WASHINGTON, August 23, 2015 — In our previous article, we reviewed some of the history and major concerns that likely led to last week’s stock market collapse. In this piece, we’ll pinch in on the immediate concerns that need to be addressed to get both markets and the moribund U.S. economy back on track.
With China’s complete failure last week, it’s once again up to America, as usual, to take the lead. But currently led by an Administration that cares greatly about ideology and little about the American people, that will be a tall order indeed, and investors great and small have every right to be skeptical at this point.
No one is really minding America’s economic store right now, a situation that’s likely to persist until January, 2017. Unfortunately, we’re dealing with some prickly business, employment and economic issues in real time this week, so let’s review them briefly.
The financial punditocracy will say what they will, but the elephant in the room this week is the Chinese economy. The invincible leaders of the People’s Republic have seemed not so invincible lately.
Pushing the yuan/renminbi as an alternative reserve currency seemed like a swell idea until it wasn’t. With the Chinese now directly manipulating that currency for their own benefit, they’ve only succeeded in ripping many economies, particularly emerging market economies, out of their moorings.
Worse, the initial Chinese answer to plummeting Chinese stocks and market averages was what one might have expected from a Communist government: death threats against those who were selling stocks or selling them short.
The usual suspects, of course, were nefarious foreign capitalists shorting the daylights out of grossly overvalued Chinese stocks. But the more likely culprits were the millions of newly minted small investors who’d tossed their life savings into Chinese stocks and were now desperate to get even the few yuan that remained of their money back out again before it all vanished into thin air.
Worldwide, markets and investors, fearful of the ripple effects from China’s enormous but plunging economy, launched an epic selling panic, dumping everything they could to get liquid. This in turn, clearly led to margin calls late in the week, which often lead to investors selling their most expensive holdings (like Apple) to raise cash. When news that Chinese manufacturing was continuing to contract at an alarming rate hit the Friday tape, that slaughtered commodities—again—which in turn led to heavier and heavier selling that just built on itself.
Even worse, China’s surprising and continuing currency devaluations inspired other countries, particularly in emerging markets, to devalue their own currencies to stay competitive against what they are seeing as a predatory Chinese economic decision. This, in turn, is leading to fears of a full-out currency war, again raising the specter of the kind of deflationary disaster we witnessed in the 1930s.
The Chinese need to get their act in gear. The time for worrying about whether other countries respect them and regard them as major players is long past. They are respected and they are major players. Now their government needs to grow up and act responsibly like major players are supposed to do.
Although given the ridiculously high price at the pump this summer, consumers might not have noticed—but the price of a barrel of West Texas Intermediate crude oil has cascaded down from a spring peak of $62 and change in late spring to Friday’s brief dip below $40. This is causing immense damage not only to oil majors. It’s having a ripple effect on energy industries in general and is starting to result in massive job layoffs in that industry.
This oil price drop has been killing the S&P 500 for months. Worse, it’s not helping consumers either. Gas prices are still considerably above where they bottomed late last year when oil never broke $44 bbl.
By rights, prices at the pump should now be below $2 per gallon. Instead, they’re closer to $3 in many states. We’re getting plenty of excuses as to why this is so, most focusing on mandatory summer fuel blends. But the entire situation is fishy and is currently helpful neither to the oil industry or consumers.
Consumers remain highly suspicious of the whole game, and rightly so. They’ve been gamed before by Washington insiders, New York and Silicon Valley tycoons. This crony capitalist cadre has transformed the U.S. economy from a free-range, Wild West capitalism to an almost feudal oligarchy over just a few decades. Trust has been lost, cynicism has settled in, and consumers across the country are digging in and simply not buying, save for necessities.
In a traditionally consumer-led economy, this is disastrous. But America’s new Robber Barons and their wholly-owned politicians have only themselves to blame
Mediocre earnings season
Second quarter numbers have mostly been reported by publicly traded companies at this point. Most companies were actually still comfortably profitable, but many didn’t make their predicted revenue or profit targets.
Much of this, in our opinion, can be attributable not only the our clearly slowing economy, but to the phony earnings per share companies have boasted of for years, courtesy of QE. By borrowing money at near-zero interest rates (like you and the Prudent Man cannot), companies have financed, almost for free, massive stock buybacks.
By reducing the number of shares available to investors, companies are able to make even dwindling earnings seem more impressive. That’s because these earnings are divided into a smaller and smaller number of shares, thus “increasing” earnings per share (and decreasing price-earnings ratios) to create the appearance of ever more robust corporate profitability.
But in many cases, it’s all been a mirage, happily perpetrated and encouraged by feckless Washington politicians who want to win re-election.
With the end of QE last fall, this game has come to an end, and we started seeing what real earnings actually looked like in the currently reported quarter. It wasn’t pretty. Reality never is.
We largely dealt with this issue in our previous article. Like markets themselves, individuals hate protracted bouts with uncertainty. While it knows it must eventually hike interest rates, if only to re-arm themselves with traditional financial tools the Federal Reserve continues to dither on the interest rate question. Until and unless they do, neither companies nor individuals will have the confidence to make economic commitments.
Trillions of dollars are sloshing around in the U.S. economic system at the moment. If even a fraction of this sum were put to work either via investments in plants and equipment, consumption, or both, our almost nonexistent economic recovery would take off like a rocket-sled in a matter of months. But uncertainty about interest rates keeps everyone in stasis. No real decisions are being made.
With an Administration that doesn’t care, a Congress that can’t get anything done, a central bank operating without conviction or courage, and a cadre of impossibly wealthy oligarchs sweeping up whatever money shows up and keeping it for themselves, the American economy has achieved a near-entropic state. Those who have get more. Those who have not get nothing. And no leadership anywhere is forthcoming. Small wonder the Fed doesn’t know what to do about interest rates right now.
The problem is, we’re paying our central bankers the big bucks, bucks that will get even bigger when they transfer to private industry, which most of them will inevitably do. So what are we getting for making them rich?
Action plan for Monday
We posted three charts in our first article of this series, giving you a clear picture of how nasty the trading action was on Friday. Below are two more annotated charts from ETF Digest** that illustrate the overall technical damage with stunning clarity.
The first chart illustrates the action on the NYSE as depicted by the highly respected technical tool known as the McClellan Oscillator. In a nutshell, the oscillator, based on market moves as amplified by trading volume, is an amazingly accurate depiction of where markets are likely to go once they achieve “overbought” (overly optimistic) or “oversold” (overly pessimistic) levels.
As ETF expert Dave Fry annotates the latest chart of the oscillator (our first chart below), we can see that in one gigantic move from Thursday through Friday, the “NYMO” sliced right through the bottom “oversold” line like a hot knife through butter:
Dave’s second chart sketches out the action in the more complicated measure known as “the VIX.” This is another mathematical construct that essentially tells us whether markets are lazy and complacent, or hyperactive and (generally) fearful. This VIX chart, again as annotated by Dave Fry, illustrates the colossal spike of fear that initiated earlier last week and took off for the stratosphere during Friday’s horrendous action:
Both these directional tools are rendered more effective by the volume of trading on any given day. The theory here is simple. If trading is light, no matter how convincing the move may be in the over all stock market, that move may not have much investor conviction behind it.
Contrariwise, if a large amount of trading volume is supporting a directional move, even if it’s a small one, that large amount of volume make the move significantly more convincing.
As you can see on both charts above, the Thursday-Friday collapse in stocks was directionally massive and also backed up by overwhelming volume in a summer that’s generally seen incredibly light trading volume and patterns.
This means that that the current Wall Street smackdown is not an anomaly, and must be taken very seriously.
As for our portfolios, we confess to being caught a bit over-invested, playing the contrarian game as we usually do. We paid a price for it.
Given the market’s currently very oversold condition, both the NYMO and the VIX indicators give us a hint that we’ll at least get a good, perhaps even healthy dead cat bounce here, maybe a bit more. But given Friday’s rout, we may not get this relief rally until Tuesday.
However, the damage to the bull case has now been done. Any rally here should be used as an excuse to get out of more volatile investments, particularly oils and perhaps banks as well. A big down move such as the one we’ve just experienced, means that, barring some miraculous interventions by Beijing or China today or Monday, markets will resume their downward momentum some time next week, perhaps earlier rather than later.
If we see that things are looking really bad, we may put on some short positions, one of which we’d unfortunately taken off earlier last week. Our general favorite ETF for this strategy is SDS, the double-short S&P 500 ETF that will make us money when the market rockets down.
Do note, however, that leveraged ETFs like this one should only be traded if you sit at your own trading computer each day like the Prudent Man does, or if you work with a full-service broker you trust who will alert you ASAP if the trade should turn against you.
Otherwise, we think it’s time for little guys to mostly withdraw from this market until some kind of All Clear is sounded or until the selling just exhausts itself, which is usually easy to spot, as volume dries up to just a trickle.
We will continue to hold our REITs, a couple of utilities, and our preferred stocks and bond funds and ETFs, however. Everything is going to suffer damage, but these should absorb only minimal hits. The ones we hold have higher than average yields, and direct excellent cash flows to sustain those yields. In this environment, we’re not going to completely sacrifice income to get out of the market entirely and tuck our money in our mattress.
But to be honest, during Friday’s bloodbath, we sure thought about doing just that.
We’ll be back tomorrow, and hopefully not in full triage mode. Stay tuned, and don’t miss the next thrilling episode.
**Note: All charts in this section were borrowed from Friday’s free edition of “Dave’s Daily.” This is a generally daily feature of Dave Fry’s ETF Digest, an online publication to which the Prudent Man subscribes. We don’t advertise here. But that said, Dave offers an additional more action-oriented and extraordinarily useful service for ETF traders that’s understandably behind a pay wall. To link to the free part of ETF Digest, click here. Should you wish to access Dave’s trading service, which consists of three specific portfolios and a considerable selection of helpful articles, follow the links at the site to set up a subscription.Click here for reuse options!
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