Words from the (investment) wise for the week that was (August 25 – 31, 2008)

The gyrations of financial markets ahead of the Labor Day weekend tested the patience of bulls and bears alike. As big swings took place in thinly-traded markets, I was reminded of Albert Schweitzer’s words: “As we acquire more knowledge, things do not become more comprehensible but more mysterious.”

None the wiser, I also did not succeed in capturing a leprechaun and finding the gold during my visit last week to the Emerald Isle. However, the beautiful Irish scenery, hospitality and “open for business” attitude resulted in a very successful trip and will keep me going back in search of the “buried treasure”.

Nervousness about the financial system was still paramount as investors realized that none of the problems were likely to be fixed anytime soon. The upshot of the week’s trading was a further weakening in credit markets, judging by the elevated credit spreads. Global stock and bond markets ended another volatile week on a mixed note, whereas crude prices gained surprisingly little on the impending arrival of Hurricane Gustav and a festering geopolitical situation with Russia.

Next, a tag cloud of the text of all the articles I have read during the past week. This is a way of visualizing word frequencies at a glance. As expected, words such as “banks”, “prices”, “credit” and “financial” featured prominently in my reading matter.

I do believe we are still in a primary bear market where stock markets are, at best, faced with a prolonged convalescence period characterized by sub-optimal returns. Whether significant further declines will take place from these levels and valuations overshoot to bargain levels is anybody’s guess.

However, in the short term I give the nascent stock market rallies the benefit of the doubt provided the mid-July lows are sustained. For any rally to become more enduring will require further base building and an eventual shift in central bank policy to targeting GDP growth rather than inflation.

The rally’s lack of breadth, however, is worrying, causing Richard Russell (Dow Theory Letters) to warn: “If July 15 was a true bottom, the market should be roaring up today, and that’s not what’s been happening. Caution is warranted!”

But we should also take note of the fact that 64% of stocks in the S&P 500 are currently trading above their 50-day moving averages, as pointed out by Bespoke. “As shown in the chart below, the reading has been creeping higher and higher since mid-July, and looks to be on its way to the 80% to 85% levels seen twice over the last year. Readings above 50% are signs of a healthy market, and it hasn’t been above 50% for much of 2008.”

Seasonality indicates that “September has firmly secured the rank as the worst month of the year” (Stock Trader’s Almanac), but that a year-end rally typically starts in late September / early October.

Before highlighting some thought-provoking news items and quotes from market commentators, let’s briefly review the financial markets’ movements on the basis of economic statistics and a performance round-up.

Economy
“Global business sentiment remains weak and fragile and consistent with recession in the US, Europe and Japan,” according to the Survey of Business Confidence of the World conducted by Moody’s Economy.com. The survey results suggest that the Asian economy (ex Japan) continues to post growth that is near its potential. “Across the globe, sentiment is consistent with an economy that is near recession. Pricing pressures remain very elevated, but fell notably last week.”

The minutes from the FOMC meeting of August 5, released on Tuesday, indicate that committee members were concerned about the near-term risks to growth. Most participants expected inflation to fall, although they remained wary about upside risks to inflation. Given the problems in financial markets, members did not view current monetary policy as overly stimulative.

Other economic reports released in the US during the past week included the following:

• The GDP growth rate in the second quarter was revised upward to 3.3% from 1.9%, exceeding expectations. In the first quarter, real GDP increased by 0.9%. The better-than-expected outcome did not change most economists’ view that the economy was weakening, with the beneficial effects of rebate checks and foreign demand fading fast. Corporate profits edged down for the fourth straight quarter, falling twice as fast as in the first three months of the year.

• New orders for durable goods rose by 1.3% in July, surpassing expectations for only a slight increase. Core capital goods orders also surprised on the upside, increasing by 2.6% over the month.

• Existing home sales increased by 3.1% over the month in July, according to the National Association of Realtors. This increase put the annualized pace of sales up to 5 million units. However, substantial slack persisted, with inventories hitting a record high of 11.2 months. Furthermore, the median price of an existing house declined by 7.1% in year-ago terms, slightly worse than in June.

• Personal income tumbled by 0.7% in July after rising by 0.1% in June. Excluding the tax rebate effect, disposable personal income rose by 0.5% in July, up from 0.3% in June. Spending growth slipped to 0.2% from 0.6% the previous month. Real spending fell by 0.4% as price growth remained high. The core PCE deflator rose by 0.3%, matching the fastest rate since September, while the top-line deflator rose by 0.6%. The saving rate fell back to 1.2% from 2.5% in June but remained inflated by rebates.

Source: Slate

Summarizing the US economic situation, John Mauldin (Thoughts from the Frontline) said: “Even many mainstream economists are now suggesting we will be in a recession by the fourth quarter, if we are not in one now. The recovery, when it comes, will be tepid until credit spreads signal an end to the credit crisis. It is going to be Muddle Through for 2009. This is NOT going to be good for the stock market. When will it be safe to get back into the water? Pay attention to credit spreads.”

Data releases from Europe and Japan underlined rapidly deteriorating economies flirting with recession. The Japanese government announced a $107 billion set of fiscal measures, including tax cuts and larger government-guaranteed loans, in response to the weakening economy.

Week’s economic reports

Source: Yahoo Finance, August 29, 2008.

In addition to the Fed releasing its beige book on September 3 and interest rate announcements by the Bank of England and the European Central Bank on September 4, next week’s US economic highlights, courtesy of Northern Trust, include the following:

1. ISM Manufacturing Survey (September 1): The consensus for the manufacturing ISM composite index is 49.5 vs. 50.0 in July. If the consensus forecast is accurate, it would be consistent with weakness in other parts of the economy. Consensus: 49.5 versus 50.0 in July.

2. Employment Situation (September 5): Payroll employment in August is expected to have dropped by 85,000, taking the tally of consecutive monthly declines to eight. The jobless rate is predicted to have held steady at 5.7%. Consensus: Payrolls: -75,000 versus -51,000 in July, unemployment rate: 5.8% vs. 5.7% in July.

3. Other reports: Construction spending, auto sales (September 2), factory orders (September 3), ISM non-manufacturing (September 4).

Click here for a summary of Wachovia’s weekly economic and financial commentary.

A summary of the release dates of economic reports in the UK, Eurozone, Japan and China is provided here. It is important to keep an eye on growth trends in these economies for clues on, among others, the trend of the US dollar.

Markets
The performance chart obtained from the Wall Street Journal Online shows how different global markets performed during the past week.

Source: Wall Street Journal Online, August 31, 2008.

Equities
Global stock markets, in general, were mixed during the past week. The MSCI World Index rose by 0.6%, with the MSCI Emerging Markets Index closing unchanged.

Among mature markets, the US stock indices were mostly lower, but European stocks turned in good performances, for example Italian Comit 30 Index (+2.6%), French CAC 40 Index (+1.9%) and German XETRA Dax Index (+1.3%). Australia (+4.1%), Japan (+3.2%) and Canada (+2.4%) also shrugged off the gloomy economic outlook and moved higher.

The emerging markets category saw solid gains in Hong Kong (+4.3%) and Taiwan (+2.0%), whereas large declines were registered by Pakistan (-7.9%), Russia (-3.3%) and Turkey (-2.6%). The Russian Trading System Index ( 16.3%) and the Chinese Shanghai Composite Index (-13.6%) were the worst performers for the month of August.

With the exception of the Russell 2000 Index (+0.3%; YTD -3.5%), the US stock markets closed lower as shown by the major index movements: Dow Jones -0.7% (YTD -13.0%), S&P 500 Index +0.7% (YTD -12.6%) and Nasdaq Composite Index -2.0% (YTD 10.7%).

Particularly noteworthy, the MSCI World Index has outperformed the MSCI Emerging Markets Index over the past month (-1.6% vs -8.2%), past three months (-11.9% vs -21.0%), YTD (-15.4% vs -23.2%), and also since the stock market peaks of October 2007 (-20.7% versus -28.6%).

The Russell 2000 Index is trading above both its 50- and 200-day moving averages, whereas the Dow Jones Industrial Index, S&P 500 Index and Nasdaq Composite Index are above their 50-day averages but still below the important 200-day line – often used as an indicator of the primary trend.

Click here or on the thumbnail below for a market map, courtesy of Finviz.com, providing a quick overview of the performance of the various segments of the S&P 500 Index over the week.

The thrifts and mortgage finance group (+16%) was the best-performing group for the week, led by Freddie Mac (FRE) and Fannie Mae (FNM), up 61% and 37% respectively. This is a strong reversal from being the worst-performing group during the previous week with a decline of 23%. The stocks were driven down recently by speculation on whether a government bailout was imminent, a prospect that would probably wipe out the equity holders. Those concerns seemed to diminish last week after some analysts estimated that the firms had enough capital to last at least until next year.

The homebuilding group was the second-best performing group, gaining 9% on housing reports being interpreted as showing signs of a stabilizing market.

The trucking group (-7%) was the worst performer, led by its single member, Ryder System (R). A brokerage analyst downgraded the trucking sector, predicting that freight volumes in the peak shipping season through November might be weaker than expected because of the soft US economy.

The Internet retail group (-6%) was the second-worst performer, led by its largest member, Amazon (AMZN). A blog posting by a newspaper reporter raised the topic again of how well Amazon’s Kindle electronic book reader was actually selling.

Fixed-interest instruments
Global government bond yields were mostly lower during the past week, as investors dismissed the threat of inflation and priced in concerns about a global recession.

The ten-year US Treasury Note declined by 4 basis points to 3.83%, the UK ten-year Gilt yield by 13 basis points to 4.48%, the German ten-year Bund yield by 5 basis points to 4.17% and the Japanese ten-year bond yield by 5 basis points to 1.42%.

Currencies
The US dollar maintained its recent rally as the currency benefited from the view that foreign central banks will be quicker to cut rates than the Fed will be to tighten rates.

The past week saw the greenback rising against the euro (+0.7% – a six-month high), the British pound (+1.6%), the Swiss franc (+0.2%), the Australian dollar (+1.2%) and the Canadian dollar (+1.6%).

Sterling has come under further selling pressure as pessimism about the UK economic outlook intensified, dropping to a 12-year low on a trade-weighted basis ahead of the Bank of England’s interest rate announcement next week.

The Japanese yen was the only currency to gain against the US dollar during the past week, closing 1.1% higher on the back of better-than-expected economic data and the announcement of a $107 billion fiscal stimulus package.

Commodities
The dollar’s strength and growing concerns of slowing demand knocked dollar-denominated commodity prices as seen in the Reuters/Jeffries CRB Index, which declined by 0.8%.

West Texas Intermediate crude traded between $115.0 and $118.76 a barrel last week before closing 0.8% up at $115.46 on Friday. The gain was relatively small given the impending arrival of Hurricane Gustav and concerns about the geopolitical situation with Russia, but word from the Department of Energy that it would release strategic oil stocks to combat any disruption kept oil prices in check. (The Gulf of Mexico is responsible for 25% of US crude oil production and 15% of US natural gas production.)

The chart below shows the past week’s movements for the various commodities:

Now for a few news items and some words and charts from the investment wise that should be of help with keeping our investment portfolios on a winning path. As the Irish say: “Go n-eírí an bóthar leat. May the road rise with you.” And also wishing you a fabulous Labor Day weekend.

Hat tip: Barry Ritholtz’s Big Picture

YouTube: Take a load off Fannie
The story of Fannie Mae, as narrated by The Band.

Source: YouTube, August 24, 2008. (Hat tip: Barry Ritholtz’s The Big Picture.)