It is official; the S&P 500 closed in bear market territory today, over 20% off its bull market high of 1562.15 set on October 9, 2007. The five year long bull market is finally in the books. The S&P 500 is the last of the major indexes to enter bear market territory as the NASDAQ and Russell 2000 hit this pivotal level in March and the DJIA fell into bear territory earlier this month. Here is the run-down on the previous bull market…

What I find amazing is that the bull market lasted exactly 5 years to the day. The bull market began on Oct. 9, 2002 and ended on the exact same day in 2007. (What I find even more amazing is that nobody has pointed this out yet!) Back in October, I was convinced that the market couldn’t possibly peak on the fifth year anniversary of its beginning, but the significant punishment taken by the financial stocks convinced me to stick with my strategy and thankfully I did as my clients have profited nicely ever since.

With the bear market official, several questions will now become common banter among financial pundits. What’s next for the market? When will the bear market end? How much further do we have to go? Read the rest of this entry »

Have you noticed that what you pay at the pump or the check-out counter seems to have little correlation with government inflation figures? Does it seem that prices for daily necessities are going up at a rate far greater than 4%/year? Well, the following will attempt to explain why your experience is far different than what the government is telling us.

Over the past 20 plus years, the government has made several “adjustments” to the primary measurement of inflation known as the Consumer Price Index (CPI). In this article, I will explain what those adjustments are and why they have resulted in the significant understatement of the CPI.

If I were a lawyer (which I’m not) and if I were prosecuting the government, the first steps I would need to take is to establish that the government and more specifically the Bureau of Labor Statistics (BLS) has both the means and motive to manipulate inflation statistics. Read the rest of this entry »

On September 13th, 2007, the Associated Press reported…

The world’s tallest building, still under construction in the booming Gulf emirate of Dubai, has become the world’s tallest free-standing structure, its developers said on Thursday…The developer announced in July that Burj Dubai, Arabic for “Dubai Tower”, had exceeded Taiwan’s Taipei 101 which is 508 metres tall, to become the tallest building in the world.

When I read about the Burj Dubai, an unsettling feeling came over me. I don’t remember when or where, but at some point in my life I recall being told that economic calamity soon followed the construction of a new “world’s tallest tower”.

I was anxious to determine if there was truly a relationship between the construction of “towers” and market peaks, so I pulled up the ever-so-handy Wikipedia to do a little homework. Wikipedia was enormously helpful because with every building on the list it also listed the buildings that it surpassed and was proceeded by in height. Here is the link to the Empire State Building page. (I figured you could start in the middle and work your way in either direction.)

Let’s take a look at how the stock market performed after the construction of a new “world’s tallest tower”. (I didn’t include communications towers or tourist structures such as the Eiffel Tower, the Tokyo Tower or the CN Tower. Also, I didn’t include the Petronas Twin Towers in Malaysia because only the Antenna was taller than the Sears Tower – not the roof.)

* Annual Returns provided by Crestmont Research, specifically from the Crestmont Stock Market Matrix . Returns are calculated as “Individual Investor Real Returns” which are adjusted for inflation, reinvested dividends, transaction costs and taxes paid.

What I found remarkable was just how well the “Tower” indicator predicted secular bear markets in stocks. I was surprised to discover that not a single building taller than the Empire State Building was built during the nearly 40 years between the two secular bull market peaks in the 20th century. Furthermore, construction on a single “tower” was not initiated for the 31 years between the two most recent secular bull market peaks (1968 and 1999).

But what I found even more astounding was the number of “Towers” built at secular bull market peaks. After 37 years of no “towers” being constructed (1929 – 1966), two “towers”, the World Trade Center Towers and The Sears Tower, were started within a couple years of one another and finished at essentially the same time. After an 18 year span with no “tower” construction, three “towers” were built right at the end of the Roaring 20’s just as the US was entering the Great Depression. Ironic!

Just for kicks, I thought I’d check out if this indicator worked in foreign markets as well. I was curious to know when the tallest tower was built in Japan and what sort of time proximity it had to the Nikkei crash in ’89. Sure enough, the two events coincided. From 1988 – 1991, the Tokyo Metropolitan Government Building (also known as “Tax Tower”) was built in downtown Tokyo and was the tallest structure in Japan until 2006. From 1990 - 1993, the Nikkei lost 60% of its value as Japan fell into a decade and half deflationary accident. Today, the Nikkei is still 60% below its peak of 18 years ago! (The Midtown Tower became Tokyo’s tallest structure in 2006 and consequently, the Nikkei was the only major stock market to depreciate in 2007!)

Whether you accept the Jewish/Christian Bible as Truth or not, it’s hard to ignore the seemingly strong relationship between market peaks and “tower” construction. I haven’t studied the world’s other religions as much as I’d like or should, but I believe that the theme of “pride before a fall” is interwoven throughout all religious texts such as it is in the Christian Bible. Regardless of your religious beliefs (or lack there of), it might be wise to take an objective look at your investment strategy and search for ways to insulate yourself from the possibility that equity prices may fall substantially.

I think I’ve provided a fairly objective view of our capital markets in my Market Outlook. I explain why a lot of financial advisors fail to find ways to protect their clients in secular bear markets which you can read by clicking this link.. For additional ideas on Wealth Management in the current market environment, I might suggest taking a look at my Stagflation Alert. Both have been fairly “spot on” in explaining why the market is behaving as it is.

Several significant events happened today which I think are worth noting.

Oil Prices Hit New Record High
Oil hit a new high of $98.62 before closing at $96.70. USO, the Crude Oil ETF, is up over 45% for the year.

While this development is bothersome, it was to be expected as there has been an unprecedented draw in inventories over the last 13 months. Since the beginning of October ’06, energy inventories are down 7.5%.

In June, I made my first post suggesting that oil prices would continue to climb in light of the draws in inventory. Since then, the rate of inventory draws has accelerated. Initially, the climb in oil prices was a subtle confirmation for me but now it just flat out scares me. I’m very concerned about oil prices and where they might go.

It is currently estimated that the world is consuming around 88M barrels a day and only producing 85M. Production is going to continue to decline as the 40 year-old “elephant fields” lose production capacity. There hasn’t been a major oil discovery in over 4 decades and even if there is one tomorrow, it will take years for it to begin producing. If there are any supply disruptions in the form of weather or geo-political instability, the ensuing rise in energy prices could be detrimental to the entire global economy.

With that said, prices should pull back at some point. But that was my sentiment in October and I was wrong then so I could be wrong again. Prices may continue to climb until prices choke off demand.

The US$ down over 10% YTD!
As of today, the US$ trade-weighted index is down over 10% YTD. This means that most of the stuff we buy from overseas is now 10% more expensive than it was 10 months ago and everything we make here is 10% cheaper to foreigners. Wall Street will tell you that this is good for “multinationals” like MMM, CAT, BUD, ect. The government will tell you that this development will benefit our trade deficit. There is much debate whether either of these are true. What I do know is true, is that these trends have resulted in hardships for my 89 and 92 year-old grandmothers who are struggling to pay their utility bills and nursing home dues.

A falling US$ will lead to more inflation, higher interest rates and quite possibly a significant sell-off in US equities.

Gold reaches new cyclical high
Given the prior two trends, it’s certainly not shocking that Gold closed at another cyclical high today, not far from its all time high of 870 – a level which should get taken out soon, but possibly after a pullback. The two primary Gold ETFs, GLD and IAU, are up 30% YTD.

While Gold is near its all-time highs when priced in US$’s, it is still very cheap when priced in oil and other commodities and still well below its cyclical highs when priced in Euros and other established foreign currencies.

GM Takes $39B Write-down
Of all of today’s developments, the GM story is the most intriguing to me. Today, they announced a $39B write-down. According to an article by the Associated Press, the primary driver behind this write-down is “a $38.6B non-cash charge related to accumulated deferred tax credits in the U.S., Canada and Germany.”

But the article went on to say:

But the markets aren’t buying it, sending GM stock into a mild decline. That’s because there’s plenty of other bad news. Just a few years ago, General Motors Acceptance Corp., the financing arm that’s 49 percent owned by GM, was the company’s life preserver, with robust profits from loans relating to the housing boom. Now it’s an albatross, contributing a $757 million loss in the third quarter–virtually all of it attributable to mortgage write-offs.

On CBSmarketwatch, the following was said…

GM said that confidence has been shaken by sluggish earnings growth in its core North American automotive market and setbacks at GMAC Financial Services, its lending business.

GM said there was a “significant” decline in net income at GMAC and increased corporate expenses. GMAC, of which General Motors holds 49%, lost $1.6 billion. It was caught up in the subprime turmoil that has rocked mortgage and credit markets.

What makes this intriguing for me is not that GM’s stock got hammered today because of this news. I am neither long nor short GM (Although I do drive a GMC Envoy). It’s intriguing because it is representative of how much our nation’s earnings are tied to the financial space. While “financial” stocks only make up 22% of the S&P 500’s capitalization, there are a lot of non-financial companies that derive a substantial part of their income from “financial activities”. Therefore, earnings from “financial activities” accounts for even more earnings in the S&P than earnings from “financial stocks” alone.

And why is this important? I have long argued that the earnings in the financial space are a sham, which it is finally becoming apparent that I was correct. (It didn’t take a genius to figure this out, banks have always “cooked their books” and when they issued blow-out earnings in Q1 despite the troubles in housing, it was pretty evident that something was amiss.) Since earnings in this space were questionable at best, I have also argued that we should discard their earnings when trying to value the S&P 500. As of Q2, the average P/E for the S&P, including the financials, was in the neighborhood of 18, higher than its historical average of 14.5 but not grossly so. But if you take out the financial stocks, whose P/E was under 10, you have an average P/E in the 20+ range, significantly higher than the historical average. But what if financing activities actually account for 30+% of S&P earnings? Now we’re north of the 21-22 neighborhood and approaching extreme valuations particularly given the inflation picture.

By proceeding, I acknowledge that I have read and understood the Disclaimer, Performance Reporting Disclosure and Copyright Statements .

The following news item regarding NovaStar Financial Inc., ticker symbol NFI, was released by the Associated Press today.

KANSAS CITY, Mo. (AP) — Mortgage lender NovaStar Financial Inc. said Monday it was terminating its status as a real estate investment trust, retroactive to the beginning of this year, after determining it could not pay investors a required dividend. The company’s shares plunged more than 21 percent after the announcement.

Back in February, right the peak of the REIT market, I wrote about the fragile nature of REIT yields. If you have REIT exposure in your portfolio, I’d recommend checking out the post.

By proceeding, I acknowledge that I have read and understood the Disclaimer, Performance Reporting Disclosure and Copyright Statements .

If you would like to see the video, Click here to watch.

This morning, another CNBC commentator blamed part of the market’s problems on some Quant funds that have gone south which has led to people liquidating their shares. I’d argue it is quite the opposite - the market is going south which is resulting in Quant fund underperformance. Due to the irrational nature of the market, Quant funds should be expected to perform poorly. This was a theme that I started to watch in August of last year.

If you would like to take a look at my post from August ’06, simply click here.

My take on Quant Fund performance (or lack there of it) is merely another indicator that we are in the initial stages of a bear market. Two things take place at market tops that handicap Quant strategies.

1. Market Breadth deteriorates meaning the majority of stocks decline while a few large names hold up the cap-weighted indexes.
2. Investors are irrational during inflection points.

Read the rest of this entry »

Hedge Fund/Investment Bank/Subprime/Leverage Meltdown

For quite some time, I’ve warned about the following risks in the market:
1. Hedge Fund Scandal
2. Housing Bubble and Subprime Fallout
3. Investment Banking Accounting
4. Leverage in the Market
Read the rest of this entry »

Bonds swooned today pushing the 10-Year Treasury note to its highest closing level since May 15, 2002. As expected, equities sold off in tandem with bonds (not even Greenspan’s jawboning could save the markets today). As I mentioned in my post June 7th, history suggests that equities could sell off even further given the recent sell-off in bonds.

One of my favorite analysts, Steve Saville , recently wrote an enlightening piece on the relationship between increasing bond yields and equity corrections. In his commentary he writes:

…a downward trend in the bond market will eventually take its toll on the stock market. It’s a question of when, not if, a downward trend in the bond market will drag equities lower. The “when” is typically 5-7 months, but is sometimes as long as 12 months from the start of the bond market’s decline….The current situation is that bonds are about 6 months into a downward trend, so we have entered the time-window when weakness in bonds should be starting to have an adverse effect on the stock market…If the bond market’s decline continues without significant interruption over the next few weeks then a knock-on effect will almost certainly be a sharp stock market correction. (emphasis mine)

He wrote this on June 10th, after the 10-Year Treasury note closed at 5.12% the previous Friday (6/8/10) – a full .23% lower than today’s close.

Mr. Saville goes on to speculate that rising bond yields could end in one of three ways:

1. Bond market rallies pushing rates lower and in line with equities.
2. The stock market corrects over the next couple of months thus keeping equities and bonds inline.
3. The bond market pushes equities into a cyclical bear market.

This is an update to a post I made on May 7th. I’ve copied most of the significant text so I took down the old post.

According to AAA, the average nationwide gasoline price hit another all-time high a couple of weeks ago at $3.22/gallon, besting its previous record of $3.06/gallon on August 11, 2006. Some are calling for energy prices to continue to move up calling for $4/gallon gas. Well, allow me to add some fuel to the speculation fire (pun intended).

Over the last eight months, we have seen an uncharacteristic draw in energy inventories which makes a solid case for higher energy prices this summer. Before I continue, let me provide a quick primer on the nature of energy inventories and shoulder seasons. Read the rest of this entry »

The equity and bond markets took a sizable hit today as bond yields soared. The Ten Year Treasury Note increase 13bps, its largest jump in 3 years (Since 5/7/2004). The equity markets followed suit by declining nearly 2%. Recent history suggests even further losses in the equity markets may be coming.

It was just twelve months ago that equity markets were in the midst of a 7% correction. The impetus for this correction was rising bond yields. Yields bottomed out in January of 2006 at 4.39% and gradually climbed until they reached 5.19% (0.80%) in mid-May. Coincidently, equities started their correction in early May and it lasted through early July.

Currently, Ten Year Treasuries have experienced an increase from 4.5% in March to close out today at 5.1% (0.60%). Including today’s nearly 2% drop, the S&P is just 3% off its YTD (and all-time) high.

It seems that the market is finally coming to the painful conclusion that the Fed is handcuffed and will not be able to lower rates this year due to increasing inflationary pressures. Rising energy and food prices are certainly not making the Fed’s job any easier. Energy and food prices are both up over 15% YTD according to the CRB Index.

I have maintained for some time that the next bear market will be defined by stagflation – a state of above average inflation and below average economic growth. The second cyclical correction of the last two secular bear markets (’37 & ’73) were both inflationary and it is looking like it will NOT be different this time .

In addition to the steep decline in bond prices (and corresponding increase in yields) the technical strength of the market is getting sloppy. Today, the number of declining stocks on the NYSE outnumbered the advancing stocks 11:1. Even with stocks less than 3% off their 52 week highs, more than twice as many issues on the NYSE hit 52 week lows as did 52 week highs (and at one point during the day, the S&P was less than 1.5% off its all time high). Market leadership has been neutral at best recently and today’s action should push the technical indicators that I track closer to being bearish.

With all that said, The S&P and DJI are only 3% off their all time highs. Market tops take time to develop. This could just be a simple correction. I’ll keep a keen eye on the technical strength of the market to determine if this indeed the beginning of the next bear market or just another head fake.