LANDY INVESTMENT MANAGEMENT BLOG

RISK MANAGEMENT IN STOCK MARKET INVESTING

    Investment portfolios should contain a minimum of twenty stocks, with no single industry accounting for more than 15% of the total value at the time that the portfolio is constructed. Even with such diversification, a portfolio of stocks is vulnerable to the risk of at least a 60% loss from peak to trough (there have been several 50 - 60 % stock market declines in my lifetime, but feel free to pick any number between 60% and 99%, depending on how nervous you are about investing in stocks). I hope to avoid major market declines by pulling out when I correctly foresee a recession, but even　 successful economic forecasting does not protect against all bear markets.　 Some investment pros advocate limiting a portfolio's loss to say, 20%, at which point one liquidates and walks away.　 But this method is effective only if one never goes back into stocks.　 For example, a 20%　 trigger point would have produced a 20% loss in 2008.　 But if one re-entered the market in, say, January, 2009, one would have liquidated by March, 2009 with another 20 % loss. Indeed, one potentially could string together a whole series of 20% losses.　 All that does is spread the loss over a longer time period, without limiting the total loss.　 And during the periods between liquidation and re-entry the investor remains on the sidelines with no chance of recovery.
　　 Another problem with liquidating upon some predetermined loss percentage is that it fails to protect against a rapid market meltdown.　 During the 1987 crash, stock prices dropped about 5% one day (a Friday), then another 23% the next day that the market opened.　 The total decline from the peak was about 1/3.　 If one's portfolio is already down by, say, 10%, another 23% decline in one day puts you well below a 20% loss threshold in a flash.　 Indeed in the 2007-2009 bear market, there were several days when the market opened 5% or more below the closing prices from the night before, so there was no chance to liquidate at points in between. In 1987, stocks rose to new highs by the end of the year. So any investors who liquidated after the crash and stayed away from stocks would have missed out on the recovery. Likewise, most who liquidated after the drop in early 2009 likely missed out on the recent 50% rise to new highs for the year. In both cases, liquidating to prevent further loses had the unwanted effect of making impossible the recovery of the investors’ assets.
　　　　 Corporate and government bonds are also subject to considerations regarding risk.　 Corporate bonds are subject to the risk of default (like if one owned Lehman Bros. or Six Flags bonds).　 Both corporate and government bonds are subject to the risk that their value will decline if interest rates rise or bond ratings decline.　 The most serious risk of all, however, is that inflation will erode the purchasing power of the fixed interest payments each year and will decimate the purchasing power of the principal upon maturity.　
　　 The best risk management method is to place some assets into Treasury Inflation-Protected Securities (TIPS). These are U.S. Government bonds that pay a low rate of interest, but the interest payments and the principal are both guaranteed to increase with the rate of inflation.　 Both the interest received and the increased principal value that accrues each year are taxable income.　 In IRA and other tax-deferred accounts, tax is not payable until the money is withdrawn.　 These bonds can be purchased directly from the U.S. Treasury or through a bank or broker.　 Also, there are mutual funds that invest in TIPS and exchange traded funds (ETFs) that invest in TIPS.
　　 Risk management in stock investing cannot be achieved simply by selling as stock prices decline.　 Nor can risk management be enhanced by sticking to stocks of safe companies. (Define “safe”: Citigroup? GE? Fannie Mae? Freddie Mac? AIG? Polaroid? General Motors?)　 The bottom line is that the best risk management program for stock investing is found outside the stock market: in the government securities market through the purchase of TIPS.　 For funds not needed over the next few years, the lowly stock market, after getting beaten up over the past decade, remains a good bet to resume its　 long-term (100 year) pattern of providing a　 9.5 % rate of return.　 And, even after their recent run-up, stocks remain on sale at prices 1/3 below the highs of two years ago.

IS EMPLOYMENT A LAGGING INDICATOR ?

Employment is NOT a lagging indicator, although duration of unemployment IS.  The Conference Board, a not-for-profit economic study organization, publishes three popular indexes: 1) the Leading Economic Index (LEI), which foretells turning points in the economy before we move into or out of recessions, 2) the Coincident Economic Index, which measures current economic conditions, and 3) the Lagging Economic Index, which changes direction following the others.

There are two employment indicators that are incorporated into the LEI, namely Initial Claims for Unemployment Insurance (inverted), and Average Weekly Manufacturing Hours.  Like other leading indicators, we do not normally recognize these things as obvious improvements in the economy.  After all, if over 500,000 workers file claims for unemployment insurance, as was the case this week, this is still a relatively large number and the fact that it is much lower than was the case a few weeks and months ago does not mean that the economy is improving.  But it DOES mean (with history as our guide), along with improvement in the other leading indicators, that the economy is going to improve soon.

What about total employment - the actual number of workers on payrolls?  That is the figure most people relate to as a measure of the health of the economy.  That is not a lagging indicator, either.  In fact, it is a Coincident Indicator. The first Friday of every month the Bureau of Labor Statistics of the U.S, Department of Labor releases monthly data showing nonfarm payrolls.  This figure is one measure of how the economy is doing right now.  It is one of the Coincident Indicators tracked by the Conference Board.  In addition, it is one of the four indicators examined by the National Bureau of Economic Research (NBER), which is widely recognized as the group responsible for determining the dates of the beginning and end of recessions.  The other three indicators that the NBER considers are sales,income and industrial production.  Employment typically rises when recessions end.  However, in our most recent recovery from recession, 2001, employment did not rise until over a year after the NBER called the end of that recesssion based on improvement in the other three indicators.  Indeed, that period of time was dubbed, "The Jobless Recovery."  That lag in employment was unusual and it did not knock Nonfarm Payroll Employment off its perch as one of the Conference Board's Coincident Indicators.  And Employment remains one of the four indicators considered by the NBER in fixing the ending date for the current recession. 

The Unemployment Rate has no official status as part of any broad index of economic conditions.  Observers have pointed out problems in drawing conclusions from changes in the employment rate.  For one, as labor market conditions worsen, unemployed workers may become discouraged and stop seeking jobs.  Their dropping out of the labor force makes the unemployment rate fall, disguising worsening conditions.  Conversely, as the economy improves, discouraged workers tend to become optimistic as they hear reports of hiring, then enter the labor force where they add to the unemployment rate while they actively seek work.  These leakages plus changes in the calculation of unemployment over time have brought much criticism to the use of the Unemployment Rate as an economic indicator.  The Unemployment Rate does tend to lag the ups and downs of the economy cycle.

There is one additional measure of unemployment that is a Lagging Indicator, as defined by the Conference Board: Average Duration of Unemployment (inverted).  This measure looks at people who have recently found jobs and tells us the average length of time they had been unemployed.

What are the labor market indicators telling us now?  Of the Leading Indicators, Initial Claims for Unemployment Insurance peaked in March and the four week moving average of claims has fallen steadily since April.  Average Hours Worked in Manufacturing began a small improvement in June.  These indicators and the overall LEI point to an early end to the recession, and the recovery may well be underway, already.  Nonfarm Payrolls, a Coincident Indicator, has continued to deteriorate in recent months, but we are well past the peak in net job losses.  This year's massive declines in manufacturing inventories argues for a pick-up in factory hiring, as has recently occured in the auto and steel industries.  Thus, the outlook is becoming more positive for gains in Average Weekly Manufacturing Hours this month and next, soon to be followed by gains in nonfarm payrolls during the fourth quarter.

The Unemployment Rate and the Average Duration of Unemployment have continued to worsen, and they can be expected to improve only after the economic recovery is well underway.  To summarize: Average Duration of Unemployment and the unemployment rate are lagging indicators, Nonfarm Payrolls is a coincident indicator and Initial Claims for Unemployment Insurance and Average Manufacturing Workweek are leading indicators.  The last two of these have already turned for the better.  The next one to improve, as the economy recovers, likely will be Nonfarm Payroll Employment.

A CHICKEN IN EVERY POT, AS THE ECONOMY GETS HOT

It is time to smash the myth that the U.S. financial crisis will cause any recovery from the current recession to be slow and unimpressive.  In fact, history tells us the opposite.

It may surprise readers to learn that during the  Great Depression, after collapsing from 1929-1933, our economy actually expanded sharply from 1934-1937 (industrial production regained its prior peak), declined during 1937- early 1938, then began another robust recovery that lasted beyond the end of World War II.   

As  summarized by Christina Romer, Chairperson of the Obama administration's Council of Economic Advisers, the early 1930s saw the failure of nearly half the nation's financial institutions, yet the recovery years of 1934-1936 displayed increases in real GDP of 11%, 9% and 13%, respectively and the unemployment rate fell from 25% to about 15% during that period.  Clearly, that financial crisis, which was far worse than that of today, did not prevent our economy from recovering rapidly.

During 1937- early 1938, our economy fell into another decline.  Most monetary economists, like  Milton Friedman,  Anna J. Schwartz and Allan Meltzer, placed blame for this on the Federal Reserve Board, which tightened money by raising banks' reserve requirements in late 1936.   Keynesian economists, like  Paul Krugman, tend to blame the federal government's cutting back on fiscal stimulus, which also occured.  Christina  Romer sides with the monetarists in crediting the subsequent expansion of the money supply with pulling us out of the Depression, while stating recently that the New Deal was too small a program to have been effective.  She points out that the current stimulus package's fiscal effect is about twice the size of FDR's New Deal, as a percentage of GDP, and will last twice as long.

By 1938-1939, fiscal and monetary policy had turned expansionary, again, and the economy expanded rapidly through and beyond the Second World War.  Examination of economic data from the Great Depression and its aftermath shows that a financial crisis can cause an economic calamity, but there is no evidence that recovery from such a debacle is necessarily sluggish, indeed the evidence is to the contrary.  Due to the cloud of pessimism overhanging our national outlook as expressed by most observers, I look for the nascent economic recovery to surprise on the upside.  In other words, a chicken in every pot, as the economy moves from cold to hot.

It may surprise readers to learn that during the  Great Depression, after collapsing from 1929-1933, our economy actually expanded sharply from 1934-1937 (industrial production regained its prior peak), declined during 1937- early 1938, then began another robust recovery that lasted beyond the end of World War II.   

As  summarized by Christina Romer, Chairperson of the Obama administration's Council of Economic Advisers, the early 1930s saw the failure of nearly half the nation's financial institutions, yet the recovery years of 1934-1936 displayed increases in real GDP of 11%, 9% and 13%, respectively and the unemployment rate fell from 25% to about 15% during that period.  Clearly, that financial crisis, which was far worse than that of today, did not prevent our economy from recovering rapidly.

During 1937- early 1938, our economy fell into another decline.  Most monetary economists, like  Milton Friedman,  Anna J. Schwartz and Allan Meltzer, placed blame for this on the Federal Reserve Board, which tightened money by raising banks' reserve requirements in late 1936.   Keynesian economists, like  Paul Krugman, tend to blame the federal government's cutting back on fiscal stimulus, which also occured.  Christina  Romer sides with the monetarists in crediting the subsequent expansion of the money supply with pulling us out of the Depression, while stating recently that the New Deal was too small a program to have been effective.  She points out that the current stimulus package's fiscal effect is about twice the size of FDR's New Deal, as a percentage of GDP, and will last twice as long.

By 1938-1939, fiscal and monetary policy had turned expansionary, again, and the economy expanded rapidly through and beyond the Second World War.  Examination of economic data from the Great Depression and its aftermath shows that a financial crisis can cause an economic calamity, but there is no evidence that recovery from such a debacle is necessarily sluggish, indeed the evidence is to the contrary.  Due to the cloud of pessimism overhanging our national outlook as expressed by most observers, I look for the nascent economic recovery to surprise on the upside.  In other words, a chicken in every pot, as the economy moves from cold to hot.

MORE THAN JUST GREEN SHOOTS

Several recent economic reports showed real growth in some areas of the economy.  The green shoots famously noted by Ben Bernanke were mostly signs of optimism for the future, but lacked immediate realtime impact on our economic wellbeing.  Or they were a slowing in the rate of decline (such as for auto sales), instead of actual increases.  So, here is a list of signs of real growth reported within the past thirty days:

1)  Housing Industry: 

    (A) Housing starts rose, both single-family and multi-family

    (B)  Sales of existing homes rose

2)  The Consumer:

     (A)  Consumer spending rose (although retail sales,within that, continued to fall)

     (B)  Personal income rose

3)  Manufacturing:

     (A) Durable goods orders rose

     (B)  The factory production component of the ISM survey rose above 50, implying expanded production (although the overall index is merely contracting more slowly).

     (C)  Average manufacturing workweek hours rose (even as average workweek for the overall economy fell).  This manufacturing component of the monthly employment report is one of the two employment indicators within the Index of Leading Econmic Indicators.  The other one is initial claims for unemployment insurance, which has been improving since April.

As these and other indicators continue to strengthen, the economic recovery, which has already begun, will become more apparent.

EMPLOYMENT DATA BULLISH FOR STOCKS

Recent employment data supports optimism regarding both stock prices and the economy.  While the U.S. shed over 400,000 jobs in June, job losses typically continue for several months after recessions end.  Job figures like employment and  the unemployment rate do describe current conditions, but tell us nothing about the future course of the economy. 

For guidance on when the economy will turn up, we look to the Leading Economic Index (LEI).  This predictor of economic turning points is comprised of ten indicators, two of which are stock prices (we can see these every day) and initial claims for unemployment insurance (announced weekly at 8:30 every Thursday morning).  Here, we find our basis for optimism.  The LEI has risen sharply two months in a row.  And the major employment indicator within the LEI has also performed positively.  Initial claims for unemployment insurance (four-week moving average) peaked in early April at 660,000.  They have declined choppily ever since, and last week recorded a recent low at 615,000.  The other labor market indicator within the LEI, average weekly hours worked in manufacturing, improved slightly in June, as well.

So, here is the stock market/recession/employment  sequence:  1) stock prices rise, the LEI rises and intial claims for unemployment insurance decline,  2) the recession ends, then, a few months later... 3) employment starts to increase and the unemployment rate falls.  Stock prices likely will rise as unemployment claims continue to fall and the economy pulls out of recession.  When employment losses turn into gains and the unemployment rate begins to fall, the March low in the stock market and the end of the recession will be distant images in the economy's rear view mirror.

FORD FACES FIGHT FOR ITS FUTURE

In the old days, Ford Motor Co. (F) faced  relatively minor threats to its profitability :  the UAW, legacy medical and pension costs, a crushing debt load, retooling costs to meet safety and environmental standards, rising gasoline prices and high quality foreign competition from titans Toyota and Honda.   But now, things are going to get REALLY tough.  After seeing its two American competitors go down the financial drain,  Ford now must compete with streamlined versions of GM and Chrysler, which are having many of their contractual burdens (previous labor contract provisions, inefficient dealer networks, huge debt repayment obligations, etc.) swept away by the bankruptcy process.  This is all reminiscent of the challenges facing the airline industry over the years.  As airline after airline declared bankruptcy (some more than once), rather than liquidating, most continued to function under Chapter 11, then emerged leaner and meaner to compete with and weaken the survivors.  The result has been that airline stocks and bonds  have remained a wasteland for investors over the decades. 
A similar scenario is now facing the auto industry, but with one crucial factor that makes their situation potentially worse than that of the airline industry: the bankrupt auto companies have financial backing from the U.S. Treasury.  This is a problem going forward, not only for Ford, but also for Honda (HMC), Toyota (T M) and Nissan (NSANY), which sell widely in the U.S.   Indeed, the competitive problem is made worse by the fact that the U.S. Treasury is providing $12.5 billion of TARP funds plus additional TALF funds to GMAC, which is now offering relatively easy low-cost  financing to buyers of GM and Chrysler vehicles. 
If I owned a hardware store (as I used to), I would not want to have even the most incompetent government-owned competitor nearby if it had an unlimited source of funding.  We have no way to know whether our government will be able to successfully pull out of its financial involvement in the auto industry, as it intends.  But, until Treasury starts to dial back its involvement in GM, Chrysler and GMAC, investors would do well to turn their attention to other industries for investment opportunities

Hyperinflation Not on the Horizon

The Federal Reserve has headed off a deflationary depression for the U.S. economy.  It did so by printing money and pumping it into the banks and the credit markets.  Now, signs of an impending upturn in the economy are increasing and even economists Nouriel Roubini and Paul Krugman have said that the recession is likely to end this year.  However, the vigorous creation of money has aroused fears among many that inflation will arise and quickly get out of control and turn into hyperinflation.
Analysis of the money supply data shows that such fears are premature.  The record-breaking expansion of bank reserves (about 900%) simply has not leaked out in a meaningful way into M2, which is the broad money supply used by businesses and consumers.  This measure of money, M2, has increased by 9% in the past year, but the rate of increase is decelerating: 6% (annual rate) since the end of last year and only 4% over the last three months.  This is way lower than in the early 1980s, when all measures of money were growing at more than 10% and their rates of growth were accelerating.  Then, double digit money growth led to double-digit inflation.  It is possible that the fear-mongers of inflation will be right in the long run, but it is way, way too early to jump to that conclusion at this point. 
Critics of the Fed believe that as the economy recovers, the Fed will be afraid of angering the administration and the public by raising interest rates too soon, which could torpedo the upturn (the Fed made that error in 1937 and turned a recovery into Chapter 2 of the Depression).   They claim that keeping rates low for too long will allow inflation to gain traction.  They overlook the fact that Bernanke can first head off inflation by undoing quantitative easing (sell into the market those securities that had been purchased with the newly printed money, and then retire the moneys received for those securities).  This can be done quietly, without generating criticism since no interest rates need be increased.  Rates will remain stable as private capital from a growing economy replaces that of the Fed.  The Fed’s next step will then be to raise rates, but they are at such a low level now (0 - 0.25 %) that it is hard to see how raising the Fed Funds rate sharply to 1% or even 2% can be feared as providing much of a brake on a growing economy.
Once the economy gets rolling, it will likely gain momentum for three reasons: (1) there is much unused capacity and production can be increased quickly and easily, (2) inventories are very low and have been dropping for months.  Production will have to increase just to match the present low level of sales in many industries.  As sales increase, production will have to increase even more to bring inventories to a higher level.  (3) Employers who have cut employment to the bone will have to hire early in the business cycle to meet demand for their products and services.
As the economic recovery takes hold, the Fed will sop up much of the newly printed money, then gradually raise interest rates.  Those concerned that inflation will get out of hand would do well to monitor the M2 money supply as a necessary precursor of inflation.

RECESSION'S END IS NEAR AS JOBLESS CLAIMS DECLINE

Initial Claims for Unemployment Insurance for the week ending May 16 were 631,000, down 12,000 for the week. Importantly, the four-week moving average of Initial Claims has resumed its downward course.

After a tick upward last week, it has now fallen five of the past six weeks, giving support to the likelihood that the recession will end very soon.

The four-week moving average peaked April 4 at 660,000, then declined over the next four weeks.

That marked the first time since the summer of 2007 (before the recession even began) that the moving average had fallen four weeks in a row. Based on past economic cycles, four consecutive weekly declines usually presage the recession's end within two months.

Surprisingly, last week's figure broke the string of four declines. That was unexpected; once the initial claims figures start to drop, they usually keep going down, steadily.

Today's data revealed that the four-week moving average has now dropped to 628,500, confirming the fact that we have passed the peak in initial claims and our economy is likely to come out of this recession soon.

THE U.S. ECONOMY: NOT A REPEAT OF JAPAN

     The Federal Reserve’s program of quantitative easing (printing money by purchasing debt securities on the open market) is making waves of liquidity that are spilling over into the broader money supply. That is why the likely effect of quantitative easing in the U.S. will be much more positive than the experience of Japan.

     In 2001, Japan faced declining GDP and deflation, even though the Bank of Japan had cut interest rates to near zero. In March, 2001, the Bank of Japan began its program of quantitative easing by directly purchasing on the open market financial securities, including government debt and asset-backed debt securities. This pumped up the Bank’s current-account balance (bank reserves) more than 600% . As a result, M1 (cash in circulation and some deposits), which had risen 8.2% in 2000, and 8.5% in 2001, spurted by 27.5% in 2002, its peak year of growth.

     However, that creation of money did not spill over substantially into broader classes of money. M2 (which includes deposits at more banks) rose from 2.1% in 2000 to 2.8% in 2001, to only a 3.3% increase in 2002, and then grew at a lower rate thereafter, although quantitative easing continued a few more years. M3 (which includes CDs and more types of savings accounts) shows a similar pattern. Japan ended quantitative easing in 2006, calling it a success, having attained anemic economic growth with low inflation.

     The Federal Reserve in 2009, after lowering the Fed Funds Rate to near zero, has begun to engage in quantitative easing, but with very different monetary effects from those in Japan. Our Fed’s quantitative easing is larger than that of Japan. The Fed has boosted bank reserves by 895.6 % (almost nine-fold) from 4/23/2008 - 4/22/2009. This growth in reserves has spilled over to a broader measures of money to a much greater extent than happened in Japan. Our Adjusted Monetary Base has risen 108.7% in the past year, M1 is up 13.5%, M2 is up 8.5 %, and MZM is up 9.9%. So, even with our financial industry contracting, our broad measures of money continue to grow at a rates that are robust, by recent historical standards. Comparisons with Japan’s economic performance simply do not hold up. In Japan, growth in bank reserves never had more than a minimal effect on M2 and M3, which is to say that little of the money created by the central bank ever made it out into the broader economy.

     The Federal Reserve is supplying an abundance of money to the economy in order to block the possibility of a deflationary spiral downward to a Depression. In order for their efforts to work, the Fed, under Ben Bernanke, is “printing money” by creating new bank reserves through quantitative easing. The Fed's creative efforts through the TAF, TARP, TALF, and a myriad of other programs are proving effective in getting the growth in bank reserves to spill over into broader money, where it is liquifying our economy, sustaining the green shoots of our nascent economic recovery.

UNEMPLOYMENT CLAIMS DATA POINT TO ECONOMIC RECOVERY

     Initial Claims for Unemployment Insurance, a measure of job losses and a useful harbinger of economic turning points,  is starting to trend lower and could soon signal an imminent end to the recession.  Among the several components  of the Leading Economic Index (LEI),  Initial Claims data is especially useful  as a “leading indicator of the Leading Indicators,” since claims typically rise steadily during a recession, then fall right before a recession ends (usually within 2 months, or less). 
     Past deterioration in the Initial Claims data shows the worsening of this recession.  At the start of this recession in early December, 2007,  Initial Claims for Unemployment Insurance were only 340,000.  By late June, 2008 the figure was 405,000; rising to 508,000 at year-end and on to its 674,000 peak last month.  If Initial Claims continue to fall, as they have recently, then the March peak will have turned out to be slightly lower than the prior post-Depression peak of  695,000 during the recession of 1982, even though the labor force is 40% larger now than it was in 1982. (it was 110 million in 1982, and is 154 million, now).
     The U.S. Labor Department releases  weekly claims data every Thursday morning.  It is very timely;  the data announced on April 30, 2009 applied to the week ending April 25.  The data are revised one week later, as the figures for the next week are announced , and there are no revisions beyond that.  Since the figures are seasonally adjusted and are battered by holiday closings, the appropriate way to look for a change in trend is to compute the four-week moving average, which is a rolling average of the past four weeks.  Weekly claims peaked March 28 at 674,000 and the four-week moving average peaked  April 4 at 660,000 and has declined over the three weeks since, to 638,000.  From the  recession’s start in December, 2007, the four-week moving average has fallen three consecutive weeks on only one occasion, around the turn of this year when it was  subjected to statistical noise around the holiday season, and has not declined as many as four weeks in a row since the summer of 2007, when the economy was still growing.   So, we await next Thursday’s announcement with anticipation that this decline will continue for a fourth consecutive week.  In that happy event, we will gain confidence that the labor market trend has reversed and we can expect to come out of  this recession by summertime.