Stock Market Denial

The Stock Market is in a State of Denial

First, you may have noticed that the market has not exactly ignored the problems.  The S&P 500 peaked about five weeks ago at 1344 and then proceeded to fall 7.1%.  It has since climbed back by 4.6% in a rally that looks somewhat anemic by past standards.  This type of action is actually typical of the way most bear markets begin.  Generally bear markets go through three psychological phases----denial, concern and capitulation.  Most often, but not always, the market rallies between each phase.  The denial phase is the initial downleg from the bull market high, and we are only at the start of that downleg now.

Read more: Comstock Partners, Business Insider

This pretty well sums up our thoughts  on where the markets sit now. Most market letters rarely discusss risk, but that is a main concern of this letter. Our view frankly is that  we exited stock positions prior to the Japanese earthquake, though we do not claim to be seismic experts. The point  then and now was that the risk was not worth staying long, as was quickly the case. We will take a very long view this weekend, listing reasons for being cautious as well as other factors that you are not likely to read in other letters.

The point of this letter is to prepare you for one of the great buying opportunities in the rest of this bear market, it is coming in a year or two. But to be prepared one must be informed, in cash, and aware of what is happening, as Kipling remarked, when others are losing their heads. We listed the reasons for exiting the stock market weeks ago and they are all equally valid now. The better bets will probably be made by taking short or defensive positions rather than going long now.

So, let’s begin.

 

Stock Market

Others are calling for  resumption of the bull trend, we are not so sure. Here the hourly chart of the SPX appears to have traced out four of five waves. At bottom the MACD is topped out. Note that the top of this latest rise is lower than the previous highs of February to early March. This is precisely what Comstock is pointing out. Wave 4 has not overlapped  so this is an acceptable interpretation, again we never claim to be Elliott Wave Experts.

Our longer term internal indicators are improving from the big sell off but are still below previous levels. The weekly advance decline chart is still in ‘pedal to the metal bull mode. Again the weekly A/D line is still headed up. It does not evidence topping action yet. 

We usually show the NYSE Summation Index but this is the NASD summation index. As you can see it got hit pretty hard, not back to last July levels but harder hit than the NYSE which is not shown. The usual suspects, APPL, GOOG, PCLN, are doing well. This is because quant formulas are simply selling out of declining stocks and moving to those still going up. This is the very definition of a crowded trade, more and more in fewer and fewer net positions.

The S & P has more than 50% of its stocks above their 50 day moving average. So what’s the problem?

 

Bonds 

Not surprisingly bonds show the opposite picture.  Stop reading here, go back to page 2, and compare!  We have lower highs in stocks and higher highs in bonds. This is the very point of tech analysis, listen to what the market is saying, the market is getting more defensive with more net bond positions. This is in spite of all the selling by PIMCO and the FED. Here we see a potential Wave 4 holding coming right back to the top of Wave 1. MACD is holding  a bit higher than at Wave 1 which is what should happen.

Our point here is that bonds are holding up rather well. Frankly we would rather put in some  bids for TLT at lower prices and see if those are filled orders this next week.

Given my failed attempt to establish a dollar position I am hesitant to even show the next chart but …

 

 

 

Currencies

 

Red black bars are the US Dollar. The black line is the Australian Dollar The Aussie is basically a commodity currency, tied to their production of all sorts of minerals. Note that at the extreme of the 2008 crash, the dollar rallied to new highs and the Aussie sank to a low along with commodity prices. Now with new highs in oil, gold, etc, the Aussie is at a higher high than in mid 2008. The US Dollar however, amid a ultra bearish positive sentiment reading of only 7%, is at a higher low. It took out the previous low from last fall. It did close up this week. We are inclined to believe that the slightly lower low resulted from the Japanese earthquake and the necessity of closing down the carry trade to bring Yen back to Japan.  Our point is that the US Dollar is at an extreme low, no one likes it, as commodity currencies like the Canadian Dollar and the Aussie seem to be hitting some resistance at high prices.  Recall that there is so far, no shortage of oil even though oil is over $100.

 Carry Trade – borrow US Dollars at near zero interest, invest the money at higher rates overseas, now those trades are closed, Dollars sold and Yen bought, hence the recent spike up in Yen and move down in the dollar, got it?  Yes Bill Griffith on CNBC was intoning that the Yen was at record highs against the Dollar but of course neglected to mention why.

We will then conclude with  a section entitled, What Could Go Wrong?

The Markets Now

• Stocks have regained most of their losses since 2008, mood has improved such that this weekend WSJ reports on page B1, Crisis Props are Falling Away, In other words, the Federal Government has given the all clear, don’t worry signal. This is actually a signal to worry, read on.
• Internals are slowly deteriorating, see page three. The internal top of most markets occurred in April of 2010.
• Bonds continue to show strength in spite of FED sales, PIMCO sales, assertions oil will soon be $150, a $14 trillion debt,  and gasoline  at $4. Why is this happening, what does the bond market know, what is the bond market seeing in the future?  Answer, danger in stocks and commodities.
• Are we Japan in 1989?  The headlines for Google and Apple (company of the year, decade, century) are similar to what we read about Japan in 1989. Since then Japan has had two lost decades.  Like Japan we have refused to write off bad loans, how many under water mortgages are there-40% of all existing mortgages despite all the stimulus.
• We noted prior to the earthquake that the flash crash could happen any time. We have noted that amazingly the market has rallied again and again just an internals are about to fall below moving averages possibly triggering massive computer generated sales. When the earth quake occurred, that is just what happened.
• Dividend yields are less than 3% on major stocks, P/Es are over 20, these are signs of market tops, not entry points
• A peak in commodity prices is the last phase of a bull cycle.  Oil prices were the last to top in the  summer of 2008. We are there again now, okay prices could go higher still.
• Time sequences (QE II ends in June)  suggest June, 2011 as a final top. As we said a few weeks back three months may seem like forever but now June is only two months off. 

This is the weekly chart of the SPX with the parabolic stop and reverse sell signal displayed. It is currently on SELL signal. It would require a weekly close over 1339 to generate a BUY signal. Now look back at how the top formed in late 2007 -2008. We are starting to see that same up and down action, signs of distribution at the top, pattern. Notice the RSI over throw above 70 is the  most extreme measure since the bottom in late 2008!  These are all warning signs of topping action!

Needless to say this information  is not featured on buy and hold CNBC or the front page of the WSJ. Believing you can get out in time is like believing the tsunami will not come two miles inland, it went instead six miles inland.

What Could Go Wrong – aside from Earthquakes, Tsunamis, Supply Chain Interruptions and Such

All the following events have occurred in the past, and could occur without warning again, this is why Nassim Taleb is famous for his Black Swan thinking.

• ChaosStan now extends from Afghanistan on the East to Libya on the West, revolt has spread from Central Asia to Libya in West Africa, and no one is in charge, anywhere.  This usually ends badly. Think Germany invades the Sudetenland as France goes on summer picnics.
• Three of the PIGS did collapse, Ireland, Portugal, and Greece, does anyone really think that is the end of it? Does anyone think the three have reformed?
• Cities and states are at war with their government unions. In 1976 it was only New York City that went bust, does anyone think the protestors in Madison, WI are going to become reasonable?  Just this morning a student reported to me that tiny Floresville, TX re-financed its ‘new civic center’, the reason, it could not make the payments so it got a new loan!  Houston, TX is already taxing non-profit churches to pay for street repairs; defaults take many forms.
• The Egyptian Stock Exchange closed in the wake of the revolt. When it re-opened, prices plummeted again. For those that think it cannot happen here…during my first sojourn as a stock broker, the exchanges had shortened trading hours two days a week. The computers of that era could not match up  the trades on ten million share days. Now at billion share days and ‘trading in the nano-seconds’ could it happen again. Such trades at the end of the day are DKed, which stand for Don’t Know. This means the exchange cannot match up the two counter parties. While that may sound strange indeed it was counter party failure risk that caused Greenspan to rescue Long Term Capital Management. The same fear caused Hank Paulson to rescue Bear Stearns, but not Lehman, and then the exchange did collapse. The inability of Lehman to pay off its short term commercial paper with long term non-performing mortgages locked up the short term funds market, and bang, no Exchange.
• DuPont Walston collapsed in 1974. It was then one of the five largest firms in terms of offices in the US. The offices were sold or assigned piecemeal to other brokerages. But it was months before clients could transfer their accounts where they wanted them transferred. Could that happen again?
• As recently as 2001 during my PhD stay at the University of Texas at Austin, a hacker stole 50,000 of  our social security numbers. Not to worry said UT; but hackers still abound. The next likely attack is not so much a back pack nuclear weapon as someone at multiple terminals in an unreachable Yemen or Tadkistan.
• Stephen Lerner wants millions of people to refuse to pay their mortgages which would collapse bank balance sheets. This is the same SEIU group that has helped stage rallies in Wisconsin. With 40% of mortgages under water, will he have to try very hard to pull this off?  Remember all the failed mortgages are still on the books.  As unemployment rises, and the 99 weeks of unemployment checks come to an end, many will simply stop paying. It will be impossible and impractical to evict them, then what?
• The Flash Crash was no accident but a triggering of sell stop orders by computers acting on quantitative models. A similar event caused portfolio insurance to run markets down in October of 1987. Flash crashes in other stocks have occurred. The events during the Japanese crisis are a dress rehearsal for what might happen in any of the above scenarios.

So, we do see this scenario as a high risk environment. I read a story about one rice farmer in Japan who never dreamed the waves would come six miles inland, but they did. He was scrambling to drive out of his muddy fields on narrow roads, realizing that if  one wheel of his vehicle veered into  the mud , that would doom his escape. This is a worthwhile parallel. If in fact a top is expected in June, the time to exit is now, not June, just ask the rice farmers.

Concluding thoughts in case you are still wondering where I stand

Rather than go into another litany of charts we would ask you to consider these things about the environment.  The landscape is just about where we were when I exited Ross Perot’s broker school (DuPont Glore Forgan) in April of 1973; hmm, here it is April of 2011.  How similar is it?

Nixon handily beat McGovern, Barack handily beat Bush.

Viet Nam was the endless war, now we have two or three wars.

Nixon and Kissinger had a plan for Viet Nam but no one knew what it was. Today Barrack has handed over leadership in Libya to France but France rejects NATO and now does is unwilling to take The Colonel out.

Gasoline prices were going up, rationing was taking place, now gas is over $4 in California.

Stocks were at fresh highs (DOW 1,000+), stocks are at fresh highs (DOW 12,000+).

Inflation was high, now inflation in commodity prices, deflation in housing prices.

REITs were a popular income stream, REITs are popular again. But retail space is probably double what it ought to be, can you see vacancies coming ?

Social mood had turned negative. Bill Cosby was out and Richard Pryor was in (ponder that change for a moment).  Radical groups were active the world over.  Today’s Sunday paper features a photo of riots in downtown London, forget Tunis, Tunisia.

The result was the worst melt down  since 1929. The DOW sank from 1,000+ to 577 by December, 1974.  Again we have had two of the four negative periods for stocks expected during an 18 year period of stagnation. We have two more to go, it is not a question of whether but when. Prepare now.