Peter Dag & Friends: August 2012

8/31/12

INDICATORS DRIVING ASSET PRICES: PRODUCTIVITY AND PROFIT INDICATORS

Productivity is a measure of economic efficiency that shows how effectively economic inputs are converted into output. Productivity is measured by comparing the amount of goods and services produced with the inputs which were used in production. Labor productivity is the ratio of output of goods and services to the labor hours devoted to the production of that output. In other words, productivity measures the output per man hour, or the output generated by one hour of labor. This is labor productivity. Output per hour of all persons is the most commonly used productivity measure. Labor is an easily identified input to virtually every production process.

In terms of costs, it represents about two-thirds of the value produced. Business sector output is based on GDP, but also includes a subset of the goods and services included in GDP. The business sector comprises about 80% of the GDP, since it must exclude those portions of the economy for which productivity measures cannot be constructed. General government, the output of employees of non-profit institutions, private households, and the rental value of owner-occupied real estate are excluded. The primary source of hours and employment data comes from the Bureau of Labor Statistics which provides data on total employment and average weekly hours of production and non-supervisory workers in non-agricultural establishments.

Unit labor costs are calculated by dividing total labor compensation by real output, or equivalently, by dividing hourly compensation by productivity. That is, unit labor cost is equal to total labor compensation divided by output. Compensation is a measure of the cost to the employer of securing the services of labor. It includes wages and salaries and such things as bonus and incentive payments and employer contributions to employer benefit plans.

Real output is the total output of the economy after inflation, as mentioned above. Productivity growth, which is a main determinant of economic growth, depends on the economic times. For instance, in the 1970s when inflation was rising from 2-3% to 15%, productivity growth was very low (between 0-1%). However, in the 1980s after inflation started to decline from 15% to close to 2-3%, productivity growth steadily rose. In the manufacturing sector in the 1990s, it was not unusual to find productivity growth around 5-6%. Such strong productivity growth was the main reason why in the 1980s and 1990s the U.S. achieved such high levels of wealth and prosperity.

Growth in productivity is one of the most important indicators providing information on the health of the economy. Let's see why this indicator is important. Let's say you are the only producer of a widget in a country that does not have competitors for your product. It takes an entire day to produce one widget and you sell it for $50 at the end of the day. Your income is therefore $50 per day. Then, because of some technology that you have learned to apply to the process of building widgets, you improve the output per day from one widget to two widgets. Since you are the only producer, your income has increased to $100 per day. In other words, as you doubled your productivity, your income has also increased by the same amount.

Growth in productivity is closely related to growth in income. A country cannot hope to grow faster, or a person cannot become wealthier, if productivity does not increase accordingly.

Productivity also has an important impact on profitability. In order to increase profitability, corporations have to absorb increases in wages in raw material costs and other costs. Let's say that productivity increases by 4% and all these other costs also increase by 4%. The impact on profits after productivity is taken into account is zero. In other words, costs have not increased because the improvement in productivity has absorbed their impact. Productivity is a major determinant to economic growth. As productivity slows down, the economy will eventually slow down because income, which depends on productivity, slows down. As income slows downs, sales slow down and the whole economy suffers.

The first sign that the economy is improving is when productivity increases. The increase in productivity suggests income and profitability are also going to increase. As a result, the whole economy will benefit. Data on productivity are released by the Bureau of Labor Statistics.

Trends in corporate profits are also an indicator of economic health and future economic activity. The reason is that as corporations’ profits increase, business is likely to increase investments to expand capacity, buy new machinery, and hire more employees. Another important indicator of corporate profits is earnings per share of the S&P 500 corporations. Earning per share information is available weekly in Barron's.

Periods of low inflation have usually been associated with strong productivity growth. Periods of rising inflation have been associated with periods of slower productivity growth. The importance of strong and rising productivity growth is in the fact that business is capable of absorbing higher wages without impacting profitability. The problem with lower productivity growth is that business will not be able to absorb increased costs, and therefore, will experience downward pressure and profitability. The only line of action is to cut employment, cut costs, and cause a slowdown in the economy. For this reason, maintaining strong productivity growth is one of the paramount objectives of policy makers.

(From Chapter 2 of my book Profiting in Bull or Bear Markets. Published also in Mandarin and on sale in China).

George Dagnino, PhD Editor,
The Peter Dag Portfolio.
Since 1977
2009 Market Timer of the Year by Timer Digest
Portfolio manager

Disclaimer.The content on this site is provided as general information only and should not be taken as investment advice nor is it a recommendation to buy or sell any financial instrument. Actions you undertake as a consequence of any analysis, opinion or advertisement on this site are your sole responsibility.

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8/25/12

Observations

It was a year ago. I signed the contract and finally owned part one of my dream – an elegantly shaped blue hull Sabre 38”.

The boat was in Hilton Head. Hurricane Isabel was coming. Because of a misunderstanding with the insurance company, they told me I was not insured when Isabel was going up the east coast. It was their mistake.

We made it to Annapolis and the boat was safe. As we were heading north on the Intracoastal Waterway, I kept repeating to myself that the boat was going to be a long-term love affair. Don’t get too excited, I kept saying. The number of systems that need maintenance overwhelms the first-time owner. I am lucky to keep the boat in a well run boat yard with superb service in all aspects of boat maintenance. Luke, the manager, runs a tight ship and offers great technical advice.

I go to Annapolis for a few days after I finish publishing each report. I take it easy, as I promised myself. I am slowly becoming acquainted with all the systems and the sailing capabilities of the boat.

Driving to Annapolis is also therapeutic for me. I start thinking about many things. I like driving and if you know I70/I76 you realize it is a challenge -- truck traffic, work in progress, and narrow lanes, up and down an old and busy turnpike. Certainly not like I95 from Baltimore to Rhode Island, which is a permanent parking lot.

How much money is being wasted maintaining the turnpikes. Toll fees have increased by 50%. Gas is up to $2 per gallon. And all those trucks. Very dangerous. By keeping gas prices at ridiculously low levels, we are subsidizing the transportation (Detroit) and airline industry. It just does not make any sense. Then we complain about the energy crisis.

This happens at a time when the world is going to high speed trains. The problem with this solution is that it would make the airline and car industries obsolete for distances of less than 600 miles. This is the reason we keep saying that trains have to make it on their own merit and the market has the final say. Nonsense. What about all the money we spend on turnpikes?

(This Observations appeared in the 9/20/04 issue of The Peter Dag Portfolio ).

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About US economic freedom

In this blog and in The Peter Dag Portfolio I always, and I mean always, made the point that a country shows sluggish growth when there is too much concentration of power (read: low economic freedom).

Today's Barron's says, and I quote :" Research has shown that a national economic performance is strongly influenced by the degree of economic freedom. ....Frasier Institute has found that the noticeable decline in economic freedom in the US from 2008 to 2009 was confirmed by a further ticking down in 2010 - an acceleration of a long slide that began in 2009"

Markets always win. There is no redistribution of wealth if wealth is not created in the first place. That we like it or not!

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8/23/12

INDICATORS DRIVING ASSET PRICES: INFLATION INDICATORS

The most popular measure of inflation is the increase in consumer prices over a 12-month period. When one reads in the newspaper that inflation is 2.7%, it means that the consumer price index, which will be discussed in greater detail later in this section, has risen 2.7% in the previous 12 months. Investors need to follow closely the trend in inflation. To do so, they need to compare the current growth in consumer prices versus what it was a month ago, two months ago, and three months ago, and so on. Later on in this book, we’ll provide ample background on how to predict the trend of inflation.

Inflation is a very important measure to follow because the economy and financial markets thrive during times of declining or low inflation (below 3%). Years when inflation is rising are characterized by extreme volatility of the economy and the financial markets. This is not only true for the U.S. economy, but also for any economy around the globe - from Latin America to Europe and Asia. As it has been shown conclusively by Milton Friedman, inflation is solely and exclusively a monetary phenomenon. In other words, inflationary pressures depend on the monetary policy followed by the Fed. In Chapter 6 we will discuss in great detail how central banks can impact the inflation of a country.

From an investment viewpoint, changes in inflation impact the financial markets and asset prices in different ways. Declining inflation is favorable to stocks and bonds. However, rising inflation makes real estate, precious metals, and other hard assets more attractive than stocks and bonds.

Commodity prices are probably the most sensitive and meaningful indicator about future trends in inflation. Commodities are raw materials to be used in the production of goods. These are commodities such as:

• Grains and feeds (examples in these sectors are barley, wheat, and corn)

• Commodities classified as foods (in this category: beef, broilers, butter, cocoa, eggs, ham, hogs, pork and steer)

• Fats and oils, such as coconut meats, coconut oil, coconut palm, lard, soy bean and tallow

• Oil, which includes different types of crude oil, domestic crude grades and refined products

• Fibers and textiles – such as burlap, cotton and wool

• Metals, including aluminum, copper, lead, steel scrap, tin and zinc

• Precious metals, such as gold, silver, platinum, and palladium

• Miscellaneous commodities such as rubber and hides

All these commodities are used in the production of goods and the change in price of these commodities provide very useful information on trends of the economy. Most of these commodities tend to follow the same trend most of the time. This seems to be difficult to accept. However, when the economy is strong, demand increases across the board of the commodity spectrum.

There are two types of commodity prices. One type of price is called spot price and the other one is the price of futures. In the spot market a commodity is priced for immediate delivery. In the futures market a commodity is priced for delivery at a future date. For instance, the price of oil for delivery in a month is different from the price of oil for delivery in two months, three months, and so on. The difference for all these prices is market conditions, storage costs, interest rates and transportation costs.

Spot prices of industrial materials are the first ones to respond to acceleration or deceleration in manufacturing and overall business activity. Since it is difficult to analyze all these commodities one by one, to make the process of analysis simpler, analysts have established indices in groups of commodities that have the same functions: grains, foods, fats, fibers and textiles, precious metals.

The most popular index of these commodities is the CRB Index, which consists of two indices: the CRB for spot prices and the CRB for futures prices. The CRB index for spot prices is an index that reflects the price of the components of the spot level, while the CRB index for futures reflects the futures price of the components. The CRB industrial materials index (spot and futures) can be found on the website of Bridge/CRB daily.

Commodity prices reflect the judgment of the marketplace, the strength of the economy, and the inflationary policies of the Fed. An overall strengthening of the commodity market reflects the fact that the economy is very strong and the increase in the commodity prices will eventually be passed on by the producers of goods to the final consumer. An increase in commodity prices has an inflationary implication. Under these conditions investors should expect upward pressure on short-term and long-term interest rates. This is the main reason why commodity prices provide crucial information for the investor. By closely watching the trends in commodities, the investor can begin to think about the possibility or rising interest rates and the tightening of monetary policies, which will be discussed in great detail in Chapter 6. Of course such trends greatly impact the risk in investing in stocks and bonds.

Other important gauges of inflation are gold and crude oil prices. Although crude oil prices have much more volatility than gold, due to the fact that they are controlled by a cartel, the basic trends and turning points are the same. It is always a good assumption to believe that all commodities follow the same trend. It is very difficult, for instance, to see an increase in gold prices without an increase in copper prices or crude oil prices. Or to put it in a different way, a strong move in copper without sharply rising gold prices or other commodities would make the increase in copper suspect. The reason is that commodity prices are driven by the strength of the economy and when the economy is strong, all commodities rise. On the other hand, when commodities are weak, investors should expect weak commodities.

The importance of following many commodities and indices is that they all tend to rise in the same direction when inflationary pressures are rising and are strong. The more commodities rise, the higher the risk of rising inflation. If most commodities decline, the outlook for inflation is benign.

Another indicator which is important to follow to determine inflationary pressures is wages. Wages usually accelerate when the unemployment rate declines and stabilizes, meaning that the labor market is tight. These are also times when unemployment claims are low.

Acceleration in wages, as we will see in the next section, is not necessarily inflationary, because increases in productivity absorb increases in wages. In fact, this is exactly what you want to see in a strong economy. The ideal situation is to experience wages growing at a 3-4% pace and productivity expanding at the same rate. In these conditions, labor costs (wages adjusted for productivity) is zero and wages are not inflationary. However, if productivity growth is zero, labor costs adjusted for productivity rise at a 3-4% pace and this is clearly inflationary. Information about wages and productivity is released by the Bureau of Labor Statistics.

The producer price index provides information on the pricing power of producers and manufacturers of goods. There are several measures released by the Bureau of Labor Statistics: the producer price index for finished goods; semi-finished goods - that is goods that need further processing; and producer prices of raw materials. The producer price index is a family of indices that measure the average change over time in the selling prices received by domestic producers of goods and services.

The producer price index (PPI) measures price changes from the prospective of the seller. This contrasts with other measures, such as the consumer price index (CPI), that measures price change from the purchasers’ prospective. Sellers and purchasers’ prices may differ, due to government subsidies, sales and excise taxes and distribution costs. Over ten thousand PPIs for individual products and groups of products are released each month. PPIs are available for the products of virtually every industry in the money, mining, and manufacturing sectors of the U.S. economy. New PPIs are gradually being introduced for the products of industries in the transportation, utilities, trade, finance and service sectors of the economy.

Producer price index data are widely used by the business community as well as the government. The three major uses are:

1. As an economic indicator. The PPIs capture price movements prior to their retail level. Therefore, they may foreshadow subsequent price changes for businesses and consumers. The President, Congress and the Federal Reserve employ this data in formulating fiscal and monetary policy.

2. As a deflator of other economic series. PPIs are used to adjust other economic information for price changes to translate those data into inflation-free dollars. For example, constant dollar gross domestic product is estimated using deflators based on PPI data.

3. As a basis for contract escalation. PPI data are commonly used in escalating purchasing and sales contracts. These contracts typically specify dollar amounts to be paid at some point in the future. It is often desirable to include escalation clauses that account for increases in input prices. For example, a long-term contract for bread may be escalated for changes in wheat prices by applying the percent change in the PPI for wheat to the contracted price for bread.

While both the PPI and the consumer price index measure price change over time for a fixed set of goods and services, they differ in two critical areas: 1) the composition of the set of goods and services, and 2) the type of prices collected for the included goods and services.

The target set of goods and services included in the PPIs is the entire marketed output of U.S. producers. The set includes both goods and services purchased by other producers as inputs to their operations or as capital investments, as well as goods and services purchased by consumers either directly from service producers or indirectly from retailers. Because the PPI target is the output of U.S. producers, imports are excluded.

The target set of items included in the CPI is the set of goods and services purchased for consumption purposes by urban U.S. households. This set includes imports. The producer price index, as its name suggests, is an index and as such is a tool that simplifies the measurement of movements in a numerical series. Movements are measured with respect to the base period when the index is set to 100. An index of 110, for example, means that there has been a 10% increase in prices since the base period. Similarly, an index of 90 indicates a 10% decrease. The typical way of expressing the increase in producer price index, for analysis purposes, is done by comparing the index of this month to the index for the same month twelve months ago.

It is used by comparing the rate of change over twelve months. The formula used is dividing the current month by the same month a year ago, subtracting to the result one, and then multiplying the outcome by 100.

The turning points of all these measures take place at the same time. When one of those indices slows down, they all slow down. The difference is in their volatility. Changes in producer prices of crude materials are much more volatile than producer prices of semi-processed goods and changes in producer prices of finished goods.

A broad measure of inflation, the one that we all relate to, is the consumer price index. The consumer price index (CPI) is a measure of the average change over time in the prices paid by consumers for a market basket of consumer goods and services. The CPI provides a way for consumers to compare the change in prices of the market basket of goods and services.

The consumer price index affects nearly all Americans because of the way it is used. Three major uses are, 1) as an economic indicator, 2) as deflator of economic series, and 3) as means of adjusting dollar values. The CPI reflects spending patterns of the population. It is based on the expenditures of almost all residents of urban or metropolitan areas, including professionals, the self-employed, the poor, the unemployed, and retired persons, as well as urban wage earners and clerical workers.

Not included in the CPI are the spending patterns of persons living in rural, non-metropolitan areas, farm families, persons in the armed forces and those institutions such as prisons and mental hospitals. The CPI market basket is developed from detailed expenditure information provided by families and individuals on what they actually bought. The CPI represents all goods and services purchased for consumption by the referenced population. The Bureau of Labor Statistics has classified all expenditure items in more than 200 categories arranged into eight major groups. Major groups and examples of categories in each are as follows.

1. Food and beverages (breakfast cereal, milk, coffee, chicken, etc.)

2. Housing (rent of primary residences, owners equivalent rent, fuel oil, etc.)

3. Apparel (men’s shirts and sweaters, women’s dresses, etc.)

4. Transportation (new vehicles, airline fares, gasoline, etc.)

5. Medical care (prescription drugs, medical supplies, physician services, etc.)

6. Recreation (television, cable television, pets and pet products, etc.)

7. Education and communication (college tuition, postage, telephone services, etc.)

8. Other goods and services (tobacco and smoking products, haircuts, etc.)

Also included within these major groups are various government user fees, such as water and sewerage charges, auto registration fees and vehicle tolls. The CPI also includes taxes that are directly associated with the prices of specific goods and services. However, the CPI excludes taxes such as income and social security taxes not directly associated with the purchase of consumer goods and services. The CPI does not include investment items, such as stocks, bonds, real estate, and life insurance.

For each of the more than 200 item categories, the Bureau of Labor Statistics has chosen samples of several hundred specific items within selected business establishments frequented by consumers using scientific statistical procedures to represent thousands of varieties available in the marketplace. Each month the Bureau of Labor Statistics data collectors visit or call thousands of retail stores, service establishments, rental units or doctors’ offices all over the United States to obtain price information on thousands of items used to track and measure price changes in the CPI.

The CPI index, like the producer price index, is used to compare the current level of the index to a given reference point. So, if the index is 115, and the reference index is 100, that means that prices have increased 15% over the reference time. The most useful way of measuring the CPI index is to compare the rate of change over 12 months, which is computed by taking the value of the index this month divided by the value of the index the same month a year ago, subtracting one to the result of the ratio, and then multiplying the outcome by 100. By making this computation every month, one can chart the trend in inflation every month.

The Bureau of Labor Statistics also produces specialized indices and the most common one is core inflation, which is the CPI excluding the change in prices of food and energy. The reason analysts like this index is because the core inflation index is less volatile because the two elements like food and energy provide great volatility to the overall index itself.

Acceleration in the consumer price index indicates that inflation is increasing. The consumer price index reflects the price of a basket of goods and services, which are bought by the typical consumer. It is not unusual to see commodity prices accelerating ahead of an acceleration in consumer price index. On the other hand, a sharp decline in commodities of a few months is an indication that the economy is weakening and that the growth in consumer price index will soon decline. Information on the consumer price index is available from the Bureau of Labor Statistics.

The National Association of Purchasing Managers releases data on prices paid by purchasing managers. This index oscillates around 50. Inflationary pressures are strong when more than 50% of the purchasing managers report that they are paying higher prices. When this index falls below 50, it is an indication that the risk of higher inflation is decreasing and inflation is being brought under control.

This information is very useful for investors. If the odds favor rising inflation, it is also true that there is a strong probability that interest rates will rise, pointing to higher risk for the financial markets. On the other hand, a decline of the index below 50, since it provides an indication that inflation is subsiding, suggests that interest rates are likely to decline, thus providing a favorable environment for stocks and bonds.

Finally, the Bureau of Labor Statistics releases the employment cost index on a quarterly basis. This index reflects trends in both wages and benefits paid to workers, and it represents the most comprehensive figure of labor costs. The importance of following the rate of change in the employment cost index is twofold. First, an acceleration or rising growth in the employment cost index means that the labor costs for corporations and businesses is increasing. Therefore, business will try to pass this increased cost to consumers. An increase in the rate of change in the employment cost index is likely to be reflected in higher inflation rates. The employment cost index is important because an increase in this index means that labor costs for business is increasing, suggesting that the profitability for businesses is under downward pressure, and when margins decrease, business can only react by cutting costs and increasing layoffs.

The employment cost index has importance as an inflation indicator, and therefore, is a gauge that will point to the direction of interest rates and also has importance in the fact that it signals a downward pressure on the profitability of business. Inflationary pressures arise only after the economy is growing rapidly. They are reflected by an increase in the growth of commodity prices, in rising growth in producer price index and consumer price index, with the price index of the National Association of Purchasing Managers moving decidedly above 50. During such times of rising inflation, the growth in the employment cost index is also rising. Declining trends in inflation are found after the economy has been slowing down for some time, commodity prices are declining, the change in producer price index and consumer price index are declining, and the price index of the National Association of Purchasing Managers is declining below 50. During these times, the growth in the employment cost index is also declining.

(From Chapter 2 of my book Profiting in Bull or Bear Markets. Published also in Mandarin and on sale in China).

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8/22/12

From a well-written article in The Guardian by Larry Elliott

What financial liberalisation actually led to was a concentration of power exercised without restraint, the enrichment of a small elite, moral hazard on a colossal scale and a series of crises that became ever more serious as they burrowed their way from the periphery of the global economy to its core.

There are two obvious lessons for the present day from the Latin American debt disaster. The first is that there will be a further writedown of Greece's debts, either through a debt amnesty or through a default that may take place inside or outside the eurozone. Greece's economy is now around 20% smaller than it was three years ago, and that means the debt arithmetic does not add up.

The second lesson is that leaving the financial system untouched, unreformed and unpunished almost guarantees another severe debt crisis. This might look unlikely at the moment because the banks are currently reluctant to lend, but sooner or later memories of past speculative excesses will fade, as they did after Dutch tulips, the South Sea bubble and the Wall Street crash.

Can anything be done to prevent this happening? One thing that would help would be a rethink of the way economics is taught, since the messianic belief in abstract – and failed – models coupled with a complete absence of historical perspective increases the danger of mistakes being repeated.

In a new collection of essays about the teaching of economics after the fall, the Bank of England's Andrew Haldane says the crisis was an analytical failure or intellectual virus. "This virus had contaminated almost everyone by 2007, causing them to view the pre-crisis world through spectacles far rosier than subsequent events have shown was justified."

There was no sense of the risks that were being run. On the contrary, it was assumed that the global economy had achieved a state of bliss, in which the models "proved" that all the big problems of the past had now been solved. Some basic knowledge of the teachings of Adam Smith, Karl Marx, Friedrich Hayek and Maynard Keynes might have prevented the groupthink.

Smith warned about the dangers of monopoly power, while Hayek said the price system would only work its magic if competition prevails. Marx said history was moving towards a system of monopoly capitalism, and Keynes said this was particularly dangerous when it took the form of financial speculation.

All these great thinkers would have their own take on the crisis. Smith would want to see multinationals broken up, Hayek would be arguing that it would be better to allow banks to fail than to keep them in a zombie-like state, and Keynes would want to see finance become the servant of industry not its master.

The Marxist perspective, exemplified in a new book by John Bellamy Foster and Robert McChesney, is also useful. This argues that the strong western growth rates in the middle of the 20th century were something of a mirage, caused by high military spending, postwar reconstruction, higher welfare spending and the investment in road networks that allowed the full flowering of the age of the automobile.

Since then, a number of things have happened. There has been a concentration of capital but a shortage of profitable investment opportunities. So far, there has not been a wave of innovations like the car, the plane, cinema and TV to give the global economy a shot in the arm, although it is possible that digital, robotics, genetics and green technology could act as a catalyst. The result has been a declining trend rate of growth, and the increased financialisation of western economies as the surpluses have been re-cycled through the banks in a search for yield. Hence the Latin American debt crisis. Hence the sub-prime mortgage crisis. Hence the inability of the global economy to emerge from its torpor.

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8/20/12

Wow! And now read this article by Niall Ferguson.

Just click here.

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INDICATORS DRIVING ASSET PRICES: CONSTRUCTION INDICATORS

Construction indicators are important because this sector is a major source of employment. Trends in housing starts and building permits reflect the strength of the economy and provide an indication of future economic trends. Housing starts and business structures rise when interest rates are stable or declining and the economy is improving.

However, as soon as uncertainties arise and interest rates begin to increase, consumers and investors immediately curtail their purchase of houses and investment in new constructions. Trends in the housing sector are closely related to trends in interest rates. An increase in interest rates raises the cost of borrowing, and therefore, considerably raises the cost of buying either a house or a property. For this reason, an increase of interest rates is followed by slower growth in the housing sector and eventually in an outright decline.

The odds favor higher interest rates as long as the housing sector is strong and people borrow to buy houses. Interest rates will decline only after a prolonged decline in the housing sector, a sign that investors have decided to wait for much lower interest rates before beginning new investments in the construction business. Following a decline in interest rates, there is a sense that business conditions will be improving with the construction sector being one of the first ones to revive. When interest rates decline, which is typically preceded by a prolonged decline in the housing sector, the low cost of money again encourages investors and business to borrow to invest in housing and construction projects.

The housing sector revives only after interest rates have passed their peak and are on their way down. The housing sector will grow rapidly as long as interest rates are declining or are stable. The first signs that the housing sector is likely to weaken happen when interest rates bottom and eventually begin to rise due to the strong economic environment. Information on construction activity is available from the Census Bureau.

Other important data in this sector are the level of new home sales and existing home sales. They provide information on the consumers’ willingness to spend. These reports also indicate the average price paid for houses and provide an indication of the level of inflation existing in the real estate business. Home sales are closely related to the behavior of housing starts. These data are available from the National Association of Realtors.

A strong construction sector is associated with a rapid growth in housing starts, in building permits, and in the level of new home sales and in existing home sales. The period of strong construction is typically associated with declining or stable interest rates. The construction sector weakens following an increase in interest rates and will remain weak as long as interest rates are on a rising trend. The main reason why the construction sector is so sensitive to interest rate strengths is because borrowing costs are one of the main determinants in purchasing and investing in such sector.

(From my book Profiting in Bull or Bear Markets. Published also in Mandarin and on sale in China).

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8/17/12

A very timely video

This is a timely video. It may tell you what will happen to the stock market.

The above chart is the updated version of the one shown in the video (click on the chart to enlarge it). Can you tell what is likely to happen to the market? Until when? How are the bonds likely to perform in the meantime?

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8/13/12

What happens to the market when the incumbent loses?

The market declines from mid-September to the end of the year. For a detailed chart just click here.

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Interesting seasonal pattern in an election year

According to Bloomberg "Selling in May and go away" is not a good idea in an election year.

The market, on average, has risen from the end of June to mid-September. It declined until the end of October to resume its upward trend at the beginning of November.

The graph is found by clicking here

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Technical patterns

Since June the S&P 500 has been rising. However, since July the difference between stocks advancing and declining has a slight downward bias.

In other words, the market went up with an increasingly lower number of advancing stocks.

Interesting divergence.

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8/10/12

Technical patterns this morning

The pattern is quite consistent when the trend is well defined:

*** Weak equities.

*** Weak commodities.

*** Strong bond market.

The idea is that if the market remains weak, bonds are the asset of choice.

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8/8/12

INDICATORS DRIVING ASSET PRICES: MANUFACTURING INDICATORS

The index of industrial production released monthly by the Federal Reserve provides a complete picture of trends in manufacturing. It is a comprehensive report showing the growth in various sectors of the manufacturing industry. The manufacturing sector is very strong when growth is above .3 or .4 on a monthly basis. Accelerating industrial output is a sign that employment, sales and income are strong and the economy is robust.

A slowdown in the industrial production index is a sign that employment and income will slow down, and sales are weaker. Trends in the industrial production index, as we will see later, is also closely related to trends in overall commodity prices. A strengthening industrial sector is usually associated with firm commodities, and a weakening manufacturing index is accompanied by declining commodities.

Average weekly hours paid per production on a supervisory worker per week is an important indicator of economic activity, especially in manufacturing. The importance of this indicator lies in the fact that when manufacturing wants to reduce output, the first thing they do is cut working hours. Eventually, they will layoff workers. The same thing happens when the economy improves. First, manufacturing expands working hours, and then hires workers. Average weekly hours provides clues on the future of industrial production. Changes in average weekly hours tend to lead changes in economic activity.

Another indicator that provides clues on the future of industrial activity is overtime. Average weekly overtime hours of production is a leading indicator of economic activity because the manufacturing sector tends to cut overtime first, when they see economic activity or demand for goods slowing down. The same thing happens when the economy starts improving. The first action that the businessperson takes is to extend overtime hours before hiring new people. All the above data are available in the industrial production release.

New orders for durable goods and new orders for consumer goods are important data because they provide an indication of what is on the books of manufacturers. Rising orders suggest manufacturing will have to place those orders into production, and that manufacturing will have to step up production activity. If, on the other hand, orders decline or slow down, there are fewer orders to be processed through the manufacturing plants, and industrial output is likely to decline.

When orders are received by an organization, they are not filled right away because the organization or the plant is busy fulfilling previously received orders. Current orders are therefore placed in a backlog and are scheduled to be produced in the future when manufacturing capacity becomes available. For this reason, rising orders are a reliable indicator that the manufacturing sector will improve.

On the other hand, if orders begin to decline, the organization will have to reduce production. For this reason, orders are a very important leading indicator of what will happen to the manufacturing and non-manufacturing sectors. They are an excellent indicator of future economic health.

Orders for durable goods are particularly volatile because big-ticket items are subject to consumer sentiment. The volatility of new orders is caused by the fact that most consumers react at the same time to changes in interest rates and inflation. The reason is that to purchase durable goods - items that have a shelf life of three to four years like automobiles, refrigerators, furniture and so on - people have to commit large sums of money and everybody reacts at the same time and in the same way to changes in interest rates, causing volatility in orders.

When economic conditions change because of rising inflation or interest rates, all consumers will respond to that increase at the same time, and therefore, orders decline sharply. The rise in inflation produces a very important chain reaction in the business and financial cycles. A rise in inflation has a very important effect on income of the working and non-working populations. Rising inflation reduces the purchasing power of consumers and the more inflation rises, the higher is the loss of purchasing power.

The outcome is that consumers defend themselves against the loss of purchasing power by first decreasing purchases of big ticket items and then eventually the small ticket items. The outcome to lower purchases is a decline in orders, and therefore, a slowdown in economic activity.

The increase in inflation is also accompanied by increasing interest rates, and therefore, an increase in borrowing costs. This increase in borrowing costs leads to further declines in purchases on the part of the consumers and investments on the part of business. On the other hand, when inflation and interest rates decline, because of the lower cost of borrowing and increased income caused by lower inflation, consumers are inclined to borrow to purchase those items they found too expensive when inflation and interest rates were rising.

A decline in inflation has exactly the opposite effect of the rise in inflation. A decline in inflation is welcomed by consumers because it increases the purchasing power of the working population. Also, declining inflation is accompanied by lower interest rates. So we have two positive effects on consumer purchasing power. One is lower inflation that increases purchasing power and lower interest rates that decrease the cost of borrowing. Both lead the consumer to purchase and businessmen to invest. The outcome is an increase in orders, which results in the improved growth of the economy. This is the reason why orders provide important information about the future of the economy. Orders for durable goods represent the willingness of business to expand capacity and improve productivity, which is a very important element for economic growth.

Another important indicator concerning manufacturing health and trends is unfilled orders, or the backlogs on the books of the manufacturing sectors. If unfilled orders increase rapidly, manufacturing does not have the capacity to produce goods, and implies manufacturing will be busy filling these unfilled orders. It suggests that the economy will strengthen. If on the other hand unfilled orders decline, manufacturing will be forced to slow down and produce fewer goods. Information about orders is released by the Census.

The National Association of Purchasing Managers provides two important reports: one on the manufacturing sector and one on the non-manufacturing sector. The index provided by this professional group is important because it is an index that oscillates above 50 or below 50. An increase in the index well above 50 implies that the economy is expanding more rapidly. A decline in the index means that the economy is slowing down. If the index falls below 50, the economy is growing very slowly. From an investor viewpoint, this index is very easy to use. It provides simple guidelines to develop an investment strategy. When the index rises above 50, investors have to look for those events that are typically associated with a strong economy growing at an above-average pace. Investors should look for rising interest rates and upward pressure on inflation. We will see later how this could be used to develop an investment strategy.

However, when the index falls below 50, investors are warned that the economy is growing at a below-average pace, and therefore, should expect events that are typically associated with a slower growth in the economy, such as declining interest rates and declining inflation.

An important indicator released by the purchasing managers is called vendor performance. This is an index that shows the percentage of companies reporting slower deliveries. When this indicator rises, more and more companies are reporting slower deliveries, which is an indication the manufacturing sector is very busy and the economy is very strong.

A rise in this index is good news for the economy. A decline in this index is bad news. This index oscillates around 50. If it stays above 50, the economy is strong, and if it goes below 50, the economy is sluggish.

Vendor performance can be used to confirm the trends and the information provided by the overall index of the National Association of Purchasing Managers. Investors using this indicator will be warned that if this gauge rises above 50, the economy is strengthening, growing above potential. Therefore, they should expect rising inflation and interest rates. The higher the indicator goes above 50, the more pronounced the increase in inflation and interest rates is.

hen this gauge falls below 50, the economy slows down and is growing below potential. Investors should expect declining inflation and declining interest rates in the near-term. The more pronounced the decline is below 50, the more pronounced the decline in inflation and interest rates is.

Change in inventories is another important indicator of manufacturing health. Acceleration in inventories indicates manufacturing is building up inventories at a faster and faster pace trying to meet strong sales. A strong inventory accumulation suggests the economy is robust. On the other hand, when inventory growth declines, it signals a slow down in the manufacturing process.

An important gauge used to gain more insight in this process is the inventory-to-sales ratio. The inventory- to-sales ratio is computed at the merchant wholesalers and the manufacturing and trade levels and is computed by the Department of Commerce. The ratio is computed by dividing total inventories in dollar terms by sales over a month. If the inventory-to-sales ratio is low and stable, inventories and sales are in balance and the economy is doing well.

A decline in inventory-to-sales ratio indicates that sales are growing faster than inventories and manufacturing must catch up with sales. This indicates a very strong economy.

However, when the inventory-to-sales ratio is rising, it indicates that manufacturing is building inventories at a rate faster than sales. This situation suggests that manufacturing will have to slow down output to keep inventories in balance with sales. For these reasons, the inventory-to-sales ratio is an important gauge to assess the growth of the economy and to confirm the strengths or weaknesses of business activity.

For instance, in 1993-1994 the inventory-to-sales ratio declined quite sharply from 1.45 to 1.37. The information could have been used to conclude that sales were growing much faster than inventories. Manufacturing was forced to build inventories, and therefore, increase production. Declining inventory-to-sales ratio means that the economy is strong. Usually a similar trend should be found in the unemployment rate, with the unemployment rate declining as employment grows more rapidly than the supply of labor. However, the inventory-to-sales ratio rose sharply in 1995 from 1.37 to 1.45, suggesting the economy was slowing down.

In 1997-98 the manufacturing sector weakened because of the financial crisis in Asia, and because of the weakness in demand, the inventory-to-sales ratio increased from 1.36 to 1.40 over two years. This was an indication that business was slowing down rapidly, sales were slowing down faster than inventories, and therefore, manufacturing was forced to slow down production to match the growth in inventories to the growth in sales. The continued increase in inventory-to-sales ratio indicated a weakening in the economy.

As soon as the financial crisis of Asia normalized in late 1998, business from Asia increased, demand in U.S. increased, the manufacturing sector improved, and the inventory-to-sales ratio declined rapidly indicating that the economy was very strong again. The trend in the inventory-to-sales ratio is a very useful gauge to confirm other information derived from different sources.

Comparing growth in inventories to growth in sales is also a good indicator of the health of the economy. If inventories are growing slowly and sales are growing rapidly, it is clear that the manufacturer will have to increase output to build inventories to match sales. The opposite is also true. If sales are sluggish and inventories are growing rapidly, manufacturers are likely to cut back production to slow down growth of inventories until inventory accumulation matches the rate of growth of sales.

As businesses increase inventories to meet increasing sales, they have to borrow more to finance inventories. During such times, business borrowing increases placing upward pressure on short-term interest rates. When inventories are reduced, businesses will need less money to finance inventory buildup and business borrowing slows down. Slower growth in borrowing places downward pressure on the demand for money and on short–term interest rates. What is suggested is that trends in the price of money, i.e. interest rates, is greatly influenced by its demand. Inventory data are available from the Census.

The above indicators will give you a sense that the manufacturing sector is strong if:

• The index of industrial production is rising above 3-4% a year.

• Average weekly hours are rising, which is positive in the sense that income is increasing, but also negative because it might be an indication that inflation pressures are increasing.

• Rising overtime hours.

• Increases in durable goods orders.

• Increase in backlogs.

• The index of the National Association of Purchasing Managers moving above 50.

• The index of vendor performance moving above 50.

• Inventories accelerating.

• Inventory-to-sales ratio declining.

The manufacturing sector gives signs of weakening when:

• The industrial production index is rising below 3-4% a year.

• The average weekly hours are declining, which is negative in the sense that income is decreasing, but also positive because it might be an indication that inflation pressures are decreasing.

• Declining overtime hours.

• Declining durable goods orders.

• Declining backlogs.

• The index of the National Association of Purchasing Managers moving below 50.

• The index of vendor performance moving below 50.

• Inventories slowing down.

• The inventory-to-sales ratio rises.

(From my book Profiting in Bull or Bear Markets. Published also in Mandarin and on sale in China).

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8/7/12

INDICATORS DRIVING ASSET PRICES: CONSUMER INDICATORS

The most important indicator relating to consumers' wellbeing is the monthly report on employment. Strong growth in employment implies the economy is strong, consumers are making money, and they are willing to spend. A decline in employment growth means that consumers will spend less due to slower growth in income, and they will be more cautious.

What is strong growth in employment? In order to assess the strength of an indicator, one has to keep in mind that the overall long-term growth of the economy is close to 2.5% to 3%, depending on what period you choose and how you measure the long-term growth. If employment grows .1% month to month, this is very slow growth, because if you multiply times 12 to get an annual rate (this is a very rough approximation), you would get 1.2% growth in employment, which is well below the 2.5% overall long-term growth, and this tells you that business is growing very slowly.

On the other hand, if employment grows .5% month to month, a rough estimated of the annualized growth rate is close to 6% which is obtained by multiplying .5% by 12. Six percent is a very strong growth rate and reflects a very strong economy. The employment numbers are available in the early part of the month for the preceding month from the Bureau of Labor Statistics.

Another number released with the employment figures is the unemployment rate. If the unemployment rate declines, the economy is very strong; there are more people being employed than supplied by the labor force. This is a sign the economy is very strong and is creating jobs faster than there are people made available in the labor force.

When the unemployment rate stabilizes at a low level, it means that labor becomes tight and the economy is expanding at close to full capacity. Wages start rising faster and Wall Street becomes concerned about the risks of higher inflation. When the unemployment rate increases, the economy is slowing down, employment growth is slower than the growth of the labor force and the odds favor the economy to begin to grow at a below-average pace.

The Help wanted advertising index measures the demand for labor. It is an important indicator because when this indicator declines, business has decided to hire fewer people and employment in the future is likely to grow at a slower pace. The importance of this indicator is that it tends to lead trends in unemployment. This indicator is available from The Wall Street Journal or Barron's.

Retail sales is also information available monthly and represents how much consumers are buying at retail stores. Strong retail sales reflect strong employment growth, a strong economy, and strong income. It is a measure that is used to confirm the strength of the overall economy. Retail sales data are released by the Census. There are several surveys measuring consumer attitudes and the Conference Board makes available an index of consumer confidence. The University of Michigan makes available a survey called consumer sentiment. These surveys are the result of questions presented to a select sample group of consumers regarding how they feel about the overall economy, what their attitudes are towards purchasing goods, towards purchasing autos, about the future of the economy, the future of inflation, and their income. The answers are ranked and an index reflecting consumer sentiment is computed.

When the University of Michigan's Index of consumer sentiment is close to 100, consumers are very positive about the economy and its outlook, and they are willing to spend. A high consumer sentiment means that the economy will stay strong, retail sales will be strong, and employment will be strong.

However, when the consumer sentiment declines, the economy will slow down because of the importance of consumer spending on the overall business cycle. One has to watch consumer sentiment very closely, especially when it declines close to 80-90; the odds are that a recession or a period of very slow growth is imminent or actually underway.

Another indicator related to consumer wellbeing is consumer installment credit. This figure reflects the amount of money borrowed on installment credit and is released by the Federal Reserve. It is an important indicator on the finances of consumers and how capable they are in spending.

Strong growth in consumer installment credit indicates that consumers are willing to borrow more because they feel comfortable about the future, and therefore, the economy will be stronger. During such times it is not unusual for interest rates to rise. Slower growth in consumer credit is the result of higher interest rates and an economy that is slowing down.

Closely related to all these data, and probably one of the most important ones, is personal income. Income is closely related to employment, retail sales, and consumer confidence. Strong growth in personal income suggests that consumers are feeling good about the future, employment is strong, and retail sales are robust. The growth in personal income closely mirrors the growth of the overall economy or GDP.

More liquidity in the system, declining inflation and interest rates, create the necessary conditions for people to buy and business to invest and expand production. As the economy strengthens, employment increases and the increase in employment is accompanied by an increase in income. The increase in income, of course, encourages consumers to spend, and therefore, retail sales tend to rise.

A slowdown in personal income is usually a sign that things are cooling off, and is reflected in lower growth in employment and lower retail sales. A slowdown in the economy which is usually anticipated by rising inflation and rising interest rates and some tightening from the central bank, causes business to become more cautious about their outlook and about their production plans. By reducing employment to keep costs under control, personal income slows down. Because of the slowdown in personal income, consumers tend to be more cautious about their spending, resulting in slower retail sales. The monthly data on personal income is available from the Bureau of Economic Analysis.

An indicator that is widely followed because it is made available weekly by the Bureau of Labor Statistics is the average weekly initial claims for unemployment insurance, which measures the number of people applying for unemployment insurance. When this index increases, it is a sign that the economy is slowing down. When the number of people applying for unemployment insurance declines, the economy is strengthening because there are more and more people finding jobs.

One way of assessing the strength of the economy is to examine the level of initial claims. If the level is very low by historical standards, the economy is very strong, employment is growing very rapidly, and economic conditions are great. When the initial unemployment claims are high, the economy is slow and many people are applying for unemployment claims, so business activity is very weak. Not only is the trend important for this indicator, but also the levels.

The strength of the economy can be determined by the level of unemployment claims. If unemployment claims decline and reach a level close to 300,000, the economy is strengthening and is very strong. A level of around 300,000 also means that the labor market is very tight and the economy is very strong. Therefore, conditions are what analysts call “overheated”. Under these conditions investors should expect wages to be rising faster. An increase in unemployment claims suggests that the economy is slowing down and the higher unemployment claims go above 300,000, the more the economy is weakening and the labor market is not as tight. Under these conditions investors should expect wages to begin to slow down. This indicator is available from the Bureau of Labor Statistics.

A strong economy is reflected by a group of trends that are unmistakable:

• Employment growth is strong, close to 2-3%.

• Help-wanted advertising is increasing as labor demand also increases.

• Retail sales grow rapidly, above 4 - 5%, year on year, reflecting strong consumer confidence, which is usually at levels well above 90 or 100, using the University of Michigan consumer sentiment measure.

• Consumer installment credit is also rising rapidly, reflecting high consumer confidence in future income, and therefore, an increased level of borrowing activity.

Because of a strong economy and strong employment growth, personal income is increasing and initial unemployment claims decline.

A slowdown of the economy can be recognized when:

• Employment growth begins to slow down below 2 or 3%.

• Help-wanted advertising declines, a sign that business will be hiring fewer people.

• Retail sales slow down, confirming that employment is weakening.

• The index of consumer sentiment declines, measuring the fact that people don’t feel as confident about the future because of slower growth in employment and in income.

Consumer installment credit also tends to slow down as people borrow less because they see uncertainty in the future and in their income growth. This, of course, is the result of weakening economic conditions and lower unemployment figures. This situation is also reflected by initial claims steadily rising.

(From my book Profiting in Bull or Bear Markets. Published also in Mandarin and on sale in China).

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8/6/12

Thought of the day

We will continue to be crushed by financial problems as long as we do not let the market weed out the economic losers.

As in portfolio management, we should be keeping the winners and let the markets do their job.

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8/5/12

Observations

Page 5 of this service [The Peter Dag Portfolio] is the most exciting for me. It is the most obvious. Yet, it has an enormous information content. Probably because it is so simple, readers do not accept its strategic advice.

After I finished writing Profiting in Bull or Bear Markets, Susan suggested I add to each issue of this service what she called the live version of the book. Page 5 is the reproduction of the graphs on page 247.

On 11-24-03 the S&P 500 was standing at 1052. I moved the “You are here” arrow close to the configuration H, signaling a high risk area for the stock market. On 12-08-03 I decided to move the arrow even closer to configuration H signaling risk for the market was rising even further. The S&P 500 stood at 1069.

The rest is history. The subscriber area shows the previous issues. You will see that I kept the arrow in the high risk zone and recommended a defensive and selective investment strategy. When risk is high, it is difficult to make money. You have to invest in a few sectors that have a chance to withstand a period of uncertainty. Or stay in cash.

The 3 lines on page 5 can be used to forecast many variables. As far as the stock market is concerned, risk is high when the economy begins to rise rapidly, commodities are rising, yields are moving higher, and inflation bottoms. These trends were in effect on November 2003, and they prompted me to tell you that the market was at a difficult juncture.

After 12-08-03 these bearish trends became even more pronounced. I moved the arrow closer to configuration H. Risk was high and rising. The trend of the lines on page 5 is the reason for my defensive strategy: invest in stocks with high yields. The reason is that the dividends provide protection in times of unexpected volatility.

Risk will be low again, and the market will start a major up move, when we are in configuration E: a weaker economy, declining interest rates, and lower inflation and bond yields. Follow closely Page 5. (This Observations appeared in the 8/9/04 issue of The Peter Dag Portfolio).

About Spain. About Europe. About what happened.

Take your time. Read this passionate article. Click here.

8/3/12

ECONOMIC INDICATORS DRIVING ASSET PRICES - BROAD MEASURES OF ECONOMIC ACTIVITY

The broadest measure of economic activity is the Gross Domestic Product (GDP), which is available from the Bureau of Economic Analysis (BEA). From an investment viewpoint, it is not used very much because it is only released every quarter and does not represent timely data for investors. However, it is important to know what it is and what information we can derive from these type of data.

The gross domestic product represents the output of goods and services produced by labor and property located in the United States. It is measured in dollar terms and is available quarterly by the Bureau of Economic Analyses. The gross domestic product is the sum of four elements: (1) personal consumption expenditures, (2) gross private domestic investments, (3) net exports of goods and services, and (4) government consumption expenditures.

Personal consumption expenditures represent what consumers spend on durable goods such as motor vehicles, parts, furniture, and non-durable goods such as food, clothing, gasoline and services such as electricity and gas, transportation and medical care. The importance of personal consumption expenditures is that they represent roughly 60% of the U.S. economy. It is because of the enormous size of this sector of the economy that much energy is spent by economists to understand the behavior of consumers.

The gross private domestic investments represent the sum of fixed investments and change in business inventories. Fixed investments represent investments in non-residential structures and producers' durable equipment – such as machinery used in a plant. Then there are fixed investments in residential structures such as single family and multi-family homes.

A key element in the gross domestic product is the net exports in goods and services. This is the difference between exports and imports. It is a very important measure because it has a major long-term impact on the dollar, and therefore, on the returns of foreign investments as we will discuss later. One of the main elements is that net exports eventually have to become positive because a country cannot experience a negative trade deficit, with imports greater than exports, for a very long time without having their currency sharply devalued.

The last element of the gross domestic product is government expenditures both at the federal and state level. Some economists say that the greater the size of the government expenditures as a percent of the GDP, the slower the growth of the economy over the long-term. The ultimate example is what happened to the Soviet Union where government expenditures were 100% of GDP. The outcome was a total collapse of the Soviet Union.

The concept of growth is relative to the average long-term growth of the economy and the average long-term growth of the economy can and does change, depending on the overall policies of the government. For instance, in the 1970s because of rising inflation and all the problems that rising inflation brought to the U.S. and the European economy, the average growth of the economy was very close to 2%. In the 1980s and 1990s as inflation came down, the average growth of the economy grew to 3% and even higher. The question now remains what is strong growth and weak growth? In the 1970s when the average growth rate of the economy was close to 2%, strong economic conditions would materialize when GDP grew at a rate above 2%. However, in the 1980s and 1990s as the average growth rate of GDP jumped to 3% due to major improvements in productivity, strong economic growth was experienced when business conditions expanded at a rate above 3%. Similarly, when the average growth rate of the economy was close to 2%, weak economic conditions would materialize when GDP grew at a rate below 2%.

The issue is that the concept of growth is a relative concept and depends on the economic times and we will see how inflation is one of the major determinants to understand and recognize the type of growth the economy will have.

(From my book Profiting in Bull or Bear Markets. Published also in Mandarin and on sale in China).

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8/2/12

Corn and ethanol

Bloomberg - "Corn’s 60% Surge Is More Dangerous Than Euro Mess"

Bloomberg - "More than 150 U.S. lawmakers of both parties prodded President Barack Obama’s administration to cut a requirement that refiners use ethanol, as corn prices climb amid the worst drought in a half century."

These are the distortions created when governments try to ignore the market. This is what happens when decisions are made because they sound politically attractive. Governments should stay away from spending our money to give subsidies to special groups.

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8/1/12

What’s Wrong with Buy and Hold and Averaging Down?

Buy and hold is the most popular investment strategy because it requires little or no thinking about the investment process. Of course, only the thought of this should convince you that nothing comes easy in life and therefore, in itself buy and hold must have some pitfalls. The major pitfall of this strategy is that people believe that if they buy and hold a stock, over the long term they will make money.

This is true when you are very young and you have many decades ahead of you. The problem is when you are very young - 10 years old - you don't have much money to invest anyway. The issue becomes important when you reach an age when you have a sizeable nest egg and you realize that in a few years you are going to retire.

Let's say you are 45 or 50 years old. You have your retirement portfolio and want to grow this money so that when you retire at 65 you have nice capital to live on. The problem is that when you are 50, you cannot think long-term because your investment horizon is no longer like a 10-year-old person with many decades ahead. You have only 10 or 15 years. Therefore, buy and hold has little or no meaning for an investor who is 50 years old. This investor must determine what kind of investment environment he will face in the next 10 - 15 years.

The 10-year-old investor with $10 does not care, because his capital is very small and even with a crash in the economy, he will not lose much money. Hopefully, over the next 50 or 60 years the market will rise anyway. This is a reasonable assumption. Buy and hold might be meaningful for a young investor, but has little practicality for a 50-year-old, soon to be retired investor.

Buying and holding a stock involves making an investment and forgetting about the investment. Eventually you are going to make money. It is a very simple decision and there is really not much work involved. Now we have to talk about returns to better understand the risk involved in thinking long-term. In this type of investment approach, the market - over the long-term - has provided a return of roughly 10 to 11% - 8% due to capital gains and close to 3% in dividends. Advisors say that since you can expect 11% over the long-term, why try to do much else? Just find a good stock and wait for the capital to grow.

There is a major pitfall with this argument. And it is that the market does not provide a return of 10 or 11%. That is an average. This average is from periods when the markets do not do anything for many, many years, and periods when the market goes up 20-30% per year. Let's look at what happened last century.

The S&P 500 in 1928 was 17.66. In 1949 the S&P 500 was standing at 16.76 - for 21 years the market had actually gone down. Looking at the Dow Jones Industrial Average, in 1900 the Dow Jones was standing at 77.66; and in 1932, it was standing at 50.16. Here we have a span of 32 years where the market was not doing much. Another more recent period is 1968-1982. In 1968 the S&P 500 was 100.53, and in 1982 it was 109.65. Again, a period of 14 years where the market has provided no returns. In this last period, some people might suggest that stock yields were higher. However, in that period, money market mutual funds provided returns in the 10-15% range, which were much higher than the yield provided by stocks.

Buy and hold is an average. If the market has provided a 10 to 11% return, it is because there have been periods of 10, 15, even 20 years when the market did nothing, and periods of 10-20 years, like the period from 1982 to 1999, when the market provided close to 20% per year return. When you average these two periods, it comes out roughly the average long-term return. Buy and hold is dangerous.

Let’s say a 55 year-old investor is planning to retire in an environment like we had in 1968, and he wants to invest over the so-called long-term. By 1982 he has experienced several serious bear markets with its capital declining by 20-30% each time. If he or she is lucky, by 1982 he or she breaks even. This is a nerve-wracking experience indeed.

Investing blindly is not a solution. The risk is always there, whether we want to believe it or not, and the knowledgeable investor has to recognize the conditions that might create a period of well-below average returns. Another pitfall or risk of buy and hold is that if the market, as in the 70's, goes down 30-40%, investors believing in long-term investing would be seriously shaken because their assets were reduced by 30-40%. Managing volatility of return is still an issue the investor has to face.

Another way of investing is averaging-down. By following this strategy, investors decide to increase their investment in stocks by a given amount of money with some regularity. For instance, an investor decides to invest $50 or $100 every month in stocks. With averaging down people are urged to keep investing even if the market declines. By investing the same amount of money as the price of the stock declines, the investor owns an increasing amount of shares of that particular stock. This is a mechanical rule that has a lot of appeal because it requires not much work and not much understanding of what goes on in the market place.

This investment strategy is based on the assumption that the market always goes up; and as we saw before, the market does not always go up, there are periods where the market can provide no returns for maybe 10-20 years. The averaging down strategy consists in buying more shares or investing more as the price of an asset declines. Again, this is one of the popular, easy formulas because they are simple to understand and there is not much work involved.

The problem with this strategy is that as every poker player knows, when you have losing cards in your hand, you're better off saving your money and fold. What is the rationale of continuing to invest when the market declines 30-40%? Why keep losing money? Losing money seriously impacts the total return of your portfolio.

It is considerably more profitable to wait until the conditions are better with a little bit of work and then start investing when the time seems to be more appropriate. No serious investor buys in a declining market because the probability of losing money is very high. Serious investors buy when the market is oversold and starts rising, when there are serious reasons to believe there is a turning point underway and the market is turning up. There is no easy way of making money or managing volatility. Making money, as any businessperson or investor knows, is very difficult and intensive work. It is a knowledge-based "game", and the following pages will provide you with further information on how to play it successfully.

There are no easy formulas in investing. Everybody would be a millionaire. Successful investing is a process that takes time and dedication. The objective of this book is to provide a framework to begin managing your money, recognizing why asset prices change, so that you can make informed decisions according to the odds you have of making money.

(From my book Profiting in Bull or Bear Markets)

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