October 2005 TeraDime Newsletter

 

Market commentary:

 

As of today the Dow Jones Industrial average is entering the Bear Market territory based on my technical indicators, Gold is hitting a 17 year high and technically is very bullish (never a good sign for stocks). S&P 500 closed below its 200 day moving average the second day in a row and this is very bearish. NASDAQ 100 (QQQQ) is trading below its 50 day moving average, but above the 200 day moving average � this is neutral. The close below 37.80 for QQQQ will be very bearish.� We have high energy prices, rising interest rates, Gold gaining over 1% daily, and a Federal government that cannot count ($100 billion for Iraq, another $60 billion for Katrina, etc�) and a federal budget deficit that is out of control. �The Chinese are still buying our bonds and I do not know why.� If I were sarcastic, I would say that this is probably the cheapest way for them to get paper into their country. ��

 

What does this all tell us? The market believes that we are heading for stagflation (inflation + slow economic growth). What would be a reasonable course of action right now?

 

First, follow your asset allocation strategy. We are getting closer to the end of this year and at some point, you will have to start thinking about rebalancing your portfolios. Here are several suggestions for the next year.

 

  1. Bonds - Look at the % allocation to bonds; due to their exceptional performance during the last several years, you probably have some bond funds that appreciated significantly and may represent a large chunk of your portfolio. In my case, the appreciation on the Municipal bonds is over 19%, I will be selling some of these bonds (not all) to get back to my target allocation.
  2. Emerging Markets - If you invested some of your money in the emerging market funds and they did as well as the associated emerging market indices, then you should be sitting on about a 15% gain year-to-date. You may want to reduce your exposure and get back to the appropriate asset allocation. You do not want to be overweight in emerging markets if it has appreciated too much. The good rule is to rebalance if you are over 2.5% of your target allocation. So for example if you target to have 15% of your assets in the emerging market fund and as of the end of this year you have 18%, you probably want to sell some of it to get back to 15%.
  3. Small cap stocks (value and growth) - �Small capitalization stocks had a great run for the past 4 years, at some point their luck will run out, I do no know when, but I am a strong believer in reversion to the mean theory. This means that it would be a good time to lighten up on your small caps (by the way, the small cap value funds have PE ratios above 17, which does not provide much �value� anymore) by the end of the year.

 

Where is one to invest?

 

1                    The Federal Reserve says that inflation is contained. Yes, and President Clinton did not inhale. Then why is Gold hitting a 17 year high?

2                    Last year the price of natural gas was under $7 for 1000 BTUs, but this year the futures market is pricing natural gas at $14+. Do not be surprised if your $500 gas bill this winter will become a $750 bill (at least). Use the money from selling those municipal bonds to buy warm clothes.

3                    If we are heading for inflation, a good idea is to be invested in Large Cap value stocks that pay decent dividends. There are several ETFs that do that (VTV from Vanguard and JKF iShares from Barclay�s Financial Advisors).� Both have pretty low expense ratios, although Vanguard ETFs are naturally cheaper.

4                    If inflation is present (or should I say when the Federal Reserve declares that inflation is present), bonds will take a dive. So, stay away from the long end bonds. I actually have a pretty simple formula for bond investing: if you think that a 30 year mortgage is cheap (in other words, that the interest rate is low on a 30 year mortgage), do not buy long end bonds. If you think that interest rates on a 30 year mortgage are very high, then buy long end bonds. Of course it is not that simple, but be cautious with bonds, and definitely do not overweigh on long end bonds. Investors are not being paid now for the risk of holding the bond for so many years. The 10 year Treasury is yielding 4.3% while 1 year CDs can be found at 4%.

5                    Banks - there are great banks now that are cheap. 5 years from now, people will say, �2005 was a great time to buy bank stocks�. Why? Because in the rising short term interest rate environment, banks are being �squeezed�. They are paying on deposits 4% (1 year CD) and forced to lend at 5.5% on 30 year fixed. That is only a 1.5% margin (banks need 3% margin to be profitable). Because of that, the stocks are cheap. Speculators are looking at short term profits, and are currently selling bank stocks. Don�t get me wrong - some small mortgage lenders will get hit hard, and you should not invest in them, but big banks will do just fine. �The good news is that many big banks like Citigroup, JP Morgan Chase, and Bank of America, do a lot of commercial banking and have operations all over the world. So, when they are not making money back at home, they are making money somewhere else. Banks are offering low PE and high dividend yields. This is a classic value.� But the stock prices will not appreciate until short term interest rates stop rising. By the way, Citigroup is trading at PE of 11 with dividend yield of 3.9%. Bank of America has PE of 10.4 and a dividend yield of 4.8%! You can invest in banks via an ETF with a quote of XLF (Financial component of S&P 500). Top holdings in XLF include AIG, American Express, Citigroup, Bank of America, JP Morgan Chase, US Bank Corp, Wachovia, etc� The compositions of XLF have a PE of 12 and dividend yield of 2.3%.

 

So the theme for 2006 should be:

 

Overweight on Large Cap Value;

Overweight on Short-End Bonds;

Underweight on Small Cap Stocks;

Underweight on Long-End Bonds;

Find companies that will be able to pass increases in price to consumers due to inflation (inflation that does not exists according to our government, but I am a skeptic); Monopolies are bad for consumers and great for your investing portfolios. MSFT will actually be a value company below $22 per share (Something to keep an eye on next year)

 

 

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