FMX | Connect – www.fmxconnect.com - (Reported 7/20/2010)
Below are Excerpts from Bert Dohmen’s Wellington Letter: A Fundamental and Technical Analysis of the Economy and Investment Markets.
Summer Rally or Bull Trap?
The stock market has been in a broad and very volatile consolidation phase since the end of the May plunge. This is normal. The latest rally occurred on low and declining volume. That’s bearish.
In our view, the secular bear market is still alive. Don’t let a weak summer rally distract you. We expect that in the fall of this year, stress in the financial markets will intensify. During such a time, you have to be either in government-only money market funds, short stocks, bear ETFs, or U.S. Treasuries. The last three should do very well.
Some high-profile economists say that money market funds or U.S. T-bonds are a poor investment because of the low yields. That’s shallow thinking. Consider that in 2008, money market funds returned about 2%. An investment in the S&P 500 LOST YOU 50% OF YOUR PORTOFOLIO. Which was better?
Furthermore, Treasury bonds soared in price as yields plummeted. The ETF which is proxy for 20-year Treasuries, the TLT, gained a huge 28% from mid-2008 to the high that year. That was certainly better than losing 50% in stocks.
This May was one of the worst performance periods for hedge funds in about 18 months. Judging from the hundreds of hedge fund people I met at a conference in May, these so-called smart people may have a bad second half of the year as well. Even the “Long/Short” funds were not short. Instead, they were bargain hunting. Only one out of hundreds of people I spoke with were competent in advanced technical analysis. No wonder they were bargain hunting.
Currently, the stock market is in a choppy summer mode, which is occurring on low volume. That’s normal after a plunge such as seen in May. After the bargain hunters have exhausted their capital, the markets should plummet again. In our view, now is the last chance for investors to exit stocks.
The average investor for U.S. stocks is a dying species. Over the past two years, he has decided that bonds are likely a better investment. That means that stock mutual funds continue to see outflows of money. With their cash levels nearing record lows, they would have to keep selling stocks in order to meet redemptions.
The average investor is totally disgusted with the stock market, high-frequency trading, and all the games being played. He won’t be back for a long time. That leaves the large institutions and their money managers. But they are also gun-shy after the huge losses of 2008. Pension and endowment plans were pulverized. Do these money managers really want to risk their jobs again?
The chart below (courtesy of Alan Newman’s Crosscurrents) goes back to 1982. The line shows the market capitalization of the stock market. It has remained basically unchanged since 1999. However, trading volume has soared. In fact, it has more than tripled since that time. This means that short term trading is the preferred activity now. Given that about 70% of daily volume is from high-frequency trading, the stock exchanges would probably have to close if these were prohibited. The biggest casino in the world is now on Wall Street.
CHART COURTESY OF ALAN NEWMAN’S CROSSCURRENTS
When 70% of all volume is short-term trading, do fundamentals really matter? Wall Street analysts always like to talk “fundamentals,” which to them means actual earnings compared to Wall Street forecasts. They say that over 80% of the firms “beat the forecasts,” implying that this is great performance. To us it just means that Wall Street forecasts are very poor. Or could it be that these forecasts are designed to be beaten so that it lures money into the market? Oh, we are so cynical.
With most earnings beating forecasts, why is the stock market down? Why did we have a severe plunge in May? Obviously the fundamentals everyone looks at are not important.
The fact is that earnings forecasts are often wrong. The only important fundamentals in this environment come from the credit markets. If there is no credit growth, then there can be no economic growth and therefore no job growth. Without job growth, the governmental deficits at all levels will continue to spiral out of control.
We all know about the runaway federal budget deficits. They cannot be financed in the long run. But a more immediate problems involve the individual states and the municipalities. The latter are already starting to declare insolvency. Harrisburg is the latest. This will infect the entire muni-bond market, making it difficult or impossible for even the stronger cities to do any bond financing.
And then we have the states. It looks like the “Build America Bonds,” which were issued with the help of the federal government, may not get the federal help investors thought they did. As the recession intensifies, tax revenues will dry up. The states will raise taxes to compensate, causing an exodus of profitable companies from these states. The unprofitable ones stay because they don’t pay taxes, anyway.
In Europe, the problem is similar. The ECB has put $500 billion into the bank system over the past 2 years. Instead of lending, the banks have used the money for high-leveraged “carry trade” speculation. We wonder why the regulators everywhere still allow banks to speculate. It’s not a banking function. Nothing was learned in the 2008 crisis. Apparently, they all consider that episode a “black swan,” something that happens once in a hundred years and won’t happen again for a long time. They will be very surprised.
The 2008 episode weakened the global finances of governments, corporations, and individuals. The reserves they had were able to help them survive. But if there is another crisis of the same magnitude, there won’t be any reserves. The global mountain of debt at all levels has grown immensely in the past two years. We haven’t seen the deleveraging that usually occurs in a recession. Everyone was too busy “bargain hunting” and speculating again in the rally. That’s why the next wave may turn into the KILLER WAVE.
Many money managers are now trying to convince investors that high dividend big cap stocks will protect you during a market decline. Is it true or just another Valium for worried investors? Let’s look at the S&P High Yield Dividend Aristocrat Index, as reflected by the ETF that mirrors the index, the SDY. All 50 companies in the index have increased dividends each year for at least 25 consecutive years. Well, that sure sounds safe. How did it do during the 2008-2009 bear market? Here is the chart of the SDY:
As you can see, the SDY plunged 60% during that time. That is more than the common S&P 500 index, which contains a lot of stocks not paying dividends. As you can see, things aren’t always what you hear in the media. Furthermore, look at the formation over the past three months: it’s a bearish “head and shoulder” pattern.
Source: Dohmen Capital
Bert Dohmen’s Wellington Letter, P.O. Box 49-2433, Los Angeles, CA 90049
Phone: (310) 476-6933 Fax (310) 440-2919 Website: www.dohmencapital.com E-mail: client@dohmencapital.com
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