Back on Track: Market Heading Down

Earlier in the week I presented this chart and wondered whether we were on the shallow or the steep down slope. The difference being how rapidly the market will unravel IF it is going to unravel. By Friday, it became clear that we are on the steep downward slope.

To revisit my Last Gasp Theory (first mentioned April 5th http://liverocket.blogspot.com/2008_03_30_archive.html)
1. The market bounces around in 10% cycles prior to one final surge – The Last Gasp
2. The Last Gasp is a large run-up of ~15%+
3. The surge continues as the recession officially starts, peaking within a few weeks of the recession’s beginning
4. The subsequent crash happens quickly and is much deeper than the run-up

The last few weeks look really, really like the the Last Gasp is playing out. In theory, we are out of whack with #3 because the Q1 GDP was revised up to 0.9%. My take: whether or not the Recession has begun may be less important than what people think. An dmost people think that we are in a recession.

(BTW hug apologies. I work for Cisco Systems and there is an investment community there. On Thursday, as the market was racing up, I shared my thoughts that it was a head-fake: a false rally. I was rightly criticized for not sharing those thoughts here. Going forward, I will post my thoughts here first, and then copy and paste there. You deserve to get the latest ideas first.)

Other than a neat chart, why do I think worse has yet to come? Start with the Dow’s P/E of 82. (http://online.wsj.com/mdc/public/page/2_3021-peyield.html?mod=topnav_2_3002)
That’s a clear sign that the market has over valued equities.

To understand what is about to happen, you have to consider the origins of the disconnect between economic fundamentals and the stock market’s prices.
For a few months, the Fed has been peddling the following story that
- outside of housing and banking, the economy isn’t that bad and it will be better by the 2nd half of 2008
- Exports will boost our economy

Clearly, both are wrong. As I showed before, latest export figures show a fall in exports. It’s hard to predict the trend. Pushing up exports will be the harvest season that just began. But pushing it right back down is the newly invigorated dollar (5% higher than in March) and the slowing European economies.
Bottom line – with the $2B pullback, the economy needs at least a $5B+ surge to bolster the broader economy. That's a lot of corn and wheat.

Meanwhile, the economy is doing worse not better. Unemployment and inflation are both up. Last week’s preliminary retail report for May showed consumer weakness. Spending went to food and gas, and not to discretionary items like clothes and durables. At this point, the question is not about Bull market or Bear market. We are in a Little Bear market. The question is: will the Little Bear become a Big Bear?

I think the market is about to react furiously, like the betrayed spouse who is waking up to the facts that they have been lied to and ignored the truth displayed before their eyes.

Beyond financial market behaviors and psychology, we have the very real problems of the investment banks and hedge funds. These are the players at the table who make the markets move. As pointed out previously, lately they have been rushing into cash (http://liverocket.blogspot.com/search?q=morgan). JP Morgan showed that the rush is happening at exactly the same rate as happened in previous recessions. Money sitting on the sidelines is money not pushing up stock prices.

March: Hedge Funds suddenly re-gain access to easy money. The Fed didn’t just lower lending rates to 2%, they also began lending to investment banks.

April: Hedge funds drive up bubbles in food, gas and commodity metals. The target is determined by two things: the only recession-proof investments are food and energy and, secondly, many commodities have less stringent margin requirements than equities.

May: Lenders face insolvency. The dominos from housing are falling: a terrible Spring season for housing sales means lenders are starved for liquidity: builders and homeowners aren’t paying back loans. Banks have capital/cash requirements and they aren’t meeting them. Meanwhile, their customers are facing the same problem: the collateral they put up has dropped in value. Banks are making margin calls.

June: Lenders and others begin panicking. They now have 4 weeks to get cash or begin fire sales. But banks are getting smacked around. Home builders are dropping prices even faster to raise cash to pay back the banks, but the new prices pressure home prices overall, hurting the individual homeowners that are behind payments or looking to re-finance.
Meanwhile, the consumer is not spending. The stimulus package fizzles.

I’ve mentioned the 90 day cycle wherein funds make investment decisions around 6 weeks before the end of the quarter. In this case, late May. Yep, the market started sagging exactly when you would expect the funds to start heading for the exits. Smart money began leaving 3 weeks ago. Next up: retail investors like you and me. Unless, like me, you have been in cash and short positions.

To make matters worse, the funds are getting pressured by their lenders, the banks, who need that cash back. Now. That pressures funds to sell even more.

So it's a convergence of liquidity an dfinancial pressures pulling money out of the stock market and a weaker than expected corporate earnings (thanks to the now-hibernating consumer). Unfortunate timing for longs.

Can the Fed do something to stop the slide? Not really. They can’t risk another rate cut. In fact, they want to stop the rampant speculation that is driving up inflation.

And then there is market psychology. The economic data will no longer be fuzzy – one week positive and the next week negative. Too much economic data is going to be released shows a sharp downturn. It’s not that the economy is slowing – it’s also that the Fed has been singing songs of good cheer, making investors feel foolish.
What are the steps? Denial, anger, and then acceptance? Something like that. We are exiting the denial stage, next up is anger. Angry investors are dis-investors. Which will add to the market plunge.

I've published my watch list. Next step: shorten the list and buy. I’m thinking about buying in Friday on the back of a bad week of economic data. I have been looking for my target stocks to pullback with the broader market. No such luck. I like Friday because I see bad news ahead.
- April export/import data (Tuesday)
- May Retail Sales (Thursday)
- May CPI (Friday)
- June Consumer Sentiment (Friday)

It's possible that retail data will continue to be both positive and negative. Sales could be up, but largely because of inflation. Strip out food and energy, and you’ll see falling spending on consumer durables. That will no doubt be echoed in the import/export figures in things like lower imports of clothes, cars, electronics, and so forth

BTW I am seriously thinking about jumping into silver. I think gold jewelry is too expensive for most folks, so retailers will be shifting to silver.