Sensible Investing

We are just a few days into the second quarter earnings reports, and so far they have been good.  We have seen better than expected announcements from bellwethers such as Alcoa and Johnson & Johnson, while Goldman Sachs and Intel reported blow-out earnings.   On top of that, the Fed raised its economic forecast for the rest of the year and for 2009, something that hasn’t happened for a while.

All these news drove the market considerably higher today.  The bulk of earnings reports is still ahead, but so far it appears that the recovery is still on track and that the probability of a market consolidation is declining.

Even after the rally off the March lows, S&P 500 is still over 40% below its peak in 2007; it is now at the levels of 1997, twelve years ago!  In fact, the ten year period from 1999 through 2008 is the worst decade in market history, returning compounded annual average of negative 1.38%.  The second worst decade was 1929-1938, returning -0.89% and this period of course included the Great Depression.  Early 1930’s were a great time to get into the market for long-term investors, and I believe that is the case today as well.  History doesn’t necessarily repeat itself, but it does rhyme.

While I am optimistic long-term, short-term outlook still remains as cloudy as ever.  Relatively benign economic reports and company earnings convinced majority of the economists that the worst of the crisis has passed; recovery is expected later this year or in 2010.  These reports and expectations are most likely already reflected in stock market prices, however.  While the rate of decline has slowed, at present the economy is still contracting, and housing prices are still falling.  In order for the rally to continue, we will need to see actual evidence of positive GDP growth.  Just like last quarter, coming earning reports in July and August should provide some clarity.  In the meantime, there is a good chance that markets will be indecisive and move sideways for a few months.

It has been reported in numerous publications that the next wave of foreclosures could be caused by so-called “option ARM” loans.  These loans allow the borrower, at low introductory rate, an option to pay each month either the full monthly payment (including principal and interest), only the interest payment, or so-called “minimal” payment that is even less than the monthly interest which leads to negative amortization.  After a fixed period of 3 or 5 years, full monthly payments on remaining balance must be made.  The vast majority of such loans were underwritten in California in 2004-2007.

Well, the first of option ARM loans are resetting, and so far the borrowers are not complaining.  Since the index to which the rate is tied (typically LIBOR), is currently at very low levels, the loans are currently adjusting to 1-1.5% below the introductory rate.  While we can’t expect these conditions to persist and the rates will eventually go up, at least for now it appears that we don’t have to worry about this foreclosure wave.  Quite the contrary – extra few hundred dollars a month for option ARM holders may turn out to be another “stimulus” package – at least for the short term.

Last week, for the first time in well over a year, all major indices crossed above their 200 day moving average, which, technically, is considered a bullish sign.  I am not a big fan of technical analysis, but many traders are, so it is wise to pay attention to such events.  Of course, with today’s market action we may end up below that average again.

In my previous post, I argued that a period of consolidation and sideways movement may be in the cards, as investors are now searching for evidence of actual recovery as opposed to lower rates of decline.  We may see this evidence in second quarter company earnings that will be coming out in mid-July.  Until then, markets could be stuck in the trading range.

The mood at the G-8 meeting that took place last week in Italy was decidedly more upbeat.  Measures to stimulate world economies were no longer topics for the discussion.  Instead, the group acknowledged that the worst of the crisis has passed and started considering ways to back out of the dramatic rescue steps taken last year. Monetary policies have to be brought to normal levels to contain inflation.

In this short video, Peter Lynch, former manager of Magellan Fund and one of the best portfolio managers of all times, shares his views on market fluctuations, futility of market timing, and importance of staying the course and being fully invested.

Here’s an excellent post on what we fear the most is least likely to happen.  During the internet boom of late 1990’s, we saw books entitled “Dow 36,000″ and “The Roaring 2000’s”.  The author of the latter book recently published his latest work, called “The Great Depression Ahead”.  The library of current doomsday scenario book is extensive. I am sure they sell well, but is the world really coming to an end… again?  I don’t think so.

From March to May of this year, stock market gained nearly 35%.  Indeed, we are seeing more evidence of stabilization of economy and it appears that consensus among economists is for recession to end later this year.  However, it looks like that the market has already discounted the predicted weak economic recovery.

So where do we go from here?  Again, no one on this planet, yours truly included, has an ability to predict future market moves.  Having said that, we could be in for a period of consolidation and sideways movement in the market, until we see more evidence on economy progress (or lack thereof).  The key is to be invested in high quality companies that are able to weather the recession better than competition and will emerge stronger when the recovery finally arrives.

VIX, a measure of future expectation of market volatility, dropped below 30 a few days ago for the first time in 8 months and since the collapse of Lehman Brothers.  VIX, also known as “fear gauge” was over 80 late last year.  If often moves inversely to benchmark market indices.

While some may argue that lower VIX demonstrates investors’ complacency, it is encouraging to see yet another indicator to return to normal levels.  VIX traded in the range of 20 to 30 during 1998-2002 and then 10 to 20 in 2003-2007 prior to the start of the financial crisis.

Here’s a link to an interesting article that takes a historic view of major bear market and subsequent recoveries.  Make sure to take a look at the money market funds as a percentage of S&P 500 chart.  Note that the rally of the last two months only used up about one sixth of cash sitting on the sidelines.