The markets are finally pulling back (a bit), due to the possibility the U.S. may lose its AAA rating. I never thought I would hear such talk. However, we are still not letting go severely even though the bad news continues to pour in. This is almost always a good sign, as the markets go up 6-9 months in advance of a bottom. Although the immediate trend is due for a pullback, the general short term trend is still up, showing investors believe the worst is behind us. As is usually the case, stocks climb the proverbial wall of worry. That’s when it goes up…even though there is no good reason and no sane person would suggest such. The market is telling us that the economic rebound will be stronger than most people think, and that is a very fair assumption. With inventories at incredibly low levels and gazillions of dollars coming into the economy, it should be strong. Damn strong. I’m not saying the long term issues that I have been addressing are cured. No way. But that’s a discussion for tomorrow. It’s hard to believe it was just 2 months ago when the Dow hit 6500 and all seemed lost. (Remember that asteroid hurtling towards earth?) What a difference the sunshine makes.

One very good thing is that the US credits markets are returning to a semblance of normalcy, Bank of America raised $13.5 billion in an equity offering, and it appears that the 19 largest US banks, which were the focus of the Treasury’s stress tests, are able to come to market with relative ease. Many of these 19 have already raised substantial amounts of both equity and unsecured debt. Even more important is that 3 month LIBOR continues to drop, falling -4 basis points to 0.71% at today’s (5/20) London fixing. The fact that borrowing rates are declining and the aggressive deleveraging of bank balance sheets is winding down, there is optimism that the stage is being set for a recovery. The strength and timing of the recovery is still open to question, but presumably the worst of the economic news is behind us – at least for the US.

LIBOR Lesson – (Skip this paragraph if you are experienced in Libor.) LIBOR is the interest rate banks charge each other for one-month, three-month, six-month and one-year loans. LIBOR is an acronym for “London Interbank Offered Rate” and is the rate charged by London banks. This rate is then published and used as the benchmark for bank rates around the world. Interbank lending rates - the three-month dollar, euro and sterling LIBOR rates - declined to record lows last week, indicating the easing of strain in the financial system. After having peaked at 4.82% on October 10, the three-month dollar LIBOR rate declined to 0.83% on Friday. LIBOR is therefore trading at 58 basis points above the upper band of the Fed’s target range - a substantial improvement, but still high compared to an average of 12 basis points in the year before the start of the credit crisis in August 2007.

Most recently the markets have been moving sideways, with another surprising run to retest the highs. This market has been unbelievably resilient, and we haven't seen a rally this strong in my 25 years plus in the business. Paradoxically this is more a sign of a bear market rally than a new bull market. Long-term bull markets move up in a stair-step fashion and build bases along the way -- that gives them staying power. The last strong bear market rally like this one occurred from 1975 into early 1976, and then the markets were ultimately down into late 1982. This rally is also very similar to the bear market rally from late 2001 into early 2002, which would also suggest a brief setback and then a rally to new highs--and then a retest of the lows.

What I don’t like is trader sentiment on the S&P 500 has moved from 2% to 85% in just two months. I initially went positive over 8 weeks ago, largely because of the intense pessimism that was abound. I still don’t think most people are in this market, which is why it should go higher. Everybody is talking about it, mostly in terms of “I’m waiting for a pullback to get back in”. that tells me that isn’t going to happen. However, with sentiment rising almost to the peak #’s in October 2007 which was 89%, that makes me nervous. That is simply nuts. How could traders be nearly as bullish as late 2007, after the massive shocks to our financial systems and the massive debt taken on by the government? Typical Bear Market low P/E ratios in the 5 - 8 range for a major bottom are the norm, not the 12 that we saw in early March.

Strategy: Real return investments continue to be the place to be. I couldn’t have hit the call for high dividend stocks and corporate bonds any better, and they are still the way to go. I want to be getting paid a good yield or dividend in this market, and there are still many extraordinarily high yields out there. Corporate bond spreads continue to tighten, which is great news for the issues we’ve bought, but makes it harder to find excessive opportunities. That said they are definitely there. Just in the last few days you could have picked up yields of 15+% GMA for less than 2 years. Amazing. For those not (overly) greedy, there are incredible bargains.

The longer term still has severe obstacles. We are building an unsustainable debt. This week, the federal government published two important reports on long-term budgetary trends. They both show that we are on an unsustainable path that will almost certainly result in massively higher taxes. By 2016 we will have to fund Social Security out of general revenues, as the surplus we now have will be gone. And there are no trust funds. They are a myth. It as if I wrote myself a check for $2 trillion and then declared I was worth $2 trillion. The money is just not there. Social Security makes Bernie Madoff look like a small-time crook. And Medicare is in far worse shape. Now that is unsustainable.

Even Obama recently said “US Long-Term Debt Load is 'Unsustainable,'" Yet they announced a $1.8 trillion deficit, which is really going to be at least $2 trillion, and are getting ready to pass health-care programs that will mean at least a trillion in deficits for as long as one can project. How will they pay for it? Even getting rid of the Bush tax cuts will only produce a few hundred billion a year, which is nowhere near enough. They project much lower medical costs in the future, because they assume they are going to figure out ways to cut costs and make medical care more efficient. As if no one has ever tried that. Yes, there are some savings on the margin; but the only way you really cut costs is to ration health care, especially health care in the last year of life, which is about 30% of health-care expenses. That is going to be very tough in the US. But when faced with a real budget crisis, the choices are going to be stark. And that crisis is coming if we do not control spending.

You cannot propose massive increases in spending without creating crushing debt that the markets will simply not allow, pushing interest rates much higher and really slowing growth and hurting the economy. It is a simple fact that you cannot increase the debt-to-GDP ratio without limit. We found the limit on personal and corporate debt this past year. We pushed the limits until the system crashed. And now the US government wants to basically do the same thing. They are planning to see where the limits on government debt-to-GDP will be. Unless cooler and more rational heads in the Democratic Party prevail, this is not going to be pretty. Sometime in the middle of the next decade we will hit the wall, and it will make the current crisis pale in comparison. The only way to solve the problem is to grow GDP more rapidly than debt, and for that to happen you have to have policies which are shaped for the growth of the economy or massive savings by consumers. And right now we have neither.

A year ago, even six months ago, the great debate centered on whether the credit market crisis would precipitate either a US or global recession. A majority predicted a manageable recession in the US, but nowhere else with the possible exception of the UK. Uncertainty was great, and kept increasing until recently—but no longer. The good news today is that this uncertainty has disappeared. For we now know with probability that everything sucks everywhere. Welcome to a risk free world! For example, according to standard business cycle theory, "pent-up demand" on the part of consumers is a principal driver of recovery—but it will not be this time around. The shift towards less consumption and more savings due to the implosion of household balance sheets and to demographics is most probably permanent. If so, this bodes poorly for hopes of a pent-up demand-driven recovery.

It appears that we are half way through, (at best) what is likely to be an 18-25 year secular bear market, because if you look at long waves in the past, they tend to last about 18 years. The longer than normal bull market of 1982-1999 could easily push the bear higher. If you go back to the last secular bear market, you will see that the S&P 500 peaked in real terms in January 1966 and bottomed in July 1982, 18 years later. But there were plenty of mini-cycles in between that had substantial rallies. In fact, there were four recessions and three expansions during that entire 18-year period and unless you were a completely passive investor, you definitely wanted to be in the game during the three expansions because the S&P 500 rallied an average of 50% during those phases. Again, it is important to note that these were rallies you could rent, not own, but they did last an average of 20 months. Once again the Buy-and-Hold strategy fails. Tactical investing i s and has been the way to go. If you’d like to learn about our personal unique (and trademarked) investment style, Top-Down Tactical (TDT™), click this link: TDT™

Long story…ah, longer, I am still not totally sold on the bull case for equities long term, but I am willing to ride the wave for the time being. Valuation is not compelling. Sentiment has completely swung towards a bullish consensus (which is a contrary negative). Home prices and employment are still in freefall, the former undermining the balance sheet and the latter exerting a drag on the income statement and suggestions that a mild improvement in the negative growth rate is something to be excited about seems off base. It seems hard to believe that after being burned by two bubbles seven years apart that the baby boomer is going to line up at the trough one more time. So, it’s difficult to ascertain who the marginal buyer is going to be. Disposal of durable goods assets to pay off a record household debt burden seems like a multi-year deflation story as far as we are concerned. Since the boomer household is income constrained and underweight fixed-income securities on its balance sheet, we believe that demand for high-quality bonds is going to strengthen in coming years. Government policy will remain highly pro-cyclical but there is no match for the contractionary effects from a shrinking US household balance sheet.

If you’d like a review or just a free 2nd opinion, give me a call at 916-925-8900. It’s not easy to find someone that knows what they are doing, and maybe we can help.


Cheers –Keith
916-925-8900

Keith Springer is President of Capital Financial Advisory Services, a registered investment advisor, providing Wealth Management and Mortgage Consulting Services.  For more information on how to build and maintain a solid retirement plan, please contact Keith at
916-925-8900 or Keith@KeithSpringer.com