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The Beginning of The End?

Is this the beginning of the end of this two year bear market rally? There are several signs that are indicating that this cyclical bull market that began in March of 2009 is on its last legs.

The "Smart Money” Indicator

The "Smart Money” refers to the largest institutional traders which can be said to drive the markets short term. According to Charles Biderman of Trim Tabs Research, the institutional investors own about 75-80% of all stock and therefore it is wise to track what they are doing. The "Smart Money” indicator is a put/call ratio which measures how bullish or bearish these institutions are. Purchasing PUT options is done to hedge downside risk whereas purchasing CALL options is done with the expectation of rising markets. If there are more PUTS versus CALLS then this indicates the overall position is to expect declines and thus they are purchasing protection accordingly.

The reason that this is important is that it appears that the "Smart Money” has already begun to question this rally by shifting from very bullish in early 2011 to extremely bearish in the 2nd quarter of this year and beginning to sell into this rally. Given it is largely the purchasing power of institutions that have been the driving the rally, as they begin to sell, there will be less buyers which would indicate price declines. The Smart Money indicator is not perfect however in the past we have seen significant crashes/corrections come a few months after an extreme bearish reading. This recent shift from bullish to bearish in a very short time should be considered a warning sign of potential decline ahead.

Government Stimulus

The US Government has been financing its activity and stimulus through borrowing. This borrowing is similar to a credit card; you can continue to borrow but eventually you have to pay it back. The more you borrow, the worse your credit rating gets which causes interest rates on borrowing to increase further limiting the amount you can borrow. At some point when you get into too much debt and your payments become too high, you are no longer able to borrow anymore and it can lead to not being able to make payments on the debt leading to default and often bankruptcy.

When the economy started to slow down in spring of 2010, the Federal Reserve (The Fed) embarked on its QE2 (Quantitative Easing) stimulus program. The program was designed to ease the money supply thereby providing systemic liquidity and stability to the financial markets. The largest banks and financial institutions were essentially credited with excess reserves which would allow them to lend out more money which was the goal of the program; lend more, people spend it, the economy grows. Unfortunately this did not have the desired effect because the banks don't want to lend (despite what they state publicly) and people don't want to borrow anymore as the average person is saturated with debt.

The result is that the banks and financial institutions awash with cash and nothing to do with it began investing the excess reserves in risky assets such as stock, bonds, commodities, etc which is why we've seen these asset classes move in tandem which is very rare. This was a desired effect of The Fed which is to re-inflate the financial markets in hopes that consumer confidence would go back up, people would begin spending, and re-grow the economy. The stimulus money has essentially been driving speculation in every except for real estate because the money has had nowhere else to go. This has largely worked for the last two years however we are beginning to see cracks in the dam again.

More Stimulus anyone?

Stimulus is like a cup of coffee; the first cup will wake you up and keep you going for a while until you begin to get tired again. The next cup always has less of a stimulus effect until eventually it doesn't work as sleep must come at some point. Monetary stimulus is the same; each round of stimulus has less and less impact.

Since QE2 began, we have seen only one quarter of increased positive GPD (Economic Growth). The most recent reading of GDP growth is slowing already. Is the economy already fizzling out? With continued high oil and food prices, we will likely see further weakening of our economy ahead due to decreased consumer spending.

It appears that The Fed is recognizing the lack of effectiveness of Quantitative Easing (QE) as expected. Recently Fed Chief Ben Bernanke indicated there would be no QE3 and directed the problem to congress to be fiscally disciplined (Austerity). As we are seeing in the Euro zone, Austerity doesn't work either. As we've seen, QE2 has had minimal impact. If the economy weakens anew and there is no additional government stimulus, I expect that we will see the economy go right back to recession, credit deleveraging, and deflation.

If the economy weakens again, The Fed will be pressured to do a QE3. Given the state of our national debt, and that S&P and Moody's (credit rating agencies) have essentially threatened to downgrade our credit rating from the coveted AAA rating, making the case for QE3 will be tougher. If the government increases the debt limit and if The Fed does QE3, it will likely have even less impact than QE and QE2, and the bond markets are likely to demand higher rates on US Treasuries which in turn would increase the cost of mortgages thus killing the already weakening housing market. If home prices don't go up, how can the banking crisis recover? The banks are still holding on to enormous amounts of bad assets from housing. As we are starting to see recently, the housing market has resumed its decline and is likely to get worse which will further weaken bank balance sheets and the banking crisis could come roaring back.

The Government/Fed is checkmated either way.

We've Seen This Movie Before

Japan has been an excellent case study for what we are going through now as they saw their economy begin to slow long-term going back to 1990 to current. Each time the Japanese economy would start to slow, the Japanese government would stimulate; they have been doing this for over 20 year. They have been able to repeatedly stimulate because they went into their economic contraction as net creditors to the world.

Japanese Treasuries are currently yielding around 1-1.5% largely because they have high internal demand for their debt; the Japanese have been net savers. The problem is that as their population ages, retirees go from being net savers to net spenders. In order to fund their lifestyles they will begin selling assets such as government bonds. If internal demand for these bonds decreases, Japan would have to go out to world markets to finance their borrowing and rates for Japanese bonds would likely go much higher resulting in a diminished ability to continue borrowing and they would effectively become bankrupt.

This strategy has not worked in Japan for the last twenty years yet the US Government is trying to go down the same path as Japan. The main difference is that Japan went into their crisis as net creditor to the world and had the luxury of long-term stimulus; we do not.

What's to Come?

Only time will tell what will come of this mess. We may see a short term correction similar to last year and get another year or so out of this rally. We may see a decline similar to what started in October 2007 and accelerated in October 2008. We may see nothing either way for many years. No one knows. What I do believe however is that this is not the environment where taking risk is likely to payoff and therefore investors should go to and maintain a conservative allocation until a more favorable opportunity comes.

Being conservative means that if the markets go up, your portfolio still goes up, just not as much as it otherwise would have if you remained growth oriented. Meanwhile if a significant decline does occur, a conservative portfolio should see declines that are much smaller compared to more aggressive portfolios thus allowing you to "live to fight another day.” It is all in the mathematics of a decline. For example, a portfolio that sustains a 50% loss needs a 100% rate of return to recover. A 40% decline would need to earn a rate of 66.7% to break even. A decline of 10% would only require a return of 11.1% to recover. And a decline of 5% would require only a 5.25% return to break even.

Many people are concerned about the value of the dollar and the Fed's efforts at debasing the currency. A quick look at the Dollar index going back to 1980 shows that the Dollar has already been devalued in the mid 80's and again more recently. In fact, the only asset that went up in 2008 was the US Dollar. So while the Fed has been printing plenty of money, credit deleveraging is happening much faster and thus the money supply continues to contract rather than increase. It is difficult to have inflation when the money supply is contracting as it is a matter of supply and demand. If there are too many Dollars chasing the same goods, then prices go up (inflation); conversely if there are less Dollars chasing the same goods, then prices tend to go down (deflation). The US Dollar is the Value play in this environment.

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