THOMAS NOGALES FINANCIAL, LLC
August 2007 Update
The S&P500 is at 1455 on 31-July-2007

This page can be linked to at   ( www.thomasnogales.com/emails/2007-8.htm ) after September 1, 2007.

The Thomas Nogales Financial Market Alert Timing Model is in the stock market.  Since our last buy signal in February 2003, the S&P has risen 77%.

Year to date, the S&P500 index is up 3.58% and the TNF Balanced Portfolio is up 1.71% (with half the stock market risk.)

  Here’s the year to date performance of the TNF Balanced Portfolio by asset class.

As of 7/31/07

Market Alert Model
The TNF core model is used to time large cap stocks. It’s currently IN the stock market. Stocks are ok to hold. Inflation is under control.  Stay invested with proper diversification. The market had its share of volatility this past month.  I see no evidence of a recession ahead.  The TNF Market Alert model remains firmly in the market. 

Year Ahead Timing Model
The YAT model is used to indicate periods of buy opportunities within the Market Alert Model’s timing cycle. The TNF Market Alert Model always trumps the YAT model. The YAT model is positive. With the recent drop in the S&P500, the odds have increased that the S&P500 will be higher one year from today.

Interest Rate Model
The TNF Interest Rate model is negative on interest rates and long bonds.  

Stock Trends
I posted the following message on the web side on July 26th.
26Jul2007: Subprime loans will not sink the stock market at this time. The recent declines will run their course. Stay invested. Don't sell into these inevitable mini-panics. If you're feeling stressed, you may be too over-weight equities. Read my article on asset allocation or buy my book and align your investment goals with your psychological make-up.

The concerns about sub-prime loans are understandable but I don't believe we're at the point in the business cycle where these loans are fatal to the markets. The employment numbers remain good. It would be a much different matter if job growth was terrible. Such a situation would increase loan defaults.

Reits have been badly banged up over the last couple months losing over 13% on the year. The worst year for Reits in the last 30 was 1998 when they lost 18.2% for the year. Again, the issue was credit worries with failure of Long Term Capital Management causing a panic in the credit markets. Interestingly, the S&P500 was UP 28% that year. Personally, I believe the stock market is over-reacting to the sub-prime problem. More on sub-prime below.

Commentary
I’ve received some emails this past month from subscribers asking my opinion on the likelihood of various events that could trip things up. This is a good time to examine what could tip the scales and cause the market to weaken.  First, I’d like to say that I think it’s very important to maintain a balanced portfolio at all times.  My timing models should be used to manage stock and bond allocations within a balanced portfolio.  I never recommend a 100% or leveraged position in any assets.  I will over-weight asset classes when the probability of success is very high but that doesn’t happen very often. 

A major theme I keep hearing is that the world is floating on a wave of loose money and once the “excess liquidity” flow ends the house of cards will collapse.  This notion is very prominent on “bear lair” type websites.  It has some validity but is vague and over-reaching.  We have to keep our eye on the ball.  Reasonable interest rates and rising earnings are the ideal mix for a continued bull market.  Until one or the other changes dramatically, investors will likely be safe. 

Let’s step back a bit and examine where we’ve been. 

World Liquidity
Where is it coming from? 

After the market crash in 2000-2002, the US government had to pump cash into the system to keep the economy from imploding.  Injecting fiscal liquidity was the correct prescription.  Governments worldwide lowered interest rates and started spending.  The Federal Reserve loosened lending rules and lowered interest rates.  The banks took advantage of it and starting loaning cash.  The TNF Market Alert model quickly went bullish in February 2003 at an S&P500 level of 828.

Loose lending wasn’t enough.  Lots of money had to be spent.  Now, a reasonable man might have thought, “If we have to spend billions, this is a great opportunity to build a vast nationwide commuter train system with speeds approaching 200mph.  In an era of rising oil prices this would be a neat thing to do”.  But, the Neocon crew in D.C. got to decide how to spend the cash.  We got wars.  Nothing expends cash faster than war and especially one with vague objectives and an open timeline. 

The world is not at dire risk due to extremists with car bombs but truly is threatened by fanatic regimes if they obtain nuclear weapons.  I believe President Bush did the right thing going after Libya, North Korea and Iran.  They all were attempting to develop nuclear weapons.  Things would have worked out better for everyone if Bush had focused on these countries directly and not wasted resources on Iraq.  I would have enjoyed riding on a bullet train rather than spending my tax dollars on bullets.  Regardless, it didn’t take long for the war’s fiscal stimulus along with loose lending to hit the streets of every town in America.

Sub Prime
I sold a property in 2004 and received four offers over full price.  The borrowers were all pre-approved for 80/20 loans.  Each buyer had no money down.  This “financing method” was ideal for people with no cash and weak job histories.  In these 80/20 loans, part of the loan is at a low rate and the balance at a rather high rate. For example, 6.5% and 11%. 

As a finance guy, I was astonished and thought, “I can understand a bank making such loans but who is getting stuck with the high yield and risky part of the loan note? Certainly, no bank in its right mind would make such loans and hold the paper?”   These lending practices so fascinated me that I stopped at my Bank of America branch and spoke with a manager.   I wanted to know how the bank was handling the resale of the paper.  Who was buying that 11.25% note from the bank? The loan officer told me the bank was selling the 6.5% paper and keeping the unsecured higher yield notes!  Yowser!

Mind you, the Federal Reserve regulates bank lending practices and reserve requirements.  So, these wild lending practices were either US government approved or conveniently ignored.  This is the origin of the current sub-prime loan mess.  It’s much bigger than the S&L debacle of the 1980’s and caused directly by the Feds.  So, don’t listen to crackpots who blame the Trilateral Commission or some Jewish banking conspiracy. 

The stock market swooned in July supposedly because no one seems to know who’s holding all that risky paper.  I suspect that banks gradually offloaded those loans to private investors via hedge funds and private placements.  In short, it went to rich guys with too much cash.  Well, it’s my theory. 

The press reports that people are worried that major banks will fail or credit will suddenly dry up as the loans fail.  I’m certain many hedge funds will fail and lots of rich doctors will lose money because they invested in things they didn’t understand.  Some banks will fail.  Heck, even Harvard University has already lost $350 million.  Serves them right.  Anyone who agrees to loan their money to a hedge fund where the operators get to skim off 20% of the profits needs their head examined.

The stock market is impacted because, as these leveraged deals unwind, the banks and hedge funds have to liquidate stock to pay their creditors.  The Federal Reserve says the problem will remain largely contained within the real estate industry.  I think that’s correct.

The collapsing sub-prime market will dry up loans for weak borrowers but not for good credit risks.  Isn’t that the way it should work?  I don’t think this credit problem is the end of the world for stocks or the types of bonds the average investor holds. For example, the TNF Balanced Portfolio holds mostly US Treasuries.  They benefit from credit panics. Let’s look at reality.  Other than sub-prime, loans are not failing at a dangerous rate.  In addition, corporations have not been borrowing recklessly.  Quite the opposite is true.  Most firms in the S&P500 have a good financial structure and not excessive debt.  

I’m not worried about all that sub-prime paper spreading to the broader stock market.  Short term, the problem will have an impact due to fear running its course.  However, as long as employment remains good, some sub-prime borrowers will be able to gradually refinance.  Most others will continue paying their bills.  If things get bad, the Feds will step in.  Why?  Because the Fed created the mess and will be obligated to clean it up too.  They can provide guaranteed refinancing to borrowers and essentially insure the first 20% of the loan.  First, they’ll let a lot of greedy, rich guys lose a lot of money.

Sub-prime paper and other financial excess will impact the corporate bond market but therein lays opportunity.  According to a rating agency: "... 50.7% of the corporate bond market is now rated BB or lower, the first time this has happened, marking a decade-long shift toward more aggressive finance strategies and the evolution of the leveraged finance market." Still, the current bond default rate is 1.4%.

When enough paper goes bad and the notes get priced cheap enough, shrewd investors will see one of the biggest junk bond buying opportunities of a lifetime.  A good bond fund like LSBRX will take advantage of it when things are priced cheap.  But, we’re not yet ready to jump into junk bonds. 

I suspect the real problem with the stock market is more than just sub prime loans.  It’s a deeper concern that America’s leadership has lost its way.  People are worried. Ask anyone; people simply sense something is very wrong.  I think a lot of this has to do with the Iraq war and a lack of confidence in the nation’s leadership.

A Stock Market Scare Scenario
I’ve heard enough of this yammering about the worldwide liquidity crisis.  You want my take on how things could really go bad?

Here's my scare scenario.  Problems for the stock market won't come from spending and waste but from a lack of it.  The system may destabilize if America’s consumption and massive deficits are reduced too quickly.   The exact spending-slowdown trigger isn't yet known but could be caused by the ending of the Iraq war.  Most Americans see it as a failed policy founded on wrong-headed ideology and half-truths.  The public wants it over and done with.  The Democrats want it over too because they have their own laundry list of waste and foolishness to fund.

The impact of spending on the economy is a serious matter.

In 2002, Leon Levy, the head honcho at Oppenheimer wrote a book just before he died.  It was called The Mind of Wall Street.  It was a so-so read, but he was dead serious at one point about the future. 

His book was published during the market crash (August 2002).  He said that the stock market was in grave danger and would sink much lower and back to 1995 levels.  He said, "The only thing that could hold up this economy would be a massive fiscal expenditure program on the level of WWII."  That's exactly what we got.  Please recall, that the wars are as old as the bull market.  That's not a coincidence. 

If the war money spigot is turned off, corporate profits could fall. A combination of a Democrat election win, a war wind-down and tax increases could do the trick.  A spending reduction could expose a cascading group of inter-related problems. 

In a worst-case scenario, I don’t think problems will hit until sometime in 2009 - after the 2008 election.  Both parties want to continue the war so the fiscal impact is put off until after they’re re-elected and 90% of them will be.  Incumbents don’t like to talk about reality during elections. I don’t know when the Iraq war will end, but something is up.

I have a first hand account that American teams are now in Jordan processing certain at-risk Iraqi Muslims for emigration to the US.  We’re probably talking about 10,000+ people out of the 1.25 million who have fled Iraq into Jordan.  The teams then move to Syria where another +1 million refugees have fled.  These people are coming to America because there is no chance of them ever returning to Iraq.  It’s a tacit admission that these people will never go home because the situation will not improve.

Another event was the theft of $300 million dollars from a bank in Baghdad. Three bank guards supposedly cleaned out all the cash from the vault one evening.  The tellers arrived the next morning to find the bank doors open and the guards gone.  Call me a skeptic, but I don’t think three guys pulled it off.  In a country where your whole family is murdered if you cross some tribal boss, this doesn’t ring true.  I think the cash was stolen all right, but by insiders.  It will be divided up among leading politicians.  They are cashing out because the game is almost over. Prime Minister Maliki then said a couple days after the theft that American troops could leave “anytime they want”. 
 
Another event is the growing crackdown on illegal immigration in the US.  If an economic slowdown is ahead, then we won’t need as many low-wage workers.  Arizona recently passed a law punishing firms caught hiring illegal aliens.  The first offense gets the business license suspended for 10 days and the second offense gets the firm closed down.  Other States will follow.  This is happening concurrent with expanded border enforcement. 

The war and very loose fiscal control has pumped enormous volumes of cash into the world economy.  Globalization is big but can it survive a US spending slowdown?  If globalization can continue despite a war wind-down then stocks could continue to do well.  My scare scenario is as much conjecture as all the other talk and you shouldn’t give it too much credence.

The Fringe
I’m no expert on government fiscal management or international banking and doubt many people are.  But, you wouldn’t know it with how all these Internet ‘experts’ talk about the big financial numbers and then conclude a major crash is imminent.  They feed on each other’s ignorance. 

When I see corporate profits actually falling, then I’ll know the stock game may be in the last innings.  That doesn’t mean stocks will crash.  It means stock prices will likely stagnate and maybe for a long time.  Meanwhile, other financial assets will outperform.

I don’t think gold is the answer.  I like gold but I think it’s very unwise to put all your money into it.  In my book, How To Invest If You Can’t Afford To Lose, I explain how to own gold in a portfolio.  The wise investor balances it with bonds because the two are inversely correlated.  All or nothing investment strategies are a prescription for financial failure.  Don’t make that mistake.

A few years ago, the big fear was the aging of America and how this demographic wave would cause stocks to slump.  There wouldn’t be enough workers and people would stop spending.  Look what actually happened.  The world’s corporations opened shop in Asia.  Consumer goods prices are cheap and stock prices have soared.  I can’t predict what will happen next year and don’t think many others can either.  World markets are adaptive to labor shortages and excesses of all kinds.  Wise investors spread their wealth around and work the averages. 

Oil Depletion
Business is red hot in Asia amid rising oil prices.  At some point you’d think rising oil prices would bite.  A recent report by a federal agency stated that oil demand would exceed supply within five years and cause a price spike.  Exxon said that isn’t true and the world had 20 years or more of oil available.  Regardless of who is right, I believe the era of cheap/free energy is over. 

We will see a surge in new nuclear power plants over the next ten years.  Alternative fuels will increasingly power automobiles.  There will be big winners and losers among corporations. 

Concentrating money in a single asset is only a wise strategy if you are certain you know how the future will unfold.  I have no confidence in my own crystal ball.  Therefore, I will hold a balanced portfolio.  If my stock model indicates to exit stocks, I will.  Until then, I’m in the game.

International Reits
Two international real estate investment trusts are now available – DRW and RWX.   These products are not the same as US Reits where 90% of income must be paid out to investors.  They may invest in commercial property but are a different critter.  This is Wall Street looking for a way to attract cash.  I’ll pass.

The proliferation of all these various ETF products is a reason for concern.  What some investors view as opportunity is really just a way to over-concentrate your portfolio in very narrow market sectors.  I don’t care if its Reits, dividend funds, technology sector funds or sub-prime loans.  Highly focused investment should be avoided by most investors or limited to a 10% portion of your portfolio.  

A Safe Path
I’ve hammered away on investment balance in this e-letter and for good reason. If you’re worried about losing your savings or not having enough, then properly balance your assets.  Hold some stocks but perhaps reduce the allocation if the market has you stressed.  It’s ok to be fearful.  That’s your intuition warning you that it doesn’t understand something and doesn’t see an immediate solution.  The sub-prime fiasco should be a life lesson for all of us.

Best Regards,
Thomas Nogales Financial, LLC    (www.thomasnogales.com)
Tom Gleason, Manager & Researcher

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Disclaimer:.
Investing involves risk and the future performance of the models cannot be guaranteed. TNF is not a registered investment advisor and nothing published by TNF should be considered personalized investment advice. Any investment recommendations made by TNF should be made only after consulting with your investment advisor and only after reviewing the prospectus or relevant financial statements.  TNF does not receive any compensation for mentioning stocks, funds, or financial products.