In the headlines

A look at some of the market movers over the past week:

• The US government agreed to rescue Citigroup
• President elect Barack Obama is expected to look for a high number when implementing a stimulus plan
• Homebuilders joined the legion of industries looking for government money
• The US Treasury announced a new program that will focus on freeing up consumer lending
• Mining giant BHP Billiton dropped its $66 billion offer for Rio Tinto
• The OECD is expecting a recession through mid-2009 followed by a slow recovery in the US
• Existing home sales declined in October
• The market is awaiting next week’s initial GAO report on the TARP
• In an effort to boost its economy, China’s central bank cut rates by more than 1%
• Third quarter GDP was revised down to an annualized decline of 0.5%
• The conference board’s reading on consumer confidence improved in October
• All eyes are on the results of Black Friday shopping

Commentary

The holiday-shortened week was a great one for investors as the S&P 500 index bolted up 12%. The gains were sparked by a big 6.5% jump on Monday as investors cheered the government’s efforts to save Citigroup.

Though business activity slowed considerably during the week because of the Thanksgiving holiday, investors heard all they needed to bolster all the indices. Aside from the rescue of Citigroup, the government stepped in during the week to offer further assistance through additional funding designed to free up consumer lending such as credit cards, student loans, and auto loans. Meanwhile, economic data released during the week continued to paint a bleak picture of the US economy over the next few quarters.

Looking ahead

Heading into next week, the big question is whether the good cheer that investors carried through the past week will hold up.

With the close of the month of November, there is plenty on the economic calendar next week. The most important reports on the schedule will be the Fed’s “beige book” report on Wednesday and the dual employment reports coming Wednesday and Friday. Off the schedule, we will also have reports on Black Friday shopping and TARP usage to look forward to.

Earnings season will be continuing to wind down this week, so the company-specific news dominating the headlines will likely be focused on financial companies dealing with the turbulent times. Homebuilders, however, are scheduled to report third quarter earnings during the week, and investors will key on their results looking for signs that the housing market is starting to recover.

The big gains from last week gave investors plenty to be thankful for on Thanksgiving and it was a good reminder that the direction of the market can be very difficult to predict. This will hold true moving forward as well, and that means that while we enjoyed the gains last week, the market could turn right back around next week. As I’ve heard it cleverly put, picking tops and bottoms is best left for bathing suit shopping.

So while we find ourselves lacking a working crystal ball to predict the near term movements of the market, we continue to be believe in the longer term prospects of the global economy and global equities. For that reason, we continue to recommend the simple strategy of consistently investing new money on a regular basis to build your retirement nest egg.

In the headlines

A look at some of the market movers over the past week:

• Leaders from the so-called Group of 20 met to discuss the state of global finance
• Company insiders are busy snapping up shares in the open market
• Multiple Goldman Sachs executives opted out of 2008 bonuses
• A survey by the National Association of Business Economists shows a pretty dim outlook for the US in the near term
• Japan’s economy entered recession
• Embattled Yahoo! leader Jerry Yang opted to step down from his CEO position
• Citigroup announced 52,000 job cuts, but couldn’t seem to stem the slide in its stock
• Dallas Mavericks owner Mark Cuban ended up on the wrong side of securities laws
• Bank of America doubled its stake in China Construction Bank
• Industrial output was up more than expected, but may not portend a recovery
• It’s been a rough year for most hedge funds
• The Producer Price Index (PPI) dropped a record amount in October
• Consumer prices posted a likewise steep drop
• Minutes from the most recent Federal Reserve meeting show that more rate cuts could be on the table
• Economic leading indicators fell in October
• Congress held off on pushing through a bailout package for US automakers
• Rumors on Friday suggest that Barack Obama will name New York Federal Reserve president Timothy Geithner the new Treasury Secretary

Commentary

Selling pressure continued on the markets this week with major downswings on Wednesday and Thursday pushing the S&P 500 index down nearly 14% by Thursday’s close — the lowest level on that index since 1997. Excitement over the potential naming of Tim Geithner as the new Treasury Secretary sent markets on a roaring upswing to help Friday finish with a 6.3% gain, but even with that the S&P closed the week having shed over 8%.

Economic news continued provide a drag on the equity markets this week. The only upside highlight of the week was industrial production notching a better performance than expected for October. However, this was largely explained away as just a recovery from a lackluster September because of Hurricane Ike. The Producer Price Index and Consumer Price Index both logged significant declines showing that the drop in energy prices is helping to moderate price levels. While this would have been heralded as good news earlier this year when inflation was beginning to look like a problem, today it’s being taken as a sign that recession is deepening and The Fed will have its work cut out trying to prevent a deflationary spiral.

Meanwhile, company specific events played a big role in the markets this week. Front and center were Citigroup and the “big three” US auto makers. Citigroup’s stock continues to struggle as investors weigh the possibility that loan losses will overwhelm the company and induce a forced sale or government rescue — either of which would make the equity close to worthless. Massive layoffs at Citigroup and a follow-on investment from Saudi prince Walid bin Talal failed to comfort investors. The company, which was at one time the world’s largest bank, now carries an equity value of just over $20 billion and a stock price of under $4 per share.

The US automakers didn’t have much luck either this week. Hopes were high that some agreement would be reached so that Ford, General Motors, and Chrysler would receive some kind of funding or bridge loan to help them survive quickly-dwindling cash reserves. Supporters of such an action say that a failure of any or all of these companies would severely impact the US economy and ripple out into other areas, while opponents claim that the automakers do not have sustainable business models that would allow them to operate profitably without continued bailout funding. Talks reached a standstill when Congress demanded a recovery plan from the automakers before moving forward.

Since the one bit of news that seemed to cheer investors during the week was the announcement of Tim Geithner as a potential successor to Hank Paulson as Treasury Secretary, readers may wonder who Mr. Geithner is and why his appointment is so important. He has a pretty impressive resume, which includes serving as Undersecretary for the Treasury for International Affairs under Treasury Secretaries Robert Rubin and Lawrence Summers as well as serving as a director at the International Monetary Fund. His most recent position as the president of the Federal Reserve Bank of New York is also very notable as he is also the Vice Chairman of the Federal Open Market Committee under Fed Chairman Ben Bernanke.

However qualified Mr. Geithner may be, though, the reaction at the end of the trading day on Friday was much more straight forward. Investors tend to hate uncertainty of any kind. The length and depth of the current recession is a very large current source of uncertainty and investors have certainly reacted very unfavorable to that. Another current source of uncertainty, though, is the Presidential transition from George Bush to Barack Obama. Positions such as Treasury Secretary have taken on extreme importance in today’s crisis, so the unveiling of who will be taking over these financial positions should bring some comfort of certainty to investors.

Looking ahead

With a wake of so much bad news from last week, what can we look forward to next week? Unfortunately, extreme volatility is probably still all that I can promise will be on the menu for sure. It’s unlikely that economic reports will cheer the markets much next week, as it seems unlikely that existing home sales, consumer confidence, personal income, or personal spending will surprise to the upside. A preliminary reading of third quarter GDP also has a good chance of bringing on pessimism as the market expects it to decline to an annual rate of contraction of 0.6% from 0.3% last quarter.

On the brighter side, though, as I’ve discussed in the past, the market tends not to move based on what is happening currently, but rather what is expected in the future. So though current economic readings continue to decline, the market is already looking ahead to the next quarter and next year to see what they will hold. Any indication of light at the end of the tunnel — even two quarters out — could cause markets to begin to recover. At the same time, there have been some indications that President Elect Obama may be naming the rest of his economic posts next week and that could likewise spark markets to the upside.

To a large extent corporate earnings will be lighter next week due to the Thanksgiving holiday. There will however be some notables like Hewlett Packard and Deere that will report prior to Turkey Day. More likely, though, the major company specific news that we’ll see will be continued focus on the travails of Citigroup and the automakers.

In retrospect, this has now been one of the worst stock market collapses that we’ve ever experienced. Not only has any excess excitement been shaken out of the market, but there seems to be an overdose of pessimism which has brought the S&P index’s current earnings multiple markedly below its long term average. While this doesn’t mean that there isn’t room for the market to fall further — after all, investors don’t always act rationally — we don’t recommend making any drastic changes to your long term investment strategy. 

In the headlines

A look at some of the market movers over the past week:

• China unveiled a $586 billion stimulus plan
• As losses increased at AIG, its bailout got bigger
• American Express converted to a bank holding company in hopes of accessing TARP funds
• Citigroup launched an aggressive mortgage modification program
• Talks continued on the possibility of bailing out the big three US automakers
• Hedge funds recorded another lousy month in October
• Economists have turned very bearish on the US economy
• Treasury Secretary Hank Paulson materially changed the way the TARP program will try to achieve its goal
• GE got some help from the FDIC
• Wal-Mart reported a strong quarter, but was cautious about the future
• The OECD cut its growth forecasts for 2009 again, now showing a contraction next year
• The Euro area officially fell into recession
• It’s unclear what can really be expected from the G-20 summit over the weekend
• It may be too late for GM by the time Barack Obama takes office
• Retail sales caused a fresh round of bearishness

Commentary

Investors weary from dizzying volatility were still without respite this week. Though a 1.3% drop on Monday could be considered calm in light of recent times, the gap between low and high was still nearly 5%. Monday was followed by four days all with 2%-plus moves, including a truly rattling day on Thursday where a loss of 4% from the open was followed by a massive rally that took the S&P up 11.5% from the nadir.

The 6% loss that the S&P index finished the week with was driven primarily by increased pessimism over the state of the US and global economy. Though it was a light week for economic reports, nearly all of the numbers reported were worse than expected, from initial unemployment claims to the big drop in retail sales. If there was any economic highlight it was the fact that preliminary consumer confidence readings for November came in above where the market had expected. Meanwhile, as earnings season grinds on the market has been met by one company after another projecting future earnings to be weak.

And the wildcard in the whole mess is the government. Now caught in a bit of a no-man’s-land between the lame duck Bush term and the upcoming Obama Presidency, there is clearly somewhat of a holding pattern feeling in a lot of the government’s actions. Top of mind in this category is the “to bailout or not to bailout” question that faces the government when it comes to the major US automakers. Less the fault of the Presidential overlap, the market also responded poorly to the Treasury’s decision this week to abandon its initial plan to use TARP money to buy troubled assets directly from banks.

Looking ahead

It continues to be tough to say what we have to look forward to next week aside from continued volatility. Monday will likely be dominated by reviews of what the G-20 conference over the weekend accomplished or failed to accomplish.

On the economic front PPI and CPI will be released during the week and both are going to show that price growth on both the producer and consumer side has slowed drastically, though this is less likely to be much encouragement at this point. Midweek we’ll see the minutes from the most recent Federal Reserve meeting, and there will likely be a focus on the implications of what was said at that point.

The earnings calendar remains heavy through next week, with Lowe’s and Target reporting Monday, Home Depot and Saks on Tuesday, BJ’s Wholesale and Ross Stores on Wednesday, Dell and Gap on Thursday, and HJ Heinz and JM Smucker rounding out the week on Friday. There’s no reason to think that the general tenor of the reports will be any different from what we’ve heard over the past few weeks. Current numbers are likely to be moderate to weak, and outlooks will be very much on the conservative side.

As I noted above (and have been mentioning for weeks now), the one assurance that we have in this market is volatility. The reason is simple — financial markets are made up of a combination of actual finance and a healthy dose of psychology. In the quiet times — those years when the economy is relatively stable and the markets don’t move a whole lot in one direction or the other — finance takes a much bigger role. In times of great excitement or great despair, psychology tends to take over. And this is what we’ve seen recently.

The big five and even ten percent swings in the market are simply not dictated by financial or economic fundamentals. Sure, the moves are happening because of changes in some fundamental factors, but they not moving based on those factors. That may seem like a small difference, but it’s important. The economic reports that we’re getting from day-to-day to not equate to fundamental changes of these magnitudes. Instead, what investors are doing is taking these current period changes and reacting based on the direction of these changes and the expectation that these changes will persist and get significantly worse.

The problem with this is that there’s really no way to know whether investors’ are right or wrong in these predictions. Six months ago investors obviously weren’t bearish enough. Are we still in that same situation today? Or have investors swung the other way and gotten too bearish now? A lot of it boils down to a guessing game.

Still, we can’t simply sit back and wait for an economic recovery to show itself before jumping back into the market. Just as investors are trying to anticipate the economic bottom, they will likewise try to anticipate the beginning of the recovery. By the time good economic numbers start coming out, the market will long since have started its recovery.

What’s an investor to do then? We believe the answer for most investors is to avoid playing this guessing game at all and not only keep your money invested, but continue to consistently invest new money. If you don’t need the money for at least the next five years you have the luxury to be able to wait for the recovery and in the meantime take advantage of beaten down stock prices. Unfortunately, we can’t predict the timing of a turnaround, but we can predict that a turn will come and we want you to be there for it.

I suspect this economic downturn must relate to anticipated holiday spending, so I went out to find some statistics on what the outlook was for this year.  According to an annual survey by the National Retail Federation (Holiday Consumer Intentions and Actions Survey), U.S. consumers plan to spend more on average this year than last at $832.36; this is up 1.9% over last year’s average ($816.69), but it represents the lowest increase since the survey began (2002).  So it appears that there will be some reservations about holiday spending as Americans look for ways to save money. 

Here are a few ideas:

• Gift Exchange -There are many variations of the gift exchange, including Secret Santa and White Elephant. I can say that this is something we are doing on my wife’s side of the family this year instead of the traditional get-everyone-something arrangement. This is going to save us both time and money.

• Shop Online - Research the items you want to buy and compare prices to make sure you are getting the best deal. Also, look for specials and coupons. Some popular websites that may help:

http://www.dealcatcher.com/  - This site is a good source for printable coupons, links to deals and coupon codes.

http://www.mysimon.com/ - This is a comparison shopping site to research the best prices on almost anything.

• Be creative - at the expense of sounding cliché, sometimes the best things in life are free. A great gift doesn’t mean it has to be expensive, so use your imagination and give something that the recipient will really value. As a parent with a young child, I can say that I would appreciate a night of free babysitting more than just about anything right now. Here is a source for some other good cheap/free ideas:

http://familycrafts.about.com/cs/giftgiving/a/120400a.htm

Even if you have additional money to spend this year, it’s still a good idea to shop smart.  You can always put some extra funds toward retirement.  Please post a comment with your plans for this holiday season and include any ideas on other ways to save money.  Happy Holidays!

Kevin Jaegers, Senior Investment Advisor

In the headlines

A look at some of the market movers over the past week:

• Barack Obama was elected the 44th President of the United States
• Drivers are keeping more in their wallets as gasoline prices continue to fall
• Machinists at Boeing agreed to a 15% raise and returned to work
• JPMorgan is making a huge push to modify $70 billion worth of mortgages
• Despite a rock bottom Federal Funds Rate, mortgage rates are on the rise
• A flagship Goldman Sachs hedge fund has lost nearly $1 billion amidst the market downturn
• Auto sales in October were downright ugly
• Stocks fell hard in a post-election sell-off
• The Bank of England cut rates by a hefty 1.5%
• Forecasted sales declines at Cisco sent investors running
• Analysts’ are heavily cutting back fourth quarter and 2009 earnings estimates
• Reports from the service sector showed worse than expected drop
• Owners of GMAC debt could be out of luck if the auto lender doesn’t turn itself around
• Wells Fargo encouraged investors when it completed an $11 billion sale of new stock to help pay for its Wachovia acquisition
• Though Yahoo! has come back to the table Microsoft does not seem interested in a renewed bid for the search company
• US unemployment climbed to 6.5%

Commentary

While it was a memorable week historically, if not politically, for the United States of America, it was a forgettable week when it came to equity markets.

The election of Barack Obama as the US’ 44th President made him the first African American President, and, to many at home and around the world, signaled a change in direction for the country. However, an historic election day stock market rally that added 4.1% to the S&P 500 was erased by a two-day, post-election plunge of 10%. The S&P index lost nearly 4% on the week, and with the exception of Monday, every day showed a large, volatile swing.

While some may have been cheered by the changing of the guard at the top post in the US, many others continued to focus on the very real near term challenges. Economic reports during the week were pessimistic on the whole, particularly when it came to unemployment numbers. The market continues to seem very unsure of what, if anything, can be done to abate the economic downturn, as well as what timeframe a recovery might come in.

Meanwhile, earnings reports from companies across industries have been mixed on the whole, but the outlooks have been anything but. Whether they’re looking at real data or being extra cautious, management teams have been particularly bleak in their forecasts for the remainder of 2008 and next year. Many investors also still fear that analysts’ earnings estimates for the next three to five quarters remain on the optimistic side.

Looking ahead

If November was supposed to bring an automatic stock market recovery, we haven’t seen it yet. Looking forward to next week it’s hard to know what to expect — aside from continued volatility. The economic calendar will be light, with retail sales numbers and a preliminary reading on the Michigan Consumer Sentiment Index for November coming at the end of the week. A more likely market mover for the next week will be developments in the response of governments around the world to the continuing financial turmoil.

The earnings calendar remains robust next week before starting to taper off somewhat the following week. Retail names will be among the major groups reporting numbers during the week, and pessimism from the CEOs of that group could incite more selling among investors that already fear further slowing in consumer spending.

We understand that our continued beating of the “invest consistently” and “don’t get scared off by the market” drums may seem overly repetitive. However, we believe that it remains just as true today as every past mention. Why is that? When it comes to capturing the returns that equities have historically offered, we have yet to find a system that consistently works for timing the movements of the market. Investing consistently over varying market conditions, on the other hand, has been time tested and battle proven.

Over the past two months, there have been eight days where the market has gained 4% or more in a single day. There have been two days where the market has jumped more than 10% in a single day. Let me repeat that: more than 10% in a single day. When a recovery does come, we expect that it will start in an unpredictable, volatile, and abrupt fashion. Those who have chosen to move to the sidelines to wait for the market to prove it has started into a recovery may miss a very significant part of that recovery. Worse still, sidelined investors may try to jump back in at the wrong times — reentering after a big gain only to get burned by a swing back down and scared out all over again.

So instead of trying to do the impossible — guessing market movements — we choose to stick to what has been proven over time, namely, the long term appreciation of the stock market. This doesn’t mean that the current market crash doesn’t hurt — it most certainly does. But the golden phrase that King Solomon’s wise men told him to engrave on a ring, “this too shall pass,” is no less true today than it was back then.

Historically, election years have usually been good for the stock market; the average gain in the last seven months of the year was 7.2%.  Overall, looking at market trends since 1945 the S&P 500 has posted an average gain of 10.7% during the 28 years a Democrat was president vs. 7.6% during the 35 years of GOP residency. While we cannot predict who will win the election or what will happen we can take a look at some historical trends in the market based on party leadership.

There have been 27 Presidential elections since the start of the Dow Jones Industrial Average in 1896.

• The Democrats have won 12 times and the Republicans 15 times with the white house switching parties 10 times
• During election years, the Dow has been down YTD on Election Day only seven times.  Three of the seven times, the incumbent party was defeated.

The two months prior to Election Day the Dow, on average, has increased +1.92%.

• This year the Dow closed 9/2/08 at 11, 516.92 and closed 10/30/2008 at 9,180.69, this is a decrease of -20.28%
• When the current office is held by Republicans, the average is +0.6%
• When the current office is held by Democrats, the average is +3.5%
• When a Republican is elected, the average goes to +2.2%
• When a Democrat is elected, the average goes to +1.5%

In first Year of Elected President’s Term the Dow, on average, has increased +4.85%.

• When the White House stays Republican, the average increase is +8.2%
• When the White House stays Democratic, the average increase is +0.5%
• When the White House changes from Republican to Democratic, the average increase is +13.7%
• When the White House changes from Democratic to Republican, the average goes to being down -4.6%

Whatever the outcome is in the election, it seems as if the historical numbers are in our favor. 

Jessica Slaters, Investment Advisor.

Source: www.stocktradersalmanac.com

A look at some of the market movers over the past week:

• Morgan Stanley had to use $23 billion to help prop up its money market funds
• Talks between GM and Chrysler continue as the US auto makers struggle
• BP announced a better than expected third quarter
• Whirlpool announced 5,000 layoffs as the global economy continues to slow down
• GM’s GMAC is looking into becoming a bank holding company to be able to access Treasury bailout funds
• Consumer confidence plunged to an all-time low this month
• The Federal Reserve cut the Fed Funds Rate 50 basis points to 1%
• Japan announced an economic stimulus plan and cut interest rates
• Sprint decided to keep its Nextel unit after failing to find a buyer
• GDP fell in the third quarter, but not as much as expected
• Crude oil had its worst month in October since futures began trading 25 years ago

Commentary

October finished on a good note with stocks shooting up over 10% for the week. However, that’s about all the good we can say about this past month. While a 10% weekly gain might normally be a heady week, after the month we’ve had it’s only part way to climbing back out of a deep hole. In the end, the S&P 500 index shed 17% in October.

The data out this week focused on two economic releases — the Federal Reserve’s interest rate decision on Wednesday, and the third quarter GDP reading on Thursday. In typical market anticipation, all three indices had a major rally on Tuesday ahead of the Fed’s decision, with the S&P finishing up nearly 11% on the day. When the decision to cut rates by a half percent came out on Wednesday, the S&P backed off some of the gains of the previous day.

GDP, meanwhile, is an interesting story. Prior to the release, the briefing forecast was a positive 0.3% annualized rate of growth, while the market was expecting a negative 0.5%. And this was coming off a slower-than-normal but better-than-bad second quarter in which the government’s stimulus checks helped push annualized growth to 2.8%.

The negative 0.3% rate that was released seemed to comfort the market. This may seem strange because it shows contraction and means that we will end up entering a “true” recession if next quarter’s number is negative as well. However, with the markets down heavily from the highs of last October, there is already a good deal of pessimism priced in. What market participants are looking for now are signs that things aren’t going to end up in a worst case scenario — and the GDP release seemed to be that.

Most other economic indicators released throughout the weak also showed a slowing economy, including a much worse than expected reading of consumer confidence by The Conference Board. One of the few upside surprises was better than expected growth in personal income.

Meanwhile, earnings season continued to chug along, delivering some surprises, but largely falling within the bounds of expectations. Earnings at most companies don’t seem to be falling alarmingly quickly, but the forecasts delivered by most management teams warn of slowness continuing next quarter and potentially through much of next year.

Looking ahead

October is a strange month. For whatever reason, the worst declines in the history of the stock market have taken place during this month. The steep decline that kicked off the market’s plunge in to the Great Depression was in October. As was the dive of 1987. And surely October 2008 will go down in history with those two previous crashes. Maybe it’s haunted? After all, the month does conclude with Halloween.

Of course, saying that we can breathe a sigh of relief just because we’re now out of the month is about as plausible as saying that October is a haunted month. Yet that’s what many commentators seem to want to believe. If you haven’t heard this already, let me be the first to tell you: if we start to see a rebound in November, it’s not because the changeover from October from November is magical, it’s simply because pundits and traders have convinced themselves that November will bring some type of recovery.

There’s no magic in the markets, there’s psychology in the markets. Anytime something is talked about enough, investors, traders, and so forth can convince themselves that it is so. And it doesn’t take a Nobel laureate to figure out that when enough participants are convinced of something, it’ll end up being a self fulfilling prophecy.

But we steer clear of all of that, and that’s where our advantage is. By avoiding taking action based on who wins the Super Bowl (don’t laugh, some people actually do that), the shape of a graph, or the phase of the moon, and instead consistently investing in a diversified portfolio of funds and holding onto them over the long term, we’ll capture the long term appreciation of commerce around the world with far less hair lost in the process.

It was very important for them and for you to understand that no one can predict what the future will hold so it’s imperative to have a properly allocated and diversified investment strategy based on your risk tolerance and time until retirement. This doesn’t mean picking all the funds available to you, but rather building a portfolio that includes all the major asset classes (Lg Cap, Sm Cap, etc).  For someone nearing retirement age, they should probably be more conservative, while someone with 20 or 30 years until retirement can stand to continue to invest more aggressively.  

I know it’s tough with how the market is, but now more than ever it is time to have a good game plan and stick to it.  People should approach investing like coaches approach football games.  Coaches set a game plan going into the game and stick to it.  They review hours upon hours of game film and monitor the strengths and weaknesses of their team and opponent and create a strategy that gives them the best chance of success.  During the game, coaches make minor adjustments, but don’t throw their game plan out the window at the first three-and-out or turnover.  It seems people create game plans but then throw them away at the first signs of market turmoil.  If you’re not sure how to come up with a game plan for your retirement or are worried that your game plan doesn’t fit your retirement goals, feel free to contact us to talk through your situation. 

Needless to say, the football analogy connected with a lot of the people I talked to and I had a lot of new friends. Unfortunately for me, they were all MU fans.      

As always, if you have any questions or would like to discuss your account, feel free to call us at, 1-877-627-8401.

Jeff Studebaker, Investment Advisor

In this post I’ll talk a little bit about what happened to all of those mortgages once a borrower closed on a house/apartment/condo and how they added to the fire.

Historically, banks originated loans and held them on their balance sheet as assets.  They made money by lending at a higher rate than they paid on customers’ deposits.  Since the banks were holding the loan on the balance sheet (i.e. they were hurt if the loan went into default or otherwise underperformed) they were generally very selective in the loans they made.  This began to change when many of these banks and other lending institutions began to sell the mortgage loans they originated to financial institutions who would package them into mortgage backed securities (MBS) a type of asset-backed security. 

These structured securities allowed the originating bank to book a profit on the loan quicker and also freed their balance sheet and enabled them to make more loans.  Since the originating bank was no longer at risk if the loan went bad many began to relax their lending standards.  In order for banks to sell their loans, the loans just had to meet the minimum standards of the Federal Housing Administration (FHA) — an entity whose stated goal was to boost the rate of homeownership in the United States.

Financial institutions then created the MBS and sold them to institutional investors who desired a “stable” asset that produced a regular level of income.  The idea behind mortgage backed securities was that if you pooled a large enough number of mortgages you were actually decreasing your overall risk by diversifying through large numbers of individual loans and over various geographic areas.  In other words, one bad loan wouldn’t ruin your day.

In addition, mortgage backed securities were divided into “tranches” based on risk level and interest rate, allowing buyers to make purchases based on level of risk they were willing to accept.  The process for rating these tranches was similar to other fixed income securities. Rating agencies like Standard & Poor’s and Moody’s would give the tranches with the least risk investment grade ratings (think GE and Berkshire Hathaway debt), while slapping lower ratings on riskier tranches.  So in many cases, a pile of high risk sub-prime loans were magically turned into supposedly high-quality, investment grade fixed income securities.

After securitizing and selling the loans, these financial institutions were able to buy more loans and repeat the process over and over again.  As the real estate market continued to boom, all parties involved got hungrier and hungrier for more and more loans.  Everyone involved was happy until the real estate bubble started to deflate.  As defaults began to rise, the buyers of the MBS’s started to see losses that they weren’t expecting to see from such a supposedly high grade security.  Buyers quickly stopped buying the MBS’s, sticking the financial institutions with a bunch of unsalable mortgages. That caused the financial institutions to stop buying new loans, which in turn meant that the originators had to hold them on their balance sheets and quickly curtail their new lending.  In the end, this meant that a new home buyer suddenly had a lot more trouble finding a loan, which helped slow the pace of home buying.  With new buyers kept at bay, home prices started to fall and those who had overextended themselves to buy a property found themselves without clear path to safety.  It’s not too hard to see how this situation can feed on itself and create a downward spiral.

So now we have between $1 and $1.5 trillion dollars in sub-prime mortgages that no one wants and a large number of buyers who can’t keep up with the payment on loans they shouldn’t have taken out. The result? A frozen market.  Individual and corporate balance sheets are now full of loans they don’t want, which restricts their ability to spend or lend additional money.  And the spiral continues…

As always, please feel free to add to the commentary and ask any questions you might have.

Scott H

In the headlines

A look at some of the market movers over the past week:

• South Korea announced that it is launching a bailout program of its own
• ING received a $13.4 billion lifeline from the Netherlands government
• President Bush announced a series of global economic summits to address the current economic slowdown
• The Federal Reserve launched a new plan to help stabilize money market funds
• Fed chief Ben Bernanke spoke out in favor of a fiscal stimulus package
• Asian countries considered a massive program to shore up the region’s economic situation
• Apple managed to report good numbers despite the difficult economic environment
• Yahoo! announced big layoffs along with their quarterly report
• Consumer sentiment continues to be underwhelming
• Credit Suisse announced a big third quarter loss
• Goldman Sachs announced that it will cut 10% of its staff
• Foreclosures are still dangerously high but may be showing signs of slowing
• OPEC countries agreed to cut production in an effort to support the fast-falling price of oil
• Former Fed Chairman Alan Greenspan testified before Congress on his part in the financial crisis

Commentary

The market stats for the week were all too familiar for investors. Three out of the five days were down days, four out of the five days had moves of 3% or greater, and the week finished down just shy of 7%.

News-wise, coverage focused on the worldwide economic uncertainty. Though financial markets appeared to loosen up to some extent sparking a big gain on Monday, economic reports throughout the week — including a decline in third quarter GDP in the UK — were sobering. Earnings reports throughout the week were mixed, though even positive reports were overlooked by investors as they continued to focus further into the future.

At this point it is unclear exactly where the market is taking its direction from. Down more than 40% from a year ago, it would seem that even a significant recession has already been priced in. Reports have been making rounds that significant liquidation selling from troubled hedge funds has put downward pressure on markets, while even healthy hedge funds and mutual funds may be selling in anticipation of investor redemptions. At the same time, individual investors, worn down from the market’s wild volatility, may finally be throwing in the towel and selling.

Looking ahead

Last week I began this section by saying:

The more volatile and emotion-driven the markets become, the more difficult it is to predict what factors will play significant factors in its movements. That said, the news events that will cause the most commotion on the markets next week will likely be those that are unscheduled such as new information on the bailout progress.

It’s hard to come up with something more applicable this week. Volatility has continued and we’re somewhat at the mercy of a spooked market right now. Investors will continue to process economic data to try and figure out just how bad the economic downturn will be.

That said, at a time like this it’s important to keep in mind that the stock market and the economy do not typically move coincidently. Economic readouts give us a picture of current and recently passed activity levels. The stock market, meanwhile, tries to anticipate economic activity in advance. This means that stock market declines will precede the bottoms of economic declines and stock market recoveries will likewise precede economic recoveries. So even if the economic picture gets worse from where it currently stands today, that does not necessarily mean that stock market will.

Going into next week we have a heavy calendar on both the earnings and economic fronts. There are a handful of economic reports that could significantly impact the markets. On Monday and Tuesday we’ll see September new home sales and October consumer confidence, respectively, and both are expected to show declines from the prior month. On Friday we’ll see personal income, personal spending, and another reading on consumer sentiment.

The two highlights of the economic calendar, however, will take place right smack in the middle of the week. On Tuesday, the Federal Reserve will make its October policy statement. Based on implied probabilities calculated by the Federal Reserve Bank of Cleveland, the expectation is that the Fed will cut rates by anywhere from a quarter point to three quarters of a point. The following day, an advanced reading on third quarter GDP will be released. After a jump of 2.8% (annualized) that was driven by government stimulus payments in the second quarter, the briefing forecast is for an annual rate of 0.3%, while the market is expecting a decline of 0.5%.

Week after week we will continue to bring you a weekly recap and a look ahead to the next week. However, it’s important that our weekly coverage of news and events is not translated as a short term focus from an investing perspective. We continue to be firmly focused on the long term when it comes to investing, and while the current period is certainly trying, we expect that investors holding their investments, and continuing to invest, over the next five to ten years will benefit handily from the eventual market recovery.

This year has been a rather tumultuous year for investors, with the past month being extremely volatile. The Dow Jones Industrial Average is down more than 35% year-to-date as of Oct. 24. I believe fear has been responsible for a significant portion of the market’s return as investors are overly focused on the health of both our financial system and the economy. I like all of the advisors at Smart401k read and learn as much about the market as we can. One of the things that I have noticed has been the steep selloff in the high yield bond market.

For those of you that are not familiar with high yield bonds (aka junk bonds), they are corporate bonds that have been assigned a credit rating below investment grade by Moody’s or Standard & Poor’s (The two main credit rating agencies).  Bonds with a credit rating of BBB or lower from S&P and Baa or lower from Moody’s are considered high-yield bonds.  Because of their lower credit rating, these bonds generally pay a higher yield than investment grade bonds.  (For more information on bonds click here)

Similar to the stock market, the high yield bond market has been plagued by fear.  This fear has resulted in a steep decline, approximately 25% YTD as of Oct. 24^th, in the Merrill Lynch High-Yield Master II Index, a common benchmark for the high yield bond market.  According to Moody’s, the market has priced in a rise in the default rate to almost 20% which would top the record of 15.4% set during the Great Depression in 1933. The uncertainty in the market has also pushed the yield spread over U.S. Treasuries from around 3% a year ago to over 15%.

A number of bond fund managers, including Dan Fuss from Loomis Sayles, have observed the decline as well and see the current market as an investment opportunity. Mr. Fuss recently gave an interview with Morningstar and said that the current bond market is the best buying opportunity he has seen since 1974.

Please note, I am not advocating or a recommending high yield bonds but rather wanted to write about an observation of recent events. Please feel free to contact us if you have any questions regarding high yield bonds or if you have any questions about your account.

Buck Wendel, Investment Advisor

Scheduled to appear are the following managers:

Dan Fuss - Loomis Sayles Bond and Loomis Sayles Strategic Income

Don Hodges - Hodges

Kent Croft - Croft Value 

Michael Cuggino - Permanent Portfolio

If you aren’t a regular listener go here to find out when it will air in your area. If you aren’t able to listen on Saturday, they typically post excerpts from the show within a day or two on the show website www.mutualfundshow.com.

Good listening,

Scott H

In the headlines

A look at some of the market movers over the past week:

• Emerging from a weekend of discussions, the Eurozone announced actions to aggressively deal with the global financial crisis
• The UK government bought majority stakes in Royal Bank of Scotland and HBOS, the country’s largest mortgage lender
• Germany joined the US in putting forth a large bailout package for its financial sector
• In a change of course, the US Treasury decided to invest bailout capital directly in US financial institutions
• Spanish bank Santander agreed to buy US bank Sovereign Bancorp
• Investors in Morgan Stanley cheered as the bank completed its investment from Mitsubishi UFJ Financial
• Intel led a group of companies that topped earnings expectations
• Pimco grabbed the spot as manager for the US government’s commercial paper bailout efforts
• UBS accepted a $60 billion bailout from the Swiss government
• The Federal Reserve’s beige book showed a underwhelming picture of the US economy
• Retail sales fell more than expected in September
• OPEC scheduled an emergency meeting as the price of oil continues to plunge
• Chrysler is being shopped by its private equity owner Cerberus
• Google managed to confound pessimists by beating earnings expectations
• Industrial production fell sharply in September
• Berkshire Hathaway chief Warren Buffett spoke out in favor of US equities in a New York Times opinion piece

Commentary

The market posted strong gains on the week, with the S&P 500 index climbing 4.6% for the week. But I’ll excuse investors that overlooked this fact after getting viciously whipsawed during the week.

After a miserable week last week with the S&P losing over 18%, Monday saw the index soar nearly 12%. Tuesday and Wednesday, however, the market plunged yet again, losing 9% Wednesday alone. A 9% swing from low-point to the closing price led to a 4.3% gain on Thursday, and a volatile day on Friday ended with just a small loss.

It’s difficult to say what was really driving the market this week outside of raw emotion — fear in particular. Not only were the daily changes large, but the trading volume has regularly been double or triple the average over the past two years, and the difference between the high and low point of the day exceeded 7% every day of the week.

Clearly, work toward freeing up the credit markets, economic projections, and the ongoing earnings announcements are playing into investors’ sentiment. However, to say that this is a market being driven by fundamental factors is probably far from the truth.

Looking ahead

The more volatile and emotion-driven the markets become, the more difficult it is to predict what factors will play significant factors in its movements. That said, the news events that will cause the most commotion on the markets next week will likely be those that are unscheduled such as new information on the bailout progress.

Looking at scheduled events, the economic calendar is light as we approach the end of the month, and the weekly unemployment claims and crude inventories readings will likely be most notable. Existing home sales will be released towards the end of the week, but it seems unlikely that that will move the needle too much given the highly pessimistic housing starts numbers that investors have already digested from this week.

The earnings calendar, meanwhile, will be in full force next week with more major companies reporting than I can easily list. The question on earnings though is not only whether they come out better or worse than expected, but whether they will be drowned out by the din of the rest of the market.

In recent weeks I’ve spent a lot of time reviewing similar historical market slumps with the intent to show that we’ve been through similar times before and that we’ll see the other side of this — and along with it higher stock prices. More recently, though, I’ve heard a number of predictions that we’ll experience a stock market over a number of years that will bounce up and down without really going anywhere, and I thought this was worth addressing.

Looking over the history of the Dow beginning just before the Great Depression, there have been three periods of time when the market has flattened out its growth trajectory and basically gone nowhere for more than a decade. The first of those periods was the Great Depression. During that period there were some steep declines and some recoveries, but the market didn’t start to move appreciably higher until around 1949.

The second such period started in the late 1960s. After a peak in early 1966 the market bounced around aimlessly until the early 80s. And what of the third period? Well that started some time right around the end of the 20th century. That’s right, we’re in it. The Dow’s current level of just over 8,800 — we saw that back in early 1998. In other words, we’ve returned to where we were 10 years ago.

Putting this all together I think we need to take away two things. First, the idea that what we’re going through is “unprecedented” sells a lot of newspapers, but it’s doing nothing to help individual investors. While the specific combination of events we’re facing right now may be undeniably new, the idea of financial and economic turmoil putting a strain on stock prices and making the future look bleak is not new.

The other takeaway is the fact that the periods following the market’s long, flat stretches have been incredible wealth creation engines for investors that haven’t given up on the stock market. The market gained over 450% from 1949 to 1966 and climbed well over 1,000% from 1982 to 1999. While frustration over the current gyrations of the market is very understandable, backing away from the market now makes it highly likely that you’ll miss out on the next big bull run.

Fortunately, this week you don’t have to take my word for the advisability of not only holding, but buying, stocks right now. Warren Buffett, one of the best if not the best long-term investor, wrote a great op-ed piece for the New York Times on Friday laying out exactly why he’s putting his own money on the line in support of US stocks.

I try to be optomistic in everything I do.  Like when my beloved Chiefs start out 1-4, I remind myself that this is a rebuilding year, and at least they will probably get a good draft pick next year.  Or when I play a really horrible round of golf (worse than usual), I try to focus on how nice the weather is that day.  But in this market, it’s been tough to stay positive - really tough. 

After some thought, I have come up with a few positive things, or at least opportunities, to think about:

• Gas is cheaper. Let’s assume the average family drives 30,000 miles a year. Gas is about $1 less per gallon here in the Midwest. Assuming you average 20 miles/gallon, that’s a savings of $1500 per year.
• Investment opportunities. I believe that we have witnessed some panic selling recently, which may indicate the market is a bit oversold. This should present some good buying opportunities if you have a long-term investing horizon.
• This condition is not permanent. We have been in this downturn about a year. Bear markets on average last 14 months.
• This market is a great learning opportuity. Always be mindful of when you anticipate needing your retirement money. It’s easy to get caught up in being overly-aggressive when the market is doing well, but bull markets are not permanent either. Make sure that you scale back on your risk as you approach that retirement date. Even when times are good, the next bear market may be just around the corner.
• Lifestyle changes - As much as I hate to say it, some Americans became too comfortable living beyond their means. This market has forced many of them to make lifestyle changes that will enable them to be more financially responsible in the future.

If you are interested in reexamining (or establishing) your budget, go to our calculators page (in the Tools and Resources section) and use the link at the bottom to access a free excel budgeting tool.

Remember that during every bear market, most investors feel hopeless and become discouraged with investing; often at just the wrong time.  Things will once again become good in America, so stay positive and enjoy some financial lemonade - I believe better times are ahead.

Kevin Jaegers, Senior Investment Advisor 

On Monday, we were greeted with an increase of more than 11% or 900 points on the DOW and everyone was relieved (I would have been happy with a increase of 300 points and thought the 900 point increase portended more volatility).  Tuesday was relatively quiet.  And today, as many have seen, the DOW declined almost 8% or more than 700 points.

I, like many of you, have felt a bit of whiplash lately.  I couldn’t remember a time when we had this much volatility on a day-to-day basis so I went back and did some digging.  Here’s what I found.

In the eleven (11) trading days we’ve had in October the smallest point swing in the DOW, from intraday high to intraday low, has been 475 points. The average daily swing in October has been more than 800 points. 

To put this in perspective, over the last five years, 1259 trading days, we’ve had only twenty-one (21) days where the point swing was equal to or greater than the smallest we’ve experienced in October.  In fact the average point swing was only about a quarter (25%) of what we’ve experienced lately.

So what does it all mean? 

In my opinion, the market continues to follow a herd mentality.  Whichever way the leader points, the herd goes.  Either euphoria reigns like it did on Monday, or panic reigns like it did today.  I am not discounting the effect of the ongoing turmoil in with financial institutions or the economic weakness that we are seeing.  I am however saying that this is nothing new.  The market has had time to reflect on a slowing economy as well as the time to adjust itself to a slowing economy for the last several months.

On the positive side, we’ve seen further action by a number of government’s worldwide.  Several, including the U.S., are investing directly into weakened financial institutions in order to shore up their capital structures and promote a loosening of the credit markets.  With time, these actions will work through the market and begin to free up the capital that businesses need to operate and grow.

In addition, oil closed today below $75/barrel, almost 50% below its peak in July, which will result in more money in everyone’s pocket.

What I’d like you to take away from this post is that I expect continued market volatility, however irrational it may be.  But I also continue to believe that this is a long-term buying opportunity.  The market and the economy have proven their resilience time and time again.  I believe this will again be the case and think we will look back on this time and realize that it was a good time to be a long-term investor.

Scott H

P.S. For those of you who haven’t joined the 1% challenge and taken advantage of the discount, I encourage you to do so today.  To learn more about the challenge, click here.