Stock Market Update – The Super Elastic Bubble Plastic rally
The market continues to be incredibly resilient, even in the face of less than rosy news, much like that toy of our youth, Super Elastic Bubble Plastic. Fun to play with, solid as a rock as the bubble grows and devastating when it pops. For now, we’re in the bubble growth phase. By the way the market is holding up, we clearly have a “buy-the-dips” mentality by those who feel they have missed this rally and feel the need to get in. Can this rally continue? You better believe it….largely because no one does. I turned positive back on March 9th basically because everyone was so incredibly negative, and I expect this rally to fizzle when the majority is positive. That is not today. Everybody wishes they had gotten back in earlier, assuming they were smart enough to get out in the first place. (Hopefully you have been reading my commentaries). What’s worse is that most say they will get back in as soon as it pulls back some. That alone tells you that it just isn’t going to give people the opportunity. With the individual investor still shell-shocked on the sidelines licking their wounds, institutional investors have been buying up this market anticipating a recovery. This is a very common scenario as the institutional investors tend to buy early and sell to the unsuspecting individual investor at the top. Institutional investors are so much more successful because they do not act on emotion. That’s one of the reasons it’s so hard to manage one’s own money, and why it’s so important to work with someone that knows what they are doing.

Economic Update – Hope for the recovery, prepare for its failure
The market is digesting a trifecta of bad news, and holding up quite well. The Census Bureau reported the April Trade Deficit is at -$29.2 billion. This follows a revised March deficit of -$28.5 billion. Today’s figure was in-line with the consensus estimate. Unfortunately for the US economy, it does not appear that trade will contribute much to a recovery. Exports fell to the lowest level in 3 years. This lack of exports this fare in 2009 suggests overseas demand for US goods remains weak that US exporting industries have not been able to take advantage of the sagging dollar. We just had a 10 year treasury auction that was just dismal, almost 4%. That’s up from about 2% just a few months ago. The world clearly doesn’t like our spending and the financing of it. The fact is that people -- not least the Chinese government -- are already distinctly dubious. They understand that US fiscal policy implies big purchases of government bonds by the Fed this year, since neither foreign nor private domestic purchases will suffice to fund the deficit. This policy is known as printing money and it is what many governments tried in the 1970s, with inflationary consequences you do not need to be a historian to recall.

To round out the triple play, throw in rising oil prices, which crossed $70 per barrel this morning, and this at a time when the economy is still in recession. I’d hate to see what it will be at when the world economies fully recover. Unfortunately for the consumer, higher per-barrel oil prices act as a very effective tax thereby reducing consumption. As energy prices rise and demand picks up, inflation is an inevitable by product. Rising inflation acts as a drag on real economic growth and puts pressure on the Fed to raise rates to offset inflation. Although, if the inflation is being imported into the US via higher oil prices, the effectiveness of monetary policy is diminished.

No doubt there are powerful deflationary headwinds blowing in the other direction today. As I have said, assets are being destroyed faster than the government can inflate…today. There is still surplus capacity in world manufacturing. But the price of key commodities has surged since February. Monetary expansion in the US, where M2 is growing at an annual rate of 9 per cent, well above its post-1960 average, seems likely to lead to inflation most likely not this year but almost certainly next.

Can the markets go higher? Absolutely…but for how long? There are serious obstacles that still exist that will likely push us back to retest and possibly break the lows. The demographic challenge of an aging population is turning spenders into savers. The personal savings rate in the USA at the end of April 2009 was 5.7%. Just over a year earlier ago the nation’s personal savings rate was 0.2%! And that trend is going to continue. With 70% of our nations GDP coming from consumer spending, this is devastating. Private sector deleveraging, reregulation and reduced consumption all argue for a real growth rate in the U.S. that requires a government checkbook for years to come just to keep its head above the 1% required to stabilize unemployment. Five more years of those 10% of GDP deficits will quickly raise America's debt to GDP level to over 100%, a level that the rating services - and more importantly the markets - recognize as a point of no return. At 100% debt to GDP, the interest on the debt might amount to 5% or 6% of annual output alone, and it quickly compounds as the interest upon interest becomes unsustainable.

In addition, housing is nowhere near a recovery, as we will start to see increasing commercial and prime loan defaults. This could become massive. For most of the past 50 years, the loss rate on all bank loans has stayed well under 2 percent. The Fed estimates that over the next two years the loss rate could reach 9.1 percent. You know all those historical comparisons that end with "the worst since the Great Depression"? Well, 9.1 percent would be EVEN WORSE than during the 1930s. Still looking forward to a soft landing or a quick recovery? The Fed projects that the median loss rate could hit 8 percent on mortgages, 10.6 percent on commercial real estate loans, and 22.3 percent on credit card loans. A number of banks that made riskier loans face loss rates that are much higher. Banks can't just absorb losses of that magnitude and briskly bounce back. To survive, they'll have to sell assets, hoard cash, curtail lending, and simply wait it o ut. None of that generates economic growth. Oh, let’s not forget about the unemployment rate, which was pegged for 2009 at 8.9 percent—which happens to be lower than where it is now. With unemployment forecasted to rise for the rest of the year, we can expect higher default rates and even deeper bank losses than the Fed predicted.

Strategy – It’s summer time so ride the wave
In the short term, we are overdue for a correction. Since June 2, the DJI is essentially unchanged (8740 to 8739 today), while the S&P 500 has lost just 4 points. But, over the
same period, the % of Stocks Above their 10-DMA has dropped from 89.5% to 56.5% and Buying Power has fallen by 26 points (162 to 136). These signs of deteriorating breadth and contracting Demand suggest substantially more market weakness than implied by the nominal changes in the major price indexes. Therefore, investors should avoid becoming complacent.

A Tactical investment strategy, much like our TDT™ , is a must in this market, with buy and hold investors continuously getting punished. Our strategy of high dividend paying stocks and high yielding corporate bonds, both in the double digits should continue to do extremely well. I want to get paid while I wait and see. This is a dangerous market, so be the expert or hire one.

If you’d like someone to talk to that knows what they are doing or a free 2nd opinion, give us a call – 916-925-8900.

Cheers -Keith
KeithSpringer

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