At the time, we posed the question as to which was the relevant trend: the four-year market rise from the early 2003 low or the sharp 6% decline that had just preceded the conference.  We differentiated clearly between our advice to speculators and to investors.  Acknowledging that we had just added 20% to our still low equity holdings–an addition that was strategic, not long-term in our view–we anticipated that momentum was still a powerful positive.  While we believed the four-year rally was likely to climb still higher, the predominant advice was caution aimed at longer-term investors.  In today’s market, we are largely agnostic on the short-term trend.  We remain cautious, however, about the long-term picture for many of the same reasons we identified in 2007.

Over the past two centuries, stock prices have moved consistently in long cycles between strong performance and weak performance.  Such cycles have averaged about a decade and a half apiece, with significant variation.  Long strong cycles invariably end in investor euphoria and great expectations.  Conversely, long weak cycles end with investors fearful and swearing off equity ownership.  The current negative investor outlook profiled in yesterday’s USA Today article led several TV talking heads to counter that those absent investors will likely miss out on great returns in the years ahead.  I would argue that a more comprehensive review of past long weak cycles indicates that cautious investors may well be rewarded rather than penalized over the next few years, although they will undoubtedly stay cautious far too long.

In 2007 we examined the three long weak cycles of the twentieth century, not simply as a history lesson. Our intent was to evaluate whether there were some characteristics we could employ to determine whether the current long weak cycle was likely to continue.  The analysis of three years ago is still relevant today.

Each of the following graphs shows a simplified progression of stock prices from the beginning of each cycle to the end.  While the precise patterns unfolded differently in each cycle, there were some common characteristics.

In two of three profiled cycles, stock prices rose above the cycle’s starting point after the initial decline.  In all three instances, the final low was below the starting point 13 to 16 years later.

In each cycle, volume dropped significantly from the beginning of the cycles and from the intracycle highs to the sequential lows, sometimes down to small fractions of earlier volume levels.

The initial declines in each cycle failed to wipe out investor enthusiasm.  Investors’ desires to own stock were not eliminated for a significant number of years until after the second or subsequent major declines.

In every instance, the long weak cycle ended after well more than a decade with extremely cheap valuations– high dividends, very low price-to-earnings ratios and very low price-to-book values – even though those valuations had been expensive at some point within the cycle following the initial decline.  By the end of each cycle investors had largely given up and did not want to own stocks.

Another instructive example of investor behavior is seen in the following graph from Ned Davis Research, an excellent data source.

The current weak cycle, which began in 2000, looks very similar to the cycle that began in the late-1960s, albeit with grander dimensions.  The initial price declines in each instance put huge dents in the value of individual investors’ equity holdings.  The rallies that began in 1970 and 2003 rekindled enthusiasm for stock ownership, but not to the same degree seen at the initial highs.  Behavior subsequent to those rallies differs somewhat from the 1970s to the present.

The 1973-74 declines so discouraged investors that there was tepid enthusiasm for the 1975-76 and subsequent rallies, despite prices returning essentially to former highs.  In the current cycle, even after suffering through the two biggest bear markets since the Great Depression of the 1930s, investors have quickly brought equity holdings back toward their prior peak.  The strength in equities over the two decades leading to the turn of the century built such tremendous confidence in stocks that the need to own them will not easily be extinguished.  While the anecdotal examples of investor fear cited in USA Today’s article indicate a tendency to retreat from equities, the Ned Davis graph clearly shows current equity holdings well above the historic mean.  Most investors certainly have not abandoned hope for common stocks.

Additional evidence exists as well to indicate that markets remain firmly in the grip of the long weak cycle that began near the turn of the century.  If a new long strong cycle indeed began at the March 2009 low, the weak cycle will have been much shorter than the two-century average and far shorter than any of the 20^th century’s weak cycles.  That the weak cycle is finished is especially unlikely because the preceding strong cycle was the strongest in history, combining both its duration and the extent of the market’s advance.  The resulting excesses were the largest ever.

Even more convincing, never did stocks become cheap by standard measures of valuation.  Even at the depths of the declines in 2002-03 or 2008-09, at best, valuations approximated long-term norms.  They never approached the cheap valuations that ended all prior long weak cycles.

None of these factors would preclude even a substantial move higher, especially in an era of government stimulus and seemingly never-ending quantitative easing.  Intermittent rallies notwithstanding, however, the ultimate end to this long weak cycle probably lies some years in the future, with stock valuations at give-away levels and most investors not wanting to play anymore.

Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

For more than a decade we have been warning about elevated risks in the economy because of excessive debt levels.  Over that same period we have warned about equity risk stemming from historically extreme valuations, excess leverage and the secular weak cycle that the markets entered just after the turn of the century.  Those that seek yield from high dividend-paying stocks bear an inordinate risk that such yields will compensate only partially for principal losses in a declining stock market environment.

Bonds have been the traditional vehicle to provide portfolio yield.  While we made some profitable forays into the Treasury market in recent years, our clients would have been better served had we simply ignored interest rate risk and held Treasuries throughout the past decade.  With the 10-year note yield now around 2.5%, profit potential has been substantially reduced, and an increase in yield could quickly produce bond market losses. Moves in corporate and municipal bonds have been far more volatile.  As the economy contracted in 2008, prices of corporates and munis fell hard with fear growing about the survival of our financial system.  The Federal Reserve’s efforts to shore up the system boosted investor confidence, however, and corporates and munis rocketed upward in price.  That rally continues today.  Willingness to accept risk was rewarded.  In fact, the more risk accepted, the greater the reward.  The riskiest of junk bonds, CCC-rated, returned over 100% in the first twelve months of their rally off the financial crisis lows.

The continuation of the bond rally becomes increasingly problematic the lower rates fall.  Economic conditions are weakening again, and the Fed has indicated its intention to hold short rates near zero for the foreseeable future.  In fact, the softness in the economy is increasing the prospect that the Fed will serve up another large dose of quantitative easing, already being referred to as QEII.  There is political opposition to further bailouts, but analysts are leaning toward the belief that the Fed will once again act by their September meeting.  They could undertake another program of purchasing more Treasury notes and bonds, despite their already very low yields.  All else equal, that would sustain the bull market in Treasury paper.  All else, however, is not always equal.  China is the largest foreign holder of our Treasury securities.  They have cut back their holdings over the past two months.  Others have stepped up to replace the Chinese, but that could change fast.  At current low yield levels, it would take only a minor rise in yields to turn a full year’s total return negative.  Should yields rise simply to where they were just over one year ago, losses would be significant.  At these yield levels, the risk from a rise in yields is substantially greater than the potential reward from a further decline in yields.

Regardless of what happens to Treasury yields, there is far more significant risk in corporate and municipal bonds.  Rising rates would hurt all bond prices.  While falling Treasury rates would benefit Treasury bond prices, the reasons for those falling rates–weak economic conditions with or without deflation–could do a great deal of damage to corporate or muni bond prices.  We do not want to take that risk.

For money not invested in stocks or bonds, we have over the years made generous use of laddered certificates of deposit to boost portfolio yield.  The Fed’s actions to reduce short rates virtually to zero removed most of the attractiveness of that alternative.  Compounding that rate reduction is the decrease in demand for borrowed funds by banks that formerly issued large volumes of CDs.  We continue to put some money in one and two-month CDs, but we have been reluctant to extend maturities beyond that at the minimal yields available.

Clients ask why we do not buy longer CDs at higher yields.  We constantly weigh that alternative.  Evaluating our expectation for possible changes in rates, we set minimum yield levels for various maturities.  Currently we would not tie money up for three months for less than 1% or for a year for less than 2%.  The full year rate is not available today and the three month rate only available in the rare instance in which a bank badly needs short-term funds.

To tie funds up for a very small return is to lose the option to use that money more productively in a stock or bond transaction which could arise very quickly in an environment of great economic and market uncertainty and volatility.  For example, just over a year ago we deployed a significant portion of client portfolios into 10-year U.S. treasury bonds when yields spiked up to 4%.  Although we took profits on that position just a month later, the boost that it gave the full year return was far more than could have been earned with the same money in a CD for the entire year.  While we can never be sure that we will find such strategic opportunities, they have occurred with sufficient frequency over the years that we are unwilling to forego such options unless we are being rewarded adequately to do it.  Right now we are clearly not being paid much to tie up funds, so we are keeping most of them liquid.

We are working doubly hard, however, to locate options to earn even small amounts of safe additional yield.  Our recently opened program bank operation is a case in point.  This program enables us to increase the yield on money that is effectively liquid and FDIC guaranteed, while earning higher returns than are available in safe money market funds.

We are also exploring the possibility of buying longer CDs from the few banks that would allow us to cash in CDs early without the typical penalty.  Such an alternative would get us somewhat better returns while enabling us to retain the needed liquidity.  Unfortunately, those opportunities are difficult to find.

Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

The week ended with stocks showing a negative bias but no clear directional conviction. The major equity indexes closed mixed with the Dow, S & P, Wilshire 5000 and New York Stock Exchange Composite all down by a fraction of one percent for the week, with the Nasdaq and small cap indexes up by a fraction.

As might be expected, trading volume was generally light through most of the week, quite possibly because this is one of the last weeks of summer. It was somewhat noteworthy, however, that we saw a continuation of the recent pattern of volume shrinking on days of rising prices and volume rising when prices fall—indicative of sellers acting rather more aggressively than buyers.

Monday began ominously as prices opened almost 100 Dow points lower than Friday’s close. There was no follow-through selling, however, and a low volume rally brought prices back to virtually break-even at the close. Tuesday and Wednesday saw more low volume attempts to rally early each day. In each instance, sellers came in to take away much of each day’s gain in the final hour. Bad economic news pushed prices down Thursday on rising volume. A poor opening today led to new lows for the week in the middle of the day except for the Nasdaq indexes. All in all the market action was weak, but selling was not aggressive. Nasdaq’s positive divergence at today’s price lows offers some hope for the bulls.

In all likelihood the last week of August will again be slow as traders head for the beaches to enjoy summer’s end. One possible caution: a variety of market conditions and patterns are flashing warning signals. While there is no certainty that they will resolve to the downside, it appears that we are in a window that probably extends well into September in which disappointing news could lead to a very sharp decline in stock prices. Seasonally, September is the worst month of the year. We remain cautious.

Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

Whether from a recognition of the financial folly or from pangs of conscience, increasing numbers of Americans are turning their backs on the concept of further bailouts.  The latest polls show that a majority in this country want the Fed to discontinue its stimulus efforts.

The largest and most aggressive bailout program in world history put at least a temporary floor under a plunging economy.  The recovery it stimulated, however, has been one of the weakest on record.  Recent economic readings increasingly point to the growing potential for a renewed slowdown or even a double dip recession.

The Fed acknowledged in its recent statements that it has been surprised and disappointed with the recovery’s lack of progress.  Chairman Bernanke has expressed concern about the unusually uncertain economic outlook.  It is that uncertainty and the still precarious economic condition that prompt my strong suggestion that you maintain your employment income stream.

A great many people retired over the last decade with a million to several million dollars in investments, fully expecting that their various retirement income sources would allow them to live their “golden years” as planned.  The behavior of the financial markets over that most recent decade, however, has introduced unexpected speed bumps and has turned many golden dreams to dust.

I have vivid recollections of non-clients coming to our office in 2002-03 somewhat in shock, having seen as much as half or more of their nest-eggs disappear in the market decline that followed the bursting of the dot.com bubble.  Several were literally in tears as they evaluated their economic alternatives.

Although we made money for clients in each of those difficult early years in the new century, we remained cautious. We warned listeners that the economic and market excesses had not been solved by the largesse of the Greenspan Fed, which brought interest rates down to 70-year lows.  Those historically low rates furthered the real estate boom and precipitated the bubble from which we still suffer.  Unfortunately, we lost some clients at that time who decided our cautiousness was out of touch with new era opportunities in both residential and commercial real estate.  We readily admitted that we had no real estate expertise. Nonetheless, we repeatedly warned that leverage in real estate was extreme and that, notwithstanding recent experience, real estate was a cyclical commodity.  When any financial commodity is overleveraged at a historical price extreme, the danger is serious.  Unfortunately, the risk was realized, and latecomers to the real estate party were punished severely.

Whether because of the collapse of the real estate bubble or merely coincident to it, common stocks were again battered from 2007 to 2009.  Despite the price rally into the end of the decade, stocks lost money over the full span of this century’s first ten years.  Because of the historically typical tendency for investors to buy high and sell low, most investors in equities did far less well than did the weak stock market indexes themselves.

So far bonds have proven to be the new century’s most profitable securities investments, largely because government rescue efforts directly lowered short-term interest rates and because the Fed purchased well over $1 trillion of fixed income securities.  Once the Fed effectively promised not to let financial institutions fail or hurt investors, bonds of all types leaped in price.  Junk bonds, rated barely above default levels, returned over 100% in their first twelve months of recovery.  As is typical of investors in every era, they project recent results into the indefinite future.  Because bonds have beaten stocks and cash over the past decade, investors are pouring money into bonds, notwithstanding interest rates at or near historic lows.

Bonds, at least Treasury bonds, could continue to be profitable if the economy remains weak and especially if deflationary tendencies become more dominant, which looks increasingly probable in the short run.  Corporate or municipal bonds, however, are likely to be good investments only if rates stay low, yet we skirt deflation or a significant recession.  Should deflation or a significant recession occur, prices of municipals and all but the most secure corporates would likely be hurt by the threat of default.

Whatever is left in retiree portfolios after this difficult decade is now earning precious little.  The Fed has pushed risk-free rates virtually to zero.  If you’re willing to lend the U.S. Government money for two years, you’ll receive an annualized return of just about one-half of one percent.  You will receive about 2.7% per year from a ten year U.S. Treasury bond. If retirees choose to avoid risk, their investment income is far below what they had anticipated.

Retirees face difficult choices.  They can seek higher returns in equities that continue to face strong headwinds.  The problems that led us into the unprofitable last decade remain:  excessive debt and excessive speculation.  Those problems have been compounded by severe unemployment and an extremely weak real estate market.  The potential long term success of government rescue efforts is unknown but increasingly questionable.

The retiree can stretch for yield in corporate or municipal bonds but assumes the risks listed earlier.  On a risk/reward basis, there is far more room for rates to rise and hurt bondholders than to fall and provide benefit.

The safest approach for those for whom this is an option is to stay employed and keep the stream of income flowing.  It broadens the scope of future options.

Should deflation take hold, even for as little as a year, it could leave a deep scar on the psyches of consumers.  Once people begin to expect lower prices, they defer purchases and the economy slows.  That can easily become a self-reinforcing cycle.

Fed Chairman Bernanke has vowed that he will not allow the economy to fall into deflation. But should it begin, he may not be able to control it.  He has already poured an unprecedented amount of money into the banking system, but there it remains.  For a variety of reasons it is not being loaned out.  More money does the economy no good if it just sits.  It is only of benefit if it circulates, and the Fed Chairman can’t force that to happen.  On the other hand, Carmen Reinhart and Ken Rogoff pointed out in This Time Is Different that over the past 800 years, inflation is the normal response to excess debt and monetary crises.  Government almost invariably tries to print away excessive indebtedness.  Whether deflation affects us initially or not, it is a relatively safe bet that inflation, possibly even virulent inflation, lies somewhere in our future.

As inflation and deflation battle one another, investing will continue to be a complex and difficult endeavor.  Should inflation become severe, it will likely do serious damage to the assets of retirees heavily dependant on fixed income.  Employment incomes rise over time to compensate for inflation. For most people, having that regular paycheck is likely to be the safest defense against uncertain conditions.  Keep your job.

Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

Ned Davis Research’s studies show a more bullish short-term picture.  Investors around the world are increasingly demonstrating a preference for riskier assets, with volatile emerging markets leading the world’s more established markets.  Such trends are typically bullish until investors reach an extreme level of confidence, which often marks a market top.  Current international readings do not yet look extreme, however, which bodes well for the short-term.

On the domestic front trader optimism, a contrary indicator at extremes, has grown steadily over the past several weeks.  Elliott Wave International reported that the Daily Sentiment Index jumped from just 10% bulls on the S&P 500 at the July 1-2 lows to 73% bulls five weeks later with the index more than 10% higher.  That’s the highest bullish percentage since May 3, just days before the May 6 “flash crash” which saw the Dow drop more than 1000 points intraday.  The ISE Sentiment index, which measures sentiment in the options market, is showing readings almost identical to those leading to the April market peak that preceded the 16% decline to the July lows.

With these various indicators pointing in opposite directions, they obviously can’t all accurately forecast the market’s direction, at least in the same time frame.  They are, however, consistent with the conflicting picture we’re also seeing on the fundamental side of the ledger.  Second quarter corporate earnings continue to come in above expectations, while weekly and monthly economic statistics continue to deteriorate.

This is not a normal environment.  Governments around the world have provided more stimulus than ever before and might provide even more.  At the same time there are countries and banking systems on the verge of default.  We can’t know how this will ultimately work out, nor how intermediate chapters will unfold.  The range of possibilities is huge, and the prudent investor will remain far more flexible than normal to facilitate moving rapidly should events play out in an unanticipated manner.

Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

The week’s activity settled nothing by way of offering greater insight into the market’s likely next direction.  As we have indicated in prior posts, a great deal of technical damage was done in the decline from the market’s April highs.  Then surprisingly a significant amount of that damage was repaired in a strong early July advance.  Prices stalled this week near earlier June highs, which lent encouragement to the bears.  The fact that this week’s attempts to decline failed to gather much strength provided equal encouragement to the bulls.  The week closed with the Dow Jones Industrials and the Russell 2000 small cap average just above their respective 200-day moving averages.  Many analysts view this average as the line of demarcation between a strong or weak market.  To complicate the picture, however, the S&P 500, the Nasdaq Composite, the New York Stock Exchange Composite and the Dow Jones Total U.S. Stock Market Index all closed slightly below their 200-day moving averages.  Neither bulls nor bears appeared strong enough this week to move prices convincingly, despite both positive and negative economic and corporate earnings news.

Monday begins the seasonally weak period that on average extends into late October.  While no single year needs to conform to long term seasonal patterns, it is potentially helpful to be conscious of what has occurred with some frequency over the decades.  There remain a great many conflicting technical and fundamental conditions, and this market could yet move strongly in either direction.  An overriding consideration, however, is that stocks are still selling at well above average valuations, from which levels stocks have historically earned far below average subsequent returns.

We cover a broader array of investment subjects in our mid-year commentary, which is posted below this entry.

QUARTERLY COMMENTARY
Second Quarter 2010

July 23, 2010

The comfort of the prior four quarters was sharply shaken in the June-ending quarter as the stock market, measured by the S&P 500, declined by 11.4%.  For equity holders there was no place to hide except for a few emerging markets, generally too small and risky to attract traditional investment money.  Most declines were in double digits.  In our domestic market, all sectors declined with only the defensive utilities, telecom and consumer staples avoiding double digit losses.  The S&P 500 closed 2010’s first half down by 6.7%.

Bonds continue to be the most productive asset class, as the Federal Reserve has kept short-term rates just above zero.  Virtually all bonds have done well during this period of Fed largesse.  At the short end of the fixed income curve cash returns are practically non-existent.  By dropping rates to all-time lows, the Fed has forced investors to take risks to earn any return whatsoever.  So far that risk-taking has had positive results.  As yields have come down, however, risk levels have risen.  And a great many investors, who have already lost considerable personal wealth over the past decade, can ill afford having that risk realized and losing yet more money.  This is especially true of retirees and institutions that cannot easily replace lost capital.

In this environment in which most investors have experienced losses, we are pleased that our clients have earned small positive returns both for the quarter and for the year-to-date.  Great uncertainty still exists, however, both domestically and internationally.  There exists a broad range of potential outcomes for the world economy.  Several countries are arguing strenuously for the imposition of austerity measures to rein in loose monetary and fiscal policies that have characterized the worldwide rescue effort.  The U.S., among other countries, is still leaning toward further stimulus despite the massive debt that has already been created.  How this debate and many other economic uncertainties unfold will have profound effects on the securities markets in the quarters and years ahead.

In his July 21 appearance before Congress, Fed chief Ben Bernanke categorized the economic outlook as “unusually uncertain.”  Because the Fed normally attempts to keep investors and consumers confident, such words likely betray a far greater concern about possible economic outcomes than have any recent Fed releases.

There are clearly conflicting indicators for the probable direction of stock prices over the remainder of the year.  Generally, second quarter corporate earnings are coming in better than had been expected.  While a great deal of technical damage was done to stock indexes in June, surprisingly strong repairs were accomplished so far this month.  On the flip side, the housing crisis remains severe, and unemployment will likely drag on the U.S. economy for years.

There’s an old saying in the investment business:  In the short run, the stock market is a voting machine; in the long run, it’s a weighing machine.  In other words, investor sentiment controls markets in the short run, while the fundamentals prevail over time.  We don’t have a strong feel for how sentiment will develop over the next few quarters.  On the other hand, debt levels, because of rescue efforts, have gone from dangerous to extremely perilous throughout major sections of the world.  We do not yet know whether the concerted efforts of world governments and central banks will effect a lasting recovery.  We do know, however, that our children, grandchildren and their grandchildren will be burdened with the greatest debt legacy in world history.

A second major fundamental concern is valuation.  As indicated in our last quarterly commentary and on my blog site (www.ThomasJFeeney.com), contrary to the contentions of most financial analysts, stocks are not cheap.  Measures of price to dividends, book value, sales or cash flow are at or near all-time highs except for the bubble period from the late-1990s to 2007.  Price to earnings is less extreme, but still above long term averages.  From valuations at or near these levels, stocks have historically performed far worse than average.

We urge clients to remain conscious of where markets are in their long term cyclical patterns, which we have discussed intermittently over the years in commentaries and at our seminars and conferences.  As we have frequently explained, the latest long weak cycle began in 2000.  The two century-old pattern of alternating long strong and weak cycles reveals that both strong and weak cycles tend to last on average about a decade and a half, although with considerable variation.  That this current cycle has so far lasted only about two-thirds as long as the average is far from determinative by itself.  A far more important indicator that we probably remain in the long weak cycle is the fact that all prior weak cycles have continued until investors largely gave up on stock ownership and valuations plummeted to extremely low levels.  In this cycle, not only have stocks not descended to such valuation depths, valuations have actually remained closer to historic highs than lows.  While this does not mean that stocks won’t rally from here, it is unlikely that we are yet at the beginning of the next long strong cycle.  Should markets head higher in the short run, such an advance would likely retrace before a more lasting bull market rally could evolve.

Given unprecedented debt levels throughout the world and speculation common about first world countries in danger of default, the risks to economic progress and to common stock holdings are at historic highs.  Investors must recognize that this is not a “business as usual” scenario.  We can’t know for certain that the risks will be realized.  It would be foolhardy, however, not to recognize the potential for huge losses in risk-bearing assets should government rescue efforts fail to achieve long-term success.  The financial system was essentially broken just a year and a half ago but for government rescue. From that point the economic recovery has been significantly substandard by comparison with prior recoveries from recessions, despite the greatest stimulus effort in history.  If consumer and investor confidence cannot be sustained, it is highly improbable that governments will be able to restimulate their economies with anything like the same firepower that they unleashed in their initial effort.  We are at an extremely tenuous point in the recovery.  Continuing success is dependant upon lasting consumer and investor confidence.  The outcome is unknowable.

Many of the same considerations affect the fixed income markets as well.  As mentioned earlier, the Fed has pushed the return on risk-free securities essentially to zero.  Safe cash equivalent yields are non-existent.  Bonds, which have been wonderfully profitable for the past three decades, are inevitably approaching a point below which yields will not go.  The possibility exists that bonds could remain productive, despite current low yields, if business conditions remain weak and especially if deflationary forces prevail.  On the other hand, with 10-year U.S. Treasury notes yielding less than 3%, there is far more room for interest rates to rise than fall.  Few current investors know how dire conditions can be for bondholders once rates begin a rising cycle.  For more than four decades from 1941 to the early 1980s, rates rose and the total return on bonds was considerably less than the return on risk-free cash equivalents.  In a highly uncertain environment, conditions can change dramatically and quickly.  Should foreign lenders to the United States turn squeamish about sending more money to this country, rates could rocket upward and bonds would take big losses.  While not likely in the short-run, that outcome is certainly possible and should impose discipline on those inclined to blindly stretch for yield.

Conditions are likely to change rapidly over the next several quarters.  I have attempted to keep clients and other interested readers in tune with our shorter term thinking through weekly posts on the blog site mentioned earlier.  I encourage you to take a look.

Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

Back to volatility.  The five days of this week saw the Dow Jones Industrial Average make seven rallies or declines of more than 100 points. Obviously this is not investors changing their opinions from hour to hour.  Well more than half the market’s daily volume now comes from computerized trading, much of it of the “high frequency” variety that depends on physical proximity to the trading posts.  Physical proximity shaves nanoseconds off order transmission time and provides a slight, but measurable advantage.  An IBM executive recently explained that it takes about half a second to click a mouse.  The new exchanges are being designed to execute a million trades in the amount of time it will take to click a mouse.  That’s not investing, folks.  I suspect that inadequately controlled high frequency trading was largely responsible for the 700 Dow point drop-then-recovery within about 30 minutes on May 6.  These operations, which have no long-term orientation, can severely exacerbate normal market fluctuations.

Another major force in today’s markets is the big investment bank trading for its own account.  Some of the biggest banks can move markets on their own for a while.  They know what they want to promote for their own profitability, and they are capable of influencing markets to a measurable degree.  The Volcker rule is designed to eliminate banks’ trading for their own accounts.  Eventually authorities are going to have to do something about high frequency trading as well. 

I am certainly not an advocate of unnecessary regulation.  On the other hand, Wall Street has proved over the decades that its primary focus is profit – its own.  Customers come a distant second.  Wall Street firms will argue long and hard about how their great new systems provide tremendous liquidity.  Don’t believe it.  Where was the liquidity on May 6?  These are tools solely for Wall Street profit.  Their functions need to be better understood and controlled before they do serious harm.

Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

We must be willing to assume certain risks if our economy is to grow. On the other hand, assuming additional risk is not a guaranteed prescription for success either for businesses or for individuals. Over the decades one can observe a cyclical pattern of alternating insufficient risk assumption and excessive risk assumption.

For businesses, too much risk assumption leads eventually to excess inventory, excess capacity and excess debt. When that becomes prevalent in an economy, recessions result. The most excessively indebted go out of business as inventories and excess capacity are worked off. That natural selection process is short circuited if government intervenes, as it did recently by bailing out banks, insurance companies and automobile companies. Moral hazard results when companies no longer fear the consequences of their own mistakes. The current disgust of the populace is clearly understandable when profits are enjoyed privately and losses are borne on the backs of taxpayers.

While risk assumption takes many forms, one of the most easily measured is debt. The first of the graphs below, both from Ned Davis Research, is one I have pointed to frequently over the past dozen years. The explosion of debt that began in the 1980s had a salutary effect on the economy for many years. It reached excessive levels, however, eventually exacerbating the decline that began in 2000. What we have been experiencing for the past decade has been far worse than a normal cyclical inventory recession. Rather, it has been a credit crisis involving massive deleveraging and monetary crises in many parts of the world.

The Bush administration initially and the Obama administration over the past year and a half have attempted to solve a problem caused by too much debt by creating massive quantities of new debt.  I have objected vociferously to government attempts at solving economic problems our generation created by issuing promises to pay that will have to be borne by future generations.  It’s a moral issue.  The rescue attempts may or may not succeed, but the undeniable consequence will be a huge anchor weighing down the economic ship to be sailed by our grandchildren and their grandchildren.

An additional moral question attends the Federal Reserve’s attempt to promote risk- taking–and hopefully business growth–by reducing short-term interest rates effectively to zero.  All else equal, such a rate reduction will reduce business costs, improve profitability and hopefully lead to increased employment and greater general prosperity.  We see very little comment, however, about the intergenerational inequity that such actions produce.  A growing number in our society are past their income-producing years and are dependent largely on fixed incomes to live.  If they choose to accept no risk with their savings, they will earn essentially nothing in a money market fund comprised of U.S. Treasury securities.  If they let the government borrow their money for two years, they will be paid the royal return of 0.61%.  They can earn slightly more each year, 1.74% and 2.98% respectively, in five and ten year U.S. Government notes.  With all the new debt the government has recently created, however, many are worried that inflation over those time periods might exceed the nominal returns, leading to negative real returns.  The government has effectively said to a vulnerable segment of our society that you must take risk if you want to earn any return.  Unfortunately this group has little capability of rebuilding capital should the risk-bearing investments fail.

A few years ago I had dinner with Robert Parry, then President of the San Francisco Fed.  I made in essence the same observation about the highly negative effect on retirees from what was then an even less aggressive Federal Reserve interest rate stance.  He acknowledged such a negative effect with some distress but justified it as a form of unintended collateral damage in the war against business stagnation and unemployment.  The elderly, unfortunately, have a far weaker voice than that of the business community.  And they contribute far less to political campaigns.

When most people talk about the desirability of risk assumption, they are typically speaking about businesses.  It applies also to individuals as consumers.  For individuals there are obviously times and conditions more appropriate for risk-taking than others.  As a populace we have become increasingly more risk-bearing over generations.  Perhaps the quintessential example of excessive risk assumption was the past decade’s mania in which a greater percentage of our population than ever before opted to own homes.  This, of course, was good for business while the surge was in full bloom.  Only in its aftermath did the extent of foolish risk-taking become apparent.  A great many bought homes that they could afford only if prices continued to rise and mortgages could be serially refinanced.

To a lesser degree the same principle applied to consumer purchases generally.  We became increasingly enticed to purchase whatever we wanted.  Not having enough money was no barrier as long as new credit card applications appeared regularly in our mailboxes.  Because the government fought with a vengeance any semblance of a recession, we became convinced by personal experience that tough times and unemployment were things of the past.  In such an environment, there was little need to save.  We could buy with abandon and take other risks and a favorable future was our birthright.  Unfortunately, the bankruptcy statistics of the past few years are the sobering testimony to the folly of that behavior.  The second Ned Davis Research graph below shows how dramatically leveraged the average household remains.  My concern is that promoting additional risk assumption, which might provide a short-term economic lift, could intensify long-term negative economic consequences in an economy still highly overleveraged.

It is far from clear what the optimum level of leverage is for either businesses or households.  Almost certainly, the appropriate level will vary over time depending upon a great array of conditions.  Certain conditions create a situation which some have called the paradox of thrift.  If the individual is overindebted, it may be prudent to cut back on consumption and reduce debt.  What may be wise for the individual may, however, be destructive to the overall economy, which relies on the expansion of consumption and risk-taking.  There is no easy answer.

If You Want To Promote Term Limits

While not a highly political person, I am a strong advocate for term limits.  If you would like to support the campaign of a candidate for whom the first issue addressed on his website is term limits, email us and we will be pleased to pass along contact information.  You can then decide whether you agree with the candidate’s positions and whether you wish to contribute.

Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

As we suggested last week, the stock market went into the long Independence Day weekend significantly oversold and in need of “at least a brief recovery rally.”  This holiday-shortened week saw that rally begin.  Each day produced gains, albeit on rather tepid volume.  This week’s rally recovered slightly more than half the decline of the prior two weeks. It has served to work off the short-term oversold condition and has forced many shorts to cover.  The weak volume signals a rally that was largely an internal affair for Wall Street firms with minimal public participation.  While that could, of course, change, most lasting rallies begin with a more enthusiastic sendoff.

The rally has also partially repaired some of the technical damage done since late-April. A great deal more needs to be done, however, to prove that this is anything but a relief rally in a more extended down leg.

Next week begins the second quarter earnings announcement parade.  Expectations are for strong year-over-year growth compared to the very weak results of second quarter 2009.  There is room for disappointment if earnings are less than great or if guidance for future quarters reflects diminished enthusiasm.

Bond yields ticked up this week, and next week’s new issue calendar is heavy.  Analysts will be looking to see whether that bond supply will divert money from the equity market.  We are eager to see whether the public returns to equities next week to sustain this week’s rally or whether this proves to be no more than a technical bounce from a severely oversold condition.

Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

We described last week the S&P 500 having found support after its May and June declines at the 1040 level. Earlier this week all major equity indexes fell convincingly through 1040 or their equivalent levels. Prices ended the week at levels seen early last August, nearly a year ago.

The equity markets, down more than 8% over the past two weeks, remain seriously oversold on a short-term basis. That condition normally leads to at least a brief recovery rally, but buyers have so far remained conspicuously absent. Market analysts anticipate hefty corporate earnings gains to be reported over the next several weeks. Those expectations, however, have been so universal that it’s unlikely they will provide significant market support. Optimistic outlooks released in conjunction with quarterly earnings announcements may be needed to resurrect buying interest. Unfortunately the recent tendency has been for companies to ratchet down their optimism about prospects for the next few quarters.

Besides the technical damage to stocks this week, the equity markets also suffered from a spate of weak economic data. Reports came in below expectations on vehicle sales, pending home sales, domestic and Chinese manufacturing, consumer confidence and employment levels.

Jobless claims have stopped declining and have begun to rise. Average hourly earnings declined for the first time in seven years. Considering the number of unemployed whose jobs have been eliminated, plus those now unemployed for more than six months, this is currently the worst job market since the Great Depression of the 1930s.

New negative reports come out every week about the condition of state and local finances. The decline in municipal fortunes is forcing large numbers of layoffs, which look likely to grow even larger through the remainder of this year. This will continue to put downward pressure on consumer spending.

Market bulls have been strongly encouraged over most of the past year by improving manufacturing data, which resulted from a needed rebuilding of depleted inventories. Now that this has been largely accomplished, additional growth in business-to-business commerce will depend heavily on renewed spending by end consumers. We made the point several times over the past year that the economic recovery would be short-lived unless consumers came back with renewed vigor. We also thought such renewed vigor improbable given the highly leveraged consumer balance sheet. While the consumer has shed some of that debt, its level remains near historic highs. With unemployment likely to remain very high for several years and normal retirement age fast approaching for the Boomer generation, the consumer is apt to reduce spending and add to savings. Consumer conservatism does not bode well for a continued recovery.

Growing regulation and increased taxes are both likely in the year ahead, and each will tend to depress equity prices. For both technical and fundamental reasons, intermittent rallies notwithstanding, the path of least resistance for common stocks looks to be down.

Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.