Heron Financial Group

We conclude that stocks are at the cheapest valuations in 50 years. We thought US stocks would close out 2011 with a gain of at least 8%. On a valuation basis stocks should be 15-25% higher. However, investors dont care until the situation in Greece is resolved, and that wont be until the New Year at the earliest. So rather than obsess we need to stay focused on the final destination. Of course we can deliver a 50 page financial plan, but sometime a simple picture is worth a 1000 words. Thus we present a basic tool for visualizing your assets via a pie chart.

The Europeans do not yet have a political structure for engineering a rescue, and that will be the over-hang in Europe. They will figure it out - eventually. The risk remains whether Italy, Spain, Portugal, Ireland will require equivalent rescues. The largest unknown risk is: of all the banks and hedge funds that sold Credit Default Swaps on Greek bonds, do any have enough capital to pay off their exposure. Remember that the US Treasury directed $62 billion to AIG to cover CDS exposure at that firm in 2009. We doubt that the European central banks are prepared to do the same.

Who wins from the volatility of last week? High frequency trading firms that can effectively manipulate the markets by placing thousands of one sided trades on individual stocks, or even more effectively on thinly traded ETFs, to force the market one way or the other. There are no uptick rules and no margin requirements preventing these firms from setting up an initial position, manipulating the market in the right direction, and closing out the trades with a profit a few minutes later. Who loses?Pension plans, endowments, mutual funds, individual investors and corporations.

Following the positive jobs report today, stock prices swung between gains and losses, and closed at the low for the year. Where have we seen this before? April-July 2010. In that time frame, stocks fell 15.6%, erasing all the gains of that year, but still closed out 2010 with a gain of 15.1%. Our forecast for 2011 remains at plus 8%, which would be 13.7% above current levels. So what are we doing this week and next? Buying stocks!

Why do we find Nantucket so interesting? Generally speaking the families that summer on Nantucket represent the top 1% of incomes and assets of any families in the entire country. In the summer of 2009, these decision makers were so frightened that families with $10 million in the bank were afraid to buy a T-shirt on Main Street. In the summer of 2010, families unwound a bit and actually went out to dinner, though the reduced patronage put a number of island restaurants and retail stores out of business. This summer things are growing again.

US earnings reports start the second week of July. Research in Motion?s negative pre-announcement this week is the only earnings miss worth mentioning. Earnings among financial service stocks are under pressure. Without junky mortgage backed securities to sell, not much profit on Wall Street these days. Excluding financials, earnings are expected to grow 11% in Q2, though year over year revenues are expected to be flat. Most economists expect GDP growth to accelerate in the second half of the year as the Japanese supply chain issues are sorted out and commodity prices moderate.

Stocks rallied in April, closing at the high for the year and the highest level in three years. With stocks up 9.1% through April 30th versus our 2011 forecast of 8%, we see stocks as fully to slightly overvalued. In fact, given the lack of substantial ?new? news to push stocks one way or the other, we expect a 10% trading range that could last through the summer and into the fall. On February 28th, David Edwards commented on Bloomberg Radio that ?the S&P 500 could fall 10% in the next six months,? but that he wouldn?t change his strategy because he expected a 20% rally on the other side.

So if we couldn?t predict either the Libyan civil war or the Japan earthquake, how did we ?know? that the two year rally in US stocks would falter? Quick answer is that we didn?t ?know? anything. But we do have a good sense of when stocks are fairly or over-valued. Consider the game of backgammon, which comprises a board, 15 pieces per side, and dice. For a given configuration of the pieces and a given roll of the dice, there is only 1, or possibly 2 or 3 optimal moves that a player can make. It is so simple that if two experienced players played 100 times each to win about 50 games.

Americans are in a tough spot, but American business is in great shape with record profits, strong balance sheets and solid revenues from international operations. The stock market is getting frothy, as typified by increasing M&A activity. In 5weeks, the S&P 500 is up 5% on the year, and our forecast for the whole year is 8%, which gives us that ?walking on thin ice? feeling. We?re not in the position to jump out of the market. We would turn bullish if we got sustainable job growth of 250K/month or better.

As the first 5 days of January go, so goes January! As January goes, so goes the year! That?s the theory, anyway. US stocks gained 1.2% in the first week of the new year, on top of the 6.7% gained last month. That?s a year?s return in 6 weeks, which makes us think ?too far, too fast.?

The easy money has been made, particularly in certain economically sensitive sectors. Returns in bonds could be flat or even negative over the next several years. We?ve substantially increased our exposure to boring old consumer staples, utilities, REITs and telecomm stocks, which offer dividend yields starting at 4% and ranging up to 12%. We expect US GDP growth to range between 2-3% over the next 4 quarters. In that environment, we would forecast gains in the S&P 500 of 8-10%, but now we wonder whether December?s 6.9% gain has already accounted for most of 2011?s stock market returns.

We?ve been trying to understand what makes the market psychology schizophrenic, and we remember, of all things, the Diana Ross concert in Central Park in July 1983. Over 500,000 people gathered on the Great Lawn for an annual free concert (Simon & Garfunkel, the Beach Boys, the B-52?s were acts in other years.) About 15 minutes into the performance, a terrible thunderstorm blew in, the sky turned black, lightning split the sky and over 2 ? of rain fell in the next 30 minutes, which quickly turned the meadow into a swamp.

Investors chasing yields have bid up the prices of corporate bonds and preferred stock, while Treasury bonds, near post-war lows, barely yield more than inflation. Emerging markets stocks and bonds are doing well, but the high returns of 2008 are unlikely to happen again. Indeed, after a decade of pariah status, perhaps the only asset class that offers a reasonable risk-adjusted return is U.S. stocks. Even so, expect no more than 8 percents returns including dividends until the debt deflation process is complete in another 5-10 years.

With federal tax credits for housing done, housing sales plummeted 26 percent in August. To soak up excess capacity in construction, the Obama administration just proposed a $50 billion infrastructure spending plan. Whether such a stimulus can be approved by a recalcitrant Congress two months before midterm elections is of course a big question. There already should be another round of excellent earnings in October, however, as well as an 8 percent year-end return in the S&P 500.

The time to buy stocks is when the economic forecast is grim. If you wait until the forecast looks good, stock prices have already moved higher. Fears of a double-dip recession have kept a lid on stock prices since April. The stock market, however, now feels like a pressure cooker on the boil, with earnings growth as the heat source. Short-covering rallies, meanwhile, are usually explosive to the upside. Heron therefore continues moving cash into stocks, as there are plenty of companies with great prospects and reasonable valuations.

The gold market looks like yet another bubble. Over the last three years gold gained 85 percent while the broader Commodities Index declined 19.8 percent. The current surge, however, is related to 'fear factor' trade compounded by huge hedge buying of gold futures. Meanwhile, even after the rally of the last week, stocks still look cheap. The S&P 500 should close out 2010 with a gain of 8 percent, which is 9 percent higher than current levels. Corporations flush with cash and with surging revenues and earnings are a buy.

Many investors are hesitant to add to their stock allocations due to negative returns over the past decade. The problem is that alternative investments have performed just as badly, if not worse. Ten thousand appears to be a hard floor for the Dow, despite investors' fears. Markets are thinner and more easily manipulated during the summer time, but July earnings reports should paint a rosy picture. NASDAQ is implementing expanded 'circuit breakers' to sideline stocks with unusually large moves - anything to reduce volatility and get investors interested in stocks again.

Leverage ratios are way down since the financial crisis. The issuance of leveraged securities such as collateralized debt obligations, collateralized loan obligations and commercial mortgage-backed securities is nearly completely halted, and so the 'brushwood' necessary to stoke the next financial crisis is almost entirely absent. Heron also comments on the significance of Greece, Thursday's 'flash-crash,' the weakness of financial regulation, technicals vs. fundamentals, and investment strategy.

The S&P 500 rallied in March to an 18 month high, but is still below pre-recession levels. The daily volatility of the stock market has declined to levels not seen since the summer of 2006. The overall stock market, however, is still slightly overvalued. Corporate earnings and Federal Reserve policy over the next year will determine whether current levels are sustainable, and whether the U.S. avoids another double-dip recession. Sound frameworks for investment analysis will be crucial.

Heron Financial Group president David Edwards says the 6.9 percent decline in the S&P 500 since January 19 was a normal market correction, and he expects positive returns in the S&P by the end of the year. He proposes several regulatory reforms to discourage "negative sum" products and restore investor trust.