Cooperative Holiday Season Expected, But New Year Brings Challenges

With only 27 trading days left in the year, we foresee the equity mutual funds and hedge funds catching up on performance by buying on dips and taking the market as high as they can before the end of the year, possibly upwards of 11,000 on the Dow and 1150 on the S&P.  We also anticipate volatility as the market gurus forecast 2010.  Through the holiday season, the atmosphere for the markets should be mostly positive as a result of working middle- and upper-class Americans feeling more comfortable spending on purchases that they have postponed.  This will keep confidence up and assist the retail sector, leading to a cooperative stock market for the rest of 2009.

Although we believe that the worst is behind us and that the market should inch higher for the remainder of the year, the beginning of 2010 will present several challenges and the high probability of a significant correction.  Furthermore, a repeat of the past eight month’s market performance is highly unlikely.  As such, we plan on moving portfolios toward more defensive asset allocations once the New Year is upon us.  As always, we will continue to buy high dividend stocks and covered calls to protect our positions.  We will trade the ranges with all of our core stocks and maximize profitable trades for all accounts.

While it is true that the major indices have risen mightily from their 52-week lows, it is also true that the global recession of 2008-2009 has left the economies of the world with several fundamental and systematic lingering effects that may take several more years to resolve.  Our current concerns regarding the US economy and its effort to fully recover are focused about consumer confidence, unemployment, and the strength of the dollar. 

Third quarter Gross Domestic Product (GDP) figures showed that the US economy grew at a rate of 3.5%.  This prompted Fed Chair Ben Benanke to proclaim that “From a technical perspective, the recession is very likely over at this point.”  While the first positive reporting of GDP since the second quarter of 2008 obviously came as great news, a large portion of the growth came from short-term government programs and other initiatives, such as Cash for Clunkers, public works projects, and aid to state and federal governments.  According to Christina Romer, chair of the White House’s Council of Economic Advisors, the stimulus added between 3% and 4% to the quarter’s growth, which shows that the economy would have shown little to no growth without the bump received from government spending.  Consumer spending, on the other hand, rose by 3.4% for the quarter, the biggest increase in nearly three years.  Its portion of GDP accounts for about 67%, still below its 71% share held only a few years ago.

Other upbeat news includes the Conference Board’s Leading Economic Index (LEI) rising for the sixth straight month in September with its largest six-month gain in 26 years.  Additionally, corporate earnings for the third quarter were largely positive, with 80% of companies beating earnings estimates and 48% beating revenue estimates.  The theme from most executive commentary was that the worst is behind us and that they are seeing signs (although tenuous in some cases) of improvement in 2010.  As a result, the market has had enough fuel to warrant its continued run higher.

Unfortunately, there are a few major hurdles that must be overcome before the US economy can truly be deemed healthy, namely unemployment and the strength of the dollar.  The Bureau of Labor Statistics recently reported that the number of unemployed persons increased to 15.7 million, bringing the unemployment rate to 10.2%, its highest level since April of 1983.  Since the start of the recession in December 2007, the number of unemployed persons has risen by 8.2 million, and the rate has grown by 5.3 percentage points.  Regarding the subject, The Economist wrote that “the grim milestone demonstrates that, even though the recession is apparently over, for the average worker it remains in force.”  We agree, as it is difficult to imagine a true recovery in which the average individual or someone in his or her immediate family is unwillingly unemployed.

Our second concern threatening the reemergence of the US economy is the strength, or more accurately, the weakness, of the dollar.  Now this concern is really a double-edged sword because there are pros and cons to each perceived type of dollar.  For example, when the dollar is strong, our dollars are able to buy more foreign goods, thus keeping inflation in check and making dollars more valuable in the global economy.  On the other hand, a weak dollar will make US goods more competitive overseas to increase exports and induce foreign investment.  It also creates inflation and makes importing goods, such as oil, more expensive.  As Exxon Mobil CEO Rex Tillerson suspected, “If you put the price of oil, which is priced in dollars around the world, and if you look at what some of the currency effects are with the weak dollar – in our view that is contributing about $20-25 a barrel to the price.”  That’s 25% to 30% of the value of oil coming directly from recent currency effects!  Additionally, you can easily see what the weak dollar and federal financial concerns have done to the price of gold, which is currently priced at over $1160 per ounce and makes new record nominal price highs almost every day.  As a nation with a heavy debt burden, it is no accident that the Federal Reserve has devalued the dollar and kept interest rates at all-time lows; however, in the long-term, a strong dollar is desired because it shows global faith in the stability of the economy and controlled inflation expectations.

It has been almost a year since the Federal Fund interest rate was reduced to 0%-0.25% emergency levels and the Federal Open Market Committee ( FOMC) has unanimously decided to continue this policy.  The question now becomes when economic improvement will necessitate raising interest rates from current exceptionally low emergency levels.  Liz Sonders, Schwab Senior Vice President and Chief Investment Strategist, believes that the Fed will raise rates sooner than many believe, perhaps as soon as the first quarter of 2010, and that it would be worse news if the economy justified 0% interest rates too far into the future.  Immediate benefits to increased rates include the following: increased money market, CD, and savings account rates; stabilization of US dollar; and limiting the risk of more asset bubbles and a higher degree of economic instability that comes with staying at 0% for too long.

Finally, I would like to take this opportunity to wish you and your family a Happy Thanksgiving and to thank you for allowing us to serve your financial needs.

Wall Street’s Summer Rally

Following our latest economic outlook post, the S&P 500 fell 67 points to 879, plummeting through the 890-950 range that contained it for more than two-and-a-half months.  Just six sessions later, though, it had soared higher to the top of the range.  Since then, it has proceeded to continue riding momentum to a level of 1010.  The question becomes whether the March-May run was the first leg of a new bull market, followed by a 10-week consolidation, and now the second leg of the bull.  At this time, we do not foresee a new bull market; however, it is possible to see a fun summer rally for another 5 to 10%, especially given the amount of short-covering that is occurring from hedge funds.  This is a traders’ market and we are continuing to take advantage of the volatility.

On the technical side, the following points in the S&P mark the most widely cited levels of overhead resistance, some which we just broke through today:

1000 is deemed “psychologically important,” just as it was on the way down.
1006 provides chart resistance from the early November high.
1007 is the 38.2% retracement line of the 1982 to 2007 bull market.
1008 sets off trend line resistance from the early May high.
1011 is a Fibonacci extension resistance based on recent consolidation width.
1016 is the 38.2% retracement line of this bear market, so far.
1150 marks the down trend line from the 2007 top.

If we can maintain a level above 1016 on the S&P 500, we could see Goldman Sachs’ near-term targets of 1050-1100 on the S&P 500 and 10,000 on the Dow.  Should this occur, we would then recommend extreme caution, as the country will still be faced with the grim reality that when the rally is over the economic recovery will be going at a snail’s pace.  Specifically, we feel there are still risks to overcome before the economy begins to fully recover, such as the diminished likelihood of near-term rebound in consumer spending, unsustainable profits based principally from corporate cost-cutting, the expensive and controversial health care package, increasing default rates of commercial real estate and consumer finance securities, and a slower than expected recovery in residential home sales.

Earnings season has shown us that companies have taken drastic actions to beat expectations and maximize profits.  Unfortunately, the largest cost-cutting measure that has enhanced earnings is layoffs.  In other words, while companies have typically had reduced revenues, their earnings are higher due to trimmed payroll expenses.  These sorts of corporate earnings victories are not sustainable in the long-term and re-focus our attention to the most important figure to track, unemployment.  Today’s unemployment report showed that 247,000 jobs were lost in the month of July, a vast improvement from prior months and better than most analyst expectations.  Hopefully job creation is right around the corner, although most signs point to that occurring only once businesses feel comfortable about their outlook in a post-recovery economy.

On a related note, consumer spending, which accounts for two-thirds of domestic output, has taken a hit during the recession as individuals cope with the realities of decreased income and the need to increase savings.  As a nation highly dependent on consumers for economic growth, it follows that the economy cannot fully recover without consumers recovering first.  For that to happen, a drop in the levels of both unemployment and the underlying fear of unemployment are crucial.

While we are confident that the economy has stabilized significantly and made vast improvements from its gloomiest days of the economic meltdown, there are simply too many reasons to remain cautiously prudent and avoid getting caught up in the “irrational exuberance” of the market, especially if we reach Goldman Sachs’ target levels.  Last week, second quarter Gross Domestic Product came in at -1%, which was slightly better than expectations.  We are hopeful for the return of positive GDP for the third quarter with continued growth into 2010.  In summary, if the upper ranges are broken we can take advantage of a further rally; however, signs of a slow recovery will eventually lead to a correction, especially when Congress is back in session.  Such events, of course, would provide a good opportunity to protect your portfolio from the downside.  The recovery is certainly an ongoing process and we will continue to provide updates on our economic outlook and investment strategies.

As Seen In Forbes… TMG a Leading Provider of Wealth Management Services for Two Years in a Row

As was published in Forbes Magazine, we are pleased to report that Tellone Management Group was selected for a second year in a row as one of the leading Wealth Managers of Southern California.  For more details, please view a copy of the press release of this recognition (see below).

Equally exciting is Charles Schwab’s limited time “Make the Move” promotion.  In an effort to assist clients in this challenging financial environment, any new-to-Schwab clients that open an account with Tellone Management Group prior to December 31, 2009 will be reimbursed on all transfer of account fees and waive all security fees on executed trades through June 30, 2010.  This combination helps offset the cost of transferring assets and enables us to more economically invest cash and rebalance your portfolio.  Furthermore, as a firm that actively works to increase client account balances through short-term trading opportunity, we believe that this offer provides incredible value to potential clients.  For those of you with friends and family that may benefit from this unique opportunity, please know that we welcome referrals and the chance to help individuals who can profit from our wealth management experience.

Tellone Management Group, Inc. Selected as One of the Leading Wealth Managers of Southern California

Anaheim Hills, CA, June 25, 2009 – Tellone Management Group, Inc., a provider of personalized Investment and Financial Planning services for over 30 years, has recently been selected by Goldline Research as one of the leading Wealth Managers of Southern California for 2009.  Following last year’s recognition in Goldline Research’s “Most Dependable” series, this marks the second consecutive year in which Tellone Management has been evaluated by the independent market research firm and satisfied its strict benchmarks to be deemed among the best in the wealth management industry.  The list of Southern California Wealth Managers receiving this distinction can be seen in the June 22nd issue of Forbes Magazine.

During the course of Goldline’s research study, which was conducted from late March 2009 through mid May 2009, more than 2,100 Securities and Exchange Commission (SEC) registered investment advisors (RIA’s) and more than 5,100 individuals holding the Certified Financial Planner (CFP®) designation in the region were identified and evaluated.  Out of that substantial and diverse group, a total of ten firms were chosen to comprise the list of “Leading Providers.”  “Those selected provide extensive client service that exceeds the industry standard,” said George Shaeffer, Analyst for Goldline Research. “We believe that they are setting the benchmarks for the industry as a whole.”

Dean Tellone and Steven Wolfe, wealth managers at Tellone Management, expressed their thoughts on the firm’s recent recognition.  “Our mission has always been to increase our clients’ wealth while providing excellent service for their financial needs.  By applying a direct managed account approach rather than relying on a mutual fund management style, we were able to protect our clients’ assets during a very difficult time in our country’s history.  We are proud that our dedication and integrity have been noticed.”

About Tellone Management Group, Inc.

Tellone Management Group’s team of professional advisers has been providing wealth management services since 1975.  The Anaheim Hills based Registered Investment Advisor offers services in the areas of finance, tax, and estate planning, manages over 800 accounts through Schwab Institutional, and controls ten successful investment partnerships which provide varying degrees of financial investments in stocks, bonds, and mortgages. Using active investment strategies, Tellone Management provides added value to their client accounts by quickly adapting to the current market environment with a dual emphasis on short-term trading and long-term investments.  Above all, they work to maximize net-worth by integrating a personal and comprehensive financial program.

About Goldline Research

Goldline Research (www.goldlineresearch.com) is an independent market research firm that specializes in evaluating professional services providers to help consumers identify and select leading services firms. Goldline Research’s proprietary research process includes market analysis, individual company interviews and, in many industries, interviews with consumers of those services to gain feedback on market conditions and provider service levels. Goldline Research’s lists have been published in leading publications including local, regional and national magazines.

Too Far, Too Fast

We have been waiting to predict the next move in the market, but current technical and fundamental data is flashing warning signs of a near term pullback.  The question is: When will this downturn take place?  Since the S&P’s low of 676 on March 9, the market had soared upwards 40% to 946 over the past three and a half months.  Yet, the past five weeks of the rally have shown a clear range, with support levels around 890 and resistance around 950.

During the recent rally, we have witnessed a reduction in the extreme fear generated by the fall of Lehman Brothers and the accompanying financial crisis.  Such measures confirming fear retreat include the falling volatility index (VIX), decreasing credit spreads, and rising Treasury yields.

The reality may be, however, that the market has come too far, too fast.  While cognizant of the fact that the market tends to lead the economy by three to six months, we simply do not see the type of economic recovery that has been built into current market prices.  A survey from our business-owning clients confirmed this belief, as the general consensus was that they do not see their businesses getting any worse, yet they do not see the level of optimism that Wall Street has been projecting.  Much of the optimism from the market centers around a recovery in corporate profits, but according to Doug Kass, founder and president of Seabreeze Partners Management, “63% of companies in the S&P 500 missed first-quarter revenue goals, but 67% beat profit expectations.  That smacks of accounting games and unhealthy cost cutting via layoffs, not real progress.”  Additionally, as NYSE volume has lightened up from its March 20 peak at 2.4 billion to its 20-day exponential moving average of 1.3 billion, buying pressure has eroded from its recent highs, and selling pressure has continued to move sideways; we tend to believe that momentum may be exhausted for now.

From a financial planning standpoint, one positive note that has come from the recession has been consumer deleveraging, which can be seen from a 5.7% savings rate reported in May, and is a vast improvement from the negative rate of last year.  Unfortunately and ironically, what is good for the individual is not necessarily good for the economy in the short-term, as this increased emphasis on postponing discretionary spending essentially hurts corporate profits.  In the long-term though, it will be good to get away from a debt-based economy.  However, the U.S. government continues to print money and spend at an increasingly alarming rate. This has led Federal Reserve Chairman, Ben Bernanke, to encourage Congress to confront spending issues, including Social Security and Medicare, highlighting that a crucial component was the setting of tax rates that “achieve an appropriate balance of spending and revenues in the long run.”  According to Liz Sonders, Senior Vice President and Chief Investment Strategist for Charles Schwab, “While we have few doubts that some government action was necessary to address the financial crisis, the danger is that the U.S government won’t know when, or how, to stop its interference in the private markets.”  We will see how this all plays out.

In the meantime, with unemployment and debt keeping consumers on the ropes and our recent occurrence of big moves off the bottom, the potential for revisiting the lows and disappointment in economic results remains a real threat.  Therefore, caution is warranted.  We continue to use covered calls to protect our high dividend stock holdings and have used puts and Proshares to hedge our gains.  As always, we continue to trade the ranges and stay diversified with gold stocks to enhance our clients’ yields.  For any specific questions, call us if we can be of assistance.

Getting Closer to the Bottom

According to the National Bureau of Economic Research, the recession in the United States officially began in December of 2007.  Over the last 15 months, we have watched the market react violently to the economic slowdown.  Just last week, the Dow Jones Industrial Average reached its 12-year lows, thus bringing us back to levels that we have not seen since 1997.  Todd Kenyon of Seeking Alpha writes that “since 1900, there have only been two occasions where the Dow cracked 12-year lows: April 8, 1932 and December 6, 1974. In the first case, it occurred 3 months prior to the bottom. In 1974, it marked the exact bottom.  In each case, the recession still had months to go, and unemployment was months from peaking.  In 1974 the market rocketed 45% in six months, and about 65% in 15 months off the bottom.” 

Throughout this process, we have been waiting for the market to reach attractive levels while maintaining downside protection for our client accounts.  While we are not attempting to call the bottom, we do feel that the Dow has major support and unbelievable values at or near 6000.

For those with employee sponsored retirement accounts, such as 401k plans, we advocated a switch to a more conservative mix of cash and fixed income in the last blog.  At this point, we now suggest that new contributions per pay period be directed toward income and growth stocks.  Similarly, we recommend that our clients with mid- to long-term time horizons start dollar cost averaging back into the market with a low of 6000 in mind.  It is important to understand that everyone’s financial situation is unique and there is no single strategy that works for everybody.  For those clients looking for assistance and guidance regarding 401k/403b asset allocation, we would be happy to help you assess your options.

We still believe that the economy will start to show signs of life, especially within real estate, beginning in the summer.  We expect any improvement in GDP to be gradual as consumers and companies deal with the credit market realities and the new saving mentally of the American people.  However, once we start hearing positive news and investors feel confident that we have put in a final low, we will then witness a much improved market.

In an effort to facilitate this upturn and help bring the GDP back to its long-term growth potential, President Obama signed the 2009 American Recovery and Reinvestment Act into law on February 17.  The economic stimulus package consists primarily of individual and corporate tax relief, infrastructure projects, and help for state and local governments.  To read a brief overview of the package, please click here.  The Obama administration believes that the keys to resolving the crisis revolve around shoring up lending, stabilizing housing prices, and reducing unemployment.  The Tellone Management Group investment team, as well as investors throughout the world, will continue to monitor their performance in these areas.

Don’t Try to Call the Bottom

Since our October market update in which I stated that this is the worst financial crisis I have seen in my thirty years as a wealth manager, both consumers and investors are more scared and have retreated even further. The big three U.S. auto companies are in trouble and the markets have made lower lows. Until we see a solid bottom, caution is warranted.

I have recommended our 401K investors to be in fixed income or cash until the dust settles. With the markets trying to find a bottom and the possibility of much lower lows, we sold most of our mutual funds (representing about 10% of our portfolios) in last week’s rally. I have been very disappointed with their ability to protect their investors on the downside. By selling we can lock in capital losses to combat potential tax increases with the Obama administration. What is working well for us is our intraday trading and protecting our portfolios with ultra short Proshares positions.  We are very active in protecting our investor’s principal, as I feel it is better to be safe than sorry. The economy is not going to turn up for a while and we are going to hear negative news from different sectors that are adversely affected by the recession. However, I am anticipating that the markets will present great opportunities going into in the second quarter of 2009.

In other news, a new year is approaching and with this new year comes a new President and administration, and more importantly, new tax policies.  While President-elect Obama has not been specific with details or commitments, the hints he has dropped indicate that the tax increases he campaigned with will most likely be postponed until after 2009.

Even with this uncertainty, it is prudent to take action now and help shape your income tax liability for 2008.  Here are some traditional tax strategies to consider:

• Income deferral into 2009.
• Pay deductable items before the end of the year, such as property taxes, the January 2009 mortgage payment, charitable contributions, state income tax estimates.
• Analyze your stock portfolio and consider tax loss harvesting to offset any stock gains from earlier in 2008.
• Max out your 401K deferral with your employer.
• Business owners should consider any new equipment needs and purchase this year instead of 2009.

These are only a few but enough to start us thinking about tax savings.  For more detailed information on 2008 strategies and tax law changes, check out the “Year-End Tax Planning for Individuals” article, which is located in the news and resources section of the Tellone Financial Services website.  For questions more specific in nature, don’t hesitate to call.

Time Will Restore Confidence

In our August market update we stated that we felt the financial stocks had more surprises like that of Lehman Brothers, but the fall out here and abroad has been much worse on the financial markets than originally expected.  In my thirty years in the wealth management business, this is by far the worst financial crisis I have ever seen. However, I am optimistic that the worst is behind us. Time will restore confidence and successful testing with higher lows will stabilize our markets going forward. We are witnessing history in the making with this market. As a result, the economy has increasingly become the main issue facing our presidential candidates. Here is a quick rundown of the main events that have occurred during this turbulent time:

 

• Sept. 7: Government takes control of Fannie Mae & Freddie Mac
• Sept. 11: Lehman Brothers says it is looking to be sold
• Sept. 14: Bank of America purchases Merrill Lynch for $29 per share
• Sept. 15: Lehman Brothers files for Chapter 11 bankruptcy
• Sept. 16: Government provides $85 billion emergency loan to rescue AIG
• Sept. 17: Barclays buys Lehman Brothers’ North American banking division for $250 million
• Sept. 19: President Bush stresses need for a bailout plan to confront the financial crisis
• Sept. 21: Goldman Sachs and Morgan Stanley become bank holding companies
• Sept. 24-27: President Bush, Barack Obama, John McCain, and other Congressional leaders work to create an acceptable bailout plan
• Sept. 26: Washington Mutual becomes the largest thrift failure and bank operations are subsequently acquired by JP Morgan for $1.9 billion
• Sept. 29: Citigroup makes bid to acquire Wachovia’s banking operations for $2.1 billion in stock; Bailout package is rejected by the House of Representatives; The Dow falls 777 points, which is the largest one-day point drop in history
• Oct. 1: SEC bans short selling against 800 financial companies until bailout pact enactment
• Oct. 2: The US Senate votes in favor of the Wall Street bailout plan
• Oct. 3: The House of Representatives passes an amended bailout plan and President Bush signs the historic $700 billion Troubled Asset Relief Program; Despite Citigroup’s previous offer, Wells Fargo acquires Wachovia in $15.1 billion all-stock deal that includes no FDIC assistance
• Oct. 6-10: The US stock market has its worst week ever, falling 18.2% in five trading days
• Oct. 9: The International Monetary Fund announces emergency plans to bail out governments affected by the financial crisis, after warning that no country would be immune from the ripple effects of the credit crunch
• Oct. 10: The Dow falls nearly 700 points to 7882 in the first few minutes of trading, rises over 1000 points, and falls again to close down 128 points
• Oct. 13: The Dow rises by 936 points to 9387, its biggest one-day gain by points and largest daily jump in percentage terms since 1933

 

Over this time period, we have surely seen our financial markets tested and the media has been quick to equate this downturn with that of almost Great Depression-like proportions.  The good news is that this is no Great Depression and while the economic situation is not ideal, the United States will recover stronger than ever with better values. We feel we are currently seeing the final capitulation needed to bring us back to a stable stock market. This term refers to when investors log in to their accounts to sell everything across the board, market orders, current price, wherever – just get me out!  When people say they’ll never touch the stock market again, that is when we have capitulation. This activity, though, generally occurs at the bottom because it both exhausts selling pressure and causes bargain hunters to enter the market to buy stocks that are deemed to have tremendous value.

Of course, having access to cash is exceptionally important during any type of market.  As a good part of a balanced financial plan, we recommend keeping any money you might need in the next year or two in low risk investments, such as our Tellone Mortgage Fund. Conversely, having too much cash because of a stock market downturn has its downsides, including missing out on any opportunity that comes when the market recovers and paying additional transaction costs to make the switch.  Most of the stock market gains lately have come from big one-day rallies, so if you have already made up your mind and plan to sell shortly it is best to wait until the markets get overbought or at least above the Dow 9000+ threshold, which will provide a much better opportunity to sell underperforming stocks.

In general though, for the long-term investor, it is a good idea to remain calm throughout the financial turmoil (see “The Case for Stocks as a Long-Term Investment“).  Know that these periods of extended pullbacks are not uncommon and represent about 12% of the markets history over the past 75 years.  Additionally, markets tend to revert to their long-term averages, so the best strategy during rough times is to ensure that your portfolio is properly diversified in order to capture any rebound.  The market is currently anticipating a recession, so we are focusing on stocks that are oversold and will do well through the recession. We believe that holding what is already way down is a good idea.  You should also take advantage of undervalued stocks that have a great future, as the investment outlook is much better today than it has been in several years.

We have been taking advantage of the extreme volatility to enhance our short-term trading strategy by utilizing Ultra Short Proshares to hedge our portfolios and make money on the downside. However, we have not been happy with the performance of mutual funds (about 10% of our total assets) because they have not protected principle the way they should. We are sticking with stocks so we can protect our downside. It will take several months for this financial turmoil to pass, but America will be better and stronger and the world will be more united.

The Case for Stocks as a Long-Term Investment

The following is an article entitled “The Case for Stocks as a Long-Term Investment.”  It was written on October 10, 2008 by Mark W. Riepe, CFA, who is the Senior Vice President of the Schwab Center for Financial Research.  We believe that this is an excellent piece for all investors with long time horizons because it stresses the potential benefits of staying the course and remaining invested in the market during this extremely volatile time.

It’s been a tumultuous time in the markets, for sure. While it’s important to learn from the past, good investing requires more than looking in the rearview mirror. You’ve got to keep your eyes on your long-term goals. Even if the recent market plunge set you back, you can still achieve those goals if you keep saving and investing in a disciplined, diversified manner. We believe that for the vast majority of investors, this means not abandoning the equity markets, even if your gut is telling you to do just that.

Here are five reasons why we believe sticking with equities makes sense for most investors.

1. Cash may feel safe short-term, but long-term it’s far from it. Right now, returns on money markets and Treasuries are negative after inflation. So, rushing to cash is not a very sound long-term investment strategy. Of course, everyone needs an emergency fund of three months of vital expenses in case you hit an economic bump in the road. And for that, money market funds or interest bearing FDIC-insured checking deposits work well. If you’re retired, we think you should also have a full year’s worth of spending in cash, so you don’t need to pull money out of your equity portfolio during a bear market, thereby undermining your portfolio’s long-term growth potential. As you can see in the graph below, cash has significantly underperformed stocks over time, and is the best defense against the ravages of inflation and taxes.

Equities have been the best defense against taxes and inflation

2. Stocks are volatile over the short-term, but long-term they remain the key to portfolio growth. As you can see in “Equities Have Outperformed Other Asset Classes” below, stocks (both large-cap and small-cap) have dramatically outperformed bonds and cash over time. During a down period like we’re in, it feels like “this time is different.” But is the present time really so different? The graph below includes periods such as the Great Depression, three major wars (World War II, Korea, and Vietnam), oil embargos (1973 and 1979). In all cases, the equity markets have demonstrated short-term vulnerability, but long-term resilience.

Equities Have Outperformed Other Asset Classes

3. Market rebounds historically have preceded economic rebounds. We believe the economy has been in recession since late last year, putting it at the average length for post-World War II recessions. As you can see in the chart below, which combines all of the 10 prior recessions into a single average line, the market typically peaked about seven months before the recession began, but bottomed quite decisively by about six months into (or 60% of the way through) the recession, with an average peak-to-trough decline of just under 25%.

S&P 500 Performance Pattern Around Recessions

Indexed price-only data from 1947-March 31, 2002. Source: Ned Davis Research, Inc.

Now let’s break that trend down into all 10 recessions. As you can see in the table below, three months after the trough (but still in the throes of bad economic news), the market was up an average 16%, six months later up 24%, and a year later up 32%.

S&P 500 Performance Following Recession Lows

	S&P 500 Percentage Gain
S&P 500 low date in recession	3 months later	6 months later	9 months later	1 year later
06/13/49	15%	19%	27%	34%
09/14/53	10%	18%	28%	39%
10/22/57	6%	10%	19%	32%
10/25/60	16%	25%	28%	31%
05/26/70	17%	21%	39%	45%
10/03/74	14%	30%	52%	35%
03/27/80	18%	31%	39%	37%
08/12/82	38%	42%	61%	58%
10/11/90	7%	29%	29%	29%
09/21/01	18%	17%	3%	-14%
Mean	16%	24%	32%	32%
Median	15%	23%	28%	34%

Source: Ned Davis Research, Inc.

We think this recession could be longer and deeper than average, but we do NOT think we are headed into anything like the Great Depression. Not only are we much stronger economically (see below), but there are many more safeguards in place currently to prevent a further downward spiral. Among them: FDIC insurance (which insures bank deposits for consumers who ultimately drive the economy), globalization (which provides a market for U.S. exports), more proactive countercyclical fiscal and monetary policy, and signs that housing may be bottoming.

So, if history repeats itself, the market should bounce back before the economy, and when it does, the bounce back tends to be fast and furious. If you leave for the comfort of cash, you won’t enjoy any of the rebound when it arrives. And if you think you can time the turnaround, beware. That means you have to make two timing calls correctly, getting out and getting in, which experience shows is extremely difficult. Typically, individual investors bail at market bottoms and reenter after the market has had its initial big rebound.

Recoveries are front loaded

	Average Annual Return Following Bear Market
	12-month period	24-month period	36-month period
If fully invested	47%	28%	20%
1 month of cash after bear	33%	22%	17%
3 months of cash after bear	18%	16%	12%
6 months of cash after bear	11%	13%	10%

Finally, the deeper the market has fallen, the faster it tends to come back. Schwab’s Chief Investment Strategist Liz Ann Sonders compares this phenomenon to pushing a beach ball into a pool: If you hold it lightly below the water and let go, it bounces back lightly, but push it down deep and let go, and the ball pops high out of the water. The markets seems to be much the same.

4. Long-term savings and stock investing is effective through thick and thin. We’ve experienced down markets many times before: the oil embargo of 1973-1974, the crash of 1987, the bursting of the dotcom bubble, and 9/11. But these downturns don’t have to derail your savings and investment plans. Take a look at the graph below which shows how dramatically a hypothetical and very disciplined saver was able to grow his money over 35 years, through all kinds of markets. Our fellow was making $21,000 a year in 1973 and saved and invested 10% a year. Like most of us, he had raises over time and continued to save and invest 10% of his or her pay a year over the last 35 years. In this case, with an aggressive investment mix and steady investing through some volatile times, he ended up with around $1.5 million. Why was he successful? It wasn’t because he could control the market. No one controls the market. But, you can control your level of savings and investment. In the past, these have proven to be a formidable duo, even through times as tough as we face now.

Progress Toward Goal More Important Than Short-Term Performance

5. Stocks Snapback from Fear-Driven Markets. A hackneyed phrase is that investors oscillate between fear and greed. When one emotion gets too powerful relative to the other, stock markets become volatile places. There now exists a method that some believe is a gauge of the collective fear among equity investors. This mirror into the collective soul of the investing public is called the VIX. VIX is actually the ticker symbol assigned to the Chicago Board Options Exchange Volatility Index. It measures the expectation of traders as to the volatility of the S&P 500 over the next 30 days. The higher (lower) the VIX the more (less) volatility that is expected.

Since the VIX was introduced in the 1990s, there have been a number of periods where the index has spiked upward. Typically, this has happened after periods of poor performance. The question we asked was: “How does the stock market perform after a period where the VIX has been at unusually high levels?” Let’s first focus on days when the VIX has been above 30. In the four weeks after those periods, the S&P 500 index has been up 4% on average and up 22% in the one year after the VIX has been at that high a level. What’s more interesting is that, if we restrict our focus even further to just those days when the index was 35 or higher, the subsequent upward has been, on average even higher whether we’re looking at four-week or one-year periods. Finally, on rare occasions, the VIX breaches 40. This has tended to be an even more positive development for stocks in the past. Where are we now? The VIX closed at 69.95 on October 10.

Snapback Strength

	Median S&P 500 Total Return
VIX Greater Than	Next Month	Next Year
30	+4%	+22%
35	+5%	+24%
40	+10%	+32%

While we believe equities should remain a part of the portfolios of many investors, it is important that every investor be thoughtful as to the percentage of their portfolio that should be devoted to stocks. For investors who need their portfolio within a few years, equities are rarely appropriate. For investors who are uncomfortable with the volatility inherent in equity markets, then we suggest they temper their stock exposure with investments in other asset classes (for example, bonds and cash).

It is important that equity investors maintain a diversified portfolio within the equity asset class. Equity investors should diversify across both domestic stocks and foreign stocks, across large company stocks and the stocks of smaller firms. Finally, equity investors should take care that their equity portfolio is not unduly vulnerable to poor performance in any one sector of the economy, or any one stock.

Important Disclosures

An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although money market funds seek to preserve the value of your investment at $1 per share, it is possible to lose money by investing in this type of fund.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. Any investments and strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and are not intended to imply future results.

Past performance is no guarantee of future results.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

Your Financial Security at Schwab

In light of recent financial events, we are posting an open letter from Charles Schwab, Chairman and a director of The Charles Schwab Corporation since its incorporation in 1986.  Additionally, the links provided below allow for further insight on the subject of your personal finances.

Asset Safety with Schwab Institutional

How the Crisis on Wall Street May Affect You

Perspective on the Financial Markets and Your Financial Security at Schwab

The current environment for investors is in many ways unprecedented and clearly unsettling. As a long-time investor myself, and a believer in the American economic system, I know it is very hard to sift through all the information out there and make decisions with confidence and comfort.  It is especially difficult when the news around you creates concern not just about your own financial well-being but also about the safety and stability of the financial institutions you depend on.

I would like to offer some perspective on the current environment and on Schwab’s stability and strength specifically.

Financial Security at Schwab

I want to assure you that Schwab is financially strong, that we are absolutely confident in our continued financial health, and that we take appropriate precautions to give you peace of mind about the security of your money here.

• Our capital structure and liquidity are sound.
• Our internal controls and business standards are designed to keep your assets safe.
• We have strong credit ratings from Moody’s, S&P and Fitch, the major ratings agencies.
• Your brokerage assets are held separately from the company’s assets and are protected by SIPC insurance; Schwab Bank deposits are FDIC insured.
• Schwab Money Funds all continue to meet their objective of maintaining a $1.00 NAV and offering daily liquidity for investment and withdrawal.
• Schwab money market funds will participate in the recently announced U.S. Treasury Temporary Guaranty Program.

Is this a tough environment?  Yes.  Is it a time to be rash? No. Everyone, businesses and individuals, feel the effects of this difficult credit market, no one is immune to it.  But because we’ve managed our business carefully and because of the confidence and trust that you-our clients-have placed in us, our business has performed exceedingly well, despite a market environment that is as difficult as I have ever seen.  I mention this because our track record of strong financial performance has helped support a strong and stable company and will continue to do so in the future.

As the founder and chairman of this company and a client with my own assets here at Schwab, I want to reassure you there is no other place I would feel more comfortable with my bank deposits, cash, money funds, and diversified investment portfolio.

The Markets

For this past year, the financial markets have been struggling to overcome problems that arose initially out of a collapse in the subprime mortgage market. That in turn triggered larger economic issues which have led up to the current instability in the credit markets, and subsequent crisis in the financial services industry.

How bad is it? Market cycles like this are part of the process that a free market economy goes through.  But this is certainly one of the more pronounced ones in recent memory.  The discomfort of getting through it is awful for most of us, but in the end, it is a cleansing process that removes excess from the system and returns us to equilibrium. I’m encouraged that everyone within the government is now actively engaged in working on this problem. Over the coming days we’ll learn more about the resolution and how it will be put to work.

What is our advice during these trying times? Clearly, there is no single piece of advice that applies to everyone. Each of us has our own timeframe for investments and comfort level with risk.

But having lived through market downturns like this before, I do believe that everyone should review their portfolio to ensure that their asset allocation is in line with their long term targets. And if they are aligned, stick with it. During times of uncertainty, some investors make the mistake of trying to time the market by simply stepping out. History suggests that asset allocation, diversification and periodic rebalancing are the tools that investors should use to weather market downturns. Having the right investment mix doesn’t mean that the value of holdings will never go down-but rather helps strike the right balance between risk and reward given your goals. We’re available to help with that process if you need it. 

At the same time, I am mindful that some investors have grave concerns and are looking for safety at all costs.  For those people, there are solutions that should provide them comfort.  Despite the more dramatic news over the last two weeks, there are still many financial instruments that are managed to be conservative, and there are protections in the system such as FDIC insurance for banking products and SIPC for brokerages. In addition, the U.S. Treasury Department recently announced a temporary guarantee program that provides increased protection for money market funds.

In the midst of all the negative news, is there anything to be optimistic about?  I think there are some positive signs.  I think ultimately we’ll all be a healthier society coming out of it.  I also believe everyone, both individual investors and businesses are going to put a greater focus on risk management in the future, and regulation will become better, which will be healthy long term developments.

I hope this perspective on the current situation is helpful, but please contact us if you would like additional insight or help, either on the phone or at one of our branch offices. We are here to help.
 

Chuck Schwab

Range-Bound Trading 101

Over the past month, we have witnessed a short-term rally in the market that has been driven by two main factors: increased confidence in the financial sector and a drop in oil prices.  Our strategy of trading the ranges is proving to be the major way to make profits and add value to our portfolios in this current environment and for the rest of the year.  We will explain more as you read.

The financial sector has been aided primarily by investment banks trying to move forward by selling off their worst performing assets.  One example is Merrill Lynch selling over $30 billion worth of CDOs (collateralized debt obligations) at 22 cents on the dollar.  Even though they are taking a significant loss, investors have been happy to see that these asset-backed securities that represent subprime mortgage exposure are now off the balance sheets.

Another significant event was the signing of the Housing Rescue Bill by President Bush.  The measure, which has been regarded as the most significant housing legislation in decades, allows homeowners who cannot afford their payments to refinance into more affordable government-backed loans rather than losing their homes.  Furthermore, it offers a temporary financial lifeline to troubled mortgage companies Fannie Mae and Freddie Mac and tightens controls over the two government-sponsored businesses.

While both of these developments have helped financials, we are reluctant to say that the worst is over.  It was only two weeks ago when we saw the FDIC close two regional banks, First Heritage Bank, which was headquartered in Newport Beach, and 1st National Bank of Nevada.  Therefore, we believe it is still possible that a few more banks can go under in the near future.  We don’t like how Lehman Brothers has been selling off assets; a major financial institution like Lehman would send the markets back down to the lows reached last month. We feel that could be the final wash out for the financials and would create a great buying opportunity for long term investors.

Oil reached its all-time trading high of $147.27 per barrel on July 11.  Since then, we have seen a decrease of over $30 per barrel.  This alone has been vital in stimulating the market.  The reason for this is simple; high oil prices can essentially be treated as a tax on the consumption of gasoline and other energy products.  Thus, removing the “tax” puts more money back in the wallets of consumers, who are then free to spend their discretionary money elsewhere which should help lead the economic recovery process.

In other news, we are only three months away from the presidential election on November 4.  This is significant because over the past 20 presidential elections, the market is usually in a small trading range during the period between the end of the first-half of the year and the day of the election.  Two of these election years presented double-digit gains in the S&P 500 during the four-month time frame.  The rest have remained within a range of +6.5% and -3.2%.  The thing to note is that this time period tends to translate to relatively little change in the indices, most likely because investors are taking the time to assess the candidates and their proposed policies.  Therefore, we do not expect a long-term rally to develop in the next few months due to the uncertainty of the election.  Similarly, at this point, we do not see the market reaching new highs for the year.  Nevertheless, lower oil prices combined with low interest rates would provide the basis for an improved economy next year and a much better stock market overall.

As mentioned in previous articles, we continue to like technology and feel that the Nasdaq composite will outperform both the Dow and the S&P 500 for the rest of 2008.  Above all, we are confident that our trading strategy will continue to work well and help us to maintain strong performance.  Enjoy the rest of the summer, it is going fast.