Feb

17

US Economy and the Stock Market

By Chuck

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It seems as if every day that passes the economy and the stock market are dying a death of a thousand razor cuts. For it seems that each day is marked with one piece of economic data or another that point to a deteriorating economy. Our long time readers know that back in July of last year we raised the caution flag on the sub prime issue, when the market hit fresh lows in August of last year many were saying the worst was over, and those same people said that again in November and again just last month when the major indices dropped to even lower lows. But all through that we have maintained our stance and would not be swayed from what we see in our own research.

From unemployment data and their trends, manufacturing and service industry data indicating contracting growth, the continuing decline in the housing markets and their prices, to the substantial losses that financial institutions are suffering. Many signs have shown to us that things were only going to get worse and indeed they have. There is an old saying in the stock market… and that is when everyone has a negative outlook then that is the time to start buying. That saying was born out of the early 1900’s when information took many days and weeks to travel to everybody. It is what is known as a contrarian indicator. Contrarian indicators range from extremely high short interest, overwhelming sentiment in one direction or another , or high put or call ratios on the options. These are just some of the popular pieces of data that investors or traders will use a ‘contrary indicator’. And for them that signals that they should start betting in the opposite direction of the current sentiment.

Investing on the methodology of contrarian indicators can be very rewarding or very damaging to a persons money. The contrarian investor is essentially placing a bet on a roulette wheel and hoping they are right . For us, we do not subscribe to the contrarian view of trading or investing. We rely on evidence of a shift in trend, not betting on a shift in trend. There is a huge difference there. Last November, around the time of the Thanksgiving holiday, there was an interview on the US financial television channel CNBC with financial analysts that represented many different brokerage institutions and some independent analysts. The consensus was that the losses that were suffered by the banks and other financial companies had reached it’s peak and that it was going to start improving. I remember very clearly saying to myself  "on what basis and/or factual evidence do you have to make that claim". Those analysts were making those statements on the view of a contrarian methodology, in that the losses, and the decline in the markets had reached extremely oversold levels. And that the Federal Reserve would continue to cut interest rates so the worst of the crisis was over. I became angry at these supposedly expert analysts for discussing a perceived course of the markets based on nothing factual. Unless they had inside information from the large financial institutions which told them that the losses were all  accounted for and it will now improve then they had no right to make the claim that the worst was over. And if they did have inside information then they had just signed their arrest warrant by acting on that information.

My favorite book, that many of you already are aware is "Reminiscences of a Stock Operator", written by Edwin Lefevre. This book provides an insight into the life of one of Wall Streets greatest traders of the early 1900’s… Jesse Livermore.  During the time of the Great Depression and the market crash  of 1929 Mr. Livermore refused to be swayed by those who were bullish in the market, those who were claiming that the markets were going to go to new highs. Instead Mr. Livermore, who was an expert at ‘reading the tape’ (see the end of this commentary for an explanation of ‘reading the tape’) was seeing warning signs that to him signaled something was not right. Mr. Livermore, despite criticism from some of his fellow traders, went short on the markets and he turned out to be correct, and made substantial sums of money while others were committing suicide from their huge losses. Mr. Livermore was not trading on a contrarian view of the market, but instead was a pro at reading the tape and seeing the warning signs. In spite of the overwhelming bullish sentiment on Wall Street at the time he went against the crowd and bet on a fall.

As I said at the beginning of this commentary our economy and the markets appear to be dying a slow death inflicted by a thousand razor cuts. When will this end? We can’t say. Unlike those in the media who claim to know when it will end we won’t make a statement like that just to get attention. Instead we will stick to the facts and tell you what we see. And what we see is problems continuing to grow, there has been little in the way of any sign of a reversing trend in the economy or in the markets. We monitor every bit of economic data that is released and even do our own digging. We take the data that is released and form our own view and analysis of the facts and even apply a technical analysis to the data. And the analysis that we continue to see shows us no change in direction of the economy for the better yet. And this is why we won’t say when this will be over. I cringe when I hear people saying that "the bottom is in". Lisa and I are never swayed by opinions which are based on hope or conjecture, instead we use the charts, our own analysis, and our own digging through mountains of data.

I would like to bring to your attention something that may be very alarming. At a minimum it should be taken into context with what is unfolding in our financial markets so that you grasp the magnitude of the problems. Tucked away on the Federal Reserve web site is a place where statistical data can be viewed and/or downloaded. The Federal Reserve keeps track of the amount of money that financial institutions have on hand. In other words, the health of the banking and financial institutions of this country. Something very shocking is in this data and we would like to know why this does not get discussed by the media. The image below is a screen capture from the Federal Reserve’s web site for statistical data on "Non Borrowed Reserves of Depository Institutions". The key word in this data is "Non Borrowed". This data, if we are correct in our assessment of what this reveals, and we believe we are correct, shows how much money banks have on hand that is a result of their normal operations (i.e. deposits from their own clients, investments, loan interest, etc). In a healthy economy a bank will always have a flow of money coming from their own day to day operations and will always meet the required amount of liquidity to remain solvent. The data below shows that in January 2008 the amount of money that banks had on hand from their own normal operations actually went negative! This is very concerning indeed. What the financial institutions have had to do is make up this difference by borrowing money from the Federal Reserve in order to maintain the required amount of liquidity. Where did all of that money go? That is what we would like to know. Unless we are interpreting this data incorrectly we see this as a substantial financial crisis in the making. The financial institutions are having to maintain proper operating liquidity by borrowing money from the Federal Reserve at record levels.

(Source: Board of Governors of the Federal Reserve, Washington,D.C.)

A fellow Financial Sense colleague discusses this situation in great detail and I strongly encourage everyone to read Ty Andros’s article which can be obtained by clicking HERE. Mr. Andros presents some very interesting data going all the way back to 1920. When you see his chart on "Total borrowings of Depositary Institutions From the Federal Reserve" going all the way back to 1920 you will be shocked. Maybe this is why the Secretary of Treasury, Henry Paulson said in a statement following the approval of the economic stimulus package by the House of Representatives that "time was of the essence" in getting the money approved and out to the American people. We would like to see the media cover this… instead of talking about how global growth will keep our economy thriving, or how the worst may be over, or even saying that stocks are a good buy now.  What implications will this have down the road when this money has to be repaid? What happens if the banks can’t repay the borrowed funds? What happens if they continue having to borrow more and more?

The whole issue regarding the "Non Borrowed Reserves" will be followed closely by Lisa and I. There are differing opinions of what this data actually means, some say it is simply a ‘technical calculation’ change. But we will remain skeptical of that claim unless we are proven otherwise. It is concerning to us as well that the Federal Reserve has been holding the auctions (TAF) in a manner in which it allows the financial institutions to remain anonymous, to prevent the general public from finding out what banks are needing the money. There is likely much more to this story… and when we find it we will let you know.

Tomorrow I will discuss the possibility of a ‘double recession’ scenario that may end up being a trap for the bulls in 2008.

Reading the Tape: This expression is an early form of describing technical analysis of price movements. In the early days of the stock market prices were printed on a tape machine. And ‘reading the tape’ was what one did to get a feel for the balance of greed and fear (bulls and bears). By reading the prices tick of the tape puncher, the early technical analysts were able to perform in their mind what we do today by plotting price movements in charts.