March 27, 2010
A blind view of the Market
In the past steep downturns have led to steep upturns, therefore the Great Recession of 2007-2009 should usher in the Great Recovery of 2010, or so reasons last week's cover story in Barron's: Double-Dip, Hell No! The problem is a myopic, if not blind, view of the big picture, which is being diced into smaller segments making absolutely no sense out of context. Obviously the Great Recession will not be over until it becomes the second Great Depression. Like the story of the five blind Indians, who each grabbed a hold of a leg or the trunk of an elephant to deduce this was the entire elephant, projections as above are equally blind. As usual this author projects “more of the same”, meaning economic growth of 4% through the first half of 2010, followed by 3% growth for the second half. Likewise he expects unemployment to recede to 8.5% by year-end. All are terribly rosy and out of touch with Main Street.
Wall Street vs. Main Street
Unlike the S&P 500 companies with soaring earnings from exports, small businesses are not selling much, as they rely on domestic consumption and Americans are still not buying. Multinationals continued to layoff workers and cut costs domestically. While cash on hand for the S&P has soared to $932 billion, as a result of slashing capital expenditures. Last year total banks lending fell 7.4%, the biggest decline in almost 60 years. While the largest corporations can go to the bond market for financing on better terms, smaller companies must depend on bank financing. Of these only 34% reported adequate access to credit. Yet banks cannot increase lending as they struggle to cope with mounting mortgage and commercial loan losses.
US consumer debt, like Greek government debt, remains at an unsustainable 122% of disposable income. With unemployment sky-high, it is much more difficult to get new mortgages or credit cards. Although the stock market has gone up allot, the wealth effect is not being felt on Main Street, which has a relatively little of its wealth invested in stocks and bonds. The bulk of their wealth is tied up in their homes, which are worth less today than in 2007, with prospects of further declines still ahead. No wonder consumer confidence continues dropping as the fear of unemployment haunts us. The recent signs of economic improvement stem largely from tax cuts, expanding credit, low interest rates, falling inflation and massive stimulus spending. What happens when much of the stimulus ends next week?
Most corrections are Double-Dip by nature
One of the very basic tenants of the Market is that for every correction, from a 30-year Bear Market to a ten-minute correction, there is invariably at least one counter-trend rally, sandwiched between the two “dips”. Take wave 4 in the weekly S&P in the final bull market run from 1995 to 1997 below. In a complex a-b-c wave 4, wave a is followed by a counter-trend rally b to a new high, only to plunge even further in wave c to complete the a-b-c. Wave b then, is no more than a “head fake”, which operates in the market like clockwork. Yet in waves of larger degree such as the current Supercycle wave IV the structure is cut into pieces and called a “recovery”, and wave c labeled a double-dip. Instead we should view it as one organic whole, with an interim head fake. You will find the identical pattern simplified, in wave 2.
What's more, the fractal nature of the market is demonstrated by the segments a-b-a and a-b-c which echo the larger a-b-c, while a-b-b echoes the larger structure inverted. This is the essence of a fractal, where the whole is repeated in its parts. Like the snowflake below, this is one of nature's playful characteristics. (hint: look in the white spaces for the repeating floor plan of a Gothic Cathedral)
In a corrective Diag II, as this Supercycle Wave IV exemplifies, waves a, c e are identical to inverted Bull Market moves. In effect, the wave 4 “correction” in the bull market chart is analogous to the Bear Market Rally wave 4 just completed. Since a recovery is over once real GDP exceeds that of the previous peak, it's a no-brainer to deduce that wave 5 to a lower trough must still lie ahead, and sustainable recovery back to the current level remains a long way off.
In addition, if we examine the monthly charts for the Dow and the S&P, the c wave has so far only slightly exceeded the drop in wave a. Typically wave c measures at least 1.168 the length of wave a, and often 2.618 the drop in wave a.
How far will wave 5 likely drop? By Elliott's guidelines, the minimum dive is the previous 4th wave of one lesser degree at Dow ~5170; however Dow ~2700 should come in sequence, since the Diag II at the bottom left remains to be “swiftly” retraced. In all likelihood, Wave 5 will be the longest of waves 1, 3 5, consistent with a Crash. We can expect a smaller bounce near the area of Dow 5170, and a final trough just below Dow 2700 to complete wave c. Only then can we begin wave d, the “Mother of all Rallies” to a new high in the Dow.
While the S&P initially came down in 3 waves characteristic of a “sideways” correction, the Dow dropped in 5 waves (the difference is the Dow lacks a large a-b found in the S&P's structure), which signals a “sharp” correction. Since sideways corrections do not contain a new high, the S&P's wave d should peak in a “triple top”, as you see above, near the March 2000 high, while the Dow could climb substantially higher, as it did previously in the 2008 wave b peak.
Behavioral shortcomings
Research into behavioral finance shows our selective memories fail us in predicting market catastrophes. Memories are shaped to a great extent by the present, since we filter the past through our current perception. This explains why we make the same mistakes each generation, and why we're making them again now. Only Elliott's filters allow us to perceive with an eye on history, to act contrary to an irrationally exuberant crowd. In 2008, 95% of all investors lost money, as I showed recently; we are back at that juncture in the Vix, bonds, Emerging Markets and several other measures. Although the market is highly overvalued by in historical terms of earnings and the replacement value of their assets, for most money managers, the incentive to make a bold contrarian call and risk embarrassment is minimal. Like sheep awaiting slaughter, most managers remain long the market and feel they will only lose money if everyone else does too. False safety in numbers!
This time is different for bonds
Since the crisis, governments have printed trillions of dollars to stimulate their economies and to bail out financial institutions. Rather than inflationary fears, it is apprehension over the ballooning government debt, brought to focus by the Greek drama that concerns bond lenders the most. Last week was a “preview” as lack of investor appetite for US government bonds sent rates to the highest level since last June. Like Social Security, which will pay out more than it takes in this year, due to plunging payroll taxes; fear that a similar drop in income tax rolls will provoke lenders to demand higher yields. The reason interest rates are relatively low and likely going much lower is lack of faith in the economic recovery, and for good reason.
“Buy when there's blood in the Streets, sell when there's irrational exuberance”
Nathaniel Rothschild
That's precisely what we did in bonds last week. Since the price of bonds moves inversely to yield, a spike in yield made bonds a relative bargain again. On Thursday we completed selling our inverse bonds at top dollar, and began scaling-into 30-year Treasuries. By Friday, we had completed buying our long bond allocation. As stocks begin a precipitous decline, the initial knee-jerk reaction will likely be a flight to quality in Treasuries. As with stocks, an intervening rally against the trend will temporarily push interest rates far lower, and send bond prices soaring. Only when the dust settles, will fears of government default, alla Greece resurface, and spell disaster for heavily-weighted long-term fixed income allocations. By then we will be comfortably back in inverse bonds. The message is clear: Bear Markets highly favor nimble traders, while a “buy and hold” strategy invariably leads to continuous “round trips” and losses. Realize that our strategy was precisely the opposite of that employed by most investors last week who sold bonds, precisely when they should have been buying. Navigating in these markets without the benefit of Elliott charts, is like flying a plane without the use of navigation instruments in a fog.
US Housing
Uncle Sam will start bailing out homeowners who owe the bank more than the properties are worth, and giving temporary support to the unemployed. This is yet another useless costly program, which will at best postpone foreclosures, since more than half of all borrowers who got loan modifications so far defaulted anyway. While such loan modifications will temporarily reduce the glut of foreclosed homes for sale, it provides incentives to fraudulently claim hardship and lower property values by many of the same borrowers who overstated income to buy homes they could not afford in the first place.
The 4thQ saw a 14% increase in mortgage delinquencies - the seventh quarterly rise, a 21% spike in the number of mortgages past due 90 days or more and a 16.5% increase in seriously delinquent prime borrowers.
New home sales fell 2.2% in February to a record low of 308,000, existing home sales also dropped.
To put it all in perspective, the multi-century big picture shows this 30-year plus Supercycle Wave IV Bear Market is the same A-B-C pattern we have seen in wave 4's at several degrees of trend. Again with the A wave is comprised of a Diag II. The Barron's author, like countless others, makes no distinction between recessions and/or degrees of Depressions. This being a Supercycle wave IV, it corresponds in degree with the first Great Depression, everything else was mild by comparison while its structure should look much like the previous cycle wave 4.
This structure is the identical we recently experienced in the smaller wave 4 just completed, only inverted. Shown below in detail from October 2008, you see the second Diag II is now in place. This means a LONG way down in aggregate with the first.
Again the 1964-1977 “Cycle” Bear Market, one degree of trend lower, shows the identical pattern, although most often incorrectly labeled as a “running correction”, it is and A-B-C with a Diag II in the A wave. Following the smaller Diag II, which echoes the larger, at the top of wave e below, the gap in the chart indicates a mini-crash. This time we can expect an all-out crash, with a similar gap, on a much larger scale.
Crashes are mass realizations of reality
The stage is now set for a veritable financial collapse. The dollar is about to implode, bonds are on the starting blocks for a final sucker's rally, and stocks have likely completed wave b of transitioning down to begin the 5th wave. How long before the masses realize this recovery is all mirage? The third of the third is usually the point of recognition and the minimum downside is for wave i of the 5th is 1040. When the chasm between reality and perception spans this wide, a sudden, abrupt reconciliation is bound to send investors reeling and the Market Crashing.
Best wishes,
Eduardo Mirahyes
Exceptional Bear