Tuesday, October 5, 2010

The House of Cards

The House of Cards

Today Japan came out with their own quantitative easing program which not only included buying their bonds but also stocks. Japan doesn’t like their strong currency as they are the biggest exporter to China. We are trying to increase our exports worldwide with our own quantitative easing and destruction of the dollar. There is a move around the world from Europe, Japan and the US to destroy their currency in an effort to export their way into growth.

Our FED came out a few weeks ago declaring the need for inflation. The FED has been desperately trying to prop up housing prices but instead have weakened the dollar and caused soft commodities- corn, wheat, etc to surge. In the next 6-12 months food prices will soar. What will happen when food and energy prices rise to 2008 levels while housing prices and activity stay soft?

The politicians are out trying to influence their vote. One of the biggest issues is the Bush tax cuts that will expire at the end of the year. Obama is on record stating he is for only middle tax cut while leaving the upper sector to pay the bill. He is also telling congressman he is for the extension of tax cuts for ALL. How can this be? Why doesn’t he publicly come out and just state for ALL. He is simply using Chicago style politics. His constitutes are out stating tax cuts remain for everyone just to get the vote. After the election if he doesn’t extend the cuts for everyone he can state he never stated it. The markets have already priced in a Republican congressional victory. If it doesn’t happen the house of cards will fall.

Class warfare is in full swing. The consumer which accounts for over 70% of overall consumption is in save and debt payoff mode and isn’t going to spend anytime soon. Our government has taken over spending and when they started in 2009 they have had no respect for a spending limit or the number of trees used. Don’t they realize someone eventually will have to pay?

The “extend and pretend “scenario is still alive. Many foreclosures that were going to happen have been delayed due to banks using a robotic signature. It will be a lawyer bonanza and will keep the influx of bankruptcies to stagnate. Some people who haven’t paid their mortgage and were due for eviction will be able to stay in their bank-owned house longer. Nothing like rewarding those who game the system putting a damper or delaying the inevitable.

Besides the personal tax rates, the capital gains and death tax rate will expire (and go up) at the end of the year. If they aren’t extended the incentive to “sell” will be huge. So far nothing has been stated about whether the tax will expire. Another concern that is in the health care bill is a new sales tax of 3.8% on house transactions. Many think once the republicans get the majority they will repeal the health care bill. Both democrats and republicans are to blame for the current economy doldrums and should be shown the door.

The printing presses are in full swing. We are racing with other countries to devalue our currency. We are going to pay back our IOU’s with cheaper dollars. The problem occurs when we issue debt what foreign country is going to invest in our paper when the dollar keeps going down? This will cause our interest rates to spike. In Greece their rates went from 6% to 24% in 2 weeks. I doubt this scenario will happen this quickly here but a move from 2.5% to 4% in the 10 yr. bond would spell trouble for our economy even if it happened over a 6 month period.

My last blog I was very concerned about the market and it has gone straight up. The move was boosted by the FED actions and the negative investor psychology. Mutual fund cash is very low meaning whatever cash they receive they are putting it to work. This also shows the bullishness by fund managers. They believe the market will rally because the FED will keep the market up. This “don’t fight the FED” has worked 90% of the time. I think this time it won’t work and the market is in a very critical juncture. Some of it is politically motivated to keep the market up through the election.

One positive result of this free money is companies are able to raise money through debt issuance (or is it?). Many companies are using proceeds to buy back stock or increase their dividend. Short term this keeps their stock propped up. Longer term the bond will have to be paid off reducing the company’s cash.

What makes me so bearish? The market is still in a cyclical bear market that started in 2000. The markets are rallying the past year on less volume on up days and higher volume on down days. Sentiment has gone from bearish to bullish over the past 6 weeks. Traders are taking on risk believing our government will bail them out by keeping rates low. It’s a win/win situation if rates get pushed toward zero stocks will rally and if the economy pick up stocks will also rally. There is only fear and greed never a win/win situation.

The new highs/lows list, advance/decline line and trin all are misleading the strength in the market. The expansion of EFT’s , preferred stock and interest sensitive issues currently mask these indicators to the upside. Many technical indicators that worked well in the past are worthless.

The upcoming decline will make 2008-9 look orderly. Some individual stocks will lose 20-30% in one day. No one will be able to claim the short seller was at fault since short interest is very low. The market goes down 2/3 faster than it rallies. DOW 6,000 could easily be seen by next March.

What will change the bearish outlook? The list is too long but below are a few-

1. Stronger dollar
2. Reduced government spending.
3. Stable tax rates
4. Keep capital gains rate the same.
5. Free trade
6. Stable consumer prices
7. Companies go bankrupt
8. No extend and pretend
9. Balance both state and federal budget
10. Fund state pensions to a realistic level.

Technically a move above 11,250 for a few months would be a good signal. There are some important long term cycles that are currently activated that indicate a long term trend (2-4 years) will be established over the coming months. If the markets don’t turn soon the trend will be higher.

Gold has kept its run intact. The July decline was very shallow keeping the naysayers running for cover. The FED wants to inflate and gold is a hedge against a weaker dollar and higher inflation. The trade is crowded and when it does drop the drop will be sharp. Play gold on the long side and use stops. Higher interest rates will cause the price of gold to fall if they ever rise. The rise in rates needs to be caused by a better economy not a failed debt auction otherwise gold goes higher. The 1980 top in gold when adjusting for inflation needs to trade for about $2300 an ounce in which people might be taking their gold fillings out.

The current environment in our financial markets is at a cross roads and will lead to a resumption of the bear market. Most people are leaning on one side of the boat that being long gold, long stocks and long bonds while being short dollars. It will end ugly. If the market acts well for the next 3-4 months then the trend mentioned earlier will leave plenty of time to make money. As for sectors which will under perform on the upside and lead the downside include- restaurants (margins squeezed), retailers, jewelers, housing, financials and some tech (competition creates oversupply of phones, TV’s and pads) .

The upcoming weeks bring a deluge of earnings. Earnings will be up sharply but REVENUE and future guidance will put pressure on the market. Many stocks will beat the bottom line, show no top line growth and guide down future quarters.

The house of cards is ready to fall so extreme caution is needed. Use stops for those in the market. Just as only a few can win the lottery one can’t count on the US government to keep both the bond and stock markets from falling. Just ask Japan. A 2-3 trillion dollar stimulus is cup of water in the ocean compared to bank derivative exposure of 223 TRILLION.(As of June 2010). Remember its return of capital not return on capital. Putting some capital overseas is a way to diversify against a weak dollar and inflation. Australia and Canada are countries in much better shape than the US.