October 10, 2009
In the Eye of the Hurricane – now that our guard is down the worst is just ahead!
Where is the motor for growth going to come from?
The winning Bear Market strategy - timed trading
Alternation - why a Crash is so likely now
The key to the Crash is likely the plummeting Dollar
Government's deficit out of control
Bonds will collapse along with stocks, commodities & Emerging Markets
Real Estate – the worst I still ahead
While the consensus indicates we have just lived through the worst economic and financial phases of our lifetimes and are emerging in recovery, nothing could be further from the truth. Since March we've been in the Eye of the Hurricane in financial markets, where earnings appear to be on the mend and the worst is past -- when in reality the worst is still ahead. This mammoth storm's second wave is only now approaching. This time, a virtually bankrupt federal government has little firepower left to ease human suffering: those long-term unemployed, homeless and hungry. Investors have taken down their portfolio's shutters, put back the lawn furniture and trash cans (bought small stocks, bonds and emerging market ETFs) just in time to have them hurled back like fire bombs at their portfolios, leaving masses of depressed former-investors, with little hope of recovery, or future prospects.
Other than a back-to-school blip in September, unemployment continues to creep up, consumption is not recovering, households are de-leveraging, credit contracting and future government spending is pared back by fear of unsustainable budget deficits. So where is the motor for growth going to come from? A jobless recovery is not a foundation for sustainable growth.
In the last two quarters pessimistic earnings expectations were beaten through aggressive cost-cutting. Obviously, we've already cut to the bone. What's more, cost-cutting acts like a negative spiral on the overall economy, especially real estate, retail and employment. Without revenues increasing commensurately, this job-less sucker's rally is tracing out an “A” top. We don't expect the majority of companies will report positive surprises this quarter. Nor do we see the 35-40% earnings rebound in the first quarter, currently being discounted at these levels. Without drastically improving profit margins, big disappointments lie ahead. Yet margins are already approaching the high end of their long-run averages, making this market highly susceptible to an impending blood bath.
Free Enterprise Nation, a group dedicated to exposing excessive government spending in the interest of public awareness, indicates the current level of government spending is not sustainable without adding more debt to the balance sheet. The Congressional Budget Office, on the other hand, estimates that Federal receipts will be $2100 billion this year, but outlays of $3500 billion. To put that in perspective, that's double the $1800 billion spent a decade ago, while receipts are just 4% higher. Receipts are optimistically forecast to catch up with this year's spending only in 2016, if spending were to remain constant, yet another myth. That's assuming they grow at twice the pace of estimates for the economy, whose projected rate of expansion is yet another leap of faith. Obviously these estimates factor in a strong recovery, one that's just not materializing. When deflation takes hold of the economy, plummeting wages and prices will have a commensurate effect on dwindling tax receipts. It looks like we'll be paying back the principle plus interest on this stimulus for generations.
Elliott's guideline of alternation tells us this time will be either opposite or drastically different in a similar vein. The plunge from October 2007 was slow and grueling, so this one must be fast and furious – in other words a crash. As you see below, this scenario is the 1929-1932 collapse inverted. In 1929 the Crash occurred at the top followed by a rally just like the one now ended. Afterwards the Market continued to drop 83% to the trough. This time, the Crash will likely come in the months ahead take us down at least part of that ~71% to the trough which represent S&P ~300 and Dow ~2700. The reality check will be brutal for most.
Likewise, in 2008 bonds were the big winners, as stocks tanked. All bonds, including Municipal bonds rallied recently, as if they were riskless and investors anticipated a repeat of 2008, sending yields to the lowest levels in more than 40 years. Yet on Thursday the tide turned, investors began growing wary of the debt issued by cash-strapped states and the overly extended Federal Government. Take the example California which had to raise yields from 4.63 to 5%, while cutting the size of the issue by $360 million just to get it to fly. Even then, retail participation dropped from 75% to 50% from last month. Towards the end of the week, yields rose and bonds dropped as concern re-emerged about states' weak finances and a rumored drop-off in the Fed's Quantitative Easing. These are previews of the devastating losses ahead. Unlike last year when bonds soared as stocks plummeted, this year, they're set to plunge hand in hand. In the Daily Treasury ETF chart wave b marks the top, although it could still be exceeded slightly by the Diag II in process.
The Diag II above in the long ETF, corresponds with the Diag II in the inverse fund below. We sold TMV on Friday. On Monday traders short TMV approximately one hour after the opening and immediately place an order to cover at 59.65 GTC. (59.5 is the min downside of wave iv)
In Bull Markets any idiot can piggy back on Warren Buffet's long-term portfolio, however Bear Markets are neither as simple nor as kind. Warren Buffet will likely experience the greatest embarrassment of his career as the $5 billion in puts he sold go heavy in the money for a loss of ~$100 million. Obviously now is not the time to follow either Warren Buffet or Mario Gabelli. Buy & Hold (even inverse funds) results in countless round trips, with little or no profit. The winning strategy is timed trading, where you scale-in an out of positions, taking profits along the way for a high average price, rather than attempting to top tick the Market. That's what we do best. See example below in TMV.
Although spot prices for gold continued to surge on Thursday, the gold ETFs have clearly begun a dramatic reversal. This week's high will not likely be exceeded for quite a long time. Gold, traditionally an inflationary hedge, serves little purpose in times of severe deflation. In the market collapse just ahead, most investors will be buying dollars with their stocks. Currently near 75.76, the dollar index must drop to a minimum of ~73 to retrace the previous Diag II. From that level the Dollar will trace out an enthusiastic rally ahead to new highs, lasting at least 2-3 years. Commodity-based currencies such as the Australian Dollar and Canadian Dollar will go into sharp decline, as demand for commodities of all sorts contracts with economic output. When market manipulation was evident wave ii to the far right would invariably be exceeded by a b wave – not likely this time.
In the weekly dollar index below we see the dollar's plunge will only be complete after a minimum of 72.5 is reached. Once complete, wave III begins and should climb to new highs. Diag IIs in wave I indicate the beginning of a long move up. The Diag II on the way down is a continuation of a substantial drop.
A closer look at the Dollar index shows we are in a wave (iv) bounce, and likely forming another, larger Diag II if (iv) overlaps (i), since 4 one degree of trend lower, already overlaps (i). This would mean a much bigger drop than the minimum and perhaps the key to a Crash. This being a Diag II, could mean a drop well below the previous trough of 70.
Commodities, especially natural resource commodities, will plunge as consumption is sharply curtailed in favor of paying down debt and saving. In Deflation, cash appreciates like a high-yield money market fund, with the interest accruing to expanding purchasing power, while debts are paid back with more valuable dollars. The longer you wait the cheaper a coveted item becomes, that's why deflation expectations become self-perpetuating. Housing is a good example. Today you can buy the same house as in 2006 for 40% less...buy it for cash and take an additional 10-15% off. Wait 3-6 months and the same house will likely plunge to 20-30% of its former value.
Decoupling myth
“Decoupling”, the notion that Emerging Markets can continue to grow even if developed markets fall into recession or worse, is yet another myth. As in bonds, herd-like strategic allocations have moved substantial funds into Emerging Markets of late, just as they're peaking once again. As usual, retail investors invariably catch the tail end of the trend, only to be left standing when the music stops. While Emerging Markets are up several times their developed counterparts, the higher they climb, the harder they will fall. Only inverse Emerging Markets offer potential gain. China, Brazil, India and Russia the BRICs will all go down the chute harder and much faster than they rallied. Emerging Market valuations are back to irrationally exuberant levels, deep in bubble territory. When these Markets crash, there will be no exit.
Real Estate – the worst I still ahead
In commercial real estate debts amounting to $3500 billion are coming due in the next two years, yet the proprieties’ values which serve as collateral have plunged. Hotels, shopping malls and office towers are far less in demand - consumers are saving rather than spending, there are far fewer banks and countless small businesses have folded. What happens when these loans go underwater, meaning the property value is less than the loan, as in residential real estate? What's more, loans were previously re-packaged into securities and sold, that liquidity remains frozen. Essentially there is no liquidity or lending. Recalling the fortunes that were made by investors when tens of billions of dollars of commercial real estate were sold in the 90's by the Resolution Trust, people don't want to sell at a loss, only to see others get extremely rich. Once again this time will be slightly different, and investors would be wise to take relatively smaller losses now than 70-80% losses later. Since the recovery of all real estate is job-growth dependent...there has never been a worse time to own real estate. The worst is ahead, not behind us!
Economist's Projections are usually wrong
Economist's Projections are usually wrong since they are linear, and the economy operates cyclically like the seasons. When there is a reversal of the trend these projections are ALWAYS wrong. Just a year ago the IMF forecast growth of 3.9% for the global economy for 2008 and 2009. Not a month later when Lehman collapsed, they cut those projections in half! The unpredictable is bound to happen. (Yet those who have been with us for several years know that we accurately forecast the collapse of both Lehman and Bear Stearns's a year before these occurred.) By spring 2009 the consensus among private forecasters expected the worst economic performance since the First Great Depression and little recovery in 2010. Essentially don't make investment decisions based on economist's projections, a coin toss is just as good. Only Elliott's Market patterns, expertly interpreted, indicate with any degree of certainty what lies ahead for the market and the economy. With fleeting signs of a global recovery, optimistic investors are already hanging on forecasters words, expecting better-than-forecast results - don't you fall for it!
In the Dow the slide is beginning with a Diag II, compounding the previous Diag II in the b wave. This would indicate a bounce back to overlap the first touch point in wave ii. Afterwards, the minimum plunge is the area of 5170, substantially below the March low. Yet this could be just wave iii of 5, meaning wave 5, after a bounce, would plunge to ~2700, equivalent to S&P 500 ~300.
After carefully studying the charts, it is highly likely that a Dollar collapse will be the catalyst that sets off the Crash, and why bonds will Crash too. All courtesy of the Fed!
Best regards,
Eduardo Mirahyes
Exceptional-Bear.com