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Archive for June, 2009

If you are bullish on the market (positive), then you had to like the fact that we fell into a dangerous area (around 896 on the S&P 500) and then rebounded.  We ended the week on not such a hot note. However, we ended above the danger zone.  So, what are we looking at this week?  If you have not read last week’s price alert, please do so before going on.

The price levels of 894 to 895 are KEY.  If you are bullish on the market, you want the market to stay above those levels.  At the end of this past week, we were 16 points ahead of those levels.  We have a very big economic report on Friday with the unemployment number.  If I had to map out a course for the market, it would look like the following:

On Monday and Tuesday, we could see fireworks to the upside or the downside.  I don’t think these two quarter ending days will be mild.  Following the fireworks, we probably will have a few days of calm leading up to the unemployment report.  Friday, anything can happen depending on those numbers.  It comes down to the birth/death ratio, which is the number of jobs that the Government “estimates” we created during the month.  If you have read any of my past alerts, you will see how the Government manipulates the numbers.

For the past 7 years, the Government has estimated a big number in April, then a lesser amount in May, then a lesser amount in June, and then a small amount or even negative amount in July.  If the trend of a negative job number from the Government stays intact, this jobs number could be ugly.  If so, I think that we have topped in June and are heading down to test the March lows.  So, stay tuned…this should get interesting.

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One of the most important aspects of determining risk in the stock market is watching price levels.  A price level is where the stock market closes at the end of the day.  If the S&P 500 ends the day at 895, that is the price level that we want to analyze.  Think of price levels as road markers.  If you are making progress and passing up important road markers, then you are making progress.  If you are not able to pass up important road markers, then you are losing ground. 

899 on the S&P 500 is an important price level.  The stock market fell below that price level yesterday, which is a warning sign.  You don’t want to stay below that level.  Now, the stock market will struggle to end a day back over that price level.  If it fails to do so in the near future, we might be looking at a significant decline.  The longer we stay below that price level, the greater the risk that the stock market rally that started in March is over.  As I have written since that rally started, we are always trying to answer one question.  Is this a pause in the bear market or is the worst behind us?  I still feel that this is a pause.

The next days will give us some clues.  Today is somewhat of a waste because the Federal Reserve Board is giving their Fed statement.  The market behaves very erratically on Fed Day.  Tomorrow’s reaction to the events of today will probably be more telling.

For those of you that follow technical analysis, there are two different moving averages – the simple and the exponential.  The price level of 899 represents the 200 day simple moving average.  The EXP 200 day moving average is 941.  The S&P 500 failed miserably at trying to close above that level.  While traders where cheering that the S&P 500 rose above the simple 200 day MVA, I think that many missed that the 200 day EXP MVA was a failure and a huge warning sign.  

Incidentally, the 200 EXP MVA gave its first warning November 7, 2007, when the S&P 500 was over 1500.  These moving averages are great indicators of bear and bull markets.

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Wall Street (which drives me crazy) calls even the smallest bit of good news “green shoots.”  The analogy is that grass starts to grow in the form of a “green shoot.”  Well, I have many “green shoots” in my yard right now.  Unfortunately, these green shoots are weeds more than anything.  John Mauldin made a very good observation in his latest writing.  He said:

“My premise for uttering the heresy “This Time It’s Different*” is that the fundamental nature of the economic landscape has so changed that comparisons with post-WWII recoveries is at best problematical and at worst misleading.”

His point is that Wall Street is looking at this recession through the lens of past recessions since WWII.  It is like comparing apples to oranges when you think of what makes up the problems that we face today.  Last week, the S&P cut their investment ratings on 22 banks.  Banks depend on strong investment ratings so that they can attract investor money.  The Consumer Price Index saw its largest drop since 1950.  Once again, it looks a lot like deflation more than inflation.  The reality is that there is a higher probability that we are in the throws of a deflationary problem which is something that only time can solve.  The problem with the weeds in my yard is that I cannot do anything about them unless I want brown spots all over my yard.  I will have to wait until next year and make sure that they don’t come back.  This is unlike any recession since the 1930’s. 

This week will have some interesting events.  The Federal Reserve Board meeting, that always makes for an interesting day.  The Treasury is set to sell billions of dollars of Government Bonds on the open market.  It will be interesting to see how interest rates hold up.  Once again, a rising interest rate environment is the last thing that a debt laden economy can handle.

As I write, the S&P 500 is below a critical price level of 900.  If the market were to close below that level, we would want to watch the next couple of days very carefully.  Once again, we want to evaluate whether this stock market rally is the beginning of a new bull market or nothing more than a bear market rally.  It is my view that this is nothing more than a bear market rally.  Thus, you want to be monitoring your risk very closely right now.  I will update more frequently this week as it warrants.

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 As an investment manager, I am constantly looking into the future and evaluating indicators to determine which investments make the most sense.  Since originally warning of the risk in stocks back in 2007, my indicators have not given any signs that the risk for being in the stock market has changed.  As long as the bear market is around, investors really need to be careful regarding the amount of money that is invested in stocks and stock-based mutual funds.

 

What has to change for stocks to be a prudent choice again?  Although there is a laundry list of reasons for investors to be cautious, one risk remains at the top of the list.  It has been the driving factor for the credit crisis.  Until we get past the foreclosure crisis, I believe this bear market will remain in control.

 

In the simplest of explanations, the foreclosure problem can be explained this way.  For years, the mortgage industry gave loans to people who could not afford them.  For example, Joe wants to buy a home.  He goes to the mortgage company and finds out he can qualify for up to a $100,000 home.  The mortgage company determines that loan amount by looking at Joe’s income and expenses.  Joe can afford the $1,000 a month mortgage. 

 

The mortgage industry thought that it would be a good idea to come up with loans other than a 30-year or 15-year mortgage.  With these new loans, that $1,000 a month payment would purchase a much bigger house.  In fact, it is possible that the $1,000 a month payment could buy a house valued at as much as $400,000.

 

In order to accomplish that magic number, the mortgage company had to make a few adjustments to the traditional loan.  First, they arranged it to where Joe just paid the interest for that month versus interest and principle.  This one little change made a big reduction in the amount that he had to pay. 

 

Second, they were able to give him an adjustable rate feature.  This gives Joe a much lower payment the first 3 years or so.  However, that rate adjusts after the first 3 years and the $1,000 goes up to $2,500 a month.  By then, the mortgage company rationalizes with Joe that he can simply refinance the mortgage and get the payment more manageable.

 

So, imagine millions of people just like Joe taking out adjustable rate mortgages and facing a higher mortgage payment in the future.  This is what has happened.  Millions of adjustable rate mortgages had a payment change and the consumer couldn’t afford the mortgage anymore.  They couldn’t refinance the home because the home was now “under water” or worth less than the mortgage.  This is what led to the foreclosure crisis. 

 

So, if we had hundreds of thousands of people facing higher payments in the year ahead, would it be reasonable to assume that we could have a high number of foreclosures? 

 

Well, this is what I wrote to my clients in 2007.  I showed the following graph which pointed out the billions of dollars of mortgages that were about to have higher monthly payments. You can see by this graph that during the first quarter of last year, the largest number of mortgages changed.  As a result, we had the beginning of the worst of the foreclosure crisis last year. 

   

 

Unfortunately, that was round 1 of the foreclosure crisis.  That graph only represented sub-prime mortgages.  Now, we have all of the other types of mortgages whose monthly payments will change coming due this year and into next year.

 

  

This graph shows that we are at the beginning of payment changes for mortgages that will not peak until 2011.  It looks like we will not be out of this problem until 2012. 

 

When you have waves of foreclosures, you have problems with the banking system and everything that is tied to those mortgages.  It gets much more complicated.  To make the problem more challenging, a good percentage of these homeowners owe more than the house is worth.  Look at the following percentages of homeowners with the various types of mortgages:

 

73% homeowners with Option Adjustable Rate Mortgages owe more than the value of the house.

50% homeowners with Sub-prime Mortgages owe more than the value of the house.

45% homeowners with Alt-A Mortgages owe more than the value of the house.

25% of Prime Mortgages owe more than the value of the house. 

 

Contrary to what the Government and Wall Street want you to believe, the risk is still extremely high for the economy and the stock market.  What has plagued the stock market is still the problem. 

 

So what is the bottom line for investors?  There are two things to consider.  First, make sure you understand the amount of risk that you are taking in your company 401(k) plans.  Remember the easiest way to define risk is by looking at the overall percentage of your plan that is invested in stock-based mutual funds or individual stocks.  Second, if your money is with a financial advisor, find out what their strategy is in the event that the bear market is not over.  If they have no strategy and instruct you to just “ride it out,” move your money to an advisor that can manage money in a bear market. 

 

It has never been more important to understand risk than today.

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When everyone thinks the same way, everyone is likely to be wrong.         The Art of Contrary Thinking – Humphrey Neill

Everyone thinks that we are going into hyper-inflation.  I have argued that deflation is more of a problem than anything else.  Debt is a deflation problem, not an inflation problem.

Unfortunately, time is the only thing that cures a debt crisis.  You just don’t have the elements that create inflation.  People are not going to all of the sudden start buying things and circulating printed money.  All of that money that is being printed will be absorbed by debt and losses. 

Scott Burns wrote a good piece the other day about his discussion with Lacy Hunt.  It is a good hysterical perspective on deflation.  Ironically, he talks about Irving Fisher in the article and refers to him as the greatest American economist.  Irving Fisher was the same guy who argued repeatedly that there would be no depression or stock market crash prior to the Dow Jones Industrial Average losing -86% between 1929 and 1933.  Most of his work on deflation was written in 1933 with the Great Depression as the backdrop.   

The difference between the Great Depression and today is that the Government has been more proactive in solving the debt problem.  The similarity is that both situations (1929 and today) were created as a result of a debt crisis.

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Forget about what the Government, Wall Street, or the economists say about the probabilities for the stock market and the economy.  Instead, look at what the people in the day to day trenches are doing with their money.  A key indicator is the actions of the corporate insiders and whether they are buying or selling their company stock.  Think about it for a moment.  If the corporate insiders, the individuals who are seeing the actual numbers and projections for the future, are selling their company stock, then there is obviously something that concerns them. 

According to Wall Street, this is intended to be the buying opportunity of a lifetime.  If so, then why would you sell?  Let’s take a look at the latest statistics that show whether corporate insiders are positive or negative about the future.

In the last few weeks, corporate insiders sold over $335 million in stock versus the buying of only $12 million  (www.financialarmageddon.com).  This begs another question. Is it more concerning that insiders are selling or that insiders are just not buying?

The reality is that the economy is not in good shape and the fundamentals do not suggest that we are remotely close to being out of the woods.  Let’s take a look at a few other variables.

Unemployment

I wrote last Friday about the huge discrepancy in the unemployment report that the Government gives and the unemployment problem that is really facing America.  However, the numbers get even more distorted when you consider other variables.  The temporary workers distort those numbers.  This is the classification of workers who are jumping from temp job to temp job just to make ends meet.  They will count as employed.  The latest shadowstats.com repoprt shows the unemployment number around 20.5%.  That is a far cry from the reported 9.4% unemployment and suggests that a huge headwind faces this economy.

Interest rates

The Government is going to have a tough time getting this economy jump-started if interest rates continue to increase.  This is going to be a key risk factor for the stock market.  This week the Government will be holding another significant bond auction in order to raise money to fund our enormous spending appetite and deficits.  Buyers are demanding higher rates of interest for the bonds thus increasing the interest rates of the government bond markets.  Interest rates were up again last week.  Of course, this affects the interest rates of the consumer markets.  The last thing that a debt crisis needs is rising interest rates.

Price Levels

Let’s not forget the price levels that we watch to determine if the market is making headway and still a good investment or if the risk level has become too high.  The price level of 943 is a huge price level that the S&P 500 has had a tough time getting over.  The longer that the S&P 500 stays below that price level, the larger the chance that the bear market declines will return.  Thus far, this has been a real challenge for the market.

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As we have talked many times in the past, one of the most important pieces of evidence that you can look at is price levels.  As a review, price levels act as road markers on the journey of investing.  They tell you if you are on track versus going the wrong way.  The price levels were telling investors back in December 2007 that if they were invested in the stock market they were heading the wrong way.  As a result (admittedly looking back), those road markers were very accurate in giving out a warning.

Price levels are nothing more than the price of the S&P 500 at the end of each market day.  Yesterday, when the stock market closed for trading during the day, the ending price level was 942.  So, if you are following the road markers and on the right track, then your investment accounts should be doing pretty good.  The opposite is true. If followed, these road markers can tell you when it makes sense to get off of the investment road completely.

Well, we have traveled up to a very important road marker. It is a huge direction changer.  If this road marker is successfully passed and if this road marker stays behind us, then being equity invested will still make sense.  In the event that we cannot pass up this road marker for good and stay under it, there is a good chance we would then be going in the wrong direction.  That road marker first starts with the S&P 500 closing and staying above the price level of 943.82. 

What happens here will speak volumes about what we are up against.  I will be posting more this week as this is something that warrants attention.

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