Have Stocks Bottomed?

After busting through its previous support level of 1,200, the S&P 500 dropped to an intraday low of 1,100 in early August. As we pointed out in our last technical analysis update, longer-term charts show that stocks have significant support in the 1,100-1,150 range. That support level has been confirmed by the price action over the last six weeks. The S&P 500 has tested, let’s call it, 1,125 on four occasions over recent weeks. Each time, the market hit 1,125 it bounced higher. But the rallies have failed each time the index approached 1,225. Stocks have carved out a 100 point range between S&P 1,125 and S&P 1,225. A break below 1,125 on the index would likely signal another 5-10% of downside while a break above 1,225 would signal further gains. The key levels to watch are 1,125 and 1,225.

Pay Risk for Pensions and Annuities

High interest rates are not the problem with the real-estate market. Anyone who bought a house in the ’70s or ’80s can attest to that. The actual problems? Weak appraisals, 20–30% cash at closing, high labor costs, and high input costs for basic materials top my list. So the Federal Reserve’s long-bond-buying binge is a real head scratcher.

As you can see in the following charts, traders jumped on the news, buying up long bonds last week to front-run the Fed buying that will begin in October and last through June 2012. Traders have done quite well.

Annuities and pension funds cannot be thrilled. They invest new money in longer-term bonds to match up liabilities. Thanks to the Fed, they are now left with much lower yields. As a group, they can ill afford such a headwind, and a fabricated one at that. The Fed claims it is trying to help Main Street, yet that is exactly who is hurt most by such low rates.

How to Profit when Stocks Plummet

Over the last two months, stock-market fluctuations have been extreme. In August, 400-point swings became a common daily occurrence for the Dow Jones Industrial Average. September has also seen its share of volatile days. Since the end of July, one common measure of volatility, standard deviation, has increased by over 130%. For many investors, extreme bouts of volatility can fray the nerves. Stock-market gyrations cause anxiety and stress and lead to emotionally charged investment decisions. But falling markets aren’t uniformly negative—they do create opportunities. Here are two ways to profit from stock-market corrections.

Tax-Loss Harvesting 

Plunging stock prices inevitably push some of your holdings into the red. With tax-loss harvesting, you can turn the losses into an asset. How? When you harvest losses, you create a tax shelter that can be used to offset future capital gains. But you don’t just want to sell securities and park the proceeds in cash. The key to successful tax-loss harvesting is to realize losses without giving up exposure to the markets or sectors you are selling. The proliferation of exchange-traded funds has greatly simplified investors’ ability to properly harvest losses. According to Bloomberg, there are over 1,100 ETFs listed in the United States—many of which track similar sectors of the market. For example, there are 144 large-cap stock funds and 35 funds tracking the technology industry. The redundancy of ETFs works in your favor for tax-loss harvesting.

Let’s look at a hypothetical example of how you can use ETFs to harvest losses. Assume you own the world’s largest ETF, the SPDR S&P 500 fund, at a $10,000 loss. You can sell the fund, recognize the loss, and reinvest the proceeds in the Vanguard Large-Cap ETF (Symbol: VV). The $10,000 loss can be used to offset realized capital gains this year or in the future while maintaining exposure to large-cap stocks. The SPDR fund and the Vanguard fund are highly correlated, but they track different indices, so they shouldn’t violate the IRS’s wash-sale rule.

Buy Quality at a Discount 

Tumbling stock prices often lead to indiscriminate selling. Investors stop distinguishing between good companies and bad companies and cyclicals and noncyclicals. Savvy investors can take advantage of the panic selling and buy quality companies at discount prices.

We saw indiscriminate selling in the utilities sector when stocks first started to trade down this summer. From July 21 to August 8, the S&P 500 Utilities index plunged almost 12% as the broader market fell 17%. Why did utilities suffer such a steep loss? Was it the slowing global economy or the escalating euro-area debt crisis? Utilities aren’t sensitive to the business cycle, and few would be impacted by developments in Europe. Investors were likely selling utilities stocks along with the rest of the market even though the move in utilities wasn’t justified by the fundamentals. Those who spotted the opportunity were able to buy utilities stocks at their best yields in over two years. When indiscriminate selling ensues, buy quality.

What We’re Reading 9-23-11

Global Stocks Drop 20% Into Bear Market, Lynn Thomasson and Michael Patterson, Bloomberg

The Spend Now, Tax Later Jobs Bill, Alan Reynolds, The Wall Street Journal

Obama’s Tax Morass, Daniel Henninger, The Wall Street Journal

The Real Effects of Debt, Stephen G Cecchetti, M S Mohanty and Fabrizio Zampolli, BIS

In Pockets of Booming Brazil, a Mint Idea Gains Currency, Paulo Prada, The Wall Street Journal

A Little Inflation Can Be a Dangerous Thing, Paul A. Volcker, The New York Times

Buffett’s Dad Was the Ron Paul of His Day, Philip Klein, The Washington Examiner

Down 58% in 2008

Legg Mason Value Trust fund outperformed the stock market every year from 1991 to 2005. The word “legendary” would often precede the name of its manager, Bill Miller. He was legendary for building positions in companies by dollar-cost averaging down while other investors were selling. His style is described in The Wall Street Journal article “The Stock Picker’s Defeat”:

Mr. Miller’s swing-for-the-fences approach makes even other value investors flinch. Christopher Davis, a friend of Mr. Miller’s and a money manager at Davis Funds, recalls discussing his investment strategy with Mr. Miller in the early 1990s. “One of my goals is to just be right more than I’m wrong,” Mr. Davis recalls telling Mr. Miller. “‘That’s really stupid,’” Mr. Miller countered, according to Mr. Davis. “Bill said, ‘What matters is how much you make when you’re right. If you’re wrong nine times out of 10 and your stocks go to zero—but the tenth one goes up 20 times—you’ll be just fine,’” Mr. Davis recalls. “I just can’t live like that.”.

In 2008, Miller dollar-cost averaged down Bear Stearns right up to its collapse. He added to Freddie Mac and insurer AIG until, in September, Freddie Mac, which had been as high as $34 during the year, dropped to less than a dollar as part of a government takeover. At that point he decided to sell AIG, but the damage had been done.

Legg Mason Value Trust lost 58% in 2008. In December its assets under management had dropped from the year before, due to market performance and withdrawals, from $16.5 billion down to only $4.3 billion. Its “legendary” market-beating performance was wiped out, putting it in Morningstar’s worst-performing fund class for one-, three-, five-, and ten-year periods.

From 1997, relative to the stock market Legg Mason Value Trust has been less than extraordinary, especially for those who got in near the peak. The simple and tragic math for recovering from a 58% loss is a gain of 138%. The fund still has some ground to make up. Imagine how that must feel for the retiree who’s been counting on it.


Twisted Monetary Policy

At the Fed’s policy meeting yesterday, Mr. Bernanke announced that what America desperately needs is a rearranging of the deck chairs. Facing opposition from, well, just about everybody who isn’t a trained Keynesian economist (read: those with common sense), the Fed decided to lengthen the maturity of its Treasury portfolio. Bernanke & Co. will sell $400 billion in short-maturity Treasury securities and purchase Treasuries with maturities of 6–30 years. Investors have dubbed the move “Operation Twist” because the Fed is twisting the slope of the yield curve.

This latest attempt to stimulate growth was widely anticipated by investors, but equity markets plunged following the announcement. Why the sell-off? The Associated Press tells us that “The Federal Reserve did what investors expected Wednesday—it said it would buy Treasury bonds to help the economy. But stocks fell anyway. The reason? The Fed made it clear that it thinks a full economic recovery is years away.” Are we to believe that staff economists at the Fed just broke the news to financial markets that the economy isn’t doing so hot? C’mon, these are the same staff economists who told us only weeks ago that the economic slowdown was transitory. The Fed didn’t break any news to the market. The financial markets are always way ahead of the Fed.

So why did the stock market plunge following the Fed’s Operation Twist announcement? The most logical explanation is that investors were pricing in more monetary stimulus than Mr. Bernanke delivered. It was Mr. Bernanke who came to the rescue of traders and speculators following the August Fed policy meeting. He promised to hold rates at zero and stimulate more if needed. The 2011 low in stock prices was reached August 9—the day of the last Fed meeting. Without Bernanke’s August threat of more stimulus, stock prices would be much lower than they are today. Investors were hoping for more.

What does the Fed expect Operation Twist to achieve? Bernanke & Co. want lower long-term interest rates—as if sub-2% rates aren’t low enough—and higher asset prices. The Fed believes that swapping shorter-term Treasuries for longer-term Treasuries is functionally equivalent to quantitative easing. The theory is that when the Fed prints money, it swaps a short-maturity asset—bank reserves—for a long-maturity asset—Treasury securities. With Operation Twist, the Fed is doing something similar: swapping short-maturity Treasuries for long-maturity Treasuries. The hope is that investors who sell their long-maturity Treasuries to the Fed will buy competing long-maturity financial assets (read: stocks) and drive up their prices. Sounds good in theory, but the Fed outsmarted itself here. Operation Twist is bad policy and bad economics.

Why is Operation Twist bad economics? First let’s look at interest rates. Rates are already at historic lows. A drop of another few basis points isn’t going to help stimulate the real economy. If the Fed is trying to ignite a refinancing boom, lower rates aren’t going to help. Many homeowners don’t have enough equity to refinance. Lower interest rates aren’t going to change that. And by flattening the yield curve (pushing long-term rates down in relation to short-term rates), the Fed is likely to impair credit creation—that’s negative for economic growth. This is simple economics—basic supply and demand. When you lower the price of a product, supply falls, especially when the cost of producing that product hasn’t changed, as is the case with bank loans. With its August move, the Fed flattened the short end of the yield curve. Three-month CDs now yield 11 basis points while two-year Treasury notes yield 19 basis points. There is almost no profit to be made by banks in extending short-term loans. And with Operation Twist, Mr. Bernanke is taking away the profitability of riskier, longer-term loans.

It makes one wonder if Operation Twist is not just the first step of a broader plan by the Fed. We’ll have more on what the Fed could be planning and how to profit from it in the coming issue of Young Research’s Global Investment Strategy.

Chanos on China

Mr. Chanos provides a sobering reminder of the dangers lurking in the world’s second largest economy.

Copper Signals Trouble

Copper is said to have a PhD in economics for its ability to forecast the economy. Copper is used in everything from construction to autos to electronics. What do copper prices signal about the economy today? Global economic momentum is slowing. Copper prices are rolling over. The red metal has broken through a two and half year uptrend with further losses signaled. Stay tuned.