Friday, January 30, 2009

Not Just a Shampoo

Technical analysis is said by some to be pure nonsense. The Chartered Financial Analyst program that my son is studying for dismisses it out of hand in favor of fundamental analysis. I have never understood why they are mutually exclusive.

Charting is a time honored system going back to Japan's rice markets centuries ago for analyzing market action. It's proponents state that all the information of a market is in two items, volume and price. All of the fundamental information, known and unknown is within those two items.

Recently I have been watching the broad market pattern known as a "Head and Shoulders Pattern." In todays case, that would actually be an "inverted" head and shoulders pattern and is suggesting a possible bottoming for the market.

Below I have compared the 2003 market bottom to the current situation. There appear to be similarities but it needs to be emphasized until a pattern "resolves," it is simply a potential. Prior to 2002, there was at least one such pattern that did not resolve successfully and was simply a pause in an ugly bear market.

At the time I recall investors panic, news flow was terrible and pronouncements of the demise of market was rampant. Not so dissimilar to the current situation.


2009








2003




The following article written in January of 2003 has many similarities to today. There are meaningful differences but the emotion of the market is very familiar I think you would agree.




2003: The "Great Bear Market of 2000-200[?]" Continues
January 01, 2003

In order to know where we're going, we need to know where we've been, so we'll begin with a review of the carnage inflicted by the "Great Bear Market of 2000-200[?]" in 2002. To state that it was another Year of the Bear is stating the undeniable.

As you've no doubt heard by now, 2002 marked three consecutive down years for the markets, the first time that's happened in 60 years (since 1939-1941). The DJIA has fallen four consecutive years only once before, the infamous Great Depression years of 1929-1932. We'll discuss market sentiment in more detail below, but suffice it to say that the consensus of mainstream Wall Street is that after three losing years, the markets are "overdue" to bounce back. Unfortunately (for the bulls), we beg to differ and we stand firmly in the camp that says 2003 will tie the Great Depression's historic losing streak.

Of the major indices, the Nasdaq Composite led the way lower in 2002 with a 31.5% decline. It was the first time in its 22-year history that the Nasdaq lost ground in three consecutive years. At its year-end close of 1,335, the Nasdaq sits (it's too weak to stand) down a stunning 74% from its March 10, 2000 peak of 5,132.

The S&P 500 followed with a 23.4% loss. All ten of the industry sectors tracked by S&P lost ground for the year, the first time that's happened in the 21 years of sector reporting.

The DJIA held up the best, slipping "only" 16.8% in 2002. Still, it was the DJIA's worst yearly drop since 1977. Only 3 of the 30 DJIA stocks managed a gain for the year: GM, PG and EK.

Indeed, the Great Bear dined at a global smorgasbord in 2002: The DAX in Germany crashed 44%. The FTSE 100 in London and the CAC 40 in Paris both had their worst years ever. The FTSE dropped 24% and the CAC plunged 34%. The Nikkei 225 in Tokyo sagged 19% to a 20-year low. South America's largest market, the Bovespa in Brazil, tumbled 17%. The list goes on and on and on.

The U.S. dollar cratered in 2002, falling 10% against the yen and 18% against the euro. Add the exchange rate losses to the U.S. markets' losses, and many foreign investors are sitting on a 40-50% devaluation of their dollar assets.

According to CBS MarketWatch, 94% of all stock mutual funds lost money in 2002. Lipper & Co. calculates that the average equity mutual fund lost 21% in 2002.

When the bean counters finish tallying the data in a couple of months, 2002 will likely be the first year in 14 to show net fund outflows from equity mutual funds. Bond funds will show over $150 billion in inflows, a record high. (Smells like another bubble about to burst.)

The equity markets' most recent data shows the Great Bear's appetite is still voracious. The DJIA's 6.2% drop last month was its worst December since, ahem, 1931. Let's recall what ensued in 1932: The DJIA tanked another 46% before finally bottomed on June 28, 1932 (at 42.30)! We think a similar fate awaits the DJIA in 2003.

2002 wasn't all red ink for investors. Government bonds soared as interest rates approached absolute zero (more below). The average long-term bond mutual fund gained 5.5% on the year. Yet the interest-rate sensitive Dow Jones Utilities Average lost an unusually sharp 27%. (So much for safety in "conservative" dividend-paying stocks.)

Crude oil futures gained 50%, as the situations in Iraq and Venezuela worsened.

Gold was in the green by 23%, soaring to a five-year high at $348.50. Gold stocks rocketed higher by an average 71%. Gold mutual funds were the best performing sector for the second year in a row. According to preliminary data by Morningstar, eight of the top ten mutual funds in 2002 were gold funds. The other two were members of our Great Bear Funds roster: the Prudent Bear Fund and the Rydex Venture 100 Fund.

On the Economics Front
It was really pretty simple in 2002. Despite the all-out efforts of Sir Alan of Greenspan & his Merry Monetarists, the economy is still stuck in first gear, if not neutral.


The Fed's unprecedented eleven rate cuts in 2001 (a cumulative 475 basis points) failed to spark anything more than a flicker of recovery. The Fed's last cut, 50 basis points on November 6th, was perhaps the last rate cut arrow in its quiver. It won't make a bit of difference anyway. More grease isn't the answer when pushing on the proverbial string is the problem.

As mentioned in our reports numerous times over the past five years, near-zero interest rates haven't helped Japan recover from its burst real estate bubble, 21 years ago. The U.S. economy is acting every bit as comatose, and the U.S. equity markets are following Japan's example, too.

Aside from appeasing the politicians' need to "do something" about the economy, near-zero interest rates have their negative consequences:

Savers and investors are penalized with near-zero returns on bank accounts, treasury bills and money market funds. The real return (after taxes and inflation) is negative.

Low investment returns tend to encourage investors to chase higher yields in much riskier securities, such as junk bonds. This is not a prudent thing to do in a deepening recession (or worse).

A collapsing dollar. The historic low returns on U.S. securities just can't compete with European rates. Moreover, the dollar's 15% drop in value in 2002 brings many foreigners' losses to 40-50%. We're nearing the "cry uncle" point, Foreign money will just stay home. According to Fox News, Europeans have reduced their purchases of U.S. stocks from $84 billion in 2000 to just $11 billion in 2002. 2003 will likely show a net outflow.

The U.S. trade deficit also has continued to inflate in its own Hindenburg bubble. The deficit has inflated nearly four-fold over the last four years, reaching a colossal $450 billion in the latest twelve months.

Personal bankruptcies have soared. CNN reports there is a shortage of federal bankruptcy judges!

There's one remaining sector that the bulls cite as evidence of continuing strength in the economy: real estate. Housing has been propelled to extreme valuations by the lowest mortgage rates in 40 years, This bubble will burst shortly after the Fed's next interest rate move, which will likely not be a cut but a hike, necessitated to defend the plunging U.S. dollar.

Now given that even the anal-ysts parading across CNBC can see the real estate bubble about to burst, it pains us to agree with them. But the evidence is building day by day:

In many areas of the country, apartment and office vacancies have soared.

Mortgage delinquency rates have doubled.

Inventories of unsold properties have soared.

Prices of those home that do sell have leveled off.

Foreclosures have soared.

Permits for new construction have plunged.

More and more real estate agents are starting to talk about it being a "buyer's market," for the first time in a decade.

The Economic Outlook for 2003
We continue to be unequivocally bearish on the U.S. economy as well as the U.S. markets. This is not just another routine bear market for stocks, and it's not just another routine recession for the economy. Unfortunately, the potential for a "3D" scenario, a "devastating deflationary depression," is very real.


The market ended 2003 27% higher than it began. The point is, there are no guarantees, but if the market begins to tell us there is life after panic, don't ignore it.

John Barnyak
President

Think or Swim

There are times in the economy when crawling back into the womb is a very alluring thought. But life continues and we have a choice, repeat history or learn from it. During the dotcom bubble there was a phrase I grew to loathe, "the paradigm has changed." It hadn't. Only perception, fear and greed had changed in relative quanitities.

Having said that, this time it's different. Yes, that is the other cliche' I hated. It's never different. But since we have to go back beyond meaningful memory of anyone in this country, this time I think it is in fact different. The fundamental drivers of investment behavior have shifted and our hardwired attitudes will not be appropriate over the next decade.

The US banking system is insolvent. The US debt burden is reaching levels that are not business as usual. Discussion of nationalizing the country's largest banks is a daily occurance. The policy responses and real economic activity that will be forthcoming are going to be new and heretofore unacceptable. Other nations are in similar or worse conditions. Iceland, one of the go-go economies of the past few years is cooked. It turned itself from a small fishing nation into a rather large hedge fund. Now it is a defunct hedge fund.

By the estimates of some at the annual economic forum in Davos Switerland this week, 40% of global wealth has evaporated in the past five quarters and it is getting worse. What are the fuels to drive any investment positions higher?

In 1981 the Fed Funds rates was 16.39% as Chairman Volker took inflation by the throat and squeezed. That marked the moment of a secular change and interest rates began to fall over the next twenty-seven years ushering in the greatest bull market for bonds in memory as lower rates drove bond prices higher. Today the Fed Funds rate is 0.19%. Unless we slip into a truly deflationary environment, bonds lack a significant upside now. Baby boomers nearing retirement age are trained to believe bonds offer a steady and acceptable return. In the years ahead, bonds will offer negative real return and steadily declining value.

The major question still facing investors and policy makers is whether we are indeed facing longer term deflationary pressure or inflation ahead. We would do well to step back and discuss the nature of inflation. It is not a rise in prices. By definition, inflation is the increase in the supply of money. A rise in prices is the result of inflation, not the cause.

The creation of money in the public sector may be offset by the destruction of credit in the private sector, approximately four $trillion and counting. However any way you slice it the two trillion dollar deficit needing to be funded by someone, somewhere, is unlikely to attract willing contributors for essentially zero return. The "sound as a dollar" dollar looks suspect with fundamental strengths more resembling emerging market economies like argentina. we will be structuring client portfolios to reflect this future.

What will provide real investment gains over a reasonable time period is going to be with strategies and tactics unfamiliar to most people. The CNBC, Cramer style rant of the past decade has ill equipped many for the challenges and opportunities to come in the coming decade.

John Barnyak
President