Posted on Wednesday, July 15, 2009 - by Henry Walter
July 2009 Roundup
Please Note – The views and opinions expressed in this article are those of the writer and do not necessarily reflect the views and opinions of High Falls Advisors, LLC.


OUTLOOK

Since government officials have been busy telling us that the worst is behind us, the news that 467,000 Americans lost their jobs in June caused many investors to have second thoughts about just how good things are, or how much worse they might get.

Talk about another stimulus package grew louder and doesn’t help build confidence, nor does the situation in California, the tenth largest economy in the world. California is still unable to resolve its $26 billion budget shortfall due to a political impasse that makes spending cuts and tax increases impossible, and its bonds were recently downgraded to BBB by Fitch Ratings. As California starts to issue IOUs to pay its bills, Treasury Secretary Geithner refused to rule out bailing out California and other states with tax dollars. Voters are demanding the government “do something” and are asking a lot of questions about the financial mess we are in, but few want to hear the real answers. Meanwhile, foreign creditors are concerned that American politicians don’t have the backbone to cut favored programs, or guts to raise taxes.

Back to the stimulus package. We understand that only 7% of the funds in the current stimulus package have been disbursed, but that is what Congress had in mind. They want distributions in 2010, an election year.

On CNBC’s Squawk Box, Black Swan author Nassim Taleb told listeners, “Anything that’s fragile like the financial system will eventually crash. We’re in the middle of a crash. So if I’m going to forecast something, it is that it’s going to get worse, not better.” Taleb’s point is not a popular one, but it’s more realistic than the poppycock coming out of Wall Street and Washington.

On the other hand, economist Lakshman Achuthan, managing director of the highly-respected Economic Cycle Research Institute (ECRI) notes that the ECRI gauge of future U.S. economic growth has turned positive, and believes the recession will end and the expansion will begin somewhere between the second and third quarters. “The recovery is unfolding in a reasonably normal fashion, including the doubt,” Achuthan said.


OUT-OF-FAVOR: AN OPPORTUNITY?

Dalbar, a Boston-based financial services market research firm, has been measuring the effects of investor behavior since 1984. As reported in our December 3, 2008 bulletin, and based on an analysis of actual investor behavior over the 20 years ending December 31, 2007, the average equity fund investor earned an annualized return of 4.48% compared to an annualized return of 11.81% for the S&P 500. (Data through the end of 2008 is now available but the report is expensive. The information will eventually find its way to the Internet, and we will pass it on to readers.) The main reason for this poor performance is that investors do the opposite of what they should do. Encouraged by the media and Wall Street gurus, they load up on equities just as a bull market is ending and euphoria (and bubbles) is rampant, and then, after going through denial, finally cut back just as the bear market is about to end, as they watch their 401(k) plan shrink. Greed and fear in action.

This behavior also seems to apply to groups or asset classes. Invest in a “hot” group and you may enjoy a decent return for a while if the momentum continues, but risks are increasing that the “hot” group will turn cold as investors search out new “hot” groups and dump the now overvalued old “hot” group on the public. This can happen quickly. Just look at the fertilizer group which moved from “hot” to “cold” almost overnight in June 2008. On the other hand, buying into an “out-of-favor” group, before it makes its move, can result in out-sized gains, with lower risks. Of course, a group can remain out-of-favor for longer than one would wish, but that is where research and analysis come in, but there are no guarantees.

To illustrate, one “out-of-favor” group that may be worth looking at is natural gas. Natural gas (NG) prices have collapsed, as have prices of stocks in this group. NG peaked at over $13 per thousand cubic feet (Mcf) in June, 2008, and is now below $3.50 per Mcf. So in one year it is off over 70%. Stocks haven’t done much better with the Fidelity Select Natural Gas Fund (FSNGX) down 54% over the same time period.

The basic reasons for the price collapse; plunging demand and expanding supply. That’s enough to turn off many investors looking for instant gratification. But let’s look a little more closely at what is going on. You will see that some of these problems are self-correcting.

Industrial demand accounts for about 50% of total demand with home heating making up the balance. The current serious recession is substantially reducing industrial demand. (Heating demand depends on the weather.) If we are patient, industrial demand will recover as the economy rebounds. On the supply side, with NG storage at all-time highs and prices low, drilling for new supplies is grinding to a halt. Rig counts are down 50-75% and are likely to drop further as the NG selling price is now below cash costs for many producers.


NOW HERE IS WHERE IT GETS INTERESTING

Natural gas is relatively clean compared to coal, so there is a lot of pressure from politicians and environmentalists on utilities and industry to replace coal usage with NG. Already environmental groups have convinced a group of Montana Utilities to suspend plans to build a coal-fired plant in favor of a natural gas-fired plant. The group is optimistic that other coal-fired plants like Sunflower in Kansas and Desert Rock in New Mexico will follow Montana’s lead. With the Obama administration’s pledge to change direction, and the war on greenhouse gases officially underway, natural gas should benefit at the expense of coal. There are no alternatives; solar and wind are way off in the future, and nuclear has its own set of problems.

Until recently, the U.S. natural gas market was not well-supplied and so prices were volatile, often depending on the weather outlook or hurricane forecast. As a result, many utilities and industrial users preferred to depend on coal and oil. In the last few years the situation has changed completely. With new “fracturing” technology, the U.S. is becoming the “Saudi Arabia” of natural gas with enormous reserves in the Barnett Shale area in TX, Haynesville LA/TX, Marcellus PA/NY, and Horn River Basin in BC. Also changing is the regional nature of the market. NG, unlike coal and oil, must be liquefied and shipped in special cryogenic oceangoing vessels as liquefied natural gas (LNG). The U.S. built an enormous infrastructure to RECEIVE natural gas in the form of LNG from foreign sources, but currently lacks the capability to export NG. Foreigners do not want to sell NG to the U.S., the price is too low, but they want to buy our gas but there is no way to ship it to them even though they are willing to pay much higher prices. This situation is changing.

Encana (ECA) 69%, ConocoPhillips (COP) 13%, and Devon Energy (DVD) 67%, are the first, second and third largest North American natural gas producers by volume. The percentages show natural gas production as a share of their total business, so if you are looking for exposure to NG you may be better off with ECA or DVD. The United States Natural Gas Fund (UNG) is an ETF that tracks the price of natural gas. There are a number of good quality independents with major stakes in natural gas like XTO Energy (XTO), EOG Resources (EOG), and Chesapeake Energy (CHK). For those using ETFs take a look at Revere Natural Gas (FCG). As with any investment, there are a number of things that could go wrong so keep your positions small and add gradually over time. The worst case scenario is if the current recession turns into a depression, which is not completely out of the question.

The information provided is not specific financial advice or a recommendation to buy or sell. We must review your profile, needs and accounts specifically to determine what is right for you.

The above information is based on usually reliable sources, but is not guaranteed. In the interests of full-disclosure, the writer holds positions in ECA, UNG, XTO and CHK.

You should consider an Exchange Traded Fund’s investment objectives, risks, charges and expenses carefully before you invest. The fund’s prospectus contains this and other information about the fund, and should be read carefully before investing. A prospectus may be obtained from your advisor or from the fund company directly.


BRIEFLY

• Congress blocks bill to audit the Fed. With the Federal Reserve creating and disbursing trillions of dollars in response to our current financial crisis, Americans, regardless of their opinion of the bailouts or their political affiliation, want to know where the money has gone. There was a last-hour provision to the 2010 spending bill that would audit the Fed. The provision never saw the light of day because the Senate majority evoked arcane Rule 16, which prohibits policy legislation from being added to spending bills. In the House, Ron Paul’s bill to audit the Fed has 249 co-sponsors, but parliamentary fine print will most likely block it too, and the Fed will retain its right to operate in secrecy.


• Morningstar has introduced 10 new categories. Four new categories are dedicated to a finer slicing of equity-sector categories: Consumer Discretionary, Consumer Staples, Equity Energy and Industrials. The other six will be under one new broad asset class: Commodities. Here are the six: Commodities Broad Basket, Commodities Energy, Commodities Precious Metals, Commodities Agriculture, Commodities Industrial Metals and Commodities Miscellaneous.


• The FDIC has now closed 53 banks this year. It looks like the pace is accelerating. Problems with construction & development loans and commercial real estate loans will undoubtedly close a number of banks going forward.


• Tax receipts have fallen sharply and even more steeply than anticipated from both individuals and businesses, federal and state. At the local level, the tax revenue base is rapidly evaporating due to massive declines in housing prices. You would expect this in California, Florida and Nevada, but it is rapidly spreading to other states including New York. Assessors’ offices even in Rochester are starting to see increases in requests for reassessments.


• Most of us were brought up to believe that saving money was “good” for the country and for the individual. Now it seems like it is downright un-American to save. In spite of that, the savings rate in May 2009 jumped to 6.9%, the highest rate since 1993, according to the Commerce Department. “People are scared” says Bernard Baumohl, an economist at the Economic Outlook Group in Princeton, NJ. “There has been a fundamental shift in the behavior of American households.” That is, savings are now a priority in financial planning. (We should add that an independent analyst, TrimTabs, says the Commerce Department used old data and neglected to make some appropriate adjustments and the real number is more like 1%, so it will be interesting to see what revisions in the official number will be made in the future.)


• The stock market adage “sell in May and go away” is based on the belief that the period November to April each year shows significantly stronger growth than the other months. Does this occur every year? No. But frequently enough that it’s worth paying attention to.



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Posted on Thursday, June 11, 2009 - by Henry Walter
June 2009 Round-up

PERFORMANCE
After a spectacular performance in March and April, the market rose modestly in May. Year-to-date the Dow is still negative, down 3.1%, but the broader S&P 500 is +1.8%, the Russell 2000 (small stocks) +0.4%, and NASDAQ +12.5%. Overseas, Europe is +5.7%, Asia-Pacific +11.7%, with China +44.6%, India +51.6% and Taiwan +50.1%. Latin America was strong with Brazil +41.7%. Looks like the BRIC countries was the place to be.

Treasury yields surged to their highest level since November, not what Ben Bernanke had in mind. For example, the 10-year Treasury’s yield, which had dropped to 2.04% last December, closed the week at 3.5% after rising as high as 3.7% during the week. In May we also saw oil make the biggest monthly gain in 10 years and silver the biggest monthly gain in 22 years. And during the month of May alone, the price of gold rose from $890/oz to $979, a 10% increase. So far this year, 36 banks have failed, 305 are on the list of “problem” banks, and, according to the FDIC, one-fifth of all U.S. banks are in trouble. And it looks like General Motors will file for bankruptcy with the end result that the U.S. government and UAW will own most of the company, and it will become a government ward. Naturally, the biggest losers in the GM fiasco are the U.S. taxpayers.


OUTLOOK
Who should we listen to? Certainly not the large investment banks that have their own agenda to sell you products and services with high fees and commissions attached. If you turn to “independent” advisors they are all over the map from “opportunity of a lifetime” to “the worst is yet to come”. The truth is no one can predict the future, but that doesn’t stop them trying. Perhaps we should listen to ourselves and consider different approaches rather than trying to find an “expert” who can tell us what to do. What Chris Davis said at the 2009 Morningstar Investment Conference (see “Bear Markets” below) makes a lot of sense to us. We also think most investors would be better off over the long-term in index funds and so-called lazy portfolios. Also, investors should be prepared to take some chips off the table when there is euphoria in the air (not now), and add some chips when there is fear and despair in the air (possibly now or soon).

Regardless, here is what Martin Feldstein thinks about the current outlook, courtesy The Bruce Blog. He is an economics professor at Harvard, former chairman of the Council of Economic Advisors and president of the US National Bureau for Economic Research. “The positive effect of the stimulus package is simply not large enough to offset the negative impact of dramatically lower household wealth, declines in residential construction, a dysfunctional banking system that does not increase credit creation, and the downward spiral of house prices. The Obama administration has developed policies to counter these negative effects, but, in my judgment, they are not adequate to turn the economy around and produce a sustained recovery. Having said that, these policies are still works in progress. If they are strengthened in the months ahead – to increase demand, fix the banking system, and stop the fall in house prices – we can hope to see a sustained recovery start in 2010. If not, we will just have to keep waiting and hoping.”


IS THE U.S. INSOLVENT?
You be the judge. This is from the transcript of an interview Steve Scully of C-SPAN had with Pres. Barack Obama. It was taped on May 22 and aired on May 23. Scully: “You know the numbers, $1.7 trillion debt, a national deficit of $11 trillion. At what point do we run out of money?” Pres. Obama: “Well, we are out of money now. We are operating in deep deficits, not caused by any decisions we’ve made on health care so far.”


MORE ON INTEREST RATES
As noted above, interest rates on Treasury notes and bonds spiked last week, although they fell back a little on Friday. And as rates go up, bond prices go down. Investment grade corporates were spared since they were not bid up during the flight to safety late last year. So, is the Treasury bubble about to burst? We don’t know, but we still retain our hedge (TBT, Proshares Ultra Short 20+ Treasury ETF) just in case. One interesting development last week was the news that China was now buying Treasury bills and short-term notes in place of bonds, and diversifying into gold, that barbaric relic! And China is not the only country trying to protect itself from the financial and economic mismanagement in the U.S. Already countries and investors are wary that the UK will lose its triple-A rating, and the influential bond fund manager, Bill Gross of PIMCO, said in a recent interview on Bloomberg Television that the U.S. might eventually lose its triple-A credit score.


INFLATION
Many observers believe that spending is out of control and as a result inflation will become a serious problem in a year or two, if not before. In fact, recent speeches of Fed officials would lead one to conclude that they want inflation to help reduce the burden of debt at every level in the economy. Trial balloons are starting to pop up. Recently, Gregory Mankiw, former White House adviser, and Kenneth Rogoff, who was chief economist at the International Monetary Fund, suggested what the U.S. economy may need is a dose of good old-fashioned inflation. “I’m advocating 6 percent inflation for at least a couple of years”, said Rogoff, who is now a professor at Harvard. “It would ameliorate the debt bomb and help us work through the deleveraging process.”

But in a recent Op-Ed article in the New York Times (May 29, 2009), Nobel Laureate and Princeton economics professor Paul Krugman, argues inflation is not a problem and that the only thing we have to fear is inflation fear itself. To read the full article Google “The Big Inflation Scare”. Just in case Professor Krugman is wrong, we favor hard assets in our portfolios.


HOUSING
We found a recent New York Times article, describing the growing wave of foreclosures, of great interest. The first wave of foreclosures was mainly from the “flip-this-house” crowd who basically walked away from speculative real estate purchases as the market tanked. The second wave centered on sub-prime borrowers whose low “teaser rates” adjusted sharply higher in 2007 and 2008 – making their monthly mortgages suddenly unaffordable. Now we are in the middle of a possibly much larger wave, brought about by the dismal economy. This wave is still “intensifying” according to some economists. In fact, up to 60% of all home mortgage defaults this year will be due mainly to job losses, up from 29% a year ago. The main source of swelling foreclosures hasn’t been toxic sub-prime loans recently, but standard prime mortgage loans. Credit Suisse has a nice chart summarizing the whole situation. Google “New Mortgage Loan Reset Chart”, click on the first entry and then click on chart to enlarge.


BEAR MARKETS
Chris Davis, who runs Select American, Davis New York Venture and the Clipper mutual funds, was the opening day keynote speaker at the 2009 Morningstar Investment Conference held last week. Throughout his career Davis said he often envied his grandfather and father, legendary investors Shelby Cullom Davis and Shelby M.C. Davis, for having lived and worked through severe bear markets that allowed them to buy great companies at bargain prices and set themselves up for years of strong returns. As Shelby Davis told his grandson, “You make most of your money in a bear market, you just don’t realize it at the time.”

“Now I finally got my chance and it feels like hell,” referring to the fact that the funds he runs suffered steep losses in the bear market that began in October 2007.

Over the last few months he has been buying globally dominant, self-financing companies like Johnson & Johnson (JNJ), well-managed companies with the capital and mind-set to exploit the market dislocations like Berkshire Hathaway (BRK.A) and Lowes (L), selected financials, and energy, commodity and agriculture related companies because of the growth of the middle class in emerging markets is inexorable and will continue to increase demand for resources.


BEST PERFORMING STOCKS OF THE LAST DECADE
In a recent issue, Business Week listed the 20 best-performing stocks of the decade. Business Week restricted the list to S&P 500 members with betas less than 1. Here is the list with percentage gains:



What is significant is the predominance of resource stocks. Ten of the twenty are energy companies of one kind or another. Many of the rest are involved in healthcare. How did EK do during the decade? Not well, down over 90%.


END NOTE
Since we are running out of our allotted space, we’ll have to end it here. But we have some interesting material on alternative energy, and some notes on pension funds, insurance carriers and target-date funds which we will try to pick up in July.

For questions or additional information on this blog entry, please contact us.

Posted on Wednesday, May 27, 2009 - by Henry Walter
New Info On EK Fixed Income Fund
Posted on Tuesday, May 27, 2009 - by Henry Walter

Fixed Income Fund, New Information

In item #11 of the May, 2009, Roundup we noted that the key to assessing the health of a stable-value fund is the market-to-book-value ratio, and that we had asked Kodak for a reading. We now have a response that at the end of February, 2009, the ratio was 94%. We assume that the ratio applies to the synthetic GIC portion of the Fixed Income Fund, which is most of it.

According to the Hueler Companies (www.hueler.com), which tracks such things, the average stable-value fund at the end of 2007 had a ratio of 99%, and at the end of 2008, 95%. The lower the market-to-book-value ratio, the more dependent investors are on the financial strength of the wrap providers. We don’t pretend to be an expert on stable-value funds, but we assume that a low ratio would put pressure on the crediting rate. The crediting rate is the actual yield an investor receives.

If you have specific questions about the Fixed Income Fund you can contact SIP through T. Rowe Price or call Kodak Benefits. Depending on your question, they may not have an immediate answer, but they should be able to research the question and get back to you.

For questions or additional information on this blog entry, please contact us.