Cash Is Less Painful Than Doing Something Stupid

A Brief Performance Update
Hindenburg Omen - Riding a Lead Zeppelin?
Looking To the Presidential Cycle
Oily Omen
More Transport Weakness
Cash Collared Consumers
Housing Holdouts
Employment-Challenged Economy
So what's next?
Time to Put on My Coaches Hat & the BSU Broncos

A lot has changed since my last letter.  Many aspects of worldwide markets have seemed to turn on a dime and are pointing to a volatile future.  Unlike my last few letters, there is no silver lining in my tone.  This letter will print longer than normal because of all the charts and graphs. 

One of my favorite leading indicators on the health of the economy is the Growth Index from the Consumer Metrics Institute.  It does an astonishing job of taking the pulse of the American consumer.  Most other consumer based indicators are lagging by months, but this indicator gives weeks, and sometimes months of lead time - making it a very unusual and helpful indicator about the economic future.  If you are not familiar with this index, below are some helpful charts and comments to jumpstart your learning curve.  It is currently firing a thumbs down. 

It seems like every data point we turn over we find nothing but slimy snails and worms, and my general comment after massaging the numbers is yuck!   When I think about the unconscionable amount of my children and grandchildren's future that has been mortgaged to produce the worst economic recovery since the Great Depression, it makes me want to pull my waste basket out from under my desk and purge my lunch. 

The tone on Main Street these days is anger and frustration.  November elections will soon purge many misguided politicians back into the private sector.  I can still remember the turbulent 70's - bad economy, poor job prospects, war, political strife, and an uneasy pit in my stomach.  Most of my readers also remember those days too and we all survived... and later prospered as we will do again. 

However, now is the time to CAREFULLY navigate the minefield we are charging into.  Predicting the future is a dangerous game.  2009 proved just how powerful government intervention can be in manipulating the markets.  But this time around, we have already used up most of our dry powder, so fighting off the economic boogie man (gross amounts of government manipulation) will prove impossible.  One day my grandchildren are going to ask me what it was like to live through one of the worst managed, politically manipulated, self serving economic calamities in our country's history.  I am sure I will have a good answer when this mess is over in about 8 more years. 

Heed My Warning
The chances are high that we are about to experience a waterfall decline in global equity markets.  Not a normal kind of decline, but something along the lines of September and October of 2008.  If you are long equity assets, now would be a good time to sell and sit in the safety of cash.  As Warren Buffett said, "sitting in cash is a painful thing to do but it is always less painful than doing something stupid". 

Quote of the Month
"The economic news has turned decidedly negative globally and a sense of ‘quiet before the storm' permeates the financial headlines. Arcane subjects such as a Hindenburg Omen now make mainline news. The retail investor continues to flee the equity markets and in concert with the institutional players relentlessly pile into the perceived safety of yield instruments, though they are outrageously expensive by any proven measure. Like trying to buy a pump during a storm flood, people are apparently willing to pay any price." - Mapping the Tipping Point by ‘Tyler Durden' of Zerohedge -August 21, 2010


A Quick Performance Update

To improve the consistency of producing this letter, I am going to pull performance updates out of this letter and send a dedicated performance update out once a month to clients and interested parties.  We will continue to provide links to our normal performance reports, which can be found in the top right hand column of this letter.  However, our traditional performance section updates will soon take on a consolidated and enhanced format. 


Are Markets Riding a Lead Zeppelin?

Much has changed since I wrote you last. The double-dip argument has grown stronger, fundamentals for the most part have continued to deteriorate and job losses mount. This month we take a look at what has happened recently through charts and indicators, some of which might surprise you. 

The internet has been a buzz about the recent sell signal from an indicator with a scary name called the Hindenburg Omen.  It has many data points which generally means that the data has been curve fitted to produce the desired result.  With that being said, it is hard to argue against its impressive real-time track record.


Chart 1 - A daily chart of the New York Stock Exchange Index showing the times when the Hindenburg Omen has triggered. Red circles mark signals that triggered corrections and purple triangles mark failed signals. Look at the successful signals (circles) versus failures (triangles) since 2000.  There have been 12 HO signals with only two false signals. That is a pretty good track record in anyone's book.  Most recently, the indicator fired on August 12th and was confirmed when it was triggered again August 20th.  Chart courtesy of Metastock.com

First, we look into what was a little known trading signal on Wall Street until August 12th.  That was the date the indictor fired for the first time since June 16th, 2008.   As the first chart shows, the market subsequently suffered a series of mind-numbing drops until it bottomed in March 2009.

Named for the German-made hydrogen dirigible that exploded after completing its maiden trans-Atlantic voyage on May 6th, 1937, the Hindenburg Omen has been discussed on just about every financial news channel over the past few weeks. 

So what exactly is the Hindenburg Omen? It is a technical indicator that uses a combination of market breadth metrics such as the number of new highs, new lows, and unchanged issues on the New York Stock Exchange, together with the McClellan Oscillator to measure the health of U.S. stocks. When it triggers and is followed by a second signal within 36 days, it warns of an imminent stock market collapse according to theory. (For a more detailed explanation, see the first three links in More Reading at the end of this newsletter). 

After the Hindenburg Omen warning on August 20th, a number of financial news programs again buzzed with discussions of the coming market meltdown. Should we be worried?


Looking to the Presidential Cycle

Two challenges exist with the latest Hindenburg Omen warnings.

First, there are a number of different versions of the code. The code we used in Chart 1 has more filters so it issues fewer signals than the original formula, or that used by Peter Eliades in 2005 (see Past Performance of the Hindenburg Omen...in More Reading). Depending on who you listen to, there is considerable debate on how many times, or even whether a valid signal has been issued. 

Secondly, data between different providers is varied which causes further confusion. Our data comes from Reuters, so for the most part it is very reliable.

Another challenge to a big collapse from here is the election cycle. Michael Kahn of Barron's Online commented in Taking Stock of a Scary Market on August 18th (see More Reading section below) that we are entering a period in the election or presidential cycle in which stocks often put in major lows. That multi-year low traditionally comes near the end of September of the mid-term year. That is only a month away!

Does that mean stocks can't go much lower?  Cycles are useful but shouldn't be relied upon to generate pinpoint signals.  At best, they provide an overall framework as opposed to a specific time-sensitive trading strategy.

We have written about the presidential cycle frequently; there are some good reasons to suspect that the usual mid-term year lift may at best be muted this time around, if it comes at all, and here's why.

Since the turn of the twentieth century, successive administrations have become increasingly adept at getting the unpleasant job of fiscal management out of the way in the first two years of their term. This has allowed them to crank up the stimulus spigots in the last two years of their term to get the economy firing on all cylinders leading into the next election. The better they performed this task, the greater their chances of re-election.

For those not familiar with the presidential election cycle, a simple system we developed that bought the Dow at the mid-term election low and sold at the high in November of each election year 26-months later outperformed the inverse system that bought at the end of November each election year and sold in September of the mid-term year 22-months later by a factor of more than 13 to 1 between 1902 and 2006. Put another way, 93% of the Dow gains over that 102 year period occurred in the 26 months leading up to elections versus just 7% for the 22 months after elections, all thanks to a carefully orchestrated government cutback and stimulus cycle. Over time, governments have gotten better at this which skewed returns even further.

That lopsided performance began to come undone after 2004 as the Bush Administration curtailed the traditional post-election cutbacks and revved up the stimulus pumps to address the effects of the recession. Then President Obama wasted no time turning the election cycle completely on its head by spending trillions in stimulus and bailout programs immediately upon taking office.

As a result, many would argue that in lieu of some sort of monetary miracle, the stimulus spigot is now running on fumes as we enter the traditional election cycle lift. Under crushing fiscal deficits, where would the money come from to kick Quantitative Easing 2.0 into gear?

Unless they have been living under a rock, politicians should be acutely aware that voters who are also taxpayers are getting downright fed-up with a spendthrift government as Obama's recent low approval ratings would seem to indicate. Slowly but surely voters are concluding that we can't continue borrowing from the future with Uber-Keynesian abandon to finance the fiscal fiesta today.

As the economy has deteriorated, it has become painfully clear to even the most avid helicopter cash-dropping advocate that you can lead the consumer to the mall but you can't make  them spend.... unless you first give them more cash. Take away the cash-copters and spending, and the economy will quickly cool. Now that the candy men (and women) in Washington have blown their stimulus-sweet voter treats, what's next?

Let's see what some of the other indicators and charts have to say.


Oily Omen

Industrial economies like ours run on oil.   I wonder how many appreciate just how influential a commodity it is?  I'll use this next chart to demonstrate.


Chart 2 - Chart from the late 1960's to date showing the year-over-year percentage increase in oil prices with the dates they peaked. Oil price just mixed the 100% mark in July 1987 (red arrow) but just four months later, the Dow experienced its biggest single-day drop in history. Without exception, each time oil prices year-over-year have increased 100% (horizontal red line), a recession followed.

Take a close look at when the price of oil has more than doubled year-over-year. At the far left, it first occurred in December 1973 and then again in January 1980. Oil jumped slightly less than 100% by July 1987, but then more than doubled by September 1990, February 2000, and June 2008. Do those dates mean anything?

The dates may not be significant, but what is important is what happened in each case in the ensuing months.  If you said recession, give yourself a pat on the back. Without exception, every time oil prices have increased 100% year-over-year, recessions followed. Sometimes it took months, sometimes more than a year, but it happened each and every time.

When oil prices doubled in June 2008, the recession followed in December. As the above chart shows, oil prices were up 100% again by January 2010.  Needless to say, it is not a ringing endorsement for a V-shaped recovery.


Cash Collared Consumers

Measures such as the consumer confidence index and the consumer sentiment index are well known. They poll consumers to gauge how they are feeling. However, a relatively new index from the Consumer Metrics Institute (CMI) measures "consumer demand on a daily basis, providing nearly two orders of magnitude more resolution than the Bureau of Economic Analysis's GDP releases."


Chart 3 - Consumer Metrics Institute Growth Index which has led GDP as well as US stocks since its inception. Chart courtesy of dshort.com, data courtesy of the Consumer Metrics Institute.

"As a result we can see timing relationships that simply can't be seen in quarterly data," according to the Consumer Metrics Institute website.  

Chart 3 shows how the CMI Growth Index has led both GDP and the S&P500 Index since its inception. It is now indicating that both will be significantly lower later this year, possibly taking both GDP and the S&P500 back to early 2009 levels. But without trillions in stimulus, what will drive the next surge in the economy?

Next, we see how performance for the S&P500 from 1929 to 1945 compared to the period from 2000 to present; after correcting for inflation. The two periods are similar in more ways than just stock performance. They were both marked by unprecedented government intervention financed by the taxpayer.

The big question is whether the government approach will be any more successful than it was eighty years ago?  This chart suggests that if the SPX outcome is similar, we should conservatively expect another 20 to 30% drop in the S&P500 over the next two years before economic recovery can begin in earnest. The problem is that it took World War II to finally fix the economy last time we were in a similar fix. 


Chart 4 - Chart comparing the S&P500 between 1929 and 1945 to 2000 to present after correcting for the official inflation rate. Chart courtesy of dshort.com

Here is how Doug Short, creator of the above chart, explains it.

"Many people don't realize that the cyclical bear market that began in 2007 is a continuation of the 2000 bear because in nominal terms the index peak in 2007 was a couple percentage points above the 2000 high. We also see that the low in 2009 actually took the market lower than the same point during the Great Depression."

What if the real inflation rate over the last decade was higher than the "official" Consumer Price Index estimates? Since GDP is measured by subtracting CPI, it would mean that real GDP is lower than reported and may still be in negative territory. It would also mean that the inflation-adjusted S&P500 performance is even worse than shown in the above chart.

Compare the official CPI with the figure developed by ShadowStats which uses the statistical calculations used before the number was substantially altered by successive governments after 1982.


Chart 5 - Chart comparing the official CPI with actual according to the author. Chart available at http://www.shadowstats.com/alternate_data/inflation-charts

According to ShadowStats.com, the real inflation rate is nearly 6% higher than the official rate (chart 5). This means that real GDP is somewhere around -3.5%, not +2.5% that's being reported. If this is true, the recession is still in play in real terms.


More Transport Weakness

In a growing economy, transportation demand increases. Is that happening now?


Chart 6 - Chart of the Baltic Dry Index which measures the rate to ship dry goods by sea over the last five years. As we see, February through August each year (yellow rectangle) has historically been a period of growth for transport demand. This was not true in 2008, and it has not been true in 2010.

Our first metric is the Baltic Dry Index, which measures the cost of transporting dry goods by sea. As the next chart shows, demand has traditionally been strong from February through August; that was until 2008. Demand appears to resurge in 2009, but it was short-lived, and has now dampened again in 2010.  

Based on year-over-year percent change in the next chart, this trend is showing little sign of improving. Demand is softening in the same way it did in the fall of 2008.


Chart 7 - Chart showing year-over-year percent change in the Baltic Dry Index with the recent weakening trend in transport demand.

There is a similar trend in rail traffic according to the latest data from the Association of American Railroads (chart 8). Chart 9 shows the latest LA Port traffic figures.


Chart 8 - Comparison of US rail traffic for all commodities showing that 2010 is looking similar to 2008, but at significantly lower levels. Demand is on track to return to 2009 levels. Chart courtesy of http://www.aar.org/


Chart 9 - Chart of monthly LA Port import and export traffic.  According to the latest data, imports are up but exports are down 4% since May. Chart courtesy of CalculatedRiskBlog.com

On the positive side, port traffic has rebounded, but most of the improvement is inbound traffic (imports). If economic growth is to be sustained and our manufacturing sector to grow, we need to see growth in exports, and that hasn't happened.


Housing Holdouts

Housing was an important factor in economic growth until 2007. How is the industry fairing now?

Building Permits, housing starts, and new home sales have traditionally led existing home sales and prices. For starters, according to the National Association of Home Builders, builder sentiment measured by the Housing Market Index (HMI) is still deteriorating.  Builder sentiment fell to 14 in July and again in August to 13, the lowest level since March 2009 (chart 10).

Much of this is due to falling new home sales, which in May dropped to the lowest level since the data was first recorded in 1963. May sales were revised down from 300,000 to 267,000 units. New home sales in June did improve marginally, but the initial estimate of 330,000 made it the worst June on record. Now the question is how much will this figure drop in future revisions?

Both existing and pending home sales also showed more weakness in June, and preliminary estimates of existing home sales in July of 3.95 million (annually) would make it the lowest level since 1996 according to Thomas Lawler (Realtor.com).


Chart 10 - Chart comparing the NAHB Housing Market Index (HMI) Builder confidence declined again in August to the lowest level since March 2009.


Chart 11 - Chart showing official Unemployment Insurance Weekly Claims from 2000 to present courtesy of CalculatedRiskBlog.com


Chart 12 - Chart showing three unemployment estimates; the official U-3, the higher U-6, and the highest estimate courtesy of http://www.shadowstats.com/alternate_data/unemployment-charts


Employment-Challenged Economy

In spite of what the government claims in that millions of new jobs have been created, reality simply does not bear that out. Jobs are still being lost and unemployment remains near Great Depression levels by some estimates.

On August 19, we learned that weekly jobless claims hit 500,000 which is the highest number since November 2009. The official unemployment rate (U-3) shows unemployment of 9.5% with the U-6 estimate that includes the official discouraged and underemployed workers, at 16.5%. But the true unemployment rate could be even higher if the data from Shadowstats.com are to be believed (see chart 12). These data that are arrived at by using unemployment calculations prior to the changes to remove various categories of unemployed from official estimates in an effort to make the number look less negative (read: to help incumbent parties get re-elected) over the last two decades.

Employment is a lagging indicator, but the rate of change lags far less, if at all. However, the problem is that the very steps being taken by government to address unemployment and fix our economy is risking doing more damage than good.

Let me explain. Trillions have been spent since 2004 in attempts to re-ignite long-term demand in an economy that is roughly 70% dependent on consumer spending. The government claims to have created millions of new jobs, but unless I am missing something, what they have created for the most part, is government jobs. I have yet to see any data indicating any significant improvement in private sector employment.

Government jobs and the wages they pay compete with small businesses, which have created the lions' share of new jobs over the last decade. The more jobs the government creates through various "infrastructure" make-work projects, the fewer workers there are that are willing, or available, to work for private enterprises. To compete, private employers must pay higher wages: a situation that puts small businesses under greater stress in a weak economy.

This course of events is not new. It was why it took nearly a decade and a world war to fix it last time we were in such a pickle.


So What's Next?

There are many who still believe that spending our way out of trouble is the best solution: some are even Nobel Laureates. This approach belies the results to date and an accurate assessment of history. How can anyone with an understanding of history believe that spending more money and creating more debt can cure a debt problem, and break our obsession with debt? It failed to work in the 1930s and it's not working now.

If that is the case, why do politicians continue to doggedly pursue this solution? There are a number of reasons. They include a poor understanding of what really drives economies by both elected and non-elected officials, combined with selective myopathy when it comes to lessons in history. But most of all, the fault can be traced to giving into populist political pressure.

A poor understanding of economics combined with a misguided attempt to adopt an ultra-Keynesian solution supported by popular opinion has taken us in the wrong direction while saddling us with unprecedented levels of debt in the process.

As traders and investors, we can't control what politicians do any more than we can dictate crowd behavior. All we can do is take appropriate action to preserve what we have and profit where possible.  Stock markets continue to move erratically partly due to low volumes and partly due to a growing mistrust by investors about where economic policy is taking us. Regardless of the reasons, we must take action commensurate with what our common sense and indicators are telling us.

So what is Jim Miekka, creator of the Hindenburg Omen, doing right now? According to the Wall Street Journal on August 16th, although he isn't exactly bullish about stocks following the first signal, Miekka didn't say it was time to head for the exits just yet.  However, he did offer the following comment.

"I'll be dancing close to the door."  

No doubt he'll be dancing even closer to the door following the second Hindenburg signal August 20th.


More Reading...

Taking Stock of a Scary Market Signal
http://online.barrons.com/article/SB50001424052970203651904575437701553249446.html

Past Performance of the Hindenburg Omen 1985 - 2005
http://www.safehaven.com/article/3880/the-past-performance-of-the-hindenburg-omen-stock-market-crash-signals-1985-2005

Hindenburg Omen Flashes - Yahoo Finance
http://finance.yahoo.com/banking-budgeting/article/110355/hindenburg-omen-flashes

Consumer Metrics Institute website
http://www.consumerindexes.com/


Time to Put on My Coaches Hat & the BSU Broncos

My youngest daughter, Annabelle, began soccer practice this week and I am not sure who was more excited, me or her.  I love to get involved and coach my girls in the sports they play.  As they get older and play in more advanced leagues, my ability to coach them will be more limited, so I cherish the time we get to spend together now. 

Sarah has decided to hang up her cleats so she can concentrate on basketball.  It is crazy how competitive kid's sports have become. Kids are now choosing one sport to specialize in while they are in elementary school.  When I was a kid, you didn't even think about specializing until high school.  I start coaching Sarah's basketball team in October so my fall schedule is about to become crazy busy.

In case you haven't already heard, the Boise State Broncos, ranked third in the country in the AP, will be playing Virginia Tech on Monday, September 6th in a game arranged and heavily promoted by ESPN.  It is being called the game of the week by ESPN and it promises to be a barn burner.  Compared to other top 10 schools, Boise State is tiny.  It would be like the smallest college football team in your state being ranked in the top 10.  Despites the schools size and limited resources, their coaching staff are second to none and as a result their players have speed and ability that few teams can match.  If you like rooting for the small guy who has a habit of beating up on over ranked competitors, then Boise State is your team. 

I am very serious about the warning I gave on global equity markets in the introduction of this letter.  Risk is very high these days, so protect what you have and don't let this market get the best of you. 


Working to grow your wealth,


John M. McClure
President & CEO
ProfitScore Capital Management, Inc.


P.S. ProfitScore provides its separately-managed accounts to individuals, advisors and institutional investors.  If you would like to hire us to help you navigate this difficult bear market, below are three ways to contact us:

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Posted 08-29-2010 10:47 AM by John M. McClure