Welsh Investment Letter – August 2010

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A Guide to Federal Reserve Monetary Policy, the Economy, and Financial Markets

By James Welsh, Registered Investment Advisor                   jwelsh@welshmoneymanagement.com

Investment letter – August 15, 2010

My approach combines both fundamental analysis and technical analysis, which is unusual. Most economists and market strategists rely almost exclusively on fundamental analysis, which focuses on the economy and estimates for corporate earnings. Technical analysis utilizes measures of price momentum, moving averages, and charts of the major market indices like the DJIA and S&P 500. I believe the combination of both disciplines is better, since each provides a different perspective. The probability is higher that my analysis is on target, when the fundamentals and technical indicators are aligned, especially at major turning points in the economy and stock market.

In the June 14 letter, I reviewed the Major Trend Indicator (MTI), which is a proprietary technical indicator that attempts to confirm the onset of bull and bear markets. It is far from perfect, but overall is pretty good. Although the MTI indicated that a new bear market began on June 8, I expected that the S&P would rally up to 1,130-1,150. As the S&P approached the 1,130 level, I sent out a Special Update on August 4, which suggested it was time to sell into strength and become more defensive.

“I think this rally is another opportunity for investors to sell into strength and become more defensive. The market is near at least a short-term high. As long as the S&P holds above 1,080, the uptrend from the July low is still intact. It is possible that the S&P could make a new high above 1,220, as long as selling pressure remains muted. Although this Friday’s jobs report could obviously bring in some selling if it is a disappointment, I don’t see much on the near term horizon that is likely to cause a period of sustained selling. This suggests the market could hold up until Labor Day, and grind higher. The problem for most investors is that when the market turns south, it is likely to come without much warning. That is why selling into strength makes sense, even if the S&P pushes a bit higher in coming weeks.”

Over the next 4 trading days, the S&P tested the 1,130, with highs of 1,126.56, 1,123.06, 1,129.24, and 1,127.16. From the high at 1.127.16 on August 10, the S&P dropped more than 50 points within hours to 1,087.68 on August 12. It is clear that the market made a short term high in early August. More importantly, the Major Trend Indicator gave a sell short signal as of the August 13 close. This suggests that the high just under 1,130 may mark more than just a short term peak. In April, I suggested selling and becoming more defensive, when the S&P was above 1,210. The S&P peaked on April 26 at 1,219.

From a practical sense this sell short signal from the MTI suggests investors should become even more defensive. As discussed in the July 13 letter, and the August 4 Special Update, “The potential for additional gains from current levels is certainly possible. However, if I’m right about the coming economic slowdown in the second half of this year, and especially in 2011, the approaching high in the market should be followed by a nasty decline. If and when the S&P falls below 1,040, the next stop will be 950 or lower.” So this signal could be an indication that this decline has commenced. However, it must be noted that the MTI is not immune from an occasional head fake.

After the market bottomed in September 2001, the MTI gave a bear market buy signal in early October, as noted on the chart above. That rally lasted until January 2002, when the MTI turned down. Although it is not marked on the chart, you can see the decline in the MTI, under 2002 on the S&P chart. This was a sell short signal. The S&P fell until late February, and then launched another bear market rally into late March. The sell short signal in late March 2002 turned out to a great signal, after the head fake signal in January. The same pattern occurred between December 2002 and February 2003, just before the S&P fell into the March 2003 low.

In the very short term, based on a 60-minute S&P chart, a quick drop below last week’s low at 1,076.69 looks like it will complete the first portion of the decline from the high last week at 1,129.24. If correct, the completion of this first leg down should be followed by a rally that retraces at least a portion (35% to 70%) of the decline, and results in an S&P rally back to 1,090 to 1,106.

Just as it seemed like a good idea to sell into strength with the S&P above 1,210 in April, and near 1,130 last week, investors should sell into any rally back toward 1,100. It is certainly possible that the market could hold up until Labor Day. With the election coming up in November, the urge by both parties to say whatever it takes to win could give the market a lift.

And, it is possible that investors will conclude that another round of Quantitative Easing by the Fed is the right medicine for what ails the economy. I don’t agree with that view, and believe it is just a matter of time before investors realize that another round of QE by the Fed is failing to prevent the contraction in credit from continuing. As noted in the July letter, for the first time since 1960, the 12 month growth rate in M3 money supply has not only fallen below zero, it has contracted by -5.6% over the last 12 months. Since peaking in October 2008, total commercial and industrial loans by large banks have plummeted by 24%. The Fed is not planning more QE because the first round was such an overwhelming success. They are doing it because they don’t have any other options.

Aggressive investors can establish short positions, by either buying the short S&P ETF SH or SDS, which will approximate a 200% over time. I would recommend scaling into positions, since there is a good chance of a bounce back toward 1,090-1,100. Conversely, a decline below 1,056 would suggest the rout is on.

Fundamentally, the U.S. economy is fading as forecast. Whether it turns into a double dip is secondary. As the economy slows, concern that it might develop into a double dip should be enough to cause selling pressure to increase. In addition, the EU stress test does not change the fact that European banks are in worse shape than their U.S. counter parts, or that Ireland, Spain, and Portugal are accidents waiting to happen. And, over the next 12 months or so, it is going to become apparent that Chinese banks were too aggressive in lending the equivalent of 25% of China’s GDP in a single year, and there will be losses.

The U.S. consumer represents 70% of U.S. GDP. The next two charts show you everything you need to know about the level of consumer demand in coming months. Without more jobs, consumer spending is going to be weak, which is why retail sales are far weaker than in prior recoveries.

As you can see, other than gasoline sales and car sales, most retail sales categories were negative. Overall retail sales were up .4%, but if gasoline and automobile sales were excluded, sales were down -.1%. It should be noted that the increase in car sales was driven by deep discounting, which suggests that some of the July sales were drawn forward so sales in coming months could be weaker. The chart below shows how the current recovery stacks up to the recoveries following the last four recessions 31 months after each had begun. Thirty-one months after the beginning of the 1973-1974 and 1981-1982 recessions, retail sales were up more than 20%. The 1990-1991 and 2002 recessions were followed by tepid recoveries. Still, retail sales had gained 10% after 31 months. Despite all the fiscal stimulus and Quantitative Easing, retail sales are still down about 4% from 31 months ago. Who knows. By the time the Fed is executing QE3, rather than buying Treasury bonds or mortgage backed securities, the Fed may start buying cars, washing machines, and homes directly from underwater home owners!

DOLLAR

Investors can buy the Dollar bullish ETF UUP on a pullback below $23.80, using $23.35 as a stop.

Jim Welsh

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