Thoughts on P3 and the secular bear

Hi guys.

Sorry for being so quiet on the blog lately. I’ve been busy trying to take my mining site out of beta among other things, and not following the day-to-day action much.

In response to comments about Elliott Wave and EWI, I actually don’t read EWI anymore except for Prechter’s monthly essays. I don’t see that the short-term stuff offers much of an edge over just following basic technical and sentiment indicators. Trying to force the market into fitting a specific pattern has just not been a good way to go, but the intermediate-term technical indicators have been doing quite well.

For instance, put:call, vix and weakening RSI have nailed the tops in November, January and March-April. The last was just screaming SELL as loud as the market ever does, and we got the follow through we deserved.

Short-term oversold conditions in late May and July were marked by the VIX and weakening selling as indicated by RSI.  Constantly anticipating a hard 1930-style P3 is just a bad way to play. Of course you don’t want to be caught long without protection at any point in this environment, credit crunch and depression that it is, but there is a tremendous degree of speculative enthusiasm and stubborn optimism among traders that is making this a long slog down.

Of course I think this is a secular bear market that won’t end until there is real value restored in stocks and real estate, which means solid after-tax yields high enough to compensate scared investors for the risk of further capital losses. But there is no reason why we have to get there in 3-4 years — this could go more like ’66-’82 in the US or post-’89 in Japan.

That said, we have not had full-on recognition of the extent of the economic problems within the financial community, with most analysts and economists clinging to the hope of Keynesianism. Trading horizons are so short-term among the big players that these considerations hardly matter. The technicals are all that drive the machines and guys like Paul Jones, Cohen, etc.

This is a deflation though, no doubt at all. Credit is contracting hard, and prices of everything not directly traded as futures or set by the government are falling. This includes private sector wages, groceries, capital goods, etc. In this environment we do not have the same set-up as for the rolling sideways market of ’66-’82 (only in nominal terms was that a sideways market – in real terms it was a 75% loss). The ’30s and Japan are still the corollaries to watch.

Also remember that the public sector has gotten itself into huge trouble, which is just starting to take effect with austerity measures in Europe and pending bankruptcies in US municipalities. US states are also broke and will have to finally deal with their union problems. Shrinking government worker salaries, if not payrolls, will put further pressure on demand for goods and leave banks with more bad loans. None of this is inflationary. Remember, in the ’70s private debt was low and growing, and companies were increasing their revenues and profits so that by ’82 Dow 1000 was a bargain. Now we’re in a generational de-leveraging, frugality-restoring mode, Kondratieff winter for lack of a better term.

The last couple of years should give deflationists confidence that we’re able to correctly assess the situation. Where is that dollar crash? What about $200 oil? What, in 2010 China still owns trillions in treasuries? Bernanke has tripled the US base money supply but a dozen eggs is still $1.50 and the long bond yields 4%? Obama spent how much, and unemployment is 17% ?

We make it way too hard on ourselves trying to get every squiggle right. Stocks and real estate are expensive and cash is still the way to go. Gold is still increasing in purchasing power. This is not bizarro world, it’s so far just a very big dead cat bounce after a 60% crash. US stocks are about where they were 12 months ago, and other markets are much lower, so clearly momentum is broken and bears should be confident so long as they’re not over-levered.

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PS- In response to Roger, upon first glance VXX looks like a fine vehicle for trading volatility. It seems to have tracked the VIX without much error since launch. Of course VIX futures and long-term OTM puts are also fine for going long vol.

Analysts and institutions: stocks “extremely cheap” despite 1.7% yields after 80% rally. Hussman & Prechter: another crash likely.

Bloomberg today gives a tour of the bull camp, which believes in a V-shaped recovery and soon-to-be record S&P earnings:

Even after the biggest rally since the 1930s, U.S. stocks remain the cheapest in two decades as the economy improves…

…Income is beating analysts’ estimates by 22 percent in the first quarter, making investors even more bullish that the rally will continue after the index climbed 80 percent since March 2009. While bears say the economy’s recovery is too weak for earnings to keep up the momentum, Fisher Investments and BlackRock Inc. are snapping up companies whose results are most tied to economic expansion.

“The stock market is incredibly inexpensive,” said Kevin Rendino, who manages $11 billion in Plainsboro, New Jersey, for BlackRock, the world’s largest asset manager. “I don’t know how the bears can argue against how well corporations are doing.”

S&P 500 companies may earn $85.96 a share in the next year, according to data from equity analysts compiled by Bloomberg. That compares with the index’s record combined profits of $89.93 a share from the prior 12 months in September 2007, when the S&P 500 was 19 percent higher than today.

Those figures would be for operating earnings, not the bottom line. In recent years it has been increasingly common to simply call operating earnings “earnings” and to imply that multiples on this figure should be compared to historic multiples on the bottom line. Ken Fisher, readers may recall, was running obnoxious video web ads through 2007-2008 touting a continued rally just before stocks fell off a cliff. His equity management firm makes the most money if people are all-in, all the time, as it collects fees as a percent of assets.

Record Pace

The earnings upgrades come as income beats Wall Street estimates at the fastest rate ever for the third time in four quarters. More than 80 percent of the 173 companies in the S&P 500 that reported results have topped estimates, compared with 79.5 percent in the third quarter and 72.3 percent in the three- month period before that, Bloomberg data show.

It is impressive how companies have protected themselves since the downturn began, but the way they have done this is by simply cutting costs, hence the stubborn 9.5% (headline U-3) or 17% (U-6) unemployment rate.

David Rosenberg, as usual, is the cooler head in the room:

Alternate Valuation

David Rosenberg, chief economist of Gluskin Sheff & Associates Inc., says U.S. stocks are poised for losses because they’ve become too expensive. The S&P 500 is valued at 22.1 times annual earnings from the past 10 years, according to inflation-adjusted data since 1871 tracked by Yale University Professor Robert Shiller.

Economic growth will slow and stocks retreat as governments around the world reduce spending after supporting their economies through the worst recession since the 1930s, said Komal Sri-Kumar, who helps manage more than $100 billion as chief global strategist at TCW Group Inc. The U.S. budget shortfall may reach $1.6 trillion in the fiscal year ending Sept. 30, according to figures from the Washington-based Treasury Department.

“The correction is going to come,” Sri-Kumar said in an interview with Bloomberg Television in New York on April 21. “You now have a debt bubble growing in the sovereign side, and we’re slow to recognize how negative that could be.”

We are still in the thick of the largest credit bubble in history. Consumer and real estate debt has yet to be fully liquidated (and hasn’t even started in China), corporate indebtedness is the highest ever, and now government debt has reached the point of no return where default is inevitable.

Equity is the slice of the pie left over after all debts are serviced, so to say that it is cheap when it only yields 1.7% (in the case of S&P dividends) is insane. It is much safer to be a creditor of a business than an owner, so debt yields should be lower than equity yields. In today’s perverse investment climate, even 10-year treasuries of the US and Germany yield more than twice equities.

This extreme confidence in stocks and dismissal of risk considerations further indicates that this is a toppy environment, highly reminiscent of 2007.

John Hussman explores this theme a bit further in his latest market comment:

As of last week, our most comprehensive measure of market valuation reached a price-to-normalized earnings multiple of 19.1, exceeding the peaks of August 1987 (18.6) and December 1973 (18.3). Outside of the valuations achieved during the late 1990′s bubble and the approach to the 2007 market peak, the only other historical observation exceeding the current level of valuation was the extreme of 20.1 reached just prior to the 1929 crash. The corollary to this level of rich valuation is that our projection for 10-year total returns for the S&P 500 is now just 5.3% annually.

While a number of simple measures of valuation have also been useful over the years, even metrics such as price-to-peak earnings have been skewed by the unusual profit margins we observed at the 2007 peak, which were about 50% above the historical norm – reflecting the combination of booming and highly leveraged financial sector profits as well as wide margins in cyclical and commodity-oriented industries. Accordingly, using price-to-peak requires the additional assumption that the profit margins observed in 2007 will be sustained indefinitely. Our more comprehensive measures do not require such assumptions, and reflect both direct estimates of normalized earnings, and compound estimates derived from revenues, profit margins, book values, and return-on-equity.

That said, valuations have never been useful as an indicator of near-term market fluctuations – a shortcoming that has been amplified since the late 1990′s. The lesson that valuations are important to long-term investment outcomes is underscored by the fact that the S&P 500 has lagged Treasury bills over the past 13 years, including dividends. Yet the fact that these 13 years have included three successive approaches (2000, 2007, and today) to valuation peaks – at the very extremes of historical experience – is evidence that investors don’t appreciate the link between valuation and subsequent returns. So they will predictably experience steep losses and mediocre returns yet again. Ironically, before they do, it also means that investors who take valuations seriously (including us) can expect temporary periods of frustration.

I’ve long noted that the analysis of market action can help to overcome some of this frustration, as stocks have often provided good returns despite rich valuations so long as market internals were strong, and the environment was not yet characterized by a syndrome of overvalued, overbought, overbullish, and rising yield conditions. In hindsight, the stock market has followed this typical post-war pattern, and we clearly could have captured some portion of the market’s gains over the past year had I ignored the risk of a second wave of credit strains (which I remain concerned about, primarily over the coming months).

It is important to recognize, however, that even if we had approached the recent economic environment as a typical, run-of-the-mill postwar downturn, we would now be defensive again, as a result of the current overvalued, overbought, overbullish, rising yields syndrome. I do recognize that my credibility in sounding a cautious note would presently be stronger if I had ignored further credit risks and captured some of the past year’s gains. But the awful outcome of this same set of conditions, which we also observed in 2007, should provide enough credibility.

Hussman proceeds to offer a detailed statistical analysis of how valuation and market action impact risks and returns. Curious parties are encouraged to read his essay in its entirety.

Here is how he rather bluntly sums up the current environment:

As of last week, the Market Climate in stocks remained characterized by an overvalued, overbought, overbullish, rising-yields syndrome that has historically produced periods of marginal new highs, slight declines, and yet further marginal highs, followed somewhat unpredictably by nearly vertical drops. I’ve often accompanied the description of this syndrome with the word “excruciating,” because the apparent resiliency of the market and the celebration of each fresh high, can make it difficult to maintain a defensive stance. Interestingly, the analysts at Nautilus Capital recently noted that the most closely correlated periods in market history to this one were the advances of 1929 and 2007. While exact replication of those advances would allow for a couple more weeks of further strength, we’ve generally found it dangerous to expect history to do more than rhyme. These hostile syndromes have a tendency to erase weeks of upside progress in a few days.

I have to agree with this assessment as well as that of Robert Prechter that this spring offers perhaps the greatest short-selling opportunity in history.

Congratulations Daneric

There has been a lot of Elliott Wave bashing this year in spite of Prechter’s late February 2009 call for a rally from SPX 700 to the 1000-1100 area, and his call for maximum levered shorting about a week ago (he called for a 100% short position at about SPX 1020 in August), as well putting a sell on the long bond just before it collapsed under QE last spring, and recommending longs on USD late this summer and fall.

A lot of bears are fans or subscribers, and a lot of them lost money in 2009. Naturally, when they made money in the crash it was on their own brilliance, and what is a newsletter for if not to excuse your losses? But really, if you went 100% long SPX at 700, went 100% short in August and 200% short last week, you’d be up about 36% in under 12 months (after at least doubling your money from going “short with maximum leverage” in July 2007 and covering last February 24.

I do occasionally have nits to pick with EWI, but the bashing they get these days is just nonsensical. Who else, besides Prechter and Mish (and I harbor a suspicion that Mish learned about the credit cycle in part from reading Prechter) called for deflation while the bubble was raging?

At any rate, EWI is not the only game in town. Daneric has actually been more accurate in his medium/short-term calls than Hochberg over the last several months, and he posts every day for free. He suspected even as late as November that the top was not in, and that stocks would drift over 1100 on a sinking VIX before possibly topping out in January. Bravo! He counted the ending diagonal this month, said it looked finished a week ago, and on the evidence of this week’s decline is now finally calling Primary wave 2 over.

Summer school

There are still a lot of people out there who didn’t absorb last year’s course on the credit cycle, particularly the chapter on inflation and deflation. To remedy this gap in your elementary economic education, before buying resource stocks or saying that any market will go to the moon on Fed-powered rockets, you are required to read this refresher by Mish Shedlock. An except is below:

…there are practical as well as real constraints on what the Fed can and will do. Nearly everyone ignores those constraints in their analysis.

Congress in theory and practice can give away money. Indeed, Congress even does that to a certain extent. Extensions to unemployment insurance, increases in food stamps, and cash for clunkers are prime examples.

However, those are a drop in the bucket compared to the total amount of credit that is blowing up. Take a look at the charts in Fiat World Mathematical Model if you need proof.

The key point is it is the difference between Fed printing and the destruction of credit that matters! As long as credit marked to market blows up faster than handouts and monetary printing increase we will be in deflation. Deflation will not last forever, but it can last a lot longer than most think.

Also ponder this missive from the dean of Deflation U, Robert Prechter:

“The Fed’s balance sheet ballooned from $900 billion just five months ago to more than $2 trillion, by buying outright, or swapping the pristine credit of U.S. Treasury debt for the questionable paper held by troubled banks, brokerages and insurance companies. One of the marketplace’s most strongly held beliefs is that the U.S. dollar is on the verge of an imminent collapse and gold is set to soar because of the Fed’s historic and irresponsible balance sheet expansion… We agree about the irresponsible part, but not about the near-term direction of the dollar and gold. Our forecast is being borne out by the dollar, which has soared straight through the Fed’s most aggressive expansion to date. Just as Conquer the Crash forecasted, the Fed is fighting deflation but, as the book says, ‘Deflation will win, at least initially.’ The reason is that there are way more debt dollars than cash dollars, with about $52 trillion currently in total market credit. As this enormous mountain of debt implodes, it is swamping all efforts to inflate. Of course, the Fed has explicitly stated that it will keep trying. Its initial effort was akin to trying to fill Lake Superior with a garden hose. But $2 trillion still won’t do the trick of stemming a contracting pool of $52 trillion. The only real effect is that taxpayers get hosed. Obviously not all of the $52 trillion is compromised debt, but the collateral underlying this mammoth pool of IOUs is decreasing in value, placing downward pricing pressure on the value of related debt, which won’t show up in the Federal Reserve figures for many months. A reduction in the aggregate value of dollar-denominated debt is deflation, which is now occurring. Eventually the value of credit will contract to a point where it can be sustained by new production. At that point, the U.S. dollar may indeed collapse, as gold soars under the weight of the Fed’s bailout machinations. But deflation must run its course first. In our opinion, it has a long way to go…”

Also consider an oldie from yours truly  (Some Basic Points on Inflation and Deflation):

#1 The business cycle is the credit cycle.

#2 Inflation is a net increase in money and credit, not just prices (mainstream opinion) and not just money (common misconception among contrarians).

#3 Deflation is a net decrease in money and credit.

#4 There cannot be both inflation and deflation at once.

#5 The central bank and the government bring about inflation by absolving banks of the responsibility for their actions. 9:1 fractional reserve lending would not be rewarded in a free market devoid of FDIC insurance and a central bank to print the money to pay for it and other bailouts for bankers.

#6 Price increases themselves are not inflation. If you have a fixed expense budget and your grocery and energy bill goes from $500 to $700, you must cut back $200 somewhere else (for instance, many are deciding to forgo eating out).

For points 7-11, click here

Also see, Why Bailouts will Not Stop the Depression