Spring Lamb Market

My son just informed me that the snow we are having is too near the birthday of a spring lamb like himself. I hate to remind him that such young creatures often end up with mint sauce on the side at Easter. The cavorting market of the past month may meet a similar fate. I also am optimistic (hopeful) that the worst of the stock market may be behind us but not without some testing.

The 25% rally in three weeks certainly felt good. But to expect that it presages the beginning of a V-shaped recovery simply is wishful thinking.

The market has suddenly priced in significant rebound in earnings that are unlikely to emerge for some time. What I find most troubling is the sectors that have climbed the highest and fastest. Leisure/accomodation has gained 35%, homebuilders, 40% and retail stocks up 30%.

These consumer driven sectors may have presented some good short covering opportunities, but to expect consumer driven industries to drive the recovery flies in the face of sober reality. Increased consumer spending and tight credit means game over for many of the business models built on ever expanding consumption.

There have been a few comparable gains in such a short period.

* December 1929
* June 1931
* August 1932
* May 1933
* July 1938
* September 1982

Only in September 1982 and in May 1933 was it the beginning of a prolonged bull market. In 1982 the markets were coming off of extremely high interest rate levels and beginning a secular decline in interest rates that was to last 25 years. 1933 and in 1933 Franklin Roosevelt was inaugurated and took the United States off the gold standard unleashing a wave of monetary stimulus.

Clearly the 1982 event does not contain a background comparable to today. The 1933 change of administration and radical departures from practices that mired the nation in depression may have similarities that only history will determine. However, I think we can expect a retracement of much of the recent gains and hopefully followed by a successful test of the recent market lows. The only thing worst than being late to the party is being arrested by the cops before you even finished your first drink. We suggest cautious sipping.

The charts still show a definite intact downtrend, albeit a few hopeful sprigs. But like the snow covered flowers in our garden, they may not all make it. Don't count your tulips before they are bloomed.



The technically overbought condition, the beginning of quarterly earnings reports and historical "outlier" characteristic of this lovely four week run makes me willing to protect some of the recent profits while remaining hopeful that spring is perhaps near at hand.

John Barnyak
President
www.stonehouseasset.com

Diversification

The concept of diversification has been so oversold and underdelivered in recent years. For many, the pig's breakfast of various collected stocks and mutual funds has provided little more than a dangerous delusion. Chasing performance from one stock to another or one stock theme to another does not provide the basis for a diversified portfolio. Over the past few years I lamented that "nothing" seemed cheap and with good cause. Nothing was cheap.

Diversification should mean that the performance correlation is negative or uncorrelated. In other words, when one zigs, the other zags or just pays no attention at all. As interest rates fell, treasury bonds and the stock market we actually somewhat correlated although for different reasons.

Bonds rose as interest rates fell over years, but stocks rose on easy credit excess leverage. In 2007 as the first shots were fired in the subprime mortgage debacle that linkage began to fail as investors began to move away from risk to security with the US Treasury bond the ultimate security.

Lets look at the performance of asset classes over the past few years. The first chart is a look at how ineffectively the US/International diversification worked.






Not at all. The effects of globalization are seen clearly as a connected world provided an efficient (if not effective)interconnection of equity performance worldwide. As Warren Buffet says, it is only when the tide goes out that we see who's standing naked in the water.




The truly diversified market shows the effective non-correlated comparative performance of Treasury Bonds, Rydex Managed Futures and the S&P 500. In the worst financial melt down of our lifetime the diversified portfolio would have weathered the storm reasonably well.

The conclusion is that one should not mix diversification with performance seeking. The decision OF the asset class is more important than what is IN the asset class.
Within our model currently we are weighting domestic stocks more than foreign, technology more than manufacturing, but the true proof of a good portfolio will be the weighting of fixed income (and various durations therein) versus equity.

John Barnyak
President
www.stonehouseasset.com

Listen to the Moral Silence

After a short period working as a broker for one of the premier investment firms in the world it became clear to me there were essence two levels of investment recommendation. It was not buy and sell, it was buy and silence. When I stopped hearing the drum beat of "buy!" I assumed it was time to sell the investment in question. Eventually when I left the company, I described my time there as being the driver of the getaway car for the Pope. I had gone to the company proud to be associated with the most elite and powerful investment house in the industry. I left aghast and cynical and swore to speak truth to power.

I believe there are great opportunities for investments ahead as always. To understand the truth is be to be armed to profit. A damning interview about the banking system and the fraud implicit on this week's Bill Moyer's Journal is another clarion call for trust but verify.


John Barnyak
President
www.stonehouseasset.com

Animal Spirits

"Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits - a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities."

John Maynard Keynes, who was the father of fiscal policy wrote those words in his 1937 opus, General Theory of Employment, Interest and Money. Until this weekend I perhaps gave the importance of the animal spirits Keynes referred to short shrift. While accepting that confidence is important, my thinking has been that positive realities such as raising employment and stablizing housing prices would be the impetus to confidence. Maybe it is as much the other way around.

Several recent conversations give me pause. In discussing the recent positive stock market action and the fact that we see some hopeful technical signs, a client expressed her fear that she would lose money if we indeed did begin to take more constructive steps in her investment portfolio. The constant drone of negative economic news and analysis assaulting her each and every day has convinced her of how dire her own plight is. This despite the fact that her investments have been making money for the past six months. There was a severe cognitive disconnect between her participation in the collective mood of the country and her personal situation. Her urge at the moment is strongly toward inaction. A risky proposition.

A second conversation was far more troubling and the thinking more pernicious but understandable. The attitude that, "the fix is in," is one that requires rapid and decisive resolution at the national policy level. Increasingly we are beginning to believe that the institutions of power are in malignant alignment contrary to the common good and that no amount of personal action can succeed against powerful forces. Again, the animal spirits that urge action rather than inaction are absent.

The apparent flailing about in seeking a solution to the banking crisis reinforces the theme of business as usual. With a tweek here and there, a trillion dollars or two or three will once again grease the same wheels of commerce and finance that put us in the current situation. There is a sense that, these things happen and if we slap some paint on the structure all will be forgiven. Once again, the word responsibility is thrown about easily, but the concept of consequence rings hollow.

The theater of the banking industry grows tiresome. That Vikram Pandit of Citigroup can state that his salary will be $1 until Citi returns to profitability is nothing more than sophistry when seen in context of the hundreds of millions Citi paid him when buying his previous hedge fund, or the tens of millions in deferred compensation and retention bonus paid last year.

To millions of investors and the general public this feels like a wink and a smirk amongst the inner circle while so many see personal financial foundations rocked and ruined. Until this smirk is gone mistrust will quell the animal spirits that move the rest of us to take current action for future good.

The forcing from office of CEO Wagner from General Motors this week and the stated inclination of the Obama administration to move GM to bankruptcy may be a shot across the bow of the financial industry.

From the first souk on the Silk Road mankind has found opportunity in risk, persistance and the anticipation of better times ahead. There are new and shifting opportunities for those who both maintain capital and take risk. These two apparent contrary actions require balance but a positive attitude. To cling to cynical despair means "they" have indeed won. Challenges must be met both nationally and personally. Fetal is a tactic, not a strategy. Last year we did some fetal. Now it is time to strategize whether you think it is just a game or not. There is no option to take ones ball and go home.

John Barnyak
President
www.stonehouseasset.com

A Turning Tide in Fixed Income

If you were fortunate and bright enough to have balanced your portfolio over the past year with a healthy dose of treasury bonds, you did well. Now the trick is to keep it. The entire point of diversification is to benefit from rebalancing. While many are still shell shocked from equity performance last year, others may be straining to pat themselves on the back.

Lately I have seen too many portfolios which should now be rebalancing as they move back toward riskier investments, but are unable to because of near 100% allocations to stocks. Now is not really the time to be fleeing risky asset classes. That ship has sailed. But a diversified portfolio with its sizable allocation of fixed income has a new challenge ahead.

The economic conditions that caused a 20+ year bull market in bonds are in the process of reversing. Pay attention. While the true diversification of treasury bonds in a flight to safety benefited mightly last year, it is now arguable that treasury bonds have created their own bubble. Like all bubbles, when it goes, it goes fast and painfully.

For this reason bond allocation should be focusing on "spread product." That is, the higher risk bonds which suffered along with the equity market last year. If an investor maintains a large bond allocation on principal, the coming year will present crucial decisions. Below is the first quarter 2009 bond performance of: the 20+yr treasury bond, the short position in 20+yr treasuries, high yield bonds, the aggregate bond index of a diversified range of bonds, corporate bonds, mortgage backed securities and finally, emerging markets bonds.





The 20+ treasury did quite poorly this past quarter losing 11%. Mortgage backed securities fared somewhat better with 1.5% gains, while the short position in 20+ Treasuries did as expected and was higher by almost 16%

This new bubble suggests somewhat of a dilemma in allocation strategy. In fact the only truly diversifying bond is the risk free treasury. In a crisis it provides powerful protection. The other bonds on the risk curve act substantially like equities and move as broad markets move. In other words what is the advantage of having ANY bond allocation now? The alternative is to short the one diversifying asset class, treasuries. Does that then bring any benefit not accrued to simply investing that portion in equities?

It is entirely possible as some are predicting that corporate bonds, beaten down in the previous year will perform better than stocks. Therefore the bond allocation may be no longer a question of diversification, but rather of performance.

Our clients will be encouraged to maintain a modest exposure to treasury bonds, higher allocations of spread product, i.e. corporates, high yield and emerging market fixed income allocations, but overall, bond allocations will migrate to the lower levels of strategic allocation.

John Barnyak
President
www.stonehouseasset.com

First Quarter 2009 Recap

The general tone of those I talk to regularly is tending to a PTSD type mood. The collapse which occurred with blistering speed in the fourth quarter of last year settled into a volatile, but generally sideways market over the past few months. The emotional damage done in a catastrophic investment climate lingers. The greatest challenge now is coaxing clients out of their foxholes and back into the light. It is of paramount importance that investors remain aware that the investment market anticipates economic improvement by six to nine months. In other words by the time the all clear is sounded, some of the best opportunities will be past.




In the chart above we see a reasonable gain in long duration treasury bonds, a small gain in gold and in every other asset class very significant losses.

But if you look more closely at the most recent three months something else is found.




The US treasury bond in the first quarter gave back half of what it had gained in the fourth quarter when investors fled from all risk. The extreme reaction at the end of last year is obviously abating as investors begin to sell Treasuries in anticipation of other better alternative investments or an assessment of higher future interest rates.

The commodity index had a good quarter with a gain approaching 10%, the technology laden Nasdaq index contributed nearly 5 percent gains while the S&P 500 and foreign EAFE index fell. Real Estate continued to dissolve.

The common link in the results is the weakness of financially based sectors. The S&P 500 and EAFE index have significant banking components, while real estate is largely depending on credit availability.




March alone provided most of the quarter's gains with broad gains in all asset class as well as gain in bear dollar plays. Given the bad news that continues to be reported, GM likely bankruptcy, first time unemployment claims for the month over 700,000 and quarterly financial reports expected to be worse than the fourth quarter, the positive market action is encouraging. Returning to strategic allocations in the near term, while awaiting better guidance for tactical alpha producing positions is now recommended.

Given the positive market action of the Nasdaq we are over weighting the Nasdaq and technology. The lack of legacy costs found in the manufacturing sector, low debt and clean balance sheets make this area of the market makes me believe it will lead the market. Additionally, the increasing savings rate at the expense of consumer spending, contracted credit availability and the expectation of technology spending to enhance productivity and competitiveness favor the sector.

John Barnyak
President
www.stonehouseasset.com

Saving for the Future South Park Style

For all the convoluted explanations sometimes the basic facts are clearest when explained by those outside of the mysterious ways of high finance! We could use a lot more "emperor has no clothes" humor. So when you hear something that doesn't make sense, it very well might not. Ask, probe, question. Black boxes are for magicians who make things disappear, so no black box investments for us.




Bailouts