DECEMBER NEWSLETTER
When I go out to buy something I always like to ask myself one question: am I getting my monies worth or not? Generally speaking, if I am going to spend ten dollars I want to receive more than ten dollars of value in return for the effort, and the same holds true in the markets. If I am going to buy an ounce of gold at US $815 an ounce, I want to know that the ounce of gold is worth more than the price I paid. Why more? Anything else is just an exchange of like items and the transaction in and of itself has a cost, but more importantly, I haven't increased my net worth. The only thing worse would be paying more for something than it is worth and that is to be avoided at all costs. Once I do that, I have to rely on finding a bigger fool than me to take the item off of my hands. This "greater fool" theory drove the housing market for several years and is almost always present in the final blow-off phase of any bubble. A fresh example would be analysts who projected oil at US $250/barrel when it hit US $145 back in July. To date, I have not seen a US $250 print in the December crude futures contract.
I really struggle to drive the concept of value home to my clients and the US government certainly doesn't help. We live in a world where we throw around numbers like trillion as if they it doesn't mean anything, and worse yet, as if there are no consequences. I am old enough to recall when the government talked about spending millions and that made the elders shudder. This week, in just two days, the United States Federal Reserve together with the US Department of Treasury gave away US $1.12 trillion and no one really seemed concerned. Citibank was one of the beneficiaries as they received US $322 billion in what was described as a bailout "for the good of the country", and I have to wonder what country they're talking about. I happen to think that's a lot of money, but I also know it's relative to what your balance sheet can support.
The government insists that it is loaning taxpayer money because there is a better than good chance it will be repaid, and of course it is for the good of the country. I would like to explore that line of thought in the paragraphs that follow. I questioned the wisdom of the loan right from the start because Citibank has a market cap of US $38 billion, nine times less than the loan, and it is losing money right now. Estimates have the losses close to US $23 billion this year, so repayment will not begin anytime soon. What's more, I find it very strange that Citibank is losing big money and yet a share is now yielding a 9% dividend. That's right! Shareholders are getting 9% (nine times the Fed rate) for running the bank into the ground. Since it doesn't make a profit, that dividend can only come from taxpayer money or the sale of assets. Now, I don't know the terms of the loan, but I have to assume that the bank is receiving preferential treatment; maybe a grace period and a low rate around 3%. The Fed refuses to disclose the terms, assuming a need to know bases, and the Fed obviously feels the American people don't need to know.
If I am right about the terms of the loan, Citibank must cough up US $9.66 billion a year in interest alone. Then it must return the capital, let's say over twenty years, so that's another US $16.1 billion a year for a grand total of US $25.76 billion a year (capital plus simple interest). We already know that no payments will be made in 2008, and many assume that 2009 will be worse than this year, so it is reasonable to assume there will be no return to profitability until 2010 at the earliest. That means no chance to pay even simple interest and therefore the debt will increase over the short run rather than decrease. What's more, I cannot find even one year where Citibank made a US $26 billion net profit, the amount needed to pay off the loan, and since no real changes in upper level management occurred, it is hard to envision how the same group of geniuses' could make it happen in the current deflationary environment. Citibank recently announced that it is cutting 50,000 jobs, and I must admit that is a hell of a lot of janitors, but it won't change much. Unfortunately, they didn't eliminate the right jobs. They should have started with the CEO, CFO, and the board of directors!
What did happen though is that the rich get richer at your expense. By that I mean that the Saudi prince announced he was increasing his stake in Citibank when the share price hit $3.50 just several days before the bailout was announced. If you think he did that without talking first to Bush and then to Paulson, I have a bridge in Brooklyn I would like to sell you. He bought, the bailout was announced, the price goes to US $7.05 and the price makes a cool billion or two at your expense. Where is the SEC and charges of insider trading? Nowhere to be seen; or maybe following Martha Stewart around trying to see if she made another $30,000 in ill gotten gains! These types of dealings have been going on for so long now that they have become the rule rather than the exception. The Prince walks away with a quick billion and the American people are stuck with a bill for US $322 billion that Citibank will never be able to pay.
I know what you're thinking; maybe Citibank is the exception to the rule! Well, I went through the same exercise with AIG, Lehman Brothers, and Goldman Sachs and it always ends the same way. None of them can pay the "loans" back, and I can't believe that someone in the Fed or Treasury can't figure that out. That begs the question of why the loans are being made in the first place, behind closed doors, and without disclosure to the American public, and there is only one conclusion that can be drawn: the American people are being defrauded as they have been for decades. The only difference now being that it is done openly and there are more zeros involved. Once I know that then it's up to me to decide what I want to do and how I want to do it. The goal is obviously to recognize a situation for what it is, develop a plan that allows me to profit from it, and then implement that plan.
For those of you who read my work, you know the current downturn in the market comes as no surprise to me. I began looking for a top in the Dow way back in mid-2006 and I identified the October 2007 top almost as soon as it happened. I have been bearish ever since and the market has backed me up on a regular bases. We saw the Dow fall down from an all-time closing high of 14,164.53 on October 9, 2007 all the way down to the
closing low of 7,552.29 on November 20, 2008. For those of you who are keeping score, the late great bull market began way back on July 12, 1982 with the cash Dow at 776.92 and rallied 13,387.61 points during a twenty-five year period. In just thirteen months the bear market devoured 49% of that gain and, in spite of the bottom callers, is far from satisfied.
I do not think a twenty-five year bull market can be offset by a thirteen month bear market and anyone who believes that we can shift back to business as usual is in for a nasty surprise. Any decent bear market will require a minimum of 25% of the previous bull market, i.e. a six year bear market under the best of conditions. I know that technology and the internet speed everything up, but the markets react to human emotions much more than technology and those haven't changed much over the last five thousand years. What is possible is the first leg down in this bear market may have run its course. I emphasize the word may because I am not sure. I honestly have my doubts because we did not appropriately test the support from a 50% retracement of the entire bull market coming in at 7,470.42. Some of you may think I am splitting hairs, but the market almost never leaves a job undone. What's more this level is doubly important since it was also the 2002 low before we began the last leg up in the bull market.
Since the decline picked up speed back in September, we have seen just one reaction extend beyond two sessions and that was a six session reaction beginning at 8,175 on October 27th and finishing up at 9,625 on November 4th. That was the now infamous Barton Biggs "we've see the bottom" call. The reason I still have my doubts as to whether we've seen a temporary bottom has to do with the fact that sellers have yet to capitulate. I know we've seen a series of 90% down days, and they were followed by two 90% up days just this last week (highlighted by weak volume), but rallies seem to come more from a lack of selling than a desire to buy. I have noticed though that the Lowry's buying pressure is now almost 30 points above its all-time low, so that is one point in favor of a temporary bottom. In order to feel comfortable that this leg down is over, I want to see three things:
- I want to see the current reaction extend beyond six sessions,
- A higher high as well as a higher low, and
- I want to see an increase in both volume and breath when the Dow rallies.
When I look at how the Dow moves during a session, I still see a market that falls much easier than it rallies and that tells me that sellers are still out there. Simply put, rallies seem to spring from a sellers urge to cover shorts rather than a buyer's urge to go long.
Finally, let's take a look at a daily chart of the cash Dow and you can see that the index has engaged in a series of distributions (blue and red horizontal lines) as it worked its way lower. When I say distribution, I am
referring to stock moving from strong hands to weak hands. It may seem like a stretch to say that the current range (9,250 to 7,750) is distribution due to the size of the range, but consider the intervention and it is entirely possible. We've seen the rules of the game changed for short sellers and the government openly taking positions in companies in an effort to shore up the market. That is the very thing that can create a huge range. Note to how the sideways movement has eliminated the oversold condition with RSI in neutral territory and the histogram positive. Below are the relevant Fibonacci numbers:
On Friday the December Dow futures contract closed up 123 points at 8,823 and really will not have accomplished anything until it first closes above 9,052 and then makes a higher high. The latter requires a close above 9,587 in the December contract, and emotions aside, that would surprise me. I currently am short with 65% of my positions on, having taken 35% off at 7,750 and will do one of two things: take 255 off with a close above 9,052 or add 35% back on with a close below 8,145 in the cash Dow. Until then I just sit and watch.
Now I would like to discuss this new concept of asset (stocks and commodities) deflation together with monetary inflation. I'll be honest and say right from the start that I think folks make this stuff up as they go along. I have experienced firsthand inflation (US:1979-1981), hyperinflation (Peru:1988-1991), and deflation (Peru:1992-1993 and Ecuador:1995-1996), and a significant amount of recessions in Europe, the US, and Latin America. Personally, I cannot recall of one instance of asset deflation together with monetary inflation and I do not see this mix in the US at this time. I do agree that the Fed is creating liquidity at a staggering rate, but this liquidity is not making its way to the general public. It is for the benefit of a select few and they are hoarding the money to no one's benefit; probably not even their own. You've already seen the decline in stocks, so I won't dwell on that, and for an idea of what is going on in commodities just look at a daily chart of the Baltic Dry Index below:
Never have I seen a chart of a major index look as bad as this. Just when you think the worst is priced in, it falls to a new lower low in spite of already being grossly oversold (this happened on Friday).
I have no doubts as to the pressure on the economy from asset deflation, but I do not accept the idea of monetary inflation simply because the Fed prints money. For inflationary pressures to push to the surface there has to be a strong demand for that money, and I see no signs of such a demand. Yes, the dollar has risen against most major currencies, but that has nothing to do with increased demand for money in the conventional sense. Rather deflation has made servicing debt considerably more expensive and that in turn led to a scramble for dollars, thereby pushing the greenback higher. Take a good look at the daily chart for the US Dollar Index below:
I contend the increased demand due to the need to service debt has a limited shelf life during deflationary times. The US in particular, and the world in general, are swimming in debt and a person's first instinct is to pay it. Since most of the debt in non-productive in nature you eventually come to the conclusion that the situation is hopeless and hand over the keys to whatever it is and seek higher ground. I think we are close to that point now and that is why the US Dollar Index has moved sideways out of its recent uptrend (dashed red line).
There are several indications that the dollar has topped including the fact that the RSI, MACD, and the histogram all failed to confirm the latest high. Also, the US Dollar Index was never able to really work past significant resistance at 87.37 despite three separate attempts. You have upward pressure on the dollar as people try to pay down debt, but don't forget that you also have downward pressure as demand for commodities (all priced in dollars) diminishes. The key will be when the December US
Dollar Index breaks and closes below 84.95. On Friday the December contract closed at 86.70 and close to the middle of the recent range. Finally
I have been watching the formation over the last month and I would not be surprised to see a head-and-shoulders formation. We have a possibility with one shoulder and the head already present, but we'll just have to wait and see if the other shoulder develops.
Right now of all the things you can invest in, there are only three that offer any security: 30-day Treasuries, cash, and gold. Of the three, I prefer gold and it has been acting a lot better with each passing day. On Friday the December gold futures contract rallied 7.70 to end the week at 816.20 as it
appears to be consolidating recent gains. Gold improved its position considerably when it finally managed to break and close above what was the 772.50 resistance. The next real key will be found at the horizontal red
and green line at 826.00 seen in the chart above. Assuming gold can get past this level, we should then see a quick trip up to the old historical high at 850.00 and then beyond. I know most of you have lost faith in the yellow metal, but assuming the bottom is in we should now be embarking on a move to the upside that will take gold much higher than anyone anticipated (including me). The one primary driver will be general economic conditions, whereby the US creates money at here-to-for unthinkable quantities. This will combine with a terrible deflationary spiral that will consume everything in its path, forcing people to seek out the one true store of value, and that is gold. If you have it, your chances for economic survival will increase exponentially. If you don't, well you can guess as to what the outcome will be like.
ebo@dtanalysis.com
Dow Theory Analysis SAC
November 30, 2008
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