The Market Ticker

1. Oil is now well north of $60. Much of this is simple demand but a not-so-small part of it is Iran screwing around with those British sailors. This is unlikely to get resolved quickly, and if there are shots fired you can bet oil will be $100+ almost immediately. High energy prices cause problems for everyone up and down the economy due to inflationary pressure - they force prices up at the producer level as everything is impacted from the cost of making steel to the cost of a truck getting products to the store.
2. Millions of "Option ARM"s will reset in the next 18-24 months. This is just starting now and is going to get a lot worse. Many of these homeowners are underwater and cannot refinance out. An alarming foreclosure rate is developing rapidly, as are large REO (owned by bank) foreclosed property inventories - this tells you that the banks cannot get rid of the properties they foreclose on at a profit in a reasonable fashion. That's not good.
3. The money supply used by consumers is drying up. All the home equity lines of credit have been made that, realistically, can be. This has driven the US Saving's Rate to a negative amount for the first time since the Depression. While there is some dispute over exactly how bad this is for the economy, one thing is certain - if you draw down your savings and replace it with debt, you will pay interest expense that wasn't there before which will further crimp your lifestyle for a very long time.
4. There is a very real possibility of a liquidity crunch coming in the equity markets. Many people are poo-pooing this but I believe the possibility is VERY REAL and will show its ugly head soon. There is no quick way out of this one - the problem lies in the bond markets, where risk premiums are going up. This radically raises effective interest rates because interest paid to private parties is, after all, about the chance you won't pay the lender back. That is, if there is a 1-in-100 chance of default, then if there are 100 loans of $1,000 each in that "bond" the interest rate must be at least 1% higher than a bond that has no risk of default - otherwise nobody in their right mind would buy it. The fed has very limited control over what REAL interest rates are due to this - if loans become very risky then the Fed could cut its rates to zero and it wouldn't matter!

Now let's look at the "fundamental analysis" of the markets. Fundamental analysis encompasses many things, including the earnings growth potential of a given market or stock, its debt levels, and price relative to sales and earnings.

The "talking heads" are all talking about single digit growth in earnings this year - and they may be overstating the possibility of a good year for earnings. This is important because right now the S&P 500 is selling at a P/E of about 15.6! The P/E of a stock is usually thought of as "valued fairly" when it is equal to the next year's expected earnings increase in percentage. This means that the S&P 500 is extremely overvalued - by about fifty percent - if indeed earnings are only going to grow in the single digits this year!

This is not a positive factor at all. If in fact earnings growth is decelerating, as is predicted, by approximately 12.5%, then the market suddenly looks VERY overvalued! For all of 2006 the s&P500 grew earnings at 13.04%. Zacks expected earnings growth in '07 to be 10.52%, while more recent predictions have been "high single digits." It could be said that the S&P was "slightly overvalued" at the end of 2006. If these deceleration numbers are accurate, then it REALLY looks overvalued now!

A peek at the technicals of the market is at least as disturbing. Technical analysis is the viewing of past performance in an effort to glean a hint of where the market is headed in the future. It is not an exact science and in fact is often DEAD WRONG, but it does provide some hints and the strength of the signals given can usually be calibrated in some fashion.

Here is a chart of the last year's S&P 500 action:

Last summer we moved down to the 1225 level in the S&P, rebounded for a bit, tested that low again and then began to move higher - a move that persisted until the end of February. This is a common pattern - what is called a "double bottom". The decline going into the bottom last summer, however, was fairly orderly - it was not so much a plunge as a slide over the course of a month or so.

In February we fell off a cliff. We then tested that low and breached it, then retraced about 3/4 of the loss and failed in the advance at that point. This is fairly negative signal and in fact is sometimes thought of as a "double top", although the more "traditional" pattern retraces all the way back to the top and meets resistance there. What tends to back this, however, as a potential "double top" is the small dip in the middle of February that preceded the plunge - the advance failed there at that point of resistance.

A look at the two year chart shows a similar plunge in October of 2005, but that one was followed by a retracement which did not stall out and a subsequent solid advance.

Going back even further, to the tech bubble days, we see a more ominous trend. The bubble saw S&P numbers near 1550 at the peak. Those values have not been seen since, and the retracement from those highs was almost fifty percent! Perhaps most importantly, as we approached the 1500 level the advanced stalled and then failed, and has failed a retest.

Look at the present day chart, it appears that the trend remains solidly down. If you draw a line from the top of the recent highs through the failed retest, you see a downtrend line that remains unbroken - with lower highs being taken since that failure.

In addition volume on up days has been notably weaker than on down days. Markets (or individual stocks) rising on weaker volume is not a good sign. It means that prices are rising more because of fewer sellers than lots of buyers. Volume shows conviction behind the move and is an important confirmatory signal that the move you're seeing is "real".

And, as we sit now, it appears that MACD (momentum) is turning negative.

What does all of this mean? In my opinion, it means we are headed for lower markets. On a technical analysis perspective I would expect a retest of the lows of February in the 1370 range. If that is violated, and especially if it is violated on heavy volume due to a geopolitical or business blowup of some sort (say, in the mortgage lending space) we could very easily find ourselves back in the 1220 range within a very short period of time.

This would be a roughly 15% haircut on the broader markets.

Of far more serious concern is the possibility that we fail at the 1220 range. That would put the next real support at the 1175 level and, below that, around 1130. The latter would represent a 20% correction.

There is VERY STRONG support around 1070-1090 - failure there takes us under 1000 in very short order, potentially all the way back to the lows of the crash near the 790s!

Finally, and possibly most importantly, the yield curve in US Treasuries is present inverted, although mostly at the very-short maturities. This has an extremely high correlation with recessions. While this signal has dissipated a bit in the last couple of weeks it is still worrisome - until a more-normal appearance resumes this is a signal that you must pay attention to due to its very high predictive value.

Will it start Monday? This is not possible to know. It is entirely possible that we will first see yet another attempt at an advance, or even two or more. But unless we can break out above the mid February highs in the S&P 500, from a technical analysis perspective the trend is downward!

When you add to all of this the economic background issues I just don't see higher markets in the near future, nor do I see support for the "quick recovery" we had going into last fall that led us to the highs we recently enjoyed.

Now will the worst happen? Not necessarily. But what I believe, and what I've planned for in my portfolio at the present time, is that we're going to see:

1. A meltdown of significant proportion in the mortgage lending space. This is unlikely to leave any ALT-A lender untouched. Any lender with more than a very small portion of their portfolio (say, 10-20%) in most ALT-A and any Subprime product is likely to find themselves with a very serious liquidity problem. In my opinion the lending space has so many good "short selling" targets in it that its hard to figure out which represents the best opportunity! The homebuilders are also good targets, although many of them have taken huge haircuts already. I fully expect this problem to get worse - far worse - before it gets better. Indeed, I wouldn't be surprised if the real estate market does not turn around materially before 2010 with total real price declines of at least 15-20% in many markets. Some will see much larger declines, and a few (those which didn't participate in the boom!) will be mostly spared.
2. I expect the housing market problems to spread. Construction jobs are quite a significant component of the economy and they're going away in the residential space quickly. There are already signs that consumer spending is starting to contract - its not showing up in the numbers to a great degree yet, but those numbers are lagging indicators. Where it is showing up is in places like Circuit City, which just announced that they are laying off many workers to hire lower-wage replacements! While this problem may be company-specific I'm not taking that bet until I see evidence of it. WalMart has announced that same-store sales have slowed and shifted materially to Sams' Clubs, which may indicate some belt-tightening by the consumer (buying larger lots at a given time as a hedge against rising food prices)
3. I expect food prices to rise materially in the year ahead. This is quite inflationary and is driven by our government's foolish emphasis on Ethanol. Corn is a feedstock for our nation's livestock programs, and diverting it to make fuel has already caused significant increases in cost for chicken farmers. Tyson has warned that we should expect significantly higher prices. Soda prices have already gone up significantly - as recently as the winter months you could buy 12 packs of many soda products for $2.50 each or 2 for $5 - now they're in the high $3 range! That's an incredible price increase and it is all on the back of the corn syrup used for sweetening the drinks. If this sort of inflationary pressure shows up in the rest of the food chain consumers are in for a major sticker shock at the grocery store.
4. I expect gasoline and oil products to rise materially in price. If there is a blowup in Iran of some sort we are essentially certain to see $5 gasoline almost instantly. This will destroy the recreational marine market, among others, seriously trash an already mortally wounded US auto industry and certainly add to recessionary pressures.
5. I do not expect that Gold, Silver, and the stocks of these firms are a safe hedge. The prevailing wisdom is that you hide there in bad economic times. The problem with this is that if liquidity becomes an issue there will be no safe place to hide in the metals sector either.

So what do you do if you're in the equities market right now and fearful of trouble? Here's my take:

1. If your investment goals are very conservative (or you are retired) and most of your money is in fixed income, insure that none of it is in investments that have exposure to "CDOs" - that is, mortgage-backed bonds! This is absolutely critical! If you are holding bond mutual funds find out what is in those mutual funds' portfolios and what their investment philosophy is regarding CDOs and, if you don't like the answer, GET OUT and switch to a DIFFERENT bond fund without that exposure! If there is a significant blowup in these securities this may not stay contained to one credit grade and even very "safe" bonds may take BIG losses. You buy bonds (and bond funds) for safety and current income - don't jeopardise either.
2. If you have long-term stock positions consider purchasing a hedge against a significant decline. You can currently buy "PUTs" on SPY (the S&P 500 ETF) for about 2% of your position's net value with a "deductible" 10% below current price, good until December 2008. This is quite-cheap insurance and will prevent you from taking more than a 10% loss in those positions or having to sell them (and pay the income taxes on the capital gains.) If you are holding mutual funds you can determine what ETF has a similar portfolio and do the same thing by buying PUTs on THAT instead; it does not have to be on the exact same security (there are no options traded against mutual funds, for example.) MOST ETFs have options traded against them.
3. If your investment goals are moderately aggressive you might consider a position in the ETF "SRS". This is a fund that seeks to produce results of twice the downside of the real estate industry. That is, if an "index" of this industry would rise 10%, this fund would drop 20%; if the index would decline 10% this fund would rise 20%. It is not exact, of course, but its a good way to play a diversified decline in this sector. Note that this sort of purchase carries more risk because they try to double the downstroke in the sector. The converse, of course, is that a move up will cost you double what it would if you just shorted a similar index. (On the converse, if you think the R/E industry will improve at some point in the future you could sell short this ETF and play it that way!)
4. If your investment goals are more aggressive consider short-selling or buying PUTs directly against mortgage lenders and/or builders. This is an area where specific stocks need to be researched; you can't just "scattershot" everyone - you'll lose money - guaranteed! I won't make specific recommendations here, as that sort of research is your job (and your responsibility.) I will tell you that I believe there are at least a dozen high quality short and put-buying opportunities in this sector right now. Short sales and PUT buying needs to be monitored regularly - you can't just short a company and disappear for six months, and you must pay close attention to margin requirements. This is not for the small-nutted folks, but if you have an aggressive posture in the markets it can be extremely profitable.
5. I would not short the entire market - at least not here. That is a truly speculative play. However, if we break the late February lows to the downside, especially if it happens on strong volume, I would have to seriously consider shorting the S&P500 by short-selling the SPYders.

Remember that in a down market capital preservation is critically important. When the 2000 crash came the indices fell 50%, but many people lost far more than half of their portfolios.

DO NOT ATTEMPT TO BOTTOM FISH! Several associates of mine thought "the worst was over" when tech stocks were cut in half, bought in heavily, only to see them collapse to 10% of their former price - or go underwater entirely! If you miss the first 5-10% of the upswing when this is over but only take 10% of the loss that everyone else suffers you will be so far ahead you won't care about not "calling the bottom." There is almost no chance of being right about when "it's over" - if we do see a recession I would not be heavily back into equities on the long side until there is at least one full quarter of solid earnings growth behind us. Until then, I'm remaining defensive.

This sort of down move tends to be violent, unanticipated until its well underway (at which point you've already taken BIG losses) and impossible to get good insurance against at any sort of reasonable price once it begins. Therefore, if you are going to hedge your holdings against this sort of damaging market downturn you need to do it BEFORE the plunge occurs - its too late once it starts as the premiums will go through the roof just as they would if you could buy insurance a day before a hurricane was to hit your home!

There are some who believe we are headed for a full-on depression. I am not so cynical. I do, however, believe that we are looking at a deep and quite-possibly prolonged recession, followed by several years of very slow economic growth. I also believe that there is no chance that the housing market is going to see any material turnaround until 2010.

Mistakes by policy and lawmakers could make the situation far worse, but are unlikely to make it better - the seeds of this problem were sown in the years after the 2000 tech explosion when money basically became "free" (I enjoyed it just like everyone else - I bought a new truck in 2001 with zero interest for three years and no money down), and now the chickens have come home to roost.