Stock Market Setback Soon?

Dear Readers,

Those of you who have been with us for some duration will recall that Doug Casey (Casey Research founder and my favorite partner of all time) periodically experiences what we call “guru moments.” These involve his making declarative statements about some pending market event that, more often than not, then comes true.

None of us, not even Doug, know where these insights come from – and I can’t even tell you how it is that we can discern the difference between a passing remark and a guru moment. We just can.

As far as I can tell, the only two members of the team with the ability to spot one of these moments are myself and Louis James, head of our metals division and editor of our weekly Conversations with Casey. I suspect this is so because we talk most frequently with Doug. Perhaps, I can only theorize, our regular conversations allow us to subconsciously recognize when Doug’s level of conviction about some pending market event rises substantially above the normal range of expression?

While not all of Doug’s guru moments come true, his batting record, if we could reassemble it, is well above average – which is why Louis and I sit up and take notice when one occurs.

One that comes readily to mind occurred in the middle of December of 2004, when Doug told me that there was going to be a rally in the dollar. Which was decidedly contrarian because over the two-year period prior to that conversation, the dollar had lost 57% against the euro and pretty much everyone was bearish about its near-term prospects. Doug’s guru moment became a lead article titled The Dollar Bounce for the January 1, 2005, edition of our Casey’s International Speculator. Here’s an excerpt from that edition…

But now, not despite the dollar being all over the world's media as a disaster, but because of it, it's probably time for a bear market rally. By definition, the masses are trend followers, not contrarians. Regardless of what the long-term fundamentals of a currency may be, in the short term its price is set by the psychology of buyers and sellers. Right now everyone knows how badly it's done, and they're all sellers. As I write, the euro has hit a new all-time high of $1.36 against the dollar.

Everyone and their dogs have finally become aware of the dollar's problems. Therefore I suspect that it's almost time for Business Week to run a cover story projecting the death of the dollar, ringing the bell for a temporary bottom. But the dollar is still (for the moment) the world's currency. The recent anti-dollar hysteria will wear off and sellers will buy back a lot of dollars, simply because the dollar is still, for all its faults, a liquid and convenient holding. (Doug Casey, “The Dollar Bounce,” January 1, 2005)

Almost immediately following that guru moment, the dollar took off on a year-long run, as you can see in the chart here.

As to how he does it, some time ago I came to the conclusion that a lifetime of studying markets and constant reading – combined with a powerful natural intelligence – allows Doug to subconsciously recognize useful patterns. When those patterns converge in a certain way, Doug can intuitively identify an important near-term consequence.

As you might suspect from this long warm-up, Doug has just had another guru moment. It is that the U.S. stock market is approaching a cliff.

While only time will tell whether or not Doug’s concern is justified – typically, we don’t have to wait long – I mention this here and now because it’s important to think through the investment implications of another stock market crash.

The following chart, drawn with tools available on Bloomberg.com, shows the S&P 500 over the past five turbulent years, plotted against the GDX index of large gold producers, DXY, the dollar index, and GLD, a proxy for gold bullion.

While the situation today is much different from 2008, when the last crash occurred, the potential investment consequences are worth thinking through.

For example, in the 2008 crash the stock market got pretty beat up, but the large-cap gold stocks got positively hammered. And the junior Canadian exploration stocks (not shown) got nuked. Gold bullion also got beat up, but not nearly so badly, largely trading on the flipside of the dollar, which rallied. As you can see, while the stock market has since come back, both it and the dollar remain stark underperformers to gold and gold stocks.

Doug’s guru moment aside, I would have to say that the rest of the team’s views on the broader U.S. stock market is one of ambivalence. Based solely on traditional financial metrics, such as the P/E ratio and dividend yields, the stock market is not particularly overvalued. And, besides, the stock market is really a collection of individual issues – and so in that collection are almost always to be found good companies selling at good prices. In addition, there is a lot of money on the sidelines at the moment that is not earning any real yield… money that is available to prop up stocks, given even a modicum of encouragement.

Yet there is a legitimate concern that the P/E ratios, which have improved considerably over the last year, have improved largely because of deep cuts in staff and other expenses. In most cases, it is decidedly not due to an increase in revenues. With the bulk of the cost cutting now behind corporate America – and as the unemployment report shows, companies made a lot of cuts – it becomes unlikely that quarterly earnings reports will continue to surprise on the upside. That greatly increases the risk that earnings will stall out and any further surprises will point to the downside.

On that front, David Rosenberg of Gluskin Sheff made the following observation in his daily briefing this morning…

EARLY START TO EARNINGS SEASON LESS THAN STELLAR

We were struck by the Alcoa report, which is usually the bellwether for the entire reporting season — a penny a share for a company that supposedly has a link to the “booming” global economy (not to mention Chevron’s warning). This is a company that during the 2003-07 up-cycle never reported anything less than 16 cents a share (the best was 88 cents). So like everything else, the “new normal” in a post-bubble credit collapse for this corporate giant is one cent.

If this pattern holds true for the other companies due to release their earnings in the near future, then that alone could be enough to cause Doug’s prediction to come true, and sooner rather than later.

If and when trouble occurs, I would suspect the following will occur:

Gold and silver bullion prices will fall. For a brief period of time, "the market" will read a possible deflationary outcome in the crash. Deflation, the market reflexively believes, is bad for tangibles, and so there will be a sell-off. I do not believe, however, that the sell-off will be very long in duration or particularly deep. That's because...

The dollar will rally and then fall. In my article on Monday titled "What the Deflationists Are Missing," I commented that the big money increasingly shares our view that U.S. politicians, in their constant quest for reelection, will use the government’s fiat monetary powers as aggressively as needed to help stave off a further erosion in the economy prior to the November elections.

Thus, while it will be natural for investors to move money out of equities and into "safe" investments during a crash, which will boost the dollar, the follow-on monetary implications of the crash will be clear for all to see. Those implications, simply, will be for the taps on the money supply to be opened even wider.

Gold stocks will fall, and probably fairly hard. In the last go-around, there was a huge demand for redemptions on the part of investors, which in turn forced money managers and other institutions to simply dump everything they could get a bid on.

The devastation in the junior mining stocks was particularly bad, in good part because some big players had moved into the space and owned small stocks in big quantities they had no business owning. While there has been a resurgence of interest in the gold stocks, of all sizes and descriptions, over the past year, I don't see the same overinvestment in the sector as heading into the 2008 crash. And I don’t see nearly so much uncertainty about where the economy is ultimately headed: towards a serious inflation. In the last crash, there were more deflationists than inflationists stalking the land.

This time around, the added pressure on the dollar from an inevitable new wave of government spending programs should cause both bullion and precious metals stocks to bounce back quickly. Looking at the chart above, you can see that in the 2008/2009 crash, gold stocks turned back up before the broader market – a phenomenon we have witnessed in similar market conditions in the past – and then outpaced the broader markets, by a wide margin, to the upside. For the reasons just mentioned, this time the bounce should come even sooner and likely be more pronounced.

What to do? It really boils down to your personal temperament. If your portfolio is significantly overweight in precious metals stocks at the moment – personally, I would define “overweight” as having more than 25% of a portfolio in precious metals stocks – and if a serious loss in those stocks would cause you a great deal of anxiety, even if only over a relatively short period of time (1 to 3 months?), then consider lightening up for a bit. Park some money in cash, and be prepared to buy back your favorite stocks in any serious setback.

As for precious metals bullion, if you have a trader’s mentality and are heavily invested in one of the electronic forms of gold, moving some of that money into cash on a temporary basis with an eye to buying it back cheaper might work out. For physical bullion you keep close at hand, however, I wouldn’t bother going through the hassle and expense of selling in order to buy back later.

At this point the risk of not owning precious metals and related investments is far higher than the risk of owning them. So, you should view any possible broader stock market crash with a certain amount of tranquility, even if your brokerage statement temporarily disappoints. That's because while others will be wondering what to do in the next crash, you’ll already know – buy more precious metals stocks and bullion.

(For a list of the best of the best junior precious metals stocks – the ones you want to own now and will want to load up on in a correction, look no further than Casey’s International Speculator. With a three-month no-risk trial, you can try it with… well… no risk! More here.)

As for other equity investments, maintain a bias for deeply undervalued companies with solid businesses – because they’ll get hurt the least – and don’t be afraid to sell anytime your profits move into the double digits. Even if there isn’t a crash, the odds of the broader markets having a repeat of 2009’s banner year are extremely slim – so take profits when you can. This is not a time to be cavalier or overly optimistic about what’s coming next.

Speaking of times like these, that’s the name of a song by the Foo Fighters that has stuck in my brain this week. I like the song’s energy and the message. Definitely a worthy entrant for any collection of dramatic music. Here’s a link…

Watch Out for That Banana Peel!

Of the many banana peels that might ultimately cause the stock market to slip, the upcoming interest rate resets on a variety of variable-rate and mostly suspect paper is worth keeping an eye on. These resets are important for a number of reasons, starting with the reality that the payments on those mortgages will rise to the point where many struggling mortgage holders will default, adding to an already terrible situation. That the vast majority of these mortgages are now underwater when compared to underlying property values doesn’t help. The quantity of “jingle-mail” the banks receive – envelopes used to return the keys to unwanted homes to the banks – will soar.

And there’s an important big-picture consideration as well. Namely that the current administration knows the next wave of resets is just over the horizon, and so will look to stabilize its political fortunes by continuing to keep interest rates low. And by continuing to buy hundreds of billions of dollars’ worth of mortgage-backed securities. Both of those efforts add tinder to the coming inflation, in that they require the Fed to create cash out of thin air – to buy the Treasury bills that set the pace for near-term interest rates, as well as the mortgage-backed securities.

One largely unnoticed government action with potentially large consequences was announced in a Fannie Mae press release last week. Our favorite real estate sage, Andy Miller, forwarded it along with the following note:

David, read this. It may not seem earth shattering, but it is. I have been predicting this for 2 years. Everything I have said to you and your subscribers is actually unfolding more or less the way I thought it would. This is huge. Andy

Fannie Mae Launches Special Approval Designation to Support Florida Condo Market

Realtors Commend New Flexibility

January 7 2009. WASHINGTON, DC — Fannie Mae (FNM/NYSE) announced today that it is undertaking a comprehensive review of hundreds of condominium projects in the state of Florida in an effort to allow additional projects to become Fannie Mae-eligible through a new "Special Approval" designation.

A dedicated team of six Fannie Mae professionals based in Florida is conducting a thorough examination of condominium projects across the state that may not currently meet Fannie Mae's standard eligibility criteria and assessing specific criteria more closely, including occupancy, homeownership association dues, financial stability of the project and property condition. Projects deemed to be sufficiently stable following the closer examination are granted a Special Approval designation, meaning lenders can originate and deliver mortgage loans secured by units in these projects to Fannie Mae.

Full article here.

Simply, Fannie Mae, the government’s de facto mortgage lending arm is preparing to expand its coverage to an even broader collection of failing condominium projects in Florida, where the problem is particularly acute, setting the precedent for similar initiatives nationwide.

By warming up to back loans that previously didn’t qualify for government insurance – for example, jumbo loans or projects where the loan-to-value ratios are out of whack – Fannie Mae, which now has an unlimited line of credit with the Fed, is setting the stage to transfer yet more private risk and outright losses onto the bruised shoulders of struggling taxpayers.

“Whatever it takes” remain officialdom’s watchwords. But all any of this really achieves is to kick the can down the road, making the situation far worse in the process. Unless and until the private sector returns to real estate lending – and when they do, it won’t be at values anywhere near today’s levels – this important sector of the economy will continue to struggle.

That’s It for Today…