Michael Michaud's  Instablog

By D.R. Barton, Jr. of Van Tharp Institute

Click Here for Van Tharp Institute 2009 - 2010 Trading Workshops Schedule

It’s been just a year since the credit / real estate bubble burst, and there is already serious discussion about another one.

In the current political and economic climate, the global response to the crisis was infusion of trillions of dollars of capital to attempt to reduce the impact of the bursting bubble. With that much extra liquidity chasing the same amount of goods and services (or really a lesser amount, given the global economic contraction), the price of something eventually has to go up.

The game is already afoot.

In places where the economies are a tad more nimble than in the U.S., Europe and Japan, the capital infusion has made a quicker and bigger impact. The manufacturing industries in Asia have recovered much faster than their western counterparts (you didn’t think Americans were going to stop buying big screen TVs, now did you?). Add that to the extra liquidity in the global markets and extremely low worldwide interest rates and you have cash chasing assets again, especially in Asia including Australia. As a case in point, Australia’s central bank has already begun raising interest rates to try to cool off inflationary pressures there.

A cover story in the Wall Street Journal trumpets “fear of a new bubble,” citing some compelling statistics. Included are run-away real estate prices in Hong Kong, Singapore, South Korea and Australia. And perhaps most telling is the fact that risk premium spread—the difference between junk bonds and highly rated bonds—is at its lowest level since February 2008 (before the investment banks Lehman Brothers and Bear Stearns collapsed).

So What?

Financial bubbles at their most basic occur when asset price levels far exceed any reasonable fundamental valuation. And the story always ends the same way. If Asian assets suffered through a bubble-collapse cycle, the ramifications would be felt (and felt strongly) in the rest of the world.

As with all bubbles, the support of the tangential financial markets is necessary. And the equities markets are certainly lending their support. Let’s take a look at an insightful chart from the folks over at Chart of the Day.

The fact there were 6 distinct rallies of greater than 15% during the bear market of the Depression is well known among market followers. This chart shows where the current rally from the March lows fits in with those of the past era.


Bulls could make a reasonable case that this might show that the current action isn’t a bear market rally, but has now escalated to full-fledged recovery. A more cautious view would be that the markets haven’t had time to digest the credit contraction from last fall and that the huge cash injection has merely given the market a “sugar high” and will delay meaningful recovery as it works through the system.

In either case, make sure your profit-taking and stop-loss exit plans are in place. And do take into account the fact that volatility is starting to creep back into the market.

Great Trading!
D. R.

About D.R. Barton, Jr.: A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena. He is a regularly featured guest on both Report on Business TV, and WTOP News Radio in Washington, D.C., and has been a guest on Bloomberg Radio. His articles have appeared on SmartMoney.com and Financial Advisor magazine. You may contact D.R. at the Van Tharp Institute

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Eight months ago, the stock market began a very large rally -- the gains exceeded 60% in the S&P 500. Everyone knows this. But here's a fact that has gone virtually unreported: The vast majority of those gains (about 90%) were from March through August. By comparison, September and October were sluggish.

Yet the past two months have been the very time when the financial press has been the loudest about "green shoots," "recovery" and "new bull market." So the question is WHY -- why so much enthusiasm, even as the evidence literally fades away?

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November 2009 Financial Forecast | What's Inside?

Special Section: The November Financial Forecast includes an eye-opening special section on Goldman Sachs. These new insights about one of Wall Street's most storied firms have broad implications for Wall Street as a whole. You will see a picture of Goldman's history plotted along a 100-year chart of the Dow. You will also learn how the same sentiment driving the market today will drive the course of mega-deal makers in the future. This is a can't-miss special section.
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About the Publisher, Elliott Wave International

Founded in 1979 by Robert R. Prechter Jr., Elliott Wave International (EWI) is the world's largest market forecasting firm. Its staff of full-time analysts provides 24-hour-a-day market analysis to institutional and private around the world.

By Van K. Tharp, Ph.D. of Van Tharp Institute

Click Here for Van Tharp Institute 2009 - 2010 Trading Workshops Schedule

Since my book Safe Strategies . . . came out, I have been saying that we are in a secular bear market. Most of my beliefs about this come from the wonderful work of Ed Easterling (Unexpected Returns: Understanding Secular Stock Market Cycles) and Michael Alexander (Stock Cycles: Why Stocks Won’t Beat Money Markets Over the Next Twenty Years). Alexander’s book was published at the end of the secular bull market in 2000. Easterling’s web site had predicted a bear market starting in 2000, even though the book wasn’t published until 2005.

Secular Markets

A lot of people try to define a secular market by the health of the economy; however, this is inaccurate. There are periods in bear markets when the economy does quite well, and there are periods in a bull market when the economy can be doing poorly. The following table shows the bull and bear secular markets since 1900. Both types of markets had periods of economic expansions and contractions to various degrees within them.


Secular markets relate to the cycles of corporate valuations based on the price earnings (PE) ratio. During a secular bull market, PE ratios go up. During a bear phase, the PE ratios go down. This has nothing to do with any underlying economic conditions, although bear phases do seem to correspond to inflationary or deflationary periods.

So what’s been happening to the PE ratio since 2000? Robert Schiller’s version (which is based upon a smoothing function) looks pretty much as expected. The PE has dropped dramatically since 2000.


You can see the end of the secular bull market and start of the secular bear market in 2000 quite clearly drawn with this data. PE ratios have had two small upswings since 2000, but the ratio is definitely on a downward spiral. Now look at the next chart, which shows the PE ratios based on real earnings. Can you believe it?


It shows a distinct 2000 peak and initial drop as in the Schiller chart, but then it shows something very abnormal happening now. Based on real earnings, the S&P 500 PE ratio is more than 3 times higher than its 2000 high. All I can say is “Wow!” Incidentally, I don’t look at this data (usually) more than once each year. A fund manager in our Blueprint class two weeks ago was kind enough to point out this occurrence to me.

Did we suddenly begin a secular bull market? Did the last secular bull never end? What is going on?

What’s going on is a statistical fluke. First, the PE ratio is based upon real earning, including one time write offs. The 2008-9 period saw a massive drop in S&P earnings. Look at the magnitude of the recent earnings drop.


The PE ratio has spiked up simply because earnings have fallen so much farther and so much faster than equity prices have fallen. That’s what is happening.

What Would You Do?

Now let’s go back to the very beginning of this year. Suppose you are the incoming administration (whether you are a Democrat or a Republican president is irrelevant), when corporate earnings were flagging and it was in your best interest to get the economy booming. The situation is pretty dire because debt levels are way up and countries are losing trust in the dollar, but you have to do something. You could manipulate the statistics fed to the public such as the CPI, but that’s already been done as much as possible. So what do you do to stimulate things?

* Lower interest rates to nearly zero.

* Stimulate the ailing car industry by creating Cash for Clunkers—a program that loses its effect as soon as the program ends.

* Stimulate the housing industry by giving a rebate to first time homebuyers. (Such a program qualifies poor people for buying a declining asset and could cause the potential for many more mortgage defaults in the future. One of my houses in Memphis was purchased by a lady who had to borrow most of her deposit from her 401K. She also required that I pay most of her closing costs so that she could afford to buy the house from me. On a national level, doesn’t this sound like another housing disaster waiting to happen?)

* Use your banking friends—like Goldman Sachs—to manipulate the market. (More on this below.)

Wouldn’t taking all of these steps get the economy booming? You would probably think so given where the Dow and S&P indexes are today. The following chart of the S&P 500 shows a 50% plus rise since early March.


How to Manipulate a Market

A fund manager from the USVI at the Peak 101 Workshop two weeks ago mentioned that trading for him is especially difficult right now because so many formerly reliable market factors and relationships simply don’t work anymore. The current S&P PE ratio “imbalance” mentioned earlier is but one example. In large part, I believe these effects arise from the government pouring money into the stock market through big money players, especially Goldman Sachs.

In a July feature article in Rolling Stone, Matt Taibbi suggested that Goldman Sachs has manipulated and profited handsomely from eight market bubbles since the Great Depression. These include the energy bubble of 2007-8 and the bailout bubble of 2008-9.

Reported elsewhere in July, a former programmer was accused of stealing some valuable software from Goldman Sachs. Interestingly, the Assistant U.S. Attorney on the case said, “The bank has raised the possibility that there is a danger that somebody who knew how to use this program could use it to manipulate markets in unfair ways.” (emphasis mine).

Here, though, is the best part according to the assistant U.S. Attorney: The proprietary code lets the firm do “sophisticated, high-speed and high-volume trades on various stock and commodities markets,” prosecutors said in court papers. The trades generate “many millions of dollars” each year. (A Bloomberg article on the theft noted that in 2008 Goldman earned $2.3B. In millions, that would be two thousand, three hundred millions.)

Conclusion

From a technical standpoint, notice what happened on that last price chart of the S&P when the index hit its 200 day moving average (i.e., the thin red line) at the beginning of June. It tracked the MA down for about five weeks and then took off again. Also, notice that the entire index price increase since early March has been on decreasing volume.

From a fundamental standpoint, companies are actually much weaker now than they have been in several quarters—earnings are atrocious compared with recent years.

Yet, the market has been going up strongly for over six months now. Why? Draw your own conclusions, but I hope you don’t truly think that the economic picture is anywhere near as rosy as the market’s current level might have you believe.

About Van Tharp: Trading coach, and author, Dr. Van K. Tharp is widely recognized for his best-selling books and his outstanding Peak Performance Home Study Program - a highly regarded classic that is suitable for all levels of traders and investors. You can learn more about Van Tharp at Van Tharp Institute

The Market Last Week and Ahead

First, the most important date report in the financial universe, the US Non-Farm Payroll Report is Friday. Last Friday authorities seized nine US banks. If people continue to carry trade the dollar and if they start to unwind those trades more traders and investors will have to cover their dollar shorts. That could possibly lead to a domino effect and that could possibly lead to a bit more of a correction. If it was a domino effect, it could be suddenly sharp.

Major Data Reports This Week

Tuesday: Australia Central Bank Interest Rate Decision

Wednesday: Australia Building Approvals, Euro-Zone Producer Price Index

Thursday: UK & Euro-Zone Central Bank Interest Rate Decisions

Friday: Australia Quarterly Monetary Policy Statement, Japan Concident Index, Australia Foreign Reserves, Canada Net Change in Employment, US Non-Farm Payrolls.

My Stock Pick This Week

Is a short-sell on a contract clinical development services company in the biotech industry. Fundamentally its current income is okay with its balance sheet holding about 60% debt to equity which is a negative in this cash is king time we are in currently, their cashflow stinks, and the stock-chart looks like it could provide a good low-risk high-reward short opportunity, especially if the broad market continues to sell off.

Sell Short Kendle International – Ticker KNDL

Sell Entry: 17.60 to 16.59

Stop-Loss: 18.66 or Higher

Take Profit Areas: 15.58, 14.57 to 13.56, 12.65 to 11.14

Kendle International Company Profile

Kendle International Inc., a clinical research organization, provides clinical development services on a contract basis to the biopharmaceutical industry worldwide. The company’s clinical development services include clinical trial management, clinical data management, statistical analysis, medical writing, regulatory consulting and organizational meeting management, and publications services. It operates through two segments, Early Stage and Late Stage. The Early Stage segment focuses on its Phase I operations. The Late Stage segment comprises clinical development services related to Phase II through III clinical trials; late phase clinical development services related to Phase IIIB and IV clinical trials. It also provides regulatory expertise and consulting services at various stages of drug and device development; designs clinical programs and clinical trial protocols, reviews programs, and provides gap analysis; offers consulting services for nonclinical development for small molecules, biologicals, vaccines, and devices; assists in the U.S. Food and Drug Administration application process; and involves in collection, analysis, and reporting of drug safety data. In addition, this segment offers customized clinical data management with the ability to connect into and utilize a customer’s own data systems. Kendle International operates in North America, Europe, Asia/Pacific, Latin America, and Africa. The company was founded in 1981 and is based in Cincinnati, Ohio.

Click here to review and trial the Trading Software we used in determining our buy long position on KNDL.

Click the Kendle International Stock Chart for a larger view.

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The idea of earnings driving the broad stock market is a myth.

It's corporate earnings season again, and everywhere you turn, analysts talk about the influence of earnings on the broad stock market:

* US Stocks Surge On Data, 3Q Earnings From JPMorgan, Intel (Wall Street Journal)

* Stocks Open Down on J&J Earnings (Washington Post)

* European Stocks Surge; US Earnings Lift Mood (Wall Street Journal)

With so much emphasis on earnings, this may come as a shock: The idea of earnings driving the broad stock market is a myth.

When making a statement like that, you'd better have proof. Robert Prechter, EWI's founder and CEO, presented some of it in his 1999 Wave Principle of Human Social Behavior (excerpt; italics added):

Are stocks driven by corporate earnings?

In June 1991, The Wall Street Journal reported on a study by Goldman Sachs’s Barrie Wigmore, who found that “only 35% of stock price growth [in the 1980s] can be attributed to earnings and interest rates.” Wigmore concludes that all the rest is due simply to changing social attitudes toward holding stocks. Says the Journal, “[This] may have just blown a hole through this most cherished of Wall Street convictions.”

What about simply the trend of earnings vs. the stock market?

Well, since 1932, corporate profits have been down in 19 years. The Dow rose in 14 of those years. In 1973-74, the Dow fell 46% while earnings rose 47%. 12-month earnings peaked at the bear market low. Earnings do not drive stocks.

And in 2004, EWI's monthly Elliott Wave Financial Forecast added this chart and comment:


Earnings don’t drive stock prices.

We’ve said it a thousand times and showed the history that proves the point time and again. But that’s not to say earnings don’t matter. When earnings give investors a rising sense of confidence, they can be a powerful backdrop for a downturn in stock prices. This was certainly true in 2000, as the chart shows. Peak earnings coincided with the stock market’s all-time high and stayed strong right through the third quarter before finally succumbing to the bear market in stock prices. Investors who bought stocks based on strong earnings (and the trend of higher earnings) got killed.

So if earnings don't drive the stock market's broad trend, what does?

The Elliott Wave Principle says that what shapes stock market trends is how investors collectively feel about the future. Investors' mood -- or social mood -- changes before "the fundamentals" reflect that change, which is why trying to predict the markets by following the earnings reports and other "fundamentals" will often leave you puzzled. The chart above makes that clear.

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Robert Prechter, Chartered Market Technician, is the world’s foremost expert on and proponent of the deflationary scenario. Prechter is the founder and CEO of Elliott Wave International, author of Wall Street best-sellers Conquer the Crash and Elliott Wave Principle and editor of The Elliott Wave Theorist monthly market letter since 1979.