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Feature Article 

Market Update

By

Van K. Tharp, Ph.D.

Part I:  Market Commentary.

The overall market closed up in 2004, despite being in red light mode since July 6^th, when the Federal Reserve started raising int-erest rates.  The Dow Jones Industrials rose from 10,454 to 10,783 � a gain of 3.1%.  The S&P500 rose from 1112 to 1211 (a gain of 8.9%), while the NASDAQ 100 rose from 1468 to 1621 (a gain of 10.4%).  However, this was an election year and markets do tend to rise during election years.

However, the election year is over and it�s now 2005.  And while I wish you all a very happy new year, my guess is that this will not be a happy one for the stock market.  For the first four months of the year, there will be two opposing forces acting on the stock market.  First, rising int-erest rates will tend to dry up capital and eventually it will be sucked out of the stock market.  However, a great deal of cash is sitting on the sidelines and will probably go into the market early this year.  People seem to be very optimistic.

Every financial magazine I could find on the news stands had headlines about where to put your money for 2005.  And most of them had plenty of good stock picks � a very ominous sign for the market overall.

The 1-2-3 Stock Market Model IS IN RED LIGHT MODE.  BE CAREFUL.

But before you make specific decisions on where to put your money, let�s take a look at what the market is doing.  Right now it is going up.

Currently, all three averages are over their price five weeks ago.  However, the market is going up very slowly.  A 4% drop in a single week, could easily change the whole picture.  But so far, the market just wants to poke up a little at a time.

Most of 2004 has been characterized by almost no change in the markets at all.  Weekly changes for the major averages usually average over 2%.  In 2004, they have typically been under 1%.  I would not expect that to continue throughout 2005!

The table below shows the five week status of each of the major markets.

Incidentally, this data is calculated by hand based upon last Friday�s close (i.e., Dec 31st).  There is always a possibility of human error in our numbers.

Part III: Our Four Star Inflation-Deflation Model.

As mentioned in my book, Safe Strategies�, we are due (in terms of cycles) for a deflationary bear market.  And, indeed, there are major deflationary forces at work in the world today.  These were listed in the Safe Strategies�book. 

The United States at this time is a huge debtor nation.  Our government has the largest debt of any nation ever (probably over 35 trillion including future obligations).  Our corporations have huge debt and individual also have huge debt.  As a result, the Federal Reserve has stated that it will do whatever it takes to make sure that we do not have deflation.  This means turning up the printing presses.

However, the printing presses are currently fighting the deflationary forces.  And the net result, right now is that inflation seems to be slightly winning.  Indeed, that was the Fed�s rationale for raising int-erest rates.  And they have been raising int-erest rates since July of 2004.

Let�s take a look at what the model is showing us right now.  Remember, the model says that the more stars, the more likely we are to have inflation.  Let�s look at those four factors.

Commodities Prices are definitely going up.  Commodity prices, as measured by the CRB, are basically flat over the last two months.  But they are up about 10% on the year.  That�s certainly a sign of inflation.  Some of that increase is due to the decline in value of the dollar.  However, commodity prices are usually passed through to the consumer so expect inflation.  It�s still strong enough to give us one star for inflation. 

Consumer Price Index � Consumer prices, as measured by the government-adjusted consumer price index are starting to heat up � much faster than most analysts have expected.  The CPI gives us another star, and this is now a strong one. 

Gold Prices � Gold hit a new high within the last month and has trailed down a little.  Much of this increase is still due to the weakness of the dollar.  However, it�s now at 435.6. 

With both the dollar falling (more about that) and inflation starting to look nasty, we should expect a huge jump in gold.  And, for those of you who are not watching, gold stocks have not yet recovered to new highs.  Gold gives us our third star.

int-erest Rates � Short-term int-erest rates are starting to go up and long-term int-erest rates are still declining.  As I mentioned last month, much of this is due to the unwinding of the carry trade with the anticipation of the federal reserve starting to increase rates.  This again points to inflation.  Thus, we have another star here.

What�s the net result?  We have four stars pointing toward inflation.  Expect an inflationary bear market scenario. 

Part IV: Tracking the Dollar.

The dollar is again hitting new lows.  However, thanks to a rally from January through May, it was only down a little over 4% on the year.  However, to put things into perspective, the dollar is down about 10% since May of 2004.  That means that if all of your wealth is in the U.S. dollar, that you�ve lost 10% in the last 7 months if you have the same dollar worth as you did last May.  Thus, it looks like it is time to start playing the Max Yield Strategy or to at least do something to protect wealth from a dollar decline.  Be careful here.  Follow the guidelines we set for you in Safe Strategies for Financial fre-deom.

Fundamentals (i.e., with the main factor being the US debt) suggest that the dollar has a long ways to go on the downside.  However, we could have made that argument for much of the last ten years.  The dollar is once again looking very shaky and putting 20% of your portfolio in the max yield strategy makes good sense right now.

Incidentally, the dollar probably won�t fall very much further versus the Euro because the Euro is not in great shape either.  Thus, you need to be in commodity type currencies during 2005 such as the New Zealand dollar or the Australian dollar.

What This All Means.

Our big picture continues to suggest that the stock market is a very weak place to be.  Be very careful.  We still expect a long term, inflationary BEAR market. 

The first few days of the year have been a disaster for most stock portfolios, especially if you are heavily invested in stocks that have done well since the election.  While this could be people taking their profits, if it is, those profits pretty much disappeared in the first two days of 2005.  Be very careful.   If the first full week of the year continues like the first few days, it�ll be a strong signal to switch to bear market mode.

We haven�t had a lot of int-erest in the Teleseminar on rare stamps.  The fact rare stamps were one of the best investments in the last inflationary bear market; plus the fact that one of the world�s top investors is buying everything he can get his hands on (i.e., Bill Gross of Pimco); plus the fact that none of you are int-erested in the teleseminar tells me that rare stamps are very much the place to be. 

There are three sets that can be acquired fairly easily in which less than 50-100 copies are know to exist of each stamp.  I�ve completed most of my accumulation, but with only a few copies available these are probably investments of the century. 

Incidentally, my wife is now very upset that I�m spending money on rare stamps.  She said, �How will you ever get out of them.  You are just throwing away our money!�  Perhaps, this is still more evidence that stamps are a good investment.  But it just shows the resistance that the average collector must now deal with these days.

Van Tharp is the author of the New York Times Best Seller � Safe Strategies for Financial Fre-edom, Trade Your Way to Financial Fre-edom and Financial fre-edom Through Electronic Day Trading. His training materials are among the best the world.

Editors Note: Throughout the issues you will see certain words with odd spellings, such as Fre-deom and mort-gage. This is because spam filters are likely to block message that contain certain words and this is one solution.

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Trading Tip

Trading Tip

by  D. R. Barton, Jr.

Housing Bubble or Housing Bull, Part IV: 

As we weigh the likelihood of a housing bubble, this week our attention turns to the subtle world of int-erest rate gyrations.  To most folks, int-erest rates seem like a straight forward issue.  The Fed (full name: Federal Open Market Committee) raises rates and lowers rates and mort-gage rates follow this lead.  But alas, things aren�t that simple.

One of the bullish cases that is made for the housing market is that while The Fed has raised int-erest rates consistently over the last year, the housing market has continued to soar.  But let�s take a look at the numbers behind this simplistic analysis and see if we can make some sense of what�s really happening.  But first, a quick quiz. 

1.      What was the Fed Funds Rate one year ago?

2.      What is the Fed Funds Rate now?

Most astute market observers and fully two-thirds of the boneheads know that The Fed has been raising rates over the last year.  In fact, the Fed Funds rate has climbed from 1.00 percent at the end of 2003 up to 2.25 percent at the close of 2004.

3.      What was the national average for a 30-year fixed rate mort-gage one year ago?

4.      What is the 30-year fixed rate mort-gage now?

By our simple logic from above, a 1.25 percentage point rise in the Fed Fund Rate should drive a commensurate increase in mort-gage rates.  But the numbers tell us otherwise.  At the end of 2003, the national average for a 30-year fixed rate mort-gage was 5.88 percent.  At the end of 2004 the rate had changed to -- drum roll please � 5.83 percent!  While the Fed Funds rate had risen by 1.25 percent, the 30 year fixed rate mort-gage rate actually dropped a smidge, by 0.05 percent.  How can this be?

Blame the free market for foiling The Fed�s best-laid plans.  Long term mort-gage rates are not controlled by the cost of funds (though the cost of money clearly influences the process).  Rather, the mort-gage rates that you and I pay are influenced almost completely by the secondary market in mort-gages.  Fannie Mae, Freddie Mac and other mort-gage investors were created to provide a more efficient mort-gage market, and by most objective measures they have done just that.

The secondary mort-gage market, in simplistic terms, works like this.  Fannie Mae (or another investor) buys your mort-gage and thousands of others from individual lenders.  These mort-gages are then held in the investor�s portfolio or bundled with others and sold as mort-gage-backed securities.  Regardless of the ultimate destination, these huge mort-gage investors have created a secondary market for mort-gages and this in turn allows the free market to dictate what rates are offered to home buyers.  In essence, your mort-gage is almost certainly not �owned� by the lending institution that issued the mort-gage.  And they didn�t set the int-erest rate.  Nor did The Fed, as we have seen.

So what does this say about the housing bubble or lack thereof?  Fed Funds Rates have gone up; long-term mort-gage rates have not.  (As an aside, adjustable rate mort-gages are much more closely tied to the machinations of The Fed.  The trends that I�m describing here are for long-term, fixed-rate mort-gages.)  The flat int-erest rates reflect both the continuing strong demand in the housing market and the market�s optimism that this demand will continue.  Score one for the housing bulls. 

But there is an ominous downside lurking.  If demand softens for any reason, the market will correct and most likely over-correct the int-erest rate differential making the mort-gage rate zoom up much faster than other rates.  If this occurs, the amount of leverage currently in the market (as described in the last two articles) could lead to an undesirable housing liquidation that could start a downward spiral.

D. R. Barton, Jr. is a lead instructor for Van Tharp Institute courses. He is the Chief Operating Officer and Risk Manager for the Directional Research and Trading hedge fund group. D. R. has been actively involved in trading, researching and teaching in the markets since 1986.  D. R. has created extensive and innovative new training products and taught extensively in many investment areas including intra-day trading, swing trading, and cutting edge risk management techniques. 

His writing credits include co-authoring Safe Strategies for Fin-ancial Fre-doom and co-creator and contributing author on Fin-ancial Fre-doom Through  Electronic Day Trading. He also writes a stock screening newsletter called Ten Minute Trader, has feature articles in Market Mastery, writes for Traders-U and is a regular contributor to Tharp's Thoughts.

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Tax Tips

Tax Tip of the Week

Estimated Payments Due By January 15th

by

Steve Meredith

By January15^th you may have to make your final estimated tax payment to the federal and state governments.  Here are some rules to remember and tips on preventing penalties from the IRS.

If you owe more than $1,000 you must make tax payments as you go.  Your payments can be made either by withholding or paying quarterly estimates.  Unless you meet one of the exceptions, payment of estimated taxes is to be made in four equal installments on April 15, June 15, September 15, and January 15.

Penalties are assessed for not paying the tax timely.  To avoid the penalties there are two �safe harbors� you can use.  The safe harbor amounts are based on either a) 90% of the current year (2004) tax, or b) 100% of last year�s (2003) tax.  If your in-come is over $150,000 the percentage is increased to 110% of last year�s tax.

You can also make unequal payments using the Annualized Income method.  This is good for people in seasonal work, or people who have a large unexpected increase in income.  Realtors and Stock Traders frequently have income that varies from quarter to quarter.  People sometimes have a sale of something like a rental house that causes a large one time capital gain in only one quarter of the year.

If you get a W-2 from your own corporation you can pay your tax by doing some extra withholding now.  You can adjust your withholding so that more tax is paid in for you and the tax will appear on your W-2.  W-2 withholding is automatically deemed to be paid in equal installments, regardless of when it was actually withheld.  For example, if you think you may owe $5,000 and haven�t paid any estimates, you can pay the tax now as withholding and avoid any penalties as long as it is W-2 withholding.

You can make estimated payments with a voucher (form 1040-ES) or pay by phone with a credit card (charges will apply) by calling 1-888-729-1040.  The voucher is available online at the IRS website, www.IRS.gov

Best wishes for a happy and prosperous New Year!  Stephen S. Meredith, CPA, PLLC

Steve. Meredith is a CPA in Richmond Virginia.  He specializes in preparing income tax returns for all types of businesses, estates, trusts, and individuals.  He also consults with new business owners on how to properly structure their business to get the maximum benefit from current tax laws.  Steve deals with many real estate investors and stock market investors.  He has clients nationwide and lectures regularly across the country on tax topics. 

The information contained in this article should not be construed as rendering tax or legal advice.  You should consult your own tax advisor as to the applicability of any of this information to your personal situation

Listening in....

Excerpts from Dr. Tharp's Discussion Forum

Convincing My Wife 
Author: Kurt

I have a strong desire to become a full-time trader. I have created a business plan, studied much of Van's materials as well as others and have begun the process of building trading capital. The problem is my wife is not at all sold on the full-time trader idea (which is making it hard to build capital). She looks at trading as gambling. Part of the problems is two friends of mind have failed at being full-time traders (both were undercapitalized).

She wants to know if anyone can become successful at trading with the proper coaching or training? She also would like me to provide examples of success full-time traders? Any ideas or help would be greatly appreciated.

Reply To This Message 


Re: Convincing my wife 
Author: PMK

Kurt,

I am 3 years through a 5 year plan to build a successful trading business (and I have a wife too) so I think I am qualified to attempt to answers your question.

There are 4 key elements to this:

1 Have an achievable business plan
2 Be well-capitalized
3 Know why you will succeed where (many) others have failed
4 Educate you wife fully on 1,2,3

1 If your business plan has you making any money in the first 3 years then it is too optimistic. My own experience was 6 months losing 30%, 6 months losing another 15%, 6 months losing 5%, 6 months breakeven, then 12 months making 10%. From next year my business should be cash-flow positive (i.e actually make more than it costs to run). I am pretty smart, have a computing degree, and worked on Wall Street for 7 years, so I assume my learning was reasonably fast (though nowhere near as fast as I hoped it would be :-). You can adjust these timelines depending on your own level of experience and expertise going in to this.

2 You have hit on this main reason for failure, but being well-capitalized is not just about having a big enough trading account. Since from 1 we assume no income for 3 years, you need to be able to cover business and personal expenses from another source, and also have enough cash left to trade with. This usually sounds impossible for most people and they start out with much less and then can't afford to go through the first 3 years of the business plan. Ideally your wife is earning enough to support you both or you have a large stash of cash to see you through the learning curve. In fact, after 3 years is exactly where you should be significantly increasing your trading account size now that you have learned how to consistently make money so don't just set aside enough for the 3 years and then not be able to increase your account when you really need to.

3 If you have 1 and 2 in place, you still need to have the confidence and knowledge to know you will succeed. This is a personal thing that I cannot answer for you, but if you are unsure about this you will not be able to convince others (wife, clients, etc). The arguments you use to convince yourself are the same ones you will need to convince others later on.

4 Once you have 1,2,3 in place the next stage is educating your wife so she has the same understanding of your plan, how long it will take, how much it will cost, and what the chances of success are. If she trusts you then you should be able to get her to the level that she is comfortable with the plan. Keep her in the loop at all stages. From my experience the main concerns to address are: Why should you succeed when the failure rate is so high? How do we survive financially while you are learning/building the business? What are your plans to exit the business if it doesn't work and how do you measure that and know when to admit defeat? Can you promise me that you will not lose more than the value of your trading account? Why is this the best way for us to make money?

Hope this has helped you formulate a plan at least and got you thinking. Good luck in your endeavour.

Paul 


Read the full, unedited thread on the forum,   link here. (Hint for finding it, look at the heading and the date) Van K. Tharp and traders, investors and wealth builders around the world connect on this site, share ideas and learn from each other. Search specific topics 

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