The question on every investor’s mind is: are we experiencing a mid-expansion slowdown or are we on the cusp of a recession?   But even a recession would be just a bump in the road when compared to the damage to the economy, and the value of our investments, which would be brought about by a decline in the value of our homes or the huge US trade deficit.  

 

Housing prices nationwide have increase by 50% over the past five years, although some speculative markets, think parts of Florida and California, have shown prices decreases this year. Given the run up in housing prices, a 10% correction is not out of the question but it could put the economy into a tailspin. Why?  Homeowners have been taking out the increase in the value of their homes through home equity loans and/or refinancing with higher principal balances.   If, for example, a homeowner had 20% equity in her home, but the value of the house fell by 10%, 50% of her equity would be wiped out. (Don’t believe it? Run the numbers. This is the downside of leverage.) 

 

A downturn in the housing market could exacerbate a decline in home prices. New homes construction has slowed, there’s a backlog of houses and condos purchased by speculators to be worked off, mortgage rates could go higher, and mortgage terms are getting tighter as a result of the subprime debacle. Why would mortgage rates go higher since the Fed is cutting rates, you ask? The answer is that many mortgages, including adjustable rate mortgages, are priced off of LIBOR, a London-based rate.   Interest rates in Europe and elsewhere outside of the US are going up (and US interest rates could go higher, as discussed below). The result of a decline in housing prices and/or increasing mortgage rates will be a reduction in consumer spending that could plunge the US economy into a recession.

 

The annual US trade deficit has ballooned from approximately $100 billion in 1997 to an estimated $800 billion in 2007.  What does the world do with all those excess dollars? It invests some back in the US stock market, buys American companies, real estate, and US Treasury securities. Foreigners buying US Treasuries is good for us because it helps us finance our domestic budget deficits. The 2007 deficit is estimated to be in the $200 billion range.

 

Along with trade and fiscal deficits, the value of the dollar vis a vis other major currencies has been declining. Compared to the Euro (and a market basket of Western European currencies prior to the Euro), the dollar has depreciated in value by 38% over the past ten years. You’ll only hold a depreciating currency if the return on your investment exceeds its decline in value. In other words, the yield on US Treasuries has to compensate a European, for example, for holding a security whose principal value declines each year as the dollar declines, and provides a net return equal or greater than the return on Euro dominated government bonds. 

 

The bigger our trade deficit, the bigger becomes the problem of recycling dollars.  By the way, our single biggest import is oil and oil is priced in dollars. Thus, as the dollar declines in value, the price of oil will increase, adding to our trade deficit (and inflation). A vicious circle if there ever was one. Will the world keep accepting US dollars? Probably, but at a price. Foreigners will demand higher interest rates on US Treasuries to compensate them for the dollar risk. This will have a ripple effect through our economy, driving up the cost of corporate borrowing, home mortgages, and causing a decline in stock prices as returns adjust to higher interest rates.

 

The government lacks the tools to quickly address either a housing value or trade deficit problem. Lowering interest rates further to ease the homeowners/mortgage holders plight would increase the fiscal deficit and create inflationary pressures. Let’s hope for a soft landing here. The only cure for a trade deficit is further depreciation of the dollar, a likely scenario, and a solution to our dependence upon foreign energy, an unlikely scenario in the near term. Let’s hope foreigners will be happy to hold more dollars at the current interest rates. But, it’s just that – a hope.

 

A decline in housing values or a trade deficit-induced crisis could throw the US economy into a recession of the depth not seen since the 1970s. Interest rates would go higher, unusual in a recession, and the stock market could correct by 40%. Invest cautiously.

The major US stock indices are within 2% of their highs for the year (and all-time highs for the Dow and S&P 500). In the past eight weeks they have gyrated from these levels to down 10%, then back up. This illustrates the speed of corrections and price movements in today’s electronic and global markets. It also illustrates the folly of market timing and why, unless you’re glued to your screen every day, you should invest for the long term and not try to outguess the market.

 

Over the next few weeks the markets may hit new highs, while moving in a choppy sideways pattern. The drivers will be the economy and earnings. The principal economic event to watch is new jobs creation. Secondarily, watch real wage growth and retail sales. These three indicators should begin to line up and tell us whether we’ve had a mid-cycle slowdown or are heading into a recession. Third quarter earnings results will be released during the latter half of October. These will give us an indication of the impact of the recent credit problems on corporate America as well as providing another clue as to the strength of the economy.

 

Two other areas to watch are housing/mortgage and energy.  The subprime mortgage problem is both old news and contained. New housing starts are running at 1.3mm annually, a number which is getting a lot of press because it’s so low. That’s true if you compare it to the 2.2mm starts in 2005, but it’s around the long term average. New housing starts aren’t the problem. Adjustable rate mortgages tied to LIBOR, as I wrote about last week, are the problem. LIBOR, right now, is decoupled from US Treasury rates and is heading higher because of the strength of global economies. This will take dollars out of consumers pocketbooks. Energy prices are rising, oil is at record highs and there’s every reason to expect it to continue to climb, particularly because oil is priced in dollars. As the dollar weakens, and it’s at a record low against the Euro and the Pound, oil producing nations increase their price to maintain the real monetary value of their oil. With our trade deficit, there’s no reason to assume the dollar will reverse direction anytime soon.

 

Where does this leave us? Let’s return to our first point: we can’t time the market. So, don’t pull out money waiting for it to go down, and don’t stop investing. But, review your investments, particularly, those that worried you during the correction.   This isn’t the time to be taking a lot of risk, either. 

Believe that a part of the economy will be particularly strong or a part of the stock market is undervalued? Sector mutual funds are one way of investing in market niches. Sector funds enable you to pinpoint your investments in areas such as healthcare, biotech, and technology (or financials, after the Fed rate cut). ETFs are another, but have some additional risks. See ETFs: New Wave or Riptide.  The common cautionary note about sector funds is they’re just that: an investment concentrated in one area, where all the companies share similar characteristics and react to macroeconomic or industry events in the same way.  Thus, sector funds offer only limited diversification – within a group but a group where all the stocks will move in the same direction, for the same reason. Sector funds offer the advantage of professional management, the portfolio manager should be able to pick the best stocks in the sector, and are a sound way for an investor to participate in sectors where they wish to invest a small portion of their assets but don’t want the risk of having to select a single stock – avoiding the needle in the haystack theory. 

 

The hidden risk of sector funds, or more than meets the eye, is that mutual funds in the same sector may have very different investment philosophies and/or definitions of what comprises suitable investments.  To illustrate this point, let’s look at two top ten funds from the Utility and the Natural Resource sectors. (For a list of the best mutual funds in these and other sectors, see MUTUALdecision’s Top Ten Funds List.) 

 

The JHT Utilities Trust (JEUTX) and the Fidelity Select Utilities Growth fund (FSUTX) are both top ten ranked utility funds but they’re different. JHT defines utilities to include telephone companies, such as A&T, and has a foreign stock among its ten largest holdings. The Fidelity fund is focused on power generation and delivery companies. The two funds only have three stocks in common among their ten largest holdings. The same is true for the Blackrock Global Resources fund (SGLSX) and the Vanguard Energy fund (VGELX). Blackrock’s top holdings are focused on exploration, drilling and coal. Vanguard owns more of the traditional large integrated oil companies. They have no stocks in common among their top ten holdings.  

 

Neither strategy in our examples of top performing utility and natural resource funds is right or wrong, they’re just different.  That’s the point. Before investing in any sector fund (or any mutual fund), review its stated investment objectives and its top holdings. Then you’ll really understand the nature of the fund and if it’s the right fund for you. Sector funds have their place in your portfolio, not as core holdings, but as a diversified way of making targeted investments in selected niches. Lastly, don’t forget sector funds carry more risk than broadly diversified (investing across many sectors) mutual funds.

So, what’s the Fed going to do tomorrow? I continue to believe it’s possible there won’t be a cut in the Fed Funds rate. I also believe the stock market will respond negatively, whether or not the Fed cuts rates.

 

The Fed might not cut rates for four reasons:   The self-correcting mechanisms containing the subprime mortgage/debt securitizations problems are working smoothly.  Pimco, and few organizations know more about debt than Pimco, announced the launch of a distressed debt fund last week. Pimco is the second major financial firm to make such an announcement.  The debt market is correcting itself.  A second reason why the Fed won’t cut rates is fear of inflation as evidenced by rising energy prices. Oil was back at $80 per barrel last week. The economy is still growing. Granted, the last jobs report was weak but one report doesn’t make for a sea change.  Solid retail sales offset the jobs numbers (at least for now). Lastly, US exports are strong because of strong global demand and that buoys our growth. 

 

Whether or not the Fed cuts rates, I expect the market to react in the same way – it will go down. This will be a short term reaction but it’s based upon the assumption that if the Fed cuts rates, it will be fulfilling the market’s expectation and the old adage of buy on rumor, sell on fact will hold true. If the Fed doesn’t cut rates, (some) investors will be disappointed and the stock market will decline. It will only be a brief sell off, then the market will resume trying to figure out the fundamentals, so let’s take a look at them.

 

The big question is whether there’s a recession in the offing. The answer to that will become clear over the next 30 - 45 days as we get additional information on employment, retail sales and, in October, third quarter earnings reports. Stay tuned. Right now, it is anyone’s guess as to whether we’ve in a mid-cycle slow down or on the cusp of a recession.  If a recession is coming, expect the stock market to decline by 15% from present levels.

 

The mortgage debacle has been picked over but one aspect of it which hasn’t received enough attention is that most adjustable mortgages are re-set based upon LIBOR (London Interbank Offered Rate), not a US interest rate index (and certainly not the Fed Funds rate). LIBOR is a global index, impacted only in part by what’s going on in the US. Because of stronger economies, central banks around the world are tightening rates. Thus, there’s upward pressure on LIBOR. The result may be an unpleasant surprise for US home owners who discover that their mortgages rate has been re-set higher, rather than lower, even if US interest rates decline. This could be the ticking time bomb that pushes the US economy into a recession.

 

For now, let’s use any market correction as a buying opportunity, all the while having identified our sale candidates if future economic news is not good.

A current theme among Wall Street wealth managers is for individual investors to have index funds as their core holdings and to focus the remainder of their assets in high alpha investments, which will produce returns not correlated with the market. 

 

A quick digression for those of you who aren’t familiar with alpha and beta. In traditional finance, the return not correlated with a broad market index, such as the S& P 500, is referred to as alpha. The return which is correlated to the market is beta.  An index fund should have the same return (positive or negative) as the index it mimics.  (One of the controversies surrounding some ETFs is their performance has not tracked their underlying index.)

 

The theory behind Alpha and Index Funds is multifold:  1. the major indices are a good place for an investor to be, both from a risk and return perspective;  2. you can’t outperform the major indices, so don’t waste your time;  3. find those investment niches with high alphas to increase your return and reduce the overall risk in your portfolio. Even if you don’t subscribe to this theory, you might find it an interesting exercise to review the alphas -- every investment has one -- of your current holdings. They will tell you something about the correlation and diversification of your portfolio.

 

Where to focus your alpha energy? Investments in real estate, commodities, and energy are less correlated with the stock market (although I’ve never thought commodities were suitable for individual investors).  The Wall Street pros also recommend stock fund mangers who have unique strategies and can demonstrate a high alpha relative to the market (and, of course, positive relative performance). Ask your investment advisor for suggestions.  The alphas for individual mutual funds (and individual stocks) are available from some brokers and online premium services. 

 

Alpha and index fund investing makes a great deal of sense. You know what to expect in terms of risk and return when you invest in an index fund. Having a portion of your portfolio in index funds leaves you free to concentrate your investment time and energy (think alpha waves) on those investments which can make a difference. Picking high alpha investments, which by their nature are less correlated with the stock market, should reduce the risk/volatility of your portfolio and, depending upon the investment, provide above market returns. 

The stock market was living for the moment last week. It rallied in response to strong retail sales, then took a 250 point nose dive at the end of the week over a poor jobs report. Problems with the subprime mortgage market and securitized debt of all types lurk in the background. The big question is what will the Fed do next Tuesday? An article in the New York Times over the weekend said a rate cut of 25 basis points is a sure thing. The only question is whether the Fed would cut fifty. 

 

The New York Times has a much larger circulation than this blog and many times the number of reporters (I have only me), but I think they’re wrong on this one.  Mr. Bernanke is not going to cut rates to placate a bunch of wealthy Wall Street types who are crying because they’re no longer minting money. So I’m going to that the other side of the bet.

 

The Fed will not cut rates next week. The US economy is strong, the world economy is strong, the mortgage and securitization problems are being worked out in an orderly manner and one bad jobs report doesn’t mean we’re headed into a recession. Lastly, Mr. Bernanke will show Wall Street that he doesn’t work for them.

 

My scenario suggests another choppy week for the market this week, a decline next Tuesday (the 18^th) afternoon, although not as much as some would expect, then a slow upward trend.

Which of your investments worried you most during the recent market correction?  If it was one of your smaller holdings, you’re not alone. But, we all have only so much time and so many brain cells to devote to investing. If you’re focusing yours on a tiny portion of your investments, the majority of your net worth is going unwatched.

 

Many investors I speak with are focused on only one or two of their investments or, worse, are fixated on the one they sold which has since gone up in price.  Have you ever taken a flyer? Bought a few shares of something on a tip? Stop and ask yourself: suppose this purchase doubles or triples, what impact will it have on your net worth? It will be insignificant. And, any change to your net worth will be dwarfed by the movement of your primary investments.

 

Let’s put some numbers to this. If you have a stock or mutual fund which is 1% of your total portfolio and it doubles in value, it’s now only 2% of your total holdings.  Your net worth has only increased by 1%. And, let’s face it, despite what we think, it’s unlikely that many (or even a few) of our investments will double over the short term.

 

The key to building a strong investment portfolio is to set your goals and diversify, but not have so many investments you can’t follow them all and to avoid investments which are too small to be meaningful.  Here are some rules of thumb: no stock or bond should be less than 2% of your portfolio. No mutual fund should be less than 5%. If you’re uncomfortable holding that much of a particular stock or fund, the investment is too risky for you and you shouldn’t own any of it. Think about the 2% and 5% guidelines for a minute. If you own only stocks, that would be a 50 stock portfolio, a lot of stocks for anyone to follow. It would be 20 mutual funds.  In both cases, more securities than you need to achieve diversification. So the above percentages are only minimums. The maximum holding for a stock should be 5%, that’s 5% of your net worth tied to the fortunes of one company (remember Enron, if you’re wondering why). 

 

For mutual funds, the bigger and safer the fund’s investment focus, the more you can invest in it.   Bigger and safer means, for example, Big Cap stocks for both domestic and foreign funds, investment grade bonds and US Treasuries. To be conservative, you should put no more that 10% of your next worth into any one fund. 

 

This brings us to index funds. If it’s a fund mirroring a big index, i.e., the S&P 500, the Lehman bond index, the Morgan Stanley Japanese stock index, you can invest more than 10% in a single fund. If it is a smaller index, i.e., the technology sector, the 5% rule applies.

 

Diversify, but don’t have so many investments that you can’t follow them all. Avoid investments which are so small they won’t make a difference. Focus on the big picture; don’t let the tail wag the dog.