Preparing for "The Big One" (Wave (C) Down)
Jay Taylor
We hear much babble these days in the mainstream press about the bear market in stocks being over and that "green shoots" promise that a warming of summer will bring much life to the equity markets. The implication is that the good times are here again. We think those kinds of remarks are nothing more than self-serving propaganda out of Washington and New York as the purveyors of paper money products seek to con the public into the continuous belief that wealth is derived from the printing presses. That is the big lie of our establishment. But as with Pinocchio's nose, each lie begets a bigger lie until low and behold people start to see reality. The falsehoods that policies are making things better policy is clearly exposed by the biggest plunge in corporate profits and the highest PE ratios in our history that the unthinkable is happening. Ron Paul now has over 200 co-sponsors in Congress to audit the FED! God
Check out the charts above. They show that stocks are not only overpriced, but that they are the most overpriced they have been in at least the last 75+ years! The chart above on your left shows S&P 500 earnings, adjusted for inflation. Down more than 90%! And because stocks have not fully adjusted for the plunge in earnings, PE ratios for the S&P 500 are higher than any time in at least the last 75 years. The S&P PE ratio never rose much above 20 times from 1935 until the 1990s. From a historical perspective, stocks became more and more expensive during the 1990s as monetary inflation was pushed into financial assets rather than into consumer goods and services. The stock market crash of 2000 took the PE ratio down a lot, but not anywhere near the levels that are seen at true bear market bottoms in range of 7 to 10 times like we had in the 1930s, 1970s, and 1980-82 timeframes. Now PE ratios are absolutely ridiculous! The S&P 500 is currently at around 120 and far above anything we have ever seen before! All of this suggests that the equity markets are not only overpriced-they are ridiculously overpriced!
But what about green shoots, Mr. Taylor? Isn't it possible that the market in its infinite wisdom is figuring out far better than you can what the future holds? After all, I have heard you say many times that markets are forward-looking mechanisms and that the collective wisdom of the markets is far greater than a few policy makers or any one individual. I certainly do have to keep an open mind, and I will leave that possibility open. It could be that the markets are telling us things won't be as bad as they may seem to me. But it's also true that markets rise and fall dramatically from time to time and that a rise like we are seeing is simply a correction to an initial overreaction in the first leg down that occurred last autumn just as happened in the 1929-1931 time frame. We are certainly seeing some signs that the rate of decline in our economy has not been as rapid as it was in the past so the market may have correctly predicted that. But from a fundamental point of view, I do not see that anything of substance has changed in the U.S. economy except that the government is taking more and more of our present and future resources to bail out bad companies. That is not a very promising policy if you want things to get better in the future than they are now.
Moreover, the news just keeps getting worse overall. For example, just today, John Williams put out his latest newsletter and highlighted the following data:
- May CPI-U Annual Deflation of 1.3%
- May Annual Production Fell at Fastest Pace Since Post-World War II Production Shutdown
- May Annual Decline in Housing Starts Continued Record Fall-Off, Monthly Gain Lacked Statistical Significance
So where are the green shoots? I just can't see them. And with the U.S. consumer-the engine of the world's economy now dead-where is the global demand coming from to get the global economy moving again? I just don't see it. And if you think it will come from China, check out the following from the latest issue of "Bert Dohmen's Wellington Letter"( www.dohmencapital.com) :
"The vast majority of analysts are predicting a continued commodity boom, including oil, primarily fueled by buying from China. As you know, our view is the opposite.
"China is buying raw materials and stockpiling them. Do they feel that today's prices are cheap or are they supporting prices of commodities that they also produce? If it's "bargain hunting," we have to consider that such decisions are made by bureaucrats. And usually they are not the brightest lights in the candelabra. Example: the bureaucrats running the Sovereign Wealth Funds went bargain hunting in late 2007 and 2008 in the U.S., pumping billions into major Wall Street firms and banks. At the time, we wrote that they were much too early and that they would lose billions on these alleged "bargains." As we know now, they did!
"The commodity bulls try to persuade you that China's demand for commodities will cause a great commodity boom. Our answer: China's economy is 25% the size of the U.S. How can this possibly absorb all the excess production from the rest of the world? Demand from all around the world is down around 50%. This is a sucker trap.
"Although "official" numbers still show 8% economic growth in China, we don't believe them. We predict that industrial production in China will turn negative by next year or earlier.
"One of our valued clients sent this email: Yes, very [concerned] regarding the demise of Chinese industry. I have had similar reports from colleagues here in the oil and mining sectors, who contract in China. They say that the main manufacturing cities are almost desolated, and factory owners are just coming to their premises in the dead of night and closing the gates, leaving their workers to arrive in the morning to nothing.
"The Chinese government has recently been implementing huge bailout programs in order to stop the economic deterioration. But it won't work: they have no control over the diminishing demand for Chinese products from abroad. Consumers worldwide just don't have the money to keep China's industries busy producing goods. Low interest rates, lower bank reserve requirement, infrastructure projects-none of them are sufficient to replace the plunging demand for Chinese goods.
"But the government is desperately trying to keep prices from plunging. China is the world's largest producer of zinc. But there is a huge surplus of the metal. Therefore, the government may buy 100,000 metric tons to support prices. Zinc purchases by the government were 59,000 tons in January, but it had little effect.
"The government has been buying aluminum, zinc, corn, and cotton to support prices after exports fell the most in almost 13 years in January.
"China is importing basic materials, and producing steel, as if they were afraid of future shortages. China's daily crude steel output in May reached 1.5 million tons, equal to an annualized rate of 544 million tons vs. 500 million tons in 2008. But that's not controlled by the central government. Imports of iron ore are continuing at a record pace. Copper imports are soaring. The government has already warned its steel mills about excessive production.
"History shows that when governments start stockpiling surplus commodities to support prices, you're still a long way from the bottom in prices. In fact, it shows how desperate the situation is. No one, even a country like China, is bigger than the marketplace.
"The Chinese government reports that 30% of the nation's aluminum production capacity is idle, 20% of cement and plate-glass capacity, and 70% of semiconductor production is idle. This is what a Depression looks like. The government's stimulus program of $585 billion will just enhance the excess capacity.
"Steel prices worldwide have plunged. The largest Brazilian iron ore producer just had to cut its price to the Chinese by 48%. Does that indicate big demand or a huge surplus?
"The government doesn't want to close factories, as that will only increase the risk of civil unrest. Hungry people often foment revolutions.
"According to the WSJ, China's auto industry has the capacity to produce about 12 million automobiles a year, but only 9.37 million were sold in 2008.
"China was the supplier of goods to the world, while domestic consumption didn't keep pace. The fallacy of analysts is to think that the government can crank up domestic demand to replace the lost exports. But that will be impossible in our view. China's economy will suffer along with the rest of the world.
"Rising prices don't always reflect rising demand. Take crude oil, which just hit $73. All the numbers reflecting excess inventories and diminished demand make the case that there is a huge surplus building. Yet, the price of oil has recently doubled. To us it's similar to 2008, when oil hit $147, although the numbers at that time confirmed that fundamentals didn't support the price. Our technical sell signal came just about at the top. Thereafter, the price of oil plunged by 70%. Reality returned.
"Recent oil inventory numbers show six billion barrels stored globally. That's a value of $420 billion. In our view, much of this is stored by speculators who are betting on prices rising. When they finally can no longer afford the storage and interest costs, there will be a rush for the exits. Who will they sell to if everyone is a seller? And all the buyers of the energy stocks of the past two months will have huge losses.
"China's oil imports between January and March increased over 30%. But that was only 9% of total global demand. China is also accumulating the basic metals. In Q1 China accounted for 75% of shipped iron ore globally. In a stagnating economy, and overbuilt construction sector, who will use that iron?
"Bottom Line: We don't believe the hype about a commodity boom. This is a speculator boom, some of it produced by novice investors being enticed into the commodity ETF's by the hype in the media. Thus these ETF's have to buy the underlying commodities. Eventually, there will be a rush for the exits and commodity prices will plunge."
Do you see why I am concerned? The U.S. consumer is now down for the count and it is going to take many years if not decades of savings for him to recover. Even then, we wonder if it will ever happen, given the trillions of debt now being laid on the shoulders of the American taxpayer to bail out fat cat bankers. So where is the growth for the global economy to come from? If you believe what was said above, China is setting itself up for the same kind of disastrous mal investment situation that the U.S. has set itself up for. Can a planned economy grow and prosper? We don't think it can. The U.S. was until now, still a largely free-market economy, though those freedoms have been gradually being eroded for many decades. China starts out with a totalitarian mentality and they never were really a free-market economy. They may have liberalized some from where they are today, but they have never been a free-market economy, as we once were. And so to me, from a purely logical fundamental point of view, unfortunately I think the stars may be lined up for the Worst-Case Scenario projected by Dr. Robert McHugh and shown on the left below:
The worst-case scenario, which Dr. McHugh refers to as a "cataclysmic, nation changing event," would have the Dow falling below 5,000. Actually that is a rather tame decline, compared to the comments of a couple of my radio show guests, Ian Gordon and Jeff Schuller, who was my guest last week. Go to http://www.modavox.com/voiceamerica/vepisode.aspx?aid=39193 to listen to my interview with Jeff Schuller. You may also listen to my interview with Ian Gordon by going to http://www.modavox.com/voiceamerica/vepisode.aspx?aid=38122. Ian sees the Dow falling to 500 and gold rising to $2,000! Whatever the ultimate decline for stocks turns out to be is anyone's guess. Projections can be made on the basis of various technical tools, but in the end only God knows. The important thing is that we are prepared for the next big decline so that we are not stuck with the kind of horrendous losses we suffered through last year. Because of the confidence I have in Dr. McHugh's work, I have been watching it every day. His best guess now is that the (B) wave higher will last until perhaps the third week of September. This (B) is simply the bounce off of the horrendous (A) down last autumn.
The (C) wave down, which could get underway in September, give or take a month, is the granddaddy of market declines that we want to get ready for. As we suggested in our June 12 letter, we think it wise to take some profits out of uranium and gold shares even now. Build up cash so that we have the ability to increase our hedges against a major market decline and also so that we can buy up gold shares at a much lower price. Our thinking is that gold shares will most likely get hit hard with any major decline in the equity markets, and that should lead to some excellent buying opportunities. In fact, in a small way I can tell you that your editor began this process in his own IRA last week. We will keep you posted in our weekly letter regarding our views on this matter and if need be, we will send out a rare alert if/when we are facing an impending crisis decline. Here is the latest from Dr. McHugh regarding his views of where the equity markets are now:
The Central Planners announced the largest regulatory overhaul of the financial system since the Great Depression, on Wednesday. This should restrict and restrain lending, which should inhibit economic growth, and help set the stage for wave (C) down later in 2009. Raise cash between now and then.
Wave A-up topped on June 11th intraday, of an A-up, B-down, C-up move for (B) up that started on March 6th. We cannot be sure if B-down will be a relatively shallow sideways triangle, or a deeper zig-zag. Too soon to tell. This move will correct the rally from March 6th to June 12th, which was 2,408 points. If it corrects 38.2 percent of that rally, then the Industrials could fall 919 points from the June 11th intraday top, to just under 8,000, 7,959ish. A 61.8 percent decline would take the Industrials down to the 7,400ish area. We would not risk more in a short-trade than one can afford to lose entirely, given that the PPT is highly active in stock markets at this time.
Once wave B-down finishes, we should see a final rally leg, wave C-up to complete (B) up, which finishes the correction of the October 2007 to March 2009 plunge. The rally from March 6th has been 3 months versus the 17 month decline that preceded it, or 17.5 percent of the time. If (B) up takes 38.2 percent of the time (A) down did, we are talking about a conclusion to (B) up around the autumn equinox, the third week of September, 2009. That happens to be when the crash of 2008 started.
OUR INFLATION/DEFLATION MODEL REFLECTS (B) WAVE UP
The (B) wave up to correct the (A) wave down last autumn is clearly evidenced in our IDW, which is comprised of a broad base of stocks, key equity sector indexes (autos, housing, China, India), U.S. Treasury bonds, commodities, and precious metals. From the index peak of 145.04 in May of 2008 to June 18 when our IDW recorded a reading of 128.76, we have had only five components that have risen. Except for the Global U.S. Dollar Liquidity (GUSDL), which exploded higher-thanks to modern-day printing presses-by an astounding 261.46% since the May peak, all of the other rising components point toward deflation, not inflation. The indicators of deflation in our database are: U.S. Dollar Index +9.11%, Long Term U.S. Treasuries +0.25%, Gold/Rogers Fund +85.36%, and Gold/Silver +25.43%. We find it amazing that, even with a 261.46% increase in global liquidity, our IDW has risen a measly 24.5% from its bottom. Actually, if we take out GUSDL from our IDW, our IDW would have peaked at 155.98 and bottomed at 92.57 and it would now be at 122.57. The inclusion of GUSDL has suggested a less severe swing in our IDW than has actually occurred. And if GUSDL is excluded, we have now had a 32.8% bounce up from the bottom, which is well within any kind of normal Elliott wave counter wave from the initial bottom.
Our view here is that we are temporarily enjoying a normal bounce in the markets and that the rise in commodity prices is really driven by excessive liquidity pumped into the system, accessible merely to professional traders like pension funds, hedge funds, mutual funds, etc. Without any end demand, these markets will, in our view, fizzle out later this year. That event combined with the likelihood of more dramatic problems in the financial sector should send our IDW plunging again. Our suggestion is that you seek to build up cash now for the remainder of the (B) wave up, which now looks like it could last through the summer and possibly into the third week of September. Taking advantage of this anticipated strength to lighten up starting with inflation hedges in base metals, energy and uranium. Cash can be used to hedge against a general market decline using tools like BEARX or SDS and at some point to hedge against a major decline in Long U.S. Treasuries (TBT) and also to potentially pick up quality gold shares a bargain basement prices if, as we suspect, they too may get hit hard initially in the next major leg down.
June 25, 2009
Jay Taylor, Editor of J Taylor's Gold & Technology Stocks
www.miningstocks.com
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