Mid Week Update 01/28/09

January 28, 2009 · Posted in Weekly Posts

World markets have rallied the last few days after suffering considerable erosion in prices earlier. As we have written earlier, all of the world’s major markets are showing essentially the same behavior. This has continued today. Over the past three days some less than terrible news has emerged globally. Today we have Wells Fargo report earnings that were not surprisingly awful but perhaps more importantly they stated they will not be looking for TARP funds. A number of regional banks have stated the same. In addition the administration appears to be headed towards setting up an aggregator bank which would purchase the toxic assets of banks cleaning up their balance sheets and allowing them to start lending again. There are also rumors circulating that the Treasury may opt to convert the dividend paying preferred shares they have received from banks in exchange for TARP funds into common shares. This would free up cash flow for the banks. These developments are viewed as positive from a financial sock standpoint as they allow greater transparency into bank’s books and remove the persistent fear of further hidden landmines. However, the Obama administration, unlike it’s predecessor, is likely to demand far more intrusive government control over bank’s activities. It remains to be seen how the market reacts to the regulatory details that follow the aggregator bank implementation. The net result of all this good cheer has been a strong overnight rally in most major markets and in the US today. The volume action accompanying this move has been muted. This is a red flag going forward.

As we stated in our morning update, we liquidated our SDS positions at the open and established longs through SSO. We liquidated these later in the day at a profit.

The financials and major indices in the US closed solidly above the resistance levels they had been pushing on for the last two weeks. The S&P broke through the 850ish level to close at 874.09. While volume was up over the last few days it was not up a lot. Typically we would look for a clear expansion of volume over the average of the previous few days. In the case of the S&P it was about ~15% greater. The volume was consistent with the failed rallies we have seen for the past six months. The financials, the sector which led the rally, saw somewhat better volume increases of ~75% over previous days. What this means is that the rally of the past few days and especially today has not yet attracted much money from the sidelines to the broader index and is really focused on the financial companies. One has to expect that a portion of the volume was short covering. This low volume rally behavior is replicated around the world. That leaves the rally very vulnerable to a reversal due to a news event or simply to fading momentum unless the next few days see increased participation.

For now this should be regarded as a relief rally in the financials and not much more. The charts still do not give comfort that a big move up is in the offing. The fundamentals certainly do not portend a large move up. A pullback may turn into nothing more than a return to the trading range we have endured since November. Our intention is to remain on the sidelines with respect to the S&P and look for an expected entry point on the short side if an extended move appears likely. Specifically, further big movements upward on decreasing volume would be an indication of a pending reversal. We’ll be looking for global market confirmation. Should we see evidence of volume picking up decisively we will reconsider the short view. We want to avoid taking a position only to be locked back into range bound trading.

Each action that the government takes to actively participate in the markets by direct purchase or ownership of assets (as opposed to a regulatory role) distorts the markets. We fully support ensuring that markets are adequately regulated. Free markets are not inherently stable. Government has a proper role in ensuring their stability through appropriate regulation. However, governments actively participating in equity markets will distort the price behavior, add additional moral hazard, and add an additional degree of uncertainty to investment decisions. Anyone who has ever been caught out on the Yen when coordinated intervention occurs or been short equities when the Fed cut rates unexpectedly understands that the proper functioning of markets is impaired by random acts of government intervention. The direction that this administration is headed means we will be seeing a lot more ad hoc acts of government intervention.

The Fed stated today that the economy continues to weaken. This is the case globally. We are a long way from a true recovery.

To recap some items from last week’s wrap-up:
The dollar continued to exhibit strength though this has moderated. We believe dollar strength is temporary. Readers should see our article “The Dollar’s Rise is Temporary” as well as read “How a Reserve Currency Can Collapse – An Extrapolation of Current Trends”. The dollar is in a flight to “quality” bubble despite being well down from highs it had enjoyed a few years ago.

We added precious metals positions last week. The turmoil in global financial paper will drive physical assets higher. Frankly, we dislike the very idea that modern markets need something like gold to hang on to. However, what we like and dislike are irrelevant – what will work for us is what’s important. We have more to say about this in the Members Only Post “Gold - Reluctantly”.

To view previous Members Only posts - “The Coming Bond Debacle” or “Gold - Reluctantly” simply follow the instructions under the “Become a Member” tab and select the “One Month Free Membership” when you get to the Products page. You must complete the checkout process in order for the Membership to complete. Registration is not sufficient. You are under no obligation to continue beyond the One Month Free Trial and your e-mail and address will not be shared with third parties.

We hold the following positions as of 01/28/2009.
Short Treasury Bonds through PST*
Long gold and silver bullion through CEF
Long gold mining stocks through TGLDX
Long Agricultural commodities through RJA
Short US dollar through UDN**
Long Australian dollar through FXA**
Trading accounts approximately 40% in cash. Likely target is either short S&P when trend develops, or precious metals.
401k remains 100% in cash

This continues to be an interesting week.

*ProShares leveraged short ETF. Investors need to understand thoroughly the risks associated with these leveraged products in light of their personal investment needs and risk tolerance.

** Position is currently in loss but we are sticking with it for now. Consider adding to UDN on further weakness.