The Contrarian Value Advisor
Mid -Third Quarter 2010 Update
The double dip debate continues on Wall Street. Virtually everyone recognizes that the
economy has slowed down, but a majority of investors still believes that a return to
recession will be avoided. It seems many investors are buying into the idea that double
dips are rare. Having been around for the one in the early eighties and witnessing how
easily the economy returned to recession, I find the argument that double dip is rare, a
rather specious argument. Consumer spending is clearly slowing as is housing.
Manufacturing is relatively flat and exports are slowing. The jobs picture is showing no
signs of improvement and in fact, is beginning to deteriorate once again. The massive
fiscal and monetary stimulus of the past eighteen months has seemingly yielded little
more than a temporary bounce, along with some newly paved roads and a whole lot of
new debt. It seems it’s time for the debate to shift away from whether a double dip is
coming, to just how deep the recession will be. I haven’t changed my opinion that a
deflationary meltdown is just ahead.
After experiencing a sharp sell-off in May and June, the stock market spent most of July
in rally mode, retracing about sixty percent of the decline. Ten days ago the market
gapped down and appeared to be rolling over once again. However, sentiment got so
negative, so quickly, that it looks like another relief rally is in store. This rally won’t
likely go as far or last nearly as long as the July rally. I expect something on the order of
three to five percent and expect the market to be heading down again before Labor Day. I
continue to believe we are on the verge of a very dramatic sell-off that will take the
markets down to new lows, well below the March 2009 lows. So while there may be a
few percentage points of upside directly ahead, there is more than fifty percent of risk just
beyond that. My expectation is that the decline will be steep and fast. Investors who are
not yet positioned for this decline should use any remaining strength to prepare for this
next leg of the secular bear market. My targets remain 4000-5000 for the Dow, 500 for
the S&P and 1000 or below for the Nasdaq. There will be few places to hide but
commodities, financials and technology stocks are likely to take the hardest hits.
As I have been saying for a while, the Armageddon scenario that was narrowly avoided
in 2008 is about to return. Policymakers kicked the can down the road. Little has been
done to fix the system despite financial reform and more regulation. The major problem
remains. The system is dramatically overleveraged. It cannot withstand a return to
recession. This excess leverage will turn an ordinary recession into a deflationary
meltdown. Many large financial institutions around the world are likely to fail. The speed
with which this all occurs will overwhelm the policymakers. It is unlikely that they will
be able to cobble together enough support for a TARP II in a timely enough fashion to
avoid financial Armageddon. It was hard enough the first time and there is so much more
resistance to the idea now, both in Washington and within the public at large. I believe in
the next few months we are going to see what happens when you decide that no financial
institution is “too big to fail”.
Needless to say, the U.S. Treasury market has been strong of late. I hear many pundits
calling it a bubble and warning investors away from it. The truth is that the thirty year
Treasury bond is breaking out and just beginning what is likely to be the final leg of the
secular bull market that began nearly thirty years ago. This blow-off leg is likely to
produce some stunning returns as the yield on the thirty year bond falls to 2%. Over and
over we hear that four percent is not an adequate return for tying up your money for thirty
years. This is true in an inflationary or perhaps even a disinflationary environment.
However, in a deflationary environment, such as the one we are about to enter, a 4%
government guaranteed return could be quite compelling. Over the next several months,
the Treasury securities will be one of only a very few assets that will be appreciating
while most markets are plunging. Those trading down the credit curve to investment
grade corporates will pay dearly for their efforts to reach for more yield. Most everything
below government guaranteed paper is going to suffer as spreads widen dramatically. The
municipal market is also likely to come under a lot of pressure as state and local
governments struggle under the weight of declining revenues. This country has not dealt
with deflation for over seventy years and as a result, many investors have a difficult time
comprehending just how devastating and broad-based, the effects of deflation can be. As
I have said before, deflation is not just about declining prices, it is about the involuntary
liquidation of debt and the dislocation of substantial numbers of people from jobs and
homes. The U.S., as well as the world, is about to find out just how devastating deflation
can be.
After bottoming in December, the dollar had a strong six month rally that took it up
twenty percent. It has given back a bit more than fifty percent of that gain in the past two
months. It bounced off its 200 day moving average ten days ago and that may have
marked the end of the correction, although a retest of those lows is likely. Then I believe
we will see a resumption of the dollar rally with the dollar index likely headed for 95 or
perhaps a bit higher. Those still focused on a weak dollar and the implications for
inflation need to realize that this is a scenario for another day. That day is coming but for
the next several months the story is all about dollar strength and deflation. As the global
economy deteriorates, investors will flock to the U.S. dollar for safety. I continue to
expect the Euro and the Yen, as well as the commodity currencies in Canada, Brazil and
Australia to come under significant pressure during the deflationary meltdown.
Gold remains a crowded trade. It is a sign of just how many investors are wrongly
focused on the inflationary implications of the enormous monetary and fiscal stimulus
coming out of Washington. Despite claims to the contrary, gold will not hold up in a
deflationary meltdown. I am among the most bullish analysts on the long-term prospects
for gold and continue to forecast that gold will reach $5000 or higher by 2014. However,
near-term, gold is likely to suffer the same fate as most other commodities in the
upcoming deflationary bust. I continue to forecast that copper will fall below a dollar,
silver decline to $8 and oil decline to $20-$25. My target for gold remains $850 with a
plunge to $600 a possibility in a panic sell-off.
Conclusion
The markets continue to trade in the trading range they have traded in for several months.
There are lots of charts of various markets as well as many individual stocks showing
clear head and shoulder patterns indicative of a top. Many of these top formations have
been building since the beginning of the year. We came close to a breakdown in June but
investors became so negative so quickly that the markets regrouped in July and spent
most of the month in rally mode. Clearly, investors are nervous and it doesn’t take much
to tip them into the bearish camp. Then, as we sell-off, the markets become oversold
rather quickly and we rally back to the top of the trading range. This has been the pattern
for a while and has led many an investor to a more trading-focused strategy. There are
those that will argue that the nervousness among investors will limit the downside risks. I
disagree. At some point, the fundamentals will become negative enough that the oversold
condition will remain oversold and selling will beget more selling. I believe that point is
drawing ever-nearer and the likelihood is that the next sell-off will be the one that breaks
through the bottom of the trading range and takes us into full bear mode. Many stocks
look like they have the potential to decline by fifty to seventy percent in the meltdown
with commodity, financial and technology stocks likely to be among the hardest hit.
I believe we are on the verge of a global collapse the likes of which we have not seen in
the post World War II era. It is the result of fifty years of overspending and massive
leveraging that has reached its limits and is now in reverse. Most people want to believe
that it can and will resolve itself in a gradual and manageable way. Unfortunately, the
degree of overleverage and the state of the global economy with all its imbalances argues
for a much more violent and volatile correction of these excesses. Massive involuntary
liquidation seems inevitable. Add in the fact that policymakers are pursuing policies that
in many cases exacerbate the problems and you can easily get to a financial Armageddon
scenario. What the ultimate catalyst will be that finally tips this thing is impossible to
know for certain. There is no shortage of candidates, both economic and geopolitical. It
won’t take much to send things into a deflationary meltdown, given the precarious nature
of the financial system. A financial panic of historic proportions is very near at hand.
Investors need to understand that we didn’t put the Armageddon scenario in the rearview
mirror in 2008. We simply postponed it. I expect we will revisit it before this year is out
and this time we won’t have the tools or the resolve to prevent it. As that reality hits,
panic will set in.
David A. Hunter, CFA
Chief Market Strategy
KCCI, Ltd.
(888) 267-9101
dhunter@kccidirect.com
August 18, 2010