October 28, 2009
The Dollar Index
I have previously written about the dollar index as the one parameter holding the fate of most markets. The reason is that the dollar is the currency with the lowest financing costs and as such it is acting as the world's primary carry trade source. During the last half year the dollar's fall has been announced so firmly that it now is taken for truth. In the long term it may be the case, but in the shorter perspective I believe that the dollar has one last moment in the spotlights before its fall, due to the great carry trade Ponzi scheme. Since the market is certain of the dollars demise, and the low cost of borrowing dollars, huge amounts of dollars have been changed to EUR, GBP, SEK, CAD, AUD etc and invested in bonds, stocks and commodities. The result is that we have an all the same market where only the dollar falls and everything else rise. As long as the dollar fell this all worked fine and was fueled by even more carry trading. However, such an environment is extremely sensitive for set-backs, and I believe that we will have one now. The reverse may be rapid since the dual leverage in terms of both currency and investment appreciation that were working to the investors advantage previously now is reversed.
Above is the fundamental analysis of why the dollar should appreciate. I use Elliott Wave analysis for timing. In the above chart I show the Dollar Index for October. The yellow wedge is one of the most accurate patterns indicating a turn, and I only show one in the smallest time frame - there are several wedges all on different time frames. The strong change in direction indicates the change in trend, supported by the Elliott count. The count implies that we will have a Minute wave 1 finished anytime soon. This will be followed by a retraction to the 75.67-76.13 level which will serve as an excellent entry point for anyone interested in going long the dollar.
October 23, 2009
Fundamental analysis of the rally
I have tried to gather my points as to why the present rally is not sustainable. I chose not to be specific about what rally I refer to for the simple reason that we are dealing with an all the same market, possibly with the exception for gold and silver. In other words, what goes for stocks also goes for commodities and most currencies in relation to the US dollar. Knowing the facts is particularly important since the opinion that the crisis is over is nowadays used as a circular evidence for the crisis being over.
The Baltic Dry Index representing shipping freight rates is still slumping, see figure (courtesy of Bloomberg). With respect to this there are several images floating around the internet illustrating the shipping problems.
The banking industry is still bankrupt. The main reason why the banks have recovered is that they have stopped using mark to market accounting rules and have rid some of their toxic debt at central banks. For example, EU banks have an exposure to Eastern Europe of staggering US$ 1.6 trillions. In many aspects European banks are far worse off than their US counterparts, since European banks in addition also have a substantial exposure to the US housing market.
A fair amount of the GDP growth that has been reported over the last couple of months is government inflicted. As such it can be considered nothing else than borrowing from the future. In terms of car and housing purchases it will become all too obvious in the very near future.
Unemployment rates are still rising, and the rates will most likely not start to fall for another year or even more. Since fewer people have a job and those who have a job realize the likelihood of keeping it is reduced even people with a job are less inclined to spend what they earn. This is actually a good thing since the heart of the matter is a credit bubble and the only way to solve the problems is for people to start spending less and saving more. Frugality is the new normal.
China has been presented as the savior of the world. This week China reported a GDP growth of 9% which is taken as proof of the strong Chines economy. The only problem is that the Chinese central bank is printing money at an annual rate of 25%! In that perspective a 9% GDP growth is sub-par.
PE ratios are at their extremes. For S&P 500 the PE ratio is at 28 for operative earnings and 140 on reported earnings after write-offs! For the Swedish Large Caps the operative PE for 2009 is 22 and for 2010 it is 26.
All in all, disregarding any technical analysis, to me this indicates that the risk in the stock market is significantly higher than the possible rewards of being long. Can the current trend continue? Yes. Can it continue for long? I highly doubt it.
The Baltic Dry Index representing shipping freight rates is still slumping, see figure (courtesy of Bloomberg). With respect to this there are several images floating around the internet illustrating the shipping problems.
The banking industry is still bankrupt. The main reason why the banks have recovered is that they have stopped using mark to market accounting rules and have rid some of their toxic debt at central banks. For example, EU banks have an exposure to Eastern Europe of staggering US$ 1.6 trillions. In many aspects European banks are far worse off than their US counterparts, since European banks in addition also have a substantial exposure to the US housing market.
A fair amount of the GDP growth that has been reported over the last couple of months is government inflicted. As such it can be considered nothing else than borrowing from the future. In terms of car and housing purchases it will become all too obvious in the very near future.
Unemployment rates are still rising, and the rates will most likely not start to fall for another year or even more. Since fewer people have a job and those who have a job realize the likelihood of keeping it is reduced even people with a job are less inclined to spend what they earn. This is actually a good thing since the heart of the matter is a credit bubble and the only way to solve the problems is for people to start spending less and saving more. Frugality is the new normal.
China has been presented as the savior of the world. This week China reported a GDP growth of 9% which is taken as proof of the strong Chines economy. The only problem is that the Chinese central bank is printing money at an annual rate of 25%! In that perspective a 9% GDP growth is sub-par.
PE ratios are at their extremes. For S&P 500 the PE ratio is at 28 for operative earnings and 140 on reported earnings after write-offs! For the Swedish Large Caps the operative PE for 2009 is 22 and for 2010 it is 26.
All in all, disregarding any technical analysis, to me this indicates that the risk in the stock market is significantly higher than the possible rewards of being long. Can the current trend continue? Yes. Can it continue for long? I highly doubt it.
October 16, 2009
Dollar Index
The Elliott analysis in the above plots shows that both on a long and short term the count is at a probable low. Today it has reached above its bottom from September 23, invalidating several alternative counts. Furthermore, yesterday's activity didn't manage to fall below its previous low implying a change. Combined with a clear three wave pattern down this looks very much like the beginning waves i and ii in a larger trend upwards.
Another reason for a change in decrease of the dollar is that almost no-one is expecting it. Some time ago there was reported 3% dollar bulls, the remainder being bears. With 3% potential buyers and 97% potential sellers, I don't see how the price will be able to continue downwards.
October 12, 2009
Fractional Reserve Banking and Deflation
In order to understand the present credit crisis (that's correct, the crisis is far from over) it is necessary to understand fractional reserve banking. This is a principle that is unknown to most people and is also the root cause of our present problems.
The present banking system (and it works the same way all over the globe) requires banks to keep only a fraction of their clients deposit. The rest of the deposits they are free to lend to others. The Swedish regulatory reserve requirement for banks is 8%, in the US it is 10%. Mathematically, it is possible to show using an infinite geometrical sum that the money supply increases by (1-0.08)/0.08 = 11.5, that is an increase by 11.5 times the original money supply! This is not so much a financial problem as a moral one since it makes money lose its value, and it works quite well as long as people pay their mortgage and credit card debts. But what happens when someone has taken on too much debt and is unable to pay it back? This is money that the bank assumed it had so it is accounted to its full value in the bank's balance sheet. In a bankruptcy the lender must write down some or all of the mortgage. What is worse, since the bank needs to maintain its reserve requirements of 8%, it now has to reduce its outstanding debt by another 11.5 times the failed loan value. The reason for this is that the failed loan of course is taken from the bank's reserves. In other words, a failed loan of 1000 SEK results in a reduced money supply of 1000 SEK + 11 500 SEK = 12 500 SEK. Considering that both consumer and corporate debt has risen for a long time, this was an accident waiting to happen. The larger the debt, the more likely some of it will fail and when sufficiently much of it does it will ripple throughout the whole economy. A debt that took decades to build up will take several years to unwind.
There is a moral aspect of fractional reserve banking too that is easily explained by an example: Assume you have a valuable painting. In order to keep it safe, you hand the painting over to a painting storage who is allowed to put it on display in return for storing it. However, what this person does in addition to displaying your painting, is to make 11 copies of it. For the sake of argument the copies are identical to your original. The copies are then sold to others who are not aware that they are copies. In a couple of years, you watch an ad in the paper that your painting is sold to a significantly lower price from what you bought it for. If you knew in advance, would you still use the same the painting storage? This is essentially what happens in a fractional reserve banking system, and most people still happily deposit their money in banks! In any other case apart from banking this would be considered as fraud.
The present banking system (and it works the same way all over the globe) requires banks to keep only a fraction of their clients deposit. The rest of the deposits they are free to lend to others. The Swedish regulatory reserve requirement for banks is 8%, in the US it is 10%. Mathematically, it is possible to show using an infinite geometrical sum that the money supply increases by (1-0.08)/0.08 = 11.5, that is an increase by 11.5 times the original money supply! This is not so much a financial problem as a moral one since it makes money lose its value, and it works quite well as long as people pay their mortgage and credit card debts. But what happens when someone has taken on too much debt and is unable to pay it back? This is money that the bank assumed it had so it is accounted to its full value in the bank's balance sheet. In a bankruptcy the lender must write down some or all of the mortgage. What is worse, since the bank needs to maintain its reserve requirements of 8%, it now has to reduce its outstanding debt by another 11.5 times the failed loan value. The reason for this is that the failed loan of course is taken from the bank's reserves. In other words, a failed loan of 1000 SEK results in a reduced money supply of 1000 SEK + 11 500 SEK = 12 500 SEK. Considering that both consumer and corporate debt has risen for a long time, this was an accident waiting to happen. The larger the debt, the more likely some of it will fail and when sufficiently much of it does it will ripple throughout the whole economy. A debt that took decades to build up will take several years to unwind.
There is a moral aspect of fractional reserve banking too that is easily explained by an example: Assume you have a valuable painting. In order to keep it safe, you hand the painting over to a painting storage who is allowed to put it on display in return for storing it. However, what this person does in addition to displaying your painting, is to make 11 copies of it. For the sake of argument the copies are identical to your original. The copies are then sold to others who are not aware that they are copies. In a couple of years, you watch an ad in the paper that your painting is sold to a significantly lower price from what you bought it for. If you knew in advance, would you still use the same the painting storage? This is essentially what happens in a fractional reserve banking system, and most people still happily deposit their money in banks! In any other case apart from banking this would be considered as fraud.
October 08, 2009
Latvia vs Sweden
Lately the Swedish government has expressed strong opinions about the Latvian budget, more specifically the reductions in its planned spending cuts. Latvia is way over its head in debt, both its government and its citizens.Most of that debt is provided by Swedish banks, in particular Swedbank and SEB.
Last Monday MarketWatch wrote that Reuters reported that Latvia Prime Minister Valdis Dombrovskis had asked the state chancellery legal department to prepare amendments that would limit a borrower's "liability to a lender connected with the purchase of a sole home is limited to the value of the collateral" rather than the value of the entire loan. In other words, if house prices falls no-one would have to pay a rents on a mortgage that is larger than the present value of the house.
These kinds of populist ideas always have unforeseen effects that the person presenting them always disregard. If I as a lender can't trust the government in the country where I lend my money to defend my property, the risk for me increases and for that I want compensation by charging higher interest rates. In economics terms this represents a shift upwards in the supply curve, i.e, the supply of money at a certain price (interest rate) decreases.
A professor of mine once said that Some people God punishes immediately, although in a completely different context. In Latvia's case the punishment came after two days when Latvia received no bids for one of three government debt securities it tried to sell at an auction, the NASDAQ OMX Riga exchange said as reported by MarketWatch. A further consequence is that even more auctions will be canceled since they were depending to the failed one.
If you are our of your own money and you can't attract money there is really only one thing to do and that is start printing new ones. I think Latvia will be forced to leave its peg to the Euro and with failed debt auctions it may be sooner rather than later.
Last Monday MarketWatch wrote that Reuters reported that Latvia Prime Minister Valdis Dombrovskis had asked the state chancellery legal department to prepare amendments that would limit a borrower's "liability to a lender connected with the purchase of a sole home is limited to the value of the collateral" rather than the value of the entire loan. In other words, if house prices falls no-one would have to pay a rents on a mortgage that is larger than the present value of the house.
These kinds of populist ideas always have unforeseen effects that the person presenting them always disregard. If I as a lender can't trust the government in the country where I lend my money to defend my property, the risk for me increases and for that I want compensation by charging higher interest rates. In economics terms this represents a shift upwards in the supply curve, i.e, the supply of money at a certain price (interest rate) decreases.
A professor of mine once said that Some people God punishes immediately, although in a completely different context. In Latvia's case the punishment came after two days when Latvia received no bids for one of three government debt securities it tried to sell at an auction, the NASDAQ OMX Riga exchange said as reported by MarketWatch. A further consequence is that even more auctions will be canceled since they were depending to the failed one.
If you are our of your own money and you can't attract money there is really only one thing to do and that is start printing new ones. I think Latvia will be forced to leave its peg to the Euro and with failed debt auctions it may be sooner rather than later.
October 02, 2009
High Yield Bonds plunge
One parameter that is crucial for the direction of the markets is the cost of borrowing for companies. One suitable proxy for this is the iShares High Yield Corporate Bond ETF (HYG) that is traded on NYSE. Although not annotated in terms of Elliott waves the above picture presents what is the single largest one day drop since March. The drop in HYG yesterday implies higher interest rates for companies that need to borrow and is a break of confidence from their lenders.
October 01, 2009
USD/SEK - The Big Picture
The main reason for why the Swedish stock market bottomed in November 2008 instead of March 2009 when e.g. DJIA and S&P 500 bottomed is the USD/SEK exchange rate. In the 3 quarters spanning July '08 to March '09 the krona depreciated by approximately 50%. Consequently, including currency effects, SWE30 could be seen to have bottomed in early March 2009 instead of November 2008. Nevertheless, also the krona stands at a crossroads judging by the Elliott wave pattern it is exhibiting. A brief recapitulation of the USD/SEK ratio in the new millennium shows that following the dotcom bubble the krona has apreciated significantly until April 2008. It is also evident that it is a 3 wave reactionary move. From mid 2008 until March 2009 an impulse like Primary wave <1> followed, in turn followed by a corrective, three waves Primary wave <2>. At present it is of particular interest to identify the ending pattern in Intermediary wave (C) since it may be an ending diagonal (orange lines). Ending diagonals usually promise swift reversals at least to the start of the diagonal, in this case the end of Intermediary wave (B). Taking into consideration that the following wave is Primary wave <3>, a long term target is significantly above <1>.
As can be seen in the plot above, the Elliott wave pattern shows that the bottom of Primary wave <2> is finished and that the krona will depreciate severely from this point forward. Similarly as for SWE30, it is a Primary wave <3> that may be in its initial stage so buckle up for a rough ride!
The reason why I use USD/SEK instead of EUR/SEK is that the two plots are essentially presenting the same pattern, but since Sweden can be considered to be like Europe x 1.5 in relation to the US, I believe USD/SEK will present the clearest Elliot wave pattern and also the best trading opportunities.
OMX Stockholm 30 - The Big Picture
When is the best time to initialize a blog focusing on the stock market? Of course it is before a major unexpected move in order to be able to say "I told you so!" and be able to prove it! My aim is to present Elliott wave analysis. A reasonable first posting would be to briefly describe Elliott wave analysis. However, no need to reinvent the wheel and for that reason I refer the Elliott wave novice to any of the excellent tutorials that exist at www.elliottwave.com.
Having relieved myself of a detailed description of the underlying theory, let's jump right to an example. Below the daily graph of the OMX Stockholm 30 index, or SWE30 as I will denote it. The plot displays data from the Cycle degree wave b in summer 2007 to present day. From b, SWE30 declined until November 2008. I have annotated the decline according to Elliott wave as Primary wave <1>. Each Primary wave is partitioned into Intermediary waves (1)-(5) and each Intermediary wave is partitioned into Minor waves 1-5 as can be seen in the plot. From November and onwards SWE30 has moved first upwards in wave (A), then sideways in wave (B) and from March 2009 solidly upwards in wave (C).
What is so interesting with this plot is the position in the Elliott count that we are at right now at what appears to be a major shift in the trend. Elliott waves are by no means bullet proof, but a means to identify the most likely continuation of an existing pattern. Right now that most likely continuation, according to the presented count, is downwards. Furthermore, an Elliott wave practitioner knows that wave 3 is most often the most dramatic wave with the largest move. On a scale as high as Primary wave <3> it is definitely not a time to be long in any stock.
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