Jeflin’s Investment Blog

During the recent stock market rally, it was easy for investors to get complacent about the future and engage in reckless speculation. The common refrain is that there is nothing much to fear except fear itself. After all, esteemed economics professors, including Paul Krugman, have ascertained that the worst is over.

Nevertheless, in the short term, the stock market rally is almost done. Window-dressing and opportunistic trading aside, we can expect a consolidation or downward correction. If you are sitting on cash, well, liquidity never hurts. If you are vested in blue-chips and getting attractive dividends, just maintain the status quo. 

I won’t be looking at stocks for a while. Inaction is a decision too when it comes to safe investing. Of course, you can always add to your portoflio if you are a long-term investor. For the time being, I am keen to accumulate gold. We may still be in a deflationary environment but the impending inflation from all the printed money is no laughing matter.

As it is, we are damned if we store our cash under the mattress and damned if we don’t. Think of inflation as a silent tax which eats away at our wealth which have been accumulated painstakingly from investments and savings. The same amount of money will purchase lesser goods in future.

The Federal Reserve has lighted the fuse of hyperinflation with its intervention in the Treasury bonds market. While its Quantitative Easing through buying debt with printed money achieved a shock and awe effect in March, this weapon to control interest rates has become blunt after repeated use. Long term interest rates will find its own level according to supply and demand, not artificial intervention.

In fairness, the Fed has little choice but to intervene because if nobody wants to buy US debts, then interest rates have to rise to attract investors. The cost of borrowing will increase and add to the ballooning deficits. Thus, inflation is deemed the lesser of two evils especially when there are still strong deflationary pressures to counter.

Whether monetization of debt is indeed the best option for the Fed may be debatable but one thing is clear, it doesn’t generate real wealth. All these money created out of thin air only serves to transfer wealth from solvent savers to insolvent debtors who are greedy and irresponsible. This redistribution of money from current taxpayers (and our future generations) is tantamount to looting but because it is done subtly, public outrage is manageable.

Thanks to decades of over-consumption (fed by easy credit) and an entitlement mentality, America is in a rut hole and currently experiencing a harsh deleveraging process. Being a keen student of the Great Depression, Ben Bernanke is determined to get credit flowing again, induce more consumption and stabilize asset prices. And America is not alone, all over the world, trillions of dollars are being spent to reflate the economy.

The problem is these governments are in debts, and can only finance their massive stimulus programs, bail-outs and loans guarantees by borrowing and money-printing. I am not against Keynesian policies but there is a fine line between starting a bonfire and a forest fire to stay warm. Saving all the too-big-to-fail institutions will eventually put nations at risk of defaults.

The latest figures show that the US has racked up fiscal deficits at 13% of GDP in 2009. Timothy Geithner’s promise to the Chinese that the US will keep its deficits to within 3% of GDP was met with derision. Clearly, nobody is taking his commitment seriously. US federal debt stands at nearly $13 trillion, almost equivalent to 2008 GDP, and that is not including obligations to Medicare and social security.

The US is so deeply entrenched in debt (it will be deemed insolvent long ago if it was a business), it will take a lot of time and political will to sort out the mess as well as to encouraging Americans to live within their means.

Because of the sheer size and the lack of fiscal discipline, there is little hope of US ever repaying its debts. Its current modus operandi is to roll over the principal and interest by issuing new bonds, at the expense of more debts. When US debts lose its allure, the house of cards will collapse, similar to the last stages of a Ponzi scheme.

Ponzi schemes survive by robbing Peter to pay Paul, thus, a constant influx of investors is needed to provide impressive returns to existing investors. If no more suckers come in, the game is over. Though the US government is big enough to guarantee US Treasuries, but with so much “risk-free” goodies being issued, investors must be wondering where is the breaking point, leaving them with worthless paper assets.

The crumbling of the mighty United States of America is akin to Britain after WWII when she gave up her empire and her currency collapsed. To peep at the future of America, one has only to study the “fiscal meltdown” of California due to a budget shortfall. Top state officials have pleaded Obama administration for emergency aid but to no avail. The worry is that a bailout of California would set off a dangerous precedent and other states may make similar demands.

California needs deep budgetary cuts to balance the books but this may worsen the state’s recession - unemployment figures will spike and housing market decline further. California is the 8th largest economy and its slump will be detrimental to America and global economic recovery. Of course, California may eventually be saved by the federal administration and all will be well.

But what happens if the United States is the one now facing the fiscal crisis? No institution is big enough to rescue them and unlike a business, you can’t force it into bankruptcy and auction off its assets. Not unless you want to risk a war with America. Thus, it is more likely that another Bretton Woods style conference to write down debts and devalue all nations’ currencies may follow.

I am increasingly skeptical about the viability of paper money as a store of value, especially the US dollar. You can feel the uneasy truce in the dollar’s status as the world’s reserve currency when the Russian Finance Ministry had to issue two conflicting reports in a matter of hours on their confidence in the greenback. Not reassuring at all.

In public, the three largest creditors of US debts, China, Japan and Russia will maintain that the US dollar is crucial and hope that the US economy is back in the pink of health. A weak US dollar does no good to export nations and reduces the worth of their investments in US debts. The currency in which trade is settled still remains dominantly U.S. dollars. And we don’t need any disruption in trade now. But away from the public scrutiny, US Treasuries are being dumped in exchange for commodities. At the very least, you won’t find any more buying frenzy in the US Treasuries.

If you are talking about safe investing, gold and silver should really be in our portfolio. With the amount of paper money in circulation (and more coming up off the printing machines), a tiny fraction of fiat currencies is enough to bid up prices of precious metals. Even though gold has fallen recently, it is an adjustment from overbought levels.

To date, about 160,000 tons of gold has been mined from the ground and at US$950 per ounce, it is worth US$4.9 trillion. But with at least US$60 trillion of paper money in circulation (currencies, savings, deposits, money-markets and CDs), gold is grossly undervalued.

It is prudent for investors to allocate 15%-25% of their portfolio to gold bullion, gold mining stocks, etc. Over the next weeks, gold may dip further and I see it as a good opportunity to accumulate gold. Buy gold to keep up with inflation and think about profit later. As far as I am concerned, that is the best safe investing advice.

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Time flies when we are having fun… we are now into the 13th week of a stock market rally that started in March. The embers of the stock market rally has not flickered out entirely but there are signs of investors taking some profits off the table.

In the short term, stocks may still rise. Blue chips have retreated slightly but are generally holding up while rotation plays have seen penny stocks enjoying a new lease of life. Some of the penny stocks have dubious fundamentals but this indicates investors’ appetite for quick gambles before getting up from their seats in the casino.

I have constantly stressed on a major stock market correction because I am not convinced that global economies will experience a V-shaped recovery. Yes, the worst may be behind us, as vouched by Paul Krugman.

He said: “I will not be surprised to see world trade stabilize, world industrial production stabilize and start to grow two months from now. I would not be surprised to see flat to positive GDP growth in the United States in the second half of the year.”

Before we get carried away, he tempered his optimism with another remark: “In some sense we may be past the worst but there is a big difference between stabilizing and actually making up the lost ground.” That implies we may not see full employment nor optimal production and consumption any time soon.

The harsh reality remains that employment, retail sales and auto sales are dismal. Non farm payrolls shows the smallest decline since October 2008 but the unemployment rate was worse than anticipated. Consumer spending, which powers two-thirds of the U.S. economy, dipped while consumer borrowing in April fell by twice as much as analysts had expected.

For the time being, bears have not asserted their full presence and range bound trading will be the order of the day. In the event of any drastic correction, the stock market has a tendency to fall slowly and then all at once. However, it is impossible to predict the timing of this reversal or what event will percipitate the downfall.

It could come from the energy sector which has been leading the market rally. Despite Goldman Sachs forecast of $85 price levels by year-end, actual demand in energy has not spiked tremendously. Hence, when the music stops for this fund-driven commodities run, things can get ugly like the collapse of oil trader Semgroup last year.

Or the tremors may emanate again from the financial sector. It has yet to discharge the first batch of toxic assets from the subprime crisis (saved only by the abolition of mark to market accounting) but could already be gearing up for the next lot of toxic waste from commerical loans, defaults of prime borrowers (people with sound credit and conservative, fixed rate mortages) who now comprise the largest share of new foreclosures in the 1st quarter, credit card delinquencies, and the possible unravelling of the $640 trillion OTC derivatives market.

Rising interest rates, Treasury bond yields and the demise of the US dollar are also factors which can cause irrational behavior in Mr Market. And, not to discount the highly unlikely but nevertheless possible mother of all crisis, a bailout of the US Treasury which has been heaped with the irresponsiblity of the financial sector. Its troubes could dwarf the collective collapse of AIG, Lehman Brothers and General Motors.

The US dollar is a sign of investors’ confidence in the US economy. While America still retains its status as being the most economically competitive country in the world, investors are growing jittery about the size of US deficits - ballooned further by stimulus and bailouts. At some point, not even America’s innovation, political stability or military superiority can prop the dollar’s value.

Ben Bernanke was astute enough to note that US cannot “borrow indefinitely” but he did not have a ready solution. Since “quantitative easing” (money printing) became fashionable in the Federal Reserve’s diction, Ben Bernanke had enjoyed a few early victories.

Initially, the monetization of debt (snapping up U.S. Treasury bonds which foreign creditors did not purchase) was successful in boosting Treasury bond prices and containing interest rates on medium and long-term U.S. bonds.

However, the buying spree could not prevent T-bonds from returning to its equilibrium - plunging prices and surging interest rates. The Fed has also poured half a trillion dollars to purchase mortgage-backed securities but mortgage prices are not on the mend and rates have still surged.

Success is limited because the Fed must print money to buy T-bonds. But the more dollars printed, the greater the inflationary pressure which prompt bond holders to ask for higher rates since they will be paid back in cheaper dollars.

Clearly, the T-bonds market could do without the Fed intervention as it results only in more investor selling. The corrresponding increase in interest rates could undermine stimulus packages and threaten nascent recovery in the housing market. Creating artificial demand is self-defeating and the US has little choice but to cajole, entice, threaten the Chinese or international investors to buy its T-bonds.

However, even if there is no love lost for the US dollar, until another reserve currency has been established, its current weakness has ramifications for the wider economy - commodity prices are being driven up which worsen the panic over inflation. People are worried about their declining cash value and buying assets which they don’t need.

We have to remember that amid green shoots and a “satisfactory” bank stress test, part of the current stock market rally was sparked by a fear of inflation. That is not a good thing. I mean, just look at the Zimbabwee stock market. The key Zimbabwe Industrials Index trekked up nearly 600% and 12,000% in twelve months.

You will have easily trumped Warren Buffett’s achievements but when you cash out your stocks in Zimbabwe currency, you realise all the capital gain is illusory. Zimbabwe economy is crumbling which shows clearly that stock market advances driven by inflation fears does nothing for the economy in terms of creating jobs, production or private investments.

I will rather see the stock market consolidating than to rise because market participants have no choice but to jump in because the US is frantically printing money to pay its debts while debasing its taxpayers’ and other nations’ savings.

The Federal Reserve is toeing a very fine line in maintaining a Goldilocks environment (not too cold and not too hot). It has to constantly tweak its monetary policy to adjust to new circumstances and making mistakes are increasingly costly. And the worry is that the weapons in its arsenal are dwindling.

In the current range bound trading climate, there are very few value investments available. Price-earnings are not attractive and there is little inclination to add on to positions unless second quarter results bring more cheer. This time though, investors will be looking for solid results instead of semi-bad news.

At the moment, a whole gamut of emotions (indecision, uncertainty, volatility, anxiety) run wild in the stock market. Any forays must be made on a short term basis. While I have taken some profits off the table and awaiting the next opportunity to enter the stock market, I am still holding on to substantial portions of my long term stocks which offer solid dividends.

With each passing week, the case for a bearish reversal out of this stock market rally becomes stronger. For the time being, the bulls triumphed by breaking out of a potentially ugly double top pattern. This raging bullish sentiment pretty much sums up last week’s stock market actions.

The bulls are buttressed by the highest level of consumer confidence (up for three consecutive months) since last September. Investors are no longer stricken by fear with the volatility index (VIX) trending lower into the 30s.

Businesss conditions have also improved as the credit market thawed. A major indicator is the TED spread (difference between what banks and the US Treasury pay to borrow for three months overnight). It is often viewed as a measure of systemic risk in the economy and willingness of banks to lend to one another.

From a high of 465 basis points, it has fallen to only 48 basis points, near its long-term average of about 50 basis points. The return of liquidity is crucial for businesses to function and expand their operations.

Investors’ renewed appetite for risk and inflation fears have prompted an exodus from the safe haven of US dollar. In May alone, the greenback declined by about 5%. Not surprisingly, holders of US dollars and Treasuries are clamoring for higher interest rates to hold these “undesirable” assets. This does not bode well for the issuance of US debts nor its struggling housing market.

Reuters reported that surging government bond yields may spark credit crisis II, something which the Federal Reserve will try its utmost to prevent. For better or worse, we can expect more intervention from the Fed in the weeks ahead.

Stocks as well as commodities like copper, gold, silver have benefitted from the abundance of adventurous money seeking greener pastures. Crude oil enjoyed an especially good run - its biggest monthly gain in ten years’ time.

To be sure, fundamentals for the energy sector remains intact. Supply of oil is decreasing while demand is increasing. In short, the era of cheap oil is over. We need to discover more oil fields and extract them from more challenging conditions which make drillers and exploration companies market darlings.

However, I am skeptical that demand from vigorous economic activities has enabled oil to spike from March lows of $40 to $66 in a matter of weeks. Goldman Sachs is confident oil will run up higher and has advised investors to sell bearish $34 puts for oil.

Nevertheless, rising crude oil prices is a double edged sword which can harm the healthy growth of green shoots due to consumers having lesser discretionary income from rising gas and food prices. There will be more layoffs as businesses suffer lower profit margins. It is unclear how the economy will grapple with higher fuel costs.

There is also a huge supply overhang of oil being stored at sea in supertankers. This will put a ceiling on oil prices in the near term as the floating oil supply cannot be stored indefinitely (usually 6-9 months).

GDP figures are far from encouraging. There is a contraction of U.S. economy at a revised 5.7% annual rate after sinking 6.3% in the fourth quarter. Investors must have read between the lines and smelled something good there because their bullish sentiment was not dampened.

The figures released last Thursday suggested that prime fixed-rate loans were supplanting risky subprime loans and rising adjustable-rate mortgages as the force behind the foreclosure crisis. According to the Mortgage Bankers Association, the foreclosure rate on prime fixed-rate mortgages doubled last year.

For the first time, those loans made up the largest share of new foreclosures. In the first quarter, a seasonally adjusted 6.06 percent of all prime loans were delinquent, up from 5.06 percent in the last quarter of 2008.

Clearly, the worst of the housing market woes are yet to come. This time, it will come from prime borrowers which will be an immense challenge for the Obama administration as they occupy a substantial percentage of loan portfolios in most banks. We have seen how the subprime crisis wreck havoc around the world, hopefully, the global financial system is now better prepared to withstand the shock of prime borrowers defaulting en-masse. 

As the 1st quarter earning report season draws to a close, investors can take heart that corporate profits (especially the banks) have emerged from the abyss of never-ending losses. However, don’t expect to scale dizzying heights any time soon.

The stock market rally has priced companies optimistically to the point that price-earnings ratio are dangerously high. It seems that earnings are not important currently, investors are only concerned with the timing, momentum and hype.

This is the sign of speculators and a bubble forming again. While a bullish flag is being waved enticingly, it is wise to remember that technical patterns are just a guide and can change quickly in either direction.

I feel strongly about a major stock market correction but Mr Market does not consult any of us on its mood swings, thus it is difficult to pinpoint the exact moment of the rally breakdown. There is no doubt though that the bears will get the upper hand soon.

The stock market was in an oversold condition in March but since then, it has rallied furiously due to discount recovery. As a leading indicator of econmic activity, the stock market has priced in almost all the good news and could experience a long way down, if the actual economic numbers don’t add up as predicted.

It is not safe to hang around when the market suddenly realizes that it has overshoot itself, and that the trillions of dollars are not going to create miracles by stimulating demand and creating a recovery soon.

There is nothing more detrimental to our psychology than seeing our friends get rich. With each day that stock markets continue their impressive surge, lingering skepticism are transformed into belief and rational people are behaving once again like gamblers.

It was only months, if not weeks ago, that the same investors and businesses were perched on the precipice of financial ruin. Those who got badly burned were swearing off stocks or any form of investments. Now, the rolling good times have erased all these memories.

To be sure, the current stock market rally is surprisingly resilient compared to the typical dead cat bounce which hovers in the 20% range but we have to remember that if something doesn’t go on forever, it has to stop. Indeed, a setback in the stock market is imminent, after such a heady run-up.

For the second straight day, US stocks began on a strong note, only to have the momentum died down at the close. Despite repeated attempts, the inability of S&P 500 to break through the psychological resistance of 940 is telling.

While much uncertainty in the financial sector has been cleared up after the stress test, the bears are not convinced. In fairness, the bears are correct to believe that there could be more skeletons in the closet which require greater capital infusions.

And you don’t get anybody more authoritative than the messiah of free market speaking about banks’ capital requirement. Alan Greenspan, the former Federal Reserve chairman who is heavily castigated for his role in Wall Street’s orgy, says banks still have a ‘large’ capital requirement especially in commercial banking.

Wheez, if only Alan Greenspan had been as discerning about this financial crisis during his reign. If only the credit binge was curtailed by raising interest rates and stringent lending standards. If only he had been more forceful on curbing the extensive leverage on Wall Street. If only…

Regardless of capital requirements, I believe the likelihood of a domino effect from collapsing banks in America rocking global financial markets is remote. Not when the Federal Reserve are satisfied with the banks’ viability and stand ready, willing and able to intervene whenever doubts appear to the contrary.

On the economic front, I have to say that fundamentals have not improved significantly even as the worst of the crisis is over. The stock market, being a forward looking indicator, is hoping to reflect an economic recovery in the 4th quarter this year.

Whether this is a realistic scenario is up for debate but for now, we can only look in the rear view mirror and take note of dismal results. Japan’s economy shrank at a recod 15.2% pace, dragged down by plunging exports, thinner factory output and wary shoppers. Mexico fell 21.5% while Germany’s Q1 fell at an annualized 14.4%.

European banks which have a significant presence in Asian markets are not out of the woods yet and this is where the next trouble spot could be. It is necessary that they conduct a similar stress test in the near future to ascertain the extent of their troubles. ABN Amro is seeking further capital intervention from the Dutch government and they won’t be the last crying for help.

Unfortunately, they don’t enjoy the privilege of a Federal Reserve to create trillions of dollars out of thin air to backstop their losses. Following in the footsteps of Iceland, Kazakhstan could be headed for IMF’s intensive care unit after three financial institutions defaulted on their payments.

Britain may also lose its AAA credit rating for the first time as government finances deteriorate in the worst recession since World War II. Standard & Poor’s lowered its outlook on Britain to “negative” from “stable” and said the nation faces a one in three chance of a ratings cut as debt approaches 100 percent of gross domestic product.

As Jimmy Rogers remarked in an interview to CNBC, “Governments have not solved the essential problems that caused the crisis but instead they flooded the world with money.”

“Trying to solve the problem of too much consumption and too much debt with more consumption defies belief and will not work. I mean … you give me 5 or 6 trillion dollars, I’ll show you a very good time, there’s no question about that.”

Even Federal Reserve officials seem to agree. According to the minutes, there are possible signs of “stabilization” in the U.S. economy but they are not convinced those improvements will persist. With the global financial system still “vulnerable to further shocks,” the Fed is prepared to purchase $300 billion of Treasuries to counter “significant downside risks” to the outlook for the economy.

The bull-bear royal rumble is definitely underway but it will be weeks or months before a victor emerges to determine the primary trend of the stock market. Meanwhile, the path will not be smooth, probably three steps forward, two steps back situation.

This period allows for consolidation where investors mull over and react to the good and bad news. Since history suggests that major market collapses may need multiple tries before they can find solid footing, the bears will have opportunities to gain the upper hand again.

If you are not careful, the resurgence of the bears may wipe out recent gains quickly as seen in the rally in the last six weeks of 2008 - only to suffer deep setbacks in a matter of weeks. Thus, for investors who are sitting on profits for some long term positions, it could be wise to unload some positions and prepare for a fresh onslaught on the stock market later on.

“Sell in May and go away” may not be relevant this year. For a month commonly associated with disinterested stock market activity, we have seen a 36% jump in the benchmark S&P 500 from March’s 12-year low.

Economic reports turn out better than expected, swine flu has been downgraded to a harmless entity, and US banks have passed the stress test. No wonder, investors are seeing green shoots everywhere, even among a pile of stinking, toxic shit.

Speaking of the stress test, there are much debates on the methodologies, “adverse” assumptions or suitability of a 25-to-l leverage ratio for tier-1 capital, but it is undeniable that uncertainty has been eliminated substantially.

Since the test procedures are out in public, investors can extrapolate their own worst case scenarios based on current recommendations and findings. Unless the Treasury Department has prepetrated a fraud out of this stress test, it is the most authoritative guide to date.

Judging by the resilience in the stock market rally, the Obama administration has skilfully orchestrated leaks and pre-release discussions with banks to test market reaction. Come to think of it, there is no way the US government will let the banks fail, not when they have unwittingly become a major, if not the biggest, shareholder vested in the banks’ profitability. The auto industry will have given an arm to be in this position but apparently, life is full of inequality.

In the short term, technical indicators, measures of confidence, and volatility all suggest that the stock market rally could persist. We are now either in the last stage of the bear reign or the first wave of a primary bull market.

A representative measure of a stock market rally is the S&P 500 lying less than 50 points away from the 200-day moving average. If the S&P 500 closes above this closely watched metric (something not seen since December 2007), the trend reversal from bearish to bullish cannot be ignored.

The VIX index also slid to its lowest level since the collapse in September 2008 of the US investment bank Lehman Brothers. With market volatility abating, investors have grown accustomed to the effects of a tight credit market and are betting that the worst of the recession is over. They believe that a renewed stock market rally is taking root.

There is also lots of money, in the region of trillions of dollars in household cash, sitting on the sidelines. What began as a massive and impulsive short covering off a historically oversold bottom will now attract all these idle cash. Having missed out on the lucrative actions, value investors are keen to play catch-up in the stock market. As such, we can expect equities to move up another 15-20 percent from their current positions.

Strong technical indicators have formed not only in global stock markets but also for depressed commodities like oil, base metals and agricultural products. Nevertheless, after such a heady run in the stock market, a major correction is imminent. That will be healthy for consolidation purposes. Over the next 2-3 months, we should expect a range bound trading where the bulls and bears slug it out.

Optimists will use this period to buy the dips to accumulate positions providing strong support. On the other hand, any uptrend will face strong technical resistance as bears reposition for an anticipated decline by selling rallies. Longs which have their money trapped for a long time will also sell into these rallies.

I believe the overall effect will be the stock market hovering between the 50 and 200 EMA’s for several months. If the primary bull trend is to develop, the crossover has to happen convincingly. Meanwhile, economic reports must continue to show gradual improvement.

Since inflation is bound to return with a vengeance, we must prepare to move a portion of our money back into assets which provide strong capital gains and income. I don’t encourage any speculation in penny stocks as there are many companies with dubious balance sheets, still flirting with bankruptcy. They will continue with their scams under this illusion of wealth and prosperity.

To be sure, real economic progress must depend on increased productivity through technological innovation, not manipulation of stock market by hedge funds or financial engineering. Thus, all the money created out of thin air by the Federal reserve must be channelled properly to product tangible benefits, else we will face another super bubble in another few years time.

And not to forget, the most pivotal moments in the swine flu saga are yet to come. Will it roar back in the regular influenza season and affect the rest of the world. The fear is that it could evolve into a more lethal strain and bring all economic activity to a standstill.

Like the swine flu, the financial crisis may have another, and hopefully, the last outburst before exhausting itself. This will be violent, so stay focused on the technical and fundamental indicators if you decide to accumulate positions in the stock market aggressively.