The Dead Cat Bounce Completed Wave A

July 10, 2010

The Dead Cat bounce completed wave a

Wave a of the a-b-c upside correction completed on Fridayat S&P 1078. From here we head down in 3 waves to b, the counter-trend move, or “head fake” that's always sandwiched between two segments in the direction of the one larger trend. The most likely trajectory is shown below in orange where the sub-b wave stretches up to overlap the beginning of the triangle in wave ii just to the left, the along with the alternate in the red dashed line. On Friday we closed out half our long positions at mid-day to reduce risk, and on Monday we will close out the remainder at the opening, with the exception of long gold, long crude oil and inverse bonds.

Below is the big picture daily chart for the S&P, wave b now should retrace between 50% and 61.8% of the upside just completed to the area of 1040 ± 4, assuming no new high the sub-b wave. Once complete the c wave must reach at least S&P 1180, and possibly a new high in the a-b transition back down into wave 3.

The daily VIX below shows the next move is up in another increase in volatility to complete the Diag > before dropping back to at least 20, where the lower Diag II began, before spiking up off the chart.

While Pension with its 3-day trading limitation, must sit this one out, Traders can take advantage of several trades for the first leg of b wave. As you see below traders can go long a doublefull position in DRV, shortly after the opening and place a trade to sell all limit 38.5 GTC, where the Diag > began, which must be overlapped at a minimum. If you were to buy at the closing price the trade is worth 10% in just a couple of days, which is a huge return annualized. Traders may invest 20% in each of these three, given we have a clear exit point, in very low-risk trades.

Likewise in EDZ buy at market, sell at the min upside of 43.28 GTC, the return here from Friday’s close is 7.6%

Lastly buy TZA at market shortly after the opening; sell all limit 39.6 GTC. The return assuming purchase at Friday's close is 8.2%

The three above are the only ones worth trading, as the others don't display the Diag > giving the minimum safe upside.

We will likely sell UCO, long crude oil on Monday, at a min of 98.5; however this estimate does not include the a-b transition, which should be slightly higher. I will instruct you in Monday's allocation. Oil is never quite in sync with stocks.

As you see below the move in Gold is terminal, as indicated by the two Diag > although an upside above 57.5 is likely. Lately gold has been a hedge against volatility and it should have one last, albeit terminal rally.

Huge Money Market inflows

Unlike the average investor, we attempt to hitch a ride with the secondary trend without getting caught up emotionally, with the intent of bailing out when the wave count completes, just as sentiment reverses. As you may have read, tens of billions of dollars poured into money funds last week, the biggest weekly inflows in 18 months, as double-dip fears caught hold of mass psychology. Oddly enough, that's just when the upside correction kicked off. Likewise, some of the biggest money managers have gone into 40% cash, up from their usual 5%. Once again, individual investors and professionals alike are on the wrong side of this market. It is highly unlikely that either group will match the indices, much less beat them. Meanwhile the Death Cross, the crossing of the 50-day moving average below the 200-day moving average of the S&P – all the rage among“wannabe technicians”, is actually an intermediate-term contrary and therefore bullish indicator, as Alan Abelson points out in Barron's. While it does indicate the Bear Market has much further to plunge, when the degree of trend is this large, there is a substantial lag time before it actually takes effect, enough time to stage a spectacular rally. In the meantime, the Death Cross has timed the start of the wave 2upside correction perfectly, so as to whip-saw the greatest number of investors, while many others will miss the move entirely parked in money funds. Not until we get near the very top, in likely a false breakout, after missing the move entirely, will the “herd of investors and money managers” stampede back into long positions, just in time to be decimated by the Crash.

Long Bonds are a losing investment

Barron's cover story this week warns that bond fund holders will likely get slammed when interest rates rise. This has been our long-held conviction. But rather than advising the purchase of inverse bonds, like those we own, they suggest buying individual long bonds, so investors can hold them to maturity, as they go underwater. Its like telling investors to hold on to stocks through a crash, “they will eventually come back”, without taking into account the time value of money, nor an “out of whack” the risk/reward ratio. With interest rates so artificially low, they can only go up, and the move has already started. Besides, should investors need the money in the interim, they are in a lose/lose position, since short-term maturities have negligible yields, while longer-term maturities would mean even greater capital losses, the longer those bonds are held. For those who cannot conceive of inverse bonds, cash would be the next best alternative, since at least they have the option of buying stocks at the very bottom. Meanwhile in a deflationary environment, as the price of everything drops, your money gains purchasing power, not so tied up in underwater bonds. While the drop in the dollar is temporary and short-to-intermediate term, deflation is here for the long haul.

Below the weekly unlevered long bond chart. A downward pointing Diag II means the beginning of a long move down. With thea-b transition to the downsidecomplete, we go into free fall! It could not be simpler -Long bonds are a losing investment.

Meanwhile in the inverse bonds hourly chart we see an upward move kicking off with a Diag II to indicate the beginning of a long move up. While a pullback to at least 41.25 is highly likely, we sold half our position on Friday, with the intention of buying back near the low.

California's Public Deficits

Terminator Governor of California, Arnold Schwarzenegger, has called for a pay cut for public workers to the minimum wage of $7.25 per hour, as the state struggles with a $19 billion deficit, the largest in the country. Only the state controller stands in the way, although courts have ruled against the state controller, in favor of the governor. Although the governor's office claims the money withheld from public employees would be paid back once the 2011 budget is agreed to, where the shortfall will come from is anyone's guess. In any case, minimum wage has to be better than last year's IOUs.

A job-less recovery is an illusionary recovery

The private sector added only 83,000 jobs in June following a poor 33,000 in May. If this were a real recovery, at this stage it should be adding hundreds of thousands a month. More people are discouraged from seeking work, and so drop out of the labor force, when the opposite should be happening. Forty-six percent of the unemployed 7 million Americans have been out of work for more than 27 weeks, a post-war record. The longer they remain unemployed the less employable they become. This feeds directly into wage deflation, which inevitably leads to mammoth deflationary cycle. Once again a job-less recovery is an illusionary recovery.

Overblown Earnings Expectations

While profit margins were already at all-time highs in the 1stQ. As always, analysts continue to forecast earnings in a straight line, expecting an 83% gain before extraordinary items from 2009 to 2012. The S&P trades at 12.5% times this year's forecasted earnings, since most still believe that the double-dip recession will be avoided, on a fundamentals basis the market looks fairly priced. Apparently these earnings forecasts are much too optimistic since government stimulus is being replaced by austerity. The economy is certainly deteriorating, and totally inconsistent with such overblown expectations. If shares fell just another 15%, they would be at the same P/E as at the bottom of the market in March 2009. Yet like any Deflationary Depression, what appears fairly priced today, will only get cheaper and cheaper with the passing of time. According to Russell Napier's Anatomy of a Bear, before this downdraft is over, stocks will likely trade at a multiple of 6 or less. In the meantime, we have started on a major upside correction, the public will only catch on once the momentum is about to reverse.

Bank Earnings expected to plunge

Bank earnings are expected to plunge in the second quarter after trading commissions dried up, while takeovers and initial public offerings froze in the wake of the flash crash. Credit Suisse estimates revenues from fixed income, commodity and currency operations to fall more than 30% from the 1stQ at Goldman Sachs and Morgan Stanley. JP Morgan Chase, Bank of America and Citigroup are also expected to have suffered in their securities business. Deflation is a powerful force. Overall the money supply is shrinking, despite the Fed's quantitative easing and signals the banking system is struggling. On top of this is the upcoming regulation and taxation, in addition to Commercial Real Estate loans largely under water, do not bode well for future bank earnings.

Evidence against Recovery

What was previously touted as growth looks more like a temporary surge in retrospect. We humans overreact as a matter of course. In 2008 when world economies ceased up, companies slowed production to the point where they were running out of stock, so although the economy remained anemic, production had to be ramped up just to catch up. That's why in the 4th Q of 2009 and 1st Q of 2010 national output rose by such a seemingly healthy rate, yet 2/3 of that was inventory restocking. Meanwhile private consumption and exports have been weak – and neither is building momentum. New orders are slowing. As we saw states spending cutbacks have offset increased federal spending. Even as investors remain overly optimistic about recovery, with a combination of tightening fiscal policy and ultra-loose monetary policy, the rise in interest rates is inevitable. Like a stock market Crash is the sudden mass realization of reality, the sudden realization of fiscal deficits means a spike in interest rates is likely to come on just as suddenly, out of blue.

How can there possibly be robust expansion when the services sector, which accounts for 78% of US economic output, continues shrinking from 55.4 in May to 53.8 in June. Can we expect anything but sluggish growth in the second half? Perhaps more importantly the prices index fell over 11% from 60.6 in May to 53.8 last month, confirming that deflation should be our major concern. Without a pick-up in incomes, where will consumer spending come from? Meanwhile the Baltic Dry Index, (BDI) a gauge for commodity shipping demand and costs, considered a leading indicator, fell for the 29th consecutive session to the lowest level in more than a year. A plunging BDI does not bode well for commodity prices in the second half. Cooling Chinese demand for iron ore, copper and coal, prompted by ongoing monetary tightening in the world's former “growth engine” will likely mean slumping commodities prices all-around.

Fiscal Stimulus

While fiscal stimulus accounted for 4.4% of world growth last year, according to Morgan Stanley, this year it will amount to negative 1.6%. How is it possible to spend almost $800 billion in the US and not have more lasting effects to show for it, other than a huge tax bill down the road? Fear of these taxes on “global earnings” have US citizens living abroad lining up to vote with their feet – the current wait to secure an appointment at the US consulate in Hong Kong to surrender their US citizenship is 11 months.

A Traders Market

As we saw last week, some of the best short-term rallies occur in Bear Markets, with the short-term swing of the pendulum from pessimism to optimism, resulting in big rallies when stocks are ripe for “upside corrections”.

The Dollar

Until recently the dollar was inversely correlated with world stock markets. When stocks dropped the dollar rallied. That's no longer the case, perhaps the European debt crisis was a distraction, and now we realize the US economy is not looking so good. Consumer confidence, home and car sales, manufacturing and employment data all point to rapidly slowing economy. Yet relative to Europe, the US Federal debt is substantially higher as a percentage of GNP. While government spending in austerity-bound Europe is expected to drop in each of the next three years, the Obama administration is in no hurry to follow suit, as ultra-low interest rates and a strong dollar have allowed politicians to slide. That's all about to change.

A bullish bias in a Bear Market is for losers

The ideal for money managers and market timers alike is a high alpha, the returns over and above those of the S&P 500. In effect it's returns in excess of the S&P in up and down markets that measure a manager's skill. According to FundQuest, over the last 30 years active managers had a positive alpha in bull markets, but a negative alpha in Bear Markets. In essence, it would seem logical that you cannot expect to outperform in Bear Markets with a bullish bias. In 2008 our “trader” accounts returned over 360%, besting even John Paulson, the top hedge fund manager that year. Paulson, who made big bets shorting mortgage-backed securities, earned 340% before his 20% profit allocation. By comparison our subscription fees are infinitesimal. Our Pension accounts, which remained 50% in cash throughout 2008, yielded 240%.

A plunging dollar acts like inflation to lower returns on T-bonds for foreign buyers

The dollar appears to be tracing out a smaller Diag II denoted by the dashed lines to the far right below. If so, the next move is up to at least 85, followed by a long drop off the bottom of this chart. It is likely the dollar's weakness that will be the catalyst for higher interest rates, since Treasury yields have been supplemented by an appreciating dollar until just recently, when the dollar begins depreciating fast, its effect is just like inflation for foreign buyers of our Treasury debt.

Remaining charts not for trading. Unlike those already mentioned for trading, these do not contain a Diag > and for now we will pass on them until the b wave down completes

Although there is a Diag > in FXP the min upside is only 0.75 of a point and not worth trading.

TYP shows a failure, indicating the upside is strong, but does not provide an exit point.

Best regards,

Eduardo Mirahyes

Exceptional Bear.com