Monday, October 26, 2009

Is the Rally Toast?

The market was down for the 4th time in 5 days today as bonds sold off and the dollar strengthened.

A few folks out there have called me a "permabear" claiming that I missed the recovery. I wanted to try and explain to you why being bullish after a 50% bounce is simply silly.

Before I start:

I thought many of you might be curious as to how I have invested during this huge bounce.

Let me admit my mistakes by answering the following question and update you on where I stand with my portfolio:

Did I miss a nice move in stocks since March? Yes!(although I was hedged long(an S&P 500 fund, and a few other typical long funds) and short(BEARX) in some retirement funds).

Overall however, despite my super permabear stance(according to a few readers), my portfolio has done pretty well because the government backed equity bounce has also been very positive for bonds and metals which is where I hold some large positions. My largest individual holding is PIMCO's PTTRX which is up 12% YTD.

As a result I am up since March and pleased with my portfolio's performance. I will be reallocating some positions here in the near future as I prepare for the next storm that appears to be just over the horizon.

Also, to be fair and transparent(unlike our banks) let me also add that my trading account was repeatedly raped for a few months starting in March.

This wasn't too painful because my trading account is a small piece of my retirement. However, like all investors I made some mistakes:

Did I own some options that expired worthless? Yes. Did I get humiliated by SRS? Yes. Did I learn some valuable lessons? Of course. Did I blow up my trading account? No but it was down big at one point.

I have always stressed diversification on this blog, and I have also repeatedly advised everyone that money used for trading this type of market should be a very small piece of your nest egg. Congrats to anyone who caught this move.

Alrighty back to my post:

So why do I think this rally is toast? Because essentially the market is currently a total sham with zero liquidity.

As you can see below, the P/E ratios of stocks have now surpassed even the insane levels seen at the top of the tech mania:





P/E's close to 150? How did this happen?

In a nutshell: The market morphed into a rigged casino. The people that rigged the game of course were the major players on Wall St. They did it using HFT's(high frequency trades). Where did the liquidity come from that allowed them to begin such a trading game? The taxpayer bailouts of course! The Reuters piece below does a nice job explaining how it all worked.

So how out of control did this HF trading game get? Well It appears the SEC is about to dig in and find out because HFT's now account for up to 70% of all daily trading:

""High-frequency trading now accounts for an estimated 50 percent to 70 percent of all U.S. equity trading and is growing fast in other regions and asset classes. In it, banks, hedge funds, and independent shops use ultra-quick algorithms to make markets and capitalize on tiny spreads and market imbalances.

Some politicians and investors have raised concerns the practice, which effectively replaced traditional market-makers over the last decade, creates a two-tiered market favoring the most sophisticated players."

My Take:

Wall St has once again found a way to create another bubble. Basically what is going on here folks is the banks have taken your taxpayer money (via the TARP and other Fed bailouts) and created an equity bubble in the stock market by buying practically every stock under the sun(good or bad).

Look no further than the the P/E ratios above if you don't believe this is going on! The fundamentals are being completely ignored as the trading desks continually press the BUY button on their quants and bid up the markets.

Stocks now sit at unsustainable bubble levels as the economy continues to burn. Don't believe me? Take a look at Andrew Smithers comments in the Bloomberg article below:

"Oct. 26 (Bloomberg) -- U.S. equities are about 40 percent overvalued and headed for a decline as central banks pull back on quantitative easing that pushed up asset prices, according to economist Andrew Smithers.

“Markets are very vulnerable to an end of quantitative easing,” the economist said in an interview at Bloomberg’s Tokyo office on Oct. 23. “Central banks, they’ve got to stop some time and if that happens everything will come down.”

In “Valuing Wall Street,” his March 2000 book co-authored with economist Stephen Wright, Smithers argued that U.S. equities were grossly overvalued and should be sold. The Standard & Poor’s 500 Index plunged 49 percent over 2 1/2 years from a then-record high reached that month. Smithers said he stopped buying equities in the 1990s and began purchasing them again only for a brief period during the lows of the current crisis.

Asset purchases have doubled the size of the Federal Reserve’s balance sheet to $2.1 trillion since the start of the current financial crisis. The Bank of England has spent 175 billion pounds ($286 billion) over the last seven months to rescue the economy. Both banks are sending signals they may be ready to start winding down their programs."

The Bottom line:

As you can see above, Smithers is no slouch. He correctly predicted the tech collapse back in 2000.

I am very close to hopping back on the short bus. If the bond market continues to rumble the banks are going to get crushed.

The risk of higher yields in the bond market is increasing for a variety of reasons. Unimaginable government deficits and the threat of even higher deficits as a result of healthcare reform are at the top of the worry list in the bond pits.

Let us not also forget about the massive bond issuance's that must be sold this week.

Another concern regarding higher yields in the bond market is the risk that the economy might be beginning to recover. This sounds counterintuative but its factual.

Why?

Because if the economy recovers, inflation will become a large risk because rates are too low. The Fed may be forced to raise rates as a result which would be catastrophic for the banks and their bloated mortgage filled balance sheets.

Ironically, a bad economy with low rates is the perfect "sweet spot" for the banks. They can borrow short for next to nothing as rates sit at zero and then lend long. Even the dumbest of all bankers can make money in this environment. The spreads are to die for as long as the loans are good.

Overall folks, this rally looks to be on its last leg. As the government stimulus dries up, so will the economy and there is no money left for another one because we are trillions in the hole.

I think we are close to seeing another big rollover in equities. Please be very careful with your nest eggs at these levels.

Also, Keep an eye out for my 401K post that I am currently working on. Hint: It may be time to say goodbye to this investment tool.

More Later.

Disclosure: Short treasuries in longer term accounts via TBT. No new positions were taken at the time this article was published.

Long gold and silver via GLD and SLV. Long bonds via PIMCO's (PTTRX).

12 comments:

Anonymous said...

Thanks for the folio update and the comments on why this rally is on its last legs. Let's face it, if we didn't make mistakes we would not be reading & posting on these sites. I feel your pain in missing the March rally although my portfolio benefited from some purchases made in the winter months the year before as the market headed south so I have made a little money but nothing compared to what could have been. Kicking myself as I had my finger on the botton to buy a big bank in the $3.s and today it's in the 20's and I sat on my hands the whole time when knowing better. You win some and maybe the point is you didn't loose some.
Agreed about the market and the economy, I'm anxious to see how things hold up when all the goverments help vanishes and we all know that can not go indifinetly. I'd keep a diversified portfolio but be prepared to live in a world where leverage is out.

Jeff said...

Anon

Yeah I totally agree.

I kick myself at times as well but it could have been worse. I know a few guys that were balls to the wall shoret and really got punished.

Good luck moving forward with your folio.

THe market shook off the awful consumer data today. Lets see how we close.

$44 billion treasury auction results at 1PM. That will be a big one for the bond market and interest rates.

Best of luck

Anonymous said...

I'm starting to see more chatter about 'bond vigilantes' smacking this false recovery down. What took them so long?

Anonymous said...

Heres a question: when the downturn starts, is the dow going to smash below the 6500 level, proving that what we saw in march was not the "bottom"?

Neil said...

"A few folks out there have called me a "permabear" claiming that I missed the recovery. I wanted to try and explain to you why being bullish after a 50% bounce is simply silly."

Not to be snippy, but if being bullish after a 50% bounce is "silly" and if you werent bullish back in March, when is the time to prove you arent a permabear.

Dont get me wrong, unlike angry Anon, I like your commentary and analysis. However, you are what you are and to me it seems unlikely you have the capacity for bullishness.

Neil said...

Oh and that second part is not a snip. I say, embrace your bearishness! Just be cognizant of it.

jeff said...

Anon

The problem the bond vuigalantes have is the whole financial system goes poof if they take rates higher.

The auction went well today so bonds moved higher.

The problem the bond market has is central banks around the world are now raising rates.

If the Fed doesn't follow the currency will get trashed.

Believe it or not, I would be more worried about the Fed raising rates vs. the vigalantes taking them higher.

jeff said...

"Heres a question: when the downturn starts, is the dow going to smash below the 6500 level, proving that what we saw in march was not the "bottom"?"

I believe we will break 6500. We never saw true "capitulation" selling at the lows.

The bottom usually occurs when no one ever wants to own stocks again.

Time will tell.

GL

jeff said...

NEil

HEHE Good point.

However, If this was a rally based on an economic recovery then I would feel like I missed something.

If stocks roll back over and retest what have I really missed? YOu would only be ahead if you sold at the highs.

I want to place my nest egg in the markets when I feel stocks are fairly valued.

I actually hate being bearish because the markets are very volatile.

Being a bull when the economy is good and stocks are fairly valued.

Making 8-10% a year stocks as companies prosper is a much easier market to invest in. You just go long and enjoy the rise.

That being said, I have tried to accept me current permabearishness and accept it for what it is.

I do have a bullish side and one day when stocks are fairly valued you will see it.:)

getyourselfconnected said...

Jeff,
Great post. I have lost the will to write tonight as the tax credit for home speculators looks good for an extension.

As for the bearish/bullish debate I guess it depends on what you are trying to accomplish. If you like action and moving in and out then jumping at bottoms and then smiling about one that you caught can be fun.

If the stock market goes back to DOW 6500 and S&P 666 then I think almost 95% of average investors are going to take their ball and go home, never to return.

Jeff said...

Get

Thanks bud!

Oh they will come back. It may take a generation but our obsession around speculation always seems to return no matter how bad we blow ourselves up.

Anonymous said...

They'll come back sooner than you think. It will take a number of capitulation type corrections to make the "something for nothing" crowd move on.It's become ingrained in society that somebody else will take care of you this make your money work for you rather than you work for your money. Some hard and hungry times have to happen for people to finally get it.