Agora Financial’s Rude Awakening

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Laguna Beach, California

• The lofty highs in the market…and the cracks in its foundations,
• A spot of Dow theory: Following the trucks downhill,
• Keeping an eye on the fundamentals, lessons from ‘01 and more…

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Eric Fry, reporting from Laguna Beach, California…

Last summer’s credit crisis is over; the stock market has told us so. The Dow Jones Industrials and the S&P 500 both soared to new all-time highs yesterday.

Amidst the intoxicating comfort of record-high stock prices, the summertime blues of last August seem like a very distant and insignificant memory. Bear Stearns did not go bankrupt, and neither did Countrywide Financial. The Dow did not tumble to 6,000, interest rates did not soar to 10% and the dollar’s value did not evaporate…completely.

That’s all good news. In fact, that’s very good news.

But this good news conceals a few troubling sub-plots…like the fact that mortgage credit remains as scarce as vegans at a pig roast…and that the U.S. dollar continues to plumb the murky depths of currency debasement. Stock prices are rising – we can’t deny it – but signs of economic distress within America’s middle-class are multiplying as rapidly as well…carnivores at a pig roast.

A sharp upswing in credit card defaults, for example, is joining the sharp upswing in mortgage defaults. Balances on consumer credit cards jumped at an annual rate of 11% in May and June. With two exceptions, that’s the highest rate since the last recession in 2001-02. But these troubling phenomena are problems for another day – according to the received wisdom on Wall Street – if they are problems at all. Sure, these difficulties may capture a few headlines on the back pages of the Wall Street Journal. But the “page one” headlines belong to the “Resilient American Economy” and the “Benefits of a Weak Dollar” and the “Genius of Ben Bernanke.”

“It’s all good, bro,” as my volleyball-playing buddies here in Laguna Beach like to say. “It’s all good.”

Maybe so…But despite record highs on the Dow and widespread optimism on Wall Street, some things aren’t exactly “all good.” In fact, as our colleagues over at the Survival Report observe, the Dow’s record high may be less good than it appears. Read on for all the grisly details…

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Fun for Now
By “Mish” Shedlock and Brian McAuley

The Dow and S&P both soared to new all-time highs yesterday…But there may be a few problems lurking beneath the surface.

Back in 1999, when the Nasdaq was going parabolic in what would be its last hurrah, the market was sending clear signals that all was not well. But you had to look beneath the surface to find them. There were technical divergences building up (declining market breadth, etc.), and also some key indexes like the Dow Transports that failed to participate in the continuing rally.

According to the Dow Theory, when the Dow Transports begin to lag the Industrials, it is a significant event. This divergence signals that not all of the market agrees that the future is full of blue skies and sunshine.

In May 1999, both the Industrials and the Transports made new highs. But from that point forward, the Transports declined and continued declining, even while the Industrials rallied to a new high in January 2000.

Back then, almost no one trusted the “sell” signals issuing from the Dow Theory. Instead, almost everyone talked about how the “New Economy” was impervious to things like the business cycle, an inverted yield curve, and — especially — an antiquated stock-trading theory based on the Industrials and the Transports. I mean, how 20th century could you get?!

Despite all that, it wasn’t long before the Nasdaq peaked in March 2000 and the bear market began. Looking back, all the signs were there for those who wanted to remove their blinders: The yield curve had inverted, there was a Dow Theory divergence between the Industrials and the Transports, and the rally into the 2000 high had become very narrow and concentrated in a relatively small number of stocks (i.e., market breadth had declined significantly).

Fast-forward to today, and we have many of the same market conditions — albeit on a smaller scale. The yield curve has been inverted for over a year. Since the high in July, the Transports have failed to follow the Industrials to a new high and instead have languished near their lows.

Market breadth on this advance has been poor. In fact, we have an enormous divergence between some parts of the market that have rallied to new highs and other more economically sensitive parts of the market that have not followed.

This divergence often occurs at the beginning of a downturn, which is why we suggested put options the Transports in last month’s Survival Report. We now have short positions in the weakest areas of the market – the financials, the Transports, and the home-improvement sector. Even if market indices like the Dow continue to make new highs, these sectors are likely to remain very weak, and could easily lead the rest of the market to the downside.

The weakness of the Dow Jones Transportation Average is not merely a technical divergence, however, it is also a fundamental sign that the economy is struggling. As the nearby chart clearly shows, there is a reduced demand for trucking. Coming out of the 2001 recession, shipments increased until 2005, then declined throughout 2006 and so far through 2007.

Supply Chain Digest is also reporting that inbound container volume growth has slowed dramatically at U.S. ports over the past year, with May 2007 traffic down 0.2% from a year earlier. This confirms the slowdown we are seeing in truck tonnage, and also suggests the consumer-led economy is slowing.

Net-net, it’s time to short Transports. Here are six reasons why:

1. Housing has clearly stalled and shows no sign of recovery. With mammoth numbers of ARMs resetting between now and March 2008, things can, and likely will, get much worse. Shipping material for new construction will continue to weaken.

2. Shipping needs to furnish new homes will continue to weaken, as well.

3. Commercial real estate is poised to fall. Deals are collapsing as “people who can get out are getting out.” The rate of increase of building new stores, as well as the merchandise required to fill those stores, will fall. That clearly means reduced shipping demand.

4. A weakening job market means less consumer demand. And falling consumer demand means fewer items need to be shipped.

5. Credit card defaults are rising. One reason is the housing ATM has been shut off. This is an ominous situation for cash-strapped consumers, who will be forced to cut back on purchases of stuff they do not need at prices they cannot afford.

6. Until recently, truckers have been able to pass on rising fuel costs, but that has changed in the face of falling demand.

The key thing to remember about avoiding a downturn in stocks is that by the time everyone realizes a bear market has begun, it will be too late to do anything about it –because stock prices will have already declined. When the Fed began its rate-cutting campaign in January 2001, stocks rallied on the belief that the Fed would rescue the market. But only two months later, the S&P 500 was down 20%, and over the next year and a half, the S&P lost over 40%. You have to prepare ahead of time, when everyone is still convinced that everything is fine.

There is very little chance we will see another bear market like the 2000-2002 bear market again in our lifetimes — those come around only once every couple of generations. But an “average” bear market is certainly possible over the next year, especially given the housing situation and the market action we’re seeing. Since the end of World War II, the average bear market has taken stocks down a little over 25% in a time span of 10-12 months. Certainly nothing to sneeze at, since it would take a gain of 33% from that low just to get your portfolio back to even.

So enjoy the rally while it lasts, but keep a very close eye on the Transportation Average.

[Joel's Note: Even though Countrywide Financial did not tap out entirely (they stumbled back to their feet on the 9th count) readers of Mike Shedlock’s Survival Report are still in a great position on that company. Mike issued a short sell on the nation’s largest homelender way back when everyone thought the housing boom would go on forever. As of yesterday’s trading, their CFC play is well into the triple digit profit territory.

Now the Survival Report’s editor has uncovered another weakness in transport…and the rewards for savvy investors could be just as pretty as their last. If you’d like to take a peek at Mr. Shedlock’s service and avail yourself to his next recommendation, here’s a link to all the info you need. The Survival Report

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Rude Endnote: So, are we headed for a drastic downturn in the markets? Will the market continue setting lofty records, remaining impervious to the lessons of yore? If you’d like to comment on anything in today’s Rude Awakening, send your scribes to us at the address below.

Cheers,

Joel Bowman