Commentary for the week ending 5-21-10

Concerns over European debt and new domestic banking regulations helped send markets significantly lower for the week. At the close on Friday, the Dow lost 4.0%, the S&P dropped 4.2%, and the Nasdaq was lower by 5.0%. Gold sold off from its highs last week and oil was down 2.2% to close right at the $70 per barrel level.

Source: MSN Moneycentral

“What is going on with the market? Will it keep going lower?”

We heard these questions many times this week. The answer is, we don’t know. No one does. The Dow has risen over 60% since its lows back in March of 2009, and we were due for a correction at some point (A correction is officially defined as a drop of 10%, a milestone we passed this week). So will the market keep heading down? The momentum is certainly lower, but there is no telling how long it will last. Value investing is in our nature, so we are always on the lookout for a stock that is “on sale.” However, the market is just too volatile right now and we are comfortable waiting on the sidelines for a little more stability. A brave investor could pick up some potential bargains now, but there is little sense in us trying to “catch a falling knife,” as they like to call it.

As mentioned above, several factors contributed to the sell-off this week. The European debt story just won’t go away and will likely be around for some time. Also, the senate passed a financial regulation bill which we will discuss later. A story on CNBC this week caught our attention, as we feel it may explain some of the recent volatility. Hedge funds have been loading up on liquid assets in recent months and are now looking to “de-risk.” Liquid assets are things like S&P 500 stocks, and loading up on these stocks contributed to their rise in price. The new buzz word amongst hedge funds is “de-risk” (we heard it many, many times in their interviews), so when they de-risk, they sell those liquid assets, which causes the prices to fall. They also sell assets which have reached new highs, like gold and other commodities (whose prices have also dropped this week). These hedge funds are only a small part of the market, but it still may have added to the rise in volatility we have seen.

Scores of new government regulations and interventions, both here and abroad, are also causing investors to worry. The financial regulation bill passed the Senate this week and is being described as the biggest overhaul to the financial industry since the Great Depression. Wonderful. Aside from the fact that Wall Street is not the culprit in the recent downturn in the economy, this bill does nothing to prevent another credit crisis from happening. However, it succeeds in forming new government bureaucracies and increasing fees. These costs will be borne by the consumer who will find less credit available to them due to new regulations on banks. Maybe a little less credit would be good, since lax lending practices contributed to the recent meltdown, however, less credit for businesses would cause serious problems.

In a recession, it is important to reduce burdens on the public to help spur new investment, production, and consumption for the economy to recover. Presently, nothing coming out of governments worldwide will help, and it keeps getting worse. The financial regulation bill is just one example. Recently, Australia announced a plan for a new 40% tax on mining companies (in addition to the taxes they currently pay). Brazil, China, India, and Congo have also announced similar plans. This will ultimately result in higher costs to consumers and hurt mining companies and their employees.

Quietly announced this week, the U.S. government plans to dramatically increase taxes on oil companies (the current 8 cent per barrel tax will be raised to 32 cents) for two reasons. One is to pay for the oil spill in the gulf (which will sound good to the public, except they already have a fund for this, plus, BP has announced they will cover these costs). The other is to pay for unemployment benefits. It is bad enough that they raised taxes on our businesses here in Florida (amongst other states) to pay for these extended benefits, but now they will take advantage of the unfortunate oil spill to pay for their overspending. Raising taxes on businesses will prevent them from hiring new employees, as we can see from the stubbornly high unemployment rate.

In addition to the volumes tax hikes proposed by the Federal government (we will spare you from discussing them in detail), virtually every state and local government has proposed a new tax or “fees” in order to pay for their spending. We are going in the wrong direction and an already tapped out consumer can’t afford these new burdens.

We don’t often discuss government policies here, but these new burdens will ultimately hurt consumers and businesses, resulting in a lower stock market. The U.S. economy has fared well to this point and businesses are returning to profitability. The headwinds in the economy keep accumulating and it would be unfortunate to see a reversal in the growth we have achieved.

Next Week

Along with the news coming out of Europe, more corporate earnings and economic reports will have an impact on the market next week. For the economic reports, we will be following the home sale numbers, consumer confidence, durable goods, and personally income and spending releases.

Where are we investing now?

The recent drop in the market is tempting us to add to stock positions, but we will remain on the sideline for the time being. The volatility is troubling and we are looking for a bit more stability. Our outlook still remains the same, as we are still optimistic through the end of the year since the easy money and stimulative measures will help push the markets higher. Higher interest rates, higher taxes, increasing government involvement in the private sector, and a still-high unemployment rate have us worried for the longer term.

In equities, we are focusing on higher-quality and multi-national stocks, but some smaller, value-style stocks look promising, as well. We continue to avoid banking and insurance sector stocks, and new government regulations have us staying out of oil companies. TIPs are important as we expect inflation to increase in the future, while U.S. treasuries are a sector we are very bearish (pessimistic) on as yields will increase over time. Commodities remain a longer term favorite, as inflation will also impact prices to the upside. Government policies will weaken the dollar over time, although we have been getting hurt on this trade recently with recent drop in the Euro. Municipal bonds will play a more important role in our portfolios over the coming months and years as higher tax rates take effect. Finally, we are optimistic about international stocks, as emerging markets (excluding China, and now Australia) are areas we favor.