There are a lot of uncertainties permeating the market right now, not the least of which is healthcare reform. Will that reform entail a public option that could add $1 trillion to the deficit?  How is reform going to be financed?  And is it going to mean higher costs for employers across the board, or just the healthcare insurers?

Investing is made infinitely more difficult when 18% of U.S. gross domestic product (GDP) is hanging in the balance.

And you still have to consider:

• That unemployment is likely to keep rising, perhaps over 10%.
• That the U.S. Federal Reserve’s policy of quantitative easing is slowing down.
• That there is almost certainly a second wave of home foreclosures on top of the current commercial real estate epidemic.
• And that retail sales are still a long way from recovery.

There is also reason to believe that the U.S. dollar will continue to be weak, though it probably won’t sell off precipitously.

The U.S. dollar has weekend against the Euro lately, having fallen 0.8% Friday.  Technically speaking the chart shows a traditional “cup and handle” formation that could lead to an acceleration of the dollar’s downward trend.  Gold prices, up about 13% Friday, confirm this trend and could soon break through the $1000/oz resistance.

Fundamentally, if the economy – encumbered by high unemployment and a relapse of the housing market – does not pick up the dollar could be further imperiled.

Weakness in the dollar will also be affected by the Fed’s withdrawal of liquidity, which is likely to proceed at a gradual pace.

Finally, diversification away from the dollar among the world’s central banks is taking place, albeit at a slower pace than many analysts have suggested, and that too, is weakening the dollar.

Let’s concede that there is no currency that could supplant the dollar as the world’s major reserve currency. So, it’s unlikely that the world’s central banks will simply abandon the dollar anytime soon. However, we must also acknowledge that a reduction in the weightings of the U.S. dollar within central bank reserves is already underway.

An Aug. 14 article by BNP Paribas currency strategist Ian Stannard in Euromoney recently described this gradual shift in currency reserves.  The article noted that only 62.5% of global currency reserves are in U.S. dollars, down from about 66% in 2005.

So I do not anticipate a sudden shift in central bank reserves, but rather a continuation of the measured restructuring we’ve seen so far. Thus, the slow weakening trend in the U.S. dollar is likely to continue.

So, in this very uncertain investment scenario, I prefer to go for more secure returns in bonds.  And we can achieve great diversification at a cheap cost with the iShares iBoxx $ Investment Grade Corporate Bond Fund (NYSE: LQD).

For starters, its weighted average coupon of 6.26% offers a current yield slightly north of 6% at today’s prices.  Investors are assuming interest rate risk, which means that if interest rates climb, the value of the bond has to come down.  But in the short term, there is no immediate threat of inflation.

Looking at the major holdings of the fund – which has no single position that accounts for more than 1.26% of its total holdings – I see some names that have demonstrated continued stability and others that have shown recent signs of improvement, such as American Express Co. (NYSE: AXP).  So I do not expect any major credit spread hiccup here.  I certainly do not see any hiccup that a 6.26% coupon would not compensate for.

For an additional hedge against dollar weakness, I suggest you revisit my June 8 recommendation of the iShares SPDR Gold Trust ETF (NYSE: GLD). You may also consider buying a bit of the PowerShares DB US Dollar Index Bearish (NYSE: UDN) fund.  Do not go overboard. Err on being light, rather than heavy on hedging, since timing currency moves is very difficult.

Recommendation: buy iShares iBoxx $ Investment Grade Corporate Bond Fund (NYSE: LQD) at market.  Consider hedging part of the US dollar risk by buying the iShares SPDR Gold Trust ETF (NYSE: GLD) and PowerShares DB US Dollar Index Bearish (NYSE: UDN). Both funds should account for a fraction of your position.  Have a 5% stop loss on UDN (**).

Source: Buy, Sell or Hold: The iShares iBoxx $ Investment Grade Corporate Bond Fund

Managed futures programs – alternative-investment vehicles that enabled professional money managers to take positions in a wide variety of securities and derivatives – posted strong returns in a year that was marked mostly by investment losses. The average managed futures program returned about 14%, according to the Barclay CTA Index, and 11.4% as measured by the Stark 300 Traders Index.  By comparison, theStandard & Poor’s 500 Index and the tech-laden Nasdaq Composite Index each plummeted nearly 40% in 2008, while the Dow Jones Industrial Average nose-dived 33.8%.

Computer-Based Trading

Managed futures funds are managed by commodity-trading advisors, or CTAs, who monitor and trade in up to 150 to 200 different futures markets that run the gamut, including such asset classes as:

• Stocks.
• Fixed-income investments.
• Currencies.
• Agricultural products (commodities).
• Metals.
• Energy products (including – but not limited to – crude oil).

The positions the traders take can either be “long” (buy the underlying asset) or “short” (sell the underlying asset), based on expectations of future price movements.  These managers often employ “leverage” – using borrowed funds to buy on margin – which allows them to maintain larger positions in the underlying assets than they otherwise would be able to if they paid upfront in full. Buying on margin is a tactic that can dramatically increase returns when the manager has made the correct market call, but which likewise magnifies the losses when the investment manager is wrong

CTAs typically trade managed futures using a systematic investment process based on the pricing trends of the underlying markets.  Most traders do not consider overall market fundamentals. Nor do they study reports that depict the latest statistics on the global markets or the supply-and-demand dynamics for the various commodities. Instead, they use computer-based algorithms to create models that detect pricing trends and look solely at technical factors behind the numbers.

Linus Nilsson is a senior analyst within the Managed Futures Team atMan Investments (OTC ADR: MNGPY), a global “fund-of-funds” manager that allocates about $2 billion to externally managed futures funds. Nilsson points out that virtually all underlying manager trades are directional in nature using an unbiased strategy and says that CTAs are just as likely to be short as long in any given market.

“The computer-driven model tells them what to trade, when to trade, which side to trade, and when to get out of those positions,” Nilsson said. “Managers look at technical price trends, rather than fundamentals, and then manage the risk around those trends.  Everything is price-based and we generally focus very little on macro issues.”

According to Nilsson, managed futures perform very well during prolonged crisis situations, though high volatility is not imperative for trends to be established and profitable trades to exist.

“As long as you have trends that are exploitable, managed futures funds will make money,” said Nilsson.  “Looking at the equity markets from 2002 to 2006, basically we had a very smooth non-volatile trend and CTAs were able to take advantage.  Likewise, crude [oil] rose from 2006 to mid-2008, a nice trend that saw prices continue to print new highs all the time.”

By contrast, Nilsson claims that managed futures funds also benefited from the dramatic reversal in the prices of energy and other commodities over the second half of 2008.

“After a little pain, CTA models recognized the shift in prices, realigned fund allocations, and went short to the end of the year to take advantage of the new trends. It was a beautiful environment for managed futures.”

Paul Wigdor, president of Superfund USA Inc., a public managed futures fund that oversees $1.7 billion in assets apportioned across 18 countries, confirms that his firm’s managed futures product incorporates no fundamental overlay and the traders’ personal views do not influence buying or selling decisions.  They seek price trends in the marketplace and rely on technical factors which suggest whether markets should go up or down.

“We use a fully systematic trading system that is all computer-driven, black box-driven, quant-driven … whatever you want to call it,” Wigdor said. “We don’t care about embargos or what news may be coming out of the Middle East or China.  Our systems look only at price and consider such factors as volatility, resistance and support levels, relative strength indicators, moving averages, and how they all interrelate.”

Wigdor also points out that his firm’s fund has an exit strategy every time a trade is made so the managers are better able to control the risk.

“We put a ‘stop limit’ in each time we take a position,” Wigdor said.  “When a trade moves in our favor, we may ratchet up or down our stops as appropriate.  When the models pick up that the trend has reversed, we get stopped out of trades and losses are limited.”

Removing Emotion From the Investing Equation

Curtis Lyman, managing director of HighTower Advisors LLC, and principal of its West Palm Beach, Fla.-based Alpha Wealth Division, recognizes the need for some trend-following quant-driven modeling as part of his asset-allocation process.  He believes that rules-based computer-driven trading often makes the most sense and is comfortable including managed futures within his clients’ portfolios.

“Frankly, the ‘black box’ is one of the reason we use managed futures,” said Lyman.  “We like the fact that a portion of our portfolios loses the human element altogether and we would be far less comfortable if a manager had the ability to swing from a chandelier and load up on one position or another based on emotions.”

In Lyman’s opinion, quantitative trading allows for a pretty good control of risk, at least for that allocation of the portfolio.

2008: A Study in Stock Market Chaos

For investors who want to gain an understanding of managed futures as an asset class, Superfund’s Wigdor believes that 2008 stands as an effective case study for how managed-futures programs are supposed to work.

“In the first half of the year, we were long commodities across the board – everything from gold, oil, corn, soybeans, wheat, and oats,” Wigdor said.  “We were also long currencies from commodities-oriented countries like Canada and Brazil.  If you remember, money was flying into long-only commodities products and they did very well during the first six months of 2008.”

Wigdor is quick to remind his investors that these positions were established because of the pricing trends of these commodities markets and the computer-driven models did not consider fundamental issues whatsoever.

“In July and August, we experienced a big correction in commodities,” he added.  “Oil plummeted; others markets followed.  Our stops got triggered, though not until we suffered sizable drawdowns, or peak to valley declines.”

Wigdor explains that computer models never try to pick the absolute top or bottom of any market, but are merely trying to capture the majority of the price movements.  He notes that portfolios will always experience some giveback when markets reverse as the models attempt to validate that the trend has ended.  While long-only funds may also recognize the price shifts, they are not set up to take advantage of the reversal.

“There is always going to be some lag time as the models determine if the trend has reversed or this shift just represents noise in the markets,” Wigdor said.  “By October, we reestablished positions and this time were short many of the same commodities markets that we had previously been long.  We continued to be short equities and interest rates and finished the year with returns of 30% and 46% in our two U.S. funds.”

Likewise, Nilsson said that Man Investment’s investors benefited from exposure to managed futures in 2008, since that asset class was one of the few that actually delivered positive value to investors.

“A large number of CTAs did very well in 2008 and managers who were short equities throughout the year, and were fortunate to be long commodities early and shift to short positions late, were greatly rewarded,” Nilsson said.

Investors have seen a number of “false starts” this year, but Nilsson says he sees several promising possible trends and said the fund is slightly short the U.S. dollar and generally short sovereign debt.

A Competitive Comparison

Nilsson also believes that many investors have shied away from managed futures because of the miconception that it’s an especially risky asset class.  In reality, he believes that CTAs are actually better able to control risk, particularly in volatile environments like those experienced last year and in the first part of 2009.

“Dating back to the 80’s,  managed futures actually have similar risk profiles to equities and, at times, they are much more stable,” Nilsson said.  “Plus, they often outperform the more traditional asset classes over time.”

The following chart with data from both Stark & Co. and Bloomberg LLC depicts the risk/reward profiles of both managed futures and U.S. stocks.

Hightower’s Lyman admits that volatility, at times, can be quite high in managed futures funds, though these days, everything is relative, especially given the intense price movements in traditional stocks and bonds over the past year.

“Investors really must look at managed futures from a longer-term perspective of at least five years,” Lyman said.  “You have to give [the programs] time to work.  In fact, during periods of big drawdowns in managed futures, other asset classes are probably doing well because of the non-correlation characteristic.  Bear in mind, the addition of managed futures to a well-balanced portfolio will most likely lower its volatility and enhance its returns over time.”

Not Just for the “Rich and Famous”

Historically, managed futures has been an asset class reserved almost exclusively for institutional players and high-net-worth investors qualify as “accredited investors” – meaning they have an income of several hundred thousand dollars and a net worth of more than $1 million. Lyman believes that certain liquidity issues still prevent many smaller investors from participating.

“While the underlying futures markets are very large and liquid, most of the managed futures products themselves trade in L.P. (limited partnership) structures which often do not provide the daily liquidity that is important for many investors,” Lyman said.  “Instead, participants typically can access their money by selling units on a monthly or quarterly basis, as predefined by the managers of the fund.”

Lyman sees some opportunities for traditional retail investors to diversify into managed futures through mutual funds that may provide daily liquidity, but he does not believe that many of the biggest and best managers will offer access through investment vehicles of that type.

“To get daily liquidity, these managers may have to disclose insight into their trading methodologies,” Lyman said, noting that most managers would be reticent to share such closely guarded proprietary information.  “Through mutual funds, retail has certain tools available to access this asset class, but the products are not exactly the same as those available to accredited investors.”

Superfund’s Wigdor likes the idea that the asset class has been democratized and that more investors now have the opportunity to invest in managed futures.

“What sets us apart from other managed futures firms is that we concentrate on providing greater access to many types of investors.” said Wigdor.  “Right now, we offer monthly liquidity with no holding periods, no lockups, no short-term redemption fees.  We continue to work on making this alternative investment more mainstream and therefore available to previously uptapped markets.”

And given the recent risk-adjusted performance relative to more traditional asset classes, greater access may be a pretty good thing.

Source: Managed Futures Programs – Once Restricted to the Wealthy – Are Going Mainstream

[Editor’s Note: This is Part II of a two-part story.  To read Part I, which appeared yesterday (Thursday), please click here.]

Managed futures programs – alternative-investment vehicles that enabled professional money managers to take positions in a wide variety of securities and derivatives – posted strong returns in a year that was marked mostly by investment losses. The average managed futures program returned about 14%, according to the Barclay CTA Index, and 11.4% as measured by the Stark 300 Traders Index.  By comparison, theStandard & Poor’s 500 Index and the tech-laden Nasdaq Composite Index each plummeted nearly 40% in 2008, while the Dow Jones Industrial Average nosedived 33.8%.

“Managed futures funds like drama and volatility, so 2008 was a banner year,” said Curtis Lyman, managing director of HighTower Advisors LLCand principal of its West Palm Beach, Fla.-based Alpha Wealth Division.  “While I don’t know what is going to happen tomorrow, some of the major dislocations in the marketplace still exist, which could offer the potential for a good environment for this strategy moving forward.”

While investors who participated in managed futures programs reaped significant performance benefits both on an absolute and relative basis last year, many retail investors and even some institutional players are still unaware of this product and the characteristics that contributed to the lofty returns.  And while the entire asset class still only holds about $225 billion, according to Barclay Trading Group (NYSE ADR: BCS), it has grown significantly over the past two decades as investors learn about its performance history and strong diversification features.

“Managed futures, as an asset class, is still relatively unknown,” said Paul Wigdor, president of Superfund USA Inc., a public managed futures fund that oversees $1.7 billion in assets apportioned across 18 countries.  “We are trying to build this asset class  by educating advisors, investors, and the media about this product.  We are not trying to replace the more traditional asset classes, but merely to educate people about the need to diversify beyond just stocks and bonds.”

The Lowdown on Managed Futures

Before making an investment in a managed futures account, an investor must first develop some insights on the overallfutures market. Afutures contract is considered a derivativeinstrument, whose value is determined by the movement of the underlying asset or market. The contract represents an agreement to buy or sell an underlying asset at a predetermined price and date in the future.

Managed futures funds are managed by commodity-trading advisors, or CTAs, who monitor and trade in up to 150 to 200 different futures markets that range from equities to fixed income to currencies to agricultural products to energy to metals.  The positions can either be “long” (buy the underlying asset) or “short” (sell the underlying asset) based on expectations of future price movements.  These managers often employ “leverage” – using borrowed funds to buy on margin – which allows them to maintain larger positions in the underlying assets than they otherwise would be able to if they paid upfront in full. Buying on margin is a tactic that can dramatically increase returns when the manager has made the correct market call, but which likewise magnifies the losses when the investment manager is wrong.

CTAs typically charge investors management fees in the range of 1.5% to 2%, and may also earn incentive fees of 20% to 25% on any new profits generated by the managed-futures fund.  While some investors may claim that such fees seem excessive, performance is always quoted on a “net of fees” (after fees have been paid) basis, so the returns these funds generate can be accurately compared to the gains or losses generated by more-traditional investment vehicles.

Other factors that are important to note:

• The managed-futures industry is highly regulated by the U.S. Commodities Futures Trading Commission (CFTC).
• The future exchanges offer tremendous liquidity,
• And the existence of clearinghouses to guarantee transactions reduces the counterparty risk.

“Our fund is publicly registered and regulated by the SEC and CFTC,” said Superfund’s Wigdor.  “In light of Madoff and other scandals, our clients take great comfort in its transparency.  We file 10-Ks and 10-Qs; our auditor is Deloitte & Touche and our [net asset value] is computed by PNC Bank (NYSE: PNC).”

A Look Back at the Beginning

While managed futures remain an untapped market in many investment circles, the earliest futures market was actally formed in the mid-1800s when the Chicago Board of Trade was established to provide an outlet for Midwest farmers to sell their products to East Coast merchants.  The farmers were able to lock in prices and often hedge their operations against poor weather conditions or other situations that could adversely impact future sales.

In the early days, agricultural-based contracts dominated the futures markets and the first financial futures were not introduced until 1975. Today, more than 70% of all futures transactions are based on financials as their underlying securities, with contracts related to stocks and interest rates among the most frequently traded, according to Man Investments.

The Joys of Non-Correlation

For most investors, the main appeal of a managed futures account is its ability to provide significant diversification to a well-balanced portfolio.  Because the managed-futures asset classes are largely non-correlatedwith stocks and fixed-income products, an allocation can reduce the overall portfolio risk, while offering the potential for yield enhancement, particularly during challenging times for traditional assets like those experienced in 2008.

Hightower’s Lyman agrees that non-correlated assets can be a welcome addition, which is why he incorporates managed futures into portfolios of his more-sophisticated clients.  He believes managed futures play an important role in his clients’ overall risk-adjusted returns.

“The addition of managed futures offers the potential to smooth out portfolio performance because of their low correlation with equities,” Lyman said, noting that he builds client portfolios that are designed to provide consistent returns over time and that are broadly diversified across various asset classes.

Managed-futures assets can be particularly beneficial during some of the stock markets roughest stretches, he said.

“Since we are always looking to reduce volatility through the inclusion of low-correlated asset classes, managed futures represent an investment we need to consider,” said Lyman.  “From a performance standpoint, if you look at the 10 worst months for stocks since 1987, managed futures on average have dramatically outperformed.”

However, it’s important to note that investors use managed futures as only one piece of a well-diversified portfolio. In fact, due to the highly regulated nature of the futures markets, most investors will limit this part of their portfolio to no more than 10% of their total assets. And as the various asset classes rise or fall in value over time, investors will need to periodically rebalance their holdings to make sure that they do not exceed that 10% allocation limit.

Lyman has not experienced any problems working within the regulatory framework and says the portfolios of his most-aggressive clients tend to allocate an average of 5% to 7% of their holdings into managed futures.

Source: Managed Futures Can Put Investors in the Black – Even When Stocks Are Deep in the Red

It’s enough to make you succumb to the Two Minutes’ Hate.

But let’s face the truth. As egregious as salary escalation seems – coming as it does on the tail of the worst U.S. banking crisis since the Great Depression – the reality is that this is the U.S. government’s fault. After all, it was the U.S. Federal Reserve and the Obama administration that created all the bailouts and the special-loan-subsidy schemes for banks that would otherwise have been on their last legs.

In a truly free market, ex-Citibankers (NYSE: C) would be on every street corner of Manhattan – selling apples – and that would properly hold down the pay of those bankers still lucky enough to have a job.

The sudden rebound in demand for bankers is a symptom of overall market conditions right now. The U.S. stock market is way up from its lows, there are three Chinese initial public offerings (IPOs) due to come to market this week (one of them for a company with no earnings), the volume of home mortgage refinancing has been running at record levels, the FHA index of home prices has dropped only 0.3% this year and the volume of new corporate debt issuance is also high. Commodity prices are well off their lows, and oil prices are again close to $70 a barrel, which would have been considered an excessively high level only three years ago. That’s not a picture of a financial market – or a global economy – in deep recession.

Far from it.

To some extent, this is good news. A revival of the financial system and its ability to finance businesses and home purchases is exactly what the huge monetary and fiscal stimulus was meant to produce. A modest revival in world trade, as inventories cease being wound down and Chinese production ramps up again, is also a necessary precondition for economic recovery.

As the banking bonus news suggests, however, much of the activity is coming in some pretty funny places, where the excesses of the past decade were concentrated and where you wouldn’t expect to see such a quick revival.

That gives us a clear indication of just what the problem is. Because bankruptcies weren’t allowed to happen back in September and October – as they would have in a free market – there are more institutions in the market than there should be, Citigroup and Merrill Lynch most notable among them.

Moreover, in a true free market, the entire credit-default-swap (CDS) business – a product that caused $180 billion of losses to the financial system through American International Group Inc. (NYSE: AIG) – would be nothing but a smoking ruin. But in the market we are living in, those $180 billion worth of losses have been transferred to the tab of the taxpayers of America.

With Citigroup and Merrill Lynch bankers mooching around on street corners, financial sector salaries would be forced down to a more reasonable level.  As it is, the few unemployed unfortunates who worked at Lehman Brothers are not enough to depress the market. Likewise, credit default swaps have caused huge pain to the unfortunate employees of Abitibi-Bowater Inc. (NYSE: ABH), General Growth Properties (OTC: GGWPQ), and Six Flags Inc. (OTC: SIXFQ), each of which went bust partly because their creditors were playing in the CDS market and had no incentive to find an alternative to bankruptcy. Had CDS caused the pain they should have to financiers, the product would no longer exist, to the considerable benefit of the rest of us.

Inevitably, we are going to have to pay the price for all the bailouts. The financial sector will eventually shrink to its proper size, as will its members’ earnings. CDS will eventually be sharply restricted, to prevent their holders from forcing random companies into Chapter 11. Interest rates will have to rise, to accommodate the huge debt-funding needs the government has incurred. Money will have to be kept tight, to pay for the indulgences that Fed Chairman Ben S. Bernanke granted during the bubble, as well as for the even greater-indulgences of the bust.

Which is probably why you don’t want to hold U.S. stocks right now.

[Click here to check out a related Money Morning story on the salary increases some banks are offering in order to retain key employees.]

Source: Who’s Really to Blame for the Crooked Financial System

On Monday March 9, barely three months ago, I strongly recommended buying Diamond Offshore (NYSE: DO) as part of Money Morning’s “Buy, Sell, or Hold” feature.  Both the stock and the Standard & Poor’s 500 Index had both hit 52-week lows the Friday before.  But oil had already bottomed three weeks prior, and the lax fiscal and monetary policies of governments around the world seemed almost certain to promote reflation.

Additionally, since the earlier oil bottom, Diamond Offshore stock had been outperforming the market.

Diamond not only had compelling fundamentals, it sported an incredibly high dividend yield, particularly if you combined both the regular and the special dividend payouts. That made the stock a compelling buy.

Not only has Diamond Offshore’s stock turned around since that early-March recommendation, the U.S. stock market as a whole turned around.

Making an investment at a market bottom is a rare opportunity. It is both risky and difficult to try and time the market, but that is precisely what we have done with two of our Buy, Sell, or Hold recommendations. I recommended the iShares MSCI Brazil Index exchange traded fund (ETF) (NYSE: EWZ) on October 27, and the fund went on to appreciate 92% in the subsequent eight months.

Now, Diamond Offshore stock has climbed more than 60% from a March 9 bottom of $54.29 a share, to its current level above $90.

I have consistently advised readers to slowly build stakes in our recommendations over a period of time. And that strategy helps mitigate risk and take advantage of panic selling.  In the cases of the iShares Brazil ETF and Diamond Offshore, we were actually able to boost our profit exponentially by starting our investment at the very bottom.

Diamond Offshore’s special dividend yielded an incredible 13% when we bought it. Since the stock has run up in value, however, that same special dividend has been reduced to a 7.4% yield but remains considerably high.

As I pointed out in my previous recommendation, Diamond Offshore likely will keep paying the dividend in order to help recapitalize other holdings of its experienced and savvy majority holders. And some analysts question whether this is sustainable over the long-term.  Obviously, Diamond Offshore at some point will depart from this special dividend, but I don’t expect that to happen anytime soon.

Still, with the strong gains that we’ve seen so far, it would be prudent to take some profit by selling half of the position and allowing the rest to ride on a pure valuation and risk-management call.

Let me explain.

The whole investment was predicated on three general types of factors: Macroeconomic, company fundamentals and the special dividend.  And everything I expected worked like clockwork, without any negative surprise showing up from nowhere to derail our initial investment thesis.

On the macro side, all the factors we analyzed are playing out as we expected. Oil prices have been very supportive.  This is not only supported by the monetary and fiscal reflationary policies I have outlined but also by strong demand from China.  The monetary base expanded significantly.

The type of massive fiscal stimuli deployed by the United States and China is common knowledge.  And China is doing its part by supporting its economy with massive investment and taking advantage of its $2 trillion in foreign exchange reserves and to gobble up resources at low prices.

On the company-specific side, Diamond Offshore did indeed beat earnings expectations by a mile and expanded margins as we predicted.  This was aided by sharp rebound in oil prices and strong execution on the part of management.

Similarly, the dividends were paid out and the special dividend likely will stay in place for a few more quarters.

But even with all of this upside, there are many uncertainties about the market that are could reinforce headwinds and spur more profit taking.  The Iranian elections could result in a more moderate regime that might ease tensions in the Middle East and allow some rapprochement between Iran and the United States.  This might be conducive to lower oil prices, even though the risks of Iran’s continued pursuit of nuclear weapons under the veil of a nuclear electricity policy will remain.

The Federal Reserve’s balance sheet expansion and the large issuance of U.S. Treasuries is coming under criticism from many quarters and has already achieved the normalization of many financial markets.  We could see a slowdown in any of these stimuli deployments.

In addition, the heightened risks of inflation, dollar weakness, and interest rate increases in the longer term have brought long-term interest rates up.  Higher rates have already increased the cost of mortgages and put renewed pressure on the already badly hit housing market. Together with higher oil prices, this could put the brakes on future economic growth.  It does not mean that the recovery will stall, but continued increases in job losses, as is typical in recessions will keep damping prospects.

Profit-taking also poses a risk ahead of the earnings season, as the United States and other stock markets have seen strong gains over the past three months.  Should this transpire, we could see a counter-trend correction due to a temporary fly-to-safety into bonds for a while, a strengthening of the U.S. dollar, and a drop in commodity and pro-cyclical stocks.  This could affect Diamond Offshore in the short term.

We must also consider Diamond Offshore’s opportunistic purchase of a semi-submersible unit PetroRig I.  We will not have the price and terms of this deal until closes on or around June 25.

Some analysts believe that this purchase – or the possibility that Diamond will get more aggressive in serving Brazilian oil major Petroleo Brasileiro SA (NYSE ADR: PBR), also known as Petrobras –could jeopardize the special dividend, but I disagree.  The issuance of a $500 million, ten-year debt placement will cover this purchase and raise the operating and financial leverage of the company, thus raising the potential upside for earnings-per-share (EPS) in this new pro-cyclical bull market for commodities.  And I believe the recapitalization needs of the sister company in the group has some more length to go.

Recommendation: Having obtained already very strong profits, sell half of your holdings in Diamond Offshore Drilling Inc. (NYSE: DO) in light of heightened risks that could materialize. Set a 20% trailing stop on the remainder.  I have little doubt that over the long-term we can expect DO to consistently outperform the market.

(**)  Special Note of Disclosure: Horacio Marquez holds no interest inDiamond Offshore Drilling Inc. (NYSE: DO).

Source: Buy, Sell or Hold: Time to Take Profits on Diamond Offshore Drilling (NYSE: DO) ]]> http://www.contrarianprofits.com/articles/buy-sell-or-hold-time-to-take-profits-on-diamond-offshore-drilling-nyse-do/17904/feed 0 http://www.contrarianprofits.com/articles/as-key-global-markets-stumble-gold-and-dividend-stocks-may-keep-investors-on-course/17088 http://www.contrarianprofits.com/articles/as-key-global-markets-stumble-gold-and-dividend-stocks-may-keep-investors-on-course/17088#comments Tue, 26 May 2009 13:53:56 +0000 Jason Simpkins http://www.contrarianprofits.com/?p=17088 Is the hoped-for economic rebound merely a mirage? And if it is, how should you play it? For the past few months, optimistic analysts and investors have been scouring the global economy for so-called “green shoots” – a new financial buzzword that refers to any early indicators of a financial recovery.

Investors believe they’ve seen enough evidence that the U.S. economy may be bottoming out to ignite one of the strongest stock-market rallies in years. After closing at a 12-year low on March 9, the Standard & Poor’s 500 Index has soared 32%. The  Dow Jones Industrial Average has zoomed more than 27%, and the tech-laden Nasdaq Composite Index has rocketed 34%.

In a March 15 interview on the CBS show, “60 Minutes,” U.S. Federal…

In February 1995, the U.S. economy was in great shape. The 1990-92 recession had been over for a couple of years, the Federal Reserve was beginning to ease interest rates, the Clinton administration was beginning to make progress on sorting out the United States’ modest long-term budget problem and there was this new thing called the Internet that looked as though it might bring some exciting new possibilities.

The stock market, too, was strong, with the Dow Jones Industrial Average broke through the 4,000-point level on Feb. 23, 1995, putting it almost 50% above the bull-market high of September 1987.

That level of 4,000 is equivalent to about 7,800 today, when you inflate it by the growth in nominal gross domestic product (GDP) in the intervening 14 years. In other words, if things were looking as good as they were in February 1995, and the market was moderately bullish as it was then, you’d expect the Dow to be around 7,800.

The Dow surged 2.85% yesterday (Monday), to close at 8,504. But the economic conditions we’re looking at today are nowhere near as strong as they were back in the spring of 1995. And that paints a somewhat bleak picture of where the U.S. stock market may be headed.

To get the ultimate doom-laden view, I talked last week with Robert Prechter, who for 30 years has run an investment company based on the Elliott Wave Theory, propounded in 1948 by Ralph Nelson Elliott. I’d wanted to meet Prechter ever since I had seen ads he ran in Barron’s back in the bear market days of 1981-82. The Dow was around 800 at that time, and he forecasted that the U.S. stock market was about to enter a huge uptrend, which might last as long as 20 years, and for which 3,000 on the Dow was only the first stage.

“Boy, he’s bullish,” I remember thinking – it was considered bold at that stage to forecast a Dow of 1,200, which would have been 15% above the index’s all-time peak set in 1972.

But Prechter was right.

He was also right in 1987, when he predicted the sharp bull market of that year would end, but that the pullback would be only a temporary problem before the market went on to greater things.

In the late 1990s, Prechter turned bearish, explaining that the “fifth wave” of an Elliott Wave cycle – and therefore the bull market – was coming to an end. He was a few years early, but by following his advice after about 1998 you would have avoided a decade in which your money made an all-in return of approximately zero.

He was still bearish in 2003 – as was I. In cash terms, we were both wrong and went on being wrong for the next four years, as the Dow zoomed from 8,000 to around 14,000. Of course, as he pointed out to me last week, if you accounted in gold, stocks had in fact declined somewhat between 2003 and 2007. It’s not the Elliott Wave system’s fault that the denominator in the equation – the U.S. dollar – fell out of bed through excessive money printing.

Prechter even managed to call this year’s March bottom, expecting a substantial bear market rally at around 6,300 on the Dow, close to the bottom. However, he expects the market to resume its downward trend shortly, ending with a decline similar to the 86% in real terms of 1929-32 as we are in a long Elliott Wave downswing. That would take the Dow down to around 2,000.

Personally, I would not go that far. This does not look like a reprise of the Great Depression, although it could still turn into one with enough policy mistakes – another “stimulus plan,” or a big dose of protectionism, for example. However, the downward macroeconomic momentum looks bigger than in either 1974 or 1982, bear markets that both brought real-term drops of slightly more than 50% from previous highs.

The current crisis more closely resembles the British crisis of 1972-75, which caused a drop of 72% from the high, or the Japanese crisis after 1990, which brought a drop of 70% within three years, and led to a long-term bear market that has left that market in its current doldrums, about 80% below its peak. For us to see a similar 70% decline from the Dow high, we’d have to be looking at an index that had fallen all the way down to about 4,400. At that point, it would about as cheap as after the 1987 crash, though still not as cheap as it was in 1982, before the great bull market began.

Bulls will respond that corporate earnings are still above the levels appropriate for a 4,400 Dow, to which I would respond that profits might have further to fall. So far, we have seen only a collapse of financial sector earnings, while non-financial earnings remain close to their 2007 highs, when GDP was also at record highs. A period of higher corporate taxes and slow growth – coupled with consumer spending that’s low because U.S. consumers need to save, rebuild their asset base, and pay down their debts – could well cause a further period of earnings deflation, which would return corporate profits to their historical average percentage of GDP – if not to an even lower point.

Where Prechter and I differ is on inflation. He sees a further collapse of asset prices and debt values, with consumer debt and commercial real estate wreaking more havoc on bank balance sheets. That could cause massive price deflation, and a decline – rather than an increase – in the price of gold.

Personally, I look at the over-expansive monetary policy pursued by the Fed for a decade now, and its continuance, and see inflation ahead. Inflation would also help Uncle Sam finance those deficits, so it seems more likely than not.

That difference in opinion aside, Prechter was both charming and fascinating. Maybe we can combine our views, and agree that the deflation will be of the dollar’s value, so that prices will inflate in dollar terms, but deflate in such other hard currencies as the euro, the renminbi (China’s yuan), or the Brazilian real. We shall see.

The bottom line: While the market could go up a little further in the short term, it’s not the time to get aggressive.

[Editor's Note: When Slate magazine recently set out to identify the stock-market guru who most correctly predicted the stock-market decline that accompanied the current financial crisis, the respected online publication concluded it was Martin Hutchinson, a veteran international investment banker who is one of Money Morning's top forecasters.

It was no surprise to our readers: After all, Hutchinson warned investors about the evils of credit default swaps six months before the complex derivatives did in insurer American International Group Inc. Then, last fall, Hutchinson "called" the market bottom.

Now Hutchinson has developed a strategy for investors to invest their way to "Permanent Wealth" using high-yielding dividend stocks. This strategy is tailor-made for an unpredictable stock market that's backdropped by an uncertain economy. Just click here to find out about this strategy - or Hutchinson's new service, The Permeanent Wealth Invesor.]

Source: Elliott Wave Disciple Robert Prechter Sees a Possible 2,000 Dow

What happened in the past when cash reached these levels?

• In September 1974, cash on hand reached $604.5 billion, representing a record 1.21 times the U.S. stock market’s capitalization. That preceded a 31% gain in equities between October 1974 and March 1975.
• In July 1982, just as a 20-month bear market was ending, cash as a percentage of the U.S. stock market’s value rose to 95%. The S&P 500 began a six-month, 36% advance. According to Bloomberg, the eight previous times that cash peaked compared with the market’s capitalization, the S&P 500 rose an average 24% in six months.

This time, of course, it didn’t take nearly as long for the market to rally.

Still, the greatest appreciation so far has been in smaller stocks. That’s normal in an early bull market. But if the bull market continues, the big, blue-chip stocks are likely to lead the market higher for two key reasons:

• First, there is still over $8 trillion on the sidelines earning next to nothing in short-term deposits. Investors tip-toeing back into the market are likely to gravitate here since these stocks are the safest.
• And then there is the growing influence of cash-rich sovereign wealth funds…

Sovereign Wealth Funds – The Financial Assets of a Country

Sovereign wealth funds are the financial assets of a country – usually part of the national savings – that are owned and organized into a state-controlled fund and put to work to earn a higher return on investment.

(Sovereign wealth funds are not the same entities as foreign exchange reserves, which are often used for short-term currency stabilization and liquidity.)

In the past, most countries put their liquid assets to work in foreign currency deposits, government bonds or gold. (The hard-working Japanese and Chinese, for example, have kept our interest rates low by maintaining a steady appetite for U.S. Treasury obligations.)

But with the dollar relatively weak and interest rates on Treasuries near record lows, U.S. government bonds are not generating the kind of returns you write home about.

So world governments are slowly moving money into global equity markets. And the sums involved are fairly staggering.

Sovereign Wealth Funds Control More Than $7 Trillion…

According to The Economist, sovereign wealth funds already control more than $7 trillion today. The exact amount is impossible to ascertain due to lack of transparency.

But China, Saudi Arabia, Singapore and the United Arab Emirates alone are known to control more than $2 trillion. And more money is being allocated to these funds all the time.

What does this mean for you as an investor?

Expect to see cash coming off the sidelines to accumulate shares of the largest, most liquid firms around the globe. Quite frankly, they are the only companies that can easily absorb buying on this scale.

For example, take a look at the Dow Jones Global Titans Fund (NYSE: DGT). It holds the world’s 50 largest publicly traded companies.

World-Class Diversification in a Blue-Chip Portfolio

When you buy this cheaply valued blue-chip portfolio, you’re getting world-class diversification.

Companies like:

• Exxon Mobile,
• IBM,
• Proctor & Gamble,
• Wal-Mart,
• Coca-Cola,
• Nestlé,
• Toyota Motor,
• Roche Holdings,
• Samsung Electronics

… Are just a few of the names that are major holdings of the DGT fund.

These firms will almost certainly be an early stop for U.S. investors who get frustrated with low yields and start venturing back into the game.

These same companies are a natural home for sovereign wealth funds – and the growing trillions they control.

History shows that cash on the sidelines always grows itchy with time. The Dow Jones Global Titans (NYSE: DGT) is a good way to take advantage of it – ahead of the crowd.

Source: Sovereign Wealth Funds: $7 Trillion Reasons to Stay Invested

In fact, some stock market mavens are even starting to bandy about the “E” word – exuberance – and say it’s time to adopt a highly defensive position, or to even take some money off the table.

“Awhile back, I said that fair value on the Dow Jones Industrial Average was 7,800 – and that was if the economy was operating efficiently,” said Money Morning Contributing Editor Martin Hutchinson, a former international investment banker who now operates the Permanent Wealth Investor trading service – and who was recently cited by Slate magazine for having called the stock-market bottom. “But the economy isn’t operating efficiently. We’re rolling up huge deficits, and are rolling out huge stimulus packages. Those will both be highly inflationary. I’d say that – right now – fair value on the Dow was about 6,500 to 7,000, though it could easily bottom out at around 5,500.”

The closely watched Dow zoomed 214 points, or 2.6%, on Monday to close at 8,426, although it dropped modest 16.09 points to close at 8,410.65 yesterday (Tuesday).

U.S. stock prices have been on a two-month roll. On Monday, the Standard & Poor’s 500 Index gained 29 points, or 3.4%, to close at 907, a four-month high. That broad index, used by investing professionals to benchmark the market, opened the year at 903.25. It closed yesterday at 903.8, meaning it’s actually in positive territory for the year.

The tech-heavy Nasdaq Composite Index jumped 44 points, or 2.6% Monday, to close at 1,763. Even with yesterday’s 0.54% decline, the Nasdaq is up 11.0% for the year.

It’s not just the fact that the market has bounced back that has Hutchinson and some other investors concerned – it’s the forcefulness with which stock prices have escalated. After closing at a 12-year low on March 9, the S&P 500 index has rallied about 34%.

Investors have become increasingly optimistic that the U.S. government finally has a handle on the credit crunch and the financial crisis that’s grown out of that nightmare of bad debt and parsimonious lending. There’s a belief that the U.S. housing crisis has reached bottom. Even Money Morning’s Hutchinson says that the rate of decline in the U.S. economy has almost certainly slowed substantially, meaning a bottom may not be far away.

But a bottoming out in the economy doesn’t necessarily mean the U.S. economy’s many problems are at an end, Hutchinson says. With all the stimulus money flowing through the economy, inflation is certain to be a problem, meaning interest rates have to increase, Hutchinson says.

For instance, during the 1990s, inflation averaged 2.9% and the 10-year Treasury bond averaged 6.67%. The gross domestic product (GDP) deflator inflation index was at 2.9% for the first quarter of this year, and yet the 10-yearTreasury was trading at 3.15%, Hutchinson says. That means interest rates have to increase – a lot, a process that’s certain to blunt an economic recovery, he believes.

And if that happens, U.S. stock prices – ahead of themselves already – will drop back, as well.

It was back in mid-October when Hutchinson said the fair-value level of the Dow was 7,800. To drop back to that fair-weather/fair-value target of 7,800 from its current level, the 30-stock, blue-chip index would need to fall 7.0%

That’s more than just a modest decline, and would clearly be painful in its own right. But the Dow would have to drop an alarming 17% to 23% to reach Hutchinson’s foul-weather/fair-value range of 6,500 to 7,000, and a downright sickening 35% to hit his possible market bottom of 5,500.

And Hutchinson isn’t the only investment expert preaching caution.

Take Pacific Investment Management Company LLC’s (PIMCO) fixed-income guru Bill Gross, who says investors are far too optimistic about the U.S. economy’s near-term prospects.

“Do not be deceived by the euphoric sightings of ‘green shoots’ and the claims for new bull markets in a multitude of asset classes,” Gross wrote in PIMCO’s May outlook. “Stable and secure income is still the order of the day.”

In theory, the stock market is forward-looking, meaning stock prices reflect a future – three to six months down the road – that is obviously unknown to investors. The hard-charging rally of U.S. stocks in recent weeks has prompted an even stronger belief that the economic rebound is at hand, and that the recession that started in December 2007 may soon be over – if it isn’t already.

That doesn’t mean there are no profit opportunities available. Plenty remain. But it does mean investors need to invest cautiously, and may need to make some profit plays more suitable for bear-market environment – just in case.

Some “smart-money” strategists say that it’s time to take money off of the table, MarketWatch.com reported. In a recent research call, for instance, Raymond James Financial Inc. (NYSE: RJF) market strategist Jeffrey Saut says he has put his trading account all into cash, and has taken defensive positions (typically those that are designed to rise in price if the market falls) in case of a correction in stock prices.

“We have made a lot of money over the last eight weeks and continue to think the trick from here will be to keep that money,” Saut wrote in that research call.

Converting your profits to cash is one way to play this uncertain stretch, Hutchinson says. But there are several other strategies that will position you to continue generating profits, while also hedging against potential market unpleasantness. In his Permanent Wealth Investor trading service, Hutchinson says to:

• Buy high-yielding stocks for both income and capital gains.
• Buy gold both to profit, and to hedge against the inflation that’s certain to arise from the big government spending programs.
• And buy so-called “inverse funds,” to hedge and to profit. One such suggestion is the ProShares UltraShort 20+ Year Treasury Fund (NYSE: TBT), which seeks investment results that correspond to twice the inverse daily performance of the Barclays Capital 20+ Year U.S. Treasury Index.

A new bear market isn’t a foregone conclusion, either. U.S. Federal Reserve Chairman Ben S. Bernanke says the U.S. recession could end this year, and says that economic activity could pick up substantially in the year’s second half.

And there’s also an interesting wildcard at play. It’s a bit of anecdotal evidence that has proven bothersome to some investing professionals because it doesn’t fit with the way market rallies typically play out.

In most stock-market rallies, the initial catalyst comes from the big institutional players, who ignite the upturn. As the media drumbeat of the rally grows stronger and louder, retail investors start to join in – a little at a time at first, but then in growing intensity. By the time the main group of retail investors make the move, however, it’s usually almost time for the institutional players to cash out, since the trend they invested to profit from is typically almost played out, MarketWatch reported.

That’s pretty much what happened during the dot-com bubble, and is why individual investors took it on the chin.

This time around, however, it’s been different.

But this time around, anecdotal evidence – such as trading data from online brokers E *Trade Financial Corp. (Nasdaq: ETFC) trade and TD Ameritrade Holding Corp. (Nasdaq: AMTD) seems to suggest that it’s been the retail-investing crowd that’s driven this rally from the very beginning, while institutions have stayed on sidelines, cash in hand, Barry Ritholtz, chief executive officer and the director of equity research at Fusion IQ, told MarketWatch.

“The ‘dumb’ retail money is leading the gains,” Ritholtz said.

That could end up being good news for the stock market: Institutional investors, afraid to have missed the rally, might step in more forcefully, fueling a new-and-longer leg of the current bull market for U.S. stock prices.

If it turns out that this is just a “bear-market rally,” however, bad economic news will halt the rally and cause investors to punt.

The bottom line: Over the long haul, economic reality will guide stock prices, Ritholtz says.

“In this type of environment, the market is guilty until proven innocent,” he said. “We have to assume this remains a bear market until we see a more normalized economy, a recovery in some employment measures, and real estate to actually start improving – not just to stop free falling.”

Source: Is the Stock Market Rally For Real?

No matter what our government says about the true health of bank balance sheets, the real stress test for the U.S. stock market lies in what happens next to the BKX. I have a feeling the major averages will start following the banks should they continue moving lower, but who really knows? The safest prediction I can make is that the S&P 500 won’t be hanging around 850 much longer.