Market comments for January 5, 2009

As we begin 2009, I know many of you are encouraged by the rally that we've seen over the past several days. While the markets are showing some signs of improvement, most of it is based upon an optimism that is emerging about the Obama administration taking over the government. While overall I believe that the markets will continue to improve over the next quarter, the longer-term outlook is still quite dismal.

I continue to see the disturbing similarities between this crisis and the great depression, as both were triggered by bursting massive debt and speculative bubbles. While it appears that the Federal Reserve has done everything he can to save the economy, the opposite is true as they made many of the same mistakes that were made in 1929.

The ironic thing about this situation is that Ben Bernanke wrote his thesis on the great depression. However, his key mistake which he has admitted to recently, is that he under estimated the impact and the magnitude of the subprime crisis on the liquidity of the banking system. Because of this error, he basically took on the same tactics that was taken on in 1929, which was to add massive liquidity through overnight and term repurchase agreements.

The problem with this tactic is that each time liquidity is added; when the banking institutions pay back the repurchase agreement they have to give back more than received, due to the overnight interest rate. So, this gradually takes liquidity out of the system making the situation worse rather than improving the conditions as it was intended.

So in hindsight, the fed was actually draining liquidity rather than adding liquidity. To add insult to injury the magnitude of this operation grew until the point where we saw massive failures in the banking system. It was at this time that Bernanke and his associates at the fed realized their error. But these errors were not realized until major systemic issues had been caused by their actions. This set the tone for the next several bank failures that will keep things negative for the next several years as it turns out.

While it all started with Bear Stearns it was accelerated with the failure of Lehman Brothers!

If you look at just about any chart and look at September 15, 2008 (the date of the Lehman Brothers failure) you will see at this point is where all the systemic issues really became obvious.

In my opinion, the fed or the treasury department did not fully anticipate the magnitude of the failure of Lehman Brothers. The unfortunate part of this story is it appears they did not have any purchaser that could step in to bail out or to merge with Lehman due to their size like they did with Bear Stearns. Instead, they were focused on the situation at AIG which appeared to be even larger so decisions were made to bailout AIG.

The reason why I'm discussing these past events is because they have shaped our future. The systemic risk that began in September is long from being over. The best analogy would it is half time in a game that were losing 50 to 0; just before we return to the game for a further flogging in the second half.

In looking at the current economic situation, I see the following; housing prices continuing to decline, the commercial banking system remaining locked up, more bailouts of major corporations, and rising unemployment to 12% or greater. Not to mention, that the federal government will have to finance up to $2 trillion in 2009.

In the first part of this crisis we witnessed the mass destruction of capital, the banking system and several major corporations. We also saw the failure of confidence which was the primary driver behind the lack of liquidity. With banks and other institutions not willing to take on any risk by lending, it has further locked up the economy and placed market sentiment at its lowest level in 70 years. This will perpetuate further economic declines in the months and years to come.

In looking back on the last several days, the market has rallied 8% since the lows of December 23. Most of these gains came after the tax loss selling was completed. There are some seasonal tendencies for the market to be strong right at the end of the year, as well into the first week of the year. It is believed as the first week goes so does the month of January and therefore the year. So, it will be interesting to see how we complete this first full week. As I discussed in my last report, I expected the market to remain in a trading range for the last two weeks of the year. The market did remain within a trading range until last two sessions where we saw a sharp rally to penetrate and close above recent highs.

My expectations for the markets continue to be positive throughout the first quarter. It appears that the market has rendered a minor bottom, and therefore, prices are likely to stay in a sideways pattern, but trade with an upward bias for the next 2 to 3 months. There are cautions however, as it is likely that the market will remain in a very emotional state suggesting that volatility will remain high and we will see the market trading to the extremes to the upside and then back to the downside, continuing the spirit of choppy the pattern that has been unfolding for the past 11 weeks.

As I mentioned earlier, I continue to expect to see housing prices decline over the next several months. The Case Shiller home price index showed an 18% drop year-over-year in October and I do not see any improvement in the market moving forward. It is unlikely, as some reports have suggested, that the first-time home buyers will bail us out of this situation

When you look at the current situation closely if the subprime failures are $2 trillion, the first thing that will need to be done is that those homes will need to be purchased refinanced to eliminate that asset off the books of the banks. Estimates that I have seen suggest, that just to bailout the subprime mortgages alone will be 5 trillion dollars.

With all of the bailout scenarios for other corporations in the insurance industry and banks etc. there is little hope that there will be adequate money available for government financing, mortgage financing and corporate financing. This suggests that the credit crunch will be a very long-lived situation, which I currently can find no exit point or any solution that will get the capital in the system to move the economy forward and get it growing again. As I said before, the proposed stimulus plan is not likely to have any impact on the real issues in the economy.

However, market participants will continue to believe that most of the carnage in the economy has been discounted by the market. While this may appear to be correct, for the time being, I expect a massive wave of negative economic news to hit in the first quarter. Further, it is not likely that the really bad news will show up until the second or third quarters of next year. This is contrary to most reports that you hear as many economists are expecting that the markets will improve by the second or third quarters of this year. Once again, it is my opinion that the magnitude of the liquidity crisis is being under estimated. The appetite for capital is going to be huge, and I expect that at some point the markets will compete with the government for the money driving interest rates much higher. This event most likely will not happen until the second and third quarters of this year. It's

One of the big stories that has been unfolding over the last couple of weeks is the crises at the auto makers. As you are aware General Motors and Chrysler have received funding. Also GMAC has been approved to be a bank holding company which now gives them access to the TARP funds, which they have already received $6 billion. However, I expect that we will still see layoffs in the second and third quarter of this year by the automakers, as it is obvious that the business models are currently running do not work with the current employment level. They will need to make massive adjustments to make the business models work especially in an economy that is contracting.

The big issues in the U.S. economy are the deleveraging by the banking system which has triggered further economic issues in other sectors of the economy. Currently, nobody is buying anything other than what they need. The market sentiment has deteriorated to the point that no one is buying cars, furniture or any other durable goods.

This places the economy at further risk and there are currently reports that there will be somewhere between 75,000 to 100,000 storefronts closed in the first six months of 2009. These closures will not be mom-and-pop shops that major players such as Home Depot, Lowe's, Kmart and all the other retailers that are out there as the economy continues to contract over the next 4 to 6 quarters. The estimates are for approximately 600,000 people to be laid off. This surge in closings and unemployment combined with lack of activity will spread further into the manufacturing and other sectors before the contraction is finalized. I don't see a bottom of this particular economic cycle until sometime second maybe third quarter of 2010.

The realities are in America in 2009, we don't need to have two of anything! We don't need Best Buy and Circuit City, we don't need Home Depot and Lowe's, and we don't need Sears Kmart or Target. The contraction in the retail area alone will be brutal as consumers continue to pullback as the uncertainty of jobs and the economy will continue to unfold.

The banking system is likely the contract further as well in 2009. I expect it there will be somewhere between 100 and 150 banks closed this year. This number is likely to accelerate should some of the events that I discussed above occur. This suggests that the FDIC and other government agencies will be stressed even further. Most of these failures will be the second tier of the banking system such as, Community Banks and other smaller regional banks that are continuing under pressure as the lack of business activity is affecting them across the board.

The week ahead is likely to be very volatile as we have international risk with the situation in the Gaza Strip. This could end up to be a very volatile situation changing the landscape nearly overnight. So, while the current patterns suggest the market is likely to remain stable there is still plenty of news around to generate anxiety and volatility

While we've started the New Year, and it's nice to see positive numbers on the sheets, unfortunately, it's more like a do-over or using an Etch-a-Sketch after you've messed up a project. it's easy just to start over... as that is the one of the nice things about new year.

All my hopes are for a better year, but it appears that there is much work to solve the issues of the economy and move things forward. I do believe that there will be several tradable rallies over the next 12 to 18 months. The current rally is likely to last through the first quarter suggesting that there will be many opportunities, most of them in individual stocks versus indexing/ETF or mutual funds.

Index	Started Week	Ended Week	Change	% Change	YTD %
DJIA	8515.55	9034.69	519.14	6.1	2.9
Nasdaq	1530.24	1632.21	101.97	6.7	3.5
S & P 500	872.80	931.80	59.00	6.8	3.2
Russell 2000	476.77	505.82	29.05	6.1	1.3

 

From a technical viewpoint: looking back at the last couple weeks, the configuration that has unfolded has continued in the sideways pattern. The close at 931.80 on Friday suggests that the market is trading in the upward C-wave. This suggests that the market will unfold in one of two configurations. First the length of this C-wave will be equal to the A-wave. The A-wave was 155 points in length and if you measure from the low at 857.40 this would suggest the market will move toward a target price of 1012.40/1028.90. The second configuration suggests this sequence would only 61.8% of the length of the first A-wave, suggesting that the length of this way would be 95 points, which projects prices to the 961.90/976.35 levels.

The configuration further suggests that today's action will be the eighth day of the pattern. This suggests there is a 70% probability for a high to be rendered today, if the 938.60 level is not penetrated over the next two sessions. A failure to close higher today will also suggest, that the market will set up a minor decline toward the 894.55/874.65 levels. However, if a close is rendered above 938.60 then the market will extend the gains of this sequence toward the 961.90/976.35 level before a high of this particular sequence will be completed.

S & P 500	Support		Resistance
1	925.60	935.90
2	921.05	938.60*
3	916.50	943.65
Extreme	907.35*	951.40

*key pivot points

Expect a flat to lower open with a 60 percent probability for a higher close today.

The intermediate charts suggest that a minor low is in place and that a rally over the next 6 to 8 weeks one unfold toward a minimum of 1012.40/1028.90 levels. The longer-term pattern suggest that the configuration that is likely to unfold over the next 12 to 16 weeks will be an upward (A., B., C., X., A., B., C.,) pattern, which will be complex in nature. This suggests that a very choppy sideways pattern will unfold with an upward bias.

During these types of configurations most of the opportunity that will be available will be in individual stocks and not in mutual funds or ETF's. However, depending on the magnitude of this rally, there could be an opportunity in ETF's and mutual funds. The extreme target for this pattern suggest there is about a 40% probability for a rally toward the 1096/1138 levels.

A rally of this magnitude would be playable on all levels of the markets, both from indexing viewpoint as well as individual stocks. However, the configuration on a longer-term basis suggests that there is still a 60% probability for a new low in this sequence. The target for the downside of this sequence would be 660/585 levels. Based upon the configuration, this type of event would not occur until the second or third quarters of this year.

The current configuration suggests that this pattern will remain intact as long as the market remains above the 805 level. So, this suggests that the pattern for the market to trade in will be 805/1038 for most of this quarter.

The short-term VPM models have issued 912 new buys versus 192 exits or a positive ratio of 4.75 to 1. The bullish percent is up to 80.86 this is a very overbought condition. However, in reviewing the short-term models on VPM in the research area, you will see that 100% of the sectors are long and 96.08% of the groups are long illustrating a very bullish short-term outlook. Most of the sector and group indices in VPM on a short-term basis are only about one half way through their normal holding period, but they have exceeded their normal expected return. This suggests that the market is vulnerable to a pullback at these levels.

The intermediate VPM models have issued 847 new buys versus 85 exits or a positive ratio of 9.96 to 1. This brings the bullish percent to 15.11. I discussed several weeks ago that the current configuration of the database suggest that we would see approximately 1500 to 2500 new buys come out over the next several weeks.

VPM's intermediate models have been that buyers for the last four weeks. While the market is getting some traction here we are a long way from signaling new sustainable uptrend. In fact, the market still remains in a major downward trend, even though the expectations for the next quarter are positive. The ratio on the intermediate models would have to rise above 42% to signal a new uptrend.

I currently have no expectations for the market to get that bullish to signal such an event. I expect should the quarter stays positive, as I have suggested in this report, that many of the VPM portfolio's will not be invested greater than 50% at any point any time.