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Thursday, 9 September 2010

Why the Furious Bear Will Come Back

Simon Maierhofer

The Top Ten List has become a staple of David Letterman's Late Show. We don't quite have the space to discuss ten reasons why the bear market isn't over (if we did, we'd probably put you to sleep), but we'll take a crack at a Top Five List. Without further ado, here it is:

#1: Forget About Earnings

Using past earnings numbers to project future performance is like basing your Roulette bet on the numbers that won previously. Old numbers simply don't have the crystal-ball-like properties needed to foretell the future.

Just because last quarters earnings were good, doesn't mean the balance of 2010 will be good. In fact, there is reason to believe that the next earnings season won't be so rosy.

Retail sales, which make up about one third of the economy, fell in May and June. This can't be good for future profits. Additionally, the expectation that taxes will go up might have moved some companies to pull some of next year's income into this year.

Even if earnings continue to rise, the January and April earnings season have shown that stocks (NYSEArca: VTI - News) can drop significantly despite great earnings (see chart below).

#2: Budget Deficits

The 2011 U.S. deficit projection for 2011 was raised from $1.2 trillion to $1.4 trillion. How much is one trillion? For $1 trillion, you buy 40,000,000 VW Jettas at a price tag of $25,000 each. You could buy 5,574,136 houses at the median price tag for existing single-family homes ($179,400). You could buy the star power of LeBron James for the next 50,000 years. You could pay the annual salaries of all 535 members of the Congress for the next 10,742 years, or the annual salary of 14.7 million teachers.

Every entity deals differently with budget deficits. The state of California, a state with a $1.8 trillion economy, is planning to cut state workers salary. As many as 200,000 state workers could be reduced to receive minimum wage salaries. It doesn't take an economics Professor to determine how bad that will be for the economy.

#3: Banks - Nothing but Fluff

Back in 2008, the ETF Profit Strategy Newsletter considered financials a 'downward spiral with no stop-loss provision' and recommended to short the financial sector via the Direxion Daily Financial Bear 3x Shares (NYSEArca: FAZ - News). Even though nothing had changed fundamentally, the newsletter recommended covering all shorts on March 2nd and going long the financial sector (NYSEArca: XLF - News).

The 2009 rally in financial stocks (NYSEArca: IYF - News) and the broad market was largely perception driven and relieved the deeply oversold condition created by the 55% 2007 - 2009 sell off. Fundamentally, however, nothing had changed.

In September 2008, President Bush said: 'The house of cards was much bigger and started to stretch beyond Wall Street. When one card started to go, we worried about the whole deck going down.'

The government postponed the collapse of the 'whole deck' thus far. As of recent, however, some disturbing information has surfaced. Bank of America admitted to hiding bad assets and Goldman's 82% profit drop shows that the days of fat trading profits - such as seen in Q3 and Q4 2009 and Q1 2010 - are over.

For right now, banks (NYSEArca: KBE - News) have found a new way to 'turn profits.' Banks are cutting their provisions for bad debts. Yes, at a time when 1 out of 4 Americans have a sub-600 FICO score, banks are dipping into their reserves to cover bad loans and reporting it as profit. Banks have reduced their loan loss reserves between 23% and 73%. It doesn't take an economist to know that taking money from your savings account and transferring it to your checking account can't be counted as income.

#4 Real Estate

In late July, the market allegedly rallied because new home sales jumped 24% to 330,000 units in June. We feel the urge to put this number into perspective. May sales were revised from an original 300,000 units to 267,000 units - this is an all-time low.

Bouncing off from the lowest level on record, new home sales did indeed increase 24%. Is that reason to celebrate though? Chances are the 330,000 will be revised lower in the future. Regardless, 330,000 homes sold pales in comparison to the 1.4 million homes sold in 2005.

The U.S. Census Bureau reported that the number of vacant properties, including foreclosures, residences for sale and vacation homes, reached 18.9 million. It shouldn't be too long before those bleak fundamentals are reflected in the performance of real estate ETFs like the iShares DJ US Real Estate ETF (NYSEArca: IYR - News) and SPDR DJ REIT ETF (NYSEArca: RWR - News). The UltraShort Real Estate ProShares (NYSEArca: SRS - News) is one of the few ETFs that benefit from falling real estate prices.

#5: Consumer Confidence

During periods of economic expanse the Conference Board's Consumer Confidence Index has averaged a reading above 100. Recessions average a reading of 71. The current confidence reading is at a dismal 50.4. The chart below paints this sad picture.

Consumer spending is said to make up about three quarters of the economy. How can the economy recover without participation by the consumer? It can't. That doesn't mean stocks can't rally temporarily. Such a disconnect between the economy and Wall Street's dream world tends to be short-lived.

Sentiment Confusion

It is important to distinguish between consumer sentiment and investor sentiment. Consumers are the engine of the economy. When consumers are negative and don't consume, corporate profits fall.

Investor sentiment moves with the stock market. If stocks are up, sentiment turns positive. If stocks are down, sentiment turns negative. We have seen this scenario play out a few times in recent years.

In 2000, extreme optimism sent the Nasdaq (Nasdaq: ^IXIC) and technology sector (NYSEArca: XLK - News) down as much as 82%. In 2007, extreme optimism sent the financial sector spiraling by 85%. The S&P 500 (SNP: ^GSPC) and Dow (DJI: ^DJI) dropped more than 50%.

Just as pessimism soared to the highest level in years, even decades, and investors started to throw in the towel, the ETF Profit Strategy Newsletter issued a strong buy signal on March 2, 2009. From there on, the major indexes rallied relentlessly for over a year.

This rally didn't go unnoticed, in fact by April 2010, optimism had reached another crescendo. By many measures, optimism surrounding the April highs was more extreme than in 2000 or 2007.

The ETF Profit Strategy Newsletter warned that 'the message conveyed by the composite bullishness is unmistakably bearish. The pieces are in place for a major decline.' The ensuing decline reduced the major indexes by nearly 20%.

More importantly though, the optimism surrounding the April highs is indicative of a major market top, a top that implies a decline much deeper than the 20% we've seen thus far. This conclusion is certainly supported by the above-mentioned Top Five list and many other indicators.

To many, the market's performance seems random. There are, however, many patterns and indicators (such as sentiment) that can help investors to significantly increase their odds of profiting.

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