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Signs Of The Times

Bob Hoye
Institutional Advisors
Posted Apr 11, 2008

Last Year:

"Demand For New [innovations] Funds Offers a Chance [for academics] to Test Theories, Make Money"

- Wall Street Journal, April 21, 2007

The article was accompanied by a cartoon of an academic, complete with gown and mortar board hat, riding a bull.

"Hedge Funds are rediscovering the fundamental law of supply and demand: As they rush to sell stock in their funds to the public, they are flooding the market."

- Wall Street Journal, April 23, 2007

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This Year:

"Above The Subprime Fray, Canadian Western Bank Outshines Rivals"

- Calgary Herald, March 21, 2008

As part of the story, CEO Larry Pollock, noted "We were not smart enough to understand that stuff".

"Banks will raise what capital they can, then they will slow down their growth and stop lending, and what should be a mild recession becomes a more serious one."

- William Isaac, FDIC Chairman from 1981 until 1985
-- Bloomberg, April 8, 2008

In the first half of last year, we ran the "Dearth Of Credit" piece by von Mises a few times. The key to the Austrian theories on credit is that the contraction is not caused by bankers calling loans, but just becoming a little concerned and stopping aggressive lending. The rest follows, and the comments by Isaac suggest banking conditions are well along the usual path.

* * * * *

Stock Markets: In reviewing our comments from the January 24 edition, there were some not-bad calls. We noted that our expectation of an important low being set in late January was working out and that shorts could cover and traders could take a long position on the general market. Rebounds amounting to around 50% of the losses were possible.

The count on the Nasdaq decline was interesting as it set a classic 55-trading-day crash, that in some examples marked the end of a fabulous bull market. That was the bottom week of that hit and our January 31 edition called for the rally to run for some 6 to 8 weeks, which counts out to around now. Also expected were a few "bad news" hits, but generally by around now "the street could conclude that 'brilliant' policy has ended the disquiet and the recession has been cancelled".

These "fundamental" expectations also seem to be working out. What's next?

First of all, is the market up when it should be? - Yes. How sound is the technical action? - Not good, as A/Ds and buying power have not been robust.

While the rally is not sensationally overbought, the momentum things on the SPX are at levels reached on the last few rallies. The overall stock market is again vulnerable to the next phase of contracting liquidity as well as news of banking calamities suffered in the past few months, but not yet reported.

On the nearer-term, our March 13 edition concluded that the Bear Stearns Panic was a test of the January low and that the rebound could run for a few weeks. This fit with our goal of a rebound until around now.

As of yesterday, and signaled by slumping financial stocks (LEH), the market seems to be faltering. The other interesting feature is that the coal sector (BTU) and rails (BNI) seemed to run out of steam at the same time.

Over the past week, spreads and the yield curve were quiet, so the slump seems due to internal deterioration.

Sector Comment: Readers know our long condemnation of the banks, which goes back to our "Sell" of last July and that it applied to "Widows and Orphans" as well.

On the rebound out of the January trashing, we expected a 50% retrace on the BKX and that was accomplished in only two weeks at 96 on the index of banks stocks. We have been bearish since and last week noted that our Bank Trading Guide was on the "Sell". This reached a high in early March that also had an RSI at above 85 and typically the high for the BKX is set within the next 3 weeks, or by late March. The key high was 86.5 on April 1. The key comment was on March 27 and that was to sell aggressively.

Base metal miners were also expected to rally out to a seasonal high in March. And as we noted last week on the SPTMN, there is overhead resistance at the 858 level set a few weeks ago. So far the mining index has reached 867 yesterday.

Our policy in this sector is to buy on weakness in the last part of the year and to sell on seasonal strength around now.


The Long Bond: This week, former Fed chairman Paul Volker, said that conditions were similar to the 1970s. Inflation, a dollar crisis, and a lot of concern. What definitely is not part of that lamentable condition was that long-dated treasuries were on their way to a record high of 15 per cent, as the bill rate soared to over 16%.

Instead, long rates have been hanging around 4.35%, with the bill yield at 1.38%. Obviously, the Greenspan "Conundrum" is still on.

Fortunately, there has been an explanation. All of the great financial bubbles since the outstanding example of 1873 were followed by very dramatic declines in short-dated market rates of interest. In the order of 500 bps to 600 bps. Of course, the senior central bank has always followed with a sensational series of cuts in administered rates.

This time around, the post-2000 decline in short rates to around 1 per cent was leveraged into the greatest credit bubble in history. With this, any asset class was bid up and leveraged. All bonds were bid up as well, but the long treasury is the only bond sector that is still in play. In the last week it has recovered from 117.40 to 119.42.

Regrettably and implacably, overall credit is probably contracting faster than central banks can create their portion. This was the case during the post-1929 period when the Fed was flushing up liquidity by buying bonds out of the market. And The Economist observed, in late 1929, that Fed policy was "benign". The problem was that the Fed was trying, but the contraction overwhelmed every effort - mainly because global credit markets are vastly bigger than all the central banks put together.

Again the long bond is on a rally and it will likely be turned away at the 121 level. Getting beyond 122 would be a surprise. At some point, further deterioration in liquidity will prompt offside accounts to dump long treasuries.

As mentioned above, over the past week there has been little change in spreads or the curve.

The Dollar Index: According to Ross, the DX is on the path to an important low. Two weeks ago we noted that it had to decline further on the test of the 70.70 low. So far the low is the 71.42 reached earlier today.

Also, as noted last week the dynamics of the long decline have registered a "Downside Capitulation" on the weekly, which has shown a number of reliable readings. This condition can last for a few weeks before an intermediate rally gets underway.

This summarizes the key dynamics and another item used at important lows is the "Sequential Buy" pattern. This is in play and all that is needed now is weakness into tomorrow.

The dollar index is poised for a rally and the "sequential' could be the "Goldilocks" confirmation for a significant move.

The Canadian Dollar has been expected to weaken, based upon widening U S corporate spreads and weakening commodities.

Since December, it has traded between 97 and 102+. The latest decline has been from 99.80 last week to 97.88. This is within a decline from almost 103 that is setting a series of lower highs. New lows within 6 to 8 weeks seem possible.

Miscellaneous: Over the past five weeks the Baltic index has plunged from the rebound high of 8560 to 7619 on March 25. Since then it has recovered to 7760.

Back in January, our view on stock and commodity markets as well as the Baltic, was that the "good times" would run into March -- maybe April. Within a few weeks these could be heading down.

Grains have continued the rebound after the slaughter of the wheat spike. Rice has been the leader in accomplishing outstanding gains as well as the rare incitement of riots. Although involving a different staple, in the distant past "peasant bread riots" typically marked the end of a huge bull market in grains.

Once again, this is within a move for commodities likely to run into March - April.

In late February, the grains as represented by Goldman's GKX index, reached a rare "Upside Exhaustion" reading. The action topped out at 513 at that time and plunged to 405 at the first of April. The rebound has made it to 446. There is resistance at 450 and the season for strength is soon coming to an end.

With this, Ag stocks have revived with Potash making new highs. It is time to start selling again.


Energy Prices: Crude oil gave a rare "Upside Exhaustion" reading in early March, from which the reversal could have occurred within a week. This was the case as the high was 110.35 on March 17 and the initial decline made it to 98.65.

We were looking for the test and it made it to 108.22 and then slipped to 99.50 on April 1. Last week we noted that declining through this would set the downtrend. But, the continuous contract has soared to 110.19 at yesterday's close. The May contract reached 112, which seems to be in a squeeze.

Oil stocks are not making new highs. The XOI set the high at 1581 at the end of the year and plunged to 1212 with the January crisis. The main rebound made it to 1472 at the end of February and the March financial crisis took it down to 1292.

The action now seems to be a big test of the 1472 and so far it made it to 1432 yesterday. From the January low to the recent high, daily momentum has recorded quite a recovery.

The oil patch is again vulnerable to problems in the banking patch.

Last week's view on natural gas was that more gains were possible as it usually has its seasonal high well after the one for crude. So far, the high has been 10.36 set in mid March. The first drop with crude was to 8.75 with the March crisis. The next high was 10.21 at the end of March and it has been churning around since.

There is a possibility that natgas could get up to a seasonal high over the next 6 weeks or so, but the action has been vulnerable to financial hits, as well as to the pending recovery in the dollar.

As advised last week, natgas stocks should be sold.

Base Metal Prices: Usually, we play the metals for a seasonal high around March. Sometime the seasonal can run later, but we should consider that our index, which had declined from 811 in October to 605 in December has soared to 828 in early March. This compares to the high of 826 back in July.

The initial decline from the March high was to 731 at the end of March, and the recovery has been to 779. Following a similar pattern, Goldman's metal index has recovered to 496 and a little above neutral momentum.

Base metal prices could trade at current levels for a week or so, but in recovering within our time frame are vulnerable to the next financial crisis and pending strength in the dollar.

Gold Sector: The high-profile GFMS research group has issued advice that while gold could reach 1100, it could fall to 600 next year.

Their reasons are that global jewellery sales could drop, and as GFMS states this demand is "the cornerstone of the gold market and makes up more than half of global demand". Their other concern is that US interest rates will be rising such that altogether "The whole basket of drivers will unwind".

It is worth noting what happens in your typical post-bubble contraction, which is what a rational researcher would expect on this one. Jewellery consumption that was fueled by the boom will decline significantly, which was the case in the post-1929 example. But, this was more than offset by the increase in investment demand for gold, which is another feature of a post-bubble contraction.

Another salient feature of a post-bubble contraction is that real long-dated interest rates soar. Typically, this is a combination of the nominal rates going up as the rate of consumer-price inflation turns down--eventually to less than 0 per cent.

Gold has its best innings during the first few years of a post-bubble bust, and then with some cyclical correction can eventually recover its purchasing power over a much longer period. In so many words, the real price has enjoyed a significant increase - as real interest rates have soared - on six out of six great post-bubble contractions.

It seems that the orthodox gold crowd is still handicapping itself with inadequate research.

On the near term, the dollar index is close to turning up, and the latest zoom in commodities is getting overdone within the time window for a top.

On the metals, the rally was likely to run with the silver/gold ratio rising and when this reversed, the top for both silver and gold would occur within two weeks. That was the case, for example, in January, 1980. This time around, the ratio reversed on March 6 and the high for both was on March 17. An intermediate decline for both is underway and silver has been expected to be weaker than gold.

The low for the gold/silver ratio was 46.2 at the turn, and now it's at 51.7. No big move but it is in the right direction and the new trend has been set. The gold/silver ratio always goes up during a post-bubble contraction.

Another feature of the reversal in the ratio is that, typically, some 2 months later senior gold share indexes can be down at least 20 per cent.

Our advice through February was to sell the seniors and to eventually buy smaller caps when opportunity arrived. We are not there yet. The advice was to play the short side on silver stocks.

Gold's behaviour through the ugly course of a post-bubble contraction has been consistent. The real price has had a significant increase during the first few years following the climax of a mania. From the 1720 example to the sixth one in 2000 there have been no exceptions.

On the financial side, this has been accompanied by a steepening yield curve, widening credit spreads - and soaring real long interest rates. Including the usual mob of distraught policymakers, this is working out so closely to previous examples that it is tempting to call it "Rational De-exuberance".

-Bob Hoye
Institutional Advisors


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The opinions in this report are solely those of the author. The information herein was obtained from various sources; however we do not guarantee its accuracy or completeness. This research report is prepared for general circulation and is circulated for general information only. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized.

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