From the August 01, 2008 issue of Futures Magazine • Subscribe!

Post card from the edge

The Dow Jones Industrial Average kicked off the third quarter by officially entering bear territory, dropping to 11,296, on July 1, a 20% decline from its Oct. 9, 2007 high of 14,165 (see “It’s official”). The S&P 500 followed a week later. In the background, the U.S. economic slowdown grinds on, with first quarter real gross domestic product (GDP) coming in at a meager 1%, the unemployment rate rising to 5.5% and consumer confidence circling the bowl at its lowest point since 1980. The third quarter forecast for equity indexes is, in a word, bleak.

“We are still heading lower,” says Andrew Waldock, principal of Commodity and Derivative Advisors LLC. “There are too many negative factors to hold a rally. Most open interest is on the short side by commercial traders,” and every time the S&P trades above its 200-day moving average, professional traders are selling.

Sentiment has become aggressively negative, notes Addison Wiggin, executive publisher of research firm Agora Financial. “Energy stocks have been the only ones keeping the Dow up. The financials and everything else are getting hammered; and they should be. They are losing money. As an investor, you should be selling,” he says.

Even short-term bulls are conflicted and tempering their expectations. Registered investment advisor George Slezak says we are in the final leg up of the 2003 bull market and notes that the broad market is performing much stronger than the Dow.

Independent trader Art Collins was slightly long in late July, but bearish longer term. “It just seems like everything is falling apart,” he says. “The pattern that started in 2001 is not going to play out until 2012,” he says, and near term, the Dow is more likely to hit 10,000 than 15,000.

“The volume is all to the downside,” says Larry Levin, president of Secrets of Traders. He says there are three big issues currently weighing on the equity markets: high commodity prices, international capital flows and current credit conditions. “That three-headed monster is a real reason for people to step out of equities and into futures. But there are not a ton of people willing to buy this stuff and push us into a trend higher any time soon,” he says.


Record high prices for dollar denominated commodities, especially food and energy, are in large part the result of a remarkably weak U.S. dollar. The U.S. dollar index future, which measures the dollar against a basket of currencies, was 0.7267 on July 1, up slightly from 0.7105, its all-time low set on April 21. In addition, the extreme weakness in the U.S. economy is hitting Main Street hard, even as we arguably or narrowly avert the official definition of recession. U.S. consumers face rising unemployment, food and gas prices, and the negative wealth effects from the battered housing market and tight credit.

“While the U.S. economy has slowed, we are not seeing that in the Asian economies,” says Michael J. Zarembski, analyst for optionsXpress Inc. “This is a new dynamic,” and as the United States adjusts to these new higher prices, we are likely to see capital leave equities and chase higher returns in commodities.

Agricultural exports are likely to continue rising, not only due to the declining value of the dollar but because of worldwide shortages of soybeans, corn and wheat and demand driven by China’s newfound appetite for red meat. “This is a genuine issue in tight corn and cattle stocks that fails to get mentioned,” and will continue eating into ending stocks, Waldock says. He is skeptical of U.S. dollar stabilization, and says commodities indicate more dollar weakness. “We could see a rally of 3% to 4% in the U.S. dollar index. If we do, that rally should be sold,” he says.

Slezak is concerned about the potential bursting of what he sees as a “commodity bubble” and a resulting deflationary spiral similar to what Japan experienced in the 1990s after the collapse of the Nikkei/Dow. Japanese capital then sought refuge in real estate; that bubble burst and led the country to its decades-long deflationary economy. The Commitment of Traders (COT) report shows open interest in crude oil futures has increased to 1.35 million contracts from 500,000 contracts in 2002 due to investment interest. He says if the market returns to 500,000, a huge supply would hit the market, resulting in plummeting prices.

“This is going to be a world-wide unwinding,” he says, adding that crude could fall to $20 per barrel, gold to $300 per ounce and the Dow to 9,000.


Despite recent stirrings, the U.S. dollar remains anemic. While this has offered some benefit for large cap exporters and helped the U.S. trade deficit, it also has created opportunities for non-U.S. buyers to snatch up U.S. dollar denominated assets.

“From March to April we have seen a total net outflow from U.S. securities of about $25 billion,” Zarembski says, and at the same time we have seen a rise in non-U.S. purchases of U.S. government debt, which increased to $80 billion in April from $53.62 billion the previous month. “This money can shift on a dime when opportunities exist in other asset classes,” he says, adding the money flowed from securities into government debt at about the same time the heart of the credit crisis was hitting. “We are going to see more of that as money tries to find what’s hot at the moment. There’s a fear factor.”

While those foreign buyers are doing us a favor by helping to stabilize large financial companies, Wiggin says that optimism is misplaced.

“They are expecting the U.S. economy will rebound and they will end up owning a big chunk of it.” However, he also says that it is a bet that assumes other economies won’t supersede that of the United States, that non-U.S. exchanges will continue to be subordinate to U.S. exchanges and the world will continue to price things in dollars. “They are making a big mistake. They should be investing in their own. Saudi Arabia, Abu Dhabi, they should be investing in their own infrastructure,” Wiggin says. “Maybe they just have so much money they can afford to do both!” he laughs.

Even as the beleaguered investment banks invite foreign buyers to shore up the books, Waldock says the process will be long and painful.

“The United States is finding itself the road kill rather than the vulture. We made a killing off the suffering of others for a long time and payback is a bitch,” he says, adding that the financial sector will be among the last to recover and that the dilution of stock, through capital raising and deleveraging near market lows, will draw out their recovery.

The inflation of the housing bubble by low cost and easily available credit and the resulting devastation of the housing market, which is ongoing, continue to have negative implications for credit conditions (see “Recession hurts,” Futures, June 2008).

Wiggin refers to the current situation as a “balance sheet recession,” and notes that the recent spate of Fed fund rate cuts have not filtered down to home buyers. Banks are simply applying the spread to heal their balance sheets and credit conditions for individuals are not likely to ease any time soon. “The number of resets on mortgages, which is a root cause, doesn’t finish until the end of 2008. And the Option Arms, another class of exotic mortgages, will begin resetting in equal numbers in 2009 and go through 2010,” (see “Hell to pay”). “If you just look at the numbers, we are not going to be out of this for a couple years.”

But it appears the credit situation is improving for business. “We are starting to see the spread yields between corporate bonds and Treasuries have narrowed since the crisis in March,” Zarembski says. He believes that while write downs will continue, the worst is over as far as the institutions are concerned but that conditions will remain tight for homeowners.

“A lot will depend on what the market believes the Fed will do the rest of the year,” Zarembski says, adding rates are likely to remain at 2% for the rest of the year. “No one wants to get in the position of raising rates as we get into an election.”


In the next 90 days, Levin expects the Dow to test below 11,000, and for the S&P 500 to test 1257. “All the volume is on the downside. When we move on the upside, it’s short covering and short lived,” Levin says. “The Nasdaq has a little better chance of hanging in there,” he adds, although much rides on the success of Apple’s new high-speed internet enabled iPhone.

“For the next quarter or so we are going to be in a malaise,” Zarembski says, adding that he is expecting range trading for the DJIA between 11,000 and 13,000. The S&P 500 will stay between 1200 and 1450. The Russell 2000 has upside potential to 760, with a low of 680. He says smaller companies and independent energy companies are doing better than most, but not necessarily on their own merits. “If you need liquidity, you move what you can actually sell; and smaller stocks are more difficult to move, so you haven’t seen as much selling in the Russell as you have in larger indices.” The Nasdaq composite, he says, has an upside potential of 2500, with support between 2300 and 2250.

Waldock is looking for more weakness before the fourth quarter. He expects the DJIA to take out the January/March lows and trade between 10,900 and 12,300. The S&P 500 also will take out its lows and trade as low as 1100, with 1350 – 1380 on the high side. The Russell 2000 will test the January/March lows: 630 to 660 and possibly trade up to 750. The Nasdaq is the strongest of the lot and should hold the January/March lows, testing the 1750 to 1775 area with a high of 1950.

“The Dow may not recover,” Slezak says. “The broad market is performing much stronger than the Dow, and because of that, we could get above the October highs on the Nasdaq and the Russell and see the Dow fail to make new highs.” Short term, he expects the Dow to head for 13,500 and for the Nasdaq to put in a high for the year, but after September he expects a protracted decline.

“This is going to be more of a traders’ market,” Zarembski says. “Even though things are going to level off, there are still individual stocks where a wise investor could find opportunities. I would be looking for companies that pay a decent dividend and have been beaten down a little bit.”

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