The market has had a spectacular run lately, both up and down, which has been fantastic if you are a trader, but not if you are a long-term investor. Odds are that if you are a long-term investor you should be in bonds or cash anyhow at this stage of the game as the data clearly shows that equities are about to, or should be at least, take a rather large decline. The bulls have no data to stand on, zero, and the bears have all the evidence in the world including the Federal Reserve telling us that there is little to be excited about and what meager recovery we do have will take years to play out. How that could be interpreted as bullish is beyond me, but I am sure someone will read it that way. As for those waiting for quantitative easing part 2, keep waiting because it is not going to happen unless something different happens, like higher rates or a much stronger dollar.
What data am I pointing to? Pick a data series. The ECRI has been my favorite lately since it has never thrown off a head fake in the -10 range, we are at -9.8 now. Unemployment is also a favorite of mine, where is it getting better? Initial claims are stuck at 450,000+ per week, last week was a gift of seasonal adjustment, that will work itself out in the next couple of weeks. The employment reports are terrible and even the JOLT report was bad. I will say employment has stabilized kind of like how the Titanic stabilized when it finally hit the bottom of the ocean, but I fear there is a ravine close by and we are sitting very close to that edge, look for downside surprises in the employment reports. Housing is DOA and that is certainly not going to change, as I write this the Home Builder Confidence came in at a disheartening 14, need I remind you above 50 is considered positive? Tomorrow we are facing more housing data that is more than likely going to be worse than expected. Face it, there is little data in the bull’s camp except the data can’t get much worse or can it?
On the earnings front, well, we certainly had some great numbers last week, but what about this week? IBM missed on the revenue component and guided down by a couple of cents, no big deal, but big enough to emphasis a slowing in the second half. Texas Instruments met expectations, revenues were mildly light, but considering it is usually easy to beat estimates by a penny or two they couldn’t. Zions Bank, the fabled regional banks that were going to go gang busters this quarter, came in way below estimates, ($.84) vs. est. ($.54) and were light on the revenue side as well. Worse, on the top they said credit was improving, but they are setting aside more for credit losses and their charge offs increased between 1Q and 2Q10, how that is an improvement is beyond me, and we are talking about banks that get to carry loans at make believe values. Even Tupperware missed when people are spending less and eating leftovers! As I write many of these companies are trading lower off between 3 and 6%, not good news for the S&P futures.
Of course, we have a whole slew of earnings this week, a couple hundred companies, so why make big deal over these few firms. Oh, wait, they are IBM, Texas Instruments and Zions Bank, pretty big and respected companies that are leaders in their respective fields. Could earnings improve? Yes. Will they? I honestly do not know because, frankly and like it or not, earnings have been a mixed bag this quarter, but I also think earnings do not matter right now. The macro data is overwhelmingly bad and considering CEO’s do not want to repeat 2009 with negative warnings it is unlikely they will give negative guidance. I do not blame the CEO’s since they were punished relentlessly by the likes of Cramer in 2009 for not being positive enough and even today you only see CEO’s that give the most optimistic forecasts given air time on the TV. It is also or should be widely known that CEO’s are terrible at giving accurate forecasts, look at 2000 earnings releases and see what kind of guidance CEO’s gave back then. Clearly they did not see the slowdown coming when people like myself saw it a mile away, the same may hold true today.
So, is it too late to get short this market? Maybe, it depends on what happens tomorrow. My forecast is for the S&P 500 to initially drop to the 960-980 area where it will rebound, I obviously have no idea when it will happen or how long it will take. After it rebounds I believe it will drop to 860 so there is plenty of time to get short, depending how you plan on shorting it. If you are using options you have to be careful and trade them. If you are using leveraged ETF’s I think there is a lot of danger in holding them, but unleveraged ETF’s, like SH (I own SH), is safer to hold. I believe the best time to get short was 100 points ago, obviously, but last week was a great opportunity as well. Tomorrow, Tuesday, everyone is going to be looking to get short so you will pay a premium to jump on the bandwagon and will be assuming more risk than reward in the short-term.
What is interesting is that the rally, the whippy 7% gain, was a 61.8% retracement from the lowest closing low, 101ish on the SPY. It goes to show that the rally in itself was nothing more than a technical bounce and was rejected when it tried to go higher. That, to me, confirms that there is much more room on the downside than there is on the upside right now. Yes, stocks can move higher depending if ‘something’ happens like a stress test that was designed to not fail actually impresses people, but I actually believe that is irrelevant at this point. Europe is not the cause of our problems, we are as the data is all U.S. data that shows we are if not in another recession/depression certainly going to slow down significantly. I am short so I do not have to worry about working in new positions, I hope you were short as well. (I own various SPY put options, SDS, SH, TZA, BGZ, TYP)
Since the meltdown last year much attention has been paid to how rating agencies determine the difference between AAA and junk paper. In a nutshell, and as you already know, the agencies gave AAA ratings to paper that was literally worthless and according to several books I have just read it is clear that the agencies had no idea how these debt instruments actually worked, I am referring to CDO and asset backed paper. Therefore, I humbly submit this new, simplified, rating system to the SEC and the ratings agencies.
My rating system will clear up any confusion as to the safety of the bonds you buy and investors will be fully aware of the risks. I am confident my recommendations will be turned down because the last thing Wall Street wants is transparency or to give the average (or institutional for that matter) investor a shot of actually understanding the risk they are assuming when they buy fixed income. I mean, what kind of fun could we have if AAA rated paper was actually safe? I am assuming Wall Street likes the fact that they can game the system and make total junk into AAA, which is exactly what they did with ABS. The last thing they want is for investors to make money because that would mean there is less money for them to make, right Goldman?
So, here is my proposed rating system:
AAA – Will now will be called “we think you will get your money back”
AA – Will now be called “we are somewhat confident you will get your money back”
A – Will now be called “you probably will not get your money back”
BBB – Will now be called “crappier”
BB – Will now be called “total crap”
B – Will now be called “are you freaking serious?”
CCC – Will now be called “what, do you hate your money?”
Unrated – Will now be called “there is a sucker born every minute, congratulations you are the sucker”
After reading so many stories about the financial crisis there is one thing that is consistent, regardless of who is telling the story or what context that story is being told, the ratings agencies had no idea what they were doing. In fact, in The Big Short, I highly recommend that book, there were several accounts of money managers talking to the ratings agencies and they said they were totally clueless. They went on to say that their models could not even calculate negative returns, how is that possible? No one at the biggest agencies had any idea how CDO’s or asset backed securities were created. They had no interest in looking at the makeup of what was sub-prime and what was not. They never looked at individual loans and instead used an “average FICO score,” how could you give a AAA rating when you did not look at the instruments backing the bond? These agencies are clueless and they still have no clue.
Sure, they are now downgrading this junk paper, 2 years later, but where were they when defaults were at 4-5%? This is why I am confident that the U.S. and the U.K. will keep their AAA rating right up until the day these countries are in receivership. After all, past actions do dictate future results. For example, Did AIG keep their AAA rating pretty much right up until they were acquired by the government? How about Freddie and Fannie, by the way there was never a government guarantee to this debt, it was merely implied, read a prospectus if you don’t believe me, did they not keep a AAA rating until the end? Then there is Executive Life, an insurer in the early 1990’s that collapsed with the help of Michael Milken’s junk bonds, which kept their AAA rating right until they were in receivership. Executive Life was downgraded only after receivership.
These firms cannot foresee risk or rate risk properly. After lawsuits were filed these firms defenses revolved around “free speech” and not around actually rating risk. Seriously? They now admit that one needs to do their own research and not trust their ratings alone. This must be news to all the insurance companies or pension funds that can only invest in A to AAA paper only. What they are telling you is that their ratings are not real and must have been always been fake. So, how can you trust their ratings on such things as sovereign debt? One simple question, do you think the U.S. will ever actually pay off its debt, all $12T worth of their debt? Not a chance, but they keep the U.S. at AAA and that is why their ratings are a joke.
P.S. – Sorry for the bad attempt at humor, come on, I am a geek, what do you expect?
According to Ben and now his number 2, Donald Kohn, there are no more asset bubbles in the US, none at all. This is coming from the same Fed that missed the mother of all housing bubbles and continually either lied to themselves or us to the severity of the bubble, when they realized it was busting, after the fact. These are not exactly what I would refer to as credible words of comfort when they messed up so badly to begin with.
However, considering we lost millions of jobs in the last 6 months alone and had horrible economic data all while the stock market climbed an unprecedented 60% from its lows, a feat that usually takes 2 years after a recovery has actually occurred, there is no bubble. Right. In my opinion we went from one horrific bubble, what was the mother of all bubbles, to the greatest ,biggest, most fantastic bubble of all time created by the Fed on purpose. I realize that everyone thinks everything is fine now that the market is up and we had a wonderful 3Q09 GDP figure, which will be revised down to 2.5-3%, that was 110% stimulus induced, and do not fool yourself and think it was not, but things are ugly.
We are still reporting 500K initial claims a week, last month if you look at the official number we actually lost some 276K jobs, the BLS added some 86K via the birth/death model, and unemployment is at 11%+. That’s right, I said unemployment is at 11%+ right now and I can prove it. According to the BLS they understated employment by some 800K in the beginning of this year, this was announced in September 2009 by the BLS, which means we are not counting some 800K people who are unemployed because the BLS fudges the numbers with the birth/death model, go look to see their actual numbers they add in HERE.
My point is that there has never been a point in history where the market climbed 60% from its lows in a mere 6 months while we are still shedding jobs. Given that employment has been overstated, or understated depending on how you look at it, and we have had weak or anemic, albeit better, economic data this equity move is unparalleled and is the basic definition of an asset bubble. Here are 2 other things that should make you say hmm, treasuries are doing very well, still, which is highly unusual in a economic recovery, come on stocks and treasuries can’t both be right, and precious metals are also going through the roof.
It is impossible to have every or virtually every asset class go up and have them all be right. According to the markets, which are horrible future forecasters, see September 2007 Dow 14,000 for proof, we are facing deflation or a continued recession with treasuries going up, inflation with commodities doing very well or a complete economic recovery with stocks and corporate bonds going through the roof. Do you see my point? They cannot all be right, it is not possible. I know I will get hate mail for this next statement, but here it goes, stocks are stupid money and that is a fact. Credit markets and the FX markets are always where the smart money is, hence the reason why those markets dwarf the equity markets. If you think about it you know I am right, stocks are last in line during bankruptcy!
The point I am making is this, equities are for gamblers, like me and probably you. The credit markets represent the smartest of the smartest money and what is that market telling you? Treasuries are saying there are still major problems out there, as they are going up, and corporate bonds are pricing in 2% GDP growth. Stocks, however, are pricing in some 4%+ GDP growth with job creation and even credit expansion, none of which is actually happening in real life. I can talk until I am blue in the face about valuation and such, but it will do absolutely no good because people do what people do, they see stocks go up and jump on at the very end to ride them all the way down.
In fact CNBC stated today that the retail investor is coming into the market now. Why? Because human behavior is predictable. They wait for things to go up and then see their friends buying stocks, making money and feel left out and jump on the bandwagon. I saw this happen in 1999/2000 only to see people get killed when the market corrected, which it will, because when we see the behavior I am talking about it is the sign of an asset bubble. It is what happened during every bubble we have had and then we will look back in a year and say how were these people so dumb to fall for it? For the record, I do not think all people are dumb I just think people make bad decisions based on faulty advice and herd mentality.
I also do not think retail investors are jumping into this market as net flows do not show that type of activity, equities still show net redemptions not in flows, so CNBC is flat out wrong. Oh, there is also no money on the sidelines so just forget about that argument it does not exist. That money is sitting in money market accounts because people want it liquid and/or it is part of an asset allocation. In fact, that money has not moved off the sidelines in 15 years so I highly doubt it will move now. If it did, which it is not, that is further evidence of a bubble driven by cheap money as the Fed is literally forcing people to risk their principle to make any return.
The Fed can say all they want that there is no bubble because you and I know there is a major bubble out there. Well, you should know that unless you think 60% rallies happen all the time in a mature market and economy. I think what the Fed is saying is that there is no bubble in securitization or in the housing market, which is debatable, but there is one heck of a bubble in stocks. The one thing I do know for sure is that all bubbles pop, I just do not know when, but this one will go soon and it will be spectacular.
I can say with 100% certainty that I am not sure which way the markets will trade. What I do know is that perfection has been priced into equities and they currently trade at 130x current earnings and 26x future earnings. I know that only 25% of the S&P 500 has beaten earnings expectations with even fewer beating on the bottom line and estimates have been substantially reduced.
I realize that my bearishness has not paid off, well not totally at least. I called a top on August 7th and we basically have seen slightly higher prices over that close, but nothing to be jealous about. In fact, we are trading right in the area that I said was the top and we are on our way back down, kind of. Frankly, this is not the selloff I was looking for, but there are telling signs that I am correct. Treasuries had not sold off during this parabolic rally, which should make you nervous, and that is currently my largest positions, 2 year notes to be exact.
I expect treasuries will outperform in the near term as the dollar gains strength, although today we are seeing a weaker dollar along with weak stocks and weak commodities which is a bit odd. Perhaps we are seeing the decoupling of commodities from the dollar and stocks, but I do not think that is the case. What I do think is happening is people are taking profits from some commodities like gold and oil, both of which have done fairly well this year. However, industrial metals are fairing OK today with silver up 8 cents and palladium, one of my favorites, up over a dollar which is more than likely due to the weaker dollar, but it is possible people see these metals as the recovery play, which is what I am doing on a longer term basis.
Regardless, I do believe this is the beginning of the selloff which could be as little as 7-8% to as large as 20%, depending on who you listen to. I am in the camp of somewhere between the 8-20% range based on a severely overbought market and the underlying fundamentals. If we do not produce 4% GDP growth then there is simply no way equities can remain at these prices which mean there is a lot more pain for those who are not defensive at this stage. I do like corporate bonds which have only 2% GDP growth built into their prices which makes them much less risky than stocks.
I just finished reading an article on CNBC.com where they tell you that selling may happen in September, but you do not have to be the seller, which I found odd. Basically, it said that you should hold your stocks even though a correction could be coming (I thought we were over the buy and hold philosophy?). Frankly, I think that since we do not know how severe the selloff might, or might not, be one would be more inclined to reduce some risk now and be ready to buy when they think it bottomed.
Now, I sold all but about 7% of my equity holdings, which is my comfort zone, and am ready to buy when I think prices are right. I may or may not be right to do this, but so far I have done OK with this strategy and I do believe, based on what rising treasuries are telling me, that I am correct. I just do not see how one can be so completely bullish on the market right now, but that is what makes a market work. The only reason I can foresee strong equity prices is because the liquidity provided from the Fed is so great that there is no place to put assets, but even that philosophy is setting you up for disaster as the Fed could rein in that liquidity fairly quickly.
No matter what you may think I am sure you can agree with me on a few points. Nothing goes straight up and when AIG, Fannie and Freddie are the leaders in the market, up over 200% apiece, there is a problem. There is virtually no equity left in those firms and the government also indicated that they will replace Freddie and Fannie with something else in the future. As for AIG there is nothing there to really salvage as they owe the taxpayers some $130B, but for some reason the stock is parabolic. That type of leadership is not what you want to see in a market that is up some 50% from its lows.
For those reasons, plus slightly less bad fundamentals is why I do not want to risk capital at this stage on the long side. Being short is just plain dangerous as well mostly because of the massive liquidity, but the fact that you really cannot borrow shares to short is another major reason to not short anything, you can’t. The whole thing is just odd and anyone who thinks that it is not weird that the market never goes down is simply not thinking logical. Whether you agree with me or not you know that nothing, ever, goes straight up like what we have seen since July.
I suppose if I was a conspiracy theorist I would have a logical explanation like the Fed is buying stocks or some other government controlled entity. However, I am not that demented, I don’t think at least, but I do think something stinks to high heaven here. How long can we see stocks and bonds trade up in tandem? It just doesn’t make sense, period.
While I feel comfortable in my bearish position I am also willing to say that there is nothing stopping the market from going to the moon. Especially if you cannot short stocks or you make it so expensive that shorting the stock is not a realistic solution, which is not a conspiracy theory as we all know this is happening. Either way we will see what happens, but I cannot stress, based on the pure mathematics, not just my opinion, that there is just a ton of risk in stocks right now.
We did not test the lows of Friday, October 10th, but based on the selloff yesterday and the decline in the Asian markets it looks like the testing of the lows will be tomorrow. Currently the Asian-Pacific markets are down 2 to 6% with the Nikkei leading the selloff.
This thing is not over, but we need to hit the lows before the recovery starts. Even after the lows are reached the 1% or higher daily swings will not stop. Volatility will remain high for months as the market reacts to new lows and economic data. We avoided a complete meltdown in the banking sector, but that risk is mitigated now.
That is good news for us, but the market needs to capitulate to stop the constant 5% daily drops. Unfortunately, this means a one day 10 – 20% or more declines in equities, on top of the 38% loss we have already. Yes, this is a tough pill to swallow, but it needs to happen. Buy on extreme weakness, greater than negative 3% daily drops, and be cautious on strength and unload loosing positions or weaker holdings.
Continue dollar cost averaging, carefully. We are not out of the woods yet, but some companies are trading at great prices with high yields. Buy strong balance sheet firms and consumer cyclical as they should hold up under selling pressure and a recession which could last 2 years.
Oil traded down big time which is in part due to a stronger dollar, but also because world demand is declining rapidly. Gold has lost its luster at the moment, but it looks somewhat attractive at the moment. The good news is treasuries, the longer term maturities, are seeing some strength which was not there a week ago, while this is a sign of flight to quality it does represent confidence in the government and should help keep foreign dollars in the dollar, which we need right now.
Be careful and cautious. We have been calling this market pretty well, but if we are right this will turn very bad in the short-term.
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