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  • The Building Pressures for a Deflationary Outcome
    It should be no secret by now why the Federal Reserve chairmen Ben Bernanke has been so resolute in enacting the massive US debt purchases that began in 2010 and presumably will continue as we speak. It’s not to keep interest rates low (he only has power over short-term rates anyway and he has already brought them to near 0 %). It’s not to bail out the banks, at least explicitly, even though the main benefactors of these purchases are the largest banks. It’s not even to bring down the unemployment rate (no matter what he says about the FED’s dual mandate). The FED has never really been too concerned with jobs and it’s a stretch to think that they have suddenly gotten religion and are working to better the lot of the downtrodden worker class. The scary word that nobody wants to talk about (or at least be truthful about) is D-E-F-L-A-T-I-O-N. Mr. Bernanke is terrified of the prospect of asset prices resetting and his friends in both the banking industry and in government are 100% with him on this one. 

    Before we go any further, maybe we should discuss some of the classical definitions of deflation and then try to see why we might be heading that way. Deflation is defined at as:

    “A decline in general price levels, often caused by a reduction in the supply of money or credit. Deflation can also be brought about by direct contractions in spending, either in the form of a reduction in government spending, personal spending or investment spending.”

    We can see how the Bernanke solution is aimed directly at the classical deflation definition by making sure there is no shortage of the supply of money or credit. Here is where the problems arise and why the solution may not provide the long-term fix we are hoping for.

    Problem #1: Credit Creation Lacking

    The transmission mechanism is not fully functioning for a variety of reasons. So while the FED has made an ample supply of money available, the credit creation process has been hamstrung by banks who are still trying to clear their balance sheets of bad loans and have tightened lending standards for just about everyone. So credit is not flowing. Score 1 for deflationary risks on the rise.

    Problem #2: Housing not in Recovery

    Typically the largest asset that any individual owns is real estate. The numbers on housing do not look good and by many measures the market is still grossly overvalued by more than 20%. In addition, since this was the source of the problem for many financial institutions and Fannie and Freddie, the credit creation cycle here is even more restrictive than that of the general economy. Score another 1 for deflationary risks on the rise.

    Problem #3: People are Afraid

    People are still scared. Even though the stock market has doubled from its March 2009 lows, and even though Consumer Confidence has risen from where it was during the dark days of the crisis, there is a palpable fear out there. A fear of a system not designed to help the middle class anymore and increasingly manipulated to benefit a select few. A fear of losing your job or fears of not finding another if you have been laid off. These fears have been suppressed somewhat by the rise in the equity markets but not everyone has participated and not everyone buys the ‘’miracle” of QE2. These fears are made evident whenever we get an external event such as the Middle East revolts or another EU debt blowup. All it takes is a little poke and the markets swoon like teenagers at lookout point. The equity market cannot go higher forever and when it stops, fear will rear its ugly head. So those big screen TV purchases and those new cars (with 0% financing!), and all the trinkets and baubles that seem to transfix the American psyche will not help when people get scared. To give some backing evidence I cite the results of a Bloomberg News poll:

    “March 10 (Bloomberg) -- Only 1 American in 7 has faith a lasting economic recovery has taken hold and a plurality say they are personally worse off than they were two years ago.

    Almost half of the respondents in a Bloomberg National Poll conducted March 4-7 (2011) believe the U.S. is in a “fragile” rebound and could fall back into recession. More than a third of the country believes the U.S. never emerged from recession.

    Sixty-three percent of Americans say the nation is on the wrong track, compared with 66 percent who said so in December, which was the lowest in the national mood in the one and a half years the Bloomberg poll has been conducted.”

    Risk of Deflation 3, Bernanke 0.

    Problem #4: Reversion to the Mean

    I hate to bring in statistical concepts but in simple terms asset prices in America have simply moved too far too fast and this bubble has taken almost 25 years to build. Using the equity market as measured by the SP-500 index, from the October low right after the market crash in 1987, the market has advanced at an approximate 22% average annual clip. I know we all expect to make 20% + each and every year but much of this was engineered by low rates from the FED, and massive leverage by the financial community. If you think that a 22% annual rate of return for the next 25 years is something reasonable then you have nothing to worry about. If you think, as I do, that a 22% annual return was the machination of a bubble economy gone mad, then there is plenty to worry about. Risk of Deflation 4, Bernanke 0.

    Problem # 5: Withdrawal of Stimulus

    Perhaps the most pressing problem that the FED will face that they actually can influence is how to withdraw the stimulus. For many of the reasons stated above I believe that Mr. Bernanke is terrified of any actions that catalyze fear in the economy or financial community. Raising rates is out of the question because let’s face it the banks are still in deep trouble. He may try to pay the banks interest on excess reserves, but that only works if he is worried about inflation because it will further restrict credit creation. Normalizing the environment will not be easy and the longer the FED continues this low rate, high liquidity environment, the greater the chance of a backlash. A large enough backlash will be the best catalyst that deflation could ever hope for. Risk of Deflation 5, Bernanke 0.

    Problem # 6: Emerging Markets

    The emerging markets have served as the drivers of growth in commodities and have been frankly keeping the world afloat while the developed world pampers its bankers. There will be a time for correction (that nasty mean reversion trick) that will bring the emerging markets down and naturally dampen their inflation issues. Perhaps the catalyst will be oil prices, or maybe a true ‘Jasmine Revolution’ in China, but whatever the trigger it will not be pretty. You see countries like China are traveling down much the same road as we did. Your economy booms and your people go crazy and fill their houses with stuff. When they have too much stuff or their neighbor has better stuff, they buy a bigger house to fill with more and even better stuff. Eventually the prices of stuff and the houses it fills have moved too far too fast and have to correct. Risk of Deflation 6, Bernanke 0.

    Problem # 7: Euro Region

    Perhaps the statement that sums up the Euro zone crisis response should be “never have those with so much to do, done so little”. With the economies of Greece, Ireland, Portugal, Spain, and a number of others all teetering on the brink, the Euro region leaders seem to believe that putting off the crisis will somehow make it go away. Their refusal to allow banks to fail and their continued belief that all is needed is a little time and very low interest rates will be disastrous in the end. The unfortunate thing is the US has followed roughly the same path, so you can draw your own conclusions as to the outcome globally. Risk of Deflation 7, Bernanke 0, looks like a shutout.

    Problem # 8: Government Just Doesn’t Get It

    With all the problems of unemployment and lack of growth and people losing their homes, not a day goes by without a new proposal from Congress to address the issues of the day. The only problem is they refuse to address the issues in America and instead choose to solve the problems of the rest of the world. While the plans are made to cut benefits for elderly Americans and lay off teachers and put off infrastructure investment, we apparently are developing plans for a jobs program for the Middle East (and I’m not referring to NJ and Delaware). So the wealthy Saudi royal family can keep their gilded Mercedes and pet chimpanzees without having to worry too much, we are going to invest in a stimulus program for Middle East economies. How about that ! They are also apparently very interested in suppressing the violence in Libya and are “looking at all options”. I wonder if the kids who are trying to learn and better themselves in our own cities while dodging the violence of drug dealers and inner city life could use a little help first? Forget the score: 8 is enough !

    This does not have to be the doom and gloom scenario that everyone seems to have made it out to be. If the FED is even partially successful, the decline can be controlled and not happen overnight. In fact I believe this is what the FED should be planning instead of trying to put back the status quo of 2007. A controlled asset devaluation, which BTW should make the dollar stronger (remember the strong dollar policy?), will open opportunity up not only for those who are prepared, but also for the millions who up until this point have not participated in the economic ‘miracle’ of FED policy. This will also set the stage for the next economic boom in America and give us a fighting chance in the new century.

    Apr 20 6:16 AM | Link | Comment!
  • Linear Regression Analysis Technique for Current Market Action
    I often use linear regression channels to help in my assessment of market trends and I thought I might detail some methods so that other investors can benefit. In the current somewhat overheated market these techniques are invaluable in assessing reasonable entry points as stocks move higher and higher.

    What is a linear regression? On a typical stock chart we have price represented over time as the main characteristics with a ‘Y’ axis (price) and an ‘X’ axis (time). A linear regression analyzes the relationship between these 2 variables ‘X’ and ‘Y’ and attempts to find the best straight-line path through the data points. The goal of the regression analysis is to find the best line that comes closest to predicting ‘Y’ (price) from ‘X’ (time). The way I use it is to build a trend channel based upon a linear regression of recent price action in an attempt to determine what a reasonable entry point might be.

    Let’s take a look at a quick example using the SP-500 index itself. What we are going do first is draw a linear regression channel using a Raff regression channel tool built-in to TC2000, my favorite charting software. Developed by Gilbert Raff, the Raff Regression Channel is a linear regression with evenly spaced trend-lines above and below. The width of the channel is based on the high or low that is the furthest from the linear regression. The chart below shows the SP-500 with a Raff regression channel drawn from the December 2010 low to the close on 3/3/11.

    The way I would interpret this is as follows:

    1) The midpoint of the regression channel sits roughly at 1340. A break above this level would indicate to me that the index would more than likely try to test resistance at the upper channel band, which currently sits just under 1400. A failure to break above the mid-channel line might indicate that a test of the lower channel boundary, currently around 1300 is in the cards.

    2) Using the levels defined above I might decide to increase or decrease my market exposure as the situation dictates.

    The Raff regression channel technique can also be used with individual stocks to help pick reasonable entry points, especially where a stock has risen very rapidly. Let’s take a look at a known high flier in the tech space: NFLX (Netflix). Here is the chart:

    The basic technique is to identify the beginning of the latest trend (up or down) that you wish to analyze and draw a set of regression channels from that point forward. We are going to use the correction that finished in July 2010, in which the stock declined about 22% in a little more than a month. You can see the action has been choppy but the essence of the analysis is the same. The stock has fallen below the midpoint channel line and looks like it may test the lower channel. If you were fundamentally bullish the place to add to your positions would be after a successful test of the lower channel line or a break above the mid-channel line. If a stock breaks out above the upper channel line with volume that is always a very bullish signal and may indicate an acceleration of the trend.

    I hope this short introduction to regression channel analysis helps you in making better day to day investing and trading decisions. In the future I hope to expand upon this technique and demonstrate how I use consolidations after a big run-up to gauge an entry point into a high flier. Thanks for reading.

    Disclosure: I am long SPY.
    Mar 04 7:38 AM | Link | Comment!
  • What's the True Cost of Federal Reserve Market Manipulations ?

    What’s the cost of admission ?
    In today’s marketplace it’s all about the cost of admission, whether we are talking about jobs, real estate, or capital market opportunity. In the past 25 years we have all confused the price of admission with the ease of entry. Real Estate purchasers found it far too easy to enter the fantasy realm of wealthy property baron without really assessing the true cost of their actions. In contrast, job seekers are finding that the cost of admission to continued employment is higher than they may be able to afford as education, training, and skills are priced at a premium. We find the capital markets present us with quite a conundrum these days. While the Wall Street financiers can access virtually unlimited capital making their entry into the markets easy, I again wonder if we are missing the true cost of admission and sowing the seeds of disaster. The FED has announced the details of their QE2 (Quantitative Easing) program, designed to further suppress the cost of capital. Since short term rates are already near 0%, the FED has said they will be focusing on medium term (5 to 7 year) notes when they begin their $600 billion dollar program this month. The objective is to drive capital out of medium term bonds and into riskier assets. For banks this means making more loans to businesses and consumers, for consumers it is supposed to force them to stop saving and start spending money and boosting the economy. The problem I see with all of this is the effect the devaluation of our currency already has had on asset prices. Oil is rising again, agricultural commodities are soaring and Wall Street is up to it’s old tricks, namely borrowing from the taxpayer and investing the money overseas in faster growing markets. The rise in consumer prices is troubling and may give the FED pause before too long.

    In last month’s issue of my newsletter we were looking for an early November target on the SP-500 of 1223 (Page 2 Chart October Issue). On 11/5 we closed at 1225.85 and it looks like we have begun a correction. Having met our target price for the bullish cycle we face something of a quandary as our target was calculated without knowing whether the FED would actually commit to further easing. The next few weeks will be critical in determining whether this may be our top or alternatively all that money printing is going to propel risk assets higher. There are two scenarios that we need to assess: (1) the market has seen its top for 2010 and any action from this point on will be grinding lower with sell-offs and subsequent recoveries never getting past 1225.85, or (2) the market may correct a bit here (1150 ?) and then resume it’s upward bias, taking out 1225.85 and hurtle towards 1380. The wild card is whether the FED gets cold feet and let’s rising consumer prices dampen their monetary easing efforts or raises the bar even higher and commits more than $600 billion when it sees the economy not responding in the manner it intended. There is some anecdotal evidence in that Goldman Sachs and Pimco, 2 firms that have access to retired FED officials who in turn have access to current FED officials, have hinted that the FED may be prepared to inject far more than $600 billion into the economy if necessary. As we don’t have access to insider information let’s wait and see.

    The Fixed Income markets are responding in a choppy fashion after the FED detailed its plan. Prior to the details being announced, the 10 year treasury note gained some traction and the yield declined from 2.7 % to under 2.5%. However, after market participants assessed the potential that rising consumer prices may indicate nascent inflation they began selling and yields are once again rising. Part of the problem in our markets this year has been volatility. The FED’s actions have the potential to further de-stabilize the fixed income markets and create bubble like conditions in commodity and equity markets, defeating the purpose of stimulating economic growth. Out of instability comes fear and fear always trumps economic potential when investors get confused. I believe we will see more selling in the 10 year note in the short term, but a good entry point may be approaching as yields rise to near 3%.

    The election is over, the FED is still manipulating markets, and investors are still confused. While there is still little clarity, we are getting closer to determining what the trend may be over the next 6 to 12 months. A little more patience and analysis and we’ll soon know what we need to do.

    Disclosure: Disclosure: No Positions
    Nov 16 6:32 PM | Link | Comment!
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