More Market Pain Before Huge Market Gains

by: Joseph L. Shaefer

Nothing has improved in the U.S.'s, Europe’s, China’s, Brazil’s or the rest of the world’s economy. (Though we may enjoy a minor breather this week if the news is so-so. So-so is better than unmitigated bleakness.)

But before we bemoan our lot in life, remember this: We’re not down in the U.S. as much as they are everywhere else. Of the world’s 12 biggest economies, 11 are in full-blown bear markets, down 20% or more. This is terribly important because, in a globalized world, the U.S. cannot stand apart from problems elsewhere. We hang together or we hang separately. I believe the U.S., down but not yet as much as the others, will see our markets fall further before we see a real rally.

I am a fundamental value investor – but I don’t mind checking in with the gurus of the technical approach every now and again. What this market looks like to me is what the technicians call “a bear flag.” Imagine an upside-down flagpole with a flag fluttering upward to its right side.

According to technical guru Martin Pring, author of the definitive Technical Analysis Explained (1985, continually updated to its current 4th edition), this formation is “…bearish in nature. When the price breaks down from the flag, the almost vertical slide which usually precedes the formation of the flag resumes.”

Nothing goes straight up or straight down. So the slide from 12,724 on the Dow on July 21 to 10,719 on August 10 (2005 points in 20 days, surprising all of us with its velocity and causing us to see red ink on our August statements) was met by a relief rally. And now it looks as if that "fluttering flag" relief rally has stalled with no breeze and we are ready to resume “the almost vertical slide.” But I believe we can sidestep the worst of its fury.

A cursory look at the recommendations for your due diligence in our articles since late June show that we are mostly in income closed-end funds and inverse ETFs. That’s because the “climate,” globally and in the US, is not looking good:

  • Europe is diddling about when it should be acting in its own best interest. Heads are in the sand, hoping that they can muddle through. If Greece defaults, the bank recapitalization among the strong nations would probably cost somewhere north of $250 billion to a half-trillion dollars in direct costs and an incalculable amount higher in credit risk, loss of credibility, and possibly a U.S.-style mortgage crisis.
  • U.S. Corporate earnings are about to disappoint. And soon. Pre-announcements trying to soften the impact of lesser earnings are coming from such key leading indicators of economic well-being as basic materials (especially copper and iron ore), chemicals, energy (oil, natural gas, and coal), and semiconductors used in consumer electronics. A deceleration of productivity growth in the U.S. has been in the cards for months, with employees running ever faster just to keep their jobs. That takes its toll in health risks and accident risks.
  • Unemployment in the U.S. has gotten worse, not better, this summer. A worldwide slowdown could drive U.S. joblessness even higher in this deflationary (none dare call it stagflation) environment.
  • Retail sales are not improving. Gasoline is the only consistently rising component. All others are on a roller coaster that is meant for pre-schoolers – up 5 feet, down 3 feet. Nothing scary, just boring for the rest of us.
  • Home sales and foreclosures are not improving. (As prices fall, sales will improve, however.) We got into this mess because of stupid government, lender, and buyer actions in housing – which must improve to pull us out.
  • Leadership is AWOL. Congress is more concerned with mud-slinging the other party, and the administration is more concerned with blaming the previous administration or Congress.
  • Finally, there are scores of fundamental/value/investor sentiment indicators I use to gauge the most propitious times to be fully invested or on the sidelines, and none look all too rosy right now.

However, I believe this next decline might be faster, shorter, more violent, and more scary than most believe. That means it is likely to end sooner, provide more fantastic buying opportunity, and be a buyer’s delight – for those who kept their powder dry and their emotions in check. What gives me cause to think this, besides the fact that the faster and uglier it is, the more likely it will burn itself out by the fall?

My geopolitical read is that Europeans will realize they must follow the German model of hard work. The northern tier in Europe is already moving in that direction. If Greece, Portugal, et al, cannot, the eurozone will survive – but will be quietly marginalized until its debt is more manageable and then, perhaps, given “new status” in the EU – like an associate membership.

Unemployment will not improve much in the U.S., but I don’t believe it will continue its till-now precipitous decline. Young people seeking a job for the summer are now going back to school. Plus, looking out a year or more, Boomers start retiring in droves. That massive bulge of post-WWII population retiring will open up lots of slots in the work force, fortunately. Yes, some will need to work beyond typical retirement age. Others will want to, and already have the jobs. But I’ll wager the bulk will decide it’s time for them to enjoy the rewards of a lifetime of work, and will travel, relax, and do what they choose to.

More people employed during their acquisition years will equal higher retail sales. It won't happen overnight, but as the markets see that demographic trend kicking in, the markets will respond favorably.

New home permits have plunged. That’s good. It means we can now work down the existing home inventory. Bad for builders, good for the economy. And home prices are giving ground grudgingly. As they do, sales are being made. They will increase.

Finally, November is soon upon us. Since the stock market typically looks forward a year, November 2011 may well be a time of the beginning of optimism, knowing that we might get some adult leadership within a year. Government bailouts are going to be a thing of the past. We’ve seen that enemy, and the enemy is us.

Government spending and Fed meddling have succeeded only in preventing the natural course of events, which is to accept that bear markets are necessary for the formation of bull markets. They are two sides of the same coin, yin and yang. And so it is for the economy: We must have rests between heartbeats, exhalations between inhalations. We need to correct the excesses of credit and bad decisions.

These next few weeks will likely be a trying time time for investors. I think the virulence of the decline will result in a hockey-stick recovery, and I think investors will breathe a lot easier come November, barely a month away. For now, we are holding inverse ETFs like RWM, SBB, SH, SEF, and EEV. But we are also writing put options on those great companies already selling at or a smidgen above where they sold in March 2009. Among them are TOT, COP, STO, UVV, and SGG.

Disclosure: We, and/or those clients for whom it is appropriate, are long SBB, RWM, SEF, SH and EEV. We are also writing puts to buy a number of fine companies as their prices decline, STO, TOT, UUV, SGG and COP among them.

The Fine Print: As Registered Investment Advisors, we see it as our responsibility to advise the following: we do not know your personal financial situation, so the information contained in this communiqué represents the opinions of the staff of Stanford Wealth Management, and should not be construed as personalized investment advice.

Past performance is no guarantee of future results, rather an obvious statement but clearly too often unheeded judging by the number of investors who buy the current #1 mutual fund only to watch it plummet next month.

We encourage you to do your own research on individual issues we recommend for your analysis to see if they might be of value in your own investing. We take our responsibility to proffer intelligent commentary seriously, but it should not be assumed that investing in any securities we are investing in will always be profitable. We do our best to get it right, and we "eat our own cooking," but we could be wrong, hence our full disclosure as to whether we own or are buying the investments we write about.