Fagan Associates Columns

An article appeared in the financial newspaper, Barron’s this past weekend in which columnist, Lawrence C. Strausss interviewed Paul Hickey and Justin Walters, the founders of Bespoke Investment Group.  Within the article, Walters was asked, ”Why are you bullish?”  His response puts in a nutshell why we remain cautiously optimistic on stocks or at the very least believe the jury is still out regarding the sustainability of this economic recovery.  Walters notes that “obviously the financial crisis of 2008 and early 2009 has made the individual investor and even institutional investors so worried that, any time you see any kind of pullback of 3% or 4%, it seems like people think the world is going to end.  And all of the news just becomes completely negative.”

The stock market has sold off approximately seven percent over the past seven weeks as investors have chosen recently to view the economic glass as half empty rather than half full.  With this in mind, as part of a two part series, over the next two weeks we’ll take a look at some of the positive influences on the stock market as well as the negative.  Given the fact that we are in the midst of a pullback, let’s look first at the negative influences, discussed in order of perceived impact.

The biggest drag on the economy continues to be the weak labor market.  High unemployment has a ripple effect, negatively impacting business and consumer sentiment and therefore business and consumer spending.  Historically, at the height of an economic recovery the Unemployment Rate gets below five percent to a rate that many consider full employment.  With unemployment hovering around nine percent, we believe that it will be a period of two to five years before we achieve such low unemployment rates.  This is due to the fact that what historically leads the United States economy out of recession is the housing market which remains in a funk as we will discuss below.  Given the bubble in housing during the last economic expansion, the Unemployment Rate may not get much below six percent during the height of this expansion.

The second issue negatively impacting our economy and therefore the stock market is, as noted above, the weak housing market.  In fact, it would be easy to cite the housing market as the main culprit for the deep recession and relatively weak recovery, thus far.  Quite often when a bubble bursts in any sector of the economy, it takes many years for that sector to recover to its prior highs.  We believe that this will be the case with the housing market as many potential homebuyers are reluctant to step in and buy due to a continuance of falling prices in housing, relatively cheap rents and a weak labor market which adds future economic uncertainty. 

The third economic drag was the catalyst behind economic growth over the past decade and that is public sector spending and hiring.  Now without getting into any political debate, let us state that, in the aggregate, the public sector is responsible for every job created in the United States since 1998.  Without the public sector, the U.S. would have experienced a contraction in the labor market.  Like it or not, the public sector right on down from the national level to the municipal level must curtail spending and therefore hiring as it tries to “right-size” itself for the economic climate and projected tax revenue.

The fourth economic drag is the paradox of thrift.  Americans are in the process of repairing their balance sheets.  For the fifteen year period including 2008, the average American spent more than they took in by borrowing more on their credit cards, home equity loans or by dipping into their savings accounts.  We are in the process of reversing this trend and unfortunately, this process will take a bit of time.  It is very similar to dieting.  You are not just going to wake up thinner.  It will take time, effort and discipline.  Correcting the excess in credit will also take time.  Once again, this will be measured in quarters and years, not months.

The political rhetoric will heat up.  Historically as this occurs, public sentiment tends to sour.  When public sentiment sours so does investor sentiment and the stock market has a difficult time making headway.  It appears as if the Presidential Election rhetoric has already began.

Global geopolitical risks will remain on the front burner.  Portugal, Ireland, Italy, Greece and Spain (PIIGS) will continue to make negative headlines as they try to fix their debt-laden budgets by perhaps restructuring this debt and by reducing spending in their public sectors.  European Monetary Authorities continue to try to buy time and taking several measures.  Once again, whether it works or not will take quarters and years rather than months.  One can also not ignore the Middle East which remains a hotbed of political tension.

THE BOTTOM LINE – Keep in mind that this column was intended to be negative.  Next week we will cite the many positives which if nothing else should provide a floor near current levels.  We will conclude this article with our current opinion of the potential for investors over a foreseeable time period.

Readers of our column, listeners to our radio show and those close to us know that we are huge sport fans.  We are especially fond of baseball, specifically the routine, symmetry and the fact that there is always hope due to the lack of a time clock.  That said, the start of baseball season usually provides us with a lot of anxiety as we are fans of the New York Mets and ask ourselves why we couldn’t have been brought up Yankee fans.  Ironically, some of the terminology utilized in baseball works well in formulating investment philosophies.  We note some of them below.

DON”T SWING FOR THE FENCES!  So many investors (especially younger ones) are looking for the home run.  They want to day trade their way to financial freedom and are constantly looking for the next Google or Microsoft.  Reality is that most baseball rallies are built one single at a time and that solid financial portfolios are built through diligence and discipline.  Home runs can occur but mostly they come while you are swinging level and not trying to hit one.  It is also important to recognize that some of the most prolific home run hitters also strike out the most.

SACRIFICE.  In baseball many wins are constructed through the sacrifice bunt (especially in the National League which doesn’t utilize a designated hitter).  Likewise, most investors are best served by making sacrifices and contributing on an ongoing basis to 401(k) plans and to Individual Retirement Accounts.  These dollar cost averaging techniques take the market timing aspect and emotion out of the process and help investors build solid financial futures.

CURVE BALL.  A prudent investment strategy requires a plan of action should your investment choice go down in value rather than up, as you had planned.  What if the stock market or your investment throws you a “curve ball?”  What are you going to do?  How will you respond?  Do you have a plan of action to rebalance your portfolio at a specific level or on a periodic schedule?  Always expect the unexpected.

GOOD PITCHING ALWAYS BEATS GOOD HITTING.  As we have witnessed over the past several years, sometimes the stock market goes nowhere.  Sometimes there are limited opportunities.  During these period of times, don’t lose hope.  Keep your nose to the grindstone.  Keep your eyes on the ball and over time, this will pay off.

THE THIRD BASE COACH.  OK, this might be a stretch, but runners rounding third base are always looking for help and advice from the third base coach.  Likewise, frequently investors are wise to get professional help especially when facing difficult decisions.  The learning curve can be steep and costly should you try to invest on your own.  As we have stated time and time again, experienced investors have a better chance at differentiating between an opportunity and danger.  They tend to have a better feel for when to act rationally and when to act irrationally.  We use the example of buying low and selling high.  That flies in the face of rational thinking.  Why would anybody move toward something that is down and out.  The answer regarding investing is quite simple – investors should always try to buy potential and sell a lack of potential.

PINCH HITTER.  Many investors tend to evaluate their investment portfolios during regular intervals.  For instance at the end of every calendar quarter.  The problem with this is that your investments know no calendar.  They go up and down in reaction to different types of data, including that which pertains to the economy, corporate profits, geopolitical events, monetary policy, etc….  Investing is not a static situation.  Rather it is evolutionary and sometimes revolutionary.  Therefore, you need to be ready to act when the situation dictates.  For individual securities, this may be at a moment’s notice.  For mutual funds, this is most likely in response to an accumulation of data that would cause one to act.  Either way, the calendar does not dictate when changes are warranted, among other criteria, the investing environment does.

THE FINAL SCORE.  You’re the batter.  You’re the investor.  One way or another a pitch is going to be thrown.  You have a decision to make.  Do I swing at the pitch?  Do I make the investment?  If you choose to make an investment have a plan on what to do if it doesn’t work out.  It you decide not to swing, always remember that unlike baseball, when investing you can pass on as many pitches as you want and only swing at those you think you can make effective contact with.  There are no balls or strikes.

HOME PLATE.  OK, you’ve reached your goals.  You’ve achieved your objectives.  Now, don’t go back.  Try to protect your principal and remove some risk.  Stocks have nearly doubled off their first quarter 2009 lows and now may perhaps be the time to scale back a bit of risk, especially if you will be in need of the principal over the near term.

An article was recently published in AARP, The Magazine that detailed the trials and tribulations of a particular investor who, looking a “safe investment for his 86-year-old mother and his mentally disabled brother” committed a grievous investment error.  Through the advice of the broker, a friend he had known since he was nine, this individual invested “about a third of his savings” in a structured product.  Unfortunately, what the investor did not realize was that the principal of the structured product, described by the broker as a “low-risk, high-yield investment called a principal-protected note” was guaranteed by Lehman Brothers, the investment firm that collapsed during the Fall of 2008.  Prior to following the article along to determine the mistakes that were made as well as some other revelations regarding the financial industry, for the purpose of this article, let us first define a structured note as an investment whose return is determined by a underlying pool of securities and whose principal is either partially or completely guaranteed by the issuer.

As we assume the reader is a regular to our weekly columns, we trust you picked up on the first major mistake the investor committed, which was to invest one-third of the money into any one vehicle.  Prior to making an investment into a particular security, ask yourself “what happens to my financial well-being if this does not turn out as intended.”  If the answer is calamity, then either don’t make the investment or scale back the commitment.  This gentleman broke the cardinal rule of putting too many eggs in one basket.

The second mistake, the clue to which was outlined in paragraph one of this column, was committed mostly by the broker and Lehman brothers as they described the investment as a “principal protected note” implying little or no risk to the investor.  That said, the individual is also at fault as he assumed that this principal protection meant no risk to him.  What he failed to realize or didn’t want to realize due to the allure of perhaps high returns was that the principal was not protected by the FDIC or other government entity, but rather by an investment company, which was on shaky financial ground.  Know whether or not there are guarantees and if so, who is the guarantor.

Despite the inherent but not-so-obvious risk, according to the article in AARP Magazine, “sales of structured products keep rising.  In 2010 Wall Street firms and major banks sold a record-breaking $51.86 billion of the investments to U.S. consumers.  Their pitch:  low risk to principal, and high yield.  Their favorite customers:  older Americans who are scared of outliving their money if it remains parked in low-yielding CDs and bonds – and are often desperate to find a safe, better-paying alternative.”  Our response, “Wall Street is a marketing machine, continually developing both core and fringe products that take advantage of the current environment.  In this case, the period of low interest rates is pushing some conservative investors out into an arena in which they are unfamiliar and ill-equipped in which to compete.  Caveat emptor.” 

Why then if these products are difficult to comprehend and carry unforeseen risk are sales skyrocketing.  According to the magazine article, “structured products are extremely profitable for sellers.  For buyers, not so much.  At best, you pay high fees for an illiquid investment with limited potential gain….What’s more brokers are highly motivated to sell them.  The sales commissions on structured products range from three to ten percent.”  What most investors don’t know is that despite its’ efforts, the financial industry remains one of high commissions, creating either a real or perceived conflict of interest.  With this in mind, always ask your broker, what commissions for your firm and you are generated should I purchase this product.  (By the way, Fagan Associates, is 100% fee-driven earning 0% from commission.)

The article notes that these investments are also illiquid and that “most aren’t traded or listed on exchanges.  If you want out of your investment, your only option may be to sell it back to your broker at a loss.”  Generally speaking, never invest in anything that is not registered in your name at a reputable brokerage firm or where you are unable to calculate the value on a daily basis during the course of a business day.  This limits negative surprises.

Finally, a section of the article in AARP Magazine is entitled “How Brokers Sucker You.”  The article notes that “a sales pitch for a structured product often starts like this:  A bank customer complains to the teller about the awful yield on CDs and savings accounts.  The sympathetic teller refers the customer to a securities broker right there in the bank, who enthusiastically describes a product he or she claims is a secure alternative.”  Close your eyes and think of the bank.  What comes to your mind?  Safety and security are two images that come to ours.  However, keep in mind that although this is true for the side that is insured by the Federal Deposit Insurance Corporation (FDIC), there is a side to the bank that is no different from Wall Street, one in where there is substantial, non-guaranteed risk to principal.

Unfortunately, within one year the individual who invested one-third of his savings into this structured product lost everything within a year.  We hope that our attention to this unfortunate occurrence will prevent any of our readers from experiencing this type of life-altering event.

This past week, Standard & Poor’s (S&P), perhaps the country’s premier rating services agency, reduced its outlook on direct debt of the United States Government.  In a lengthy release S&P stated that “it affirmed its ‘AAA’ long-term and ‘A-1+’ short-term sovereign credit ratings on the U.S.  Standard & Poor’s also said that it revised its outlook on the long-term rating of the U.S. sovereign to negative from stable.”

S&P elaborated on the reason behind the change to negative from stable, the first such change ever for the United States.  “Our ratings o the U.S. rest on its high-income, highly diversified, and flexible economy.  It is backed by a strong track record of prudent and credible monetary policy, evidenced to us by its ability to support growth while containing inflationary pressures.  The ratings also reflect our view of the unique advantages stemming from the dollar’s preeminent place among world currencies.”

“Although we believe these strengths currently outweigh what we consider to be the U.S.’s meaningful economic and fiscal risks and large external debtor position, we now believe that they might not fully offset the credit risks over the next two years at the ‘AAA’ level.”

“More than two years after the beginning of the recent crisis, U.S. policy makers have still not agreed on how to reverse recent fiscal deterioration or address longer-term fiscal pressures,” this according to S&P credit analyst Nikola G. Swann.

What could this shot across the bow mean?  Well, most likely nothing for now.  However, should our elected officials not get the country’s fiscal house in order, Americans might expect a continuation of the decline in the dollar and inflation in the form of higher interest rates.

Like it or not, however we believe for the good, the financial markets will most likely determine how quickly our politicians respond to this pending crisis.  For example, just this past week the Euro rose to a fifteen month high relative to the dollar.  Despite the fact that a weakening dollar is good for exports, too much so makes imports (see oil) more expensive and is thus inflationary.  Furthermore, also this past week, the ultimate safe haven, gold, crossed over the $1,500 per ounce mark as debt concerns surrounding the United States as well as the countries of Western Europe has sparked interest in not only this precious metals, but semi-precious metals, industrial metals and commodities, as well.  In fact, in addition to tensions in the Middle East and global demand, many analysts believe that oil would be some $30/bbl lower if it not for the falling greenback.

All the while our Congressmen fiddle as Washington burns.  S&P’s Swann also stated that “our negative outlook on our rating on the U.S. sovereign signals that we believe there is at least a one-in-three likelihood that we could lower our long-term rating on the U.S. within two years.  The outlook reflects our view of the increased risk that the political negotiations over when and how to address both the medium- and long-term fiscal challenges will persist until at least after national elections in 2012.”

In response to S&P, U.S. Treasury Secretary Timothy Geithner said this past Tuesday that there was “no risk” that the United States would lose its ‘AAA’ credit rating noting that “the President recognizes and the leadership in the Congress recognize that we have to start to bring these deficits down.”  In our opinion that is easier said than done as America must guard against forfeiting its reputation as the “land of opportunity” for one as the “land of entitlements.”

Standard & Poor’s has effectively managed to heighten the increasingly contentious debate between Republicans and Democrats, one which came to the attention of most Americans with the publishing of the recommendations on how to deal with our budget deficit by White House Fiscal Commission co-chairs Alan Simpson and Erskine Bowles and may only end with what may be one of the most important elections of our collective lifetimes, the 2012 Presidential Election.

THE BOTTOM LINE – America and Americans, including our elected officials, respond best in a time of crisis.  Make no mistake about it.  If we do not get the U.S. budget deficit under control, a crisis will occur.  Perhaps Standard & Poor’s, which by the way many believe is itself not without fault for the way it did or more accurately did not dispense accurate ratings information during the recent financial mess, has, by way of its ratings outlook revision from stable to negative, in a roundabout way issued a challenge to our President and Congress.  “Fix it.  Get us on the right track.”  Unfortunately, we believe that “fixing it” will include spending cuts by all municipalities, Federal, State and Local; tax hikes and changes to entitlement programs, including Social Security and Medicare.  If this is what it takes to right the ship, we’re all for all of the above and we believe so are the financial markets.

During February 2009, the Federal Reserve conducted a stress test of sorts, one in which evaluated the capital levels of the nineteen largest U.S. bank holding companies, those deemed “too big to fail.”  As a result of this test and according to a press release from the Federal Reserve, “the Federal Reserve advised bank holding companies that safety and soundness considerations required that dividends be substantially reduced or eliminated.  Since that time, the Federal Reserve has indicated that increased capital distributions would generally not be considered prudent in the absence of a well-developed capital plan and a capital position that would remain strong even under adverse conditions.”

In laymen’s terms, the Federal Reserve was attempting to make certain that the largest U.S. Banks had adequate capital to take them through another financial crisis without being bailed out by the U.S. Treasury.

Speed forward to present day.  A week ago Friday, the Federal Reserve announced that it had completed a second stress test, called the Comprehensive Capital Analysis and Review (CCAR) and as a result announced that “some firms are expected to increase or restart dividend payments, buy back shares, or repay government capital.”

One of the banks that have since announced dividend increases include J.P. Morgan whom raised their dividend from $0.05 per share per quarter to $0.25 per share per quarter for a yield of 2.18% based upon the closing price Thursday, March 24.  Prior to the whole financial mess that came to a head during early 2009, J.P. Morgan was paying a quarterly dividend of $0.38 per share resulting in a yield of more than 3.00%.  We believe that if an investor were to own only one bank, it would be J.P. Morgan.  We believe that they provide the best opportunity for capital appreciation relative to the risk that you would be assuming.  In addition, we believe that further dividend increases are likely and would provide a hedge against inflation.

Another bank that responded to the recently concluded CCAR by raising their dividend was Wells Fargo which announced a special $0.07 per share dividend for the first quarter in addition to their normal $0.05 per share dividend for a total dividend of $0.12 per quarter.  We believe that this “special” dividend may be incorporated into their normal dividend for the second quarter and beyond.  If so, Wells Fargo will now pay an annual dividend of $0.48 per share for a yield of 1.50% based upon their closing price Thursday, March 24.  In addition, the Board of Directors of Wells Fargo announced a 200 million share buyback plan totaling $6.4 billion.

Finally other financial institutions either announced dividend increases, share repurchases or plans to begin to repay the TARP funds borrowed by banks from the Federal Government.

THE BOTTOM LINE – It appears as if the Federal Reserve believes that the worst is behind us for the economy and as such the banks.  However, more so now than ever, there will most likely be a wide moat between the winners and the losers.  We believe that J.P. Morgan is a winner.  Another bank we are high on that is not cited in this column is First Niagara, a bank that combines the potential for capital appreciation along with solid income from dividend payments.

Many investors purchase or sell securities at precisely the wrong time.  Specifically, they buy high and sell low!  We believe that part of the reason behind these untimely transactions has to do with the rational expectation that one should accentuate the positives and reduce or eliminate the negatives in life.  Unfortunately, many times this does not work when investing money.  Let’s take a look at a couple of examples how this natural reaction works against you when investing.

We have many clients who own common stock in Ford Motor.  Ford has recently been trading at approximately $14.50 per share, twenty-five percent below its fifty-two week high of $19.00 set within the past twelve months.  In our opinion, the stock has been weighed down by a number of factors, not the least of which being the slowdown in the economy as well as the tragedy in Japan.  This drop in value has generated several telephone calls from individuals who think that Ford Motor may be a timely buy at these levels.  To bolster their case, they justifiably cite many reasons why business should remain strong for Ford, including their long-term global business outlook.  The question as to whether or not Ford is a good buy, in part because the share price has dropped is an appropriate manner of investing.  One may believe that the price has fallen to a point that more buyers than sellers will step in and, given the current economic environment, the share price will begin to rise.  Conversely, we are also receiving contacts from individuals who are concerned that the recent decline in share price is not yet over and are deciding whether or not to unload their shares.  They believe that the uncertainty surrounding the issues noted above will continue to weigh down the stock.  Only time will tell which investor has made the correct decision, the one who perhaps buys shares at this time or the one who sells.  However, both are making decision based upon the share price fluctuation and many times, this is a mistake.  Just because a stock you buy goes up, it does not mean you made a wise investment and conversely, just because a stock declines after your purchase, it does not mean you have made an unwise

decision.  We suggest that investors make informed decisions based upon the fundamental outlook for the company, the industry it operates in and the macroeconomic outlook both domestically and, the case of Ford Motor, globally.

Our second situation pertains to the individual who contacted us during 2010 and wished to

purchase shares of Ford Motor because it had moved from ten for fourteen dollars per share.  Or the individual who wishes to purchase shares because his neighbor has made a ton of money with Ford or the individual who won’t sell his or her shares because “Ford has been good to me over the years.”  All of these situations may be accurate, but it does not answer the prevailing question when deciding whether or not to make an investment.  That is, what is the potential for the stock price to appreciate?  Again, to answer these questions, one must once again look at the fundamental data surrounding business conditions for Ford Motor.

In our opinion, the change in the share price over a period of time is not nearly enough of a reason to purchase or sell the security.  You purchase a stock because you believe it has potential.  You sell when you believe there is a lack of potential or to move on to a company with more potential.

The potential for an investor to buy high and sell low is clearer when analyzing cash flows into mutual funds.  Mutual funds experience their greatest net inflows after having beaten their peers on a total return basis over a given time frame.  However, many of these same investors are buying high only to experience pain as those investments that made the mutual fund successful correct back down to a reasonable price.  For example, the emerging market funds during the year 2010.

Finally, cash outflows from bond-based mutual funds are at their greatest after interest rates rise.  This occurs because the trailing returns are subdued by the inverse relationship between bond prices and interest rates (as interest rates go up, the value of bonds decline and visa versa).  However, poor returns on bond funds are usually an indicator that the bond fund will perform better in the future.  This is once again due to the inverse relationship described above.  Therefore, generally speaking you should sell bond funds after a period of good performance and buy bond funds after a period of underperformance.

We revert back to our initial observation that when investing, it is often prudent to accentuate the negative and reduce the positives.  This translates into buying low and selling high.

As he does every year, famed investor, Warren Buffett, the “Oracle of Omaha” and Chief Executive Officer of publicly traded Berkshire Hathaway, writes a letter that precedes the Annual Report.  Needless to say, due to the historical stellar investment returns that Mr. Buffett has achieved at this conglomerate, what he has to say and what Berkshire has done is closely monitored.  We thought it might be of some benefit to investors to relate some of what Buffett has to say.

One of the more popular tenets Warren Buffett adheres to is one in which “we simply attempt to be fearful when others are greedy and greedy only when others are fearful.  This can be illustrated in the fact that during 2010, “in the face of widespread pessimism about our economy – we demonstrated our enthusiasm for capital investment at Berkshire by spending $6 billion on property and equipment.  Of this amount, $5.4 billion – or 90% of the total – was spent in the United States.  Certainly our businesses will expand abroad in the future, but an overwhelming part of their future investments will be at home.  In 2011, we will set a new record for capital spending — $8 billion – and spend all of the $2 billion increase in the United States.”

Should there be any doubt as to what this investment means, Mr. Buffett follows up this paragraph with “money will always flow toward opportunity, and there is an abundance of that in America.  Commentators today often talk of ‘great uncertainty.’  But think back, for example, to December 6, 1941, October 18, 1987 and September 10, 2001.  No matter how serene today may be, tomorrow is always uncertain.”

Why do we focus on the day-to-day deafening negative noise filling our airwaves, newspaper columns and internet when someone with the business acumen of Buffett observes that “throughout my lifetime, politicians, and pundits have constantly moaned about terrifying problems facing America.  Yet our citizens now live an astonishing six times better than when I was born.  The prophets of doom have overlooked the all-important factor that is certain:  Human potential is far from exhausted, and the American system for unleashing that potential – a system that has worked wonders for over two centuries despite frequent interruptions for recessions and even a Civil War – remains alive and effective.”  Wow!

Buffett wraps up the less Berkshire specific section of his letter with “we are not natively smarter than we were when our country was founded nor do we work harder.  But look around you and see a world beyond the dreams of any colonial citizen.  Now, as in 1776, 1861, 1932 and 1941, America’s best days lie ahead.

Why do we believe they do not?  Do we listen to, read and then draw conclusions from those that have a vested interest to disseminate such negative information?.  As we often say, the Weather Channel has to sell advertising and can only do so by providing exciting, riveting weather-related information, sometimes regardless of the fact that perhaps it is 75 degrees and sunny outside with a forecast of more of the same.  We can say the same thing of the Business Channel.  All this said, we do believe that America is faced with many challenges.  However, over the long haul, we’re with Buffett.  We’d rather be on the side of America then bet against it.

As of the close this past Wednesday, the stock market as represented by the S&P 500 (the largest 500 publicly traded companies domiciled in the United States) has doubled from its ominous-sounding intraday low of 666.79 set on March 6, 2009.  With this in mind, rather than focus on how much higher this index might be able to go from here, a prudent investor is asking his/herself what could derail this upward momentum.  As prudent investors, our response detailed below.

First and foremost, the catalyst for the recovery that we have witnessed initially in the stock market and subsequently in the U.S. economy can be directly attributed to trillions of dollars of stimulus from the Treasury Department as well as the Federal Reserve in the form of a reduction in interest rates, taxes and two rounds of quantitative easing.  The hope is that this “kindling” will be enough to light a lasting fire under the economy, one that won’t go out after this “kindling” either is removed or runs out.  To date, this stimulus has been relatively effective, but, in our opinion, temporary in nature and temporary in its impact.

With Unemployment hovering around nine percent and down from a multi-decade high of over ten percent, a substantial change in the direction of the recently improving labor market could derail this stock market by dimming the optimism currently shared by businesses and consumers and result in a reduction in spending on both fronts.  For businesses, this would mean a curtailment in the addition of employees and reduction in capital investment.  For individuals, this would imply a reduction in discretionary spending as well as a reduction in spending on big ticket items like homes, cars and appliances.  Keep an eye on the job market.

A second potential catalyst for some serious downside to stocks could be a second leg downward in the housing market.  As is well documented, from mid-2003 through mid-2008 home ownership in the United States climbed from an historically normal low-sixty percent range to the mid to upper sixty percent range as banks and other financial institutions such as government agencies Fannie Mae and Freddie Mac eased lending standards and then packaged those loans to unsuspecting investors.  The result was a near cataclysmic drop of more than 30% in housing prices nationwide which ran concurrently with a severe economic slowdown which, as a nation, we are still emerging from.  At the present time housing demand remains tepid despite the historically low mortgage rates, rates which are slowly helping new homeowners soak up the excess inventory from overbuilding.  Should this demand weaken substantially, the entire U.S. Economy would also weaken placing this recovery in jeopardy.  Watch the housing market.

Rising commodity prices that may eventually cause inflation or worse stagflation is a cause for concern.  Food costs have risen 0.5% over the past month at the retail level while geo-political tensions in the Middle East as well as strong demand from the BRIC (Brazil, Russia, India, China) Countries have fueled higher energy costs.  The result is that consumers have less discretionary dollars in their pockets and businesses have become a bit cautious.  Watch food costs.  Watch what you pay at the pump.

Keep an eye on the politicians.  While researching the historical returns of the stock market over the past century or so we found that stocks during the third year of a Presidential Election Cycle (calendar year 2011) outperform the other three years by about a two-to-one ratio.  Furthermore, during the first six months of this third year stock investors reap almost their entire gains for the year.  After that, stocks historically move sideways until the Presidential Election, November 2012.  The reason is clear.  As the election season draws near, the political rhetoric and divisiveness grows thereby dimming the optimism of most Americans.  Listen to the news.  Listen to the rhetoric.  See if the Democrats and Republicans continue to play nicely together or begin swinging at each other.

THE BOTTOM LINE – We’ve had a nice rally off the lows.  Time will tell whether this was a short-term, cyclical rally or the beginning of a longer-term, secular move.  By paying attention to the job market, the housing market, commodity prices and our elected officials you may find a chair should the music stop.

Investors in the U.S. stock market seemed to have a classic case of “bubble-phobia,” loosely defined as “fear that this bull market will collapse in a similar fashion to ones in the not so distant past.”  These symptoms can afflict both the experienced professional as well as individual investors and include a failure to commit an appropriate percentage of assets to stocks based upon a fear that the current bull environment is unsustainable.  This “bubble-phobia” can further manifest itself in a lack of action by the investor thereby keeping said investor out of the stock market and reducing one to being reactive rather than pro-active.

Our prescription for the above referenced malady is simple – set up disciplines and follow those disciplines.  One way or another, decisions are made.  Either you make them, or through procrastination, they are made for you.

To help ease your case of “bubble-phobia,” we point to several reasons why the stock market is not in a bubble.  First and foremost, investors can feel comfortable that relative stock valuations are reasonable.  The thirty stocks that comprise the Dow Jones Industrial Average are expected to earn an aggregate of $945 this calendar year.  With the Dow trading at just over 11,800 this places the Dow’s Price-to-Earnings (P/E) Ratio, a common tool used for valuation, at 12.5, somewhat below the normal historical range.

Corporate profits benefit from a stable interest rate environment, one which makes for a more healthy current business climate as well as enabling business to better predict future trends.  Over the past two years, the ten-year U.S. Treasury Note has traded between 3.00% and 4.00%, very predictable indeed.  Furthermore, the Federal Reserve appears to be on hold with regard to raising interest rates.  In fact, some believe that the next move from the Fed will be to lower rates.

At this time, rampant inflation appears not to be an issue.  Due to the slack in the economy, both the Consumer and Producer Prices Indices, key measures of inflation, are subdued and now, with oil trading somewhere around $90 per barrel, the pressure on manufacturers and service providers to raise prices appears to have ebbed.

The leading stocks over the past few months have been quality companies with sound earnings and foreseeable growth in corporate profits.  They have not been speculative companies.  Historically, a market led by the “blue chip” companies, usually has not reached its peak.  It is when it is led by the speculative companies, those that retail investors like, the market has historically topped out.

Finally, retail investors have not fully embraced this rally.  As long as “bubble-phobia” continues to persist, there is most likely room left to run.  At this point in time, stocks are still climbing that venerable wall of worry.  At this time and if history is any guide, after a brief, relatively shallow pullback, we look forward to strong stock market at least over the first half of 2011.