Sunday, December 28, 2008

2008 and a look ahead to 2009

As the year 2008 ends I want to take this opportunity to reflect upon the past year and also give you some insight on what I see going forward in 2009.

As most of you know, the reason I started this blog several years ago was in response to the financial pain a number of my fellow pilots within Emirates suffered during the bear market decline of 2000-2003. My intent at the time was to try to try to mitigate the effects of further financial damage to my fellow colleagues' portfolios going forward and allow them the opportunity to make the best of what is offered to us within the limited confines of the Emirates Group Provident Fund.

This blog has grown somewhat from what I initially intended and I know much of what I write is now distributed to not only other colleagues within Emirates (including doctors, dentists, administrative staff, management, etc) but also pilots in other airlines (that have similar self funded provident funds) as well as family and friends of the those who subscribe to the blog. I am honored and humbled that my words are held in such high esteem by many of the subscribers to this site that you would recommend my thoughts on the markets to those outside our small community.

My background in Technical Analysis allowed me to ride out the 2000-2003 decline period totally unscathed. It is this same background that recommended starting in Aug/2007 that you consider reducing your exposure to equities and to be totally out of equities in Jan/2008. Unlike other "investment professionals" (who care more about their monthly commissions than the best interests of their clients), my recommendations are "real time" and reflect the exact positions I personally have taken in my own accounts (and those that I manage for family and friends).

I came to the realization years ago that no one cared more about my financial destiny than ME and it is that ethos that led me to pursue my own independent financial education. The financial frauds over 2008 have only gone to prove my theory that no one cares more about your future than YOURSELF!

My intent with the blog was to promote the concepts of Technical Analysis and hopefully inspire others to pursue their own individual pursuit of independent financial thought and analysis. As such, my blog was initially designed for educational purposes (the "give a man fish and you feed him for a day; teach a man how to fish and you feed him for life" thought process).

For those that have the time and interest to pursue their own investment path based upon the concepts I have provided; I recommend you do so. Hopefully I have given you the basics to allow you to become an independent financial thinker as this is ultimately what each of us needs to survive going forward.

Alternately for those who do not have the time and/or interest to learn to "fish for themselves", I will continue to offer to the best of my ability the road going forward as I see it. Irrespective, you can rest assured I will present the most honest and clear vision I see and I will in no way ever recommend anything other than what I have done in both my personal account and in those accounts I manage for others.

As we close the year, I want to start by reflecting on the "where we are now" and where I see us going in the future.

I am pleased with my calls to begin exiting equities starting in Aug/2007 and recommending a total non-equity position as of Jan/2008. Here are the closing statistics for 2008:

Dow Jones Industrial Average: -32%
S & P 500: -37%
NASDAQ 100: -40%
Dow Jones World Index: -42%

Anyway you look at it, 2008 was a brutal year. In fact, since 1896 it was the 3rd worst bear market on record for the Dow Jones Industrial Average (only beaten by 1907 and 1931). Having said that, there is a real possibility that we have not yet seen the worst of this ultimate decline (more on this later).

From a technical analysis point of view, we have erased 100% of the entire bull market advance from the lows set in 2003 to the lows of Nov, 2008. However, since the bottom in the S&P 500 on Nov 20, 2008 we have risen approx 20% and there are calls from many that "the bottom is in" and "now is the time to buy". I cannot stress how much I disagree with these calls as outlined below.

Normally I restrain my comments to Technical Analysis because that is the tool I utilize most in finding the direction of the markets. However, I will go into some Fundamental Analysis below to give you some perspective on where I think we might be heading.

This recent price action is consistent with historical counter-trend bear market rallies within cyclical bear markets. In fact, during the 1929-1932 bear market there were 6 such instances where the market as defined by the Dow Jones Industrial Average rallied on average 44% (52%, 40%, 42%, 46%, 44%, 39% respectively between 1929-1932) before ultimately finding its market bottom after an 89% decline top to bottom. Similarly, in the 2000-2002 bear market the NASDAQ had 2 rallies of 44% and 52% (average 48%) and still achieved an ultimate decline of 78%.

Using history as a guide, it can be assumed that numerous bear market rallies of 44-48% can be expected in any cyclical bear market. Assuming the lows on the S&P 500 were made Nov 20 @ 752.44, we can project that this current bear market rally may take the SPX to 1083-1113 (44-48% rise off of the low) before the start of the next down leg. I fully expect that next down leg will take out the lows set in Nov/2008 and that ultimately we will not find a bottom in this market until we see an S&P 500 at or below 500 in 2009.

My reasoning for this is based upon the historic notion of "value". It was forgotten over the past number of years in this "juiced-up", greed driven modern day world of investment banking and rampant stock market speculation that stock market valuations are ultimately based upon earnings and, as such, the price of a stock index should ultimately reflect the earnings potential of the companies that are the constituents of that stock index. For those who are new to investment this is known as the P/E ratio (Price to Earnings ratio).

If a company is earning $1 per stock share per year, historically investors have been willing to pay $10-$15 for that share of stock. In other words, the Price/Earnings Ratio (P/E Ratio) has historically averaged 10-15. So the P/E ratio tells you what the price of the stock should be, based on the company's earnings. If the P/E ratio is higher than 15, the stock is probably overpriced; if it's below 10, the stock is probably underpriced.

Historically the S&P 500 has had a "fair value" P/E ratio of around 15 based upon trailing 12 month earnings. Also it is critical to note that in all cases of serious recessions, the P/E ratio has fallen to at least 10 or less IN ALL CASES. Using history and the previously mentioned fact that this is the 3rd worst stock decline in history, would it not be reasonable to assume that the P/E ratio of the S&P 500 would not fall to at least the level of previous recession levels? And if so, what level would that be?

Now the fun begins. As of Dec 31, here are the P/E ratios for the S&P 500 index:

-19.96 (based upon reported trailing 12 month earnings)
-12.50 (based upon "estimated" forward 12 month earnings for 2009)

Using the closing price of the S&P 500 on Dec 31 of 903.25, the P/E ratio is telling us that for the previous 12 months the reported averaged earnings of all the 500 companies within the index was $45.25 (903.25/19.96 = $45.25). So far, so good.

Now we are going to take the "estimated" earnings for 2009. This is what many base their "forward valuations" on when determining whether the stock index is "cheap" or "expensive". Based upon the above, the "estimated" average earnings for the same 500 companies in 2009 is $72.26 (903.25/12.50 = $72.26). Using this logic, the "investment community" are telling us now that the stock market is "cheap" based upon its forward P/E of 12.50. Does this make sense to ANYONE given the current state of the U.S. economy? Will the average U.S. company make 59% MORE in earnings in 2009 than in 2008? I find that very hard to believe and hence the reason I never use "investment community" forward projections in my investment decisions.

Given my thoughts that companies will make no more money in 2009 than they made in 2008 (I actually think they will make less but will keep it simple for the purpose of this analysis), we can project possibly where the S&P 500 will be valued going forward into this bear market.

Historically during the last 10 bear markets associated with recessions (which this one will now become #11), the average P/E ratio at the market bottom was 10.4. Even worse, in 5 of those 10 cases the bottom occurred at 8 or less.

Using this historical data, it is rational to project that the bottom of this bear market will not occur until the P/E ratio of as reported REAL earnings (and not the estimated earnings B.S. that is put out by the "analysts" of the investment community) comes in at between 8 and 10.

Using the trailing 12 month earnings, that tells me this bear market will not end until the S&P 500 index reaches the level of 452.50 (10x trailing 12 month earnings) to 362.0 (8x trailing 12 month earnings). Using the price top that was set on Oct 09, 2007 of 1565.15, this would be a decline of 71%-77% from high to low and a further 50-60% from current levels.

I do not want to sound alarmist but that is just the realities of what we can expect before this is all done. I think it is reasonable to expect that given the greed, fraud, and deception that was accepted as the norm over the past 20 years as just part of our "modern day capitalist economic system", it is reasonable to expect this sort of decline before all is said and done.

It is interesting to see the reaction in the general population as the calendar turns from one year to the next. I find it amusing to see the hope and positive expectations that come with a date change from one year to the next. It is human nature to crave what is easy and to not admit when things are obviously going to be worse.

What we are going through now is like the frog put into a pot of cool water that is set on the stove. Unable to discern that the temperature of the water is rising, the frog will stay in the pot until it is ultimately boiled to death. The shift in temperature occurs so gradually that the frog has no idea it is being boiled alive. That is what is happening right now. The general population "feels" that things are not right but they are unwilling to come to the realization that their world has changed and they must react. I must admit my greatest fear is that 99% of those who invest in the markets have no idea what is happening. We have gone through a paradigm economic shift over the past 18 months and the majority look to 2009 with new optimism that now that 2008 is over all is well and things "cannot be worse than 2008". I hate to tell you this but.......yes they can.

The real story here is the world has changed and we are in the early stages of what will become a multi year severe recession or depression. For 26 years we have had nearly continuous artificial economic expansion and the boom which we experienced must now give way to the bust. This is nothing new; it is simple economics, but over the past generation we have become so used to being saved by non-stop government manipulation and private investment fraud in our capitalist system that we are unwilling and unprepared to face the music.

There has been a generation of constant conditioning that times would always be good; there would always be another job if you lost the one you have and asset prices would always rise in value. And as such, if you would always have an income and your income and assets would always rise over time, many felt there was no need to save for a rainy day (since a lot of people hadn't even seen a rainy "economic" cloud during their entire adult life). Frankly, many people didn't seem to believe that rain actually existed. Well, not only does it exist but we are releasing a deluge that we've been storing up for at least 12-15 years. The bad news is the storm just began and it is not going to blow over simply because we have turned the page on the calendar to 2009.

I fear the current 20-something generation (of which my children are a part of) as well as most people in their 30's and 40's have no concept of the hardship they will face over the next 10 years in attempting to get their education, careers and finances in order. The sense of entitlement engrained in most people due to prior conditioning has not prepared them well for the hardships that are to come. The backlash towards the older generations that this is of "their" doing will be tremendous.

When you get that sort of change in mindset, investment return is virtually meaningless. People who thought they'd never need reserves of any kind suddenly discover that they do. You can expect the new harsh reality will finally result in a new found desire for saving for the future instead of spending for today. It is times like that where preservation of capital is MUCH more important than returns on capital. Making nothing this year has been considered a success given the losses that most have endured; I suspect 2009 will be the same. Being able to maintain your net financial position as this unfolds will be a huge success. Live to fight another day.

Now onto the technical analysis. Having said all the above, there are times when you will be able to make money in the markets in counter-trend rallies within bear market declines. We are currently in one and it may be a doozy. For those who are in cash and want to "dabble", now might be the time. For those that are still in equities, I would highly recommend you look at the coming rally as a gift from the gods that will allow you to get out before the next crash.

As I mentioned in my last update, this problem began in the U.S. and it will not end until the U.S. markets recover. Hence it is very important (irrespective of which market you may want to invest in) to watch the U.S. for the first signs of a bottom and recovery.

Of all the indexes in the U.S., I rely on only 1 index to point the way; the S&P 500 Index (click on all charts to enlarge):

SPX 30 minute chart:

This is a short term trading chart I use. Disregard the indicators but note the well defined 100 point trading range the market has been in since late November. A close above 918 is bullish; a close below 818 is bearish.

SPX 60 minute chart:

This chart gives a somewhat similar perspective over a longer time frame. A break of 918 and I think the market has a good shot at the next level of resistance at 1007; a break of 818 and we revisit the bottom at 741.

SPX daily 6 month chart:

Key points:

-nicely established down trending channel appears to have been broken to the upside over the past few trading sessions,

-most of the technical indicators are still bearish but on the verge of turning bullish,

-breakout above the 50 day moving average (887.26) on 31 Dec. This is the first break since 16 Dec (which ultimately turned out to be a false breakout). The only problem is this breakout occurred on low volume as it was during the holiday season. A basing above the 50 dma along with increasing volume would be very bullish short term.

-note the narrowing width between the Bollinger Bands (upper 916.19, lower 847.94). The Bollinger Band is an algorithm that calculates the range the market will stay within 95% of the time. Constricted Bollinger Bands ultimately lead to a price breakout in one direction or the other; which direction is unclear but there is going to be a big pop soon. Based on the firming technical indicators, the "best guess" direction is up.

-the resistance at 918 is well defined. A break above this level will lead to huge computer buy programs in the majority of investment firms. First target would be the resistance level at 1007 along with the 50% Fibonacci level at 1003.

SPX daily 1 year chart:

The 1 year chart shows the latest decline that began from 1440 back in May 2008. Note the declining volume on the latest price advance; this is bearish as it indicates the "big money" has not yet entered the markets. We need to see an increase in volume along with price rise to be sure we are on the right side of the trade. So far that is not the case.

In the event there is a market bounce, the first target area would be the 50% Fibonacci retracement level of 1091 (close to my 1100 target based upon historical bear market rallies I discussed previous)

SPX Weekly Candlestick chart:

This is the chart that prompted me to call for a 100% withdrawal from equities the 1st week of Jan, 2008 when the 13 week exponential moving average crossed below the 34 week exponential moving average. The rest is history.

We are still in a huge declining bear market. The MACD is curling up and the Full Stochastic is coming out of oversold territory. That is bullish short term and this market could easily climb back up to challenge the 34 week moving average (as it did in late May, 2007) before turning down again. I expect this sort of price action to fake everyone into thinking the worst is over before the next down leg.

It is unsafe and unwise to re-enter the markets on a longer term buy-and-hold investment basis until the 13 week ema has crossed above the 34 week ema.

SPX Traditional Point and Figure Chart:

I still like PNF charts for their lack of "noise". This chart turned bullish on a price print of 885. Very clear resistance shown on the chart at the 915 level. Structure of the chart projects a price target of 1010. Looks bullish.

SPX % greater than 50 dma:

This is a chart that shows the percentage of the 500 stocks in the S&P 500 index that are trading above their 50 day moving averages. This does not work well as a 'signal generator" but gives me some idea of the generally bullish or bearish nature of the market.

Note the 10 day Ema crossed above the 20 day EMA Nov 25. That tells me the general structure of the market is now bullish. More important is percentage of companies that have stock prices greater than their 50 day moving averages has now risen above 50. Now the majority of stocks in the SPX index have bullish short term price chart action; this is a bullish sign.

The market closed Dec 31 at 64.8% (64.8% of all the companies in the SPX index have their stock price above their 50 day moving averages). The high over the past year was 68.53 in late Aug, 2007. Getting the % of stocks >50 dma above this level will be critical to continue the rally.

Bottom Line:

There has been some improvement to the technical picture over the past week. The key to where this market goes from here lies with 918 to the upside and 818 to the downside.

My expectation is we will see 918 taken out to the upside soon. I expect we will have an "Obama" rally as human nature will look at the glass as being 1/2 full and expect (actually hope) all will be solved with the change in administration.

I expect the forthcoming rally will go into late spring and could reach as high as the approx 1100 level on the SPX that I talked about previous. I expect along with that will come calls that the bottom is in and now is the time to buy before you miss the boat. There could be nothing further from the truth and those that buy into that rally assuming the worst is past will be crushed.

I intend on participating in the expected rally as a short term trade. I will be quick to exit at the first sign it is reversing downwards.

As of today, my "strategic" positioning in my provident fund account remain as follows:

-100% BlackRock/MLIM US Dollar Cash Fund (actual positions: USD cash 91%, equities 9%)*

2009 Predictions:

I expect going into summer the true nature of this economic decline will be felt. I expect the following in 2009:

-the U.S. unemployment rate as reported by the BLS (Bureau of Labor Statistics) will reach close to 10%. This monthly statistic is known as "U3" in their monthly report and it is currently at 6.7% as of the end of Nov, 2008.

Note the method in which this unemployment rate is calculated has been "massaged" over the years (as is inflation data as well) and as such it is difficult to compare this rate to the recorded levels of unemployment during periods such as the last depression. By strict definition, the U3 rate only takes into account workers who are completely unemployed (as opposed to getting any sort of income from any sort of part time work) and are actively searching for work over the past 4 weeks. You get a few bucks selling papers on the corner; you are not "unemployed". You knock on doors daily for 4 weeks and don't find a job and give up until things improve; you are not "unemployed". I think you can see the problem with a statistic such as this.

One alternative report is known as “U6″, which the BLS lists under “alternative measures of labor underutilization.” It’s defined as "total unemployed, plus all marginally attached workers plus total employed part time for economic reasons, as a percent of all civilian labor force plus all marginally attached workers". In other words, it captures those that have not looked for work over the past 4 weeks (discouraged and have given up even though they want a full time job) plus those who have found a part time job to survive even though they want full time work. To my mind this better defines what the true unemployment rate should be.

In the last report U6 came in at 12.5% for Nov 2007 (it tends to be double the U3 "official" BLS unemployment rate reported in the media). This measure is a much better "apples to apples" comparison to historical rates of unemployment. If we hit 10% on the U3 in 2009 the U6 will be at least 20%; close to unemployment levels of 25% last seen during the Great Depression. I think we will get there in 2009.

-the stock market will have a strong "Obama" bounce into the spring. From there reality sets in and we head MUCH lower. This is contrary to most forecasts that believe the markets will be flat to down in the first half of the year and then stronger into year end. I like not being "with the crowd" on this as they usually are wrong.

If I was to predict a path, it would be up into late spring followed by a large correction into the late fall (to at least the 500 level on the S&P 500 index) followed by a rise into year end as the market correctly anticipates an economic turn around in Q2 2010. I expect a "headline" decline on Dec 31 2009 of 15-20% but expect a much lower level mid-year before a rise into year end.

-housing has not bottomed. Expect another 20% decline from current levels for 2009.

-at least 2-3 more major banks will fail in the U.S.

-we do not hit bottom until houses cost 3x average annual income and the S&P 500 trades at 8x trailing earnings.

Overall I am not optimistic for 2009. We will not see another 40%+ "headline" decline by 31 Dec 2009 as I expect by then the markets will have turned up into the next bull market but the yearly range in the markets will be extreme.

Historically the stock market bottoms 5-9 months BEFORE the economy turns around so if the economy does not turn until Q1 or Q2 2010 I expect the stock market will reflect that by bottoming in Q3 or Q4 2009 or very early in Q1 2010.

I will know we have turned the corner when the charts indicate a bottom is in. We are a long way from that point and are in for a hell of a tough road ahead before that becomes reality.

All the best to you and your families in 2009.

Dwayne Malone

*Strategic allocated percentages are as per how funds were originally allotted. Due to market fluctuations and ongoing equity monthly purchases these amounts vary several % from that posted (refer to current % holdings).

Legal Disclaimer: The content on this site is provided without any warranty, express or implied. All opinions expressed on this site are those of the author and may contain errors or omissions. NO MATERIAL HERE CONSTITUTES "INVESTMENT ADVICE" NOR IS IT A RECOMMENDATION TO BUY OR SELL ANY FINANICAL INSTRUMENT, INCLUDING BUT NOT LIMITED TO STOCKS, OPTIONS, BONDS OR FUTURES. The author will reveal his current market positions and holdings but actions you undertake as a consequence of any analysis, opinion or advertisement on this site are your sole responsibility.


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