6/15/2009 10:40:41 AM
This week's letter is focused on mismatched expectations. Our market outlook is pretty direct and to the point with a couple of charts to illustrate our concerns.
I believe that the mismatch between expectations and what will actually occur, in terms of an economic recovery is about to manifest itself, and it isn't going to be pretty. Recall the equities markets are anticipatory in nature. Market participants have been anticipating a recovery, or at least they have been anticipating that the sell-off in equities was overdone in comparison to the recession that we have been undergoing and that the recession is unlikely to continue for much longer.
Rather than have you perceive me as pessimistic, I would welcome all of you readers to take a step back and observe what is actually happening and what must take place for the recovery scenario to justify a continued movement higher for the markets.
For a recession to move into a recovery, we would have to see growth in the economy, not just a slow down in the rate of contraction. Don't get me wrong, the economy will recover and I am a believer that the slow down in the rate of contraction is an important indicator of that.
The problem, once again, is that there is money flowing in from the sidelines, a lot of money. There are a number of fund managers who are concerned they could lose clients and perhaps even their jobs. Why? Because they are sitting on cash and they need to put it to work in case this rally is for real. Of course, if they had put money to work at the market bottoms, like we did in our model portfolio, they wouldn't have to worry about that as they could easily be enjoying significant gains. There is also a lot of money flowing in from bonds to equities as the price of bonds craters and yields continue to soar.
If we ignore the money flowing into equities at this time, then we need to understand reasons that would drive market participants to want to be buyers of equities versus holding or selling equities, i.e. what would drive the indexes to new highs.
First, and perhaps most importantly, investors have to believe in a growth story. For a growth story to work out, at the end of the day, consumers must be buying things. When consumer sentiment is high and consumers feel like they have excess cash, they increase their spending and that drives economic expansion.
Of course, business spending and government spending are also part of that equation, as well as a rise in exports versus imports. While we could go heavily into trade, with protectionist sentiment on the rise, etc., we shall save that for another letter. We could also explore government spending plans through the stimulus many governments have enacted, but that is also best explored in detail in its own issue. We will focus on business spending and the consumers and their effect on the economy.
Businesses won't continue or even initiate spending unless they see demand for what they produce. In an expanding economy, most businesses see demand pick-up and are willing to spend more. In the case of a contracting economy, many businesses have successfully cut costs to profitability. There have been two major areas of cost cutting, capital investments have been pared to a minimum and labor costs have been significantly reduced by showing workers the door.
The former will take care of itself causing a lag in the realization of lowered costs or increased output, but it will be initiated when companies see expansion around the corner. That hasn't yet happened. The big gotcha in this whole equation is new jobs and the cessation in the growth of unemployment.
With businesses continuing to release employees at a rapid pace and with few new jobs being created, there is an abundant need for the unemployed to seek a source of income. While the government dole can provide a buffer, it isn't a long term solution and it creates a drag on our economy which perpetuates the contraction. This is really the crux of the matter.
Recall that under President George W Bush, the U.S. economy achieved what was termed as a jobless recovery. The equities markets began their upward move in fall of 2002. Jobs didn't begin to increase and the jobless rate decrease until a few years later. The recovery was afforded by cheap money from the Fed and others. That was the same cheap money that powered the bubble in housing prices.
Fast forward to today. We have the Fed with even lower interest rates, the U.S. and other governments with stimulus plans trying to get the economy to ignite. However, jobs are still being lost faster than they are being created, a lot faster. Even if jobs begin to be created faster than they are being lost by 2011 (assuming the same sort of lag as in the most recent recovery, an assumption we believe is overly optimistic), the unemployment rate is likely to spike up well over 10 percent on a national basis, given that we have already reached 9.4% from the prior months 8.9%. We could go on about the shadow unemployment rate already being near 14%. Recall that the Great Depression saw unemployment rates of around 25%, which was generally reflective of people out of work instead of our current massaged numbers.
While we aren't likely to see rates that high, the government is trying to convince us that the unemployment rate is going to top out at 8.9% this year, per the Fed's assumptions and the model for the stress testing assumed this would be the case. The worst case model the stress testing was conducted against assumed that unemployment would top out at 10.0% or the banks would need more capital. If we get a single additional month with the same hike in unemployment as last month, unemployment will have reached 9.9%. Do you really think that unemployment will be contained at 10.0%?
What I am trying to say, less than succinctly, is that the government is trying to keep all of us optimistic so that consumers that still have jobs will continue to spend. However, with this number getting smaller, the government debt getting larger, and businesses not yet spending on their own, this could prove to be a train leaving the station. If you catch up and step on the train right at the beginning, it is near the platform and moving at a slow rate of speed. If you find yourself sprinting after the train, you will quickly find it gaining speed while your ability to catch up is limited to your foot speed while carrying your luggage. Now that isn't a pretty picture.
Market pundits will all have their own perspective on where the market is going. They will justify the direction based on whatever they can muster. I am not buying into moving immediately into a mode of economic expansion because I recall the economic expansion under the last President, and the smoke and mirrors that were regularly used to make us believe that the economy was doing better than it was. Mainly, this came down to attempts to make the job picture look better as well as misdirection about inflation. It was obvious when the price of milk, bread, and eggs had doubled that inflation was rampant. The CPI, however, didn't move up much. That doesn't even take into account that the price of gasoline was excluded from the core inflation rate.
We seem to be at a point where an ideology has taken hold that the public must be fed optimistic reports that everything is OK. Part of this ideology is also that the public won't make good decisions for themselves. The remaining part of this ideology is that the government needs to step in to make these decisions in the best interests of the public.
I think that market participants are just now waking up to the mismatched expectations of what we are being told by government officials and what is really taking place. Recall that before the onset of this crisis, various officials including the former Treasury Secretary, the former Fed Chairman, and the current Fed Chairman all told us everything was fine. Clearly it wasn't. In fact, "the Maestro" Alan Greenspan was known for his obfuscation while he served as chairman of the Federal Reserve. Once he left office, he began to tour on the lucrative lecture circuit and shared an entirely different view of the economy. Apparently, he could see things going bad, and once he wasn't required to provide an optimistic message, he didn't. This was looked on as in bad taste, since he was undermining the current Fed Chairman, but at least he was speaking plainly.
Once it becomes clear that the banks will require more capital reserves, the latest talk about the banks repaying TARP money will switch to the next bailout. Perhaps this time we will be able to avoid a collapse of the financial system, but it will still be a difficult time for the economies of the world, and in particular, for those laboring in those economies, but even worse for the growing number of the unemployed.
Personally, I am ready to have them give it to me straight. I am tired of the government and company CEOs trying to provide the most optimistic message possible instead of being forthcoming and saying that things are tough and may get tougher but here is what we will do about it. How hard is that? I guess it depends if you subscribe to the ideology that the public are incapable of making good choices for themselves. Then you can justify telling the public or shareholders anything you want in their best interest.
I think I remember how that attitude went back in Boston, Massachusetts in 1773. Then, a group of colonists rebelled over taxation without representation and had a little tea party. By 1776, a new nation was born because the overlords were arrogant enough to think that the people couldn't decide for themselves. I think we are headed for a revolution in this country and around the world. It may not begin as a solution to the global economic glut, but it will be brought on by it. It actually starts with mismatched expectations between what we are being told by our government and the economic realities that will shortly hit home.
Market Outlook and Conclusion
On Friday, the TED Spread closed in the normal range only off a fraction of a point from a week earlier. Interbank lending markets are functioning normally.
The price of oil continues to climb with the price of crude oil (as determined by the near month futures) closing at $72.04 for the week, just off the yearly high set on Thursday.
We believe that a downside move has begun and the question is how significant will this move be. There is enough disinformation floating around that we think it is time that the market participants need to be shaken up a bit so this move may be more than we anticipated. We were looking for a move of 4 -5%, but it could end up being the beginning of a retest of the lows. We doubt that but have been urging readers to take defensive action and did so in our model portfolio.
We could once again look at the Dow and see that the Dow was unable to close above 8800, closing at 8799.26 on Friday. With the 200-DEMA below that level now, the close was actually above this important resistance level, but a one day move isn't sufficient to assure a continued move higher, especially a light volume move as seen on Friday.
Rather than drag out a view that the markets are headed lower with a tremendous number of charts of theories supporting our view, we will feature only two charts. We will look at the VXN, which measures implied volatility and tends to move inversely with the NASDAQ-100. We will also look at the Philadelphia Semiconductor Index to determine where it is going. The reason we are looking at both of these charts is that the semiconductors and NASDAQ-100 have been leading the advance. Where they go, the market either follows or other leadership needs to manifest itself.
Let's first take a look at the implied volatility of the NASDAQ-100 by looking at the chart of the index for it:
The chart states pretty clearly that I don't know whether the bulls or bears will win out here. However, since trading is about probabilities, the probability is greater that the VXN will break the intermediate term downtrend and begin to move higher. This would be a significant reversal and suggests the NASDAQ-100 will be moving lower.
It is now time to aggressively short the market, at least for a short/intermediate term trade. The bears are getting the upper hand and a resultant move could be larger than you would think, even in a single day.
We need to also look at the semiconductors to have another input. The semiconductors are a significant influence on the NASDAQ and therefore a good barometer of where the market is headed. The Philadelphia Semiconductor Index is a good proxy for semiconductors, in general.
Last week we wrote, "A number of trading services are coming out bullish this week on the semi-conductors as they break out. That is a momentum trade and it is a good one, if the economic expansion continues without a hiccup. If the markets decide to pull back later this week, it could easily stall semiconductors as their index approached a double top." Looking at the chart, we believe the bulls are bears are fairly evenly matched and the optimists will anticipate the 50-DEMA crossing the 200-DEMA and will pile in to the semiconductors. We are mindful of the tweezers-top which is an example of a powerful double top formation.
You need to consider putting on some short/intermediate term short trades and should have already taken defensive action on your long positions. Follow what we do in our portfolio to make some profits on the downside and watch for us to add to our long-term portfolio when we call the next bottom.
Our long term portfolio currently holds an average gain of over 88% per closed position. Our unrealized gains on open positions are up more than 148% and we have ample cash to enter new long-term positions as well as short/intermediate term positions.
We believe that you can use this bull/bear clash to your advantage. To see how we will play this actively, you should consider a subscription to the McMillan Portfolio.
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