Nine Reasons the Countertrend Rally May Be Over

After this positive earnings season, there's little to further catalyze the market to the upside. To the contrary, there are a number of factors -- many of them from abroad -- which, taken together, should apply considerable downward pressure on global financial markets throughout the remainder of 2009 and 2010.

Fundamental Factors

1. Reversal of the pent-up demand effect.

Perhaps the single most important fundamental insight that drove my countertrend rally prediction was that production and shipments had contracted far more sharply than underlying demand. Economists and equity analysts projected the October 2008-February 2009 production declines in a linear fashion into the future, and this produced massive estimation errors. It was clear to me that once the psychological panic phase had passed, production and shipments would not only normalize in line with true underlying demand, but there would also be a pent-up-demand effect that would “juice up” the economic and corporate data from March through June.

The pent-up-demand effect alluded to above has probably run its course. But that, in and of itself, isn't the main problem. The problem is : Economists and equity analysts have once again made the mistake of projecting linearly. They have taken second-quarter figures and projected forward from there. The problem is that the true level of normalized underlying demand is below that which was reflected in the data in the second quarter of 2009, due to the pent-up-demand effect. This means that once the pent-up demand effect wears off, demand will quickly settle back to a lower normalized level. Not only that, from this lower normalized level, aggregate demand is still contracting at a fairly rapid pace due to declining employment, real wages, and profits.

To sum up. The third quarter and particularly, the fourth quarter, are likely to bring substantial disappointments in economic data and corporate earnings.

2. Interest-rate sensitivity.

In March, investors were vastly underestimating the simulative effects that extremely low short- and long-term government-borrowing rates would have on the economy. High financial-services penetration and high levels of leverage in the US magnify the interest-rate sensitivity of the economy. Low rates provide fuel for investment and consumption in an economy where credit can be delivered through a wide array of mechanisms. In addition, refinancings increase disposable income for businesses and consumers that are highly indebted.

However, interest-rate sensitivity works both ways. And this means that as interest rates inevitably normalize -- i.e., long-term government bond yields move beyond 4.25% and above -- a major stimulative factor will be removed from the economy.

High levels of consumer and business leverage has put the economy between the proverbial rock and a hard place. Normalization of financial markets and an uptick in growth will essentially dampen the rate of recovery through the effects that an increase in interest rates will have on an interest-rate-sensitive economy.

The result of this conundrum will be sub-par growth and increased macro volatility.

3, The mess in Europe.

Europe is in trouble -- and more than is realized. Government debt in Europe is far greater than in the US. The demographics are dismal. Entrepreneurial growth dynamics are non-existent. Property values are significantly more overvalued than in the US. The corporate sector is considerably more leveraged than in the US. The banking system is much more leveraged than in the US and capitalization levels of banks are grossly inadequate. The monetary and fiscal mechanisms in Europe to counteract the economic crisis are lame.

Furthermore, the multi-party parliamentary systems of most European nations are dysfunctional. Europe is essentially one year behind the US in terms of the bursting of the property bubble and the financial-system crisis. Thus, these twin crises will accelerate in Europe in the second half of 2009 and 2010. In addition, the rate of contraction in European economies is already surpassing that in the US, and unemployment will be greater. I expect the focal point of the global financial crisis o gravitate towards Europe in late 2009 and early 2010. The inability of European institutions to effectively deal with the crisis may trigger political and social unrest not seen in many decades.

4. Disappointment from Asia.

In my view, the consensus regarding Asia and China in particular, is far too optimistic. Asia’s economies are far more dependent on exports to the US and Europe than most people understand. I expect many Asian economies to experience a dramatic collapse. In particular, despite massive stimulus efforts, growth in China will start going flat to negative by late 2009 and through 2010.

The Chinese are currently compensating for the collapse of the export sector through massive (and wasteful) public spending and completely irresponsible loan growth directed by the government. While the Chinese can certainly sustain this level of fiscal stimulus and bank lending for a while, they will not be able to grow it from current levels. In the absence of a recovery in the export sector – unlikely given my outlook for Europe above – this implies flat growth in 2010.

In addition, there is a wildcard: The effects that internal migration trends will have on the country. For the past 30 years a main driver of growth in China has been the incorporation of labor from the countryside. Most of this production was either zero productivity or was not even part of the cash economy (i.e. the production was not captured in GDP accounts). The export sector collapse has halted and even reversed this secular trend. This is a hugely important development that few if any analysts have understood, much less incorporated into GDP forecasts.

5. Commodity collapse.

Many folks are still waxing lyrical about “peak oil.” And there is much speculative chatter about buying commodities generally as a hedge against inflation. These speculations have fueled massive run ups in various commodities via ETFs which have inflated prices to current levels. Economic disappointments in Europe and Asia will soon prove such speculations to be untimely and will cause sentiment on commodities to reverse. This will trigger a dramatic unwind of these structurally unsound markets in which activity by legitimate commercial actors is being overwhelmed by financial speculators. I expect crude oil to revisit the 30s and perhaps even the 20s. Other commodities such as copper, which the Chinese have propped up through stockpiling, will also collapse back towards 2008 lows.

6. Emerging-markets crisis.

Most emerging markets outside Asia are highly dependent on commodity exports. The Russian economy will be devastated by lower oil prices. Ditto for nations such as Venezuela and Mexico. Brazil will be tremendously affected by the decline of various agricultural and industrial materials commodities. Emerging markets are also highly dependent on investment and remittance flows. After a brief dawn in mid 2009, these external factors should once again become a major drag on emerging economies in late 2009 and early 2010.

7.Valuations.

Amateurish articles were being published in the financial press proclaiming that based on current earnings, fair value for the S&P 500 was 600, 500, 400, or even 300. These articles seemed blithely ignorant of the concept of normalized earnings or of the idea that current equity values must discount the net present value of all cash flows into the indefinite future -- not the cash flows of any particular year or years. History has shown that when valuations reach such extreme lows, the probabilities of upside appreciation are quite favorable.

This countertrend rally since March has brought valuations within parameters that are still low, but which are at least near levels that can be considered normal. It can be empirically shown that with valuations at current levels, odds for current upside or downside are close to even. As such, valuation no longer provides a support for the market.

Psychological Factors

8. Psychology.

Fundamentals are important. However, just as critical are 2 factors. First: Which fundamentals will market participants focus on? There's an overwhelming amount of data available, much of it contradictory. Which data market participants choose to focus on depends on their biases and their state of mind. Second: How will they interpret the data? The same data can be interpreted by reasonable people in different ways.

The psychology that pervaded marginal market participants from late 2008 through early 2009 was one of “irrational despondence.” The doom and gloom got completely ridiculous. Pundits were proclaiming the collapse of the US dollar, the end of the American dream, deflation, hyperinflation, and much more sensationalist and even contradictory nonsense.

The nonsense got so out of hand, in fact, that people were calling for the nationalization of the US banking system -- a position driven by hysteria and an utter lack of understanding of the fundamentals of the US financial system At this time, the marginal market participant was seeing only the downside and completely ignoring potential upside. It was pretty clear that as soon as people realized that things were not as hopeless as they'd been led to believe -- and that there were viable short-, medium- and long-term solutions to the various problems afflicting the nation -- the market would rally strongly. The problem is that after 3 months of psychological relief, better-than-expected news seems to have become old hat.

And the old bearish bugaboo tales of deficits, debt, money growth, etc. seem to be coming back in style. The mood has shifted from one of surprise (that things weren't as bad as expected), to one in which people are focusing once again on the fact that it's “still bad.” In this context, folks are looking for reasons why things are bad -- and this causes them to gravitate towards bearish explanations and ways of looking at the world.

Put it together: Worse-than-expected news and a prevalent psychology that seems to be looking for bad news. It's a recipe for lower asset prices.

Technical Factors

9. Exhaustion.

Many market participants bought into this market at levels at or around 920-950. After the major scare that took markets to 870, many of these Johnny-come-lately traders and investors will be relieved at the opportunity to bail out at break-even levels. Today, after a substantial scare and the shift in psychology, the 950 resistance looms much more formidable than it did a few weeks ago, and the market is likely to exhaust itself at or around this level.

I see one major risk to this technical and psychological outlook: Almost nobody seems to believe that the S&P 500 can rally significantly beyond 950. Indeed, various sentiment indicators are flashing levels of pessimism not seen since March of 2009. And cash levels remain extremely high.

This could conceivably lead to a short-squeeze type of situation. Ultimately, though, such a move up -- if it were to occur -- will be doomed. In the end, it's far more important that the flow of fundamental data will be turning from marginally positive to marginally negative.

Moreover, at the local scene, the FBM KLCI seems to look tired as it is exhausting itself around 1120s with decelerating momentum. As the new moon looms on Tuesday, a reversal from here could see a near-term 25% or 38% retracement of the rally started since March09.

I see US markets languishing, probably trying to find a range somewhere between recent highs and the March lows. Perhaps that range could be somewhere between 750 to 850, with short forays outside such a range. Technology stocks should outperform in a big way while energy- and commodity-oriented stocks should suffer steep declines. Sector and stocks selection will be the name of the game in the second half of 2009 and 2010.

The best opportunities to make money may be on the short side in Europe, Asia, and emerging nations -- for those that know how to navigate these markets. The currencies and equities in these markets are little understood -- particularly in the US -- and their prospects are vastly overrated.

Gold Would Go Fast And Furious Soon.

This week, I’ve looked deeply into the issue of inflation, researching what some of the smartest people have to say on the subject.

There are those, like billionaire investor Warren Buffet, who believe that inflation is inevitable: "A country that continuously expands its debt as a percentage of GDP and raises much of the money abroad to finance that, at some point, it's going to inflate its way out of the burden of that debt."

Then there are those, like Nobel Prize-winning economist, Paul Krugman, who don’t believe inflation is just around the corner. Although the powers that be have increased the money supply by a trillion dollars, most of that money is sitting in commercial bank vaults as excess reserves and isn't out in the real world creating “inflation” by buying up cars, houses, and flat-screen TVs.

Although in ordinary times, the Fed’s recent actions would cause “inflation," wrote Krugman in a New York Times article, these aren't ordinary times.

“Banks aren’t lending out their extra reserves. They’re just sitting on them -- in effect, they’re sending the money right back to the Fed. So the Fed isn’t really printing money after all.”

In my opinion, banks aren’t lending yet, but that's likely to change. Think about it in market terms: The short-run situation may be irrational and emotion-driven (banks may fear to lower cash reserves if case additional regulations are introduced), but in the long run, it's the fundamentals that drive prices. Banks have money but want to earn more, so they'll eventually lend it to earn interest.

Nobody can be absolutely sure what the future holds for inflation. In my view, the vast majority of signals are screaming “inflation ahead."

As far as implications for the USD Index are concerned, we've been sideways for approximately a month now -- a considerable amount of time -- thus making the correction more likely to be completed soon. This is naturally bearish news for the US dollar and bullish for the precious-metals market.

There are signs that the general stock market may move lower in the short term, because it has snapped the neckline of a head-and-shoulder of the S&P. Should that be the case, it could affect the prices of precious metals --particularly silver. Still, I believe this would only be temporary.

The breakdown below the neck level (currently below the 90 level) has been confirmed by a relatively high volume just after it materialized. Additionally, we witnessed a brief pullback to the neck line, which didn't close above it, thus confirming the formation. Unless we see a sharp move above this line (89 level) on Monday or Tuesday, the technical picture remains bearish for the general stock market.

GOLD

Last week has been disappointing for precious-metals investors as gold, silver, and corresponding equities followed the general stock market lower.

Gold moved lower despite the technical similarity to a previous pattern that was followed by higher prices. Higher prices were likely, but of course, not guaranteed. In order to make calls that have the greatest probability of being correct, it's important to always take what the market provides and use it on an “as is” basis.

Currently, gold appears to be close to bottoming out, as it seems to be forming the zigzag correction pattern. As mentioned in the past, precious metals tend to correct in a zigzag fashion, and this time we could see another example of this tendency -- meaning the bottom is rather near. Meanwhile, the medium-term chart has not changed much in the past week.

The bullish cup-and-handle formation is still intact, even though the “handle” is now considerably bigger. This doesn't change the overall bullish implications this chart has on gold prices. Additionally, the stochastic indicator -- which has proven a valuable tool in timing local bottoms in the past -- is also suggesting that the bottom is rather near. I'll provide you with one more chart from the premium version -- one indicator suggests that higher prices are likely in the future.

The long-term situation remains inflationary and favorable for the precious-metals sector; however, the short-term situation is rather cloudy. In the very recent past, precious metals have taken the general stock market’s lead, while the dollar has been trading sideways without a decisive breakout or breakdown from its trading range. The long- and medium-term trends are down for the USD Index, so a breakdown from here is more likely than another counter-trend upswing. Still, a significant plunge in the general stock market may negatively affect prices of gold, silver, and corresponding equities.

Investors who are already in the market and plan to keep their positions for at least several months don’t need to trade the rest of the downswing. Short-term speculators might want to wait a little longer before opening a long position in the precious-metals market.

Cheap VIX : Just The Slow Beginning Of 3rd Q, Plain And Simple.

You can't refer to the cheapness or the richness of the Chicago Board Options Exchange Market Volatility Index (VIX) outside the context of historical volatility. The VIX is, first and foremost, a measure of the anticipated volatility of the near-term options on the S&P 500 Index, and the most important clue over the years to the current level of the VIX has been the short-term (10-day or 20-day) historical volatility of the S&P (the VIX calculation doesn't exactly equate to a historical volatility but it is close enough).

So the use of the VIX level as a "fear gauge" must always be assessed net of the major influence of historical volatility on the VIX. While it is tempting after Friday's VIX implosion to less than half its peak levels in January to suggest that investor fear has dissipated to dangerously low levels, this assessment is seriously complicated by the fact that the VIX is not 'low' in the context of the recent volatility of the S&P.

It's a point I've always tried to hammer home. Implied volatility attempts to divide the volatility of the underlying over the stated time frame (usually the next 30 calendar days). There are always expectations of impending news events, and so on, but the best "prediction" tool is simply the volatility of the underlying over the past 2-4 weeks.

What else would you base your markets on besides what you "feel" right now? And as we know, realized volatilities utterly caved early in the cycle, and those "cheap" options actually overbid. That's not uncommon.

Equity volatility is seasonal. According to a recent study by Larry McMillan: 'There is also a seasonality to VIX patterns ...You can see several patterns (over the past 20 years). Early in the year, there is typically a small peak in VIX in January, followed by a slightly higher one in March. "

"Then it goes into a decline during the spring and into mid-summer. It probably comes as a surprise to no one that the low in volatility occurs around July 1 of each year. What might come as a surprise though is that volatility typically rises quite a bit during July and August. Then it really gets going in the fall -- In September and October, when the stock market typically has major declines. It peaks in October."

"After that, volatility becomes surprisingly docile for the rest of year, until by Christmas, it is almost back at the July lows. Not every year follows the pattern exactly, but most are a reasonable approximation. 2008 followed quite closely, and this year the pattern is typical as well.'

"So is it time to assume that the VIX will rally according to these past seasonal patterns? Perhaps, but I'd also suggest the possibility, based in part on the ongoing compression of historical volatility, that the VIX might continue to decline to surprisingly low levels -- perhaps as low as 20 -- before it bottoms."

Well, first off, I feel great that the absolute master in this business agree with some data I came to similar conclusions regarding the early July cycle trough.

Which is also why it drives me nuts when I see "analysis" on the cheap VIX that fails to put it in its proper context, which took the form of assertive directional calls in both directions. On the one hand, analysts said "smart" option money was right to lower bids, as they "knew" the bull would continue this 3rd Q. On the other hand, they said 26 VIX was a red flag of complacency, and bearish.

In truth, neither interpretation was correct. It was a prediction that the always-slow start of 3rd Q was upon us, plain and simple!

Dissecting The Minds Of The Pros.

Billionaire investor George Soros thinks the worst of the global financial crisis is behind us.

In a June 20 interview with Polish television, the Hungarian-born Soros acknowledged that: “Definitely, the worst is behind us.”

For those who like to interpret “Soros-speak,” that’s as powerful a sign as any that Soros -- one of the world’s most successful investors -- is “going long."

But is he wrong?

On the one hand, the World Bank's busy rolling the markets with recent updated figures that project a 2.9% decline in global economic activity this year. Then there are the signs that the green shoots (how I’ve come to detest that term) may be more like weeds. Debt's devastating the developed world, and the once-mighty G-7 looks more like a G-1 every day.

On the other hand, I wouldn’t bet against him. When it comes to financial influence and acumen, Soros is about as powerful and prescient as they come. He’s made billions over the years speculating on things that others simply couldn’t see -- or, more often, didn’t want to see. He’s legendary for making big bets on market timing, even if, by his own admission, he isn't always right.

For the millions of investors tempted to interpret Soros’ comments as bullish, I urge caution. In fact, this advice applies to any comments that might be made by such investment legends as Warren Buffett, or even Soros’ former investment partner, noted author and commentator, Jim Rogers.

I preach caution for 3 reasons:

1. Despite the fact that each of these men is fabulously successful, the typical retail investor has no idea how much money they’re betting on the upside, or what percentage of their wealth is involved in any publicized position.

2. It’s not clear what -- if any -- protective stops are being used, so you don’t know whether the positions they’ve taken represent core portfolio holdings or speculative trades.

3. These revelations -- disclosures, really -- are usually made after the fact, which means that investors who may want to tag along for the ride are put in the risky position of having to make “me too” investments.

So if you’re a savvy investor, what steps can you take to translate moves being made by 3 of the best investors of our time into profits of your own?

1. A good place to start is by taking the time to understand precisely what drives these guys. Even though superficially they're different -- Rogers hunts for opportunities around the world, Soros tends to pursue investment plays involving currencies and macroeconomic trends, and Buffett's a deep-value guy -- they have much more in common than you think. That’s especially true since the core elements of the strategies these 3 investors use to win and profit usually run counter to Wall Street’s conventional wisdom.

2. Take the very concept of profits, for example: Most people are surprised to learn that none of these gentlemen spends the morning rubbing his hands together and cackling over how much money he’s going to make that day. But nearly all have gone on record at one point or another about the importance of not losing money in the first place. They’ve also repeatedly stressed the importance of waiting until the really compelling opportunities develop before putting money at risk.

Rogers, once Soros’ partner at the Quantum Fund -- a hedge fund that’s often described as the first real global investment fund -- goes a step further: He describes his investment process as waiting until somebody puts money down in the corner, then “walking over and picking it up.”

3. Moreover, none of these 3 investors believes you have to take big risks to make big money. In fact, all 3 believe, as I do, that it’s how you concentrate your wealth that matters.

This flies in the face of what Wall Street pros would have you believe, which is that you need to diversify your assets to get ahead. Diversification as Wall Street pros practiced it is a complete misuse of the math and a proxy for an entire establishment that doesn’t know what it’s doing.

The thinking is that by spreading your money around willy-nilly, some of your holdings will rise in value, even as other parts of the portfolio fall. Even so, by diversifying, Wall Street pros say that you'll be better off for it over the long run.

Granted, there are some instances where taking steps to “diversify” leaves you better off than if you’d done nothing at all, but one of the critical problems with diversification as Wall Street pros have practiced it is that it doesn’t work when everything goes down at once ! -- as so many investors who'd been led to believe they were protected found out the hard way in 2000, and again in 2007.

That’s why, for example, I’m a proponent of concentrating my efforts on a few relatively high-probability choices, especially when it comes to trading services. It’s a strategy that individual investors should consider, as well.

4. But what matters most is that people put the comments they hear from these guys into perspective and think for themselves. It’s important to remember that Buffett, Soros, and Rogers don't care about what other people think. That’s one of their real strengths. Nor do they care what the markets will or won’t do.

In fact, none of the 3 -- at least as far as I can tell from the research I’ve done -- subscribes to the “random walk” theories, which I take to be complete bunk.

5. The bottom line is that Soros, Buffett, and Rogers have demonstrated time and again that they’ll only make a move when they’re darned good and ready -- when they’ve done all they can to scope out the situation at hand, and to make sure that the percentages are in their favor.

That, by itself, is a terrific lesson for retail investors to learn. Wall Street tries to push investors into action with advertisements portraying “real” people making trades from their kitchens, or getting the latest quotes on their mobile phones. They show attractive retired couples who’ve achieved their dreams with big sailboats, or antique cars, or expensive vacations. Ignore those messages, and you’ve effectively elbowed aside the artificial sense of urgency that Wall Street pros are trying to create.

Not only is this manufactured urgency designed to separate more of you from your money, but they wouldn’t do it if they knew that most investors got it “right” more often than they got it wrong.

Buffett, Soros, and Rogers act only when they believe the time is right. Buffett has referred to this as waiting for the Sunday pitch. If you’ve never heard that term before, it’s one that dictates extreme patience. You only take action when the one pitch you know you can hit out of the park is on its way -- then you swing from the heels, and give it all your effort.

There’s one final thing these guys do better than almost anyone: Keep everything in perspective. They assemble their portfolios with diligent planning, attention to detail, and an emphasis on the objectives they expect to achieve. They make investments based on a clearly defined set of expectations and don't hesitate to cut their losses if they find out they were wrong.

In that sense, every investment choice they make fits a specific role in their portfolio. Nothing, if they can help it, is left to chance. So to the extent there’s any action to be taken right now, let me leave you with one final thought.

No nation in the history of mankind has ever bailed itself out by doing what the US is doing now, which means that placing bets on a “recovery” is really a fool’s errand. On the other hand, making choices that capitalize on the trillions of dollars now being injected into the world’s financial system is the place to be. History shows that it’s better to be generally long resources, inflation-resistant choices, and real companies with real earnings.

Not only will these kinds of profit plays fall less than others if the markets stumble and fall from here, they’ll also rise faster and farther once the capital infusions start to work their way through the global financial system and the rebound gets under way.

And I’ll bet my bottom dollar that George Soros knows it.