The end of an Era

It is my belief that we have reached the end of an era. Exactly when that ended (2000 or 2007) and to what degree is up for debate. However, what is evident is that we have reached the end of the era of low interest rates and easy credit that began in 1981. Likewise, if this turns out to be true, and interest rates have made a major bottom, that means U.S. Treasury bond prices have made a major top (since interest rates and bond prices are inversely correlated). The case for the end of the Bond bull market and the start of a major Bull market in interest rates can be made, I believe, from both a fundamental and technical perspective. From the fundamental perspective, the amount of outstanding U.S. Government debt issued is so large that it CANNOT be paid back and this type of fiscal situation is not sustainable in the long run, and I believe that eventually, the piper will be paid.In my view there is simply no way we can afford to pay back the debt when our GDP is 70% consumption. According to an official government website, treasurydirect.gov, the total public outstanding debt as of March 24, 2010 is $12,662,466,657,519.82. Bond Investors will demand a higher interest rate for the simple economic principle that risk requires compensation. If government debt is going to be considered high risk, you can bet high interest rates will come with it. In my opinion, it is only a matter of time before the Credit Worthiness of the U.S. government is put into question not just by foreigners (namely Japan and China) which fund a good portion of out debt, but by its own citizens. That is the fundamental part of the argument. From a technical perspective, above are two charts, both of the 10-year U.S. Treasury Bond yield. In Technical Analysis, we say that when downtrend lines are broken, they are retested, meaning the price of the security temporarily goes against the(new) trend to find support on the downtrend line in the case of a turn from a downtrend to an uptrend, and retest to find resistance at the uptrend line in the case of a turn from an uptrend to a downtrend. Granted, a break of the uptrend or downtrend lines are not guarantees that the trend has changed, but rather an indication of a possible trend change, hence the question mark next to the "retest after breakout" annotation on Chart 2. If the downtrend in interest rates is continuing, then the downtrend line will not act as support and the 10-year yield will break back below the downtrend line. However, if I am correct in my analysis and interest rates bottomed in 2008, the spike low in the Fall of 2008 was just a final thrust down in interest rates (and thrust up in bond prices) before making a major trend reversal. Chart 1 is the same as Chart 2 except that it is shown on Logarithmic Scale, while Chart 1 is shown in Arithmetic scale. Chart 1 illustrates the long term downtrend line on the 10-year Treasury yield. When that is broken, it will certainly be something to pay close attention to, because it will likely signal the start of a multi-decade move up in interest rates. In addition, on chart two I show a common indicator called the MACD, which stands for Moving Average Convergence Divergence. Without going into too much detail, this is an indicator of momentum. When price makes a lower low or higher high and the indicator does not confirm with a higher high or a lower low (depending on the trend), it is called a divergence. In this case price (Interest Rates) have made a lower low, but the MACD has made a higher low, creating positive divergence. This is another sign that the momentum in the long-term downtrend in interest rates is slowing dramatically and a turn higher is coming, possibly (likely in my opinion) as early as this year (2010). I will post an update if and when this happens. As a side note, rising interest rates are generally not positive for equity prices, and with the way things look now, if interest rates spike higher, it could be accompanied by a precipitous drop in equity prices and quite possibly a resumption of the bear market in U.S. equities. I will also post an update on the stock market soon.

The U.S. Dollar in a deflationary environment

Most people would think that the dollar would fall in value when the Federal Reserve is printing money. There are two problems with that assumption the way I see it. First, In a deflationary environment, banks don't want to lend. The money that the federal reserve is printing is being held on Banks' balance sheets and is not getting out in to the economy. Simply put, there is very little velocity. Second, the money that is getting out into the economy (increase in the supply of dollars) is vastly overwhelmed by the volume of credit contraction (decrease in the supply of money and credit). The supply of and value of credit is contracting as debts are either being restructured (partial value loss in credit) or defaulted upon (total value loss in credit). That is just the supply side of things. The demand for Dollars is also going up as debtors are scrambling for dollars to pay off their debts. So, there are two forces causing an increase in the value of the dollar: The contraction in the supply of dollars, and the increase in the demand for dollars. From an investment prospective, instead of keeping their wealth in long term bonds, investors are keeping their wealth in short term T-bills and other safe cash equivalents, even plain old dollar bills. Thus, the demand should be for safe dollars rather than for exotic financial instruments and debts. The effect should be rising interest rates and a rising Dollar. Time will tell If I'm right. I'll post an update when new developments arrive.

Interest Rates in a Deflationary Environment

People Normally Associate Rising rates with Inflation (Since the Value of Dollars is going down, people expect to be compensated with a higher rate of return.)However, This chart displays how it is indeed possible (and I think likely in this environment) to have rising interest rates in a Deflationary environment. When the Demand for money and credit goes down, one would expect the price of money (Interest Rates)to go down as well. However in this case I think the supply of Credit (people willing to lend out) is contracting faster than the demand for money and credit, so the price (interest rate) goes up.

DJIA, VIX and valuations

Lets take a look at the Dow Jones Industrial Average. As you can see, it is right up against the downtrend line from October 2007 when the Dow made its all time high at 14,198.10. This is no time to be buying stocks, it is the time to be safe. We are in a secular bear market, and if you are familiar with Elliot Wave theory the next big move in the market could be a decline of super cycle degree. After all is said and done, the Dow could be at 1,000 or below. Yes, 1,000. Don't listen to Cramer and others on CNBC and the media telling you this market is cheap. By NO means is it cheap. the S&P 500 P/E ratio is currently floating around all-time record levels. Unless earning soar, Prices have to fall to MUCH lower levels to get us back to bear market bottom territory. If you stay liquid, in SAFE cash equivalents, you will have your wealth safe to snatch up the bargains of a lifetime. A great book to read about this is Robert Prechter's book "Conquer the Crash: You can survive and prosper in a deflationary depression", in which he outlines exactly how to stay safe during this bear market so that at the bottom you will have a good portion of your wealth in tact. Back to the market, the preferred count at this time is that we are in an ending diagonal, which is a pattern that completes moves, and often leads to violent reversals once complete. Another indicator that is showing a sign of complacency in the market (and from a contrarian standpoint a sign of a reversal) is the CBOE Volatility Index (VIX), a measure of fear in the market, Shown above in Chart 2.The VIX is at levels not seen since before the 2008 crash. There is positive divergence developing on the weekly time frame, indicating a bottom is near. Stochastics, a measure of overbought or oversold conditions, are at extreme oversold conditions, indicating a turn up in the VIX is near. When the VIX starts to turn up, the initial move should be swift, along with a precipitous selloff in the market. This would likely indicate the bear market rally is over, and Primary wave 3 down should begin.

Signs the Bear Market Rally is waning

Here I show the Weekly S&P 500 chart but without Elliot Waves this time. Since the rally started in march, momentum has been waning on the upside. Does this mean the market can't go higher? No. But it does caution to be on the lookout for a reversal. As you can see, price is bumping up right against the downtrend line resistance from the October 2007 highs. In addition, the Moving Average Convergence Divergence (MACD) (an indicator of momentum) Histogram is not keeping up. Each week price has been making higher highs,while the histogram has been making lower highs for the most part. This is called negative divergence, where price makes a higher high but the MACD, or any indicator or relative price (such as another index) makes a lower high. Until (or if)the indicator (or whatever index is being used as a comparison) makes a higher high, this serves as a non-confirmation, and indicates lower prices ahead. Should the indicator make higher highs, this would serve to negate the divergence. This goes for downtrends as well. For example, as you can see, in March, the S&P 500 made a lower low, but the MACD made a higher low. This is called positive divergence, and indicates waning downside momentum. This indicates a trend reversal is near unless the indicator were to make a lower low, which would negate the divergence between price and the MACD. The MACD has two parts to it, the regular MACD, and the MACD Histogram, with bars. Generally when you get histogram divergence but no regular MACD Divergence (as in this case), you get a pullback, with one final move up (or down) in price for which the regular MACD does not confirm, creating negative divergence. Just because there is no negative divergence on the MACD, that does NOT mean the market has not topped out. Price is first and foremost. There need not be divergence for price to reverse trends. However, the MACD histogram divergence indicates that momentum is waning, although not to an extreme. What could happen is we could get a pullback in the market, with one final higher high to produce the regular MACD negative divergence, which would signal a long term top is likely in place. Key support for this market is the 991 level on the S$P 500. If that is taken out, it will likely indicate the bear market rally is over. However, please remember NOTHING is certain in the market. Traders trade off of the most likely outcome, or in other words probabilities, not certainties.

S&P 500 Weekly Elliot Wave Count

As Elliot Suggested, Markets move in a series of 5 waves in one direction, with a 3 wave correction in the opposite direction of the trend. There are different degrees of trends, from Grand Supercycle waves lasting many decades, to Subminuette waves lasting only minutes. That is what makes Elliot Wave Theory so great: It applies to any time frame you are looking at. When the Stock Market bottomed in March 2009, 5 Intermediate waves down could clearly be counted. The question now is whether this Bear Market will unfold as 5 Primary Waves down, or only Three. Waves of a Primary Degree are used to count major impulsive and corrective trends in a cyclical bear market. If this should unfold in only 3 waves, this move up since March would be Primary Wave B up, with a Primary Wave C down to come. If this should unfold as 5 waves down, this would be Wave 2 up, with Wave 3 to come. We would then get another Primary Degree bear market rally in a primary wave 4, with one final primary wave 5 to end the secular bear market. Regardless of which count is correct, new lows should be upon the stock market before it reaches its Secular Bear market bottom, which should make for the best buying opportunity of a lifetime.

Dollar doomed? Not so fast

If you ask the average Professional Trader/Investor their opinion on the Inflation/Deflation debate, chances are they will tell you we are headed into a period of hyperinflation, Gold is headed to $5,000 an ounce, and the U.S. dollar is done for. This is evident by the EXTREMELY bearish sentiment numbers on the U.S. Dollar, and the EXTREMELY bullish sentiment numbers on Gold. Very few traders think the dollar is putting in a major bottom and commodities and equities are putting in a major top. This extremes in sentiment to one side of the trade is precisely why I take a contrarian view. I do think the dollar is currently in the process of making a significant bottom. This is supported by both the technical and fundamental aspects of the U.S. Dollar. Fundamentally, what we saw last Fall (2008) was consumers and businesses deleveraging, going into conservator ship mode. The credit markets were almost completely frozen, and debtors were racing to find dollars to pay back their creditors. In order to accumulate dollars, people had to sell their assets, and buy dollars. This simple supply and demand relationship sent asset prices plummeting and the value of the U.S. Dollar soaring. It does not seem to me that this process of debt retirement is finished. Essentially, for so many years, consumers have been short U.S. dollars (borrowing in U.S. Dollars). When the dollar is weak, and asset prices are on the rise in terms of dollars, the music in musical chairs is still playing, and the consumer can continue to borrow at low interest rates and withstand a substantial sum of debt on their personal books. However, when asset bubbles (in the most recent case the housing bubble) pop and the music stops, prices and asset values plummet, and people start to pile out of the "Short Dollar" trade, essentially "covering their shorts" by selling their assets in order to pay their debt. The fear that ensues in markets after asset bubbles pop act like a domino effect. Prices fall, which induces more selling, which in turn causes prices to fall further. This process is completely necessary to rid the system of excesses. However, in doing so, there is a substancial CONTRACTION in the money and credit supply, thus leading to DEFLATION, not inflation. Inflationists will argue that the fed can always just print more money and keep the money supply up through that method. It is true that the fed can print as much money as they want, but I think a fundamental issue that people miss about the Inflation/Deflation debate is the fact that you can lead a horse to water but you can't make him drink. Bank credit has contracted since the March bottom in asset prices, and this implies that banks are unwilling to lend. The money is not getting out into the economy, and even the supply of money that is added, is dwarfed by the volume of credit destruction, or in other words contraction. I also think people commonly mistaken the definition of inflation. They think it refers to the supply of money in the economy. In fact, M3 is determined by the supply of money and CREDIT, and what we have seen these past few decades is credit inflation, not monetary inflation. With Banks leveraged up 30:1, 29 dollars of credit was created for every dollar deposited by a saver in a Bank. While other banks were not as leveraged, there still was credit being created out of thin air. What started in 2008 is what I believe to be a multi-year process of debt retirement, deleveraging, credit contraction, and thus DEFLATION, not inflation, as many people argue. After the system is cleaned out of all its excesses, can there be inflation and thus reason to worry about the dollar? Absolutely, but all the talk of the dollar losing its reserve status and losing all its value is most likely off by a few years. Consider the Stock Market bottom in early March. Nobody wanted to buy stocks when the Dow was trading at 6,500. Everybody was talking about the Dow going to 5,000, more layoffs, bankruptcies, and the complete collapse of our economy was not out of the question in the minds of most. Of course, none of that happened, and the stock market has rallied 50%+ since. Now all of a sudden stocks are attractive again, and complacency has returned to Wall Street, specifically in commodities. It is this extreme level of bullish sentiment, that convinces me commodities are due for a reversal in the near future, possibly after a blow off top in Gold, just like we saw in Oil in the Summer of 2008, when it hit $147, only to crash to $35 by the end of the year. The "gloom and doom" pessimism that existed in the stock market in March now exists in the dollar. Consider this daily Chart of the U.S. Dollar Index a measure of the value of the U.S. dollar against a basket of currencies. From a technical perspective, momentum on the downside has clearly been waning, and the Dollar looks just as attractive at these levels as stocks did in march; To a contrarian, that is.