09/17/08   The Impossible is Now Common

Editor’s Corner

The Impossible Is Now Common

Ron Rowland

The financial world is changing before our eyes this week. The headlines tell the story: Lehman Brothers bankrupt, Merrill Lynch taken over by Bank of America, AIG effectively nationalized, and even the mighty Goldman Sachs now getting pummeled after a disappointing quarter. What will happen next? Anyone who claims to know is being less than truthful, because the fact is we are in uncharted territory. The unthinkable has happened, and the impossible is now common.

For many investors, the best advice right now is “Don’t just do something: sit there!” Decisions made in haste rarely look wise in hindsight. Those with a prudent strategy and long-term perspective should be able to ride out the storm with minimal discomfort. Unfortunately, as most investment professionals can attest, few individual investors fit this profile. It does not help when a major money market fund closes.

Combined with widespread fear of more bank failures, the conditions are now in place for a panic. The flight to quality is already well underway, driving Treasury yields sharply lower. Meanwhile interbank lending has almost stopped completely; LIBOR more than doubled in one day this week. In an atmosphere where no one trusts anyone, investors have ceased to care about yield and will pay nearly any price to have the safety of U.S. government debt.

The Federal Reserve surprised markets this week by passing up an opportunity to reduce rates. It seemed like the perfect time to prescribe a dose of confidence, but the FOMC clearly felt otherwise. One thing that may have affected their thinking: with the Fed Funds target now at 2%, the Fed doesn’t have much room to maneuver. Lowering rates to 0% did not help Japan in the 1990s, and arguably made their problems much worse. Bernanke may be trying to keep his options open in case the situation spirals further out of control.

Retreating crude oil prices were one of the few bright spots amid the wreckage, but that changed in a flash today when the U.S. Embassy in Yemen was bombed, killing at least 16 people. More turmoil in the Persian Gulf is the last thing markets need right now. After approaching the $90 area, crude oil futures jumped to $97.35 today. Gold also rose sharply as the dollar lost ground and investors bought the one financial asset that is not also someone else’s liability.

The trillion dollar question is this: have we seen the selling peak? At some point, fear takes over and everyone who can sell will have done so — at which time markets have to turn up. Obviously we are closer to the bottom than we were last week. Yet in the darkness it is impossible to see what lies below.

Sectors

Relative strength was largely unchanged, but in absolute terms almost every sector lost intermediate-term momentum over the last week. Consumer Staples, Consumer Discretionary, and Health Care remain the top three sectors for now, with Consumer Staples beginning to show signs of breaking ahead of the others. Materials, Energy, Utilities and Technology are weak and getting weaker.

Styles

Small Value is the last man standing in the Style arena this week. Everything else is down for the count, and an ambulance is en route to take Mid Growth to the hospital. Style action is in part being driven by sector action right now; because the Large Cap indexes tend to have more exposure to the weak sectors like Financials and Energy, they are being outpaced by Small Value, Small Blend and Small Growth. It seems odd to call Small Cap stocks a safe refuge, but to some extent that is what they have become. Managers who can are shifting their portfolios away from Large Cap and toward Small Cap, and you see the result in our rankings.

International

China, Latin America, and Emerging Markets are now declining at annualized rates in excess of -100%. This implies those markets will disappear completely in the next twelve months. No such thing will happen, of course; the main thing this tells us is that downside momentum has reached levels that cannot be sustained for long. It does not, however, mean that a rally is imminent. The U.S. and, strangely, Japan are for now the closest thing the world has to market stability.


Note:

The charts above depict both the relative strength and absolute strength of various market sectors, styles, and geographic locations on an intermediate-term basis. Each grouping is sorted (top to bottom) by relative strength. The magnitude of the displayed RSM value is a measure of absolute strength, which is our proprietary method of measuring and reporting the intermediate-term strength as an annualized value.


“There’s nothing wrong with cash. It gives you time to think.”

Robert Prechter, Jr. (b 1949) American financial author


Pick-of-the-Week

Cash Is King

Brandon Clay

Cash

“When in doubt, stay out!”

Such is the market situation today. A couple of weeks ago we recommended our first short position. Today, we’re making our first recommendation to stay out of the market. We think cash is the best option for a portion of your portfolio. But not all ‘cash’ is equal. This market has forced us to identify an asset class. Let me explain.

Cash and Cash Equivalents

Without getting too philosophical, we define cash as physical money. In the United States, the portraits of Washington, Jefferson, Lincoln, Hamilton, Jackson, Grant, and Franklin printed on green and purple paper in your wallet is the only money we consider cash. Cash is physical paper and U.S. minted coins issued by the Federal Reserve.

However, ‘cash equivalent’ funds are just as stable as Federal Reserve notes. These are highly liquid securities. Examples of cash equivalents are U.S. Treasury Bills, checking accounts, and, until recently, money market accounts. Theoretically, these can be easily converted into cash of the green, folding variety.

When is a Dollar Worth 97 Cents?

But that’s just it. On Tuesday, it was proven that financial theory does not always match fact. Reserve Primary Fund, the oldest money market fund in the country, fell below $1 per share by closing at $0.97. In economic parlance, Reserve Primary ‘broke the buck’. This is the worst thing a money market fund can do. But that’s not all. Depositors are scheduled to get 97% of their money back, but they must wait a week to make withdrawals. Indeed, we live in interesting times.

So with a $62 billion (as of 9/15/08) money market fund going bust, the entire financial system has become anxious. Investors are looking for more liquidity. Now the average investor is forced to ask a important question: what is the best way to be in cash?

Different “Cash” Options

U.S. Treasuries are considered the safest investment in the world. Backed by the full faith and credit of the United States Government, they can be purchased through your brokerage account or directly at Treasury Direct without commission. Rates vary between different securities. Talk to your broker for more information about Treasuries. Keep in mind, short-term Treasury Bills have become so popular that they have almost no yield at this time.

Checking accounts, and usually savings accounts, are another safe option for depositors. If you deposit funds into an FDIC-insured account, then your money is protected up to $100,000 per bank. If you have more than $100,000 to protect, spread it out among several banks.

Money markets funds are another relatively safe option for investors. We keep some of our capital in a money market fund, but we also perform due diligence to keep our funds safe. The Treasury-only Money Market Fund is safer than a garden-variety money market fund. It only invests in short-term U.S. Treasuries. That said the yield typically will be lower than a regular money market fund.

Finally, there’s the standby ‘cash-in-the-mattress’ option. Withdraw your thousands of dollars, preferably in large bills, and go hide it. Bury a safe chock full of greenbacks in your house’s foundation. You could also dig a hole in your backyard and hope that Fido isn’t looking for an old bone. If you want to get technical, this is the only cash option available. However, this option adds a new level of stress to your financial situation. It may not be the best choice since you’re taking on new risks like fire and theft.

Regardless, we recommend you hold a portion of your investments in cash or cash equivalents. One day the storm will pass. For now, we will live to invest another day.

All the best.


Note:

Keep in mind, the Pick of the Week is usually intended for aggressive investors. Don’t risk money you can’t afford to lose. You will need to decide when (and if) it is time to sell.