The Survival Report March 2006 Please e-mail all questions and comments to:
Recession Alert There are increasing signs of stress in the economy. Our view is that the odds of a recession are high starting sometime in the 4th quarter of 2006 or first half of 2007. Following are a look at several indicators that are signaling caution: A shrinking labor force, the personal savings rate, tightening yield curve, 10 year treasury yields, a slowdown in housing activity, a slowdown in consumer credit. The following chart shows the personal savings rate. Consumers have been spending more than they have been making, on average, for a complete year. This is the first time this has happened since 1933. One of the reasons that this was possible was cash out refis from housing to support. Housing turned down in the summer of 2005 and anyone purchasing in one of the bubble areas during the summer boom is now likely underwater. Personal Savings Rate Yield Curve The following chart shows the yield curve from 1999 to present. Symbols in above chart: $TYX is the yield on 30 yr long bond.$TNX is the yield on the 10 year Treasury note. $FVX is the yield on the 5 year Treasury note.$IRX is the discount on the 13 week Treasury bill.Note how the yield curve inversion in 2000 signaled the recession that started in 2001. In January and February of 2006 the yield curve inverted across the entire curve from 6 months to 30 years by as much as 20 basis points. It has since flattened. As of March 12 2006, there is a slight inversion of about 2-5 basis points. If symbols were available for the 6 month and two year notes we would plot them but alas the data simply is not available. Our view is that an inverted yield curve is a sufficient but not necessary condition for a recession. Regardless, the curve did invert even though it is now primarily flat. The prevailing consensus seems to be a sigh of relief at the flattening. We do not see it that way. It has flattened by rates rising at the high end and every rise on the ten year treasury is another nail in the coffin for housing. Furthermore, a flat to inverted yield curve reflects an environment in which it is progressively harder for banks to make money by borrowing short and lending long (the carry trade). It simply is not a good environment for bank profits. Employee Compensation In October, The Labor Department for the first time published the Employee Compensation Index (ECI) adjusted for inflation by the Consumer Price Index. Inflation adjusted compensation for all civilian workers declined 1.5% during the year ending September 2005. This was the largest decline on record. Wages have continued to lag this entire recovery. Nonfarm payrolls Nonfarm payrolls have risen between 0.1%-1.7% on a year-to-year basis between December 2003 and February 2006. Historically this is anemic payroll expansion for a recovery. Such timid employment growth is unlikely to generate inflationary pressures in the near term. Housing has provided about 50% of the jobs during this recovery and we just do not see those numbers being made up for elsewhere. Housing There is no doubt that the bubble has popped. Sales have dramatically fallen in Florida, California, Massachusetts, Arizona and numerous other states. Massachusetts house sales plummeted 21 percent last month. It was the biggest year-over-year sales drop in almost 11 years and slowest January since 1996. Foreclosures in Ohio are at their highest levels since 1977 and are rising practically everywhere. Florida Housing Activity January 2006
The above numbers are typical of sales volume declines that we are seeing for various other bubble areas such as California, Arizona, and Massachusetts. What is interesting is that on a year over year basis median home prices are still going up in some locales. Some look at rising median home prices and are calling for a "soft landing". Unfortunately this landing, when it comes, will be anything but soft. At this point y-o-y prices are not the best way to look at things. House prices are up y-o-y only because of a blowoff exhaustion top in speculation in the summer of 2005. Since then we have seen a dramatic declines in prices. Indeed, as we noted earlier, anyone that bought a house in bubble area near the peak is likely behind, some by as much as 30%. The major home builders, Centex, Meritage, KBH, etc are now offering deep discounts (as much as 25%) in some locales. Anyone buying a house at the "wrong time" is immediately 25% in the hole. It might take 10 years or more to break even. That does not even take into consideration the high likelihood of substantial further declines. Housing has been one of the bright spots during this recovery. The boom is now over. This will impact the paychecks of Realtors. It will also put a halt to furniture sales, appliance sales, roofing, landscaping, lumber, drywall, plumbing and all of the trade jobs associated with housing. Close to 50% of the jobs created in this recovery were directly attributable to housing. Conventional wisdom suggests there will be a capex boom that will make up for a decline in consumer spending. We do not buy that logic at all. For starters consumer spending is 70% of the economy and if consumers are not spending why should business be expanding? With a negative savings rate, falling home sales, and falling home prices, consumer spending simply has only one way to g down. Fed Watch New York Federal Reserve Bank President Timothy Geithner said on Thursday March 9th that the downward pressure on bond yields has made financial conditions easier than they would be without the foreign buying. "Policy would have to act to offset these effects in order to achieve the same impact on the future path of demand and inflation," said Geithner. "To do otherwise would run the risk that monetary policy would be too accommodative." It seems that the FED has finally awaken to the fact that Japan and China are (via purchase of US treasuries) holding US long term interest rates lower than they would otherwise be. Is the FED really just figuring this out? Let's hope not. We do not really know what the FED is really thinking. What we do know however, is what the FED is actually doing. What the FED is doing is hiking into a housing bubble that has clearly popped. Our view is that the FED has long overshot neutral. The collapse of the housing bubble is proof. The lagging affect of hikes (at least 3 hikes have not yet been felt with perhaps two more coming), should be enough to give the FED pause for concern. But just as the FED way overdid things by slashing rates to 1%, it is all too likely they have way overdone things by hiking. A key question is "Does the FED have a choice"? Our view is that the FED must at any costs (consumers be damned) preserve corporate balance sheets to weather the upcoming recession. Looking back at 2001-2003 when the FED was slashing interest rates like mad, it is entirely likely the FED was attempting to preserve the banking system itself. Banks lent hundreds of billions to "dotcoms" that were imploding left and right as well as to places like Argentina that were defaulting. Banks were likely technically insolvent. We believe interest rates were slashed and held at absurdly low levels to attempt to bail out banks. This was done on purpose not caring what the aftermath might be. It turns out the aftermath was a housing bubble of enormous proportion, skyrocketing consumer debt, and other associated problems. Still the FED in all their hubris likely feels they saved the day. The housing bubble and the consumer debt bubble will be dealt with like every other bubble: when they pop. The housing bubble is popping now. Just as the FED's eyes were on deflation in 2002, they seem to be on inflation now. In all likelihood the FED simply does not see the deflationary credit bust that is coming. We believe they will be powerless to stop it whether they see it coming or not. The housing bubble is the bubble of last resort and it has popped. Global Review The most significant recent event is the end of Japan's QEP (Quantitative Easing Policy). Basically, Japan has flooded the world with about ¥30 trillion since 1999, with ¥20 trillion of that coming since 2003. We are now on the verge of a change. "The BOJ policy shift marks a symbolic step toward the normalization of the Japanese economy," said Teizo Taya, an adviser to Daiwa Institute of Research who helped form policy as a central bank board member five years ago. "The central bank will eventually move to raise short-term rates from zero, and that's a necessary process for Japan to achieve sustainable economic growth." The implications of this change can not be over emphasized. The carry trade (borrowing YEN at zero% interest rates and buying US treasuries now yielding close to 5%) has helped hold down US interest rates as well as provide cheap capital to finance our trade deficit. Just as Japan appears to be coming out of deflation, signs point to an upcoming recession in both the US and the UK. In the face of a US slowdown it remains to be seen how firm Japan is at ending their deflation fighting tactics. For now, we feel too many eyes are on the YEN carry trade and a worldwide slowdown led by a housing bust in the US may delay Japan's normalization process. That said, the YEN carry trade has a history of spectacular blowups, and we suspect this time will be no different once eyes are shifted to some other problem An enormous housing bubble is now popping in the US, UK, Australia, and China. A slowdown in consumer spending in the UK is related to the popping of their housing bubble. We are closely monitoring the UK as it appears we will follow a similar path. For now, it seems the UK has peaked and we are lagging by about one year. The US seems to be lagging Australia and the UK by about 12-18 months. The US/China duopoly has carried much of the banner for this latest economic cycle, and it is showing signs of stress. Treasury Secretary Snow wants China to revalue the RMB up, in effect begging for higher prices on imports. The rationale of Snow is that the RMB is undervalued and it will save US jobs if the RMB were to be revalued. Unfortunately that is simply faulty thinking. The labor cost differential between China and the US is about 20-1 or perhaps 18-1 and that differential simply can not be made up by a 5%, 10%, or even a 15% hike in the value of the RMB. However a 15% hike in the value of the RMB could increase US prices of goods coming from China substantially. In short, US policy is flawed. Copper and Oil are showing signs of topping. The former is consistent with a turndown in housing in the US and China. Oil is showing signs of weakness even with tensions heating up between the US and Iran and the US and Venezuela. We are monitoring both closely. The US dollar has remained strong since bottoming back in March. Note that the absolute bottom was perfectly marked by the cover of Newsweek depicting "The Incredible Shrinking Dollar" accompanied by talk of Bill Gates and Warren Buffet being short the dollar. It just goes to show you: By the time such phenomena make the cover of major magazines and everyone is talking about them, the trend is ready to stall if not indeed reverse. The YEN is undervalued here, especially if Japan starts to raise rates. Will Japan chicken out in the face of a global slowdown or not? We think a delay is likely. 2006 may prove to be the most volatile we have seen in years and yet no one seems prepared for it. We have been grinding higher for so long - more than 2 years now - that most have forgotten that markets can and do decline more than 5% at a time. Buying-the-dip has worked so well for so long now that it has become an engrained, unconscious reaction, which is just how it always is just before a trend change. But we can remember what the swift declines of 1998, 2001 and 2002 felt like, and we aim to keep you in front of these changes in sentiment and market trend. The signs are clear if you look in the right places, so let's now look at some of the signals the market is sending us through a few key charts and see why we are starting the Survival Report out on such a cautious note. The Survival Report is here to help you navigate through the difficult environment that is today's financial markets, keeping you out of areas filled with potential land mines, and in areas that present the most long-term potential - both on the long and short side. The first reason we have to be careful going into this summer is that 2006 is the scene of the often-cited 4-year cycle low, which last occurred in 2002. The 4-year cycle has been a consistent feature in the US stock market for well over 100 years, and even when the cycle low failed to produce an outright market decline, there has always at least been a significant increase in volatility. But more often than not there has been a significant decline into the cycle low, and the market is currently telegraphing an undercurrent of weakness that takes on added weight in this context. In the last month we have seen a number of inter-market and technical divergences, telling us that the rally from the low last October is running out of steam. For instance, while the Dow Industrials and Dow Transports have continued to new highs this spring, the Nasdaq 100 (the NDX) has been lagging severely behind and has not even been able to approach its January high. This Dow-NDX divergence is the same type we saw in the spring of 2002 prior to the waterfall decline throughout the summer, and whenever we see the more speculative indexes fail to advance with the 'blue chip' indexes it is time to be cautious. (I think we need some type of transition here letting the readers know that the next section will be the trading ideas…) S&P Bullish Percent Index Breadth indicators are telling us that fewer and fewer stocks are participating in this latest rise, which can be seen on the S&P 500 Bullish Percent (BPSPX) chart. While the S&P 500 itself has rallied back to its January high, the BPSPX is making a lower high. In simple terms, fewer stocks are participating in each rally. Dow Wedge & Volume Divergence Along with more technical indicators like the one above, we have price patterns that are clearly bearish until proven otherwise. The Dow has worked itself into a wedge, which could give way to a quick decline to 10,250 when broken. The Dow is on our watch list as a potential short candidate. Nasdaq 100 The NDX is showing a classic Head & Shoulders top. If the NDX closes solidly below 1650 for two or more days, it should lead to a swift decline to 1540-1550. The NDX is on our watch list as a short candidate. Aggressive players might consider taking a position in QQQQ either as a pure short or via QQQQ puts. Dow Transports Break Down Although the Dow Industrials has yet to break down out of its wedge, the Dow Transports has already down so. Until proven otherwise this break is bearish and it is time to be short Dow Jones Transportation Average iShares (IYT). Recommended Action to Take: Short Dow Jones Transportation Average iShares (IYT) at $79.00 or better. Utility Index A trendline in the Philadelphia Utility Index that have been in place since the 2002 lows is now broken. It appears the bull market in Utilities is over, which is a bearish confluence of many different market forces: interest rates, liquidity, the stock market trend, and the economy all affect the utility stocks. We also take the breakdown in utilities and transports as a sign that the environment that persisted during the last 3 years is now changing. We will take advantage of this trend change directly by establishing a short position using Dow Jones Utilities iShares (IDU). Recommended Action to Take: Short Dow Jones Utilities iShares (IDU) at $77.00 or better. Market Summary: Treasuries Treasury yields at the long end of the curve had the chance to break down and give us a nice buying opportunity in the last few weeks, but instead they have broken higher through resistance and look ready to trade even higher in the coming weeks. So while we are on the sidelines observing the decline in bonds, let's look at some charts and see where we might find the next possible entry level for some ETFs we are currently monitoring as potential long candidates. $TNX Weekly Chart: The weekly chart above shows the 10-year Treasury bond yield breaking through resistance at 4.6% on its way to the next minor resistance at 4.8%. While 4.8% may prove to be a point of pause, we need to take a step back and find our bearings with respect to the long-term trend. Consider the monthly 10-year treasury chart below from 1991 to the present: $TNX Monthly Chart: The long-term downtrend (shown by the blue trend lines) is clear and we appear to be heading to the upper range of this channel, which is currently near 5.2%. The 5.2% level will be useful for us in two ways if the 10-year yield were to reach it: it could provide us with a very good buying opportunity - the likes of which we haven't seen since 2000; it also gives us a very good line in the sand with which to monitor the long-term trend, and will continue to provide a clear stop-loss for all long positions in bonds and bond ETFs. Long bond yields have been in a downtrend since the early 1980's, and despite the recent rise they remain firmly in that downtrend. The chart of the 30-year Treasury yield below shows that entire time span from 1980. You'll notice that the upper bound of the downtrend channel on the 30-year is near 5%, below the trendline on the 10-year at 5.2%. Both of these upper trendlines are within short striking distances from here, and we will be watching to see how yields respond in the next few weeks if they decide to test them. For all of the bluster by treasury bears (and treasury bears are practically everywhere), the long term trend for lower yield is still intact. Admittedly a trend from 1981-2006 is a very long trend, but bull markets do not typically end in pessimism with everyone bailing at exactly the right time. Unless "It's different this time" bull markets end with optimism and bear markets end with pessimism. We fail to see why this time will be any different. Furthermore a seasonal trade in treasuries will likely present itself soon, and we will have more to say about the seasonal pattern in treasuries next month. In the meantime patience is the key. We could be approaching another excellent treasury bond buying opportunity or we could be about to witness a 25 year long trend come to an end. The technicals and seasonal patterns will guide our view but for now we are on the sidelines in the belief that patience will provide an excellent trading opportunity if we just sit back and let the trade come to us. On our watch list as potential buy candidates are the iShares Lehman 20+ Year Treasury Bond Fund (TLT), the iShares Lehman TIPS Bond Fund (TIP), and the iShares Lehman 7-10 Year Treasury (IEF). Market Summary: Gold Until recently, we were quite positive on gold and gold stocks. But every bull market goes through periods of correction, and when a significant correction is on the horizon it pays to step aside for a while, let the dust settle, and see how the market reacts. This is one of those times for gold. Since last summer gold has rallied over $150 to a high in early February at $575, and traced out a well-defined channel along the way (black lines on the chart below). The first leg up from July to October went largely unnoticed outside the gold community. The second leg up, from early November through December, peaked in a Japanese buying panic as the Yen completed a 10% decline against the US Dollar. The most recent leg up from late December to February showed clear signs of distribution and exhaustion, even as it attracted heavy press coverage. While gold had remained in its bull channel through early March, it has now broken down and has confirmed a new downtrend. If gold is destined to rally beyond the recent high at $575, we will likely see a choppy, overlapping decline from here that will probably frustrate most traders. But as we step back and watch gold from the sidelines, we will be able to dispassionately assess whether it is merely wringing out some of the speculative excess (a necessary step in any bull market), or whether $575 will stand as a more long-term high water mark. As gold attempted to rally back to $575 in February, the HUI Gold bugs index remained far below its previous peak - another glaring red flag for the yellow metal. When gold is nearing a trend change, the HUI usually anticipates the turn and begins diverging from the action in the metal. This time has been no different. Note that while gold rallied to retrace most of its decline from its early February peak, the HUI remained far below its early February peak - a clear sign that the gold stocks did not believe the rally in gold. It also appears that the HUI has formed a Head & Shoulders top, with a neckline at 296, which will provide heavy resistance now that it is broken. The weekly chart strongly suggests that a decline toward 275 will find support there, and the daily chart above also suggests a continued decline towards 250-275 is likely. If those support levels to not hold, we could be in the middle of a much more serious decline. The bottom line for gold is this: It is time to be on the sidelines with gold and gold stocks (at least as far as trading shares are concerned). As with treasuries, patience and seasonality are factors. Although we are both long term gold bulls, we are in no rush to second guess this decline with especially with weak seasonal tendencies at this time. $CRB - Commodities Accompanying the breakdown of Gold in the charts above is the potential breakdown long-term breakdown of the CRB commodities index. The CRB has been in a bull market since late 2001 - its longest trend in over 25 years. But that may be ending here is early 2006 as the CRB is currently trading below its trendline. This is another red-flag for industrial commodities, such as oil and metals, more so that agricultural commodities like grains. A breakdown of industrial commodities, especially crude, in the face of increasing mid-east tensions between the US and Iran, and the US and Venezuela is a clear warning sign about the strength of the worldwide economy. Light Oil Oil double topped at $69, and is sitting right on its trendline from the 2001 low. Energy stocks have declined along side of gold and look to continue down for the time being. We will be watching the chart of crude itself for a breakdown below $61 or a breakout above $69 for the next intermediate-term trend. A weekly close below $61 would add to the evidence that the breakdown of the CRB commodities index is real.
Crude itself could be in a correction or it could be the start of a more serious decline, but for now we are ready to open a short in British Petroleum (BP) with what appears to be a good entry point. Recommended Action to Take: Short British Petroleum (BP) at $67.50 or better Our exit points will be based on how oil stocks perform in reaction to the price of oil, as well as how oil itself reacts in the face of increasing tensions between the US and Iran and the US and Venezuela. Japan Small-Cap Fund In contrast to our long-term bearish view of the US stock market, one market that we are positive on over the long-term is Japan. Japan is coming out of deflation and the Japanese stock market is acting in advance. The trailing P/E of this index around 8.7, which is far more attractive than anything in the US. JOF is a small cap fund that has consolidated and reduced its premium over NAV during this 5 month consolidation. We think JOF will eventually break higher out of this consolidation, so we recommend going long here.
Recommended Action to Take: Buy Japan Smaller Capitalization Fund (JOF) at $15.50 or better. Currency Profile: Canadian Dollar If the commodities bull is coming to an end, we will likely see a major shift in currency trends as well. Currencies of resource-strong economies like Canada, among others, have enjoyed tremendous bull markets against the US dollar over the past 4 years - but that may be coming to an end. The similarity of the Canadian dollar chart to the CRB chart above is unmistakable, and if we see the trend change in the CRB confirmed we will likely see the Loonie follow. Those who have diversified out of the US dollar into "commodity currencies" such as the Canadian dollar, the Australian dollar and the New Zealand dollar should be on alert: the weakness of the US dollar versus these currencies could be at an end. The Survival Report will keep you updated when we see confirmed changes in these trends. Current Survival Report Recommendations We have established an initial trading list for this inaugural edition of the Survival Report made up of stocks and exchange-traded funds whose charts are sending strong signals right now, but we will most likely be adding more short positions as market conditions deteriorate and more charts will let us know it is time to be short. If the 4-year cycle decline plays out as expected this year we should have some nice profits on the short side before we head into any seasonal bounce into winter. The stock market trend over the next 6 months will likely produce more short opportunities than long, but there are always neglected areas of the market waiting for attention. One is beverages, represented by BUD (Anheuser-Busch) and KO (Coca-Cola Co.) which are on our watch list and are close giving us a long-term buy signals. Both of these stocks pay good dividends and are emerging out of long downtrends. Other areas are Pharmaceuticals and Biotech, with stocks like PFE (Pfizer Inc), MRK (Merck) and DNA (Genentech Inc) on our watch list. In contrast, the energy sector looks prone to short-term weakness and we have included BP (British Petroleum) and PXP (Plains Exploration & Production Co.) as short positions. As US equity markets look ready for a decline through the summer, IYT (iShares Dow Jones Transportation Average) and IDU (iShares Dow Jones US Utilities) will likely bear the brunt of it. If the US dollar continues its rally and the world wide economy slows, ETFs like EWG (iShares MSCI Germany Index) and EWC (iShares MSCI Canada Index) are especially vulnerable. EWG (iShares MSCI Germany Index) EWC (iShares MSCI Canada Index) BUD (Anheuser-Busch) KO (Coca-Cola Co.) PFE (Pfizer Inc) MRK (Merck) DNA (Genentech Inc) PXP (Plains Exploration & Production Co.) TLT (iShares Lehman 20+ Year Treasury Bond Fund) TIP (iShares Lehman TIPS Bond Fund) IEF (iShares Lehman 7-10 Year Treasury) QQQQ (NASDAQ 100) $INDU (Dow Industrials) $HUI (gold and silver stocks) Our goal is to provide you with a rational discussion on a wide variety of markets so that you can better survive all the market conditions over the next 10 years and beyond. We certainly intend to provide far more than mere buy and sell signals. Indeed we expect to have some subscribers that do not take our trades at all but instead formulate their own trades based on the investment analysis that we provide. Our portfolio is just a starting point. It will be built up over time. Over the past 6 months we were in the $HUI from 170 until 340 or so and numerous other plays in energy and silver and even the $SOX. Past performance however, does not guarantee future results. For the purpose of this newsletter all that matters is what we do from here on out with the base we are building now. We will inform you when we think it is time to be conservative or time to be aggressive. We will also tell you what ETFs and currencies we are watching and why but it is up to you to make the final financial decisions. We are long term bullish on both gold and energy but for now we are on the sidelines. If you happen to like gold or energy now despite our analysis, then please adjust our viewpoints according to your own preferences and time horizons. Ultimately you are responsible for the decisions you make and it is important, especially with shorts that you do not use excessive leverage. Some of you may choose to make these trades via options instead of straight out buys or shorts. Should you wish to do this we would in general recommend going starting one or two strikes in the money, and going out a few months to give the trade time to work. The idea however is to not pay too much time premium and the deeper ITM (in the money) you position, the less time premium there will be. Indeed volatilities are so low that one might even consider buying some out of the money "crash puts" in case there is a sudden steep decline in the Nasdaq. Bear in mind that round after round after round of those "crash puts" have expired worthless. We will have more to say about options, volatilities, and asset allocation in future issues. Asset allocation in particular is likely to be a key factor as to how well one does and with what comfort levels over the coming years. We will talk more about treasuries in the next issue, but please take a look at the yields on 6 month treasuries right now at 4.77%. That yield is far above the current yield of stocks on the S&P 500. On average, we feel it will be tough for the major US indices to beat those yields. Cash parked in short term treasuries, or a high yielding money market account is a very viable and recommended option. That cash will provide a means to put on future positions that we recommend or that you find on your own. This is not the time or the place to be "all in" regardless of what Wall Street or anyone else tells you. For now, this issue seems long enough. With that thought we wish to leave you with a quote from Bernie Schaeffer of Schaeffer's Investment Research. The chances for a "cold, grey market that will last you for the rest of your life" are not trivial. The core of the market's "resiliency" is merely complacency twice over. The first level of complacency is the astounding willingness of so many players to sell cheap put premium. The second level of complacency is the refusal of these put sellers to panic on market plunges, which allows the structural support from the put buyers to take hold. The upside is a market that "never" goes down, no matter how terrible the external circumstances. The downside is that there is no such thing as "never" in the market, and at such time as this structural support does break it will break hard, so hard as to be beyond the imagination of any who have not experienced live markets like that of 1987. In this man's opinion, it is sheer folly to be 100 percent invested in equities under these circumstances. We could not possibly agree more. Stocks are overvalued by every historical measure. The FED is hiking and possibly even targeting asset bubbles in housing and junk bonds. Language from the FED indicates they are going to keep hiking until they "break something". That something is likely to be housing. Those being very conservative here are very likely to be rewarded later. Indeed, opportunities will present themselves around the globe for those that are patient and have enough cash cushion to take advantage of them. We look forward to helping you find some of those opportunities. |
Testimonials: I love your new newsletter (as well as Whiskey and Gunpowder). Background explanations beautifully and thoroughly explained. Your recommendations are very convincingly written and I have reconsidered some firm beliefs as to likely market movements. - D. Mosier GREAT newsletter!!! You did a great job summarizing the key factors in today's market. - L. Berman |
