Funds, Bonds, Feds, Meds

September 4, 2006

According to the Investment Company Institute, fund investors pulled about $8.4 billion out of stock funds in June. As is often the case after fund investors bail on stock funds, stocks moved back up after investors did.

The last time investors turned negative on stock funds was in February 2003, when they cashed out $11 billion. And wouldn't you know it, February 2003 turned out to be a great time to get into stock funds. The S&P500 climbed around 20% over the next 6 months – and over 36% for the year after February 2003.

As we've noted before, early this year fund investors were plowing tens of billions into funds – right before the market caved in. Now that market is rebounding, and inflows have improved again. This sort of buy high/sell low/buy back high is exactly why fund investors typically underperform the market, and why we try to do the opposite of what most investors do.

<b>Bonds – another rally?</b>

Bond king Bill Gross (who manages the Harbor Bond fund that is found in several of our portfolios) may be right after all. The big move up in interest rates that threatened to bring down the over-inflated housing market reversed course, leading to fairly nice gains in bonds in recent weeks. 

The thinking these days is that the economy will weaken in coming months – enough to nip inflation in the bud. Recent stock market strength seconds the notion by adding that the economy may slow, but won’t collapse. All bets are on for the utopian soft landing. So far so good. Falling longer-term interest rates should offer some support to the housing market. 

If we could do it all over we would have increased our bond stake in our model portfolios when the bond market was slipping a few months ago. We didn’t see panic selling by fund investors so it was hard to see it as a big buying opportunity – and we already have bond funds in all of our portfolios.

<b>Federal “Open Sesame” Market Committee</b>

Notes from the August 8th FOMC (Federal Open Market Committee) <a href="http://www.federalreserve.gov/FOMC/minutes/20060808.htm">were released</a> on August 29th, giving investors an inside look at what the handful of experts in charge of your financial future are thinking. 

This past meeting was more significant than most, as the powers that be have decided to stop their rate increasing campaign at a 5.25% Fed funds rate, which is the foundation of many shorter-term interest rates.

A few things are apparent from the new Fed notes: They mention the real estate market more than the people on a typical episode of House Hunters. 

The recent trends in the housing market were discussed about a dozen times. What about the stock market – the core measure of the health and profitability of our nation’s corporations (and employers)? One brief mention. Compare this to the Federal Reserve stock market obsession of the late 1990s.

The Federal Reserve seems to have no idea where inflation or the economy are going, though they try to disguise their cluelessness with lines like, <i>“…most participants expressed the view that core inflation was likely to decline gradually over the next several quarters, although appreciable upside risks remained.”</i>

In fact, the primary logic behind coasting for a while at a 5.25% fed funds rate is to see what happens. (“…keeping policy unchanged at this meeting would allow the Committee to accumulate more information.”)  

Maybe they should have paused on the way down (cutting rates) and “accumulated more information” on how nuts the housing market would become with a 1% Fed funds rate and “free money – no questions asked” signs practically hanging in bank lobbies.

<i>“The full effect of previous increases in interest rates on activity and prices probably had not yet been felt, and a pause was viewed as appropriate to limit the risks of tightening too much” </i>

Like a teenage driver, the Fed seems less concerned when hitting the (economic) gas pedal than when applying the brakes. Nobody likes a fun sponge. 

Toward the end of the meeting this zinger came up: <i>“Conveying the degree of uncertainty and conditionality about Committee expectations of future developments was seen as a major challenge.”</i>

In other words, they don’t know how to tell us (in a way that won’t cause panic) just how clueless they are about the future of the Frankenstein Economy they created in the lab of the world’s most powerful bank.

One voting member didn’t even want to stop raising rates – so great his fear of inflation. Nine others saw things differently. If Fed members start to think something big and bad is starting to happen – wildfire inflation or a deep recession – we’ll see some C.Y.A moves. Nobody wants to take the blame if big economic trouble brews.

<b>Drugs on the move</b>

It seems the fears of lawsuits and poor product pipelines swirling around big drug companies has fallen to the wayside. With interest rates turning south and fears of mild recession taking center stage, the high dividends and reliable earnings of drug companies are finding fans. This has helped our Healthcare SPDR (XLV) exchange-traded fund beat the market in recent weeks.