Investment letter – April 20, 2010

The majority of the financial ‘experts’ in the world did not see the credit crisis coming, including the Federal Reserve, SEC, numerous Congressional committees with financial and regulatory oversight, and certainly not the heads of the financial institutions that failed or required a federal government orchestrated ‘bailout’ to stay in business. To simply chalk it up as a Black Swan event is an intellectual copout that concedes an unacceptable level of helplessness in the face of less than mysterious forces. Labeling the largest financial crisis in history as a Black Swan event also provides a degree of absolution to those responsible, who were either blinded by ideology or straightforward greed. The millions of honest hard working people who lost their job deserve better, as do the millions more who work hard and play by the rules. Politicians from both parties and anyone else looking for just one cause for the crisis are missing the bigger picture, and more likely trying to point a finger away from their own contribution. A crisis of this magnitude was not the result of one dynamic. It was a team effort with many contributing players.

With an election coming in November, Congress is highly motivated to show American voters it is enacting legislation in the Financial Regulation Reform bill that will insure a crisis of this magnitude never befalls this country again. Unfortunately, I have yet to hear anyone address what was undoubtedly the most important factor in the crisis. The following chart explains why the crisis was so big, and a fifth grade math student can understand it, and that is not an exaggeration!

Between 1965 and 2000, the median home price was consistently around 3 times median income. During this 35 year period, the U.S. economy experienced a recession in 1969-1970, 1973-1974, 1981-1982, and 1990. Home prices are very sensitive to interest rates, and between 1965 and 2000, interest rates fluctuated wildly. The Federal funds rate jumped from 4.5% in 1965 to 21% in 1981, before working its way down to 5.0% in 2000. The 30-year mortgage rate rose from under 6% in 1965 to almost 18% (not a typo) in 1981, before dropping to 7% in 2000. It is remarkable that this relationship between median home prices and median income was maintained, despite extreme fluctuations in interest rates and periods of economic recession. It begs the question, How was this possible?

This relationship was maintained because between 1965 and 2000, home buyers were not allowed to buy a home if their mortgage payment was more than 33% of their verified income. The reciprocal of 33% is 3 to 1, which is why median home prices held very close to the 3 to 1 multiple of median income. However, between 2000 and mid 2006, median home prices rose to 4.6 times median income. This was made possible because lending standards were trashed, and prospective home buyers could purchase a home with no money down and without verifying their income. The lax lending standards created an incremental increase in demand that pushed low end home prices up. This allowed the owners of those low end homes to trade up, which set off a chain reaction of trade up demand that pushed mid and upper end prices higher. Some blame the crisis on the Federal Reserve for keeping rates at 1% for too long. The Federal funds rate was 1% between June 2003 and June 2004. After that, the Federal Reserve increased the funds rate by .25% at each of the next 16 meetings. It is almost preposterous to suggest the entire crisis was the result of Fed interest rate policy, after considering the impact lower lending standards had on increasing demand from weak borrowers.

In effort to allow more low income Americans to realize the dream of owning a home, members of Congress pushed Fannie Mae and Freddie Mac into lowering their lending standards. Both firms received lending quotas from the Department of Housing and Urban Development (HUD), and both firms felt obligated to meet or exceed those quotes, which they did. In testimony before the Angelides Commission, which is investigating the financial crisis, Daniel Mudd, former Freddie Mac CEO, said, their ‘standards slipped’, as they ‘were balancing against our housing HUD housing goals.” Former Federal Housing Finance Agency Director James Lockhart testified that Fannie and Freddie “would have incurred the wrath of Congress if they missed those HUD goals.” In 2008, Fannie Mae and Freddie Mac held 56.8% of the $12 trillion in outstanding mortgages. Did lowering their lending standards at the behest of Congress contribute to the increase in home values and subsequent crisis? Absolutely. Fannie Mae and Freddie Mac have been taken over by the U.S. government, and the taxpayers will have to make good on their combined losses of at least $400 billion. It’s also worth noting that between 1988 and 2007, Fannie and Freddie made almost $200 million in campaign contributions to Congress. The three largest recipients in the Senate were Christopher Dodd, John Kerry, and Barack Obama.

But to suggest that Fannie and Freddie were the cause of the crisis is an exaggeration, since sub-prime lending was a big deal in the private sector too. Independent nonbank mortgage brokers originate almost 40% of all mortgages. Since 2007 more than 300 have failed, including Ameriquest, New Century Financial Corp., and Ownit, while Countrywide Financial was acquired by Bank of America. Washington Mutual, the largest bank failure in U.S history, was a big player in sub-prime lending, and according to the Senate’s Permanent Subcommittee on Investigations rewarded loan officers and processors based on how many mortgages they could churn out, and awarded members of the President’s Club with lavish all-expense paid trips to Hawaii and the Caribbean. The emphasis was on quantity, not quality. Lending standards? We don’t need no stinking lending standards! After reviewing more than 50 million documents, the Subcommittee determined that borrowers were steered into sub-prime mortgages, even though they qualified for prime loans, which would have cost the borrower less. But Washington Mutual’s brokers made more in commissions on sub-prime loans. The Subcommittee also found that the bank knowingly included fraudulent loans in mortgage securities sold to investors. I have no doubt that these same practices were duplicated at many of the firms that failed, and some that were bailed out.

Twenty-five years ago, bank lending was largely dictated by the amount of loans a bank had on its balance sheet relative to its capital base. If a bank could make a loan, and then sell it to someone else, the bank could make more loans, without increasing its capital base or loan reserves. Although the bank would make less money on each loan it didn’t hold onto, it could increase earnings, by significantly increasing loan volume. The process of moving mortgage loans off bank balance sheets was initially facilitated by Fannie Mae in the early 1980’s. Fannie Mae would buy mortgages from banks all over the country, package them together, and sell them to Wall Street and institutional investors. This was fairly easy to do, since lending standards were fairly strict and uniform, and most mortgages were ‘conventional’.

There are many advantages to the ‘securitization’ of mortgages. Borrowers get lower mortgage rates, due to competition. Pension funds and insurance companies are able to increase their investment returns, since mortgage backed securities offer a higher return than Treasury bonds. The success with mortgage securitization has led to the securitization of car loans, credit card receivables, and numerous other assets. This has increased the flow of credit into many sectors of the economy, and until the music stopped in 2007, kept the economy humming. Between 1982 and 2007, our economy was in recession only 16 months. In the 25 years prior to 1982, there were 64 months of recession. A growing economy generates more jobs, a higher standard of living, and a tide that lifts the fortunes of most Americans.

The decline in lending standards however exposed a fatal flaw in the securitization of mortgages. If there are no negative financial consequences when a prospective home buyer can purchase a home with no money down, a mortgage broker can help a prospective homebuyer directly or indirectly falsify data, and a lending institution doesn’t have to maintain lending standards if they know they’re going to bundle the ‘bad’ loans and sell them to be securitized, an open season for fraud and abuse is created. Everyone involved got to make a lot of money, as they shoveled the bad loans to unsuspecting buyers of mortgage backed securities. This type of fraud was allowed to develop over a period of years, while the Federal Reserve, Federal Deposit Insurance Corporation, and Office of Thrift Supervision did nothing.

The decline in lending standards created a wave of additional demand that pushed home prices far beyond their historical relationship with median income. As any fifth grade math student learns, if you have a broad data set and prices temporarily move away from the mean average, values will revert to the mean at some point in the future. In terms of housing prices, this meant that home prices at some point could fall by as much as 33% (from 4.6 to 1, to 3.0 to 1), or slightly less if the decline was stretched over time and incomes rose. The following is a quote from my September 2007 letter. “Between 1965 and 2000, the ratio of the median home price to median household income fluctuated in a narrow range between 2.8 and 3.2. During this 35 year period, increases in home prices were supported by a rise in household income. This relationship provided underlying support for home prices, even when recessions developed in 1970, 1974, 1981, 1990 and 200l. However, between 2000 and 2006, the ratio rose from its long term
average of 3 to 4.6. This means median home prices have the potential to fall 33% should the
ratio fall back to its long term average. I don’t think this is likely. But I’m sure if the average homeowner in Japan was told in 1990 that their home was going to lose 33% of its value, they wouldn’t have believed it possible. In fact, real estate values fell by more than 50% in Japan.” I discussed this relationship on a number of occasions in late 2007 and throughout 2008. According to the Case-Shiller Home Prices Indexes, the 10-city index fell -33.5% between July 2006 and April 2009, while the 20 city index lost -32.6%. This reversion to the mean by median home prices should not have been a surprise to anyone. The bust in housing prices was not caused by some mysterious Black Swan event. Just basic mathematics.

S&P, Moody’s, and Fitch were in business to be the watchdog, rating the quality of Wall Street offering’s of debt, and determining the level of risk for each issue for investors. Unbelievably, the “risk models” used by S&P, Moody’s, and Fitch, didn’t even include the potential for a national home price decline! Why? Because home prices hadn’t fallen nationwide since the depression, they assumed a nationwide decline could and would not occur. Even though housing prices were stretched 50% beyond their long term mean average, the rating agencies were more wowed by Wall Street’s financial engineering than basic mathematics. It must be noted that the rating agencies are paid by the Wall Street investment brokers, who sell mortgage backed securities. If one of the rating agencies had refused to provide their standard AAA rating on a batch of mortgages, they risked losing the business to one of the other agencies, who would gladly rubber stamp the pool with an AAA rating. Between 2004 and 2007, the rating agencies received billions in fees from the Wall Street issuers of mortgage backed securities. Could the conflict of interest in this relationship be any more obvious?

I remember in 2004 hearing ads touting loans of 125% of a home’s value, and thinking that didn’t sound right. I’m sure Alan Greenspan heard some of those ads, but no alarm bell went off in his head. Even when a fellow member of the FOMC expressed his concerns about this type of lending and the Fed’s oversight responsibility, Alan decided it wasn’t necessary. Greenspan is a true believer in the power of the marketplace to allocate resources far better than any bureaucrat. This is why he allowed the tech bubble to grow, rationalizing that millions of investors knew more than the Fed. The tech bubble showed that the ‘marketplace’ was far from infallible in allocating resources, even if better than a bunch of bureaucrats. Tens of billions of dollars were evaporated when the tech bubble burst, but that didn’t dent Alan’s faith. It is ironic that the housing bubble, which followed so closely behind the tech bubble, didn’t even elicit a raised eyebrow from the Maestro. Greenspan also believed that the enormous increase in derivatives after 2000 would spread risk, making the financial system safer in the process.

In 1999, when the head of the CFTC grew concerned about the unregulated nature of derivatives after the collapse of LTCM in 1998, Greenspan, along with Robert Rubin and Larry Summers, crushed the proposal to increase oversight before it could get off the ground. This opposition to increase oversight and regulation was supported by many members of Congress, who believe less regulation is usually best. Between 2001 and 2009, Rubin received more than $126 million in cash and stock during his eight years at Citigroup. On February 27, 2009, Citigroup needed to receive $25 billion from the U.S government, in large part due to its exposure to derivatives. Contrary to Greenspan’s expectation that derivatives would lower systemic risk, unregulated derivatives enabled the virus to spread throughout the global financial system with incredible speed because no one knew their counter party’s risk levels.

The investment banks were so confident in their ability to control investment risk, they sought to increase the amount of leverage they were allowed to employ. More leverage would allow them to increase profits, and of course, generate even larger bonuses for themselves. It is not uncommon for an investment banker’s bonus to be 500 to 1000 times the income of the average worker. (Is anyone really worth that much more than the average worker?) In 2004, the SEC allowed investment banks to increase their leverage from 12 to 1 to 30 to 1. Leverage unfortunately works both ways. In good times, $30 of borrowed money increases profits, but if an investment loses just1%, $30 is lost. Not much of a margin for error, even for Master’s of the Universe. Place a few big bets on an overpriced asset, as housing was in 2005, 2006, and early 2007, a decline of 30% in the underlying asset burns through capital very quickly.

Not satisfied with the amount of leverage they were permitted to use by the regulators, the big banks also established off balance sheet entities that allowed them to book fees from structured investment vehicles, but not set aside any reserves that are normally required for a bank. When the first shock waves spread through the financial system in August 2007, Fed Chairman Bernanke didn’t even know these SIV’s existed. This says as much about the subterfuge used by the big banks as it does about the lack of oversight exerted by the Fed and FDIC.

Too big to fail is capitalism’s kryptonite. Capitalism depends on creative destruction, even when it is self inflicted. If poorly managed firms are not allowed to fail, the overall economy is burdened. The cost to our society for mismanagement, as executed by investment banks, behemoth banks, insurance companies, and supposed non government agencies, will run into the trillions of dollars, and take a generation to recover from, if we’re lucky. Whenever the subject of breaking up the banks and investment banks is raised, the standard response from executives is that their immense size provides the economies of scale required to achieve efficiencies that benefit the overall economy. As financial firms grew over the last 15 years, most of the realized efficiencies were passed along to the shareholders of the public companies, included in the large bonuses paid to executives, with the remainder distributed to consumers via lower costs. The ‘efficiencies’ are a pittance to what their poor judgment has and will continue to cost our society. They may not like the changes we need to make, but as the saying goes, they earned it the old fashion way by screwing up so badly.


If the lending standards that had weathered so many changes between 1965 and 2000 been preserved, median home prices would have held near the long term 3 to 1 average of median income. The economic downturn would have been much shallower, despite the 30 to 1 leverage and derivatives. The economy may have still experienced a recession, but a full blown financial
crisis would not have erupted. The severity of the crisis was driven by the nationwide decline in
home values, which was only made possible by the additional demand generated by the virtual elimination of lending standards, and ridiculous leverage on an overpriced asset. Strict adherence to the old lending standards will also significantly reduce the opportunity for fraud by borrowers, mortgage brokers, and lenders.

Allowing prospective home buyers to purchase a home with no money down invites irresponsibility, since they are risking almost nothing. Home buyers need to put at least 5% down, and the down payment cannot be borrowed from a government agency, ie. FHA. If a home buyer realizes they could lose money, they will be more careful not to overpay for a property, and more conscious of their ability to make their mortgage payments.

The securitization process needs to be modified so that any mortgage originator is required to hold 5% of the loan on their books, and be second in line behind the homeowner to absorb any loss beyond the down payment of the home buyer. A financial disincentive to the mortgage originator for not maintaining their lending standards might provide more persuasion than the ‘threat’ of regulatory oversight. As we have painfully learned, it isn’t always the lack of regulation, as it is the absence of proactive oversight. During the last 10 years, every regulatory body – the Federal Reserve, FDIC, Office of Thrift Supervision, and numerous Congressional committees were MIA, or worse, complicit.

The rating agencies need to be compensated by the buyers of the securities they are rating, and not by the issuers. This will remove the built in conflict of interest that now exists. S&P, Moody’s, and Fitch may not like it, but this change may force them to do a better job in the future.

In 2008, Fannie Mae and Freddie Mac held 56.8% of the $12 trillion in outstanding mortgages. Today, Fannie and Freddie, along with the Federal Housing Authority FHA represent more than 90% of all mortgage activity. The U.S. government has effectively doubled down on the bets it made through the GSE’s. The ceiling of $400 billion in estimated losses to be covered by the American taxpayer was lifted late in the afternoon on Christmas Eve 2009. Interesting timing. A proposal in 2003 to increase the supervision of Fannie and Freddie was squashed by those who wanted more lending for affordable housing. As Representative Barney Frank of Massachusetts, the ranking Democrat on the Financial Services Committee said, “These two entities — Fannie Mae and Freddie Mac — are not facing any kind of financial crisis. The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing.” Going forward, Fannie Mae and Freddie Mac cannot be used to achieve a political agenda, and need to be dismantled, even if it takes 10 years.

Total U.S. GDP is roughly $14 trillion. At any given time there are $40 to $60 trillion or more of derivatives floating around, and no one knows who owns how much of what. Forty years ago, over-the-counter stock options were standardized, so they could be traded through a clearing house and on exchanges. The same thing must happen with derivatives. Period. The five largest investment banks – Goldman Sachs, Citibank, J.P. Morgan, Morgan Stanley, and Bank of America – dominate the derivatives markets and make a ton of money doing it. They oppose the clearinghouse/exchange solution, since it will reduce their revenue and profits. Adapting to this change will give them the opportunity to show how smart they really are! If this is not included in the final financial reform bill, we will all know that the Big 5 have seen a nice return on their campaign contributions and lobbying efforts.

We must take whatever action is necessary to prevent too big to fail from ever bastardizing capitalism again. Even if it takes 10 years to accomplish. The goal is more important than the process used to achieve it. If every financial institution that trades derivatives is required to trade through a clearing house or exchange, the level of transparency would increase dramatically, and lower the need to break up the ‘too big to fail’ entities. If every financial institution is prevented from setting up off balance sheet entities, and the regulators do a much better job, a clearer picture of the real financial health of each institution would emerge. Creating a $50 billion reserve fund combined with measures for far greater transparency may be enough.

We have learned a lot about how the crisis came to be and the necessary solutions to prevent anything similar from befalling us in the future. In the coming weeks and months, we will see if change we can believe in becomes a reality, or whether money and power is allowed to conduct business as usual.

The housing bust: A statistical portrait
Percentage of mortgages bundled into securities 55.8% in 1994 74.2% in 2007
Percentage of subprime mortgage packaged into securities 31.6% in 1994 92.8% in 2007
Percentage of mortgage originations that were subprime 4.5% in 1994 20.1% in 2006
Share of mortgage originations by federally regulated savings institutions 29.8% in 1987 8% in 2006
Share of mortgage originations by less-regulated mortgage brokers 20% in 1987 58% in 2006
Average annual rise in home-price value 3% 1990-1999 8.6% 2000-2006
U.S. home-ownership rate 63.5% in 1985 68.2% in 2007
Ratio of median home price to median household income 3.2 in 1985 4.6% in 2006
Household debt as a percentage of disposable income 74.9% in 1985 137% in 2007
Foreclosure rate on mortgages issued between Jan 1999 and July 2007 2% on prime loans 13.7% on subprime loans


Eventually, the National Bureau of Economic Research will determine that the recession ended last June or July, as discussed in the July 2009 letter. As I GUARANTEED last month, nonfarm jobs increased by 162,000 in March, which included 48,000 temporary Census Bureau jobs, and 81,000 jobs from the Labor Department’s birth/death model. Of the 15 million workers still unemployed, a record 44.1% have been out of work for more than 26 weeks. The underemployment rate climbed to 16.8%. For the first time since data was recorded in 1969, the Bureau of Economic Analysis reported that personal income fell in 2009. On a brighter note,
average hours worked rose to 34.0 from 33.9 hours, another 40,000 temps jobs were created, and the household survey recorded an increase of 264,000 jobs. As discussed previously, the household survey tends to lead the establishment survey at turning points in the labor market. This suggests job growth will gradually improve in coming months.

Factory output jumped .9% in March, lifting the capacity utilization rate to 73.2%. The 30 year average is 81.0, so there is still plenty of excess capacity to dampen price increases. Business inventories rose .5%, while retail sales ‘soared’ 7.6% versus a year ago. Don’t forget, in March 2009, retail sales were down 5%, so most of the altitude came from the comparison to a very weak month. The Consumer Price Index only rose .1% in March, so inflation remains under wraps. That’s not likely to change given the excess capacity in production and the labor market. The cyclical recovery that began last summer will continue, but compared to prior recoveries after nine months is weaker in terms of GDP and job growth.

After the 1981-1982 recession ended, the economy expanded for almost eight years, for ten years after the 1991 recession, while the recovery that began in 2001 last six years. The current recovery likely started last June or July and is not likely to last as long, or be as strong as the three previous expansions. None of those recoveries faced the type of secular and cyclical headwinds that will dampen growth in the next few years. Consumers need to reduce household debt from 97% of GDP currently, to something less than 90%, and increase their savings rate from 3% to near 8%, or higher. That’s the foundation consumer’s will need to support a lasting self sustaining recovery. In 1982, household debt from just 44% of GDP, and the savings rate was almost 10%, while interest rates were 15% to 20%. With interest rates near generational lows, consumers will need to pay off their debt from income, rather than a lower cost of money. Higher interest rates will make this more difficult. Credit availability will never get as loose as it was between 2001 and 2007, so consumer’s reduced access to credit will curb consumer spending. Home prices may fall a bit further before bottoming out in a process that could take three more years. It is highly unlikely that home prices will be appreciating much anytime soon, so the opportunity to pull equity out will be virtually nil. Bank lending is still contracting, and the banking system will remain under pressure through at least the rest of 2010. Small businesses are being squeezed by weak cash flow and bank’s high lending standards. Since small business is responsible for the majority of job creation, job growth will be more hindered than in prior recoveries. Tax rates have trended lower since 1982, but that is changing at all levels of government. Spending by states represents 12% of GDP, and after growing at an average annual rate of 6% over the last 30 years, most states will be forced to lower the rate of increase in spending, cut services, and raise taxes when they formalize their 2011 budgets in June.

According to the International Monetary Fund, the government debt to GDP ratio will be 100% or more by 2014 in Britain, France, Italy, Japan, and the United States, and will be closing in on 90% in Germany. Historically, future economic median growth is reduced by 1% or more, if government debt exceeds 90% of GDP. The IMF’s estimates are based on the assumption governments will make the tough choices necessary to bring their budget deficits down to 3% of GDP. This means the countries that comprise more than 60% of world GDP will be reducing spending, cutting services, and raising taxes. This will lower GDP growth in each of these countries and retard global growth. Mismanagement by the large multi-national banks and
insurers forced governments to increase deficit spending dramatically just to keep the global economy from imploding. Developed countries are now between a rock and a hard place. Any country that doesn’t develop a credible deficit reduction plan will be playing chicken with the global bond market, at the risk of seeing their borrowing costs skyrocket. (Think Greece.) Any country that is forced to pay a higher rate on the money it borrows than its GDP growth will find its interest costs claiming a larger share of its budget. Like a dog chasing its tail, higher interest costs will also make it more difficult for that country to cut its deficit.

It is not going to be easy for the U.S. to significantly cut its budget deficit. Roughly 88% of the budget is mandated by law, which is great for members of Congress. With spending on autopilot, they can spend most of their time campaigning for their next election. The crew sworn in after the election in November won’t have it as easy. The breakdown for every $1.00 spent in the 2010 federal budget is: $.21 Health care (Medicare, Medicaid), $.20 Social Security, $.20 Defense, $.14 Aid (Food stamps, child care, housing, and heating assistance), $.06 Benefits (Veterans, retired government workers), + $06 Interest = $.88. Other than defense, in order to lower any portion of this expenditure of $.88 per dollar spent, Congress will have to do some heavy lifting that won’t be very popular back home in their districts. The government also spends $.03 Infrastructure (Highways, transportation), $.03 Education, $.02 Research and Development, $01 International Aid. This suggests that most of the deficit reduction will come from higher taxes, but in order to raise enough money, tax rates will have to be increased substantially on the top two or three brackets. Think Eisenhower Era.

The secular and cyclical headwinds facing this cyclical recovery suggest the odds of a ‘normal’ expansion are lower. The largest credit bubble in history popped in 2008, forcing central banks to respond with unprecedented intervention and governments to run unthinkable budget deficits. In coming quarters, central banks have to remove the excess liquidity gracefully, while governments must risk the political backlash they surely are going to get as they reduce spending, services, and raise taxes. In my January 2009 letter, I said we would see marches on state capitols within two years. The Tea Party is just the beginning. We live in an uncertain time, which means no outcome should be taken for granted. The best way to approach this degree of uncertainty is by using technical analysis, in addition to the fundamental analysis I discuss in this letter. Historically, technical analysis has warned of impending changes in economic fundamentals, before they have become obvious to the majority of investment strategists. At this point, the technical action in the stock is quite healthy, which suggests that any meaningful change in the economic fundamentals is still months away. That jibes nicely with my view that most of the economic reports in coming weeks and months will be supportive of the recovery story.



The economies of Brazil, India, and China are enjoying growth that is far stronger than in any of the developed countries. This has caused a run up in the price of oil, and many raw materials like copper and iron ore. The combination of strong growth and higher raw material costs is causing inflation to creep higher in these countries. China is also dealing with real estate speculation in the wake of their enormous lending spree in 2009. China has increased rates and announced a number of steps to curb real estate speculation. India increased their rates by .25% on April 20 to 6.0%, as inflation is running 9.9%. All three central banks will increase rates further, and adopt other measures of monetary tightening in coming months. It is important to monitor these changes, since less accommodative monetary policy will slow growth, and these three countries have been the locomotives driving global demand.

Although higher raw material prices are inflationary for developed nations, they are also a bit deflationary, since consumers will have less money to pay down debt, increase savings, and shop at the mall, if they are paying more for gas. The primary challenge for the developed nation’s central banks is not inflation. Their challenge is balancing the removal of excess liquidity and the tightening of fiscal policy that is coming, as governments work to reducing their budget deficits. As the BIC countries tighten monetary policy, and developed countries tighten both monetary and fiscal policy, the risk of another global slowdown will increase. I haven’t heard anyone mention this, which means it’s not on their radar screen.

Last month, I suggested shorting China via the ETF FXI at $40.40 or higher. On March 25 it traded between $40.40 and $40.69, with at stop at $42.00. FXI opened at $42.02 on March 30. FXI traded up to the January high at $44.60, before dipping and testing the trend line connecting the February 5 low and March 25 low. Since the uptrend from the February low is intact, I will send out an update when I think it’s time to short again. If FXI closes above $44.80, it should run to November’s high at $46.66.


Per last month’s instructions, we are short the 10-year Treasury bond through the ETF TBT. After trading as high as $50.68, TBT pulled back to $47.89, which was the buy point. Keep the stop at $46.55. The yield on the 10-year Treasury bond reached 4.01% on April 13. If it runs back up to 4.0% again, a move to 4.2% is likely.


In last month’s letter, I wrote, “Gold rallied about $100 after making its low in early February, so a similar rally could take Gold above $1,140, and possibly above $1,162. Go 50% long GLD below $105.80, and add below $104.50, using $103.80 as a stop.” The low on GLD was $106.24. Gold did not have one more dip, and the high on the rally was $1,170.70. As long as gold holds above $1,124.30, there is a chance of gold rallying above the high on April 12. Sooner or later I expect gold to fall below the February 5 low at $1,045 and GLD to crack $102.88.

In last month’s letter I wrote, “The .618 retracement of the decline from October 2007 (1,576) to the March 2009 low (666) is 1,228.00. If the S&P does make this run up to 1,210-1,225, it will do it on higher volume, which will make the technicians happy. A good jobs report will make the economists happy too. When everyone is happy, it’s time to get nervous, and I will likely send out a Special Update.” On April 8, I did send out a Special Update reiterating my view that “the market is likely close to a short term high, and vulnerable to a pullback of 4% to 7% in coming weeks. Selling into any additional strength from here, or becoming a bit more defensive is advised.” The S&P pushed up to 1,213.92, before selling off on the Goldman Sachs news.

Interestingly, the 21 day average of total volume has jumped from 1.034 billion shares on April 12, to an average of 1,198 billion shares on April 19 and April 20. This is an increase of 15.8%, with the market rallying after the Goldman sell off. Most technicians would view this as bullish behavior. I’m not so sure. Volume rose as the market declined into the low on October 2, November 2, 2009, and February 5. Normally, technicians view rising volume on a sell off as a negative, but that hasn’t been the case, as the market subsequently rallied to new highs after each of those declines. I think the increase in volume now is an indication that investors are finally convinced this rally is for real, and as such, is a sign of optimism and a short term top. The market should get above the high at 1,214 to finish the rally phase that began on February 5. Last week, more than 900 stocks made new 52 week highs, the advance- decline line also set a new high, and the majority of market averages set new peaks. This indicates that the market’s internal strength is healthy, which is why any decline is unlikely to exceed 4% to 7%. This broad market strength also suggests that any decline will be followed by another rally that challenges or exceeds the high I expect soon. The major trend is up, and will remain positive as long as the S&P holds above 1,044. The intermediate trend is positive as long as the S&P remains above 1,086.

I believe the market is in a cyclical rally within the context of a secular bear market that could last until 2014-2016. Sooner or later, I anticipate a decline of 20% to 30% to develop, if the fundamental headwinds exact the economic toll I expect. That decline should be preceded by signs of technical weakness that just aren’t present now.

E. James Welsh

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