Tuesday, December 7, 2010

State of the Market in Early December 2010

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.

There is a lot of controversy currently on whether the markets are bullish or bearish as we enter December. Most investors are on the bullish side, yet there are voices of caution saying the market has gotten too frothy. There is substantial evidence that the market is indeed over done on the upside. Yet, there is a case to be made that it can get even more overpriced.

The first thing investors should note is that the U.S. stock market has entered a period of volatility, with the Dow Jones Industrials commonly going up or down more than 100 points in a day. Such wild swings are not healthy for a market. They indicate indecision on the part of traders. The market, like everything else, will eventually break if it is bent too much.

Certainly investors are generally very bullish, probably much too bullish at this point. At the end of November, Investors Intelligence had the bulls at over 55% and the bears at around 21%. These are classical points where the market frequently turns. When too many people become bullish, there is eventually no one else to buy and too many bears mean there is no one else to sell. A recent global survey supports this view with large money managers having only 3% of their funds in cash – the lowest level ever recorded. The large funds, who move the markets with their actions, are basically tapped out and have no more money to invest. So where is the money coming from for the rally we saw the first three trading days of December?

Quite simply, it’s coming from the Federal Reserve. This doesn’t mean the Fed is buying stocks. It means the Fed is pumping money (newly printed money) into the financial system and this money is finding its way into the markets. For its current quantitative easing program the Fed bought $8.17 billion in treasuries on December 1st, $8.31 billion on December 2nd and $6.81 billion on December 3rd. Not only did this drive U.S. stocks up, but gold broke above $1400 an ounce and oil hit $90 a barrel – both inflation indicators. The rising price of oil is particularly significant since oil tends to hit seasonal lows in December and February and yet it is going up now instead of down. Higher oil prices percolate through the economy and lead to higher prices for a large number of items. They also increase the U.S. trade deficit, which means the government has to borrow or print even more money in order to fund it.

Despite the obvious inflationary implications of quantitative easing, the Fed consistently denies it will lead to inflation even though excess money printing has always led to inflation in the past. The original form of money printing was cutting the amount of gold or silver in coins. It only took a short time before coinage was invented in 600 to 700 B.C.E. before one of the Greek city states caught on to this idea – the government had over borrowed and wanted to pay back the money it owed with cheaper currency (this should sound familiar to Americans in 2010). Paper money was invented by the Chinese before 1000 A.D., but they eventually had to stop using it because they made so much of it that it led to huge inflation. The lessons of what happens when too much money it created go way back – yet governments continue to it over and over again and with the same predictable outcome. Yet, even though I have researched this extensively, I have not found any government that ever admitted its role in creating inflation. It’s always someone else or something else that is responsible.

Most market observers are bullish on the market because expansionary Fed policies should make stocks go up. We have not only had a zero interest rate policy (ZIRP) since December 2008, but the Fed is on its second round of money printing through quantitative easing. Under ordinary circumstances, the stock market should be rising. However, circumstances have hardly been ordinary since the Credit Crisis began.

We only have to look at what happened to the Japanese stock market to predict the long-term impact of current Fed policies. The Japanese have had close to zero interest rates for most of the 2000s. They also started engaging in quantitative easing. This didn’t keep the Nikkei, which was close to 40,000 at its height at the beginning of 1990, from falling below 8000 in 2003 and in 2008/2009. The Japanese made other attempts to push their stock market up as well – and these worked temporarily. Ultimately economic reality prevailed however. In the long run this approach is not likely to work any better for Fed Chair Ben Bernanke.

The current quantitative easing program of the Fed is not working as planned either. Interest rates were supposed to go down and so was the trade-weighted U.S. dollar. Neither has happened. Interest rates went up – and this is a negative for the market – and the dollar also went up instead of going down. Interest rates are possibly going up because foreigners are selling some of their large holdings of U.S. treasuries (the exporting countries are extremely angry at Bernanke’s policies). The dollar is going up because of the banking crisis in Ireland. The 85 billion euro bailout there has not calmed markets because everyone realizes that there are major problems remaining in Portugal and Spain. Both countries deny they need a bailout, but so did Ireland right up to the last minute.

The market is also rising on economic data that is being reported as ‘good’. This is mostly wishful thinking on the part of the mass media and the government press releases that they publish without much examination or by putting in context. Auto sales and consumer confidence have been two oft cited pieces of evidence of an improving economy.

Auto sales which are supposedly taking place at a rate of 12.2 million a year have frequently been brought up as evidence of a recovering economy. At the bottom of the Credit Crisis, when the economy literally stopped dead in it tracks, auto sales were approximately 10 million a year and at the top they were 17 million a year. So, they are indeed doing better than they did when the economy was completely frozen (whether this can be referred to as a recovery is quite another matter). The improvement in auto sales taking place now though is nothing compared to the increases in the 1930s during the Great Depression, which lasted for many years after the first big increases in auto sales were reported.

Consumer confidence rising to the 54 level also got a lot of hype. The number needs to be over 90 to indicate an economy that is doing just OK. The number during a boom would be well over 100. The slight chances in this figure are nothing but statistical noise – meaningless changes caused by random movements. What caused the slight increase were consumers becoming more confident about the future state of the economy. This is not surprising since they keep reading in the papers and hearing on TV that the economy is getting better, even though they don’t see it in the everyday lives. The ‘present conditions’ number is still at an incredibly low 24. It has been stuck around this level for a quite a long time.

The November employment figures last Friday also threw some cold water on the economic recovery scenario. The government admitted to unemployment rising to a rate of 9.8%. The underemployment rate, which includes some discouraged workers and people forced to work part time was 17.0%. There has been little change in these figures during 2010. Investors should remember that the stimulus bill from early 2009 was supposed to prevent unemployment from rising above 8.0%. The Fed’s first round of quantitative easing was also supposed to fix the economy. Even though both failed, Washington is one of the few places where lack of success isn’t a reason for not repeating an action.

The failure of Washington’s policies can be seen by how little the GDP improved despite the massive stimulus that has been applied. In fiscal year 2010 (ending September 30th), the U.S. ran a budget deficit of 1,290 billion dollars (or $1.29 trillion). During the same time period, the GDP increased by 635.5 billion dollars or slightly less than half of the budget deficit. So for every two dollars being run in deficits, the U.S. is getting less than a dollar of economic growth (and this is with a zero interest rates on Fed funds, the return would diminish as interest rates got higher). The borrowed money for the deficit still has to be paid back or reduced by creating inflation. There is no way the U.S. will be able to pay back its national debt (the accumulation of all the annual deficits) and the higher the total becomes the greater the inflation that will eventually be necessary to deal with it.

At the moment, the U.S. stock market looks like it could be topping. Along with the volatility, the technical indicators, such as the RSI, MACD and DMI are fairly negative. The Dow industrial Average broke below its 50-day moving average in late November, but rose above it on December 1st. The Dow is leading the market down and it should be watched for the future direction of the market. The other major indices – the S&P 500, the Nasdaq and the small cap Russell 2000 - have still managed to stay above their simple 50-day moving averages. Until all the indices have fallen below their 50-day moving averages, the stock market should still be considered to be in an uptrend.

While there will always be some stocks that go up no matter how bad the market, at the moment, it is a generally a good idea to avoid buying any more stocks or commodity ETFs. The upside profit potential is probably limited. If you have large profits, you should consider taking some money off the table. The classic trading rule of thumb is that if you have a 100% profit in something, you should sell half of your position. It also a good idea to keep reasonable stops (an automatic sell at a price you have selected before hand). What is a reasonable stop depends on how much profit you are willing to potentially give up.

If you have a large portfolio and wish to hedge it or you just want to take a short position on the market, you can do so by buying the VXX, the ETF for the VIX (the volatility index). The VXX is not perfect because it unfortunately doesn’t precisely track the VIX. The big advantage of the VIX is that when it gets very low, there is limited downside risk of loss (shorting a stock can have an infinite risk of loss). In the current environment, a VIX around 18 or below seems to be a good buy. It is possible that the VIX still has to fill a gap in the 16s to 17s. If this happens - and it may not – this should be considered a very good buy point. Like all investment positions, it’s generally not a good idea to buy 100% of the position you ultimately want all at once. Buying on days when the market is up a lot is the best approach.

Investors should be cautious at this point. The bullishness seems overdone and things always look best at a top. The market could indeed go higher, but a lot of risk is being taken on to make whatever extra money can be made. If you are a day trader or very short-term trader, this can be a profitable time for you. For position traders, with a trade horizon of several months or more, this is not the best of times for additional long positions.

Disclosure: Own VXX.

Daryl Montgomery
Organizer, New York Investing meetup

This posting is editorial opinion. Investing is risky and the possibility of loss always exists. The above content should not be considered a recommendation to buy or sell any security.