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Author: JsnStein Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 113  
Subject: Market summary 7-22-06 Date: 7/22/2006 9:29 AM
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Introduction

Instead of focusing on an individual sector I have decided to present my overall view of the current environment. I believe this will give more substance as to what I have been watching and why. There is a method to this madness! In subsequent weeks I will write a more detailed view on individual sectors.

First, I need to give a brief introduction to how I analyze the markets. I generally look at everything as pieces of a bigger picture, like pieces of an ever-changing puzzle. I believe a good analogy is the game of chess. I look at every move that can be made by every piece on the board, and the repercussions of those moves. Then I form an overall opinion and strategy based on that analysis. Then once a move is made, I reanalyze that move as well as the reasons for that move and reform my opinion and strategy based on the changes while again looking at every move that can be made. Similarly, my analysis of the markets will appear to be a disjointed collection of thoughts as I lay out my analysis of each of the pieces. However, I will attempt to explain what role each piece plays in the overall picture.

Now which “piece” should I start with? I think China is a good start, as China seems to be at the core every economic discussion lately. First, I think China is to some degree a red herring. No one focuses on how small the Chinese economy is in comparison to the other major players. I am sure that heretical statement will raise howls of protest from the speculative hoards.

China is still a developing nation. It's China's growth from a developing nation to a developed nation that receives all the attention. But China is far from becoming a developed nation. It is China's position as the marginal player that makes it so important, similar to how Sandra Day O'Connor (and now Anthony Kennedy, although less so) was so important on the U.S. Supreme Court. I don't want to diminish the important role China is playing on the world stage, but for those that read the financial press I believe it's role is overstated. China is the Japan from the 80's. And just like the Japan of the 80's China will eventually fade from view, but it sure is exciting now! (In case it isn't apparent, the “exciting” statement was said tongue-in-cheek.)

China's growth is tremendous, their reforms have been met with resounding success, and their potential is ginormous. So why do I say they are red herring? China is not at the root of the world's economic imbalances and thus focusing on China for solutions are not the answer to correcting them. China is as much a victim of the excessive liquidity pumped into the system an its imbalances, as they are a purveyor. When I think of China I think of a bunch of children in a rowboat in the middle of an ocean of money struggling to keep their little dinghy afloat. But a huge wave of cash off in the horizon is coming to capsize them and they will (rightly) blame us in the developed world for the huge waves they had to deal with. Although, it must be pointed out they are having a lot of fun riding those waves and are not complaining while their boat is upright.

My next, obvious focus is liquidity. Japan's low interest rates (specifically ZIRP, Zero Interest Rate Policy) coupled with massive deficit spending in the U.S. is at the root of this excess of liquidity. It has been stated that Japan has ended ZIRP but its interest rates are still extremely low and its currency belies this. Deficit spending in the U.S., although being reduced is still promoting the creation of liquidity. Some would disagree with my final point but I contend that monetary policy in the U.S. is neutral to slightly accommodative. It is not restrictive.

That leads to my next point, equities, interest rates and inflation in the U.S. This is at the root of my prognostication. First, the stock market; I could write a book on this topic so I will summarize. I will recommend a book if my facts are too sparse. That book is Unexpected Returns – understanding secular stock market cycles by Ed Easterling. Although I disagree with some of the conclusions made in this book, it contains a lot of historical data and analysis that is quite compelling. The web site for the book, www.crestmontresearch.com is free and contains a lot of the graphs and charts in the book. To briefly summarize (some of this is not in the book, it is my analysis augmented by the facts in the book); looking through history we have bull and bear cycles. I think there is strong evidence that we are now in a bear market. At the turn of the previous century extremely volatile economic swings and an unstable monetary base marred the economy. This lead to the creation of the Federal Reserve in 1913, and this subsequently lead to the roaring 20's bull market. That ended in 1929 with the crash and the start of the Great Depression. The ensuing bear market was then exacerbated by incompetent, protectionist economic policy. By the 1940's it was widely understood that stocks were an extremely risky endeavor, which gave birth to the next bull market. The 1950's and early 1960's were a glorious time, the era of the nifty 50. That ended around 1966 and gave us the stagflation and bear market of the 1970's. By 1982, almost 17 years later, the Dow was at the exact same price it was back in 1966 and stocks were widely understood to be a bad investment. This gave birth to the bull market of the 1980's and 1990's. They were a glorious time. That ended in 2000… Do you see a pattern emerging? Can you guess where in the cycle we are?

I find it laughable when anyone states, “stocks are cheap”. Based on what? Compared to the irrational exuberance of the 1990's?!? In the year 2000 we had 2 decades of declining interest rates and inflation, a period of relative peace never seen before in recent history, including the end of the Cold War. Stable and consistent economic growth only briefly interrupted by minor recessions. In other words, we had the perfect environment. How do you improve on perfect? The only other option left is to go in the other direction, away from perfect. What that means exactly is unclear but the general direction is established bringing with it declining stock multiples, a secular bear market. This period will end when it is widely understood that stocks are risky investment. No bull market has EVER begun any other way. Do you really think, this time will be different?

I also believe real estate will be included in this bear market. In a period of steadily declining interest rates, the price of real estate steadily goes up because of the declining interest expense. That is unequivocally over. I believe the next 5, 10, 15 years will see flat to negate real returns on real estate. If interest rates go through the roof the decline may happen all at once via a tremendous crash, or the life may simply be sucked out of the market slowly over a period of time. The net effect is the same.

Actually, I didn't cover near as much as I wanted to but this is already more than I planned on writing. As usual, I have a problem with being pithy. I completely left out currency and oil and didn't really talk about interest rates and inflation. I guess those will be left for later. However, I do want to mention a couple things about interest rates before closing. We have an inverted yield curve, which portends a weak economic environment in the near future. But the talking heads are coming out telling us why this time it is really different. Oh good grief… The standard argument is that long term interest rates are being pushed down by foreign buying. OK, whatever, it's not different this time. There was a reason every time the curve inverted, why is this reason special? It's not; it is simply that the Pollyanna's need some (poor) excuse to explain why it is different this time. The inversion causes weakness as much as it portends it!


Currencies

The pennant formations fell apart before being completely formed so I am back to neutral and watching. Last week I mistakenly neglected to even mention my Canadian Dollar trade. The Canadian Dollar broke down through its channel so I traded it. I didn't believe in that trade so I sold a small position in case the break gained a little momentum. I probably shouldn't have traded it at all with it being in such a solid bullish trend. A solid uptrend, like the Canadian Dollar has been in, doesn't reverse that quickly. I would have much preferred a break to the upside. When it stalled at an uptrend line right above the 200-day MA I moved my stops to right above the market and predictably got stopped out at a small loss.

Australian Dollar: Neutral to slightly bearish.
British Pound: Neutral to slightly bullish.
Canadian Dollar: Neutral to bullish.
Euro: Neutral to slightly bullish.
Japanese Yen: Neutral to slightly bearish.
U.S. Dollar Index: Neutral to slightly bearish.


Energy

The breakout to new highs has been less than noteworthy. Unleaded gas appears to be forming an inclining wedge pattern. Due to the fact we are nearing the end of the summer (well, at least closer than a month ago), a break lower could turn the intermediate trend down and create a good short trade.

Crude Oil: Neutral to slightly bullish.
Heating Oil: Neutral to slightly bullish.
Natural Gas: Neutral to slightly bearish.
Unleaded Gasoline: Neutral to slightly bullish.


Grains

I think corn's jetpack malfunctioned; it is now falling like a rock, as are most of the grain markets. I hate weather markets. Being right about the direction doesn't matter, there is no place to put stops that won't get hit due to the extreme price swings. “Oh no! Drought! BUY! BUY! BUY! Darn! Rain! SELL! SELL! SELL!” I am a very rational and analytical person and I find these swings of emotion quite annoying.

Soybean oil's breakout to new highs failed and Soybeans are still trading in a long channel. Soybean meal is looking to test new lows.

Corn: Neutral to slightly bearish, weather market.
Oats: Neutral to slightly bullish, weather market.
Rough Rice: Neutral to bullish.
Soybean Meal: Neutral to bearish, weather market.
Soybean Oil: Neutral to slightly bullish, weather market.
Soybeans: Neutral, trading in a channel, weather market.
Wheat (CBOT): Neutral to slightly bullish, weather market.


Interest Rates

The trend is still lower and the yield curve is still inverted. There is an interesting paradigm playing out here. The curve is inverted, meaning that shorter rates are higher than longer rates. However, when looking at the charts the short treasuries are still in a solid downtrend whereas the longer term rates have formed what may be an intermediate term bottom. Which tells me that the inversion may get much worse before it reverts. I think this scenario fits nicely with crude oil's recent break out to new highs, which would point to more petro-dollars flowing into long term treasures. Well, that and China is probably still trying to support their currency. Can anyone say, rubber band?

2-year Notes: Neutral to bearish.
5-year Notes: Neutral to bearish.
10-year Notes: Neutral to bearish.
30-year Bonds: Neutral to bearish.


Meats

The advance in cattle is stalled and pork is weak. Nothing tradable.

Feeder Cattle: Neutral to slightly bullish.
Live Cattle: Neutral to slightly bullish.
Lean Hogs: Neutral.
Pork Bellies: Neutral.


Metals

The swing higher is stalled. Although I want to short silver the expanded ranges create the need for wider stops making any potential trade's risk to reward unappealing. If I can find a good entry I will take it.

Copper: Neutral.
Gold: Neutral.
Palladium: Neutral.
Platinum: Neutral.
Silver: Bearish.


Softs

Cocoa took a major dive on Monday. Did I mention I hate weather markets? OK, cocoa gets crossed off the list. And it is a great example of why hard stops are needed; the whole bull move was erased in one day.

I have changed my stance on cotton #2, the charts are now beginning to look bullish.

Sugar is resting on support from the previous low from last month and the 200-day MA. A bounce or a break will get me short.

Cocoa: Neutral, weather market.
Coffee C: Neutral to bearish.
Cotton #2: Neutral to bullish, weather market.
Lumber: Neutral to bearish.
Orange Juice: Neutral, weather market.
Sugar #11: Bearish.


Indexes (Stock Markets)

Trend is down, momentum is down, no reason to buy only to sell. I already noted most of my reasons to be bearish in the introduction. My initial price target for the Dow is 9,500 and that is based simply on the fact that I believe this to be a bear market. Because of that belief the standard metric to define a bear market is down 20%, we need to get to 9,500 on the Dow for it to be defined as a bear market. However, the Nasdaq is going to be defined as a bear market far sooner.

Actually, I am expecting some consolidation (maybe?). The real bear case will begin to be made toward the end of next month, that is when people are really going to get scared and start selling. The September / October time frame always brings out the nervous people preparing for another crash and should also begin to bring more “weaker than expected” economic numbers. A crash is possible due to the extraction of liquidity. I am not planning for a crash, although I do want to be heavily short to profit from a crash if it does happen. At the very least I think we can expect an acceleration to the downside in this time frame.

Dow Jones Industrial Index: Bearish.
Nasdaq 100: Bearish.
S&P 500: Bearish.


Notes

In the last week I have been reassessing my strategy and I have diagnosed a problem. In the first part of the year I had a string of very successful trades. As I watched trade after trade go to a large profit, it felt like I could not do anything wrong. At the end of this time, about the same time I began writing these posts, this period of euphoria has lead to a period of mediocre trades that has begun to lead to a feeling that I can't do anything right.

If I look at the results of the last few months, I have had a series of small profits and small losses, basically a breakeven as my account is up slightly. However, I haven't had a really successful trade, nothing like I had in the first part of the year. But probably more importantly, I have watched a couple big trades occur that I had foreseen but did not take full advantage of. Namely, the short homebuilder (in the stock market) and short Nasdaq trades. I profited from both of these trades but not nearly as much as I believe I should have.

Now, because of the ensuing frustration and general malaise I have begun to take trades based on weak signals. I think of the market axiom, if you look at a chart long enough you can find a trade. I am not entering good trades, I am entering every trade and it is feeding this destructive cycle. So it is time to take a step back and reevaluate what I am doing before this gets out of control.

There is also an additional emotional component to this. I have gotten my trading to a point that I am seriously considering taking my trading full time. This is coupled with the fact that my current full time job has become unbearable and a change has become necessary regardless of what I intend to do with my trading. There are some other personal issues surrounding this situation as well that I won't go into. This has created additional pressure, exacerbating me feeling the need to push my trading goals to unrealistic levels.

I know the solution. The solution is always evident; realizing the need for the solution is the most difficult part. In general, I am going to refine my trading rules to accomplish two goals. First, I have been extremely bearish on the stock market and have been beating myself up for missing most of the move. The problem is that I don't have adequate trading rules to take advantage of trades that are based mainly on fundamental analysis. If the chart doesn't give me a trade trigger I stand back and wait for a trigger while becoming increasing frustrated that I am not in the market. On Monday, two weeks ago I began to enter an order to short the Nasdaq but stopped asking myself what (in the chart) was telling me to trade this? The answer was nothing so I didn't enter the trade (in hindsight it would have been a great trade). I need rules to accommodate this situation.

My second goal is to create some better rules as to what to watch. I have been watching too many things and seeing (weak) trades everywhere. The goal is not to trade everything like some mythical market maven but to find the few, strongest trades that offer the most potential. A great example of this is corn and sugar #11, especially sugar #11 because I have already made a good trade in it. I have been bearish on these markets and thus every time they go down I kick myself for not being short. The goal is not to be short everything I am bearish on. As a matter of fact, I shouldn't be bearish at all. I need to wait until these markets give a good trade setup and then take that trade. If a good trade setup is not presented being bearish is irrelevant, I shouldn't be short even if the markets go down.

The two rules sound like they contradict but they don't. I have been solidly fundamentally bearish on the stock market and the chart is also bearish. Thus waiting for a trigger in the dailies is stupid. In contrast, I can't make a solid fundamental case for being bearish on corn or sugar. I am bearish based on a few fundamental factors and a weak chart. So I guess the real issue is simply being able to distinguish between the two and having rules to trade them appropriately.


Open Positions (average true range)


Liquidated (trade results)
Short Sept. Canadian Dollar (small loss)


Jason
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