Stock Market Update 07 May 2008

It has been several weeks since I've updated the blog. In that time, I have not changed my positions within the Emirates Provident Fund.

The markets have come off a bottom that was reached in mid-March and as of today the Dow Jones World index is up 11.4% (still down 9.2% from the highs). This movement is in line with my premise that the markets would find a bottom in the spring and be strong throughout the summer. So why am I still positioned 50% bonds/50% cash? Here is my reasoning.

From a fundamental point of view, this credit crisis is not over. To recap what is currently happening, since last summer the housing market collapse in the U.S. has led to most of the investment banks having to take billions of dollars in write-downs on derivative products they were holding on their balance sheets. This led to a question amongst the banks as to who was "solvent" and who was "insolvent" given none of the banks wanted to disclose to the others (and the rest of the world) how bad their balance sheets really were.

Unable (or unwilling) to lend to one another, the supply of credit has dried up and with that a huge amount of leverage has come out of the system. This credit contraction has led to the declines we've faced to date.

In order to try to alleviate the problem, the U.S. Federal reserve has done the following recently:

1) the FED just announced last week it is expanding its Term Auction Facility (TAF). This is the program the Fed announced last December to funnel money to big banks (a.k.a. "primary dealers"; the largest banks in the U.S. and the "customers" of the Federal Reserve) in exchange for riskier-than-normal collateral (which consists of primarily derivative paper written on sub-prime mortgage loans). They essentially take the "high risk" paper from the banks and exchange it for "low risk" 10 year treasuries which the banks can then use as collateral to borrow against.

At the time they set up the program, they made it sound like a temporary, emergency measure, with biweekly auctions of up to $20 billion. Note this TAF is an "abnormal operation" in that during normal operations banks can go to the FED credit window for short term loans but this borrowing is published for all the world to see. In the TAF operations the FED does not have to disclose to the world who is looking for the loans. In other words, they have "bent" the rules to hide information about which banks are in trouble to save those banks from having their customers withdraw their money (as happened with the Northern Rock run on the bank).

Then, earlier this year, they expanded this facility to $50 billion. And on Friday, they've just bumped it up — again — to $75 billion per auction, or nearly FOUR times the original level. If the credit crisis were truly behind us, why would the Fed need to be dishing out so much more money to the banks? It makes no sense....unless.....we are not over this thing yet by any stretch of the imagination.

2) the Fed also announced on Friday that it's expanding its Term Securities Lending Facility (TSLF). This is the newer, more radical, program whereby the Fed gives big brokers temporary loans (up until the introduction of this program they have never given loans to brokers; only to primary dealer banks within the U.S. banking system) by exchanging the FED's high-quality Treasury securities in exchange for the brokers inferior quality junk paper.

Until now, the Fed was accepting only derivative securities (rated AAA) based on home and commercial mortgages. However, under the Fed's new rules it now makes it possible to take in a lot of other garbage, including securities backed by credit cards, car loans and student loans. The question I ask is......why? The only answer I can come up with is.......because they have gone through all the mortgage derivatives they can swap and still the banks won't lend to one another because they all know their balance sheets are even worse than we thought. As such, it is possible that most are bordering on insolvency. So what is left on the balance sheets to swap for investment grade government paper (10 year US Treasuries) to try to get this whole thing moving in the right direction again......all the lower rated credit facilites (personal loans, auto loans, credit cards, student loans, etc) that have yet to see massive defaults. This move is without precedent in the history of the FED.

In addition, it is important to understand that only the first wave of the credit crunch has come and much more is forthcoming in the future (Alt-A home mortgage resets, credit card defaults, auto loan defaults, etc). In reality, all the bank right-downs we've seen to this point have only been on the losses on the derivatives written on home loans. What happens when the actual loans themselves (mortgages, car loans, credit card loans, etc) begin to default in large numbers? Is this action the type of thing the Fed does when credit conditions are improving? Or is this the sign the Fed has its back literally against the wall, still desperately searching for ways to put the crisis behind us? Doesn't it sound like a black hole in space which sucks everything into it? This spells potential disaster.

Enough of the fundamentals; having said all that, the stock market is behaving like we are on the dawn of a new and wonderful day. Hmmmmm. However, it is-what-it-is and the market can remain irrational for much longer than many would believe.

Stocks appear to have put in a minor bottom and are in what appears to be wave A of an A-B-C correction (goggle Elliot wave theory for more specifics). They are technically overbought and due for a correction very soon. That will be wave B down followed by wave C up. I am awaiting a correction into wave B before I commit funds into stocks but this will be a short term trade only (maybe up to mid-late summer?). I expect before this whole problem blows over we will be considerably lower in the markets than we were in March.

On to the charts. I will start with a "Top-down" view to give you some perspective of what is happening in the bigger picture and then move on to the shorter term.


First chart is the Dow Jones World (DJW) monthly chart (click on all charts to enlarge):



This chart is still bearish from a long term perspective. I would need to see the closing price at the end of May above the 12 month moving average to turn long term bullish.


DJW Weekly Line chart:



This chart went bearish when the 13 week moving average crossed below the 34 week moving average. It has not reversed to date and is still bearish.


DJW Point and Figure Traditional Chart:



This chart has gone bullish on a price print above 288 and projects a price target of 352. This is a potentially bullish sign for the medium term as this chart does not "whipsaw" as much as many others do. As such, I use it a lot in determining the "intermediate" term direction of the markets.


DJW Point and Figure 1-box chart:



This chart went bullish on a price print of 273 and has yet to reverse downwards. It projects a target of 329. This is short term bullish.


DJW Daily Line chart:



Also short term bullish. Price has broken above the 50 day moving average and the descending downtrend line from the October, 2007 top. It has also broken above the previous level of resistance at 285.10 setting up a bullish "higher high, higher low" pattern. Price has just penetrated the 50% Fibonacci retracement level at 290.73. All momentum indicators are positive but indicating an overbought condition.

There is very little not to like about this chart other than the market has come too far-too fast and is in need of a retrace. As such, I will wait for that to occur (which will be wave B as discussed previous) before I move back into equities for a short term trade.

The next 2 charts are one's I monitor to get a feel for what the market wants. Essentially, when investors are uncertain they move into bonds (primarily 10 year US treasuries) and when they believe things are ok they move into stocks (primarily the S & P 500 stocks).

I monitor this via the ratio charts below; one for the short term and one for the intermediate to long term.

First chart is the short term:



As can be seen, this chart gave a "go to bonds" signal back in the 3rd week of October. In hindsight this was a great call given what happened to the markets over the winter. Also interesting to note that it gave a "go to stocks" indication on April 1st and has been on this signal since. Another short term bullish signal for the markets.

Lastly, note that S & P has broken above it's downtrend line last week and yesterday the 10 year treasure price has broken below its uptrend line. This confirms the "go to stocks" call in the short term.

Now look at the weekly chart going back 10 years:



Note the areas I've highlighted and how today looks very suspiciously like it did back in Apr-May 2001. Note the ratio touched just below the 34 week ma back in 2001 (as it is doing now) but abruptly reversed upwards; confirming bonds as the place to be over the intermediate term. Could this be a replay and all those buying the market now are buying a "sucker rally"?

This will be interesting to watch over the next 2-3 months and I will republish it as necessary. This is another tool I have in my bag of tricks and it is telling me it is still too early to go back into the stock market over the medium to longer term.


Bottom Line:

As stated before, I believe we will see a strong market into the summer/fall. My short term charts have turned bullish and I will be moving my position from bonds into stocks once the market has a corrected it's current overbought position (I suspect this will occur in the next 1-2 weeks).

At this time, I see no indication that a new bull market has begun; this is a bear market rally. As such, I will maintain a 50% cash position until there is solid evidence the worst is behind us. I do not think that time has come yet.

My positions remain as follows:

50% Fidelity International Bond Fund
25% Euro cash
25% Australian dollar cash

As always, when I make my changes I will publish them immediately.