Sunday, November 2, 2008

The Week In Review

First the Rally
Rebalancing
My understanding is that much of the rally was the result of major asset class rebalancing within the mutual fund industry.

Say you run a “balance fund” where you are supposed to own 50% stocks and 50% bonds. The first 27 days of October, the stock component of your portfolio is down 27% for the month! At the same time, your bond holdings are up a few percent. Your fiscal year ends on October 31, so you need to rebalance to close out the year.

If you started October with $100 and a split of $50 stocks/ $50 bonds, then on October 27, you had a split of $36.5 stocks/ $52 bonds. So you have to sell about $8 of your bonds to buy $8 stocks.

If this is the case, then you would expect a lot of stock buying and a lot of bond selling going into month end. Stocks rallied 15.5% (S&P 500) and bonds (30-Year US Treasury) fell -5.4% in the last 4 days of October.

The same thing occurred in October 1987, when stocks rallied and bonds sold off in the last four days of the month (S&P 500 +13.3% and US Treasury -3.5%). That was the high for the first post-1987 Crash bounce. Stocks worked their way lower for a month, finally retesting the October 1987 low in early December 1987.

Again, crashes have always had at least one retest before a final low is put in!

Bailing Out Insolvent Countries
Did you notice the 22% rally in the South Korean stock market on 10/29? The rally was the result of a US Government bailout of the South Korean Government. Call it whatever you want - a “Swap”, a “REPO”… It was a bailout. It was a lifeline to an insolvent country.

Basically what our government did was trade 30 billion US Dollars for Korean Won (their currency). We did so, because clearly nobody trusts Korea enough to buy the new Won they intended to print to inflate their way out of their once-a-decade financial calamity.

I get the feeling that Korea will end up like that strung out relative who asks you for 100 bucks on Monday and then shows up on Friday to beg for more because they already blew the first 100. I have no doubt that Korea will be knocking on the Fed’s lending window again the near future.

This stuff is going on all over the world. On 10/29, the latest bailouts were South Korea, Brazil, Singapore, Mexico ($30 Billion each) and New Zealand. Ukraine ($16.5 Billion), Belarus ($4.5 Billion) and Georgia ($2 Billion) recently got loans from the IMF (International Monetary Fund). The IMF is financed in US Dollars by the US Government via the UN. It is headquartered in Washington DC and is run by (get this) a former Communist – un-freakin believable…

The total “REPO”/”Swap”/US Government lending money to foreign governments and banks program is now at least $450 billion. The US Government is no longer the “lender of last resort”, it is the “printing press of last resort”.

Internals of the Rally
I know that the markets will bottom long before the “fundamentals” do. The Stock Market is used as a “Leading Economic Indicator” by the US Government, because it moves before the economic data comes out to tell you why it moved. That fact is a big reason why I rely on charts so heavily, instead of the opinion of some talking head on television.

Maybe the markets put in a major low this week and the Bear Market is over. I have no clue, but I want to look at what happened last week and see if I can come up with some possible scenarios for what is going on and how it will impact my money.

Where is the Volume?
If this is the end of the Bear Market, then I would expect to see massive volume on the first couple up days. Because when this Bear Market ends, the first few weeks of the new Bull will most likely experience incredibly large volume on the up days. The last few days of rally, although impressive, have been on below-average volume (Red line in bottom chart).

Even worse, the rallies are doing the same thing they have done the entire leg down – they are spiking up into declining moving averages (Blue Line). Is anybody excited about this chart? I’m looking to short any further rally.

I think that the light volume which allowed traders to ping prices around from key level to key level last month is also what is allowing for the current spike up rally. My fear is that when the sellers show up, they will be able to spike the markets down just as hard and as fast as they rose.

Insurance Company Meltdowns
Several insurance companies got crushed this week. They seem to be the next shoe to drop. Take a look at how Hartford did this week. It was down -57% (Black Box and Arrow) on 500% of average volume (Red Arrow)!! That isn’t grandma selling, that is the big boys running for the hills.

This is The Hartford! As in, the 4th largest insurance company in America! They’ve been around since 1810. They look like the next US Government nationalization candidate.

Prudential looks the same and may also be on a fast track to nationalization.

I am going to make the blanket statement that the Life Insurance Industry cannot be allowed to fail. Insurance companies were allowed to fail in the 1929 – 1932 Bear Market and it ruined a lot of people. Moreover, it stigmatized the word “insurance” in the minds of an entire generation of Americans. If the government allows even one major insurance company to fail, then many other companies will unravel as investors take their money out of the insurance companies (a “Run” on products like annuities, life insurance, defined benefit plans, pensions, 401Ks, 403Bs…) and the current financial crisis will get several orders of magnitude worse.

So watch out if you own any insurance stocks, because AIG seems to be the model for how things will be taken over and with AIG trading for $1.96, that doesn’t seem to be a profitable venture for a stock or bond holder. I would include Berkshire Hathaway in this group, because of their heavy exposure to the insurance industry.

The root cause of the demise of Hartford is either in their Commercial Real Estate holdings, their Bond holdings or a combination of both. Remember, insurance companies have incredibly large portfolios of Commercial Real Estate and Bonds. They take in your premiums and buy assets designed to pay out when your claim is expected. The best assets for this have proven to be Commercial Real Estate and Bonds.

My guess is that the insurance companies made too many promises they could not keep and they used massive leverage to back up these promises. Now leverage is killing their balance sheets as asset prices fall.

I remember reading how Modern Portfolio Theory opined that the optimal leverage for a Hedge Fund was 6.2 to 1 (620%). That leads to great performance on the upside, but when prices fall, all it takes is a 16% move down on asset prices to wipe you out. The problem with this Bear Market is that you have a lot of funds with massive leverage, who are all trying to sell at the same time to cover their margin calls!

Leverage is just borrowing to buy stuff (think a margin account on steroids). But just like with a margin account, when your equity falls below a certain level, you have to come up with new money by either selling holdings or depositing a check.

It is clear from the recent actions out of Washington, that the only entity left that is able to buy these assets is the US Government. This is because the only currency being accepted by sellers in the US Dollar. Thus all the lines of credit to companies, money market accounts and foreign governments.

How much stuff does the US Government need to buy before the economy starts to grow again? I have no clue. But the markets will tell me long before it occurs. And I will tell you what I see, when I see it.

The Bond Markets
I’ll get into Commercial Real Estate at a later time. Today I want to focus on the Bond Markets.

I have been taught to look at how stocks perform within a group to determine where the strength is. I want to show you the internals of the Bond Market to show you what is working and what is not.

I list the following charts of components of the bond market from most safe to most risky –

SHY – The 1 to 3-year US Treasury Index
TLT – the 20-year US Treasury
LQD – The Investment Grade Corporate Bond Index
HYG – The High Yield (Junk) Corporate Bond Index

In which of these would you like to have your money focused? My clients are in equivalents to SHY. It hurt last year to draw the low yield, but we avoided losing a lot of money!

All I can say is that on this spike up rally in stocks, the safe bonds (SHY, TLT) have pulled back into massive support. At the same time, the risky stuff (LQD, HYG) are rallying up into declining moving averages. Look at all the volume on LQD between 100 and 107, and on HYG between 90 and 97. It will take forever and a day to get back up through all of that stuff… LQD looks real heavy to me. It looks like a little concerted selling can take LQD back down to 80 very quickly. We’ll see.

There will be a time to swap out of the safe stuff and into the risky stuff, and I will be waiting for it when it comes.

The Deflation Trades
The Inflation trades have now become Deflation trades. TIP is the Inflation-adjusted US Treasury Index. It has been hammered lately as it is pricing in Deflation.
If my thesis is correct and inflation will be ramping up in the not too distant future, then this sell off in TIP may prove to be very profitable.

The vaulted “Yen carry Trade” continues to unwind as investors sell assets in Emerging Markets and cover their borrowing in Yen. This has led to massive demand for Yen and the Yen (FXY) has gone vertical the last few months. The Yen has now pulled back into big support and a key moving average. I need to keep this one on my buy list.

Notice how the Yen has pulled back into support, while the New York Stock Exchange ($NYA – bottom of FXY chart) has rallied up into resistance. That can’t be a good thing for stocks.

Remember how the Dollar was doomed and the Euro was the “New Dollar”?
Here’s the Euro (FXE). I see a broken chart with price imploding, and long term moving averages rolling over and starting to point down (Green & Blue Lines). That is the definition of a Bear Market. Maybe next summer is the time to go to Europe again…

What does all of this mean? The assets in Bear Markets have bounced on low volume. The assets in Bull Markets have pulled back on light volume. I think the stock market rally will end in a nasty selloff as soon as the big volume sellers decide to start liquidating again. I am building shorts in anticipation of this.

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