WEEKLY UPDATE

May 20, 2010

Stocks Break 200-day Moving Average with Today's Big Drop

For months we've been talking about the developing sovereign-debt crisis in Europe and the fallacy of a "jobless recovery" as the stock market had continued to climb higher on its sugar high from Washington's liquidity injections. It now appears that the stock market is beginning to equilibrate with the realities of Main Street.

Stocks Break Down-trend Support

The U.S. stock market has traded lower in 10 of the last 14 trading sessions and with today's 376-point drop in the DJIA, the Dow has fallen below its key 200-day moving average trend-line, a move suggesting that bear-market territory is in sight. The following chart shows the Dow dropping through the 200-day moving average (blue line) today.



Stocks have a number of headwinds to overcome right now. The Euro continues to weaken, which is a sign of the Eurozone's uncertain future…and stock investors do not like uncertainty. While European countries now threaten to slip back into recession, receding economic growth in China has pushed the Chinese stock market into bear-market status. Here in the States we have high unemployment claims haunting our market, home prices falling below year-ago levels, and new home sales dropping off after the expiration of government subsidies. Despite what some market analysts say, there is no such thing as the "jobless recovery." The market has simply gotten ahead of the economic recovery that is still only in the budding stage.

Meanwhile Bonds Rally!

The chart below really says it all. Bonds have been the safe haven for investors for more than a year now. As stocks fall and cracks in the economy surface, bond prices have benefited from a strong rally that has taken government bond prices back to the highs they reached at the peak of the credit collapse in '08.



Thankfully we did not heed the advice of the many "experts" who since the start of the year have been recommending that we sell our bonds and invest the money in the stock market. Having said that, we will be looking for the later stages of this rally to develop and with it, an opportunity to reap some of the profits we have earned during this strong rally phase of the bond market.

Asset Allocation

While we are guided by our macroeconomic views, we approach each client individually with recommendations suited for their particular set of objectives and tolerances for different types of risk. We feel very good about our current allocations and look forward to recommending re-allocation of assets as these markets move ahead.

Take care,
Greg

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May 10, 2010



A year ago we in the U.S. were circling the wagons to bail out systemically important companies of ours that were drowning in debt (e.g. AIG, GM, Fannie Mae and Freddie Mac, the "Wall Street banks"). These institutions were collapsing under the weight of expanding debt amid falling asset prices. The problem has since grown to gigantic proportions as we now attempt to bail out entire countries from their debt problems. Greece was promised a $150 billion bailout last week from the EU and IMF, but the celebration lasted only a single day before investors realized that this bailout would likely not defend Greece from eventual default, given the need for austere financial reform (unaddressed by a simple liquidity injection) and Greece's bleak financial outlook.

The financial troubles of these countries are actually similar to those experienced by the many families who suffer from excessive debt. Think of a family who runs up their credit cards right to the limit but doesn't have to worry because every few weeks another bank sends them a new credit card with an even higher limit. The family uses the new card to make the payments on the old cards, but they never pay off the debt. That works until the credit card companies realize that this family is not creditworthy, so they stop raising their credit limits. The family has hit the wall. They can either cut back on their spending and start paying off their debt or ignore the problem until they run out of all sources of cash. That family is Greece, Spain, Portugal, Italy, the United Kingdom, Ireland and Iceland. (I won't even go into the status of our municipal governments, let alone our national government.)

The point is this common problem now extends to well-established countries, threatening their ability to pay their national debt and to keep the promises they made to their own citizens. These countries are being forced with the choice of either implementing effective financial reform and a credible commitment to deficit reduction, or ignoring the problem until the market realizes these countries are not creditworthy. In the event that the market makes this decision about any given country, as it arguably did with Greece just recently, borrowing rates for the country would sky-rocket such that the country would not be able to afford servicing its outstanding debt with additional debt - this is of course assuming that investors even want to purchase the country's new debt issues…at any interest rate.

The Eurozone (i.e. the bloc of 16 European countries that uses the Euro as their primary currency) has hit a wall and even though the only real way out of their mess is to cut back on their debt, the EU and the IMF decided to double-down on their bets and commit €750 billion ($960 billion) more in debt guarantees. This injection of money is a short-term solution to the short-term problem of illiquidity in European markets - it only buys time for these countries to fix their long-term solvency issues of excessive debt, and in the process it compounded this problem with additional debt.

The U.S. is Not Immune to a Similar Fate

We in the U.S. postponed the day of financial reckoning because our government in concert with the Federal Reserve Board printed trillions of dollars to flood the financial system when liquidity was lacking. Including liabilities related to Fannie Mae and Freddie Mac, our national debt now equals approximately 100% of our annual GDP. Many economists assert that this is putting us in the path of an eventual credit crisis, but for the time being we have postponed that unappealing outcome. The question that remains is: How much longer do we have before our runaway deficits make us "The New Greece"?

Computer Glitch Blamed for Big Drop in the Market

Don't believe it. I, like many, do not believe that a simple computer glitch or a fat-finger trade brought last Thursday's stock market plummet. Frankly, a very wide array of stocks across different stock exchanges was affected to the same degree during the same time period. This is not the first time this has happened. I remember sitting in my office in 1987 and watching the effects of program trading as pre-set sell targets were triggered pushing stock prices drastically lower. We ended that black Monday with a one-day drop of 12%. This Thursday was a milder version of that fateful Monday.

The chart below shows the DJIA over the past week and breaks down the action in 15-minute intervals. The top half of the chart below shows the price action of the Dow while the lower half shows the trading volume. This chart clearly shows that selling pressure was building momentum for nearly an hour before the market finally started rebounding. This type of action dispels the rumors that a computer glitch or a single "fat-finger" trade caused the market drop in free fall.



So... Why did the Market Fall?

I believe that trading programs triggered a cascade of sell signals that overwhelmed the market. A week earlier the market fell below its 20-day moving averages and failed to rally above that measure, leaving technical analysts worried that the great bear-market rally was coming to an end. By Thursday morning the market then fell below its 50-day moving average and at that point sell pressure began to build. The next level of support was the 200-day moving average which was broken briefly on Thursday, but it was at that point that buying came back into the market and the Dow recouped much of its losses but still ended the day down 300 points. We ended the week with a loss of roughly 900 points off our recent highs.

Monday's Response:

In response to this weekend's bailout news, our stock market rallied 404 points on the Dow earning back a portion of the losses it had suffered the past 10 days. Treasuries retreated from Friday's highs but are still well ahead of levels they were at before the crisis in Greece began to build. We will have to wait a bit longer to see if the latest bailout measures will stem the tide of concern lapping on the shores of Europe.

Take care,
Greg

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May 4, 2010

The Greek Honeymoon that Lasted Just One Day

The honeymoon for Greece following the European Union and IMF's agreement to a three-year $145 billion bailout lasted only one day. Last night Greek bonds fell once again under selling pressure as institutional investors grew more and more skeptical of the effectiveness of a Greek bailout. At the heart of the markets' concerns is the growing possibility of a debt-crisis contagion across the Eurozone - if the EU and IMF cannot assuage Greek default fears with this unprecedented flood of liquidity, then the market may be pricing in a broader Eurozone debt problem that will be too much for the EU and the IMF to handle with a bailout.

Concern about Greece triggered selling across all major stock markets. In London the market was down 2.6%, Germany was down 2.6%, and France fell 3.6%. The Dow was down 2.0% at the close while the S&P 500 fell 2.4%.

Our Market Holds Above the 50-day Moving Average

While US stock markets were down all day they did hold above their 50-day moving averages, which is important. If the market can hold above this key level it could gain a foothold, but a headwind of other technical indicators signals much weaker conditions ahead. In the chart below I placed a box around the last six trading days highlighting how the market has fallen through the 20 and 34-day moving averages (green and blue lines, respectively) and closed just above the 50-day moving average (yellow). The next few days will be interesting for market analysts to follow.



Treasury Bonds Rally Strongly

As has been the story for nearly two years, whenever investors run from other markets they seek a safe haven in U.S. treasury and government-backed debt. That was certainly the case today. Short-term treasuries, government-backed mortgage bonds, and inflation-protected treasuries all rose in price today. While it is true we have a huge budget deficit and troubles of our own, we are still comparatively attractive to investors seeking a safe investment.

Looking Ahead

Many leading economists like Kenneth Rogoff, Professor of Economics and Public Policy at Harvard University, and former chief economist at the IMF, have been saying for months that history tells us that after most credit collapses (like the one we just went through) a sovereign debt crisis will soon follow. Today's concern over Greece, Portugal, Spain, and the United Kingdom should come as no surprise. This story is far from over; it seems as if the second act has just begun. Stay tuned!

Take care,
Greg