We are publishing this edition of Views from the Crows Nest about a week ahead of schedule. We believe this is necessary because of risk in our current market environment. The majority of people rarely listen to warnings of imminent danger unless they understand the worldview of the person issuing the warning, and have sufficient time to process and accept the context of the warning. We are willing to risk being slightly early rather than risk being too late. Forewarned is forearmed.
"Facts do not cease to exist because they are ignored." - Aldous Huxley
Humans are complex creatures, and we create an exponentially complex world. Chief among the unique human qualities is our ability to delude ourselves, individually and collectively. On an individual level some make lifestyle decisions that are self-evidently harmful but they create bizarre rationalizations to excuse themselves from stopping the destructive behaviour. On a collective level - as nations, races, or religions - we often engage in activities that are clearly contrary to our best interests or blatantly opposed to the beliefs that we twist in order to support our actions. Impression management reigns supreme, it would seem.
Why do we do this over and over again? This is one of the great unanswered questions of the human condition. Where do we search for answers - the great religious texts, timeless classic philosophical works, the world of psychology, or cosmology? Besides alcohol, what inspires local fans to dress up in costumes for a sports event? Other than an appetite for power, what causes a high-profile public official to stand solemnly before the cameras and justify needless destruction of human life or property "in the interests of national security"? Why do most people behave differently in groups than they do as individuals? What makes some people stand aside from the crowd and express the unpopular minority view? The behaviour of individuals is challenging enough to decipher...groups are harder to understand.
Perhaps some of the answers can be found within the nascent study of Mass Psychology, as pioneered by James Dines. What is it about the anger or euphoria inspired by groups that makes normally discerning people lose the advantage of higher cortical function? As some of you may have, your author recently experienced an amazing episode of beautifully innocent Mass Energy. I could feel the buzz start to radiate through my entire body from several hundred yards away. The helicopter circled overhead, local police cleared the streets with lights and intermittent siren blasts, the crowd of normally-cynical junior high students cheered incessantly, noise makers and Canadian flags swirled, and participants of every age peered up the street in anticipation. The tears nearly froze on my face. As the main attraction approached, the fury escalated to an unthinkable level. The middle-aged bearer of the Olympic Torch was literally swept along by the crowd, with a gait resembling both glide and bounce. His face seemed too small to hold the smile he was powerless to contain. And then it was done.
So what does the Olympic Torch relay have to do with world of investing? They are both examples of the intoxicating power of Mass Energy. Both are intelligently orchestrated. Both require a large group of people, and both require a certain set of pre-existing conditions, including anticipation, a desire to achieve noble ideals and re-assert our abilities, and a need to forget about the challenges, failures and tragedies of the past. The difference is that the Olympic Torch relay did not have losers. A major rebound rally after a killer Bear Market has the ability to draw in large numbers of the faint-of-heart at the last moment and create significant financial loss for them. It's been said that the peak of market rallies is the period when securities pass from strong hands back to weak hands. Such is the tune that is re-played incessantly in investment markets... and the music is blaring loud and clear right now.
Has the peak of this Bear Market Rally already passed? Peering into the future of investment markets is like driving in a nocturnal snowstorm...it's very challenging and is fraught with very real risks. It also leaves one open to criticism after the fact...once the white space to the right of "today" is safely populated with historic record to the left of today. Warren Buffet once said that "Because investing is inexact, it's better to be approximately right than risk being precisely wrong." In times of imminent risk, caution is the only prudent course.
Even before your author first published Views from the Crows Nest in December 2009, we were gravely concerned about the state of our planet's finances. While being partially to fully invested in rising markets, we've consistently repeated our pessimistic predictions for another major correction or crash in the second half of 2010, or perhaps slightly sooner. In the April 2010 edition of this newsletter, we shared our view that we are in the early stages of "The Second Great Depression." Some of those who have only recently started reading or hearing our work have dismissed our cautious (and recently downright pessimistic) market views because it doesn't fit their worldview. We're fine with these reactions because we can only help those who want our help and who are open to contrarian views. Our clients trust us to call it as we see it. We would love to be wrong about this, but fear that we are correct.
Looking back, we observe the near-term peak of late January 2010, followed by the February 8th low, rally to the high-water mark of 1217 on the S&P 500 on April 23rd, slow decline and then drop starting May 4th, brief spike back upward to another near-term (lower) high and then an apparent holding of support in the last few days of May with a couple positive reversal days before a significant drop on Friday June 4th, and more negative action on Monday June 7th. The next 48 hours will be critical, as key markets closed on June 7th right at key support levels. If support holds over the next few days, we could be setting up for a classic "head and shoulders top." If support fails, then we believe markets are breaking down somewhat sooner than we anticipated, and our portfolio managers will react accordingly.
Until the last few days, "The Herd" of Wall Street prognosticators seemed to think that everything is just fine, which could help us all in the very short term. The roughly 2000 Analysts covered by Bloomberg have consensus S&P 500 growth forecasts of 25% for the next 12 months and 19% for the following 12 months. This news item comes with a bulls-eye-accurate explanation: "Structural changes are often omitted from analysts' assessments until the evidence is truly overwhelming and the implications have already imposed themselves," wrote Mohamed El-Erian, who oversees $1.1 trillion as chief executive officer and co-chief investment officer at Newport Beach, California-based Pacific Investment Management Co. (PIMCO), which runs the world's largest bond fund. "Structural changes are among the hardest things for analysts to identify and to price." To us, this is roughly equivalent to planning out a road trip without bothering to factor in the reality of the vehicle's condition, road construction, weather conditions, etc. Analysts are supposed to be "thought leaders" but sound more like cheerleaders...never under-estimate the inclination of Wall Street to talk up their own book of business!
If support holds in the next few days, we believe that the current environment paradoxically creates a very short-term opportunity for markets to grind a few percentage points higher before the music stops. The orchestra is visibly sweating under the strain. Juiced by injections of government stimulus globally, there might be enough positive earnings news (soon to be released) that latecomers with cash (individually or in mutual funds) can push prices higher. Then we think the orchestra collapses from exhaustion after this final crescendo. We have chosen to sit in the seats closest to the fire exit and hopefully avoid being trampled by the exiting crowd.
So, why are we so pessimistic on the prospects for equity markets once this decline starts? There are many reasons, and what follows is a summary of a partial list, cobbled together from various research sources including Harry Dent, Eric King, Felix Zulauf, Bill Laggner, Richard Russell, Bill Fleckenstein, David Rosenberg, John Mauldin, Mike "Mish" Shedlock, James Dines, Eric Sprott, et al.
* The crash of 2008/2009 was essentially a debt-liquidating destruction of private capital, triggered ostensibly by the U.S. Sub-Prime crisis. Governments (taxpayers) and central banks were able to step up and bail out the worst of the imprudent institutions. They rationalized this action because these firms were "too big to fail." This time around we are dealing with a much larger over-burden of debt carried by nearly every industrialized nation around the world. Who is capable of bailing out the governments of the world who cannot afford to service or re-pay their own debt? The next downturn could be much worse than what we experienced in 2008 and early 2009. Even if this view is too pessimistic, why would you ride it down and see how far it will fall?
* European banks are collectively in much worse shape right now than were the worst American banks back in 2008. They are much more vulnerable from a leverage stand-point, and have massive exposure to sovereign debt issued by Greece, Spain, Portugal, Italy and Ireland. That's essentially why Greece was bailed out by the E.U. and the IMF (including some Canadian tax dollars)...to save the European banks. And now Spain is looking increasingly shaky, and this has significant direct North American consequences, since several major U.S. banks own large quantities of Spanish bonds. The U.K., U.S. and Japan are also on extremely shaky ground from fiscal and economic perspectives. This is far from over and will not end well.
* Every major country around the world is attempting to de-value its own paper ("Fiat") currency in an attempt to make its own exports more attractive and imports less attractive, thereby stimulating its domestic economy. As James Dines characterizes it, we're witnessing "competing currency devaluations" and collectively this amounts to a "fool's race to the bottom." Human history has ZERO examples of Fiat currencies that have survived...ZERO examples of success! Click Here to link an exceptional interview with Felix Zulauf
* From a macro perspective, governments never create wealth; they only re-distribute it inefficiently. This is ringing true right now when one compares the amount of "temporary stimulus" (dollars borrowed on behalf of taxpayers) and the resultant GDP growth, especially true in the U.S. As Eric Sprott recently noted, "Buying dimes with dollars" is neither sound nor sustainable business practice. And already we're starting to see signs of the US stimulus wearing off: the ERCI weekly leading indicators are pointing downward, and the U.S. private sector is adding real jobs at an anaemic rate. Those who believe that the U.S. stimulus will be enough to allow the private sector to take over new job creation do not have any evidence to support their view.
* Gold is getting more and more interest from more and more market participants for various reasons. Since "Gold is the Hitching Post in the monetary universe" its persistent rise is confirmation of virtually every concern addressed herein. Those who claim that Gold is in a bubble didn't see the Crash of 2008/2009 coming either. Gold is Money.
* Governments control short-term interest rates via their central banks, though governments and central bankers both claim independence from each other. There is essentially one significant short-term interest rate that is not controlled by central bankers: the London Inter-Bank Overnight Rate (LIBOR) is the price charged by large UK-based financial institutions on overnight loans to their best UK and US-based clients - other institutions just like them. The lower that LIBOR is, the lower the perceived risk by bankers in the economy and markets. While it is not yet at the same levels it was in late 2008, the LIBOR rate has recently stopped falling and is creeping up steadily. This is the canary in the coal mine.
* The next 18 to 24 months will bring the maturity of many more Option Adjustable Rate Mortgages (Option ARM's) in the U.S residential mortgage market, as well as approximately $2 Trillion of Commercial Mortgages. With the unemployment picture static and commercial vacancies escalating, who will re-finance these and if someone does, at what price? Residential and commercial real estate prices in the U.S. must come down to reach a new equilibrium in today's reality, and Canada will not be immune to this pain.
* Almost every market and economic commentator is looking to the Emerging Markets and specifically China to bail out the rest of the industrialized world. They point to high current GDP, a huge population that is rapidly urbanizing and morphing into a middle class, thus creating domestic consumption. The trouble is that urbanization has been fuelled by creation of manufacturing jobs for export purposes, China's highly centralized government has also injected massive stimulus into its own economy to keep its GDP growth rates high, and there is a pretty obvious real estate bubble building especially in Shanghai. How can China continue to grow its export-dependent manufacturing sector that is supposedly fuelling everything else when their largest trading partners (North America and Europe) have rapidly aging populations, too much debt and resultant declining consumption? In late 2008 and early 2009, Chinese equity markets led the recovery in industrialized counties. China's equity market peaked over 8 months ago and is about 25% below its peak. To your author, this is also a significant warning signal
The game plan for navigating the challenges ahead is straight forward in concept: we won't ride this market down. Client portfolios are holding about 35% cash right now. If markets move higher in the next few days, but start to falter on the upside as we approach short term "ceilings," equity exposure will be partially trimmed or completely eliminated. Once key support levels ("floors") are reached our portfolio managers will either add to equity exposure (if support appears to be holding) or completely eliminate it if these levels don't hold. Cash and precious metals will continue to be used as a defensive position, with some fixed income and potentially a few short positions.
When do we think that the current fragile situation breaks and we start another major crash? As previously noted, driving in a nocturnal snowstorm is extremely difficult. We look at all the signals and credible warning signs available, and arrive at our conclusions as best we can. In a nutshell, we see that a short -term equity market rise is possible through the end of June or even as long as early August, as long as support holds over the next few days. Markets have a way of remaining irrational for extended periods of time, so rational analysis doesn't always work perfectly. Perhaps we have a rally for the next 3 to 8 weeks and then markets start to trail downward on low summer volumes before we get a major decline. We could also be at that tipping point right now. No one is ever exactly sure until we have the benefit of hindsight, but because we perceive high current risk, caution and defence will be used
When will we become optimistic about markets? When almost everyone else is panicking, and "Chicken Little" re-appears. That's when investments move from weak hands back to strong hands. In the meantime, get defensive in your portfolio and preserve your current value. It's wiser to be early and cautious rather than be cavalier and late.Fear and Greed are destructive to your wealth; Patience and Discipline are accretive to your wealth.
That's all for this issue of Views from the Crow's Nest. Please forward this newsletter to anyone you think might benefit from the information.
If you're not already a member of our Client Family and are curious about how we might be able to serve your family, please call us at 403-517-2234 or click here: andrew@integratedwealthmanagement.ca
Cheers,
Andrew H. Ruhland, CFP, CSA
Wealth Management Advisor
President, Integrated Wealth Management Inc.
