In early 2010 as the stock market rally was approaching a year old, the concern became rising rates.  At that time, I argued that perhaps interest rates would stay lower longer than most thought.  Although the economy was starting to grow again, it wasn’t growing at such a fast clip that rates would go up.  In addition, investors were so scared from two bear markets in just ten years that treasuries would have a bid underneath them for some time (investors would continue to buy bonds) keeping interest rates low.  Lastly, there was evidence (and there still is) that for every $1 the Fed creates in stimulus, there is a negative multiplier effect and only $.86 is actually going into the economy.

Since the spring, not only have rates not gone up, they’ve fallen even more.  Interest rates on 10-year treasuries have fallen from 4% to under 3% pushing bond prices up.    Is there another bubble about to pop?  Many of you think so.  I think so.  I just think there are a lot of people who may have the timing wrong.  Bubbles can get bigger and last longer than we originally think.  But, eventually, they do pop.  So, just how expensive are treasury bonds?

Below is a picture of the “P/E ratio” on 10-year treasuries.  Assuming the interest you receive on treasuries are your earnings, the P/E ratio on treasuries is currently 35.  In comparison, the P/E ratio on the S&P 500 currently is around 15.

The picture above I created shows the “P/E ratio” on bonds from 1962 to present.  In 1982, bonds were very cheap as were stocks at that time.  Now, bonds are very expensive while stocks I think are not.  This is one main reason why stocks can rally further.  It’s not that stocks are dirt cheap.  But, asset allocators and managers out there are comparing bonds versus stocks using the above metric to determine where there is value.

I’m not calling for an immediate rise in rates but you better have a plan for when they do start to rise whether it’s selling treasuries short or some other tool.  It will happen eventually.

This morning GDP QOQ (Annualized) was released at 2.4% vs. the estimate of 2.6%.  At first glance, you think uh oh.  Then, there was the revision to last month’s number.  It was a big revision UP.  You put it all together, and it shows a economy that slowed down very fast last month.  As you know, I watch this number carefully because it correlates so well with the S&P 500.  (Below is the picture including today’s data).

As you can see, really what we need right now is some stabilization.  I believe that if the economic data that continues to be released over the next few months is mediocre, the stock market can rally further.  What the market has been reacting to over the past 3 months has been the sharp drop in all the leading economic indicators.  Some stabilization in the Europe & the U.S. combined with continued growth in the emerging markets could be just what the bulls want.

The market was off to a reasonable start this morning after great earnings by Apple last night. But, for most of the day, the major indices were basically flat. Then, Ben Bernanke began to speak to Congress giving his semiannual monetary policy report. The more he spoke, the more equity prices fell. I immediately flashed back two years ago when I used to see some politician on television and down we’d go. I’d look on my Bloomberg machine and see that a speech was scheduled later in the day and you’d watch the put options. The speech would start, the market would fall, and S&P 500 put options would fly. Maybe that trade is back on. It sure was today.

I was able to listen to most of the speech and watch the reaction tick by tick in the markets. And what I heard was Ben Bernanke (who I do like) give ALL his various options if the economy gets worse. This wasn’t in his statement but rather in response to a question. Remember, the complaint has been that the Fed is out of bullets. “Helicopter Ben” confidently said there are plenty of tools in his belt. First, he said he can change the language to let people know that the Fed will be more accommodating for a longer period of time. This will give the market more confidence that higher rates aren’t in the cards. Second, he said he could lower interest rates. Third, he said he could buy more bonds to keep rates down and inject more into the system.

Let’s analyze each of these options. First, he can change the language. So, basically that means do nothing. It’s jawboning and cheerleading with no real action. Second, he said he can lower interest rates. ALL the way down from .25% to 0%. Really? Remember when the Fed had rates at 5% or 6% back in the day? We would all wait to see if they were going to drop rates by .5% or .75%. Now, does he really think dropping rates from .25% (basically nothing) to 0% (literally nothing) will do any good? Last, he talked about buying bonds. That’s legitimate and certainly gives us a green light to buy more bonds. But, these different tools don’t sound like tools to me. They sound like the Fed is running out of bullets. I first thought to myself no wonder the stock market is falling. But, then I thought wait a second. This is the problem. We’re still relying on the government to fix everything. Hasn’t the Fed done enough? They’ve done their job. They’re finished. They’ve injected more capital in the last two years than we’ve ever seen. They’ve lowered rates to practically nothing to encourage activity. They’ve purchased bonds to keep rates low for longer than we had originally anticipated. And, they purchased all the “junk” that bank couldn’t sell. What more should we want? But, we saw the market sell off because the Fed wasn’t giving us any new information and inventing any new tools they could whip out of their belt that would surprise us and get the economy back on track any faster.

All those smug politicians asking questions to Ben Bernanke as if they have a clue about finance always cracks me up. I wish he would have asked them “What are you guys (& gals) going to do to get the economy back on track?” How about lowering taxes to stimulate small business growth which in turn creates jobs? But, no. What I saw was Congress cutting Ben Bernanke off in mid sentence so they could look smart and act like bullies.

This evening, I heard a politician say in an interview the Fed has a lot of options because they have so much on reserve. However, it’s not about the reserves. That’s like buying a stock because the company has a lot of cash. When a company has a lot of cash, that’s great but it’s what they do with that cash that’s important. We’re relying on the management to earn a return on that cash, not just sit on it. If the Fed has reserves, that doesn’t help anybody.

Again, I’ll reiterate. The Fed has done their job and it’s time for Congress & the President to step up to the plate and figure out how to grow our economy. All I see right now is other countries growing and the U.S. is about to embark on massive tax hikes which will drive capital offshore to these faster growing countries. America has a tremendous opportunity in front of it. We can capitalize on emerging market growth if we choose helping those unemployed find work and grow our economy. Instead, I think we’re wasting that opportunity.
Today’s drop wasn’t Ben Bernanke. It was a reminder that the Fed isn’t going to really do anything else. It’s up to someone else to take over. Ultimately, that’s not good in the long run.

A few days ago, I posted a picture of initial jobless claims on top of the S&P 500 to show you the correlation of jobs and stock prices.  You’ll hear from some “pundits” that jobs don’t matter.  We’re a service economy now and manufacturing here in the states is never coming back.  And while I believe that, my job is to figure out what makes stock prices go up or down.  Job growth is one of the many components that affect stock prices.  Today, we got another confirmation that jobs do matter. The change in non-farm payrolls figure came out at 7:30 a.m. CST.  The number (which will be revised) came out at a -125,000.  This was a little better than estimates, but once again this number is going in the wrong direction.

I know it’s hard to believe government numbers and we know they change over time but the point is this:  If you believe we’ll have more jobs and a robust economy, you buy stocks.  If you believe we’ll have stabilization like we did in the mid 2000s where jobs were created even at a slow pace, you buy stocks.  If you think unemployment is going to stay over 10% and increase, then you avoid stocks.  This is a longer-term indicator and while things look very bearish based on the above graph, I think we are setting up for a tradable rally in the next few days.  As always, we have to monitor the strength to determine whether or not it should be shorted or not.  We often get rallies into holidays that are somewhat patriotic.  This year, it may be the opposite.  I think the rally comes after the holiday.

Short-term (starting in the next few days) – Bullish
Medium-term – Bullish
Long-term – Bearish

With the market bouncing up and down on a daily basis, nerves are high.  The question I get more than any other is whether or not this is a new bear market or just a bump in the road.  I’m going to lay out some historical characteristics of bear markets vs. corrections in a bull market.  In 2007, there were several signs that the market was beginning to deteriorate.  It’s not just about looking at the level of the Dow Jones Industrials.  During 2007, in addition to the economy beginning to slow down, the internals of the stock market were getting weaker.  Anytime I analyze the NYSE, filtering through the various types of securities traded takes some time.  Closed-end bond funds, REITS, preferred stocks, etc. are traded on the NYSE.  Stripping those out and looking just at the operating companies gives an investor a much better sense of actual buying/selling and the future direction of the markets.  In 2007, the number of companies making new highs began to fall while the ones making new lows started rising.  In addition, the amount of volume (shares traded) was increasing on down days and falling on up days.  Various stocks began to enter their own private bear market.  Then, various sectors did the same.  Eventually by 2008, the entire market was in a downturn that eventually snowballed into what amounted to a stock market crash.  This progression that led to a new bear market was typical even though the drop in 2008 and the intensity were not.  Bear markets such as this one tend to look like a lower case “n” where they roll over.

A correction, on the other hand, happens very rapidly, is news driven and very scary.  As an trader and advisor, I tend to remember each year based on what the stock market does.  I remember 1998 as though it was yesterday.   In 1998, the stock market had started off the year very strong with 20% gains (based on the S&P 500) in just the first four months of the year.  That was followed by a mild correction (5%).  From the spring to midsummer, the S&P had gained another 10% and was at new highs.  Just as quickly as the rally had started, it came to a violent end.  What caused this abrupt turnaround?  In August of 1998, Russia defaulted on its debt and the financial markets went into a tailspin.  Long Term Capital Management (LTCM), a hedge fund collapsed.  The Federal Reserve sponsored a bailout of LTCM by its creditor banks. The Fed intervened and said they were trying to prevent a financial crisis.  Sound familiar?  LTCM eventually liquidated in year 2000.  In one month, the market had fallen 10%.  For a month it bounced around these low levels until it eventually fell another 10% bringing the correction to 20% from peak to trough.  It bounced 10% and eventually re-tested the lows.  That was the end of the correction, not the beginning of a bear market.

I believe Russia in 1998 is today’s Greece.  The stock market was in a well defined bull market and a 20% correction came virtually out of nowhere.  However, it ended and the stock market went on to make new highs before eventually peaking in March of 2000.

Below, I’ve overlaid the 1998 stock market on top of our current stock market.  There is a very similar pattern.  But notice in August 1998 (blue line) how the market took an initial drop (10%), paused and took another leg down.  I’m not necessarily predicting another 10% fall from these levels in the stock market, but it did happen in 1998 and that was a correction in a bull market, not the start of a bear market.

There are several instances over the past several decades of corrections that look very similar to what we’re experiencing in the markets in 2010.  With that said, there are several headwinds today that are different from 1998.  In 1998, we were dealing with taxes heading down, corporate profits rising, interest rates in a long-term downtrend, and a more peaceful geopolitical environment.  Therefore, there are more doubters of the recent rally than in 1998 and justifiably so.  It’s important to constantly monitor the overall strength of demand & supply of equities rather than try to predict how investors will feel a few months from now.  Over the next few days, I’ll be monitoring that demand & supply to see if any bounces are just the dead cat variety.

In the last few weeks, we’ve seen investors shifting away from “risk” assets.  That money has gone into treasuries primarily. We’ve seen rates fall from 4% in early 2010 to it’s current level of 3.2%.  Remember in late 2008, the panic caused investors to drive treasury rates to around 2%.  Can we get there now?  Perhaps but the uptrend we’ve been for over a year now is still intact based on the MACD.  As many of you know, I’m not a person that relies on one indicator.  But, below, you can see 10-year treasuries on a monthly basis going back to 1992.  The most reliable indicator was using MACD  on a monthly basis.

We haven’t changed direction yet based on the MACD. The fear trade is currently driving rates lower.  Keep this indicator in your back pocket when you’re allocating your overall portfolio.

In the last month, we’ve seen the dollar race up over 10%, 10-year government bonds’ yield drop from 3.8% to 3.2%.  We know Europe is in big trouble, emerging markets such as China are putting on the brakes and raising interest rates.  Money is flowing INTO the United States at a feverish pace because investors want safety and they want to invest in companies that don’t sell products to foreigners (at least for now).

Let me be clear that I don’t want to build a long-term portfolio based on a rising dollar and betting against emerging market consumers.  But, for the time being, it’s working.   This led me to run a screen for the biggest U.S. companies that have 85% or more of their revenue coming from inside the borders.  See below.

A few years ago, a book was written called The Black Swan by Nassim Taleb.  The story goes that everyone always thought the only color swan in existence was a white one.  One day, out of nowhere, a black swan comes swimming in the pond.  Where did it come from?  We never knew there was such a thing.  Taleb goes on to tell various stories about chance and randomness and how we prepare for various things we think we know about.  But, what about those things we don’t know about?  There are so many things we can’t prepare for because they are unknown.  They are the “black swans”.

I live just outside San Antonio, Texas.  I bought a new home in the fall of 1998 and a month after I moved in, San Antonio had a 100 year flood.  In 2002, we had another 100 year flood.  So much for the 100 years.  Here was a perfect example of the “black swan”.

In 2000, the stock market crashed.  Granted it took awhile but it collapsed.  A once in a generation sell off… Not.  In just 8 years, it happened again.  Except this time, there was no place to hide.  Hedge funds closed down, advisors went out of business. Bonds went down, stocks went down, real estate went down.  Diversification didn’t work.  Only cash did.

Let’s go back to September 11th, 2001 for a minute.  That was a classic “black swan” event.  A plane hitting a building affected your retirement portfolio.  Who would have thought that would ever happen?  We plan on interest rates going up or down, the economy speeding up and slowing down, inflation, and deflation.  But, a plane hitting a building?  Prior to 9/11, I never met with an individual and listed out the various risks and said “don’t forget about planes hitting buildings”.  Back in the 80′s, terrorism was basically guys in the streets of some countries throwing rocks at each other.  Now, it’s a different game.

Greece…another “black swan”.  It’s spreading now and it’s affecting all the PIIGS (Portugal, Ireland, Italy, Greece, & Spain).

An oil spill,  financial reform…  Where does it end?

Because there is so much we don’t know compared to what we do know, diversification matters.  Real diversification is essential.  You’ve heard me a thousand times beat down portfolios that are just a basket of essentially the same thing.  Plenty of investors think they are diversified by owning baskets of mutual funds.  But, they found out in 2008 they weren’t really diversified.  I’ve always been a proponent of diversifying with income, some principal protection, and some investments that can give me some capital gains.

Yesterday was another one of those “black swan” events.  Out of nowhere, the market drops 1000 points in 15 minutes.  How do you prepare for that with a mutual fund portfolio?  The answer is you don’t.  For those of you who have individual bonds that were up yesterday, who owned some gold, who had a lot of cash, and some stocks, you slept well.

These “black swans” are happening a little too frequently for my blood.  Perhaps all these “black swans” are really white after all since they are now occurring with such frequency.  Investors may need to get used to the fact that it will always be something.  What will be the next crisis?  I have no idea and neither do you.  That’s why it’s so important to have an overall strategy that goes outside the stock market.

As the economy recovered in 2009, Australia was the first country to start tapping on the brakes to prevent further inflation by raising interest rates.  They haven’t stopped.  Now, we see China is tapping on the brakes as well.  For the last several years, all we heard was if you’re going to invest, it better be in “global growth”.  While this is certainly true in the long run, what about now?

The argument has been our country is driving dollars offshore.  There are billions of people industrializing.  The U.S. dollar is going to zero.  Interest rates are going to the moon and inflation is right around the corner.  But, let’s review the last few months.  Earlier this year, I discussed on a podcast that perhaps we should maybe prepare for lower interest rates in the near term, not higher.  I thought of this because literally every person I talked to then (and even now) believes inflation is here and we better prepare.  So, I first examined the contrarian view.  Since then, the numbers have proved me correct.  Inflation could be a problem down the road but even though the monetary base has exploded, the multiplier effect has been going down.  Money isn’t circulating as fast as people would have imagined.  So, we’re still in a flat to deflationary environment.  Thus, the Fed hasn’t raised rates and long-term rates have actually come down.

In the last few weeks, the Greece situation has been the hot topic and money has come out of the Euro and into U.S. dollars.  Yes, the dollar has risen.  Now, we all know the government doesn’t want this to happen.  They need a weaker dollar so we can inflate our way out of this.  But, the dollar is going up, interest rates are coming down, and the place to be is the United States of America.  Put on your global hat for a minute.  Let’s say for a minute you’re a billionaire with money and assets that have to be allocated anywhere in the world.  You look at the most exciting places to invest:  China, Latin America, India, etc.  Exciting but risky and they’re growing so fast that their government has started to put the brakes on to slow it down.  That’s typically not the best investing environment.  On top of that, some of the brightest investment minds we have are saying China is another bubble about to burst.  So, that’s out (for now).  Then, you look across the pond to invest your money.  Good ‘ole Europe.  The grandfather (or mother) of the world.  But, they’re falling apart, behind the curve, their currency is falling, and it’s just a mess.  What’s left, the United States of America.  Money is flowing into U.S. treasuries, the U.S. dollar, and stocks with limited international exposure.  Small caps, mid caps, etc. are the place to be.

If you put a gun to my head and said you can only invest in two areas for the rest of your life and you have to stick with it, what’s it going to be?  Emerging markets and materials would be my choice.  But, fortunately, we have a little more freedom than that.  So, we look for rotations and try to track where is the money flowing.  In the last month, Chinese stocks are down over 10%, the S&P is down about 2%, and the Russell 2000 (small cap American stocks) is up slightly.  The dollar is up 4.5% and 10-year treasury rates have fallen from 4% to 3.5% meaning money is coming into U.S. bonds.

I perceive this rotation as America being the hide out and the safe place to be for the short-term.  Again, this isn’t a long-term trend but it could last a while.  The global growth story is out there and has been for some time.  Now that the retail investor is catching on to this, I think we have to put our contrarian hat on for a minute.  The place everybody likes to bash is the place attracting the capital.  The U.S. of A.

For well over a year now, the economy’s been recovering, the stock market’s been recovering, confidence has been rising, and the perception of risk in the stock market has been dropping at a rapid rate.  Just look at the VIX (the volatility index), or the price paid for options.  It’s dropped over 80% since the fall of 2008.  Money’s begun flowing back into the stock market.  If you’re in cash, you’re an idiot (not really but that’s how they want you to feel).  The pressure to own stocks has been extremely high.

A couple of weeks ago, Goldman Sachs (GS) got hit with a lawsuit from the SEC.  The market fell but bounced right back up like a championship fighter getting a cut and shaking it off.  But, the combination of Goldman Sachs testifying and getting grilled by Congress, Ben Bernanke saying our deficits could mean higher taxes, interest rates, & lower benefits, and Greece & Portugal’s debt being downgraded was too much.  The Dow Jones was down over 200 points (the biggest point drop since January) and volatility index spiked up over 30% on Tuesday.  It was like the market had been in a trance and someone snapped their fingers in front of its eyes.  Oh yeah, stocks do have risk.  They can go down.  It’s amazing how sentiment can change so fast.  The world felt like it was ending on Tuesday.  It’s not ending but we could have a meaningful correction.  After all, there hasn’t been a 10% correction in the indices since the rally started in March of 2009.  Is this normal?  Partially.

After a major collapse and recession like we had in 2008, it’s common for the Federal Reserve to pump money in the system and “put America back to work”.  With that comes a rebound not only in the economy but the stock market.  We’ve had plenty of rebounds over the last 100 years.    This one isn’t necessarily longer than most (over one year now) but the trajectory of the recovery has been amazing.  The persistent buying has been rather remarkable.  It’s akin to the late 1990s bull market.  Stocks aren’t necessarily as expensive as they were then, but I don’t think they’re dirt cheap either.  In fact, when looking at how expensive stocks are measured by the P/E ratio of the S&P 500, investors are still paying less and less for stocks.  This is a common trend where investors will continually pay up for stocks for several years and that is followed by several years of investors wanting a better deal.  Instead of looking at the P/E ratio on a daily basis, below is a 10-year moving average of the P/E ratio on the S&P.  Before you send me e-mails about how P/E ratios don’t really matter.  I’ll agree that it’s not the end all be all of valuating a company or the stock market.  But, it’s one metric and its part of the overall equation.

You’ll notice that investors had a big headwind during the 1970s because while stocks went up and down, the P/E ratio continually pushed lower making it difficult to buy and hold stocks and see them appreciate.  The 1980s and 1990s were just the opposite.  Not only were corporate profits rising, but investors were more willing to assume risk and pay more for those profits.  However, after peaking around 23 or so in 2002, the 10-year moving average P/E ratio on the S&P 500 has been falling and is now down to 19.  It would not surprise me if this continues to fall over the next several years based on history.

The point of showing you this is not to assume you won’t make money in stocks but to show you how valuations do matter over a long period of time and it’s like a freight train.  Once it starts moving in one direction, it’s hard to slow it down.  Combine that with higher tax rates and potentially higher interest rates, and it could be an interesting decade for stocks.  One that begs we pay attention and don’t assume.  Those are the longer term challenges.

Getting back to the current market action, the lack of a correction doesn’t guarantee one.  I’ve heard the argument for lack of volume for over 12 months.  I’ve heard the argument that it’s been XX days since a correction, therefore we have to have one.  Does it feel like we’re due for one?  Sure.  In fact, it seems like everyone is now agreeing on the same story.  The economy’s recovering, we’re due for a correction, and once we have that minor correction, we’re off to the races again.  Heck, I agree with that, which is where the contrarian in me comes out.  Everybody agreeing with each other does concern me.  However, instead of getting into the psychological games with myself, I’ll rely on the same several indicators that have helped me make money during this run.  I can still see that there is more demand for stocks and less supply overall.  That points to higher prices over the medium term.  If you’re holding some cash, continue to average in which I’ve been advocate of for several weeks.  If you’re 100% invested, cull out weak stocks and sectors and take profits on specific positions.  We are still overbought in the very short-term and I certainly don’t have a problem with those wanting to short for hedging purposes or a trade, but I think hanging on to shorts too long might be a losing battle.