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The 10-year train wreck and what's ahead

>> If, on December 31, 1999, you had asked a hundred experts where the domestic stock markets would be in 10 years, nearly all would have said “up.” They would have disagreed on the amount, but not the direction.

We now know the experts would have been wrong. Very wrong. As of December 31, 2009, here’s where three major markets stood after 10 years:

• Dow Industrials: 8.5% down

• S&P 500: 23% down

• Nasdaq: 44% down

And that’s without accounting for inflation. Investors would have done better in bonds. In fact, they would have done better in plain old cash—bank accounts and money markets.

Ahh, but what about the future? The S&P index of 500 large-company stocks went up 23.5 percent in 2009. With all that momentum, won’t it keep going up in 2010?

We don’t see why. There may be some upward spikes, but we think stocks cost too much in relation to their 12-month potential. According to Yale’s Robert Shiller, the average P/E ratio for large-cap stocks over the last 130 years is about 16. It now stands at 20. Twenty-five percent higher. That lofty level might be justified, if it were not for all the obstacles on the track. For example:

• The unemployment rate is 10 percent, and we still have about 15 million unemployed or under-employed. They won’t be buying much.

• The residential housing market remains weak, despite vast government support. That support is due to disappear in the spring of 2010.

• Increasing defaults on commercial mortgages will continue to cripple banks and restrain lending to consumers and small businesses. Over 130 banks failed in 2009; another 400 or so are on the FDIC’s watch list. The credit crunch continues.

• Massive government debt may eventually spur high inflation, leading to a Catch 22 for the Federal Reserve: If it raises interest rates to hold back inflation, it will also hold back the recovery.

Self-defense: Consider the merits of watchful waiting (provided you have a portfolio that’s appropriate for your age and situation). It’s dangerous to get out of stocks, because it’s extremely hard to know when to get back in. But with stocks looking expensive, it may not be a good time to increase your equity holdings. Sometimes the best action is no action.

How to spot and avoid investment traps
A Financial Threats.com Word to the Wise

>> Suppose someone offered you a 9 percent return on a two-year loan to what appears to be a successful company. Would you bite?

We hope not. Because it’s an obvious trap. We’ll explain why in a moment, but first understand this is no hypothetical case. It’s an actual deal that many Midwestern people fell for. The company behind the deal is under investigation for allegedly running a Ponzi scheme—using money from recent investors to pay back early investors.

The interesting thing is that every person who invested in this alleged scam was probably familiar with the old saying, “If it sounds too good to be true, it is too good to be true.” Yet they put their hard-earned money into it.
Why? The reason must be that they didn’t know how to evaluate the promised return. Fortunately, the process is simple. All you have to do in this case is plug “short-term corporates” into your search engine—and you’ll see that 9 percent is way too high for a 2-year loan to a solid company.

A simple rule
In the fixed-income markets—especially bonds and notes—market prices are generally a much more reliable guide to value than in the stock markets. So the rule is, If a fixed-income security has an abnormally high yield, you can be certain it carries an abnormally high risk. For all practical purposes, there are no big bargains in the U.S. fixed-income markets. High return means high risk; low risk means low return. No exceptions, no matter how good a salesperson’s story may sound.

Though stock market pricing is looser than fixed-income pricing, the same sort of thinking applies. When Madoff investors were told they’d get 15 percent a year, every year, no matter what, alarms should have gone off in the investors’ mind. Long term, the return on large U.S. companies is only about 9 percent, depending on the period measured. So how could Madoff return a perpetual 15 percent? Only by taking a lot more risk. Or by committing massive fraud.

And you can take that to the bank.

For more help on how to avoid scams, read Scam Alert, especially the section that begins with Online help.

About those rosy forecasts

>> Good things are happening: With third-quarter GDP up 2.9 percent (revised downward from 3.5 percent), the unemployment rate slightly down, and stock markets up by double figures year-to-date, an optimist could argue that our troubles are almost over. That may be why some stock market gurus are predicting that stocks will continue their erratic march upward.

Don’t hold your breath. Despite the rampant optimism, there are good reasons to remain wary:

We could go on and on with dark predictions. But does this mean the optimists are necessarily wrong? No. What the dark-side facts and estimates tell us is that, by all that’s logical, 2009 will not be a great year for U.S. stocks. But the markets are only semi-logical. They’re like us, partly logical and partly emotional. (For sophisticated documentation of this point, read the new book, Animal Spirits, by George Akerlof and Robert Shiller, Princeton Press, 2009). Which means the current surge could continue, despite logic. Given all that, what’s an investor to do?

Self-defense: Consider this approach: Don’t necessarily rush out of stocks just because they look over-priced, because if you do, you may not know when to get back in. Major upward moves can occur in less than a week. On the other hand, think twice before making big bets based on short-run surges. Bear markets usually include short-term rallies, followed by dismal drops.

For some of the best guidance and information about your investments, go to www.wsj.com, www.smartmoney.com, www.nytimes.com/pages/business, www.vanguard.com, www.fidelity.com, and www.marketwatch.com. If you’re more sophisticated than the average investor, be sure to include www.bloomberg.com and www.barrons.com.

Caution: No one, including FinancialThreats, knows what the markets will do. Humans cannot predict the future, and the past is not a reliable guide.

Fear stokes Treasury prices

>> A curious thing has happened.  The huge amount of money pumped into the economy by the federal government should have raised interest rates and lowered bond prices. Instead, the price of Treasury bonds rose significantly in the third quarter. This happened because investors seem to think Treasuries will protect them from the effects of deficits and deflation, in case the recovery slows to a crawl. But if the recovery picks up speed, prices would rise and so would interest rates—two events that usually depress the price of bonds.

Self-defense: Consider two adjustments to your bond portfolio: Reduce the percentage of Treasuries in favor of corporate bonds and increase the percentage of shorter-term securities. One example worth a look: Vanguard’s Short-Term Investment Grade bonds, which yielded 4.28% at the end of the third quarter.

Think all AAA bonds are safe? Sorry!

>> The big news in bonds is Standard & Poor’s warning that U.K. bonds may lose their triple-A rating, followed by an equally dismal warning from Bill Gross, arguably the leading bond expert in the U.S. On Bloomberg television, he said that even the U.S. might eventually lose its triple-A rating. This would be a big deal, because ratings affect interest rates—the lower the rating, the higher the rate. Over time, higher rates could cost both countries many billions of dollars.

One result: As of mid-July, the year-to-date return on seven-to-10-year Treasury bonds, as measured by The Barclays Capital index, was down 6.3 percent. Meanwhile, yields (which move in the opposite direct of prices) rose to about 3.6 percent. The U.S. government has borrowed so much money that bond investors fear a return to long-term high inflation when the recession is over.

Corporate bonds, on the other hand, are less encumbered by huge amounts of debt and strike investors as a better deal. As measured by Barclays Capital, the year-to-date return on Intermediate-Term corporates was over 11 percent.

Self-defense: Depending on your circumstances, consider increasing the weight of corporate bonds in your portfolio relative to Treasuries. While you’re at it, take a close look at bond index funds for their low costs and high diversification. Note: In 2008, when the average intermediate-term bond fund lost about 4 percent, the broadest bond index gained over 5 percent. Finally, think about adding to your bank or money market account. This recession’s fat lady hasn’t sung yet, so it would be good to have, say, nine to 12 months of living expenses in a cash account.

Emerging markets surge, but…

>> So far this year, the best gains among the world’s asset classes have come from emerging markets. At the end of July, THE MSCI Barra Emerging Markets index was up over 40 percent, compared with a much lower increase for developed nations. Helping the gain was a promise by the Group of 20 nations to give the International Monetary Fund $750 billion, raising its total resources to $1 trillion. But are these markets worth all that enthusiasm? Many economists expect GDP growth in developing countries to fall from double digits to a less exhilarating 4.5 percent. That may sound good, but the fast-growing population in these countries means there may not be enough jobs, even at that rate of growth. Some of the fall-out could include a movement way from a market economy and toward centralized control (Venezuela, for example). Millions of people are hungry for a sense of stability—at any cost. Even smaller developed economies (Ireland, Italy, Greece) are shrinking. Riots have already occurred in normally peaceful countries like Greece, Italy, and the Baltic states.                         

Self-defense: Think twice before investing heavily in developing countries, despite (or because of) recent gains. For the average investor, it may be better to play for smaller gains in a diversified international stock fund.

Do you have this kind of annuity?

>> There is a type of annuity that guarantees a lifetime income of at least a stipulated amount. At least means that if your investments do better than the stipulated amount, you get the higher return. If not, you get the stipulated amount. Sounds wonderful. But if you have one of these—or are looking to buy one—there’s something you should know:

For policies written between 1997 and 2005 to 2006, the guarantee applies only if your account continues to have a required minimum balance during a waiting period that typically runs to 10 years. If you don’t notice that provision in your policy—and your balance drops too low—you could lose the guaranteed lifetime income. Policies written in the last few years may alleviate this problem with a no-lapse clause. But even then, if you withdraw too much money, you could still lose your guarantee.

Self-defense: Read the fine print in your policy; ask your salesperson or the company to confirm your understanding of what is guaranteed—in writing. For more information: www.annuity.com/guaranteedannuity.cfm,




Copyright © 2009 Richard Evans and Andrew Bromberg