THOMAS NOGALES FINANCIAL, LLC
April 2008 Update
The S&P500 is at 1322 on 31-March-2008

This page can be linked to at   ( www.thomasnogales.com/emails/2008-04.htm ).

The Thomas Nogales Financial Market Alert Timing Model is out of the stock market. 

Year to date, the S&P500 index is down 9.5% and the TNF Balanced Portfolio is down 1.3% (with half the stock market risk.)

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

As of 3/31/08

Market Alert Model
The TNF core model is out of the stock 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 neutral.

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

Gold Model
The TNF Gold Model is positive on gold.

Caution on Commodities
It's time to be careful with commodity futures funds and ETFs. These funds have moved up double digits year to date and I believe it's time to take profits and rebalance your portfolio. Speculative money may be fleeing the dollar and pouring into the various commodity index funds and etf products at too fast a rate.

Admittedly, a huge demand for commodity products exists. For example, China has purchased half of the entire US soybean crop. There's no shortage of demand for other agricultural products either. However, strange price distortions are growing in the agriculture futures market. In particular, the futures contract prices are higher than the spot cash prices in the expiring month. This should be impossible if market participants are rational because why would anyone bid more for the current month's contract if the cash market is lower. Yet, that is what's happening. Academics and experienced traders have varying views about why this is occurring and say you can't blame it all on commodity index funds. There is no consensus on this freakonomics but it's enough to make me cautious. The New York Times had a good article on the subject.

I'm not saying to abandon commodities as an investment class but I do advise being careful. If your portfolio allocation to hard assets is 25% then consider rebalancing back to that.

I do not believe gold is in a bubble - it's real money. Do not sell. Gold is also an excellent proxy for oil because the two are positively correlated 70% of the time. I believe oil and gold are going higher although with some violent swings along the way.

The Consequences of Negative Interest Rates
The commodity anomaly is likely the result of negative interest rates. When the level of inflation exceeds the return investors can receive on short term cash, money stampedes into other investments. This can cause speculations. A few years ago restless cash went into housing and now, perhaps, it's commodity funds.

The official CPI inflation rate is about 4.2% (it's actually closer to 5%) but money market accounts pay under 3%. Thus investors lose purchasing power in safe investments like CDs and money market funds.

Historically, gold and hard assets have done very well during periods of negative interest rates. The chart below shows the year over year change in the price of gold against the level of real interest rates. The X axis is the real interest rate (money market rate minus the inflation rate) and the Y (vertical) axis is the return on gold one year later. If investors don't get at least a 2% real return, they'll switch to gold and other hard assets. The slope of the red line shows the effect of negative rates. When real rates are below 2% gold usually rises in price. The real return on cash is now about -1.5%. Thus, we're seeing vast amounts of money going into commodities.

What Will Cause a Trend Change
The only event that will reverse the rise in gold is interest rates rising to over the rate of inflation or a certainty things are headed that way. Gold won't actually drop until investors are convinced the government will stop stealing their money. They need a real return of more than 2% for holding cash.

The Fed Funds rate is now 2.75% whereas inflation is, let's say, 4.25%. Thus, the Fed would have to raise rates to about 6% right now to draw money out of gold. Higher rates is the tactic Paul Volcker used in 1980 to stop inflation and the flight to gold. In fact, the government will have to raise rates higher than 6% because by year end inflation will be rising and they'll be chasing it. Considering the fragile state of the economy, it's not too likely we'll see a 2% real return any time soon.

With real interest rates well below zero, the recent sell-off in the gold market is thus a correction and does not signal a downtrend for gold.

The Declining Dollar
Negative rates also lead to a weak dollar that declines against other currencies. I've recommended a portfolio allocation to the BWX etf which invests in unhedged foreign bonds. It's up 8.2% year-to-date through 3/31/08.

The dollar has declined against most major foreign currencies I've purchased. These figures are year to date through March!!!

FXE (Euro) +8.1%
FXA (Aussie) +4.3%
FXF (Swiss) +14.2%
FXC (Canada) -3.2%
FXY (Japan) +11.8%

Recession?
The US economy is in recession - of that there is no doubt. And, it's the worst kind of recession where a falling housing market leads to reduced consumer spending and falling employment which then feeds on itself in a downward spiral. That's why the Fed and the Treasury are pulling out all the stops to prevent a feared, uncontrolled, freefall decline in the economy. They can't stop falling home prices but hope to reduce the blowback by preventing foreclosures and a subsequent mood of desperation engulfing the economic system. If employment starts to fall rapidly then the US could spiral into a depression. That's how serious the current situation is.

Clearly, the government is focused on preventing a consumer led economic collapse. Thus, the dollar decline is not a primary concern at this time. That's why I've recommended gold, BWX, and currency hedges.

Speculation is a consequence of negative interest rates as frightened money heads for the exits. Investors must keep their wits about them and not follow the pack over a cliff. For that reason, I'm warning you about commodities.

The Big Markdown
Financier Mort Zuckerman says the economy may be in a perfect storm. "We are looking at the worst set of macroeconomic conditions since the Great Depression,'' Zuckerman said in an interview with Bloomberg Television. ``I don't know where the bottom is. The federal government's going to have to do a lot more to contain what I think is the potential of a perfect storm."

Municipalities are in big trouble too. "Half of U.S. states project budget deficits for the next fiscal year as the slowing economy curbs tax collections, forcing local governments to spend savings, cut funding for programs and borrow or raise taxes, the Center on Budget and Policy Priorities, a Washington-based research group, said in January."

I've labeled the process of asset deflation and deleveraging "The Big Markdown". It's underway in full force. The stock market appears sanguine and just stands there wobbling to and fro. Which way will it go?

Let's look into my database at the year-over-year changes in the leading economic indicators, corporate earnings, and stock prices since 1999. These figures are through 29-Feb-2008.

The Treasury Secretary has admitted the economy is in a steep decline. He's right on that. The leading economic indicators are in a free fall. The LEI statistic forecasts the direction of economic activity 6-9 months ahead. The year over year rate of decline now exceeds 2001-2002. It declined below -5 in late 2000 and stocks subsequently fell for two years. In late 2007 it again fell below -5.

Let's look at forecasted rate of change for earnings for the S&P500 as tallied by Standard & Poors. The chart shows the forecasted year-ahead, "as reported" corporate earnings. The current decline is as pronounced as 2002.

The Stock Market
But, what about the S&P500? It's still doing fairly well. The PE ratio for the stock market is currently at 20 (1320/$67) based on forward 'as reported' earnings. The historical average is 16 so stocks aren't cheap. Why doesn't the stock market take a dive? Probably because overvaluation was much worse in 2000. Also, investors expect (or hope) the Fed and the treasury to engineer a massive liquefaction of the economy with checks being sent to every house in the land and more than once. They expect, rightly, that the government will spend whatever it takes to prop up mortgages and the banks and stocks. They Fed will actually go into the markets and buy stocks if that's what it takes. They'll also let foreign Sovereign Wealth Funds buy up stocks to keep the game going. The stock market must not fall or a depression may result.

I wouldn't buy a bank stock until the Fed starts raising rates thus signaling an all-clear for the financial intermediaries. As for other stocks, I think there's too much downside risk and especially with dividend yields averaging only 2%. If it doesn't pay a dividend you probably shouldn't own it. Many stocks will be swept away if investors panic. Panic could erupt if aging baby boomers fear their retirement savings are at risk. Well, those savings are at risk. Housing, auto sales, banking and the dollar are all in a steep decline. These are the traditional metrics that influence employment and future purchasing power. The move away from manufacturing and towards services in the US means employment won't be as cyclical as in the past. Consumer spending reamins a major factor and, with stagnant wage growth and weak job growth, purchasing power is flagging.

If stock prices fall then small investors will pull back more on spending. We'd see waves of layoffs across various industries. That can't be allowed to happen because it will start another wave of asset sales. In addition, pension funds would become seriously under funded and some will fail.

Don't overweight stocks because a retrenchment is already in progress. "Given all this, the recession will lead to a sharp increase in corporate defaults, which had been very low over the last two years, averaging 0.6% per year, compared to an historic average of 3.8%. During a typical recession, the default rate among corporations may rise to 10-15%, threatening massive losses for those holding risky corporate bonds." "Now that a recession is underway, US and global stock markets are beginning to fall: in a typical US recession, the S&P 500 index falls by an average of 28% as corporate revenues and profits sink. Losses in stock markets have a double effect: they reduce households’ wealth and lead them to spend less; and they cause massive losses to investors who borrowed to invest in stock, thus triggering margin calls and asset fire sales." - Nouriel Roubini

The Next 9 Months
I recently heard a former congressman (a republican) and author discussing his book on the radio. He stated that 80% of all congressmen of both parties are corrupt or indifferent to the needs of their constituents. They only care about re-election and personal gain. If we take that to be a true statement, which I believe it is, then the stock market will likely weaken after the 2008 election. The politicians will stop wasting money on giveaways to Wall Street and will just let the thing go once they're back in office.

Frankly, I don't see how they can prop up employment which underpins the entire system unless they print so much money that nominal stock prices don't fall and stressed borrowers don't lose their homes. They'd have to make wages rise and house prices go up via inflation so the debts are erased. That approach would mean spending trillions more. The result would be higher inflation and rising long term bond rates. But, long term bond rates over 6% would also kill stocks because the stock market discounts earnings based on bond rates. Could a combination of weak consumer spending and higher interest rates drag down stocks? Is such a confluence of events likely?

Rates could go to 9% within a few years according to the manager of the Loomis Sayles Bond fund. "He [Fuss] says the federal deficit will start rising this year, surging from 1% of gross domestic product to 4% within a few years, due to expanding entitlement programs and an underfunded military. "When the U.S. Treasury becomes your borrower and you know it's coming time and again, it puts upward pressure on interest rates," he says. And a mounting deficit will cause inflation to rise. Fuss says yields on ten-year Treasuries are headed to 9%, compared with 4% today. He says the picture reminds him of 1966-67, when the Fed could not take a tough line on inflation because it had to support the troops in Vietnam and the president with lax monetary policy."

For all the above reasons of inflation, bond rates and valuation, I am not positive on the stock market. Personally, I am only 10% in stocks and they all pay dividends. I believe it's best for Joe Average to be cautious until the smoke clears. The market can withstand lower earnings if there's an expectations of things improving. However, a rising trend in interest rates and rising unemployment will cause a series of stepped declines in stocks. I suspect the S&P500 will eventually have a PE under 10.

The inflation problem is growing worldwide. Money creation is on the upswing in the major developed nations and could lead to a broad international inflationary environment.

"... for the last four months, Euro zone inflation has been running at the fastest pace in 14 years, and in China inflation has accelerated to an eleven-year high. This underscores the danger that the upswing in international inflation may be converting a disinflationary environment, which the global economy had been enjoying, to an inflationary one." -Economic Cycle Research Institute, March 2008

Sometime within the next year, we'll see long interest rates begin to rise. At that time, an enterprising investor may wish to invest a portion of their bond allocation in a reverse bond index fund like RYJUX which profits from rising rates.

Summation
America's problems are epochal and not just financial. We can't stimulate the economy out of this mess. Peak Oil has placed a huge tax on the world. Plus, we have a large cohort of aging workers who are becoming risk adverse and won't spend as before. Finally, the nation's enormous debt problems are undermining the currency and the government's options for mitigating the crisis. This won't be a normal recession.

The giveaway strategies to Wall Street clearly indicate the desperation in Washington. The politicians see it as absolutely necessary to prevent a broad economic decline prior to the election. The government will print money to bail out the banks and the stock market and create inflation to pay for it. The costs will run into the trillions. Then there's the 50+ trillion of unfunded future liabilities for social security and medicare. Congress lacks the will to tackle the problem and will likely resort to the printing press.

Nobody knows for sure how things will play out over the next couple years. I believe it's wise to diversify assets among other currencies. I would hold some dividend stocks but underweight equities as an asset class. I would stay 20 miles from long term bonds. Most investors should consult (and soon) a fee-paid financial advisor willing to take a stand to protect the savings entrusted to their care. Holding everything in dollars and maintaining the traditional 60/40 stock and bond mix could prove catastrophic because these asset classes are all at risk. Yet, this is what most financial advisors recommend and it's also the course set by most pension funds.

The credit collapse isn't over and will likely spread to prime borrowers and credit card debt. Banks in Europe and Japan haven't been honest about their exposure to US debt so avoid stocks there too. If US unemployment picks up speed then the bottom is a long way off.

We are on the cusp of a great transition. How much longer can the world afford to buy America's bonds and import its inflation? At some point they will say no. Asian nations are already working on a unified currency and so are countries in the Middle East. It's a certainty the dollar will lose its status as the world's reserve currency to be replaced by a mix of others. This is very negative for the dollar long term.

A new gold standard is unlikely for international settlements and commodity pricing thus a new currency concept is required. If world leaders possess the wisdom, they can design a new multi-currency monetary system to replace the dollar standard. The index weighting should take into account the amount of currency in circulation, inflation, and the nation's fiscal policies. Properly done, it would be cross-cultural, apolitical and encourage sound money and political balance. Until then, buy gold.

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

Author of: How To Invest If You Can't Afford To Lose

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