Intermarket Analysis

At April 30 I’ve posted “Kiss this rally goodbye“. Well, I was wrong by 2 days and 18 points in the S&P. I’ve said that the peak will be 1404 at April 30 but now it looks like the real peak was fixed at 1422 at May 2 (both intradays). After yesterday 3.5% carnage in financial stocks they are tumbling by another 2% today. Financial sector is a leader in rallies and falls, so we won’t see that May 2nd 1422 level for months and, who knows, maybe years or even many years.

What happened? In this post 2 days ago (and the follow up discussion) I’ve suggested that Feds will have to make sacrifices in order to save the bond market. That had to do something nasty to scare the money out of stock market into bonds. My proposal was that the Feds will either suggest that they will allow Countrywide to fall or they will hint of possible rate hike.

Yes, they made a hint that the rate hike is possible, that worked very well – I was right. Second, the SEC declared that investment banks will now have to disclose the liquidity levels. That worked even better. The market is tanking exactly as Bernanke wants it to.

Yes, we know that Bernanke put exists for the bulls. Now we know that Bernanke call for the bears exists as well. Those who think that he will allow the stock market to rise at the expense of the treasury bonds are terribly mistaken. He will make all necessary sacrifices

1. The expectations are running high

The week of April 28 Barron’s ran a cover story “The Bulls are Back”.

bull in the water

AND NOW, FOR SOME GOOD NEWS: THE OTHER SHOE isn’t going to drop. After a winter of discontent marked by massive write-offs on Wall Street and a wilting economy on Main, America’s portfolio managers have declared that the worst is over. More than half of the institutional investors participating in our latest Big Money poll say they’re bullish or very bullish about the prospects for stocks through the end of 2008. Their forecasts suggest they’re even more upbeat about the first half of 2009.

The market expectations run high:

Market sentiment

This Barron’s declaration prompts me to write several posts that I want to unify by the title “Where is my recession?”. The goal is to carefully run through the bulls and bears arguments and collect the readers opinions that will help to proceed to the next step.

Are the bulls correct and the economy (what they really care of are the profits of listed corporations) is on the way to bottom soon and recover going into later this year? Or what we see is a classic front page indicator marking the foolish euphoria right before the real meltdown starts?

2. The economy as a dynamic equilibrium

First of all, what are we talking about? What is a downturn or a recovery? If we think about the economy is like a big barge that almost always exists in a state of some kind of dynamic equilibrium. Dynamic equilibrium means that there is a multitude of forces that are constantly pulling and pushing this barge in different directions and those forces sums up into one force that is making this barge to slowly drift in one direction. Most of the time this barge is slowly drifting in one direction with GDP growing close to 2.5% trend growth. Sometimes it slows below 0% or above 5% – way out of the trend.

What it this trend move at all? The civilization exists by consuming natural resources and converting them into goods. The western market economy proves itself to be the most efficient in processing the natural resources, which makes the developing world to ship their natural resources to us rather then trying to process them themselves. The whole process of working out natural resources and consuming the final goods is quite profitable and the western world is booking the profits according to this advantage.

Sometimes the inefficiencies develop. They can be different. Sometimes the natural resources are overconsumed and that moves the profit from the processing to extraction, i.e from the West to the developing world. That makes the West profits to fall and the chain of overproduction unfolds backwards until it hits the initial resource extractors. Sometimes one of the West countries tries to book future profits and that makes it fat and lazy and then the creditors come and bankruptcies follow.

To sum it I can say that when GDP grows too fast it it inefficient, when it grows too slow it is unprofitable. The economy is bouncing between the efficiency and profits but makes it very slow, in 4 and 8 years cycles. This process is slow and the economy spends significant amount of time at the both ends of each swing. When a trend develops it takes a lot of time before it can be reversed.


So the purpose of this exercise is to find out if the forces that are pulling the economy out of this recession are on the rise while the negative forces that are pushing are deeper are contained.

3. The bull argument

Let me try to collect the essential bull arguments.

  1. The interest rates are extremely accommodative. Compare current rates with 8% rates at the beginning of the 1991 recession
  2. The Feds are extremely cooperative with all other measures. For example, they are lending to non-regulated institutions, which never happened since 1930s
  3. The stimulus package will help the consumer to overcome all the temporary problems ad restore confidence and consumption
  4. The subprime incident is almost over

The following posts will address those questions

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

I don’t think the last decline was final bottom of the financials, but let put this into prospective.

If any talking head on TV will try to fool you into the stock market because financials are doing fine, just look at this chart:

When financials bottom

During the last recession, financials actually bottomed in Spring of 2000, just before the stock market topped and about a year before the recession of 2001 started. During the 40% smackdown of the S&P 500 the financial sector was a place to be.

The performance of the financials doesn’t mean the bear market is over – just the opposite. Don’t get fooled again!

Today we’ve got the final (third) confirmation of bear market – DJ closed below intraday low made back in August. No signs of an intermediate bottom so far, which I expect 2-4 weeks from now.

We are at the point when many sectors already slided into bear, so I want to slice and dice a bit. The list will be sorted in chronological order. I take P/E from here, it doesn’t exactly matches the index I’m using for chart.

Sector Topped % from top P/E
Homebuilders $HGX July 05 58 4.5
REITs ICF Feb 07 40 34
Financials XLF June 07 30 79 for banks, 50 for services
Transports IYT July 07 23 15
Telecoms IYZ July 07 23 24
Consumer discretionary XLY July 07 25 5 to 15, no single number
Semiconductors $SOX July 07 36 10
Industrials XLI Oct 07 12 mostly low teens

As you can see the bear market is underway for a while already and some industries quite possibly already did the bulk of the decline. Try to tell this to permabull Kudlow.

What about other sectors?

  • Basic materials are in triangle and must break down soon (could be a good short)
  • Energy has no sign of topping so far, so we must assume that the trend is still up, but I suspect that upside is limited
  • Most of the various technology sectors are in the bear already
  • Biotechs are not cyclical at all, I see them flat for the last 2 years, could be a way to park money when you have no better ideas
  • Pharmaceuticals look slightly better then biotechs
  • Consumer staples are still in uptrend, could be used to hedge when you have too many shorts
  • Utilities are the only sector that is not trading according to textbooks. Classic sector rotation theory says that utilities must be early decliners together with financials, but this time they are not. Utilities hate inflation and in this cycle we had relatively low inflation and Feds already started to cut. That could be something related to our Kondratieff Winter phase. At any rate, I would not be long utilities now, just in case they start trading by the books

Any corrections are welcome and good luck with our investments!

Look at the Hong Kong index:

hang seng

It is painting a monstrous triangle that has to be broken one way or another and lead into sizable move. Which way it will go?

As far as I know Hong Kong is heavy in semiconductors and affiliated sectors. If you look at US semiconductors index ($DJUSSC) it broke down to the ’05-’06 trading range breaking through all moving averages, even 600 DMA. So why in heck there is even a slightest chance that Hang Seng will not follow? It will, as soon as within this month

Update. I was wrong that Hong Kong s heavy on semiconductors – it is not. But the correlation with $SOX is not invented by me, I took it from Murphy book and I think it still holds. The nature of this correlation is unknown to me, then

First of all, this is another victory for the “Dow Theory”. Formulated 105 years ago it says the bear market is triggered when Dow Jones and Transports are making simultaneous lower low on a daily closing metric. According to great Dow the bear market was triggered back in November. This theory never failed before, never. And today it scored one more victory when, two months later, all major indexes completed the bear market pattern on much simpler and universally accepted TA charting method.

Usually the Dow Theory followers are getting out of stocks few weeks later after the day the Dow Bear starts, when stocks rebound a bit. This time it was back in mid-December. You can imagine how happy they are now 🙂


This bear is still young and not very dangerous. But give it 2-3 years and it will be a mighty beast, and the blood will be on the streets.

Dear bear, please be kind to us, grow fast and leave young, get back to your forest in 2010!

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