U.S. Stock Markets at a Critical Juncture — A Look Back in Time Will Reveal the Prudent Course of Action

May 22, 2008

There’s a saying “Fool me once, shame on you. Fool me twice, shame on me.” Our motto at maalamalama is to never be fooled. We are at a crossroads today where things are going to get a lot better or they are going to get a lot worse. As the permabull sales culture of the commercial investment industry dictates, the practical deluge from the commercial investment industry about the worst of the crisis being over has been almost non-stop for the past several weeks. Here is just a sample of numerous recent headlines that have crossed my desk in the past several months that proclaim or support that now as the best time to buy stocks in a long time.

“Are You Ready for Dow 20,000?”
“IMF Chief Says Worst of Financial Crisis is Over”
“Paulson Says Worst of Financial Crisis is Over”
“Citigroup Chief Says Worst of Credit Crunch Crisis is Over”
“Financial Crisis Mostly Over, [JP Morgan CEO] Dimon Says”

Astonishingly, the person that inspired the Dow 20,000 headline, James Finucane, was predicting this mark within a timeframe of just one year and called today’s markets, in his words, the “perfect” setup, implying that this is about as risk-free opportunity as you will ever receive in your lifetime to make a fortune by investing in the U.S. DJIA index. Numerous other journalists seem to agree as evidenced by the latest headline I read just four days ago in the New York Times that boldly announced:

” An Alarm is Blaring: TIME TO BUY” (emphasis mine).

Besides the fact that the commercial investment industry will always utilize any rally to inform their clients that a massive bull run is coming and to stick their clients with the “better invest now if you don’t want to miss out” sales approach, perhaps some of these extremely giddy predictions about the imminent future of stock markets are also based upon a look back at history.I’m guessing that within the past few weeks, the hundreds of people in the commercial investment industry that have presented their case for an imminent monumental bull run in U.S. markets have gathered their courage from previous times in recent U.S. stock market history when a contrarian few predicted market crashes that never happened. For example, in 1979 BusinessWeek ran a story called “The Death of Equities” due to raging double-digit inflation in the late 1970’s that caused a Paul Volcker Fed to raise the Fed Funds rate to over 19% by mid-1981.

However, by slashing the Fed Funds rate more than 13% just five years later to less than 6%, the Feds saved the equity markets, the great crash that some called for didn’t happen, and the extreme negativity back then gave rise to a strong bull run. The difference between now and then (which I explain in great detail to my maalamalama members) is that every monetary manipulation of past decades has contributed to the enormous stresses that exist in the global economy today. Today’s crisis is much worse because it has the compounding interest of all the problems of past decades factored in as well and it is rooted in the past. Furthermore, the Feds have already slashed interest rates to 2.00%, and we are still firmly in the middle of a crisis. In the past such actions had already spurred great runs in stock markets. The Fed’s ability to use money expansion as an artificial means to prop up markets is just about finished, unlike back in 1979 and the early 1980’s when money contraction had caused severe market difficulties, and there was enormous room to use monetary expansion as a means to turn around stock markets. Back then, U.S. Federal Reserve chairman Paul Volcker made the extremely difficult but proper decision to fight inflation instead of to “paper” over the problems.

Today, there are two types of people in the bull camp. Those whose bullish stances serve the bottom lines of their companies, but not the bottom lines of the average investor’s portfolio, and those that believe that the U.S. Federal Reserve can translate the debasement of the U.S dollar into stock market support and another strong upleg one final time. Though I believe that U.S. stock markets will correct strongly before year’s end, that’s not to say that I believe that things will fall apart in a linear fashion. The odds in fact favor some back and forth volatile up-and-down activity in U.S. markets as the Feds and the G7 finance ministers will continue to employ behind-the-scenes policy maneuvers to combat the severe stresses the global financial system currently faces.

However, when the battle ends, it is my belief that severe downturns and steep losses in the stock markets will commence almost on a daily basis. In any event, here is why I find the above statements from our nation’s political and financial leaders so untrustworthy. Besides the fact that the world financial system still has tremendous stresses that have not been solved, one only has to look back in time just one year ago to a very similar critical turning point in markets. Back then, people were also fiercely debating whether markets were going to fall apart or continue to strongly rally, again with those arguing for a continued rally vastly outnumbering those calling for a severe correction. In April, 2007 U.S. Secretary of the Treasury Hank Paulson declared, “I don’t see it [subprime mortgages] imposing a serious problem. I think it’s going to be largely contained.” President Bush soon followed with public statements about the strength of the U.S. economy, paying no heed to all the cracks that were crystal clear in the foundations of the U.S. finance system, and all of Wall Street followed with self-proclaimed bills of clean health.

Just check the progression of stock charts of every major U.S. housing stock and financial stock after our most-listened to political and finance leaders told the world there was going to be no problem from subprime mortgages. Almost every single one of these companies saw their stocks soar from 12% to 25% in a matter of weeks based upon this renewed, though extremely misguided, confidence. Just months later after this false rally, the markets suffered a strong downturn but then again seemed poised to recover. In fact, I even blogged about the foolishness of listening to these demagogues about their declarations of a strong economy back then in an article entitled “Government Foolishness…Again.” However, when the markets rallied at the end of the year, I strongly recall public sentiment being extremely rosy for an extremely bullish 2008. Then, at the start of 2008, many of the largest financial and housing stocks proceeded to lose 40% to 85% of their value in a matter of weeks.

And here we are again, about one year later, standing at the same crossroads and receiving the same illogical and abundant declarations that the crisis has bottomed out and a great rally is on its way. The fact is the worst of the subprime crisis is still not over, let alone the dollar crisis. And the spin continues in every manner to try to convince the masses that again, everything will be just fine. The spin regarding the reasons for the moonshot in oil prices is even more remarkable, as any truth behind the massive spike in oil price would severely diminish the possibility of a strong U.S. market rally and consequent rally in other major global markets.
Recent comments of OPEC President Khelil received almost zero coverage while comments about the U.S. economy on its way to recovery are plastered across every website and every national newspaper and TV station. In response to criticisms of a spiking oil price, Algerian oil minister and President of OPEC, Chakib Khelil stated:

“Prices are high … because of the devaluation of the dollar. There is a direct relationship,” Khelil said. A former World Bank economist, Khelil said he had looked into the issue and estimated that for every 1% decline in the value of the dollar in the past two years, there has been a $4 increase in the average oil price. Chakib in fact recalled that the last time the OPEC nations acquiesced to international pressure to raise production last September, that raising production by a significant half a million barrels a day, accomplish very little in stemming rising crude oil prices due to the fact that supply and demand were not the major determinants of oil price.

“If we can take out that impact, if the dollar index goes back to where it was two years ago, we would see a much lower price than we do today … at $55 to $60 (a barrel), you could say that whatever we did would have an impact,” he said. “Because the major parameter influencing oil prices would be supply and demand…OPEC has to be credible,” he said, and as president he aimed to ensure that “OPEC does what it says it’s going to do — not lie about its intentions or the reasons that are really controlling the market.” If supply and demand were truly the great drivers of the price of oil right now, and not U.S. dollar debasement, countries like Saudi Arabia, Venezuela, and Nigeria, would necessarily have to massively re-think their government subsidy programs that enable their citizens to buy a liter of oil more cheaply than a liter of soda, or even more remarkably, at the same cost as a liter of bottled water. In any event, dollar debasement will force these governments to massively rethink these subsidy programs anyway, probably sooner rather than later, due to massive profits abroad that are being forfeited to provide cheap oil at home. While I have blogged about instances in the past where it appears that OPEC has manipulated oil prices for political reasons, in this case, Khelil presents a sound argument to explain the current situation.

In the end, betting on a huge rally in U.S. stock markets as professed by the huge preponderance of mainstream analysts is the equivalent to remaining in a building where hairline cracks in support columns and walls have started to appear. Your boss may tell you to keep reporting to work everyday and he or she may claim that your worries are unwarranted as the building remains standing for an additional three months. But with the probabilities so high that the building will crumble, why risk your life? Could a rally to a 14,000 or 15,000 DJIA also spur a global market rally as the overwhelming majority of talking heads claim? Sure, with intense continued market intervention by the U.S. Federal Reserve, this may just happen. But if I were a Vegas odds maker, I’d start the line at about 10:1 against this happening. And that’s far from the “perfect” set up currently marketed by the commercial investment industry. Instead, I’d put the odds not only at 10:1 against a strong rally happening but I ‘d put the odds at 3:1 that markets will move strongly in the opposite direction. And the best case scenario in my estimation? That markets will trade sideways for the next year or so.

Still, I think the odds favor a steep correction and are strongly against a steep run higher. Just as one should position oneself to prosper from mania in markets well before it happens, the same applies to crisis. You can’t very well position yourself for a crisis after the crisis starts and expect to prosper and outperform all of your peers. As far as the exact timing and exact recommendations of how to prosper and the timeframes within which to position yourself with certain opportunities, I provide this much more specific guidance within the confines of my Global Stock Picker investment newsletter and SmartKnolwedgeUâ„¢ Platinum Membership. The battle has just begun.

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