Riding the Storm

[David Randolph]

This article's objectives are:

1) To describe why I'm turning bearish on the general market
2) What I'm about to do with that information

Before I start I want to tell you a story. I've been an analyst since 1999 and made hundreds of articles and analysis (not in English). At the end of 2002 I was at the height of my fame, since I correctly predicted the technology bubble and the collapse that followed. I was a long term Bear almost since the market peak in 2000.

At the end of 2002, as of now, I was about to write the biggest and most in depth of my articles, predicting the year of 2003 in several financial markets. It was a 50 page report (if you want to read it (at least you'll understand the charts, look here: 2003, segundo César Borja (the article has 2 parts)

I was so attached to those predictions that I couldn't think of anything else as 2003 progressed. Everything started as I expected and a Bull Market started in 2003 on equity markets. I called the bottom correctly and I was long at the exact bottom of the market. But soon after I turned bearish again and lost a ton of money.

I don't want to repeat the same mistake here, so let me make this clear: this is my thinking of what I see at this point in time, but I can change opinions as things evolve, and it won't take a full article like this to do that, it may be just a feeling !

With this posted, let me proceed with my bear case:

1. Evidence of a looming Bear Market

1.1. Inverted Yield Curve

The yield curve just inverted, that means short term interest rates are now higher than long term interest rates. This is something that puts the «carry trade» in check (the carry trade was a sure thing to make money: institutions borrowed short term and lend long term, getting the spread, or difference, between the two yields.)

But that isn't the point here, the point is: does an inverted yield curve mean a recession or a decline in equity markets?

Well, at least the last time, it did, as you can see on the chart below:



You can read this article for an historic analysis of the effect an inverted yield curve has on equity markets: A Study on the Flattening Yield Curve

2.2. Consumer Recession

The last recession on the US in 2001 was a very mild one, because it was an investment recession, which accounts for just about 20% of the economy. Consumption accounts for roughly 80% of the economy, so just a moderate decline in consumer spending will have a much more serious effect on GDP. That didn't happen for 14 years, since 1991 Consumption never had a declining year. But consumers at this point seem very stretched by at least 3 imbalances: debt, real wage growth and the housing market.

2.2.1. Debt

The next two charts show a reality you probably know, everybody is deep into debt now:





(if you please read this article for more in depth analysis)

Households have more and more debt and less and less real wage growth:

2.2.2. Real Wage Growth



So you have an unpleasant combination here: debt is growing and real wages are falling.

You may say: «yeah, yeah, but that's been the case for some time now and the Consumer help up pretty well, as did the stock market»

And you're right. That was possible because of the housing market bubble and refinancing. But that seems to be ending now, as you can see on the chart and articles below:

2.2.3. Housing Market Index




Most overvalued housing markets
Home sales fall
Mortgage applications hit 3-year low
Is it time to cash out?

I was just perplexed when I read that a median-priced San Francisco home costs $766,000, wow, and I thought the Lisbon market was hot (it is very hot, but a medium-priced home costs about $200,000. My own apartment with sea view and pool cost me just $180,000). Anyway, I know America's GDP per capita is about 3.5 times larger than Portugal's GDP per capita, so that explains a lot.

I think these 3 factors, record debt as a percentage of disposable income, negative real wage growth (partly due to inflationary pressures) and a housing market bubble that sooner or later will implode are making a perfect storm on consumer spending for 2006 or 2007 (the market always looks ahead).

2.3. Market Internals

You know I've been, at most, a reluctant bull. I was just getting bearish in September and October when I noticed that Commercial Hedgers were starting to cover their shorts. At that time that was a strong enough signal to let go of all my bearish considerations and quickly go to full invested.

The 3 Stocks on Fire Portfolio performance rose from about 150% in 2005 to the actual 184% because of that wise decision. But, at this moment and suddenly, commercials are going short again with a vengeance, with speculators staying long:

2.3.1. Commitment of Traders Report



You can see they started covering shorts by mid year and briefly went long in November. But this last week they initiated a very strong short position as you can see on the last red candle on the chart above. Open interest has been declining but the mood is set for it to rise as the market goes down, with commercial hedgers shorting more and more S&P500 contracts and speculators buying more and more on the dips, until they capitulate at a much lower point (because commercial hedgers always have the deeper pockets, they win over the long run at the futures markets)

The majority of analysts is bullish now, and the market certainly has to adapt to new economic conditions. Who is or was recently factoring in a consumer recession in 2006? Almost nobody, and yet, evidence shows that is a quite possible outcome.

As more and more analysts and traders see this the market will go down and we will probably come to a situation where we have more bear analysts than bull analysts. That's where I'll be looking for a trend reversal, from bearish, to bullish.

But for now, the picture remains like this:



Bulls are 55% where as bears are 21%.

2.4. Some defensive plays are starting to do well

You know Gold always plays a defensive role in not so good economic conditions. You know gold has been rising even in the face of a rising US Dollar, which is a powerful macroeconomic divergence favoring higher gold prices in the future.



Also, the Swiss Market and the Swiss Franc are rising steadily (also a defensive play, showing people are starting to run away from risk):



2.5. Technical Analysis



As Lucas Scott said, the real bull market was in 2003. Since December 2003 until now the S&P500 rose just about 8%. That means the bull trend was eroding before the bear trend starts. In fact, the bear market has started long before the bull market has ended.

I understand what Metro says, about the S&P500 not representing the market, but I disagree. Metro says «all stock indices» or «small cap indices» are making new highs. That's a fact, but I think that's because small caps underperformed large caps on the second half of the nineties and they were just playing catch up with large cap valuations.

I think of the rise since March 2003 as a bull run inside a larger long term Bear market that started in March 2000. The longer term trend may resume now, with the consumer finally giving up spending (not give up, slowdown on spending, of course).

If my scenario unfolds, this will bring stocks to really cheap levels and a great long term buying opportunity, because when recessions come is the best time to invest in stocks for the long term.

But that's too far away from here.

On a much shorter time frame look, this final week of December doesn't bode well for the beginning of the new year, and the SPYs just broke a short term support yesterday:



3. The way to proceed

3.1. Short stocks in general

Given this strategic orientation I will short 2/3 of the 3 Stocks on Fire and 3 SOF Fast Portfolios. That is 10 short positions at 3 Stocks on Fire and 2 short positions at 3 SOF Fast.

I will look for stocks with this kind of characteristics:

1) Price above $5
Those are the ones most people can short.

2) Average volume of at least 1,000,000 shares
I need plenty of liquidity if a short covering rally unfolds

3) Declining trends on price
They should be declining already, showing their weakness against the general market

4) Stocks that increased the number of outstanding shares in 2003, 2004 and 2005
If the company sells its own shares in the open market, why shouldn't I? If they need financing in good economic times, imagine if the economy turns as I'm expecting? A company selling it's own shares on the open market helps my bearish operations.

5) Market cap between $100M and $10B
The company can't be too big or it is harder to move down a lot. If a $1B company declines 50% it's only a $500M change in value, for a $100B company to decline 50% it needs to lose $50B in value. Yet, I make 50% on my investment either way.

6) With deteriorating working capital
If the ratio between assets and debt was already deteriorating in good economic times what will happen when the economy falters?

7) With no profits or little profits
Without net earnings to finance operations the company will seek for further financing increasing debt or diluting shareholder value by selling shares in the open market. That will make sure my bear operation bring profits home.

3.2. Long selective sectors and stocks

As for long plays (5 on the 3 Stocks on Fire Portfolio, 1 on the 3 SOF Fast), I need to search for stocks with specific stories or within specific defensive sectors, like gold, for example.

I still don't know what to buy, since the right attitude is to sell stocks in general. But I know some stocks will rise even in a Bear Market, one just has to pick them even more carefully.

As opposite to the short candidates, I'll look for companies with low P/E, buying back shares, plenty of working capital and an ascending trend starting (MESA is a perfect example, probably I was silly when I sold it).

Well, this is it, I'm going for lunch now, I wish you all a Happy new Year 

[stocky]

Good one. Applaud

[Fré]

Great post David.

2 questions for you or for others:

1) Do you have any specific 'gold stocks' in mind?

2) Which are the moest defensive sectors to play in?

Can you consider the Pharma industry as a defensive investment these days?

Thx

[bw6458]

THANKS FOR THE MARKET SUMMARY    ... I HAVE BEEN FEELING BEARISH FOR SOMETIME AND COULD NOT FIGURE OUT        HOW THE MARKETS GOT AS HIGH AS THEY DID. 

HAPPY NEW YEAR ...

I LOOK FORWARD TO AN EVEN GREATER RETURN IN '06    ...

SHORTSRUS FOR THE TIME BEING      

[shawFund]

Thank you for your analysis and happy new year. I will read this article and all other linked articles.

Many people are expecting January effect. The market hit hard in the last week of December and many indexes are about to enter oversold condition. The market may have January crash. The market did have a January crash last year. Let us see what will happen January 2006.

What I see:

1. housing bubble is for real and I am glad I sold my house June this year in LA area
and made a lot of money. I did not plan to sell it but realtors came to our house, offered the price we could not refuse. The house I sold now is put into the market again by the buyer, 10% less than the price few months ago I sold to him. Housing market in Los Angeles is very soft right now. We are not going to buy another house in LA within next two years.

2. debt and real wage:

   The US government spent huge amount of money on war with Iraq and big tax reduction. US government has a huge debt.

   Many US residents also have huge debt problem. But the job market is pretty good right now in the US. All my friends are having stable jobs and earning good money. I have not heard anyone I know of lost job or is not working right now.

    The wage: for us, the real wage increased 5% each year for all my family members during past few years. 

    Also holiday buying seems very strong. We went to local big, small malls. the crowds are bigger than last year. Each time I have to spend at least 15 minutes just trying to find a parking space.

    I bought a lot of hot items with deep discount. During check out, surprising thing is that the final price is even 20%-40% lower than the reduced tag price. This made us very happy because we thought that the tag price already gave us a bargin.

   
   

[starfire]

David, excellent analysis! Will you be explaining in more detail (or links) for the inverted yield analysis. I am looking for something that you have written. In the meanwhile, here's to

You and Ramsburg,

" A great New Year"

Make it a FUN New Year!

[metro]

Good article David - Thanks

December has been a month with many momo stocks slowing down but break outs are still working and plenty of great looking charts. When more charts look weak and more stock are breaking down then I will switch but am in no hurry to short in an up trending market as would rather stay with the trend.

The S&P EQUAL WEIGHT INDEX is now at 1657 and has its 50-day EMA at 1645 so will see if that support holds if it gets there and its trend line is near 1600. These are the largest 500 stocks and they generally do better in the second part of a rally so may continue even if small caps do not do as well. Large caps can handle inflation and higher rates better.




Usually when the Fed stops raising rates and for sure when they lower them the market goes down.

The 4-year cycle high is due in the first quarter on 2006 so if it plays out as most think then we will see a big pullback starting before April  into the 4th quarter when the 4-year cycle low is expected. Obviously if it always worked then trading would be a snap but this cycle has been pretty good.



We sell soon see if the the January crash happens like last year but so many are expecting it that it may surprise on the upside as the broad markets are near all  time highs and earnings are very strong and corporate cash at very high levels. Plus there maybe a boost from rebuilding in the South though that may take more time to get under way and show up on balance sheets of companies.

In 1986 things did not look good at the end of the year and people like this year figured the markets were in for a rough time for 1987. But surprise - there were so many bears the market took off:



However - later in the year was the crash of 1987 as the market had rallied so fast.

I am not looking for a killer rally but am not ruling it out as there has been no euphoric buying that can come when shorts finally give up and go long. It may not not happen at all but would be a nice set up to short. Other then that kind of even I think it better to wait for a weak market when stocks are not performing well.  One can try and make a few more % points by shorting early but to me not worth the risk. When shorting it is good to do so at break downs or at pullback to resistance on lower volume after a breakdown has happened. The same as trading long but only reverse.

The Armstrong Business Model suggests that in longer view that business stays good until 2007



The weighted S&P index that the fund managers use is not the total S&P 500 really as only 100 stocks make up 70% of the index. It is designed to make fund look good if they do better then the index. (You know they did not even but GOOG into the index as it would have made it look better) I use the Equal Weight Index as it is all the 500 in equal weight just like we buy here.

In September the S&P weighted broke down and all were saying it was the end of the bull market but the Value Line and other broad market indexes looked good so I stayed long and we had a good rally. That index still is not so good as it is a bearish rising wedge but I will still stick to using the Equal weight as a better indicator. Here is the Bull/Bear phases as of late



As a NASDAQ indicator this is a simple chart that does a pretty good job. You buy or sell on the 20-day EMA cross. Can have whipsaws but has worked well.



And this one when the 10 and 12-day EMA cross



Enough for now - I am not in any hurry to go short as once the bull run does break there will be plenty of time to short as it will last for months  I think. And metals and many commodity stocks should continue to grow as their bull market is only a couple of years old and may have 15 more to go. And Japan though up 50% also likely just beginning a long term bull run.

Happy New Year

[la-onda]

excellent analysis; I have to reread all the postings during the weekend.
That´s the real extra value for being a 3stocksonfire member 

thanks and best wishes for 2006

cheers
Oliver


what about investing in other markets (Japan, Germany)?
Outlook is much more positive IMO

[valueseeker]

Interesting comments on Japan & German, Oliver.

Here is the article on the performance of the ROW v.s. US.

http://www.marketwatch.com/news/story.asp?guid=%7B517E8D15%2DF0B3%2D4E16%2D881E%2D44C27118D2C1%7D&siteid=mktw

Austria - 51%
Japan - 40%
Denmark - 37%
France - 23%
Germany - 27%
India - 42%
Brazil - 28%
Turkey - 59%
South Korea - 54%

Dow - (-0.6%)
Nasdaq - 1.4%
S&P 500 - 3%

It kind of tells me a few things:

- the rest of the world is growing fast, and there are troubles in the US (debt and housing market being 2 that I can think of).
- Maybe the rest of the world will keep the US economy going (GDP is still growing at 4% and job market being pretty good) and we may not see a bear market in 2006. I want to be prepared if we do.
- Maybe I should put some money in the mutual funds that invests overseas. :-)

[Lucas Scott]

Valueseeker,

Another way to look at it might be that foreign markets are overbought and the US markets are looking more attractive in comparison. This quote from the article you posted:

The outlook for emerging markets, which have outperformed U.S. equities for five straight years now, is positive

I would bet that at this time back in 1999, when the US markets were on fire, the talking heads were saying "the US markets are the place to be, not the foreign markets."

[irod]

Here's what I've read:

Market finished year badly because of lackluster investor interest because of holidays. Media, as always, trying to scare people, this time with yield curve and recession talk.

Foreign investors have driven bond yields down, because overall they've made good money in the stock market this year just because of currency appreciation. So foreign capital is arriving heavily thus driving bond yields down. This will cause the Fed to stop raising rates and the stock market will party.

Consumer confidence is high. Consumer spending for the holidays was way up from last year, and earnings season is coming.

I don't know...

[metro]

This DOW chart is from about 8 weeks or so ago and just noticed it. Interesting that the % that make it is 89% so maybe when the pullback ends the DOW will finally make a break above 11,000. Would be interesting as so many think we may have a repeat of last year at this time.



Also noticed that the SOX closed with a hammer at the 50-day EMA and support line with oversold CCI and Stochastics



The S&P 500 though could still sell off a bit more to the 50-day and support as that could make a better set up,

[David Randolph]

Thanks for all the great, great posts on this thread 

1. What happened?

Basically, I was wrong and Metro, willey, and other folks, were right. The market took off to the upside and never looked back, closing Friday at new highs.

Although I was wrong on my assessment of the general market, I made money, not as much as I should, but still made little money (performance on the 3 Stocks on Fire Portfolio grew from 184% when I wrote this article to the actual 186.62%). Why? Because of two things:

1) I had an extraordinary long pick which was GIGM.
2) I didn't persist on being wrong, I waited for the market to tell the truth before I plunged. Because the market never turned bearish as I expected I stayed with a low commitment on the bear side, and my experience saved me from steep losses.

Now you may ask: but is there any plausible explanation for the market rally, other than the ones metro so kindly provided?

I think I know what happened, and it is a long term issue: The market is looking far ahead into the future. It is not discounting 6 months from now, but 18 months from now. It isn't afraid of an economic slowdown, because of two factors:

a) The slowdown is completely discounted on stock prices. Stocks in the housing sector (mortgage related and home building related) are already trading at deep discount multiples, it is like the housing sector is already in recession. Also, consumer related stocks are very cheap at this point, if we compare earnings and sales multiples with the overall market's multiples.
b) The FED's moral hazard. Nobody is afraid of an economic slowdown or recession because the FED can always save the economy and the market. If the stock market or the economy goes down, the FED will lower rates or use other tools to inject liquidity in the economy and everything will go back to growth. So, why worry? This environment is great to buy stocks for the long term; we have a «goldilocks» economy.

I believe A) and B) were the reasons why I was wrong. My bear case was destroyed because the market was already familiar with it (hence the discount valuations) and because of the FED's moral hazard (a dangerous long term issue, but short to medium term bullish).

2. Lessons for the future

I was wise on not plunging on the bear side, to wait some time for technical confirmation. But I was dumb to lose so many good stocks that took off this last week. So, in the future, I should avoid making too deep articles because that puts a cap on flexibility.

Trading plans are important, but the flexibility to change them quickly in a changing market environment is even more important.

Writing a very long article to defend a stock market opinion doesn't help and it can be dangerous. Also I should concentrate more on individual stocks and don't pay so much attention to the general market indices, because really good stocks will go up in bull and bear markets, and really bad stocks will go down in bull and bear markets.

So I should go long very good stocks and short very bad stocks, in bull and bear markets.

3. Immediate actions

Actually I've never been so happy in being wrong. Last week's bullish breakout is a good sign for the future and for 3 Stocks on Fire's three Portfolios. Note that I said «three» portfolios.

This means the 3 Pennies on Fire Portfolio is coming back to action 

I love bull markets and I feel encouraged by the market action to make real money in 2006 for the 3 Stocks on Fire Portfolios.

Now, I have some selective short picks that I'm not willing to let go so soon. They are the «bad stocks» and they will probably go down even in a bull market. But I need to close those SPY and QQQQ's short positions. And I certainly need to build some long positions on good stocks and put the portfolios up and running.

Thanks for reading, I hope you're learning as much as I am with www.3stocksonfire.org and let's make some green 

[valueseeker]

Applaud Dave for admitting you were wrong.

I was going to write a week ago to ask you to wait for Tues. 2PM Fed notes before deciding short or long but didn't get a chance to do it. I was 80% invested long on Monday but 100% invested long by Wed. morning.

I have been in GIGM since last earning report noticing it was acquiring a company. This has one of my best performing stocks this year as well and I see it continuously go up from here.

Earning seasons start tomorrow morning with Aluminum gian Alcoa.


-Valueseeker

[akclide]

Excellent work David,
                            There will be times when we are wrong,as long as we can keep an open mind and are willing to change our thought process,we are already ahead.even in a bear market there are plenty of stocks that go up and vice versa.My two cents at the end,I think Oil & gas service industry is going to do well this year.There is a lot of work out there for them.Everytime you drill a new well.You need companies to make the location(dozers,backhoes,dumptrucks,water trucks etc).Than you need drillers,next comes cementers and than loggers,and than stimulation work(acidizing,fracturing etc.).well pullers(workover rigs).Old wells need to be pluged.Cementers,casing pullers.and of course workover rigs.Just some ideas to look into.Some companies associated with the above work.
Drilling:
   ATW,UNT,PTEN
Service:
     SNSA,TRMA,TDW,SPN,PHII
International:
      HNR,CEO,VPI
Equipment:
    NTG,CFK,BTJ,GRP   Good luck to all