Posted on Tuesday, August 25, 2009 - by Henry Walter
August 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. 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.


OUTLOOK

According to Bridgewater Associates, a large money-management firm in Westport, Connecticut, the optimists see signs that the recession is ending, and they forecast the normal next step: a stronger stock market. In other words, they believe the economic and stock market recoveries will continue to look like a V. The pessimists believe the most important development isn’t the end of the recession, it is the long process of debt reduction by families and businesses, and they fear that any recovery will be more like a W or a series of W’s. (As reported in the Wall Street Journal, Aug. 10th. 2009). And the process of debt reduction could take 6-8 years according to Harvard economist Ken Rogoff, which in turn will slow retail sales and overall economic activity. There is about $20 trillion in excess private sector debt to be eliminated. Regarding the V and W, David Kotak, president of Cumberland Advisors, points out the up leg of a V and the first up of a W look the same when you are in them.

But let’s see what policy makers and other influential commentators have to say.

“We just had a meeting with Sheila Bair head of the Federal Deposit Insurance Corporation (FDIC),” Senator Jim Bunning (R., Ky.) remarked at a July 16 hearing of the Senate Banking Committee. “She is a pretty honest lady and tells it like it is. She told us that unless something dramatic happens that we could lose up to 500 more banks.” As we write, 77 banks have gone belly up so far this year including Colonial Bank with 346 branches across Florida, Alabama, Georgia, Nevada and Texas, and the 6th largest bank failure in history. There are now 305 banks on the FDIC’s “troubled” watch list.

“I don’t think the worst is over. It’s very likely that more jobs will be lost. It would not be surprising if GDP has not yet reached its low.” Larry Summers, former Treasury Secretary and president of Harvard, currently head of the National Economic Council, and a candidate to be the next chairman of the Federal Reserve if Ben Bernanke is not reappointed.

“To be honest, a new bubble now would help us out a lot even if we paid for it later. This is a really good time for a bubble . . . There was a headline in a satirical newspaper in the U.S. last summer that said: ‘The nation demands a new bubble to invest in.’ And that’s pretty much right.” Paul Krugman, Nobel Laureate, Princeton professor and Op-Ed editor for the New York Times.

“Our comfort level with the “unloved” bull remains firm. But even though the S&P 500 is up 49.7% since the March 9 lows, now is not the time to become complacent with such a healthy gain. In fact, we’ve started to look ahead 12-18 months down the road and ask ourselves . . . what could go wrong to cut this bull market short?” Jim Stack, InvesTech Research, frequently interviewed on PBS and other financial programs and usually right based on rigorous research.


NATURAL GAS

Last month in a piece titled ‘Out-of-Favor: An Opportunity’ we suggested looking at natural gas. Here are a couple of additional notes on the natural gas market for those interested. Exports of natural gas are limited because most terminals, if not all, were built to receive liquefied natural gas (LNG) from foreign sources, but lacked the capability to export natural gas to markets in Europe and Asia desperate for it. Europe is in particular need of alternative sources as Russia cuts off supplies each winter. Kitimat LNG Inc., a Canadian company, is building a LNG export terminal in Kitimat, British Columbia, and Apache (APA) and EOG Resources (EOG), two large U.S. producers, have signed on to the project. Others will follow. Originally, the Canadian project was conceived as an import terminal. But a year ago the company realized that new North American supplies made the facility unnecessary, so in September, Kitimat announced it would build an export terminal instead. Other export terminals are being planned.

Oil and natural gas are increasingly interchangeable in a growing number of industrial applications. The ratio of the price of oil to natural gas is historically around 6:1, reflecting the thermal content of each. Currently with oil at $70 per barrel and natural gas at $3.50 per Mcf, the ratio is more like 20. As a result, current natural gas prices correspond to oil at $21. As the recession ends and industry starts to use more energy, this ratio is likely to drop as users switch to the lowest cost source of energy. Coal is not an option because of pollution. The smart money is betting that the ratio will drop because the price of natural gas will rise. It is possible it will drop because the price of oil drops. Most believe the latter is unlikely because developing countries have an enormous appetite for oil.

In the original article we did mention the United States Natural Gas Fund (UNG). We would avoid it as regulators are cracking down on position sizes, and this is a huge fund. This crackdown has no effect on the fundamental story, but it might add a little volatility to NG prices in the near future, which we would welcome as it would give us the opportunity to buy high quality stocks at lower prices. Sooner or later, LNG exports, falling production and rebounding U.S. industrial demand will push North American natural gas prices higher along with the prices of natural gas stocks.


CHINA

Even if you believe, as we do, that the economies of Asia, and in particular China, will grow much faster that those in Europe, North America and other developed countries, caution is advised. But first, to illustrate why investors are bullish on China and emerging markets in general, here is some data from Birinyi Associates. From 1970 to 2008 (38 years!) Birinyi found that emerging markets, which included China for part of the measured span, had a 16.12% annual compound return, compared with 10% for the S&P 500 Index. During the same period, EAFE returned 10.23%, modern art 9.64%, high grade corporate bonds 8.74% and New York City taxi medallions 8.15%.

Why the caution? Because as a result of the huge injection of liquidity into world economies, it is beginning to look like a massive bubble is forming in the Chinese stock market as hot money from around the world, eager to get a piece of the action, pours into one of the few economies reporting strong growth. The Shanghai Composite is already up 103% since its low in late November, 2008. Could it go further? Absolutely, from 2005 to 2007 the composite rose six-fold before crashing 70% in 2008. But trees don’t grow to the sky and analysts are increasingly questioning the economic data coming out of China.

Without getting into too much detail, China’s economic statistics are based on recorded production according to John Makin, an economist at the American Enterprise Institute, rather than being a measure of expenditure growth as U.S. data are. This permits the government to consider funds from the stimulus as part of production before they’re actually spent. (For more details see Barron’s, August 17, 2009, page 6.)

But long-term, China is where the growth potential lies. As an example, there are 10 cars per 1000 people in China compared with 760 cars per 1000 in the U.S. Add in India and the other Asian tigers and you can see why there is so much interest in Asia as investors keep their eyes on where the growth is.


BRIEFLY

• The 2009 Fortune 500 includes 140 American companies, the lowest number on record. China has 37, its largest presence ever. Seven of the top 10 are oil companies.


• The case of Jones v. Harris, now pending before the U.S. Supreme Court, could create new standards for setting mutual-fund fees. Three investors in Oakmark funds sued Harris Associates alleging that the fund’s fees were excessive, and that the board of directors was not sufficiently independent. One legal loop-hole permits former executives of investment managers to become “independent” board members once they have been out of the firm for two years.


• Vanguard is launching some new low-cost bond index funds and ETFs later this year. Three will track broad benchmarks for government bonds, three for corporate bonds, and one mortgaged-backed securities. The main attraction, besides dealing with a reputable firm, are the low expense ratios of 0.15% for each fund.


• Dollar-cost averaging was a viable strategy even in 2008. We just saw an analysis of a theoretical investor who purchased $1000 of the SPY at the start of each month beginning when the S&P 500 was at 1400. At the start of August with the S&P 500 about 1000, $15,000 had been invested and the value was almost $16,000. The reason that returns are positive is that shares were purchased at very low prices early this year, especially in February and March assuming the investor had the guts to follow-through. Unfortunately human nature is such we doubt if many investors would have had the guts to buy at the start of February and March when the market was in free-fall.


• In a report called “Demographics and Capital Markets Returns,” Robert Arnott and Anne Casscells argue that the crisis is not in Social Security, but in demographics. “When an entire society ages,” suggest Arnott and Casscells,” . . . the thing that matters most is the ratio between the workers to retirees. Unfortunately, the aging of the baby boom generation, which is a significant bulge in population, will cause a dramatic increase in the ratio between workers to retirees, one that will put enormous strain on society and cause friction between generations.”

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

Posted on Wednesday, August 5, 2009 - by Henry Walter
Update to July 2009 Roundup
In “Out-of-Favor: An Opportunity?” which appeared in the July, 2009, Roundup, we included data from Dalbar on actual investor behavior for the 20 years ended December 31, 2007.

We now have the data for the 20 years ending December 31, 2008. During that time period, the average equity fund investor earned an annualized return of 1.87% compared to an annualized return of 8.35% for the S&P 500. In other words, the average investor underperformed the S&P 500 by 6.48% per year. During that same time period, inflation averaged 2.89% per year.

Investors did even worse in bond funds (0.77% vs. Barclays Aggregate of 7.43%). The disparity in bond funds is largely due to the underperformance of managed bond funds caused by mortgage-backed securities

Note: Data presented reflect past performance and are no guarantee of future results. Current performance may be higher or lower than the performance shown. You should consider a fund’s investment objectives, risks, and 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 copy of the prospectus can be obtained from or at . Indices are unmanaged and do not reflect the payment of advisory fees and other expenses associated with an investment in a mutual fund. Investors cannot directly invest in an index.

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

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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