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June 15, 2008

Words from the (Investment) Wise for the Week That Was (June 9 - 15, 2008)
by Prieur du Plessis

The Electric Light Orchestra lyrics "... you took me ohh, higher and higher baby, it's a living thing, it's a terrible thing ..." have been mulling through my head over the past week as central bankers' inflation-fighting rhetoric moved to centre stage.

A succession of hawkish comments from US policymakers persuaded pundits that the US rate-cutting cycle was over, resulting in a stronger US dollar, plummeting government bonds, predominantly lower global stock markets (with Asia seeing the most red), and non-agricultural commodities coming off the boil.

Ben Bernanke, Chairman of the Federal Reserve, said on Monday that the danger of a "substantial downturn" in the US economy had abated during the past month but that inflation risks were growing.

A flood of similar comments from other Fed officials followed, all of which seemed to emphasize concerns about keeping inflation expectations in check, with some making specific reference to the need for a stronger dollar to temper inflation.

In addition to Bernanke, the line-up of Fed speakers included Vice Chairman Kohn, New York Fed President Geithner, Dallas Fed President Fisher and Philadelphia Fed President Plosser. The latter two Fed members have been the biggest inflation hawks at the Fed, having dissented at recent FOMC meetings on either the need to cut rates or the quantum of rate cuts.

Although a rate hike by the Fed isn't a fait accompli, it was widely accepted that the commentary was a clear indication that the Fed was at least done with cutting rates.

Foreclosure filings last month were 48% higher compared with a year ago, according to RealtyTRac. This reminds me of the following e-mail I received from a reader last week: "My daughter has a social club for singles in 'US Big City'. She heard members talking about not paying their mortgage payments because it takes ten months for the banks to foreclose and their condo/house (with no money down) is worth much less than what they 'paid' for it. This way they can save $10,000 to $15,000 before they have to move ... this may not be about being able to afford the mortgage. Many home prices have dropped by 25% in 'US Big City'!"

What can one say? In the words of Jeff Saut, Chief Investment Strategist of Raymond James: "Sometimes me sits and thinks and sometimes me just sits! Manifestly, It's a Mad, Mad, Mad, Mad World!"

Before highlighting some thought-provoking news items and quotes from market commentators, let's briefly review the financial markets' movements on the basis of economic statistics and a performance round-up.

Economy
The tone of the most recent US Beige Book was of weaker growth, with the collection of anecdotes noting that "economic activity remained generally weak in late-April and May". The report was consistent with greater inflation risk from rising prices for energy and other commodities.

The US Consumer Price Index showed an increase of 0.6% in May and 4.2% compared to May 2007. As expected, the largest single increase was in energy prices and food prices, which increased by 17.4% and 5.1% respectively from a year ago.

Still on the inflation front, the US Import Price Index rose by 2.3% in May, led by petroleum prices which rose 7.8% and were up 68.8% over the year. The increase in import prices was larger than expected and bolstered the case for the Fed to end monetary easing.

Fed funds futures are now pricing in a 100% chance that the Fed will raise rates by 50 basis points at the October meeting, while there is a 24% chance of a 75 basis point increase. As far as the January meeting is concerned, the futures are pricing in a 98% chance of rates increasing by 100 basis points to 3%.

Paul Kasriel, chief economist of Northern Trust, sees the rate situation as follows: "Fed rhetoric will continue to lean on the hawkish side until the June 24 and 25 FOMC meeting. A 2.0% Federal funds rate is the most likely case for the outcome of this meeting. The appreciation of the dollar since Bernanke's comments on June 9 suggests that open mouth policy is working. However, action might be necessary because talk tends to lose power if it is not backed by action eventually.

"Will the Fed tighten monetary policy in the absence of improving economic conditions to contain inflation and support the dollar? It is conceivable the Fed could engage in a one-off 25 basis point hike in the funds rate, which could not make a material difference on business activity because the Fed has taken radical preemptive action as an insurance against the possibility of a severe economic downturn and/or continued financial market disruptions."

Inflation also remains the major bugbear in other parts of the world. Examples include UK producer price growth staying elevated, with PPI and import prices rising by a record 8.9% and 12.7% respectively from a year ago, and German consumer price inflation accelerating to 3.0% in year-ago terms.

Although the European Central Bank moved to damp down market expectations of a flurry of interest rate increases in the coming months after Jean-Claude Trichet's statement of the previous week, bank officials' tone was still decidedly hawkish.

The Bank of Japan left the overnight call rate target at 0.5% in the face of Japanese consumer confidence falling to a 6½-year low.

WEEK'S ECONOMIC REPORTS

The next week's economic highlights, courtesy of Northern Trust, include the following:

1. Producer Price Index (June 17): The Producer Price Index for Finished Goods is expected to have risen 0.8% in May, reflecting higher food and energy prices. The core PPI is most likely to have moved up 0.2% after the 0.4% increase seen in April. Consensus: +1.0%, core PPI +0.2%.

2. Housing Starts (June 17): Permit extensions for new single-family and multi-family homes advanced in April. However, the large stock of unsold new homes suggests builders could be reluctant to break ground as yet, with housing starts projected to have declined to an annual rate of 970 000 from 1.032 million in April. Consensus: 980 000.

3. Industrial Production (June 17): The manufacturing man-hours index declined 0.2% in May, which is indicative of a reduction in industrial production in May after a 0.7% drop in April. Consensus: 0.1%; Capacity Utilization: 79.7 versus 79.7 in April.

4. Leading Indicators (June 19): Interest rate spread and stock prices are the only two components likely to make a positive contribution in May. Initial jobless claims, consumer expectations, vendor deliveries, and real money supply are expected to make negative contributions. Forecasts of money supply and orders of consumer durables and non-defence capital goods are used in the initial estimate. The manufacturing workweek held steady in May. The net impact is a steady reading of the leading index after a 0.1% increase in April. Consensus: 0.0%

5. Other reports: NAHB Survey (June 16), Current Account Q1 (June 17), Philadelphia Fed Survey (June 19).

Markets
The performance chart obtained from the Wall Street Journal Online shows how different global markets performed during the past week.

Source: Wall Street Journal Online, June 15, 2008.

Equities
The MSCI World Index dropped by 2.9% during the past week as concerns about inflation and hawkish central comments gathered momentum, with emerging markets (-5.3%) bearing the brunt of the declines.

Asian stock markets, in particular, suffered big losses, for example: the Chinese Shanghai Composite Index (SCI) (-13.8%), the Hong Kong Hang Seng Index (-7.4%), the Taiwanese Weighted Index (-7.3), the South Korean Kospi Index (-4.6%) and the Japanese Nikkei 225 Average (-3.6%).

The Shanghai Composite Index has slumped by 52.9% since its high of October 2007 on concerns that measures to keep price increases in check will erode corporate earnings. This rout helped to narrow the price-earnings gap between the Shanghai Composite Index and the S&P 500 Index to 3.1% from 127% at the beginning of 2008, according to data compiled by Bloomberg.

Thanks to a solid close-of-week rally, the US stock markets fared relatively well, as shown by the past week's index movements: Dow Jones Industrial Index +0.8% (YTD -7.2%), S&P 500 Index 0% (YTD -7.4%), Nasdaq Composite Index -0.8% (YTD -7.5%) and Russell 2000 Index -0.9% (YTD -4.3%).

The beleaguered Philadelphia Bank Index edged up on Thursday and Friday to close the week down by 4.3%, with embattled Lehman Brothers (LEH) - plunging by -20.1% for the week notwithstanding a 13.7% gain on Friday - weighing heavily on the performance of the financial sector.

The Dow Jones Industrial Index and the S&P 500 Index remain below both their 50- and 200-day moving averages, but the Nasdaq Composite Index and Russell 2000 Index succeeded in creeping back to above their 50-day moving averages (although still below the key 200-day line). Importantly, all the major US indices managed to survive another week above their March lows.

I penned some thoughts on the US stock market, including a few interesting charts, in a post two days ago. Here is the link: Stock Market: Up, Down, Sideways?

Fixed-interest instruments
Government bonds got dumped as the yield curve adjusted to shifting expectations about the timing of a possible interest rate hike by the Fed.

The front end of the Treasury yield curve, being the most sensitive to Fed policy moves, sold off sharply with the yield on the two-year Note spiking by 64 basis points during the week to close at 3.04%. The yield on the ten-year Note, which is more sensitive to inflation pressures, rose by 32 basis points to 4.26%.

As far as the rest of the world is concerned, short-dated bond yields were mostly significantly higher. For example, the yield on the UK two-year Gilt jumped by 40 basis points to 5.45%, whereas Japanese two-year yields surged by 11 basis points to 1.0%.

US mortgage rates also increased sharply, with the 15-year fixed rate rising by 24 basis points to 6.00% and the 5-year ARM 39 basis points higher at 5.87%.

Credit market stress increased as shown by the widening spreads of both the CDX (North American, investment grade) Index and the Markit iTraxx Europe Crossover Index.

Currencies

The pick-up in expectations of US interest rate hikes triggered an impressive 2.4% rally in the US Dollar Index to its highest level in 3½ months and its best weekly performance since January 2005. The greenback also benefited from pundits' belief that the US would use the weekend's G8 meeting to mobilize support for the currency.

The dollar gained 2.9% against the Japanese yen, 2.6% against the Swiss Franc, 1.1% against the British pound and 2.5% against the euro. The Eurozone currency corrected sharply on Irish voters' rejection of the European Union's new reform treaty - a repeat of three years ago when the Dutch and French condemned the original constitution.

John Mauldin (Thoughts from the Frontline) commented as follows: "Six years ago I talked about the euro rising to $1.50, but I also noted that by the middle of the next decade it is likely to come back to par. We are halfway on that journey, and I still think we will arrive at my predicted point. I think it is possible that the dollar could rise 10% or more this year against the euro, which would help inflationary pressures."

Commodities
The US dollar's gain impacted negatively on commodity prices, particularly crude oil which ended a volatile week 2.2% lower at $135.5 per barrel. Gold bullion and other precious metals suffered the same fate.

However, gains in agricultural commodities, following the flooding in the US Midwest, pushed the Reuters/Jeffries CRB (+1.0%) to an all-time high. Both corn (+13.3%) and soyabeans (+7.8%%) set new records, whereas wheat (+10.1%) also moved up strongly on concerns about this year's US crop. Separately, cocoa (+3.7%) climbed to a 28-year high due to a lack of rain in Ghana and the Ivory Coast.

The chart below shows the past week's performance of the various commodities.

Now for a few news items and some words and charts from the investment wise that will hopefully assist in steering our investment portfolios on a profitable course.

Source: Slate, June 13, 2008.

Bloomberg: Marc Faber says oil, stocks, real estate are overvalued

Source: Bloomberg, June 9, 2008.

John Authers (Financial Times): Decoupling thesis is wide off the mark

Source: John Authers, Financial Times, June 11, 2008.

Bloomberg: Global confidence wanes as officials prepare to increase rates
"Confidence in the global economy ebbed in June as central banks prepared an assault on inflation that's likely to push stocks and bonds lower, a survey of Bloomberg users on five continents showed.

"The Bloomberg Professional Global Confidence Index fell to 21 from 22.7, with respondents becoming more pessimistic in every region. A level below 50 indicates negative sentiment. Customers in three of Europe's largest economies also said the dollar may end its two-year swoon against the euro because the Federal Reserve will probably lift borrowing costs.

"The threat of tighter monetary policy dashed the recovery in confidence that had been building since the index hit a low in March, when the Fed rescued Bear Stearns Cos. from bankruptcy. Spiraling oil and food prices are forcing central banks from Indonesia to North America to switch from fostering growth to quashing inflation."

Source: Joshua Gallu, Bloomberg, June 12, 2008.

CNBC: Pimco's Paul McCulley on the US economy

Source: CNBC, June 11, 2008.

CNBC: Henry Paulson on everything

Source: CNBC, June 9, 2008.

Reuters: NBER chief - US slipping into recession
"The US economy likely peaked in December or January and is now slipping into a recession, the head of the influential National Bureau of Economic Research said on Wednesday.

"'I think we're heading for a recession,' Martin Feldstein said at the Reuters Investment Outlook Summit in New York. He stressed that he was speaking from his personal opinion, not that of the NBER, the unofficial arbiter of US recessions.

"'My sense is that the risk to overall GDP growth over the next six months is still very significant,' he added.

"The NBER has not declared a recession and is unlikely to do so for many months. Feldstein, who is also an economics professor at Harvard University, will step down from his NBER post at the end of the month.

"Feldstein said the current downturn was different from the norm because it was triggered by the housing slump rather than tightening of US interest rates. As a result, housing also holds the key to recovery, he said."

Source: Emily Kaiser and Ros Krasny, Reuters, June 11, 2008.

The New York Times: Jobs show recession is here
"The jobs report today has depressed the stock market, for obvious reasons. The popular theory that we would avert a recession and the economy would pick up in the second half now looks very dubious.

"One unfortunate milestone reached today was that the 12-month change in private sector jobs, before seasonal adjustment, is down 125,000 jobs. (After seasonal adjustment, there is a small increase, for some reason.)

"Over the last nine recessions, dating back to 1953, that indicator has a perfect record. Every time it has turned negative, the economy is already in recession. And once it turns negative, it stays that way for quite a while.

"During that stretch, the figure never went negative without a recession being under way. That is not a complete coincidence, of course, since the employment figures are one factor the National Bureau of Economic Research weighs in setting recession dates.

"If we assume that this year falls within the previous parameters, then the recession started sometime between May 2007 and March 2008, with October 2007 the most likely. Based on other data, October is probably the earliest date that the recession could have begun.

"Again assuming the previous data is predictive, the last negative job number will arrive between November 2008 and November 2010, with August 2009 the most likely month."

Source: Floyd Norris, The New York Times, June 6, 2008.

David Rosenberg (Merrill Lynch): US consumer spending taking strain
"The expected drop in US consumer spending is likely to outweigh the impact of the Treasury's fiscal stimulus package hugely, warns David Rosenberg, economist at Merrill Lynch.

"Last week's Federal Reserve flow of funds report showed US household net worth fell $1,700 billion in the first quarter, the biggest decline outside the tech bubble, Mr Rosenberg says.

"'But back in 2001 and 2002 it was strictly a stock market story and what we are seeing unfold today is asset deflation on two fronts, both residential real estate and equities, at a rate that is almost without precedent.'

"He says the ratio of household net worth to disposable income has fallen to a level which, if sustained, would be consistent with a rise in the personal savings rate to 2.5%, leading to a drop in consumer spending of about $150 billion.

"Food and energy inflation is estimated to be draining discretionary spending by another $300 billion annually and the contraction in the jobs market is crimping personal income by $125 billion. Furthermore, the credit crunch has led to a fall in new household borrowings in the first quarter and this looks to have impinged on household cashflow by a further $200 billion, he says. This adds up to a $775 billion cut in cashflow, equal to a near 12% hit on discretionary consumption.

"'This swamps the fiscal stimulus by a factor of seven and is precisely what the peak-to-trough decline was in the 1973 to 1975 consumer-led recession.'"

Source: David Rosenberg, Merrill Lynch (via Financial Times), June 11, 2008.

Bloomberg: Gary Shilling sees "big nose dive" in consumer spending

Source: Bloomberg, June 13, 2008.

Paul Kasriel (Northern Trust): Decline in MEW impacting negatively on consumer spending
"In this past cycle, it had become very easy for households to turn their increased 'paper' housing wealth into actual cash by borrowing against their increased home equity. This borrowing is called mortgage equity withdrawal, or active MEW ... defined as mortgage equity withdrawal consisting of refinancing and home equity borrowing.

"At an annualized rate, active MEW peaked at $576 billion in the second quarter of 2006. Active Mew has slowed to only $114 billion in the first quarter of this year - the smallest amount since the fourth quarter of 1999. There is no doubt in my mind that active MEW, which actually puts additional cash into the hands of households, played an important role in boosting consumer spending in this past expansion. And there is no doubt in my mind that the recent and likely continued decline in active MEW will play an important role in retarding consumer spending in the recession."

Source: Paul Kasriel, Northern Trust - Daily Global Commentary, June 13, 2008.

Asha Bangalore (Northern Trust): Bernanke attempts to prop up dollar, but is incorrect about assessment of economy
"The ECB is widely expected to raise the policy rate at the July 3 meeting. This is not a terribly supportive action for the dollar. The Fed is in a tough spot and not in a position to raise the Federal funds rate. The alternative is to talk about a strong dollar and raise the importance of inflation, which Bernanke has done in the past week. He was concerned about economic growth and inflation but inflation appears to be of greater significance.

"In order to reduce the inconsistency of monetary policy for a strong dollar and a weak economy, the Fed appears to have moved the emphasis to inflation and the dollar. In doing so, Bernanke made these remarks last night.

"'Before turning to those issues, however, I would like to provide a brief update on the outlook for the economy and policy, beginning with the prospects for growth. Despite the unwelcome rise in the unemployment rate that was reported last week, the recent incoming data, taken as a whole, have affected the outlook for economic activity and employment only modestly. Indeed, although activity during the current quarter is likely to be weak, the risk that the economy has entered a substantial downturn appears to have diminished over the past month or so.

"'Over the remainder of 2008, the effects of monetary and fiscal stimulus, a gradual ebbing of the drag from residential construction, further progress in the repair of financial and credit markets, and still-solid demand from abroad should provide some offset to the headwinds that still face the economy. However, the ongoing contraction in the housing market and continuing increases in energy prices suggest that growth risks remain to the downside.'

"With all due respect, we beg to differ with Bernanke's assessment of the economy. On several counts, the economy is not improving! First, a new cycle low for banking index was recorded on June 9, which implies that the credit crunch is not on its last legs. The recent Senior Loan Officers Survey showed significant tightening of loan underwriting standards across the board - consumer and business loans. The fragile status of banks suggests that additional tightening of lending standards should not be surprising. The broader implication is that economic growth will suffer a setback because credit is the oil that lubricates business activity."

Source: Asha Bangalore, Northern Trust - Daily Global Commentary, June 10, 2008.

Asha Bangalore (Northern Trust): Inflation expectations, market forecast of Federal funds rate, and history
"Inflation and inflation expectations have a prominent spot in recent rhetoric of Chairman Bernanke and other officials of the Fed. The Fed has constantly stressed the importance of 'well anchored inflation expectations'. Despite the tough talk about inflation and inflation expectations in recent days, the market estimate of inflation expectations, as measured by the difference between the nominal yield of 10-year U.S. Treasury note and 10-year TIP rate, has moved up from a recent low of 226 bps on May 1 to 249 bps on June 10.

"... the Fed is in a tight spot and cannot raise interest rates to contain inflation and support the dollar. But, the Federal funds futures market is projecting a higher Federal funds rate. The November Federal funds futures contract projects a 50 bps increase in the federal funds rate. The January Federal funds futures contract implies a 2.75% federal funds rate. There has been a rapid change in expectations in the last week with the November contract implying a 2.50% federal funds rate today from 2.085% on June 3, when Bernanke presented the latest economic outlook and noted the concern about inflation and the dollar.

"However, against the backdrop of weak economic data, this projection should be viewed with care because history fails to support this forecast. The Fed has not raised the Federal funds rate until the unemployment rate has declined. The unemployment rate has not even peaked yet, so considerations of a higher Federal funds rate by year-end appear far fetched."

Source: Asha Bangalore, Northern Trust - Daily Global Commentary, June 11, 2008.

Paul Kasriel (Northern Trust): CPI justifies hawkish Fed rhetoric
"The Consumer Price Index (CPI) advanced 0.6% in May following a 0.2% increase in April. Year-to-date, the CPI has risen at an annual rate of 4.0% compared with a 4.1% increase in all of 2007. The energy price index moved up 4.4% and the food price index rose 0.3% in May.

"The core CPI, which excludes food and energy, increased 0.2% in May, putting the year-to-year gain at 2.31%, down from the recent high of a 2.47% jump in January."

Source: Paul Kasriel, Northern Trust - Daily Global Commentary, June 13, 2008.

Asha Bangalore (Northern Trust): Import prices continue to advance
"The import price index increased 2.3% in May after a revised 2.4% gain in April (previously estimated as a 1.8% increase). This puts the year-to-year increase at 17.8%, the largest gain on record. The imported petroleum price index (+68.8%) and the imported food price index (+13.9%) both contributed to the overall gain. In addition, the import price index excluding fuel moved up."

Source: Asha Bangalore, Northern Trust - Daily Global Commentary, June 12, 2008.

Jim Sinclair (Mineset): Bernanke has painted himself into a corner
"The euro is down hard today on the premise that this is the start of increased interest rates in the US, a statement that is totally ludicrous.

"There are two possibilities here:

1) Bernanke and Trichet are in the midst of a pissing contest with the US Fed not paying any attention to the financial hell they are about to release.
2) Saving face at the Fed is more important than the cost thereof.

"There is only one result possible: Any nitwit knows what happens if you increase the discount rate when business is accelerating its downturn.

"Now what happens if the Fed does not increase rates? Bernanke has painted himself into quite the corner.

"There is absolutely no possibility on earth that the Fed can start a series of increases as that will end the financial world, not as we know it, but totally."

Source: Jim Sinclair, Mineset, June 10, 2008.

Asha Bangalore (Northern Trust): Retail sales - temporary boost from rebate checks
"Retail sales increased 1.0% in May, with a significant probability of rebate checks providing a temporary boost to the headline."

Source: Asha Bangalore, Northern Trust - Daily Global Commentary, June 12, 2008.

Asha Bangalore (Northern Trust): Additional evidence necessary to call bottom of housing market
"The 6.3% increase in the Pending Home Sales Index (PHSI) of the National Association of Realtors to 88.2 in April, is impressive after the downward trend that has been in place for several months. The PHSI increased in the Midwest (+13.0%), West (+8.3%) and South (+4.3%) but fell 1.9% in the Northeast. It is too early to attribute a single-month's gain to a major improvement of conditions in the housing market. The April reading of the PHSI points to sales of existing homes in the May to June period.

"... the increase in the PHSI for April is a signal of improving conditions but we need to see data for sales, prices, and inventories for a few consecutive months to call a firm bottom of the housing market."

Source: Asha Bangalore, Northern Trust - Daily Global Commentary, June 9, 2008.

Bloomberg: Mortgage bonds resume stumble, trading near lows
"Some of the US mortgage bonds at the center of the yearlong credit crisis are slipping toward new lows, as climbing gas prices, unemployment and interest rates deepen concern that homeowner defaults will increase.

"The benchmark Markit ABX index linked to the last-to-be-repaid of originally AAA rated subprime-mortgage bonds from the first half of 2007 fell today to a record low of 50.55, down about 16% from May 19, suggesting a corresponding drop on similar securities. Top-rated, bonds of 'option' adjustable-rate mortgages are also falling, according to a report from RBS Greenwich Capital.

"'There's a tremendous amount of extraneous events going on away from the mortgage market that are making people scared,' said David Castillo, a senior trader at Further Lane Securities. 'Market activity over the last two weeks is down significantly over the previous four weeks.'

"Non-agency mortgage bonds, the type that have experienced unprecedented downgrades and price declines since mid-2007, lack guarantees from government-chartered Fannie Mae and Freddie Mac, or federal agency Ginnie Mae. The market totaled $2.1 trillion on March 31, excluding derivative exposures, according to Fed data."

Source: Jody Shenn, Bloomberg, June 11, 2008.

Eoin Treacy (Fullermoney): US government bonds in long-term bear market
"The US 10-yr yield bottomed in 2003 and bonds are now in a secular bear market. The recent fall in yields found support above the lows near 3% and would need to sustain a move below that level to offset scope for a rally towards the upper side of the base over the coming years. Yields took 22-years to fall from their accelerated peak and may yet take as long again before they reach the highs of this secular move.

"This is a long-term cycle, and it will not be the same as the last bond bear market, but it will give context to almost every other asset class over the coming decades."

Source: Eoin Treacy, Fullermoney, June 10, 2008.

John Hussman (Hussman Funds): Return on Treasuries not compelling
"... my inclination is to expect some downward pressure on yields as economic signals deteriorate. There is a good deal of 'headline pressure' from the spike in unemployment, rising oil prices, and weak housing. All of these are likely to reinforce some retrenchment among consumers, which could help to tip the US economy more definitively into recession.

"Still, the prospect of 10-year total returns of just 4% in Treasury bonds is not particularly compelling on an investment basis, so the primary driver of bond returns will be speculation about economic weakness and a 'flight to safety' from credit concerns."

Source: John Hussman, Hussman Funds, June 9, 2008.

David Fuller (Fullermoney): Stock markets - give upside benefit out the doubt
"The Fullermoney view has been that important lows were reached following a selling climax in January. A rebound occurred but those lows were tested a couple of months later, and mostly held during further climactic selling in mid-March. Sentiment indicators, which we prefer in attempting to identify important lows, reached their most extreme levels since at least October 2002 as this year's January and March troughs were established.

"Following the mid-March lows, most stock market indices experienced orderly rallies which carried into mid-May. A few indices remained generally weaker, even extending their overall declines, but many more were stronger and pushed to new all-time highs. The weaker markets usually had a heavy weighting of banks, whilst the new highs were mostly achieved by what we think of as primarily resources indices.

"In late May I said that a stock market reaction had commenced. Subsequently and gradually, technical action for most indices continued to deteriorate, and not without reason.

"Bank indices, which we generally regard as lead indicators, deteriorated in the west, breaking their January and March lows, and experiencing significant additional declines in some instances. Petroleum contracts spiked higher, as have corn prices in a move that has firmed most agricultural commodities. Central bankers have become noticeably more hawkish in commenting on rising inflation. Long-dated government bond futures have weakened. Most forecasts for GDP growth and corporate profits have been lowered.

"'Stuff happens' as some analytical genius once said, and investors now have more to worry about than the credit / derivatives crisis and its knock-on effects, which were bad enough. The Wall Street leash-effect has been negative with the Dow and S&P 500 indices approaching their January and March lows. The Nasdaq and Transports had been much stronger, but they too have suffered technical deterioration recently.

"In other words, the news probably could not get much worse, although perhaps this statement shows a lack of imagination on my part. Is there any good news out there and perhaps more importantly, scope for it to improve?

"Valuations have improved as a consequence of the earlier sell-off, although they are not timing indicators. Moreover, valuations are neither sufficiently attractive nor the economic environment encouraging enough to persuade conservative bears to buy aggressively, and we can be reasonably certain that hedge funds which can short stock markets have been doing so.

"Short covering could provide the fuel for a technical bounce, now that stock markets are technically oversold on a short-term basis. Also, many investors hold reasonably high levels of cash, but what would persuade them to buy?

"I do not know, although I suspect many would want a catalyst; not least evidence that the January and March lows were holding. Also, I suspect that central banks will remain an influence. From China recently to the USA previously, we have seen evidence that monetary officials would like to check the stock market slide. Psychologically, the Fed and US Treasury's actions are probably more important, due to the leash-effect and also because the US is still perceived as the epicentre of global economic problems.

"Meanwhile Wall Street and other leading stock markets are approaching their moment of truth in terms of the year's earlier lows. Once again, the recovery hypothesis is for the bulls to prove. Financials need to improve their relative performance.

"Anything less would be inconsistent with the support building hypothesis that I have been advocating. I have previously said on many occasions that I would give the upside the benefit of the doubt, provided the January and March lows for most indices held. I am concerned by the recent deterioration but will not change my medium-term view against the background of today's somewhat overstretched declines and while most of the year's earlier lows continue to hold."

Source: David Fuller, Fullermoney, June 12, 2008.

Eoin Treacy (Fullermoney): Philadelphia Bank Index becoming overextended
"The Philadelphia Bank Index is leading other banking sectors on the downside, but is becoming overextened as it approaches a potential area of support near 60. An upward dynamic is needed to check momentum while a sustained break of the lower highs with a move above 90 would be needed to question downside scope.

"The fact that the Fed has been supplying cash to the banking sector for the last number of months is well known. This is not something we would expect to continue in perpetuity and is more of a stop-gap measure to get the economy through the credit crisis."

Source: Eoin Treacy, Fullermoney, June 10, 2008.

CNBC: Meredith Whitney - Investment banks' recovery not imminent

Source: CNBC, June 11, 2008.

Financial Times: Banks face $10 billion monoline charges
"Citigroup, Merrill Lynch and UBS, the banks most exposed to Ambac and MBIA, could face further writedowns of up to $10 billion after the bond insurers last week lost their fight to retain their triple A credit ratings.

"Wall Street executives said they had been wrong-footed by the timing of the downgrades by Moody's and Standard & Poor's, saying they had not expected the rating agencies to take action for several months after affirming the triple A ratings of Ambac and MBIA in February and March.

"'I think Moody's jumped the gun,' a Wall Street executive said. "They and other credit rating agencies have been under pressure to anticipate developments, rather than lag behind the curve, and this looks like an attempt to do just that.'

"The banks have used the bond insurers to hedge holdings of complex bonds such as collateralised debt obligations and other mortgage-backed securities.

"The prospects of further writedowns related to bond insurers, also known as monolines, could deepen concerns over the financial health of US and European banks.

"Meredith Whitney, analyst at Oppenheimer, said in a report this week that UBS had the largest exposure to monolines of $6.3 billion, Citigroup came second with $4.8 billion and Merrill Lynch followed with $3 billion."

Source: Aline van Duyn and Francesco Guerrera, Financial Times, June 10, 2008.

Richard Russell (Dow Theory Letters): Lowry's Buying Power Index making new lows
"'On June 3, June 4 and again today, Lowry's Buying Power Index dropped to new lows, showing that the strong, persistent demand needed to push the broad list of stocks substantially higher was simply not in evidence. Nor is it likely to emerge in the near future. There is not a single case within our 75 year history in which the Buying Power Index was still making new lows eight or ten weeks after an important market bottom.'

"The implications of the Lowry's statement is clear enough. If there is no case of Lowry's Buying Power making new lows many weeks after an important market bottom - then the fact that Lowry's Buying Power is now making new lows indicates that the stock market has NOT yet put in an important bottom. In other words, we have not yet seen a bottom so far in 2008. If this is true, then the major averages and many, if not most, stocks are fated to break to new lows.

"Whew! That's a critically important observation. Let's suppose the Lowry's stance is correct, suppose the January-March lows were only temporary stops in a bear market that is fated to head lower. I've stated that this is a critically important question - are we in a bull or bear market? If Lowry's is correct, if the bear market lives, then in due time the market will smash below its January-March lows, and in doing so we will have a forecast of worse times ahead. To put it another way, new lows will mean that the market has not yet discounted the worst that lies ahead."

Source: Richard Russell, Dow Theory Letters, June 9, 2008.

Coloradoan: Litman-Gregory study - focus on longer term
"Litman-Gregory ... with the help of Ned Davis Research ... studied periods of S&P 500 market declines of 15% or more since 1950.

"It found that the average length of the 12 declines was 28.5% and that the median loss was 24.6%. The average gain in the intermittent periods was 112%. The gains' periods lasted on average about 3½ years.

"There were numerous market declines of 10% to 15% but they quickly reversed. However, there were few periods where the decline reached 15% and did not go to 20% or more, which is the official designation of a bear market.

"Over the period since 1950, bear markets have generally not lasted as long as bull markets have. During the 58-year period, the market has risen in 46 years and declined in only 12 years.

"In the 12 loss periods, a 15% or more loss in the S&P 500 occurred over six months.

"Seven of the nine recessions occurring since 1950 overlapped market declines. In six recessions, stock prices began recovering before the recession ended. In seven of the 12 declines of 15% or more, there was no recession.

"Of the 12 bear markets since 1950, investors recovered their losses in about 14 months. The median recovery period was eight months. Dividends played an important role in investor returns. On average, dividends allowed investors to recoup their losses in about seven months.

"The Litman-Gregory's study looked at the S&P 500 total return performance in years immediately following market declines of at least 15%. In 11 of the 12 periods following declining stock prices, the market produced a positive total three-year return. However, in the five years following a 15% loss, positive returns were in single digits half the time. On average, the market return was 9.8% annually in the five years following the point at which a 15% loss was reached.

"According to Bob Brinker's Marketimer newsletter, corrections in the 15% to 19% range are extremely rare in a presidential election year. In the past 60 years, there have been only two brief and mild recessions during presidential election years. There has never been a bear market, a decline of 20% or more, in a presidential election year."

Source: James Watt, Coloradoan, April 27, 2008.

Bloomberg: China's benchmark stock index tumbles
"China's stocks plunged 8.1%, the most since February 2007, after the central bank ordered lenders to set aside record reserves to curb credit growth and inflation.

"More than half of the benchmark stock measure's 300 members slumped by the 10% daily limit, dragging the CSI 300 Index 45% below its October 16 record.

"Industrial & Commercial Bank of China led banks lower after the central bank said June 7 it will raise the reserve ratio for the fifth time this year by a full percentage point, withdrawing about $61 billion from the financial system.

"'Panic is arising from a jolt of bad news,' said Peter Chiang, Singapore-based chief equity strategist at DBS Asset Management Ltd., which oversees the equivalent of $18 billion. 'There are problems with inflation, China is slowing down and corporate earnings could be vulnerable.'

"The CSI 300 has fallen 40% this year, the steepest decline among the world's 20 biggest equity markets, on concern that measures to keep price increases in check will erode earnings. The rout has wiped at least $1.31 trillion from China's stock market and helped the CSI 300 close a price-earnings gap with the Standard & Poor's 500 Index to 3.1% from 127% at the start of 2008, data compiled by Bloomberg show."

Source: Zhang Shidong and Chua Kong Ho, Bloomberg, June 10, 2008.

Eoin Treacy (Fullermoney): African stocks outperforming rest of world
"Africa remains an interesting, if high risk, investment destination. It may also be benefitting, at this time, because it is non-correlated with the rest of the financial world and is currently outperforming. However, investors should also be aware that markets with such small capitalisations are easily manipulated and often rise extraordinarily because of the weight of money. When investors eventually decide to take their money out, apparently strong markets can turn into laggards overnight. I have every belief that Africa will eventually emerge as a safer place to invest but it will take decades and the path will be far from linear."

S&P Africa Frontier Price Index

Source: Eoin Treacy, Fullermoney, June 9, 2008.

Bloomberg: Analysts lose 17% for investors in brokerage picks
"Investors who followed the advice of analysts who say when to buy and sell shares of brokerage firms and banks lost 17% in the past year, twice the decline of the Standard & Poor's 500 Index.

"Buying shares on the advice of Merrill Lynch's Guy Moszkowski, the top-ranked brokerage analyst in Institutional Investor's annual survey, cost investors 17%, according to data compiled by Bloomberg. Deutsche Bank analyst Michael Mayo's counsel to purchase New York-based Lehman Brothers lost 59%. Citigroup's Prashant Bhatia still rates Merrill 'buy' after its 56% retreat from a January 2007 record.

"Of the 39 analysts tracked by Bloomberg who follow stocks in the Amex Securities Broker/Dealer Index, 32 produced losses for investors. Investors who bought brokerages on 'buy' recommendations, sold when they switched to 'hold' and speculated prices would decline when analysts said 'sell', lost 17% in the last year through June 3, compared with the S&P 500's 8.5% drop.

"'One would expect that if there was any industry Wall Street estimates would be more precise on, it would be their own,' said Richard Weiss, who oversees $60 billion as chief investment officer at City National Bank. 'But this particular debacle was so global in nature and pervasive, you can't blame them for missing this one.'"

Source: Eric Martin and Josh Fineman, Bloomberg, June 6, 2008.

Fortune Magazine (via CNN Money): Buffett's big bet
"Will a collection of hedge funds, carefully selected by experts, return more to investors over the next 10 years than the S&P 500?

"That question is now the subject of a bet between Warren Buffett and Protégé Partners, a New York City money management firm that runs funds of hedge funds - in other words, a firm whose existence rests on its ability to put its clients' money into the best hedge funds and keep it out of the underperformers.

"Protégé has placed its bet on five funds of hedge funds - specifically, the averaged returns that those vehicles deliver net of all fees, costs, and expenses.

"On the other side, Buffett, who has long argued that the fees that such 'helpers' as hedge funds and funds of funds command are onerous and to be avoided has bet that the returns from a low-cost S&P 500 index fund sold by Vanguard will beat the results delivered by the five funds that Protégé has selected.

"We're way past theory here. This bet, being reported for the first time in this article (whose author is both a longtime friend of Buffett's and editor of his chairman's letter in the Berkshire annual report), has been in existence since January 1 of this year.

"It's between Buffett (not Berkshire) and Protégé (the firm, not its funds). And there's serious money at stake. Each side put up roughly $320,000. The total funds of about $640,000 were used to buy a zero-coupon Treasury bond that will be worth $1 million at the bet's conclusion. That $1 million will then go to charity."

Source: Carol J Loomis, Fortune (via CNN Money), June 9, 2008.

Richard Russell (Dow Theory Letters): "Happy time" for the US dollar
"If you're a fan of the US dollar, maybe this is 'happy time'. Below we see one year of Dollar Index action. The low was recorded on March 17. From there the Dollar headed higher. During May-June the Dollar Index formed what appears to be a head-and-shoulders bottom. This week the Dollar broke out above its bottoming formation and also above its long declining trendline. Larry Kudlow on CNBC keeps shouting that we need a 'strong dollar' and that 'a strong dollar will set stocks heading higher'. Kudlow may finally be getting his long-awaited strong dollar, but we'll just have to wait to see whether he gets his rising stocks as well.

"A strong dollar should also be good for bonds, but bonds have more to worry about than just the dollar. They have inflation to worry about plus the possibility that the economy may be turning up.

"Of course a strong dollar would be a negative for gold. There should be strong support at the 850 level, even in the face of a strong dollar. I think gold is simply biding its time as it builds a base for its next advance. By the end of this year, gold should be considerably higher."

Source: Richard Russell, Dow Theory Letters, June 13, 2008.

Continue to Part II

Dr Prieur du Plessis
investmentpostcards.com

With 25 years' experience in investment research and portfolio management, Dr Prieur du Plessis is one of the most experienced and well-known investment professionals in South Africa. More than 1 000 of his articles on investment-related topics have been published in various regular newspaper, journal and Internet columns. He also published a book, Financial Basics: Investment, in 2002.

He holds the following degrees: BSc (Quantity Surveying) (Cape Town), HonsB (B & A) (cum laude) (Stellenbosch), MBA (cum laude) (Stellenbosch); and DBA (Doctor of Financial Management) (Stellenbosch).

Prieur is chairman of the Plexus group of companies, which he founded in 1995. Previously he was general manager: portfolio management at Sanlam, responsible for the management of investment portfolios with total assets in excess of $5 billion.

Plexus is a pioneer in the mutual fund industry and has achieved a number of firsts under Prieur's leadership. These include the authoritative Plexus Survey, a quarterly analysis of the consistency of the performance of unit trust management companies, the Plexus Offshore Survey, the Plexus Unit Trust Indices, and the PlexCrown Fund Ratings.

Plexus is the South African partner of John Mauldin, American author of the most widely distributed investment newsletter in the world, and also has an exclusive licensing agreement with California-based Research Affiliates for managing and distributing its enhanced Fundamental Index™ methodology in the Pan-African area.

In 2001 Prieur received the Santam/AHI Business Leader of the Year award for corporate leadership, business acumen and entrepreneurial flair. He was also profiled in the book South Africa's Leading Managers (2006). Plexus received the AHI/Old Mutual Enterprise of the Year award in 1997 and was also included in the book South Africa's Most Promising Companies (2005).

Prieur is 52 years old and lives with his wife, TV producer and presenter Isabel Verwey, and two children in Welgemoed, Cape Town. His recreational activities include long-distance running, motor cycling and reading. He belongs to the Cape Town Club, Johannesburg Country Club, Gordon's Bay Yacht Club and Swiss Social & Sports Club.

Copyright © 2008 Dr Prieur du Plessis

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