Association for Investor Awareness - Week of 04/01/2010

Economic Momentum Is Increasing
Expect A Marathon, Not A Sprint
Stocks Are Leading The Way Back
Black Swans Do Exist
Index Funds Shine
The Bottom Line This Week

Something odd is occurring on the way to Armageddon that the army of doom and gloom predictors never expected. Instead of suffering a meltdown, Wall Street and Main Street are throwing parties.

We'll be the first to admit that the gaiety isn't setting any records. Nevertheless, economic growth is a healthy 4% and may be somewhat higher. We won't know until the Fed shakes the numbers out after the first quarter ends today. We should get the verdict next week.

As to the stock market, nobody has anything to complain about. Since our newsletter was published last month, the Dow and the Nasdaq went up a heartwarming 5.7% and 7.9% respectively. Those are nice gains in anybody's book.

Economic Momentum Is Increasing

The big question now is whether or not more good news is on the way, or if the party is over.

As far as the economy is concerned, we have little doubt that it will continue to grow. The low end of the predicted range for the year is 2%, but that level seems overly pessimistic to us. The high end is about 4.2%. If we had to choose between them we wouldn't take the average. Considering how much momentum already exists in the economy, we think the high 3% area will win the office pool.

The biggest engine for growth is consumer spending, which is moving up strongly. Tiffany's, Williams-Sonoma, FedEx, and dozens of other firms are reporting that sales and profits are exceeding expectations. It's a solid trend that feels like a real turnaround, not a seasonal blip.

However, there are some concerns about the staying power of consumers, primarily because the unemployment rate is high. We think the worrywarts are looking at the wrong number. If 10% of the adult population is out of work, it means that 90% still have jobs. That's a lot of shoppers. Their purchases are more than enough to keep the economy moving.

Business spending is also starting to rise. That's to be expected because consumers are depleting the inventories that built up during the recession. As warehouse shelves continue to empty, suppliers will need to replace what's being sold. That process will take several months, and it will contribute a great deal to growth.

Expect A Marathon, Not A Sprint

All in all, the economic outlook is good. However, there are still some impediments to growth that are likely to keep the recovery on medium heat rather than on a fast boil.

The biggest problem is the credit crunch. Instead of using the Fed's bountiful billions in bailout funds to jump start the economy, banks are holding onto much of the money. They are using it to make up for the bungling losses they chalked up during the recent bust.

Many people think the financial geniuses should have been left to deal with their own mess, but the government felt otherwise. Come to think of it, the bankers are the government, or at least an influential part of it – so we should not be surprised that they voted themselves out of trouble.

Many banks are also building up a war chest for a merger and acquisition spree that appears to be on the way. Whatever the reason for their miserly attitude, it can be tough to get a business loan.

In addition, rising taxes are a concern. Nearly all the Bush tax cuts will expire on December 31. To make matters worse, over $2.8 trillion (that's with a "t") in new federal taxes will start to be phased in. The double hit will be a dead weight on nearly every part of the economy.

Lastly, investors worry that interest rates are likely to rise. The Fed is doing its part to hold them back, but it doesn't have the final say. Because debt risks are increasing, the enormous private market for bonds is starting to push rates up on its own. If the cost of money increases by very much, it will have a negative effect on the housing market, auto sales, and many other parts of the economy.

Stocks Are Leading The Way Back

On Wall Street stocks are enjoying stellar growth. Since this time last year when the bull did an end run around the bear, the S&P 500 has gone up 73.4%. It was a thrill to watch.

Some analysts believe the upturn was just an oversized dead cat bounce that was to be expected after the equally oversized plunge from late 2007 to early 2009. We might be inclined to agree if the economy was going nowhere. Since that's not the case, we think stocks have further to rise.

Stock market history also suggests that prices will go higher. The old adage that "bull markets climb a wall of worry" is true. As we mentioned above, there is no shortage of concerns that make investors nervous. Typically, bull cycles don't end until investors are convinced that they will go on forever.

One caution is in order. No rising trend goes very far without stumbling. The stock market is no exception. After the recent impressive gains, we think a 10% to 15% pullback is likely, after which the market should resume its upward path.

Black Swans Do Exist

Until 1770 everybody took for granted that all swans are white. No one even considered the possibility that a black swan could exist. However, naturalists with Captain Cook found them when they visited Australia.

Even when the good captain brought a black swan back to England, many people were not convinced. The bird looked just like a regular swan that someone had dyed black. That's how difficult it can be for people to accept something totally new.

A black swan is an event that no one would expect. When they suddenly appear, they can have serious consequences. Pearl Harbor was an example. The terrorist attack on 9/11 was another. When they happened, stocks plunged, and the economy nearly followed them down.

We are bringing up the issue of a black swan event now because the world is becoming a volatile place with rising tensions. A big enough shock could upset the fragile balances. For that reason, we urge you once again to place stop loss orders on all your stocks. You have insurance on your life, your house, and your car. You should have stock market insurance as well.

Index Funds Shine

When the stock market has a good run, index funds usually outperform mutual funds. That's because index funds are always fully invested in the group of stocks they follow. As a result, brokerage and management fees are almost non-existent. The low costs mean that nearly all the gains an index fund makes go to its investors.

Mutual funds, on the other hand, always keep some money out of the market where it can't benefit from rallies. Mutual funds also have high research and management costs. Of course, their trading fees are also high.

The broad market advance we are having now is ideal for index funds. Our favorite is the iShares Dow Jones Select Dividend Index (DVY), a blue chip fund that tracks the Dow Industrial Average. When the current bull market started on March 9, 2009, this ETF was priced at $24.90. Today it is $46.16, a 85.3% gain. We owned the fund throughout this period and richly deserve our profits. We expect to see more of them this year.

More aggressive investors may prefer the PowerShares Dynamic Small Cap Fund (PJM). This ETF tracks the Dynamic Small Cap Index that consists of approximately 200 companies. Last March the fund traded for $10.86. It has since gone up to $20.22, an 86.2% gain.

You probably noticed that over the past year the small cap PowerShares fund barely outperformed the blue chip iShares fund. During normal market conditions we would expect the small stock margin to be greater.

After a deep stock market slide, however, investors favor safer blue chips. Later they turn to small caps. We think the latter are coming up to bat now and should have a good 2010. 

The Bottom Line This Week

Both the economy and the stock market are doing well. Stocks are leading the race by more than a few laps, and they may be due for a correction. The economy is the tortoise in this race, but it should have its usual staying power.

We don't see any black swans on the horizon, but nobody ever does. The way to deal with their unpredictability is to go about your normal business but take precautions against shocks. In stocks, that means you should put stop loss orders on everything.

Looking ahead, we think the iShares Dow Jones Select Dividend Index will continue to make gains. The PowerShares Dynamic Small Cap Fund may do even better as investors feel more comfortable giving up some safety in exchange for a shot at higher performance.

Until Next Time

The AIA "Advocate For Absolute Returns", a publication of The Association for Investor Awareness, Inc., tracks market trends, industry news, the SEC, global trade and finance and Washington developments for you because they affect your investments. But who doesn't? Many sources report these issues as abstract facts. We feel that's not enough. The AIA Advocate's job is to warn you of what's important and how these developments translate to ground-level forces and threats that directly affect your wealth as well as your current investment opportunities. Not just information, but information you can use. Until next time...


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Posted 04-01-2010 11:52 AM by Research & Editorial Staff