While sitting on large cash positions, it is prudent to take some time to examine the big picture. Markets all over the world and the vast majority of asset classes remain firmly in downtrends. Powerful countertrend rallies are to be expected and are overdue. Countertrend rallies can last weeks or months. They will come at some point - we should not let them take our eye off the bear-market ball. We are far from having significant evidence that a lasting bottom is in place.
The Bailout Bill
Since Congress has political risk if they take no action concerning the financial crisis, we can expect some form of a bailout package to pass in the coming days. Once something passes, we can expect a rally in stocks. The market's initial reaction to the bailout plan on September 18, 2008 was very positive. The reaction since then has been muted. We have come nowhere near the highs made in stocks on September 18, 2008. The market thinks the bailout will help, but is thus far not convinced it will solve all our problems. When something is passed, we should focus on how the market is acting in a few days or weeks, not a few hours.
After passage of a bailout bill, the market will ask:
- How long will it take for the Feds to start buying toxic assets?
- How will they decide what to buy first?
- How much will they be willing to pay?
- Will banks have to take more write-downs?
- Will the program expose problems of greater magnitude than expected?
- Will it work?
- With housing still in a tailspin, will private capital migrate back to banks?
The fact that the questions above cannot currently be answered exposes the lack of detail and clarity in the poorly written and conceived bailout bill. Vague is the operative word. Two of the major problems with the credit markets are lack of trust between financial institutions and poor transparency. A vague bailout bill, which may alter accounting rules, will not provide immediate help on either front. Relaxing standards on mark-to-market accounting will create an environment with even less transparency and trust.
Government intervention will continue for the foreseeable future. Unfortunately, this regulatory risk makes the markets very unpredictable and volatile. New announcements can come out of the blue, making it very difficult to stomach inverse investments or shorts. You can be right on the fundamentals and still experience significant short-term pain during a government-press-release-induced reversal in stocks. Money managers are spending as much time reading the Washington Post as the Wall Street Journal due to the excessive intervention into the "free" markets. Currently, the main driver of asset prices are changes in government policies, which does not inspire a lot of confidence for investors.
If the U.S. government were a publicly traded company, would you invest in it? Assuming the answer is no, then why would anyone believe the government can pull all the right economic strings to alter the course of natural events in a complex global economy?
Regardless of what bills are passed in Congress, the risks for the longer-term will remain elevated. Regardless of the market's direction in the coming weeks and months, problems in the financial system will remain. Alan Greenspan recently said this was a once in generation financial event. All will not be suddenly be right with the world after a stroke of President Bush's pen.
Economic Weakness Comes Into Focus
Once some form of the bailout is passed, the market will shift its focus to the economy. As you might imagine, focusing on the economy will most likely curb buyer's enthusiasm for stocks.
Based on the latest figures from Case-Schiller, we still have over 10 months of supply of homes on the market. As stated several times in the past, we cannot expect to see any real stability in home prices until we get down to at least 6 or 7 months of supply. Prices of homes will continue to be under pressure, which means more problems for financial institutions (or taxpayers if we begin to buy garbage assets from Wall Street - assets that the free market wants no part of).
Tuesday's bounce-back rally in stocks shows a significant speculative element remains in the financial markets. My guess is this speculative element must be reduced further before a meaningful bottom can be found. Bear markets end with extreme pessimism. Tuesday's buying does not look like extreme pessimism. Each time the markets make another new low, more speculators and everyday investors decide they have had enough. We made new lows Monday. A few more people permanently headed for the door.
If stocks make new lows again after a bailout bill is passed in Washington, the downside risks will become very high. Lower lows in stocks after a "rescue package" is in place could be the spark that sets off a serious and prolonged run for the exits. This bear market will most likely end when investors come to grips with the fact that policy makers and regulators cannot permanently alter the natural laws of supply and demand. All the government tinkering does is postpone the day of reckoning and/or prolong the time it takes to move to a recovery. If you disagree with that statement, I suggest you brush up on your financial history. It is possible more tinkering can keep the financial system propped up for a while longer, but not very likely. If the lows made Monday can hold, there is some hope for a decent rally in stocks.
The complex, global, and unregulated credit default swap (CDS) market still poses a significant risk to the financial system. If the average investor understood the CDS market, they would consider moving a higher percentage of their assets to cash for the short-run. The CDS market may continue to operate without major problems, but it is not likely.
Every morning, I review the charts of numerous markets, asset classes, and investments. While they show the potential for furious counter-trend rallies, their overall health is very poor. We have bear markets occurring simultaneously in numerous assets classes. This is very rare. This should not be ignored.
Gold: Not Time To Throw All Caution To The Wind
Even gold, despite some recent strength, has not yet given the "all clear signal". While there is no question gold still has very positive long-term prospects for a variety of reasons, risks remain in an environment where there is open trader talk of possible U.S. dollar intervention by global central bankers. Relatively small positions in gold are prudent. However, a "prove it to me" approach is still painted in the charts of gold, which could change in the coming days. I remain a long-term gold bull, but the metal has failed to make a new high since March 17, 2008 (almost seven months ago). Gold's lower lows and failure to make a new high during a very serious financial crisis, tells me the following:
- For the moment, the markets are more concerned about economic weakness rather than inflation (the focus will change in the months and years ahead).
- Dollar strength is curbing the demand for all commodities, including gold.
- Central bankers and policy makers do not want to see high gold prices. High gold prices put a spotlight on excessive money creation and government intervention into the free markets (all related to debt and currency debasement). Central bankers and policy makers still carry a heavy hand in the financial markets. They can crush the little guy in the short run. They can alter markets in the short-run. Gold's 28% drop between July 15, 2008 and September 11, 2008 is a painful illustration of this concern.
- From a possible small allocation to gold, I am willing to miss some of the next move up rather than expose significant amounts of capital to possible further declines in the yellow metal. The vast majority of investments and asset classes have lost money since July 15, 2008, including gold and weak-dollar investments. Gold remains over 15% below the March 2008 high even in the face of a serious global financial crisis.
- If and when gold finds a strong and sustained bid again, there will be plenty of time to profit from what could be eye-popping gains. For the short-term, a patient and "prove it to me" approach remains prudent in terms of keeping allocation levels relatively low. This applies to all asset classes, not just gold.
- A good technical analyst looks at all charts in an unbiased manner. If we push the favorable fundamentals aside, the chart of gold is not anything to get overly excited about (yet). Even with a subconscious bullish bias toward gold, I have trouble interpreting the chart as overly bullish. I don't make the charts, I just read them.
The long-term fundamentals for gold have not changed and remain very favorable. However in the current process of financial deleveraging, all asset prices (including gold) could remain under pressure. I remain confident gold will play a more significant role in portfolio construction sometime in the very near future. For those who have a very large exposure to gold, a reasonable stop-loss strategy should be considered to protect against renewed weakness, which may or may not occur. Gold is very close to giving some clearer buy signals. I am willing to wait, but ready to act. A good start would be for it to hold above the $895-900 range for more than a day at a time.
Inflation and Dollar Weakness Will Be Back
Governments around the globe continue to flood the financial system with cash. Bailouts, which are funded with debt, add to already bloated deficits. These injections of cash will eventually lead to inflation. On the other side of this credit crisis, inflation will most likely begin to accelerate at alarming rates. While it is prudent to protect capital and remain conservative for the short-term, we cannot lose sight of the fundamental factors which continue to set the seeds for future price inflation, especially in food and energy. As a result, investors who make a decision to leave the financial markets for good could regret that decision when inflation begins to seriously erode their purchasing power. In a similar vein, risks to the U.S. dollar remain high in the long-run, something that cannot be counteracted with CDs, money markets, or a mattress. Currently, it is a time to protect principal and keep a watchful eye on signs of renewed inflation. Weak dollar investment strategies should not be put in the attic, but kept within an arm's reach. They will be very relevant in terms of wealth protection in the years ahead.
Reviewing Our Options
We are currently reviewing all our options, including individual stocks, bonds, ETFs, mutual funds, and dividend-paying instruments. Regardless of where we go from here, most investors should consider allocating a large percentage of their capital to cash and very short-term FDIC-insured CDs. The best thing for the time being is to remain patient - too many unknowns. At some point in the not too distant future, a few asset classes will begin to show some sustainable leadership. In the meantime, continue to read your Washington Post and watch C-SPAN.