Much has been made about the death cross of late, the 50 day moving average crossing through the 200 day moving average, although I think and know it is a significant event it is nothing compared to something else I have noticed. We are all aware of the primary reason of the bull run over the past 12 months, massively oversold markets, combined with marginally better economic data and, most importantly, a weakening dollar. Why the dollar weakened is important to note, quantitative easing via the Federal Reserve’s asset purchases or the printing of money. Although we will not know the long-term implications of QE for some time to come it is safe to assume it accomplished its goal, weaken the dollar and boost the economic data through negative interest rates, essentially.
We all know the market action of late, a horrendous selloff which was only a surprise to the parade of bulls on CNBC and those who kept their heads buried in the sand, but those out in the real world knew it was coming. What was unexpected was the 4th of July rally that took us back up some 7% on the backdrop of pretty bad economic data. Some of the bounce was because of a technical bounce and some of it was because of the expectations of stronger earnings which started last week. I fully expected 2Q10 earnings to be good, but I expected to see more top line misses and the outlook from CEO’s to be downgraded as well. So far, it is a mixed bag, but the outlook or guidance remains very bullish for many firms, however, a look back through prior earning announcements, particularly 2000 releases, as Mark forwarded to me, shows that Intel did not foresee a slowdown there either, so trust the economic data rather than CEO guidance going forward.
Back to what is going on in the equities market and why the dark cross is less important than the other ‘grey swan’ that is going on. First, everyone and their grandmother knows or knew about the dark cross, not that it takes away from its importance, but when everyone knows about it very rarely does the market deliver the results we are looking for. Except the market kind of did deliver, but stopped short and rallied all the way back to some important moving averages where it failed to break through, very bearish from my lens. At the same time we saw the selloff begin the dollar was moving towards the 89 mark on the DXY, but it stalled after a dramatic breakout and reversed course. Not only did the DXY reverse course, but it got crushed moving down from 89ish to about 82.5, not an insignificant move.
Exhibit 1-1 2 Month DXY Chart
Why is this a big deal? It is a big deal because stocks went up on a weak dollar trend which meant a better environment for U.S. companies to sell products abroad. Basically, a weaker dollar is better for U.S. exports and sales as we become more competitive in the world. It made sense for the markets to not like the move of the DXY from the low 70’s to 89, but to not like the move from 89 to 82.5, well, I am perplexed. The market should love this and we should be flying to at least 1,100 on the S&P 500, but we are not. This is a huge warning sign that stocks cannot rally on a weak dollar and it means more than the dark cross.
Exhibit 1-2 1 Year S&P 500 and DXY
The charts show the trends pretty clearly, lower dollar higher equity prices, higher dollar, lower equity prices, but over the past couple of months things have been out of whack. What else is going on during this time period? Treasury yields are collapsing to historic lows. We have the 2 year treasury under .60%, the 10 year under 3% and the 30 year under 4% which is a sign of 2 things, risk aversion and fear of deflation. My belief is deflation is the clear danger as of right now, it is fairly evident from my lens and the market is pricing it in as we speak. The credit markets have been pricing it in for some time and will continue to, I am bullish on debt securities, have been for some time now, but the equities markets, well, it has not priced in any real deflationary pressure at all.
Exhibit 1-3 Yield Curve
Granted, we have not seen total deflation yet, just the beginning sign of it, but the evidence is pointing towards it. Here is the rub, everyone says the Fed will do QE2, but they won’t do it. See my other posts as to why they will not do it, but from my lens they would be insane to even attempt QE2 at this point. The problems in the U.S. economy has nothing to do with what is happening in Europe, a little I suppose, but not directly related. My past posts about Europe relate directly to actual defaults by countries and to corporate earnings. I think anyone will find it hard to believe that the Jones’s are not buying that new car because they are worried about Hungary being kicked out of the IMF-EU rescue package. They are not buying a car because they are worried about their job and do not want to take on much debt or because their credit score is so lousy they cannot get financing, 25% of Americans have a credit score below 600 now. Instead the Jones’s are paying off debt and buying what they need, not what they want which is deflationary.
This trend will continue and so far only the credit markets are pricing this in, the equity markets are in La-La Land, still. The DXY – S&P cross is very bearish if the trend continues and will mean a big correction in the near future especially if commodities head lower as well. Commodities are not performing well and that is reflected in the Baltic Dry Index and combine that in with the above information and it is putting the explanation point on the whole theory. So far the only strategist I know for sure who is putting all of these pieces together, and has been ridiculed relentlessly by the bulls on CNBC and such, is David Rosenberg. All of the rest of the strategists are telling you to buy the dips even when they see everything I presented to you, they know what it means and, to top it off, they know the ECRI is rolling over and housing is going down the tubes. It is incredible to say the least. Be ready for some fireworks soon unless this trend breaks.
What works in a deflationary environment? Income and dividends, pure and simple. I like (and own) the following: CTL, MO, PM, WM, PFE, MRK, LLY, BPT, RYU, PEY, INB, DNH, CGO, VZ, high quality corporate bonds, strategic income bond funds, emerging market debt funds (PCY has been good to me), short and intermediate term treasury funds. Many of the above mentioned stocks have underperformed, which I like, and pay very nice dividend yields, which I love, but may not do well in an inflationary environment. This is why one has to hedge with precious metals or, at the very least, TIPS.
Well, this is beyond me, the DXY is dropping like a rock below the 50 day moving average on horrible news driving futures higher. There is simply no reason for this whatsoever as bad news usually rallies the dollar. What is more odd is gold and silver are also down fairly substantially as well. Frankly, it is not adding up in my book and something stinks. Correlations and inverse correlations don’t just break down for no reason on without any news. Perhaps one should be careful shorting this market today and look for a retest of 1040, the Euro is up large @ 1.24 + 0.0161 when the banks had to barrow a substantial amount for 6 days from the ECB which indicates problems. Stay nimble.
I am watching the happenings in Venezuela carefully as this might be an indication of things to come in the US. While most people naively think that “it can never happen here” I would like to warn you that every country where these things have happened uttered that exact same phrase. Whether it happens because the Federal Reserve loses control over the devaluation of the USD or because foreign debt buyers just stop buying US debt the one thing I am sure of is that it can and will happen here at some point in the future.
What I am talking about is massive devaluation of the currency which leads to inflation or, in this case, hyperinflation. I have stated that for the moment we do not have to worry about inflation, and I stand by that prediction, for now, at some point we will have to cleanse our demons and massive balance sheet. The one and only thing that is saving us right now from inflation is our pitiful employment situation, which is not getting any better I might add. Without employment there will not be wage inflation and we will continue to have subdued demand for products with the exception of food and energy.
Even though I fully believe deflation is here for the near-term, reinforced by the Fed itself, there is one caveat to my prediction, the devaluation of the USD. I have made no secret that I believe that the Fed and the current administration, along with the former administration, have had an unofficial policy of maintaining a weak dollar. The reason for the weak dollar policy is simple, it boosts GDP and earnings in a globalized world along with a host of other seemingly positive economic stimulus. However, a weak dollar is not good long-term for a country and hurts the population as dollar sensitive products become very expensive, i.e. $140 a barrel oil marks the low point of the USD in 2008, and is inflationary without the benefit of actual inflation.
Let me explain, inflation created by excess money printing usually enters the banking system and is loaned out to the population. This is called money velocity and creates too many dollars chasing too few of goods. However, without money velocity traditional inflation cannot happen, but even if the excess money printing does not enter the economy it can still devalue the currency based on the future expectation of it entering the system. This is what was happening up until the last dollar rally and I would like to point out that the last dollar rally was because, depending on who you listen to, short covering, fear about sovereign default (i.e. people were afraid of another systemic meltdown which, in turn, initiated short covering. This is the scenario I favor), or people felt the Fed was actually going to raise interest rates which is absurd, in my opinion.
The dollar devaluation that we have seen explains why oil prices are on the rise as demand simply is not there. It also explains why metals have also climbed for most of 2009 as well. What is scary about both oil and metals going up, especially in 4Q09, are the fact that these prices increased in the face of a stronger dollar which is counterintuitive. Well, it is for gold at least as oil could increase with a strong dollar if there is sufficient demand, but, frankly, there is not as much demand as the price indicates. Regardless, rising energy prices when the economy is weak, to me, is a warning sign of a problem and should forewarn you of things to come, inflation.
If we continue with our insanity that Washington and the Fed is telling us we need it is inevitable that we will end up in a situation like Venezuela where we will either willingly or unwillingly have to devalue our currency. There are pluses to devaluation as your debt, assuming a fixed interest rate, will remain static and your earnings will eventually increase allowing you to pay off your debt faster. However, the negatives outweigh the positives by a long shot as your savings are worthless. This is why we saw the people of Venezuela go out and buy everything they could because goods will be worth more than the paper money.
What is disturbing though is the fact that even though devaluation creates higher prices the Venezuelan government shutdown some stores for “price gouging” which is humorous, in a sick way. The government intentionally creates inflation to make their balance sheet look better, but because new goods will cost more stores cannot compensate by charging more for products they currently have. How in the world are these stores supposed to stay in business or id the governments point to put them out of business? The next logical question to ask is how would this type of scenario play out in the US?
While we do not really have any past history to use as a bench market I think what we see happening in Venezuela is probably a very good example. Right down to the black markets that are more than likely popping up all over the place to provide goods and services the population cannot receive from the usual sources. What I would be interested in knowing is if these black markets are using another medium of exchange, i.e. US dollars, gold, silver, Euros, whatever it might be, to pay for these goods and services. I would be inclined to believe that is what is happening, but there is simply no proof and I am willing to bet no one wants to openly talk about such things for obvious reasons.
What is usually accompanied with this type of devaluation is the government imposing its will that its citizens continue to use its currency no matter what. We saw this happen in Zimbabwe, but just like in Zimbabwe the black market switched over to an alternative payment system, gold. It is important to note that gold is being used because dollars or other currencies simply are not plentiful in the country and gold can be mined, of course gold has also been used as currency for thousands of years as well and at current prices a little bit goes a long way. Basically, forced price controls and forced use of devalued, or worthless, currencies simply do not work, that type of system never has in 4,000 years.
I am not suggesting the US or Venezuela will turn into Zimbabwe, but I am saying that we are facing certain financial Armageddon at some point in the future. All the US has managed to do is kick the can further down the road for others to manage and we are running out of road, unfortunately. We will have only a few choices in the very near future and the most obvious, because it is politically easier, is to inflate our way out of our problems. While this seems like a good idea I am thinking that the 77 million soon to be retired Baby Boomers who are about to be living on a fixed income will like this strategy. However, it is unlikely that they will like the alternative either, much higher taxes, less Social Security and steep cuts in Medicare.
We live in unique times and the one certainty we have is that there is no certainty of anything. I do not believe that there is any question of whether or not we will follow Venezuela, in my mind it is only a matter of when it will happen, not if. However, before we go down that road you will be comforted in knowing that Japan or the UK will more than likely go down that path before us as they are in worse shape than the US. Regardless, watching what happens now will give you an idea of what could happen here and is also why I am a big proponent of investing in precious metals.
So far holding gold, silver, platinum or palladium has been a very sound move on my part, but I actually hope that these investments turn out to be horrible for me because that will mean I was wrong about the future of the US monetary system. While I might be wrong what concerns me is that there are many people who are a lot smarter than I who are sounding the same alarm I am. I would also like to not be naïve enough to believe that “it could never happen here” either because I am sure there are millions of people throughout history who would tell us that you should never, ever, utter those words because no person or country is special.
The term “Black Swan” is used far too often in today’s discussions about the financial markets and it pertains to unforeseen events that cause havoc on the economy or the markets themselves. Last year was called a “Black Swan” event even though the warning signs were there for at least a year, some say since 2006. In today’s discussion the news coming out of Dubai is being hailed as another Black Swan event as they are talking about delaying payment on some of their debt on December 14th.
The events in Dubai is the furthest thing from a black swan event as we have all known about this problem for the better part of 6 months or more. The country is in poor financial shape and is, basically, insolvent without a bailout from its neighbor Abu Dhabi, the rulers of the two nations are related. I would be willing to bet that the bailout will come in some fashion, but only after an example is made of the smaller nation, but is this a black swan event? What is more a more relevant question is will a technical default on Dubai’s debt be a trigger for something bigger?
I do not believe that the Dubai situation is a black swan event as it was a known situation for some time and those who lent the country money knew they were way over leveraged and lent that money at their own risk. Whether or not this default, if it actually happens, will lead to other events, a domino effect if you will, remains to be seen. Since the sub-prime situation led to a domino effect in the mortgage market it is safe to assume there will be some fallout from a sovereign default somewhere along the way. Considering Mexico was downgraded to BBB and Vietnam raised interest rates and devalued its Dong by 5% there are definitely trembling in the FX markets that cannot be ignored.
The effects of these issues are unknown to me at this time because I do not know how China will respond, although I have my speculations, nor do I know what exposure US or European banks have to the Middles East at this stage of the game. I am willing to bet their exposure, especially JP Morgan, BoA and Citi, is much higher than we all think at this stage of the game since interest rates in that area of the world are much higher than the “norm” in the US and Western Europe. However, the real black swan events that I think are being ignored are the ones in Eastern Europe where currency devaluation and real sovereign default is actually happening and has been happening for some time now. Not that you ever hear about that from the media, but read about it sometime in European blogs or news outlets and it is disturbing.
Basically, I believe the greenback will have the stay of execution I have been expecting for some time now and it should rally nicely on this possible default news. In reality a Dubai default means very little to the US other than it is a sovereign nation defaulting, but it will trigger a flight to quality which means if the dollar equity trade is intact the market could be in real trouble. Further pressure for the greenback is coming from Japan who said it was concerned over the Yen’s strength last night in a Bloomberg story. This is an issue I wrote about a day ago as well, but essentially the Yen is up about 8% against the USD which is an issue for the Japanese since they export more goods than they import. A strong Yen is not good for them as it means their products will be more expensive in the US and China, expect to see Japan intervene in the FX markets to strengthen the USD/JPY pair, IMHO.
This puts the US at odds with its trading partners because while we talk like we want a strong currency we do not. A weak currency means we make our products cheaper overseas, narrow our trade deficit and essentially boost our GDP in a very phony way. As an aside it also makes corporate profits look fantastic if they generate any overseas business as a weak dollar means they can sell the same amount, or less in fact, and when those earnings are turned over to US dollars it looks like sales increased when they did not, Houdini earnings! We will have to see who’s will is stronger, the will of investors who are about to flee to the USD for protection which will surely drive up the USD or Helicopter Ben and our Congress hell bent on devaluing our currency to pay for their crazy social engineering and to make it look like they are leading us to recovery when they are really leading us to a Zimbabwean fate.
The market has not been able to hold a rally as the dollar strengthens which shows that the 60% rally we witnessed was purely liquidity driven. Essentially, the Fed, in their infinite wisdom, decided to drive investors out of less risky assets into high risk assets in order to re-inflate the asset bubble. While the Fed was busy pumping money into everyone’s pocket, except for the peoples, it has cost the dollar much of its value, or so you think.
Actually, the dollar is not near its lows of 2008 yet, but when the DXY was at 89 and it fell to 75 it felt like it plunged in value and had me concerned. I am still very concerned on a long-term basis, as I see a runaway government with deficits as far as the eye can see, but since everyone and their grandmother was short the USD, it was a given it was going to go up. Since this rally was a liquidity weak dollar rally a strong dollar will drive equities down along with commodities, which I wrote about on Sunday night I believe. As predicted, we had a super rally in the dollar and stocks got clobbered along with commodities and I suspect that will continue for a little while as the dollar rally will soon turn into a fear driven rally.
Whether I or you like the dollar long or short-term is irrelevant as the US government guarantees return of principal. This explains why at one point in time people were paying negative interest rates to the US government to buy short-term treasuries during the crisis. It was worth it for the comfort to know you were going to limit your losses because at that time you did not know if your bank was going to open its doors the next day. Do any of you remember that? Anyhow, this strength in the dollar will create selling in equities, just like a weak dollar drove the risk trade.
This explains why I stopped buying gold and this explains why I got short the market well over a week ago. It is not that I am perfect or a psychic it is just that things change, quickly. The dollar is not going to go in one direction forever and stocks do not always go up. It is also clear to anyone who is paying attention to fundamentals that the market is so far ahead of itself it is bordering on insanity. Valuations do matter and we are at a point where the valuations are just way out of whack with what is real and people are setting themselves up for real pain by not realizing this now.
If you do not pay attention to the things that are happening on the fringe of the markets, like the dollar, then you will miss the things that matter the most and impact your portfolios the most. Long-term the dollar will decline unless Washington gets their act together, but they won’t, so be bearish on the dollar long-term until proven differently, by the way that long-term bearish dollar outlook is also bearish on US equities as well. However, a short-term outlook is completely different and driven by the here and now so don’t confuse the two. I could be wrong about what I think is going to happen, but so far, I am right on the money and I think we are headed for more downside pain in the very near-term.
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