The Market Can Still Crash Further

Includes: DIA, QQQ, SPY
by: Tycoon Report

This is one of the more important Tycoon Reports you'll read, so please make the extra effort to not skim over it.  Read it, because it can save you lots of money or make you huge profits.

This will be broken down into two parts:

1. A market commentary I wrote specifically for members of The Trend Rider.  Typically, I would never copy my Trend Rider market commentaries here at the free Tycoon Report. But oddly, I literally got a bunch of e-mails from paying members of The Trend Rider telling me the same exact thing - They highly recommend I "send this commentary out to readers of The Tycoon Report just this once". It's that important.

2. Credibility. Below the market commentary is something I wrote in December 2006 talking about what stock market pitfalls you MUST KNOW ABOUT for 2007.  Why read something that's nearly 2 years old?  PLEASE know that it's not some kind of "I told you so" or "look how smart we are" scheme.  But with so many different opinions out there, yet so little clarity, TR readers keep asking me for some kind of track record and I agree - How do you know who to look to and listen to for guidance in this scary market?  If you read what I wrote in December 2006, you will understand what we saw, what people told us we were crazy for saying, and you'll know why you MUST LISTEN to us today!

You want to avoid being in a herd that gets slaughtered?  Want to recover some recent losses?  Perhaps you want to make a killing on a once in a lifetime opportunity?  Then please relax, focus on this, and don't breeze through it...

PART 1 - My latest TTR market commentary

I wish politicians didn't feel the need to stick to their guns all the time.  Politicians should be able to change what they say, and just admit that they changed their minds, or that as time passed, situations changed. 

Stock market analysts and commentators and advisors do the same thing.  They write something down on paper (or text) and they are too afraid people will look at them like they are crazy, dumb, or just unsure of what they say if they change their tune.  They think people will not take what they say in the future seriously.

But I'm not like these market commentators, and I'm not a politician. The stock market isn't the place for that sort of thing.  "Sticking to your guns" is a rookie mistake.  In fact, one of the most important principles of trading/investing is the ability and willingness to change your stance, even if you just changed it 3 days ago. 

This market is a bucking bronco but fortunately for us, the direction of the general market doesn't necessarily dictate whether or not we are profitable. The market is changing very rapidly lately, and we have to adapt to that change rapidly. 

All weekend I read and talked to some of the greatest minds on Wall Street. There is more chaos than you would believe and sentiment is incredibly fearful. Of course we see that at intermediate bottoms. This is a market that can certainly crash. But it's likely if that happens, it will be after a fast bounce higher. I think people will celebrate a government bailout package short-term. But longer term, we still have more adjustable rate mortgages (ARMs) readjusting higher. So what will they do about that? How much ammo does the Fed and the Treasury have? How many tricks do they have up their sleeve and when will they be caught by surprise again?

Hearing Treasury Secretary Hank Paulson close the Fox news interview by saying, "I'm sorry we're in this situation, and we're gonna work through it" is definitely not comforting to me. But that doesn't mean everyone else feels that way. In fact, nothing that's happening here makes me feel any better. But that doesn't mean the rest of the investment world won't celebrate.

Anyway, I think in a market that can crash, we have to have bearish exposure constantly while we also make bullish plays.  The NYSE BPI has reversed sharply higher to a column of Xs again. That means the bulls are back on the field. The technical indicators tell me to lean back toward the bull side, but the charts don't know the whole story. So we should definitely be cautious here.

Just so you don't think I'm nuts here, check out the NYSE BPI chart. You can see that while we're still only in the third quarter of 08, we have changed columns 8 times. Typically, the NYSE changes columns only a few times per year.  I thought 2007 was active with 6 column changes.


Obviously this is unlike any market I have ever seen and I've studied all markets, but that goes for everyone I guess.  Everyone's saying this is the largest restructuring we've seen since the Great Depression but this is very different than the Great Depression. The S&L crisis was different in early '90s. The government, using the RTC (Resolution Trust Corporation) inherited and then liquidated mostly hard assets like real estate from the S&Ls to clean off their balance sheets. The similarity was the government, through the RTC, took all these illiquid assets off the S&L's balance sheets so the system could decongest and so the banks could start loaning businesses money again and the system can start working. Today, the government would be taking questionable LOANS - subprime loans, many of which will default.  This should be much more difficult.

I see the government panicking, and it's not making me feel good. If they are successful, that could cause a market bottom here, but I think BEST CASE scenario, the market has one bottom here, and another one or two bottoms at the same level. So if the market jumps higher here on some sort of celebration of a bailout package (which would be a hell of a rally if it does rally), I have to believe we see a few more disasters that cause us to re-test the lows at best.  However, it's more likely that the market makes another leg lower than the one we've already seen.

With what I'm seeing the government do to curb a stock market crash, such as ban short-selling on 799 financial stocks, I know that's the wrong move because we need short sellers. This is because if the market falls through the floor and crashes, and financial stocks start dropping, who steps in to buy? Nobody! The only ones to buy are the short sellers when they close out their short positions. They have to buy back the stock that they originally sold short to close the position and take the profit. That "short-covering" is always the first bottom – not made by bold people who buy long on the cheap.

But then again, I think the greatest minds of our economy MUST have thought about the reasons I'm thinking about why it's stupid. But they did it anyway. So that gives me more reason to think they felt that the alternative was worse. The question is, what else do they see? There could VERY EASILY be a collapse of the market and economy. These guys are taking drastic measures. It's like the movie scene where the guy is sitting with a bomb on a timer in the last 3 seconds trying to decide whether to cut the blue or green wire. One will stop the bomb; the other will blow it up. Then they just say, what the hell, I guess it's the blue one and we have to take SOME action or the timer runs out and go blow up anyway.

The Fed recently had $800 billion in cash reserves. Now, after bailing out Fannie (FNM) & Freddie (FRE), Bear, AIG (NYSE:AIG) etc, they have only $300 billion and $500 billion in high risk sub-prime loans. That's not good. The Fed's job is to keep inflation low and employment full.  It's not to sell off parts of an insurance company's distressed assets or to back Fannie and Freddie or guarantee Bear Stearns' bad debt pools for J.P. Morgan (NYSE:JPM).

At one point the other day, institutions were so scared that they were paying the government to hold their money (buying Treasuries at a premium when Treasuries paid nearly 0%, knowing they would come down again in price). That hasn't happened since the Great Depression. 

A $65 billion money market fund suspended redemptions and threatened to "break the buck" by redeeming at less than face value (97 cents on the dollar). So the Treasury said they'd insure money market funds. 

AIG thought they had $20 billion in questionable illiquid assets, then within days it went to $40 billion and to $80 billion. I have to believe while the Fed is saying it's $85 billion, still, nobody knows the real number, yet the Fed will be the holders of the bad loans.

My point is the market CAN crash. Who knows what could happen here. That's why we have to have bearish exposure. That said…

Market bottoms happen when fear is extremely high – like now. At every market bottom everyone is saying – "no, this time is different" – like now. Typically you see huge volume as stocks trade higher, and Friday, as the market traded about 4% higher, the NYSE saw the highest volume traded in history. However it was stock market manipulation by the government. 

Commodity prices are down, which will help corporate profits and consumer demand. The central banks are taking extraordinary measures cooperating globally to support the market. And global markets could help a lot. Valuations have improved dramatically. Wednesday, in Britain the yield on the FTSE was higher than the ten year gilts. That happened last in March 2003 (bear market bottom) and in the late '50s – both were followed by big long rallies.

Maybe this is confusing more than helping. But I have to give you a complete picture (within reason - because I really can't type faster than the newest info is being printed).

So a big long-term buyer may be buying at the best time possible, but they have to be very brave.  (And that's not my thing. There's always money to be made out there and I'm not a long-term buy and holder typically, while I do have long-term holdings.)

I will be making some bullish recommendations on stocks that will benefit the most in the case of another bull rally. But just know that you should be playing both sides of the market - not only the bull side, and not only the bear side. If we get a panic with people dumping 401ks and all their mutual funds, it will be a relief to own some puts. Better safe than sorry.

Below is a 10-year chart of the S&P 500. I know that one bear market has nothing to do with the other, in fact they are completely different. But for the sake of illustrating what I'm thinking in terms of the CHART and what could happen, I compare the last bear market to today's market. This is what I think:

So my takeaway from the above commentary is we are in a market that can certainly crash. Sure, we will also likely get a big spike from the current levels. But the potential crash is somewhere in here. So the best thing to do is to stay hedged with some bearish positions that will profit if the market does crash, while playing the bull side as well. If you don't play the market that way, I would consider lightening up on stocks significantly on the next jolt higher, and then sitting on the sidelines for at least a few months.

Remember, you don't have to sell all or none - you can sell half. The goal is to not worry about missing the bottom, and to not worry about selling at the bottom.  The goal is to understand that you are in a market that can crash. Do you want to play that game, or wait till the rules change a bit? On a big pop higher, you will have a great opportunity to make money by entering bearish trades.  Everyone around you will probably be telling you we hit a bottom. But look above at the 2002 - 2003 bottom.  Bottoms are tested once or twice. That would almost certainly happen here.

PART 2 - What I wrote to Tycoon Report Readers in December 2006 about what dangers the market held and what you should know in 2007. 

(All TTR members have access to the track record of TTR trades, and I made a killing by taking bearish positions in financial stocks, but the article below goes into more detail in terms of the big picture.) Here it is...

With the possible economy-crippling scenarios that face us right now, we would be absolutely insane not to consider the possibility of an economic meltdown.

We don't claim to have a crystal ball, and we're well aware of both the bull arguments and the bear arguments that exist. The question is which story will be highlighted, and when. So when we structure our 2007 model portfolios, we are considering all of the possible negatives that could be unearthed, causing unprepared investors to suffer the consequences of complacency.

If the bull argument prevails, as it has been lately, then sure, we can have a great year and we'll all make good money again. But if certain bear arguments that currently exist come to the forefront, then it could conceivably cause a severe decline in the market that only a few of us will be well positioned for, and that's what we will be preparing you for in 2007.

So what's everyone else in our business doing right now? (I might make a couple of enemies here …)

While our competition might enjoy staggering subscription sales by feeding you any positive hype that they can get their hands on, the fact is that it's a win-win situation for them. They are capitalizing on the two most popular and therefore most profitable vibes right now:

  1. Ignorance
  2. Complacency

The first valuable idea that I will "download" into your brain is this:

Everyone and their uncle in my industry is upgrading their homes and cars, cashing in on your hyped up view of the market right now, because as long as they keep you excited, they will make their money. (But they forgot about the new guys in town who are here to bring you the cold, hard truth about what's going on, no matter what the cost.) That's why we wanted to get this report out to you early:

To give you the truth before the other publishers tamper with your brain any further!

In wartimes, governments can slant the majority of their entire nation's thinking to the government's preferred school of thought by using one of the most powerful weapons known to man: The Media.

So don't feel bad when you realize that, when it comes to your confidence in the market, you're the victim of that same manipulation. That your views may have be slanted/manipulated by that same powerful and sometimes hypnotizing media, in order to make the advertising dollars that keep that revenue wheel spinning.

You may be familiar with billionaire Mark Cuban – current owner of the Dallas Mavericks and co-founder of After going public with what was at the time the largest single-day gain in the history of the stock market in July of 1998, he sold to Yahoo! (NASDAQ:YHOO) for $5.7 billion at the height of the Internet bubble in 1999.

Only a couple of years later – after the NASDAQ was smashed to pieces along with Yahoo (which went from $125 to less than $5.00) – Cuban was
asked how he seemed to know when it was the exact right time to sell, while everyone else was experiencing such euphoric mania.

He said that he just recalled that famous old saying that his father used to recite: "When you're at a card game, and you look around the table at everyone else, if you can't figure out who the patsy is … It's YOU!" So after seeing that everyone else was high on the market, he knew that the game was over, and it was time to cash in his chips.

My point?

Look around you!

Right now, we are looking at the highest level of complacency in 13 years! The Chicago Board of Options Exchange's fear gauge "VIX" just hit the lowest level since 1993 (right before a 2 month correction of over 10%). I don't use this indicator to call market tops, but this sort of high complacency has set the stage for the market's worst declines in the past.

But that's not even what concerns us the most.

In this financial card game, most investors are playing without even understanding which devastating cards exist in the deck!

  • We face the risk of a currency crisis. Four years ago, former Fed Chairman Paul Volker said we're looking at a 75% chance of a currency crisis in the next 5 years.
  • For much of 2006, we had in inverted yield curve. Why would long-term investors settle for lower yields while short-term investors take so much risk? Because long-term investors will settle for lower yields now if they think that the economy and interest rates are going lower in the future. (The savviest investors use the bond market to predict the economy.) Inverted yield curves are almost always followed by a recession, or at least an economic slowdown.
  • We don't only have a housing bubble, but a credit bubble … thousands of Americans who refinanced their homes with Adjustable Rate Mortgages. Many of the option ARMs taken out in 2004 and 2005 are resetting at much higher payment schedules to the surprise of those who thought the low installments were fixed for at least five years. Since home prices have leveled off, borrowers can't count on rising equity to bail them out. 32.6% of new mortgages and home-equity loans in 2005 were interest only. 43% of first time home buyers in 2005 put no money down. 15.2% of 2005 buyers owe at least 10% more than their home is worth (negative equity.) And most disturbing of all is that $1 Trillion in 2006 and $1.7 Trillion in loans in 2007 will adjust to much higher rates.
  • Even the U.S. Government – which funded its spending with short-term financing at low rates – now must refinance trillions worth of its bonds at higher ones.
  • On November 30, the U.S. dollar hit a 20-month low against the euro (the dollar fell more than 2% against the euro in 1 week), and a 14-year low against the pound. It has dropped 6.7% against the Federal Reserve index of seven major currencies.
  • A recent Wall Street Journal front-page article said "Bush administration economic officials are eager to avoid a market-rattling crash" and "Nobody wants a rout -- a disorderly, panicky decline in the dollar," says Princeton University economist Alan Blinder, a former vice chairman of the Federal Reserve Board. A sharp drop in the dollar probably would lead foreign investors, who lend heavily to the U.S., to demand much higher interest rates. This would cause economies such as China and Japan to look to other countries for higher returns on their money.

I can go on and on, and anybody with common sense knows that there will be some scary event that unfolds at some point, which is why markets will always take big corrections for one reason or another. It's really just a question of which bogey-man gets you. Sure, we can be as bullish as anyone else is right now, but we're experienced enough to know not to "hold our allegiance to the bull side or the bear side."

We don't claim to know exactly what the next card to be drawn will be, but we know which bullish and bearish cards are left in the deck. So when we make our recommendations and construct our individual portfolios, we do so with one core understanding: That the disaster card is still in the deck somewhere, and the deck is getting smaller and smaller.

Look, of course, there are the bull arguments out there, some of which I have argued, like the fact that out of the 4-year election cycle, the pre-election year (2007) is historically the strongest. After everything you've just read, it may surprise you to know that we are not as bearish as you might think. But we know that the potential disaster you've just read about is definitely in the cards.

So what do we do in a situation like this?  We hedge.  We give you a complete and balanced picture of ways to navigate through 2007 without taking on a heck of a lot of risk, while at the same time positioning you to make massive profits if it's a calm day at sea. We construct a portfolio of stocks or options that we feel will be able to stand up to any of the cards that might be drawn in 2007.

One way is by profiting from option trades that increase in value as the market declines.  That is what you will see from me.  Another safety measure that we take when trading bullish positions is investing in companies that are focused on an area of high growth, in sectors that would feel a minimal impact of a bad U.S. Economy. But when we focus on U.S.Stocks we look for other safety measures.

When we dig through different ideas, we look for companies that can raise prices ahead of inflation. When interest rates rise, bonds become a more attractive investment alternative. This causes many companies to be stuck in the mud. If you own stock in companies that can't pass that increase in cost to its customers, the profits will decline.

We also prefer companies with high profit margins. A company with high profit margins shows that management understands the optimal costs structure of the business and doesn't spend one penny more than they need to.

If the U.S. economy hits a terrible recession, the companies with the higher profit margins can kill their competition by simply lowering prices. You see, they can still make a small profit, while their competitors with lower profit margins have to lose money on products just to be able to compete.

We also like to invest in companies that have little or no debt. Sure, there are certain sectors that by their very nature use debt as part of their every day business. Having said that, companies with relatively high debt are directly affected in two major ways when interest rates increase:

  1. The cost to carry the debt or to refinance it goes higher, leading to lower profit margins.
  2. Remember how I just said that companies with low profit margins have to lose money on products just to be able to compete during bad economic times such as a recession? Well imagine a company that has to borrow money at high rates to sell a product, costing them more in debt than they can bring in by selling it.

Okay folks, you get the point. I hope you make sure to keep reading what we write for you.  We're not the average Joe Schmoe "newsletter writers" here.  Almost all of those people either don't actually invest themselves or never managed a dime in their lives. 

Every editor, trading service Chief Investment Officer, and educator here at Tycoon has many years of real Wall Street money management experience. I not only spent my money management career on Wall Street 2 blocks from the NYSE, but I lived on the corner of Wall Street and Water Street, 1 block from the NYSE.  We eat, breath, sleep (and other things) Wall Street.  Please listen to us and don't fall for the hype any longer. We care about you folks.