Trader’s Narrative

Guest post by Robert Prechter

The following article is an excerpt from Robert Prechter’s Elliott Wave Theorist. For more information from Robert Prechter on bank safety, download his free report, Discover the Top 100 Safest U.S. Banks.

Perhaps the single greatest reason for the unbridled expansion of credit over the past 50 years is the existence of the Federal Deposit Insurance Corporation, another government-sponsored enterprise created by Congress. The coming rush of bank failures is an outcome made inevitable the very day that Congress created the FDIC. The reason is that the creation of the FDIC allowed savers to believe that their deposits at banks are “insured” against loss.

But the FDIC is not really an insurance company. No enterprise, absent fraud, could possibly insure all the banking deposits in a nation. Nor does the FDIC do so, despite its claims. The FDIC is like AIG, the company that sold too many credit-default swaps. It contracted for more insurance than it could pay upon. Because depositors believe the sticker on the door of the bank, they have abdicated their responsibility to make sure that their banks’ officers handle their deposits prudently. This abdication allowed banks to lend with impunity for decades until they became saturated with unpayable debts.

Today, most banks are insolvent, and the FDIC is broke. This condition is deflationary for three reasons: (1) Banks are coming to realize that the FDIC cannot bail them out in a systemic crisis, so they have become highly conservative in their lending policies, as described above. (2) The main way that the FDIC gets its money is to dun marginally healthy banks for more “premiums” (meaning transfer payments) to bail out their disastrously run competitors. The more money the FDIC sucks out of marginally healthy banks, the less money those banks have on hand to lend, which is deflationary. (3) The banks that have to cough up all this money will become more impoverished at the margin, so banks that otherwise might have survived a credit crunch will be thrown even closer to the brink of failure. This is another deflationary risk.

A friend of mine whose family owns a bank told me that the FDIC recently raised its 6-month assessment from $17,000 to $600,000. In the FDIC’s latest announcement, it is considering requiring banks to pre-pay three years’ worth of “premiums,” i.e. triple the normal annual fee in a single year. It will be a miracle if the money lasts through 2010. When these funds are gone, the FDIC will have two more options: to issue its own bonds and pressure banks to buy them; and to tap its “credit line” of up to half a trillion dollars with the U.S. Treasury. It’s the same old solution: take on more new debt to back up failing old debt. More debt will not cure the debt crisis.

Meanwhile, the FDIC is contributing to the deflationary trend. It has “tightened rules on required capital levels,” which forces banks’ loan ratios to fall; and it has “extended its extra monitoring of new banks from the first three years of operation to seven years” (AJC, 11/19), meaning that banks will now have to wait four additional years before they can go crazy with loans.

For more information from Robert Prechter on bank safety, download his free report, Discover the Top 100 Safest U.S. Banks. You’ll learn how to find a safe bank, the critical difference between lending and banking, tips on international banking, and more.

Robert Prechter, Chartered Market Technician, is the world’s foremost expert on and proponent of the deflationary scenario. Prechter is the founder and CEO of Elliott Wave International, author of Wall Street best-sellers Conquer the Crash and Elliott Wave Principle and editor of The Elliott Wave Theorist monthly market letter since 1979.

This is a guest post by Wayne Whaley

The markets tend to be in a good mood the week before holidays, since 1950, the S&P 500 is 40-19, up 67.85 of the time during the four day week (including Friday) of Thanksgiving for an average gain of 0.78%

On average, all of those gains come on the two days surrounding Thanksgiving, which are 51-8, up 86.44% for an average gain of 0.80%.

The week after Thanksgiving can be a bit of downer and the markets have a bearish tilt as well, 28-31, up only 47.46% of the time for an average loss of 0.24%

The Turkey trimmings really take their toll on the Monday after Thanksgiving, as it takes the big hit, 24-35, up only 40.68% of the time for an average one day loss of 0.38%.

The last five Monday’s after Thanksgiving have been down, including last year’s (2008) loss of 8.93%.

S&P 500 % Chg for Thanksgiving the Last 20 years:

I couldn’t distinguish a discernible difference in the data in up or down years.

It has been my observation that since these type trading strategies became well documented over the last couple of decades, they tend to be anticipated a day or two. Be careful.

What better way to reliquify the world financial markets than sacrificing a currency?

If you’ll recall this is a well worn script. The last time we had a financial crisis, it was the Yen that was used as the vehicle of choice. Massive amounts of capital were borrowed in Yen and invested in other risky assets with the nudge-wink agreement of central banks that it was a one way trade.

Today it is the US dollar that is being sacrificed at the altar of the new bull market… in everything. Roubini has been among the most vocal to raise the alarm. But almost everyone else has decided to enjoy the trade while it lasts.

Of course, the sensible thing is to realize that you can’t drink yourself sober, just as you can’t dig yourself out of a hole. But since when have monetary policy wonks been fans of reality?

While it is difficult to prove definitively that the US dollar carry trade is the reason almost every single asset class has appreciated, its footprints are hard to miss. Here are David Rosenberg’s recent observations on the correlations across asset classes:

Historically, there is no correlation at all between the DXY index (the U.S. dollar index) and the S&P 500. In the past eight months, that correlation is 90%. Ditto for credit spreads — zero correlation from 1995 to 2008, but now it has surged to 90% since April.

There was historically a 70% inverse correlation between the U.S. dollar and emerging markets, such as the Brazilian Bovespa, and that correlation has also increased to 90% since the spring.

Even the VIX index, which historically has had no better than a 20% correlation with the U.S. dollar, has now sent that correlation surge to 90%. Amazing. The inverse correlations between the U.S. dollar and gold and the U.S. dollar and commodities were always strong, but these too have strengthened and now stand at over 90%.

The scary consequence of the US dollar carry trade is that it has pushed almost all risky assets to be correlated. And when the music stops and someone starts to unwind the trade, it will get ugly. When everything you hold is correlated to each other and everything else in the market, even a small tremor of selling will lead to an avalanche as the value of your portfolio starts to decline all at once.

If you expect gold to be a safe haven, you’ll be sorely disappointed. Historically, gold and gold stocks have never been a stronghold in a severe sell off. So maybe that’s why short term T-Bill rates have been pushed so low.

The big new development today was the huge drop in short term Treasury bond yields. The benchmark 90 day T-Bill rate dropped to 0.005%. These are levels which we last saw just a few months ago when we were in the thick of the credit crisis:

The 30 day T-Bill rate 0.03% which is slightly higher than the double bottom it made in December 2008 and the end of October 2009 at 0.01%. And the 6 months T-Bill rate closed at 0.14% - a low it has seen twice before but is still jaw dropping. They haven’t seen these levels since 1958.

Even more shocking, for some short term government bonds maturing in January 2010 the rate fell to negative. I’m not sure why everyone is suddenly clamoring for US government bonds. Are they afraid that a new shock is coming to the stock market? is there some tragic news that is about to shake global financial market? or are major institutional investors simply afraid that the low interest rate environment and the dollar carry trade will inevitably lead to even more trouble?

And if so, how in the world is investing in US dollar denominated assets and trusting the US government in line with that sort of thinking? Honestly, I’m puzzled.

In any case, this is an important variable which isn’t getting as much attention as it deserves. One aspect of it is that it has an effect on the mutual fund cash level metric which we discussed before.

This is the where the level of cash held by US mutual funds acts as an indicator of market tops and bottoms. Usually it is adjusted to account for interest rates which need to be equalized to iron out the rewards during high interest rates and the punishment for holding cash in low interest rate environments.

While this indicator has been known and followed since it was introduced by Fosback in the 1970’s, I introduced an important improvement on this indicator - an idea that to my knowledge hadn’t been before; to adjust for real rates, not just nominal ones. Adjusting for the effects of deflation/inflation, mutual fund cash levels are actually very low - something which is bearish.

With this recent drop in benchmark rates, this metric drops even further into bearish territory and signals an even brighter red flashing light. And as persevering readers will remember, I cautioned that stocks had little room to the upside when the S&P 500 was at 1098.51 - it peeked above that level and has fallen again. We are now 17% above the long term trend. That’s a slight drop from 19.31% that we saw just a few days ago, but caution is still the watchword.

Since some time has passed since my last call on Canadian REITs, I wanted to review it and update my position on the sector.

If you’re new to the blog you probably missed my comment back in early January: Canadian REIT Review. At that time I mentioned that it was irrational for well capitalized companies like the Canadian REITs to be sold off with the rest of risky assets. Remember, not only are these conservatively leveraged, they are diversified and throw off juicy monthly distributions. Of course, a devastating bear market cares little for value. Almost everything was sold indiscriminately as global investors ran like headless chicken to escape further losses.

In early January when I wrote recommending the attractive value evident in Canadian REITs, RioCan REIT, a commercial REIT I highlighted was trading around $14 a unit:

From there it deteriorated further, making a low of $11.50 in March 2009 - along with the vast majority of risky assets. If you were or smart enough to buy at exact bottom, you would be sitting on a 65% gain right now. But if you bought earlier when I wrote about it, it is still a respectable 36% gain. And that’s not even considering the monthly distributions which would pump the total return to 45%.

RioCan, at the March lows, was yielding an astonishing 12%. Of course, because of the pervasive doom and gloom, even the largest and strongest Canadian REIT was suspect. But RioCan has had no trouble in sustaining its distributions due to its top notch management and its heavily subscribed dividend reinvestment plan that allows it to conserve cash by issuing units instead of cash.

In fact, while the US commercial real estate market is seen as the next shoe to drop, Canadian REITs have recovered nicely and are poised for their role as (benevolent) vultures. Sonshine, the head of RioCan raised $150 million, announced a partnership with Cedar Shopping Centers (CDR). As well, the head of RioCan, Sonshine, has hinted of a major upcoming US purchase in the near future.

So all in all, the situation has reversed in all aspects. Now the news is all good and the stock is zooming higher. And as a result, RioCan is now yield just 7.21%. But while things are seemingly rosy, I’m getting ready to leg out of this position. There are a few reasons for that. First, obviously, is the sentiment which has shifted into full sunshine mode.

Second, the rocket ride higher has pushed RioCan to close 26.16% from its 200 day moving average. This is a simple technical barometer which I use to also analyse the general market but it also works for individual stocks. In the past when RioCan has come this far up into thin air territory, it has been unable to sustain its momentum. The last time prices where this far above its long term trend line was back in early 2007, just as RioCan was topping out at $26.

Finally, basic technical analysis reveals that price is now butting its head against the overhead resistance. What was a zone of support has now become a zone of resistance. And while RioCan could technically rise up to $22 a unit, the chances of that are slim. The same chart formation can be seen in almost all of the REITs in Canada. For example, take a look at Allied Properties (AP_un) or Boardwarlk (BEI_un) or Calloway (CWT_un).

Considering everything, putting new capital to work on the long side or continuing to hold here is not very prudent. The probability is that prices will either meander here as they enter resistance or immediately correct. In either case, the ride is over but it was fun and profitable while it lasted.