Equities in recovery

The Dow Jones Industrial Average (DJIA) has reached a previous low at 13,000 points, but it would not surprise me if it goes lower overnight to at least touch a much firmer support level at 12,800 points (a prevous high). But from that point I expect the market to rally.

Now if we anticipate the DJIA to present good buying opportunities late in overnight trading, then we really need to be buying Australian equities today. The market has already opened higher, and I think like these buyers we should be taking our lead before the DJIA gives us the confidence that will die after opening tomorrow. The best stocks to buy are metals - gold and others severely cut down by offshore selling in recent weeks as metal prices and the Australia dollar came under pressure. As we can see the Australian All Ordinaries Index has hardly changed direction in the recent profit-taking, so there is still alot of confidence in the Australian market.

Dow rally signals buy!

The Dow was up 120 points overnight giving further confidence that the current trend is going to continue. Although the Dow had already breached its previous Apr'06 high, it was not very convincing. The overnight rise takes the Dow to a new high, signalling its going higher. That is further reason to jump into commodity stocks - particularly copper (off highs at $3.60/lb) but also gold.

Dow strikes new high!

The Dow Jones has struck a new high despite negative news by Citibank Group. Instead the market moved 191points higher to 14,11o on the back of a market belief that the Fed will support the market with further Fed rate cuts. I'm not so sure about that, though I dont see the Fed cooling that optimism for the foreseeable future. So I would be looking for Dow weakness over the next few days before I would be making a greater commitment to the market.
I dont see Americans supporting the property market just because the Fed is lower rates, or at least paused for it. There is a market overhang, a very real threat of inflation, and this market is slowing. I would be staying in gold and cash, though with copper at $3.72/lb, i am holding Matrix Metals, though it concerns me that they have not moved up yet. Am I being impatient again, or is the market worried about lower prices. Copper prices would have to fall $1/lb before this stock would be bad buying. Its a great story.

Markets due for correction

If the US Dow Jones Industrial Average and Australia's All Ordinaries Indices are any guide the market is due for a correction based on technicals.

Looking at the chart above we can see that the Dow is just off its previous highs, and seems somewhat reluctant to advance. The ASX below has already reached its previous all-time high, but it too seems to be marking time, as it waits for direction from the US market.

Based on these charts today was a good day to sell down your stocks until the market sets its direction. Of course such charts only provide an average guide of market direction, and one can expect the gold sector to respond better, although it will not be completely protected from any fall.

Another sell opportunity

The US market was up 113 points on Friday on news that the US government would provide support for loan defaulters with a good credit history. I think such support misses the point because:
1. Interest rates will rise further - squeezing even more households
2. Not all sellers will be defaulters - but investors
3. We are looking at a recession - which means job losses
4. No matter what is negotiated, you can be assured the government is going to give defaulters just enough security to retain their homes, but thats not going to give them the confidence to keep spending.
5. There are still alot of 'no doc' loans which will be resetting at higher (+30%) interest rates over the next 18 months.

Thats all depressing news for the market and the domestic sector accounts for 60% of US consumption expenditure, so expect these factors to be a significant drag on business spending. The global economy remains strong...but for how much longer?

I still remain negative. The Dow was up 113 points on Friday, but that is a daily move inspired by Bush's mortagee support and Bernacke's 'dovish' comments about monetary policy. I still think the Fed is not going to raise rates. I think they want asset prices to cool to take inflationary pressures out of the market. Paradoxically that only happens if debt is liquidated - whether by default (in the housing sector) or higher interest rates parring back business loans or leveraged investments.

Technically the charts are telling us the same. The Dow went as high as 13,428 pts before it fell back to 13,357 points on Friday. Importantly, although it breached the previous high of 13,387 points, the market closed below this important resistance. Given that half of the gains were parred back, and the Dow closed below its resistance, I think we can expect the market to fall off big time on Tuesday (after a Monday Labor Day Holiday). So today and tomorrow are sell opportunities.

For this reason, I favour sitting on cash...at least until we get confirmation of market direction from the Fed and US government. I can't quantify the extent of the falls on Tuesday, but I suspect the Dow will fall be over 350 points. Basically I think the market will come to regard Bernacke's lack of disclosure as a 'market risk', even though he is actually trying to give the market some hope of a cut. This supports his desire for a 'smooth ride' but I think the markets will gradually anticipate his position.

I will offer some stock selections after the market confirms a trend or as soon as I take a position.

Is there going to be a rate cut?

This Friday night the Fed chairman Ben Bernanke is due to give a speech outlining his monetary policy in the wake of the housing & loan crisis. This speech, addressed to central bankers around the world, is intended to shape market expectations to its scheduled Fed policy meeting on Sept 18th 2007. According to Yahoo "analysts are predicting the Fed will start cutting the federal funds rate at that time, delivering from two to four quarter-point reductions this year and early next year. The funds rate has been at 5.25 percent for more than a year".
I frankly doubt the Fed is considering such an easy monetary policy. Certainly such cuts would reduce borrowing costs for consumers and businesses and mitigate the payment shock faced by 2 million mortgage holders as their adjustable rate mortgages reset in coming months. But since when does the Fed act as a welfare agency? Consider the Fed response to the collapse of the Thai baht in 1997 that was the beginning of the Asian financial crisis. It took the Fed more than a year to respond with a rate cut in Sept'98. Alot of investors suffered in the meantime. People might argue that this was an Asian crisis, but the reality is that the Fed policy is to preserve 'sustained growth' and to do that it needs to consider the inflation consequences of its policy.
Yahoo also suggests "The Fed is seen as having the leeway to cut interest rates because inflation is easing". But the implication that inflation is a 'product demand' phenomena is wrong - its a monetary demand phenomena. Excessive growth in money supply relative to the productive capacity spells inflation in at least some segments of the market. The reason food prices were not running away in recent years whilst money supply was increasing is because financial assets like shares and property were growing appreciably. Now asset prices are falling, that liquidity has to go somewhere. Well we are not going to eat more because of falling house prices. But there will be a slowdown in investment, so wasted financial resources means economic stagnation while prices increase.
It seems more likely to conclude that the Fed on Aug. 17 was merely calming financial markets when it said the "downside risks to growth have increased appreciably". Some market pundits seem to be interpreting this as justification for a rate cut - that the Fed is now more worried about weak growth than inflation.

Concluding, I dont expect a cut in the Fed Funds Rate on Sept 18th 2007. Tomorrow I suspect Ben Bernacke might even correct the perception somewhat. So I expect a weak market next week (1st week Sept'07).

Day to sell!

Geez I hate re-writing posts...I pressed the button to send this post at 9:30AM this morning, but you didn't get it because of a power failure in the Philippines. Fifteen years ago alot of countries were having power failures...its incredible that the Philippines still has them. Which means:

1. I need to get a diesel generator and battery to stay powered.

2. I need to write blogs offline

Anyway, the big news is, today is a good day to sell your stocks. Why?

Because the technical analysis of the chart below - the Dow Jones Industrial Average - is following a downtrend. I must however say that the evidence is not conclusive. On the negative side, we already have a sucession of lower 'highs' suggesting a downtrend. The big drop in the market on Weds was a clue that the market was staying in the downtrend. On the bullish side, overnight (their Weds) the Dow had a very strong rally (240 points), all the more impressive because it closed at a high. But it didnt break the psychologically important Weds high, so thats not good. So its difficult to read which way th market is going, but I can tell you that the next 2 days the Dow is going to move in one of 2 ways:

1. Upside: It could have a very solid rally tomorrow to break out of the downtrend. I would be looking for a 250 point move higher.

2. Downside: It could have a modest fall of 50-80 points on their Thurs, followed by a much bigger fall (confirming the downtrend) on Friday.

I personally look to the fundamentals to make that decision for me, and I see two sets of news in the short term which will drive the market:

1. Earnings: The positive side is that companies will be reporting some positive earnings.

2. Debt worries: The market will be concerned about the negative fall-out from the housing problems in the market. I can see a succession of bad news. For example, the failure of hedge funds, loan defaults, lower consumer confidence, lower retail sales, etc.

I also dont think the Fed will lower interest rates because of a fear of inflation, or if they do it will be just 0.25%. The reason I expect no increase is because they didnt do it when it counted most, so why would they do it later. The Fed never cared about asset prices on the upside, why are they going to care on the downside. Its not going to support the already falling housing market, it would support higher consumer prices (meaning inflation), so they are not going to lower rates...I
think.

So I believe the market is going down. The question is - will it make new lows, or just return to its previous low at 12,800 points. The media would have us believe that market PERs are reasonable, but there is going to be alot of downgrading to those revenue models given the evaporating consumer confidence, so at the very least there is reason for weakness. But I think it will take bad inflation figures or a financial failure to get the market to fall to around 11600-11800 level, or a recession, but a recession will take time to unfold. A financial collapse of a hedge fund will unravel the market. The Fed can boost the liquidity of the banking system, starving off a run on banks, but it cannot raise investor or consumer confidence without lowering interest rates...and I doubt that will happen.

Moment of truth for Dow, All Ords

Anyone trying to gauge whether equity markets are going to continue their upward movement should be taking a close look at the main indices over the next few days. I focus on the Dow Jones Industrial Average (DJIA) and the All Ordinaries (Australian ASX) because the US leads the global market and the All Ords is sensitive to the global outlook for commodity stocks.
Looking first at the Dow, its apparent to me that the index is at a critical point where it could go either way. It might shrug off the negative news in the housing sector. At this point in time 2AM Eastern Standard Time (Sydney) the US market is down 44points, though it appears to be holding.

The ASX is at a similar turning point with the index surging over the last week to over 6200 points, not far off its high of around 6400 points. I personally dont see the ASX breaking its current resistance, even though the index finished just off its daily high. I think the index will face selling tomorrow, but I will wait for direction from the market because there are alot of 'political wills' that want this market to go higher. Notwithstanding the uncertainty, the volatility is making great trading conditions.

The gold index is poised for similar direction from the markets. We are still waiting for a break out on the up or downside. I actually think gold will fall off, along with equity markets, with $US550/oz my target.

We might know if I am wrong or right tomorrow, but it might otherwise take a day or two.

BUY BUY BUY!!!

The amazing aspect of this financial crisis was that the financial sector actually fared quite well compared to others sectors. Partly this reality can be attributed to concerns about sub-prime exposure earlier in the year and partly to the fact that the energy & raw material sectors had performed the best before the crisis. As a consequence, in the year to date financial stocks fared the worst on the S&P500, falling 7.2%, but in the month of the crisis they fell only 5.25% compared to a 6.8% fell for the broader S&P500 Index or the 10.5% ($2.2 trillion) during the 4 week crisis, compared to a loss of $5.8 trillion between Mar-2000 to Oct-2002, which was accompanied by a short recession. The implication is thus given the health of US balance sheets a subdued US economy, but not a recession.
Given that this was a financial (sub-prime) crisis you might have expected the losses to have been largely restricted to the financial sector. But it was not just a case of investors worrying about non-disclosed non-performing loans, the sell-off reflected a deeper problem.

The rationale for the equity sell off
The rationale for the sell off lies in the nature of the crisis itself. The panic arose when the sub-prime mortgage-backed security holders realised that they couldn't sell or price their exposure in the market so that they could sell them. This forced these investors to raise capital, and by the time the problem had hit the market, their financiers were demanding margin calls. This forced sub-prime security holders to sell their quality assets to cover their illiquid positions. Hedge funds and others were thus forced to sell everything as markets continued to fall, so a snow-balling liquidity problem emerged, which was only stalled when the central banks and bargain hunters moved back in the market.
Clearly there was a ‘flight to quality’ which resulted in a stronger USD. Surprisingly the panic resulted in even low-risk investments like municipal bonds and hospital stocks being sold off, whilst quality smaller stocks fared even worse, particularly those stocks exposed to the discretionary consumer, energy and raw materials sectors. The sell off was not totally irrational, given that during a credit crunch small stocks have the greatest difficulty raising capital – whether as loans or equity. Thus its understandable that the Russell 2000, a small-cap index, should fall more than the S&P500 or Dow Jones Industrial Average (DJIA). But the extent of the fall should highlight the systematic risks inherit in the market.
Individual investors added their share of panic to the market as they were not immediately in a position to know the extent or ramifications of the crisis. All 10 sectors of the S&P 500 fell between 2.6% (for consumer staples) to 12.76% (for the energy & raw materials sector). The reason of course is that investors perceived this crisis as signalling a downtrend in the economy and a softening in retail sales and commodities demand. Its interesting that the contagion was even worse in commodity producing countries like Australia, South Africa and Canada, which experienced plummeting currencies that would only preserved their local dollar earnings, even though commodity prices did not fare so bad.
But there is another reason why certain high-yielding currencies were signalled out – the carry trade. The yen carry trade involved Japanese financial institutions placing their low-yield institutional funds in higher yielding commodity markets. When there is a loss of confidence in Australia and other countries, the Japanese unwind those currency trades, resulting in a rapid drop in the $A and NZD. The worst performers were the smaller, less liquid stocks. But we must remember that the smaller stocks were trading at significant premiums prior to the crisis so they were always more vulnerable to a correction.

What can we say about the meltdown?
1. There is no question that markets are unstable, and for this reason markets are in need of greater information. This is a financial crisis, not an economic crisis. The problems started in the sub-prime credit market, investors panicked masse, leaving the Fed merely trying to prevent a self-fulfilling prophecy.
2. The sub-prime crisis took on a global magnitude as a result of European and Asian bank exposure to property foreclosures in the US market, giving investors reason to think the crisis was bigger. In reality the risks were distributed more widely.
3. The confidence problem emerges because the financial industry has created an array of new debt instruments that are hard to price, particularly in times of uncertainty. Really they were attempting to make products commodities (securities) which were never really commodities. Because these products don’t offer the same level of transparency as simpler instruments, in bad times the liquidity evaporates and the result is a market crisis. The problem was this crisis arose in one of the biggest credit markets, even though it represents just a small fraction of it. The problem was inadequate disclosure to reassure markets.
4. The crisis does however highlight a poor capacity of credit rating agencies to quantify risk, or a preparedness of the agencies to overlook certain risks for the sake of profits. The situation is reminiscent of the auditing fiasco a decade ago when the major auditing companies came under attack for conflict of interests. The credit rating agencies or investors needed to understand the nature of the instruments they were trading – they didn’t. The risk assessment was just not adequate.

What can we say about the Fed response?
The European Central Bank, the Federal Reserve and other central banks acted quickly to pumped hundreds of billions of dollars into the world's banking system, the largest injection since the 9/11 tragedy, when the Fed injected $334 billion into the markets between 12-19th Sept 2001. The actions by the Fed were an appropriate step towards restoring confidence in the banking system. Nevertheless:
1. Liquidity is only a short term measure. If the markets experience another shake out it will be because of further bad news lacking perspective. This just might give us a double-bottom entry into the market.
2. The Fed decided not to cut interest rates on the 7th Aug 2007, insisting that inflation was the greater threat to the economy - not credit disruptions. This is a sign that the Fed has a more realistic assessment of the problem.
3. The Federal Reserve will need to lower the Fed rate if they want to soften the impact of the sub-prime crisis.
I believe the Fed will NOT lower interest rates because of the greater concern about inflation, and its clear that a market anticipation of such a cut might undermine the market at a later date. I think at some point the market will conclude that the global economy is in good shape, even if the US market will be subdued for several years. It also makes no sense for the Fed to ease credit conditions for financial institutions since the financial institutions are only going to tighten credit conditions upon consumers.

What is likely to be the short term impact?
We can expect that there will be several short term impacts:
1. Credit growth will slow as banks lending activities take a hit, and their profits will tank for 2007. And credit growth is likely to fall longer term as interest rates rise. We can expect the banks to focus on their wealth management divisions as we experience a recovery in broad market equities.
2. Markets are in good condition: Investors need to place the current financial problems in perspective. The credit risk in the USA will affect only a small portion of the USA market, so the ramifications for the global economy are quite small. The global economic fundamentals are excellent. Equity market valuations are reasonable, interest rates are still relatively low, employment growth is strong, and global economic growth is booming.
Some of the selling is not unwarranted in those sectors exposed to the US property and financial markets, as well as US-based retailers who will face some exposure to lower consumer spending as US household mortgage payments rise.

So is there a long term crisis brewing in the long term?
As the dust settles it is clear that there is a short term and longer term problem. The central banks injection of liquidity was an appropriate response to the short term panic, so the immediate threat has been addressed. There is however the threat of more bad news, though it is likely to be tempered. Franklin Roosevelt once said that "the only thing we have to fear is fear itself". He made this assertion upon shutting down the nation's banks in 1933 as he assumed the Presidency. The good news is that the Fed will use this opportunity to assess the risk rating procedures of banks and credit agencies, to avert a similar flight of confidence in future.
There are 2 concerns for the Fed:
1. Inflation: The Fed, along with other central banks, are worried about inflation. This is a global problem of much greater global ramifications than a segment of the US property market.
2.. Weak property markets: We must remember that the sub-prime crisis is a problem for poor households as well as aspirational property investors in the USA. Regardless the weakness in the US property market will affect spending there, but we must remember that US households don’t look at their house values in a way which would affect their psyche, at least until it results in higher mortgage payments, and so far interest rate increases have been subdued.

So what is an investor to do?
BUY! BUY! BUY! The recent collapse in equity prices was an over-reaction sparked by institutional demands for liquidity. The global reach of the sell-off was really a manifestation of foreign institutional exposure. Clearly the best buys are those sectors that suffered the most during the sell off, so:
Commodity based currencies are going to benefit from retention or recommittals to the carry trade
Commodity (raw material & energy) stocks are likely to recoup the losses they experienced over recent weeks
Small cap stocks that we particularly punished are likely to experience the best recoveries.
There are already signs that this is occurring. The Yen was weak last weak, as Japanese fund managers re-entered forex markets to buy AUD and NZ. The commodity sectors were the strongest sectors of the economy – particularly the smaller quality stocks like Matrix Metals – up 40%.

Re: Rebound in sight

The Dow Jones Industrial Average (DJIA) has fallen from its peak of 14,000pts to 13,028pts, a decline of 7%. Today it fell 207pts. Fund managers would have us believe all is well, but the reality is there is alot of problems confronting the market with excessive indebtedness. Having said that I think the market is not far off bargain hunting. I suspect Wall Street will be down on Thurs and mid-Friday is when the bargain hunters will be re-entering the market, so I will be bargain hunting Friday in anticipation of a strong US market on Friday when it opens, and thus strong followup on Tuesday, and I will be looking to take profits on Wednesday. Why? I think the market will rally, but I think there is more bad news ahead. And I think the market will want to consolidate before to heads up again.

So hopefully you are all cashed up. I was a little late getting out of the market, though when I did, I almost liquidated everything, so I could re-enter the market. I was caught by surprise, when the DJIA broke 13,500pts I thought it was going higher, and though it weakened I thought it was looking at a 13,500pt support. But when it broke 13,300pts I knew we were looking at a further falls. I am very sensitive to falls because of the nature of the stocks I buy. So the bad news is - I lost 15%. The good news though is that I should pick up 30% on the recovery in just the first week.

I think its important to note the strategy of the Fed at this point. Its leaving interest rates steady (that is retaining an easy monetary policy) whilst responding to a falling asset market by pumping up bank liquidity. There are 2 aspects this nonsensical policy:

1. Neutral monetary result: The Fed is taking with one hand and giving with the other. Although the Fed is currently keeping the Fed rate on hold, there is no question that it will raise interest rates in future. But the reality is that the increases will lag inflation. Why? Thats the taking. Next its giving the banking system the capacity to borrow money so they dont need to raise interest rates, well at least by not as much. Who benefits from that? Well since its households are highly indebted, its the cashed-up companies that will benefit.

2. Desicrating Robin Hood's grave: Well I never believed in the notion that Robin Hood was taking from the rich and giving to the poor, as landowners were paying taxes as well. A more realistic scenario today and during Robin Hood's time is that governments allign themselves with certain interest groups. So basically governments screw everyone, just they need tax from 'discretionary' business so they screw them less. Afterall they have more choice than salarymen to move offshore. But recognise that the essence of their policy is to 'take from the poor and giving to the rich'. Errol Flynn (aka Robin Hood) will be turning in his grave. The interesting thing is that governments that profess to be big on welfare are not opposed to a policy which actually supports the mass transfer of wealth from the poor to the rich. Think about it! Sure everyone lost money in the fallout of this correction, but the poor lost all savings, so they have no capacity to buy back. Those assets will be bought back by the wealthy. The wealthy might have even hedged with derivatives. The poor will be scared off even if they could afford to raise a few thousand to benefit.

I have shown two scenarios on the chart - a more favourable 'green outlook' and a more pessemistic 'purple outlook'. The rationale is that I think the market will rally from 13,800pts, however 12,000pts is a stronger support. But I think it can only get to 12,000pts if there is a plethora of bad news. In any respect I think the spec end of the market that carried the greater burden will recover quickly, then profit-taking will set in. So I dont see the market going to 12,000pts in a hurry. But if a few financial institutions fail it could be a very different story. But even if that were the case, expect the Fed and other central banks to step in to save the market.