Things are Different This Time

After a long hiatus from blogging it is time to get back to the market, and boy has it been busy. Unfortunately the markets have been forced to look to Washington as the market catalyst which has frightened everyone with a dog, or dollar, in the fight. My weekend review indicates increased risk this coming week, and a possible change in direction for the equity markets. But beware any uptick is likely a sucker rally, and it is hard to tell if the change might be up or down. Most pros are saying we are over-do for a relief rally or retracement, perhaps even a doosey of a bear market rally. You can make money on it but you have to get out before the next down leg, however far that might be. So other than monitoring the now usual suspects in Washington what is the smart money now musing? Two things beg our attention as well as a look at the regular technical and fundamental trends that we all pay attention to. We will wrap up with what it means to the investor, the strategist, and to main street. Let’s start with that first thing, the big old ugly bear.

This Week’s Market Talk

Dow 5000? That is what the proponents of Dow Theory believe now that the 7000 level has breached. The talking heads on the financial networks have opined about a 500 for the S&P. That leaves us little “retail” investors and regular ma and pa public wondering; do we have another leg down? This week’s Barron’s magazine weighed in with thoughts from market maven Felix Zulauf. He believes we are in a secular bear market that began in 2000. He sees the S&P in the low 400s. For those of you who use Fibonacci numbers a 61.8% Fibonacci retracement from the top of the S&P is 573, and a 76.4% retracement comes in at 354. In accordance with the Street’s belief in a relief rally Barron’s says Felix has closed his shorts in anticipation of a rally back to 900 on the S&P before a selloff to the low. A secular bear market last from ten to fifteen years and Mr. Zulauf believes we could hit the nadir of that bear in the next couple of years. If he is right we have another one to six years in this bear. Given the amount of debt that has to be worked off we can certainly see this bear lasting a while longer. However, if we are going to see a historic bottom in the next several months one can envision someone making a lot of money. The legendary John Templeton made his fortune by buying stocks no one wanted in the midst of the Great Depression. Yet the risk to those of us just trying to hang on to our retirement savings is real and the immediate to mid-term risk is real and this bear has taken quite a bite out of our financial security.

The second thing is what in know as the Volatility Index or the VIX. The VIX is an options instrument that was invented to move inversely against the S&P 500. That is the VIX would go up as the S&P went down. The VIX is a great way for investors to hedge their portfolios against market risk, but like all financial instruments it is also a place for speculators to play. The VIX reached a historic high last fall of around 89 when the market was in a real panic and melt down. However, during the more recent melt down that found traders as depressed as they were last fall the VIX only nudged up to the mid fifties. This has puzzles a number of market pros. One answer to this is that investors have largely gotten out of the market and they are now using gold as a hedge instead of the VIX. This may square with the fact that gold, the usual save haven for financial markets, didn’t move much last fall. I have heard some speculate that investors have cried uncle to Mr. Market and are frightened by the amount of debt that Washington is taking on and have decided to go to the ultimate save haven. Gold recently approached one thousand dollars an once and has since retraced to the low 900 dollar range. The negative feed-back loop that the banks are now in has terrified the Fed so the immediate concern is deflation. Yet the long term concern remains inflation and devaluation of the dollar. Hence more investors have turned to gold. I think the markets are showing some fatigue and almost every asset class is suspect so it is natural that people would turn to gold as well as cash. The mere fact that the VIX is not spiking when the market sells off indicates something is a foot. This could be another indication of risk, but maybe risk to the up side as well as to the down side.

Technical Analysis

I was struck by Friday’s candlesticks for Apple, Master Card, and the S&P 500 Spider. It was indecisive. To complicate things neither Apple nor Master Card are trending, they are range bound while the S&P is decisively in a down trend. Does this mean that market risk is to the down side? Given market fatigue and the technical indicators it would seem risk to the up side is still met by significant risk to the down side.

Fundamental Analysis

This week’s big new is jobs. Barron’s take on this is that unemployment is now the main threat to the banks. They face not only mortgage defaults but also credit card defaults. GM is also looking at bankruptcy which means that too many people are employed building autos. The bottom line on this is that human capital in the developed world needs to be deployed differently which means re-training and new industries or services. I believe this has something to do with the ending of the industrial age and the beginning of an information age, but that is a topic that deserves its own discussion to itself. Suffice to say that people are losing their jobs which means they cannot service their debt which prolongs the debt crisis. In other words it is that dreaded negative feedback loop all over again.

To the Investor

Keep your powder dry and be ready for a decisive market move. Risk is real and it is to the upside and the downside. My preference at this time is trading currencies rather than equities until we can see if this market is going up or down or it will continue to trend. I would prefer it to trend because that is how I have some of my trades currently set up, but I can tell you the market never listens to me.

To the Strategist

Market risk is reflecting geopolitical risk. The big question on our minds should be can the emerging markets pull the developed world out of this recession? Twelve months ago people were talking of “decoupling” of the BRICs from the West. That notion now seems quaint. The problem is that the export led economies need someone with a big balance sheet to buy their stuff. Now that no one has that balance sheet and it is not likely that the West will be in a position to re-leverage for a number of years where will they go? Before you answer that question know that a number of oil exporting countries need oil at 70 dollars to be able to make an acceptable profit. Even the construction of China may not be enough to bring oil up to that level without a recovery in the West. Conversely the West needs cheap oil in order for consumers to have discretionary income to spend. This question may not be as easy to answer as you might think.

To Main Street

Unemployment is a threat to those of us who sell our labor to make a living. Moreover our retirement savings are also at risk and the rules we were taught have changed. We are going to have to learn more than just stocks, bonds, and money funds. The new reality is that we need to look at other asset classes such as gold and other commodities and perhaps even other currencies, maybe just for capital preservation. Things are not the same and this recession is not a typical post WWII recession. Perhaps we should just have a cold one for now.

Hope Part II - De-leveraging

O.K.! I am remiss in posting the second half of the article, and as is typical these days, a lot has happened this last week. Before I continue with the three themes that will dominate the attention of strategists and financial mavens this coming year, I have to mention two things. First this last week has seen a fundamental threat to the market, and second a technical look at broad market activity indicates uncertainty.

The fundamental event was the selloff of Bank of America equities this last week. There was a swirl of news around BofA last week that you can read about if you have not already heard, but I believe the most significant fundamental blow to the market is uncertainly and lack of transparency about what the government’s role in BofA has been. What initially spooked the market was the nationalization of Banks in Britain. U.S. markets were further spooked on BofA equity when the U.S. government “backstopped” bad debt that BofA took on when they bought Merrill Lynch last fall. This has left investors wondering what deal might have been struck between the U.S. treasury and BofA when this deal was consummated. That deal was seen by some to be a shotgun wedding with Mr. Paulsen holding the gun. The markets have seen common shareholders wiped out when the government took over Fannie Mae and Freddie Mac, hence a great deal of nervousness now surrounds both BofA and Citigroup. The markets discounted this news this last week and it has cast yet another pall and fundamental uncertainly over market risk as we begin the New Year.

The second event is technical. I have been watching the charts of two exchange traded funds that mirror the Dow and the S&P 500 (DIA and SPY). In both cases they have been range bound in a narrow trading range or channel. They look to be forming what chartist call a triangle, and triangles usually resolve in a significant break either up or down. At this point most traders are flummoxed as to whether that break will be up or down. If markets are an aggregate measure of known geopolitical and financial risks, then this last week spells increased risk to markets and to geopolitics. This last week dovetails with where we began last week’s discussion of the themes for 2009. So let’s get to the second theme of debt or de-leveraging.

Some of the smart money out there believes that the de-leveraging of excess debt largely caused by the housing bubble will take up to five years to unwind. If that is true, then we have another three and one-half years to go in this cycle since the deleveraging began in July of 2007. Now that the real economy has and is faltering and people are losing their jobs, the next round of default will be consumer loans. The banks have been criticized by members of Congress for taking taxpayer money and then not lending to the consumer. The banks are merely shoring up their balance sheets to withstand the coming losses they will absorb as consumers default on their credit card and auto debt. Oddly enough the same government that criticizes the banks for not lending will also shut a bank down when its reserves fall too low. It was excess debt that created the problem so how is it that more debt will fix it?

At this point government is the only player taking on more debt. Consumers and corporations are shoring up their balance sheets by paying off debt and increasing savings. With job losses and loan defaults increasing few in the private sector are in a position to take on much more debt, and corporations have had trouble obtaining loans at rates they can afford. This all spells trouble for equities. The smart money is seeing, at best, 5% to 8% returns on equities. This will demoralize great number of retirement investors and set up a psychological state in which many retirement investors will compound their fear of loss with more bad decisions about how to deploy their retirement savings. Savings they will need to pay for higher energy costs.

Next we will look at energy, and hopefully keep up on the fast moving events that are whip sawing the markets.

Hope is Not a Strategy

The January 19^th, 2009, Barron’s weekly magazine had two lead articles that are must reads for traders and strategists. They had the second installment of their Roundtable and their cover story is an article with their recommendations to the incoming president titled Spend Wisely. The economics editor, Gene Epstein, says in that article “Let us hope, however; that advocates of Obama’s plan prove right, and that the short- and long-term dangers linked to the nation’s debt prove to be manageable.” In a sentence Epstein summed the risks to traders, investors, and strategists for the coming year. Smart money already has framed the risk themes for 2009 and the underlying data points. So how have they framed it and what might this mean to U.S. strategy and to your money?

Data Points

2009 begins with variations on the themes from 2008. Those themes are energy, debt, and the dollar. I pick those as the bottom lines because that is where the current data points drive us. Last year we saw an inverse relationship between oil and the dollar as some people used oil as an asset class to itself. When the oil bubble unwound the dollar rose against most every currency except the Yen. The Yen and Treasuries seemed to be the only places investors could flee to sit out the de-leveraging of corporate and bank debt. Yet the dollar’s survival as the reserve currency still leaves us uncertain of its future and the future of United States’ financial health because of the rickety structure upon which it sets. Let’s look at the dollar first.

If Barron’s numbers are right there is cause for concern. In Spend Wisely Epstein says of U.S. Government debt, “The main concern: Much of the soaring debt is owned by foreigners. The share of outstanding U.S. Treasury paper held by foreigners jumped to 49.3% last year, from 31% in 2000, and appears to be heading higher. What happens if investors outside the U.S. stop buying our debt and instead start dumping some of their holdings?” This is that rickety structure for the dollar, and anybody with skin in the game should take note.

The specific risk here is most likely inflation. Bill Gross is the founder and co-chief investment officer of Pimco, a company known for their expertise in bonds. Pimco manages a great deal of money and they know the risks of inflation. In the Barron’s Roundtable Mr. Gross sums the risks to the dollar and Treasuries by explaining how governments default on their debt. “They default by inflation. They default by devaluation, and, yes sometimes they default and don’t pay their coupons.” Mr. Gross doesn’t believe the U.S. will default by failing to pay their creditors hence the strength of the dollar and inflation are the threats. Moreover the dollar is increasingly under the influence of its creditors and now almost half of those are foreigners. Mr. Gross also believes that the U.S. cannot abuse its advantage of being the reserve currency much longer. He says “If asset reflation works and the real U.S. economy kicks back into gear, the dollar can hang on. If it doesn’t work it’s a new ball game.” Sic. I take Mr. Gross’s opinion on this more seriously than I do, let’s say, German ministers because Mr. Gross is managing the risks of billions of dollars each day, and his company has a daily and quarterly deliverable to its clients. The rest of the Panel’s take on the dollar is that it survives as the reserve currency only because no other currency is strong enough to challenge it. The primary reason for this is because European banks have less equity capital than U.S. banks, and the Chinese and Japanese also are not financially fit enought to challenge the greenback.

Why should you care? Because U.S. policy is now increasingly beholden to foreigners. In 1956-57 Great Brittan and the U.S. were at odds over policy concerning the Suez Canal. In fact British military forces were engaged in military operations in the Suez region and political pressure from the U.S. via the United Nations had failed to obtain concessions from the British. It was Eisenhower's threat to sell U.S. holdings of British Sterling and British bonds that ultimately forced the British to concede. It is simply the Golden Rule in action. He who holds the gold makes the rules.

Tomorrow we continue with the debt theme and we will work our way towards what this all means to U.S. policy and your money.