Thursday, October 30, 2008

U.S. Dollar


In September, employers took 2,269 mass layoff actions, seasonally
adjusted, as measured by new filings for unemployment insurance bene-
fits during the month, the Bureau of Labor Statistics of the U.S.
Department of Labor reported today. Each action involved at least 50
persons from a single employer; the number of workers involved totaled
235,681, on a seasonally adjusted basis. The number of mass layoff
events this September increased by 497 from the prior month, while the
number of associated initial claims rose by 61,726. Layoff events
reached their highest level since September 2001, a month that experi-
enced substantial layoff activity due to the September 11 attacks. Mass
layoff initial claims reached their highest level since September 2005,
which was a month with high layoff activity due to Hurricane Katrina.
The effects of Hurricanes Gustav and Ike contributed to the higher
September 2008 layoff activity. In September, 603 mass layoff events
were reported in the manufacturing sector, seasonally adjusted, result-
ing in 81,414 initial claims. Over the month, mass layoff events in
manufacturing increased by 4 and initial claims increased by 9,170.
(See table 1.)

From January through September 2008, the total number of events
(seasonally adjusted), at 14,811, and initial claims (seasonally
adjusted), at 1,510,446, were the highest for the January-September
period since 2003 and 2002, respectively.

The national unemployment rate was 6.1 percent in September, sea-
sonally adjusted, unchanged from the prior month and up from 4.7 per-
cent a year earlier. In September, total nonfarm payroll employment
decreased by 159,000 over the month and by 519,000 from a year earlier.

Table A. Industries with the largest number of mass layoff initial claims in
September 2008

This shows the number of unemployment claims in September for each industry and then it shows the worst September for the industry, the year it happened and the total number of claims in the worst year. Notice that most industries aren't even close to their worst month. The single exception is Professional Employer Organizations. In English this means Wall Street. It also means the rest of the economy hasn't been impacted by mass layoffs... yet.

The unemployment rate in the US is 6.1%. Look a little deeper into the data and you'll find that the unemployment rate in the financial services industry is only 4.2%. Financial services is also a smaller part of the over-all economy. One way to think about it is that for every one person who is unemployed on Wall Street there are twenty two 'real' unemployed people. 22:1 is another reason people are upset with Wall Street.

How much worse can unemployment get? Today American Express Co. announced it will cut 7,000 jobs, or nearly 10% of its work force, as part of a cost-cutting effort as the credit-card company girds for further weakening of economic conditions throughout the world. American Express will not be the only company to announce lay offs. In the coming weeks, this will be a repeated story as companies try to lean themselves out for potentially tough times ahead. As companies merge, the announced cuts in the workforce are usually ignored in the excitement of the new news, but mergers in the current economic environment will effect thousands of employees. How many workers will lose their jobs if General Motors and Chrysler strike a deal? The effects also trickle down the line to suppliers as the newly formed company will try to streamline costs and survive what will be tough times.

A story discussed almost half of Nevada homeowners with a mortgage owe more to the bank than their homes are worth. 50% is an amazing number! If you add in the homeowners like them in California, Arizona, Florida, Georgia and Michigan, together they account for nearly 60 percent of all homeowners who are "underwater" on their mortgages. The fact that these states account for so much is not surprising, because some of them experienced the greatest growth in the housing market the last 10 years. Nationwide, almost one out of every five homeowners with a mortgage owes more to their lender than their properties are worth. The new data underscore the staggering scope of the U.S. housing recession, but also the challenges that government officials face in designing a massive new program to help homeowners avoid foreclosure, with layoffs soaring and the economy sinking.

Nationally, home prices are already down about 20 percent from their peak in mid-2006. By the time the housing market hits bottom, prices may be down 40 percent from the top, leaving 40 percent of homeowners underwater, according to Nouriel Roubini, economics professor at New York University. "There is a huge incentive to walk away from your mortgage," said Roubini, who has attracted attention for his gloomy -- and accurate -- predictions of the U.S. financial market meltdown. He gave no forecast for when the real estate market would bottom out.

It is important to watch the news for the types of assistance the government is going to come up with in the coming weeks. Congress is not going to wait for the new administration in 2009, they are set to attempt to tackle the problem in the lame duck session now. There are two sides to the help that will be coming. How much will it help to stop the decline in housing prices, and what the cost will be. If it is a band-aide on the bullet hole, things will get worse. In this case not only will we take on additional debt in the newest stimulus, it might not be effective in attaining its desired result, putting a halt to the falling home prices.

As we take on more debt as a country, and if this debt becomes irresponsible or ineffective in attaining its desired result, it will be important to watch its effect on the U.S. Dollar. The chart below shows the U.S. Dollar Index in both a daily and weekly view.

U.S. Dollar Index Weekly (click to enlarge)

U.S. Dollar Index Daily (click to enlarge)

Commodities are important groups to follow when there are any significant moves in the U.S. Dollar. Below is a chart comparing the U.S.Dollar, in the top pane, to Light Sweet Crude and Metals in the bottom two panes. Each chart is market with the red 55 day exponential moving average.

U.S. Dollar vs. Oil & Metals (click to enlarge)

This chart clearly shows as the U.S.Dollar became a beneficiary of the flight to quality in uncertain times, the negative effect on commodities has been significant. Commodities are experiencing the double effect of the strong dollar and the view that demand is going to be less going forward. Supply and Demand aside, the fluctuations in the Dollar will provide significant opportunities in the commodity area. Jim Rogers has come up with and index that tracks commodities and it is further broken down into sub-sectors. RJI is the international commodity index, RJA tracks agriculture, RJN tracks energy, and RJZ tracks metals. While these tracking stocks are lower in price, they have significant percentage moves.

Another way to speculate and profit from the movement in the U.S.Dollar is by investing in either UUP Powershares U.S. Dollar bullish Fund, or in UDN Powershares U.S.Dollar Bearish Fund.

UUP Powershares U.S.Dollar Bullish Fund (click to enlarge)

UDN Powershares U.S.Dollar Bearish Fund (click to enlarge)

Monday, October 27, 2008

S&P 500 Index Range And PNF Charts

This first chart has support and resistance levels calculated from the opening range starting Jan.1,2008.

S&P 500 Index Opening Range (click to enlarge)

Currently the futures are at 828.10, down 4.3%. This will most likely lead to a break of the 865 level and set up a test of 805. Below are some Point and Figure charts. Looking at these charts it isn't until a rally above 970 that things might turn short term bullish.

S&P 500 Index PNF Daily (click to enlarge)

S&P 500 Index PNF Weekly (click to enlarge)

Great Source of information based on Point and Figure charting, Dorsey Wright & Associates link. They offer free online lessons on Point and Figure charting, a lost art. There are also free weekly podcasts that cover various market conditions and outlooks.

Friday, October 24, 2008

Has Cash Been King for the Past 10 Years?

If you're like most investors, you've been nearly brainwashed with conventional market "wisdom" that stocks are the best way to grow your portfolio.

You would be crazy not to have your money in the markets, right?

But when markets drop, as we've seen in this credit crisis, it's amazing how quickly the story changes.

Steve Hochberg and Pete Kendall, editors of Elliott Wave International's Financial Forecast, challenged the notion of stocks' superiority years before this latest downturn.

Learn how cash has been king – and will remain so – far longer than the latest news headlines may have you believe in this free excerpt from Elliott Wave International's Credit Crisis Survival Kit.

Elliott Wave International has also made the full Credit Crisis Survival Kit available free for a limited time. In addition to this excerpt, it contains 14 other articles, reports, and videos that reveal how to survive and prosper during the credit crisis. Visit EWI to download the kit, free.

Cash's Invisible Reign Made Visible
[excerpted from Elliott Wave Financial Forecast, August 2008]

With respect to cash and its status as the preeminent financial asset, however, we are starting to wonder if investors will ever come around to our point of view, which, as we explained in the March special section, is that there are times when "the phrase 'focus on the long term' means "get out and wait.'" As we also pointed out, the last eight years are clearly one of these times, as cash has outperformed all three major stock averages over this period. A July 3 USA Today article shows how this outlook is actually becoming more farsighted as the bear market intensifies:

3-month Treasuries Beat
S&P 500 for past 10 Years

The article says, "Investors who bought stocks for the long run are finding out just how long the long run can be." But the farther back in time cash's dominance stretches and the rockier the stock market gets, the farther investors seem to move from ever taking anything off the table. After stating that "there can be times, long times, when stocks won't beat T-bills," a professor and popular buy-and-hold advocate is cited as "optimistic that the next 10 years will be better than the past decade." In March EWFF stated, "Cash will continue to outperform until stocks are no longer fashionable." There is no sign that such a condition is even close to happening.

It's somewhat amazing that cash is not capturing anyone's fancy because a tremendous society-wide thirst for cash is spreading fast. "In a deflation," the Elliott Wave Financial Forecast has stated, "Rule No. 1 is to unload everything that isn't nailed down. Rule No. 2 is to sell whatever everything remaining is nailed to." The banking system is surely deflating, because, echoing Elliott Wave Financial Forecast's wording again, "Desperate American Banks Are Selling Everything That Isn't Nailed Down." SunTrust is selling its stock in Coca-Cola, an asset the bank held for 90 years. Merrill Lynch sold its founding stake in Bloomberg as well as various other subsidiaries.

Meanwhile, "Americans are selling prized possessions online and at flea markets at alarming rates." Pawnshops and auction sites are booming. At, the number of for-sale listings soared 70% in eight months. This fits with our review of Craigslist's prospects when it was getting started in 2005: "This is just the set-up phase. Once the global garage sale really gets rolling, truly astounding volumes of dirt-cheap goods will be available on-line and elsewhere." The global garage sale is on. The chart of the U.S. savings rate shows that the bull market in cash has come to life.

A 30-year downtrend in savings rates ended at minus 2.3% in August 2005. In May 2008, the savings rate skyrocketed to 5%. This jolt may be somewhat overstated due to the arrival of the government's stimulus checks, but the burst should be the start of a critical new mindset among consumers. When the government showered the economy with $600 checks, many did something they never would have thought of through most of the bull market: They put the money in the bank, which is exactly what the administration did not want. In fact, federal, state and local governments are desperate for the tax revenue that a little ripple-effect spending would have generated.

According to the National Conference of State Legislatures, states must close a $40 billion shortfall in the current fiscal year. "The problem today is that tax revenue is vanishing," says a story about the sudden appearance of the worst fiscal crisis in New York since 1975. Even cities like East Hampton, New York, where someone paid $103 million for an oceanfront house last year, are out of money. "Nobody understands how it happened," says one resident. The pages of this newsletter show otherwise. If we are right, a deflationary decline is depleting and destroying cash flows in novel new ways that no one alive has experienced before.

The previous analysis was excerpted from Elliott Wave International's Credit Crisis Survival Kit. The kit, featuring 15 free resources to help you survive and prosper during the credit crisis, is available free. Visit EWI to download the kit, free.

Thursday, October 23, 2008

Trading In A Tough Market

With the volatile moves in the market lately it isn't easy to get a gauge on where things are headed. Every day there is a parade of "experts" saying this is the new market bottom. It can make for some confusing times.

The idea of spread trading is something to consider in this crazy market. Suppose you decided it was time to own a coal stock. One way to do this is to buy the one you determine to be the healthiest strongest company, and then decide who is the weak stock in the group and short that one. This is just an example, but in the chart below compares two coal companies, Peabody Energy BTU and Massey Energy MEE. The bottom pane is the spread of these two stock, BTU divided by MEE. When the moving average is sloping upward, Peabody Energy BTU is outperforming Massey Energy MEE.

Peabody Energy BTU / Massey Energy MEE (click to enlarge)

In this example Peabody could have been purchased on September 5th for 51.43 and Massey Energy could have been short sold at 50.95. It is important to use equal dollar amounts on each side of the trade. These two companies are similar in price, but in most cases the prices are very different. The idea is to benefit from the percentage out-performance of what was determined to be the stronger company. The advantage to this system is that if you are wrong, and the market continues to experience strong selling, the short side of the trade will allow you profit or limit your loss and market exposure.

This is another example of a potential trade. It involves BNI-Burlington Northern Sante Fe and CSX-CSX Corp, both railroad companies.

Burlington Northern / CSX Corp. (click to enlarge)

BTU/MEE Spread current position +9.8%
BNI/CSX Spread current position +6.7%

The key concept to remember is to employ equal dollar amounts on each side of the trade. Options can also used instead of outright positions, but they can be more complicated.

Wednesday, October 22, 2008

S&P 500 Index Update

S&P 500 Index (click to enlarge)

A break of the 865.97 level could lead to the 805.39 area. A bounce off of the 865 level will most likely lead prices to the 987 area.

Credit Crisis Survival Kit

Download Your Free Credit Crisis Survival Kit

Before it became the worst credit crisis since the Great Depression, the credit crisis used to be an arcane topic discussed only in financial publications. Now, it's on every computer, television screen, and front page of every newspaper in the world.

It may have you worried about what you can do to get through it with your personal finances still intact. What can you do about it?

Download Your Free Credit Crisis Survival Kit

Elliott Wave International, the world’s largest market forecasting firm, put together this free resource featuring 15 hand-picked reports and videos that will show you:

1.How we got into this mess

2.How to survive and prosper from it

3.When you can expect the crisis to end

The detailed analysis covers topics worrying you and millions (if not billions) of other people around the world who are learning more and more about the dangers of the Credit Crisis every day.

Here are just 5 of the 15 topics covered:

*How Do I Find a Safe Bank?
*What Happens During a Credit Implosion?
*How Do I Ride Out this Crisis?
*What If You Can’t Sell Your House?
*Buy & Hold or Sell & Fold?

Read All 15 and Download Your Free Credit Crisis Survival Kit

Saturday, October 18, 2008

Gann Grid And Gann Angles

This is a chart of the S&P 500 going back to the early 1980's. Two of W.D. Gann's techniques are added to this chart. One is Gann Angles which look like trend lines. The other is a Gann Grid which looks like a criss-crossed checkerboard.

S&P 500 Index (click to enlarge)

Gann believed that the ideal balance between time and price exists when prices rise or fall at a 45 degree angle relative to the time axis. This is also called a 1 x 1 angle (i.e., prices rise one price unit for each time unit).

Gann Angles are drawn between a significant bottom and top (or vice versa) at various angles. Deemed the most important by Gann, the 1 x 1 trendline signifies a bull market if prices are above the trendline or a bear market if below. Gann felt that a 1 x 1 trendline provides major support during an up-trend and when the trendline is broken, it signifies a major reversal in the trend. Gann identified nine significant angles, with the 1 x 1 being the most important:
1 x 8 - 82.5 degrees
1 x 4 - 75 degrees
1 x 3 - 71.25 degrees
1 x 2 - 63.75 degrees
1 x 1 - 45 degrees
2 x 1 - 26.25 degrees
3 x 1 - 18.75 degrees
4 x 1 - 15 degrees
8 x 1 - 7.5 degrees

Note that in order for the rise/run values (e.g., 1 x 1, 1 x 8, etc) to match the actual angles (in degrees), the x- and y-axes must have equally spaced intervals. This means that one unit on the x-axis (i.e., hour, day, week, month, etc) must be the same distance as one unit on the y-axis. The easiest way to calibrate the chart is make sure that a 1 x 1 angle produces a 45 degree angle.

Gann observed that each of the angles can provide support and resistance depending on the trend. For example, during an up-trend the 1 x 1 angle tends to provide major support. A major reversal is signaled when prices fall below the 1 x 1 angled trendline. According to Gann, prices should then be expected to fall to the next trendline (i.e., the 2 x 1 angle). In other words, as one angle is penetrated, expect prices to move and consolidate at the next angle.

Gann developed several techniques for studying market action. These include Gann Angles, Gann Fans, Gann Grids and Cardinal Squares.

Friday, October 17, 2008

Stock Market Bottoms

Lately it seems like every other day there is a list of "experts" on television calling another market bottom. There is one pattern that seems to occur that is worth committing capital to. It gives a defined stop area and in more times that not, gives a great risk reward ratio. An example of this pattern is shown in the chart below of the S&P 500 Index from 1974.

S&P 500 Index 1974 (click to enlarge)

The pattern in 1974 shows the market making a strong move down. This is followed by a bounce re-tracement that is more than a few days. The time frame of this bounce usually has a relationship to the time frame of the sell off. If the sell off is over a few weeks, a bottom pattern is not going to be made in a day or two. It is going to take time to form. It is important to follow the price and volume after the bounce and the market trades down trying to make a new low. If the previous low is the bottom, the second move down will have less momentum and less volume, and usually fall short of making a new low, as in the end of 1974.

Another example can be seen in the chart below from 1990. The sell off is not as dramatic and the recovery matches the "personality" of the sell off.

S&P 500 Index 1990 (click to enlarge)

In 1998 the market had a dramatic sell off the resulted in a pattern that is different than the two above. In this example as the market traded back down to the previous low, it made a new intra-day low but the close of the day was higher that the previous low close. It is important to watch volume on this type of day. Once the price on this second new low recovers and passes above the previous low, buying and short covering will usually propel the market higher with strong short term momentum. When the hope of new buyers wanting to have the market go higher is joined with the realization by short sellers that the low is most likely in place, a strong up move can follow. It isn't always worth chasing this move if you miss it. Wait for a pull back.

S&P 500 Index 1998 (click to enlarge)

S&P 500 Index Now (click to enlarge)

Thursday, October 16, 2008

Chairman Bernanke Statement

Chairman Ben S. Bernanke
At the President’s Working Group Market Stability Initiative Announcement
October 14, 2008

Good morning. Before I begin, I want to express my appreciation of my colleagues, Secretary Paulson and Chairman Bair, for their efforts in what has been an extraordinary collaboration. As Americans well know, the challenges evident in the financial markets and in the economy are large and complex, but I believe that the steps taken today will help us to overcome them. Our strategy will continue to evolve and be refined as we adapt to new developments and the inevitable setbacks. But we will not stand down until we have achieved our goals of repairing and reforming our financial system and thereby restoring prosperity to our economy.

Over the past year, the Federal Reserve has actively used all its powers and authorities to try to help our economy through this difficult time. And central banks around the world have consulted closely and cooperated in unprecedented ways to reduce strains in financial markets and to bolster our economies. We will continue to do so. However, clearly the time had come for a more comprehensive and broad-based solution.

History teaches us that government engagement in times of severe financial crisis often arrives very late, usually at a point at which most financial institutions are insolvent or nearly so. Waiting too long to act has usually led to much greater direct costs of the intervention itself and, more importantly, magnified the painful effects of financial turmoil on households and businesses. That is not the situation we face today. Fortunately, the Congress and the Administration have acted at a time when the great majority of financial institutions, though stressed by highly volatile and difficult market conditions, remain capable of fulfilling their critical function of providing new credit for our economy. The Congress's prompt and decisive action in passing the financial rescue legislation made possible the critical steps that have been announced this morning. I also find it heartening that we are seeing not just a national, but a global response to the crisis, commensurate with its global nature. Indeed, this past weekend, the finance ministers and central bankers of the Group of Seven industrialized countries announced a set of principles embodying a comprehensive approach to dealing with the crisis. The steps we are taking today are fully consistent with those principles.

As in all past crises, at the root of the problem is a loss of confidence by investors and the public in the strength of key financial institutions and markets, which has had cascading and unwelcome effects on the availability of credit and the value of savings. The actions today are aimed at restoring confidence in our institutions and markets and repairing their capacity to meet the credit needs of American households and businesses. The voluntary equity purchase program will strengthen financial institutions' capacity and willingness to lend. The guarantee of the senior debt of all FDIC-insured depository institutions and their holding companies will restore the confidence of these institutions' creditors and reinvigorate the crucial inter-bank lending markets. Additionally, the Federal Reserve is pressing forward with its facility to provide a broad backstop for the commercial paper market, so vital to the functioning of our businesses.

Policymakers here and around the globe have taken a series of extraordinary steps. Americans can be confident that every resource is being brought to bear: historical understanding, technical expertise, economic analysis, and political leadership. I am not suggesting the way forward will be easy. But I strongly believe that the application of these tools, together with the underlying vitality and resilience of the American economy, will help to restore confidence to our financial system and place our economy back on a path to vigorous, healthy growth.

Tuesday, October 14, 2008

Dow Jones Industrial Average Rally Of 1939

Yesterday's rally required some digging to come up a comparable action for the Dow 30. The chart below is from 1939. The rally then was not a 1000 points, but on a percentage basis probably felt the same. On September 1, 1939 the market had a low of 127.50 with a close of 135.30. The next trading day, September 5, 1939, had a daily high of 150.10 and a close at 148.10. The percentage move from close to close was around 9.4%. The range from low on 9/1/39 to the high the next trading day was 22.6 points or 17.7%.

Dow Jones Industrial Average 1939(click to enlarge)

There are some significant differences in the rally in 1939 and what was experienced yesterday. Most importantly the rally in 1939 was not a "V" bottom. The low for the year was made earlier and this rally occurred after some attempts to test this low. The price action yesterday might have felt like a low, and can make last Friday feel like the low, but there will be a test. As Art Cashin says, it's the second mouse that gets the cheese. The buyers who bought attempting to buy the bottom on Friday, most likely had tried to do the same earlier the past few weeks. They might be right for the short term, but major commitments of capital will be made as we test the low from last Friday, if it proves to be a bottom. Picking bottoms is a messy way to make a living!

This chart below is a larger view of prices in the late 1930's, followed by a current chart.

Dow Jones Industrial Average 1930's(click to enlarge)

This next chart shows prices in May of 1940. As fun as the upward moves feel, the down moves impart more emotion and feelings that last. The fear of the next down move will return.

Dow Jones Industrial Average 1940(click to enlarge)

Dow Jones Industrial Average Current(click to enlarge)

Dow Jones Industrial Average Weekly (click to enlarge)

Monday, October 13, 2008

George Soros Bill Moyers Interview

October 10, 2008

Video Available Here

BILL MOYERS:Welcome to the Journal.

You are not alone if you are worried about the financial melt down. So is my guest George Soros, one of the world's best known and successful investors, making billions in times of boom or bust. He's been warning for years of a financial melt down fueled by easy credit and sleepy regulation. Now he's out with this timely book, "The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means."

In the interest of full disclosure, you should know that I served three years on the board of George Soros' foundation, the Open Society Institute, dealing with such issues as a free press, the rule of law, and human rights. But I've had no involvement in his political activities and nothing to do, with his business interests unfortunately. It's good to see you.


BILL MOYERS:Let's imagine for a moment that we're not in a New York studio but we are in Neely's Barbecue Stand in Marshall, Texas, my hometown, and we're surrounded by people I know, people who have lost half of their 401(k)s in the last three or four weeks, and what they want to know is does this financial meltdown represent the end of the American dream as they have known it.

GEORGE SOROS:No. No. I think it's got nothing to do with the American dream as such. There has been some kind of an ideological excess; namely, market fundamentalism for the last 25 or so years. And now that world is collapsing...

BILL MOYERS:What do you mean "market fundamentalism"?

GEORGE SOROS:It's that markets will correct themselves, that you should leave it to the markets, and there is no need for government intervention in financial affairs. Letting markets run rampant. And that doesn't work.

Markets have the ability to adjust and they're very flexible. There is this invisible hand. But it is also prone to be mistaken. In other words, markets instead are reflecting reality. They always look at reality with a bias. There is always a prevailing bias. I'll call it, you know, optimism/pessimism.

And sometimes those moods actually can reinforce themselves so that there are these initially self-reinforcing but eventually unsustainable and self-defeating boom/bust sequences or bubbles. And this is what has happened now.

This current economic disaster is self-generated. It was generated by the market itself, by getting too cocky, using leverage too much, too much credit. And it got excessive.

BILL MOYERS:You used the word "disaster."

GEORGE SOROS:The financial system is teetering on the edge of disaster. Hopefully, it will not go over the brink because it very rarely does. It only did in the 1930s. Since then, whenever you had a financial crisis, you were able to resolve it. This is the most serious one since the 1930s, there hasn't been one as serious as this.

Unfortunately, the authorities are behind the curve. They are reacting to these crises as they emerge. One thing leads to another, one market after another gets into difficulty. And they react to it. And they don't quite understand what's hitting them. So they are not anticipating and not gaining control of the situation.

BILL MOYERS:This is what's interesting, why wouldn't the government be able to look at what you looked at and see what's coming?

GEORGE SOROS:Because actually they have been working on false premises. This sounds very strange, but there's been this development of, this belief of market fundamentalism. And particularly the idea that markets always revert to the mean and deviations from the mean occur in a random fashion. And you can calculate it.

And you will get a nice distribution and you can anticipate it. And based on that, you can manage your risk. And that actually was based on a false idea. This namely, the markets self-correcting because the market moods have a way of affecting the fundamentals the markets are supposed to reflect.

And there's always a divergence between our perception and what actually exists. For instance, take the simplest situation, namely housing.

Banks give you credit based on the value of the houses. But they don't seem to somehow understand that the value of the houses can be affected by the amount of credit they are willing to give. Now, we've developed these fabulous new ways of securitizing mortgages, which has made credit much more amply available.

And we've been able to calculate risk. And, therefore, we were willing to give more and more credit. And that has pushed up the value of the houses. Also, of course Greenspan kept interest rates too low, too long. And so you had very low interest rates, easy credit, and house prices have been appreciating at more than ten percent a year for a number of years. And the willingness to lend actually increased. There was an insatiable appetite for these new fangled securities.

BILL MOYERS:Yeah. Nobody understood, really.

GEORGE SOROS:Which they didn't properly understand. And there was always a separation between the people who generated the mortgages and packaged them and sold them to you and the people who owned them. So nobody was paying attention to the quality of the mortgages because they didn't have an interest. They — all day collecting fees. And then there were other people holding the mortgages.


GEORGE SOROS:And that was not factored into those instruments. The idea was that by distributing risk, you actually reduce risk. But by separating the principal from the agent, you actually greatly increase the risk. And that was not reflected. And the rating agencies didn't realize it. So they gave triple-A ratings. And then a few weeks later, those triple-A bonds became practically valueless. And that's what has happened.

BILL MOYERS:But how does the system become deranged like that? So separated from reality like an individual who goes insane because he or she is separated.

GEORGE SOROS:Well sometimes we get carried away. I mean, you know, let's say in the Middle Ages, people were religious. And so they had tremendous discussions about how many angels can dance on the eye of a needle. Now, if you believe that angels can dance then that's a legitimate question. And this is exactly what has happened here. You thought that you could slice and dice and engage in this kind of financial engineering. And it became very, very sophisticated and got carried away.

BILL MOYERS:What happened that we lost control?

GEORGE SOROS:There was a failure of regulations because they couldn't understand these new instruments. But they said, "Oh, well, the banks have very good risk management techniques. So we leave it to them to calculate their own risks."

And, you see, it wasn't only in the housing market. There were all kinds of other financial instruments. So there was not just one bubble. I describe in my book there is the housing bubble. But this housing bubble, when that burst, it was only the detonator that exploded the bigger bubble, the super bubble.

Which is this 25 years of constant credit expansion using greater and greater leverage. The amount of credit in the economy has been growing at, I don't know, I don't know the exact figure, but maybe at least twice as fast as the economy itself. I think it's more like three.

And now, suddenly, you have a contraction of credit. And it's a sudden thing. And it's a period of great wealth destruction. And that's how these poor people in Texas suddenly find that their 401(k) is worthless.

BILL MOYERS:So as we talk, Secretary Paulson and the government seem to be coming around to what you've been advocating and that is taking taxpayer money, public capital, and injecting it directly into the banks — in effect, nationalizing some of these banks. Why do you think that will work when everything else has failed?

GEORGE SOROS:Well unfortunately because they are delaying it, it may not work so well because there's a certain dynamism. And they're always behind the curve. So there are many things that they're doing now if they had done several months ago, it would have turned things around.

BILL MOYERS:That's a very gloomy assessment. You're saying that everything they're doing is coming too late? How does that ultimately play out?

GEORGE SOROS:Unfortunately, that is the case. I'm quite distressed about it. I hope that you know, eventually they'll catch up.

We are determined to put the money in, not to allow the financial system to collapse. And that's the lesson we learned in the 1930s. It's an important lesson. But because we are behind the curve, the amounts get bigger and bigger. If we understood it earlier, we could have brought it to a halt perhaps sooner. But they've got still a number of things to do. And this idea, you see, of just buying noxious instruments of you know, off the balance sheet of the banks was a non-starter.

BILL MOYERS:But that was the idea.

GEORGE SOROS:But it was the wrong idea.

BILL MOYERS:But this is disturbing, George. If everything we're doing keeps accelerating the downward negative feedback and isn't working, are you suggesting, can one insinuate from what you say that we're heading for 1930?

GEORGE SOROS:Hopefully not. But we are heading for undoubtedly very difficult times. This is the end of an era. And this is a fact.

BILL MOYERS:End of an era?

GEORGE SOROS:At the end of an era.

BILL MOYERS:Capitalism as we have known it?

GEORGE SOROS:No. No, no, no. Hopefully, capitalism will survive. But the sort of period where America could actually, for instance, run ever increasing current account deficits. We could consume, at the end, six and a half percent more than we are producing. That has come to an end.

BILL MOYERS:So what do we do now?

GEORGE SOROS:We are probably at the height of the financial crisis. I think it can't get much worse. I think it could get a bit worse yet. But then you have the fallout in the real economy.

BILL MOYERS:We're in a downward spiral.

GEORGE SOROS:We are in a downward spiral.

BILL MOYERS:How long will it go on?

GEORGE SOROS:Look the one thing that my theory says is that you can't predict the future because the future depends on how you react to it. So if we do the right things then things will not — will be less painful. If you do the wrong things, they'll be more painful. Now, so far we've been doing the wrong things. I very much hope that we'll have a different government in a few months and they'll be doing the right things.

BILL MOYERS:Well, don't be shy. What do you think the new government should do?

GEORGE SOROS:Well, first of all you have to prevent housing crisis from overshooting on the downside the way they overshot on the upside. You can't arrest the decline, but you can definitely slow it down by minimizing the number of foreclosures and readjusting the mortgages to reflect the ability of people to pay. So you have to renegotiate mortgages rather than foreclose.

And you provide the government guarantee. But the loss has to be taken by those who hold the mortgages, not by the taxpayer.

BILL MOYERS:You mean the homeowner doesn't take the loss. The lender.

GEORGE SOROS:The homeowner needs to get relief so that he pays less because he can't afford to pay. And the value of the mortgage should not exceed the value of the house. Right now you already have 10 million homes where you have negative equity. And before you are over, it will be more than 20 million.

BILL MOYERS:But, you're talking about taking action three months from now, whether it's a McCain administration or an Obama administration. What happens in these next three months? And I'm serious about that.

GEORGE SOROS:I am very worried about it. And I hope that they will have a new secretary of treasury, somebody else.

BILL MOYERS:Sooner than later?


BILL MOYERS:You don't think...

GEORGE SOROS:It would be very helpful if...

BILL MOYERS:You don't think Paulson's up to it?

GEORGE SOROS:Unfortunately, I have a negative view of his performance.


GEORGE SOROS:Because he represents the very kind of financial engineering that has gotten us into the trouble. And this buying off the noxious things was a...

BILL MOYERS:Buying the bad assets, that was his...


BILL MOYERS:First idea.

GEORGE SOROS:Yeah, and before that, he wanted to create a super SIV, special investment vehicle, to take care of the other special investment vehicles. That didn't fly. And they are now within a week recognizing that they have to change and inject money into the banks to make up for the whole in the equity because those banks lost money. And they can't make it up by taking their assets off their hands. You have to recognize the losses and replenish the equity.

BILL MOYERS:Is that what you would do with the bailout money now? Right now?

GEORGE SOROS:Yes, yes, yeah.

BILL MOYERS:You would put it where?

GEORGE SOROS:Into the capital of the bank so that the capital equity can sustain at least 12 times the amount of lending. So that's an obvious thing. And every economist agrees with this.

You see, what is needed now the bank examiners know how those banks stand. And they can say how much capital they need. And they could then raise that capital from the private market. Or they could turn to this new organization and get the money from there. That would dilute the shareholders. It would hurt the shareholders.

BILL MOYERS:Of the bank?

GEORGE SOROS:Of the banks. Which I think Paulson wanted to avoid. He didn't want to go there. But it has to be done. But then, the shareholders could be offered the right to provide the new capital. If they provide the new capital then there's no dilution. And the rights could be traded. So if they don't have the money, other people could, the private sector could put in the money. And if the private sector is not willing to do it then the government does it.

BILL MOYERS:The assumption of everything you say is that the government is going to be a big player now in the economy and in the financial markets. But what assurance do we have that the government will do a better job?

GEORGE SOROS:We don't. Right now they are doing a bad job. So you want to use the government as little as possible. The government should play a smaller role. In that sense, people who believe in markets, I believe in markets. I just want them to function properly. To the extent you can use the market, you should use the market.

Governments are also human. They're also bound to be wrong. Moreover, they are bureaucratic. So they are slow and they are subject to political influence. So you want to use them as little as possible. But to not to use them, see, assumes that markets are perfect. And that is a false belief.

BILL MOYERS:Has the whole global system become so complex with such gargantuan forces interlocked with each other, driving it forward, that it doesn't know how to obey Adam Smith's natural laws?

GEORGE SOROS:No, I think our ability to govern ourselves doesn't keep pace with our ability to exercise power over nature, control over nature. So we are very complicated civilization. And we could actually destroy our civilization because of our inability to govern ourselves.

BILL MOYERS:Would this all be happening if we still had a strong sense of the social compact? I mean, our social safety net has been greatly reduced. The people have a real sense that the gods of capital have left little space for anyone else. People at the top don't have much empathy for people at the bottom.

GEORGE SOROS:There is a common interest. And this belief that everybody pursuing his self-interests will maximize the common interests or will take care of the common interests is a false idea. It's a suitable idea for those who are rich, who are successful, who are powerful. It suits them to justify you know, enjoying the fruits without paying taxes. The idea of paying taxes is an absolute no-no, right?

BILL MOYERS:Unpatriotic.

GEORGE SOROS:Unpatriotic. So, yes, you must have, in my opinion, you need, for instance, a tax on carbon emissions. But that is unacceptable politically. So we are going to have cap and trade. And the trading will have all kinds of loopholes and misuse of the regulations and all kinds of ways of making money without actually dealing with the problem that it's designed to cure. So that's how the political process distorts things.

BILL MOYERS:So let's think about those people down at Neely's Barbecue going home tonight having heard you. What they've heard you say is the system is really disfunctioning right now. It's out of control. Nobody's in charge. They've heard you express your own worry that in the next three months it could get much, much worse.

And they've heard you say that you don't see much good news immediately on the horizon. So let's leave them something to think about as they go home. Let them go home and say, "Mr. Soros said here are three things we can do, simply." One?

GEORGE SOROS:Well, deal with the mortgage problem. Reduce foreclosures. Recapitalize the banks. And then work on a better world order where we work together to resolve problems that confront humanity like global warming. And I think that dealing with global warming will require a lot of investment.

You see, for the last 25 years the world economy, the motor of the world economy that has been driving it was consumption by the American consumer who has been spending more than he has been saving, all right? Than he's been producing. So that motor is now switched off. It's finished. It's run out of — can't continue. You need a new motor. And we have a big problem. Global warming. It requires big investment. And that could be the motor of the world economy in the years to come.

BILL MOYERS:Putting more money in, building infrastructure, converting to green technology.

GEORGE SOROS:Instead of consuming, building an electricity grid, saving on energy, rewiring the houses, adjusting your lifestyle where energy has got to cost more until it you introduce those new things. So it will be painful. But at least we will survive and not cook.

BILL MOYERS:You're talking about this being the end of an era and needing to create a whole new paradigm for the economic model of the country, of the world, right?


BILL MOYERS:One of the British newspapers this morning had a headline, "Welcome to Socialism." It's not going that way, is it?

GEORGE SOROS:Well, you know, it's very interesting. Actually, these market fundamentalists are making the same mistake as Marx did. You see, socialism would have worked very well if the rulers had the interests of the people really at heart. But they were pursuing their self-interests. Now, in the housing market, the people who originated the houses earned the fee.

And the people who then owned the mortgages their interests were not actually looked after by the agents that were selling them the mortgages. So you have a, what is called an agent principle problem in socialism. And you have the same agent principle problem in this free market fundamentalism.

BILL MOYERS:The agent is concerned only with his own interests.

GEORGE SOROS:That's right.

BILL MOYERS:Not with...

GEORGE SOROS:That's right.

BILL MOYERS:The interest of...

GEORGE SOROS:Of the people who they're supposed to represent.

BILL MOYERS:But in both socialism and capitalism, you get the rhetoric of empathy for people.

GEORGE SOROS:And it's a false ideology. Both Marxism and market fundamentalism are false ideologies.

BILL MOYERS:Is there an ideology that...

GEORGE SOROS:Is not false?


GEORGE SOROS:I think the only one is the one that I'm proposing; namely, the recognition that all our ideas, all our human constructs have a flaw in it. And perfection is not attainable. And we must engage in critical thinking and correct our mistakes.

BILL MOYERS:And that's one...

GEORGE SOROS:That's my ideology. As a child, I experienced Fascism, the Nazi occupation and then Communism, two false ideologies. And I learned that both of those ideologies are false. And now I was shocked when I found that even in a democracy people can be misled to the extent that we've been misled in the last few years.

BILL MOYERS:The book is "The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means". George Soros, thank you for being with me.


Thursday, October 9, 2008

The Primary Precondition of Deflation

By Robert Prechter, CMT
Elliott Wave International

The following was adapted from Bob Prechter’s 2002 New York Times and Amazon best seller, Conquer the Crash – You Can Survive and Prosper in a Deflationary Depression.

Deflation requires a precondition: a major societal buildup in the extension of credit (and its flip side, the assumption of debt). Austrian economists Ludwig von Mises and Friedrich Hayek warned of the consequences of credit expansion, as have a handful of other economists, who today are mostly ignored. Bank credit and Elliott wave expert Hamilton Bolton, in a 1957 letter, summarized his observations this way:

In reading a history of major depressions in the U.S. from 1830 on, I was impressed with the following:

(a) All were set off by a deflation of excess credit. This was the one factor in common.
(b) Sometimes the excess-of-credit situation seemed to last years before the bubble broke.
(c) Some outside event, such as a major failure, brought the thing to a head, but the signs were visible many months, and in some cases years, in advance.
(d) None was ever quite like the last, so that the public was always fooled thereby.
(e) Some panics occurred under great government surpluses of revenue (1837, for instance) and some under great government deficits.
(f) Credit is credit, whether non-self-liquidating or self-liquidating.
(g) Deflation of non-self-liquidating credit usually produces the greater slumps.

Self-liquidating credit is a loan that is paid back, with interest, in a moderately short time from production. Production facilitated by the loan – for business start-up or expansion, for example – generates the financial return that makes repayment possible. The full transaction adds value to the economy.

Non-self-liquidating credit is a loan that is not tied to production and tends to stay in the system. When financial institutions lend for consumer purchases such as cars, boats or homes, or for speculations such as the purchase of stock certificates, no production effort is tied to the loan. Interest payments on such loans stress some other source of income. Contrary to nearly ubiquitous belief, such lending is almost always counter-productive; it adds costs to the economy, not value. If someone needs a cheap car to get to work, then a loan to buy it adds value to the economy; if someone wants a new SUV to consume, then a loan to buy it does not add value to the economy. Advocates claim that such loans "stimulate production," but they ignore the cost of the required debt service, which burdens production. They also ignore the subtle deterioration in the quality of spending choices due to the shift of buying power from people who have demonstrated a superior ability to invest or produce (creditors) to those who have demonstrated primarily a superior ability to consume (debtors).

Near the end of a major expansion, few creditors expect default, which is why they lend freely to weak borrowers. Few borrowers expect their fortunes to change, which is why they borrow freely. Deflation involves a substantial amount of involuntary debt liquidation because almost no one expects deflation before it starts.

For more on deflation, including the following topics, see Elliott Wave International’s free guide to deflation, inflation, money, credit and debt. There, you can also download two free chapters from Conquer the Crash.

Learn more about these six important topics:

1. What is Deflation and When Does it Occur?
2. Price Effects of Inflation and Deflation
3. The Primary Precondition of Deflation
4. What Triggers the Change to Deflation?
5. Why Deflationary Crashes and Depressions Go Together
6. Financial Values Can Disappear in Deflation

Robert Prechter, Certified Market Technician, is the founder and CEO of Elliott Wave International, author of Wall Street best sellers Conquer the Crash and Elliott Wave Principle and editor of The Elliott Wave Theorist monthly market letter since 1979.

Is Steel A Steal?

ArcelorMittal reaffirms third-quarter guidance
Steel giant expects second-half profit to improve from first half of the year

Story link here.

Arcelor Mittal MT (click to enlarge)

Some others that might be worth keeping on the radar are U.S.Steel, Nucor,and Steel Dynamics. Below are some of their charts. One way to limit potential losses if the market does take another nose dive, is to use the option market. It can give you time and limit your loses. Options on the Basic Materials ETF XLB is also an idea that could work.

X-U.S. Steel (click to enlarge)

STLD - Steel Dynamics (click to enlarge)

NUE - Nucor (click to enlarge)

Sunday, October 5, 2008

U.S. Bear Markets

Below are a series of charts covering various bear markets over the past 100 years. While some of them might seem minor on a chart, they all on a percentage basis caused pain and fear in the stock market as well as the economy. The indicators on these charts are a 55 period moving average and an 89 period linear regression(green line) with lines showing 2(blue) and 3(read) standard deviations from this regression.

The chart below covers the period from 1917 through 1945. The roaring 20's are clearly visible and so is the painful fall that started in 1929 and didn't end until 1932. A second bear market occurred again in 1937. This one was less drastic, but a recovery was slow in coming.

Dow Jones Industrial Average 1917-1945 Monthly Chart (click to enlarge)

The next chart below shows the period from 1929 through 1954. The 1946 post world war II bear market is visible. It is not as extreme as the earlier two,but it still took 4 years for it to recover. Once this recovering was finished, a new bull moved started, and things were good again.

Dow Jones Industrial Average 1929-1954 Monthly Chart (click to enlarge)

The chart below covers the time frame from 1943 through 1970. The bear markets are marked in red circles. The 1957 bear market that was basically lead by a commodity bear market. This was followed by bear markets in 1962 and 1969.

Dow Jones Industrial Average 1943-1970 Monthly Chart(click to enlarge)

The following chart shows the market between 1959 through 1986. The 1969 bear market is shown, along with the 1973 bear market spurred by the energy crisis. Once the market broke out of the range it was in for the 1970's, a strong bull market took prices on a great move. In 1986 things looked extended when prices reached the 1729 area, as prices seemed to stall outside the 3 standard deviation area.

Dow Jones Industrial Average 1959-1986 Monthly Chart(click to enlarge)

This next chart shows that prices paused around the 1729 area, only to make another extended run to above 2500. Careers were made in calling this overbought condition. Some of the people who called this top are still seen on tv today every time the market is in a strong down move.

Dow Jones Industrial Average 1970-1987 Monthly Chart(click to enlarge)

The down move from above this 2500 area in 1987 was very quick compared to other bear moves. The move downward move stalled right at the 1 standard deviation below the linear regression.

Dow Jones Industrial Average 1987 Monthly Chart(click to enlarge)

This next chart shows the long sometime slow, sometimes fast, move from 1987 until the year 2000. While this was basically an orderly move without, it was also an unprecedented long period of time without a corrective move down. This as we know came to and end.

Dow Jones Industrial Average 1987-2000 Monthly Chart(click to enlarge)

This chart shows the corrective move back to the linear regression and then to area below 3 standard deviations. This is a big move down, and as some remember it sure felt that way.

Dow Jones Industrial Average 2000-2003 Monthly Chart(click to enlarge)

The last and final chart shows things where we are today. Prices are below 3 standard deviations. Does that mean it is a time to buy? It doesn't mean that. It means that prices have reached an extreme, and that the trend is setting up to change. Any rally will be met with resistance as prices go higher, until we establish a higher low and general feeling of uncertainty and fear subside. There are times to be a hero, this is not one of them...yet.

Dow Jones Industrial Average 2008 Monthly Chart(click to enlarge)

Bill Gross Dow 7000 or 5000

Bill Gross Investment Outlook September 2002

Okay, so what's a bond guy doing talking about the stock market again? Shouldn't he stick to his "knitting?" Isn't he really just an equity transvestite in disguise? A frustrated stock wannabe who couldn't get a job in the early 1970s and took the best thing he could find - A Bond Manager? Yeah, well maybe, but then again maybe you owners and managers of stocks could benefit from a different perspective. We already "know" bonds are going to yield/return 5% or so over the next umptyump years. How about asking the same question for stocks? Afraid of the answer?

My message is as follows: stocks stink and will continue to do so until they're priced appropriately, probably somewhere around Dow 5,000, S&P 650, or NASDAQ God knows where. Now I guess I'm on somewhat of a rant here but come on people get a hold of yourselves. Earnings have been phonied up for years and the market still sells at high multiples of phony earnings. Dividends and dividend increases have been miserly to say the least for several decades now and you've been hoodwinked into believing the CORPORATION should hold on to them for you so that they can convert them into capital gains and save you taxes. Companies have been diluting your equity via stock options claiming that management needs incentives of millions of dollars just to get up in the morning and come in to work. Then they pick you off by trading on insider information, selling shares before the bad news hits and you have a chance to get out. If you try to get a hot IPO you find all the shares are taken - by Bernie Ebbers. Come on stockholders of America, are you naïve, stupid, masochistic, or better yet, in this for the "long run?" Ah, that's it, you own stocks for the "long run." We bond managers may have had a few good relative years but who can deny Stocks for the Long Run? Not Jeremy Siegel, not Peter Lynch, maybe not even Bill Gross if you stretch the time period long enough - 20, 30, 40 years. But short of that, stocks can be, and often have been poor investments. The return on them depends significantly on their beginning valuation and right now valuation remains poor. Dow 5,000 is more reasonable. Let's see why.

To present my case I resort to a panel of expert witnesses, academicians and financial theorists with a lot more brainpower than I have. Over the past several years, in contrast to the more bullish and optimistic Jeremy Siegel, or Jim Glassman of Dow 36,000 fame, there have been several more realistic and down to earth experts that speak to low, not high, equity returns over the foreseeable future. Their primary thesis is not that the U.S. economy is headed for a depression or that the economic sky is falling but that even under near normal economic growth rates, the U.S. stock market is priced at current levels to return less than has been historically "required." Grow those earnings they say (although let's be sure what they are) at near historic rates and you'll still need much lower prices in order to offer stock investors a chance at returns that exceed corporate bonds or even inflation protected Treasuries - TIPS. Many of you readers may be familiar with Peter Bernstein via his books on risk or even gold, but recently he teamed up with common sense and actuarial wizard Rob Arnott to produce a brilliant piece of research entitled What Risk Premium is Normal? In addition, the trio of Elroy Dimson, Paul Marsh, and Mike Staunton have written a book that may have equaled or perhaps surpassed Siegel's, as well as Ibbotson and Sinquefields' study of world wealth, with their Triumph of the Optimists, a 101-year survey of investment returns. I shall refer to both sets of authors frequently over the next few pages.

Let me say first of all that it is difficult to keep this simple. I've read, reread and near-memorized both of these research gems. Their contents seem simple to me now but they were not at the beginning, so I must assume the same for most of you. Besides, you have minutes not months to get my drift, and if I am to help you I must inform you quickly and yet simply, even leaving some critical think pieces out, in order to do so. Forward. The crux of the valuation argument is this: Stocks historically return more than almost all other alternative investments but only when priced right when the race begins. If you start from day one with P/E's too high or importantly, dividends too low, you will not obtain equity returns in excess of bonds. Seems simple enough. People know that if they pay twice the market price for their house, that it will take years and years to get their money or their equity out. Somehow though when it comes to stocks they forget.

Maybe they forget because it's hard to know at any point what a stock or a stock market should be worth. Here's some help. Jeremy Siegel, "DMS" (author's Dimson, Marsh and Staunton), as well as "B&A" (Bernstein and Arnott) all pretty much agree that over the past 100 years U.S. stocks have provided a real return (after inflation) of about 6.7%. While that return has been higher than for most other countries shown in the "DMS" chart below, in none of the countries did stocks fail to outperform bonds over the past century and that includes several stock markets, which virtually disappeared during WWI and WWII. The average real return for the 16 countries shown was 5.1%. Remember that these returns are ex-inflation, so that arguments for higher nominal returns in inflationary periods and lower nominal returns during times of low inflation are neutralized.

Using the commonsensical approach that "100 years of the past" is "100 years of prologue" an investor might reasonably expect to have future real returns come close to 6.7% in the U.S. and 5.1% globally. Remember though, to get those same returns with similar economic growth you have to start at the same valuation point as an investor did in 1900. Maybe the market was super cheap then and very expensive now. Makes a difference, and as you're about to find out, that was exactly the case. Although 1900's stock market would provide 6.7% real over the next century, turns out it was because of some reasons that you probably wouldn't think of right off the top of your noggin. Most investors would say it was because earnings grew that much, so stock prices just naturally followed like a little puppy dog at the heels of its master. Wrong. The two primary components of this 6.7% real return were 1) a beginning dividend yield of 4.2% and 2) rising valuation (P/E's going up). Real earnings growth, or its twin, real dividend growth, comes in a poor third. Over those same 100 years, real dividends managed to grow at only .6% as seen in the "DMS" chart below.

Ninety percent of the market's real return then came from factors other than earnings growth. Most of it came from the initial dividend yield.

And so dear reader, in an attempt to keep this simple and help you to plough through what can get most complicated, the primary element in determining how a stock market is priced - whether it's cheap or expensive - is its yield. At 4.2% in 1900, the market needed an additional 2.0% annual push from a tripling of P/E ratios over the century to get near that 6.7% real return. Earnings growth was a pathetically small factor. How could that be? As Peter Lynch said in a recent CNBC interview when asked about the future of the stock market, "Well, since WWII corporate profits have grown about 8 or 9 percent a year…I don't see why that won't be different the next 50 years," implying that stock prices would do the same or more. The problem is, as Peter Bernstein points out in an August 2002 research piece entitled The Trouble With Earnings, at least 50% of the earnings growth over the past 40 years has been earnings of the "mystical" kind - pro forma, operating, phonied up. Those "earnings" didn't flow through to dividends. In addition a goodly portion of Lynch's 8-9 percent - and the faster portion it turns out - has come from newly created companies that are not even listed and available for purchase by outside investors. The balance after subtracting 4 percent inflation… has been near the .6% real growth of the past 100 years or the .8% of the past 50 years. You are being hoodwinked America. You pays your money and you gets…you gets…a dividend yield and a little bit of dividend growth: .6% real over the last 100 years.

Where does that leave us (you - not me - I'm out of the market) today? Well, most large market indices (NYSE, Wilshire 5000) yield somewhere in the area of 1.7%. Whoa now, did I say 1.7%? Yes siree. And despite the claims for higher implied yields due to stock buybacks (mostly fallacious) even if we grant an "implied" yield of 2.0% to the market, it's hard to see how we can get to our 6.7% real return target. Say real dividends grow at 2.0% for the next 100 years instead of .6%. Not sure why that would be but let's just say that to be more than fair. If so, then a 2% implied dividend yield, plus 2% real dividend growth, only equals 4% - far short of our hoped for or perhaps required 6.7% of the past 100 years. How to get there? Well, absent faster economic growth which would lead to even higher dividend growth than I've already generously granted, the only way to make that happen is to start with a yield of 4.7% and the only way to do that would be to cut the market averages in half or more. Dow 4,000 would do it as would S&P 400.

Now to be fair and truthful to B&A and DMS, both assert that the 6.7% real return over the past 100 years should never have been the "expected" return anyway. After all, 2.0% of that 6.7% came from a tripling of P/E ratios which is really not rational to expect again over the next century. A rather unscientific adjustment, which neither DMS nor B&A employ, would be to use the 100-year real return from equities without the tripling effect, or 4.7%. If so, with 2% real dividend growth, stock markets need to yield 2.7% and would fall by 20% in order to get there. At Dow 7,000 or so we would be fairly priced.

B&A and DMS approach it a little differently though, using an historical "equity risk premium" to get to an appropriate starting point valuation. This equity risk premium is really the excess return that investors require over and above real Treasury yields (best measured by TIPS yielding nearly 3.0%) to compensate them for the increased volatility and increased risk of owning stocks. Both B&A and DMS calculate that risk premium should be roughly 2.4% when measured against 30-year TIPS. Let me though, introduce my final chart that you can play with yourself. This chart's horizontal axis tracks the equity risk premium that you, the investor, would be satisfied with. Ask yourself this: How much more real return over and above 30-year Government guaranteed TIPS do you need to compensate you for owning stocks? If you say nothing, then the sky's the limit - Glassman theorized just this when writing Dow 36,000. If however, you have some common sense and know that even over the long term there's a decent chance of something going haywire - war, depressions, deflation, etc. - then you'll need something more than the government guaranteed TIPS rate of 3.0% to buy stocks. B&A and DMS say it has been and should be an extra 2.4% in which case the DOW is worth 5,000 on this chart. But put in your own number and see what value you get.

If you've got even half of your marbles left, I'll bet you your number is nowhere near today's level of 8,500. That means that in order to get a real return sufficiently higher than 3.0% to meet your "risk premium" requirements the market has to go down before it can go up again. And when it starts to go up again, it's only going to produce inflation adjusted, real returns of 5% over the long run if it mimics what the market has returned over the past 100 years (absent a tripling of P/E ratios). Until then, stocks are losers and anyone who owns too many of them will be losers too. As Warren Buffett has said, in the short run the stock market is a voting machine but in the long run it's a weighing machine. Despite being down nearly 50% from its highs, this market remains overweight. Forget about "Stocks for the Long Run" until they slim down to the point from which even yours truly can admit that they will outperform the bond market. And if some of this is confusing, just remember this: the market needs to yield close to 3.5% before it approaches fair value, and that means DOW 5,000. While stocks are the best bet over the very long term, they will not be, nor will they beat bond returns until they begin the race from a fair valuation. Since in the short-term the stock market is a voting machine/popularity contest, it's impossible to say exactly when, if ever, this fair valuation mark of approximately Dow 5,000 will be reached. If it doesn't get there however, future real equity returns will be lower than 5%, and a diversified portfolio of government, mortgage, and corporate bonds will be the best performing asset class for years to come. And oh, one large caveat. If the bond market continues to rally and the Fed can successfully engineer a 2% long-term TIPS rate instead of 3%, then stock markets are actually within 10% of fair valuation. That, however, would continue to support the case for bonds as the better performing asset class. Sounds like an opening for a bond geek to write Bonds for the Long Run. Count me out - one book's enough for me.

William H. Gross
Managing Director

Every month Bill Gross makes his Investment Outlook available to everyone at PIMCO's main web page. It is also available as a podcast for downloading. These Investment Outlooks void the saying that you get what you pay for! They provide great insight from one of the best investing minds available.

In his book he talks about his own personal investing alarm clock usually goes off a little early compared to the best time to buy or sell. This Investment outlook from 2002 was a little early, but its logic is sound. And best of all, it was free!!

Saturday, October 4, 2008

Friday, October 3, 2008

States Are Next To Need Government Assistance

This is a letter sent on October 2, 2008 from Gov. Arnold Schwarzenegger to Treasury Secretary Henry M. Paulson. It outlines the need for an immediate loan from the government for $7 Billion. This warning comes as California is close to running out of cash to fund day-to-day government operations and is unable to access routine short-term loans that it typically relies on to remain solvent. It's customary for California to borrow billions of dollars at the start of the fiscal year to fill its coffers until the usual flood of sales tax receipts comes in after Christmas and income tax receipts arrive in the spring.

Click To Enlarge

Oil - Light Sweet Crude

Below is a chart of Light Sweet Crude with the opening range level marked with red lines. The blue lines are the range extensions off of this opening range. With a creative eye, you can see how these levels act as support and resistance targets.

Currently we need to get back above the $100 level, and pass a test of this level, to have a strong push into the year end. The inverse could happen if we get below the $95 level with any steam. It is important to watch the strength of the U.S. Dollar to an idea of possible direction over the next few months.

Light Sweet Crude(click to enlarge)

Thursday, October 2, 2008

Top 100 Safest U.S. Banks

Free Report: Discover the Top 100 Safest U.S. Banks

Most of us think the term "deposits" mean funds that you deliver to the bank for safekeeping, but for nearly 200 years, the courts have sanctioned an interpretation of the term "deposits" to mean a loan to your bank.

Combine that fact with the latest headlines you’re reading about big name banks needing bailouts and you have a rude awakening of just how unsafe your bank may be.

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