August 2007

More signs that we’ve entered a bear market: The downdrafts are growing increasingly predictable, and the swoons no longer give way to quick, complete recoveries. By ‘predictable,’ we don’t mean to imply that one can now short stocks on the close and sleep like a baby, for one cannot. Indeed, since no one knows what will occur on the opening bell, to act as though you do is to subject yourself to open-ended risk. However, we have observed recently that once stocks get a mind to move lower, they move with a relatively high degree of fidelity to our Hidden Pivot targets.

The same has always held true when stocks were thrusting in bull markets. The more powerful the bull trend, the easier it was to forecast short- and intermediate-term highs precisely. It’s been a long time, though, since we’ve seen stocks trace out price patterns typical of bear markets. What types of patterns? Using the ABCD pattern that provides the basis for Hidden Pivot analysis, they are patterns in which the C-D ‘follow-through’ legs typically fail to reach their ‘D’ targets. That is no longer the case, however, and individual stocks are not only reaching their ‘D’ targets, they are in many instances exceeding them.

Riding Bear Rallies

‘Knowing’ where the turns are most likely to occur can help us catch powerful bear-market rallies from their inception. And because quite often we are able to predict the turns with a high level of accuracy, we can use very tight stop-losses to limit our risk. It is another trick, however, to attempt trading with the trend, since, in a bear market, that implies shorting correction highs. Such highs tend to be more elusive than downside targets, reason being that ‘everyone’ is trying to find a good place to get short in a bear market. The competition breeds deviousness in stocks, if you accept the premise that stocks always move in such a way as to thwart easy opportunity.

As this bear market unfolds, we expect the breathtaking volatility of the last few weeks to be eclipsed by even more-astounding price action. One reason for this is that the NYSE has done away with the ‘downtick rule’ that prevented bears from shorting stocks when they were falling. Now, one can short stocks on downticks as well as upticks, and that freedom is likely to embolden short sellers in ways that should cause bear rallies to be more spectacular than any that have ever occurred in the past. It will also put the Plunge Protection Team to the test, since the ‘uptick rule’ was one way in which the powers that be conspired to make the market do the bidding of optimists rather than pessimists (i.e., those nasty short-sellers). With the uptick rule out of the way, it is not inconceivable that concerted sellers both short and long might one day rout even the Plunge Protection Team and its prodigiously deep-pocketed friend, the U.S. Government.

What does a rapidly deteriorating U.S. housing sector have to do with the global economy? Answer: everything. The question was asked in the Rick’s Picks chat room yesterday, so perhaps it’s a good time to consider the implications. Let’s begin by acknowledging that the housing market is suffering not from a touch of flu, nor from a more serious malady that can be treated with powerful drugs, but from pancreatic cancer. And it doesn’t take a specialist to see that ominous shadows on the X-ray are beginning to overwhelm the host.

How do we know this is so? For one, even the optimists, taking their cue from shell-shocked home builders and a wave of high-profile bankruptcies in the lending business, are no longer trying to buck us up with feeble speculation about how and when the distress might end. Rather, they seem to be bracing for still worse news ahead, uneasy because there is no way to tell how much worse things might get. Keep in mind that these are the same guys who a year ago�six months ago�three months ago�assured us that the bottom was in. Now, evidently not wanting to further embarrass themselves, and having run out of evidence to buttress even the most timidly upbeat outlook, they’ve gone practically mute.

Rally or Else�

More immediately troubling is that credit spreads have begun to widen dramatically, signaling that risk is once again a concern to investors after many years of blithe indifference. If so, the cure of higher real rates that awaits us will be like chemotherapy ‘ toxic enough, perhaps, to kill the patient. The situation is dire, since there are virtually no buyers for subprime mortgage paper right now, and debt markets are getting increasingly nervous about it. The central banks of Europe and the U.S. have been in overdrive trying to head off a liquidity crunch, but their concerted efforts will grow increasingly futile if the world’s bourses don’t start acting soon as though they fervently believe our worst troubles are past.

Just last week, the ECB injected an astounding 96 billion euros into the banking system in a single day ‘ more than after 9/11. The Fed ran amok as well, pumping out a gusher of fresh reserves when the Federal Funds rate pushed above 6% one night. This is the rate banks charge each other for overnight loans to square their books, and the Fed has tried to keep it at 5.25 percent. But with so many banks holding mortgage paper that could turn worthless by the next sunrise, it’s no mystery why they would be less eager to lend to each other.

Chinese Fire Sale

So why is the U.S. housing market so crucial to the global economy? Simply because asset inflation, chiefly in real estate, has been the most potent force buoying the domestic economy. Let home values continue to fall, though, and it will trigger a severe recession in the U.S. with effects that would reverberate around the world. China, for one, unable to idle hundreds of millions of workers, would glut the world with distress goods. That would be extremely deflationary, but even moreso would be the ratcheting up of interest rates on virtually all forms of debt. One result is that carry-traders who have borrowed short to lend long will get crushed, since short-term rates would skyrocket. Using enormous financial leverage, they’ve been a major buyer of U.S. Treasurys, but that source of demand would dry up instantly when the yield curve goes ‘rad’.

If home values continue to fall, as seems likely, the consequences are almost beyond imagining. Most people believe the Fed will come to the rescue, but any such effort is doomed to fail unless consumers start borrowing money again like crazy. With home prices falling throughout most of the U.S., no such madness is even remotely possible.

I’m in Atlantic City for a high school reunion this weekend, catching up with friends not only from ACHS Class of ‘67, but from grade school and even earlier. To those of you who have visited the town, I’ve always advised skipping the casinos and heading straight to the only place on Absecon Island worth your while, the White House Sub shop. As a native, I should confess that I’ve already broken that rule on this visit. For starters, I’m staying at the Borgata — comped as a guest not because I am a high roller, for I surely am not, but because a Class of ‘67 buddy of mine does Borgata’s laundry.

Regarding the White House, I passed up a cheese steak sub there, opting instead for the incomparable tuna/cheese sub from Dino’s in Margate, a downbeach suburb of Atlantic City. In South Jersey, and particularly on Absecon Island, where Atlantic City is located, subs have reached their apotheosis, and sub shops do not win ‘Best of’ awards for ’subs’ per se, but for such specialized categories of subs, such as ‘Best Regular Sub,’ or ‘Best Cheese Steak Sub,’ or ‘Best Egg, Pepper & Cheese Sub’ (my mother’s favorite).

Dino’s Mayonnaise Secret

So what makes Dino’s tuna/cheese hoagie so great? In a word, the tuna. It is not just tuna salad on the incomparable Rando Italian roll, but tuna that has been whipped with mayonnaise almost to the consistency of a tuna mousse. Cheese-steak specialists have some secrets too, and one that has kept the White House’s version at the top of the ratings is that they use a very high quality of rib-eye steak, as well as stake-grown Jersey tomatoes. A whole steak sub is about 16′ long and feeds 2-3. A sub shop in Podunk would probably have to charge more than $20 to make a profit using the same super-quality ingredients that White House uses. But White House does such a huge business, serving more than a thousand subs a day, that they can buy their rib-eye in quantities that yield a profit at $14 per.

If you visit the White House, be sure to look for my Aunt Betty, who is pictured with Joe DiMaggio’s arm around her shoulder. Celebrities love to have themselves photographed at the White House, and just about everyone in showbiz that you’ve heard of is there on the wall, somewhere.

Incidentally, a cheese steak sub is not a Philly Steak. They are two very different sandwiches, and even though the latter is a legend in its own right, its purveyors make no claims as to the superiority of a ’steak’ over the Atlantic City-style sub. It is as though whites and blacks, out of mutual respect, refrained from dissing each other on the basketball court.

Don’t Miss Lucy�

I noted above that the White House is the only place worth visiting if you come to Atlantic City, but actually that is not quite correct: There is also Lucy the Elephant in Margate, just a few blocks from where I grew up. This charming, six-story monstrosity was built by a Barnum-inspired real estate developer in the 1880s to lure gawkers down to that end of the island. The southwestern part of Absecon Island was still pretty swampy when my parents moved there in the 1950s, but it’s come so far since then that I barely recognize parts of the neighborhood I grew up in. One particularly amazing development is Harbor Cove, an enclave of modest 1950s-style homes on the boulevard that connects quaintly upscale Longport with the mainland. If I had been raised in Harbor Cove, I’d probably have committed suicide, since it was just a dumpy little place in the marshes, totally cut off from the island, with mosquitoes and greenheads as big as buzzards. But now, it is quite something else. I was sailing on nearby Lakes Bay Friday, and from the water I didn’t even realize that I was looking at Harbor Cove, which is now densely packed with $4 million-and-up houses, many of them with huge yachts moored in their ‘back yards.’ Harbor Cove! Who’d a thunk it?

We’ve harped on the theme of debt deflation many times in the past, but not recently because I had despaired of finding someone who could score any points taking the other side of the argument. Alas, now my best hope for a good debate, Fred Hapgood, has let me down. Briefly a teacher at Atlantic City High School when I was a student there in the mid-1960s, Fred has one of the most fascinating sites on the Web, and the essays he has posted there and which he also freelances to big-circulation magazines make for great reading. Unfortunately, he has not brought his considerable intellectual gifts to our years-long discussion of deflation. More to the point, our most recent series of exchanges has led me to conclude that his intention all along was not to debate the issue, but to wheedle me in countless trivial ways. You can judge for yourself, since I’ve reprinted below key excerpts from our most recent series of e-mails. He started things rolling this time by quoting a letter I’d written him in September, 2006. I had concluded at the time that the housing downturn had already set in motion deflationary forces from which the U.S. economy will not recover. I still believe that is so, as most of you will already know. Here is the latest point-and-counterpoint:

Not in Kansas

Rick: (writing in September, 2006): ‘We’re not in Kansas anymore, Fred. However, if this housing downturn proves to be anything less than The Big One, I’ll have a lot of shutting up to do.

Fred: (July 2007: It’s been two (sic) years now. Long enough to make the point?

Rick: For sure, Fred — and I’m glad you’ve finally come around. We are in fact in the very maw of deflation. The problem, simply stated, is that we have a $460Tr financial economy feeding off global GDP amounting to no more than $60Tr. That first number has nearly tripled since we began corresponding and is continuing to rise (per BIS data) by several trillion dollars per month. Also, whereas it took something like $3 of borrowing back then to create a single dollar of GDP growth, it now takes closer to $9. How long can that go on?

Bad Timing, Fred

Rick (in postscript): I hope you’ll pardon my sarcasm, Fred. It’s just that your question of “long enough?” has come at a time when even the idiots who run the banking system are starting to concede they can see no end to the subprime-mortgage debacle. They seem, finally, to understand, as you evidently do not, that the problem is about to spread into Alt-A mortgages, whence middle-class America’s ten-year consumption binge originated.

Have you not read a newspaper in the last six months? Or do you perhaps have friends in Cambridge who have assured you that the toxins from the mortgage meltdown can somehow be contained? These would likely be some of the same guys who, like Helicopter Ben Bernanke, think inflation is the problem, even as they contrive to ignore the fact that real estate is a $23 trillion item on household balance sheets, food a mere $1.3 trillion item. Inflation a threat? Rubbish!

I mean, really, Fred: This is IT! How can you of all people not understand that?

Dow Turning Cartwheels

Fred: But Rick. What you said two (sic) years ago was, and I quote “…if this housing downturn proves to be anything less than The Big One, I’ll have a lot of shutting up to do.” That was two years ago and today the Dow is turning cartwheels, setting records practically every day. Unemployment is down around 4.5 or so. If you don’t have a lot of shutting up to do now, then when?

Rick: What does the Dow’s turning cartwheels have to do with reality, much less with the health of the economy? The Dow was turning cartwheels in the summer of 1929. It will ALWAYS be turning cartwheels before the bottom drops out. What do you think dot-com stocks were doing before they collapsed in 2001?

Fred: Fine. Forget about the Dow. My question remains: is two years a fair test of your prediction? Do you have a lot of shutting up to do now? If not, when? Is there anything at all that could happen that you would accept as a disconfirmation of your perspective?

Rick: I do not have any shutting up to do, Fred, not with the real estate market in a deepening crisis that is about to spread into Alt-A paper and which has already cause a quite significant decline in property values across 70% of America’s regional markets.

Real Burden of Debt

Question: What is the effective real-rate burden of a person with a 6% mortgage whose home has declined in value by a “mere” 3%. Answer: 9%. That is much more, on average, than hedge funds are returning to investors these days. Just try to imagine Joe Sixpack on the supply side of 9% yields. We are there, Fred.

But then, when have you ever addressed a single point that I’ve made, much less stretched your mind to ponder my arguments? What about that $500 trillion of leveraged financial instruments sitting on top of a $60 trillion GDP? What about $9 of borrowing to engender a dollar’s worth of GDP growth? Don’t such facts matter? And do you think that the near-tripling of public/private debt since we began our discussion is inconsequential?

Where do you come off thinking I owe YOU answers? You have yet to refute a single thing I’ve said. Why don’t you bring some rigor and intellectual honesty to the discussion by responding to a specific point that I’ve made?

Fred: “This is IT!” Uh-huh. Suppose nothing significant happens to the economy for the next two years. Will you have a lot of shutting up to do then?

A Lot of Ruin�

Rick: There’s a lot of ruin in a once-omnipotent nation’s economy, Fred.

Fred: Suppose you knew a guy who thought he had the power to predict the weather but had been wrong — 180 degrees wrong, not just wrong in the sense of not right, but wrong in the sense of predicting the exact opposite of everything that happened, without exception, for 25 years!

Now he comes around again, selling the same prediction. What would you do? What would you ask of him? Wouldn’t it be something like, Why isn’t the last 25 years an effective argument that you really can’t predict the weather? What is the difference between the predictions you are making now and those you have in the past? Have you learned anything from your record of unbroken failure? And so on. I honestly don’t see anything inappropriate in such questions.

No Recovery Possible

Rick: What’s your hurry? Let it suffice to say that forces leading to an epochal de-leveraging of financial assets have recently reached critical mass. What that implies is that we will not see ANY significant periods of economic recovery (i.e., GDP growth exceeding 3% in a given quarter) between now and the predicted K-wave deflationary trough around 2015. Is that a prediction you can live with? For my part, and unfortunately for us all, I feel quite confident in making it.

Now, what about my question: Why do we need $500 trillion worth of leveraged financial instruments (aka “derivatives”) to conduct global business in goods and services amounting to $60 trillion?

Fred: What’s wrong with those numbers? Looks like a good investment to me. You’d turn up your nose at 8.3%?

8.3% Yields a Killer

Rick: I don’t follow your point. Regardless, any investment yielding 8.3% right now is a bad bet, since the supplier of those yields is headed for bankruptcy. That’s a prediction you can chisel in stone, Fred. And, yes, I know: Not a single one of your “smart guys” would agree with me. But let them try to service an 8% loan on top of assets and paychecks that are falling by as little as 3.5%. Come to think of it, 80 million American consumers are already in that boat, with 6.5% mortgages and homes that on average have decreased in value by more like 5%. (We won’t even count such statistical out-liers as Tampa and Las Vegas, since none of your smart guys will have properties in such places.)

Fred: My point is that you give no reason for believing that $500 T in debt is in way out of line for a $60 T economy. It’s certainly not obvious. If you look at the world economy in aggregate, as a single entity, then these numbers look like that entity is paying $500 T for an annual return of $60 T. That looks like a good deal, or at least certainly not a bad one. (Not that it matters, since there is no alternative anyway. It’s not like capital could escape to Mars.)

Your point about 8.3 being a “bad bet” right now is irrelevant, even if true, since the scenario behind your “bad bet” is only bad from the point of view of the creditor. His misfortune is the debtor’s fortune, since the debtor has got access to the creditor’s money for free. And we are not playing favorites here — we are looking at the global economy as a whole, and from the global point of view, it doesn’t matter whose pocket the dollar is in or who is spending that dollar. The reason you haven’t ever seen, and never will see, a debt- led depression, is that national economies don’t care whose pocket the dollar is in either.

World No ‘Growth Stock’

Rick: The world is not a growth stock, Fred — more like a utility that is being run to maximize losses and drive shareholders to despair. So your PE multiple would be way out of line. Concerning your explanation of why we will “never” see a debt-led depression, your logic is so far beyond the pale that it verges on delusional. Are you aware of the draconian changes in the U.S. bankruptcy code?

You say it doesn’t matter who gets socked with the loss. Trust me, we all lose. Even your smart guys could tell you that. The ‘dollars’ do not transfer from Peter to Paul, either — they simply disappear from the world’s store of imagined wealth as the value of the collateral falls toward zero.

It is very puzzling to me that you are able to write so lucidly about very complex subjects but unable to bring much common sense to your economic analysis. Nothing against optimism, as I’ve told you before, but yours has blinded you to the obvious. I would guess that, paradoxically, your investment portfolio has done very well, since you will likely have bought shares in companies whose business you, more than the rest of us, fully understand.

Back from a week’s vacation in the tropics and freshly infused with sunbaked sanity, we view the stock market’s bizarre spasms in recent days as the death rattle of speculators gone criminally berserk with Other People’s Money. For how else to reckon the wild price swings of late?

On Tuesday, a short squeeze late in the session turned a deathly glum day on the NYSE into one of the most powerful bull rampages of the year, transforming a 120-point loss in the DJIA into a 286-point gain. Yesterday it was the opposite, but with an extra frillip of inspired nuttiness in the final minutes. The Indoos were up nearly 200 points when NYSE traders returned from lunch, but Da Boyz sent shares into a kamikaze dive that wiped out the entire gain and then some in less than an hour.

Bush as Greenspan

But wait, there’s more: With just a half-hour of trading to go, stocks lurched higher yet again, finishing with a 154-point gain. The pundits attributed all of it to a briefing President Bush was conducting for reporters at the Treasury Department. They may be right for once; for, by saying absolutely nothing, Dubya sounded positively Greenspan-esque when he attributed Wall Street’s freakish volatility to a ‘readjust[ment of] its assessment of risk.’

Let’s hope the San Andreas Fault does not suffer a similar readjustment any time soon, since, unlike the denizens of Wall Street, Californians do not possess the apparent coping mechanism of mental illness that appears to suit portfolio managers and their soon-to-be victims so well.

Just Missed the Top

For our part, we can’t say we were the least bit surprised by yesterday’s histrionics. In fact, a trading recommendation in the Touts section of Wednesday’s Rick’s Picks came within two ticks of nailing ther exact high in the S&P futures (see chart above), before they went into a 27-point dive. Here is the recommendation exactly as it went out Tuesday night: ‘Any significant progress above yesterday’s 1495 peak would portend a minimum 1511.00. That’s a Hidden Pivot resistance you could short with a stop-loss as tight as 1512.25. Switch to a 1.50-point trailing stop on a pullback that touches 1506.50, and use 1502.00 as a minimum objective.’

The trade was worth as much as $1,300 per contract to anyone who caught the entire move. Not too shabby, considering the initial risk was just $65 theoretical. Officially, we followed the instructions to-the-letter and missed the move. Our short offer at 1511.00 was left choking on dust when the futures topped at exactly 1510.50 before the retro-rockets kicked in.

Tan, rested and ready ‘ but for what? My week-long getaway to Margaritaville, kids in tow, allowed me to catch up completely on sleep and pulp fiction but only to partially escape the heinous stupidity of a stock market in Fed-watching mode. There was maybe even a touch of the old Tulip-o-mania, too. Or so I should infer, perhaps, having learned inadvertently yesterday via a sports-bar TV that the Dow Industrials had risen nearly 300 points in a single session.

Try as we sometimes do to tune out such piffle, even if for just a few blissful days, the headlines have a way of insinuating themselves on our brains no matter where we are. Another margarita or two might have softened the blow, but that would have wrecked the quality time I’d planned with my two sons, teaching them how to handicap sulkies and to exploit the sundry advantages of simulcast wagering.

Taste of Sin

The boys got their first taste of sin betting small sums on jai alai a couple of years ago, when they were, respectively, ages 10 and 13. Luck was on their side, as it often is, and they both left with more in winnings than they’d been able to accumulate in saved allowances over the last few years. This time, I figured that dropping a few bucks on the pacers would be just the thing to introduce them to gambling’s dark side. However, my intentions went awry when the longshot they’d bet on broke from the pack at the final turn, dusting the field in the stretch to win by two lengths.

Daniel, my twelve year-old, wanted to try parlaying his winnings into a then-available $40 million lotto jackpot, but I decided that cashing a $114 ticket was easy money enough for one day. He’s still the biggest lottery winner I’ve known personally, having collected a $14 prize on a scratch-off ticket he’d bought from a Safeway vending machine. One doesn’t want one’s kid to get the idea that betting on games of chance is the ticket to wealth, but it sure is tempting for me to have the lucky little devil pick my numbers whenever Powerball’s jackpot spirals into the zillions.

I’ll be in Margaritaville from July 30-August 7, attempting to exist without a laptop or cell phone for the first time in more than four years. Your subscription will automatically be extended by a week in my absence, but be prepared to hit the ground running when I return, especially if the stock market’s troublesome behavior continues.

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