Giving Thanks for Treading Water

Reflecting back on Thanksgiving, I recall fondly how everything was just like it always was: the same turkey and dressing, the classic side dishes that no one can change, and—thankfully—the same faces that we saw last year. From the cranberry sauce to the football games, nothing had changed.

The repeat performances, however, weren’t limited to the holiday table. Once again, the S&P is trading between 1180 and 1190. (On Monday, November 28, the S&P was trading around 1185, after making about a 2.25% gain). That’s just within a few points of where it closed last Thanksgiving, with a settlement of 1189.40 on November 26, 2010. And, it’s within a few points of where we closed in 2004, with a settlement of 1181.76 on November 24 of that year.

How you interpret these numbers depends a lot on your point of view. You might be inclined to grouse that the “same ol’, same ol’” is fine for Aunt Betty’s butternut squash, but not for the performance of a key stock market benchmark. But given all the problems of the world—persistent unemployment, relatively slow growth in GDP, and concerns about debt of every flavor and variety (sovereign, public, and private)—unchanged is not bad. The alternative, as we recall from the debt debacle of 2008 and the worst recession since the Great Depression, is for a massive shift to the downside.

Often I’m asked “how did we get here; what’s going on?” This question is usually preceded by a noteworthy move in the market: the Dow gaining 400 points to trade up to 11,500—or the Dow falling 400 points to trade down to 11,500 (or whatever price point you’d like). We focus so much on these separate moves that we don’t “get” the big picture: which is whole lot of unchanged, despite the volatility in the middle.

The real answer to the question “so what’s going on” is: nothing. The market, that arbiter of perception and reality, has made its pronouncement: nothing is going on. Sure, the stock market gyrates based on there being “deal or no deal” in the Euro zone, or perceptions of the health of the U.S. economy (How are corporate earnings? What’s the outlook for the next quarter? Will the unemployment needle budge?). But if we take a step back from the day-to-day or even the month-to-month, the line is a lot flatter than you might expect.

We’re treading water, which given all the problems out there is not a bad thing. A market that was relatively unchanged from one Thanksgiving to the next is truly something to be thankful for—given all the fear, anxiety, and uncertainty in the world, economic and otherwise. Even the unemployment picture, which has been persistently pessimistic, can’t ruffle the market too much. Currently we have about 131.5 million people working, which is roughly on par with the number of people in the workforce in 2000. Of course, the population has grown, which means that the picture is worse now than a decade ago—but it’s not so bad as to upset the market.

Treading water is not something we can do for the long term. The problems are there and, if not addressed, they will get worse, as you will read in our 2012 Outlook. As we enter an election year, the political debate has diverted our attention from the real problems to strengthen the economy and provide education and employment opportunities for more people. Instead, they fight: red state vs. blue; raise taxes or lower them. We need to look, instead, at systemic issues such as high consumer debt levels, which we’ll address in upcoming blogs.

For now, though, let us take a moment to pause and give thanks. Nothing going on is good news, indeed, and treading water will keep us from sinking.

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Past results are no guarantee of future results and no representation is made that a client will or is likely to achieve results that are similar to those shown. Please refer to Astor's Form ADV, Part 2 for additional information and risks. Analysis and research are provided for informational purposes only, not for trading or investing purposes. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information. There is no assurance that the Astor’s investment programs or funds will produce profitable returns, you may lose money. 500001-136

Behind the Unemployment Numbers: Demand, Wages, and Skill Levels

As all eyes, especially political ones, remain on the jobless numbers, the Employment Situation report for October, released on Friday November 4, held no upside surprise. The needle budged a hair, with a net gain of 80,000 people who found jobs during the month. The private sector added 104,000 jobs, while the government shed 24,000 of them. Overall, the unemployment rate dropped modestly to 9.0% from 9.1% in September, but did not move out of the range between 9.0 and 9.2 that we’ve seen since April 2011.

Although employment numbers are very important—and the direction in employment trends typically points to where the economy is going—we cannot lose sight of the fact that unemployment is really a symptom of much larger problems that need to be addressed: demand, wages, and skill levels.

For argument’s sake, let’s say that 1 million people find work, dropping the number of unemployed to about 12.9 million from just under 13.9 million currently, out of a total civilian workforce of some 154.2 million. Would the resulting unemployment rate of about 8.4% be the cure for all that ails us? What makes unemployment in the eights instead of the nines so significant? There have been periods in history when the American economy experienced strong growth with 9% unemployment. When I was in college, 6% unemployment was considered inflationary. The “good old days” when unemployment was under 5%, as we saw in the 1990s, was considered full employment—and was not sustainable.

The number isn’t as important as what drives it. In order for our hypothetical 1 million people to get hired, they need the right skills and experience to tap into the existing and future job demand. The educational attainment statistics (Table A-4) in the employment report should take no one by surprise: The lower the education level the higher the unemployment rate. In October, those who have less than a high school diploma had an unemployment rate of 13.8%; for a high school graduate, 9.6%; some college or associate’s degree, 8.3%; bachelor’s degree and higher 4.4%. As if we didn’t know it already, education and training matters—and yet the United States has a high school graduation rate of less than 70%.

Looking at unemployment by occupation (Table A-13) the rate is very low for management, professional, and related occupations at 4.4%, while farming, fishing, forestry, construction and extraction industries are all above 14% unemployment. Among the industries with the lowest unemployment rates are education and health services (5.6%), financial activities (5.8%), and information (6.6%). Construction tops the charts with a 13.7% unemployment rate. This is the real story of employment in the United States, one that we can’t ignore any longer. The continued development of a skilled workforce will position Americans to take advantage of the jobs that are created here. The evolution in our economy, with basic manufacturing outsourced to countries with a comparative advantage in labor costs, has resulted in displacement of jobs (the textile industry in the U.S., for one). Nonetheless, it’s an economic scenario that cannot be reversed, even in the name of “saving” or “creating” jobs in the U.S. The economics simply don’t justify manufacturing here what makes more sense to produce over there. At the same time, landing a well-paying job in the U.S. requires workers to have the requisite education, training, and skills.

Two other factors that we cannot overlook are demand and wages. With productivity at high levels, having risen by 3.1% in Q3 2011, employers are able to realize more output per worker, which is a good thing. Increases in worker productivity means companies are more efficient; they are able to do more with less, which is one of the benefits of having gone through an economic contraction. (If you’re going to endure the pain, you better have a gain, right?) At some point, productivity will max out, and if demand continues to grow companies will increase hiring. So where is the demand?

We can’t blame “the economy,” which has become a blanket excuse, without being more precise. Consumers are still cleaning up their balance sheets. Before the recession, people consumed 10 years’ worth of stuff in five years. The problem wasn’t just overconsumption, but an inefficient use of capital--selling appreciating assets to buy depreciating ones.
Demand is not the only variable, however; the cost of labor is also a factor. During the recession, while the value of assets (stocks, real estate) declined, wages did not. The price of labor, while somewhat improved, remains high, which makes investing to hire new people a risky proposition for employers who are not certain about future demand.

Making a dent in the unemployment rate is everyone’s goal these days, from politicians to picketers, but it’s not simply a matter of getting companies to hire someone--anyone--as if there is this big unfilled pool of jobs that is being kept under wraps. Demand for goods and services must increase to levels that give employers the confidence that they can hire, particularly as the cost of labor remains relatively high. And the people who are seeking those jobs must have the skills and experience to assume them.

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Past results are no guarantee of future results and no representation is made that a client will or is likely to achieve results that are similar to those shown. Please refer to Astor's Form ADV, Part 2 for additional information and risks. Analysis and research are provided for informational purposes only, not for trading or investing purposes. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information. There is no assurance that the Astor’s investment programs or funds will produce profitable returns, you may lose money. 500001-123

Gold Speaks--And the Story Is Compelling

Gold, as expected, has lost some of its luster, with prices falling by about $300 an ounce from around $1,900 an ounce in early September to just below $1,600 a few weeks later. (Keep in mind that as recently as early 2002, gold was trading below $300 an ounce, which means bullion lost more in one month than it was worth about nine years ago.) Although gold has recovered somewhat since then--currently trading around $1,681 an ounce --the recent selloff hardly came as a surprise. Previously we stated that gold is a “buy the rumor, sell the fact” commodity, which in the absence of any fears of a new crisis (old ones that resurface tend to get shrugged off) just doesn’t have any reasons to keep rising.

Beyond the price movements, however, gold seems to be telling a compelling story that’s worth listening to--or at least taking into consideration. First of all, gold is signaling that the world is not coming to an end. Yes Euro zone default concerns persist and fears of a double-dip recession are looking more likely to come to fruition. But these are not new fears, which is what gold would need to continue its climb. As far as gold is concerned, the current outlook is for no new cataclysms.

As I put the pieces of the story together, it seems clear to me that gold is also looking farther down the road than most of us, and what it sees isn’t all that bad. It might even be pretty good.

Gold seems to be giving a nod to the Fed’s monetary policies, including its latest move to buy longer-term bonds, instead of launching another round of quantitative easing (QE3). Thus, while the Fed is keeping interest rates low, it has not lowered them any further, which is why stock prices and gold got hammered in September. But that’s not all gold seems to be saying.

Gold appears to be indicating a scenario that will reverse the Fed’s practice of paying interest on reserves that banks have on deposit. Without a return on that money, it will flow out into the economy in the form of increased lending by banks, which will help fuel growth in response to demand. Gold won’t benefit from that at all and, as a result, its price has fallen.

And there’s more to this story as well. Gold’s price drop indicates that we probably will emerge from the economic contraction/recession without hyperinflation. This is where the Fed’s policies really shine. The Fed expanded the monetary base, but not money supply. (Think of the monetary base as cookie dough and the money supply as cookies that get baked. We’ve got a lot of dough in the system, but the number of cookies coming out of the oven hasn’t changed.) In financial terms, the Fed’s actions, including extremely low, accommodative interest rates, increased the monetary base (dough), but banks have not been lending money in a way that increases the amount of money (cookies) out there. The banks would rather keep their dough (pardon the pun) with the Fed to earn interest.

By constraining money supply while increasing the monetary supply the Fed was able to contain inflation. As we’ve written before, although some people complain that the Fed’s actions equate to “just printing more money,” the truth is the money supply has actually stayed at the banks.

Until now, gold has been a beneficiary of the Fed’s actions to keep interest rates low. Unless you were an institution, you had to do something with your cash other than keep it on the sidelines. You had to take a shot, which pushed the price of many assets including gold higher. If you bought gold over the past one or two years, then good for you--you made money. But now the premise for investing in gold has passed its prime.

Gold has a tale to tell these days for those who care to listen. The price is down and that’s basically good news for what could very well develop in the economy: the probability of an ordinary contraction/recession with no downside surprises, the likelihood of no hyperinflation, and an expected change in Fed policies sometime in the future to help increase the amount of money to finance new economic growth.

With gold off its highs, events may prove to be pretty uneventful (barring any sudden, unforeseen crises, that is)--and that’s a story worth listening to.

The Recession is Coming, The Recession is Coming

Fears of a double-dip recession have been swirling since the recovery began back in 2009. Economists, advisors, and investors have predicted, forecasted, rationalized and, in some cases, even hoped that a double-dip was imminent. The reality is they have been wrong. The economy actually thrived over the past two years, producing record levels of aggregate GDP at about $15 trillion, record levels of personal income at $13 trillion, and record low interest rates and inflation, along with high levels of productivity. The stock market produced double-digit returns in both 2009 and 2010. Even as the worst quarter for stock market performance since Q4 2008 nears a close, the market is still up from where it was a year ago.

Admittedly, unemployment has remained stubbornly high, and housing has yet to recover. While GDP hit record levels, the pace of growth has been below historic average growth rates. As a result, the last two years have felt less like an expansion than the statistics would support.

Looking back, to have flinched at the headlines about a weak economy at any point along the way (and believe me, there were compelling reasons to flinch) would have been a mistake. Market timing is challenging at best, and one wrong move can erase the profits of the last ten good moves. The portfolio management team and I have navigated away from market timing in our philosophy, always focusing on long-term verifiable economic trends. To that end, the data is suggesting that the next recession is here. Although it appears a recession is upon us, there’s no reason to panic.

As we sit here today, with the portfolio down on the year (albeit less than major market averages have suffered) we anticipate becoming more defensive, with possible inverse/negative exposure in the future. We believe this repositioning should reduce the overall risk and volatility of the portfolio further.

Based on the current economic climate, it appears the decline will be much more typical of garden-variety recessions/contractions, characterized by a slowing economy and declining financial markets, but within ranges that do not destroy investor wealth beyond levels that should be recouped during the next expansion. I compare it to a gloomy April day in Chicago with the temperatures at 41 degrees and a mix of rain and snow. It’s either a bad spring day or a mild winter day for Chicago. This contraction/recession could resemble that kind of day: either a slow growth period or a mild contraction.

The global economy is awash with liquidity, corporate balances sheets are healthy, and worker productivity is high. When expansion resumes and demand resurfaces (by that we mean real, sustainable demand) the labor market will be ready and willing to get back to work at fair wages. Then, the economy is going to light up like you would not believe. We cannot say what will spark demand, but the ingredients are there, and will create an expansion that will surprise even the most optimistic economist on the upside. It’s coming at some point. Unfortunately, it’s not going to happen in early 2012. Outside headwinds still exist that currently do not support necessary growth rates. When it does arrive though, we will identify it and ride it for all it is worth.

Analysis and research are provided for informational purposes only, not for trading or investing purposes. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information. There is no assurance that the Astor’s investment programs or funds will produce profitable returns, you may lose money. 900001-69

When Zero Is Zero

After cruising along at a slow, but steady pace for two years, the economy seemed to stall around mid-year 2011. Q2 2011 GDP, which originally had been estimated at + 1.3%, was ratcheted back in a second estimate to a rise of 1.0%. While growth is growth, its anemic nature made one wonder if the patient would rally or sink into a relapse. The start of Q3 2011 brought with it a number that is impossible to ignore: the big goose egg, an empty basket—zero.

The Employment Situation Report released on the first Friday of September showed that no jobs– none, nada—were added in August, and the unemployment rate remained at 9.1%. The 17,000 jobs that were added were completely offset by the loss of 17,000 government jobs. Even the Bureau of Labor Statistics sounded a little disheartened when it stated, “the [unemployment] rate has shown little change since April.”

Zero job growth signals that the odds for a contraction are significantly higher than any time since the recovery began. In fact, my finger is on the trigger. At Astor, we responded to the latest data by adjusting our portfolio to protect against the possibility of a shock to the economy. We have not become maximum defensive, yet, but we did reduce equity exposure even further, and also added some non-correlating defensive positions. It’s possible that we could become more defensive and even establish an inverse position in the third quarter, but only time will tell.

As of this writing, the data are indicating GDP growth for the year of around 1%. While hardly robust, it is far better than the -6.3% economic contraction experienced in Q4 2008 and job losses of 500,000 per month. Given how far we’ve come up from the bottom, flat is okay. Not great—but okay.

The markets are taking a breather as stock returns and the economic growth of the past few years are not sustainable. Even if we stay right here for the year, the three-year economic performance will look pretty good in the rearview mirror, especially when we consider how tough the road was in 2008.

Despite some investor fears to the contrary, this is not 2008 all over again. I’ve said it before, but it bears repeating: in 2008 we had a recession on top of a financial crisis. This time around, if the economy does slip from low growth into recession it will be a garden-variety contraction.

Meanwhile, the government keeps trying to jumpstart the economic engine by focusing on jobs. Against the backdrop of an unemployment rate that persists over 9% (and with an election year approaching) President Obama unveiled a $447 billion job-creation program, which includes tax cuts and a spending plan. After the job program was announced last week, economists were all over the map with their assessments.

As for this economist, I expect job growth to be more in line with demand. Even with government assistance, businesses will not hire meaningful numbers of new workers unless demand for their goods and services pick up.

I have never been a market timer, and I don’t intend to start now. I much prefer to analyze the economic data and identify the prevailing trend, which history has shown to be a far better investment strategy than guessing which way the wind will blow next. As for now, the numbers spell out a weakening economy and a greater chance of a recession occurring. After all, it’s hard to argue with a zero in the employment report. But we need to remember we have come a long way baby, even if it doesn’t feel like it. So if we do pause or even contract from here it’s not a bad place to rest.

Gold: Losing Its Luster

There’s nothing like a little fear and loathing for putting a shine on gold prices. Indeed, concern over everything from the U.S. economy heading into recession to the possibility of sovereign debt default in Europe has been cited as the force behind gold’s meteoric price rise, reaching a record $1,917.90 per ounce on August 23. Just one day later, gold experienced its biggest one-day drop in 18 months, with prices off about 5% at $1,763 at mid-day. The reason most commonly cited for the price decline is a collective sigh of relief as the aforementioned fears appear to be somewhat alleviated--at least for now along with probability of QE3 seeing less likely.

Traditionally, gold has been viewed as the “safe haven investment;” the place to (presumably) put your money because you’re quite certain that “Financial Armageddon” is just around the corner. The fact, however, is that while fear may spark gold’s rise, when financial calamity finally strikes, it’s usually a reason to sell, hence the old adage “buy the rumor sell the fact”. Additionally, when financial calamity hits, the owners of gold, like central banks around the globe as well as large fund managers need to sell assets to cover depreciating assets and pay liabilities and this drives gold prices lower.

Gold truly is a “buy the rumor, sell the fact” commodity. Consider what happened in 2008. During the first half of the year, gold rallied to more than $1,000 an ounce on fears of a pending crisis. When the crisis hit in the second half of the year, however, gold prices actually went down, trading below $720 an ounce.

Now, with gold having made a run at $2,000 an ounce, there just doesn’t seem to be a compelling reason for it to stay at such lofty levels. Even news of fighting in the Libyan capital of Tripoli, as rebels appeared to close in on Moammar Gadhafi--a significant geopolitical development--did not keep gold prices at their recent highs. This is all the more reason to expect that gold prices may have topped. As I see it, there are more reasons for gold to continue to drop than for it to reverse course and rally significantly again. First the reasons that gold will likely sell off:

The doom that everyone has feared actually hits, whether it’s another Euro-Zone debt debacle or fresh evidence that the U.S. economy is about to go into a tailspin. As I stated, fear bolsters the rally, but when the bad news comes into fruition, investors sell and gold drops.
The threat of doom subsides. Stocks begin to trend higher, interest rates raise a touch and gold eases under its own weight. Once again, investors sell.
The only reason that gold could keep rallying is a new perception of impending doom. I don’t believe this would work for the return of an old fear, because investors tend to shrug these things off as “Oh, that old worry is coming up again?” There would have to be a new fear factor in the market to create any significant upside potential for gold from here and one that was unlikely to materialize in the near term but create fear that it could.

Looking at the three scenarios--disaster strikes for real (sell), fear of disaster fades (sell), fear of a new disaster rattles the market (buy)--I think the shine is off gold.

Signs Point Away from Treasuries…But Not Because of S&P Rating

August 10, 2011 will go down in financial history. On this day, the S&P’s dividend yield at the close was 2.17%, which was above the yield on 10-year Treasuries of 2.14%. This was only the fourth such occurrence since 1958, with 1962 and 2008 providing the only other modern-day examples. More interesting to note is what it could potentially signal.

Although the sample size is quite small, based on the three previous occurrences when the S&P dividend yield was above that of Treasures, the average return on S&Ps 12 months later was 18.5%. Even 2008, in the midst of a financial market meltdown and with equity dividend yields being quickly reduced, produced a positive return of 23.5%.

The obvious question now is will history repeat itself?

To be clear, there could be more downside in the market because no one can time a bottom very well, especially when investors are panicking and irrational behavior prevails in the short-term. But a decline in confidence is very different from a decline in financial worthiness. Fundamentals do matter, and they are not as bad as the recent market activity would indicate. In fact, if the fundamentals worsen, it appears this scenario has been priced in. Even if we do enter a recession, most of the damage to the market probably has been done already because the average market decline from peak to trough is about 25%.

No one knows for sure if history will be repeated, but the fundamentals are much more favorable now than during the last S&P dividend yield occurrence in 2008. Today, there is no liquidity crisis, as there was three years ago. Corporations are flush with cash. Corporate profits are at record levels, and more than 70% of earnings reports in Q2 2011 beat estimates. Additionally the broad economic data is still positive, admittedly slow, but positive none the less. We are adding about 150k jobs per month on average and GDP at the last look was +1.3%. These are slow but positive numbers that against the back drop of the recent equity markets moves seem to have a disconnect.

Now, enter the Fed’s latest announcement meant to assure the market in the wake of the S&P U.S. debt downgrade. The Fed took the unprecedented step of signaling future action and putting a date on it. In the past, the Fed has said it will keep interest rates exceptionally low for an extended period of time. Earlier this week, it said rates will be kept at these low, accommodative levels until at least mid-2013.

Reading the Fed’s tea leaves we arrive at two very interesting conclusions. First of all, the Fed has, in essence, thumbed its nose at S&P and its debt downgrade. Normally a reduction in credit worthiness drives up rates because investors have to be enticed to buy debt that, supposedly, is more risky. Bernanke and Company, however, have essentially told S&P: “You think rates are going up? Guess again. We’re keeping them low for two years.” No silly downgrade is going to raise rates, not on Bernanke’s watch—unless, of course, economic fundamentals deem such a move appropriate.

Further, the Fed is stating very clearly that investors will get nothing—nada, zero—in interest on short-term fixed income investments for two years, so look for something else. As investors look for other opportunities the obvious place will be stocks and the market appears to agree.

Worth Less, but Not Worthless

Markets were sent tumbling yet again, with the Dow closing down 5.5% and the Nasdaq and S&P losing more than 7%, on Monday. The latest gunshot to spook the investor herd was Standard & Poor’s downgrade of the U.S. debt rating from AAA to AA+.

The rationale for the downgrade, essentially, was the inability of Washington lawmakers to get along and come up with a debt reduction plan that the rating agency deemed acceptable. No matter how much political dissention there is, however, squabbling on Capitol Hill should have nothing to do with the U.S. credit rating. To think otherwise would be like a bank raising the interest rate on a home mortgage simply because a couple doesn’t eat dinner together most nights or argues over who left the cap off the toothpaste. It’s all about the ability to pay, which is not an issue for U.S. debt.

The irony of it is, in the wake of the downgrade, U.S. Treasuries remained the safe haven, which meant the government’s borrowing costs did not go up. In fact, they went down. Unfortunately equities, the unintended victim, were trounced substantially because investors sold first and asked questions later.

Investors had already been running scared because of worries from European debt to whether a slowing U.S. economy will slip back into recession. The real reason for their panic, I would argue, has very little to do with debt levels in Greece or Italy, or whether GDP in the U.S. will drop into negative territory. It’s all about 2008.

Investors remember all too well the great flush that occurred in the midst of the financial crisis, when huge companies that had been thought to be rock solid--Bear Stearns and Lehman Brothers, to name two--suddenly went out of business. Asset values evaporated, and investors feared a return of the Great Depression.
Now as fears ripple through the market, investors vow not to be caught flatfooted again. “I’m not going to let that happen to me” is the mantra as they head for the hills, taking their cash with them.

The good news is this is not 2008. Not even close. The economy is still growing. GDP for Q2 2011 was up 1.3%. Although that’s hardly strong growth, it’s a far cry from a negative reading of -6.8% for Q4 2008. Yes, employment is soft, but we are adding jobs, even in the midst of government layoffs. Just a few years ago, the monthly job reports were showing losses of 500,000 jobs.

Demand is weak as consumers deleverage, while the government, which can account for 20-30% of GDP, has cut its spending by mandate. This could set the stage for a soft economy to go into recession, but don’t look for things to fall off a cliff.

The simple fact is we’re two years into an economic recovery and we’ve hit a soft patch, which is to be expected. We’ll either start growing from here, or slip into a recession again. Only time--and economic data--will tell. In the meantime, assets are worth less, but they are not worthless. This is far more important than a clever play on words. It is a statement of fact that this is not 2008 all over again. We are in an economic slowdown/recession, not a crisis. No big corporations are about to implode and go out of business.

Although these are painful times to be an investor, when fear grips the market with increased volatility, but there really is no reason to panic. The economy may be wounded, but it’s been on the mend and, for the moment, there is no reason to believe the patient needs to be in intensive care. And if you are looking for the right medicine to make you feel better then look no further then the dividend yield on the S&P 500 which is yielding about as much as the US 10 year treasury. Historically when that has happened in the past equities have had a very nice rally.

Solid Cushioning for Your Portfolio

As we approach the half way point for 2011, the complexion of the equity markets’ performance appears to have changed… or has it?

Sure we have hit a soft patch as the events of last quarter In Japan combined with higher energy and food prices have slowed the economy. While I believe this to be temporary and the economy re- accelerate later this year, the market’s reaction to the slowdown and the recent bout with sovereign debt concerns has created opportunities for specific ETF’s that should perform even if the economy and markets don’t recover.

First to mind is the high yield bond market (iShares iBoxx High Yield Corporate Bond Fund, JNK). High yield has benefited greatly from the general improvement in credit, demand for yield and economic recovery over the past two years. It’s clear the “soft patch” has resulted in an equity valuation adjustment, but the strong downside correlation and beta of HYG to the equity markets is greater than historical averages. The sovereign debt concerns have exacerbated this move as well, however, the strong profitability and cash levels of corporations backing these bonds equates to a magnitude of decline move in our eyes that is unwarranted. In fact we are at a point where the yield (HYG currently yields approximately 7.6%) is greater than the average decline in this sector. If HYG returns to its 5/31 closing price, this is an additional 3% kicker, but you don’t need the market to move to make money.

Another ETF play is the UUP (Powershares DB US Dollar Index Bullish Fund), a long US dollar play. The dollar has tended to rally over the past three years when stocks drop on a flight-to-quality move, providing a nice diversification. Further, if the decline in US stocks continues as a result of Euro-zone credit issues, the dollar is the likely benefactor. Additionally, if rates start to increase due to growth acceleration, the US the dollar will likely benefit as well. This would only be benefited more by austerity measures in the US.

Now looking to ETFs with direct exposure to equities, most have found tough footing on economic sensitivity and geopolitical issues of recent. Health care (Health Care Select Sector SPDR Fund, XLV) has offered investors some attractive qualities for the current market environment. XLV has been one of the strongest sectors this year, still holding gains over 12% for the year, while offering a yield to investors near 2%. In the month of June, while the majority of broad based indices have declined 4.5% – 6%, XLV has declined by half of that at slightly less than 2.5%. This is a sector that many worried about suffering from a political standpoint as the healthcare bill and other political rhetoric moved around Washington. However, to the contrary, this has been one of the most consistent performers through an up and down year,

These ETF’s we discussed above should do well for the portfolio and provide stability and diversification even if the market continues its recent decline. But from my perspective the recent weakness is “temporary”, and here’s why:

Many are looking at recent data such as GDP and jobless claims to support a slowdown that is a precursor to another recession. But remember that jobless claims are a measure of those who are not working. We prefer to look at monthly payrolls that measure the amount of people who are working (and contributing to the economy). The number of people working each month is increasing at around 200,000 and has been for the past year or so. In fact, one of the better non-farm payroll numbers we had was for April, the same month that saw unforeseen upticks in jobless claims up as high as 478! The “horrible” non-farm number for May was actually a positive number, meaning we ADDED jobs to the economy…again. Also, GDP was revised up to 1.9% again another POSITIVE data point. Let’s not shoot a nickel because it’s not a quarter.

The markets can fluctuate during any 30-60 day period but the trend for the 2-6 quarters ahead generally follows the employment and output trend. After all the market is up over 20% from this time last year so some consolidation/correction is to be expected. The events of Japan and the higher oil prices from last quarter are having a temporary impact on the economy.

But make no mistake the economy is growing! Corporate profits are at record levels, personal income is at record levels, tax receipts are up 55% from a year ago and the S&P is trading at the lowest multiple to earning in over 26 years. While the market may still go lower from here it would be a mistake to suggest a recession is coming. In fact, growth is more likely to accelerate later this year and the more probable direction for stocks in the 12 months ahead is higher

Good News! Inflation!

Written by John Eckstein- Director of Research at Astor Asset Management, LLC

While we all wring our hands about inflation and grim-faced, serious-suited bankers tisk, the fact that we have had an uptick in inflation in 2011 is good news. That and the prospect of a bit more is putting the United States into a position where job creation – and demand creation – is more likely. To explain why, I am going to call upon our trusty friends, supply and demand.

Economists usually think about supply and demand balancing on a graph that shows the quantity of a good demanded on one axis and the price of the good on the other with the price representing what would be obtained in the marketplace and sampled at monthly intervals perhaps, showing at each price where supply and demand met: this many dollars for that many cookies. The chart shows one representation of the US labor market with total labor (in terms of total hours worked) on the horizontal axis and the real (or inflation-adjusted) wage on the vertical axis. Recall what happened at the end of 2008. Many, though not all, economists would describe that period as one characterized by a sharp drop in aggregate demand, that is on the whole the US decided to consume a lot less of some things (houses in Las Vegas for example) and somewhat less of almost everything. As consumers demanded less, producers made less and thus there was less demand for labor. Now if the demand for something goes down: why then our ancient faith should teach us that the price should usually drop as well. Look at the red squares on the chart though: they represent the period 2009 to date and you will see that the real wage – the price of labor – increased over this period.

This scenario seems odd. Of course employees did not find a note on their paystub saying: “business is terrible, have a raise”, but the CPI dropped substantially with no change to the trend in nominal wages – causing inflation adjusted wages to increase – and until the end of 2010 both prices and wages moved together, keeping real wage at its new, higher level. Now it’s a bit of a puzzle why wages wouldn’t fall during a recession. The same thing happened, though not to the same extent, in the 2001 recession but wages fell, as you would expect, in the 1990-91 recession. Logic dictates that if more workers are to be hired they must be hired at a wage firms find attractive but there seems to be a bit of disconnect between the real world and the ultra-rational economic factors our models posit.

Whatever the cause of the increase in real wages, with inflation rising faster than wages over the last few months, we have begun to see some progress toward moving wages nearer to the level they were before the recession started. Call it half way there. At this point we are in the unusual situation of hoping for a bit more inflation and sooner rather than later. Enough inflation, that is, to move the real wage down to induce firms to hire more workers (thus increasing demand and – hopefully – moving the real wage back up again but for the “right” reason) but not high enough to force the Fed to hike rates prematurely. Incidentally, increasing inflation somewhat would also reduce the real interest rate which is good for getting money into the hands of firms who can invest it.

According to the Fed’s semiannual monetary report to Congress from this winter, increasing inflation to more normal levels was one of the goals of the second round of quantitative easing undertaken by the Fed which is due to end this month, Interestingly, one idea which keeps coming up in discussions of Fed thinking is inflation targeting, where the fed explicitly aims at a target for inflation, with a balanced approach of reacting to inflation either over or under the target.

Of course the real wage is not the only thing going wrong with the US economy and it is easy to overdo it with inflation. I believe, however, the recent moves are moving the US labor market towards a higher employment equilibrium.

John Eckstein is Director of Research at Astor Asset Management, LLC

The Employment Situation Road Map

At Astor we are known for creating portfolios of ETF’s using employment trends as a key factor. Research and history have proven that employment trends are an excellent indicator of the long term direction of the economy and sectors. Of course it is not a one-to-one correlation and sometimes employment trends lag a bit, but for my money sticking with the employment trend keeps you out of trouble.

Look at recent history for a few examples. Employment trends kept me out of trouble in late 2000, sitting out much of the pain of the dot com bust. Fast forward seven years, and identifying a contracting labor market in late 2007 just before the subprime debacle saved you a lot of pain, fortuitously. Now that the current recovery is well underway and an expansion is upon us, employment trends can help balance a portfolio by investing in the sectors with the greatest employment growth.

With the latest data on the US labor market released last Friday, new clues as to where the best opportunities lie are available. This will most likely be a very boring, albeit useful and informative article. I promise to have a bit more wit and even humor in the other article posted during the month. There will be, of course, short term opportunities presented with other data points, political events and economic releases, as well as cute moves to capture short term fluctuations using ETFs. My hope is to regularly identify these opportunities as they present themselves. All that withstanding, the employment report is still the grand daddy of reports to build a road map to long term directions and sustained investment goals and objectives.

As I review the latest report areas of strength, those that jump out are the following:

•Healthcare – added 34,000 jobs. Investors can purchase the iShare Dow Jones Healthcare index (IYH) to get exposure to this hot sector.
•Manufacturing – added 33,000 jobs last month. A way to play that growth is in the MZG, the claymore Morningstar super sector of companies that make stuff.
•Construction- Although construction added 33, 00 jobs, recall that it lost 2,200 jobs in January so I would not jump on board yet in this area or related business.
•Transportation – Added 22,000 jobs mostly in trucking. The iShares IYT is an excellent ETF to capture this growth. With energy prices on the rise, this will be counter intuitive and should climb the preverbal wall of worry.
The big losers (from a jobs stand point) were state and local governments which have shed 377,000 jobs since the peak in 2007. I would be careful here and not rush to sell securities related to these municipalities, such as MUNI which is the ETF that tracks the muni bond market. The default rates are very low for munis and one or two bad apples should not spoil the whole bunch, but it could add unnecessary volatility to your portfolio (read opportunity as well).

Our lesson from an employment perspective is that if you add exposure to sectors that are adding jobs and reduce to the sectors that are losing jobs, you portfolio should have lower risk and volatility. After all, job growth is a sign of health and confidence, and pockets of strength are always good. Of course there is no magic bullet that can prevent the economy from losing steam and reversing course but these sectors tend to hold up better in a down turn and run farther in the expansion.

The Time and Place

Much has been written to vilify levered ETFs. In fact, many blame them for the equity market volatility of recent years, specifically the flash crash of May 2010. I find this generalization frustrating. After all, it is just about math.

Leveraged ETFs may not track the index exactly over the medium to long-term. They may even be downward-sloping, meaning they are more likely to go down rather then up due to the effect of daily rebalancing. But, again, it is just math. The daily rebalancing impacts the long-term return and if the market is not trending it has a negative impact on price performance in comparison to the corresponding benchmark. That said, leveraged ETFs have a definite time and place and the best use is to capture short-term moves. With reduced capital requirements, an investor can hedge an entire portfolio without having to sell or raise cash. Or, if an investor is expecting a short-term move (up or down), and wants to take advantage of the short-term volatility it can be done with limited stress on the funding levels. Whether you are a hedger or an outright speculator, there is a benefit to be had from a product like this.

This is all a long lead-in to a recent phenomenon I have noticed in the major indices that have been occurring on the first day of the month. An abnormally high percentage of each month’s return, in the S&P 500 for example, has occurred on the first day of the month. Since the bottom was reached in the S&P 500 in March 2009, we have had 23 first days of the month. Of those 23 periods, the first day of the month has been the same direction as the rest of the month 17 times, or 73.9% of the time. The average return of each month since then (4/1/2009) is 2.35%. The average return of the first day of these months is 0.8%, or 34%. If we look at these numbers since January 1, 2010, these figures become more significant even. In the 14 measurable periods since then, the average monthly return for each month has been 1.35%. The average return for the first day of each month has been 1.05%, a staggering 76%.

There is an additional, equally alluring component to the “first of the month” phenomenon of late. Since April 1, 2009, 82.6% of the “first days” (23 total) have been positive, averaging 1.33%. Of the four days that were negative, the average return is -1.71%. The average return for all days in this sample was 0.81%, with the best day at 2.95% and the worst at -2.58%. A more recent view of this trend paints a similar, more compelling picture. Since January 1, 2010, 12 first days of the month have seen the S&P 500 rally, with only two showing a decline. The average return on positive days has been 1.4%, with a -1.02% on the two down days. The best day in this sample is 2.95% still, with the worst day at -1.72%.

I believe this pattern is due to two things; bullish consensus with low conviction, thus creating a chasing effect on the first day of the month as frustrated investors that missed yet another positive month just buy everything as the new month gets under way, and simply a bull market trend. Bringing this exercise full circle, whatever the reason for this might be if this pattern continues into March this is the perfect use of levered ETFs to capture this pattern. Investors can buy highly levered ETFs like UPRO and SQQQ which give triple leverage to the long side of the S&P 500 and NASDAQ 100, respectively. Since this trade is trying to capture the movement of a single day this is the perfect scenario for these products. While I am not suggesting this pattern should continue to work, and of course past performance is not indicative of future results, if you wanted to “go for it” this is a time and place for levered ETFs. In the spirit of full disclosure, my logical mind would not typically invest much capital on a pattern that I can’t explain. It is hard to ignore what I would dismiss a statistic of this significance to mere coincidence,

More interesting is you can sit out the rest of the month which will clearly reduce the risk/return profile as the lowest risk position is out. So with month end around the corner and the first day’s pop to follow you might want to keep your powder dry.

The Not-So-Secret Alpha Weapon

As the equity markets around the world turned higher in Q1 2009, and were followed by the economy soon after, many investment managers began to lag the broad averages/benchmarks as a result of being defensive. (Can you blame them?) Figuring out how to play catch up was the question, and many investors turned to emerging markets as the secret weapon. And why not? The story sounded good. Most avoided the domestic financial crush simply by not having a banking system that could support leveraged “ponzi paper” that the US and Europe were good at creating. They didn’t have the same issue we had with deficits and housing. They did not avoid the global slowdown 100%, however, their growth potential as a whole looked outstanding as the world rebounded, and they were going to lead us out of the recession.

Emerging markets were going to be the next big thing in the investment world and the upside opportunity appeared limitless. The beta of these markets is historically higher than the developed markets, and as momentum turned it seemed like the perfect trade, creating an allocation opportunity to add portfolio alpha. Emerging markets’ correlation to US stocks grew, but who cares about diversification when everything is going up, right? ETFs became the vehicle of choice for investing in emerging markets and the growth in these products swelled, ultimately breaking into the top tier by fund assets, alongside the SPDR S&P 500 ETF Trust (SPY) and the SPDR Gold Trust (GLD).

As 2010 was a grind up to new recovery highs was complete the tortoise (developed market equities) strolled passed the performance finish line ahead of the hare (emerging markets). But from the recovery lows the previous two years we still saw a large disparity in returns between these two brtheren. To be sure, the total return of the iShares MSCI Emerging Market Index (EEM) from the beginning of March 2009 through the end of 2010 was 131.5%. This compared to a 77.47% return for SPY and a similar 77.59% return for the iShares MSCI Developed Markets ETF (EFA) over the same period. As we enter 2011 and assets continue to balloon, fundamentals are no longer supporting such an large allocation to emerging markets versus developed markets as the recovery matures. The commodity story, which helped bolster resource-producing economies and their currencies, has become long in the tooth and political issues are causing excess volatility. Fundamentals do matter as do valuations. As the slow and steady improvement in the US economy hits stride, the surer bet right now is the tortoise. Year-to-date through 2/9/10 has said it all. EEM is down 4.47% compared to a 5.18% gain in SPY. As we review the fundamentals that drive US stocks, even after the lost decade, they are positively sloped and respond in kind to growing and improving economic fundamentals. This is not always the case (yet) for emerging economies. It has yet to be proven conclusively that these equity markets reflect their economies for any continued period. In fact, I am not even sure emerging market equities are positively sloped. They present great runs followed by almost equal declines. So as the train gets crowded and is about to leave the station, smart money is (or should be) rotating out of emerging equities and into more developed markets and larger capitalization stocks. There will be a place and time to re-enter emerging markets for the “beta trade”, but that may be a few quarters and maybe up to few dozen percentage points from here.