Saturday, November 29, 2008

Half Way to Zero

Saturday, November 22, 2008.

At the close on Thursday, and through most of the day Friday, the S&P 500 was down more than 50% from its October 2007 high. This is a technical milestone that I consider an important juncture so I wanted to jot down my thoughts as doing so helps gives me clarity and hopefully will help others understand what may lay ahead.

When reviewing the big picture, I like to break the market down into its three components; Fundamental, Technical, and Psychological. I will review all three below but would first like to discuss some anecdotal thoughts/observations.

Last night was our wedding anniversary so my wife and I went to one of our favorite restaurants in Tacoma, WA, called Stanley & Seaforts. We have been going there for about 20 years now. On the way there I-5 was as busy as ever and it took about 20 minutes longer than the no traffic driving time, about 5 to 10 minutes longer than I expected. Gas is back below $2.00 in our area after all! Upon arrival the parking lot was overflowing and both the restaurant and bar were also packed to capacity. As we waited for our table I watched the kitchen workers prepare meals… about 10 of them, all males who appeared to be mid-twenties to about 40 at the oldest, and of varying ethnic backgrounds. It’s kind of fun watching them work, but since I’ve been going there for over 20 years, I started to wonder where are the chefs who used to work there and how come none of them are even close to my age (upper 40’s)? This is, after all, one of the nicest restaurants in the area. Is the pay not enough to keep workers for the long term? I don’t know.

My wife and I then sat down to our meal, had a drink each and skipped the appetizers. We both passed on the steak and had mid priced meals w/salads. We shared a single dessert. We noted the little differences in the meal and that the past few years it seemed that the quality was diminishing. The tab? One Hundred and fifteen dollars! Seven or eight years ago that same tab would have been in the $60 range. My points? While I see that the cost of living has far outstripped wage growth and we all know the devastation that has occurred in our economy, the streets were still packed, and the restaurant was able to fill itself to capacity while producing a mediocre product at a very high cost. People here are evidently still spending. Sure, they were probably spending money they don’t actually have, but there were a lot of them. I started wondering what all these people do for a living – after all, Tacoma isn’t exactly the center of high finance – but to be fair the Seattle/Tacoma area has fared much better than most of the country although our economy tends to lag by about a year or 18 months. What I saw last night leads me to think over the fundamentals as I view them.

FUNDAMENTALS

In a nutshell, the securitization of debt process got completely out of control and produced the greatest boom in the history of mankind. The leveraged derivatives are collectively referred to as the shadow banking system. The shadow banking system is multiples larger than what most people know as the traditional banking system. That system was completely untracked and unregulated. The process of debt securitization is now completely broken and frozen, thus the growth that was occurring has stopped cold, and the creation of money from thin air has slowed dramatically. For growth to continue, the creation of money must be larger and larger each year. Remember that government statistics do not track this money creation nor do they control it. I would contend that the vast majority of them still do not recognize just how large and out-of-control this became. Also keep in mind that comparisons of current government statistics are COMPLETELY MEANINGLESS WITH THE PAST. The methods used are different than the past and they do not reflect the shadow banking system and are subject to manipulations. Thus the data now breeds a lack of confidence in the system.

Ludwig Von Mises noted that the size of the bust is commensurate with the size of the boom and it was Hyman Minsky who accurately described the seven bubble stages (the following excerpt is from my book Flight to Financial Freedom – Fasten Your Finances, written during 2005/2006):

HYMAN MINSKY’S SEVEN BUBBLE STAGES
The late Hyman Minsky, Ph.D., was a famous economist who taught for Washington University’s Economics department for more than 25 years prior to his death in 1996. He studied recurring instability of markets and developed the idea that there are seven stages in any economic bubble:

Stage One – Disturbance:
Every financial bubble begins with a disturbance. It could be the invention of a new technology, such as the Internet. It may be a shift in laws or economic policy. The creation of ERISA or unexpected reductions of interest rates are examples. No matter what the cause, the outlook changes for one sector of the economy.

Stage Two – Expansion/Prices Start to Increase:
Following the disturbance, prices in that sector start to rise. Initially, the increase is barely noticed. Usually, these higher prices reflect some underlying improvement in fundamentals. As the price increases gain momentum, more people start to notice.

Stage Three – Euphoria/Easy Credit:
Increasing prices do not, by themselves, create a bubble. Every financial bubble needs fuel; cheap and easy credit is, in most cases, that fuel. Without it, there can’t be speculation. Without it, the consequences of the disturbance die down and the sector returns to a normal state within the bounds of “historical” ratios or measurements. When a bubble starts, that sector is inundated by outsiders; people who normally would not be there. Without cheap and easy credit, the outsiders can’t participate.

The rise in cheap and easy credit is often associated with financial innovation. Many times, a new way of financing is developed that does not reflect the risk involved. In 1929, stock prices were propelled into the stratosphere with the ability to trade via a margin account. Housing prices today skyrocketed as interest-only, variable rate, and reverse amortization mortgages emerged as a viable means for financing overpriced real estate purchases. The latest financing strategy is 40, or even 50 year mortgages.

Stage Four – Over-trading/Prices Reach a Peak:
As the effects of cheap and easy credit digs deeper, the market begins to accelerate. Overtrading lifts up volumes and spot shortages emerge. Prices start to zoom, and easy profits are made. This brings in more outsiders, and prices run out of control. This is the point that amateurs, the foolish, the greedy, and the desperate enter the market. Just as a fire is fed by more fuel, a financial bubble needs cheap and easy credit and more outsiders.

Stage Five – Market Reversal/Insider Profit Taking:
Some wise voices will stand up and say that the bubble can no longer continue. They argue that long run fundamentals, the ratios and measurements, defy sound economic practices. In the bubble, these arguments disappear within one over-riding fact – the price is still rising. The voices of the wise are ignored by the greedy who justify the now insane prices with the euphoric claim that the world has fundamentally changed and this new world means higher prices. Then along comes the cruelest lie of them all, “There will most likely be a ‘soft’ landing!”

Stage Five is where the real estate industry is today [2005/2006]. This stage can be cruel, as the very people who shouldn’t be buying are. They are the ones who will be hurt the most. The true professionals have found their ‘greater fool’ and are well on their way to the next ‘hot’ sector, like the transition from real estate to commodities now.Those who did not enter the market are caught in a dilemma. They know that they have missed the beginning of the bubble (gold, silver, and oil today [2005/2006]). They are bombarded daily with stories of easy riches and friends who are amassing great wealth. The strong will not enter at stage five and reconcile themselves to the missed opportunity. The ‘fool’ may even realize that prices can’t keep rising forever… however, they just can’t act on their knowledge. Everything appears safe as long as they quit at least one day before the bubble bursts. The weak provide the final fuel for the fire and eventually get burned late in stage six or seven.

Stage Six – Financial Crisis/Panic:
A bubble requires many people who believe in a bright future, and so long as the euphoria continues, the bubble is sustained. Just as the euphoria takes hold of the outsiders, the insiders remember what’s real. They lose their faith and begin to sneak out the exit. They understand their segment, and they recognize that it has all gone too far. The savvy are long gone, while those who understand the possible outcome begin to slowly cash out. Typically, the insiders try to sneak away unnoticed, and sometimes they get away without notice. Whether the outsiders see the insiders leave or not, insider profit taking signals the beginning of the end (remember who has sold their rental properties?).

Stage seven – Revulsion/Lender of Last Resort:
Sometimes, panic of the insiders infects the outsiders. Other times, it is the end of cheap and easy credit or some unanticipated piece of news. But whatever it is, euphoria is replaced with revulsion. The building is on fire and everyone starts to run for the door. Outsiders start to sell, but there are no buyers. Panic sets in, prices start to tumble downwards, credit dries up, and losses start to accumulate.

This is where you may see the “lender of last resort” who is usually the government. The government, although they were talking up a soft landing, are now forced to step in to prevent the crises from spreading to other sectors. Ironically, this is where the savvy investor who profited before, really profits now. With government backing, they are asked to step in and return “normalcy” to a now damaged sector.

The government’s attempt to “put out the fire” usually works. However, the conditions beyond the year 2010 will require oceans of water that the government does not posses. You must be ready!

We are obviously in stage seven now. The lender of last resort has stepped in on multiple occasions. Savvy investors like Bill Gross (oink, oink) are stepping in to take advantage and are attempting to restore “normalcy.” And as I stated when I wrote that, “conditions will require oceans of water they do not have to put out the fire,” I still believe that more than ever, 3 years after I first wrote those words.

To date more than $8.4 trillion has been lost in the stock market. Untold trillions have been lost in real estate and commodities. As those prices have come down they have overwhelmed our government’s attempts to smooth out the business cycle and to maintain a constant rate of monetary inflation. Yes, THEIR figures show(ed) inflation, but they have NEVER accounted for all the money/debt created by the shadow banking system. Their efforts have been and will be overwhelmed until the deflationary forces have run their course. THEN, once deflation has rooted out the malinvestment, the government’s reinflation will take over. THEY HOPE, like all government attempts throughout history, that their efforts will be just right – just enough to overpower deflation, but not enough to cause hyperinflation. Unfortunately, my view is that our monetary system makes that perfect combination impossible. All fiat currencies have failed throughout history and this latest monetary EXPERIMENT that is the U.S. Dollar will also eventually fail.

There is another truth/absolute regarding all interest bearing money systems, and that is that all money is debt, and all debts get repaid WITH INTEREST in one way or the other! There are TWO and only TWO ways to pay back debt; one is to simply pay it back (with interest), and the other is to DEFAULT. The notion of “inflating debt away” is a myth – attempting to do so simply results in paying the debt and interest back in “other ways,” such as by losing purchasing power with the dollars you hold.

The Central Bankers in America and throughout the world hold much of the debt and they are asking/forcing the taxpayers to take their debts from them so that THEY do not have to default. The problem here is that there is not enough income to service all the debt that’s been created, thus someone has to and is going to default. Our politicians had a choice – the pigmen or the taxpayers. They chose us, the taxpayer. And thus, at some point in the future the debt WILL BE defaulted on by our government. The math simply no longer works. That’s what happens when the system is designed for never ending growth. Never ending growth turns parabolic and subsequently collapses in on itself.

That’s where we are from a fundamental perspective. Of course there are many, many factors at play throughout the world, but that’s the over-arching concept. Unfortunately, since this crisis began, the actions of our government and Central Bankers have caused the problems to get worse, not better. For growth to occur again, THE DEBTS MUST GO AWAY, not simply transferred from one bag holder to the next. Until that happens, the fundamental prospects for future growth of our economy will not be there.

That said, it certainly is mathematically possible for the government to “print” enough “money” to create monetary inflation. The numbers to do so ARE OVERWHELMINGLY HUGE at the outset, but get SMALLER as more and more of the debt and fiat money return to the ether from which it came. At some point the forces will be momentarily in balance, but only as we swing from monetary deflation back to monetary inflation. When will that occur? It’s hard to say, but we can look to history and to some signals/signs that the deflationary trend has reversed.

From a historical perspective, the equity dislocation of 1929 to 1932 lasted about 2.5 years as did the crash of the Nikkei index in 1990 and our own NASDAQ in the year 2000. It is said that the length of the boom is also commensurate with the length of the bust, but that is not entirely true. If you look back through history, you will find that in “free” market economies the time span of deflationary busts tend to run about two to three and a half years (2.5 yrs average), but the bust does tend to return equity prices back to the point where the parabolic growth phase began. In our current case, some say that our parabolic growth phase began after the 2003 bottom while others contend that it began in the 1990’s or even the early/mid 1980’s. In our technical discussion I will present charts that show my belief that it began in the 1980’s and that prices are most likely headed back to that timeframe. Our equity markets topped in October of 2007, thus if the deflationary phase of the equity markets takes the average 2.5 years, stocks would bottom in April of the year 2010. This will NOT be the average deflationary cycle, thus calling a bottom prior to seeing technical confirmation is simply a fool’s errand.

LONG TERM TECHNICALS

I have attached four long term charts. The first is an 80 year view of the SPX (S&P 500 Index).

This is a logarithmic chart that adjusts to percentages, so the recent moves look relatively small in relation to the entire chart.

The second chart is the same chart but is not a logarithmic chart just so you can see how dramatic the raw number changes are. It is this non-log chart that clearly shows three phases of growth transition; the phase up until the early 80’s is marked by slow and steady growth; it then accelerates into a steeper climb that lasts until about 1995; at which point it goes parabolic and ends in a double top. Why did it end? All parabolic growth ends, it collapses under its own weight as the math is simply no longer able to sustain the rate of growth.

This is a typical curve as found in all of nature. Most people are taught in school that curves have a nice rounded bell shape. That is very rare in nature and NEVER seen in the market place. As Martin Armstrong demonstrated, curves in the marketplace go through a slow growth phase, begin to grow more rapidly, then go through a phase-transition where they turn parabolic. This phase-transition occurs throughout nature, it is akin to the process of boiling water where a liquid state transitions to a vapor as the energy levels reach the boiling point. The backsides of these curves are not the same as the front side as a bell curve would be. The back side is marked by a steep decline as can be seen by looking at any historical long term market chart. This backside of the parabolic curve is typically marked by either 3 waves or 5 waves down. Armstrong prognosticates that we are currently at the place in time where the first wave down transitions to a short up phase which will be followed by another declining phase into the eventual bottom. This is exactly what Elliott Wave prescribes – an A-B-C move into the eventual bottom. Most EW experts believe that we are very near or at the end of the A wave down and that we are about to begin a 2 to 4 month period of up to sideways market action that will be followed by the C wave down into the eventual bottom.

Of course everyone wants to know where and when will it bottom (except all the “experts” on television who think the bottom is today… no wait, today… no wait, today). Well, let’s start by looking at the 80 year logarithmic SPX chart. The red line is a 100+ year trendline. If the market were to drop straight down today it would intersect that line at about the 550 level. If you extend that line out to April of 2010, it will be very close to the 600 level (the same line will be about the 6,000 level on the DOW). That has been my target since the beginning and I have said that once we reach that level betting the market short will be almost pointless and may be unprofitable from my perspective. My experience has shown that making money short by using leverage requires crisp and sharp moves over a short period of time. Thus it’s difficult to make money at the beginning of moves and will likely be difficult to make it towards the end of the move as well, with the most profit coming from the meat in the middle. Although no two crashes are identical, if one examines a chart of the 1929 to 1932 time frame they will find that following the steep and sharp decline the market retraces a large percentage of that decline and then spend a long time period in a slow grind back and forth working its way to the eventual bottom. That could happen here, or we may decline more sharply. I believe the fundamentals are WORSE than that time period so we could decline more sharply. Yes, we have more meddling and interventions, but those occur during all deflationary collapses (governments must “do something”).

Now let’s examine the 20 year SPX chart (this is a logarithmic chart).

It clearly shows a near perfect double top. Breaking the valley floor which was produced at the 2002/2003 bottom was a technically significant event in that it is required to technically verify that a double top formation is in play. It has been broken on a DAILY closing basis, having closed in the 750 area. The candlesticks on the chart are monthly and you can see that we closed at 800 this Friday.

This new lower low means to the Elliott Wave experts that this decline is on the HIGHEST ORDER of magnitude. It marks the end of the 5th and final wave up of the Grand Supercycle and that we are now in an A-B-C correction of the entire cycle. Think about what that means! If you look at the turmoil that surrounded the lower level corrections like during 1929-1932, you get a sense for how large and deep this correction can go. I am not exaggerating when I say that it is likely to be life altering.

Another characteristic of a double top is that the volume should be heaviest on the first ascent and diminish on the second. In this case the volume is much heavier on the second, but they are so removed in time and circumstance that I’m not sure volume is a valid indicator as the overall market volume also went parabolic with the rise of the shadow banking system.

The question then is how do you determine the target for a double top formation? The general saying is that the wider the top, the further down the target. In this case, I have not ever seen an example of a wider top, thus we can expect a target that is way down there. One way is to measure the distance between the peaks and assume that the price will move the same distance down from the peak. In this case that distance produces a target where the twin red lines are on the right, about 475. I note that level is beneath the 100 year uptrend line. Now, the most widely accepted way to calculate a double top target is the same as with a H&S pattern (I note that double top patterns are less reliable than Head & Shoulder patterns). Thus, you would take the height from the peak to the valley and then subtract that height from the floor of the valley. In this case, it produces a NEGATIVE VALUE as the valley floor is greater than 50% from the peak. NOT GOOD. Thus, according to this analysis we truly are HALF WAY TO ZERO.

Where do I think we’re headed? I think it depends on our government’s actions. I will most likely stop playing the short side at 600 regardless and will be a spectator from that point until all the bricks land. You see, I don’t believe in standing under falling bricks and trying to catch them, I’d much rather stand aside, watch them land, and then walk over and pick them up! I think any outcome is POSSIBLE. I try to deal with the odds the way I see the fundamentals, technicals, and market psychology line up. I do not rule out actually going to zero as that would indicate a complete failure of our financial system, and I do not rule out the fed’s ability to create inflation and move nothing but up from here to eternity. I do, however, place the odds of either of those outcomes as low. My personal gut feeling is that our government’s actions combined with how the Obama Administration is looking make a figure below the 100 year trendline more likely.

Now let’s look at the DOW 20 year chart.

I include this chart to illustrate a point about survivor bias. The DOW is comprised of only 30 stocks and thus as a measure of the market is not as good as using the S&P 500 or even a more broad index. Survivor bias artificially inflates the value of the index. This is true for all the indices, not just the DOW, but it is easy to see the influence in the DOW because there are so few stocks. As a company dies, it drops in value below that necessary to be in the index. Once that happens the index drops the loser and puts in a winner. Thus, the index over time does not reflect the true market! Had you invested in the original DOW 30 companies and held until today, you would posses FAR less cash than if you bought the index and held (another reason why index funds outperform). Note that the second peak on the DOW is higher than the first and not as clean a double top as the S&P. I believe that survivor bias is largely responsible for extra inflation of the right peak.

MARKET PSYCHOLOGY:

When I first began talking of the bubble and coming events several years ago, no one would listen, they didn’t believe it and certainly didn’t want to hear it. Now everybody is talking about it, it is the focus of media attention and was the center of political debate. Thus the negative news is now a part of the psyche. The technical measurements, the VIX, VXO, TRIN, Put/Call ratios, and other indicators indeed reflect a high level of volatility and fear. The question is have we reached a level that will produce a sustainable bottom at least in the medium term?

Answering this question was a lot easier a couple months ago before the VIX got above 60 and stayed there. I always go back to my 10 people locked in a room analogy. If they each have 100 dollars, and they are the entire market (with no new money available), and someone believes the market is going to go up, they put in a few dollars… The other people in the room see the market go up and likewise “believe” so they, too, put in a few of their dollars. Well the first guy now sees the market really take off and so he puts his entire 100 bucks in the market. It zooms and soon everyone in the room believes the market only goes up and they all put in their $100. At that point it is a mathematical impossibility for the market to go higher no matter what the participants in the room believe!

Now reverse that example and the same thing is true on the way down. Of course in the real world not every dollar is ever in or out, but EVERY WILLING dollar for that point in time can be. Of course, the truth is that stocks don’t even have to be sold for the value of the stock to go down. All that is required is the perception of a lower value and ALL the stock is instantly worth less. So, are we at that point? My take would be that we are much closer to that point than before. One thing everyone seems to be looking for is “capitulation.” You know, a very high volume sell off and a V bottom with horrid market internals. I don’t know if that HAS to happen, I tend to think that measurements of psychology when they hit extremes can show short term bottoms or tops, but knowing if they mark THE bottom or top is very difficult.

What I saw at dinner last night and on the freeway sure didn’t look like capitulation to me, but what I see in the media does somewhat. I also see the market react to the Geithner nomination and read Obama’s latest plan and can imagine that we could go through a period of HOPE. It will be a false hope as Geithner is a POOR CHOICE, someone who has already played a large part in creating, not solving, the mess we’re in. His actions are the exact opposite of transparent.

So, from a psychological standpoint I see a mixed picture. The people I see in the Great Northwet have yet to truly capitulate with their spending habbits while at the same time the “fear” indicators and media attention argue that this might be a place where people believe that we’ve seen THE bottom since the DOW didn’t break those 2002 lows? Again, I believe that had it not been for survival bias that those lows would have also been broken on the DOW.

MIXED SIGNALS:

I do see something that is sending me mixed signals at this point in time. The ten year bond is dropping to new lows in yield as are the very short term yields. This is signaling a deflationary credit collapse which is in concert with the collapse of the shadow banking system and collapse of commodities. However, it is obvious that the Fed and Treasury have reached the end of their normal policy tools – they are out of their normal bullets. I think it’s ominous that we are asking the Arabs for money… it shows desperation. Then there’s the rumor that we are buying our own treasuries – in effect printing. That would be BAD, and they certainly won’t tell us when they do this but we can look for signs. What would those signs be? How about a sharply falling 10 year? How about sharply spiking gold? This past Thursday we saw a collapsing 10 year yield and we saw gold hold up pretty well while equities crashed. Then on Friday gold shot higher right from the get go and the again the 10 year fell… then the Geithner news and another short covering rally.

These signals are definitely saying something, but is it deflationary credit collapse or is it now saying that the government is buying up their own treasuries? It’s an important question because it will influence the outcome greatly. If they are buying up treasuries another clue will come from the dollar and the currency markets. That’s why I’m watching closely and am pretty much ready for anything at this point.

Unlike the beginning of Elliott Wave 3 of 3 down, the signals are mixed and for me that means putting less of my money at risk while assuming nothing until more clear signals are in place. Protecting hard earned profits and CASH is paramount. That said, I won’t hesitate to jump on a clean move in either direction, but I am very protective and will not let a position run from me nor will I “buy down” a losing position.

There is a good argument to be made that we go higher from here which I am open to on a psychological basis but any such rally will be counter-trend and based on HOPE that will eventually run into the wall that is based upon math.

In regards to trading in this environment I want to note a couple of things. In prior bear markets using the VIX or VXO for entry and exit worked pretty reliably. The formula was simple – buy puts when the VXO was less than 30, sell them when it was above 40 in the early stages, or above 45 to 50 in the later stages. Now we have a VIX and VXO that have gone above 45 and have stayed there since the beginning of October. This is uncharted territory in that regard, but I would offer up the possibility that we are likely to stay above the 45 range for quite some time and that the formula may just have to occur at a higher level… at any rate, buying puts to HOLD for any length of time when the VIX is above 60 just doesn’t seem smart. With the IV as high as it is, using calls as a hedge for any length of time also seems risky and even if you’re right may not be as rewarding as you might otherwise expect. For me, as we are probably nearing the end of the A wave down, I think it’s time to be protective and to not give back anything earned earlier in the year.

OTHER EVENTS:

I have often talked of the other “events” that tend to follow economic events of this magnitude. Those events are much harder to predict than the stock market as they are not based upon underlying math (at least not directly). The truth is that the population of the world exploded on the back of cheap energy and easy credit. That population curve is a parabolic curve also. Nature has a way of placing limits on growth. While mankind has the power of reason on an individual basis, it would seem that making sound judgments about our collective futures is very difficult indeed. I am yet an optimist but I am also aware of history and long term cycles.

Unlike the market, I will not make specific calls about “other” future events. I will simply point you to history and ask that you look at the “events” that have followed within a decade of other times of major economic upheaval. Most people alive today have lived through a relatively peaceful time of unprecedented economic expansion and therefore have difficulty envisioning otherwise. While these events are not within our control, being prepared mentally, physically, and financially is at least somewhat within your control. These “other events” are likely coming and while I’m not saying that your entire life should revolve around this crisis, I am saying that you, your family, and your business need to be prepared for any eventual outcome.

Nate