With 2008 in the history books, we’ll use this week’s commentary to review some of the key stories over the past year. As you well know, it was not one of the market’s finest performances.

STOCKS SUFFERED MIGHTILY
Global stock markets shed about $30 trillion dollars in market value over the past 12 months. Of that, about $7 trillion came from losses in the U.S. market, according to Bloomberg.com. In fact, the drop in the S&P 500 index was the worst annual loss since The Great Depression. Also according to Bloomberg.com, Tunisia was the only country out of 69 monitored by MSCI Inc. that saw a stock market gain in 2008. When it came to stocks, there was virtually no place to hide.

INTEREST RATES DIVERGED WILDLY
It was a tale of two markets when it came to interest rates. The flight to safety turned U.S. government securities into the investment of choice for many investors and the resulting demand sent yields plunging. The Federal Reserve helped lead the way by cutting its key interest rate seven times in 2008. The Fed Funds rate went from 4.25% at the start of the year to a target rate of 0% to 0.25% by the end of the year. Conversely, investors fled corporate bonds and municipals, which helped drive a spike in their yields, according to The Wall Street Journal.

THE COMMODITY BOOM WENT BUST
We’ve heard for years that countries such as Brazil, Russia, India, and China will drive worldwide growth and keep demand high for commodities such as oil, copper, and food staples. Well, it worked for a while. By mid 2008, commodity prices were flying high. But, then, sentiment changed and investors began to realize that economic growth was slowing and there may be a limit to the world’s demand for goods. Commodity prices quickly tumbled. Oil is a good example as it surged from around $100 per barrel at the start of 2008 to over $145 by July. It then plunged and ended the year near $45 per barrel, according to Bloomberg. And, you don’t need us to tell you about the dizzying trip of gasoline prices this past year.

HOUSING PRICES CONTINUED TO FALL
In hindsight, a crack in housing prices in late 2006 was one of the first signs that our economy was headed for trouble. Since its July 2006 peak, housing prices have fallen 23% through October 2008, according to the S&P/Case-Shiller Home Price index as reported by The Wall Street Journal. The decline in home prices removed one of the economy’s growth engines and, when that stalled, it helped take the rest of the economy with it. On the bright side, mortgage rates continue to drop. Thirty-year fixed rates are near record lows at 5%, according to the Mortgage Bankers Association. And, if the government gets its way, those rates should head toward 4.5%, according to The Wall Street Journal.

UNEMPLOYMENT CONTINUED TO RISE
Since this recession started in December 2007, the U.S. economy has added 2.7 million people to the unemployment rolls, according to the Labor Department. President-elect Obama has stated that he’d like to create 3 million new jobs as part of his administration’s plan to help the economy, according to MarketWatch. While that may seem like a big number, by the time his plans get rolling, we may have lost much more than 3 million jobs. That just gives you an idea of the magnitude of the problem we’re dealing with.

WHERE DO WE GO FROM HERE?
Our country is facing a near perfect storm of economic headwinds that most of us have not seen in our lifetime. Years of easy money and a conspicuous consumption lifestyle have finally caught up with us. In 2008, the financial markets woke up to the fact that we can’t indefinitely spend money we don’t have. Now that consumers and businesses are de-leveraging, the resulting effect on the economy can be summed up in one word: contraction. The government is trying to counteract this consumer and business freeze by spending money it doesn’t have. So far, the government is successfully walking a fine line between being the “spender of last resort” and being called out as the “wizard behind the curtain.” As evidenced by the decline in Treasury yields and the stable dollar, investors worldwide are putting their faith in that wizard. Don’t be surprised, though, if that faith is tested at some point in 2009.

Weekly Focus - A Thought for the New Year

“Year’s end is neither an end nor a beginning but a going on, with all the wisdom that experience can instill in us.”
– Hal Borland

It’s “Helicopter Ben” to the rescue.

For people who follow the financial markets, last Tuesday’s announcement by the Federal Reserve was a watershed event that historians, pundits, and investors will talk about for years to come. The Fed essentially opened the floodgates to help the economy and signaled more help is on the way. Here are the key points from the Fed’s announcement.

• It established a new target range for the federal funds rate of 0 to ¼%-effectively it’s as low as it can go.

• It expects to keep the federal funds rate at an exceptionally low rate, “for some time.”

• It will use, “All available tools to promote the resumption of sustainable economic growth and to preserve price stability.”

• It is evaluating the benefits of purchasing longer-term Treasury securities as a way to lower long-term interest rates.

• Going forward, it will, “Support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve’s balance sheet at a high level.”

Money manager Bill Fleckenstein summed it up nicely by saying, “The Fed went for it, corroborating the view that many of us have held for some time: that when push came to shove, the central bank would let nothing stand in the way of printing any amount of money, and monetizing anything required to fend off the ill effects of the collapsing bubble.”

Wall Street’s reaction to all this was mixed. On the day of the announcement, the Dow Jones Industrial Average soared 359 points. Over the next three days, though, it gave back most of those gains.

For homeowners, the Fed’s action was positive. Long-term interest dropped significantly after the announcement and that may translate into lower mortgage rates. If this causes the housing market to perk up, it may give the economy the jolt it needs to begin stabilizing.

You probably remember the old saying, “We’re from the government and we’re here to help.” No doubt about it, the Fed, the Treasury, the White House, and even Congress are now “here to help.” The question is, do they know what they’re doing?

As James Grant, editor of Grant’s Interest Rate Observer, so wryly pointed out in a recent Wall Street Journal essay, “Prescience is rare enough in the private sector. It is almost unheard of in Washington.” Despite this historical lack of foresight, we’re all putting faith in the government that they can correctly diagnose our current problems and prescribe the right dose of medicine to get the economy moving again. So far, the medicine may have moved us out of the emergency room, but we’re still in intensive care.

THE SPEED AT WHICH the economy and the financial markets have moved this year is astonishing. Here’s a brief look at some of the most amazing changes.

• The S&P 500 index dropped nearly 47% in just six months between May 20 and November 20, according to data from Yahoo! Finance. By contrast, during the severe 1973 - 1974 bear market, it took the S&P 500 more than one year and eight months to drop that amount (January 11, 1973 to September 27, 1974).

• Crude oil prices started the year at $95.98 a barrel and just over seven months later, it peaked at $145.29 per barrel on July 3-a 51% increase, according to data from MSN. This helped stoke fears of runaway inflation. But wait, crude prices then plunged 76% in less than six months between July 3 and December 19. Now the talk is about deflation. Vertigo, anyone?

• The yield on the 10-year Treasury bond dropped from 4.02% on October 14 to 2.07% on December 18, according to data from Yahoo! Finance. That’s a 48% decline and nearly two full percentage points in just over two months. By contrast, for the six years ending October 14, 2008, the yield on the 10-year bond changed by less than one quarter of one percent, according to Yahoo! Finance data.

• Nonfarm payroll employment rose by 94,000 in November 2007. Just a year later, in November 2008, nonfarm payroll employment fell by 533,000, according to the Department of Labor. And sadly, from December 2007-the start of this recession-to November 2008, the number of unemployed persons in the U.S. rose by 2.7 million.

• The auto industry, as we all know, is hurting. Parts supplier Johnson Controls issued an outlook on October 14 of this year and forecasted North American auto sales would reach 12.3 million units in 2009. Just two months later, on December 16, they revised their forecast downward to only 9.3 million units. Is it any surprise that two of the Big 3 auto manufacturers are on the brink of bankruptcy?

We’re not sharing this information to depress you. We’re simply pointing out that changes are happening with lightening speed. So far, many of these changes have been detrimental to people’s wealth. But, on the positive side, let’s keep in mind that if things turned this quickly on the downside, perhaps they could also turn that quickly on the upside. A return of confidence may be one key to making that happen.

WE WANT TO TAKE A MOMENT and comment on the Bernard Madoff scandal. As you probably know, Madoff allegedly engaged in a giant Ponzi scheme that bilked investors around the world out of $50 billion. In this industry and in human relation in general, trust is of utmost importance. When that trust is shattered, people are understandably enraged and dispirited. As it relates to Madoff, it’s doubly frustrating because we rely on government regulators, such as the Securities and Exchange Commission, to monitor money managers and brokerage firms and prevent this type of fraud. Clearly, the regulators failed us.

Madoff is the latest in a line of swindlers who put their own interests ahead of their clients. Yes, there are bad apples in the financial services industry just like there are bad apples in government or any other line of work. Yet we don’t want a small number of bad apples to deter investors from seeking investment counsel. We work extremely hard to earn your trust and we do all we can to ensure that your assets are invested wisely and housed with secure and trustworthy custodians. If you have any questions or concerns about this, please let us know.

Weekly Focus - Happy Holidays

As we wrap up one year and begin a new one, we wish you and your family peace, health and happiness. It’s our privilege to serve you and we look forward to working hard on your behalf in the years to come.

The following comment might shock you, so prepare yourself. Here it is… last Monday’s closing price on the S&P 500 index confirmed that we have been in a new bull market since November 20th.

Yes, it seems rather ludicrous to say we’re now in a bull market since the S&P 500 index is still down about 40% this year. But, according to the standard definition of a bull market as reported by Bloomberg, the bull is alive. The bull is here because the S&P 500 closed last Monday about 21% above its November 20th closing low of 752. That meets the definition of a bull market, which is a 20% rise from a previous 20% or greater decline. The bear market we just exited, which lasted from October 9, 2007 to November 20, 2008, drove the S&P 500 down 51.9%, which is its third worst decline on record without an intervening 20% increase, according to Bespoke Investment Group.

Semantics aside, we’re not kidding ourselves into thinking that all is now well in the financial markets. Statisticians and market technicians may have fun playing with these numbers, but in the real world of managing money, we know that bull and bear markets don’t neatly conform to standard definitions.

Clearly, even within the context of a negative market environment, we may see significant rallies. These rallies could simply be “head fakes,” or bull runs within an ongoing bear market. For example, during the Great Depression between 1929 and 1932, the Dow Jones Industrial Average experienced nine bear markets and eight bull markets, according to Bespoke Investment Group. Each one lasted an average of just 105 days. Even though there were eight bull markets during this period, overall, the Dow dropped dramatically between 1929 and 1932, so we shouldn’t necessarily get too comfortable with the current bull market.

The point of this history lesson is we may experience a series of bull and bear markets within the context of a longer-term “secular” bear market. When we see big rallies, pundits will be quick to say the worst is over and it’s time to get aggressive. At some point, they may be right. In the meantime, we want you to be aware that big rallies may be followed by big declines. This yo-yo action can be very frustrating, but it’s a plausible scenario as the market and economy painstakingly work through the challenges we face.

HOW MUCH IS ENOUGH? The new administration is reportedly considering a two-year fiscal stimulus package worth up to $1 trillion, according to The Wall Street Journal. They have to walk a fine line though, because just like households, the government cannot spend beyond its means or else it will face negative consequences.

Since households are not in the mood to spend money, the government is turning into the “spender of last resort.” Political leaders on both sides of the aisle are arguing that it’s the government’s role to step in and prop up the economy if consumers are tapped out. This is not new. Our country has a long history of federal stimulus packages including one earlier this year.

The plan now under consideration is massive in scope. According to the Journal, it may include, “Funds for roads, bridges, water systems, school repair, spreading broadband access, promoting health-care information technology, improving energy efficiency in buildings, renewable-energy projects, and assisting struggling state and local governments.” It sure sounds nice, but economically speaking, there’s no free lunch.

Spending of this size has the potential to be both wasteful and excessively inflationary. Imagine if we gave you a budget of $1 trillion. Do you think you could effectively and efficiently spend it within two years? Okay, it would be fun trying, right!

As it relates to supporting the economy, we don’t know whether $1 trillion is the right number or not. Keep in mind, the government has already provided hundreds of billions of dollars in various backstops, facilities, bailouts, and guarantees. Combined, we’re talking serious money. Ultimately, this intervention may pose substantial long-term risks to our economy if not handled properly.

• One long-term risk is the possibility of uncontrollable inflation. Currently, few people are worried about inflation because economic growth is weak and commodity prices are plunging. But, with all this stimulus, the possibility exists that the economy could inflate beyond the government’s ability to corral it.

• A second risk is the possibility of an extremely weak dollar. If we print too many dollars and nobody wants to own them, then the value goes down. This would make our exports more competitive (a good thing), but our imports more expensive (a bad thing). It could also lead to a rise in commodity prices, higher inflation, and higher interest rates.

• A third risk is how effective will the government be in extricating itself from the economy after it’s outlived its usefulness. Many people, including some diehard free marketers, are willing to accept some level of government intervention right now to help prevent a devastating economic collapse. However, if things turn around, will the government be able to exit the economy gracefully without causing a relapse?

When the government intervenes in our economy at a level that is way above historical norms, there may be unintended consequences. As an advisor, we can’t control what the government does with all of our tax dollars. However, we can monitor the government’s actions and do our best to try and benefit on your behalf from whatever unintended consequences may result.

Weekly Focus - Think About It

“Government’s view of the economy could be summed up in a few short phrases: If it moves, tax it. If it keeps moving, regulate it. And, if it stops moving, subsidize it.”
–Ronald Reagan

We typically think of stock market volatility as a “bad” thing, but last week, we saw the “upside” of volatility.

As the chart indicates below, the broad-based S&P 500 index rose a stunning 12% for the week. Barron’s said it was the largest one-week gain in that index since 1974. In the holiday-shortened week, the S&P 500 index rose all four days that the market was open for trading. So, yes, last week was volatile, but it was all “good” volatility. By contrast, Bespoke Investment Group said for the 50 trading days ending November 23, the S&P 500 averaged nearly a 4% daily move up or down - the majority of which were down (i.e., bad volatility). Bespoke says that was the most volatile period in the history of the S&P 500 index.

Thanks to last week, the S&P 500 has now risen 19% since its November 20 closing low, according to data from Yahoo! Finance. We’d call that a very powerful rally!

The ironic part of last week’s rally is that the economic news is still terrible. Data from the Commerce Department showed orders for U.S. made durable goods fell 6.2% in October, which was the largest decline in two years, according to MarketWatch. The Commerce Department also reported that consumer spending declined 1% in October, its largest decline since the September 2001 terrorist attacks. And, of course, housing is still in trouble. The Case-Shiller home price index published last week by Standard & Poor’s showed home prices in 20 major U.S. cities fell a record 17.4% on a year-over-year basis.

The fact that the market soared last week in spite of this weak economic news is a positive development. Remember, the stock market tends to turn around before the economy does, so perhaps investors are starting to see some light at the end of the tunnel. We’ll have to wait and see if that light gets any brighter over the next few weeks.

SOME WISDOM never goes out of style. Below are a few of the late Sir John Templeton’s 22 Principles for Successful Investing that we think are worth remembering in this volatile market environment:

1. Outperforming the majority of investors requires doing what they are not doing.
2. Buy when pessimism is at its maximum, sell when optimism is at its maximum.
3. Buying when others have despaired, and selling when they are full of hope, takes fortitude.
4. Bear markets aren’t forever. Prices usually turn up a year before the business cycle hits bottom.
5. Buy what other people buy and you will succeed or fail as other people do.
6. Invest worldwide.
7. When your method becomes popular, switch to an unpopular method.
8. Stay flexible. No asset or method is forever.
9. Stock market investing takes more skill than any other kind of investing.

Source: The Templeton Touch (1983), by William Proctor.

Templeton makes it sound simple, but we know from experience that successful investing is anything but simple!

Weekly Focus - Think Inspiration, Not Spending

After you cover your basic needs, you have a choice on what to do with your money. You can save it, spend it, or redirect it to higher purposes. Prudent planning suggests that you save a certain amount, but, after that, how do you determine how much to spend for your own gratification versus redirecting toward serving your highest commitments and deepest values? One of the best ways to answer that question is to ask yourself, “Whom do I want to become?” Once you know the answer to that question, the path you should follow will unfold… and it may surprise you.

“Hope springs eternal,” wrote Alexander Pope back in the 1700s and, after a rocky start, we ended last week on a hopeful note.

If you look at the numbers in the chart below, it was another disappointing week in the stock market. Last Wednesday and Thursday didn’t help matters as the Dow Jones Industrial Average posted back-to-back 400 point plus declines. That set the stage for another nail biter as markets opened on Friday morning. Fortunately, the markets opened steady and after see-sawing above and below the previous day’s close, the Dow soared more than 6% in the final hour as word leaked that President-elect Obama would nominate Timothy Geithner as Treasury Secretary, according to MSN Money.

Geithner is currently president of the Federal Reserve Bank of New York and has been deeply involved in all the recent machinations at the Fed and Treasury as they plotted to thwart a systemic failure of our financial system. While no one thinks Geithner will single-handedly solve all our problems, his potential appointment shed some clarity on this important position and offered a glimmer of hope, which helped Wall Street close the week on a positive note.

Being hopeful and optimistic are certainly desirable traits and studies show they are associated with good physical and mental health. Unfortunately, those studies don’t tell us anything about how to manage investments. Successful money management takes hard work and we’re doing all we can to try and help you reach your goals and objectives. And, while we remain hopeful and optimistic that we’ll be successful in the long term, we don’t simply rely on having a sunny outlook to get there.

JUST A FEW MONTHS AGO, inflation was a big concern.Back then, the price of a barrel of oil had skyrocketed to an all-time high of $147, gas prices were over $4 a gallon, and other basic commodities and foodstuffs were shooting higher, too. Today, the world economy is slowing down and few people are talking about short-term inflation; instead, we’re starting to hear talk about the dreaded “D” word - deflation.

Deflation is a persistent decline in the level of consumer prices that’s typically caused by a decline in demand or a restriction of credit, or both. On the surface, you might think it’s a good thing because we’d all like to pay less for something rather than more, right? That sounds good in theory, but, when spread throughout the economy, deflation is an insidious condition that could cause serious harm.

Here are three dangers of deflation as identified by Nouriel Roubini, Professor of Economics at New York University’s Stern School of Business:

1. Falling prices may lead companies to cut production and employment levels because of reduced demand. With more people unemployed, it may exacerbate a vicious cycle of falling prices as fewer and fewer people have the money to buy goods and services.

2. Falling prices encourage consumers to hold off on purchases because they know they can buy the goods and services at a cheaper price in the future. This also feeds a vicious cycle of declining prices.

3. Falling prices increase the real rate of interest, which helps stunt future economic growth. For example, if consumer prices drop 2% in a year, the real interest rate is 2% even if the actual interest rate (nominal rate) is 0%.

Last week, the Labor Department said overall consumer prices in October declined at a seasonally adjusted rate of 1%, which was the largest amount since records began in 1947. This was the third month in a row that prices dropped. The core rate, which excludes food and energy, declined at a 0.1% rate - its first decline sine 1982.

While the headline number looks a little scary, some of the decline occurred because of a huge drop in gas prices, according to MarketWatch. Of course, we can’t count on gas prices dropping to zero, so we’d have to see other categories experience declines before we could say deflation has arrived.

The government does have some tools at its disposal to combat deflation should it occur. One of those tools is to spend massive amounts of money to re-inflate the economy. The government has started to do that and it may accelerate when the new administration takes office. The trick is to add enough liquidity to the system to keep it running well, but not too much that we end up with runaway inflation-a delicate balance to say the least.

Weekly Focus - Word of the Week

“Hypocorism.” It’s a noun that means a pet name or the practice of using a pet name. For example, “Mike started calling Peggy by her hypocorism, “Bubbles,” when they were sweethearts in high school.” Just for fun, see if you can use “hypocorism” in a sentence this week.

On second thought, maybe that wasn’t such a good idea.

Treasury Secretary Hank Paulson did an about face last week as he told Congress that the administration was backing away from the original plan of using the $700 billion bailout fund to purchase toxic mortgages. Instead, he said they would like to “consider using (the) remaining bailout funds on a second round of purchases of preferred shares in both banks and non-bank institutions that would match privately raised funds,” according to CNBC. Wall Street panned the flip-flop as the Dow Jones Industrial Average dropped 411 points on the day of Paulson’s change of heart.

To his credit, Paulson didn’t stubbornly stick to a plan that may have been less than optimal as new information became available. Like a good trader, he realized that the winds had shifted so he decided to shift, too. Wall Street took it hard because the swift change just reinforced how quickly things are changing in the economy. Wall Street doesn’t like uncertainty and this change was another example of the unpredictability of our current environment.

Glum retail sales, weak corporate earnings reports, and another jump in initial jobless claims added to the negative tone in the markets last week, according to MarketWatch. Last Thursday was the lone bright spot. After the Dow Jones Industrial Average dropped below 8,000, it staged a dramatic comeback and finished the day up a stellar 6.7%. This 11.5% intraday swing was the third biggest one-day swing in the past 46 years, according to Barron’s. Although the market finished up for the day, this stomach-turning volatility kept investors nervous and the market sold-off again the next day.

Like Paulson, we’re trying to be flexible and responsive to this ever-changing market environment.

IN 1958, A SEISMIC SHIFT OCCURRED in the relationship between dividend yields and bond yields. Fifty years later, that shift is close to reversing. If it does, what does that mean for investors?

Prior to 1958, the dividend yield on common stocks was always higher than the yield on long-term government bonds, according to Stocks for the Long Run by Jeremy Siegel. As a refresher, the dividend yield is simply the annual dividend divided by the price of a stock. For example, if a stock pays a $2 annual dividend and the price of the stock is $80, then the dividend yield is 2.5%. Fifty years ago, investors felt it was normal for stocks to yield more than bonds because stocks were riskier than bonds. Investors felt they had to be compensated for this risk by receiving a higher yield.

As 1958 unfolded, the stock market soared more than 30% and that dropped the dividend yield to below the yield on long-term government bonds and it’s been that way ever since, according to Siegel. Over the ensuing 50 years that stocks have yielded less than bonds, investors have gradually concluded that even though stocks may be riskier than bonds, the lower yield is justified because stocks may offer more growth opportunity. In other words, stocks offer the chance for a capital gain and a dividend, whereas long-term bonds bought at par and held to maturity only offer an interest payment.

Fast forward to last Friday. According to The Wall Street Journal, the dividend yield on the S&P 500 index was 3.5%, while the yield on 10-year government bonds was 3.75%. As you can see, we’re getting very close to parity after a 50-year hiatus.

In order for the dividend yield to surpass the bond yield, we would need to see stock prices continue to drop, bond prices continue to rise (remember: bond yields move opposite of bond prices), or some combination of the two. Here are some thoughts on each of those scenarios:

First, if stock prices continue to drop, the relative attractiveness of stocks may improve. With a high dividend yield, investors can take some comfort in knowing they’ll receive a payment for holding stocks, while still offering the chance for capital appreciation down the road.

Second, if bond prices rise, which leads to lower bond yields, then the economy may get some extra ammunition to spark economic growth. Lower interest rates may lead to more business investment, which could lead to higher corporate profits and, hopefully, higher stock prices.

Third, if both scenarios happen, it may set us up for a big recovery at some point in the future.

If the dividend yields end up surpassing bond yields, this reversal of a long-term trend may be a major signal that something momentous is about to happen. This “something momentous” could be a change in investor psychology that keeps stock prices low for a long period of time or it could be a sign that we’re nearing a trough in stock prices and that they’re poised to head up.

Regardless of what happens and what it may signal, we keep working diligently on your behalf to help you meet your long-term goals and objectives.

Weekly Focus - Think About It

“We don’t stop playing because we grow old; we grow old because we stop playing.”
–George Bernard Shaw

Last week’s business news underscored the severity of the current economic slowdown.

We all know October was a bad month in the financial markets. What we didn’t know until last week was how bad the economy was faring during the market meltdown. Well, on Friday, the Labor Department delivered the dreaded news that our economy shed 240,000 non-farm jobs in October. And, if that wasn’t bad enough, they significantly revised the September payroll numbers to show a decline of 284,000 jobs. The data led to a 6.5% unemployment rate in October, which is the highest rate in 14 years, according to MarketWatch.

The way the stock market responded to this news is rather instructive.

In the two days prior to the release of the employment numbers, the S&P 500 index declined a whopping 10%, according to Bespoke Investment Group. That was the largest two-day decline since the market crash of October 1987. What triggered the drop? While we’ll never know for certain, it appears that some investors were selling ahead of the anticipated bad employment numbers. According to a Reuters article, “Goldman Sachs analysts had expected up to 300,000 jobs may have been cut from non-farm payrolls in October. So, when the Labor Department reported 240,000 jobs lost last month, that did not send the stock market into a tailspin even though the figure exceeded the median forecast of 200,000.”

This is an example of how the stock market tends to anticipate what’s going to happen and, then, reacts accordingly. On the day the employment numbers were released, the S&P 500 index actually rose nearly 3%. In effect, it was a “sell on the rumor, buy on the news” strategy.

Even armed with the knowledge that markets tend to anticipate what’s going to happen, it’s still difficult to try and profit from it. There are a couple reasons why. First, one never knows exactly what news is already baked into stock prices; hence, it’s hard to predict how the market will react when the news is released. Second, at times the market may predict things that don’t actually happen. For example, there’s an old Wall Street saw that says, “The stock market has predicted nine of the last five recessions.” Clearly, Wall Street’s crystal ball is not always “crystal clear.”

Wishful thinking aside, it appears that this time the market is accurately predicting a recession.

ISN’T IT IRONIC that one of the major causes of our current financial predicament - borrowed money - is exactly what the federal government is using to try and solve the crisis? One has to look no further than the Federal Reserve’s balance sheet. The Fed has pulled out all the stops and flooded our financial system with all kinds of “new facilities” that have dramatically expanded its assets and liabilities.

As of November 5, the Fed’s balance sheet had ballooned to over $2 trillion in assets. That’s up more than 100% in less than 60 days, according to data from the Fed. And, it may not stop there. Richard Fisher, president and CEO of the Federal Reserve Bank of Dallas, said in a November 4 speech that, “I would not be surprised to see them [assets] aggregate to $3 trillion - roughly 20% of GDP - by the time we ring in the New Year.” The thought that the Fed’s balance sheet could triple to $3 trillion in the span of four months shows how serious the Fed is about trying to minimize the impact of this financial and economic crunch.

So, where does the Fed get the money to expand its balance sheet? By borrowing, of course! Last week, the Bush administration announced plans to borrow a record $550 billion between now and the end of the year, according to Associated Press. That’s necessary to help fund our federal budget deficit, which some experts predict will hit $1 trillion this fiscal year (2009). For the full year, government borrowing could total $2 trillion, according to Mark Zandi, chief economist at Moody’s Economy.com. Boy, a trillion here, a trillion there, and before you know it, we’re talking serious money.
But, just like us normal people, the government can’t continue to borrow money indefinitely without major repercussions. The government’s ability to borrow is generally limited by somebody else’s willingness to lend. And, those lenders have increasingly been countries such as Japan, China, and the United Kingdom.

At the end of August, the national debt of the U.S. was approximately $9.6 trillion, according to the Treasury Department. Of that, just three countries, Japan, China, and the United Kingdom, held about $1.4 trillion of the total. If these countries, or any of our other lenders, decide that they don’t want to own any more of our paper, then we may run into trouble financing our deficits. That, coupled with the specter of rising inflation if we juice the economy too much, may act as a governor on the government’s ability to add liquidity to the economy.

With that said, it appears that the government still has takers for our treasury securities and that inflation is not currently a big concern. Consequently, the government may continue to borrow money to help jumpstart the economy. Hopefully, they’ll borrow just enough to get us out of this economic funk, but not so much that we end up drowning in debt from which we can’t escape.

Weekly Focus - Stock Ticker
During this week in 1867, the first stock ticker was unveiled in New York City. It replaced mail and messengers and allowed investors around the country to receive up-to-the-minute stock prices. But, most importantly, the tape from the machines made for great parades!

Thank goodness, October is over.

Market historians were busy last month rewriting the record books on what seemed like a daily basis. Unfortunately, many of the new records were the type that we’d prefer to have remained unbroken. Here are a few of the new entries:

• October was the most volatile month in the S&P 500 index since November 1929, as measured by moves of at least 1% higher or lower, according to MarketWatch.
• As of October 28, this bear market represented the fourth largest decline in the S&P 500 index (on a closing basis) without a 20% rally. The only three other periods where we had deeper declines without an intervening 20% rally were in 1931, 1938, and 1974, according to Bespoke Investment Group.

•On a positive note, the Dow Jones Industrial Average rose 946 points, or 11.3%, last week. Barron’s said it was the Dow’s biggest one-week point gain on record and its largest percentage rise in 34 years. However, the end of the month heroics couldn’t overcome the early in the month carnage as the Dow still lost 14.1%t for the month, according to Barron’s.

•Crude oil prices dropped more than 32% in October, the largest one-month drop on record, according to CNBC. That’s good news for those of us who drive because the fall in oil prices has led to a dramatic drop in gas prices.

•The Conference Board Consumer Confidence Index™, fell to an all-time low of 38 (1985 = 100) in October, according to data from the Conference Board as reported by MarketWatch. This does not bode well for upcoming holiday sales.

•Gold futures prices dropped 18% in October, which was the largest one-month decline since February 1983, according to data from the Comex division of the New York Mercantile Exchange, as reported by MarketWatch.

They say records are meant to be broken. Well, we broke our fair share in October. Let’s hope the next broken record is a positive one such as, “The fastest return to an all-time high after experiencing a 40% decline in the S&P 500 index.” All in favor, say “Aye.”

HOW DO YOU DETERMINE IF THE STOCK MARKET is overvalued, fairly valued, or undervalued? On the surface, you might think that with the S&P 500 index down 35% over the past year, the market should be undervalued. Whether it is or not, we won’t know until we look back in hindsight. However, it’s helpful to look at history and see if we can place the current market in context. With the caveat that past performance is no guarantee of future results, here are some thoughts:

•Market analysts use many different measures to value the market. Some measures are quantitative in nature, while others are rather arcane, such as Kondratieff Waves and astrological cycles. We’ll just stick with the quantitative for now. One common measure is to compare the price of an index to the earnings of the underlying companies in the index. For example, if the price of the S&P 500 index is 1,000 and the underlying 500 companies in the index earned a total of $50 per share over the previous 12 months, then the index would be trading at a price-earnings ratio (P/E ratio) of 20 (1,000/50). By comparing the P/E ratio of today’s market to historical P/E ratios, we can see how this market compares to previous markets. Generally speaking, high P/E ratios are associated with high market valuations, while low P/E ratios are associated with low market valuations. Other factors may affect whether a given P/E ratio represents a high or low market valuation, but for our purposes, the above description is sufficient.

•As of last week, the S&P 500 index had a P/E ratio of 21 based on its trailing 12 months earnings, according to data from Birinyi Associates as reported by Barron’s. That’s above the index’s 60-year average P/E ratio of 17.8. So, this means the market is overvalued, right? Not necessarily.

•The stock market tends to look to the future and if it expects earnings to rise next year, then that would increase the “E” in the P/E ratio and, all other things being equal, would lower the P/E ratio as future earnings come to fruition. For example, a recent Barron’s survey of five Wall Street market strategists indicated they expect the S&P 500 companies to earn approximately $70 per share in 2009. If we apply the historical average multiple of 17.8 to the $70 earnings number, we end up with a projected S&P 500 index of 1,246 at some point in the future. That’s an increase of nearly 29% from last week’s closing S&P 500 value of 968. So, that would suggest the market may be undervalued, right? Again, not necessarily.

•Merrill Lynch’s top down estimate for 2009 S&P 500 earnings is only $60, according to Barron’s. If we apply the historical average multiple of 17.8 to Merrill’s number, then we end up with a projected S&P 500 index of 1068, which is still about 10% higher than last week’s close. So, we’re still potentially undervalued in today’s market, right? Well, you’re seeing a pattern here, so the answer is… not necessarily.

In the three examples above, we held the P/E constant at the historical average of 17.8. The bad news is, in some past economic recessions, the P/E ratio of the S&P 500 fell dramatically below the historical average. In fact, in 1975 and in 1980, the P/E ratio on the S&P 500 sank to around 7, according to Barron’s. You probably know where this is heading so, take a deep breath… if we apply a P/E of 7 to the $60 earnings estimate, that would leave us with the S&P 500 index at 420 at some point in the future. Based on last week’s closing price of 968, that means we could be in for a further decline of 56%. Ouch!

Now, before you get too worried, we think the likelihood of the S&P 500 dropping to 420 is extremely remote. We’re only showing it to you for educational purposes. And, to be fair, we should show you the other extreme, too. According to the St. Louis Federal Reserve Bank, during the bubble year of 1999, the P/E ratio on the S&P 500 hit 36. If we apply a 36 multiple to Merrill’s $60 earnings estimate, we get an S&P 500 index of 2,160. That’s a 123% increase from last week’s closing value.

Have we confused you yet? Here’s the bottom line. Whether you think the market is over, under, or fairly valued depends on many factors, two of which include future expected earnings and the multiple investors put on those earnings. Depending on where you stand, today’s market could be grossly overvalued, fairly valued, or grossly undervalued. There’s data to support pretty much any view you want. The constant tug of war among investors who think we’re overvalued, fairly valued, or undervalued may be one reason why we’re seeing so much volatility in the markets.

Weekly Focus - Think About It

“To buy when others are despondently selling and to sell when others are greedily buying requires the greatest fortitude, even while offering the greatest reward.”
–Sir John Templeton

Almost, but not quite.

As we awoke early last Friday morning and turned on our computers, we saw something that doesn’t happen very often. Pre-market opening indicators were suggesting a massive drop in the U.S. stock market when trading opened at 9:30 am Eastern time, according to MarketWatch. We already knew that many overseas markets had plummeted since most of them start trading well before the U.S. market opens. Japan’s main stock market index, for example, had dropped more than 9% prior to the start of trading in the U.S., according to MarketWatch. With that backdrop, investors nervously awaited the opening bell in New York. As the bell rang that morning, stocks dropped significantly in the first few minutes. But then, something surprising happened-no panic ensued. After see-sawing throughout the day, the Dow Jones finished with a disappointing 3.6% loss, but that was greeted with relief by many investors, who feared a much steeper decline.

It’s almost become a parlor game now with market pundits trying to call the bottom in the market. Many of them seemed to be waiting for the big washout-type capitulation day that takes the market down by double digits on record volume. Some people thought last Friday would be the day, but it didn’t happen.

With so many people looking for a big capitulation day, there’s a reasonable chance that it may not happen. According to an October 25 Wall Street Journal article, “Bear markets often end not in a crescendo of selling but [in] a cloud of indifference.” Ultimately, bear markets may end when stocks get so cheap that buyers step in and start bidding up prices.

Nobody knows whether this bear market will end with a record-breaking capitulation day or end unspectacularly as the selling pressure just peters out. This market has confounded so many “experts” that it’s anybody’s guess. Instead of worrying about calling a bottom, we’re trying to identify where the compelling values are and take advantage of them on your behalf.

ARE HUMAN EMOTIONS PARTLY RESPONSIBLE for the volatility we’re seeing in the financial markets? There’s no doubt that volatility is running rampant right now. The VIX, which is a widely used to measure of market risk often referred to as the “investor fear gauge,” rose to a record high last week, according to Bloomberg. But, is this fear rational? Do the fundamentals of our economy support the worldwide declines we’ve seen in the past month?

Clearly, the U.S. economy and many overseas economies are experiencing a significant slowdown. The ultimate severity of this downturn will not be known for quite some time. However, we do know that the financial markets are reacting violently to what’s happening. Could our emotions be getting in the way of sound investment judgment?

Westcore Funds/Denver Investment Advisers, LLC, developed a chart, which illustrates how volatility in the financial markets may cause us to turn off our rationality switch and replace it with some degree of either fear or greed. Below is a brief summary of what they call The Cycle of Market Emotions:

As markets rise, investors’ optimism begins to grow, excitement builds, and making money becomes thrilling. Over a period of time, the bull market finally reaches a crescendo, euphoria and greed set in and unbeknownst to most investors, this is the point of maximum financial risk. In hindsight, this could describe the first quarter of 2000, when the technology bubble reached its zenith. Inevitably, the market starts to drop, anxiety builds, and denial, fear, and desperation set in. Eventually, panic is followed by capitulation as some investors throw in the towel and say “I can’t take this anymore.” Capitulation is followed by despondency and it’s right here where you may find the point of maximum financial opportunity. Depression ensues, but then, when people realize the world is not coming to an end, the markets start to turn up. Hope turns into relief, which then leads to optimism and then the cycle starts all over again.

Since the current bear market is still unfolding, it’s not possible to say where we may be in this cycle. However, it would not be going out on a limb by saying we’re probably at least in the desperation/panic area. If true, we may see more pain before the next gain.

We need to keep in mind that successful investing takes more than just doing good research. It also takes strong emotional control and the ability to swim against the tide at times. By understanding the cycle of market emotions, and not letting fear or greed become dominant, you may be able to better tolerate and ultimately profit from market fluctuations. We do our best to embody these skills on your behalf.

Weekly Focus - Can You Solve This Puzzle?

Study this paragraph and all things in it. What is vitally wrong with it? Actually, nothing in it is wrong, but you must admit that it is most unusual. Don’t just zip through it quickly, but study it scrupulously. With luck you should spot what is so particular about it and all words found in it. Can you say what it is? Tax your brain and try again. Don’t miss a word or a symbol. It isn’t all that difficult.

What’s different about the above paragraph? There’s no E–but every other letter of the alphabet is there.

High volatility continued last week, but when the closing bell rang on Friday, investors were smiling as the Dow Jones Industrial Average recorded its biggest one-week gain in more than five years, according to The Wall Street Journal.

On Monday of last week, the Dow rose a stunning 936 points, but on Wednesday, it took a 733-point dive. And, for good measure, it popped higher by 401 points on Thursday. These dramatic daily swings suggest that investors still lack strong conviction on which direction the market is heading.

The government intervention in the financial markets continued last week and investors were left trying to figure out what it all means. At one end of the spectrum, you have people who are thrilled that the government is stepping in and preventing more firms from going under. At the other end, you have free-market champions who are furious that the government is propping up weak firms that otherwise might fail because of their bad decision-making. If nothing else, these historic times are keeping bloggers and opinion page writers busy arguing their particular point of view.

One surprising piece of news last week was the opinion page article penned by super investor Warren Buffett that was published in the New York Times. The normally tight-lipped investor went on the record as saying he was buying stocks last week for his personal portfolio, according to CNBC. Buffett also said, “Fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups as they always have. But, most major companies will be setting new profit records five, 10, and 20 years from now.”

Buffett says one rule dictates his buying: “Be fearful when others are greedy, and be greedy when others are fearful.” Right now, with these tremendous daily swings, there appears to be plenty of fear. And, if Buffett is right, then the prices we see today might look pretty attractive five or more years from now.

WHAT WILL BE THE CLOSING PRICE of the Dow Jones Industrial Average five years from now? While nobody knows the answer to that question with 100% certainty, it is worthwhile to look at several different scenarios. By understanding what might happen, we may be able to put ourselves in a better position to profit from what actually happens. Here are three possible scenarios:

Scenario 1: The stock market is significantly lower five years from now. In order for this to happen, we would likely need a severe and long-lasting recession that borders on a depression. In light of what’s happened over the past few months, this is not entirely out of the question; however, we think the likelihood of this happening is small. The U.S. government’s massive intervention in the economy and the global response to this crisis will likely prevent this type of complete meltdown.

Scenario 2: The stock market is about even five years from now. This could happen if we have a major recession that puts a multi-year crimp in corporate earnings. This wouldn’t be as bad as the meltdown in Scenario 1, but it would probably have to be on par or slightly worse than the early 1980s recession. Even if this were to happen, there could still be some profit-making opportunities in the stock market. For example, between 1929 and 1934 during the depth of the Great Depression, there were 9 bear and 8 bull markets as defined by an increase or decrease of 20% or more in the Dow Jones Industrial Average, according to data from Bespoke Investment Group. So, even though the Dow experienced an overall drop between 1929 and 1934, there were several significant rallies in between that offered potential profit-making opportunities.

Scenario 3: The stock market is higher five years from now. This might be the most likely scenario given the significant drop we’ve already experienced. Here are several pieces of information that help support the likelihood of this scenario coming to fruition:

–First, as we mentioned earlier, Warren Buffett said he’s started to buy stocks for his personal portfolio. That’s a comforting sign for many investors.
–Second, noted investment manager John Hussman mentioned in his October 13 market commentary that, “Stocks are now at the same valuations that existed at the 1990 bear market low. Relative to 30-year Treasury yields, the S&P 500 is priced to deliver the highest excess return since the early 1980s.” In effect, he seems to suggest that the downside risk from here may be small and that there may be some significant upside available.
–Third, noted investment manager Jeremy Grantham, who is chairman of the $120 billion money management firm GMO, wrote in an October 17 letter to clients, “At under 1,000 on the S&P 500, U.S. stocks are very reasonable buys for brave value managers willing to be early.” Grantham had been bearish on the market for many years, so this is a big turnaround for him.
– Fourth, corporate insiders are buying much more stock than they are selling as of October 10, according to Vickers Weekly Insider Report as reported by Mark Hulbert at MarketWatch. This insider buying ratio was the best in nearly 10 years, which is often a bullish sign for future stock prices.

Short of getting a copy today of The Wall Street Journal that will be printed five years from now, we know that any forecast about the future is subject to error. With that said, as outlined in Scenario 3, we think there are numerous reasons to be optimistic about the future. That doesn’t mean it will all be rosy from here. We’ll likely experience more harrowing hiccups, but, eventually, the crisis should pass, the excess should be cleared out, and the market should move higher. Time tends to heal all wounds.

Weekly Focus - Think About It

“Our interviews, experience, and involvement with people at mid-life have led us to believe that nothing is more important to fulfillment in the second half of life than the willingness to ‘risk walking new ground.’” — Richard Leider and David Shapiro