The Zoo Needs More Animals
May 12, 2008
What the #?%!! kind of market is this, anyway?
What do you get when you cross a bull market with a bear market? That's what investors and traders must be asking themselves. Everyone knows "the Trend is Your Friend", but sometimes it's hard tell who your friends are---even Richard Russell is confused these days. In late summer of 2007, the eminent Dow theorist threw in his Bear Towel and said, "I've been wrong all these years. It really is a bull market after all" or words to that effect. Just months later, as the Dow Transports were plunging (a "non-confirmation" in Dowspeak) and the Industrials were teetering, Russell jammed his newsletter into reverse and said, "I thought I was wrong, but I was mistaken. I turned out to be right after all. It's still a bear market." (I'm paraphrasing. Stockletter writers never talk like that.) And now, in his last letter poor old Mr. Russell maintains he never said it was a bear market, because the primary trend has been up since 1982. Sheesh. I guess eventually you just get too old to remember your story.
And speaking of too old for the game, Warren Buffett just announced that the credit crunch is probably history. Get your ya-ya's out--it's time to rock and roll.
Or is it? This schizophrenic market is throwing curveballs and sliders at us; you can see it move, you just can't tell where it's going. Bullish percent indicators are strongly green, telling us the market wants to rally. The VIX and VXO readings are moderate, indicating that fears of wild volatility have abated. At the same time, the financial sector continues to gush red ink and the consumer is glum and anxious, caught between record prices for food and fuel on the one hand, and a shrinking credit market on the other hand. Then there's the "sidelines factor": A lot of money fled the volatile equities markets to the "safety" of short-dated treasuries, only to find bond yields rising as the dollar sinks and inflation fears are no longer "well-anchored". What's a body to think?
Maybe the best way to parse this question is to look at the day's marketwatch.com headlines (Friday, May 9, 2008).
"AIG SHARES FALL ON INSURER'S HUGE LOSS
Results hit by $9.11 billion write-down, $6.09 billion of investment losses"
Explaining why Standard and Poor was cutting the insurance group's investment rating, S&P analyst Rod Clark said, "Although we expected that AIG would have some losses in the first quarter, the level of the additional losses exceeds these expectations." I guess it's not always a good thing to exceed expectations. So where did AIG go wrong? Well, to start with, they insured mortgages – a bad idea: "AIG sold 'super senior' credit-default swaps that guaranteed higher-quality parts of CDOs. But as the credit crunch widened, the market value of even the best parts of some CDOs declined." The "best parts" of CDO's are declining because virtually all of the underlying debt--mortgages, equity lines, auto loans and credit card debt – continues to deteriorate. How could things not be getting worse? And how bullish is that?
"CEO PANDIT SAYS CITIGROUP PLANS TO ELIMINATE ABOUT $500 BILLION IN ASSETS"
How long can this company survive if it keeps putting huge chunks of itself on the auction block? The answer is that Citi is not going to survive, not in anything like its present form. The story says, "Over the past three quarters, Citi has suffered more than $45 billion of credit losses". What it doesn't say is that Citigroup hasn't booked those losses yet; it just wrote the assets down. There's a big difference. And Citigroup still has many billions of additional exposure to mortgage risk.
Investors are puzzled. Didn't Warren Buffett just tell us that the credit crunch was pretty much over? If that's so, why do things just keep getting worse?
The Fed has been dispensing cheap liquidity to banks since last year. If all that low-rent money is doing the trick, we should be seeing an easing in the tight credit conditions. So are we? In a word, no. The latest Federal Reserve "Senior Loan Officer Opinion Survey" finds that banks are restricting, or tightening credit, rather than easing it. Some highlights of the survey: a net 78.6% of commercial real estate lenders tightened standards in the most recent quarter. 77.5% of lenders are tightening standards on subprime loans, and 62.3% are raising the bar for prime loans. Quarter over quarter, more than three times as many credit card issuers tightened their credit standards. The restrictive trend is strongest in the mortgage sector, but consumer, corporate and commercial real estate borrowers are all facing tighter scrutiny.
When lenders keep raising the bar, there are fewer and fewer borrowers who can clear it. Loan originations are falling steadily, and that doesn't seem too bullish, either.
So liquidity is pouring into the banks, but it's not pouring out. Where is all that Fed credit pooling up? Answer: It remains on the banks' balance sheets, specifically in the "Loan Loss Reserves" category. It's no secret that U.S. banks are fresh out of capital; a recent International Monetary Fund report showed that U.S. bank non-borrowed reserves fell to a negative $100 billion in the first quarter, and have rebounded only slightly. If you pull out funds borrowed from the Fed, U.S. banks can show zero free capital. Instead of a pile of capital, they have a crater almost a hundred billion dollars deep. Banks have borrowed hundreds of billions of dollars from the Fed against losses past, present, and future. They must be expecting a lot of them.
"U.S. TRADE DEFICIT NARROWS MORE THAN EXPECTED, TO $58.2 BILLION FOR MARCH"
We've been warned for years that a widening trade deficit was cause for concern. Now it's shrinking, so that must be bullish, right?
There are two obvious factors at work here: U.S. export businesses are thriving on the back of a very cheap U.S. dollar. That's very bullish. On the other hand, consumers are buying fewer Chinese DVD players, German autos, Japanese flat-screen TV's and Canadian 2X4's. That's not so bullish.
Maybe we shouldn't call this a bull market or a bear market. Maybe we need some more critters in the menagerie. Have you ever seen a crab market? It just moves sideways, running up and down with the daily tides. How about a sidewinder market? It's like the crab market, but with a poisonous bite. Then maybe we could consider a blue whale market: This one rises from the depths, breaks the surface to spout a frothy top, and then heads deep underwater again.
And I could go on. In fact, I will: There's the hummingbird market, that flits all over the place without going anywhere, all the while sucking the nectar out of trader's accounts. And the possum market: This one plays dead, only to scuttle up a tree or down a hole the moment you stop watching it.
In my gut, I feel Richard Russell is wrong. I think the primary trend is down for the foreseeable future. I also think Warren Buffett is mistaken: I don't think that credit issues are anywhere near being resolved at this point. I realize that puts me on very thin ice, disagreeing with a legendary market analyst and the world's greatest investor at the same time. But hey, if you're not living on the edge, you're taking up valuable space. Now, that's not to say that the market has to go down this week, or this month. There are all kinds of forces at work on stock prices, and it's safe to assume that some of them are hidden from the likes of you and me. We need to stay flexible and keep our eyes wide open, because between the smoke and the mirrors, visibility isn't the best. If you're looking for a bull, make sure he doesn't spout water. If you go out loaded for bear, be mindful of the sidewinders playing possum.
After all, there's a reason no one tries to cross a bull with a bear. More than likely, you'll just get mauled and gored. Let's be careful out there.
Gabriel Gray
This article was first published at www.grahamanalytics.com