When the major stock market averages declined by 10% from their 2007 highs on Monday, we were in official market correction. Sentiment is negative owing to the economic back drop of, at best, tepid growth according to the Fed, or a recession.

 

Consumers twenty-five year credit binge fueled by home equity loans, credit cards arriving in the mail, subprime and adjustable rate mortgages and automobile leases, appears to be over. Savings rates has plummeted from 14% to 0% (perhaps to a negative number if home values continue to decline). Pile on top of that the banks debt problems, high energy prices, the homebuilding industry’s woes, weak retail sales and declining consumer sentiment, it’s no wonder that many investors believe a recession is in the offing.

Investors face two challenges right now. If the economy is headed into a recession, where do I put my money? And, if the economy avoids a recession will I be in the right investments? The stock market anticipates the future. It will decline prior to the US entering a recession and it will start going up prior to the end of the recession. Investors who wait for certainty that a recession has begun will be selling stocks at the worst possible time. The same logic holds true if you wait to buy stocks until after the economic recovery, the market will have already moved higher in anticipation. Human psychology is a future complication. We’re most optimistic about the stock market when it’s roaring ahead and most inclined to buy; and most pessimistic and most inclined to sell, when it’s at its bottom. Of course, our investment strategy should be just the opposite.  The moral to this story is that you should invest for the long term and not try to time the market. 

 

If a recession is imminent, the stock market will decline by another 10%. How do you make money? To get technical, buy mutual funds, ETFs and stocks with negative betas or high alphas, such as gold, commodities, real estate and foreign stocks. Gold and commodities already have had good runs, the US commercial real estate market appears to be weakening and foreign economies are increasingly becoming intertwined with ours. Non-investment grade bonds have good yields but are not the place to be given the continuing bank credit problems. High grade bonds and Treasures have relatively unattractive yields, particularly as you go out in maturity.

 

The best performing stocks in a recession are likely to be industry leaders, companies with strong overseas sales, consumer staples and health care. The technology sector is solid and internationally focused, so we’ll add it to our list. Essentially we’re looking at companies whose sales will be strong during a recession. These stocks may not go up in price during a recession but they will perform relatively better than most other equities and are safe investments. The bottom line is it’s hard to make money during a recession.

 

If the Fed is right and we’ll see modest economic growth in 2008, the markets are at their lows and could move 20% higher over the next six months. How do you position your investments for this possibility? By staying in the market and buying the same mutual funds, ETFs and stocks as you did for your recession portfolio. The recession portfolio is a conservative portfolio. Although it will miss some of the dramatic gains made by small cap and more violate stocks, it also protects you from the downside of those stocks while enabling you to participate in any stock market rally.

 

What to do now? Review your long term goals and make sure you’ve got the right asset mix, take losses (up to $3,000 more than your gains, remembering to match short term gains and losses) to minimize your taxes, reposition your equity investments according to our recession scenario, move your bonds into cash and tighten your seatbelt. We’re in for a bumpy ride.

The Dow hit a low for the year on the day before Thanksgiving, down 9% from its 2007 high. The S&P 500 and the NASDAQ are fairing a little better, down 8% from their 2007 highs. (Significantly, all three averages are up for the year, albeit slightly.) The definition of a market correction is a 10% decline. A 20% decline is to be expected if there is a moderate recession or the expectation of one. Are we headed for a recession? Let’s review the economic facts.

Housing, and related, jobs account for 10% of our total employment.  Single family housing starts fell 7.3% in October and permits dropped 6.6%, to the lowest levels in 15 years. (You can see the ripple effect on the earnings of Home Depot and Lowes.) New housing starts have fallen for almost two years. Every time in post-war history housing has declined for two years, it has been accompanied by a recession. On top of this, the value of existing homes is declining, creating a (true) feeling of less wealth and limiting the use of home equity loans to monetize residential real estate. Even if the equity is there, home-related lending standards are tightening, making it harder to get home-equity and new home loans. Tight credit keeps buyers out of the market further slowing new home building and existing home sales.  Is this a vicious circle? Add to this some $350 billion of adjustable rate mortgages which are due to adjust in 2008. Most (all?) of these mortgages will adjust upward.  Many are two year adjustable mortgages which are arriving at their first adjustment – from that attractive low rate to a healthy premium over LIBOR. Under the best case scenario, this will take money out of consumer’s pockets. The worse case is much worse.  Thus far, tightening credit has been limited to the residential market but we now see signs of it spreading to auto loans and credit cards. There’s an excellent article in the November 26 BusinessWeek, The Consumer Crunch, which outlines all the reasons why there will be credit retrenchment in the US. But wait, you say, the Fed can solve this problem by lowering interest rates. It’s true, the Fed Funds rate can be reduced and interest rates should follow (although not necessarily LIBOR-based loans) but a rate cut will not impact lending standards. If financial institutions keep tight lending standards, it’s the same as a tight money policy regardless of what the Fed does. 

 

The Fed is predicting modest growth for 2008, in the 1.8% - 2.5% range (the low end suggests the economy is operating at dangerously close to stall speed), and continued growth beyond.  There are economic bright spots: exports, technology and farming. (Although, let’s also not forget the potential for high energy prices to disrupt the economy.)  Black’s Friday’s retail sales were encouraging and inflation is in check.   However, the consumer accounts for about 70% of the economy. Strong exports and technology sector sales cannot overcome a slowdown in consumer spending. Economists like to point out the resiliency of the U.S. economy and they’re right. But, in this instance, it doesn’t mean we will avoid a recession, it means we’ll come out of it and keep growing afterwards. The problem with recessions is that they’re hard to predict. The old saying is that the stock market has successfully predicted ten of the past five recessions. We won’t know we’re in a recession until we can see it in the rearview mirror. By then we’ll be in it or, hopefully, coming out of it.

 

The stock market is in its second major correction of the year and sentiment is decidedly negative. Is this the capitulation which signals a market bottom or will there be another 10% downward movement to reach the 20% decline typical of recessions?  The honest answer is - who knows? But, that’s not an acceptable answer for an investor who needs to know what to do with his or her money. So, let’s look at the risk/reward for stocks and bonds and make some decisions.

 

The S&P is currently selling at about 13.5x estimated 2008 earnings. This is a reasonable valuation. A market selling at under a 15 price/earnings ratio is attractive. Even if 2008 earnings estimates are 10% too high, the market moves from being undervalued to fairly valued.   If we avoid a recession, earnings and multiples suggest a 20% market rise. So the risk/reward is 10% downside; 20% upside. This is why long term investors should stay in the market. Focus on the companies doing the best – large caps with foreign sales.

 

As for fixed income investments, let’s use US Treasuries as our proxy. You certainly want to stay away from riskier bonds until the credit mess sorts itself out. Five year Treasuries currently yield 3.5%; 10 year yield 4.0%. Why subject yourself to the uncertainly of inflation and other risks over the next decade for such a low return? These aren’t attractive yields given money market fund and bank deposit rates in the 4%-plus range. You’re better off in cash than bonds.

 

The world’s second biggest economy is Japan (behind the good ol’ USA). China, India, and Brazil have economies growing at upwards of 10% annually. That’s a lot faster then the roughly 2.5% expected US growth over the next year or so (absent a recession, of course). Together those three economies almost equal the U.S. in GDP.  Add in Japan, and the combined GDP of these four countries exceeds the U.S. The CIA’s World Factbook is an excellent source of country information like this.

 

A good mutual fund investor would be wise to have at least 25% of his or her assets invested outside the US. Global investing makes sense not only to avail oneself of higher growth rates but also because international investments may respond differently to the same event. Global economies is linked and becoming more so. The stock markets of Western Europe, for example, have an 80% correlation with the U.S. markets.  Makes sense, doesn’t it? A good portion of BMW’s profits come from the U.S., so if the U.S. economy (and the U.S. stock market) turns down, so does BMWs profits and its stock price on the German exchange. You don’t gain a lot of diversification by investing in Western Europe (although it would be a play on the Euro, if you think the dollar will continue to decline). Something of a surprise is that the Brazilian stock market has a 70% correlation to its U.S. counterpart. Latin America is more closely liked to the U.S. then it would like to believe. As you’d expect, the stock markets of emerging counties, i.e., China (50%), India (40%), Russia (35%), are not as closely correlated with the U.S. market as are the Western European markets. (Of course, they’re also more volatile.)

 

A second surprise is the uniqueness of the Japanese market. Movements in Japanese stock prices have only a 30% correlation with movements in the U.S. stock market. That’s surprising because Toyota sells so many cars here and we all own at least one Japanese made TV. But it goes to show that the biggest driver of any economy is what’s going on inside a country, not how much it exports. Just like the Japanese culture, there are many unique aspects to the Japanese economy. What’s also nice about Japan is it’s the second largest economy in the world and offers the legal and accounting safeguards of a mature county. Thus, you can diversify without emerging economy risk.

 

How to decide which regions/countries to invest in? Which counties do you think are attractive investments, i.e., their economies will grow. What are the opportunities in Mexico (domestic demand)? Canada (natural resources)? Germany (banking and automobiles)? Then, like with every other investment decision, consider the riskiness of the investment. Canada and Germany are pretty safe. Russia’s GDP is clipping along at 7% per year and Egypt’s GDP is growing at 6%. Both stock markets reflect this growth but they’re riskier investments.

 

There are many excellent international mutual funds and ETFs, some invest globally, some focus by region and some by country.  International funds invest in all sizes and types of companies and, for the fixed income portion of your portfolio, all classes of debt.

It would be wise to invest 25% of your assets internationally and to diversify beyond Western Europe.

The stock market took the long way around last week, with a 300 point up and a 200 point down day, to end basically flat. The Dow and S&P were slightly up; some broader averages such as the Russell were slightly down. Volatility is exhausting.  

 

Financials had another rough week and the Transportation Index was down, at least in part, due to FedEx’s tepid forecast. The financials continued to take a pounding, reaching lows not seen since August. The Transportation Index is often thought of as a bellwether for the economy. Fewer goods shipped implies an economic slowdown.  The index’s performance was consistent with another warning from retailers of a weak Christmas selling season. The high price of oil is taking its toll.  Airline ticket prices are rising as are gasoline prices and worries about the price of winter heating bills is setting in. One pundit put the chance of recession at 40%.

 

There was some good economic news. The core CPI, ex-food and energy, was up 2.4%. Including food and energy, the CPI was up 3.6%, not great but not bad considering the increase in oil prices. The Fed came out with a forecast of slow growth into 2008, also not great but projecting continued economic expansion nonetheless.

 

The key economic report this week will be new housing permits and starts. They’re projected to be down but the question is, as it always is, whether they’ll come in above or below expectations.

 

Where does all this leave us? The economy is operating at just above stall speed and housing or energy could drag it into a recession but, thus far, it is continuing to move forward despite the significant headwinds. Recessions are notoriously hard to predict and the stock market appears to have discounted a 50% probability of one occurring. Bond yields, particularly US Treasuries, remain unappealingly low. Thus, the stock market remains the place to be, although a cautious investment approach is in order.

 

The stock market has drifted down to near its lows for 2007 as it tries to sort out the economic picture. This is an excellent base for an upward move, assuming the more likely scenario of continued economic growth. The market needs a catalyst and it will be the financials. Once the third quarter write-offs are out of the way and the banks provide some comfort that the financial crisis is behind them, even with continuing weakness in the mortgage market, the financial stocks will stabilize and the stock market will move higher. Watch the financials.

Exchange traded funds are index funds which have advantages over open-end index mutual funds. ETFs trade all day long on the stock exchanges, may be purchased through any broker, have lower fund expenses than mutual funds, and have less likelihood of generating unwanted taxable gains than mutual funds. (See The ABCs of ETFs – Exchange Traded Funds).  

There are a number of reasons, which we’ll discuss, for investing in index funds (ETFs or mutual funds) but let’s start with the fact that the S&P 500 index beats 80% of all actively managed funds. (And, an index fund has lower expenses than an actively managed fund, further enhancing its net return.) If you can invest in an index fund and be in the top 20 percentile of fund returns, that’s a pretty good place to start. 

 

You can construct a well-diversified portfolio entirely out of ETFs.  There are ETFs for almost every type of investment you can imagine.   ETFs enable you to diversify into assets which you may not otherwise feel comfortable owing because of expertise, risk and/or liquidity issues. ETFs are well-suited for investing in exotic areas such as currencies and commodities. Of course, they’re great for sectors such as small cap or international stocks. 

One of the most attractive features of ETFs is their ability to provide you with greater liquidity than if you were to directly own their underlying investments. Take municipal bonds, for example. Most Muni issues trade infrequently and the transaction costs for the individual investor are substantial. Minimum investment size can be another problem. Munis typically have a $1,000 denomination and trade in large blocks. ETFs are the answer to all these issues.  You can buy as little as one share of an ETF (generally less than $100) during market hours and at the same cost as for a stock.   

 

You can hedge an investment and/or lock in gains using ETFs.  Unlike open-end mutual funds, ETFs can be bought on margin and shorted. Investing on margin can magnify your returns and your losses. The ability to short enables you to make money when something goes down in value. Think shorting the dollar or home building stocks. However, to paraphrase TV commercials, these strategies should only be employed by a professional driver on a closed course. It’s also important to note that you don’t have to short an ETF if you think an asset is going to decline in value. You can probably find an ETF which is structured to generate an inverse return to that asset. ProFunds Group has a number of ETFs designed to perform this way. So, for example, if you think the Chinese stock market will decline, you can purchase a ProFund which should increase in value if you’re right. 

All ETFs, even those which track the same index, are not the same. One S&P 500 ETF may weight its stock holdings by market cap, another may weight them all equally. This will result in different returns. Two ETFs which track the technology sector may hold different stocks and/or in different weightings. Since most indexes are not strictly defined, think technology versus S&P 500, there will be a variety of different investment strategies employed. Different strategies to mimic an index are not good or bad, but they may have different risk levels and will produce different returns. Some ETFs  also use leverage to enhance their returns or structure there holdings to magnify any gains (thus, also losses) of an index. You need to know what you’re investing in. To understand how a specific ETF works, visit its website and read its prospectus. Want to learn more about ETFs or take a look at some of the most popular? Go to I shares, Power Shares, or HOLDRs.

 

Within five years most investors will have at least one ETF in their portfolio. Also, within five years, there will be more money invested in ETFs than in open end index mutual funds. The advantages of ETFs – liquidity, transparency and lower expenses, to name a few – will force changes in open end mutual funds.  Happily, the investor will be the winner in the competition between these two investment vehicles.

Ugly describes the stock market last week. The Dow and S&P were down approximately 4% and the NASDAQ was down 6.5%. The Dow and S&P are approaching their lows for the year, reached during the August credit crisis. It’s hard to believe that just a month ago the Dow and S&P were at record highs and the NASDAQ was at its highest level since 2000. Market sentiment is decidedly negative or, to reuse my opening word, it’s just plain ugly out there. It wouldn’t surprise anyone if the market hit a new low for the year this week.

 

                        October High      August Low      Nov. 9 Close       

Dow                      14,164                12,861             13,043

S&P                        1,562                 1,406               1,454

NASDAQ                  2,859                 2,451               2,628

 

 

What’s happened over the last 30 days to turn the market around?  More bad news came out of the financial industry with Morgan Stanley and Wachovia reporting big write-downs. Worry over the financial institutions has morphed from subprime mortgages to securitized mortgage pools, to collateralized debt obligations (CDOs), to structured investment vehicles (SIVs), and, most recently, to credit default swaps and the insurers of all these derivative instruments. None of this is surprising, or new, news and we have to keep the derivatives issue in perspective. Banks are sound, the problem is contained to the financial industry, and it’s not the first time the banking industry has experienced problems, i.e., the Mexican and Russian debt crises, Long Term Capital Management. Oil is trying its best to hit $100 a barrel, with dire consequences for home heating bills if we experience a severe winter, and the dollar continues to hit new lows (one of the reasons why oil prices continue to rise). The homebuilding industry struggles persist. It was sad to see the pioneer homebuilder, Levitt, file for bankruptcy protection this week. Lastly, retail sales were mixed and retailers are forecasting a poor Christmas season. What puzzles me, though, is that all of the above is old news. It’s been around for months. 

 

The market ignored much good news last week. Exports continued to drive our economy (and are helped by the weak dollar), productivity growth was a remarkably strong 4.9% for the third quarter, wage increases were modest (both suggesting inflation is not a worry) and Mr. Bernanke spoke about continued economic growth (albeit weak in the near term) through 2008. 

 

So why was the stock market at record highs last month and testing its lows for the year this month? Psychology. The glass has gone from being half full to half empty. Which view is right? October’s or November’s? Obviously, only time will tell. We’ll get an important piece of data, though, this week when the CPI is released. That will tell us the impact high energy prices and a weak dollar are having on inflation. My forecast is the CPI, particularly ex-energy, will come in better than expected. And, although, the market may go lower, the issues it’s concerned about have been around long enough for the consumer and business to adjust to them. I stick by my forecast that the market will show a 20% return over the next six to nine months.

Every investor should consider Exchange Traded Funds (ETFs).   The younger brother of open-end index mutual funds is growing up fast and showing greater versatility.

 

ETFs are open-end index mutual funds that trade like stocks (and closed-end mutual funds). 

 

There are three legal structures of ETFs: Open-end mutual fund (the difference between the ETF structure and a open-end mutual fund is the ETF is exchange traded, whereas the traditional mutual fund is purchased and redeemed by the fund itself), Unit investment trust and Grantor trust.   The open-end mutual fund structure has a diversification requirement, mandated by the Investment Company Act of 1940, which limit how it mimics some smaller or specialized indices and could result in a tracking error. The other principal difference for the investor is that other than the open-end mutual fund, dividends must be paid out in cash to investors (of course, you could reinvest them if you desired), rather than reinvested by the ETF. These structural differences aren’t significant for most investors. The more important question is whether it’s the right ETF for you in terms of what index it’s designed to follow. The index and dividend payout requirement are disclosed in its prospectus and most ETFs also have websites where you can find this information.

 

Tracking error is the difference between the return on the index the EFT is designed to follow and the actual return on the index. An EFT which holds all 500 stocks in the S&P 500, in the same weighting as the S&P 500, should have exactly the same return as that index, less fund expenses. That’s an easy one. ETFs that are created to track, say, the biotech stock index will have different interpretations of that index. A biotech ETF could weight all stocks equally, weight by market cap, hold big cap or small cap bio stocks, and so on. As a result, the ETFs performance will vary with the success of its strategy. A good illustration of this is in Biotech ETFs: It Pays to Shop Around, in the October 15^th BusinessWeek. The five funds BusineesWeek highlights had year-to-date return ranging from -3.7% to 27.3%.

 

ETFs are required to disclose their holdings every day, unlike mutual funds which only have to disclose once a quarter. However, this should not be a big deal because we’re dealing with index funds and the components of indexes should not change very often.

 

There are two aspects of ETF liquidity for investors to consider: the ETF and its index’s securities. Since ETFs trade like stocks, they can be traded all day long. Open-end mutual funds can be purchased or redeemed only once daily, after the market closes. You have to put your order in prior to 4PM (while the stock market is still open) or wait until the next day. The liquidity of the EFT – the frequency with which it trades and the depth of the market – is similar to a stock and parallels the size of the EFT. But ETFs also have a very unique feature, they can be expanded or contracted depending upon demand, see Share Creation/Redemption, which provides them with even greater liquidity. And, ETFs can be more liquid than the individual shares they hold, thus, providing investors with greater liquidity. This is especially true for an ETF that holds small cap stocks, which are thinly traded, or bonds other than US Treasuries, which trade infrequently.

 

Authorized Participants, think big banks who act as market makers or specialists on an exchange, trade market baskets of the underlying index’s securities to the EFT in exchange for new ETF shares, when the demand for ETF shares increases. The Authorized Participants then sell these newly created ETF shares on the open market. The process is reversed if there are more sellers than buyers of the ETF.  The purpose of this feature is to keep the ETF’s market price as close to its net asset value as possible. (The risk exists that the Authorized Participants would not, or would not be able to, perform this function during a market crisis. The result of this could be an ETF which trades away from its net asset value.)

The price at which the ETF trades is based upon supply and demand. Unlike the share of an open-end mutual fund which is purchased or redeemed at its net asset value (NAV), the price of an ETF share may trade above or below its NAV. By way of comparison, closed-end mutual funds often trade away from their NAV for extended periods of time. Unfortunately, many closed-end mutual funds trade significantly below their NAVs. The Authorized Participants provide vital role, through share creation and redemption, in keeping the price of the ETF close to its NAV.

The structure of ETFs gives the investor a tax advantage over mutual funds. Open-end mutual funds, even index funds, must sell shares of the stock they own to raise cash when redemptions exceed purchases. These sales can result in taxable gains and losses which are passed along to the investor. Thus, you could have a taxable gain on the fund you own, even though you didn’t sell it. The share creation/redemption process for ETFs shifts this liability to the Authorized Participant. If the Authorized Participant trades ETF shares to the EFT, it is responsible for the taxes on any gains if it sells the securities it received from the ETF. Of course, the investor is liable for any taxes when he or she sells an ETF or mutual fund. 

ETFs have lower fund expenses than index mutual funds, although the difference is usually only a few basis points. (Don’t be misled by ETF advertisements which compare their expenses to actively managed open-end mutual funds.) Theoretically, the expenses for an ETF or mutual fund structured to track the same index, assuming they’re roughly the same size fund, should be the same. 

 

Since ETFs are traded like stocks, the commission charged to buy or sell an ETF is similar to the commission on a stock trade. Index funds are no-load, and are commission free, although some charge a back-end fee if you don’t hold it for a certain period of time. The second cost to consider is the bid/ask spread. Even stock and ETF has one, although in most cases they’re very small, i.e., a few cents, unless the ETF is very illiquid. Transaction costs – none vs. some – favor no-load mutual funds over ETFs but the cost differential is slight

 

What are the uses and advantages of ETFs? Come back next week and I’ll tell you.

The S&P and the NASDAQ were flat last week. The Dow was down about 200 points, the result of its 300 + point sell-off on Thursday.  Citigroup was the culprit.  Its bigger than expected write-downs cost the Dow and cost its CEO his job. With the CEO of Merrill losing his job at the beginning of the week, it turned out to be a very bad week for financial company CEOs. (Is the CEO of Bear Stearns next?) All the financial stocks suffered as a result of Citi’s and Merrill’s woes but the cause of their woes is old news. We already knew about the subprime and collateralized debt problems and we knew the third quarter was going to be bad for banks and their brethren. 

 

The Fed cut rates by ¼ point. Cuts in Fed Funds rates usually boost financial stocks. Not last week. The jobs report on Friday was tremendous. 166,000 new jobs were created, twice the estimate, and well above the 100,000 mark, a broad-brush delineator between strong and weak job growth. 

 

What didn’t the stock market like last week? Oil approaching $100 a barrel? Maybe we’re finally reaching the tipping point where energy prices put a brake on the economy. But, it doesn’t feel like it. That leaves us with the housing market as the guilty party. But wait, the new home building market bottomed a few months ago and isn’t getting any worse (it’s not getting any better, either, and probably won’t for at least another year). What’s left is the value of existing homes (and slow sales/declining prices in the existing homes market).  If the value of existing homes continues to decline, the consumer will feel the reduction in his/her net worth and will cut back on spending.  (And, no more home equity loans and refinancing to take money out). If homes values continue to decline, a recession will certainly follow. Throw on top of this rising energy prices and we have the makings of a category three economic storm.  This is the wall of worry which the stock market must climb. (If the market had no worries, the averages would be significantly higher and the potential reward wouldn’t be there.)

 

Assume for the moment that housing values, and energy prices, level off – don’t improve but don’t get worse. Then, we’re left with a low-inflation, export and technology-led economy with new jobs being created each month. If this is the case, then as I’ve said for the past few weeks, the stock market is reasonably valued, 2008 corporate earnings estimates are in tact, and the stock market could rise by 20% over the next six - nine months.  

 

Oh, by the way, the decline on the Dow as compared to the S&P shows the value of diversification. I’m not suggesting you buy 500 stocks, 30 stocks really are enough but the comparison of the performance of the two indices last weeks illustrates why you diversify.