As we approach the holiday season, it reminds us that the end of the year is coming as well.  With only one month to go, it’s a natural time for investors to start to tally how they’ve fared in this difficult environment.  Some were spooked out of the market in late 2008 (with good reason) and have missed out on the entire rally.  Some, have just hung in there.  They rode it down and have ridden it back up.  While others have navigated pretty well.

But, with the new year on the horizon, fund managers, hedge fund managers, & individual investors have begun making adjustments to their portfolios.  As they do this, it’s important that we follow the money.  Over the past 10 days, the S&P 500 has struggled to go and stay above the 1110 level.  Why is this?  Isn’t the economy continuing to improve.  As you recall, the stock market is highly correlated to how fast the economy is recovering.  Up to this point, the economy was recovering at a faster and faster rate each month.  That may be behind us.  It’s not to say the economy won’t keep improving, but it may not be fast enough to sustain higher equity prices (Flag #1).

Bull markets go through many stages as they mature as I’ve discussed in previous blog posts.  I believe we are firmly in stage #2 which means much more selectivity on the part of investors.  There is profit taking, less enthusiasm for stocks, and more scrutiny.  This explains why some of the leaders of the rally since March (i.e. Goldman Sachs) have begun to lag and companies with excellent balance sheets that have lagged (i.e. Disney, Wal-Mart, & Coca-Cola) are now leading.  Having the mega large cap stocks lead a rally isn’t the worst thing in the world but it definitely tells me the character of the market has changed (Flag #2).

Let’s move to some of the technicals.  A healthy bull market is one where more and more sectors and stocks are participating.  That was the case up until about a month ago.  Now, what you are seeing is the complete opposite.  Less and less stocks are participating in the rally and the big caps are doing the heavy lifting.  Remember that most of the indices are cap weighted meaning the bigger the company, the more points they are awarded in the index.  That’s why when big caps go up, the indices go up (Flag #3).  Another healthy sign in a bull market is when there are more and more companies making new highs.  That has peaked as well.  So, the number of companies blasting through their old highs is dwindling (Flag #4).

I’m also noticing that there just isn’t the demand for stocks there was a few months ago.  Most of the up days are because sellers are pausing or resting waiting to sell at higher prices.  The demand is not there right now (Flag #5).

These flags don’t mean we have peaked.  In fact, the indices could keep making new highs for several more months.  But, when there are this many red flags and we’ve advanced as much as we have since March, you better start thinking of exit strategies.  This could simply be a major pause in a longer-term bull market.  But, given the headwinds in front of us (deficits, rising taxes, potentially rising interest rates, etc.), my bet is that 2010 will be a much different year than 2009 and this is the time to start preparing.

Happy Thanksgiving everyone!  Thanks for your support.

We often hear about the federal government contuing to keep the printing presses going 24/7.  The Monetary Base is the most common measure of this.  Over the past 50 years, the monetary base has risen about 6% per year on average.  But, you can see from the graph below it’s grown over 130% just in the last 12 months.

Just like that steroid shot when you’re kids are sick, it works in the short run and makes them feel better, but you can’t keep doing it without some long-term damage.

The Baltic Dry Index, an index that tracks the prices for shipping dry goods around the world, has risen 115% just since October 1st, causing many to believe the economy will continue to improve.  I think part of this rally in the BDI has been cause by an economic recovery and part is because the credit markets continue to ease.  This industry relies on credit heavily.

Naturally, this rally in the Baltic Dry Index has caused investors to look at the shippers as a possible investment.  But, not all of the shippers are the same.  Some shippers are very correlated to the BDI and some aren’t.  Below are just two examples, Dryships, Inc. (DRYS) and Diana Shipping (DSX).  You would think they’d both move like the BDI.  But, the pictures tell a different story.

Let’s look at Dryships first.  The picture above is Dryships compared to the Baltic Dry Index.  The BDIY is in white and DRYS is in orange.  You can see one may zig and the other may zag.  Also, the correlation is roughly zero right now meaning it’s not correlated or inversely correlated.

On the other hand, when we look below at Diana Shipping (DSX), it’s much more correlated to the BDI.  Again, in white is the BDI and in orange is DSX.  Underneath, you can see the correlation is very high.

Therefore, if you believe the BDI will continue to rise, make sure you own the right stocks that will benefit from that rise.

All the talk in 2009 has been about the weak dollar and how gold has performed.  In 2009, gold has certainly performed well, up 28%.  But, let’s look at how some other metals have performed.  It’s actually lagged.

Platinum +53% (Orange)
Silver +61% (White)
Copper + 115% (Green)

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A couple of months ago, I sold my holdings in sugar expecting some type of pullback.  The fundamentals remained strong and still do but the charts said to exit, at least temporarily.  However, I’ve kept my eyes on sugar (through the ETF SGG) to look for a new entry point.  That time may be coming soon.

When looking at the chart above, basically sugar has been moving sideways after having a huge run up in the summer.  Even though we continue to make higher lows, we’re also making lower highs.  Therefore, we’re just about to get to a point where sugar will either break down or start a new leg up.  With the fundamentals intact and the dollar continuing to weaken, new highs may be in the cards soon.  Keep an eye on this one.

When will manufacturing jobs come back to the U.S.?  That is the question I get a lot when I do speeches.  It’s a good question and one that deserves some attention.  Many believe the U.S. can’t remain a super power unless it has more manufacturing and certainly the economy can’t grow without manufacturing.

It’s no big secret that big companies will manufacture their goods the cheapest way they know how.  That has mostly been in emerging markets like China the past several years.  Just turn over just about any product, and it says manufactured in China.  Naturally, the knee jerk reaction is to say all of our manufacturing jobs are going to China and we need to get those back.  But, actually China during the last several months has lost more manufacturing jobs than the United States, even on a percentage change basis.  This is because of three things.  First, the excess liquidity and easy money caused over capacity.  There were simply too many plants built and now that demand is down, not as many plants needed.  Second, the global recession caused a big drop in overall global demand for just about everything.  Less demand, no need for manufacturing.  Thirdly, humans are becoming more efficient every year.  We’re faster and more productive and we invent computers that are faster and more efficient.  These computers continue to replace workers.  So, overall manufacturing isn’t a profession I’d want to be in over the next several years.

But, for those of you who still want more manufacturing in the good ‘ole U.S.A., here’s a bit of a change.  On Monday morning, Sun Tech Power, a solar company based in China, announced they were going to build a manufacturing plant in where?  Phoenix.  No, not some town in China named Phoenix.  Phoenix, Arizona.  Here in the U.S.  As the emerging markets continue to grow, their workers are going to require more and more money.  This will cause two things:  First, products like cars made in South Korea won’t be as cheap.  Second,  some manufacturing jobs will come back to the U.S. because they may be cheaper.

Regardless of how much manufacturing is done in the U.S., it was a pleasant surprise to see a Chinese company want to manufacture goods here for a change.

As rallies mature, they go through different stages.  First, there’s the anything goes rally where low quality investments rally along with high quality.  Mutual funds go up, stocks and bonds go up, exchange traded funds go up.  Just about every sector goes up.  It’s not about what to buy, it’s just about getting more long and reducing cash.  Then, you get to the part in the rally where there’s a little more analysis done on which company should be added to a portfolio.  The low quality stocks start falling behind and are culled out.  Companies with real sales, real earnings, low debt, high return on equity, etc. get the new money.  That’s the stage we could be entering now.  It’s not a horrible thing.  It doesn’t necessarily signal the top in the market.  But, it’s going to require you to do a lot more homework than what you’ve been used to since March.

In addition to this change that may be upon us, there is also a potential change in sector leadership.  When an economy is recovering, the types of companies you want to own are the ones that are directly tied to the economy.  These are called hypercyclical companies.  This would be a Caterpillar for example.  It could also be a technology company or a financial company.  Naturally, those have been the leaders in this rally.  Companies that are consumer non-discretionary (staples) are the ones that have lagged.  Those aren’t as sensitive to the economy and therefore don’t move up as fast when the economy is re-accelerating.  In fact, looking at this sector, it’s underperformed the S&P 500 by about half since March.  But, in the last few days, I’ve noticed a rotation.  Perhaps investors are beginning to worry that the end of the recovery is near.  They don’t want to exit stocks, but just change which ones they own.  Consumer staples can hold up better in a rising rate and/or a sluggish economic environment which I think 2010 could look like.

Keep an eye on this rotation along with a rotation out of junk and into higher quality over the next few days and weeks.

On Wednesday evening, Hewlett-Packard (HPQ) announced it was buying 3Com (COMS) for $2.7 billion in cash, a 35% premium over its closing price.  This will enable HP to sell just about everything for data centers, from servers, storage, management services and networking.  This deal is expected to close in the first half of 2010.  This deal is raising eyebrows for a number of reason.  First, it was all cash and a big premium over the closing price.  Second, this wasn’t the company many believed would be bought out.  Third, the options trading before this deal was announced has many believing somebody knew something that you & I weren’t privy to.  Something stinks.  I’m sure there will be an investigation.

The ball is now in IBM’s court whether they want to make an acquisition and there are rumors that Brocade is the company they may target.  But, investors need to focus on the bigger picture.  The M&A activity is heating up and it has been for some months.  The credit markets have been easing allowing more deals to get done and company’s are anticipating a slower growth environment.  Therefore, the bigger companies with lots of cash are using that cash to acquire growth.  I think this will continue into 2010.

Where you & I can benefit is by focusing on where the action might be for the next acquisition.  Sure, we could speculate on individual companies.  But, that’s exactly what that would be, speculation.  We know there are going to be more deals.  The easier way to benefit from the acquisitions is to buy a basket of companies that are prime.  The place I think that has the most potential is the midcap growth area.  These companies are big enough to matter to a big company, but small enough that the big companies can afford them.

Not only can we benefit from M&A activity by purchasing medium-sized growth companies, but these buyouts help the overall market.  It builds confidence that if big companies with lots of cash are finding values and pay big premiums for companies, then surely there are a lot of companies undervalued.  Hence, a higher market.  One more positive for the market.  Add it to the list.