The Dollar Destruction

As infamous trader Jesse Livermore used to say, “Conditions are ripe for a sell off.” The litany of global problems that exist seem to be compounding every day. As if the market doesn’t care, the major indexes have spiked up over the last few weeks. It does seem odd to see such strength under these circumstances.

This week however, trading started off the day quite positive but then gave back much of it by the close. Strength in the morning followed by weakness in the afternoon is usually a bearish sign. While the S&P 500 has been up three of the last four days, we‘ve had only a fractional gain this week.

Usually the start of each month and especially the start of a new quarter is a time for strength as retirement plans of every ilk get funded and new money flows into the market. With April’s monthly strength period now over, hardly a dent has been made towards a market advance.

The strong season for the market is also coming to a close. There is historical statistical evidence that gives credence to the “sell in May and go away” concept for period investing. While markets don’t have a calendar, the November through April timeframe historically has significantly outperformed the May through October period, and May is coming soon.

Investor sentiment is running high. The recent Investors Intelligence Sentiment Survey reveals that less than 16% of professional newsletter writers are bearish and over 57% are bullish. This Bull to Bear ratio of 3.65 displays even more optimism than at the market peak in 2007.

This survey has been widely adopted by the investment community as a contrarian indicator. Since its inception in 1963, the indicator has had a consistent record for predicting the major market turning points.

Another contributing worrisome factor is the coming end of the Fed’s Quantitative Easing Program (QE2). When the Fed stops buying bonds, monetizing our debt, and pumping billions of new dollars into our economy on a daily basis, how will the markets fare? That is a big question. Currently it’s as if the economy is cycling ahead with training wheels on. What happens when they come off?

Should markets correct on anticipation of or at the end of the QE2 money pumping machine, it would mean that a market top was occurring at almost precisely the same time it did last year, which included the Flash Crash.

One of the key factors that markets appear to be ignoring today is the ever rising price of oil. High oil prices have always led to a recession. Oil is a direct reflection of a falling dollar. With the ongoing destruction of the US dollar, caused in a large part by the QE2 program, commodity prices are going through the roof. Now is a time for caution.

The New Era

Many believe that the old saying, “it’s different this time” is never true. It is widely held that situations are never completely different; they’re just another version of events with slightly divergent circumstances. History may not repeat, but it sure rhymes, is another old saw bantered about Wall Street.

It is believed that the reason market events repeat generation after generation is that human emotions of greed and fear has always been and always will be present when it comes to money and investing. Today’s technological advances may create a contradiction to those old beliefs. It has made life simultaneously simpler and more complex, and has brought an element of change that hasn’t been present in the past.

Use Major League Baseball as an example. Baseball hit upon a new era with the development of steroids and human growth hormones. Old pitchers well past their prime became Cy Young award winners. Not just one but two players broke a 40 year old home run record in the same season, only to be surpassed again within a couple of seasons.

It became known as “the steroid era.” It truly was different. Fans were enthralled at the new found power of the times. They cheered along, but the Commissioner had to know that something was up. Those feats of athleticism had never been witnessed before, but the baseball brass stayed mum because ticket sales and TV revenues were doing great.

Now many fans are shocked to find out that the game was rigged by players’ use of steroids. They must have figured that players were just eating better and working out more. But no – things were different.

Today the Fed has done the same thing. They have created a new era. They have put the money printing press on steroids. Since August, the Fed has bought 70 percent of all the new government debt issued by our Treasury. The Fed is in effect monetizing our debt and creating an artificial stimulus for the economy. Fed Chair Ben Bernanke hopes that this crutch will be enough to create confidence among consumers to become a self fulfilling recovery.

Some very well known bond managers are not so sure this new era will work. Pimco’s Bill Gross calls the Fed’s path a Ponzi scheme. Gross believes that everything the Fed is currently doing will prove to be harmful in the long run.

Investors, like baseball fans in the steroid era, are currently very happy. We just had the best first quarter returns since 1999. Since the market was actually negative for the year on March 16th, if the media really called it correctly, it’s been a good couple of weeks! The commissioner (in this case the Fed Chair) is participating in the juicing of the game so to speak. At some point all this will come to a tragic end, but for now it’s just “Play Ball!”

The Luck of the Irish

In today’s feature the “Luck of the Irish” will hopefully mean that we can make some green (as in backs) from today’s trading strategy. The markets have been more volatile in both price and volume lately, for good reason. Geopolitical events in the Middle East and North Africa are becoming more widespread. The Japanese crisis is more uncertain with each passing day.

On a technical basis, all the major market indices appear to have broken their up trends and recent support levels. Because markets rose at such a fast past since the beginning of September, there is very little support between here and their respective 200 day moving averages. This could mean there is more downside to go before reaching next support.

There is a lot riding on the depth and duration of this correction. The primary reason the rally started was that traders felt that the Fed had their backs in a sense. As Ben Bernanke outlined his Second Quantitative Easing Strategy (QE2), many traders did a little math and recognized that $4 to $5 Billion of new money was going to move from the Central Bank to Primary Broker Dealers on a daily basis for the next nine months.

The Fed monetizing debt, while simultaneously pumping banks with a plethora of cash, gave a level of comfort to traders that the stock market would be a one way street up. Until mid February, that has been true. The VIX “fear index” dropped below levels of complacency not seen since before the 2007 Great Recession began. Optimism among both institutional and individual investors held bull to bear ratios at extreme levels for extended periods.

It almost felt like the golden age of investing was back, as the “mom and pop” investors who missed the double off the bottom over the last 20 plus months started to come roaring back in. Now that the belief that the Fed can print our way into prosperity is coming into question, a vacuum of confidence could occur.

In the near term it appears that the market has more downside to go as support has been violated. Using one of the oldest and most actively traded ETF’s the SPDR S&P 500 (SPY) to create a synthetic short position by Selling an April 125 Call for $4.24 and Buying an April 125 Put for $3.37 per contract could be profitable in this environment. In this example you start by pocketing $87 per contract immediately.

A couple of technical analysis methods point to SPY having a near term price target of $119. Two reasons: First, that is where its 200 day moving average is. Second, this run started at the end of August with SPY trading at $104.29. It reached a high on February 18th of $134.69. A normal 50% Fibonacci retracement puts SPY at $119.49.

Should this happen in a week’s time this trade could result in a profit of approximately $650 per contract. The risk comes into play should the market move up quickly. SPY closed yesterday at $126.18. Should SPY trade here or lower this will be a good trade.

If you currently own shares of SPY, employing the same strategy creates a collar on your position and is an even lower risk trade should the market recover as your exposure is limited, but so is your return.

There are many reasons to believe that the market could continue in its downward trajectory. Not only are markets ripe for a pullback, should it start to accelerate down, a generation of investors will be lost as they throw in the towel quickly and the confidence of even most astute investors could be shaken. If that happens SPY could overshoot $119 making this recommendation even more profitable.

The Real Price of Oil

Last week marked the two year anniversary of the March 9th, 2009 low for the S&P 500; it also was the 11th anniversary of the NASDAQ high of 5050 set back on March 10th, 2000. Is the cup half full or half empty? It all depends on your perspective.

The mood of the stock market has grown increasingly more downbeat over the last few weeks. It’s no wonder, as investors are facing widespread geopolitical turmoil in the Middle East and a catastrophe of yet unknown proportions in the world's third largest economy.

Almost defiantly, markets have displayed impressive resiliency. The combination of these events might have the ability to knock down any strong market. So far though it has absorbed these shocks, but markets remain vulnerable to a deeper correction.

Over the last couple of years governments have pumped money into their economies on a fast and furious basis to keep them propped up. This has resulted in a global increase of prices for food and energy. Higher food costs and lack of opportunity are the main factors causing much of the turmoil in Middle Eastern countries.

The problems over there are creating issues over here as we are seeing gas prices around $4 per gallon. Higher gas prices have the same effect as higher taxes only without any additional benefits. It leaves less money for consumers to spend on discretionary items, which could cause contraction for the overall economy.

In addition higher energy costs results in higher prices or fewer profits for most everything. Getting goods from the raw material stage through the manufacturing process to the end user will require additional cost. Already high food prices will surely continue to rise with the additional cost of shipping the goods from the farms to the grocery markets.

Unfortunately oil is the lifeblood of our society. Many daily activities require oil. From factories to farms, oil is needed as coolant or fuel. Heating homes, creating electricity; everything from lubricants to lipstick, and medicine to plastics, requires oil.

Americans consume more gasoline than South America, Europe, Africa, and Asia combined! We are gasoholics! We have an addiction with oil. Two thirds of all the oil used in America is for transportation.

With the earthquake that has devastated Japan; a huge problem for the country will be the restoration of power and water for many of their citizens. Electricity is out for millions and will take several weeks or months to restore. In the meantime, electricity would be rationed with rolling blackouts to several cities, including Tokyo.

A total of four nuclear plants in Japan have reported damaged and are offline – some permanently. There has to be a replacement for that energy shortfall. Nuclear power plants take years to build so it is not going to come from that source. Oil along with coal will be the most likely candidates as Japan will reopen some of their old non nuclear facilities. This will create an even higher demand for oil.

The battle in Libya as well as demonstrations in many other oil producing countries is a sign of instability. This could lead to supply issues and higher oil prices. There are several reasons to be concerned that our own economies fragile recovery could be derailed.

The United States Oil Fund (USO) is one of the most actively traded oil based funds on the market today. Through the use of the actively traded futures contracts, it tracks the price changes of light, sweet crude oil.

USO went up 21% in a recent three week period, only to pull back 4% last week. USO closed Monday at $40.91 and has big support in $38 per share range. With all the negative issues regarding potential supply disruptions and increased demand for oil, we could see price increases for the foreseeable future.

An investment in OIL could act as a personal hedge and help offset some of your increased costs at the pump. Use a stop of $37.70 and be hopeful that it drops to that level, because that will spell relief for American consumers. If the cost of oil continues to rise, you can expect the stock market to eventually capitulate and tumble due to the higher associated costs for almost everything else. That is the real price that we could pay for oil.

What a Run!

The markets continue their advance riding the Feds daily pumping of freshly minted billions of new dollars. The S&P 500 has now been up seven weeks in a row. That’s never happened before! Equally unique is the fact that the S&P has not fallen below its ten day moving average for thirty straight trading days. That too, has never happened before! The Dow Jones Industrial Average has also been up for seven straight weeks. Both indices have been up eight of the last nine weeks, with the S&P up 17 of the last 20 weeks in a row. That’s pretty impressive! However, that type of performance strongly argues that this powerful rally is most likely over-extended and overbought.

The major indexes are extended far over their 200-day moving averages. Usually they have some sort of pullback, at least enough to test the support of their historical averages. Even through the strongest of bull markets, normal ebbs and flows to and from their long term averages happen. We are currently overdue for a retraction. From the current levels a retracement just to the 200 day moving average would be around 11% for the S&P 500, and 14% for the Russell 2000. That would erase much of last year’s 12.8% gain that the S&P had for all of 2010.

Another interesting scenario is that of the dollar / gold relationship. The dollar was down this week, but gold was down as well. Lately those trades have moved inverse to each other. Long bonds also continued to see outflows. The biggest sector hit this week was taken by municipal bonds. Fears that state and local governments are on the verge of default, as well as fears of rising interest rates took its toll on muni’s once again. The municipal market much like real estate is very localized. Therefore not all muni’s are bad and there probably are some great deals to be had – but that is a topic for another time.

The stock market has too many bulls and too much complacency. The AAII & II bull to bear numbers are flashing record optimism. The VIX shows no fear. While the market continues its ascent we are still invested long. However something does not feel quite right to some savvy professional traders. A change will most likely happen soon. It would be wise to lighten up when some more sell signals occur and pivot points are breached.

For the S&P 500 a drop below 1250 might be a cause for concern. The Russell 2000 below 777 would trigger a defensive move and for the NASDAQ Composite below 2640 should also warrant protective action. When the majority of investors are on only one side of the trade with no concept of fear due to an imaginative Fed, sometimes unintended consequences come along that rebalance the market. Be careful – the markets are currently over-extended, overbought AND over manipulated.

Santa Claus Came This Year

There is no doubt that Santa Claus arrived on Wall Street this year! With the S&P 500 and the NASDAQ Composite up 14 of the last 17 trading days, the Santa Claus rally posted a return of over 6% on both indices. Not a bad return from the bearded one. But who really is Santa Claus? Is he the historical figure that we all heard about? Or is the bearded one a new Santa, one bringing billions of dollars of cash to Wall Street firms daily, from the Federal Reserve Bank?

Yes ladies and gentlemen, the new Santa is none other than Ben Bernanke. He does have the beard and he did spend the end of this year bringing gifts of large amounts of cash to the once beleaguered Wall Street banks, but after that the similarities stop. I’ve never seen him photographed in a red suit and I’m pretty sure he arrives to work in a car with no reindeer or a sleigh in sight.

Now the Fed through their QE2 program is going to continue to flood Wall Street with billions of dollars through the spring, but will the rally continue? That remains to be seen. Complacency among investors is at almost unprecedented levels. The extreme bullishness is pervasive. It’s as if investors believe that nothing could go wrong. However, it is at times like these that the majority almost always is mistaken and the market does the most damage to highest number of participants.

So where are the warning signs? Oh they are out there and it is in the form of rising interest rates. The bond vigilantes may cause Fed Chair Bernanke some headaches. Recall that the Fed is trying to buy bonds with the intent of keeping interest rates low. They want low interest rates to attempt to stimulate the housing market and to keep corporate lending rates down to motivate businesses to borrow and expand, in an effort to create jobs.

The Fed also wanted to stimulate the stock market to recreate a wealth effect for investors and retirement plans. The success the Fed is having so far with stocks is causing bond holders to rethink their strategy of avoiding stocks and holding safer Treasuries. Rising stock prices are starting to influence droves of investors to sell their bond positions, which are driving bond prices lower and conversely resulting in higher interest rates. How far and how fast rates go up remains to be seen, but printing more money to the tune of hundreds of billions of dollars historically would be considered inflationary. And inflation is bad for bonds as it also drives interest rates higher.

This new conundrum of higher interest rates with an economy struggling to stand its own is not good and will have to come to terms probably sooner rather than later. When? Perhaps next week or maybe money managers will do what they can to sustain the market one more week and wait until after the first of the year. One thing is clear Santa had his rally. The Wall Street gang is celebrating right now. While it is good to enjoy the season and the recent rally, there are some dark clouds on the horizon and to ignore them would be unwise.

Happy Holidays to all and best wishes for a healthy, happy, and prosperous new year.

According to Plan?

This week the NASDAQ Composite and the Small Cap Russell 2000 Index closed at levels not achieved since January 2008. The S&P 500 is flirting with prices that were held back in September of 2008. The stock market is responding according to the QE2 plan laid out by Fed Chair Ben Bernanke a couple of months ago.

However the bond market is responding inverse to the Bernanke plan as yields are rising across the board, driving bond prices lower. This week Treasuries experienced the second largest two day selloff in the last 50 years. Is this a sign that the bond vigilantes are out, disgusted that the national debt continues to escalate at a mind boggling pace? Or could it be that investors, who over the last year piled into bonds, are now open to taking on more risk in the stock market. This will remain a critical discussion going forward and will determine how well the Bernanke plan succeeds.

If interest rates rise at an orderly pace and the economy continues to show strength, the stock market could retest the all time highs over the next 12 to 18 months. However, if inflation starts to accelerate, it could spell trouble for both the stock and bond markets, as well as the economy. Already there are signs that higher mortgage rates are slowing the pace of the loan refinance market. Could the fledgling housing recovery fall into a double dip should mortgage rates continue to rise? The Fed is attempting to thread the needle when it comes to the inflation / deflation conundrum.

For the moment the markets are breaking out to new multi year highs. The Fed’s game plan to purchase bonds from the primary broker dealers to the tune of tens of billions of dollars per week seems to be producing the desired outcome where some of the proceeds are migrating over to the stock market. Corporate earnings, which had declined over 92% from its 2007 peak to the 2009 trough (which brought inflation-adjusted earnings to near Great Depression lows), have recovered significantly. S&P 500 earnings have surged up over 900% and are now above the levels attained at the peak of the dot-com era. In fact, earnings have only been higher than current levels for a two plus year period of time that occurred at the tail end of the credit bubble.

While earnings are above those achieved at the dot com peak, it must be noted that S&P prices are not. On December 31, 1998, the S&P closed the year out at 1,229. We were at those levels yesterday, some 12 years later. Does that mean that stocks are undervalued? Not by historical standards. The market is fairly valued today and was overvalued back in the late 1990’s.

Investor Intelligence readings display a high level of optimism: 56.2% Bulls with Bears at 21.3%. Bullish sentiment has not been this high since the end of 2007, while the bull/bear spread is approaching levels seen in April of this year just before the flash crash. Sentiment is a secondary indicator but it should not be ignored. The VIX also shows complacency among investors.

There are other outside factors that could have an effect on the market in a meaningful way in either direction. The markets have priced in the extension of the Bush tax cuts. A failure to get this done before the Congressional Holiday recess could be detrimental. Hot spots geopolitically like Korea can change the temperature on markets rather quickly. China may have inflation issues and at some point next year global debt problems will once again take center stage.

So far the Fed has managed the stock market according to plan. Participants are hopeful that this will continue. Most money managers are hoping for a Santa Claus rally or at the very least a sideways market through the end of the year to protect their bonuses. We are in the favorable season for stocks. The third year of a Presidents term has had an uncanny tendency to produce superior returns. Hopefully the stars stay aligned and the markets climb back to all time highs. Small cap stocks and the NASDAQ are the market leaders, with mid cap stocks not far behind.

* Pacific Financial Planners maintains positions in the following: ACAS, AINV, BG, DRYS, EEM, GLD, IWM, KOL, MDY, PCL, PDP, PIE, SGG, SWHC, XLF, WTNY