I know that we are in a bear market rally and have not begun a new bull market. I don't care what the MACD, RSI or candlesticks show other than for short-term trading decisions. The reason is simple: the fundamentals are so terrible right now that a new bull market is basically impossible right now. This colors my technical analysis, as I believe it should. I use technical analysis, historic chart patterns and seasonal tendencies to help me make trading decisions, but I find these estimates hollow without a fundamental understanding of where our economy is and where it is headed.

We are in the midst of an historic housing market/real estate crash and burst bubble that will be studied for decades. This is a crash of historic proportions and ties in with the bursting of a credit bubble that is also of historic proportions. As examples of this credit bubble phenomenon, let's re-cap some of the excesses of this housing and credit boom:

• Anyone with a pulse can get a credit card with a high limit and if they max this card out or can't make a payment, they can get a new card and transfer the old balance to the new card
• Anyone with a pulse can buy a house with no money down and can even get cash back at closing with no money down if they are willing to accept a higher interest rate
• Anyone with a pulse can buy discretional high-end/luxury consumer goods (e.g., cars, boats, RVs, ATVs, furniture, jewelry) with no money down and 0% interest payments stretched over many years
• Banks and investment firms levered up to over 30:1 in some cases, recklessly gambling on "can't lose" investment strategies

What is happening now is credit contraction as this unsound house of cards falls apart. In addition to the fact that all except the last bulleted item above are no longer true for most Americans, it is also the case that skyrocketing unemployment, plummeting real estate and consumer good values and fear prevent many Americans from even considering such offers even in those cases where they still exist. Aggregate consumer demand is falling off a cliff for most items that were "hot" during the boom.

To counter this sagging demand, our government has taken on a staggering debt load and forced all Americans who still pay taxes to buy more things (by simply putting the exorbitant bill on their tab). Our unconstitutional federal reserve is happy to oblige as they make money off of interest payments regardless of who the debtor is and the U.S. government is still a reasonably high quality debtor in a relative sense.

But back to the underlying theme of credit contraction for the private sector, ignoring the woeful incompetence of our bureaucracy. A decrease in the availability of credit after an "easy" credit period causes asset values to contract. Why? Without access to easy credit, there is an absence of forces to bid up the prices of most assets, especially given their current overabundant supply. What would home values become if no one could get loans to purchase a house? What would colleges cost if there were no student loans? How many could buy a "loaded" high-end SUV if you could only buy them by paying cash? In a credit contraction, consumers don't want to borrow (or buy as much even for things they can afford to buy with cash) and banks don't want to lend. Spiraling unemployment of course only adds to and reinforces the mix of pain as buying discretionary items when you may lose your job next month makes little sense for most individuals.

Corporate bottom lines and earnings are obviously affected by these trends. Think of auto sales, high end retail, essentially any company selling discretionary goods, restaurants, financial firms and banks, real estate companies and tech firms. How many people are forgoing a daily trip to Starbucks these days as an example of what happens to many businesses during such times?

These things are deflationary, as are the stagnant to declining wages that are occurring due to rising unemployment, mass lay-offs and too many people applying for every job opening. And the most powerful deflationary force of all is the real estate crash coupled with an economy overly dependent on real estate over the past business cycle. When real estate rapidly declines in value, especially in the setting of spiraling unemployment, a few key things happen:

• Foreclosures escalate, whether due to job loss/inability to make payments or debtors just walking away from their mortgages
• The banks lose money on foreclosures and the amount lost increases as the real estate prices decline further
• The "wealth effect" caused by rising real estate prices reverses and people who "own" real estate feel stressed out and less wealthy, thus they spend less on discretionary items
• Millions of real estate professionals (e.g., sales agents, construction workers, mortgage financing agents) are laid off or unable to make enough money to support themselves and/or their families

Foreclosures and bank failures are accelerating as is the downward price spiral in real estate prices. Real estate absolutely will not bottom before 2011 and this is an unrealistic and unusually optimistic/bullish scenario in my opinion. Because discretionary spending is declining due to rapidly rising unemployment, fear and a reversal of the "wealth effect," commercial real estate values are also spiraling downward at a frightening pace as businesses serving consumers experience decreased sales and a subsequent inability to keep the doors open / pay the rent. Additional bank stress comes from other consumer loans such as auto, student, RV, boat and other personal loans that begin to default.

When consumers are unable or unwilling to borrow more money and banks are unable or unwilling to lend more money due to bank insolvency, the economy grinds to a halt until the excess debt is cleared from the system. This is a rare, generational event that last happened in the United States in the 1930s. Some call it a Kondratieff Winter or a depression and we are in the midst of such a scenario now. To expect government employees to fix/reverse these trends is to ignore history and engage in child-like wishful thinking, which will only lead to greater individual financial pain.

Though a student of economics, I am predominantly interested in the investment side of things and thus seek to put the above information into the context of figuring out where to put my money, since I cannot control these market forces. The generational bear market that accompanies such credit contractions takes just about everything down with it and the last one caused an 89% drop in the Dow Jones in just 3 years (i.e. 1929-1932). Of course, the credit abuses and excesses are worse now than they were then, so it is conceivable the bear market could just as bad or even worse this time.

A few things are certain in terms of where we are:

• The real estate market crash is not even close to being over and is in fact accelerating to the downside
• Bank failures are just beginning and will accelerate meaningfully during 2009
• Deflation is the overpowering force and inflation is not a serious threat currently
• Bureaucrats / Apparatchiks cannot stop the primary trend by decree unless they make a conscious decision to destroy the currency, which would end their livelihoods and not provide them with any net benefit. Having said this, the hubris and ignorance of the people currently "in charge" creates uncertainty in the long run regarding a potentially hyperinflationary outcome.

Applying this knowledge to investment decisions gives some clear themes to follow:

• Cash is king during a deflation, but one must hold the right form of cash. The U.S. Dollar is the world's senior currency (for now) and is at least a temporary safe haven, as is short term U.S. government federal debt (i.e. bonds such as the 90 day T-Bill). Physical Gold is the ultimate form of money/cash and has always maintained its relative value through similar periods over at least the past 1000 years. Because Gold will flourish if the hyperinflationary scenario somehow comes to pass, it is in my opinion the preferred form of cash from this point forward, as U.S. Dollars no longer provide a significant yield.
• Real estate, stocks, corporate bonds and commodities are terrible investments during periods like the one we are in now. These should be avoided or shorted.
• Once the major associated stock bear market we are now in bottoms, which usually takes 2.5-5 years from top to bottom using prior historic examples, the best sector to be invested in from the long/bullish side will be Gold mining stocks if history is a good guide (and I believe it is).

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http://goldversuspaper.blogspot.com

Adam Brochert
April 26, 2009