Thursday, November 6, 2008

If I am right on this one, then you aren't going to want to read it

The last 6 weeks or so has seen a market experience incredible volatility. The Dow would trade in 800 to 1000 point ranges every day. The 1-day chart would look like a 1-year chart in terms of percentage moves.

The other characteristic was that the market would trade violently from key technical level to key technical level with virtually no resistance to any moves.

I noted these traits and even posted intraday charts on several occasions to illustrate how the traders had taken over and real buyers were nowhere to be seen.

I think I know what is going on, and I don't think I like the outcome.
There is no doubt in my mind that the government has used stock price appreciation as a policy tool. There is also no doubt in my mind that the Fed would buy stock futures to accelerate prices higher when needed to prop prices up. You can take my opinion for what it is, an opinion. But I have been pretty spot on in this Bear Market.

The rally into the election had classic fingerprint of Fed manipulation all over it. The markets would accelerate higher in overnight trading, when there is little selling volume to contend with and then you have these 200 to 300 point rallies in the last hour to make the price of the Dow look good for the headlines of the evening news. You can deconstruct the recent rally and see that the majority of the gains were done on these last hour moon shots and in overnight trading.

I think the Fed has taken a powder now that the election is over.

I think the markets have experienced this massive intraday volatility, because nobody wants to buy stocks for the long term at these prices. That tells me that prices are too high to find buyers.
If prices are too high to find buyers, then they need to fall to a level where there will again be an equilibrium between buyer and sellers. That is not a good thing if you bought recently or are fully invested in your accounts.

Don't kill the messenger, I am just telling you what I see and what is the most reasonable explanation for it.

Tuesday, November 4, 2008

Did I Miss the New Bull Market?

I know that some of you are asking yourself this questions. So I wanted to review a few things.

Like I mentioned earlier, it is amazing to me how all it takes is a few days of rallying to get everybody switched from being afraid of going bankrupt to being afraid of missing the “New Bull Market”.

This Bear Market has laid waste to people’s portfolios. Many of the “top mutual fund managers of all times” are down 40 - 50% for the year. I don’t know about you, but I can’t afford hits like that in my account. They got caught. They either bought too many financials because they were “values” or they bought too many commodity and energy stocks because they were chasing returns.

The average investor is now chasing stocks on this bounce because they have no discipline, no skills for determining what to buy and when to buy, they are down a heck of a lot of money and they are grasping at straws in an effort to make back some of their massive losses.

I wanted to take a look at interest rate cuts and tax cuts versus the stock market over the last two Bear Markets. Rate cuts are Black Arrows. Tax cuts are Green Arrows. It seems to me that the clusters of Interest Rate cuts precede at least one last leg down. I assume that if things were so great, then the Fed would not have to cut rates twice in October.

What amazes me about the chart is that there was a rate cut AND a tax cut AFTER the market had bottomed. That means you bottom on horrible news and people are still Bullish these days. Yikes!

What concerns me is that the moving averages (Red and Blue Lines) need to work their way a lot lower before the Bear is over.

When markets crash, they need time to repair the damage. They don’t just bounce and not look back. The markets were cut in half in a year. Yet everybody is still looking to buy and not miss out on the New Bull Market. Things don’t work that way. I expect at a minimum a retest or two of the October low. I would not be surprised to see us undercut the lows to scare the heck out of the remaining Bulls. Can you imagine how sick you would feel if you bought today and the markets put in NEW Bear Market Lows?

I have a couple questions for the Bulls -

If things are so good, then why did we have to bail out South Korea, Brazil, Singapore, Mexico, Georgia, Belorus and Ukraine last week?
Why did we cut rates .50% last week?
Why did Australia cut rates .75% last night?
Why will the ECB cut rates on Thursday?
Why did China cut rates twice in a month?
Why did Argentina take over the assets in the pension plans householded in their country to keep their country solvent?
Why are some floating the idea of taking over 401k plans to finance the next “New Deal”?
Why is a new “New Deal” needed or even being discussed?
Why is there talk of or need for another “Stimulus Package”?

The government tried to make you feel good going into the election.
Remember, asset appreciation has been a primary economic policy. Because it’s easier to prop up asset prices to drive consumption than it is to create jobs and use savings to drive consumptions. Americans are sick of this stuff and that’s why Obama won BIG tonight.

There are a lot of people out there who have no clue what they are doing. They never studied and they never came up with rules and disciplines for how to manage money. They don’t know when to get defensive and they don't know when to invest.

What we are going through right now concerns me. All you are seeing is classic a Bear Market, where people are terrified at the lows and then get sucked in on these vicious rallies. Emotions are driving decision making. That’s never a good think. My job is to get good information out to people so that they can make good decisions. I have had to work 18 hour days lately to overcome the insanity that passes as expertise on the television.

If you are an individual investor, then you are in an uphill battle. You need an unbiased advocate on your side. Otherwise, you will get caught up in the emotions of the day and do the wrong thing at the wrong time.

If things are so good, then where is the volume (why aren’t the big investors buying)?
The volume on this bounce has been anemic, just as it was on each bounce in the 2000-2003 Bear Market. The bounce is fast approaching huge resistance.

The Dow Jones Industrial Average
I went through all 30 charts today and they fall into 3 groups –
Oh My Goodness – Alcoa, Caterpillar, DuPont, GE, IBM, J&J, McDonalds, Merck, Microsoft and Wal-Mart

Rallying into Resistance – American Express, AT&T, Bank of America, Boeing, Citigroup, Chevron, Disney, Exxon, Hewlett Packard, Intel, Kraft, 3M, Pfizer, Proctor & Gamble, United Technologies, Verizon

Eh - JP Morgan, Kraft

Oh My Goodness can be broken down into two categories –

Hanging on for Dear Life

Rallying into Resistance

There are ZERO stocks in that Dow that look buyable. But there are many setting up as great looking shorts!

I am looking for leadership and right now I have 4 stocks that I see working. One failed its breakout hard today on decent volume. Other leadership will need to show up.

My assumption is that as the markets go through the process of testing and retesting the lows, new leadership will be able to form and eventually break out of consolidations on heavy volume. That is when I will be interested in buying again!

Until then, I am just looking to short rallies on anticipation of the highly-likely retest of recent lows.

Asset Price Appreciation as a Policy Tool

I sort of had an epiphany today. I was getting all upset about how manipulated today’s rally appears to be – 200 point gap up open, above obvious resistance and a 200-point rally in the last hour. All on Election Day for that great headline of the largest Election Day rally since 1984…

That got me thinking about the President’s Working Group on Financial Markets and as I read some articles today, all the pieces finally fell together for me.

I started to realize what a policy tool asset price appreciation has become. I started to see how prices going up made it easy for the government to avoid the tough public policy decisions required to create jobs domestically and get us back to real economic growth.

I’m not here to debate whether or not the “Plunge Protection Team” exists. I am merely going to quote a gentleman who was around when the “Working Group” was formed and opined about how the Fed could use their powers to manage the stock market, former Federal Reserve Governor Robert Heller.

A few days after the October 1989 market crash, Mr. Heller wrote the following in an op-ed, “Have Fed Support Stock Market. Too” in the Wall Street Journal (10/27/1989) –

“The stock market correction of Oct. 13, 1989, was a grim reminder of the Oct. 19, 1987 market collapse. Since, like earthquakes, stock market disturbances will always be with us, it is prudent to take all possible precautions against another such market collapse. In general, markets function well and adjust smoothly to changing economic and financial circumstances. But there are times when they seize up, and panicky sellers cannot find buyers.”

“(A)n appropriate institution should be charged with the job of preventing chaos in the market: the Federal Reserve. The availability of timely assistance -- of a backstop -- can help markets retain their resilience... The stock market is the only major market without a market-maker of unchallenged liquidity or a buyer of last resort. “

“Instead of flooding the entire economy with liquidity, and thereby increasing the danger of inflation, the Fed could support the stock market directly by buying market averages in the futures market, thus stabilizing the market as a whole... The stock market is certainly not too big for the Fed to handle.”

“In 1987, (The Fed) pumped billions into the markets through open market operations and the discount window. It lent money to banks and encouraged them to make funds available to brokerage houses. They, in turn, lent money to their customers -- who were supposed to recognize the opportunity to make a profit in the turmoil and buy shares.”

“The Fed's stock market role ought not to be very ambitious. It should seek only to maintain the functioning of markets -- not to prop up the Dow Jones or New York Stock Exchange averages at a particular level. The Fed should guard against systemic risk, but not against the risks inherent in individual stocks. It would be inappropriate for the government or the central bank to buy or sell IBM or General Motors shares. Instead, the Fed could buy the broad market composites in the futures market. The increased demand would normalize trading and stabilize prices. Stabilizing the derivative markets would tend to stabilize the primary market. The Fed would eliminate the cause of the potential panic rather than attempting to treat the symptom -- the liquidity of the banks.”

“The old saying advises: "If it ain't broke, don't fix it." But this could be a case where we all might go broke if it isn't fixed.”

I am speechless. And that doesn’t happen often.

In his 1989 Op-Ed, Mr. Heller lays out how the Fed can use its money to keep stock markets from falling. It is a very simple formula – buy stocks futures and the prices of stocks will follow.

What scares me is how all the terminology he uses to describe the stock markets are now being applied to so many different asset classes – mortgages, money market assets, commercial paper, bank stocks...

Somewhere in the last 20 years, those in power went from using an emergency tool as a last resort to save the markets from turmoil to using the power as a policy tool to drive up asset prices to make Americans feel rich and consume a lot more they could actually afford.

These days, the Fed has become the only buyer. Period! They are buying stocks, bonds, foreign currencies and soon real estate.

I think this election is more about the construction of the economy than anything else. I think the voters have figured out that the Wall Street/Washington connection has led to an economy based only on asset price appreciation. That’s great if you have assets, but if you don’t then your future looks like you’ll be working for minimum wage at Wal-Mart. I don’t know about you, but to me that seems to be a pretty terrible way to construct an economy.

The $700 billion bailout was just the final nail in the coffin for the Wall Street/Washington alliance. People are just sick of this stuff.

I am writing about this because it is amazing to me how all it takes is a rally to get everybody switched from being afraid of going bankrupt to being afraid of missing the “New Bull Market”. People are addicted to price moves!

What most concerns me now is what does Obama do? Does he take the easy road and continue the game, only to see yet another bubble blow up in 8 years? Or does he do the heavy lifting and change the economy for the betterment of the next generation.

If Obama picks another former CEO of Goldman Sachs to be his Treasury Secretary, then I know nothing has “changed” in Washington and all we will be stuck with is a bunch of Socialists with a redistribution agenda and a willingness to manipulate asset prices to further their agenda. Then, the only thing that will have “changed” is the tax rate I pay.

I hope he really is different, because we need it.

Sunday, November 2, 2008

The Week In Review

First the Rally
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.