This Week’s Commentary – September 8, 2007 – Down, Then Up

by JDH on September 8, 2007

As we start the third quarter of what for most of us has not been a great investing year, I see two possibilities for the market from here.

First, it is possible that the correction or consolidation ended on August 16. That day was the bottom, and while there may be some bumps along the road, it’s onward and upward from here. This appears to be the position taken by our friend Mr. Dines, who issued an Interim Warning Bulletin on Friday around 1:00 pm saying that August 16 was the bottom, so start buying. (I’m paraphrasing, of course. If you want to read his exact words, and see his recommendations, you will have to subscribe. Click the link on the right hand side of this page for more details).

Here are my thoughts on Mr. Dines:

First, as of Saturday morning at 10:00 am Eastern time I have yet to receive my copy. I heard about the contents from a friend of mine who is also a subscriber. I also received my last issue of The Dines Letter, that was issued on Friday, on Sunday afternoon, and then I got three copies. It would appear that the concepts of the “internet” and “e-mail” are baffling to Mr. Dines’ organization. This worries me, since he proudly calls himself “The Original Internet Bug”. I assume Mr. Dines has better things to do than read my silly ramblings on this blog, but if he is a reader, I invite him to go to the Forum and send me a message; I’d be happy to walk him through the basics of e-mail.

Second, I don’t agree with him, and apparently neither do most of his subscribers. He recommended buying a large number of stocks in his IWB, which in the past has always sent the stocks immediately sharply higher. On Friday, it didn’t. A few were higher, but many were lower. It would appear that Mr. Dines is no longer able to move the market as he has been able to do in the past. (Of course it is also possible that, like me, many of his subscribers didn’t get the e-mail).

I suspect that many of his readers have lost faith in the Old Master. His favorite stock, PNP.TO – Pinetree Capital Ltd., (which he has touted in numerous media appearances so I’m not giving away any secrets here) has been in the portfolio for a long time. It was rated a buy back on April 10, 2007 when it hit $16.15. It was still in the portfolio on August 16 when it fell to $3.50, and remains in the today, closing Friday at $4.76. I think his readers are disappointed that the guy who proclaims himself the “Father of Visual Analysis” and the proponent of watching a “trend in motion” and “Don’t Think, Look” was unable to see a trend: a stock fell 78% in 128 days and he didn’t notice. That’s not exactly the kind of thing that inspires confidence.

(Yes, yes I know. If you bought the stock back on September 7 last year at $4.53 and sold it on September 7, 2007 at the close at $4.76 you would have earned 5% on your investment for the year, so I guess that’s not too bad).

I don’t agree with Mr. Dines, and that brings us to the second possibility for the market going forward: we ain’t done yet.

I personally hold to the view that there will be more down than up over the next month or two or three. Here’s my thinking, for your consideration and comment:

First, in most corrections I have studied, there is a capitulation down day, followed by a bounce, followed by a retest of the lows before the market finally moves higher. I have no idea if August 16 was the bottom (ask me in a year and I’ll tell you for sure), but regardless past history would indicate that we will probably go back down before we resume the upward trend.

Second, it is my policy on this site to speak in plain English; I try to avoid technical jargon simply for the purpose of making me look smart. However, sometimes technical jargon is necessary, so, in the language of the market strategists: the economy sucks.

We all now know what the phrase “subprime” means. (George Orwell must be rolling over in his grave. If the prime rate is 5%, a subprime loan would have an interest rate of, say, 8%, so shouldn’t they be called “way-over-prime” loans?) Most subprime loans are adjustable rate mortgages. Many of them are in default. Interest rates increase, so borrowers can’t make their mortgage payments, so the bank forecloses and sells the house. When lots of houses are being sold, that drives house prices down. Which means that there is less incentive for new homes to be built. So the construction market slows down. Unemployment increases, as announced in some scary new job creation statistics this week. As unemployment increases, people have less money to spend. They sell houses, which drives the cycle down further.

If people are buying less, company earnings fall. As banks write off loans, they have less to lend. They stop lending to risky customers, which leads to further reduced borrowing power, and therefore even worse economic performance.

Ultimately the stock market is driven by expectations of future earnings, and at the moment it is difficult to believe that earnings in most sectors will be increasing. Hence, the market continues to fall.

Even worse, it takes time for the market to become aware of defaults in these questionable loans. Everyone doesn’t default on the same day. The only reasonable expectation at this point is that there are more defaults to come. Way more. As we find out more bad news, big one day drops on the market will happen. It’s inevitable, unless you believe that all of the problems are behind us. I don’t.

We are now experiencing a rush to liquidity. Share prices fall, so you sell whatever you have left to cover your margin requirements. The selling drives prices lower, which prompts more selling. Everything gets hit, as we have seen with our uranium and precious metals shares.

Where does this end?

At the bottom, obviously. Where the bottom is is anyone’s guess. August 16 may have been the bottom. If those levels hold, then later this month, or more likely sometime in October or November, it will be time to resume buying. Given the economy’s macro problems, it is just as possible that there will be more blood on the streets before the bottom is reached.

So What Do We Do?

First, LOOK. Let’s stop thinking for a minute, and just LOOK. Take a look at the chart of the price of uranium on the right hand side of this page. Does it LOOK like the price is going up? No, it LOOKS like it’s going down. The sensible approach is to wait to see if the $90 level holds before we start buying again.

Second, if I’m correct and September is more likely to be a down than an up month, there is no real point in having a lot of shares in the portfolio. For that reason, I spent this week doing a lot of selling. Every uptick this week was an excuse for me to sell.

As of today I am now sitting 79% in cash.

Yes, you read that right. I am almost 80% in cash at the moment.

If August 16 was the bottom, “cashing up” will prove to be one of my great investing blunders. I know what you are thinking: “What an idiot. He holds all the way down, and then sells out right at the bottom. Classic mass psychology. Now is the time to buy, not to sell.” I may be wrong, but so what?

As I just laid out, I think volatility is the order of the day, so if I am wrong, there will be many opportunities for me to get back in. Also, does anyone honestly believe that once a bottom is made stocks will just shoot up in a straight line? It’s never happened before.

Given the massive uncertainties surrounding the market, I have no problem sitting on cash at the moment.

If my premise is correct, there are, however, some investments worth considering. First, gold.

gold.JPG

If you LOOK at the gold chart you will see that the price of gold is going UP. (For you novices, up is the direction we like).

This makes sense. Back in 2000 the internet stock market bubble burst, so we all took our money and invested in real estate. The mortgage industry was only too happy to lend, and thus the subprime mess was born. In 2007 the real estate bubble is now bursting, so now we sell our real estate, but what do we do with our money? We can’t put it in the stock market because it’s going down. So where do we park it that will be safe? Gold, the historical store of value.

$700 was a major resistance level, but we have not yet reached the $728 high reached in May of 2006. I therefore believe that while the long term trend for gold is obviously up, we will probably hit some resistance before we see $730. Also, the RSI (see chart) is also hitting historically high levels, so a pullback is likely from these levels.

Therefore, I think gold and gold shares will be a great investment in a few weeks time, as gold makes its final run for the top. But not yet. Let’s let the pressure die down first.

For reference purposes, here is the chart of ABX.TO – Barrick Gold Corp.

Barrick

As you can see, Barrick is approaching it’s multi-year high, but the RSI and Money Flow Index are also at high levels, so I suspect a pullback from these levels is likely. Let’s keep some cash handy, and see if we can’t pick up Barrick closer to the $32 level.

Another Option

Of course if I believe the market will be choppy to the downside, the other option is to short, or buy puts.

Personally, I never short. If I short a stock, and the stock goes to zero, the most I can make is 100%. I prefer to have more upside than that.

However, buying puts on a stock can return more than that in a collapse. The problem with options, of course, is the time value of money. An option is a rapidly depreciating asset, sot he drop will need to come quickly.

I’m not prepared to start buying puts yet, and if I did it would only be with a very small portion of my cash. However, potential candidates for buying puts would include anything to do with real estate (home builders, suppliers), the mortgage industry (mortgage lenders, mortgage insurers) or mutual fund companies and managers (if the market falls and people sell their mutual funds, they have less assets under management, so their earnings drop). I’m not an expert in any of those areas, so I will do some research, but don’t plan to take any action for now.

The sun is shining so that’s enough for today. I suspect many of you now believe that I am crazy, so please feel free to post your rebuttals on the Buy High Sell Higher Forum.

{ 1 comment… read it below or add one }

gadge78 September 8, 2007 at 12:49 pm

agreed that dines hasn’t made good calls lately… but i’m not sure he has lost his power. the dow was down 250 points… pretty impressive. u stocks didn’t really go down… he could have had something to do with that…

who knows…