Weekly Market Returns

The markets finished slightly higher this week as we continued to move through earnings season. Traders are growing frustrated that no clear trend is emerging in the new trading year and the sector leadership is absent.

For the week the DJIA and the S&P 500 lead with a +.3% gain each, the Nasdaq lagged behind the broader indices with a +.1% advance.

The market is skeptical that the economy will maintain its forward momentum without the help of tax cuts and ultra low interest rates. This "worry" has created an opportunity for long term investors to take positions.

The strength of the economy has moderated, but the expansion continues and will continue absent a exogenous shock.

Weekly Market Returns

What an ugly week and a poor beginning of the New Year. We "knew" that the market was technically overextended coming into the New Year. The S&P 500 was flat for the year through October of 2004 and finished the year up nearly 12%. That is a long way in a short time my friends.

For the week the NASDAQ led the decline with a 2.6% move to the downside, the DJIA followed with a 1.6% decline and the S&P 500 fell 1.4%.

For those who want the ugly truth of the matter here are the YTD (year to date) numbers:

S&P 500 -3.6%
NASDAQ -6.5%
DJIA -3.6%

January is shaping up to be a negative month and some believe it will set the tone for the year. We believe we are stuck in a range bound market that depends on higher earnings in order to move higher. Valuations are at the top of their range, especially if you believe that interest rates, could, would and should move higher as the year progresses.

It's seems that the consensus was that it was "steady as she goes" for the first half of the year and rough sledding for the second half. Maybe 1/2 will be bad and 1/2 good but maybe the market experts got their timing wrong!

Central banks shift reserves away from US

We have held the position for a long time that fundamentals were not driving the value of the US dollar, in fact we have been living off of the kindness of strangers.

The US dollars position as the worlds currency is not yet threatened by the Euro, but it certainly has been weakened.

Kick-back disclosure from Edward Jones!

This link was posted on their site as a result of the $75 million fine they had to pay. Instead of trying to do right by their investors, they appear to be disclosing to their clients the fact that they do and will take kick-backs from their "preferred" fund families.

They indicate that by narrowing the available fund universe to funds offered by this group of seven families, the claim to make decisions easier for the investor. Rather than that, how about actually doing some analysis? These brokers sell a position of trust to their clients, but abuse that trust by doing no analysis on behalf of their clients.

The language in the article sounds innocuous enough... "we want you to be aware of ... 'revenue sharing arrangements' ", but these are kick-backs from fund families with (on the whole) mediocre products with average (at best) performance. The most discouraging aspect is that they will continue to engage in this behavior and are simply disclosing their way out of it. If you are an Edward Jones client, it is time to re-evaluate that relationship, plain and simple.

Just in case you think this opinion is isolated, here's what Jim Cramer has to say...

So Edward D. Jones wasn't a conservative brokerage house with a boring recommended list meant to keep its clients in healthy shape. Edward Jones simply de-emphasized research entirely, paid little attention to it, and steered people toward funds for kickbacks.


During the vast bubble and its subsequent burst, I was impressed that Edward D. Jones seemed to have its feet on the ground, not suggesting wildly inappropriate stocks for its clients. I praised the firm on my radio show for seeming to have its clients' conservative sentiments at heart.


What a chucklehead I was. Instead of pushing inappropriate stocks on clients, Edward Jones could have pushed inappropriate funds on them. Stocks can't give kickbacks, but funds can. What Jones was doing was far worse than just recommending bad stocks.

Monday, this firm agreed to pay a gigantic fine, $75 million, and to stop this outrageous pay-to-play junk where preferred funds got tons of money in return for hefty fees on the back end. To think that this firm cloaked itself in conservative clothes is just outrageous. The company exhibited a stupefying two-facedness that makes me want to scream.


Of course, it will pay the fine and be allowed to stay in business. Everyone gets to stay in business. You would think it was in the Constitution or something, that it was written, that, no matter how outrageous the fiduciary violation, you still are good to go in the financial services business because once you are in, you are in.


When I started my radio show, I alleged that there were a lot of secret revenue-sharing agreements between brokers and funds because otherwise, the really crummy funds would have no customers. Who would deliberately stay with a crummy fund? Who is that stupid?

But I wasn't able to get the documents that told you who was paying to get money and who wasn't. We now have settled the problem when it comes to brokers. Next up? The kickbacks some of these human resources people have been taking to keep their companies with bad funds for the 401(k)s. Some of it will be kickbacks to the companies, others will be under the table. What else is new?


Would anyone mind taking a pledge with me to do what's best for the client over the long term, so both he and the client make big money? Is there anyone willing to raise his right hand and swear he will do his best for his client, not for his firm or himself?


From here, the silence sure seems deafening.

WSJ.com - Jones Discloses Secret Payments From Fund Firms

Buyer / investor beware!

Edward Jones pays $75 million fine associated with kick-backs.

In case back-end loads, high management expenses and 12b-1 "service" fees are not enough, investors through Edward Jones have been sold funds from "preferred" fund families that offered them kick-backs for selling their funds. This is absolutely a case of Edward Jones offering Sales but not Advice or Analysis.

Let me hi-lite one of the most incriminating lines in this article -- "Some of the worst-performing fund families offered Jones the richest incentives to sell their products." It should not be surprising that there is a correlation! No one knowingly buys poor funds, but they are often sold them.

GM's problems are why we must address Social Security Reform in the USA now!

Unemployment, the Business Cycle & the Fed

One economic figure that we track that has us concerned is the jobless claims number, which has improved dramatically over the last year but lagged improvement typical of a recovery.

In general the difference between a recession in the labor markets and an expansion is the difference between 400,000 jobs lost a month (recession) and 350,000 jobs lost(expansion).

So the difference between good and bad is right at 50,000 jobs. In the past 6 months we have averaged 340,000 jobs lost, a level that is consistent with labor expansion. Indeed the rate of unemployment has improved over that time period, but the improvement pales in comparison to past business cycles.

One factor that we think is behind the trend in weak employment growth is the incredibly long business cycles we have had in the last two cycles versus the average business cycle since the end of World War II. Roughly, the last two business cycles lasted 10+ years. Prior to that the average cycle was more on order of 4 years, with an occasional 7 year cycle.

Booms are becoming longer and busts are becoming shallower because of counter cyclical measures undertaken by policy makers. Policy makers are more aware of the ramifications of fiscal and monetary policy. Policy makers have also become more open with their outlook and expectations, ie more transparent.

Because some of the downside has been reduced, the upside has less omph.

Weekly Market Returns

Investors, speculators, hedge funds were all running for the exits during the first full trading week of the year. We had a good run since October 28th with very little pullback. While some feel the selling is a bad omen, we think it is just protecting some gains now that we are in a new tax year.

For the week the Nasdaq was down -4.0%, the S&P 500 down -2.1% and the DJIA was down -1.7%.

We are fast approaching earnings season and results may very well determine what kind of year we have on Wall St.

Employment Situation

From economy.com
Subscription Required

The year 2004 was characterized by large swings in job creation and the labor market was not able generate a steady pace of growth that would be consistent with an expanding economy - at least 200,000 monthly. Job gains swung from a paltry 80,000 to greater than 350,000. Moreover, after the net gain of 312,000, job gains during the past two months fell below 200,000 again.

For the year, the economy created 2.2 million jobs, averaging 185,920 monthly. The recovery of the labor market from the recession is still incomplete even if the revision in payroll employment that will be published next month is included.


While last year's pace of job creation was sufficient to absorb new entrants into the labor market, it has been insufficient to bring many previously displaced workers into the fold again. The unemployment rate fell by 30 basis points over the past 12 months, but has remained unchanged during the last six months.


Many people are still not eager to join the labor force. The labor force participation rate did rise at the end of the year, to 66.1%, but this is only 20 basis points higher than the cyclical low. As the Labor Department noted, the weak and unprecedented rebound in the labor force participation rate may be due to structural and demographic trends, as well as cyclical factors. Labor force gains averaged only 110,000 during the past months - compared to about 150,000 that would be consistent with population trends. It is possible that due to shifts in the composition of the population a lower pace of labor force growth should be expected.


The Fed recently noted that there is evidence that the labor market is doing a better job generating better quality jobs than poorer quality jobs. This is confirmed in the December report. Such industries as education/healthcare and professional/technical services are adding jobs at a steady pace, while job creation is weaker in such industries as retail trade and leisure/hospitality. Temporary employment increased by only 9,000 in December, following a loss of 2,000 in November. Such weak gains in this important barometer of labor market trends are troubling and may be tracking the weak trends in retail and manufacturing payroll growth. For the year, gains in temp employment averaged 17,000 monthly. Trends in temp hiring are closely aligned to trends in overall growth in the economy.


Among jobs that pay fairly well and do not require college degrees, the past year has been good with manufacturers adding 76,000 and the construction industry adding 258,000. However, the outlook for both of these industries is much less promising. In particular, construction industry employment is expected to decline by 350,000 over the next year; manufacturing employment will be flat.


The contours of the labor market other than the changes just mentioned will be much the same in 2005 as in 2004. Economy.com expects the labor market to generate just under 190,000 monthly.

Editors Note: In our opinion it has been the sporadic labor market that has kept a lid on long term interest rates in the USA, labor costs are a much more important input factor than commodities at the present time.

Spin from within: Comments on Yuan Peg...

Say what you will about the rise of China and the growing US trade imbalance with China, our issue is not with the structural effects of the peg, but the peg itself.

You only need to look to resent history to see two other developing world currencies that pegged to the dollar that when it ended, it ended badly; Mexico and Argentina.

Markets are messy and don't always make sense but they are the fastest adjustment mechanism we have. China is only biding time with their currency scheme. Pegged currencies are like springs getting wound tighter and tighter, at some point they break.

Not today, not next week but sometime soon. The Chinese are really between a rock and a hard place because their banks are rotten to the core and they can ill afford a forex shock to output or their foreign currency reserves.

It is going to be interesting to see how they unwind this one or if the markets do it for them.

What is happening today...

Today's reaction to the release of the Federal Reserve minutes from the previous meeting is surprising. Most market participants should be aware of the current im-balance between interest rates and inflation, and we continue to believe that rates will need to approximate between 2.5% and 3% on the short end. Don't get caught up in the madness of the market and be patient; the information moving the market today is not news.

2004 Review/ 2005 Outlook

Review
Looking back over 2004 as of 12/29/2004:
For a year that energy prices were talked about so frequently you would think that energy might be the top performing sector of the market for the year. In fact energy was a close second to real estate, which was up +34.5% for the year. The laggard for the year was the Goldman Sachs Semiconductor ETF, down -14.05%.

In terms of benchmarks the S&P 500 is on track to be up 12.55% for the year as of the 29th of December but still has a negative five year return. Think about it, if you purchased an index fund in 1999, even with dividends you are negative.

Something odd that took place in 2004 is with interest rates and bonds. Long dated US Treasuries will finish the year pretty much where they started. The ten year US treasury was 4.21% on 12/31/2003 and the last we checked it was 4.32%. Commodity prices and bond prices both trended higher in 2004 a trend which should not hold. The US Federal Reserve has worked hard to reflate the global economy and we are seeing the fruits of their labor. Inflation (all urban CPI) finished 2003 up 1.82% y/y and as of last month inflation is running +3.58% y/y. Between bonds and prices, something has to give.

Outlook
In terms of our outlook, first some warnings. We are always looking to the future in our analysis. Capital markets are dynamic and as events unfold our opinions can and will change. Forecasts are a snapshot in time to be acted on when made, not months later. As with anything you see online, do your own homework, and make your own decision.

Inflation
CPI-U, the most common measure of inflation in the USA started the year at a scant 1.82% annual rate and finished with the November 2004 data point up 3.58%. This is a sharp move higher driven in part by higher energy prices, but not entirely. While the pace of inflation may moderate somewhat, the uptrend in prices will continue well into 2005.

Interest Rates
The US Federal Reserve will continue to remove stimulus applied after 9/11 and move short rates back to a more neutral range. Historically the Fed Funds rate has been at a slight premium to inflation, so that implies short rates much higher in 2005 than we finished the year. How much higher depends on inflation but suffice to say, our prediction is that the Fed continues moving short rates higher well into the New Year.

For long rates it is really odd that inflation and short rates moved so much higher in 2004 and the 10 year US Treasury barely budged. Our sense is that this is driven by Asian Countries and companies recycling their trade surpluses with us into US Government Paper. In a way we are relying on the kindness of strangers to keep rates low. The normal spread of the 10 year bond is +2.80% above inflation. That implies a 10 year bond at 6.38%, significantly higher than current rates. We would not be a buyer of long dated US bonds with spreads so low.

Valuation
Market pundits have been arguing over valuation since the market peaked in March of 2000. The perma-bears say a classic bear market isn’t over until the P/E on the market is roughly 8; the bulls are putting a 20 to 25 P/E on forward earnings. We feel that both are wrong and with inflation and interest rates where they are at; a high teens P/E for the market is normal versus historically. Valuation between 14 and 19 times trailing earnings is a range we may see for some time.

Earnings
Earnings momentum has slowed but the absolute level of earnings should continue to rise in 2005 unless we get an unexpected downturn in the economy. Slowing EPS momentum has some market gurus concerned, but not us. In the past the market has down its best with a slow but steady rise in earnings. If we could string together a couple of years of +8 to 15% EPS growth we think investors could be quite happy with the results. Slow and steady wins the race. Too fast and the Fed will hit the brakes, HARD!

Opportunity
The obvious value opportunity going into 2005 is with Pharma, lots of problems, bad headlines and valuations that have come down. While it is true that P/E’s on drug stocks are at levels last seen during the Clinton Healthcare proposal the stocks are not as cheap now as they were then. The growth rates and return on equity on the major drugs is not as high today as it was in the early 90’s making the stocks more expensive on a value/return basis.

Risk(s)
The largest risks we see as a real possibility is an oil shock caused by a petro-terror event or a significant rise in long term interest rates caused by a reduction in bond purchases by China and Japan. While both are possible we don’t currently measure them as probable.

In terms of oil terror, we take a face value that Al-Qaeda had not been able to launch a major operation. Indeed Bin Laden could only hit us with a video tape prior to the elections. Had they been able to act, they would have.

On the Asian situation and its effects on the value of the dollar and interest rates, the USA is the central bank to the world, for the moment Asian countries have no other vehicle to invest in to earn a safe return on their trade surpluses. In time this may change but hopefully not in 2005.

Firewood sales up as oil prices rise

An example of the substitution effect and how consumers are coping with above average energy prices.