Dion Money Management Blog   Money Management for Retirees and Their Families

The S&P 500 Index has recaptured all of its losses from the previous week, and the broad index is poised for additional gains today as buying has intensified across many industries and asset classes. Even emerging markets, which were devastated earlier in October, have experienced a significant rebound this week. Energy and gold prices stabilized, and materials stocks advanced after a week that saw them take big losses.

Investors appear ready to wade into some sectors that offer reduced risk, although fear remains an important obstacle for many. A rally in domestic shares is long overdue, and even bearish pundits are calling for the market to retrace its precipitous October decline. The timing and duration is difficult to forecast, but after a 25 percent decline over the course of a month—and when two-thirds of all trading days were negative—there is ample room for upside.

On Wednesday the Federal Reserve slashed interest rates back to 1 percent, one factor that supported this week’s S&P surge. At the same time, the Fed’s move to open its U.S. dollar swaps operation to emerging market central banks caused a widespread global rally again on Thursday.

The primary deterrent to more immediate market upside is the increasingly widespread call for a global recession to the magnitude not seen in the past 20 years. The current quarter could be the first of several negative growth rates. In fact, the Commerce Department’s advance GDP numbers from this week already show a 0.3 percent contraction in the third quarter—but the market expected a 0.5 percent decline and found the news heartening.

We are in the third week of corporate earnings announcements, and so far, the news has not been disastrous. With 74 percent of the firms having reported to date, there have been an equal number of positive and negative surprises; non-financial results have been strong, gaining approximately 13 percent from one year ago. However, fourth quarter estimates have declined due to the financial panic and expected global downturn. The key question, therefore, is whether the steep correction experienced to date is enough to account for continued economic weakness. Unlike other crises that have called for government intervention and financial market recapitalization, the market has already digested the most damaging losses incurred by the financial sector.

Although I expect more volatility ahead, I believe for long-term investors that quality stocks offer significant value at current prices and perhaps one of the best opportunities in a decade. For investors looking for attractive entry points, November and the next 12 months represent additional entry points for a strategy of dollar-cost averaging cash into stocks as the market strengthens. We will continue to work with each of you to ensure that your risk tolerance is in line with your objectives.

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Global markets have trended lower this week and despite exhibiting strength along the way, the selling accelerated again today. Shares in Asia and Europe tumbled, and the U.S. bourses are following suit. Investors are focused more on the looming recession than the fact that stock prices have already corrected to levels indicative of past recessions, including those of 1973-74 and 2000-02.

Economic data was mostly negative this week; news of layoffs and gloomy forecasts from major corporations such as UPS dominated the headlines. Nevertheless, there were bright spots: Dow Chemical beat its estimates thanks to price increases which more than offset commodity costs, and that included a quarter in which the company suffered weather-related losses. Dow will also proceed with its business plans, regardless of the economy, but CEO Andrew Liveris said his goal of maintaining profits above $3 per share will be impossible in the anticipated economic environment.

Another bright spot is the U.S. dollar which continues to strengthen against most currencies. While this can pose a challenge to our defensive positions in large multinational companies that export their products, these firms have weathered periods of currency fluctuations in the past. A primary benefit of a stronger dollar coupled with global economic weakness is plunging commodity prices. Oil futures contracts for $50 per barrel oil are trading heavily, indicating many people expect the price to fall much further. This will alleviate inflation pressures in the short term and help buoy spending and investments.

Nonetheless, level-headed investors with longer time horizons are finding places to invest. The stock market is a forward looking market—where prices reflect investors’ future expectations—yet many investors only focus on the long-term during bull markets, becoming increasingly short-term focused during bear markets. Initially, the credit crunch caused panic among investors, but even as the fears of the crunch abate, we are witnessing a wider acceptance of economic difficulties, adding yet another layer of worry. Much of the herd is still panicking and forcing sales due to excessive leverage; in the case of some hedge funds, this is pouring gasoline on the fire.

This bear market so far has been a restoration of value. Stocks are trading at price to earnings ratios not seen in decades. Given the extent of the selling to date, the stage is being set for an impressive rally. Many of the concerns that have weighed on stocks—dislocations in the short-term credit markets; the onset of the current earnings season; a pending Presidential election; and forced liquidation of mutual fund and hedge funds alike—are either problems or questions that are beginning to resolve themselves. Here at Dion Money Management we are committed to working with clients to conquer emotions, set goals, and focus on the fundamentals. Regardless of short-term fluctuations, the long-term story of global growth is intact, and investors who are willing to wait could capitalize on many great bargains.

A global coordinated bailout package negotiated last weekend by G7 members in Washington, followed by an agreement in Paris among EU member nations, triggered a global rally in equities earlier this week to reverse the panicked selling that plagued the markets for most of last week. In fact, between the violent swings, the S&P 500 climbed 24 percent higher from the low on Friday to the high on Tuesday.

The past several weeks have undoubtedly tested the steeliest of investors. Those of us that remained invested through the most volatile periods of the past several decades are less accustomed to experiencing a decline in all asset classes, including bonds and even our homes. The trauma inflicted by the global financial crisis will produce an economic slowdown, and this, in turn, will impact corporate earnings and profitability.

This week the Empire State manufacturing index signaled a slowdown in production as manufacturers anticipate a reduction in consumer spending. Industrial production declined 2.8 percent, although the number was affected adversely by irregular activity, such as the strike at Boeing and recent hurricanes. Retail sales fell by 1.2 percent, but only 0.6 percent when car sales are removed from the measurement.

Nevertheless, we are approaching the point where we need to guard against a harmful myopia. The economic headlines will most likely deteriorate over the next several months, and into the next quarter, but the stock markets have factored much of this short-term economic decline into current prices. Many stocks are trading at bargain levels not seen in decades and yielding far more than their historical averages. Moreover, many companies have large amounts of cash on their balance sheets, reflecting the fiscal strength they’ve created during the last bull market.

As an op-ed contributor to The New York Times, Warren Buffett reminds us that we need to be greedy when others are fearful because fears over the long-term prosperity of the nation’s best companies do not make sense. He admits that he cannot predict where the U.S. stock market will be one month or one year from now, but he believes equities will outperform cash over the next decade, and he expects to participate with 100 percent of his personal wealth. The market always moves higher before investor sentiment or the economy turns around, so he is buying stocks now.

In regard to current client holdings, I have spent this week talking with the fund managers that direct the largest client positions. Both stock and bond managers alike are focusing on defensive positions in the short term and are looking for opportunities that will arise with each step toward economic recovery.

If you have any questions or concerns please respond to this email or call your Dion account representative at 877-850-7942.

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As the old saying goes, when times get tough, the tough get going. To help you get your portfolio going in these very tough times, we’ve reviewed seven new funds from the Fidelity Investment universe.

Each promises the potential to juice your returns by boosting “Alpha,” loosely defined by Morningstar as a fund manager’s ability to add value, in the form of higher return and lower risk, when compared to the fund’s benchmark. Each new fund promises access to the kinds of investments once largely reserved for institutional investors. The first, Fidelity 130/30 Large Cap (FOTTX), offers the opportunity to mimic some of the strategies hedge fund managers use, balancing long and short positions in order to take advantage of everything Fidelity’s deep research staff knows about stocks—both good and bad. The other six, Fidelity’s Enhanced Index Funds, combine quantitative analysis with a manager’s touch in an attempt to beat their underlying indices. Here’s a look at the funds:

The long and short of it

Fidelity 130/30 Large Cap uses both long investing and short selling in an attempt to capture market gains while protecting against downturns.

Shorting a stock involves first borrowing shares from a brokerage house, then selling them on the open market and collecting proceeds from the sale. At some point, you’ll have to buy the shares back and return them to the original owner (a move known as “covering” the short sale). If the share price falls, you can buy back the shares for less than you paid, repay the original owner and turn a profit on the deal. Until that time, you can invest the proceeds of the initial sale however you wish. It’s worth noting, however, that because short-selling involves borrowing, it entails certain costs (including interest on the borrowed securities) and credit-related risks.

This structure allows the fund to invest more than 100% of its assets. Manager Keith Quinton invests 30% of FOTTX’s assets in a short portfolio, then uses the cash received from selling shorts to fund the long portfolio at 130% of assets—hence the name 130/30.

The strategy behind the model allows the manager to capitalize on stocks he likes (going long) and those he believes will struggle (shorting), thereby using Fidelity’s research to its fullest. In theory, Quinton also should be able to manage volatility better than a traditional long fund manager because part of the portfolio is likely to rise when the market falls.

Of course, the market tends to rise over the long term. FOTTX would likely benefit from that trend because of the long portfolio—though its short sales could dampen returns somewhat during bull markets.

Putting the long-short theory into successful practice requires an excellent manager with a solid strategy. Quinton, who’s had a short (since 2004) but successful run at the helm of Fidelity Tax Managed Stock Fund and Fidelity Disciplined Equity Fund, uses a computer model, ranking 4,000 large-cap names according to Fidelity’s research, recent price moves and valuation. Quinton invests long in the stocks at the top of the list—typically inexpensive stocks that exhibit momentum—and shorts those at the bottom.

The fund was launched on April 4 and thus doesn’t have a long history. Since inception, it’s about even with the S&P 500 (through Sept. 26) but lags the index by 5.2 percentage points over the past three months. The fund’s short positions appear to have helped on “Black Monday II,” as FOTTX lost 1.1 fewer points than the S&P 500 did.

At the end of May, FOTTX’s largest short position was in shares of women’s retailer Coldwater Creek, whose price is off 18.5% year to date. That investment will keep paying off as long as Coldwater continues to decline—but the nature of shorting means a rebound in the stock could weigh heavily on this fund’s returns. “Leverage can boost an investment’s positive return,” says Morningstar’s Todd Trubey in a recent article about 130/30 funds, “but it can also magnify its losses.”

Still, Fidelity 130/30 may provide a way for your portfolio to capture the market’s upside while cushioning it a bit from the possibility of further losses. And these days, improving risk-adjusted returns is more appealing than ever.

Enhancing returns

The goal of Fidelity’s enhanced funds is to outperform a benchmark index through carrying market cycles without incurring significant extra risk or volatility.

There are currently six enhanced funds: three large-cap funds, one each for value, growth and blend styles, introduced in April 2007; and one for each of the small-cap, mid-cap and international markets, launched in December. Each Enhanced Index Fund invests 80% or more of its assets in the stocks of the benchmark, but the fund uses quantitative models to attempt to better the benchmark’s performance.

Quantitative analysis, whose practitioners are often referred to as quants, informs stock picks based on numbers such as earnings, sales, assets, book value, stock price and so on. It does not measure subjective factors, such as company management or the potential for a particular market.

The Enhanced Index Funds’ managers run the stocks of their benchmark index through a proprietary computer analysis, seeking the stocks that may have the potential to provide a higher total return than the index itself. The computer models emphasize valuation, growth in sales and earnings, quality (how much net income comes from core operations), expectations for future earnings, and technical momentum in share prices.

Next, the models use “optimization techniques” to decide when and how much of a stock to buy, seeking to minimize transaction costs and limit the portfolio’s risk. The managers overweight the best stocks, as determined by the computer models, and underweight the worst. The goal: Stick close to the index, but reach for stronger returns and avoid potential blowups. For example, the fund might emphasize shares of a firm with large assets and little debt while deemphasizing stock of a company with rapidly declining earnings.

The funds, all named “Enhanced Index Fund,” and their respective indices are:

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Recession fears sent the S&P 500 Index down 9.03 percent yesterday, while the Nasdaq and Dow Jones Industrial Average fell 8.47 percent and 7.87 percent, respectively. Positive earnings from Coca-Cola couldn’t offset the negative sentiment generated by a 1.2 percent decline in retail sales and a pessimistic manufacturing and business conditions report from the New York Fed, which followed on the heels of declines in Asian and European stock markets earlier in the day.

Coca-Cola beat analyst earnings estimates by 4 percent, even though it missed revenue estimates by 2 percent. A decline in North American unit case volume was offset by gains overseas thanks to China and India, among others. Shares of Coca-Cola rose 1.1 percent on the day, outperforming the broader market by better than 10 percent. The stock is the number two holding in Fidelity Select Consumer Staples (FDFAX), which is held in the Sector Momentum Tracker Portfolio and the Fidelity Independent Adviser Fidelity Select Portfolio.

Retail sales fell by 1.2 percent, although they only declined by 0.6 percent with car sales removed. The only sectors showing improved sales were gas stations and drug stores, but their gains were small. Tighter credit played a role, as consumers find credit more difficult to obtain. Yesterday, GMAC announced it would not make loans to consumers with credit scores less than 700, and half of consumers have scores below 720. On the bright side, commodity prices are much lower this week and the savings will help consumers through a rough patch.

Elsewhere, the Empire State manufacturing index signaled a slowdown in manufacturing as producers anticipate a slowdown in consumer spending. Industrial production in September declined 2.8 percent, but that number was impacted by the strike at Boeing. Economists also blamed hurricane activity for some of the drop.

This morning, Hershey’s delivered a positive earnings report, with profits up due to lower restructuring costs and higher sales prices.  The company still faces higher commodity prices and tougher competition from privately held Mars, however. Citigroup beat the average analyst estimate with a $2.8 billion loss, although expectations were all over the map. Yesterday, State Street reported profits 33 percent higher than a year ago, but warned of possible charges in the future. Abbott Laboratories, meanwhile, reported an earnings increase of 51 percent thanks to strong product sales, and the company raised its profit forecast for the coming year. Ebay also reported earnings yesterday and swung from a loss last year to a profit this quarter.

With the markets trading sharply lower in recent days, now is an excellent time to rebalance a portfolio and begin thinking about year-end tax planning. The panicked selling we’ve seen over the past several days has left many high-quality funds attractively priced. If you would like to know which mutual funds make up our newsletter model portfolios, please call us at (800) 548-3797.

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U.S. stock markets booked another losing session on Tuesday, the second full day of trading in the wake of President Bush’s signing of the Emergency Economic Stabilization Act of 2008, the controversial $700 billion measure designed to provide relief to the beleaguered financial sector. Since last Wednesday, the Dow Jones Industrial Average has shed nearly 13 percent of its value, the steepest drop for the index of 30 blue chips since the terrorist attacks of September 11, 2001. The broad market S&P 500 is holding onto a five-day loss of 14.6 percent. As brokerages, retirement plans and mutual fund companies mail out quarterly statements, individual investors—and not large institutional players—seeking the safety of cash have been the primary force driving the markets lower.

A coordinated interest rate cut by some of the world’s largest central banks helped stocks recover some lost ground in early trading this morning. The Federal Reserve, the Bank of England, the European Central Bank and central banks in Canada, Switzerland and Sweden all cut their prime lending rates in an effort to jump-start the stalled credit markets. The Fed cut the federal funds rate by 50 basis points, to 1.5 percent, and the ECB made a similar adjustment to the benchmark rate on the euro. Although the Federal Reserve wasn’t scheduled to convene its interest rate-setting Federal Open Market Committee until later this month, policy makers decided that prompt action was needed to prop up the battered capital markets. In its statement, the Fed explained that easing price pressures and “the recent intensification of the financial crisis” justified the coordinated rate cut.

The Fed’s latest decision on interest rates follows on the heels of an extraordinary series of interventions in the private sector that began in March when the central bank brokered the sale of Bear Stearns to JPMorgan Chase. In addition to a host of innovative lending facilities and the Fed- and Treasury-backed Wall Street bailout plan signed into law last week by President Bush, the Fed announced yesterday the creation of a Commercial Paper Funding Facility. The new CPFF “will provide a liquidity backstop to U.S. issuers of commercial paper” by buying these short-term notes—they typically mature within three months or less—directly from eligible issuers. A breakdown in the commercial paper market—a primary source of ready cash for many corporations—would have made it vastly more difficult for many businesses to fund their day-to-day operations.

There was a glimmer of good news from the housing sector today as the National Association of Realtors reported an uptick in pending home sales for August. According to the NAR, its index of sales contracts on previously owned homes jumped 7.4 percent in August and is up 8.8 percent on a year-over-year basis. All four regions of the country showed increases in pending home sales, including a dramatic 18.4 percent jump in the West, the region hardest hit by the housing slump. While the NAR’s data has its limitations—it doesn’t account for canceled contracts, for instance—it is, nevertheless, a sign that steadily falling real estate prices may finally be boosting sales.

The past several days have also seen a sharp sell-off in the energy markets, a welcome development for cash-strapped consumers, particularly those in the Northeast and Midwest where the winter heating season is just around the corner. The front-month contract for delivery of the benchmark grade of light, sweet crude slipped to just over $87 a barrel in trading on the New York Mercantile Exchange this morning as the Energy Information Administration reported greater-than-expected increases in domestic supplies of both petroleum and gasoline.

For the remainder of the fourth quarter, I am looking for the markets to remain volatile, although I am confident that the economic stabilization plan enacted by Congress was an important step in the right direction and will eventually be effective at restoring order to our capital markets. With unemployment at 6.1 percent and wages stagnant, however, I believe the upcoming holiday shopping season could be one of the bleakest for retailers in recent memory. With that in mind, I am advising my clients and subscribers to look for corporate profits to bottom out in the first quarter of 2009 and for stocks to hit a low point in the fourth quarter of 2008 in anticipation of that result. It is quite possible that we will look back on this period years from now as one of the best buying opportunities in recent memory.

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1.    The plan will help restore confidence in the economy. Confidence is the connective tissue of all modern economies, the reason farmers in Iowa grow corn, small businesses in New England run bed and breakfasts, metal fabrication companies in Pennsylvania bend steel, and, yes, banks lend money. In recent weeks, that confidence evaporated, freezing the credit markets. The bailout plan marks the start of the thawing process that will allow money to flow more freely again.
2.    It will remove a disincentive for capital to enter the financial sector. Ever since the government helped save Bear Stearns largely by wiping out equity holders while accommodating a sale to JP Morgan Chase, investors inclined to invest new equity in the U.S. banking system were forced to weigh whether they thought the government would step in if their choices went sour. This quandary likely caused many to choose to stay away altogether. By eliminating uncertainty, the bailout plan should lure this capital back.
3.    It buys time for an orderly disposition of assets.  The price the government may pay for these sick mortgage assets is far less important than the ability to take time to dispose of them. The Treasury has up to two years to buy the assets, some of which have real value that can’t be realized in a market where there isn’t a market for any assets. The bailout plan helps us get out from under this dilemma.
4.    It also buys time for the financial system to heal itself. This plan prevents financial Armageddon and starts the healing process for banks. As time progresses, they will be able to re-capitalize themselves from the quarterly earnings flowing out of their core lending businesses, along with new investments from outside investors.
5.    It is a one-time investment, not a recurring expense, and it may lower the federal budget deficit over time. Directly, the plan has the potential to generate returns — maybe not enough to offset the one-time outlays, but enough to get a lot of the money back, putting the final price tag well below the $700 billion upfront price-tag. Even more important, by likely lessening the downturn’s severity and speeding the ultimate economic recovery, the bailout will reduce the federal deficit from what it otherwise would have been by improving tax receipts and other inflows that increase when the economy is growing.
6.    It will lower what we ultimately will pay for this crisis. We can argue about how much the government should pay for some of the bad assets that will be taken off the banks’ books, or whether the upfront costs may reach $1 trillion as some have suggested. But the bottom line is this: If we don’t pay for it now, we likely will have to pay a lot more later as our financial system implodes, with ramifications that extend far beyond Wall Street to Main Street, through lost tax revenue, lost jobs, lost retirement savings, etc. This plan is cheap by comparison.
7.    Besides, $1 trillion is not that big.  Even if the overall upfront outlays do reach $1 trillion, compared to the size of our economy (roughly $14 trillion), that’s still only about 7 percent of GDP. That’s significantly smaller than most other bailouts that had to be done in financial crises that have confronted other countries in recent years. The $50 billion bailout of Mexico in the mid-1990s, for example, was in the magnitude of 19 percent of that country’s GDP.
8.    It is positive, not negative, for the dollar. The currency markets seem to think that Chairman Bernanke is going to fund this bailout by printing dollars. There’s simply no indication whatsoever for this – in fact, his refusal to lower the target federal funds rate last month in the face of overwhelming odds that he would was a clear signal of his intentions. Even if the Fed changes course and lowers rates, the move would be made because of rapidly deteriorating economic conditions, not to finance the bailout. Other pro-dollar ramifications: the improved stability to the U.S. financial system; slower global economic growth; and falling oil prices.
9.    It will lessen the economic pain. The tsunami spawned by this financial crisis is just starting to hit Main Street, but this will soften the blow by greasing the wheels of commerce as banks get back into the business of financing real economic activities. Think of the plan as a sort of giant breakwater, dampening the power of the financial wave as it moves “inland.”
10.    It will dramatically improve the outlook for returns on everyone’s retirement portfolios over the next three to five years. A majority of households are stock holders, through 401(k) plans, pensions and other retirement accounts — indeed, it was the uproar from this group after the House vote to reject the initial bailout bill, sending stocks plunging, that arguably led to the about-face. By healing the financial system, this plan will allow their equity assets to rise in value over time. Our research of six of the largest financial crises over the last 20 years — Sweden, Mexico, Russia, Thailand, Hong Kong and Japan — shows that markets tend to bottom sometime between “immediately” and 12 months from the bailout announcement. And while returns during this bottoming process can be volatile, the average market appreciation in local currency terms from the point of the bailout to three years out was +49%. This is not a forecast, and every financial crisis is different, but the data suggests that the next 12 months present a historically good time to average into equity markets.  Three years from now, odds are good that we’ll all be better off.
Commentary of Stephen Auth, Director, Global Portfolio Management, Federated Investors.

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