The Bear is Out of the Box (Excerpt)

By: Michael Swanson | Sun, Apr 13, 2008
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Last week I took a short position against the broad market on Monday. As I entered this position I immediately posted a WSW Power Investor Elite bulletin. Two days later my indicators gave me a confirmed sell signal. I believe the bear is out of the box. The market may bounce a day or two after Friday's big drop, but the next 150-200 point move in the S&P 500 is down.

I'm not the only one worried about the market. George Soros came out of retirement and has taken back control of his hedge fund to make money shorting the market. You may have been trained to hate him by Bill O'Reilly and FOX News where they demonize Soros for opposing George Bush and his Iraq war game, but when it comes to financial markets he has a history of being right and being right big. He is one of the most successful investors in history.

At 77 years old he appears to be coming out of retirement with the goal of making a name of himself for the history books. He is releasing a new book called "The New Paradigm for Financial Markets" in which he claims we are witnessing the bursting of a "superbubble." He claims we are in the "biggest financial crisis of my lifetime." According to the International Herald Tribune:

Soros has been worrying about the fragile state of the markets for years. But last summer, at a luncheon at his home in Southampton with 20 prominent financiers, he struck an unusually bearish note.

"The mood of the group was generally gloomy, but George said we were going into a serious recession," said Byron Wien, the chief investment strategist of Pequot Capital, a hedge fund.

Soros was one of only two people there who predicted the American economy was headed for a recession, he said.

Shortly after that luncheon Soros began meeting with hedge fund managers like John Paulson, who was early to predict a crisis in the housing market. He interrogated his portfolio managers and external hedge funds that manage his fund's money, and he took on new positions to hedge where they might have gone wrong. His last-minute strategies contributed to a 32 percent return -- or roughly $4 billion for the year.

The more Soros learned about the crisis, the more certain he became that he should rebroadcast his theories. In the book, Soros, a fierce critic of the Bush administration, faults regulators for allowing the buildup of the housing and mortgage bubbles. He envisions a time, not so distant, when the dollar is no longer the world's main currency and people will have a harder time borrowing money.

He isn't the only one concerned. Former Fed Chairman Paul Volker called the current problems "the mother of all crisis" in a speech last week. He made the comment that before he became Fed Chairman there hadn't been a financial crisis in over 40 years. Since the 1970's though he counts 20 of them. He claims this one though is going to be the worst of them all and that the US is in the early stage of a dollar crisis.

My thinking is simple. The last bear market lasted almost three years in duration. It came as the result of the unwinding of the tech bubble in the late 1990's. This bear market isn't going to end just six months after it started and those that think it is over now are nuts. This bear market is the unwinding of the real estate and credit bubble and that has much bigger consequences for the economy than the tech bubble did.

This week Citigroup and Merrill Lynch are expected to announce write-downs of over $15 billion for worthless "level three" mortgage debt. The worlds biggest banks have so far written down over $250 billion in debt in the past year. The IMF claims that the size of the losses is likely to top $945 billion. So far the banks have been revealing losses piecemeal every quarter in fear that if they reveal the true extent of them they'll cause a Bear Stearns style run on their reserves. The government has turned a blind eye to their accounting games so far, but the bear market will not come to an end until the size of the losses are finally revealed.

At this weekend G-7 summit there was talk of forcing banks to reveal their losses over the next 100 days. According to Reuters:

Policy-makers pledged over the weekend to purge capitalism of the excess that caused the latest crisis in financial markets.

It is a tall order, made taller when governments of the Group of Seven free-market democracies promised after meeting in Washington to finish much of the groundwork within 100 days, and the rest by year-end.

The 100-day deadline, based on recommendations formulated by the Financial Stability Forum, commits supervisory bodies to set higher capital requirements and tells banks to reveal the full extent of their losses in their first-half earnings reports....

...How to value assets in markets that are no longer liquid goes to the heart of what the current credit crunch, now in its ninth month, is all about.

But not everyone is rushing to write off the G7 initiative, at least while the ink was drying on the reform plan, which the policy-makers said was about making the system safer for the future rather than providing a fast fix to the current turmoil.

It is hard to believe that the banks will all of a sudden reveal their losses for the good of the system. Not when so far the Fed has done everything it can to try to accommodate them at the risk of the dollar and inflation. When you go to the gas pump and pay more for gas you are doing so as a direct result of the Fed printing money to help the banks. More money in circulation makes the price of goods and energy rise. It is an invisible tax you are paying to help the banks and fund the bloated government deficit.

We had a little bounce off of the January lows in March. That rally has been much weaker than the previous two rallies we have seen since the S&P 500 market topped in October. Volume has been lighter on this rally than the previous two and already the advance/decline line has broken down on the NYSE, with the A/D line for the Nasdaq already sitting on its March low. The Libor rate, which banks charge each other, also has been rising in the past few weeks - suggesting that the credit crisis is actually worsening. Last week when the Bank of England cuts rates down to 4.6% the Libor rate didn't drop at all, maintaining its 1.2% spread.

Of course in the US attention isn't paid much to the Libor rate on Fox Business News. Right now its earnings season and that focus is hoping for some silver linings. Last week UPS lowered their earnings estimates and GE blew up for a 12.79% loss on Friday when it missed earnings and gave lower guidance. Moves like you see in the chart above are why you respect bear markets.

The daily stochastics for the S&P 500 gave a sell signal last week. We have had four such sell signals so far in this bear market and after each one corrections in the market followed.

Last weekend I was reading and listening to many market analysts - many of whom I have a lot of respect for. Almost all of them said the market might go higher. Even ones who were bearish on the big picture said such things as you have to "give the market the benefit of the doubt." We had two big up days since the March low and those type of days make people hesitant to say the market is going to start to drop. No one wants to be wrong or tell people the market may drop only to see it go higher. Being wrong like that can cost you your job if you are in the financial business, because people are always more obsessed with missing a rally than what they may lose by holding on in a bear market. But the big picture is clear.

It is easy to get caught up trying to figure out what the market is going to do this week or next week, but if you step back from everything all you need to recognize is that this is a classic bear market. That's all you need to focus on. When the market averages are below their 150 and 200-day moving averages and those moving averages are pointing down it's a bear market. In times like that you don't want to make big bets on stocks. You want to preserve your capital so you can buy as the next bull market begins and make money on the short side.

I've traded and experienced bear markets before. To me the situation we are in now is very similar to where the markets were in February of 2001. Back then the markets were into their fifth month of the bear market. Notice how the long-term moving averages were sloping down just as they are now. Notice how the 1300 level on the S&P 500 was acting as support from November through February back then just as the 1270 area is now. And finally notice what happened in February once the market closed below this level. The market fell all of the way down to the 1100 area by April for a 20% drop from its February high. I believe a similar drop is ahead of us in this coming quarter.

For the short-term though the market is oversold on a 60 minute chart. It would not surprise me if it bounces for 2-3 days this week. If such a bounce happens the low of that bounce will become the critical support area. If that bounce fades and then market closes below the next short-term support level I expect the drop to speed up with a quick drop to the March lows, similar in magnitude to the drop we saw in January.

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Michael Swanson

Author: Michael Swanson

Michael Swanson,
www.wallstreetwindow.com

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