The High Dividend Stock Investor's Collapsing Dollar Survival Guide, Part 6A 8 comments
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Market Update: Warning! Do not feed the bears.
1. MARKET STATUS – SPECIAL REPORT
Before ever considering investing in stocks, we must always first look at the overall market, since almost all stocks follow the major indices.
Given the recent bounce, declarations that “the bottom is in” are echoing from Washington and Wall Street.
Because avoiding bad investments is even more important than finding good ones, I present arguments that further downside is more likely.
In order to allow enough room for a full discussion, I’ve broken Part 6 into two parts. Part 6A focuses exclusively on the market, Part 6B on shipping stocks.
I draw heavily from Dr. Nouriel Roubini, perhaps the most prominent seer of the current crash and its still unfolding ramifications for the past number of years.
Debate over whether the markets have bottomed focus around the following issues.
A. The Rate of Economic Decline
The optimists say that the world wide rate of economic decline is slowing, suggesting bottoming in late 09. The pessimists, lead by Roubini, argue that in fact most indicators remain strongly negative in Europe and Japan, near negative in the U.S. and China, and even these upticks in the U.S and China were temporary.
1. THE U.S.
The Empire State and Philly Fed index of manufacturing are still plummeting, initial claims for unemployment benefits are rising and suggest accelerating job losses; the sales increase in January is an aberrational rebound fueled by bargain hunters from a depressed December.
Despite a slight recent improvement in the ISM index, the latest data that have come out - industrial production and Empire State economic conditions index - have been as depressing as any and suggest that the March ISM may show another sharp dip:
- Industrial production was down 1.4% in February after a revised -1.9% in January.
- Capacity utilization down to 70.9%, the lowest level ever recorded. And the Empire State report on economic condition fell to -38.2, the lowest level ever recorded (data from 2001 on), from -34.7 in February.
Thus, the belief that some economic indicators are showing a bottoming out of the rate of contraction is just not justified by the data.
U.S. domestic consumption, a major part of its GNP, needs to fall further as households increase savings to compensate for their loss in net worth from massive declines in housing prices (25% and another 20% likely) and stock prices (50% so far, more likely). Continuing rising unemployment will compound the decline in consumer demand.
2. CHINA
In China, credit growth was not used for investing in future growth but rather for investing in higher returning deposits. Chinese imports, mostly of raw and intermediate materials used for exports, are down 40%, falling faster than exports. Thus while Chinese exports have up to now fallen less than the rest of Asia, these free falling import figures suggest exports will soon power dive as well.
Elsewhere in Asia, Japan, Taiwan, and Korea’s exports are down 40%-50%. Per Roubini (in his March 16 article at www.rgemonitor.com): Dr. Roubini writes:
The scale and speed of synchronized global economic contraction is really unprecedented (at least since the Great Depression) with a free fall of GDP, income, consumption, industrial production, employment, exports, imports, residential investment and, more ominously, capex spending around the world. And now many emerging market economies – as argued here for a while- are on the verge of a fully fledged financial crisis starting with Emerging Europe.
B. The Effectiveness of Government Stimulus Programs
The optimists argue that policy stimulus, both monetary but especially fiscal, in the US, China and the rest of the world is starting to kick in and will contribute to the recovery in late 09. Dr. Roubini and others counter with the following.
1. THE U.S.
In the U.S., monetary easing is ineffective (“like pushing a string”) when there is too much productive capacity for the available demand. Cash strapped and nervous households and businesses don’t spend just because borrowing is cheaper.
Fiscal stimulus (i.e. government spending) will have limited effect. In the U.S., only about 25% of the $800 billion will be deployed in '09, the rest in the coming years. Half of that $200 billion is in the form of tax cuts that are more likely to be saved by anxious household. For example, only 30% of the 2008 tax cuts were spent, the rest saved. Dr. Roubini concludes in the above mentioned article,
Thus, given the collapse of five out of six components of aggregate demand in the U.S. (consumption, residential investment, capex spending of the corporate sector, business inventories and exports) the stimulus from government spending will be puny this year.
2. CHINA
The picture in China isn’t any more encouraging. China’s much heralded $480 billion spending will not be effective in the long run. China’s economy is extremely dependent on trade as opposed to domestic consumption. With exports plummeting, thousands of firms closing and millions of jobs lost, domestic consumption will not compensate for declining exports. While government infrastructure spending will be helpful in the long term, any near term spending on more export production capacity while there is already excess capacity may just lead to increasing loan defaults. Moreover, because most of this spending will be capital rather than labor intensive, unemployment and thus domestic consumption will remain a problem.
Thus without recovery of demand from the West, China will not recover.
C. The U.S. Financial System
The optimists claim and financial stocks are oversold, many major institutions say they’ll be profitable in '09, don’t need help, the financial system is solvent. The pessimists, I paraphrase much of Roubini here, paint a starkly different picture.
First, these ‘profits’ are only with the Fed and Treasury heavily subsidizing the financial sector. The Fed Funds - at 0%, with massive quantitative easing, with credit easing allowing banks to dump toxic assets on the Fed balance sheet and with a new government program that allowed banks to borrow at riskless rates almost $200 billion dollars at medium term maturities
Second, the latest version of the TALF now allows even hedge funds to borrow – up to a trillion dollars - at government rates – and leverage their investments 20 times to purchases new ABS issued by banks and reap a nice spread over LIBOR with very limited risk. With policy and borrowing rates equal to zero or close to zero for banks and broker dealers their intermediation margins are obviously positive as lending rates are much higher. But this is a direct huge subsidy of the financial institutions that is being paid by savers that are now earning 0% or close to 0% on $10 trillion of bank deposits.
Third, even with this massive subsidy, the government has allowed the banks vastly understate their write downs and bad debts. How? Via government regulators allowing over-valuation of bad assets, parking illiquid assets in level 3 “unrealistic” valuations, easing of capital requirements, using AIG to bail out its counterparties to the tune of $160 billion, and eventually, suspension of mark to market accounting.
So no surprise that Citibank (C), Bank of America (BAC) and JP Morgan (JPM) can argue that they will be making this year a profit “before provisions for write downs”. There’s the rub: while operational margins can be positive if you borrow at 0% and lend at much higher rates, the actual P&L and balance sheet of banks and broker dealers depends also on write downs. These write downs, delinquencies and write-offs are growing and spreading as the recession worsens.
In sum, without the above forms of assistance, most of the banks would already be gone, and as is are de facto wards of the government. The government is already the biggest shareholder of Citibank, and many others survive purely on government life support.
Dare we say it? Nationalization has at least partially arrived already.
D. The U.S. Stock Market
The optimists say that stock markets have already fallen in the US and globally by over 50% and are now way oversold. Earnings have fallen a lot but will recover soon as economic activity will soon stabilize. And since stock markets are forward looking and bottom out 6 to 9 months before the end of the recession we must be now at the bottom if the economy will recover at latest by year end. The pessimists counter as follows.
Earnings per share (EPS) for the S&P 500 are widely expected to be between $40-60 per share. Then, the question is what the P/E will be on such earnings. In past severe recessions, it could fall to 10-12. Thus in a best case scenario of $60 EPS and P/E of 12 puts the S&P at 720 as a ceiling, and a worst case scenario of $40 EPS and P/E of 10 at 400 – as much as another 50% drop, though even Roubini seems to see this as unlikely, with 500 the more likely floor. With the S&P currently around 760, there’s at best some additional downside, possibly much more.
Roubini has also noted that the generalization that the stock market looks ahead six to nine months is merely that, a generalization. The last recession bottomed in late 2008, GDP growth was solid in 2002, yet the U.S. stock market kept declining until the beginning of 2003. Thus in the last recession the market actually lagged the recovery by 18 months. Thus even if the economy bottoms in 2009-10, the markets could stay down into 2011-12.
E. Ramifications for High Dividend Stock Investors
In sum, we’re still in a near term trading range, with the overall trend continuing down. Continue to invest only with funds allocated for longer term investment that you don’t need for the next six to eighteen months at least. What you buy now may well go lower. Buy only at strong support levels recommended below.
1. Consider a Partial Hedge with Selected Ultrashort ETFs
See Part 4 and 5 for details. For now, however, consider taking partial positions in the following.
- UltraShort S & P 500 Proshares (SDS) – Buy under $75, Strong Buy under $65
- UltraShort Financials ProShares (SKF) -- Buy Under $141; Strong Buy below $125
- UltraShort QQQ ProShares (QID) – Buy Under $55, Strong Buy under $50
- UltraShort Real Estate ProShares (SRS) – Buy Under $58, Strong Buy under $48
- UltraShort Russell2000 ProShares (TWM) – Buy Under $75, Strong Buy under $65
Over the past weeks as the market broke to new lows, a number of readers said my buy levels were too conservative i.e. at such low prices they were unlikely to be hit. The brief rally over the past week has brought many of these already quite close. Again, these move at twice the rate of the index they short, so when the market is volatile, these can get positively hyperactive.
2. Continue to Take Partial Positions at Our Recommended Strong Support Levels
Beyond the Ultrashort ETFs if you can earn reliable dividends from 8-12 percent or more while you wait for recovery, ongoing investment makes sense.
That’s my focus at http://highdividendstocksguide.blogspot.com .
3. Use Sell Stops?
While our emphasis is buy and hold as long as the distribution is safe and fundamentals hold steady, some may want to hedge their bets, especially if they may need the cash within the next year or so. Those in that position should consider using sell stops around 15% below the Strong Buy price as partial principle protection, though you risk getting knocked out of your positions, only to see them come back soon and possibly rise higher while you miss the dividend. It’s a judgment call, though not a bad one for at least some of your holdings given the current pessimism (which of course can change, fast).
Again, our focus is on getting high yields from healthy businesses whose price will recover while we earn outsized returns. Ultrashorts are a bet on near term market direction, and we don’t try to time the market too much, since very few are successful at it.
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Regarding the limited use of select ultrashort ETFs I can only urge caution and discipline for even experienced investors. These tools require a steady hand and plenty of close attention. They are not for the faint of heart or the dim witted.
On Mar 24 09:26 AM mac.barron wrote:
> Mr. Wachtel has produced an excellent article. His (and Roubini's)
> analysis is cogent and well presented. Perhaps the one caveat would
> be that, while China needs demand for its products from the west
> to fully recover, they also have a fairly large pool of potential
> consumers within their borders which should be able to help their
> economy while they wait for the U.S. & Europe.
>
> Regarding the limited use of select ultrashort ETFs I can only urge
> caution and discipline for even experienced investors. These tools
> require a steady hand and plenty of close attention. They are not
> for the faint of heart or the dim witted.
j2eewebprogrammer.blog...
However, Ultrashort Leveraged Funds are not for buy and hold investors as they are meant to capture the opposite of a daily average movement of an index
On Mar 24 04:39 PM AssetReset wrote:
> Great Article, Great analysis, I agree completely with the economic
> outlook (and current sucker rally)
>
> However, Ultrashort Leveraged Funds are not for buy and hold investors
> as they are meant to capture the opposite of a daily average movement
> of an index
On Mar 24 02:35 PM EDGNOS wrote:
> The only thing I do not like about this article is the valuations
> of Strong Buy. It implies technical analysis, which as far as I'm
> concerned is out the window. Check out the Money section for playing
> even more aggressively on shorting financials. FAZ 3X Financial Bear.
>
>
> j2eewebprogrammer.blog...