No I was not kidnapped, nor ill, or went on an extended vacation.   However, I am back an dlook forward to sharing my musings with you on the market.  The odd thing that even with being out of pocket for so long, not much has changed.  Europe is still a mess, the US economy is still struggling and the markets are as skittish as ever.

Craig

Job’s personality was as bold as his company’s inventions.  While others saw computers as complicated machines, Apple turned them into simple devices.  No manuals were needed, just a simple intuitive process.  In short, they made the complicated simple. 

Steve Job’s passed away this week from cancer and while his loss in still fresh in our memories, his impact on the world will live on for a long time.  His ideology: make the complicated simple…make boring, cool…create an entire market where computers are used not only for productivity (as everyone in the 70s  thought), but also for fun.  Simply genius!  Steve will be missed.  Some say he lacked the number of patents to be considered a brilliant inventor, but in my mind he ranks right up there with America’s other greater inventor, Thomas Edison. 

While the passing of Jobs caused Apple shares to decline, the markets ended the week higher as ADP released their latest National Employment Report indicating that private employers added 91,000 jobs in September, which was above economists’ estimates.  (Those poor economists, when will they get it right?)  This reassuring news was proof enough to the markets that the economy still has a heartbeat and perhaps a double dip recession may not yet be as inevitable as some have lately claimed. 

As the U.S. economy is sputtering along, things in Europe took a decisively (and somewhat expectedly) negative turn this week.  On Friday, Fitch rating agency downgraded the sovereign debt credit rating to A+ for both Italy and Spain.   The company also said that the outlook on Rome’s long-term rating is negative.  None of this should be a surprise to investors as the European debt crisis has become one of the year’s most prominent themes and thus the reason why the downgrade had little impact on U.S. markets.  

With earnings season in full bloom (the period where companies report their quarterly, or yearly earnings), next week will be of interest and could (may?) provide the perfect insight for investors.  With the markets having so much volatility, one could anticipate that any unexpected report could move the markets. 

 While these current events have captivated markets, the underlying theme is as old as Athens itself: debt is much like marriage – easy to get in to and often painful to get out of.  History is full of periods where debtors and debtees have struggled over repayment.  I would encourage anyone to read The Lords of Finance by Liaquat Ahamed, to gain an appreciation for how indebted nations can impact the world and, more importantly, the tension that arises between nations struggling to repay their debt with those wanting to be repaid.  

 Unfortunately, if there is a book to be written about this current era, it will be about a generation that places such little value on history that it seems doomed to repeat it.  As the United States and many European nations lived beyond their means by leveraging the future in the 90′s and 00’s, the day of reckoning has come and no one wants to foot the bill.  As Americans spent, the Chinese lent.  And so the debate in Washington is less about whether or not to repay the debt, but instead, who is going to carry the load.  Of course the Hail Mary has been that perhaps the U.S. economy could grow its way out of debt, which is ultimately why the government’s hopes have been pinned so much on helping the economy grow.  As incomes increase, so do taxes.   Unfortunately, this has not worked out and worse still, these hopes were built upon an economic foundation that cutting taxes without instituting equally offsetting budgets cuts would somehow result in sufficient growth to repay the debt. In the end,  the growth did not occur and now the concern is how to reduce debt in a slower growing economy. 

 It should be no surprise that an economy can grow by cutting taxes with no offsetting reduction in services, programs, etc.  Who hasn’t at one time felt rich when using their credit card, only to realize that the next month they are worse off – as the bill comes due and they have to pay for the previous month(s) purchases in addition to interest on those purchases.  As long as the credit flows, a person can carry on with this charade for a long time; however, once the easy money spigot is turned off, the equation is reversed and instead of spending more than is earned, he/she is now forced to consume less than is earned as a portion of what the were previoulsy spending goew do debt reduction.   And so it is that when spending was easy, everyone was happy, but now that the bill is due, the fight has become about who should do with less. 

All of this is the other side of debt.  It is a familiar tale, but to be honest, seldom taught.  Why?  Because if it were, consumers would be wiser and less apt to buy things they really don’t need or simply can’t afford.  And so, for the past 20+ years the U.S. economy has been based on ways to encourage consumer spending through easy credit, less taxes, and a promoting the idea that “for everything else, there is MasterCard®.”

As sobbering as this phase of borrowing may be (where the debtor now repays the debtee) it is woth noting that the economy is still moving long along.  Consumption may be restrained, yet, this just  means that consumers will simply be more careful about what they buy and where and how they buy it.  While the economy is slogging along, the fact is that not every business is on the ropes.  With companies about to report earnings over the next few weeks, investors will get a good look at just how well they are doing in this economy.  While this period seems new to many investors, it is as old a history itself  – as is the recovery, which will occur after a generation of Americans is reminded why studying history is not simply for good cocktail conversations – but provides the wisdom of the past to those who live in the present

For several months, the markets have been in a tug-of-war over whether the European debt issues would affect international markets and pending that news, the markets would react accordingly with volatile days of ups and downs.  However, with the recent increase in the value of the dollar, it appears that despite all of Uncle Sam’s troubles, investors preferred to hold dollars over other currencies this week.  Yet in an odd turn, the Chinese Yuan, long viewed as undervalued, declined against the dollar this week.

The reaction in the markets started on Wednesday and continued into Thursday as the Federal Reserve began to implement Operation Twist in an effort to revive a stalled economy.  The essence of the program is a version of the Federal Reserve’s previous two stimulus programs called “Quantitative Easing,” but without expanding the balance sheet of the Fed.  The current plan calls for the Fed to sell $400 billion of shorter duration assets and replace them with an equal amount of longer maturity treasuries over the next nine months.  In so doing, long-term interest rates are expected to decline and thus make long- term borrowing more attractive.   However, with the lack of success of the Fed’s past two programs (Quantitative Easing I & II)  in getting the economy back on its’ feet, some are wondering if this latest effort will yield similar results.

The selloff in investments was broad.  Not only did equities fall, but gold (often thought of as a safe alternative in some investor’s minds) saw a decline, as did oil.  Other investments that fell were corporate bonds and copper.  Such broad selling was taken as a sign that investors were simply unloading any investments they felt would be risky, or were trying to cover their losses.  To add to this, hedge funds have been taking short positions (selling stocks they do not own) on the belief that the markets are heading down.  (When one sells short, they sell a stock they do not own and purchase it at a later date in the hopes of buying it a lower price and thus making a profit.)  Shorting the market can push it down and likewise, those who do short the market can cause a sudden rebound (called a “short squeeze”) if they suddenly feel their short positions were poorly placed.  This means that those who short the market need to purchase shares to cover themselves; this often occurs  when there is an unexpected piece of good news to counter the shorts’ negative position.

Adding to investor’s fears was new data indicating that Chinese manufacturing is declining.  China has long been viewed as the growth engine for the world’s economy, so a slowdown in manufacturing certainly could have ripple effects in those nations that rely on Chinese trade.

Finally, it appears that the U.S. Congress is in another budget dispute.  As mentioned in The QR, investors have not been supportive of Washington’s recent game of chicken.  This is certainly not helping investors feel optimistic about the future.  As the Presidential race heats up, it is apparent that the markets are not favoring the most recent actions (or inactions depending on how you look at it) of Congress.  Echoing a previous post of The QR, Peggy Noonan noted in Saturday’s Wall Street Journal (WSJ) that unless the Republicans alter their tactics, they could end up losing the 2012 race.  In her words, “As I said, Mr. Obama can’t win this election, but the Republicans can lose it by being small, by being extreme, by being—are we going to have to start using this word again?—unnuanced.”  It will be interesting to see if the GOP will get this and accept that while their base is cheering the rhetoric, Wall Street isn’t.  Considering the WSJ is the voice of conservative, pro-business, free-market philosophy and pulls no punches with President Obama, one can only wonder if the party will take this advice or continue on its current path.

Taken together, the news from Week 38 left very little for investors to cheer about resulting in the week being one where the conviction was markedly sour.  However, make no mistake, the markets have been volatile and as we have noted numerous times, a bad Week 38 can easily be erased.  With such a steep weekly decline, it would not take much to get this week’s selling reversed.  The news would not need to be terribly exciting, but more on the line of, Uncle Sam still has a heart beat!  Which by the way, he does.

This week’s current event was that the world’s banks rushed to the rescue of European banks in need of U.S. dollars and provided loans  thereby averting – at least for now – a potential liquidity crisis.  It may seem odd that European banks might be in need of U.S. dollars to avert such a crisis; however, many European banks make their money by lending abroad and those loans tend to be issued in dollars.  Before the concerns of debt issues in of the governments in Portugal, Greece, and Italy (to name a few), these banks would simply have obtained dollars by selling short- term loans to the U.S. money market funds.  But as concerns of European nations’ defaulting has grown the money market managers have pulled back on buying these bonds – leaving European banks without a source of dollars. 

To stem the potential lack of liquidity, the Federal Reserve agreed to extend loans to the European Central Bank as well as other European banks.  The move was orchestrated along in conjunction with the central banks of Britain, Switzerland and Japan:  the action relieved nervous investors who feared that if the crisis continued, it would result in the deterioration of European economies and negatively impact the profits of those who do business in Europe. 

The reaction of the markets seems to have overshadowed the foreboding news that the U.S. economy is continuing to slow down.  The latest report from the Department of Labor on unemployment noted that a total of 428,000 people joined the jobless rolls, which is 11,000 more than the previous week and above the 400,000 level that economists believe is necessary for the nation’s 9.1% unemployment rate to decline. 

As the outlook on the economy has darkened, those sectors in the market most affected by a potential downturn have taken it on the chin:  material stocks are down 10.6% YTD (year to date) and industrials have fallen 9.2% YTD, while the non-cyclical utility stocks have shown an almost 8% gain for the year.  One need only to look at the financial sector to realize how the European crisis, the depressed U.S. housing market, and our slowing economy have impacted them:  the sector is down 21% YTD. 

With such uncertainty about the future in the market, it is no surprise that the Volatility Index (VIX) has recently shot up.  Increased volatility can mean that those investing in the market have greater uncertainty about the future direction of things.  This, too, has added to investors’ concerns as they continue to watch a see-sawing market, not sure what to deduce.  One would think that after a week of solid gains, investors would have some conviction as to the future direction of stocks, but as mentioned above, predicting the market is precarious.

 While international affairs and political ramblings can sway markets, what seems at the heart of the issue is a growing unease.   These feelings have been festering for several months and fanned for political purposes, the media’s desires and by anyone else that finds value in promoting such discontent.  As Brain Belski, Chief Investment Strategists at Oppenheimer, wrote, “investors are acting as if it is a foregone conclusion that the U.S. Economy is in a recession again, Europe is shut down, jobs will never come back and systematic risk is rampant”.  I agree; however, what Mr. Belski fails to point out is how such feelings hurt the market and more importantly, why investors feel this way.

 Mind you, how one feels and how one invests, should never be combined.  Investors should be intelligent, not emotional.  If one has a feeling, they should study it to see if it is accurate, not jump at any whim that passes them by. 

 What investors are feeling can be best summed up by what Procter and Gamble is doing.  According to the Wall Street Journal (9/12/11: A1), “many of the middle market shoppers are trading down to lower priced goods” as the divide between have and have not consumers grows.  For multiple generations, Americans have always traded up, but now they are trading down.  While the disparity between the wealthy and the poor has been growing since the 1970s, it has not been until 2000 that the median income of full time workers has stagnated.  Since the 1970’s the median family income adjusted for inflation has stayed relatively flat.   In short, the American dream is under pressure and this is affecting investor’s appetite for risk.  At the same time, companies appear to be doing much better than the average American anyway you look at it. 

 What is going on?  And, more importantly, what do we do about it?  Are we simply in a phase, or is this a turning point (up, or down)?  These are the questions running through American’s minds.  It is putting them on edge and the volatility in the markets reflects these feelings.   With each news release, the outlook changes.    

 But if an investor can calm his emotions, he will look beyond the digitized hype and hyperbole and invest on what he knows, not on what he feels.  Walmart’s success in the 80’s and 90’s came in helping American’s by offering Always Low Prices, not by offering  premium products.  As wages stagnated, they found a way to meet the demand by offering products for less.  Of course this was done by buying overseas:  in 2007 Walmart alone was responsible for $27 billion in imports from China as trade groups complained that U.S. jobs were shifting overseas.  What this illustrates was that Walmart correctly saw how the retail market was changing and adapted.  Americans were not simply trying to save money by shopping at Walmart.  They were trying to get more for less: I think that it is safe to say that few people actually took the money they saved by shopping at a Walmart and put it in an account.  No.  They simply bought more.

 So while there is great uncertainty as to where the economy is going, there are also opportunities.  We may not like the times we live in, but for the intelligent investor there are opportunities. 

 This week the Federal Reserve debated the best way to revive the economy: a clear sign that past actions have yet to create the results that those on the Bank’s Board desired.   The struggle on the Bank’s board of what is the best thing to do is also occurring on Wall Street.  The idea of a double-dip recession was pretty much discounted by those in the market; however, as further evidence of the economy slowing down surfaces this argument is gaining steam.  With the market flat for the week, it appears that neither argument has swayed the majority of investors.  Only time will tell who was right. 

 But just for fun, here is a sampling of  people that felt that there would be no double dip recession: President Obama, Paul Krugman, Ben Bernanke, and Warren Buffet.   It will be interesting to see if they are correct; however, as the front page of the September 2^nd issue of Barron’s illustrated, there is a real tug-of-war between bulls and bears to which way the market is heading.   With such a lack of conviction, one can could expect that the volatility could increase as any news story could sway the markets on way for the other. 

 It was an odd week.  Normally, such negative economic news would depress stock prices, but considering the selloff in last week’s markets, this week’s reaction may be seen as a market less enthusiastic about the future than feeling that maybe last week’s selling was overdone and that a new round of Federal Reserve funding will get the economy buzzing. 

 As the markets end the week on a positive note, there were a series of non-market related events that occurred.  An earthquake hit the North East U.S. on Tuesday causing little-to-no damage while Hurricane Irene came up the coast causing significant damage in North Carolina; however, much to the surprise of everyone, the most severe damage occured in Vermont as rainfall caused intense flooding.  

 Odd events prevailed this week.  Steve Jobs, the founder and creative genius behind Apple, stepped down due to his ongoing fight with pancreatic cancer.  Job’s legacy, perseverance and sheer tenacity sets him apart as one of the, if not the, greatest entrepreneur of this era.  His ability to turn a cold machine that runs on numbers into a simple, enticing device that was cool is unparalleled.  In a world of nerds, he stood alone.   After announcing his resignation, the company’s stock dropped 5%.  In the short run the company has a stable of fantastic products, but Jobs was a wizard and had moxy.  He was a brilliant risk taker that to be honest, corporate America abhors. 

John Lennon once said (and sang) that these are strange days in deed.  He was talking about the early 1970′s; however, the song (Nobody told me) and its lyrics could easily apply to today.   Only time will tell if this week’s reaction was a vote of confidence in the Fed, or simply wishful thinking.  Most peculiar mama!

The news that rattled investors came from home and abroad.  Across the pond, the European Union (E.U.) is looking more like dis-union and at home all hopes of a speedy economic recovery have been postponed. 

It was not too long ago that the E.U.  was considered a potential rival to the U.S. as an economic power.  Now, it is being propped up by an ever increasing role played by Germany and France, as debt problems in Italy and Greece have caused both nations to take a more prominent role in trying to keep the union together.  (It will be interesting to see how long France and Germany can put aside historic differences!)  There is even a discussion that what is needed for the E.U. to succeed is for all the nations to have only one, central system for raising debt.  Instead of Greece being able to issue debt on its own (and being unable to re-pay it!), the country would need for such an action to be approved by  the E.U.  This kind of a structure seems like an affront to nationalists in many European nations, yet it is gaining traction as the possibility of defaults by other E.U. members loom ever closer.  Such a Federalist structure is an interesting idea; however, to have such a European bank would, in effect, make Europe one nation (at least financially) and with Germany as the lead nation saving the E.U., one has to wonder if European memories and national pride will derail such a bold idea. 

At home investors were hit with what we at The QR have been concerned about for over a year – that the housing market is nowhere near a recovery and could even be weakening.  On Thursday the National Association of Realtors confirmed these suspicions by issuing a report stating that in June and July,  sales of previously owned homes fell 3.5%.  The dates surprised markets because earlier reports indicated an increase in contracts signed in May and June which would mean that those signing contracts are backing out of deals, or maybe not getting approved financing. (or maybe not being approved for financing.)

The unemployment picture also indicated the economy is sagging, as new claims for unemployment rose by 9,000, leaving the unemployment rate remaining at 9.1%. 

For those hoping for a quick recovery, it is doubtful – and absent any unforeseen events that may occur, the economy and markets remain vulnerable to being disrupted by any short- term shocks.  Investors will need to be very disciplined. 

It may be of interest that this week the Wall Street Journal reported High Frequency Traders (HFT’s) now account for 65% of all trading.  (High Frequency Traders Take Wild Ride To Profit – August 16, 2011, C1).  As mentioned in Week 32, HFT’s trade high volume daily and try to make money on market movement.  They are not long-term investors and little things like fundamentals are not as important as trading on volatility. 

It should be no surprise that with the economy sputtering, President Obama’s overall approval rating hit new lows.  The President’s Gallup approval rating is fell below 40%.   This latest drop has Republican presidential candidates in a frenzy as they hope to use this as a sign to throw the bum out – after all, no one likes’em, right?  However, before candidates like Congresswoman Michele Bachmann go too far, someone might want to point out that . . . according to a recent Gallup poll, only 13% of Americans approve of how Congress is doing their job!   It is this very reason why the markets are in such turmoil: they have no confidence in Washington getting the economy out of its jam and frankly, why should they?   

With such lack of confidence coupled with the sour economic news it is no wonder as to why investors are questioning whether we are simply having a slow time getting out of the previous recession, or instead, heading towards a new one.  As the uncertainly grows, we can expect to see greater volatility, which will only be exacerbated by those trading in milliseconds hoping to profit either way. 

In previous weeks we covered the VIX (the Volatility Index), which is often used by traders as a gauge of the markets’ volatility.  The greater the number of the VIX, the greater the volatility.   In the months of May, June and July, the VIX hovered around 20 – indicating very little volatility in the market.  But this week the VIX was over 46!

However, this reflection on what occurred with the markets really doesn’t answer why we saw the market in such turmoil.  Part of the answer lies in what occurred last week with Congress.  The sheer irresponsibility of extremist conservatives claiming that a default might occur, since they would not support raising the debt ceiling, was not good negotiating but rather, a message to the markets of just how risky the United States has become for investors.  When one thinks of holding a bond backed by the full faith and credit of the U.S. government, it means that no matter what may occur, our government will honor its debts.  It is risk free.  It certainly was not meant to be that a minority of those elected could use this obligation as a bargaining chip to push their own agendas.

Yet, in the infantile antics of those in Washington, they failed to realize that if government officials were to imply that the full faith and credit was now subject to one party’s political position,  the consequences could be  a dent in the nation’s perceived credibility as well as  our future ability to honor our debts.  Sure, this budget squeaked by, but what about the next time?  Are some Americans so naive that they think stiffing the rest of the world will turn out well or am I the only one who saw China’s brand new aircraft carrier on the front page of the Wall Street Journal?

And so it is time for the adults to enter Washington and remind everyone that the United States has prospered not due to its extremism, but rather, due to its ability to be the melting pot, the nation that tolerates differences and agrees to find solutions through compromise.  And while the current budget was approved, the damage had already been done – with the result being the credit rating of the United States was lowered for the first time in history!  Such news certainly would make foreign investors squeamish. Why would any foreign investor hold bonds of another nation that might one day opt not to pay?  Can anyone blame foreign investors for balking at buying or opting to sell U.S. investments in favor of those from more secure nations, like Singapore, Austria, Hong Kong, the U.K. and the Netherlands – all with AAA ratings.

The second shoe to drop this week came with a series of conflicting economic news.  At the forefront of these stories came as a surprise on Tuesday when Federal Reserve chairman, Ben Bernanke, gave investors a mixed message by saying that the Fed plans on keeping interest rates near zero for the next two years (yes, two years!), due to what the Federal Reserve perceives as a “weak economy” going into the future – and a sign that it does not see the economy recovering anytime soon.  Bernanke added that while the Fed plans on keeping interest rates low, it would be willing to take additional measures to stimulate things – in other words, find ways to help the economy grow.  The 2:15 EST message caused the DJIA to drop over 200 points, but then it rebounded  over 500 points in the last hour of trading as investors felt that any policies implemented by the Fed would result in the economy avoiding any return to a recession.  (This is often referred to as a double-dip recession).  On Tuesday alone, the DJIA swung over 700 points – leaving any investor flummoxed.

Such volatility in the market is a clear indication that investors are very unsure about the future.  While such volatility is disconcerting, it is not uncommon and is the reason why there are always buyers and sellers.  There are those that feel the market will grow, called Bull, and also those that feel that the market will not do so well, called Bears.  On any given day the battle between those that are bullish on the market and those that are bearish gets played out.  With the host of tools at investors’ discretion, there can be times that one group can cause some volatile trading.  When this occurs the VIX can reach over 40 as we saw this week.

Adding to the volatility is the ability for investors to buy and sell stocks quickly at ever increasing speeds.  The result is that there are traders that do not buy or sell stock on fundamentals (how strong a particular company is or may be in the future), but rather on market movement.  The most extreme example of this are the high-frequency traders (HFT’s) – these are not actual humans, but computers that operate on mathematical models by trading thousands, if not millions, of shares in seconds, hoping to make a fraction of a cent on each transaction.

Another group adding to the volatility are hedge funds that use derivatives that enable them to buy the right to purchase a stock in the future, or sell it now, even though they do not own the shares.  These are called calls and puts.  As you can imagine, these types of traders are playing the movement in the market and any news – good or bad, is the fuel they need.  Needless to say, one would not need to be an anchorman to realize that this past week provided ample ammunition for traders to try to move the market using these tools.

Yet, to predict the markets’ movement this past week would have required skills beyond earthly measure.  The failure to be accurate could have caused quite a lot of pain.  And for those that did get it right, one would have to wonder if they were more lucky than talented.  (In the next few weeks we will learn about these investors as the gains and losses will be reported.  Look for the guy that predicted oil would drop!)

While stock prices were all over the place this week, the fundamentals of most companies remained pretty much the same.  So some investors simply did nothing and waited for the dust to settle.  Others saw shares of companies they liked at lower prices and mostly likely gobbled them up.  It is not uncommon for traders to throw the baby out with the bathwater and a smart investor can take advantage of these moments by either adding to their position, or realizing not to join others in their folly of unloading equities of solid companies.  (Personally, at times I wonder if these wild swings are not some sort of orchestrated event to try to push down the shares of stocks, so that they can be swept up in the future – like a pool of dolphins herding a school of fish.  Not that I have any concrete evidence of this occurring, but when one sees such a herd mentality it seems plausible . . . at least to me.)

The story of this week could be lost looking only at the week’s percentage changes.  After all, a 1.5% change in the DOW is hardly newsworthy.  However, make no mistake.  Week 32 was anything but placid as investors got taken for a ride that few will forget and most likely will leave many fidgety for weeks to come.