Investment Postcards from Cape Town

Yesterday was another ugly day for stocks, with bourses around the globe falling victim to strong selling pressure. Fueling the sell-off were concerns that the economic recession could not only be deeper and longer than previously feared, but also fall into a corrosive deflationary phase.

The MSCI World Index and the MSCI Emerging Markets Index fell by 4.6% and 2.2% respectively, tallying declines of 51.2% and 63.4% since the peaks of these indices in October 2007. Only the Chinese Shanghai Composite Index (+6.0%) and the Russian Trading System Index (+0.7%) bucked yesterday’s declines.

Click here or on the thumbnail below for a (very red) market map, obtained from Finviz, providing a quick overview of the performance of global stock markets (as reflected by the movements of ADR stocks).

As far as the US markets are concerned, the Dow Jones Industrial Index (-5.1%) plunged below the roundophobia 8,000 level, resulting in all the major indices now trading below the recent lows of October 10 and 27. This brings the lows of 2003 (Dow 7,524; S&P 500 801) and 2002 (Dow 7,286; S&P 500 777) into sight. A breach of these levels – frightfully close to the current levels of the Dow (7,997) and S&P 500 (807) – will wipe out the entire five-year bull market from 2002 to 2007.

Interestingly, only 2.4% of the 500 S&P 500 stocks now trade above their 200-day moving averages. This line is often used as a crude indicator of the primary trend of a market or individual stocks. The graph undeniably shows an extremely oversold situation, but bear markets have been known to stay oversold much longer than usual.

One can argue long and hard about valuation levels and earnings forecasts, but the extent to which stocks become undervalued in the grip of this bear is squarely in the hand of the severity of the economic meltdown. This is clearly shown by the relationship between the Dow Jones World Index and the Baltic Dry Index – an assessment of the price of moving the major raw materials, including coal, iron ore and grain, by sea and generally an excellent barometer of economic activity.

The worrisome prospects for economic and earnings growth, together with the threat of deflation, are spooking the financial markets. The extreme level of risk aversion is illustrated by the US three-month Treasury Bill rate falling to a minuscule 0.065% – a clear sign of distress and fear – and the yields on long-dated government bonds falling significantly in most parts of the world.

Here is what Richard Russell (Dow Theory Letters) – one of the few market commentators with first-hand experience of the Great Depression – has to say: “The market is warning of a coming depression. Next year there’ll be a huge problem of unemployment, job openings will have disappeared, and every business will be going over its personal thinking in terms of who the business can do without.

“The sentiment in the country will be dark grey to jet black. Fortunes will have been wiped out. Thousands of savings plans and 401Ks will have been shattered. Americans who have never experienced true hard times will be living hard times. Confusion and fear will be rampant. How do I know all this? I’ve been here before, I know the signs.”

Oversold conditions have so far not produced more than a temporary reprieve, and nobody knows how far down this bear market will fall. Until we see more signs of base formations being developed, one should tread very cautiously. And remember the old Boy Scout adage: “Be prepared”.

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Donald Coxe’s monthly investment report, entitled “Basic Points” (subtitled “Capitalism Faces Its Greatest Challenge” for the November 2008 edition), has just been published. He is Global Portfolio strategist of BMO Financial Group and widely followed for his “big picture” views.

Like many commentators, Donald was caught by surprise by the rapid financial meltdown and plunging commodity prices. He said: “… we certainly didn’t anticipate the sustained earthquakes and hurricanes we have experienced in recent months.” He argues that it will be a long time before complacency returns, but that the “era of fear” will probably end soon.

Donald’s latest investment recommendations are reported in the paragraphs below, but I do recommend you also read the full report (courtesy of Commodity News and Mining Stocks).

1. It is definitely too late to sell stocks, and it is still too early to do more than nibble at bargains. Investors should be opportunistic buyers, because today’s prices for quality stocks will look ridiculously cheap within two years – or less.

2. When the time comes to begin re-accumulating equities, buy banks and diversified financials. If there is going to be a global economic recovery, these former pariahs should perform well – under mostly new management.

3. At the same time, buy commodity-oriented stocks. They are oversold to depths we could not have imagined. When, not if, there is a global economic recovery, these stocks will once again be the winning asset class.

4. While you are waiting, you should be starting to accumulate the bonds – convertible and otherwise – of quality corporations. What could be the trigger for a major equity rally would be a sharp contraction in the near-record yield spread between investment-quality corporates and Treasuries.

5. Buy emerging-market bonds from the fundamentally sound economies, such as China, India, and Brazil. Avoid Eastern European debt.

6. Another group to be included when you are once again accumulating stocks is the leading business-oriented tech stocks. These companies will participate in a global recovery, whereas the consumer-oriented techs may have to wait quite a while.

7. This is also a good time to be looking at the railroad stocks. They benefit from lower energy costs, which may offset a significant percentage of the cutback in top-line revenues during the recession. Coming out the other side, they should be core investments.

8. Gold has been a disappointment. It has outperformed stocks since the S&P’s peaks, but not enough to be profitable. As deflation fears ebb, it will once again be lustrous.

Please click here for the full report.

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This post is a guest contribution by Bennet Sedacca*, President of Atlantic Advisors Asset Management.

“The national budget must be balanced. The public debt must be reduced. The arrogance of the authorities must be moderated and controlled. Payments to foreign governments must be reduced. If the nation doesn’t want to go bankrupt, people must learn to work, instead of living on public assistance.” - Cicero, 55 BC.

Is Debt The New Equity?

I have been negative on credit for what seems like an eternity now. I have stated many times that, “if you are not being compensated to take risk, particularly credit risk, do not take credit risk”. And so for a long time we have been void of credit risk and to be frank, remain so. But for those that must take risk, the credit market is starting to seem like a far better bet than do equities.

Before the equity market began its descent this spring, I believed the credit market was sniffing out something that the equity market was not. Please click the link for more on “The Tale of Two Markets“. When asked why I believe the stock market has corrected so swiftly, my answer has been, “it had a lot of catching up to do”.

The big question on my mind these days is whether or not the equity market has corrected enough in order to make equities cheap relative to other asset classes, particularly credit. My answer is a resounding NO!

I have stated and still believe that we are in a secular bear market in equities that will not end until 16-year trailing returns for the Dow Jones Industrial Average and S&P 500 are in negative territory. In other words, this would mean that when we marked the high for the S&P in March of 2000 at approximately 1500, a secular bear low assuming a -4% annualized trailing return for 16 years would place us at around 795 in 2016. Pretty sobering, right?

Looking at the graph below, courtesy of Ned Davis research, we can see that secular lows have been established in the DJIA when the 16-year trailing return range is between -4% and 0%. Considering that the secular bull market party that went on from 1982-2000 was the greatest on record, one must expect the secular bear to accompany it to be the nastiest on record as well.

Notably, in the secular bear market, lows stemming from the Great Depression (the most similar pattern I can come up with for the mess we face today) and the 16-year annualized trailing returns in the range of -4% seem to be the most appropriate level to use. Since this credit unwind may actually be more painful this time around, I think that is the best we can hope for. So, while equities may seem “cheap” to most, I can accept that they will rally from time to time, perhaps fiercely, but the sad truth is that the “buy and hold” approach that has scorched so many during the past eight years is still not the best risk/reward proposition. This leads me to ask, “what is the better proposition?” Debt. Yes, that 4-letter word I have been avoiding for so long.

Click here for Bennet’s full report.

* President of Atlantic Advisors Asset Management, Bennet Sedacca brings with him more than 26 years of securities industry experience. From 1981 to 1997 he worked for several major investment banks, specializing in high-grade fixed-income securities marketing, trading and portfolio management. While working for PaineWebber as a Senior Vice- president, Bennet was a member of the Chairman’s Council for four consecutive years. During his years with Salomon Smith Barney as a Vice-president, he established an institutional fixed income presence in Central Florida.

In 1997, Bennet formed Sedacca Capital Management focusing on portfolio management for high-net worth individuals and small to mid-sized institutions. He is also a contributor to the financial website, www.minyanville.com and is regularly quoted in Wall Street Journal Online, Barron’s and Bloomberg.

Bennet graduated from Rutgers University in 1982 with a degree in Economics and was a member of the International Honor Society of Economics.

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John Authers, investment editor of FT, has just conducted a wide-ranging four-part video interview with Jim Rogers, legendary investor and author.

In Part 1 Rogers gives his outlook for the US dollar and what new financial architecture may evolve post-crisis.

In Part 2 Rogers discusses president-elect Barack Obama’s economic proposals and whether it is the right time to buy back into equities.

In Part 3 Rogers discusses China, his outlook for A shares, and whether the economic stimulus package is enough to reverse the country’s slowing pace of growth.

In Part 4 Rogers recommends holding real assets because the spectre of inflation is still real despite a forced liquidation into cash prompting a decline in prices.

Source: John Authers, Financial Times, November 17, 2008.

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