Half of the people can be part right all of the time,

Some of the people can be all right part of the time,

But all of the people can’t be all right all of the time.

I think Abraham Lincoln said that.

-Bob Dylan

We have spent a fair amount of time in these pages discussing the merits of investment fundamentals and valuations and also looked at a good number of charts. Clearly we see the value in both methodologies and strongly believe that success in the markets depends upon one’s ability to implement both.

There are times, however, when both fundamentals and technicals agree and yet an investment based on these findings is unsuccessful. The company may be doing very well financially and be trading at a reasonable valuation. The chart suggests that the stock price is making a bottom. Still there is something unaccounted for and the stock price continues to decline.

Conversely economic fundamentals may be very poor jobs hard to come by and debt and deficits out of control. The stock market displays a very clear topping pattern. Stocks defy these indicators and trade higher.

Obviously there is something unaccounted for in these types of situations and that is sentiment. Just as Bob Dylan said 40 years ago quoting Abraham Lincoln over 140 years ago, “all the people can’t be all right all of the time.” And when the fundamentals and technicals are so obvious as to lead the crowd in a certain direction investors should be very skeptical.

This is exactly the case with the stock market over the past couple of months. The major stock market indexes, most notably the S&P 500 index, have formed clear head and shoulders patterns, one of the most popular technical patterns in the business.

Recently it looked as if these patterns predicted imminent doom for stocks. In addition, economic indicators have been weakening suggesting an increasing possibility of a double dip recession. The only reason that stocks could not break down decisively, we believe, is that too many traders were counting on just that possibility.

A recent article in the Wall Street Journal provides evidence to validate this theory:

“In decades of market analysis, I can’t remember a time that I’ve heard [so] many analysts quoting some support or resistance level as being critical for the market,” John Hussman, president of Hussman Investment Trust, wrote in his weekly commentary.  “The object of discussion has increasingly turned to the implications of this particular chart formation or that, as if some magic number or another absolves investors from having to think about the big picture.”

The recent focus on technical analysis has “really hammered home how the volatility is getting so extreme,” said Ryan Detrick, senior technical strategist at Schaeffer’s Investment Research.

The Standard & Poor’s 500 index narrowly fell on Wednesday, snapping a six-day winning streak in which it had gained more than 7%. But those gains came on the heels of a bigger losing streak in which the index fell in nine of the previous 10 sessions and dropped 8.5%.

“When the market goes down, people turn to the charts because it gives them peace of mind,” said Katie Stockton, chief market technician at MKM Partners. “They want answers, and if they can’t find the answers in the fundamentals, they turn to technicals.”

The S&P 500 dipped below 1040 during the losing streak, level considered the “neckline” for what chart watchers call the index’s “head-and-shoulders” formation. The head-and-shoulders pattern consists of two smaller rallies, considered shoulders, that sit on each side of a larger rally, the head. It is typically viewed as evidence of the market topping out and a precursor to a larger reversal.

But the index has bounced back in the past few days…

…to the tune of 6% in less than two weeks. Technicians trading the head and shoulders breakdown have had little opportunity to cover their shorts as stocks have marched steadily higher over that time. For now, the head and shoulders pattern has failed to work.

The predictability of these types of patterns may just be compromised by the fact that so many traders have become technicians but that is a question to explore in another issue. For now, we can simply recognize that the potential breakdown for stocks was broadly anticipated and failed for this very reason.

Last issue we discussed removing our market hedges. In the meantime we actually used the negative sentiment created by the popularity of his head and shoulders pattern as a buying opportunity (see Jesse’s My Back Pages for the play-by-play) and it has paid off.

Things aren’t so clear though today. Economic fundamentals are indeed very poor; leading economic indicators are rolling over; job growth is nonexistent and the economy is displaying none of the signs of the typical recovery. In addition, the head and shoulders pattern is popular because it usually works. These signs can’t be ignored.

Still we believe there is too much talk of deflation today. Early this year you’ll remember us discussing at length the prospect of Japanese-style deflation here in the United States. At the time very few were discussing this possibility. Today it is on the minds of nearly every economist and financial commentator and it has clearly seeped into public consciousness. Over just the past month Google searches for deflation have surged 300% and Treasury yields have plummeted to record lows in some maturities.

It is much easier for us to take a position in the debate such as the current one regarding deflation when it is less popular as it was earlier in the year. Now that traders have put on the deflation trade (long treasuries and short stocks) we find ourselves much less comfortable with the position.

We are admittedly poor trend followers, a flaw we readily recognize (see our TLT trade in recent issues for an example of selling too early). We simply believe it is better to position oneself closer to the beginning of a trade and get out near the middle than to get in closer to the end of a trend and suffer consequences similar to what new short-sellers experienced trading the potential breakdown of the recent head and shoulders pattern.

We still believe in the deleveraging thesis over the long-term, however, we now have little conviction in regards to the near-term direction of the stock market. The head and shoulders pattern may eventually work for traders, especially if most soon abandon the idea. The fundamentals still line up with the technicals and if this current rally flips traders to the bull camp you can be sure we will, in the very least, be putting our hedges back in place.

Certainly, we have not given up hope that an end to this epic bear market of the past decade may soon be at hand. There are signs that investors, disillusioned by increasing volatility and persistent poor performance, continue to abandon the equity market.

The Wall Street Journal recently ran an enlightening piece:

Small investors’ faith in stocks, which surged in the 1990s, has collapsed since the technology-stock debacle and the Enron and WorldCom scandals of 2000-2002. The 2007-2009 financial crisis only made things worse. Now, the pullback among ordinary investors means they are a declining force in a market that is increasingly dominated by professionals.

Some were tantalized by equities during the 70% rally that began in March 2009 and ran through April. But mutual-fund data and other clues suggest that that brief infatuation has ended.

In 2002, investors withdrew more money from mutual funds that invest in U.S. stocks than they put in. Then from 2007 through 2009 they withdrew money for three consecutive years. That marked the first three-year period of withdrawals since 1979-1981, according to the Investment Company Institute, a mutual-fund trade group.

Ironically, early 1982 marked the end of a long period of stock market malaise and the beginning of the biggest bull market in stocks on record. Sadly most investors had just thrown in the towel and missed out.

The article profiles the Potyks, “a comfortably retired couple in San Antonio,” who have a soured on the financial industry in general. “In the military, you learn that you want people you can respect, trust—who have integrity,” Mr. Potyk says. “Over the last five years or so, I find that our financial institutions have no shred of the character I describe.” Those who have read our recent issues will know that we vehemently agree with Mr. Potyk.

We can’t, however, endorse his reaction: the Potyks have sold all of their stocks and are now 100% invested in fixed income. The problem with this relates back to the sentiment issue we discussed earlier. Getting out of stocks today is very likely to mean selling nearer to the bottom rather than the top (give or take a few years). Likewise, buying bonds today, after a thirty-year bull market is very likely to mean buying nearer the top than the bottom (give or take a few years).

Turning to the bond market, its recent performance suggests the Potyks are not alone in their sentiments as investors have increasingly come to favor the long bond over more volatile investments like stocks. The yield on the 10-year Treasury is now below 3%. In stark contrast, fully half of the stocks that make up the blue-chip Dow Jones Industrial Average pay a dividend yield that is higher than the 10-year Treasury note.

This means that investors would rather be locked into a guaranteed 2.95% return (the current yield on the long bond) over the next ten years than own a portfolio consisting of Verizon, AT&T, Pfizer, Dupont, Kraft, Merck, Chevron, Johnson & Johnson, Coca-Cola, Home Depot, McDonald’s, Proctor & Gamble, Intel, General Electric and ExxonMobil that yields over 4%, or about 40% more in income!

Only during a devastating deflationary collapse would this bond investment outperform this hypothetical portfolio of equities (more evidence that the deflation trade is

getting crowded). Should inflation come into play over the next decade long bond investors could very easily see a 50% drop in the value of their investment. Strong, multi-national companies with pricing power such as those mentioned above would most likely be able to adapt to the changed environment and their investors would probably avoid the same wicked fate as those bond holders.

There are other signs that stocks are cheap relative to bonds. Wayne Waley of Witter & Lester recently wrote an interesting analysis of stock market values during low interest rate environments:

Since 1970, the average P/E, where E is calculated on trailing 4 quarter earnings, has been 19.55, slightly higher than the 15 most of us were trained to expect as the norm a couple of decades ago. The trend higher in trailing P/E’s is due largely to the collapse of earnings in 2008, that shot P/E’s temporarily into the triple digits, thus distorting averages, and secondly due to the fact that, as you can see in the table, stocks ‘tend to’ trade in a higher P/E plane when interest rates are extremely low, as they have been over the last decade. Anomalies, such as the 08 fourth quarter earnings collapse are the reason a lot of statisticians prefer to reference medians instead of averages. The median P/E since 1970 is 17.24.

The S&P 500 closed at 1078 on Friday (July 9, 2010). Trailing one year earnings, through the first quarter of 2010, were 60.83. We will have a better handle on second quarter earnings in a couple of weeks, but if we conservatively estimate that 2nd quarter earnings are simply equal to first quarter earnings, the trailing 12 month earnings go to at least 65.0, which would put today’s P/E at 1078/65 = 16.58, which is below the 90% confidence range (17.55-46.47) for low AIR periods.

The 90% confidence bands are very wide at all levels of interest rates and leave a lot of room for both Bulls & Bears to reside. I don’t know anyone that is anxious to pay 46.47 times earnings to own the S&P 500, regardless of the level of interest rates, so I added a table column, I called “Wayne’s (P/E) Band”, that seemed to simply make common sense given all considerations I have studied. So my take is that with interest rates extremely low, I’m inclined to view the market as cheap at 15 times earnings and expensive at 22.5 times earnings. Using trailing earnings of 65, that would put us in a S&P 500 range of 975 to 1462.5.

Last issue we wrote, “Based on the data provided by Yale’s Robert Shiller we believe that fair value for the S&P 500 is somewhere in the range of 900 to 1000,” thus our fair value estimate corresponds with Waley’s “cheap” range. However, we are intrigued by the idea that “cheap” is relative. Relative to their own past performance we believe stocks are merely fairly valued currently but compared to bonds, however, stocks are indeed cheap. To wit Waley continues, “Not only are rates in our low interest rate level where high historic P/E’s are justified, rates are way below 5% and the current earnings yield on equities (6.0%) is nearly 3 times the yield of typical mid curve interest rates (2.08), a relationship spread we have not seen in over 30 years.” Hence the glaring disparity between the long bond and the hypothetical dividend portfolio described above.

All that being said, it gives us increasing confidence to know that investors are currently abandoning the stock market just as it is becoming more attractive as an investment class. And it is interesting to note that people remember the last major bear market ending in 1982 when, in fact, the selloff that year did not even begin to approach the lows set in 1978 or 1974, for that matter. Stocks bottomed higher that year than in those prior years so the ‘bull market that began in 1982’ actually had its beginnings years before that date.

If history is to rhyme, then stocks this time may not ever approach the low set last year but investor sentiment should decline to lows not seen since 1982. And that will be the buying opportunity we have been waiting for.

“The Felder Report” – July 2010

The Felder Report (TFR) is published monthly by Felder & Company, LLC. There is no cost to subscribe. Felder & Company also syndicates Jesse Felder’s free weblog available at http://felderandcompany.com For more information contact us by mail at P.O. Box 790, Bend, OR 97709, by email at admin@felderandcompany.com or by telephone at (541) 389-3345. Felder & Company (F&C) is an Investment Adviser registered with the state of Oregon and various other states. Information in TFR comes from independent sources believed reliable but accuracy is not guaranteed and has not been independently verified. All material published in TFR is subject to change without notice from F&C. F&C’s security recommendations disclosed in TFR are the opinions of Jesse Felder and the performance results of such recommendations are subject to risks and uncertainties beyond the control of F&C. F&C is the manager of individual client investment accounts and as adviser F&C, or its associated persons, may purchase and sell securities identified, recommended and analyzed in TFR. In consideration of performance objectives of its individual client accounts, F&C may purchase and sell securities identified in TFR without notice to newsletter subscribers and may take a position in such securities that is inconsistent with the recommendations disclosed in TFR. Previous, successful recommendations may not be indicative of the results for all recommendations, and in fact certain recommendations have resulted in losses. Subscriber information is never sold, shared or otherwise distributed to third parties.

Wall Street Clients Get “Fucked” by “Shitty” Deals (In Other News, Dog Bites Man)

It’s been roughly six weeks and a thirteen-percent loss in the S&P 500 since we last published. Fraud allegations at the most prestigious investment bank in the world, a European sovereign debt crisis, a flash crash and the largest oil spill in history have filled the void between issues of “The Felder Report.”

Don’t take our silence as a sign of negligence. Our first priority is to our managed accounts and on that front we’ve been very busy (we’ll get to that later). Neither can our reticence be read as ambivalence. If you’ve been reading our reports over the past few months (and Jesse’s blog in the meantime) it should be easy to imagine that we have strong opinions on these topics.

The Goldman Sachs case is simply the latest in a long line of examples of business as usual on Wall Street. In the Abacus deal, Goldman created a product that was designed to fail for an important client who desired it to. It then sold the product to a couple of patsies, a.k.a., clients.

Hedge fund titan John Paulson was presciently bearish on the mortgage market leading up to the financial crisis and needed a mortgage portfolio to sell short. Goldman obliged by allowing him to handpick the “shitty” (Senate finance committee chairman Carl Levin’s term quoting Michael Lewis’ “The Big Short”) mortgages that would make up the CDO. The only problem is Goldman never told the buyer just how “shitty” the mortgages really were or about Paulson’s role in selecting them. Shortly after it was created the CDO lost nearly its entire value.

I don’t think that the term “conflict of interest” quite encompasses the problems with the Abacus deal. For this and other reasons, Goldman is being sued for fraud by the SEC and the Justice Department is pursuing a criminal investigation of the bank.

To further demonstrate the business mode of the bank, in the first quarter Goldman Sachs announced that for the first time ever its prop trading desk didn’t suffer even a single day of trading losses. In stark contrast to the proprietary trading desk’s smashing success Goldman handed its clients significant losses in what it called its “top trades.”

Seven of Goldman’s nine recommended trades for 2010 have been big losers so far this year. That’s a batting average that fall far short of the prop desk’s perfect quarter.

There is only one explanation for this and you will find it in any of the ‘behind the scenes’ financial books written by former insiders. The big investment houses make it a common practice to keep profitable trades for themselves while pawning the losing trades off on their customers.

In his classic “Liar’s Poker” Michael Lewis writes about his very first trade as a bond salesman for Salomon Brothers:

My first order. I felt thrilled and immediately called the U.S. treasury trader in New York and sold him three million dollars’ worth of treasury bonds. Then I shouted over to the London corporate bond trader, “You can do three million of the ATTs,” trying, of course, to sound as if it really weren’t that big a deal, just another trade, like going for a walk in the park.

There was in every office of Salomon a systemwide loudspeaker, called the hoot and holler or just the hoot. Apart from money, success at Salomon meant having your name shouted over the hoot. The AT&T trader’s voice came loudly over the hoot: “Mike Lewis has just sold three million of our AT and Ts for us, a great trade for the desk, thank you very much, Mike.”

I was flushed with pride. Flushed with pride, you understand. But something didn’t quite fit. What did he mean, “Our AT and Ts”? I hadn’t realized the AT&T bonds had been on Salomon’s trading books. I had thought my trader friend had snapped them up from stupid dealers at other firms. If the bonds were ours to begin with . . .

Dash was staring at me, disbelieving. “You sold those bonds? Why?” he asked.

“Because the trader said it was a great trade,” I said.

“Nooooooo.” Dash put his head in his hands, as if in pain. I could see he was smiling. No, laughing. “What else is a trader going to say?” he said. “He’s been sitting on that position for months. It’s underwater. He’s been dying to get rid of it. Don’t tell him I told you this, but you’re going to get fucked.”

Lewis didn’t get “fucked” but his customer did. Salomon’s great trade was its customer’s big loser. Is this starting to sound familiar? On main street this would be seen by anyone as, if not fraud, just plain bad business. On Wall Street, however, it’s just business as usual. So don’t be surprised if you meet a Goldman trader or two out shopping for a new yacht.

Deleveraging: Damned If You Do…

The European debacle is just another symptom of the disease that is a global deleveraging. During the good years governments like that of Greece overspend and overpromise by overindebting themselves. When the economy slows down they find that debt too large to service.

This is exactly the situation that, in addition to Greece, Spain, Portugal, the U.K., many local governments in the United States, our country’s largest banks, the average consumer here and quite possibly the federal government now find themselves in. The process of deleveraging for all of these players will be a long and painful one.

“Austerity” programs are the solution du jour being discussed in Europe right now. To cut the massive debt levels and reign in fiscal deficits politicians intend to implement cuts in government spending and eliminate or reduce a broad variety of social programs. These measures have the affected populations up in arms and violent protests are currently spreading across these nations. We believe these citizens are wiser than they know.

The main effect austerity programs will create is to further weaken the economies affected by them. Stimulus withdrawal and spending cuts will initially seem to cut fiscal deficits but they will also seriously reduce demand and thus revenue. Ultimately, deficits will actually widen as they did when Japan attempted to implement similar measures and become greatly counterproductive to economies already challenged by private sector deleveraging.

Austerity measures significantly raise the possibility of a deflationary vicious cycle. Richard Koo has created a playbook for dealing with prolonged deleveraging and sadly politicians around the world are ignoring it. In recent months we have written that we must learn from the mistakes that Japan has made over the past couple of decades. Otherwise we will be doomed to repeat them and it looks like the politicians are all too happy to do so.

This increasing risk of a deflationary vicious cycle is precisely what we believe the markets have been reacting to over the past six weeks. Investors’ attention last month was only diverted from the problems in Greece by the flash crash in our stock market. On May 6^th, stocks saw their largest intraday selloff since the crash of 1987. Rumors swirled about a “fat-finger” trade (trader enters in a zero or two more than intended) and inadequate trading mechanisms at the major exchanges. However, we believe the crash was simply a culmination of the converging negative fundamental (deleveraging) and technical signs for the economy and asset markets.

Last issue we drew attention to the fact that stocks were approaching significant resistance at the 61.8% retracement level of the bull run that began in the spring of 2009. The S&P 500 came within 1% of this resistance level in late April before turning lower. Specifically, we wrote:

Considering that valuations, technicals and sentiment are all flashing independent warning signals. We think it prudent to at least hedge some of our exposure to stocks at this point. We have added to our ProShares UltraShort S&P 500 Exchange Traded Fund (NYSE: SDS) position and feel very comfortable in taking profits in equities in our portfolios currently.

Needless to say, the UltraShort ETF performed very well over the past month. Stocks rallied immediately after the decline but subsequently rolled over and currently trade near the lows set on the day of the crash. Long-term treasuries (TLT) have also benefitted greatly from their perceived “safe-haven” status during the crash. These two positions together made for a decidedly profitable May for those that owned them.

Amidst the broiling negativity resulting from this market weakness, however, we have removed our hedges, sold our long-term treasuries and added to our meager exposure in equities. These are precisely the opportunities we look for to commit capital to stocks. That is not to say we are backing up the proverbial truck. But there are opportunities in the marketplace today that we haven’t seen for months.

Based on the data provided by Yale’s Robert Shiller we believe that fair value for the S&P 500 is somewhere in the range of 900 to 1000. The decline in the stock market nearly approached this level and we don’t feel the need to be hedged when we believe stocks are fairly valued.

Should the stock market rise in coming months we will be putting hedges back in place. Should stocks fall further from current levels we will likely be adding exposure to equities but we won’t become fully invested unless stocks become significantly undervalued as they were briefly during the spring of 2009.

In the short term we don’t have an opinion on which direction the stock market is headed. We do believe, though, that before this prolonged bear market is finally over stocks will see a period of undervaluation that they haven’t seen in decades.

The deleveraging environment is not one that is beneficial to companies or their stocks or many other investment assets, for that matter. The justification for above-average valuations in recent years has been the unusually robust economy. Remember the “New Economy” prophets touting a new era of stock market premium valuations. They claimed we should never suffer anything more than a mild recession ever again.

We have come a long way in the ten years since then and today’s economy looks nearly the opposite. It may very well turn out that we only experience mild periods of growth amidst a prolonged period of significant economic weakness.

The latest jobs report confirms that this young recovery is already be losing steam. Over four-hundred-thousand jobs were created in May. While this may look like good news on the surface when you dig a little deeper it is much more troublesome. The fact is nearly all of these jobs were created by federal government census hiring. Private sector hiring is nonexistent.

Pimco’s Bill Gross has termed today’s handicapped economy the “New Normal” which stands in stark contrast to the “New Economy” of the bubble years. With this sort of economic backdrop it is very difficult to make the case that stock valuations should not also be depressed for quite some time.

Even after the epic bear market we have already endured in stocks over the past decade the market is not yet generally undervalued. Amazingly, investor enthusiasm has not yet been significantly dented either though that may now be in the process of changing.

A recent poll conducted by the Wall Street Journal shows that the majority of the American population now feels that the “stock market is no longer fair and open.” Specifically, more people agreed with this statement: “Because of corporate corruption and broker practices, the stock market is no longer a fair and open way to invest one’s money.” than this one: “The stock market is a fair and open way to invest one’s money, and there are rules that make it fair and equal for all.”

People feel like Wall Street has rigged the game to make money off of them rather than for them. As the Goldman case clearly shows this is exactly how Wall Street has rigged the game and individual investors should be aware of it. The fact that the New York Attorney General is now investigating virtually every large Wall Street bank in the country doesn’t do anything to dissuade people of this notion. In fact, it’s probably contributing to its increasingly popularity.

This growing negative sentiment is both good news and bad news. The bad news is so far this has been one epic bear market since 2000 but it’s probably not quite over yet. Yes, this is the kind of sentiment that you expect to see at bear market bottoms but individual investors have not yet given up the bull ghost.

Amateur traders are still too quick too “buy the dip” and investors, retail and institutional, are still in love with equities committing the majority of their portfolios to this single asset class. When they finally give up on this strategy, and only then, will we see a major bear market low.

The spring of 2009 stock market low marked the 50% time retracement of the bull market that began in 1982 and ended in 2000. Mid-2011 will mark the 61.8% time retracement. This may coincide with the pervasive investor despair and low valuations that I believe will signify the end of the pain and the start of a new, real bull market.

And now for the good news: this next selloff may finally be the buying opportunity of a lifetime. The last major bull market that ended 1966 can be instructive here. Stocks went sideways for a few years before selling off dramatically during 1973-74 (akin to the 2008-09 selloff). Still, the bear market didn’t come to its conclusion until 1982 amidst pervasive investor malaise and extraordinary undervaluation.

This is a pattern that has repeated itself during each of the major bear markets of the past century. The “buy the dip” mentality must die and valuations must become unusually low before a new bull market can be born. Polls like this one from the Wall Street Journal show we are well on our way there. One more major selloff may be all it takes to finally put an end to this great bear.

“The Felder Report” – June 2010

The Felder Report (TFR) is published monthly by Felder & Company, LLC. There is no cost to subscribe. Felder & Company also syndicates Jesse Felder’s free weblog available at http://felderandcompany.com For more information contact us by mail at P.O. Box 790, Bend, OR 97709, by email atadmin@felderandcompany.com or by telephone at (541) 389-3345. Felder & Company (F&C) is an Investment Adviser registered with the state of Oregon and various other states. Information in TFR comes from independent sources believed reliable but accuracy is not guaranteed and has not been independently verified. All material published in TFR is subject to change without notice from F&C. F&C’s security recommendations disclosed in TFR are the opinions of Jesse Felder and the performance results of such recommendations are subject to risks and uncertainties beyond the control of F&C. F&C is the manager of individual client investment accounts and as adviser F&C, or its associated persons, may purchase and sell securities identified, recommended and analyzed in TFR. In consideration of performance objectives of its individual client accounts, F&C may purchase and sell securities identified in TFR without notice to newsletter subscribers and may take a position in such securities that is inconsistent with the recommendations disclosed in TFR. Previous, successful recommendations may not be indicative of the results for all recommendations, and in fact certain recommendations have resulted in losses. Subscriber information is never sold, shared or otherwise distributed to third parties.

The Apple That Defied Sir Newton

Investors have been increasingly embracing the stock market rally of late. One stock that continues to garner a particularly enthusiastic following is Apple, Inc.

Apple’s shareholders have become so enamored with the company, in fact, as to push the stock price to a level that now rates it more valuable than General Electric, J.P. Morgan, Procter & Gamble and Johnson & Johnson. This is evidenced by its market capitalization of over $200 billion. All of these other companies trade at a sub-$200 billion level. However, each of these other companies earns more in net profits than Apple.

Now some would argue that it’s not fair to look at Apple solely based on its earnings. I tend to agree with them. Apple has a huge chunk of cash on the balance sheet that should be factored in. Even looking at one of my favorite measures, enterprise value to EBITDA (earnings before interest taxes depreciation and amortization), which factors in both cash and debt on the balance sheet, Apple is still valued at a premium to these other companies.

This begs the question, ‘does Apple deserve a premium valuation in comparison to the best consumer, industrial and financial brands in the world?’ Based on recent history the answer is no doubt, ‘yes.’ The iPod followed by the iPhone were both revolutionary products that created tremendous growth at the company even amidst one of the worst recessions in a very long time.

Looking into the future, though, it’s hard to imagine Apple’s amazing growth being sustained. Apple is now the fourth largest company in the world by market capitalization. The law of large numbers suggests that this fact alone makes it exponentially more difficult for Apple to continue to grow. It’s a simple fact that the largest companies in the world cannot grow as fast as their smaller kin. It’s a lot easier to grow 25% on $100 million base than it is to grow 25% on $100 billion base.

Putting aside these challenges for a moment let’s assume Apple is capable of growing like it has in the past. Like all fast-growing, technology companies, Apple needs to find and successfully develop the “new new thing” to keep its growth sustained. So what will be the next iPhone-like product to fuel the company’s future growth phase?

Indeed, the iPhone is maturing and new competition from the likes of Google’s Android and Chrome operating systems is already eating into the company’s flagship product. There is much fanfare surrounding the iPad, the company’s latest venture but there are two things that I believe will prevent this product from becoming the second coming of the iPhone.

First, the iPad does not represent a completely new product line for the company as the iPhone did. To me it seems like it should replace either your iPhone or your MacBook (aside from the Apple fanboys, who will buy all three?) In that case, the iPad will probably cannibalize the sales of other Apple products rather than solely its competitors’ products.

Second, like the iPhone the iPad is a large step further into the world of closed computing where consumers are locked into Apple everything. In fact, just to register the iPad a user must connect it to a computer with iTunes installed. In addition, it’s impossible to install any third-party software outside of the app store and the app store itself is highly censored by Apple. Consumers want choice and freedom and Apple is simply denying both. In addition to turning off customers, this alienates third party developers who typically play a large role in the success of a product like this.

To further address the Google threat, netbooks based on the chrome operating system will be hitting the market within months. Essentially small laptops, netbooks can surf the web, use Google docs, run apps from the android store and do e-mail, all the things the ipad is designed to do and much more. Google’s netbooks, though, will be half the price of the cheapest iPad and based on an open system friendly to consumers and third-party developers alike.

Steve Jobs personally addressed this Google threat in an interview directly after revealing the iPad. Wired reports:

On Google: We did not enter the search business, Jobs said. They entered the phone business. Make no mistake they want to kill the iPhone. We won’t let them, he says. Someone else asks something on a different topic, but there’s no getting Jobs off this rant. I want to go back to that other question first and say one more thing, he says. This don’t be evil mantra: “It’s bullshit.” Audience roars.

Methinks, “the lady doth protest too much!” Steve sounds more than a little bit worried and he should be. The iPhone is solely responsible for the company’s growth of the last three years and makes up the majority of the company’s profits. Google is threatening this cash cow and has had some significant success in doing so already. After being on the market for only about a year Google’s Android has already passed blackberry to become the second most popular smartphone operating system and is rapidly closing the gap on the iPhone.

Apple will no doubt continue to be a great consumer technology company without the iPad becoming a smashing success but if it does not at least help sustain the amazing growth that the company has seen in the recent past the premium stock market valuation will no longer be justified. This may have something to do with the company’s top brass selling 1 million shares (the majority of their actionable holdings) over the past few weeks.

Looking at the charts, it’s obvious the stock has been on a tear over the past few years. While most tech stocks are lucky to be battling their bubble highs made back in 2000, Apple currently trades six times higher than its 2000 high.

There are also signs, however, that Apple’s amazing run may be coming to an end. Divergences on the weekly and monthly charts suggest that the stock price momentum may be faltering at the same time the company’s growth may begin to slow. This week’s run-up to $250 per share on the daily chart also feels a lot like a parabolic blow off.

Looking past the divergences, sentiment has soared right along with the stock. Analysts are uniformly bullish with fully 36 ‘buy’ or ’strong buy’ ratings. Reminiscent of those 2000 highs, many analysts are jumping over themselves to upgrade the stock and their price targets. One analyst, in particular, made news when he predicted the iPad had sold nearly a million units in its first weekend only to be proved wildly off target when Apple reported that they had sold less than half that amount.

Individual investors are also nearly as bullish sending a clear contrarian signal. Anecdotally, many investors I talk to today are uncomfortable with their investments in general, not knowing whether to own stocks or bonds at all or how much of each they should dedicate their portfolios to. But when it comes to Apple they are all very proud to own a decent chunk of stock. Seasoned contrarians will recognize this kind of smugness as the kiss of death.

All in all, there are a lot signals, fundamental, technical, insiders and sentiment, flashing yellow lights here for Apple’s stock price. That is not to say investors should short the stock. Investors who own Apple however, should seriously consider taking profits.

The Miracle of Modern Accounting

We have already discussed in these pages, the fact that stocks are overvalued on a price-to-earnings basis. After the roughly 15% rally over the past two months they are even more so. However, this is a much simplified method of assessing valuation and just as in the case of Apple, it behooves an investor to take into consideration other factors such as debt levels and the quality of earnings.

To revisit the overall price-to-earnings picture, the S&P 500 at nearly 22-times its average earnings of the past five years is now more overvalued than it was at the peak made in 1987. This ignores the fact though, that debt relative to GDP has doubled over that time. There is no way to easily quantify this in considering stock market valuation other than to understand that debt levels are much higher today on a relative basis than they were in 1987. Hence valuations might be similar on a price-to-earnings basis, but when bringing debt into the picture we are now significantly more overvalued than we were in 1987.

Some would argue that earnings coming out of recession are still depressed and improving rapidly and thus valuations are inflated. We are looking however at a five-year average or ten-year average of S&P 500 earnings, which smoothes both the troughs and peaks of the busts and booms in earnings. Our biggest concern, though, with valuations is the quality of earnings.

By far the biggest source of this earnings recovery has been the financial sector “recovery.” In fact, financial earnings have made a miraculous comeback over the past 12 months. Only a year ago, the financial sector was on the verge of bringing the world economy to its knees. If we are to trust banks earnings reports then the crisis was only a blip in the history of banks profits which have now entirely recovered.

What investors are either ignoring or are oblivious to is the fact that the entire recovery in the financial sector can be attributed to one simple rule change. The Financial Accounting Standards Board repealed rule 157 roughly one year ago. This means banks are no longer required to mark their securities to market and can maintain them on the balance sheet at whatever price they determine reasonable. This one rule change means banks no longer have to write down troubled loans resulting in improved capital ratios and vastly improved earnings.

The truth is, however, that there has been no real improvement in the health of the banking system. On the contrary, foreclosures continue to grow, and the value of these mortgage assets that were at the core of the financial crisis has not improved at all. This is why the FDIC continues to announce that they are shutting down multiple banks every Friday evening. How can a reasonable investor believe that Bank of America and Citigroup have recovered completely when their smaller brethren, who typically own much less toxic assets, are still dropping like flies?

John Hussman, one of the rare breed of intelligent and successful mutual fund managers, recently wrote about the consequences of the current state of the banking industry:

Indeed, it’s possible that banks might be able to report fairly healthy “operating earnings” to investors, and then somewhat more quietly write off losses as “extraordinary” charges over a period of years. This type of outcome is beginning to look possible, because investors evidently don’t mind repeatedly having their pockets picked as long as “operating earnings” come in above analyst estimates.

Unfortunately, in that sort of world, the economy would likely be hobbled for a long period of time, as Japan has discovered over the past couple of decades. With banks focused primarily on survival and recapitalization, retained earnings would be directed to making the existing liabilities whole, rather than contributing to productive new investment.

This is a key component of the deleveraging scenario that we’ve been discussing in these pages for months. If banks are focused on improving their balance sheets, they simply won’t be making new loans. And without new credit creation the economy simply can’t grow.

Evidence of his lack of credit creation can be seen in the Federal Reserve’s M2 measure of the money supply (M2, the broadest measure of the money supply still tracked by the Federal Reserve includes all outstanding currency, checking account deposits, time deposits, market funds, etc.). It has now declined for five straight weeks. It’s very possible that 2010 will be the first year that M2 declines year-over-year since the 1930s. We find it amazing to consider that despite all of the extraordinary measures taken by the Federal Reserve and the treasury deflation still has the upper hand.

So we would argue that a large portion of the earnings recovery is due mainly to a smoke and mirrors game in the large banks’ financial reports. Without the burden of writing down bad loans to banks are free to report good earnings and, of course, investors are free to celebrate them. Reality, however, is much less rosy for both the banks and the economy and, to top it all off, the stock market is exceptionally overvalued when considering relative debt levels and the poor quality of earnings.

The charts currently reflect this crossroads as the financials are running into significant resistance. The temporary lows that the stock market made during the Lehman bankruptcy are now clear overhead resistance. Another sign of concern is that since the summer of last year financial stocks have lagged behind the broader stock market performance. Since the beginning of this bear market in late 2007. Financial stocks have led every turn. We take it then as a sign of caution that financial stocks have been trailing during this rally of the past few months.

The broader stock market is also running into significant overhead resistance. The S&P 500 climbed within 1% last week of the 61.8% retracement of the entire financial crisis decline (SPX 1228). This is a key number, based upon Fibonacci analysis that is closely watched by traders as a potential location for at least a correction if not a change in trend.

Just as Apple’s rally has inspired investors, the strength in the general stock market has caused sentiment to become exceedingly bullish. According to Jason Goepfert of SentimenTrader, options traders have never become more bullish more quickly in the history of the data going back to 1997. Jason looks at the equity put to call ratio relative to its recently history to see if traders are more interested in buying puts to protect the downside or calls to speculate on outside in stocks. Call buying activity is simply swamping any put buyers in the marketplace currently.

Morgan Stanley also recently released a study analyzing traders’ positions in the NASDAQ. Traders net speculative positions currently are two standard deviations away from the average reading. In the past when this occurred, the NASDAQ has never been able to rise at all over the subsequent six months. In fact, it has shown an average decline of 20% after reading such as this.

Considering that valuations, technicals and sentiment are all flashing independent warning signals. We think it prudent to at least hedge some of our exposure to stocks at this point. We have added to our ProShares UltraShort S&P 500 Exchange Traded Fund (NYSE: SDS) position and feel very comfortable in taking profits in equities in our portfolios currently.

Gordon Gekko Changes His Spots

While sentiment surveys show that traders might be rip-snorting bullish right now, we believe the average investor is still sitting squarely on the fence. Most investors probably missed a large portion of the current rally due to the pervasive fear at the stock market lows roughly a year ago. Not only have they missed the current rally, we believe many of them sold near the bottom last year.

Actor Michael Douglas recently told Esquire magazine of his recent investing experience that closely follows this plot. He said in the interview that he lost nearly half his net worth during the stock market crash of 2008. He sold out and swore off stocks for good. While he might be a little too old to be considered a baby boomer that doesn’t change the fact that he could very well represent the biggest generation of investors the world has ever seen.

Baby boomers grew up with Douglas as a silver screen hero with Hollywood longevity like few others. Perhaps one of Douglas’ most famous roles was financier Gordon Gekko; a role he reprises in the coming sequel to “Wall Street.” (Interestingly, the original was released just ahead of the 1987 crash; its sequel is to be released this year. Francis Coppola denies any and all financial shenanigans and attributes it entirely to coincidence.) In real life, it seems, Douglas is no Gekko.

I can’t help but think that there are many boomers out there feeling just like Douglas and very likely similar stories of financial pain. After the internet bubble implosion, the real estate crash of the past few years and the financial crisis, baby boomers must have developed at least some aversion to financial securities and investing in general.

It doesn’t help things that Goldman Sachs on Friday was charged by the SEC with defrauding its own customers. Goldman is one of the most successful and most respected investment banks within the industry. The charges clearly show that the firm placed the interests of a large and bearish hedge fund manager above those of its other clients. News is surfacing that other investment houses, structured deals in the very same way to benefit one customer and perhaps their own cash accounts to the direct detriment of another customer.

It will be interesting to see how this combination of securities fraud lawsuits and federal finance reform play out in public. Goldman has already been facing a very large PR problem over the past year or so. This only makes things much worse for the image of both the firm and the industry. The bottom line is these issues do not inspire much in the way of investor confidence and may in fact be turning off an entire generation to investing in anything but riskless assets.

Supporting this thesis is the recent mutual fund flow data. Despite the epic stock market rally of the past year or so, fixed income funds have seen the greatest inflows. Over the first quarter of this year far more money has flowed into bond funds than stock funds.

Still, according to Dave Rosenberg at Gluskin Sheff, households have only allocated a bit more than 6% of their investments to fixed income. 25% remains in stocks and fully 30% is still allocated to real estate investments. However, if even Gordon Gekko has sworn off speculating in risk assets after being burned by three big busts, then I have to believe that there is a large segment of the population that feels the same. And the trend towards fixed income may be only just beginning.

This is in stark contrast to the bearish consensus among economists, financial pundits and traders who have loudly predicted higher interest rates and thus lower bond prices over the coming months and years. This despite the fact there is no evidence of inflation today or on the horizon. All the data point to deflationary forces at work currently.

In a recent article published by Barron’s, titled “Contrarian Alert: Everybody Hates Treasuries” author Randall Forsyth disputes the bearish case that is so popular currently and convincingly argues its opposing position:

Real, broadly defined money is experiencing the “worst annual contraction in modern reporting,” according to John Williams’ Shadow Government Statistics. That signals “looming deterioration in U.S. business conditions, an intensified economic downturn or ‘double-dip recession’ in popular terminology…

…The contraction in the money measures is in stark contrast to the popular notion of central banks around the world “printing money” by expanding their balance sheets through massive purchases of securities and other assets. But the banks have not used that central-bank liquidity to expand credit and the “shadow banking system” of securitization remains moribund.

The initial doses of fiscal and monetary stimuli pulled the economy and the capital markets out of their nosedives and powered their ascents. Now those doses are wearing off. The money supply is shrinking while taxes are certain to rise in 2010.

Combine a renewed slowdown in the economy (caused by the current deleveraging cycle) with a population getting more disillusioned with the financial industry and baby boomers generational retirement needs and it looks as if the demand for treasuries should at least maintain if not grow in the future.

For these reasons, we have used any pullbacks in the iShares 20+ Year Tresury Bond Exchange Traded Fund (NYSE: TLT) to add to our position in long-term treasury securities. We still believe that a 4% risk-free yield looks very attractive today and may look simply mouthwatering as the economy continues to delever over the coming months and years. And should Michael Douglas & Co. decide to follow suit, he may live up to his Gordon Gekko character after all.

“The Felder Report” – April 2010

The Felder Report (TFR) is published monthly by Felder & Company, LLC. There is no cost to subscribe. Felder & Company also syndicates Jesse Felder’s free weblog available at http://felderandcompany.com For more information contact us by mail at P.O. Box 790, Bend, OR 97709, by email atadmin@felderandcompany.com or by telephone at (541) 389-3345. Felder & Company (F&C) is an Investment Adviser registered with the state of Oregon and various other states. Information in TFR comes from independent sources believed reliable but accuracy is not guaranteed and has not been independently verified. All material published in TFR is subject to change without notice from F&C. F&C’s security recommendations disclosed in TFR are the opinions of Jesse Felder and the performance results of such recommendations are subject to risks and uncertainties beyond the control of F&C. F&C is the manager of individual client investment accounts and as adviser F&C, or its associated persons, may purchase and sell securities identified, recommended and analyzed in TFR. In consideration of performance objectives of its individual client accounts, F&C may purchase and sell securities identified in TFR without notice to newsletter subscribers and may take a position in such securities that is inconsistent with the recommendations disclosed in TFR. Previous, successful recommendations may not be indicative of the results for all recommendations, and in fact certain recommendations have resulted in losses. Subscriber information is never sold, shared or otherwise distributed to third parties.

First Do No Harm

This is one of the well-known, principal ethics in medicine. It is also the best advice we can think of to give investors.

Warren Buffett likes to say there are two main rules investors should live by: first, don’t lose money. Second, never forget rule number one. Ultimately, Warren’s rules and the one physicians live by are one and the same.

We spent a large portion of the last issue of “The Felder Report” on a tirade against traditional stock broker and financial adviser methods to whom “first do no harm” is a foreign concept. In fact, the modus operandi at these firms is clearly something more along the lines of “first fleece your customer.”

Stock broker, David Armstrong, recently told the New York Times, “I learned a lot about being a good salesman at Merrill. The amount of training I sat through to properly evaluate investment opportunities was almost nonexistent relative to the training I got on how to sell them.” Clearly the message to new brokers is making money for the firm is your one and only priority; making money for customers is an afterthought.

While the media and the public have been up in arms over banker bonuses the bonuses given to brokers last year were many multiples larger than their banking counterparts, a fact that has gone almost unnoticed. The Wall Street Journal reports that companies like Morgan Stanley Smith Barney paid bonuses to “top producers” (aka, commission generators) of over ten million dollars or more last year. Undoubtedly, there are many new orders for yachts being placed by brokers in 2010.

We recognize that a company’s sales force is its lifeblood. However, Wall Street sales people are nothing less than wolves in sheep’s clothing. Holding oneself out as trusted financial council and then selling the equivalent of financial snake oil is disingenuous at best and evil at worst.

Recent proposals in Congress directed at financial reform have included provisions for holding brokers and advisers legally accountable for putting their clients’ interest first:

At issue is whether brokers should be required to put their clients’ interest first — what is known as fiduciary duty… Brokers at firms like Merrill Lynch and Morgan Stanley Smith Barney, or those who sell variable annuities, are often held to a lesser standard, one that requires them only to steer their clients to investments that are considered “suitable.” Those investments may be lucrative for the broker at the clients’ expense.

So lucrative, in fact, that paying even two and half percent per year in fees and earning eight percent per year for twenty-five years will result in losing more than half of the investments’ total return to expenses. Thus, it is in the clients’ best interest to avoid brokers and mediocre mutual funds altogether.

The Times article goes further to discuss the impact on the insurance industry:

Mercer Bullard, an associate professor at the University of Mississippi School of Law who serves on the S.E.C. and Exchange Commission’s Investment Advisory Committee [says]… the insurance industry was “apoplectic because if they sell a variable annuity and they are subject to fiduciary duty, that means they will probably have to fully disclose the compensation they are getting.” This, he added, “would make clear the excessive incentives they have to mis-sell the variable annuity, which has been the cause of regulatory problems in that area.”

Even if “fiduciary duty” is too lofty a standard to apply to salespeople, is it too much to ask that insurance brokers simply disclose their compensation? We think not. Then again, unlike the insurance industry, we have no army of lobbyists in Washington making that case. The industry has fought any provision related to “fiduciary duty” tooth and nail and lawmakers have since dropped it from the current proposals in Congress.

Ultimately, all of these problems arise from the large financial incentives that directly contradict “first do no harm.” Interestingly enough, this is also the source of the country’s out of control health care costs.

Dr. Atul Gawande, in an excellent piece for the New Yorker published last year, examined the country’s spiraling medical cost problem through the example of McAllen, Texas, the most expensive healthcare city in the most expensive healthcare country in the world. Gawande writes:

About fifteen years ago, it seems, something began to change in McAllen. A few leaders of local institutions took profit growth to be a legitimate ethic in the practice of medicine. Not all the doctors accepted this. But they failed to discourage those who did. So here, along the banks of the Rio Grande, in the Square Dance Capital of the World, a medical community came to treat patients the way subprime-mortgage lenders treated home buyers: as profit centers.

This profit motive, Gawande surmises, has lead doctors to call for more treatments that increase their profit margin but are not always necessary to effectively treat their patients. Sound familiar? Can we really expect doctors or brokers to consistently put their patients’ or clients’ interests first when there is an inordinate incentive to do otherwise?

We think not and the data support this opinion. There are far too many patients and investors suffering from astronomical costs to conclude otherwise. Sadly, both the financial and healthcare reform packages making their way through Congress fail to address this root cause of the major problems in both industries.

The medical problem, however, is obviously much more important than financial one. When it comes to the health and safety of the country’s citizens there are few issues of greater significance. Unlike the financial community, the medical community at least abides by the “first do no harm” ethic. Perhaps they would do well, as Warren Buffett has done, to add a second rule: “never forget rule number one.” Because financial harm, while not as important as physical harm, is still harm and the country’s patients are suffering greatly.

Business Week recently reported that sixty-two percent of all personal bankruptcy filings in 2007 were cause by health problems. In addition, seventy-eight percent of those people had some form of health insurance. Responsible people are going bankrupt simply because they get sick.

Rising healthcare costs are also putting the country’s economy at risk. The United States now spends roughly sixteen percent of its total Gross Domestic Product on healthcare, higher than any other developed nation in the world. This means that we have relatively fewer funds than every other country in the world to invest in innovation, growth and renewal.

The majority of our massive healthcare spending is picked up by the country’s employers. This puts them at a large competitive disadvantage to companies in countries with universal coverage and countries lacking laws requiring employers to provide coverage. We are in the midst of the worst jobs recession in decades and it is time to look at the high cost of employing Americans as a possible reason for it.

Your humble editor has had a Health Savings Account (HSA) paired with a high deductible health plan since the programs began in 2003. In this program, the patient bears the cost burden up to certain amount – let’s say three thousand dollars. Once spending reaches this level during the calendar year the insurance kicks in and covers the balance.

HSAs have proven that they bring down the overall cost of healthcare by making patients more conscious of their spending. In a Wall Street Journal op-ed piece, Indiana Governor Mitch Daniels writes that by simply adding the HSA option to government employee healthcare choices the state has reduces its total operating costs by eleven percent. Healthcare costs have obviously dropped even more dramatically for Indiana government employees.

It falls upon both patients, to be smarter consumers, and doctors, to “do no harm” to patients’ wallets, to fix this failing system. Some highly-targeted government intervention in this direction would also go a long way. Indeed, requiring both doctors and stock brokers to accept “fiduciary duty” would be a large step in the right direction.

We would also recommend investigating the HSA programs available to you. Unless you have large recurring medical expenses it makes a great deal of sense to pay far less money to insurance and medical providers and keep the balance in a tax-sheltered account.

Cash Is Trash?

Stocks have rallied seventy percent over the past year and mutual fund managers have finally decided that now is the time to go all in. The allocation to cash at mutual funds is now at its lowest level since September 2007, only a month before the most devastating bear market in decades began.

Certainly, professional money managers are feeling very good about the stock market right now. Mark Hulbert, who makes a living tracking investor sentiment, recently wrote that “[among professionals] bullish sentiment is approaching dangerously high levels.”

Ironically, however, individual investors are still rather wary of the stock market (as we feel they should be).  According to the American Association of Individual Investors their attitude towards stocks can only be described as neutral. Ned Davis, Investment Strategists at the eponymous Ned Davis Research, says, “the disparity between hope on Wall Street and malaise on Main Street continues. I have never seen anything like it.”

Indeed, the “malaise on Main Street” shows few signs of improving. The Bureau of Labor Statistics reported that we lost only thirty-six thousand jobs in February and that the unemployment rate declined to nine-point-seven percent. However, if not for the fact that another large group of unemployed workers became so discouraged they removed themselves from consideration the unemployment rate would have actually increased yet again. In fact, a broader measure of unemployment (U6) that includes these folks increased from 16.5% to 16.8%. This continues to be the worst jobs recession in decades.

So why, then, are professional investors so giddy? Beats us. Stocks are overvalued in the midst of a deleveraging cycle that is anything but economically benevolent to investors (see the January “Report”). John Hussman, of the Hussman Funds, recently wrote:

A deleveraging cycle is much like a secular bear market in that the market experiences a great deal of volatility, but tends to establish a sequence of troughs, each at lower levels of valuation (even if not at lower absolute prices). In that environment, there is significant risk of abrupt spikes in risk aversion (which implies abrupt price spikes to the downside), so you can’t trade with “hot” valuation or market action criteria. It should be no surprise that Graham and Dodd wrote Security Analysis following the post-credit crisis period of the 1920’s and 1930’s. If there’s one lesson from those environments, it is that valuations and the idea of a “margin of safety” takes precedence over all other considerations.

In contrast to this “margin of safety” preference, mutual fund managers are throwing caution to the wind. Needless to say, we think this unwise.

There are those, however, that still do not buy the idea of a “deleveraging cycle” at all. The Wall Street Journal inadvertently made this very clear by running an article about the low level of mortgage refinancing with two, vastly different headlines.

The online edition of the paper ran with the headline, “borrowers miss out on billions in savings.” The print edition led with, “borrowers pass up mortgage windfall.” There is a very big difference between “miss out” and “pass up.” The former implies that there is some impediment to refinancing whereas the latter implies a conscious decision to avoid extending the duration of the debt.

Obviously, banks have tightened lending standards but we feel the “pass up” headline is just as valid as the “miss out” one. Last month we wrote about the new “cash in” trend that homeowners have begun to adopt en masse. The declining popularity of refinancing seems to us to fit with this trend. From the Wall Street Journal:

Around 37% of all borrowers with 30-year conforming fixed-rate mortgages—who collectively hold about $1.2 trillion of home loans—have mortgage rates of 6% or higher, according to investment bank Credit Suisse. Many could reduce their rates by a full percentage point if they refinanced at current rates, about 5%. More than half could lower their rates nearly three-quarters of a percentage point, according to Credit Suisse. But new refinance applications in January stood near their lowest levels in the past year. Weekly data compiled by the Mortgage Bankers Association also show that refinance activity has been muted, considering that rates are so low… The last time mortgage rates were at current levels, in 2003, refinancing activity hit $2.9 trillion, according to trade publication Inside Mortgage Finance. Last year, refinance volume reached $1.2 trillion, the highest amount since 2003 but not nearly as much as expected, considering how low interest rates have fallen.

Obviously there are many people who could easily qualify for a home loan five years ago yet are unable to do so today. Still, seventy-five percent of homeowners today

have at least some equity remaining in their homes. Surely some of them could both qualify and benefit from refinancing. For these people, there is no other explanation than they are simply choosing not to. In fact, when they actually choose to refinance they are showing a strong preference for paying the debt down further with a “cash in” type of program (see the February “Report”).

In fact, in a zero-percent interest rate environment this is the only rational thing to do. Why save money at zero percent when you can pay down debt that costs you far more? Faced with this choice any rational person will use savings to pay down debt. In this way, the current Fed zero-percent interest rate policy is actually counter-productive to growth by instigating debt reduction. This is a conundrum for Bernanke & Co. that has no easy solution.

Though some may ignore them, we continue to see signs that this is, indeed, a deleveraging cycle. Core CPI (Consumer Price Index) saw a rare decline in January. This should not be surprising to those listening to corporate America. Companies have been bemoaning deflationary forces for months.

Wal-Mart’s fourth quarter sales fell 1.6% because the world’s largest retailer was forced to reduce prices on everything from laptops to turkeys in order to attract customers to its stores. Archer Daniels Midland, one of the largest agricultural commodities companies in the world, reported its sales fell nearly five percent in the fourth quarter as the prices for the commodities it sells dropped. Food companies in general have been suffering from what TheStreet.com calls a “food price war.” Deere, one company that has benefited from the deflationary environment, reported that earnings in the final months of 2009 were helped by falling steel prices.

Companies are nearly unanimous in their deflationary reports, deflation that can only be explained by a drop in demand. Clearly, consumers are cutting back on everything including credit.

While the Federal Reserve reported that total consumer credit actually increased in January this was led by auto loans. Revolving credit, mainly credit cards, declined yet again and the trend certainly remains lower. As the Wall Street Journal reported last month, “U.S. banks posted last year their sharpest decline in lending since 1942.” Clearly, this is not your average economic cycle.

Elliott Wave International eloquently described the workings of a deleveraging cycle recently:

It may sound crazy, but suppose the government were to decide that the health of the nation depends upon producing Jaguar automobiles and providing them to as many people as possible. To facilitate that goal, it begins operating Jaguar plants all over the country, subsidizing production with tax money. To everyone’s delight, it offers these luxury cars for sale at 50 percent off the old price. People flock to the showrooms and buy. Later, sales slow down, so the government cuts the price in half again. More people rush in and buy. Sales again slow, so it lowers the price to $900 each. People return to the stores to buy two or three, or half a dozen. Why not? Look how cheap they are! Buyers give Jaguars to their kids and park an extra one on the lawn. Finally, the country is awash in Jaguars. Alas, sales slow again, and the government panics. It must move more Jaguars, or, according to its theory — ironically now made fact — the economy will recede. People are working three days a week just to pay their taxes so the government can keep producing more Jaguars. If Jaguars stop moving, the economy will stop. So the government begins giving Jaguars away. A few more cars move out of the showrooms, but then it ends. Nobody wants any more Jaguars. They don’t care if they’re free. They can’t find a use for them. Production of Jaguars ceases. It takes years to work through the overhanging supply of Jaguars. Tax collections collapse, the factories close, and unemployment soars. The economy is wrecked. People can’t afford to buy gasoline, so many of the Jaguars rust away to worthlessness. The number of Jaguars — at best — returns to the level it was before the program began.

The same thing can happen with credit.

It may sound crazy, but suppose the government were to decide that the health of the nation depends upon producing credit and providing it to as many people as possible. To facilitate that goal, it begins operating credit-production plants all over the country, called Federal Reserve Banks. To everyone’s delight, these banks offer the credit for sale at below market rates. People flock to the banks and buy. Later, sales slow down, so the banks cut the price again. More people rush in and buy. Sales again slow, so they lower the price to one percent. People return to the banks to buy even more credit. Why not? Look how cheap it is! Borrowers use credit to buy houses, boats and an extra Jaguar to park out on the lawn. Finally, the country is awash in credit. Alas, sales slow again, and the banks panic. They must move more credit, or, according to its theory — ironically now made fact — the economy will recede. People are working three days a week just to pay the interest on their debt to the banks so the banks can keep offering more credit. If credit stops moving, the economy will stop. So the banks begin giving credit away, at zero percent interest. A few more loans move through the tellers’ windows, but then it ends. Nobody wants any more credit. They don’t care if it’s free. They can’t find a use for it. Production of credit ceases. It takes years to work through the overhanging supply of credit. Interest payments collapse, banks close, and unemployment soars. The economy is wrecked. People can’t afford to pay interest on their debts, so many bonds deteriorate to worthlessness. The value of credit — at best — returns to the level it was before the program began.

Sound familiar? It does to us and we strongly agree with John Hussman that this a time when “margin of safety” must take precedence. In a deflationary environment there are few better assets than cash. Ironically, mutual funds are abandoning it just at the time they should be embracing it.

Interestingly, cash levels at bond funds are much higher than normal indicating that, not only is cash trash, long-term bonds are even less attractive to fund managers. Among professional investment managers, only ten-percent are bullish on bonds right now.

The supply and demand picture, however, clearly supports this bullish minority’s view. Dave Rosenberg, Chief Economist and Strategist at Gluskin, Sheff & Assoc., recently drew our attention to the fact that the supply of long-term treasury bonds is currently at a thirty year low. Long bonds now make up less than ten-percent of all Treasury debt outstanding.

While supply is dwindling demand may start to pick up. China has indicated recently that their forays into non-U.S.-backed foreign securities may be seriously curtailed. Asia Times Online reports:

Dollar-denominated risk assets, including asset-backed securities and corporates, are no longer wanted at the State Administration of Foreign Exchange (SAFE), nor at China’s large commercial banks. The Chinese government has ordered its reserve managers to divest itself of riskier securities and hold only Treasuries and US agency debt with an implicit or explicit government guarantee.

Refocusing China’s growing reserves on the Treasury market serves as a large and increasing source of demand for bonds.

Additionally, the first of the baby boom generation are beginning to retire. As more and more boomers seek a secure retirement over the next decade, the demand for risk-free returns should increase. Treasury bonds are one of the only suitable investments that can meet this demand.

As we’ve written before, sentiment, technicals, macroeconomic fundamentals and supply and demand are all lining up for long-term Treasury bonds and their four-percent rate may soon seem like high-yield. Thus we are adding to our position in the iShares 20+ Year Treasury Bond Fund (NYSE symbol: TLT).

Odds on Ends

Stocks have rallied right back up to their mid-January highs over the past couple of weeks; the volatility index is back to its lows; and the dollar has finally pulled back some after a very strong thrust higher.

We are inclined to use this opportunity to add to our hedges via the UltraShort S&P 500 ProShares (NYSE symbol: SDS). We are also trading the S&P 500 VIX Short-Term Futures ETN (NYSE symbol: VXX) even after disparaging the security in our last letter. Make no mistake, this is a trading vehicle and unsuitable for “buy and hold” investors. Volatility is simply too low right now considering all the uncertainties facing the economy and the markets.

In addition, stocks are running into resistance just as the economy may show signs of slowing. The government stimulus has run out and the current gridlock in congress is not a promising sign for those looking for additional measures to be put in place.

We have also started to look at the Swiss Franc as a possible beneficiary of improving sentiment in Euroland though we have not pulled the trigger and bought it yet. The CurrencyShares Swiss Franc Trust (NYSE symbol: FXF) is an ETF that tracks the currency well. We still have, “no interest in playing the whose-shit-smells-least game of foreign currency trading over the long term.” Over the short-term, however, we think the Swissie may see some interest among traders looking for an alternative to the Euro/Dollar duo that has dominated the financial news media lately. Sentiment has clearly shifted in favor of the dollar lately and this makes the trade less attractive to us.

As a final note, tax season is rapidly approaching. If you , like most Americans, rue the season of giving to the government, take a look at “the fair tax” at fairtax.org. It’s an idea we believe whose time has come.

March 2010

The Felder Report (TFR) is published monthly by Felder & Company, LLC. Subscription rates are $295 per year or $99 for three months. Felder & Company also publishes a free weblog available at http://felderandcompany.com For more information contact us by mail at P.O. Box 790, Bend, OR 97709, by email at admin@felderandcompany.com or by telephone at (541) 389-3345. Felder & Company (F&C) is an Investment Adviser registered with the state of Oregon and various other states. Information in TFR comes from independent sources believed reliable but accuracy is not guaranteed and has not been independently verified. All material published in TFR is subject to change without notice from F&C. F&C’s security recommendations disclosed in TFR are the opinions of Jesse Felder and the performance results of such recommendations are subject to risks and uncertainties beyond the control of F&C. F&C is the manager of individual client investment accounts and as adviser F&C, or its associated persons, may purchase and sell securities identified, recommended and analyzed in TFR. In consideration of performance objectives of its individual client accounts, F&C may purchase and sell securities identified in TFR without notice to newsletter subscribers and may take a position in such securities that is inconsistent with the recommendations disclosed in TFR. Previous, successful recommendations may not be indicative of the results for all recommendations, and in fact certain recommendations have resulted in losses. Subscriber information is never sold, shared or otherwise distributed to third parties.

When Will Individual Investors Find Their “Utopia”?

In 1940, Fred Schwed first published “Where Are the Customers’ Yachts?” poking fun at the investment industry and drawing attention to the relative wealth of brokers as compared to their clients. In all seriousness, it’s a question we should still be asking today.

Bill Miller, manager of the Legg Mason Value mutual fund, owns one of the ten largest yachts in the world. It’s called “Utopia” and at 235 feet long is nothing less than the Ritz Carlton on water. Miller rents it out for nearly $500,000 per week when he’s not personally enjoying its luxurious amenities.

Ironically, Miller earned one-hundred thirty seven million dollars in the three years leading up to 2008, after which the mutual fund he manages lost over two-thirds of its value. Aside from some negative press, Miller’s doing just fine – and, not surprisingly, he has kept his job. I’m sure even Schwed could never have dreamed up such a scenario.

Obviously, Miller is an extreme example of Wall Street making money at the expense of its customers rather than for them as advertised. More than that, I believe Miller is a prime example of the expensive waste that makes up the majority of an industry ripe for reform and innovation.

Many of you may find that you are already well aware of the issues presented in the following assay (yes, “assay” and “essay” – it is our goal to assay the investment industry and, in doing so, try to avoid making “asses” of ourselves). However, one major goal for us with this letter was to help investors better understand the industry, investment products and the potential pitfalls of both so that they can feel at least a bit more confident in their ability to successfully navigate them. If you already feel competent feel free to skip to the next section.

(Those of you who are still reading are the ones we are writing for anyway.) In Schwed’s time it was the stock brokers who made their fortunes (and yachts) on trading commissions. They earned fat commissions no matter how their customers’ trades performed. They had a large incentive to get their customers trading even if this was counterproductive to their portfolios’ success. As Warren Buffett says, “never ask the barber if you need a haircut.”

Today there are laws against “churning,” commissions have dropped dramatically at most brokerage firms and brokers have repositioned themselves as advisors, financial planners, insurance professionals and the like. Still, they have a great incentive to sell certain products and services that are counterproductive or even detrimental to their customers’ financial well-being.

Let’s explore the ways most advisors are compensated today. First, they can still sell stocks with a commission attached and we have already discussed the conflict with this approach. Both customers and enforcement agencies have become attuned to this and so brokers mainly sell mutual funds today instead of hawking stocks. There is a key benefit to advisors with this change: diversification means mutual funds are less volatile than individual stocks, hence, perceived risk is reduced (even though real risk may not be).

Typically, these advisors charge a “load” to buy a mutual fund which is essentially another name for a sales commission. The problem is that the vast majority of mutual funds are available directly to consumers without a load fee and it takes almost no expertise to choose among them. So advisors who get paid this way still have a strong incentive to churn (usually under the guise of “rebalancing” your portfolio) and are essentially being paid, very handsomely we might add, to save their customers the trouble of typing the buy order into a discount broker order system.

Increasingly the large investment houses are moving away from charging loads and towards charging wrap fee. A wrap fee typically runs anywhere from one to three percent of the account value and replaces the typical commission structure. The good part about a wrap fee is that it eliminates the incentive to churn an account. The problem, however, is that once an investor signs up for advisory services, abandoning the typical commission structure for a wrap fee arrangement the advisor’s new incentive is to make initial recommendations and then forget all about the customer. The advisor’s fee will keep coming in year after year without any additional attentions paid.

In addition, the wrap fee arrangement is extremely costly. For the sake of argument let’s assume a two-percent wrap fee on an account that invests in equity mutual funds. On top of that two-percent, the customer will be paying the mutual fund manager another one to two percent management fee and, in turn, that manager will be paying commissions for all the trades made in the fund. All told, we are probably looking at a total cost relative to the portfolio of at least five-percent per year. Do not underestimate just how massive this hurdle is or its deleterious effects on the ability of the portfolio to grow over time. If, as Einstein said, “the most powerful force in the universe is compound interest,” its most powerful opponent is layer upon layer of advisory fees.

Brokers also typically advise that investors buy a portfolio of mutual funds to further diversify and reduce perceived risk. However, a single mutual fund typically holds hundreds of stocks and is thus well-diversified enough already. In fact, this is why mutual funds and exchange-traded funds were created – to give investors sufficient diversification in one investment product. The more funds you own the more your portfolio begins to look like an index with one exception: you are paying ten times the amount in fees you would be paying to own one index fund.

Make no mistake: diversification beyond a certain amount is nothing more than a cop out. When a broker recommends you buy more than two or three equity mutual funds or a mutual fund manager purchases more than thirty or forty stocks for her fund it’s very similar to a fast food burger: there is very little meat to begin with and who knows how much real beef is in the stuff they call “burger,” anyway? Just as fast food chains use who-knows-what to hide a dearth of quality ingredients, advisors and fund managers use diversification to obfuscate lack of expertise, conviction, and/or a dearth of real opportunity.

Another area advisors have found to earn a decent income is in financial planning. Financial planners typically charge by the hour or charge a one-time fee for a portfolio review. There is less conflict in this arrangement than in the traditional broker-client relationships, however, financial planners rely very heavily on models to try to predict the future value of different asset classes, models that are more likely to be wrong than right because they mainly rely on historical data and extrapolate it into the future.

Here’s an example of what we mean: if in 2005 you tried to predict the future value of residential real estate prices relying on models that accounted for the prior twenty-five years of history you would have failed spectacularly to account for what occurred over the subsequent five years. Not only would you have failed to foresee the crash you would have predicted a continued gain. Obviously, we have not seen that scenario play out.

Our biggest issue with financial planners, though, is that they make overly simple recommendations based upon too little information. One such “rule of thumb” that is prevalent in planners’ tool boxes involves allocating investments to the stock market based upon one’s age. Many planners start by subtracting your age from one-hundred to determine the percentage of one’s portfolio to allocate to stocks, regardless of the relative value of stocks as an investment. The balance of the portfolio can then be allocated to various asset classes regardless of their relative attractiveness, as well. A very similar methodology is used by “target date” funds commonly employed by labor unions’ and corporate retirement plans.

Under these conditions, your humble editor would have invested fully seventy-five percent of his liquid assets into the stock market at the height of the internet bubble. Conversely, in 1982 when stocks were cheaper than almost any point in history financial planners would have had the vast majority of their customers underinvested for the biggest bull market the world has ever seen.

Still some people enjoy working with a planner because they like to be told how much to save to achieve certain life goals like paying for their children’s college tuition or retiring to an island in the Bahamas, etc. Let us put aside the flaws in the models used for such predictions for a

moment and simply consider this: why should you not simply earn and save as much as possible and, at the end of the day, be satisfied with you efforts? Ultimately, people pay financial planners for the sense of security their predictions and recommendations give them no matter how false that sense of security may be.

Another way advisors have found to earn a living is by selling investment products in the guise of insurance (or vice versa). Variable annuities are a good example of such. It is no coincidence that I know of no other product besides the variable annuity that both pays an advisor more and is the most abused financial product ever invented. Variable annuities are essentially mutual funds combined with life insurance policies but they are very easily replicated. One could simply buy an index mutual fund and a term-life policy and achieve a similar benefit while reducing the fees involved by more than ninety percent.

As mentioned earlier, the variable annuity is also one of the most abused products by salespeople in the industry today. There are many stories of elderly people being sold annuities that are very large in relation to their overall net worth and that require they pay into them when what they typically need is a vehicle that pays them – this to generate a commission for the seller despite the transaction being detrimental to the customer.

Finally, the ultimate value of a variable annuity, like any insurance product, is determined by the strength and health of the insurance company that is underwriting the contract. As we have seen over the past couple of years, even the biggest and most hallowed institutions are not insulated from financial calamity. Across the retail investment and insurance industries, nowhere is “caveat emptor” more important than with variable annuities.

Even beyond advisors, mutual funds are a massive segment of the investment industry and their managers are paid extraordinarily well for less than mediocre performance. Bill Miller is not the only example of this. The vast majority of actively managed mutual funds underperform the stock market indexes over time. The Warren Buffetts and Peter Lynchs of the world who justify their fees with above average returns over long periods of time are the exception not the rule. As Burton Malkiel likes to point out, ‘out of all the thousands of actively-managed mutual funds you can count the number that have outperformed the stock market over the past forty years on one hand.’ For this sub-par performance, the average mutual fund charges ten times as much to invest your money than its comparable index fund – that is, if you didn’t already pay a load or wrap fee to buy your actively managed fund in the first place (in that case, the multiple is even much higher).

All of this is to demonstrate why we believe that at least ninety percent of the investment industry should be taken out and shot. Advisors, financial planners, insurance professionals, mutual fund managers and the like are mainly responsible for wasteful fees if not outright harmful recommendations. The investment industry is one example where “you get what you pay for” is a lie. To overcome this problem, the industry has learned to expertly play upon the fears of investors to sell them a false sense of security.

Reform and, more importantly, innovation that inspires widespread creative destruction is sorely needed in the financial space. This has already begun with discount brokers that have changed the brokerage business models for good. Index funds and the surge in popularity of exchange traded funds have also helped but still haven’t significantly dented the business of the major brokers and mutual fund companies.

Where real change will come is in bypassing the bad advisors altogether. The business models of the financial companies of tomorrow will give investors the ability to succeed without an advisor and a true sense of security in their own competence. Companies that inform people of the drawbacks to traditional investing and make it much easier to avoid them will not only thrive but will also be the real force of reform in the industry.

Until then, there are a few, simple things to consider when putting your personal investment house in order. First, avoid the advisors at the major financial institutional altogether. Their first loyalty is to their own pocket book and then the firm they work for; just as a Toyota salesman’s first loyalty is to the almighty dollar and then to his dealership. To both brokers and car salesmen, what is in your best interest comes after those considerations, if at all.

Next, rather than ask a financial planner how much you should save and to predict the future value of your portfolio under a variety of unknowable conditions, simply save as much as you can and try to buy low and sell high. Financial planners have no crystal ball that is any better than simple common sense. In fact, the fancier the models and pie charts are the less you should trust them. Remember that it was Nobel Prize-winning economists whose financial models nearly brought the world economy to its knees only a year ago. Financial planners’ models can be just as detrimental to your financial well-being.

Avoid products you don’t understand, especially those that seem intentionally confusing. Variable annuities are just such a product. If you need life insurance, find a simple, low-cost product that you can easily understand and that fits your needs. Keep your investment portfolio separate. You wouldn’t buy health-insurance from a used car salesman and you shouldn’t feel comfortable buying the equivalent from a so-called “financial advisor.”

Finally, when it comes to investing in stocks and bonds, index funds give you very low-cost exposure and broad diversification.  We have no doubt that an investor who saves as much as possible and invests her savings in stock and bond index funds exclusively, letting common sense and her personal risk tolerance guide her in her allocation decisions, will be very successful.

Avoiding costly mistakes in investing is by far the most important factor for success. Overpaying for advice, paying for unnecessary or bad advice and investing in bad products are some of the most common mistakes made by investors of all types. The investor who learns this is already way ahead of the game.

There is, however, one more major pitfall in investing. That is investing at the wrong time. The internet and real estate bubbles are rife with examples of investors who bought at precisely the wrong time. As for when to buy which assets or, better yet, how to outperform the indexes, that is how a great investor truly earns his keep and precisely what keeps your humble editor at your service.

The Pols Are Playing With Fire

Perhaps the Obama administration isn’t quite ready just yet to follow through with, “a policy of massive spending on the country’s infrastructure to create jobs and promote a sense of hope and renewal,” as we suggested last month. Quite the opposite, it seems, as the president has gone so far as to suggest the federal government implement a “spending freeze.”

This probably had something to do with the brisk selloff in stocks over the last few weeks as the economy remains very fragile and politicians seem to be as myopic as usual. Traders evidently recognize the dangers associated with removing economic stimulus too soon. Liberal economist Paul Krugman recently elucidated these dangers in a New York Times Op-Ed piece:

The next G.D.P. report is likely to show solid growth in late 2009. There will be lots of bullish commentary — and the calls we’re already hearing for an end to stimulus, for reversing the steps the government and the Federal Reserve took to prop up the economy, will grow even louder. But if those calls are heeded, we’ll be repeating the great mistake of 1937, when the Fed and the Roosevelt administration decided that the Great Depression was over, that it was time for the economy to throw away its crutches. Spending was cut back, monetary policy was tightened — and the economy promptly plunged back into the depths.

Indeed, the last G.D.P. report showed that the economy grew nearly six percent in the final three months of 2009, the fastest rate of growth in six years.

On the surface, this is good news for the economic recovery. It is also likely president Obama’s justification for the nation being able to afford a spending freeze. Fed governor, Thomas Hoenig is also probably using numbers like this one as evidence that the economy can afford higher interest rates. (Hoenig was the only dissenting vote at the last Federal Reserve rate-setting committee which voted to leave rates at zero percent). However, Krugman accurately predicted early in January that this report would be nothing more than inventory building, a statistical blip that hides the underlying weaknesses.

As you read the economic news, it will be important to remember, first of all, that blips — occasional good numbers, signifying nothing — are common even when the economy is, in fact, mired in a prolonged slump. In early 2002, for example, initial reports showed the economy growing at a 5.8 percent annual rate. But the unemployment rate kept rising for another year. And in early 1996 preliminary reports showed the Japanese economy growing at an annual rate of more than 12 percent, leading to triumphant proclamations that “the economy has finally entered a phase of self-propelled recovery.” In fact, Japan was only halfway through its lost decade. Such blips are often, in part, statistical illusions. But even more important, they’re usually caused by an “inventory bounce.” When the economy slumps, companies typically find themselves with large stocks of unsold goods. To work off their excess inventories, they slash production; once the excess has been disposed of, they raise production again, which shows up as a burst of growth in G.D.P. Unfortunately, growth caused by an inventory bounce is a one-shot affair unless underlying sources of demand, such as consumer spending and long-term investment, pick up.

Krugman proved remarkably prescient. The majority of GDP growth last quarter was, indeed, due to inventory building. This makes the sustainability of the economy’s recent growth questionable.

As discussed in January letter, consumer spending is unlikely to come to the economy’s rescue this time because of the massive amount of debt consumers now carry. A recent article in the Los Angeles Times supports our deleveraging thesis. A few years ago “cash-out” refinancing was all the rage; putting the equity in their homes to “better use” was an inalienable right of homeowners. Today to the opposite, “cash-in” refinancing, is gaining in popularity:

The pendulum in consumer psychology appears to be swinging toward reduction of household debt — whether on credit cards or mortgages. In Freddie Mac’s latest quarterly survey of refinancings, 33% of homeowners put cash into the deal to lower their mortgage balances, the highest percentage ever. By contrast, only 27% of refinancers took cash out — the lowest percentage on record.

This is precisely what we meant when we wrote in January about a “zeitgeist of deleveraging.” It is very easy to understand the reasoning for this. If you can only earn less than one-percent on savings and you can pay down debt that costs you many multiples of this rate the decision is simple: paying down debt is much more attractive than investing savings in other vehicles. This is the right thing to do for the consumer yet presents a massive challenge for the economy.

All in all there are very few real signs that the economy is on its way to stable ground. The hawkish voice at the Fed and the fiscal conservatism in Washington should be very troubling to those that understand just how weak the economy really is.

Should we experience renewed economic weakness in coming months there are a few potential areas of concern to aware of. First, we have seen many bank failures over the past couple of years and those are expected to grow over the course of this year. The FDIC has handled this situation admirably, making nearly every affected depositor whole and ensuring a smooth transition from the failed banks to the acquired banks.

However, at this point the deposit insurance fund is very probably broke. At the end of 2007 the fund had a balance of $52 billion; at the end of 2008 that had dropped to $17 billion; although we don’t have the official numbers yet, 2009 was at least as bad as 2008. The pattern here is clear: there is a very large cost in “saving” these failed banks and the FDIC is bearing the brunt of this cost to its own detriment.

What is worse is the loss-sharing agreements the fund enters into when a bank fails. To make a failed institution attractive to a would-be acquirer the FDIC guarantees the loans the in the failed banks’ portfolios. This is a phenomenal deal for an acquiring bank as they receive all the deposits and loans of the failed banks with none of its worst liabilities. The FDIC has entered into $122 billion worth of such agreements so far. To wit, the losses in the value of the insurance fund, for the most part, do not reflect the losses on these securities that it has guaranteed as they are not recognized until their bank partner decides to sell them. This means that the financial position of the FDIC is very probably much worse than just being “broke.”

How this problem is resolved is anyone’s guess. The FDIC is funded by the banks it insures. However, the majority of these banks are in no position to help recapitalize the insurance fund. What seems more likely is the FDIC would “borrow” money from the Treasury to help it meet its obligations.

What is even more worrisome to us than the situation the FDIC finds itself in is the current state of our central bank. During the last downturn the Federal Reserve played a very large role in rescuing the world’s largest financial institutions. After spending literally trillions of dollars in this effort, the Fed now finds itself in a situation perhaps even more precarious than that of the institutions it helped to save.

To help prop up the defunct mortgage market, the Fed stepped in nearly a year ago to buy mortgage-backed securities. Since then it has accumulated nearly a trillion dollars of them which has caused leverage at the central bank to grow out of control. The Fed now has assets that amount to forty three times its capital. In comparison, Goldman Sachs maintains its assets to capital ratio closer to fifteen. Those worried about Goldman Sachs and its

competitors taking on too much risk need to take a hard look at the Fed.

The very high leverage ratio at the central bank means that a mere three percent drop in the value of its mortgage assets would render the Fed insolvent. Fannie Mae’s current default rate of five percent alone should raise alarm about the Fed’s current level of risk. There is no way of knowing, however, whether the Fed’s purchases were made at attractive prices or if its buying has artificially propped up prices whose true value is below the Fed’s cost. Still, we can think of nothing more potentially troublesome to the economy than the collapse of the Fed.

Just as you were beginning to imagine Armageddon U.S.A., however, we help you find solace in the relatively bleaker outlook of some of our trading partners. The U.K., for example, has a larger private-sector debt problem than we face. Japan, Greece and Spain are all on the brink of systemic collapse. In comparison, our problems look benign and this has been reason for the dollar to continue its rally especially in relation to the Euro. This rally will likely continue over time yet we have sold our trading positions in Short-Euro ETF (NYSE: EUO). We are glad to exit this trade with a profit and have no interest in playing the whose-shit-smells-least game of foreign currency trading over the long term.

Considering the problems across a variety of sovereigns, gold may turn out to be investors’ salvation. As it has no investment merits, though, we cannot bring ourselves to recommend it. We also believe that a climate of deleveraging means the risk of deflation is much higher than is normal and thus the risk of falling asset prices, including gold, is a risk we do not want to bear.

Finally, we took the opportunity to sell our VIX ETF (NYSE: VXX) for a profit. We believe there is a good chance that volatility continues to increase in coming months but we were troubled by correlation issues with the ETF. As the VIX Index last month overcame its December highs, the ETF failed by a good twenty percent to follow suit. This is major problem with ETFs that claim to track futures indexes. Natural Gas is another good example: as the commodity more than doubled over the past few months its respective ETF (NYSE: UNG) saw less than a thirty percent rise. After variable annuities, ETFs might be the second most important vehicle for investors to practice “caveat emptor.”

For a printable version of this issue download the PDF version here:

“The Felder Report” – February 2010

The Felder Report (TFR) is published monthly by Felder & Company, LLC. Subscription rates are $295 per year or $99 for three months. Felder & Company also publishes a free weblog available at http://felderandcompany.com For more information contact us by mail at P.O. Box 790, Bend, OR 97709, by email at admin@felderandcompany.com or by telephone at (541) 389-3345. Felder & Company (F&C) is an Investment Adviser registered with the state of Oregon and various other states. Information in TFR comes from independent sources believed reliable but accuracy is not guaranteed and has not been independently verified. All material published in TFR is subject to change without notice from F&C. F&C’s security recommendations disclosed in TFR are the opinions of Jesse Felder and the performance results of such recommendations are subject to risks and uncertainties beyond the control of F&C. F&C is the manager of individual client investment accounts and as adviser F&C, or its associated persons, may purchase and sell securities identified, recommended and analyzed in TFR. In consideration of performance objectives of its individual client accounts, F&C may purchase and sell securities identified in TFR without notice to newsletter subscribers and may take a position in such securities that is inconsistent with the recommendations disclosed in TFR. Previous, successful recommendations may not be indicative of the results for all recommendations, and in fact certain recommendations have resulted in losses. Subscriber information is never sold, shared or otherwise distributed to third parties.

“The shares crash; hopes are dashed. People forget…” –The Who

The biggest stock market crash in a generation is less than a year old and, somehow, equity investors have forgotten all about it. I guess a sixty-five percent rally in the intervening months can do that.

A variety of indicators make it clear that complacency has once again replaced panic in the minds of investors and for this reason true contrarians can no longer be bullish. The time for bullishness was back in the early Spring when the stock market crash was tailing off but investors were acting as if it were only beginning, selling anything and everything regardless of its true investment value.

While we do consider ourselves “true contrarians” this is not to say we’ve become exceedingly bearish only that we prefer to raise our guard when the crowd drops theirs. To illustrate just how far away from the bear cave the bull herd has now travelled we would note that Investor’s Intelligence just recorded the fewest bears in their survey of advisors since 1987. Stock market bears, it seems, are once again becoming an endangered species. In addition, the CBOE Volatility Index, also known as “the Fear Index,” has dropped a staggering seventy-five percent over the past year or so in another sign that investors fell a great deal of contentedness with the stock market. When we see extremes like these in either the bull or bear camp we have found it pays to trade in the opposite direction of the herd.

Aside from the troubling sentiment picture, it is also staggering to realize how fast stocks have gone from undervalued to overvalued. Speaking of 1987, according to data provided by Yale economist and “Irrational Exuberance” author Robert Shiller, the recent rally has pushed the S&P 500 to over 20 times the value of its five-year average earnings, roughly the same value it reached during the Summer of that prior year. It wasn’t until October of 1987, of course, that stocks made their famous plunge but investors who sold early weren’t kicking themselves for very long.

Stocks may, in fact, be even more overvalued than the numbers suggest. Bank earnings are arguably inflated to a significant degree due to new accounting rules that allow

them to prop up the value of certain assets, remove certain losses from stated earnings and record some very dubious gains. Essentially, the big comeback for the banks over the past year has been largely created by accounting concessions from the FASB. This is not easy to quantify, of course, but should nonetheless be factored into consideration when analyzing equity valuations.

Things don’t look a whole lot better for stocks from a technical perspective. The S&P 500 recently reached an important point of resistance. The 1121 price level for the index marks the fifty percent retracement of the decline that began in 2007. Ironically enough, November 21^st (1121 on 11/21), roughly the first time the index approached this level, also marked the fifty percent time retracement of the decline. Many skeptics wonder if support and resistance levels such as this one are effective because they are meaningful in and of themselves or if they work simply because traders focus on them so intently. In either case they do frequently mark turning points. For this reason we have been watching the 1121 level very closely for the past couple of months and stocks have, indeed, made little progress so far in surmounting it.

Sentiment, fundamentals and technicals, then, are all flashing a caution signal right now and we are heeding their warning. To take advantage of the potential for a healthy reintroduction of fear into the markets Barclay’s iPath S&P 500 VIX Short-Term Futures ETN (NYSE symbol: VXX) looks to be a logical choice and we do own it in our managed accounts. Should the “Fear Index” rise in 2010, VXX will rise with it and it looks as if there is plenty of room overhead.

To address the current overvaluation and resistance for stocks, we believe it prudent to at least hedge exposure to the stock market. Our vehicle of choice for this is the UltraShort S&P 500 ProShares (NYSE symbol: SDS) which we also own for clients. We prefer this to an outright short position simply because it is much easier to manage. As a short position goes against you it increases in value becoming an even bigger losing position. SDS, however, works more like a long position and decreases in value as it moves against you. A short sale also has the potential for unlimited losses; short-biased ETFs like SDS have limited potential for losses. This is a very simple but very important difference, especially to the average investor or trader who lacks experience in managing short sales.

The Economy in the Balance

The rally of the past ten months, in addition to easing the minds of investors, has seemingly papered over the major causes of the crash. That these problems have yet to be adequately addressed seems to matter little to investors right now. We believe, however, there is a high likelihood that investor apathy towards these issues may disappear just as quickly as it arrived.

The credit crunch is still on and shows no signs of improving. According to research conducted by Asha Bangalore at Northern Trust, net private sector lending fell $2.3 trillion in the third quarter, the first decline ever recorded in this measure. Banks are reluctant to lend money, instead focusing on shoring up their beleaguered balance sheets. In addition, both consumers and business are reluctant to borrow. Just like the banks they are focusing instead on improving their financial strength.

This is precisely the situation Richard Koo, Nomura Chief Economist, has dubbed a “balance sheet recession,” the likes of which has plagued Japan for the past couple of decades. What makes a balance sheet recession uniquely difficult for policy makers to address is the zeitgeist of deleveraging, the process of paying down debt in order to improve the balance sheet. Standard economic stimulus does not have its usual effect when the money pumped into the system by the central bank does not end up in circulation because of lenders’ unwillingness to lend and, perhaps more importantly, borrowers’ unwillingness to borrow no matter how low rates get.

In order to really understand the concept, imagine you are a credit worthy business or an individual with the ability to borrow money for next to nothing. Still, you decide not to take on any new debt no matter the opportunities available to put the money to use because of your rational fear of leverage, a fear developed by your experience of bubbles in the stock market and real estate and their aftermaths. No, you will not go down the path of greed as so many did then; their greed was far too costly. You will use every last penny you earn to pay down debt and to build savings in order to avoid the mistakes you witnessed so many make. After the experience of the past decade in the United States, this should not be so difficult to envision.

This focus on deleveraging further reduces demand in the economy causing a vicious cycle of economic retrenching. Basic economics teaches us that money spent stimulates the economy by becoming the earnings of others which is, in turn, spent in a fortuitous cycle of economic growth. Money saved, however, goes into the banking system which would normally be lent out for investment or other types of spending. In a balance sheet recession this money isn’t lent out (for reasons mentioned earlier) and therefore does not add to economic activity removing a key component of economic activity. Because more money is saved and not then lent out demand drops causing businesses and consumers to further retrench in a vicious cycle that leads to a depression.

Now imagine running a central bank in a country where every business and individual is acting this way. How can you possibly stimulate an economy that has been poisoned by the fear of debt when all of your tools promote precisely that which everyone is afraid of? This is the dilemma Japan has faced for a long time and is now a

very real prospect for America. In fact, there are many signs that this is precisely what we are seeing in the U.S. economy today.

Comstock Partners recently drew some fascinating parallels between our current situation and Japan’s economic problems that began in the late 1980’s:

The similarities between Japan’s deleveraging since 1989 and the U.S. presently are eerie.  Japan’s total debt to GDP increased from 270% when their secular bear market started to just about 350% eight years later (1998) before declining to 110% presently.  The U.S. increased their total debt-to-GDP from 275% of GDP when our secular bear market started in 2000 to 375% presently (10 years later), and we suspect a total debt decline similar to Japan’s even though the Japanese government debt tripled during their deleveraging.  The government debt relative to GDP was about 50% in both the U.S. and Japan when the secular bear market started.  We also suspect that our government debt will grow substantially just like it did in Japan as the private debt collapses.  The private debt in Japan decreased substantially from the peak seven years after the secular bear market started (dropping from 270% of GDP to 110% presently).  If the U.S. were to follow Japan’s deflationary road map, we would expect our government debt to increase from about $7 trillion (net government debt not including the debt used to fund Social Security) to about $21 trillion and the private debt to decrease from about $39 trillion to around $20 trillion.  Also, the Japanese stock market doubled during the three years preceding their secular bear market in 1987, 1988, and 1989 while the U.S. market also doubled during the three years preceding the beginning of our secular bear market in 1997, 1998, and 1999.

Clearly there are distinct similarities between our recent economic experience and Japan’s. America, having followed Japan down the path of economic gluttony is now very likely to undergo a similar, prolonged deleveraging that will manifest as a severe economic challenge for the powers that be. We would do well to learn from their example.

A classic symptom of a balance sheet recession can be found currently in the U.S. mortgage market. The New York Times recently reported that despite the lowest mortgage rates since the 1940s, refinancing of existing mortgages has dropped dramatically. In addition, mortgage applications to purchase property also recently fell to their lowest level in over a decade. Indeed, credit is more difficult to come by but we believe that demand for credit has also diminished dramatically. After more than a decade of binging on credit Americans certainly have some catching up to do in the savings department.

Statistics clearly show just how debt-dependent American consumers have become over the past twenty years. Historically, the household savings rate has averaged roughly ten percent of disposable income. Beginning in the mid 1990’s, as the stock market boomed with the internet bubble which was closely followed by the real estate bubble, consumers felt no need to save at all and for the first time since the Great Depression the savings rate actually went negative by 2005. This caused household debt relative to gross domestic product to soar from an average of sixty percent before the twin bubbles began to nearly one hundred percent over the past fifteen years. Consumer debt relative to income has also risen to similarly astronomical levels and must come back down to earth.

An argument can even be made that the current U.S. economic predicament may be more detrimental than Japan’s. Japanese households maintained a prudent level of saving throughout the economy’s bubble cycle. It was the corporate sector in Japan that really binged on debt supported by rapidly rising asset prices of the country’s real estate and stock market bubbles. Thus the major impediment to Japanese growth over the past couple of decades has been corporate deleveraging in the aftermath of those bubbles. Considering the fact that consumers make up the majority of our economy and both the consumer and corporate sectors need now focus on debt reduction it is easy to see how our economic problems could prove even more troublesome than Japan’s.

Ultimately, the past two decades of fiscal debauchery by both businesses and consumers have caused an economic hangover that can only be healed with time and increased fiscal conservatism. This, however, is the perfect prescription for a deflationary vicious cycle as described earlier. Signs in the financial markets suggest this is precisely what we are seeing right now.

The once-in-a-generation crash in asset prices, including stocks, real estate, and commodities over the past two years also goes a long way towards making the case for deflation. (Despite the rally in these asset classes of late they are all still a long way from their highs of only a few years ago). Recent trading in the dollar confirms the idea that deflationary forces are in effect. Despite popular sentiment, the greenback looks to be throwing off its long-term malaise and should be poised to rally over the coming months. As the dollar gets more expensive, by definition alternatives must depreciate in value. The “cash is king” mantra of only a few months ago may soon make a comeback. Even commodities uber-bull and inflation prophet Jim Rogers recently said he’s loading up on dollars as the inflation trade has gotten too crowded for his contrarian sentiments. A deflationary dollar rally is now underway.

Aside from deflationary signals there are plenty of signs that our current economic slowdown is more than just your run of the mill recession. We discovered a more obscure statistic while sorting through Robert Shiller’s stock market data: the bear market in stocks was punctuated by the largest earnings crash in history. Earnings for S&P 500 companies declined over ninety percent over the past two years. Even the seventy-five percent crash during 1929-1932 doesn’t quite compare to our more recent history. This is a very important statistic we believe very few investors are aware of that makes a “v-shaped recovery” a long shot, at best. It took earnings twenty years to recover after the 1929 crash. How can we expect our recent earnings crash that was significantly more painful to fair much better in its aftermath?

To further throw water on the stock market rally and the hope for a quick economic recovery, job losses during this “Great Recession” have been roughly three times greater than the average post-World War II recession and show no sign of improving. Mortgage rate resets will continue to grow in 2010 hampering any improvement in the real estate market. Commercial real estate is now following residential real estate into the abyss further weakening the already precarious state of the banks’ balance sheets. In fact, the FDIC recently announced they will be dramatically raising their operating budget to increase hiring in order to accommodate an increasing number of bank failures in 2010. This doesn’t strike us as a vote of confidence from the feds.

Ultimately, the only growth in the economy right now, according to the venerable Paul Volcker, is artificially created by government stimulus which is not self-sustaining. If Richard Koo is correct, continued stimulus will be necessary to prevent the country from falling into a more severe economic predicament. This stimulus must be geared more towards large spending projects on infrastructure and related projects rather than the typical supply side remedies which are impotent in this kind of environment.

All of this is to say that the possibility of continued economic weakness as described by the term “Balance Sheet Recession” is a frighteningly real possibility for our country even it is not the most probable outcome. We believe investors would do well to factor it into their portfolio plans.

Opportunities to do so may be found in shorting some of the major currencies that have benefitted most from the dollar’s weakness over the past few years such as the Euro, British Pound, Australian Dollar and Canadian Dollar. The ProShares UlraShort Euro (NYSE symbol: EUO) is one option that we have owned in client portfolios for the past month or two.

In addition, we believe that over the next few years leading up to the 2012 presidential election the Obama administration will follow through with a policy of massive spending on the country’s infrastructure to create jobs and promote a sense of hope and renewal. According to Richard Koo this is also the most effective form of economic stimulus during a balance sheet recession. From a sector perspective infrastructure plays such as aerospace, heavy construction and industrial equipment, may prove rewarding in this kind of environment. We don’t have any specific recommendations here just yet but we’re keeping our eyes open.

Needless to say we don’t believe the hype surrounding the inflation trade, at least not yet. For those looking to profit from deflation, long-term treasuries yield over four percent currently and if yields decline even back to the levels we saw a year ago, price appreciation will be significant. The Barclay’s iShares 20+ Year Treasury Bond Fund (NYSE symbol: TLT) is an easy way to gain exposure here. This trade, though, requires a careful eye on any signs of inflation for we may, indeed, see inflation at some point down the road. However, until all the money printing actually reaches the official money supply (a dubious prospect) we don’t think inflation concerns need outweigh those for deflation. In fact, it may turn out that we see zero-percent interest rates for a very long time, ala Japan.

What is encouraging about Japan’s example is that despite experiencing an even greater relative loss of wealth than that brought about by the Great Depression, Japan has managed to keep its economy from collapsing through perpetual government stimulus measures. However, while we mark this lost decade for stocks, Japan is now marking two lost decades. We should hope we don’t suffer a similar fate but we should also be prepared if, in the words of Mark Twain, history “rhymes.”

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January 2010

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