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Tharp�s Thoughts

Market Update for February 2009

Market Condition: Volatile Bear

by

Van K. Tharp, Ph.D.

I always say that people do not trade the markets; they trade their beliefs about the markets. In that same way I'd like to point out that these updates reflect my beliefs. If my beliefs and your beliefs are not the same, then you may not find them useful. I find the market update information useful for my trading, so I do the work each month and I'm happy to share that information with my readers.

However, if your beliefs are not similar to mine, then this information may not be useful to you. Thus, if you are inclined to do some sort of intellectual exercise to prove one of my beliefs wrong, simply remember that everyone can usually find lots of evidence to support their beliefs and refute others. Just simply know that I admit that these are my beliefs and that your beliefs might be different.

These monthly updates are in the first issue of Tharp�s Thoughts each month. This allows us to get the closing month�s data. These updates cover 1) the market type (first mentioned in the April 30 edition of Tharp�s Thoughts), 2) the five week status on each of the major U.S. stock market indices, 3) our four star inflation-deflation model plus John Williams� statistics, 4) tracking the dollar, and 5) the five strongest and weakest areas of the overall market.

Part I:  Market Commentary

Technically, 7,470 in the DJIA (Dow Jones Industrial Average) is the 50% retracement level of the entire bull market that began in August 1982.  The previous bear market bottom was on Oct 9, 2002 when the DOW was at 7,286.  We�ve gone below that level and at 7,100, we not only cut in half the October 2007 highs of 14,198.50, but we have given back 50% of the 27 year move from the start of the big bull market of the 1980s to yesterday.

If you invested in 1982 and just bought and held securities, then you�ve lost 50% of the gains that you had for retirement during that time.  And at the current level (Tuesday�s close) of 6,726.02, there is no support for a long ways.

The market still has a way to go until we reach the single digit PE ratios that usually happen at the end of a bear market.  John Williams, the economists who writes the Shadow Stats newsletter, thinks that the DOW could fall another 70% from these levels.  He might be right but that will probably be in the third downleg of this secular bear market.

Dow Industrials 1982 - 2009

In the fourth quarter last year, the economy officially contracted by 6.2%.  And unemployment reached 7.6%.  This, of course, is the official unemployment number that results from the government manipulating statistics.

Part II: The Current Stock Market Type Is Volatile Bear

I have now substituted my new market type for the 1-2-3 model (which is still in red light mode for those of you who like the old data). I�ve done this because when the 1-2-3 model goes below a certain PE ratio, it automatically changes one of the three signals to go.  However, I expect us to be in a secular bear market until the PE ratios of the S&P 500 reach single digits.  Thus, the 1-2-3 model doesn�t really fit my current beliefs. 

My advice, once again, is that secular bear markets usually end when the PE ratios of the S&P 500 hit around 6-8 (e.g., 1932, 1942, and 1982).  We�re in the worst crisis since the Great Depression and perhaps in one that is worse.  Are you willing to risk the PE ratio of the S&P 500 dropping to single digits?  My advice: get in the market when prices are above the 200 day moving average and get out when they are below  (or at least stay out until our market type turns to bullish for at least two weeks).  That would have kept you out of this market throughout 2008.

The table below illustrates the weekly market type, based on rolling 13 week windows, since October 2008. We're still in a volatile bear market. 

Notice that we�ve had some periods that could be called bullish based upon shorter term market type measures.  However, the 13-week market type is a long way from anything but bearish.

So let�s look at what�s happening in the three major U.S. indices.

So the markets finished off minus 34% to minus 42% last year.  And the DOW and S&P 500 are down nearly 20% again this year (and at the current levels they are down 20%). It�s not a pretty picture.  Can you remember when corporate pension funds expected their pensions to be up 10%?  In fact, corporate accounting almost required it.  So what are they doing now?  Bankruptcies are happening with some regularity.

Part III:  The Strongest and Weakest Market Components

I have a new model in which we track the relative strength of the various ETFs representing the economy of the entire world.  I will be publishing this once a month.  Ken Long, who developed the algorithm we use, publishes a similar report every weekend at www.TortoiseCapital.com. If you�d like more information, then I�d suggest you attend our ETF workshop, which is held several times each year. Ken explains how these numbers are derived in this workshop.

The areas in green are strong and those in brown are very weak.  By the way, I usually consider strong to be in the 70s and there is obviously nothing in that range on this particular chart.  My entire world view is continued in the charts below.

By the way, if you didn�t read my article on GLD last week, then please take a look at it.  ETFs have some additional risk that the underlying instrument doesn�t have, just like mutual funds have risks that the stocks they own do not have.  Namely, the instrument you are trading could fail (and cost you extra money), while the underlying trading instrument (i.e., gold) could be doing fine.

Also the top and bottom ETFs (shown on the 2nd table) are usually double leveraged.  I read recently that the average trade in these ETFs is about 20 minutes.  They are trading instruments only and do not correlate very well with the underlying instrument long term. 

This world view looks a little better than the world view presented last month.  There are currently 7 ETFs (other than the double leveraged and inverse funds) that are green:

1.      The US dollar bullish at 54

2.      Gold (gld) at 53

3.      Silver (svl) at 53

4.      Chile at 51

5.      Three shorter term bond funds at 50

I�d like to point out that there is NO consistency in this market� no long term trends except perhaps gold.  So this is a dangerous market to make any long term investments in today.

Click here to view larger chart

The next part of the chart shows commodities, real estate, and interest rate products.

Part IV: Our Four Star Inflation-Deflation Model

Once again, we are in a credit contraction mode, so it is not the inflationary bear market I once thought we were going to get six or seven years ago.  But I suspect that we�ll be in one by the end of 2009.  Gold is certainly suggesting that.

The entire world is experiencing a credit contraction.  We�re in a second stage deflation, which typically is supported by governments and ends when the governments fail.

�         Governments across the world are trying to reduce the possibility of deflation with near zero interest rate policies.  And budget deficits are skyrocketing as a result of this policy.

�         Economic recessions/depressions will get worse.  This worsening will cut into tax revenues and that will lead to debt defaults.  And, by the way, these defaults come with no warnings.  The next thing that will happen will be the breaking of the last bubble�debt instruments.

So with that in mind, let�s now look at our measure of inflation/deflation.

We�ll now look at the two-month and six-month changes during the last six months to see what our readings have been.  The CRB is now reaching levels not seen since 2005.

Notice that our model has now moved back to slight inflation.  This is a continuation of the weakening of deflation over the last few months.

Gold is nowhere near its all-time high (inflation adjusted), which occurred on January 21, 1980 at $850 (kitco London PM fix).  If that is adjusted for real inflation, based on the shadow stat�s data, gold would have to reach $6,650.  Silver�s all-time high also occurred in January 1980 at $49.45.  Adjusted for inflation it would have to reach $387 to hit a new high.  And does Warren Buffett still own 20% of the world�s silver, purchased at about $4/oz?

Part V: Tracking the Dollar

The dollar is continuing its uptrend because of deleveraging.

The dollar has been in an uptrend since July.  China has requested that the U.S. avoid sinking the value of the dollar. They are threatening to stop buying our debt if we don't, but why would they anyway?  

Incidentally, gold�s performance is excellent when you measure it in most other currencies besides U.S. dollars.

General Comments

John Williams (of ShadowStats.com) says that our problems in this recession/depression are structural.  What does that mean?  First, due to trade agreements with other countries, there has been a massive loss of U.S. jobs, including a loss of 3.6 million jobs in 2008.

Second, we�ve allowed our manufacturing base to disappear.  As a result of these two factors, household income is down 14% from its 1972 highs�despite now having multiple bread winners in the same household.  And this is based upon the U.S. government�s data on inflation, not real inflation.

When the U.S. dollar was decoupled from gold in 1971, the U.S. debt ceiling was $430 billion.  And I remember thinking that was a lot.  Today that ceiling is now $12.1 trillion.

What can we predict?

�          Probably double digit inflation by the end of the year and this might be based upon government statistics, not real inflation.

�          A massive sell-off of the U.S. dollar.  This might take several years to start, but it will start.

�          A debt bubble collapse when interest rates go up.  For example, between Dec 30, 2008 and Feb 9^th, 2009, the 10 year bond went from yielding 2.05% to 3%.  Thus, if you owned a portfolio of those bonds worth about a million dollars on Dec 30^th,  by Feb 9^th, that portfolio would have gone down to about $540,000.  That�s a tremendous fluctuation for just a six week period.

Crisis always implies opportunity.  And if you watch, there is plenty of it.  Right now, unless you are a very nimble trader, I�d recommend that you stand aside in cash.  Perhaps you might want to own some physical gold, such as coins, but pay no more than 3% over the spot price of gold for coins.  And wait patiently for the tremendous opportunities that will occur. 

I am leaving on a cruise in late March.  I�ll be on a ship sailing up the South American coast.  If I have internet access, you�ll get an update for March.  Otherwise, we will be skipping the March update.  Until then, this is Van Tharp.

About Van Tharp: Trading coach, and author, Dr. Van K. Tharp is widely recognized for his best-selling book Trade Your Way to Financial Freedom and his outstanding Peak Performance Home Study program - a highly regarded classic that is suitable for all levels of traders and investors. You can learn more about Van Tharp at www.iitm.com. 

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Trading Tip

Three Reasons Why the Dollar Has Not Died

by
D.R. Barton

This much is clear: the U.S. government is borrowing unprecedented amounts of money and is printing or is about to print unheard of amounts of greenbacks to cover the cost of bailouts, stimulus programs, etc.

This, however, is not a political discussion, but a financial one.  Better yet, it is a discussion of behavioral finance.

The simplified argument on the dollar goes something like this:  the increased supply of U.S. currency is now, or is going to soon be massive.  With the world being flooded with U.S. dollars, the value should go down and go down hard.

In the long run, this view is probably very valid.

But for now it�s not working out that way.  The question is �Why not?�

If I were to ask my third grade economics students this question, they�d immediately answer that we�re only looking at one side of the supply and demand equation.  Clearly, even with supply growing, demand is growing even faster.

Three Reasons People Still Want U.S. Dollars

Since last summer, the dollar has strengthened against almost all major currencies.  Here�s an example with the Euro on a weekly chart (notice that in Forex land, they use the Euro/dollar cross, meaning that downward movement equals a stronger dollar):

The chart is pretty self-explanatory.  If we fully test the October �08 lows, I would expect the first test to be a failure since the Euro is oversold on a weekly basis, and we do have a strong divergence.

However, the reasons for the dollar�s strength in the face of overwhelming fundamental forces is pretty interesting.

The dollar is still the world�s reserve currency.  As long as the world does business denominated in dollars, then underlying demand will still exist.  And if one thinks the dollar could lose this role anytime soon, there really is no close second.  The yen has its own problems, coming out of decades of non-existent economic growth.  The Euro has worse troubles than the dollar with the eastern bloc banking system on the ropes.  And the next reason backs up reason number one pretty well.

The U.S. will be the world hegemon for the foreseeable future. I have to give credit for this phrase to my business partner and market maven Christopher Castroviejo, whose Harvard education often bleeds over into his macro economic analysis. �In short, the U.S. is still the world�s dominate military power, and this will be a foundation for the dollar for years to come.

The dollar's perception is that of safety and strength. Dennis Gartman, writer of the his eponymous letter, likens the dollar to the �world�s family mattress.� It�s where people stuff their money in times of trouble. And clearly, people are voting with their trades and saying that these are troubled times.

For all of these reasons, the correlation is currently that tough economic times and downward equity moves mean upward moves for the dollar. And that�s not likely to change anytime soon.

Great Trading!

D. R.

About D.R. Barton:  A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena.  He is a regularly featured guest on both Report on Business TV, and WTOP News Radio in Washington, D.C., and has been a guest on Bloomberg Radio. His articles have appeared on SmartMoney.com and Financial Advisor magazine. You may contact D.R. at  �drbarton� at �iitm.com�.  

Does Investing in GLD Actually Affect the Price of Gold?

Van:  Last week following my article on the ETF GLD, I asked Ken Long, our resident ETF expert, "Does investing in GLD actually affect the price of gold?"

Ken: GLD is kind of in the same category of ETNs (Exchange Traded Notes*) which are promissory notes of the investment house that is guaranteeing performance of the instrument. There are quite a few of those out there that I don't include in my ETF database for analysis at all for the very reason that there is an extra degree of risk that's unsettling.  GLD isn't an ETN but it's true that no one can validate the holdings of the contracts they hold.

With regards to my own personal trading styles and systems, I consider my ETF2 trading system to be a short term system.  If I were a fundamentalist with a macro economic opinion and was looking to hedge with gold long term, I wouldn't use GLD; I'd pay the extra premium to own bullion outright or consider coins.

The worries about GLD have been floating around since day one of the ETF, being fielded, for example in the goldbug groups on Yahoo where the conspiracy theorists argue that it's really part of a shell game being played to manipulate the price of gold lower. The problem with "conspiracy theorists" is that once in awhile they are right.

There is an argument that can also be made about what your belief in the real value of an ounce of gold in your hand in your possession is worth as well. It's really a function of the strength of the social contract that respects the ownership of private property, and the willingness of someone else to accept a chunk of shiny metal in exchange for something else. So, the onion skin sets of beliefs about the reality and value of trading instruments is pretty precarious the closer you look at it.  That said, I concur that GLD in particular, when compared to other more "normal" ETFs has special risks that are political and controversial in nature.

GLD right now trades about 1.6B dollars a day in dollar volume; my sense is that it follows the spot price rather than pushing the spot price around. The gold contracts are trading something like $20B a day right now.

There are some flat out sound heuristics already available for action: no more than 10% of portfolio position in any single ETF; no use of ETNs whatsoever; maintain short term trading outlook; and after some research, perhaps exclude ETFs that trigger some kinds of alarms like GLD. 

* According to Investopedia, the purpose of ETNs is to create a type of security that combines both the aspects of bonds and exchange traded funds (ETF). Similar to ETFs, ETNs are traded on a major exchange, such as the NYSE during normal trading hours. However, investors can also hold the debt security until maturity. At that time the issuer will give the investor a cash amount that would be equal to principal amount (subject to the day's index factor).

Ken Long will presenting our Highly Effective ETF Techniques Workshop this coming May followed by a new two-day Advanced ETF training add-on. 

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