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Spain’s Downgrade Dismissed – Good Sign For Global Risk Assets

May 31, 2010 Leave a comment

On Friday Fitch Ratings gave Spain its second downgrade in a month. This headline caused a bit of a tizzy in U.S. equities as we headed into the long weekend. However, today world markets largely shrugged it off, which is not to be unexpected if indeed the sellers have reached a point of saturation. By this I mean the news wasn't a shocker and was already priced into the recent decline.

The panic stage of the recent decline looks to be in the rear view mirror which should allow global risk assets to hold their recent lows and begin working off oversold conditions. Longer-term sentiment guides such as the II (Investor's Intelligence) and AAII (American Association of Individual Investors) polls did not reach levels of pessimism expected at a significant bottom, but breadth indicators did tank to levels associated with multi-week rallies and in some cases certain guides registered unprecedented readings, such as the McClellan Oscillator. 

In the S&P 500 futures I am looking for the recovery to take price up to a minimum of 1120 with a strong possibility of heading into the mid 1140's before having to reassess the situation. Never the less, I do expect volatility to remain elevated as this continues to be a trader's market. Should my views turn out to be overly optimistic and global markets begin unraveling again on the heel's of further Eurozone deterioration then I will be sure to make adjustments along the way.

As mentioned before, I am in the process of formulating a longer-term thesis as we progress into the heat of summer. I am about 30% of the way through finishing this thesis and will publish it as soon as it is completed. Stay tuned…….

Thoughts From The FrontLine – Six Impossible Things

May 29, 2010 Leave a comment

Thoughts from the Frontline Weekly Newsletter
Six Impossible Things
by John Mauldin
May 28, 2010

In this issue:
Six Impossible Things
Delta Force
Reduce your Deficits!
Pity the Greeks
Should the US Bail Out European Banks?
Italy at Last!

Alice laughed. “There’s no use trying,” she said” One can’t believe impossible things.”

“I daresay you haven’t had much practice,” said the Queen. “When I was your age, I always did it for half-an-hour a day. Why, sometimes I’ve believed as many as six impossible things before breakfast.”

– From Through the Looking Glass by Lewis Carroll

Economists and policy makers seem to want to believe impossible things in regards to the current debt crisis percolating throughout the world. And believing in them, they are adopting policies that will result in, well, tragedy. Today we address what passes for wisdom among the political crowd and see where we are headed, especially in Europe.

I am reminded of the great line from the movie, The Princess Bride. Vizzini is the short bad guy who is trying to get away from Westley and every thing he attempts does not work. Westley just keeps on coming. At each failed attempt, Vizzini mutters, “Inconceivable.” Finally, Vizzini has just cut the rope and The Dread Pirate Roberts (Westley) is still climbing up the cliff.

Vizzini: HE DIDN’T FALL? INCONCEIVABLE.

Inigo Montoya: You keep using that word. I do not think it means what you think it means.

European leaders keep telling us that the break-up of the eurozone is inconceivable. I do not think they know what that word really means. Let’s see if I can explain the problem so that even a politician can understand.

But first, and quickly. We have transcribed the speeches from my recent 7th Annual Strategic Investment Conference I put on with my US partners Altegris Investments. To say they were awesome is somewhat of an understatement. If you have registered for my free accredited investment letter, you should already have gotten a link or will get one soon to the speeches. David Rosenberg, Dr. Lacy Hunt, Paul McCulley, Niall Ferguson, Jon Sundt, Jason Cummins, Gary Shilling and your humble analyst. That is a world class line-up.

If you are an accredited investor (basically $1.5 million net worth) and have not yet signed up for my letter, then go to http://www.accreditedinvestor.ws and do so now. One of my partners from around the world will get in touch with you and make sure you get access to the speeches. They will also show you a world class line-up of funds and investment managers that have the potential to help your portfolio weather these tumultuous times. You really owe it to yourself to take a look. (If you are a non-US investor, there is a button on the top of the home page.) In this regard, I am a registered representative of and president of Millennium Wave Securities, LLC, member FINRA.
Six Impossible Things

I have written several letters over the years about the basic economic equation

GDP = C + I + G + (Net Exports)

Which is to say, that Gross Domestic Product in a country is equal to total Consumption (personal and business) plus Investments plus Government Spending plus next exports. This equation is known as an identity equation. It is true for all countries and times.

Now, gentle reader, I am going to spare you a few pages of algebra and cut to the chase. Let’s divide a country’s economy into three sections, private, government and exports. If you play with the variables a little bit you find that you get the following equation.

Domestic Private Sector Financial Balance + Governmental Fiscal Balance – the Current Account Balance (or Trade Deficit/Surplus) = 0

This equation was introduced to you a few months ago in an Outside the Box written by Rob Parenteau. We are going to review this briefly, as it is VERY important. Paragraphs in quotes will be from that letter. As Rob noted, “…keep in mind this is an accounting identity, not a theory. If it is wrong, then five centuries of double entry book keeping must also be wrong.”

By Domestic Private Sector Financial Balance we mean the net balance of business and consumers. Are they borrowing money or paying down debt? Government Fiscal Balance is the same: is the government borrowing or paying down debt?  And the Current Account Balance is the trade deficit or surplus.

The implications are simple. The three items have to add up to zero. That means you cannot have  both surpluses in the private and government sectors and run a trade deficit. You have to have a trade surplus.

Let’s make this simple. Let’s say that the private sector runs a $100 surplus (they pay down debt) as does the government. Now, we subtract the trade balance. To make the equation come to zero it means that there must be a $200 trade surplus.

$100 (private debt reduction) + $100 (government debt reduction) – $200 (trade surplus) = 0.

But what if the country wanted to run a $100 trade deficit? Then that means that either private or public debt would have to increase by $100. The numbers have to add up to zero. One way for that to happen would be:

$50 (private debt reduction) + (-$150) (government deficit) – (-$100) (trade deficit) = 0. Remember that we are adding a negative number and subtracting a negative number.

Bottom line. You can run a trade deficit, reduce government debt and reduce private debt but not all three at the same time. Choose two. Choose carefully. And before we get into the implications, let’s look at yet another equation, although this is somewhat simpler.
Delta Force

There are two and only two, ways that you can grow your economy. You can either increase your population or increase your productivity. That’s it.

The Greek letter “Delta” is the symbol for change. So if you want to change your GDP you write that as:

Δ GDP = Δ Population + Δ Productivity

If you are a country facing a population decline (like Japan) that means to keep your GDP growing you have to increase your productivity even more. That is why I have written so much about demographics over the years. Population growth (or the lack thereof) is very important. Russia is facing a very serious problem over the next 20 years that will require either a significant increase in productivity or large immigration to stave off a collapsing economy. Russia’s population has declined by almost 7 million in the last 19 years to 142 million. UN estimates are that it may shrink by about a third in the next 40 years. But that’s another story for another letter.

One last economic insight. You cannot grow your debt faster than nominal GDP forever. At some point, the market begins to think you will not be able to pay your debts back. This is no different than the fact that a family cannot grow its debt faster than its income ability to pay the debt back. At some point, you run out of the ability to borrow more money as lenders “just say no.”

As a family’s or country’s debts grow, the carrying cost or interest expenses rise. At some point, the interest expense consumes an   ever larger portion of the budget. Increasing the debt increases the interest expense eventually to the breaking point. There are limits.
Reduce your Deficits!

Now, let’s look at the implication of all this. Let’s start with Great Britain. They are running very large deficits on the order of 11% of GDP. Clearly, that is unsustainable and the new government knows it. They are looking to cut £6 billion in their first effort, which sounds like a lot, but is less than 4% of the £156 billion deficit. There is a lot more cutting that needs to be done.

But spending cuts and tax hikes have co
nsequences. The UK retail industry is warning that a feared hike in value-added tax to 20% from the Conservative-Liberal Democrat government would cost 163,000 jobs and cut consumer spending by £3.6bn over four years. And that tax hike is just for openers.

The classic hope for any country in such a dire strait is to be able to grow your way out of the problem. Martin Wolfe wrote in the Financial Times a few weeks ago that Britain needed to let the pound drift lower so that British exports would be more competitive. A cheap pound will drive up tourism. Their trade deficit can become a trade surplus.

Here is their dilemma. In order to reduce the government’s fiscal deficit, either private business must increase their deficits or the trade balance has to shift, or some combination. Lucky for them, they can in fact allow the pound to drift lower by monetizing some of their debt. Lucky, in they can at least find a path out or their morass. Of course, that means that pound denominated assets drop by another third against the dollar. It means that the buying power of British citizens for foreign goods is crushed. British citizens on pensions in foreign countries could see their locally denominated incomes drop by half from their peak (well, not against the euro which is also in free fall).

What’s the alternative? Keep running those massive deficits until ever increasing borrowing costs blow a hole in your economy reducing your currency valuation anyway. And remember, if you reduce government spending, in the short run that is a drag on the economy, so you are guaranteeing slower growth in the short run. As I have been pointing out for a long time, countries around the world are down to no good choices.

Britain’s is a much slower economy (maybe another recession), much lower buying power for the pound, lower real incomes for its workers, yet they have a path that they can get back on track in a few years. Because they have control of their currency and their debt which is mostly in their own currency, they can devalue their way to a solution.
Pity the Greeks

Some of my fondest memories were made in Greece. I like the country and the people. But they have made some bad choices and now must deal with the consequences.

We all know that Greek government deficits are somewhere around 14%. But their trade deficit is running north of 10%. (By comparison, the US trade deficit is now about 4%.)

Going back to the equation, if Greece wants to reduce its fiscal deficit by 11% over the next three years, then either private debt must increase or the trade deficit must drop sharply. That’s the accounting rules.

But here’s the problem. Greece cannot devalue its currency. It is (for now) stuck with the euro. So, how can they make their products more competitive? How do they grow their way out of their problems? How do they become more productive relative to the rest of Europe and the world?

Barring some new productivity boost in olive oil and produce production, there is no easy way. Since the beginning of the euro, Germany has become some 30% more productive than Greece. Very roughly, that means it cost 30% more to produce the same amount of goods. That is why Greece imports $64 billion and exports $21 billion.

What needs to happen for Greece to become more competitive? Labor costs must fall by a lot. And not by just 10 or 15%. But if labor costs drop (deflation) then that means that taxes also drop. The government takes in less and GDP drops. The perverse situation is that the debt to GDP ratio gets worse even as they enact their austerity measures.

In short, Greek life styles are on the line. They are going to fall. They have no choice. They are going to willingly have to put themselves into a severe recession or more realistically a depression.

Just as British incomes relative to their competitors will fall, Greek labor costs must fall as well. But the problem for Greeks is that the costs they bear are still in euros.

It becomes a most vicious spiral. The more cuts they make, the less income there is to tax, which means less government revenue which means more cuts which mean, etc.

And the solution is to borrow more money they cannot at the end of the day hope to pay. All that is happening is that the day of reckoning is delayed in the hope for some miracle.

What are their choices? They can simply default on the debt. Stop making any payments. That means they cannot borrow any money, but it would go along way toward balancing the government budget. Government employees would need to take large pay cuts and there would be other large cuts in services. It would be a depression, but you work your way out of it. You are still in the euro and need to figure out how to become more competitive.

Or, you could take the austerity, downsize your labor costs and borrow more money which means even larger debt service in a few years. Private citizens can go into more debt. (Remember, we have to have our balance!) This is also a depression.

Finally, you could leave the euro and devalue like Britain is going to do. Very ugly scenario, as contracts are in euros. The legal bills would go forever.

There are no good choices for the Greeks. No easy way. And then you wonder why people worry about contagion to Portugal and Spain?

I see that hand asking a question. Since the euro is falling won’t that make Greece more competitive? The answer is yes and no. Yes, relative to the dollar and a lot of emerging market currencies. No to the rest of Europe, which are their main trade partners. A falling euro just makes economic export power Germany and the other northern countries even more competitive.

Europe as a whole has a small trade surplus. But the bulk of it comes from a few countries. For Greece to reduce their trade deficit is a very large life style change.

Germany is basically saying you should be like us. And everyone wants to be. Just not everyone can.

Every country cannot run a trade surplus. Someone has to buy. But the prescription that politicians want is for fiscal austerity and trade surpluses, at least for European countries. But if the PIIGS reduce their trade deficits, that will not be good for Germany.

Yet politicians want to believe that somehow we all can run surpluses, at least in their country. We can balance the budgets. We can reduce our debts. We all want to believe in that mythical Lake Woebegone, where all the kids are above average. Sadly, it just isn’t possible for everyone to have a happy ending.

And this brings us to a last quick point, which some day will be its own letter. Every country wants it currency to be valued “fairly” which means lower than its competitors. With both Europe and Britain on their way to parity with the US dollar, what will be the reaction of Asia and especially China?

As Ollie said to Stan (Laurel and Hardy), “Here’s another nice mess you’ve gotten me into!”  A nice mess indeed.
Should the US Bail Out European Banks?

The obvious answer to the above question, at least on this side of the Atlantic, is no. But that is the plan being foisted on US tax-payers by the International Monetary Fund. The IMF wants to create a $250 billion dollar bailout fund for Greece, Portugal, et al that the US will contribute roughly 20% to. This fund will loan money and that IMG debt will be subordinate (junior!) to regular Greek debt, so when Greece does default, and they will, the IMF is the last in line to get paid.

Where will the money go? It will buy mostly Greek rollover debt from European banks getting out of their Greek debt. It is a back door bailout for German and French banks. The US Senate voted 94-0 that the US should not fund any such debt if the Treasury cannot certify the probability of getting repayment. If the Obama administration allows this funding to go through, the
hue and cry will be large. It is bad enough that we have to pay for Freddie and Fannie (already $400 billion and counting!). Not meaning to be churlish, but the French and Germans can bail out their own banks.
Italy at Last! I-Pads, Paris, Milan

Next week I leave for Italy with the kids, three of their spouses and two grandkids. 13 in all. This is not quite the Normandy invasion, but it does leave you with an appreciation for logistics personnel. Planes, Trains and Automobiles. Rome for five days,  Venice for four more and then Tuscany. I will get to see Pompeii, which has been on my bucket list like forever. And a hot air balloon ride in Tuscany. I am sure lots of pasta, Chianta, pizza (my kids will force me) and so many great experiences. I am really getting jazzed.

I will write at least one letter from Italy, and have a guest or two help me out. After a quick trip to Paris to speak at the Global Interdependence Council I will go back to Tuscany for some “work” with my European partners and then up to Milan for a speech. The Paris speech is closed but the one in Milan is open. Drop me a note and I will get you on the invite list.

There is so much to get done before I leave, not the least of which is getting my new I-Pad up to speed. Yes, I relented. My intention was to wait for the next version to come out next year. But watching Tiffani use hersand another friend just work magic with hers, and I have to have one. It is going to change my book reading habits, as well as keep me even more online. Is that good? We will see. And yes, when the next one comes out, I will get it. But at least I can tell myself that one of my kids really needs this one. 🙂

Have a great week.

Your ready for some local Chianti analyst,

John Mauldin
John@FrontLineThoughts.com

Categories: Uncategorized

Quick Glance At The S&P

May 28, 2010 Leave a comment

Yesterday the Inverse-Head-And-Shoulder pattern I highlighted here on Wednesday triggered as we broke through 1094 in the ES contract. The projected target zone stands at 1120-1145. A measured move, determined by the range of the I-H&S set-up, dictates a possible 50 handle move providing the 1145 target as my most bullish scenario at this point.

A 61.8% retracement level exist at 1120 and the 76.4% comes in at 1140. There are also a couple of downtrend lines and moving averages (20 & 50 day) the market will have to contend with as it trades higher into the target zone.

Click on chart to make bigger

ES 

 

 

Categories: Short-Term Trader

EURUSD – Double Bottom Anyone?

May 27, 2010 Leave a comment

 

Over the course of the past couple of weeks I have expressed my logic for becoming bullish on the Euro and feel pretty good from a risk reward standpoint that now is as good as any to be long EURUSD. Just as the tides of global risk markets rise and fall in a synchronized manner, the Euro should certainly catch a bid along with equities, carry trades and hard assets (namely industrial metals and energy).

How high will it go?  It's possible it turns out to be nothing more than a dead cat bounce, however;  provided the widespread pessimism and sheer size of the short positions (record size in both the futures and cash markets), a rebound of 10% or more seems well within the realm of possibility. A bounce of this magnitude from the low takes the EURUSD back to the 38.2% retracement level from the November '09 peak. Approximately 1.33. Certainly not unreasonable.

EURUSD

There is no question that the Euro and its constituents have a colossal mess on their hands and unfortunately, from where I'm perched, looks like a preview to a horror flick coming one day to a theater near you. However, the market has a propensity for burning as many market participants as it can before ultimately vindicating those with the strongest hands. At some point, the late comers will scream "Uncle!" and cover their positions. As I have stated before, massive macro shifts of this scale do not take place overnight and if the Euro is to one day meltdown then it will take longer than most think.

If in fact this analysis is wrong, I'm looking at a backstop on this trade under the double bottom low around 1.21. If a stop is triggered, one can always re-enter at a later time after the market provides a better look. As always, be safe and use stops…….discipline over conviction!

More Bullish Data Suggesting A Sustainable Bounce On Its Way…….

May 27, 2010 Leave a comment

Some of you may have figured out by now I really enjoy the work Jason Goepfert does over at Sentimentrader.com  He does an excellent job of putting together intriguing statistical pieces as well as providing the most comprehensive site for sentiment based data I have come across yet.

 

This is what Jason has to say today.

 

 

Average Directional Index

 

I keep the number of technical indicators I watch to an absolute minimum.  That doesn't mean there isn't value in some of them, it's just that watching too many tends to create more problems than it solves.

 

A subscriber asked about one in particular, though, and it's throwing off an interesting reading.  The ADX indicator recently moved to an exceptionally high level, one that has been historically meaningful.

 

I don't want to delve into the mechanics of the ADX when a simple web search will turn up plenty of background (click here for an adequate one from Stockcharts.com).  As a one-second introduction, the ADX measures the strength of the current trend, using a default look-back period of 14 trading days.

 

According to Stockcharts.com, when the ADX rises above 40, it indicates a strong trend.  What they don't mention, however, is that by the time it reaches that level, the trend is most often about to end, at least temporarily.

 

No need to take my word for it, though, let's just go back to 1928 and look for any time the S&P 500 closed at at least a three-month low (so we know we're looking at downtrends here) and the ADX crossed above 40.

 

Date

1 Week

Later

2 Weeks

Later

1 Month

Later

3 Months

Later

06/02/31 11.2% 12.5% 25.8% 18.3%
09/30/31 2.1% 4.0% 9.6% -18.3%
04/13/32 0.8% 0.8% 0.3% -25.8%
12/29/41 8.6% 5.0% 5.6% -3.0%
06/13/49 3.8% 4.2% 9.1% 14.5%
08/26/57 3.5% -0.1% -2.1% -6.2%
05/10/62 0.6% -4.6% -9.1% -9.4%
06/24/65 1.1% 2.6% 0.6% 7.5%
05/16/66 2.1% 2.0% 2.8% -2.0%
08/26/66 1.3% 2.0% 2.2% 5.6%
06/20/69 0.7% 2.4% -3.7% 1.5%
07/28/69 3.1% 3.5% 4.5% 8.8%
05/04/70 -1.0% -3.0% -1.9% -1.7%
12/04/73 2.6% 1.2% 5.7% 4.7%
11/13/78 2.3% 2.2% 3.2% 6.2%
03/27/80 4.0% 5.7% 7.6% 18.3%
09/18/81 -3.0% 2.7% 2.3% 5.9%
02/23/84 2.5% 0.6% 1.7% -0.7%
12/04/87 5.1% 11.3% 15.6% 19.4%
09/24/90 3.4% 2.9% 2.6% 3.3%
10/10/90 -0.5% 4.1% 4.7% 4.7%
08/31/98 6.9% 8.4% 6.2% 21.6%
03/21/01 2.8% -1.7% 10.8% 9.0%
09/21/01 7.8% 10.9% 12.9% 18.0%
07/18/02 -4.9% 0.4% 5.4% -2.5%
07/11/08 1.7% 1.5% 5.3% -28.2%
10/09/08 4.0% -0.2% 2.3% -2.2%
03/05/09 10.0% 14.9% 23.4% 38.1%
Average 3.0% 3.4% 5.5% 3.8%
% Positive 86% 82% 86% 61%

 

The short- to intermediate-term following these signals were extremely positive, up 82% to 86% of the time, and with exceptional average returns.  The only real failure was in 1962 when we saw a short-term bounce and then a roll over into a major decline.

 

Overall, during the following month the median maximum loss was -2.7%, while the median maximum gain was +6.5%, more than twice as large.

 

It was awfully rare to get this signal during a bull market, objectively defined as a rising 200-day moving average on the S&P 500.

 

Here they are, culled from the table above:

 

Date

1 Week

Later

2 Weeks

Later

1 Month

Later

3 Months

Later

05/10/62 0.6% -4.6% -9.1% -9.4%
06/24/65 1.1% 2.6% 0.6% 7.5%
05/16/66 2.1% 2.0% 2.8% -2.0%
06/20/69 0.7% 2.4% -3.7% 1.5%
11/13/78 2.3% 2.2% 3.2% 6.2%
03/27/80 4.0% 5.7% 7.6% 18.3%
08/31/98 6.9% 8.4% 6.2% 21.6%
Average 2.5% 2.7% 1.1% 6.2%
% Positive 100% 86% 71% 71%

 

Every time, the S&P rose over the next week.  Again, that 1962 occurrence pops up, so there was that false signal.  In 1969, stocks bounced for a couple of weeks and then sunk to a new low, so that one too was only successful in the short-term.

 

Overall, though, over the next month the median maximum loss was -1.8%, while the median maximum gain was +4.1%.

 

Pretty positive stuff.

Categories: Short-Term Trader

Feeling A Little Deja-vu

May 26, 2010 Leave a comment

Earlier this week I pointed out a couple of scenarios based on two possible chart set-ups in the S&P futures. One being bullish (Inverted-head-and-shoulders) and the other being bearish ("4th-wave-triangle"). The latter being the winner late Monday as we plunged into Tuesday's reversal low.

Well, here I am again pointing out another very similar set-up up on a slightly larger scale. First, I will note that H&S patterns and their inverted brethren can and often do become triangles. So here we are, with plenty of extremely oversold readings in the market. If you want to see them you can scroll back through recent postings……I don't want to beat a dead horse – we're oversold, we all know that.

What we don't know is whether this level of oversoldness (is that a word?) will lead to more oversold OR will the market finally catch a bid and honor the Inverted-H&S pattern? I will refrain from making any predictions and simply allow the charts to dictate my next set of actions.

Buying a break above the neckline on the I-H&S, Shorting a break of a Triangle, or a third option (not graphed) Do nothing as the market continues jetting lower from today's afternoon sell-off and either creating a double bottom at Tuesday's low or making a new low. While I am uncertain as to which one of these scenarios will come to fruition, I am certain that waiting for pattern confirmation (not predicting) will provide the best chance for making a successful trade.

Inverted      
T2

 

Categories: Short-Term Trader

Will Today’s Bullish Reversal Hold?

May 25, 2010 Leave a comment

This morning's gap provided an opportunity to cover shorts initiated late Monday afternoon off the break of the "4th wave triangle".  The gap lower put the market right in the target zone of 1045-1036. If in fact Elliot Wave's "4th wave triangle" rule does stick then we should FINALLY be in for a bounce. In accordance to Elliot Wave Theory, a triangle forming after the 2nd impulse wave results in a 3rd impulse wave, or wave 5. Once completed a change in trend occurs.

Furthermore, two out of the past three days the market has opened significantly lower only to surge back to positive on the day. There have been plenty of negative headlines and indeed longer-term fundamentals are in serious jeopardy. Never the less, the market has demonstrated short-term resilience as the current sell-off looks to have reached a point of saturation. Breadth indicators certainly suggest this to be the case.

Below is a graph of an indicator called "Intermediate-Term Indicator Score", created by Sentimentrader, demonstrating the overall extreme readings registered across the board in a variety of breadth and sentiment indicators. 

Inter

As you can see from the chart above, this indicator looks nearly broken and is way lower than any reading registered during the last bear market phase.

Click Here to read a recent post regarding the statistical significance of Friday's reversal day….well, it applies to today's reversal as well. This analysis comes from Jason Goepfert of Sentimentrader.

The Euro (EURUSD) pared most of its overnight losses after retesting the low from last week. I look for this to be a successful retest with a stop on long positions placed under last week's low of 1.2143.

To reiterate a point previously made – my expectation for the ensuing bounce is that it will amount to nothing more than a retracement rally,
later setting up the pins to be knocked over once again. There are a number of fundamental headwinds which I believe will be too much for the market to hurdle as we head into the 2nd half of 2010.

Categories: Short-Term Trader