The Dow has rallied for the past two days. But, to us, it is like the type of limp, token punch a boxer throws out when he knows he's being driven back toward the ropes and a possible knockout.
Today, we look briefly at the fundamentals and then back at the stock market. Then we suggest ways for our readers to think of profiting from the market falls we feel await us in the none-too-distant future.
The Financial Times headline yesterday read, "German subprime lender is bailed out." This came on the heels of yesterday's news of the problem spreading to Australia and Japan. So much for those, including our Treasury Secretary, Fed Chairman, and some of our former Fed Chairmen, who say the problem is contained (within the industry, let alone within America)!
[Editor's Note:The 99 stocks you need to dump in 2007 . . . and the 10 to buy! Get our free report today.]
As we have long said, we believe the subprime debacle of greed and deception is only just starting to play out.
CNBC announced that U.S. investment banks are struggling with a backlog of leveraged loans amounting to $269 billion. Add this to the $208 billion backlog of the European investment banks and soon you are talking real money!
Story Continues Below
Although only in its infancy, we are already witnessing, not just American growth, but worldwide growth now challenged by a potentially catastrophic credit crunch.
We believe that the ability of private equity to finance deals at ten times EBITDA (earnings before interest, taxes, depreciation and amortization), under "cov-lite" loan conditions and at "real" interest costs that are miniscule (especially if discounted against the "true" rate of inflation, say 6 percent, as opposed to the officially "cooked" CPI of some 2 percent) is over, at least for some time.
In other words, growth needs to be financed. Today, that ready finance is under threat. It has major implications for future corporate earnings and, therefore, for today's stock market prices.
In addition, the erosion of the massive amount of liquidity, now sloshing around the world, will also have a detrimental effect on both bond and stock markets.
The Wall Street Journal (WSJ) front page yesterday contained stories of, "U.S. auto makers posted their slowest July sales pace in nine years amid a downdraft in demand." The next item read, "Fed officials have scaled back their economic output a bit.…A key manufacturing index declined." This was followed by items covering penalties for irregular business practice by such icon companies as Morgan Stanley and British Air and Marathon Oil.
On top of these lead items from a normal day in today's America, we as consumers face: $3 gas; $4 milk; escalating food, medical, insurance and service costs; and await upward adjustments in our ARM mortgages. All the while, we are expected to believe it, when we are told by our government that inflation is now running at an annualized rate of just 1.9 percent.
[Editor's Note:The 3 Best Income Stocks in the World]
Remember, our whole U.S. interest rates structure is predicated on this "official" inflation rate of about two percent. Foreigners see it as false and our dollar plunges virtually every day.
If what we believe is our true inflation rate were to be unleashed upon our American psyche, can you imagine where our interest rates, bond yields, and ARM mortgage rates would go? Then what of our GDP and our markets?
Challenger, Gray & Christmas, Inc. announced today that planned job cuts by U.S. employers increased 15 percent in July from a year earlier.
With all this, it is little wonder that a WSJ poll found, "public discontent extends far beyond the war issue." According to CNBC the WSJ/NBC survey suggests over two thirds of those surveyed feel we are either already in, or about to enter, a recession.
This is very different from last week's assurances by Treasury Secretary Paulson and other bulls that our economy is making adjustments but just fine.
So much for these basic fundamentals and the many we and our sister publication Financial Intelligence Report have highlighted these past few months.
Today's WSJ Money Section headline runs, "Out of Nowhere, Dow Jumps 150.38." In our view, "nowhere" is an understatement!
The WSJ subhead runs, "Trading Is Furious: Second 5-Billion Day For NYSE-Listed Shares."
Well, well; it is somehow hard to marry the market reaction to the gloomy fundamentals and popular recessionary sentiment. That is before you look into the figure and see the real picture.
We believe that, if the U.S. stock markets were truly in a strong bull market phase, as most of Wall Street and our government would have us believe, they would rebound with convincing strength.
Using our boxing analogy; a boxer still strong and confident may well back onto the ropes and indeed use them to rebound, but he does so actually looking strong and throwing real (not token) punches.
When we look at the recent, so called rebound, we see a defensive flight to capital (a weak token punch), not a confident convincing comeback.
Most of the recent rise has resulted from investment in large-caps in the Dow and S&P 500. Small caps, in the Russell 2000, have been left far, far behind.
To us, that looks like a flight to capital, which mirrors a similar flight in the bond markets from high yield and even investment grade corporate bonds to Treasuries. The yield on the 10-year Treasury has been driven down to 4.76 percent, as we write.
In addition to a flight to capital, we see a telling move towards defensive, large-cap stocks, with heavy overseas earnings that are in consumer staples.
Most interestingly, we note that, consumer staples are that economic sector that normally does well in an economy that is transitioning from "Late Expansion" to "Early Contraction."
This tells us that the large, savvy money managers see what is happening and that the U.S. economy is slipping towards "Early Contraction."
As our readers know, we have long forecast this downturn. We only wonder why it has taken so much longer to manifest than we would consider "normal."
We believe the answer is liquidity. The vast pools of liquidity amassed by means of lax lending, highly leveraged derivatives, low cost money, and greed have given us a world awash in cash.
A market flush with ever rising levels of cash, can afford to ignore fundamentals for a considerable time. We feel this is what has happened.
We now believe that the fundamentals are now just beginning to "force" the attention of investors. At the same time we see the liquidity frenzy ending, at least for some time.
We therefore believe the stock and bond markets are in for a serious turn. Our current estimate is that it will start in earnest sometime between the last quarter of 2007, in keeping with our earlier forecast, and the first quarter of 2008.
It could of course, be earlier!
So how can our investors profit from a falling market?
In addition to the shares of large companies with a high proportion of overseas earnings, our most conservative investors will have accumulated sizable percentages of cash, short-term Treasuries, and gold.
[Editor's Note:Buffett Says This Book Made Him Billions]
Now may be a time to put some of that cash to work.
One way would be to buy put options. Another is to go short.
However, any investor going short the market pays a Broker's Call Rate (currently some 7 percent) and must eventually cover the position, regardless of the price the stock reaches. This exposes the investor to an unlimited risk. It is therefore a somewhat dangerous tactic.
However, modern financial engineering has developed what are known as Exchange Traded Funds (ETF). These funds are very liquid and trade at low costs.
Some ETFs go "short" specific markets, such as the Dow, S&P 500, NASDAQ or Russell 2000. Some are 200 percent short. That is very aggressive.
But, if investors were to margin their ETF purchases, they could get even more aggressive on the short side!
Some of these ETFs can go short. But normally these ETFs short their market sectors by acting in the futures and derivative markets.
But, while the ETF buyers can lose in the market price of their ETF, if the market turns up and against any short positions in the ETF, they are shielded from the personal liability to cover at any price.
Another way of looking at buying both puts and market-short ETFs is a hedge to a long portfolio, if the investor fears a general market downturn.
Editor's note:
The 99 stocks you need to dump in 2007 . . . and the 10 to buy! Get our free report today.
The 3 Best Income Stocks in the World
Buffett Says This Book Made Him Billions
