Commentary for the week ending 10-15-10

The markets continued their climb higher this week. At the Friday close, the Dow rose 0.5%, the S&P 500 was higher by 1.0%, and the Nasdaq had popped higher by 2.8%. The weak dollar story continues as most commodities were higher, including a 2.0% rise in gold with a new record high set this week. Oil dropped 1.7%, but remains above the $80.00 level.

Source: MSN Moneycentral

Without a doubt, the Federal Reserve has been the story of the week. Basically, anything that moved in the market was in response or in anticipation of activity from the Fed. Fed chief Ben Bernanke spoke this week and made it all but certain that a second round of quantitative easing (a fancy term for printing boatloads of money and pumping it into the market) was in the works. Stocks and commodities rose, since QE2 is designed to pump up the price of assets, while the value of the dollar continued to drop.

The Fed believes this new stimulus will solve the high unemployment, depressed real estate values, and a perceived deflationary scenario. In order to create inflation and demand for products, they are injecting liquidity into the markets to push stock prices higher and yields on bonds lower. The low yields are designed to stimulate lending since a low yield means consumers can borrow at a low rate (we already have historically low mortgage rates). A cheap dollar is also a result, as it makes our exports more appealing since they will be cheaper to foreign purchasers.

The problem is, we don’t believe it will work and will open a giant can of worms. The first round of stimulus failed to produce anything, so we wonder what a second round would accomplish. We believe the best results will come if nothing is done at all. That’s right, if the free market is allowed to run its course, we will be much better off.

Why won’t it work? First, they see it very important to prop up the housing sector, since it was the housing sector that has led us out of past recessions. Understandably, it is also a major concern of the millions whose homes have lost their value. Unfortunately, these historically low mortgage rates have done little to spur buyer’s interest (not to mention the distractions from this mortgage fiasco). Additionally, home values are probably still too high (in many areas, at least). Propping us this sector will do nothing until the market is able to find the bottom on its own - without government interference.

Next, this weak dollar will create plenty of headaches here in the U.S. The prices of commodities have been on a tear and are positioned to go even higher. This means things you buy will cost more. Gas prices will rise. Food costs are already rising. Corn prices have soared in the last several weeks. Cotton is at the highest price since the Civil War. How anyone can think the benefits of a weak dollar offset costs such as these is beyond us.

The Fed also indicated this week that they are targeting an inflation rate of 2.0%. Inflation is seen as more beneficial to the economy than the deflation they believe we are seeing. We received the Consumer Price Index (a gauge of inflation) numbers this week, and they were relatively low at just 0.1%.

However, we also received the Producer Price Index (another gauge of inflation) and it showed a substantial gain of 0.4% last month and 4.0% in the past year. This is very important. First, it shows that there is inflation. But this inflation is seen by the companies who make the products you consume. They are not willing to pass these higher costs on to consumers in this weak economic environment. Using the record high in cotton from above, it costs more to make an article of clothing, but the store will probably not raise their prices to reflect that. That means companies are less profitable, which will result in lower stock prices.

We believe we are living in a period that will have dramatic effects on the future. These actions by the Fed are very substantial and will produce many unseen consequences. Once inflation gets started, it is very difficult to control or contain, and it could be dramatic. Also, bubbles usually are a result from artificially low interest rates (i.e. - the latest housing bubble). Could there be bubbles now forming in stocks (especially emerging markets), bonds, and commodities? Prices have certainly risen substantially in response to the Fed actions, but only time will tell, although the potential is there.

Next Week

For a change, there won’t be many economic reports next week. We will get some industrial numbers, as well as housing starts and leading economic indicators.

Next week will again be Fed overload, as many more Fed presidents will be making speeches which will be carefully followed. We will be looking for any further indicators on future Fed actions and QE2. Regardless of what is said, it will certainly have an impact on the markets.

Finally, corporate earnings releases kicks into high gear this week. Many banks will release earnings, and they are expected to be much lower than last quarter. On the other hand, many tech companies will release their numbers (most notably Apple on Monday), and earnings are expected to be solid. These mixed results have been the trend so far, as we saw great earnings from Google last week, but poor earnings from GE.

Where are we investing now?

Don’t fight the Fed. As wrong as we think they might be, it is our job to make money no matter the circumstances. We still see considerable weakness in the economy, so we are very careful with our positions. Other headwinds like higher future taxes, increasing government involvement in the private sector, and a still-high unemployment rate, continues to worry us. Also, after 2,400 corporate insiders were selling for every one buying last week, that ratio dropped to 1,200-1 this week, which is still horrible and gives us cause for concern.

In equities, we are focused on higher-quality and multi-national stocks, but some smaller stocks look promising, as well. A weak dollar would be a plus for export-oriented companies. We continue to avoid banking and insurance sector stocks. 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 mentioned above, as inflation will also impact prices to the upside along with the weak dollar. 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 (with certain sectors in China) are areas we favor.