Bad Credit No Problem as Balance-Sheet Bombs Rally 94%

http://www.bloomberg.com/news/2014-05-26/bad-credit-no-problem-as-shares-of-balance-sheet-bombs-rise-94-.html

In the U.S. equity market, the worse a company’s finances, the better it’s doing.

Stocks with the weakest balance sheets have climbed more than 8 percent in 2014 and 94 percent since the end of 2011, generating almost twice the gain in the Standard & Poor’s 500 Index (SPX) over that period, according to data compiled by Bloomberg and Goldman Sachs Group Inc.

Gold Bears Defy Rally as Goldman Closes Short Wager: Commodities

There are so many misinformed opinions on gold's recent rally from its stunning decline that I had to print this article.  The reasons/excuses/rationalizations/causations cited are conventional and stunningly misguided--even the title is misleading, and suggests Goldman's short call was prescient.  It was, but never mind that its "rapidity" was collusive and manipulative.  I'll let the physical gold bugs read and laugh (as opposed to leveraged gold longs who will read and whimper).

http://www.bloomberg.com/news/2013-04-28/gold-bears-defy-rally-as-goldman-closes-short-wager-commodities.html

Gold Wagers on Rally Jump to Five-Month High on Stimulus

http://www.bloomberg.com/news/2012-09-02/gold-wagers-jump-to-5-month-high-as-fed-spurs-rally-commodities.html

Safe Haven: Could U.S. Markets Rally in a Global Decoupling?

http://www.oftwominds.com/blogmay12/safe-haven5-12.html

Has Derivatives Deleveraging Fueled the Stock Rally?

http://www.oftwominds.com/blogfeb12/deleveraging-rally02-12.html

Silver’s set for a big monthly loss, but a rally may be coming

http://blogs.marketwatch.com/thetell/2011/09/30/silver%E2%80%99s-set-for-a-big-monthly-loss-but-a-rally-may-be-coming/

Supply side of gold

There has been much focus on the fundamentals of the rally in gold prices, mostly on increasing demand for nonmonetary (jewelry, art, industrial) and monetary (investment) reasons. Gold has a consistent record of having store of value over centuries, and has been a useful hedge against inflation, financial crises, and currency debasement.

But the supply side of the equation hasn't been addressed by the mainstream financial media. The bullish case on the supply side is equally compelling. Gold production peaked in 2001 and is in steady decline, despite much higher prices. Higher demand and lower supply can only have one long-term outcome.

http://www.brisbanetimes.com.au/business/miners-were-running-out-of-gold-20091125-jqqy.html

Dead cat bounce?

Due to my increasing anxiety with every rally in equities, I gathered some charts of the S & P 500 Index. It recorded a low of 666 in early March 2009, down from the October 2007 high of 1565. This represents a decline of 57.5% from the peak. What came next has been this powerful 50% retracement to approximately the 1000 level. A Fibonacci 61.8% retracement yields a value of 1078 as an intermediate peak for the SP 500. I would be a net seller if and when we approach that level.

For comparison's sake, between the 1929 peak of the Dow Jones Industrials Average to the low in 1932 (see first chart above), the market had a handful of double-digit gains. But in that duration, the market declined by 90%! In other words, for every 1 step up, the market took 3 steps down.

From the 1932 low to the 1937 peak, the DJIA had 3 triple-digit gains, including one for almost 300%--almost a quadruple. But none of these powerful rallies prevented the Great Depression. And investors holding since 1929 weren't whole again until 1953.

The harder a market falls, the higher the market rebounds, but the more difficult it is to get back to even--despite multiple powerful rallies. With the 2007-2009 decline "only" measuring 57.5%, this retracement rally should not have been surprising.

To the trained eye of an electronics engineer, the SP 500 chart between 2007 and 2009 looks like a waveform transitioning between logic "1" to logic "0" (see second chart above). However, instead of being an ideal waveform with uniform horizontal and vertical lines, the signal is distorted with undershoot and high-frequency ringing.

In layman's terms, this market is a dead cat bounce. And gravity will eventually cause it to fall back down before finding a steady-state equilibrium. The hope is that the SP 500 secular low of 666 will not be revisited, and that the index will find a trading range of consolidation above that low until a recovery is well-established.

I still posit this is a bear market rally--and not the beginning of a secular bull market. The world economy is still undergoing a delevering process as corporations, individuals and governments are still awash in debt. Banks haven't honestly accounted for toxic assets on their balance sheets. With unemployment climbing, tight credit conditions, and the American consumer tapped out, any economic recovery will remain muted. Equities may still rise from here, but at some point (soon), the market will become over-extended.

The disconnect between the market rally and the jobless economy

I've always posited this recent strong rally, while good for account values, was a bear market rally--a sucker's rally, if you will. While a 40% rally is legitimate by any measure, it's within a secular bear market. Why? Any recovery will be tepid, as industrial output is plummeting, cash- and credit-strapped consumers aren't spending, banks aren't lending, and the private sector isn't hiring. Barron's has a good article on the true measure of the state of the economy, tax revenue:

http://online.barrons.com/article/SB124579469824143923.html#mod=BOL_hpp_dc

I don't know when the market will wake up and realize how dire the prospects for worldwide economic growth are. But as long as central banks continue to print currency in an attempt to stimulate their respective economies, I suppose asset values can continue to rise. Aside from pivotal event-driven biotech stocks, and a few precious metal plays, I am on the sidelines, even if it means I miss the next 10 or 20%. It's never wrong to take profits.

It's been a good ride, but I am not going to fall in love with this market. I don't want my heart to be broken.

Devil's Advocate

I visited a former colleague yesterday, and presented the weak dollar/strong commodities thesis to him, with some agreement. As many of you know, this huge rally has been great for our account values, but it has made me increasingly nervous. I've asked for counterarguments against these plays, and was looking to poll some of you in our email threads last night. After a long day, I was too tired to post, so I will do so today:

1) Despite success in our holdings so far, what could derail the current rallies in commodities? Hubris is not a virtue when markets turn south.

2) Are our pivot event-driven microcap biotech stocks immune to an overall market downturn, or are we merely decline-resistant?

Well, today's actions confirms my suspicions--even if precious metals are a hedge against inflation (as are other hard assets), when the market tanks, it takes almost every sector with it (unless you are short the indices). If individuals, hedge funds and in hard times--institutional investors have to raise cash, they will sell any asset class, whether it's a gold ETF, REIT, or just regular old equities.

Having said that, nothing goes straight up (I know I have been redundant here), and corrections are healthy. The pertinent question is this a correction, or the start of another demand destruction decline?

On equities, I'm still of the opinion that we have been blessed with a strong rally since March 6, enclosed within a secular bear market. I still see too much debt within the consumer, corporations, real estate, as well as public sectors. Foreclosures and unemployment are rising, this time infecting borrowers with good credit, not just sub-prime borrowers. Commercial real estate defaults are exploding. And with 70% of our nation's GDP consumer-based, all these entities are in the de-levering mode--of course, with the exception of our nation's exploding balance sheet. And if consumers and businesses aren't opening their wallets, every attempt by the economy to recover will fail.

So where does that leave commodities? I suspect a bifurcation between commodity prices and equities overall. Even tho the world will consume less energy due to industrial and consumer demand destruction, inflation is still the boogey-man, mainly because the US Treasury has printed too many dollars. The pivot point is when those dollars start circulating through the economy, creating a multiplier effect. Currently, banks are hoarding dollars in order to recapitalize their toxic balance sheets. When and if commercial bank lending resumes, the Fed will be powerless to turn off the spigot, igniting inflation. It will be too little, too late. It is political suicide to raise interest rates and reign in money supply while citizens are losing jobs and their homes.

Will I be proven right? Nobody knows, but so far, the market agrees with me, as history has shown with 100% accuracy central banks are always late in closing the discount window. And with the economy on such shaky ground, I predict they will be late again in tightening monetary policy.

Conclusions? Commodities remain in a secular bull market--one that started in 2001, and one that corrected immensely in 2008, due to the financial crisis. In other words, we will experience a correction, and gold may correct 10% perhaps. But eventually, inflation will take root, as central banks worldwide attempt to stimulate their respective economies. Besides, inflation reduces the debt burden. In a perverse situation, central banks now want to INDUCE inflation, instead of trying to manage it. And as long as the Fed is intent on trillion dollar deficits, the US Treasury will continue to issue trillions of dollars of paper. Savers will be destroyed, and debtors rewarded. With the US government the biggest debtor in the world, guess who benefits from inflation?

As for the stock market, this bear market rally will also experience corrections, and could even go higher with the S&P 500 touching 1100. But don't count on us reaching our all-time highs. I don't see that in the cards, and if we do, it would be the short of our lifetime.

Having said that, I would appreciate counter-arguments. Sometimes losing money is more instructive, and despite our recent gains, my anxiety level is heightened. I even sold some of my winners earlier this week, and bought a few SPY puts last week. Turns out I may have been early with the puts, but better early than late.

Biotech update

All our biotech plays are green, including obesity, swine flu, renal, and various oncological drug companies. This is a relief, but it always concerns me when stocks gap up. I've taken some profits, leaving most shares on the table in case they gap up due to pivotal events. While I am bearish short-term, this bear market rally has some juice behind it as the Fed continues to pump the system with a flood of dollars.

Nominally, investors should do well, but returns will lag in real terms once inflation kicks in. More on that later...

Short Squeeze vs. Selling Panic

When Apollo Group announced explosive earnings growth earlier in the week after market close, the share price plummeted in after hours, and continued its torrid selling pressure through most of the trading session, ending up the day as one of the worst-performing stocks in the exchanges.

After market close today, Research in Motion (Blackberry manufacturer) mildly beat earnings expectations, and the share price immediately rocketed up after hours, and will open tomorrow up almost 30%.

Why the difference in outcomes? No one knows for sure, but I'll speculate APOL's future guidance by management during the earnings announcement was poor, despite the past quarter of explosive earnings growth and increased enrollment at the University of Phoenix. Allegations and a history of lawsuits and fines by the Department of Education regarding business practices and high default rates on student loans has clouded this company for months. The counter-cyclicality of for-profit education companies has taken their share prices to lofty valuations. Despite great earnings--which are backward-looking, future guidance--or more correctly, lack thereof, doomed this stock. Markets don't like uncertainty, and Wall St. is a forward-looking mechanism.

With RIMM, earnings beat expectations, and margins came in at 43-44%, both above Street projections. But more importantly, despite looming bad economic horizons, RIMM rewarded investors confident in holding market share and profit margins going forward.

Two similar earnings projections, two totally different outcomes.

My put options on APOL paid off handsomely earlier in the week, and the share price is in the process of consolidating and recovering from the bloodbath. I will not make any recommendations for regulatory purposes and also because I am neutral on APOL, having closed out my puts for a nice profit. I still have a small long-term put in place that I have mostly closed out and taken profits on.

Disclosure: I own January 2010 APOL put options, and neutral to slightly bearish.