The Federal Reserve currently finds itself in a difficult balancing act.  On the one hand, it is trying to be an active participant in thawing the frozen credit markets and stimulating a U.S. economy that has been in recession since December of 2007 (according to the National Bureau of Economic Research - “NBER”). On the other hand, it recognizes the growing threat of inflation and the damage that inflation could have on an economy that is likely to start finding its legs again later in the year. In recognizing this threat, it realizes that some its own actions with respect to quantitative easing have added to mounting inflation concerns and many, including members of my research team here at Hennion & Walsh, are interested in the details of the Fed’s exit strategy in this regard.

Outtakes from the Federal Reserve’s Open Market Committee last week in addition to recent comments from Eric Rosengren, President & Chief Executive Officer of Federal Reserve Bank of Boston provide some insight into just how difficult it will be for the Fed to determine an ideal path - if one even exists. At the Open Market Committee meeting, the Fed terminated one money market liquidity program while extending many other existing liquidity programs.  This seems to suggest to me that the likelihood of an increase in interest rates anytime in the near future is low given that the Fed is signaling that they see more rough waters ahead.    Rosengren, during a speech at The Global Risk Regulation Summit in Brussels on June 29, 2009, struck a slightly more optimistic note saying, “GDP is expected to start being positive in the second half of this year…the unemployment rate is likely to lag, so the peak in the unemployment rate is likely to be sometime early next year.” This second statement would seem to contradict the first, as 70% of GDP is based on consumer spending, and one would think that as more Americans become unemployed, consumer spending will be lower.   This would lead one to question where will economic growth come from or, perhaps, will real growth likely not start to occur until the first two quarters of 2010?

The Federal Reserve will continue to struggle to find an exit strategy for the $1 trillion that it has already pumped into the system.   The timing of the exit strategy is critical and will likely be influenced by the timing of the return of economic growth (i.e. GDP). I would suggest that the inflationary consequences associated with not implementing a measured monetary tightening policy program soon will only intensify as each week passes.

According to the Investment Company Institute (”ICI”), as of April 2009, there are now 726 Exchange-traded funds (”ETFs”) with over $529 billion in assets.  Since 1995, according to my calculations, the number of ETFs has increased by approximately 96% per year over this period.  Not only has the number and type of ETFs increased but the popularity of these products across institutional investors, financial advisors and individual investors has also risen over this time frame. For evidence of this trend towards ETF utilization, as I referenced in a post earlier this year, one needs to look no further than to Monday, September 15, 2008.  According to Barclays Global Investors, this day represented one of the largest trading days, based on volume, in U.S. history and ETFs accounted for 40% of the trading volume in U.S. equities that day – 40%!
 
Advisors, in particular, are using ETFs in different ways than they did prior to the historic market declines associated with 2008 and early 2009.  To start, advisors seem to now be looking to the ETF marketplace to gain access to traditional and exotic areas of the market, such as Commodities and Foreign Currencies,  in an arguably more transparent, convenient and cost-efficient means than they could prior to the existence of ETFs or Exchange-traded notes (”ETNs”) for these areas. Additionally, advisors have also been looking to ETF products to provide for enhanced downside protection through short and leveraged short funds similar to those offered by ProShares and Rydex Investments. However, these short ETF products often do not deliver the results that investors would expect for a variety of reasons and generally should not be considered for a long-term portfolio holding.  This last point further underscores the basic need for all investors to complete their own research and understand the pros and cons of any investment before making an investment decision.

With ETFs and ETNs now available, both long and short, for a large majority of the investable universe that many investors look to for their respective portfolio strategies, it is becoming more and more of the norm to see non-active (i.e. traditional index-tracking) ETFs in investment portfolios, just as they are becoming more prevalent, for selected asset classes, in certain Hennion & Walsh managed money portfolios.

Disclaimer: Kevin Mahn is the portfolio manager for SmartGrowth® Mutual Funds, which utilize ETFs as a core part of their investment strategy.

Muni Bonds a Safe Bet

As the recent G8 meeting showed, many policy makers across the globe are concerned that the extensive borrowing and spending undertaken by governments to stimulate the economy may lead to inflation.  However, other economists have cited the weak current Gross Domestic Product (”GDP”), low sales demand and negative profit numbers as justification that inflation worries are either premature or potentially off-base entirely.

At Hennion & Walsh, we note that inflation can occur in a period of stagnating demand - remember the “stagflation era” from the 1970s? We also point out the definition of inflation as supplied by YourDictionary, which states “When money enters circulation at a rate that is higher than the supply of goods available, inflation is occurring.”  As a result, it can be argued that price increases seem to be the eventual result of inflation, not necessarily the cause of it.

I believe that governments (the U.S. included) must eventually take responsible steps to prevent inflation from taking off significantly in the intermediate-long term.  I also believe that the current trend of rising commodity prices could indicate that the threat of inflation is no longer just a future concern but may be upon us already.

Many technical analysts are dancing in the streets these days - using their historical trading charts as their dancing partners of course.  For the first time since December 2007, the S&P 500 Index, widely considered as the barometer for the U.S. stock market, has now broken through its 200-day moving average.  This event has suggested to many that perhaps the markets are now beginning to stage a meaningful and sustainable market recovery.  If true, this may signal a buying opportunity to institutional and retail investors alike.

While I generally do not put too much weight in technical chart analysis and believe that robust asset allocation strategies have a more profound impact on portfolio performance when compared to market timing, or even security selection for that matter, it is hard to dismiss a consistent long-term trend associated with any relevant market statistic.   Hence, our Research team at Hennion & Walsh dug deep into the historical data to help determine if, in fact, the S&P 500 200 Day Moving Average could be viewed as a reliable investment timing statistic.

To start, it is our opinion to start that merely crossing through the average is not a sufficient signal in and of itself.  When markets are moving quickly in the midst of seemingly trendless volatility, the average could be crossed in both directions on multiple occasions without presenting any clear market signals.  As a result, we used a 5% margin of safety in our study.  Our research study utilized historical dating back to 1950 from Yahoo Finance and yielded the following results:

• There have been 39 potential buy or sell signals based upon our self-imposed S&P 500 200-Day Moving Average 5% margin of safety criteria over this time period.   This works out to a potential buy or sell signal roughly once every 1.5 years over this time period.

• Every buy signal suggested by our self-imposed S&P 500 200-Day Moving Average 5% margin of safety criteria was followed by increases in the S&P 500 afterwards.

• Measuring the cycle beginning with each buy signal and ending with each subsequent sell signal, using our self-imposed S&P 500 200-Day Moving Average 5% margin of safety criteria over this time period, the average increase in the S&P 500 over each cycle was approximately 42.7%.

This particular market recovery may very well be different from historical market recoveries but, as I stated earlier in this post, market statistics that possess this consistent of a long-term trend should not be entirely ignored.  Further, these results, and the recent behavior of the underlying average itself, may provide another missing piece to the investor confidence puzzle and present yet more evidence towards the case for staying (or becoming) invested, in a diversified and strategic manner, in the equity markets to take part in the next bull market.  However, it is important to recognize that the S&P 500 still has not crossed our 5% margin of safety threshold and I personally still believe that there is still a potential pullback ahead of us before the market lays the ultimate foundation for a sustained recovery.

Please note:  Past performance is not an indication of future results.  The S&P 500 Index is a broad based unmanaged index of 500 stocks, which is widely recognized as representative of the equity market in general. You cannot invest directly in an index.

Hennion & Walsh president, Bill Walsh, quoted in MarketWatch.

As the nation battles to recover from its current 18 month long recession (stated duration based on the National Bureau of Economic Research which determined that this particular recession started in December of 2007 according to their criteria), many economists believe that the eventual recovery will follow the traditional “v-shaped pattern” where we see a sharp, consistent increase once the bottom is ultimately reached.

At Hennion & Walsh, we are currently of the opinion that this recovery will be more “u-shaped” where there will be a period of general economic malaise followed by a gradual improvement in the economy over an extended period of time, which will likely begin towards the later stages of this year and early 2010.

However, as Newsweek recently reported in an article entitled, “The other W”, there is a growing sentiment that this recovery could take on the shape of a new letter; “W”, where the economy would experience a rebound, fall back down and then resume its upward movement. According to Newsweek, “The Fed, along with every other central bank in the world, is printing money faster than ever.  As a result, inflation may go back up.” As I have stated in earlier posts, I believe that the threat of inflation is upon us and investors would be wise to start taking it into consideration with respect to their individual investment strategies. In terms of whether or not this recovery follows a traditional “V”, a characteristic “U” or a new “W” shape will rest largely in the hands of how, and when, the Federal Reserve combats growing inflationary pressures.

Is it possible that the U.S. government could lose the coveted AAA credit rating on its associated debt in the near future? Bill Gross, the well known mutual fund manager from PIMCO, believes so saying recently to Reuters that he feels that the U.S. “…will face a downgrade in at least three to four years, if that…” Yet many others, including the Research team here at Hennion & Walsh, believe that a downgrade from the perceived gold standard of credit worthiness across the world at any point in the near future is unlikely.

When Standard & Poor’s updated the United Kingdom credit outlook to “negative” from “stable” earlier this week, shock waves were sent out across the capital markets and the debate began with respect to whether or not the United States would be next. To start, let’s remember that the S&P action was not actually a downgrade to U.K. debt but rather just a change to their credit outlook, which could ultimately lead to a credit downgrade in the future although it is not a certainty. Further, the U.K. is not in the same financial condition as the U.S. as evidenced by the fact that U.K. government debt now represents close to 100% of its own Gross Domestic Product (”GDP”). Finally, the U.K. economy, as measured by GDP is much smaller in comparison and thus more likely to experience financial difficulties during recessionary periods. Hence, I believe that any leap to assume that the recent S&P action with respect to the U.K. will be followed by a similar action with respect to the U.S.

Perhaps what this will help to remind lawmakers, arguably at a time when such a reminder is needed most, is to control spending and look for ways to start bringing down our growing deficit which now represents close to 13% of U.S. GDP. To this end, Treasury Secretary Geithner was quoted yesterday on Bloomberg saying, “It’s very important that this Congress and this president put in place policies that will bring those deficits down to a sustainable level over the medium term.” If such fiscal constraint is not restored, my concern is that it will become more difficult, and potentially more expensive, for the U.S. to borrow more from other countries (Ex. China currently holds over $740 billion of U.S. Treasuries) if, and when, the situation warrants.

Regardless, based upon available current data, insights and forecasts, it remains my contention that the U.S. will retain its AAA rating and distinction as a safe haven for investors for the foreseeable future.

While many international economies are still catching up to the United States on the global recession scorecard, international stock markets, specifically emerging markets, are off to a strong head start in 2009 when compared to the U.S. equity markets.

Source: Wachovia Securities.  Performance data is as of March 31, 2009. Past performance is not an indication of future results.

As you may recall (and are reminded of in the chart above), emerging markets, which are largely not directly associated with the current credit crisis gripping the developed countries of the world, experienced the largest declines of the major equity asset classes in 2008.   This has created very attractive buying opportunities and fundamental values that we have not seen, in some cases, since the Russian Ruble crisis back in 1998.  Emerging market countries in Asia, such as China, which itself has the luxury of having approximately 2 billion of its own captive consumers to help grow their economy, appear, to us at Hennion & Walsh, to offer the most intriguing growth potential, in terms of international markets, for the balance of 2009.  

However, remember that Emerging Markets have their own unique set of risks that should be carefully considered before making an investment.

The Department of Labor reported today that nonfarm payrolls contracted by another 539,000 jobs and the national unemployment rate now stands at a 26-year high of 8.9%. Perhaps even more concerning is that, according to the DOL reports, there were only two sectors that were actually adding jobs; health care and government.

However, recognizing that employment data statistics are backward looking and tell us more about how the labor market was as opposed to the where the labor market is today or will be in the future, the fact that the pace of jobless claims are now moderating is encouraging.

As we look behind the numbers, there are clearly areas of the country where the current employment situation is not as dire as in other areas. The table below which help depict these differences:

Source: U.S. Bureau of Labor Statistics. Data was last updated on April 29, 2009.

From this data, it is interesting to observe that the two areas that were hardest hit by the housing downturn; California and Florida, are also the two areas of the country that have unemployment rates higher than the national average. Conversely, in Texas, which is an area of the country where we have seen some recent pockets of strength related to housing, the rate of unemployment is significantly lower than the national average. While the relationship between housing and unemployment may not be perfectly correlated, we, at Hennion & Walsh, are starting to pay more attention to the connection. It is apparent to us that for the U.S. economy to grow out its current recession, we need consumers to start spending again given the impact that consumer spending has on gross domestic product (“GDP”) growth. Improving job and housing markets can clearly provide both psychological and concrete assistance in this regard.