number, which is ultimately good for the U.S. economy, will likely be interpreted by the street as too strong, thus indicating that the fed has cause to raise rates more quickly than 25 basis points, which will be bad for stocks in the short-term.

A weaker than expected number, which is ultimately bad for the U.S. economy, will likely be interpreted by the street as just what the doctor ordered, and that the fed can continue with its 25 basis points as the street is expecting. This will be good for stocks in the short-term.

The third possible scenario is an extreme number on either side (+- 100,000), which in my opinion will both be bad news for stocks.

Remember, these are only reactions in the short-run. In the long-run the U.S. economy and GDP cannot continue to experience strong growth in the absence of stronger job and wage growth.

See you at the open...

Market Recap: Call It A Comeback!

2005-03-30T23:44:00.000-05:00

The S&P 500 not only held its ground at 1163, but rallied 1.38% to 1181, in its best one-day gain in months. The Nasdaq was even more impressive, advancing 31.79 (or 1.61%) and crossing 2000 once again with a close at 2005.67. Many beaten down sectors led the way, including: Internet (up 3.41%), Networking (up 2.61%), and Semis (up 2.53%).

The driving force behind the rally? GDP or Crude, depending on who you ask. GDP came in where I expected (below consensus), at 3.8%, which was just what the street was looking for. Not too strong, not too week. A fine balance for the bulls out there who were looking for any reason to buy an oversold market.

As for crude, while it was down close to $2 early in the session, it closed down only $.28 to $53.95. Crude is still up 24% year to date.

The market is primarily concerned with crude and inflation these days. Any meaningful downward movement in crude, or indication that inflation is under control, and we could see a nice rally.

Meanwhile, we'll see if we can hold today's gains going into the jobs report on friday. While I'm not expecting a strong number, I'm not sure yet how the market will react to a weak number. See you at the open...

Are You Earning at least 3.0% on Your Money?

2005-03-30T16:14:00.000-05:00

If the answer to this question is no, you're losing free money. As short-term rates have been rising over the past two years, we're finally starting to see some decent yields in the money market arena.

Keep enough money in your checking account to pay the monthly bills, and put the rest in a money market account, where you can easily earn 3% per year, even with very little money to invest. Emigrant Direct offers a 3.25% money market account with no fees or account minimums. You can link the account directly to your checking account so that you can add money to your checking account online whenever need be. If you don't know how to use the internet, well, I guess you couldn't be reading this, could you.

For an updated search of the best money market/CD rates in the nation, bankrate.com is an excellent resource. As the fed is expected to continue raising rates, money market yields should continue to rise throughout the year, and those who continue to shop for the highest rates will be rewarded.

If you have the following amounts sitting in your checking accounts earning 0% interest, this is how much your losing per year by not putting it in an FDIC insured money market account at 3.25%:

$5,000: $162.50
$10,000: $325
$50,000: $1,625
$100,000: $3,250

Remember, idle money is lost money. If you choose not to invest in stocks (because of a short time horizon or fear of volatility), at least earn the highest yield you possibly can.

Opening Bell: GDP Focus...

2005-03-30T08:10:00.000-05:00

Again, today's 8:30am Q4 final GDP release (consensus of 4.0%) will likely provide either support for the S&P or the strength the bears need to break through January support at 1163.

What am I expecting? I think higher crude is having a greater impact on the economy than the consensus forecasts, and that GDP will come in below 4.0%. However, I think this will be interpreted positively if it comes in the range of 3.7-3.9%.

Why? This is still solid growth, but not too robust. Strange, you say: isn't the higher the growth the better? Not necessarily. The markets generally prefer steady, solid growth that will not cause the fed to change its "measured increases" stance.

That is, the stock market wants a weaker than expected number because it will drive treasuries up, and interest rates down. Since rising interest rates have been a major concern of the markets of late, any lower move in interest rates would be welcoming news.

Now, enough of the prognosticating. Let's see what happens....

Market Recap: Will the S&P Hold The Line?

2005-03-29T19:43:00.000-05:00

We are approaching a critical point for the S&P 500, as it closed today at 1165.36, near the January 24th low of 1163.75, and down 3.2% for the year. A close below this level will put the bears back in control, with the next solid level of support at 1100.

The bulls are looking for a bounce off 1163.75 on high volume, forming a classic double bottom. Perhaps a solid GDP report tomorrow morning will be the impetus for that rise. Ultimately, the street's reaction to Friday's all-important jobs report will determine whether we finish the week in the red or the black.

What is becoming increasingly clear is the total lack of leadership by the S&P's most represented groups, the financials (20.2% of the index) and technology (15.3%). The financials (xlf) are down 7.2% on the year while technology is off 8.86% (xlk). Rising interest rates are not helping the prospects of either of these groups.

The market cannot advance on energy alone (xle), which is highly susceptible to a mean reversion in crude prices, and still only makes up 8.8% of the S&P 500. But the more intriguing question is whether the market can advance in spite of high crude prices, as it did in 2004. We'll get a clue as to how much rising crude is effecting the economy in the GDP report tomorrow. Goodnight.

Housing: "Everyone is Doing It"

2005-03-29T13:00:00.000-05:00

Desperation is the pin that pops all bubbles. The last stage of the housing bubble is upon us, with hordes of Johnny-come-lately gamblers entering the arena with dreams of extrapolating past returns into the future. With no money in their pockets they bid higher an already overpriced asset, in dreams of selling to the greater fool. You see, they cannot stand to hear one more story of real estate fortunes being made overnight; they have been missing out on "easy money" for years, investing through that always tempting rearview mirror. But no longer...

"It just seems like everyone is doing it," Laurie Romano, a 26-year-old self-described real estate investor, says with a giggle in this New York Times piece.

A funny concept, indeed. Everyone is doing it. But where, then, will the new demand arise. If everyone who has decent credit has already bought a home, where will those new suckers come from to buy your home at an even higher price?

In the internet era, new demand came from credit, or margin (borrowing money to purchase stock) buying. After 5 straight years of 20%+ returns in the S&P 500, it was an easy concept to borrow from your broker or take out a home equity loan at 7% and make a nice risk-free return. We all know how that one ended. The game only works as long as appreciation outpaces your interest payments.

The housing bubble is no different. In this final stage, with declining demand for houses that people will actually live in, people are buying homes for investment purposes, with no intention of renting their investment for a profit. How are they doing it? With credit. No money down purchases abound, making up a staggering 42% of new home purchases. 69% are buying with 10% down or less. Interest-only and adjustable-rate loans are on the rise.

They are buying on the expectation of appreciation alone, while their rationale for appreciation is not based on fundamentals but on hype. If that appreciation doesn't outpace the interest on their loan, they are doomed.

Perhaps we live in a new era, though, as real estate brokers and wishful investors are proclaiming. In this era, houses can continue to rise at an annual clip of 20% forever. I received a flier in the mail recently from a real estate broker with the following slogan: "real estate in Manhattan only goes in one direction.....up."

Ah, if only we could ignore history. Perhaps this broker was too young to remember 1988-1995, when Manhattan prices actually declined over 10%.

But it's different this time, you say. Yeah, it's different alright. This time it will be a lot more than 10%.

Indexing: The Best Way for the Average Investor to Get Started

2005-03-29T01:00:00.000-05:00

So you're ready to invest for the first time, or ready to invest successfully for the first time after years of failed investments based on tips and fads. You don't know much about the markets, and don't care to know much more. You are comfortable with your portfolio fluctuating in value (see post) year to year, and you have a sufficiently long time horizon (at least 10 years) to wait out the natural ups and downs in the market (see post). You would be happy to earn the market's long-term average return of 10% since 1900, and don't want to spend additional time or energy endeavoring to outperform the market.

How should this type of investor, which represents most of the American public, invest in stocks? The irrefutable answer is to buy an index mutual fund or ETF. Instead of holding a single stock or a group of 5-10 stocks, these funds hold all of the stocks in a particular index. For example, the S&P 500 is an index that represents the performance of the 500 largest companies (weighted by market cap) in the United States, which accounts for over 80% of the value of all U.S. companies. Most in the financial industry consider the S&P 500 the best indicator of the performance of the market as a whole.

By holding all 500 stocks, you effectively eliminate company-specific (diversifiable, unsystematic) risk and maximize your risk-adjusted return. Practically speaking, if one of the companies in the index (such as Enron) goes bankrupt, it will have little effect on the total return of the index as a whole. This is the primary benefit of diversification: the elimination of company-specific risk.

In any given year, some stocks in the index will be up 50-60%, others will be down 20-30%, and your overall return will approximate 10% over the long haul. Why not just invest in those companies that go up 50-60%, you ask? Surely this would be much more profitable than just accepting the average of the 500 and taking your 10%.

Well, many studies have been performed that show that professional money managers have an extremely difficult time picking these winners, and in fact 80% fail to beat the S&P's return of 10% over a 10-year period. These are people that labor 80-100 hours a week analyzing companies in efforts to beat the S&P 500, and 80% of them fail. The small % that do manage to beat the S&P 500 over a 10 year period often underperform the index in the following 10 year period.

So the answer is simple as to why you want to invest in a fund that buys all 500 stocks, instead of just the ones that you believe will go up the most: it is extremely difficult to pick individual stocks over the long haul to beat the S&P 500's return of 10%, mainly because the increased company-specific risk will eventually catch up to you.

If you cannot read a balance sheet, income statement, or statement of cash flows backwards and forwards (or do not even know what these terms mean), do not attempt to pick individual stocks as investments. Afterall, what basis, then, do you have for thinking that your stock pick in particular will outperform the market as a whole. A hot tip from a friend? A crowded company store? A recommendation from an analyst or stock market guru? The fact that the stock has done well in the past? None of these are legitimate rationales for outperformance, and all are ways to ensure underperformance.

And so, if you accept the fact that you will not be the next great stock picker, and never buy an individual stock, you have already learned the most important lesson of long-term investing. By following this strategy, you will outperform over 80% of mutual fund mangers who charge their clients hefty fees to underperform the market. Congratulations.

But we still must find a way to buy the S&P 500, since you cannot buy an index. Here, we can either invest in a mutual fund or an Exchange Traded Fund (ETF). I recommend investing in mutual funds for your retirement accounts (401(k), IRA) and accounts to which you are adding small amounts to each month, and ETFs for your non-retirement accounts where you are starting with a large lump sum.

A mutual fund is an investment vehicle that allows a group of investors to pool their money together to buy stocks or bonds. A fund manager and team of analysts will choose the stocks or bonds in the fund, and buy shares from that pooled money. So, in the case of an S&P 500 index fund, instead of you having to buy shares of each and every one of the 500 companies in the index, you simply buy shares of the mutual fund, which in turn buys the 500 stocks for everyone who invests in the fund.

What's most attractive about an index mutual fund is also what allows it to consistently beat actively managed funds: the low fees. Since the fund manager simply buys the 500 stocks in the index, there is very little trading activity (turnover) and need for analysis that hike up the fees of actively managed funds to 1.5% on average. My two favorite low-cost S&P 500 funds are Fidelity's Spartan 500 Index Fund (symbol: FSMKX) with a .1% annual expense ratio, and Vanguard's 500 Index Fund Investor Shares (symbol: VFINX) with a .18% annual expense ratio. You can't go wrong with either of these funds, and you can start investing in them directly at their websites (do not use a broker!).

An alternative way to invest in an index is through ETFs, or exchange traded funds, which unlike mutual funds trade like individual stocks. They give you the flexibility to buy (or sell short) shares any time of day (as opposed to once a day for mutual funds) and provide for tax-efficiency and simpler cost-basis calculations (you aren't hit with capital gains before you sell, and the dividends are not reinvested).

The most popular S&P 500 index ETF is known as the spiders (symbol: SPY), with an expense ratio of .11%. By purchasing a single share of SPY, you are effectively purchasing all 500 stocks in the S&P 500. Another alternative is ishares S&P 500 Index (symbol: IVV), with an expense ratio of .09%.

You are now armed with the most effective tool of investing: instant diversification. While you won't be the most exciting guy at the cocktail party, bragging about make a killing in the latest can't-lose individual stock (google or taser or qualcomm), you will have comfort in knowing that you are an investor, not a gambler, whose performance will over time destroy those Johnny-come-lately gamblers whose one bad pick will bankrupt them.

You'll take your 10% because you know that if you simply put away $3,000 a year for 40 years in your index fund or ETF, you will have $1,327,777.67 after 40 years. Johnny-come-lately will be lucky to have the shirt on his back.

Market Recap

2005-03-28T20:07:00.000-05:00

Stocks edged higher on light volume due mostly to a decrease in oil prices by $.79 to $54.05 per barrel. If you've been to the pump lately any news of lower prices is welcoming, and the major indices equally welcome any decline in crude prices.

Top stories of the day include:

Another downgrade for the falling knife that is GM, this time by UBS, sending GM down 3.2% to $28.37. UBS cut its price target from $37/share to $20/share. That should tell you all you need to know about the meaningfulness of price targets.
The dollar's continued surprising strength on the year, extending year-to-date gains to 5.48% against the Euro, 3.98% against the Yen, and 2.12% against the pound.
Fears of a second Tsunami after an 8.7 earthquake hit near Indonesia. In typical fashion, wall street immediately looked for ways to profit on this news, sending shares of earthquake-related companies flying. Taylor Devices (TAYD) gained 44.7%, Benthos (BTHS) gained 6.9%, and Sutron (STRN) gained 8.0%.

Economic Data Watch: Week of 3/28/05

2005-03-28T00:38:00.000-05:00

I hope you all had a Happy Easter and are well-rested for the exciting week ahead. On wall street, each week presents a new opportunity to learn from the markets and to have a clean slate to start anew towards investing/speculating success.

Of daily interest to wall street and the speculator is economic data. While over the long haul stocks should rise at the same pace as underlying earnings, the pendulum swings in the short term are often dictated by certain economic data releases which reflect the strength/weakness of the U.S. economy.

This week, I'll be paying particular attention to the following releases with wall-street consensus estimates in parentheses:

Wednesday, March 30th (8:30am): Q4 Final GDP Numbers (4.0%), GDP Deflator (2.1%)
Thursday, March 31st (8:30am): Personal Income Monthly Change (.4%), Consumer Spending Monthly Change (.5%)
Friday, April 1st (8:30am): Nonfarm Payrolls (225,000), Unemployment Rate (5.3%), Average Hourly Earnings (.2%)

I'll talk more about the significance of each release in the coming week.

Better Things Come to Those Who Wait

2005-03-27T01:00:00.000-05:00

Your typical wall street boiler room broker will promise you the world in a day. While this is a profitable strategy for a broker to generate hefty commissions, as an investor, this is a perilous expectation that will lead you to financial ruin. And while your initial investment will more often than not be higher one day or one year later, there is also a good chance that it will be lower.

Therefore, my personal rule of thumb for investing is that you should not invest a single dollar that you expect to need/use within the following ten years. Why? Because over a ten-year period the market smoothes out those yearly ups and downs to more closely resemble its long-term return of close to 10% from 1900-2004. That is, you have a much better probability of making money over a ten year period than you do over a one year period.

Indeed, from 1900-2004, there was only one ten-year period where you would have ended up with less money than you started with, from 1929-38 (after black Monday I and the ensuing great depression). And during this period, the market declined only .65% per year, bringing a $10,000 initial investment in 1929 to $9,368 in 1938.

Conversely, money invested over a shorter five-year period of time produced twelve 5-year periods of negative returns, with the worst 5-year return declining 11.72% per year (from 1928-32).

Investing on a yearly basis, that is investing with money you will need in a single year, is tantamount to rolling a crooked die, with the odds tilted in your favor. Since 1900, the S&P 500 (including dividends) has had 30 down years and 75 up years. Therefore, in one-year periods, you would come out ahead 71.4% of the time and lose money 28.6% of the time.

If you are comfortable with these odds, by all means take a gamble. But this is not investing; it is gambling. Investing requires greater odds in your favor and to achieve these greater odds you need a longer time horizon than one year. The longer the time horizon, the better the odds in your favor. A simple comparison shows this to be true. Compared to the one-year 71.4% chance of a positive return (and 28.6% chance of negative return), examine the results for 5-year, 10-year, 20-year and 40-year periods from 1900-2004:

5-year periods: 89.2% positive returns; 10.8% negative returns
10-year periods: 99.0% positive returns; 1.0% negative returns
20-year periods: 100% positive returns; 0% negative returns
40-year periods: 100% positive returns; 0% negative returns

Thus, the risk of negative return substantially diminishes as your time horizon lengthens, as evidenced by the fact that there are no 20 or 40 year periods with negative returns; from 1900-2004, if you invested for at least 20 years, you have always made money.

As can be expected, not only does your risk of loss diminish, but also the volatility or standard deviation (a measure of dispersion from the mean) of your returns. Examine the following standard deviations and best and worst per-year returns for lengthening time horizons:

1-year: 18.36% STDEV, 52.6% best return per yr (in 1933), -41.42% worst year (in 1931)
5-year: 8.11% STDEV, 28.8% best return per yr (1924-28), -11.72% worst per year return (1928-32)
10-year: 5.09% STDEV, 19.09% best return per yr (1949-58), -.65% worst per year return (1929-38)
20-year: 3.41% STDEV, 17.4% best return per yr (1980-99); 2.98% worst per year return (1929-48)
40-year: 1.64% STDEV, 11.99% best return per yr (1950-89); 5.67% worst per year return (1902-41)

Are you noticing a pattern here? The longer your investment time horizon, the lower the standard deviation, the lower the range of values between best and worst year returns, and the greater the probability of having a positive overall return. In fact, the very worst 20 and 40 year annual returns (both of which occurred during the great depression) are still positive, at 2.98% and 5.67% respectively.

What does all of this mean for the average investor? Well, the longer you have to invest, the more you can be assured to have a positive return at the end of the rainbow. Again, I recommend a minimum of 10 years to ensure a positive, successful investment.

10 years!!! But I want to be rich tomorrow, you say, just like the investing infomercials promise. Well, patience is the most important trait of a successful investor. Only invest with money that you don't need to live on, and will not touch for at least 10 years, and you shall be rewarded handsomely. Break this rule and you will more often than not repeat the failures of investors of years past.

What type of investments meet this long-term criteria? First and foremost, savings for retirement. If you start putting money away in your 401(k) or IRA when you're 22 and assume a retirement age of 65, you have 43 years before your first withdrawal. This time horizon is long enough to give you over a 99% probability of a sizeable positive return.

Second, saving for your children's college education, which is no small cost these days. If an investment is initiated when your child is born, this leaves you with 18 years before the first withdrawal, plenty of time to ensure over a 99% probability of a positive return.

Conclusion: (1) Do not invest with money that you need to live on or will need to withdraw within 10 years. Put this money in a risk-free money-market account or CD. (2) Never invest a dollar without the expectation of keeping that investment for a minimum of ten years, through good times and bad times. (3) Once you have initiated an investment, never add to or sell that investment based on daily/yearly fluctuations in the market.

*This post assumes that you are investing in a vehicle that mimics the S&P 500, or "the market," the most common benchmark on the street. In the next segment, I will examine the various opinions on what the true "market portfolio" is and how you can invest in the consensus "market portfolio" through mutual funds and ETFs.

Risk: Can You Handle It?

2005-03-26T01:10:00.000-05:00

Before you attempt to beat the market through speculation or asset class diversification, it is vitally important to know your emotional reaction towards money and losing it. Investing and trading success is often predicated on developing a strategy that matches your tolerance for risk.

If you cannot handle the emotional highs and lows that are natural in the financial markets, investing is not for you. You are far better off reinvesting your money in 5-year CDs and government bonds, which produce a constant, predictable, reliable yield, insured by the federal government. You have to be able to sleep at night with your investments. If you cannot, you will eventually make rash decisions and significantly underperform both the market and a risk-free investment (CD).

But understand, while you're sleeping peacefully, the trade-off of a constant 4.75% is long-term return, or a larger pot of gold at the end of the rainbow. For example, the highest 5-year CD is currently around 4.75%, still near historical lows. $100,000 invested in this CD will produce $4,750 in interest income the first year, $4,975 the second year, and so on. At the end of the five year period, your $100,000 will be worth $126,115 with compound interest (excluding taxes).

Compare this with an investment in an S&P 500 index fund. Here, your returns are not constant, not insured, and utterly unpredictable. On average, the S&P 500 has returned 10.43% annually in 5-year periods since 1928. But this return is certainly not 10.43% each year for 5 years. It is far more likely for the return to look as follows: -10% in yr 1, -5% in yr 2, +35% in year 3, +25% in year 4, etc. While your overall return averages out to 10.43% per year, your equity will swing up and down like a pendulum: $90,000 after yr 1, $85,500 after yr 2, $115,425 after yr 3, $144,281 after yr 4, etc.

This is where psychology and emotions come into play. If you can't handle these swings, you will inevitably succumb to the twin pitfalls of investing: fear and greed. It is human nature to want to sell stocks at the lowest point (fear) and buy stocks at the highest point (greed). But successful investing often requires just the opposite.

The end result of being able to stomach the market's inherent volatility is a substantial reward. That $100,000 initial investment in the S&P 500 over 5 years will on average leave you with $164,223 (excluding tax) at the end of year 5, or $38,108 higher than if you had invested in the 5-year CD.

Thus you have learned one of the most important, but overlooked lessons of risk and return. That is, do not expect higher returns without greater risk, in this case (1) the volatility of your return (not a constant 10.5% return), and (2) the risk that you may in fact end up with less than $100,000 after 5 years.

Given the market's inherent volatility, in the next segment we will examine how long your time-frame should be in order to commit an initial investment: 1 yr, 5 yrs, 10 yrs or 40 yrs.

Welcome!

2005-03-25T17:00:00.000-05:00

Welcome all to market outperform, a website dedicated to doing just that: outperforming the market.

As everyday students of the markets, we are forever challenged and our education never-ending. While the wealth of knowledge we gain is satisfying in itself, those bold among us inevitably seek more. We know conventional academic wisdom recommends simply indexing the market and sitting on ones hands for eternity.

This is certainly the best strategy for those who cannot differentiate between a stock and a bond or who have trouble balancing a checkbook. And indeed it seems to be the best strategy for most of the mutual fund industry, as over 80% fail to beat their benchmark index over a ten year period. Over a thirty-year period, you can count those "market-outperformers" on one hand.

And for good reason. Trying to time a market that has an upwardly biased trend over the long-haul will inevitably lead to missing out on significant upswings that account for a large portion of performance. This, coupled with management and transaction fees, puts a large, actively managed, long-only mutual fund at an immediate disadvantage.

And why not simply seek to mirror market returns? This question must be persistently asked by investors and traders alike. Afterall, the long-haul performance of the S&P 500 has been nothing short of spectacular, gaining over 11% per annum.

And yet, we seek more. Greedy? Perhaps. But it is much more than greed that compels us.

They say it can't be done. They say it is foolish to try. And for that reason alone, we must try. We must put our own money to the test. That is the only way to know for sure.

Perhaps the Warren Buffett's and Bill Miller's of the world are just "lucky," as Burton Malkiel would likely claim. But we think otherwise. We know the great ones have more than luck on their side. They have studied the markets as closely as a cardiologist has studied the heart. They have the discipline and tenacity of a prizefighter. They remain forever humbled by the market, and learned invaluable lessons from the greatest teacher of all: ones past mistakes and misfortunes that cost them money. But above all else, they have a love and passion for the mystery of the markets.

If you don't have that passion, the market will eventually beat you. It might beat you anyway, but you haven't got a chance without it.

In the next few posts we will attempt to answer some fundamental questions in the market-beating debate. Should I be an investor, a speculator, or both? What is "the market?" How is performance measured and over what time frame? And how should we account for risk and luck in our performance metrics?

These questions and many more must be explored in our search for the holy grail of investing: outperformance.