Shenandoah (Link) - John Galt (January 1, 2009)
The question that is the title of this piece has been bothering me since the “mysterious” rally on August 15-17 of 2007. It took me the entire month of December of 2008, that’s right through yesterday, to figure out why the traditional methodologies may no longer apply, at least in my opinion. Are technical analysts and traditional technical analysis useless in a market subject to persistent illegal trading activities and government intervention?
What I propose to lay out is a theory or two as to why you can not use long term, intermediate term or even short term technical analysis to forecast the commodity, currency or equity markets of 2009. The bond markets are not even worth the time to speculate nor theorize about as they are now wards of the state with our central bank openly purchasing securitized and non-securitized assets from financial and manufacturing institutions. That is why the most dangerous period in our history is about to set forth, and I hope all of my readers have been paying attention.
It is with much sadness and regret that I must report the death of Adam Smith, Capitalism the way Mom, Dad and Apple Pie did it and Merrill Lynch per se. As I hope to lay out today for criticism and commentary or just plain hate emails (love those baby, keep them coming) I wish to point out to every geek like myself that using traditional technical analysis to forecast or prognosticate markets in the European Union, United Kingdom or any nation of North America is about 99.9% useless unless the stars are aligned just right or Paris Hilton is giving you a shoulder massage while you make your investing decisions.
Reality, in all seriousness, is that the traditional methods as I understand them are fantastic when free market economies are allowed to function with little or no interruption as programmed into computers or hell, just using a triangle, calculator and graph paper (yes, I am old). The introduction of a quasi-socialist economic structure into the marketplace eliminates the use of any tools you or I thought logical or practical for consideration.
This means the individual trader or investor has to resort back to ‘gasp ‘ fundamentals and common sense. That might seem scary to many but to those who have a cushion against the insanity it is a one hundred percent safe proposition.
How Did We Get Here?
The question has to be answered before I rant on about the shortcomings of many people I respect, read and follow with the religious fervor of a Filipino slapping chains on his bloodied bare backside during the Easter Bunny’s visit. The “West”, considered a traditional haven for protecting the ideal of individual freedom has been sliding like a drunken raccoon down an icy mountainside into socialist idealism thanks to the entitlement mentality started in the 1930’s and the new “too big to fail” mentality of this century.
Without reciting the collapse in great detail, the problems began in February of 2007 and the markets started to make corrective actions as free markets are prone to do by marking down or discounting the equities and bonds of companies involved in unwise financial schemes to expand credit to companies and individuals that would not qualify otherwise. Some of these schemes were undertaken by the Government Sponsored Enterprises (GSEs) like Fannie Mae, Freddie Mac, Farmer Mac, etc. As the lack of transparency and honest declaration of the valuations of the underlying financial instruments became apparent to the markets, the natural and logical technical reaction of the markets were some sharp equity sell offs as illustrated in the chart below.
As the markets began to take notice of the lenders failing and the impact on other financials, fundamentals overtook what looked to be a relatively stable market and the 416 point drop on February 27, 2007 took some market mavens by surprise. In reality the technicians had a hint something was up in January and many advised their clients into safety and out of the nightmare which was just beginning. The Chinese market decline was assigned the primary blame for this decline and contributed to it, but some very savvy players realized that the game was up then and cashed out of some high risk positions when they read the tea leaves and knew that the subprime problem was not a $30 billion problem as so famously announced by Ben Stein but was much, much worse than advertised.
The warnings were obvious as Ameriquest and Mortgage Lenders Network both failed before February and there were hints that the subprime lending industry was running out of liquidity and the ability to function as market conditions were changing. In the article titled Subprime Lender Implosion: Bad Omen for the Housing Market at Consumer Affairs.com the reminder was there to let everyone know that the game was up with this sentence:
“A Center for Responsible Lending (CRL) study found that one in five subprime loans issued during 2005-2006 will fail, with over two million homeowners at risk for foreclosure as a result.”
This was dismissed by many in the ivory towers and politicians paid little if any attention to the growing snowball of financial industry problems that would result as the problem accelerated month after month with ever increasing numbers of foreclosures, defaults and late payments. As we marched forward towards the summer of 2007, everything looked fine and the proverbial bull was still in charge despite grooving evidence of the problems in the subprime residential lending markets and the first cracks in the subprime auto lending and credit card industries. The cheerleading and pronouncements that Dow 15,000 was on the way blinded many to the fundamental rot occurring inside the markets themselves and the shift of some players out of equities and into bonds and commodities. Anyone with some common sense and an ability to read the charts and financial statements coming from the Financial industry could see what was coming. And gold, believe it or not, gave everyone the flashing warning light in 2007 that 2008 would be a year of great turbulence.
The XLF chart for 2007 also gives any individual a chance to see that the problems were far from over and would dramatically deteriorate into 2008.
Thus the charts were telling us something, the manipulators though were just getting started. And that is where the questions and doubt began to creep into my mind about just how “free” our markets really were.
August 2007: The Federal Reserve Becomes a Hedge Fund
Release Date: August 10, 2007
For immediate release
The Federal Reserve is providing liquidity to facilitate the orderly functioning of financial markets. The Federal Reserve will provide reserves as necessary through open market operations to promote trading in the federal funds market at rates close to the Federal Open Market Committee’s target rate of 5-1/4 percent. In current circumstances, depository institutions may experience unusual funding needs because of dislocations in money and credit markets. As always, the discount window is available as a source of funding.
On the morning of this press release the realization that the “subprime problem” was actually a full blown seizing up of the credit markets finally brought to the attention of the Federal Reserve. Before the markets opened that morning, they add $19 billion in reserves and later in the morning another $16 billion in liquidity to insure market stability and of course prevent a 1987 implosion. August 9th was not exactly a pretty day but the majority of the equity markets were behaving well. August 10th also brought our first questions from the SEC regarding the pricing of assets on the balance sheets by the banksters and thus how the investment banks were reporting these tremendous earnings while still taking more and more liabilities on to their balance sheets with RMBS and CMBS that were not priced realistically.
Thankfully for the investment bankers and the American public, the Federal Reserve was willing to become the buyer of last resort and started to purchase mortgage backed securities and trusting that the ratings on them were valid and not a piece of fiction like some of their financial statements apparently were.
Unfortunately for the Federal Reserve the hedge fund problems were beginning to show up and the mortgage capitalization crisis was starting to impact the larger lending firms like Countrywide Financial and other major banks. Liquidity was becoming the catch word of the week and rumors began to swirl that the week ending August 17th could indeed result in an emergency Federal Reserve rate cut.
Release Date: August 17, 2007
For immediate release
To promote the restoration of orderly conditions in financial markets, the Federal Reserve Board approved temporary changes to its primary credit discount window facility. The Board approved a 50 basis point reduction in the primary credit rate to 5-3/4 percent, to narrow the spread between the primary credit rate and the Federal Open Market Committee’s target federal funds rate to 50 basis points. The Board is also announcing a change to the Reserve Banks’ usual practices to allow the provision of term financing for as long as 30 days, renewable by the borrower. These changes will remain in place until the Federal Reserve determines that market liquidity has improved materially. These changes are designed to provide depositories with greater assurance about the cost and availability of funding. The Federal Reserve will continue to accept a broad range of collateral for discount window loans, including home mortgages and related assets. Existing collateral margins will be maintained. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York and San Francisco.
The chart and statement from August 17th seem innocent enough. But the rumors that swirled about “certain” financial institutions being tipped off about this emergency discount rate cut thus having an advantage by buying certain futures and options persist even to this day. The month of August 2007 marked the first time that this Federal Reserve’s ethical position was questioned and it would not be the last. In fact the reality of their interventions into the credit markets and the start of the expansion of their balance sheet by purchasing boatloads of RMBS from the banks was the true indication that they had become a hedge fund and the largest one in the world at that thanks to the backing of the American taxpayer.
The average schmuck will never be able to confirm the rumors of the tip off to certain players in the markets (like the one in the graph above) but it was convenient that Goldman’s stock had declined 9% into the 160’s when they suddenly skyrocketed again right as the Fed issued that press release which seemed to indicate prior knowledge. This intervention and the apparent attempt at market manipulation spooked this commentator into realizing that we’re playing by the house rules and those rules are subject to change on very, very short notice. By the time 2008 arrived, it became abundantly clear that those rules were never in stone and as flexible as an East German gymnast.
2008: A Little Marx Goes a Long Way
The majority of us had a pretty good insight into the disaster that was 2008. The Bear Stearns payback fiasco where the other investment banks elected to pile drive them out of existence as payback for LTCM in the 1990’s; the death of Countrywide Financial and Washington Mutual; and of course the blatant changes in the rules allowing the U.S. Government or Federal Reserve (not one and the same for those who think they are subject to the same rules and regulations) to take over a company any time they would like and sell their assets to the competition; these actions were not indications of stability nor the activities of a nation which believes in free markets and laissez-faire capitalism. Indeed, we are as a people now trained to be scared to fail and to reward mediocrity.
The challenges using any type of technical analysis to give a predictive indicator as to what the markets might do was already difficult enough without the competition of Big Brother. By intervening and changing the rules as the regulators and banksters saw fit, they in fact caused problems with liquidity inflows and reduced the desire of foreign investors to gamble on the weaker American corporations due to the risk of nationalization or partial government takeovers. In fact in a recent interview conveniently release on the last day of 2008 around noon via Reuters indicated that Christopher Cox and the SEC had some “regrets” about initiating the short sales ban. From the article:
The SEC’s office of economic analysis is still evaluating data from the temporary ban on short-selling. Preliminary findings point to several unintended market consequences and side effects caused by the ban, he said.
Several experts pointed out the unintended consequences referred to as a decrease in available liquidity to our markets which does directly impact every aspect of not just technical analysis, but the willingness of the individual to make the move to risk his capital for future investments either as a long or short position holder in the markets. If you remove the predictive elements, while not always an exact science mind you, you have destroyed the ability to make logical investment decisions and mitigate some of the risk introduced by investing itself and guaranteeing large investments in short term debt instruments (cash) like 4 week, 3 month and 6 month Treasuries.
Robert Murphy in his essay The Social Function of Stock Speculators from November of 2006 stated the following:
If this were the whole story, then stock speculation might truly be a zero-sum game, where the lucky or farsighted enrich themselves at the expense of the unlucky or dimwitted. This isn’t the case, however, because in the very process of profiting from their superior vision, stock speculators influence stock prices. When stock prices are undervalued, the successful speculator buys shares, an action that drives up the prices in question. In contrast, if a stock is “overvalued” — and by this term we mean nothing deeper than that the stock will fall in price more quickly than others in the market realize — then the successful speculator may “short sell” it, or engage in comparable actions (such as buying a put option) that tend to push down the share price.
This means that the actions of the Federal Reserve purchasing shares, warrants and bonds from the very corporations who’s equity and bond prices would corrected by speculators and investors will remain overvalued and distort the over all technical condition of that sector of the market. The TARP program along with other “innovations” of the past year plus are nothing more than blatant market manipulation which are designed to prevent overvalued corporations from achieving realistic values including “Zero” where some should have gone to restructure or be liquidated. Since we no longer run our economic model on a pure capitalist structure, to have any clue about the behavior of our markets we may indeed have to follow the Chinese markets to provide some guidance.
The graph below is exactly why I am concerned about the path we are taking as to achieve the market “stability” they have in Communist China, the United States Government would have to obtain majority shareholder and bondholder status in most of the Fortune 500 to have enough firepower to prevent market meltdowns and to insure the remainder of the economy is protected from these ongoing series of economic shocks as corporations are re-priced and/or fall into bankruptcy restructuring if they are allowed to do so.
From the graph you can see the line in the sand that I have added and get some idea as to our market’s ultimate destination and the drastic actions the next administration will take to prevent a total collapse of our equity markets.
Conclusions and Concerns
I will attempt like everyone else to use traditional technical analysis to determine future price actions in commodities and equities but to be honest, I doubt the voracity of the results. In an economy with even a little centralized planning or partial government ownership of corporations, it is virtually impossible to chart a course of investment action due to the unpredictability of the political class and their desired course of actions regarding market interventions on a day to day basis. I could post chart after chart and highlight Federal Reserve liquidity injections, the takeover of various corporations, the bank failures masked via mergers, etc. but what would be the point? Theoretically speaking, if the short sellers were allowed to do their job last fall we could indeed have put a bottom in around the 6000 level on the Dow.
The lack of a coherent policy from the lame duck administration and the wing and a prayer mentality of the Fed and Treasury with regards to macro and micro-economic management further prevents any ability to stabilize the markets or provide incentives to leave cash and gamble that we will return to the days of actual “winners and losers” where risk management can be determined with some logical assertions being introduced into the formulas.
With a new administration indicating that there will be further legislative oversight and market overhauls it is difficult to make a case for being in any type of American based asset other than hard assets that you physically can own like precious metals. The internet has been buzzing with rumors about commodity market issues on delivery and the Madoff case does little to inspire one to hand cash over to any investment manager to only get a piece of paper in return.
Even if that piece of paper says that your account is managed by “Merrill Lynch, a wholly owned subsidiary of Bank of America which is a partially owned subsidiary of the United States Government Department of The Treasury and also partially owned by the Federal Reserve Bank of New York.”
I just can not wait to see the statements, exemptions, rule changes, margin requirements and other goodies emanating from their offices in the weeks to come. Not to mention whatever creations the Obama administration creates to foul the works up even further.