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Tharp's Thoughts 

Market Update for September

Market Condition: Quiet Bear

by
Van K. Tharp, Ph.D.

I always say that people do not trade the markets, they trade their beliefs about the markets. In that same way I'd like to just point out that these updates reflect my beliefs. If my beliefs and your beliefs are not the same, then you may not find them useful.  I find the market update information useful for my trading, so I do the work each month and I'm happy to share that information with my readers. 

However, if your beliefs are not similar to mine, then this information may not be useful to you. Thus, if you are inclined to do some sort of intellectual exercise to prove one of my beliefs wrong, simply remember that everyone can usually find lots of evidence to support their beliefs and refute others. Just simply know that I admit that these are my beliefs and that your beliefs might be different.

These monthly updates are in the first issue of Tharp�s Thoughts each month. This allows us to get the closing month�s data. These updates cover 1) the market condition (first mentioned in the April 30 edition of Tharp�s Thoughts), 2) the five week status on each of the major stock U.S. stock market indices, 3) our four star inflation-deflation model, 4) tracking the dollar, and 5) the five strongest and weakest areas of the overall market.

Part I: Market Commentary

We may be looking at decisions made by Paulson and Bernanke that are worse than any made during the Great Depression. Neither of our presidential candidates seems to have a clue what is going on, or at least they won�t comment on it. The only person who speaks up is Ron Paul, who says Paulson and Bernanke should both go to jail. Ron Paul, of course, has been totally dismissed by the media and the American public. 

First, let�s go back to where it all started. Here�s an excerpt from a New York Times article on Sept 30th, 1999 by Steven Holmes.

�In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders. 

The action, which will begin as a pilot program involving 24 banks in 15 markets -- including the New York metropolitan region -- will encourage those banks to extend home mortgages to individuals whose credit is generally not good enough to qualify for conventional loans. Fannie Mae officials say they hope to make it a nationwide program by next spring. 

Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits. 

In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980s. 

''From the perspective of many people, including me, this is another thrift industry growing up around us,'' said Peter Wallison a resident fellow at the American Enterprise Institute. ''If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.'' 

Well, the whole thing failed, and we are now paying for the consequences of this action. Here is what has happened in the month of September 2008 � a month that could go down in infamy in U.S. economic history. My interpretation of some of these events could be wrong. It is a very complex situation! However, I don�t think my interpretation of the ramifications of the situation is wrong. I think the only reason we haven�t had a much bigger crash in the U.S. stock market is due to the fact that most mutual funds have to be nearly 100% invested.

• The U.S. Government takes over 79% of Freddy Mac and Fannie May, costing taxpayers about $200 billion immediately and making the possibility of foreign governments buying U.S. agency debt a thing of the past. China, for example, lost huge amounts in its investment in the two �FMs.� By the way, $200 billion is the cost of the latest debt that the two FMs have coming due. The long term cost will be much, much higher.
  
• Lehman Brothers, a 158-year-old investment bank is allowed to fail, and the ramifications of the derivative positions held by the bank no longer having a backer shakes the world�s financial system.
  
• AIG, a huge insurer that has insured a large portion of the CDOs, is taken over by the government, not because they really failed but because the price speculators were willing to pay for the CDOs had fallen so far that AIG didn�t have the cash to back it up. Now it�s a U.S. taxpayer problem.
  
• Washington Mutual is taken over by J.P. Morgan because its failure would have cost the FDIC 2/3rds of its reserves. It is the largest bank failure in the history of the United States. 
  
• When Bank of America took over Merrill Lynch, the Fed suspended a long standing rule that a bank�s deposits could not be used to back investment banking deals. So Bank of America depositors, your money was used to buy Merrill Lynch even though you don�t have any extra assets. Be careful with your money because this is an unprecedented rule change. Some bond holder could claim the money in your account if Bank of America is not careful.
  
• With three of the five huge investment banks in America failing (Bear Stearns, Merrill Lynch, and Lehman Brothers), the remaining two investments banks (Goldman Sachs and Morgan Stanley) are allowed to convert to regular bank status and collect deposits.
  
• Short selling in financial institutions has been banned, which basically benefits people who have made huge financial mistakes. However, the government can change the rules of the game any time it wants. Remember that�the government can change the rules!
  
• Hank Paulson proposes a $700 billion bailout of financial institutions. My understanding is that the government could take over much of the junk paper around (at the discretion of the Secretary of the Treasury) at full face value (not at its current junk value). Bernanke said in testimony to the Senate Banking Committee, �If the Treasury bids for and then buys assets at a price close to the hold-to-maturity price, there will be substantial benefits.� The plan was to take these over at full face value but to give the taxpayers �an equity stake� (i.e., the lowest stake on the totem pole of who gets paid in a crisis of the companies for which it buys junk at face value).
  
• We�ve had a huge withdrawal of money from money market funds, and some funds have gone below the magic $1 mark, meaning customers have gotten less than they put into the account. The withdrawal has prompted the U.S. government to consider adding FDIC insurance to money market funds. But in the meantime, most short term loans come out of such money market funds and that source of borrowing is now drying up.
  
• GM and Ford will probably fail if the U.S. doesn�t bail them out to the tune of another $50 billion. But both companies have pension plans that could bankrupt them at some time in the future.
  
• The House of Representatives failed to pass the bill with 2/3rds of the Republicans voting against it. Hmm, a Republican administration proposed the bill. The Republican presidential candidate said it was his duty to make sure it was passed. That's not a lot of co-ordination in the Republican party. And the Republicans, of course, are blaming the Democrats who actually did vote in favor of the bill. Interesting logic! And the Dow Jones Industrials immediately went down 777.68 points and then was up 485.21 the next day. So what�s next?
  
• And when I asked that question, I learned that Wachovia�s assets were being bought out by Citigroup in a fire sale that was announced on Monday. In addition, the governments of Belgium, the Netherlands and Luxembourg moved to partly nationalize Belgian-Dutch group Fortis NV, and German lender Hypo Real Estate Holding AG secured a credit line from the German government. 

Henry Paulson, the Secretary of the Treasury, is the former CEO of Goldman Sachs, which stands to benefit hugely from the bailout. He received a huge severance pay when he left Goldman and is currently worth about $500 million. At the beginning of 2008 he was worth about $800 million so I would think he is paying attention as his net worth drops. The $700 billion bailout originally contained a clause in Section 8 that claimed unlimited powers for Paulson. It said, �Decisions by the Secretary (of Treasury) pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.� However, at least Congress was smart enough to remove that clause from the bill it considered and then failed to pass. 

By the way, 25% of all U.S. banks were hurt by the government takeover of Freddie Mac and Fannie Mae. While the total amount lost was only about $15 billion, 85% of those banks have a very small net worth and that kind of loss is quite serious. Can you remember when a billion dollars seemed like a lot of money? Now hundreds of billions of dollars of shareholder value are being wiped out overnight in major banks and insurance companies.

Also remember that in March 2007, the U.S. Federal Reserve published a study that said the U.S. was bankrupt with $67 trillion in debt, including future off-the-books obligations. I believe that study is still available on the St. Louis Fed web site. However, the off-the-books debt now amounts to well over $100 trillion with all the current happenings. And, in my opinion, that could double before this crisis is over. At $67 trillion the remedies for saving the U.S. from bankruptcy include adding a 30% government tax on consumption and cutting discretionary spending by 50%. Those were not politically acceptable, so everyone in power has avoided the issue. But what are the remedies now? 

There are two fundamental problems today and neither is the toxic mortgage debt. The first problem is failing financial institutions. The government failed to recognize the domino effect the failure of Lehman and AIG would have on the rest of the economy. When these two massive giants collapsed, there was no one around to assume their part of the risk in their derivative positions and this affects all, if not most, financial institutions. Remember the derivative problem is massive. J.P. Morgan, for example, has $93 trillion in derivative exposure and no one (I repeat, no one) knows what that really means or what could happen if it unwinds.

Second, we are a borrowing society and financial institutions are afraid to lend money right now. This in turn impacts every business that needs to periodically borrow money to keep its business running. That�s why cash is king.

The bailout program, which is a resort of last measure, fails to recognize these two core issues. And $700 billion is just the tip of the iceberg. When Lehman failed, Freddie Mac and Fannie Mae�s failed, and AIG�s failed (just to name a few), it all became a government problem � the lender of last resort. And at that point, the whole system was at risk. Major company problems suddenly were no longer company problems. Instead, it all transformed into a global financial inferno, because there was no one to hold up their end (i.e., Lehman and AIG) of the derivative risk. The result is that we now have massive systemic risk. Remember $700 billion is just the tip of the iceberg because the derivative exposure is so massive. If J.P. Morgan were to fail, the government would basically have a $100 trillion problem.

Part II: The Current Stock Market Type Is Quiet Bear
(But It Really Is a Volatile Bear)

I have now substituted my new market type for the 1-2-3 model. The reason I�ve done that is that as soon at the 1-2-3 model goes below a certain PE ratio (which it is poised to do) another component will turn bullish. However, I expect us to be in a secular bear market until the PE ratios of the S&P 500 reach single digits. Thus, the 1-2-3 doesn�t really fit my current beliefs. For those of you who are still interested, it is in red light�a very bright red light.

While I think my method of measuring volatility works most of the time, it doesn�t seem to be working now. We�re having wild daily swings that are cancelling each other making the market seem quiet. I suspect our market type is really volatile bear, but finding that out for sure will have to wait until we update our models to include the average true range.

Notice that throughout the year, we�ve only had two weeks that we labeled bullish and they, in my opinion, were abnormalities. So now let�s look at what the market has done during the month of September. 

All three indices are down in the month of September�all at losses of greater than 20% for the year. Can you remember when defined benefit pension plans assumed that their retirement plans would go up at least 10% per year? How has your pension plan done since 2000? Are you currently listening to Suzy Orman telling you how good the stock market is going to be over the next couple of years? And how much you�ll make if you leave your nest egg in your mutual fund if you don�t need it in the next few years? The problem is what�s better? Treasuries�do you really think so with what�s going on? Money market funds with no insurance? Is your bank safe?

I�m also listing the strongest and weakest areas of the market in this update. The ratings give the most weight to what has happened recently so they can sometimes change rapidly. The relative strength of each component is given in parenthesis. 

Part III: The Strongest and Weakest Market Components

None of the "strongest" are really worth investing in right now. Let me repeat that: none of the strongest components are worth investing in right now. So I didn't list them. You should probably be in cash.

Five weakest components:
1. Austria (9)
2. Belgium (11) 
3. Brazil (14)
4. China (16)
5. Hong Kong (22)

These markets are also very dangerous to short right now. As I said, you should probably be in cash right now.

Part IV: Our Four Star Inflation-Deflation Model

Once again, we are in a credit contraction mode, so it is not the inflationary bear market I once thought we were going to get six or seven years ago. The entire world is experiencing a credit contraction. The world stock markets have lost $19 trillion in capital this year�probably a lot more after the market reaction on Monday. Real estate is crashing worldwide, although I don�t know the total amount. It is very difficult to borrow any money, so that might result in many businesses going bankrupt.

Yes, the Federal Reserve and other central banks are printing money like crazy, but they cannot print it as fast as money is disappearing in the credit crunch. What happens in a credit crunch is that cash is king. Once again, cash is king, but it must be safe. When all of the bankruptcies play out, then money will be printed like crazy to stimulate what�s left of the economy. And at that point, gold is the king. This is my personal opinion.

However, certain entities as they get bailed out (like Goldman Sachs if its former CEO, Paulson, buys out all its bad debt at face value), could be fantastic investments. But can you predict that? The bailout has not happened. And one bad move could wipe out a lot or all of your nest egg. 

So with that in mind, let�s now look at our measure of inflation/deflation.

We�ll now look at the two-month and six-month changes during the last six months to see what our readings have been. Notice that commodities are now down for the year after a huge run-up. 

Our model is clearly showing the credit crunch that is going on and the potential for deflation. Look at the drop in the CRB/CCI and the XLB in September!

Part V: Tracking the Dollar

The Tharp effect on the dollar showed its first contrary indicator that I can remember. The dollar went up almost the entire time I was in Europe. 

We�ve seen a huge sudden rise in the dollar. Why did the dollar rise so much in August to early September? Here is the likely scenario:

• Georgia is aggressive and attacks South Ossetian capital.
  
• Russia responds even more aggressively and attacks Georgia.
  
• The world�s investors react against Russia and there is a massive exodus of money out of the Russian economy and most of it goes into the U.S. dollar.
  
• The Internet is ablaze with rumors that all of this was orchestrated by the Bush administration to strengthen the dollar�at least short term. (The rumors actually occurred, but I have no idea what the intention was. The Internet is a great place to feed misinformation).

However, the dollar started to collapse in September off the highs. Between Sept 11th and the 22nd, the dollar lost about 6% against the Euro, which is a huge negative currency move. On September 18th, the U.S. Fed was forced to do $247 billion in currency swaps with other central banks just in case people wanted to exchange their dollars for other currencies. That amount was raised to $600 billion on Monday. That should not happen if a currency is the world�s reserve currency. And it is nice that it can do that, at least for now. Nevertheless, despite the crashing markets, the dollar is still up on the month.

What you should do?

• Obama has suggesting raising the amount of FDIC insurance. You need to make sure that you have no more cash in banks than the amount of insurance you have. To date, as far as I know, bank failures have not cost any depositors money. The FDIC has not had to pay out any money to depositors, but that�s why banks disappear overnight as they absorb into another bank. However, the change in rules that allows banks to use depositors� money to secure their investments could mean that some bond holders could have first priority over your money.
  
• Money market funds, although not insured, are generally safe. There are a few instances where because of runs, they could only pay depositors 97 cents on the dollar. But that�s not a huge loss.
  
• Watch the stock price of your bank. Wachovia�s price looked awful. However, it was taken over by Citigroup whose price looked much worse until recently.
  
• If you are a value player, be very careful. Classic contrarian, David Dreman, had a huge play in Freddie Mac and Fannie Mae and wiped out about 30% of his fund when the Fed took over 79% of them. And how many people had stock in Wachovia and Washington Mutual and watched their values disappear overnight? 
  
• Develop a game plan and a worst-case contingency plan to help you get through this safely, just as we teach in our Blueprint workshop. I cannot stress the importance of having a worst-case contingency plan under these conditions. The worst thing you can do is listen to CNBC, CNN, or any other news channel for information about what to do. These people do not know and the �talking heads� are full of misinformation.
  
• As I�ve been saying since I wrote Safe Strategies for Financial Freedom, we�re in a secular bear market. Phase II is now waking up from hibernation. This one could last a while. There will be many, many opportunities for those who survive it, but the word now is survival. And expect the entire bear to last at least another 10 years. Remember that we still haven�t seen the effect of the baby boomers getting well into retirement and needing to withdraw their retirement money from the stock market yet. 
  
• Long-term, I would expect the government to default on many of its future contractual obligations. How can it honor over $100 trillion in unfunded future obligations? This is just my opinion, but do you really trust the government? Remember what I said earlier�the government can change the rules any time it wants.

Last month I said that we were experiencing a deflationary credit contraction. September has been disaster after disaster. Let�s hope that next month is much, much better. Until October�s update, this is Van Tharp. 

By the way, if you have questions about what is going on, send them to me. I�ll answer as many as I can (as best I can) in a mid-October issue of Tharp�s Thoughts. Use the feedback form below, or email van@iitm.com.

About Van Tharp: Trading coach, and author, Dr. Van K. Tharp is widely recognized for his best-selling book Trade Your Way to Financial Freedom and his outstanding Peak Performance Home Study program - a highly regarded classic that is suitable for all levels of traders and investors. You can learn more about Van Tharp at www.iitm.com. 

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Trading Tip

More Market Madness

by
D. R. Barton, Jr. 

�Reality: A gang of brutal facts killing a beautiful theory.� �Variation of Thomas Huxley

Short selling bans are stupid, unsupported political plays.

There, I said it.

I don�t often go really far to one side of an issue, but when politicians spend so much time trying to shoot a gnat off of an elephant�s behind, I get kind of cranky.  Especially when the elephant is about to run over some of the things that we hold dear (like free markets, availability of credit, true price discovery, etc.).

The bottom line is that short selling�yes, even naked short selling�had no significant role in the fall of stocks.  In fact, documented arguments are being made that the lack of short selling has made things worse due to reduced liquidity. When you can�t make a two-way market, volume drops.

Take Merrill Lynch (NYSE:MER) for example.  On Monday (9/29) when its shares were tanking along with all of the financial stocks and the broader market (more on this below) the volume traded for the day was 38 million shares�20% fewer shares than its average volume for the last 50 days!!

Before the short selling ban, on a big market moving day like September 12^th and 15^th , MER traded 200 and 250 million shares a day.  Talk about sucking the liquidity OUT of the system at a time when it needs all of the liquidity it can get.

Basically, the short selling has not helped at all.  Despite the ban (or maybe because of  it), when the markets had their big drop on Monday (9/29), the S&P 500 was down 7.8% (as measured by the ETF, SPY).  On the same day with all of that �short selling protection�, financial stocks (as measured by the ETF, XLF) were down 13.2%.  Some protection.  Like wearing a flak jacket made out of Play-Doh.

Yes, the �brutal facts� have killed the �beautiful theory� that if we just stopped all of that �evil� short selling, then the financial stocks would fare better.

Mark Hulbert had an excellent article in the Sunday New York Times about the actual research that has been done on short selling even during this credit contraction. 

One telling fact�while short selling of Lehman was still possible, its stock had a day with the high of $14.15 and a low of $7.79.  The average price for short sales on that day was $9.29�in the bottom quarter of the pricing range.  So shorts weren�t driving the stock down as the �beautiful theories� suggest, but we were hopping on for profits after the move was almost done.  They were using, not causing downward momentum.

As for �naked� short selling (where there are no shares to borrow), the same article tells that before the ban, almost no large financial stocks had naked selling reported (meaning that those stocks did not appear on the �failure to deliver� lists).

But far be it for the politicos or regulators to take a look at the research and the facts.

I believe in the power of free markets.  A ban on short selling just can�t be justified by facts--it can only be justified in trying to find emotional scapegoats.

If we want to add regulation, how about going back to realistic leverage rules?  If firms could not go above 12:1 leverage on the mortgage related investments that proved to be poison, it�s highly likely that few or none of the storied financial institutions that we read about would have failed.  The regulators changing the rules to allow significantly more leverage is the story that is getting far too little play.

But oh, those greedy short sellers let�s get them�swat a few gnats.  Yes they may be greedy, but no more greedy than the buyers who bought these financial stocks and speculative real estate (or a bigger house than they could afford) when they thought real estate prices could only go up.  Okay, I�ll climb down off the soapbox (for now!).

Here are some thoughts on day trading and swing trading in the ultra volatile markets.  For day traders�enjoy!  Wider stops and smaller size is needed, of course, but not just for the volatility.  At important stretch points, prices are exploding up or down when those support and resistance levels are violated.  Slippage in the Russell and the Nasdaq futures in particular are as much as 5 - 10 ticks.  The liquidity of the S&P 500 offers good protection against this.

For swing traders, this volatility is extremely tough to navigate.  Strategies, models and systems have not seen broad market 48 point Average True Range (ATR) readings before.  And even when using ATR based indicators, most intermediate time frame (10 � 20 day) indicators are too slow to respond, causing whipsaws on both the up and down sides.  There is no penalty for standing aside while the smoke clears!  Until next week... 

Great Trading,

D. R.

About D.R. Barton:  A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena.  He is a regularly featured guest on both Report on Business TV, and WTOP News Radio in Washington, D.C., and has been a guest on Bloomberg Radio. His articles have appeared on SmartMoney.com and Financial Advisor magazine. You may contact D.R. at  �drbarton� at �iitm.com�. 

See Ya Next Week

There is plenty of food for thought this week with Van's extra long update. So I'll skip my section and be back next week.

Melita Hunt is the CEO of the Van Tharp Institute and a regular contributor to the weekly newsletter. If you would like to keep up with Melita�s progress regarding her lung cancer (she is a never-smoker), please feel free to read her blog at www.myleftlung.com. You can contact Melita at mel@iitm.com

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