Fred appeared on First Business to discuss some of the fundamental problems with the economy that stem from the unstable market.

Rob recommends investors look for trends in sectors in invest in, rather than trying to pick specific companies.

Rob Stein, Astor’s Managing Director, sheds some light on encouraging signs in the market.  He points out current problems are increasingly targeted at specific companies and not on indexes or the economy as a whole.  Listen to the full interview here.

 Ban lifted on Naked Shorting: Fred Smithson has some insight on the renewed pressure on  financial stocks which will no longer be protected from the ban on naked short selling unless the Securities and Exchange Commission extends it.

Keys to Today’s Trades: A look at what’s driving today’s trades, with Rob Stein, of Astor Asset Management

2nd Quarter 2008 Review

The 2nd quarter of 2008 turned out at the start to be the rebound or “dead cat bounce”, as we suggested in the previous quarter’s report. With the aggressive selling during Q1 and the excessive Fed rate cuts, it was surprising we did not see more of a rebound. However, as payrolls continued to contract each month, the Fed’s hands became tied as inflation fears took over and the equity price gains in April and May could not be sustained. The only good news in Q2 was that GDP growth for Q1 was revised up slightly, and Q2 again will show a plus sign.

While the sub-prime mortgage mess was still front and center, inflation, oil prices and the weakening economy were equally as influential on the markets. This condition has created a conundrum for the Fed. Benny and the Feds opted to leave rates unchanged during their last meeting in June. It is hard to believe they felt the economy was now on solid footing. The ECB (European Central Bank) is getting ahead of the inflation curve, raising rates to dampen inflation concerns and ignoring the weakening economic data in the Eurozone as the sub prime and solvency issues persist. This managed to put even more downward pressure on the dollar as it sunk to new lows since inception of the Euro currency. The only silver lining in this was a slight turn around to the trade deficit, even in spite of much higher oil prices which would have skewed the dollar amount of the imbalance without actually increasing the total amount of goods imported.

Now that the much anticipated rally has failed, the sub prime mess is clearly not over with, and even with energy prices slowing their upward pressure, I fear there will be more causalities to come, with a Bear Stearns type collapse not being unexpected.

3rd Quarter 2008 Outlook

Q3 will be the proverbial dropping your pants scenario. All the “if’s” and “how’s” will come to roost. I believe clarity will finally come into the marketplace with respect to balance sheets, banks, ownership of sub prime debt and the like. Additionally, the Fed and the U.S. Treasury will come to face the dire situation for the economy and the financial markets. While this sounds like bad news at first, facing the harsh realities will allow the markets and their participants to evaluate what they perceive is fair value in stocks and other securities. Of course, once we know most of the information, it will most likely appear that values for homes, equities and fixed income securities are lower than current levels. Then, at least investors (be it hedge funds, sovereign wealth funds, etc.) will be able to identify a price level or value level where they would be willing to buy and invest. This is one of the productive functions of the marketplace. Once it can function in an orderly manner with information that can be evaluated, it is just a matter of time until the boat gets pointed in the right direction. Markets operate much more efficiently under certainty. So you see, even if the economy and the markets continue their declines, as long as we have all the information on the table, we will reach that appropriate level much quicker and can move forward. However, if we continue down this path with little clarity and understanding of what is behind door number 2, then the bottom is not only farther away but further off. Although the economic data continues to deteriorate and the markets are trading like a ferocious bear, it is the reliability and clarity of the data that matters for us to move on and get on board.

Sector Outlook

The following is a chart with the performance of key markets for June, Q2 and YTD.

Equities

The oversold rally that started in March continued all the way to May 19th. For two months, there was a building belief by investors that we had made our way through the wreckage. After all, this was 14.5% off the lows (SP 500), not some measly 7% bounce. $400 billion had been written off by banks as worthless assets as of Q1. There is no text-book resolution to a credit crisis like this, with so many assets and such intricate financing and structuring surrounding it. What does $400 billion mean in this context anyways? Apparently, by the 8.5% sell-off in June, it means not enough has been written down.

The chart has been inserted to try and put some things into perspective. The equity bubble that burst in ’00 brought the equity markets down from very high levels. This has not been the case during this market sell-off. Yes, the S&P 500 rallied just over 100% from the low it made in October 2002. However, this was after a decline of 46% from its high in March 2000. It took the S&P 500 7.5 years to make a new high, not to mention that we are currently 20% below that high as we speak. Buy and hold investors in equities expect to make about 8%/year, historically. Returns come in all over the place, but surely the sum of 7.5 years would make you money, right? Well, according to the chart, from 12/31/99 through June of this year, your average annual return was virtually flat! The financial sector however has exemplified the froth this time around…and is directly responsible for the issue at hand. Since 12/31/1999, the return on the XLF (Financial ETF) is 0.4%, barely above the S&P 500, but it took a completely different path to get there. The financials left the last recession relatively unscathed and proceeded up from there as M&A, real estate financing, and exotic credit paper issuance, combined with stimulative lending practices, it propelled earnings and asset valuations skyward. The XLF had appreciated 60% at the same time the S&P 500 had risen just over 3% (dividends not withstanding). Since XLF peaked on 5/31/07, it fell 46.5% through 6/30/08. If that number sounds familiar, it’s the same percent decline the S&P 500 had from its peak in 3/2000 to the bottom in 10/2002. What took the SP 31 months to do; the financials have done in 11 months. Talk about some quick work!

As we have said in the past recessions, contractions and bear markets are all part of a recurring cycle. In fact, I believe they are actually good. However, when the contraction is centered around the financial sector, it creates a very different scenario - one that cannot be corrected with traditional methods. Rather than the typical V shaped bottom, it will take several trips to the bottom to explore value and make sure there is clear visibility. This takes time in a pattern for the economy and markets that more resembles an “L” than a “V”.

Fixed Income

U.S. treasuries have been the benefactor of the mortgage meltdown and sub prime issues. It is more than a flight to quality, it is the only asset allowed in many portfolios, so it is job security for portfolio managers as well. This has created a condition that is not supported by fundamentals or supply demand ratios. Inflation is on the rise now and only looks like it is leveling off recently because of the slow down in the economy and housing. Housing costs are a significant component to the CPI and may be skewing the numbers. Wages are rising (all be it not as much as earlier in the year), which is a main driver of inflation as more money chases fewer and fewer goods.

Further, many of the solutions to the financial crises will require an increase in supply or the new issuance of bonds. This crowding out effect will cause rates to move higher as the new securities compete for capital. Additionally, cash hiding in treasuries is actually earning a negative yield when you factor in current inflation rates and my guess is that investors will not accept that for very long. As time passes, cash will be looking for better yields, and as such, investors will sell treasuries, pushing rates up. In the meantime, spreads have indiscriminately widened on fixed income assets as fear of the entire financial system melting down permeates Wall Street. While some securities deserve to be trading for pennies on the dollar, many do not. Therefore, with negative interest, spreads not reflective of true fundamentals, inflation on the rise, and the Fed on hold (per last meetings’ minutes) many opportunities exist in fixed income investing. We are excited about these opportunities ranging from the yield curve to corporate spread trades and their potential impact on our investments.

Energy

The energy complex and energy related stocks have been the stellar performers this year as a weaker dollar, speculation, geopolitical events and shear supply demand dislocation have all had a positive impact on energy and specifically oil. Well, you might want to save this report as I am suggesting that the high for oil is in for the year and maybe longer. High oil and gas prices have become front page news almost every day. In fact, CNBC has added the price of oil as a bug on the screen permanently as we watch the price fluctuate like a tech stock from the 90s. Oil prices do respond to economic fundamentals unlike stocks, which can trade at higher and higher prices because someone justifies a higher P/E ratio. There is no real shortage of oil just a shortage of cheap easy ways to reach oil. Therefore, at higher prices, incentives to get the more expensive oil becomes justified. Additionally, higher prices lower demand for even inelastic goods like oil and gas. And yes it is possible to go further on a gallon of gas then we currently do and now consumers are trying to achieve that. If the price does not come down now, consumers will do more with what they purchase. It is possible to consume less energy with little disruption to our lives. Now, with a slowing economy, a more conscious and eco-friendly consumer, demand will be dampened. At the same time higher prices will encourage additional supply. Additionally, consumers will become more accustomed to higher gas prices and once the sticker shock wears off a consuming we will go. Oil will retreat to some level like $100 ($80-$120) and stay there for some time, perhaps beyond 2008’s end.

Precious metals

Gold closed Q1 in the midst of $160 pullback from its high of $1040/ounce. That move to the high on 3/17 in Q1 coincided with the equity market sell off as gold was a safe haven during tumultuous times. Silver shared these characteristics in Q2 as the extreme spike in March essentially pre-empted the inflation concerns shared globally in Q2. As March ended, gold moved to a $959 near-term high within two weeks, followed by a low of $850 by the end of April. This range was not taken out for the rest of the quarter, which was unable to pick up a trend. Gold, surprisingly so, found itself with a higher positive correlation to the U.S. dollar index during Q2 than it has had in the past 12 months. The last two weeks of June began a rally toward the $950 level as the equity market fear gauge heightened again. Therefore, the precious metals found themselves consolidating during the quarter for a move higher into Q3. As long as inflation concerns persist, threatening global growth and the real value of assets, metals will remain an attractive spot for investment dollars.

The Dollar

The U.S. dollar gained against the euro, albeit slightly, for the first quarter since Q3 2006. As we stated last month, long dollar was a popular play to start the year, however market circumstances precluded that from playing out as the U.S. led the way down in the global credit scenario, putting pressure on the local currency. The dollar recouped much of the loss against the Japanese yen in Q1 as investors re-established the carry trade of borrowing yen to buy other currencies.

If the economy will allow the market to sniff out any potential mid to long-term strength, the dollar should be a major benefactor. Headwinds will remain in the shape of higher trade deficits, further debt-laden federal balance sheets, high oil prices and inflation. However, these do not need to be permanent impediments to a stronger dollar. As the European central bank focuses on inflation and the Fed gets further behind the curve, the dollar will be a benefactor. The current level of the dollar is clearly influencing the trade picture and this will not only soften the contraction but will eventually support the dollar which is very close to reversing a long-term trend.

Emerging Markets

This market segment has weathered the storm during the past year’s credit meltdown. Markets such as Brazil and Russia have managed to turn in respectable years, returning 1.7% and 0.3% respectably YTD through June 30. Q2 was a big reason for that as Russian and Brazil both came in over 6% for the quarter. April and May provided a big bounce, however emerging markets caught the “flu” during the June along with other major developed markets. The Shanghai and Sensex index are different stories. With large positive trade balances, these countries derive a major benefit from strong demand in developed markets. As the later countries have suffered, so have these emerging countries. Shanghai is down 47% through Q2, with India’s major index declining 33% YTD.

Even semi-self-sufficient emerging markets like Brazil have a growth cap if the developed markets continue to underperform. If we experience a bounce in equity markets from potentially oversold levels at the end of June, these markets should show signs of life, which they have already. But if we see the global economy slip further into a slowdown, there will be no real reason to jump in on the general emerging market index (EEM) just yet. In fact, they may underperform the remainder of the year.

Real Estate

The outlook for the Real estate sector has not changed much since the last outlook report. To that end, much of what we wrote deserves repeating. The real estate and housing markets continue to be a significant drag on the economic outlook in 2008, as weakening housing market and drying up of investment capital delayed or stalled newly formed projects. Funding for new projects or even refinancing is at a standstill and the usual stimulus to the economy is gone for a while. After what was a great run for real estate in the late 90’s and 2000’s, this overheating has likely foreshadowed a sustained downturn in the sectors as others (like commodities) take the lead. With the easy money already made in the sector, it is time for a true rebalancing of risk/reward when it comes to prices. We feel that this will be painful at first, but eventually productive as it will allow the asset class’s reposition at appropriate valuations. Unfortunately this will take some time. While price declines may be over soon the rate of appreciation and the potential for new highs appears to be long off in the future. Additionally, while price decline may level off this year the economic impact from housing will remain for some time. Housing and related areas accounted for a significant portion of GDP growth and employment growth. Funding from housing was a significant contribution to consumer spending, and that is gone for now as well. The good news is that capital will be redeployed in more productive areas helping those markets that may have underperformed in recent years.

Conclusion

The 2nd quarter of 2008 restored our confidence in our models as both the hedge fund and the ETF programs had positive returns and out performed their benchmarks.

The uncertainty during the 1st quarter became clear during the 2nd quarter, allowing for asset shifts and diversification to pay dividends. The pattern of bad news on the financial sector produced the selling of stocks, buying of bonds, and selling of the dollar. This in turn would produce buying of commodities and higher oil, which would put more pressure on stocks and the viscous circle would repeat. During the 2nd quarter, assets performed more in line with their fundamentals. Inflation concerns, coupled with a slowing economy, tied the hands of the central bank, thus making a bottom further away and the spike bottom and “V” shaped formation common over the past few years less likely. Now the best we can expect is an “L” shaped bottom. Unfortunately, the bottom part of the “L” pattern will not begin until we face reality with the current problems of valuation of debt and lack of liquidity. At that point we can see the warts and all and begin to evaluate fair value. This is when the foot of the “L” will begin to form. The ECB sees things a bit differently as it raised rates at its last meeting, fearing that inflation is the problem, not the slowing economy or lack of liquidity and clarity of the financial institutions’ balance sheets. A rate hike in the U.S. would do more long term good than the short term bad it would cause. It would stabilize the dollar, which would stabilize oil, which arguably could stabilize stocks. With interest rates negative, speculation is still being encouraged but not for the dead assets the Fed is hoping what ever liquidity still exists would buy. The good news for the Fed (if this could be called good news) is the slowing economy is one cure for inflation. Additionally, the economy has lost jobs every month so far this year and the wage pressures, which have been clipping along at almost 5% year-over-year is slowing to 3.3%. This will undoubtly take pressure off of wages which is really the culprit of inflation.

Also of note is that asset class correlations have resumed more traditional behavior and diversification based on sound analysis will pay dividends. The days of assets correlating to equities for extended periods have given way to truly diversified portfolios where an ETF or futures contract can be positioned to take advantage of movements in metals, energy, or specific sectors such as transportation or real estate all within a single portfolio. To that end, a view of a slowing economy with accelerating inflation combined with lack of liquidity can be capitalized on more effectively than ever before.

About the Author

Robert N. Stein is the managing member of Astor Financial, LLC.

Mr. Stein is the author of Inside Greenspan’s Briefcase: Investment Strategies for Profiting from Key Reports & Data, published by McGraw-Hill. In 2003, Mr. Stein was named one of “The Best Unknown Managers” by BusinessWeek Magazine (January 20, 2003 issue). A University of Michigan graduate in Economics, Mr. Stein began his career as a project analyst for the Federal Reserve during the chairmanship of Paul Volcker. Moving to Wall Street, he eventually became Managing Director of several large financial institutions before returning home to Chicago in 1994 to form Astor Financial. Mr. Stein is frequently featured by the news media, including the BBC, CNN, CNBC, Bloomberg, Fox News Channel, The Wall Street Journal, and Investors Business Daily. Stein has lecturered and has written several articles about the economy and the markets. He is also the Founder and President of the Dream of Jeanne Foundation and serves as Vice Chairman on the Board of Trustees for Glenkirk. Both organizations help the mentally challenged to participate fully in all areas of community life.

Novices usually do a few dumb things when the market tanks, but you don’t have to if you know the alternatives.

Whenever the stock market tumbles, novice investors begin to squeal. They forget the scuffed knees they got when they learned to ride a bike; they think every spill in this arena is a fatal crash.

The pain would be bad enough if investing didn’t determine your personal bottom line. But, in today’s pensionless world, it does. You’re going to ride your 401(k) throughout your retirement. You’ve got to learn how.

Former President Franklin D. Roosevelt offered excellent advice to a nation gripped by far worse problems in 1933: “The only thing we have to fear is fear itself.” Even bear markets of historic proportions end, and when they do, markets quickly come back. Those timid souls who gave up on the market in 2002 have given up profits of nearly 50% since — and that’s even after our current malaise.

What you’re afraid of is the unknown. But bad markets are very well known. Generations of investors have endured them and learned from them. The dumbest investing mistakes are also the most common, and smart solutions to them are instantly available. Here are six of those mistakes and their antidotes:

Keeping saving

DUMB: Stop contributing to your 401(k) plan because you’re “losing money.” In fact, by adding to your investments at lower and lower prices you are lowering your average cost basis.

Everything goes on sale. Stock sales are called corrections or bear markets, but what they truly are is a sale. Markets always come back — always. The price can be 20%, 30% or even 40% off, but it’s still good merchandise.

SMART: Buy the ugliest stuff on the shelf. When any asset is getting beaten up, it will decline relative to others. Keep your portfolio in balance by shifting new money to categories that have fallen below the percentage gain called for in your long-term portfolio plan.

The market changes all the time. Your long-term asset allocation and goals should not.

Many our 401(k) websites have a “rebalance” button that will automate this process of restoring balance between expensive funds and cheap ones. Buying the seemingly worst possible choices forces you to buy low.

Think long term

DUMB: Dumping your “disappointing” funds for those with better recent results. This is the classic investor mistake of chasing returns.

Lately the small-cap value style of investing has gotten walloped, even though over long periods it is among the best-performing styles. For months, commodities like petroleum and gold defied the bad market for stocks, but nothing lasts forever; recently, gold fell 10% in just a few days. Never sell anything simply because it declines in price.

SMART: Even great mutual funds can be expected to underperform in as many as 3 years of every 10. Assuming the same management team is running the fund in the same way it was when you became attracted to the fund in the first place, stick with it. What Wall Street calls “reversion to the mean” predicts that hot asset classes will cool and cool ones will heat up again.

Look for new opportunities

DUMB: Rejecting investing because today’s returns are less than they were in the 1990s. Instead of the double-digit gains back then, the stock market has been delivering annualized returns of about 3.5% in this decade.

If you’re expecting lower rates of return going forward, you should be increasing your savings and you should be looking in new places for future returns.

SMART: Look ahead for investment opportunities, not behind. For example, U.S. bonds are unsteady, but others overseas are not. Look for a nice global bond fund because until very recently, foreign bonds were hard for U.S. investors to own, but now there are exchange-traded funds and mutual funds that investment in those markets.

Escape a 401(k) the right way

DUMB: Shunning the 401(k) plan because you’re afraid of Wall Street “tricks.” If you have an employer match, you’re being paid to learn how to avoid them. If your bank was offering you a dollar for every dollar you contributed, would you think that was a good deal? Of course you would. Yet some people think the 401(k) match is different.

If you’re a novice, look for a fund option that owns both stocks and bonds, like a balanced or target-retirement fund. Own it while you’re learning the ropes.

SMART: Getting out of a 401(k) when you leave the company. You can roll it into a self-directed IRA with unlimited investment options like here at Astor Asset Management, LLC. And even good 401(k) plans can have bad rules.

We have seen clients that have a 401K that included beneficiaries of plans that automatically cash out plans upon death and withhold 20% of the proceeds for federal tax (the federal Thrift Savings Plan, notably).

The beneficiary has no say in how or when they get to take the money out, and this can have a tremendous impact on their tax planning. Self-directed rollover IRAs can be inherited without a huge, immediate tax bill.

Don’t owe money — even to yourself

DUMB: Borrowing from your 401(k) because “you’re paying interest to yourself.” You can do this however you’ll pay taxes on that interest and there is no deduction allowed for interest expense. Also, if you change jobs or get laid off, the whole loan could come due on the spot.

SMART: Pay back any loan as fast as you can, because you’ll earn far more on the stocks you can buy cheaply now than on those “interest” payments.

Sell company stock the right way

DUMB: Selling highly appreciated company stock if you’re near retirement. The tax break on net unrealized appreciation will be lost forever.

This little-known tax dodge works like this: The IRS will allow you to withdraw company stock in-kind (that is, you don’t have to sell it first) from a 401(k) or other deferred-compensation plan at retirement and deposit it directly into a brokerage account. The tax “basis” in the stock becomes the value when it is transferred, not when it was originally purchased, when it was presumably worth much less.

Proceeds from retirement accounts are taxed like ordinary income, at rates approaching 40%. With this move, you pay the capital gains rate of 15% or less.

SMART: Selling excess company stock, such as the sort used for the annual match, as soon as you can. Since your income is already tied up in your job, tying your nest egg to the company as well exposes you to extra risk.

Make sure it’s not a substantial chunk of your overall portfolio. We recommend below 20%, or even 10%.

You don’t need a perfect investment portfolio to retire well. But you do need a portfolio. Today’s 401(k) plans are loaded with incentives. Take advantage of them. Don’t look back from the future in sorrow.

Call Astor Asset Management today at 312.373.6280 for all your 401K and Rollover IRA solutions. Ask for Scott Martin or Michael Hovanec.

Trader Triple Play:
The best stock plays for today’s market, with Rob Stein of Astor Asset Management.

Click here to view the video.

A look at what’s driving today’s markets with Rob Stein of Astor Asset Management on CNBC. Click here to view the video.

Astor’s Head Trader Fred Smithson, CFA on First Business Television discussing bank credit default swaps. Will they result in losses for banks?