Wednesday, December 3, 2008

Bill Miller - The Fed "Should Buy Stocks"

Somebody finally said the obvious. That “somebody” was Bill Miller, manager of the Legg Mason Value Trust mutual fund (symbol LMVTX).

What he said was that the Fed “should buy stocks and junk bonds to avert a deeper financial crisis.”

I have been very clear that I will start buying stocks again when somebody other than the Fed decides to buy something and hold it for more than an hour. Now, Bill Miller is telling the World that the deep pockets of the Fed are needed to get the markets moving higher again. Because the simple fact is that there are no buyers of stocks right now, just traders and those looking to liquidate.

You know by now that my contention is that the Fed has been buying stock futures to prop up prices intra-day. It is also my contention that the reason we are having this massive volatility is because stock prices are being propped artificially high, at a level where no real buying will take place. I think the Fed is waiting (hoping) for fundamentals in the economy to improve enough, so that these current prices become fair values for stocks and real investors will eventually show up to buy stocks at these prices. If you have a better theory, I’d love to hear it.

First, a Little about Bill Miller
Mr. Miller is a classic “value investor”. He tries to buy stocks that are inefficiently pricing fundamentals. Think Warren Buffett.

Year to Date, the Legg Mason Value Trust fund is down -59.7%. He has spent 2008 telling investors that banks stocks were “cheap” and, unfortunately, put his (fund shareholders’, actually) money where his mouth is, buying huge holdings in the likes of Fannie Mae, Freddie Mac, Countrywide and Yahoo.

This is an individual who was paraded in the Financial Media the last few years as one of Wall Street’s top mutual fund managers. He had a tremendous long-term track record, but is showing that he has no clue how to protect capital.

Kiplinger – “Buy Bill Miller Now” 12/18/2007
“Legg Mason Value has been a stinker the past two years. But Bill Miller is a gifted manager. Bet on him to rebound.” -

Take a look at Bill Miller’s Fund. Do you think the accounts I manage look like this?
Value was the hot dot from 2002-2006, just as Growth was the hot dot from 1994-2000.
You need to know when to zig and when to zag. If you can’t, or don’t have time to figure it out, then pay somebody to help you.

Now, today in fact, Bill Miller said –

It "looks as if the bottom has been made" in U.S. stocks
the "bottom has been made" in U.S. equities

"I think we will do better from here on, and that by far the worst is behind us." (Wait, sorry. That quote was from this past April)

So which is it – is “The Bottom” in and investors can now buy with impunity, or does the Fed now have to start buying stocks to help hedge funds further delever to meet a new flood of redemptions?

I really want stocks to stop going down. I really just want to get fully invested for 18 – 24 months and hang out with clients and my family again. I am sick of the 18 hour days and working late on weekends. I am also anxious to travel and visit clients again.

But I have a responsibility to protect those who have entrusted their funds under my management and I have to stay where I can push the bottoms if I need to do something.

I’ll let you know when it seems safe enough to try something other than a trade.

Tuesday, December 2, 2008

Use the Right Tool for the Job – Quantitative Easing

In the past few days I have read approximately 15 speeches and books by various economists, Fed Officials, Bernanke and Japanese Officials, on what to do when facing Deflation in a Zero-Interest Rate Environment.

My goal has always been to take the studies of academia and the teachings of the chart technicians and turn what I see and read into a profit. I’m not here to learn all the Depression and the Gold Standard and things like Novation and Quantitative Easing, for the sake of being a walking encyclopedia. I read and learn and study and battle my emotions in an effort to figure out where the markets are going and when is a good time to commit capital. That’s what I do. And these days, it seems to be all I do…

First, What is Quantitative Easing (QE)
A Central Bank normally impacts economic activity by targeting a specific short-term interest rate. Every day, the Central Bank injects or withdraws enough money from the banking system to keep the target rate at the desired level. The US Federal Reserve focuses its effort on the Federal Funds Rate. The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.

When your target interest rate approaches zero, you are forced to use other policy tools to impact economic activity. Bernanke sites three –

- Provide assurances to the financial system that short term rates will be lower in the future than is expected

- Shift the asset mix of the holdings on the Balance Sheet of the Federal Reserve

- Increase the size of the Federal Reserve’s Balance Sheet beyond the level needed to get short term interest rates to zero. This is Quantitative Easing.

So QE is simply creating more money than the economy currently needs to keep rates at near zero %.

Japan is the only real experiment with QE. Experienced an economic malaise since late 1989, Japan found itself with an insolvent banking system, systemic deflation and a 0.15% Target Interest Rate.

“In 2001, Japanese banks were still in the process of reducing their large stock of nonperforming loans. In the months prior to the launch of Quantitative Easing, 19 Japanese banks experienced downgrades in their credit ratings.”

So the Japanese were faced with what we now faced – an insolvent banking system on the verge of massive downgrades, which would cause massive, system-wide deleveraging of bad assets. Remember what Bernanke just said the tools were to fight deflation when the Target Interest Rate is effectively 0% -

The Japanese Government assured investors that they would keep interest rates at 0%, until the country saw 12 months of stable or rising Consumer Prices.

The Japanese Central Bank began buying 400 Billion Yen per month in Long Term Japanese Government Securities

Excess Reserves held at the Japanese Central Bank by Japanese Banks went from 4 trillion Yen to 45 trillion Yen in five years.

Did it work? I don’t know. Japan is still around, but their stock market is at the same price it was at in 1981. Moreover, the bad banks were spared from having to restructure and become profitable. QE started at the Green Arrow and ended at the Black Arrow.

Where or not QE worked in Japan is apparently the subject of a roiling debate in economist circles. I couldn’t care less. I just want to know how to be prepared to protect myself and my clients.

After reading a lot of his work, I am convinced that he is not stupid and that he believes to his core that the main responsibility of the Federal Reserve is to offer a stable economy with maximum opportunity.

The great thing about Bernanke is that he tells you what tools he is going to use if he ever runs into a problem in the future. It’s like in the movie Patton, where George C Scott screams “Rommel… You magnificent ------, I READ YOUR BOOK!” I feel the same way when I read Bernanke’s speeches. Look at this beautiful speech he gave in 2004 entitled – Conducting Monetary Policy at Very Low Short-Term Interest Rates

In this speech he lays out the three tools I cited above. I want to focus on the last two –

#2 Altering the Composition of the Central Bank’s balance Sheet
All you have to do is look at this chart to see how much the Fed has changed its Balance Sheet in the last year.

What the Fed is now really keying on is purchasing Long Term US Treasury Bonds. Bernanke has always hinted at the possibility of capping Long Term Interest Rates. You do this by putting a floor on prices. If somebody wants to sell a bound, you buy it at a price that lowers the yield to the level you desire.

The bailout of Citigroup a few days ago was the Fed admitting that it had undertaken QE to try and save the economy from Deflation and Depression. Look at how the Yield on the 30-year US Treasury has imploded since the announcement of the Citigroup bailout ($TYX is the 30-year Yield times 10) –

Look at how low rates are! Even worse, the Yield Curve is INVERTED on the long end (longer maturity rates higher than shorter maturity rates)! Are you kidding me? The Yield Curve is now pricing in even WORSE economic activity. Here is how the Yield Curve looked in June 2002. This was right before the Stock Market had its final plunge, before started its 9-month bottoming process.

See why I do all of this homework? See why I am looking over my shoulder on every short I take and am scanning charts everynight for hints of new potential leadership? I will be there, money in hand, when the markets do their bottoming process and leadership shows up.

There is precedent for capping Interest Rates. The Fed did it from 1942 to 1951.
It ended with rising inflation.

#3 Expand the Size of the Central bank’s Balance Sheet
“Besides changing the composition of its balance sheet, the central bank can also alter policy by changing the size of its balance sheet; that is, by buying or selling securities to affect the overall supply of reserves and the money stock.”

“(R)eserves can be increased beyond the level required to hold the (Target Interest Rate) at zero--a policy sometimes referred to as "quantitative easing."

The TARP, the Commercial Paper Purchase Program, the Money Market Purchase Program, the Term Auction Facility and all the other programs have massively expanded the Balance Sheet of the Federal Reserve. The Fed now has a total of $8.2 Trillion on and off of its Balance Sheet (up from $850 billion last year). Obviously, that is unprecedented.

The primary goal of all this purchasing is to drive down the cost of debt and credit creation (Interest Rates). Secondary benefits include deleveraging the books of banks, and lowering the cost of borrowing for the Government.

Here is how looks graphically -

There is now over $300 billion in “excess capital” sitting idly at the Fed. The money was created to allow the Fed to buy bonds from these banks in their effort to drive down interest rates. Wait, it gets better. Do you remember a few weeks ago when Paulson and Bernanke told Congress that they need the power to pay banks a rate of interest on the “excess reserves” banks held with the Fed? So now we actually paying these banks money for the privilege of buying their bonds at artificially inflated prices –

Why Are We Doing All of This?
You need to read Bernanke’s thoughts on the Depression to get an idea of what he is thinking –

“(T)he experience of the Depression helped forge a consensus that the government bears the important responsibility of trying to stabilize the economy and the financial system, as well as of assisting people affected by economic downturns.”

Bernanke believes that the Great Depression was result of the Fed not keeping enough money in the banking system. There were several causes

Monday, December 1, 2008

Man Did We Shorts Ring the Register Today

The New York Stock Exchange was down -9.05%, the Russell 2000 (Small Cap) was -11.85% and the S&P Financial Index was -16.67%. That was just today!

I was short the Dow (via DXD, +14.77%) and Energy (DUG, +19.05%).
Clients also had various shorts in Utilities (SDP, +12.72%), Materials (SMN, +19.79%), Financials (SKF, +29.32% (CHA-CHING)) and Emerging Markets (EEV, +17.84%).

I only had about 30% net short going into today. I didn’t buy it all at the top at Friday’s close. But I made some good money and took a bunch of shorts out in the last hour of trading today. Moreover, I completely avoided a day when the average stock was down -10%.

Not a bad day. See why I do so much homework?
Shorting in this environment is very hard. I have to fight Central Banks from all over the World. My goal to just scratch out small gains on each leg down and preserve capital for what is the inevitable next Bull Market. If I can end 2008 +5% or +10% and the markets are down -40% or -50%, then I will be in very good shape to position money effectively when things eventually do turn up. As long as I am doing my homework, I will be able to see the turn forming.

I think people are getting tired. Those who have held stocks the entire way down are selling. I hear the stories. I can feel the pain. I see the selling volume in mutual funds. Even the perma-bulls and Mutual Fund commercials on television are starting to talk about protecting assets, instead of growing assets. When they start telling you how to short assets, the bottom will be here.

Potential New Breakdowns
I see several key areas on the brink of starting new legs down. Most are in commodities.

Energy (XLE)
These charts scare the heck out of me. Take a look at the Energy Index. It sure looks like a consolidation pattern failing at the 50-day (Black Line). This is about as Bearish as it gets. I may just allow the remaining half of my DUG to ride here and see how much I can make if the breakdown occurs.

Natural Gas (UNG)
See how price is now stuck between key support (Green Line) and the declining 50-day (Black Line)? Natural Gas has a big decision to make in the near term. It isn’t just going to sit here. If Big Money sells, then the stocks will fall with the commodity (CHK, APA et al). If you hold these stocks and you don’t have stops in place then you are at a severe disadvantage to the professional investor who knows how to protect capital.

Agriculture (DBA)
Agriculture looks a lot like Energy.

A big move in commodities is coming in the near term. Because these charts are all in down trends and the charts appear to merely be consolidations of trends after large selloffs, I think the odds are really high that the next big move is down. So be prepared if you own any of this stuff.

Half of investing is not losing your shirt to obviously failing setups. If you lack the discipline to execute obvious trades, then pay somebody to do it for you. There no ego in investing. The markets are right and you have to follow them. If commodities go vertical on huge volume then I may look to buy pullbacks. I’m here to make money, not be right 100% of the time.

I don’t really follow Gold any more, much as I am starting to not even look at the Dow anymore. Both just move so differently from any of other comparable Index or Commodity. They just don’t give me a reasonable understanding of what is going on in the market (more on this below). So for metal, I use Silver as the proxy.

Silver (SLV)
Look at how Silver nestled right up into the 50-day (Black Line) for a few days. It was unable to break above and then had a brutal day today, down -10.26%.

These have been a safe haven for mutual funds that have to stay invested and need to find someplace to hide while the markets are imploding. Utilities are on the brink of joining the rest of the markets in the tank – same story, failure at the 50-day (Black Line) after spending two months consolidating the September 2008 Crash. They may offer a great risk/reward short set up in the near term.

Remember what I have taught you – The markets make 80% of their returns over very short periods of time and then spend a long time sitting around in a narrow range (consolidating), before having their next big move. After a big move in price, the ensuing consolidation often carries price up into the key 50-day Moving Average (Black Line). After consolidating, the next big move is normally in the direction of the move preceding the consolidation.

The Euro looks like commodities. The Euro appears to be consolidating after a sharp move lower and is setting up for the next big move.

So for the Euro, a sharp move down has been followed by several weeks of trading between 124 and 132. The 50-day has now declined to 132.5 and is falling. A break of 124 would be very bad for you if you own the Euro.

US Dollar
The anti-Euro is the US Dollar, so it makes sense that a break in the Euro will lead to further rally in the US Dollar. I will be looking to buy the Dollar on more weakness in the Euro.

I will cover the US Dollar/Euro connection later this week when I discuss Quantitative Easing and a potential Dollar Carry Trade.

I want to review two key companies in Energy to show you how much of an impact being a component of the Dow can have on the performance of your stock over a short period of time.

The two companies are Chevron (CVX) and Total Fina (TOT). Both are enormous Energy Conglomerates, with Market Caps of over $100 billion, Revenue of over $175 billion and Earnings of over $16 billion. I consider them to be similar enough that their stocks should be performing in a very similar manner.

But look at the differences in the charts of Chevron and Total –

Chevron broke support in September and then snapped right back up into it over the last two months (Pink Line). But Total broke in August and had a very weak rally the last two months.

The reason this has occurred is pretty clear to me. Chevron is in the Dow and Total is not. I’m not going to go on some conspiracy rant. That is not my intention with this. I could have replaced Chevron with Exxon, the other large energy company in the Dow. And I could have used BP, Royal Dutch or ConocoPhillips instead of Total.

I think what happens is that mutual fund managers are forced to stay fully invested at all times and sometimes they all plow into a handful of companies with way too much money. This leaves shareholders vulnerable for the time when everybody wants out of the company all at once

My concern is that if Energy and Commodities crack in near term, then the crowds in Exxon and Chevron may all run for the exits at exactly the same time. So if you hold these things, be very, very cautious.

The Bottom Line
Until proven otherwise, the mantra for the markets remains – Buy Weakness and Sell Strength. But the pressure seems to be building for a break of key support in a number of significant areas.

Big Money showed up today and sold the markets hard. I covered some shorts and am looking to reload in a number of obvious setups. If the markets rally, then they may only do so for an hour or two, or they may retest Friday’s high. Who knows. But I will know how to play it and will be looking at the intra-day charts for topping patterns to short.

Let me know if you have any questions or comments.

Sunday, November 30, 2008

The Best 5 Days in 75 Years

I emailed a buddy of mine last Friday and wrote something like – “You know the boys will pull out all the stops to get the markets to rally soon. You can’t have all the shoppers wanting to slit their wrists going into Black Friday (The biggest shopping day of the year).”

So the powers that be did their job. There were big gap up opens, huge last hour rallies, the bailout of Citibank ($326 billion) and the government promising to finance $800 billion of credit card, automobile and mortgage debt. I think the NASDAQ rallies 2% in the last 15 minutes on Friday. Did I mention that we rallied into month-end again?

Same old games.

Who are the guys who actually buy these rallies? Every other Fed-induced rally has ended in a crash. Do you think this one will be any different?

Let’s take a look
I went through several thousand charts over the last few days. I wanted to see how indexes were trading relative to prior crashes. I wanted to see which sectors were acting well. I wanted to see which stocks were holding up to be potential leadership for the next Bull Market. I wanted to see how bonds and interest are trading and how well commodities are doing in the face of all this new money creation by the Fed and the Central Banks of Europe and Asia.

I have never before seen a time where every, and I mean every, domestic stock index and international stock index all crashed in unison. It’s extraordinary!

S&P 500
All I see is a spike rally on diminishing volume into massive resistance (900). Look at how the last spike up rally failed in early November. I could rally up to the 50-day (Black Line), but the 50-day has been sold hard since this Bear Market started.

It will all come down to what does big money want to do next week. If they show up selling, then we get yet another leg down. If they show up and buy on volume, the 960 is real possibility.

The charts of all the US Indexes look exactly the same. The rally felt great and no doubt bailed a bunch of investors out for the time being. But it feels like a classic Bear Market Rally – made you feel good, make you nervous about not being in, suck you in and then roll over. We’ll see how it plays out, but I have started to build short positions.

There are 192 different sectors of the economy, as measured by Standard & Poors. I look at the charts of each sector this weekend, because at some point this Bear Market will end and I want to see if any leadership is showing up yet.

Potential Bottoms
I saw 1 potential bottom – Airlines
I looked at the charts of the companies in the sector and they look horrible. I see lots of bounces into moving averages and lots of companies being outright crushed (Southwest was the worst).
So I’ll pass on airlines for the time being.

Still look horrible.

Are still avoiding risk.

So, outside of a 5-day moon shot, nothing has changed. I sound like a broken record. I am starting to get short again for the inevitable retest of the recent lows, or worse…

If (when) things charge, I will too. But for now, I need a lot more evidence to convince me that I can risk my money again.