April 2008

Let me test my predicting powers.

I think today market action was very bearish (and I loaded more puts). First, the very happy rally of +170 points in the Dow was completely reversed to the -12 decline. And that was the 4-month intraday high combined with a complete reversal – fit the final exhaustion move.

Second, in the bear market, for any meaningful accumulation at the bottom you must expect financial stocks to outperform general indices. They are early leaders and they must lead. Today the broad financials XLF closed -1.01%, broker dealers IAI -0.94% and small mainstreet banks KRE are distressed and closed -2.08%.

Third, this is May. Sell your stocks and go away.

And finally, if this post is about stocks I need a chart. Here’s the chart, the discount (stigma) borrowing:

I think the rally from March 10th $SPX of 1273 to today intraday 1404 (nice 10.3% correction for a bear market) is over and we will start long and painful slide back to 1273 and below. The trend moves are usually slow and I expect the 1273 to happen somewhere in late June or even July.

Disclaimer: I’m just an anonymous blogger, my opinions are for entertainment purposed only

Update: Another chart, just to make the post longer. Here’s the ration of financials to S&P:

Financials are very early cycle leaders. Last time the ratio bottomed in a very beginning of a bear market, about 2.5 years till the bottom. But this metric we may easily have the bear market till 2010


I think you can dig a lot of interesting stuff from the GDP report. Let forget all those financial woes for a moment. It’s important what consumer is doing and what the private business is doing.

First of all the chain deflator is 2.6%, believe you or not. So whatever numbers you see are adjusted for 2.6% inflation.

Consumer cut its durable goods expenditures by .48%. The only other decline in the past 4 years was post-Catrina 4Q ’05. I think that was expected, nothing special. But now hold on to your chair. The food consumption went down by .05% and gasoline and energy by .05%. We are eating cheaper and driving less.

Is the business prepared for this decline in spending? Apparently not. In the 4Q ’07 business cut inventories sharply subtracting 1.79% from GDP. They thought that this would be enough to adjust for the slowdown. But in Q1 the inventories rose adding 0.81% to GDP. The early stages of the recession is not a good time to grow inventories. You can spot the growth of inventories in the outstanding banking credit that was growing most of the quarter, except late April. It is easy to finance unsold goods by credit as long you promise the bank that you will cut production. I suspect that the real cut in production just started in mid-April. I will examine it in one of the future posts.

GDP minus inventory accumulation is called “sales of domestic product”, which is -0.2%

Please read the fine post from immobilienblasen about price control in China. I want to dig a bit more into this topic.

Let start from the basics again. To simplify the things the world economy works as an entity that extracts natural resources from the Earth and process it into consumable goods. If you divide this entity into countries that are essentially sub-entities unified by some policy and other common properties of business units located in that country.

Each country has a particular competitive advantage in certain fields of processing natural resources and the logic of the world economy pushes those resources into this country. For example, Japan is very good in converting oil and silicon into flat panel televisions. So those countries who extract oil and silicon from Earth are sending them to Japan and then Japan sends those flat-panel TVs to the rest of the world. In case of Japan this advantage is in technology, patents and know-how.

In case of China the competitive advantage is the abundance of extremely cheap yet relatively qualified labor, concentrated along navigable rivers and backed up by business friendly government. There are many countries in the world with cheap labor but few of them are stable, qualified or accessible. The output from China is pretty much anything that is labor-intensive and can be easily outsourced from the West. Like plastic toys.

Now more about cheap labor. In the market economy there is a certain proportion between luxury, durable items and staples. For example, one day at ski resort will cost you the same as 10 bags of rice. The basket of consumable items will include the mix of staples and luxuries, both rice and ski resorts. The feedback loops between consumption of all those items creates this typical basket and the typical cost of labor in Western countries. Every kid in USA once in a while comes to Disneyland and this is a part of the basket.

Now very clever Chinese authorities came to a very clever idea (used in all Eastern European countries before) that they can subsidize the staples and change the proportion between various items. So the day at Disneyland (or ski resort) will cost not 10 bags of rice but 50 bags. So the typical consumption basket will include more rice and less Disney, overall supporting all the life necessities at cheaper price. The idea is that only a fraction of the country output is sufficient to be used for subsidies but overall it will make the labor artificially cheap and thus supporting the big trade surplus.

In the completely free market economy the China market would quickly adjust itself, the basket would be more expensive and include more luxury items and services, the price of labor would go up and the trade surplus shrink quickly. But this doesn’t happen.

So what is the conclusion? The world economy is in market equilibrium based on certain price of all goods. But the big player China is distorting the market mechanisms. First, they consume more natural resources than they would otherwise. Second, they produce more artificially cheap goods than they would otherwise. And this disproportion is widely based on subsidies that are coming from large trade surplus.

If anything in this artificial, non-market structure will start breaking the results may be disproportional the the cause because the market usually adjusts itself much better than any government structure. It looks to me like a big house of cards which is much more stable flat rather then tall

Just a technical observation. I love various oscillators, because they help me to visualize the market internals. This weekly chart (link) shows the relationship between percentage of the S&P 500 stocks over 200 day moving average and over 50 DMA (click to zoom).

As you can see in the bull market the 200 DMA line is mostly above 50 DMA line because many stocks oscillate above and below their 50 DMA but they mostly stay above 200 DMA. In the bear market it is exactly opposite. I think you can use this chart as a definition of a bull or bear market, not a single definition, but one of the best out of many.

This chart gave you a perfect, amazing warning back in October. The 200 DMA line in freefall while 50 DMA line was making another high.

Let zoom the same chart to the daily one (link):

I don’t think I can fetch from this chart where stocks are going next week but I can clearly see that we are deeply in a bear market. Only 40% of stocks are scrambling above 200 DMA while 70% of stocks are flying above 50 DMA.

I think the well-pronounced top in the current counter-trend run will happen when the 50DMA line will start making lower highs (examples – late October and late December)

Update: I’m adding the chart from Eugen comment:

As you can see it is indeed a very good indicator during bull market. But now it is on uncharted territory

While the fabrics of the world financial system is too complicated for anyone to understand it is sometimes possible to track several bold moves that are likely to lead into equally bold consequences.

First of all is the continuous disruption of the world food economics. After I’ve tried to explain the sharp increase of food prices by simple supply and demand the collective finger was pointed toward my nose forcing me to accept that the apparent disruption of the world financial equilibrium is also likely to be the cause.

This is very similar to the gold run that we observed in the past few years. When the trust into dollar future was fading the first reaction of market participants was to hoard something precious to them, like gold. But in the past few weeks the world market discovered that there is something much more precious than gold, like food. If you saw the multitude of movies about wars you probably know that (at least in the movies) during the war a fine gold watch will buy you few cans of spam or a bag of flour. Not that gold is so cheap, but the food is so precious. When millions of people are losing any trust to their local currency (pegged to falling dollar) they resort to hoarding rice, which is relatively easy to store. One bag of rice is equivalent to one gold watch, when the time comes.

Now the second bold move. It’s the apparent shortfall of US tax collections comparing to soaring needs of this administration spending habits. The outstanding treasury debt is quickly approaching $10 trillion, and this is one of biggest Ponzi schemes in the world. This is the story we all know.

And the third bold move is the panic at Japanese bond market this night. Inflation finally reached Japan and the bonds started to fall so fast that the trading was suspended (those guys still don’t understand free markets). The elimination of ZIRP in Japan will lead into many redistributions in the word financial system. For example, I think the eventual introduction of the unified Asian currency may prompt China to sharply increase the purchase of Yens and reduce the purchase of dollars, and now is a good time to start doing so, because the interest rates in Japan will start moving closer to the rest of Asia.

Now the result of all this. Check the chart of the 10Y bond yield:

It clearly broke the trendline by a meaningful margin. The sharpness of the upward move will tell us the magnitude of the disaster. I think this is the most important event on US markets we need to watch now

The Dow theory is, among other useful stuff, defining the relationship of DJ industrial index and the transport index to primary bull or bear trend. It’s amazing, but the Dow theory was almost 100% correct (maybe just a little late) during all the 100 years of its existence.

But I’ve recently heard an incorrect opinion (don’t want to point the finger) that the bear market is over when DJ and transports cease to make simultaneous new lows. In that case it was pointed out that the transportation index does not confirm the new low of DJ and hence the rally is due

Before applying the Dow theory in practice you need to keep in mind that transports are the classic early cycle leader. Let look at the chart:

This is the ratio between transports and S&P 500 before and during the last bear market. You can clearly see that high inflation made transports to underperform the market for two years before the bear market started. But as soon as Greenspan cut the rates for the first time the trannies are seriously overperforming the market. It doesn’t mean that the transports index will necessary enter the bull market while the rest of the market is in severe decline, but at least it can stop confirming new lows of Dow Jones index.

I think by its nature the classic Dow theory signal is much more reliable at the beginning of the bear market but it can give a premature optimistic signal of a new bull market.

Lets look at the recent chart:

It seems to me that the ratio gave a pretty good one year advance bear market warning in 2006. Then it gave a very bold confirmation in October and then quickly fell to the levels that remind of the early 2000 a the first chart. The time seems very compressed and the run that follows is very similar to the early 2001.

Knowing that the previous bear market was running till the Fall of 2002 we can conclude that the chart as we see it now keeps the door open for a nice deep and protracted bear market even if transports will fail to make new lows

I just want to put up the summary about the reasons behind rising food prices that I’ve got after reading and listening many educated opinions. I also want to deny the popular misconceptions that some people have. Of course this is just my opinion.

The main reasons I know are:

  1. Most important is the increased wealth around the globe. Wealthy people eat more meat and less grain, but it takes a lot of grain calories to raise cattle. Some people used to say that wealthy people consume pretty much the same amount of food as poor people. This is wrong. The amount of grain needed to produce one meat stake is enough to feed more than 50 people. Feeding grain to cattle produce major shortages
  2. Ethanol policies in US. We just burn food and we also burn a lot of fossil fuel to produce this food, this is very counter-productive and must be stopped
  3. Climate change. There is permanent (10 years) drought in Australia, for example. Ask Al Gore for details
  4. Free trade failure – many countries are restricting food exports in order to control domestic prices

The reasons that are often mentioned but are completely wrong:

  1. The falling dollar. This is wrong because food prices are rising all around the globe, without any relation to dollar or to any other currency
  2. This is a result of Bernanke lowering interest rates. Wrong, as mentioned above this is unrelated to dollar, hence unrelated to whatever Fed policies are
  3. The food prices are rising because of inflation. Wrong. This one is the most hard to get even for the best minds around, like Barry Ritholtz. Inflation is when the money supply and money velocity are growing faster than supply of goods and services, i.e. inflation is a monetary phenomena. There are countries that are experiencing strong inflation, there are countries where inflation is much lower, but the food prices are on the rise everywhere no matter what the inflation rate is. If you carefully examine the 4 reasons I listed in the first section they clearly show fundamentally increased demand and fundamentally decreased supply. I don’t see the inflation to be the part of this equation

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