Another piece of the puzzle fell into place last week as the economy slides into a recession. The manufacturing index fell to 48%, anything below 50 signals an economic contraction. The December jobs report was mixed. 18,000 new jobs were created but the unemployment index rose to 5.0%. Don’t be surprised to see the January or February jobs report turn negative, at which time the last remaining significant economic indicator will have slipped into the red.

 

The likelihood of further declines in existing home values was reemphasized last week. Housing prices will have to fall 15% to return to their historical relationship with rents – the point at which renters will consider/be able to afford buying a house. Commercial real estate does not suffer from the same speculative excesses of the residential market but some cracks are appearing in commercial properties as well. Unsold houses being rented are impacting apartment owners, weak retail sales are effecting shopping centers and an economic downturn will effect office rents.

 

Companies are revising their 2008 earnings forecasts downward or issuing cautionary statements, except for the U.S. auto industry. That’s odd since the auto companies biggest sellers are pickup trucks, followed by SUVs, and the demand for trucks is weakening. Oil hitting $100 a barrel last week doesn’t help the auto industry. Although, the $100 mark is a noteworthy psychological level, the different between $92, $95, $98 a barrel oil is immaterial. Rising food prices, driven by crops being planted for biofuel, is a more significant inflationary worry.

 

It’s no wonder that the Dow and S&P are down 4% for 2008 and the NASDAQ is down 6%. Hopes of a Fed rate cute may temporarily buoy the stock market but a rate cut, or cuts, won’t enable the U.S. to avoid a recession. Financial firms and banks have to loosen credit and the residential housing market has to return to equilibrium before the Fed’s actions will have a lasting effect. Look for the stock market to work its way 15% lower.

The economy faces serious challenges in 2008: 1. New home sales are at a 16 year low and may go lower;  2. Inflation will be high for the next few months as energy and food prices work their way through the economy;  3. Retail sales will be weak, as evidenced by the Christmas season;  4. Illiquidity in the credit markets will spread from mortgages to auto loans and credit cards due to financial companies tightening their lending standards;  5. Adjustable rate and subprime mortgage problems will continue; 6. Corporate profits will turn negative. These factors will contribute to, but not cause, the 2008 recession and they will be somewhat mitigated by strong export demand (thanks to the weak dollar) and, at least for the time being, good unemployment numbers.

 

The decline in the value of existing homes is what will cause the 2008 recession and cause it to be the most severe recession since the early 1980s (although not all that bad by historical standards).   The bulk of the average American’s savings is in their home and their net worth is decreasing. There will be far fewer mortgage refinancings and home equity loans to monetize housing values. Declining housing values will cause/force consumers to cut back spending.   

 

Existing home prices were down 3.3% for the twelve months ending in November.  Although sales were up slightly in November, they’re still down 20% from a year ago. Record levels of foreclosures and mortgages which rates adjust in 2008 make it unlikely the November up tick will be sustained.   There will no economic recovery until housing prices bottom. The Fed will cut rates to combat the economic downturn but financial institutions stricter lending standards will mitigate the impact of the Fed’s actions. Thus, we should expect up to four quarters of negative economic growth. 

 

Morgan Stanley, in their December 10 Strategy piece, looked at historical stock market declines and concluded that, on average, the S&P declines 9.5% from its peak to the start of a recession, 18% from there to its bottom, then rebounds by 25% through the end of the recession. The S&P (and the Dow and NASDAQ) is off about 5% from its 2007 high.  This suggests another 23% decline until it reaches its recessionary low. Forecasting is not an exact science (far from it) and the U.S. economy has proven to be remarkably resilient. Also, the S&P is trading at a reasonable level, based on its P/E ratio, so maybe the decline will be less this time, say 15% from current levels.

 

How do you invest for a recession? For stocks and mutual funds look for companies which sell consumer necessities, heath care companies, companies with large foreign sales, high dividend (make sure its secure) stocks and invest internationally. Bonds typically perform well during recessions because of falling interest rates. But with Treasury yields already low and the uncertainties surrounding corporate bonds, you would be wise to keep your fixed income investments short-term until the credit situation resolves itself. What you shouldn’t do, though, is get out of the stock market. The U.S. will come through this recession as it has every other and economic growth will drive the stock market to new highs. As the Morgan Stanley report points out, the stock market rises sharply prior to the end of a recession and nobody can pick the turning point.   Lastly, although I don’t advocate market timing, I’d put new 401-K and IRA contributions into cash for the time being. Cash is king in times like these. 

All of us at MUTUALdecision.com and the MUTUALdecision blog wish you and yours a safe and happy holiday season. Our next blog will appear on January 2. We wish you a prosperous New Year.

The countdown to the New Year has begun but before the ball drops, actually before 4 PM EST on that Monday, review your investments and place your sell orders for tax-driven transactions.  For stocks and other securities, make sure your order is placed in time for it to be executed. This is particularly important for thinly traded stock and bonds. Taking a loss will offset gains and you can take an additional $3,000 of losses (on a joint return; $1,500 on a single return) in excess of capital gains as a deduction on your income tax returns. For the maximum advantage, try to offset short-term gains with short-term losses and long-term gains with long-term losses. 

 

For mutual fund investors, even if you haven’t sold any funds this year, you still many have a taxable capital gain. Mutual funds must pass through their net capital gains or losses, and income, to their holders. Give your fund a call if you haven’t heard from it about its 2007 distributions. And, as a general rule, sell a fund before its announced distribution date and buy a fund after that date. This avoids your having to pay taxes on its distributions.

 

If you’re selling your entire position in a fund or security skip to the next paragraph, but if you’re selling a portion of your holding you need to specify the tax lot(s) you’re selling or the First In, First Out (FIFO) rule will apply.  The potential trap here is if you hold a fund or security which you bought at various times, the cost basis of each transaction could be very different. Make sure you specify the most advantageous tax lot to sell.   Mutual fund investors have a third option which is to use the average cost of their holding. Note: Before you make any tax-based decisions you should consult your tax adviser.

 

It’s not too late to make, or maximize, your 2007 IRA and 401-K contributions. Why make them? Because these are tax-deferred accounts. Even if your income is such that you can’t take a deduction for your IRA contribution, once contributed all income and gains are tax deferred.  Then, the power of tax-free compounding works for you. Using these accounts, investors can convert taxable interest and dividend (especially non-qualified) income into tax free (until they begin withdraws at age 70 ½) income. For investors seeking to diversify their portfolios in a tax efficient manner, retirement accounts are a great place for high yielding taxable investments.

 

So before you settle in to watch football or hide from the in-laws review your investments and minimize your tax liability. When the flowers come up in April, you’ll be glad you did.

For the week, the Dow was down 2.1%; the S&P and NASDAQ were off about 2.5%. The new news was inflation. The Producer Price Index increased by 3.2%, in November and 7.2% for past twelve months. The Consumer Price Index was up 4.2% for the same twelve month period. The primary culprit was energy. Gasoline prices increased 35% last month. The only reason the CPI wasn’t up as much as the PPI is that energy companies have been reluctant to pass along price increases for fear of government backlash. Energy prices have been rising, in part, due to a declining dollar. With a $60 billion monthly trade deficit, the world is awash in dollars. This puts further pressure on the dollar, driving up the cost of imports, particularly energy. This is a vicious circle.

 

The old news last week was the housing and financial issues. The financial crisis has tightened credit standards for all potential mortgagees. (These tough new lending standards are spreading to auto loans and card cards.) Tight credit slows down the demand for homes, both new and used. The result is more homes on the market and for a longer time. This puts pressure on housing prices which reduces, or wipes out the homeowners equity, making refinancing or moving more difficult. This is another vicious circle.

 

The international central bank coordination announced by the Fed last week doesn’t address any of the above problems nor does the cut in the Fed Funds rate. The Fed can’t force financial institutions to lend and lending won’t return to normal levels until banks balance sheet problems are cleaned up. And, in view of the recent inflation numbers, the Fed finds itself in a difficult situation because further lowering interest rates to stimulate the economy will also stimulate inflation.

Investors were talking about subprime mortgage problems back in April, yet it took until August for the market to react. The same may be true for energy prices and inflation. We’ve been watching $90 per barrel oil for months but it appeared to have no effect on the economy. Now we may be in for a six to twelve month period of high inflation as we experience the downside of a weak dollar and our dependence upon foreign oil.

 

The economy is operating at close to stall speed but the outlook isn’t entirely bleak. Retail sales were up 1.2% in November and the employment market is strong. The U.S. economy is resilient, witness its ability to absorb the financial meltdown of the late 1980s. Remember the RTC? However, the odds of a recession are somewhere between likely and probable. The prudent investor should prepare for a recession and a period of higher inflation (bad news for bonds). Conservative stocks, mutual funds and ETFs are in order, along with short term bonds.

If you get caught holding in football your team loses yards. If you get caught holding in your portfolio you lose money. There is no such thing as a hold investment. Yes, I know, every day hold recommendations are issued by Wall Street analysts but they’re copouts. Every investment recommendation that is not a buy is a sell, regardless of what label’s put on it. There are only two investment decisions: buy and sell. If you own a stock, bond, mutual fund, ETF, house, or car and don’t sell it, you’re making a buy decision. Why? Because you’re continuing to hold the asset and subjecting yourself to all the risk that comes along with it.

 

The buy/sell decision doesn’t mean you have to keep buying more of an asset but it does mean if you think an asset is fully priced, you should sell it.  It’s okay to hold an investment you’d otherwise buy if you’ve reached your maximum hold size given risk tolerance levels or portfolio diversification considerations. Saying an asset is a good investment but its fully priced is really saying that it’s peaked in value and it’s time to sell.

 

There are two exceptions to the buy/sell rule for taxable investors. If you have a short term gain which will turn into a long term gain if your hold for a few more days – and the operative word is days – then it would be worth considering holding the investment. Holding may also be worth it if you’re approaching the end of one tax year and by holding for a few days you can push the gain into the following year. This one’s particularly relevant right now, since most of us are on a calendar tax year. There’s a knee jerk reaction to make investment decisions based on minimizing taxes. Minimizing taxes is good but what’s even better is maximizing your net worth.  Calculate how much you’ll save in taxes if you’re holding for tax reasons, then calculate hold much – in most cases how little – the investment has to fall in value before you’ll have less money than if you sold it now and paid your taxes. I have no statistical proof, but I believe that most investors end up losing money by holding an investment in an attempt to avoid or minimize taxes.

 

Investors are emotional beings and we become attached to our investments. We don’t like to admit we’re wrong and sell a loser. It’s all too easy to hold an investment where we have a gain, in hopes of even greater profit, for too long. We need to accept that we don’t always pick “winners” and we’re not smart (lucky) enough to sell at the top. Investors also have a tendency to be on the lookout for new investments and become compliance about those they already own, particularly if they have a gain in them. We should place the greatest focus on our existing investments. The questions we need to ask ourselves are: is the investment consistent with my investment objectives and have my objectives changed? How will this investment perform given the current economic outlook? Has anything changed with the investment, the fund manager or the company’s prospects? Lastly, ask yourself if you didn’t own a particular investment, would you buy it today? If the answer is no, you know what you must do.

A front page article in Saturday’s Wall Street Journal, Evidence Grows That Consumers are Pulling Back, discussed the slowdown in spending on cosmetic surgery as a harbinger of a recession.  (I’d like to link to the article but The Wall Street Journal doesn’t allow it. Hopefully, Mr. Murdoch will change this now that he owns the paper.)  It seems as if spending on such surgery had previously been recession-proof. Perhaps it fell under the heading of consumer necessities. Now cosmetic surgeons are feeling the economic pain. The article specifically mentions a drop off in corrective eye surgery and breast implants. There used to be a hemline indicator for the stock market. For every decade starting with 1900, the stock market rose and fell following the length of women’s skirts. It would be politically incorrect for me to suggest an implant indicator, so I won’t. 

 

Are we heading for a recession, and a 15% decline in the stock market from its present levels? Plastic surgeons might say yes. Last week, though, the stock market said no. The popular indexes were up close to 2%. The past two weeks rally has moved the S&P and the NASDAQ close to their 2007 highs. The Dow has lagged somewhat, positioned approximately halfway between its 2007 high and low.  The market responded positively to an anticipated Fed rate cut. We’ll find out on December 11^th what the Fed intends to do, but a ¼ point cut seems baked into the market and some expect a ½ cut. After that’s out of the way, the market will again be left to ponder the likelihood of a recession. On the plus side, the Q3 productivity number was excellent and Friday’s report of 94,000 new jobs created, although slightly below the magic 100,000 number, was encouraging. 

 

The not so good news for the week was delinquent mortgage payments hitting their highest level in 20 years and foreclosures reaching record levels since they’ve been tracked, beginning 35 years ago. The value of existing homes is expected to continue falling into 2009 and level off 15% below 2006 values. Neither the administration’s subprime mortgage freeze nor a cut in the Fed Funds rate will solve these problems. As for the Fed, a ½ point cut would be an admission of just how worried it is about the economy.

 

The stock market is over bought right now. Wait until after December 11 and see what issues the market is focusing on before you commit any new money to equities. If you’re overweighed or nervous, reduce your equity exposure today.

Or a Yuan. (My apologies to all you Cabaret fans.) As a mutual fund or ETF investor you need to be aware of the currency risks you’re taking when investing internationally. Is your fund hedged against the dollar or not? Do you want your fund to be hedged or not? What difference does it make to you? Let’s start with the last question first.

 

Currencies do fluctuate is value, except for the Yuan.  Its exchange rate is fixed by the Chinese government, but even the Chinese are responding to pressure to let the Yuan float upward in value against the dollar.  The dollar has declined against the major world currencies for the past seven years. Take the Euro, for example. The current exchange rate is about €1.00 = $1.46, a slight decline for the recent record of $1.49, but a big change from the one-to-one exchange ratio in 1999. Any dollar based investor, such as those of us in the good ol’ USA, would have seen substantial appreciation in his or her Euro dominated investments – European stocks and bonds – made a few years ago just based on currency movement (assuming the currency wasn’t hedged). The European investor who bought dollar dominated US stocks or bonds wouldn’t have been so lucky. The Dow at 13,000 would have brought little joy to the Euro investor’s heart since most of his or her gains would have been offset by the deprecation of the dollar versus the Euro. 

 

There are ways to protect yourself against currency swings.  You can make you international investments through a mutual fund which hedges – tries to eliminate or minimize the currency risk. No hedge is prefect and all hedges cost money which reduces your return, but a currency hedge factors out one risk, leaving you with the underlying risk of the investment, i.e., the performance of the stocks or bonds in the mutual fund portfolio. Mutual funds disclose whether their strategy is to fully, partially or not hedge, so read up on your international fund before you invest in it. If you invest in a fund which doesn’t hedge you can mitigate the currency risk by investing in an ETF which is designed to go up in value as the dollar appreciates.

 

Hedged or unhedged, which is right for you? It depends, first and foremost, on how much risk you want to take. Unhedged, an adverse currency swing could wipe out all the fund’s portfolio gains and, particularly in a bond fund actually result in a loss. Secondly, it depends on your outlook for currency movements. 

 

Global diversification is an essential part of your investment strategy.  Like every other investment, you need to do your homework and understand how much, and what, risk you’re taking.

The stock market rebounded this week like a cork popping up after a fish wiggles off the hook. The Dow opened the week below 13,000, declined to 12,725, then railed 647 points to close on Friday at 13,372. The S&P and NASDAQ turned in similar performances. From a 10% correction, fears of a meltdown in the financial sector and recession the preceding week, the market rallied for four consecutive days and closed at its high for the week. What caused this swing? Equity investments in Citicorp and e*Trade demonstrated that capital was available for the financial sector and the financial stocks rallied on the news.  Treasury Secretary Paulson proposed a moratorium on rate adjustments for certain subprime mortgages and Fed spokespersons, including Chairman Bernanke, hinted at the possibility of another rate cut in December. And, overshadowed by all the good news in the financial sector, oil closed at $88.70 a barrel, below $90 for the first time in weeks.

 

Has the economic outlook improved that much to justify an almost 5% move in the stock market? No. The only change was the infusion of capital into the financial sector. That’s good and the financials responded, although I think their lows will be re-tested, but it doesn’t solve their problems. Neither does the government program. The proposed rate freeze for selected mortgages is a band aid which will benefit some homeowners but does not address the underlying problems facing mortgage lenders. The mortgage industry is in for a period of contraction due to the economic slowdown, slowing new home construction, a slowing re-sale market for existing homes and the ability of homeowners to meet their payment obligations, particularly if the employment picture weakens. Interrelated are the tighter lending standards which the major mortgage originators have implemented.  Reality will set in when the initial euphoria wears off.

 

As for oil, who knows how much of the recent movement, in both directions, was due to speculators adding to, or closing out, their positions. Demand for energy is increasing worldwide, even the US is consuming more gasoline this year than last, so don’t expect prices to fall for long. Even if crude prices do fall, consumers are in for a disappointment. Retail prices for gasoline and home heating oil did not rise as much as crude oil, the refiner’s margins took the hit, so don’t expect prices at the pump to fall by much.

 

The economy is still the big fish (a feeble attempt to tie to my opening sentence).   The economic outlook and the problems facing the economy haven’t changed.   Thus, the swing in investment sentiment we saw last week is not justified. Don’t get caught up in the moment. This is not a time to become aggressive. Stick with your long term investment strategy and don’t get hooked.