Four Reasons

The following financial market commentary was written by Matt Malick and Ben Atwater of Atwater Malick LLC. Ben and Matt have developed a sound and unique investment philosophy for their clients. They regularly write market commentaries and I plan to post them here for interested followers. You can learn more about them at www.atwatermalick.com .

Last week, the S&P 500 saw its third consecutive weekly drop and has tumbled 7 percent since reaching a 15-month high on January 19^th. The index is down 3.5 percent year-to-date, having suffered its first monthly decline since October and the biggest since it plunged 11 percent in February 2009. According to the Stock Trader’s Almanac, the performance of the S&P 500 in January is a reliable predictor of how it will fare during the full calendar year. Before last year, when the index dropped 8.6 percent in January and then rose 23 percent for the year, the so-called January barometer made only five erroneous predictions since 1950. However, below are four reasons we believe that the recent selloff is part of a temporary correction amid a rally that began in March 2009 and will eventually reconstitute itself and lead to a multi-year bull market:

1. One gauge of investor sentiment, the Chicago Board Options Exchange Volatility Index (VIX), also known as the fear index, rises when buyers are speculating that equities will retreat, because the gauge, according to Bloomberg News, moves in the opposite direction of the S&P 500 more than 80% of the time. The VIX opened Wednesday the 20^th, the first day of the selloff, at 18.51 and it ended this week at 24.56, a 33% increase. In its 19-year history, the average reading on the VIX, also according to Bloomberg News, has been 20.28. Clearly, the fear index reflected relatively little investor nervousness coming into the sell-off, a potential warning of the correction we are now experiencing. Overall, this explosion in the VIX indicates to us that investors have moved from complacency to panic too fast, often a contrarian indicator.
   
2. According to Michael Santoli, writing in the Monday, January 25, 2010 edition of Barron’s, “Citigroup strategist Tobias Levkovich points out that inflows into bond mutual funds over the past six months are three standard deviations above their 10-year average, an extreme level of change that has typically had nasty implications for the asset class in question.” In other words, the extreme favoritism individual investors are showing toward bond funds is converse to the disrespect they are showing equity funds. According to TrimTabs Investment Research, December was the fifth month in a row in which mutual fund investors pulled more money out of domestic equity mutual funds than they contributed. December’s net outflow came to $7.2 billion, bringing the total since the beginning of March to $29 billion. If the market does not resume its bull market run, this will be one of the only times in anyone’s memory when mutual fund investors predicted the market’s subsequent move.
   
3. While professional investors have been better market timers than individual investors, they have also displayed an unimpressive track record. And although sentiment has improved significantly from its lows, financial market practitioners are still mostly negative. Bloomberg News reports that 43 percent of respondents in a quarterly global poll of market professionals who are subscribers to the Bloomberg Professional Service say the international economy is improving, up from 37 percent in October. Thirty-eight percent said their country’s benchmark stock index will rise in the next six months; 33 percent say it will vary little and 27 percent say it will fall. This subdued sentiment leads us to believe that professional money managers have not fully committed capital to equities, meaning there is still a great deal of money on the sidelines.
   
4. Earnings, which fundamentally should drive stock prices over the long-term, have been very strong so far this earnings season. For example, six of our companies announced earnings this week and, in five cases, these companies exceeded the average analyst estimates. More broadly speaking, Bloomberg News reports that “a record nine-quarter earnings slump for S&P 500 companies is projected to have ended in the fourth quarter with a 73 percent increase in profits.” Also according to Bloomberg, nearly 80% of the U.S. companies that have reported earnings since January 11^th have beaten analysts’ estimates (153 out of 192 companies).

Friday’s GDP report further evidenced a stronger recover than many have yet contemplated. Bloomberg reported, “The 5.7 percent increase in gross domestic product at an annual rate reported by the Commerce Department in Washington today exceeded the 4.8 percent median forecast of economists . . . Separate reports [on Friday also] showed consumer sentiment and a barometer of business activity rose more than forecast in January.

Overall, the market appears to be in the process of a natural correction following a huge rally. This correction most likely has some distance to travel. But, as far as we can tell, the recent pullback has no fundamental economic or earnings-based rational whatsoever. This means that the market is acting irrationally, based on pessimism and fear, no reason to abandon our long-term optimism.

Pennsylvania Scientists and Economists' Call for Action

I recently received a request to join Pennsylvania scientists and economists in signing a "call to action" letter on global warming that will be presented to state legislators in the coming weeks. I thought readers might be interested in the letter and my reasons for not signing the letter. Below is the "call to action" letter and my response to the organization follows.

You can get more information about the letter and the organization at http://www.ucsusa.org/global_warming/solutions/big_picture_solutions/pennsylvania-call.html

Pennsylvania Scientists and Economists' Call for Action

We, the undersigned scientists and economists living and working in the Commonwealth of Pennsylvania, support the U.S. Scientists and Economists’ Call for Swift and Deep Cuts in Greenhouse Gas Emissions, which calls on our nation’s leaders to act quickly to cut emissions sufficiently to protect against the worst effects of global warming and states that such action creates economic opportunities for the nation.

New climate science research shows that we are feeling the effects of climate change faster and more intensely than the models projected when the statement was drafted, underscoring the need for urgent action to reduce emissions.

Taking action to move to cleaner sources of energy and reduce global warming emissions will inevitably have short-run consequences for some industries and some regions, which will need resources in order to adapt. Fortunately, climate action also creates economic opportunities for the Commonwealth, including new jobs in the energy efficiency and renewable energy industries, and the opportunity for Pennsylvania to become a world leader in renewable energy technology. Moreover, energy efficiency can help consumers to save on transportation, heating and electricity costs, and policies can be designed to assist consumers and industries make the transition to a clean energy economy.

On the flip side, without strong leadership and action, Pennsylvania could experience significant changes because of global warming, changes that will create adaptation costs for the Commonwealth. For example, by the end of the century, without action:

• Many Pennsylvanian cities would expect dramatic increases in the number of summer days over 90°F, putting vulnerable populations at greater risk of heat-related health effects and curtailing outdoor activity for many.
  
• Snowmobiling conditions would disappear from the state, and widespread ski resort closures could result as winters become too warm for snow-natural or human-made.
  
• Yields of native Concord grapes, sweet corn, and favorite apple varieties would decrease considerably as temperatures rise and pest pressures grow more severe.
  
• Climate conditions suitable for prized hardwood tree species such as black cherry, sugar maple, and American beech may decline or even vanish from the state.

The good news is that the Commonwealth is well placed to take advantage of the new economy created by strong climate change policy. Many Pennsylvanian entrepreneurs in the energy efficiency and renewable energy sectors are already experiencing growth throughout the state.

We cannot wait until the economy recovers to begin reducing global warming emissions. We respectfully urge the Congress of the United States to act rapidly and sensibly. As Congress crafts comprehensive climate and energy legislation, key provisions in the bill should:

• Require global warming pollution reductions commensurate with the scientific urgency–on the order of 35 percent below today’s levels by 2020 and 80 percent by 2050.
  
• Require polluters to buy credits for their global warming emissions at an auction, and use the auction revenue for the public’s benefit by investing in programs that can help reduce emissions and ease the transition to a clean energy economy.
  
• Require 25 percent of our nation’s electricity to be generated from renewable resources by 2025.
  
• Exclude loopholes that would let polluters delay or avoid needed emissions reductions, especially unlimited carbon “offsets” or a price ceiling that limits the fee for emissions.

We hope you will demonstrate your commitment to responsible stewardship of America's environment for our children and grandchildren by supporting scientifically and economically sound climate and energy policy.

---

Jean Sideris
Outreach Coordinator
Climate Program
Union of Concerned Scientists
Cambridge, MA

Jean,
I agree that climate change is happening and that the actions of humans are accelerating climate change. I also agree and support actions that will mitigate the external costs associated with climate change. However, I do not agree that the policies highlighted in the letter are the policies that will create the greatest net benefit to society. I have been reading about some innovative and lower cost solutions to mitigate climate change and I believe we should also consider the theory that reversing course now on “global warming pollution” will have very little affect on the estimated external costs and therefore we should be looking at ways to cope with a warmer planet. Unfortunately, when politicians, lobbyists, and scientists who discard their “scientific cloak” (as Buchanan (JLE, 1959) would have described them) get a whiff of what seems to be public opinion or conventional wisdom, whether right or wrong, their actions tend to stifle innovation, research, and better policy.

In my opinion, it is far more important that we seek out solutions to the externalities of global warming that result in the greatest social benefit at the least possible social cost and I believe we haven’t explored all options yet. I also believe that if this argument were presented to some of the economists who have not signed this letter, you might see a different level of support. In fact, if this point were emphasized more in your letter, I would sign.
Mike Gumpper

Tax on Tuition

Many city and municipal governments are struggling to balance budgets (most have balance budget requirements unlike the federal government) in the wake of this recession. Tax reveune is down and government spending is naturally high given that more citizens qualify for income assistance programs during tough economic times. The balance budget requirements of local governments handcuff cities into raising taxes and/or cutting government services at that absolute wrong time. Hence, many local and state governments are getting creative about how to raise taxes. As the state of PA contemplates legalizing table games, cities desperate for revenue are trying anything, like taxing college tuition.

http://www.nytimes.com/2009/12/16/education/16college.html

Given that most schools get federal funds and students at the University of Pittsburgh, for example, receive over $4500 per student in funding from the state of Pennsylvania, it does show some ingenuity on the part of Pittsburgh city planners to try and siphon off federal and state funds back to the city's budget. But at what cost? The city is going to take a lot of heat from a potentially vocal constituency that often has a lot of time on its hands.

A more equitable tax on students might be to tax university endowments and the profits of the for-profit colleges and universities. The University of Pittsburgh has one of the nation's largest endowments for a public university (yet they still enjoy a significant taxpayer subsidy from PA residents). I'm sure Carnegie Mellon's endowment is considerable too. State owned universities and community colleges have little or no endowment and get a considerable amount of their funding from state taxpayers.

Also, just in principle, I would be bothered by the fact that my tax dollars that partly fund higher education across the state would be siphoned off by the city of Pittsburgh to pay for retired city employees.

Dubai

The following financial market commentary was written by Matt Malick and Ben Atwater of Atwater Malick LLC. Ben and Matt have developed a sound and unique investment philosophy for their clients. They regularly write market commentaries and I plan to post them here for interested followers. You can learn more about them at www.atwatermalick.com .

In many ways, Dubai was the ultimate example of the debt-fueled excesses that led to the global financial crisis as it rapidly expanded infrastructure, transportation systems and residential and commercial real estate. Now that the global economy has slowed and the availability of credit has contracted, Dubai’s state-run companies are seeking to delay the repayment of debt, which many traders essentially view as a default.

We are following the situation as it unfolds, in particular as it relates to the long-term investment thesis behind each of our “focus list” stocks. Although global stock markets have sold-off in response to the news, losses have been relatively modest thus far, and we are not making any immediate changes in our client portfolios. Frankly, outside of potential portfolio exposure in financial stocks, we expect the direct impact of the these events on our companies to be nonexistent. But, the indirect effects on the financial markets are indeterminate and impossible to predict. Any action at this time would be emotional rather than enlightened.

For those of you who are interested in learning more about Dubai, here are links to an excellent two-part 60 Minutes story from August of 2008, when Dubai’s growth was at its peak. We find it particularly entertaining to watch this report with the benefit of hindsight.

http://www.cbsnews.com/video/watch/?id=4312234n&tag=contentMain;contentBody

http://www.cbsnews.com/video/watch/?id=4312039n&tag=contentMain;contentBody