Post card from the edge

Futures, Aug 2008 by McMahon, Chris

Depending on whom you speak with, U.S. equity indexes are either at the end of a short-term downward correction or standing on the precipice of an extended repricing. Our experts take a look.

The Dow Jones Industrial Average kicked off the third quarter by officially entering bear territory, dropping to 11,296, on July 1, a 20% decline from its Oct. 9, 2007 high of 14,165 (see "It's official," page 27). The S&P 500 followed a week later. In the background, the U.S. economic slowdown grinds on, with first quarter real gross domestic product (GDP) coming in at a meager 1%, the unemployment rate rising to 5.5% and consumer confidence circling the bowl at its lowest point since 1980. The third quarter forecast for equity indexes is, in a word, bleak.

"We are still heading lower," says Andrew Waldock, principal of Commodity and Derivative Advisors LLC. "There are too many negative factors to hold a rally. Most open interest is on the short side by commercial traders," and every time the S&.P trades above its 200-day moving average, professional traders are selling.

Sentiment has become aggressively negative, notes Addison Wiggin, executive publisher of research firm Agora Financial. "Energy stocks have been the only ones keeping the Dow up. The financials and everything else are getting hammered; and they should be. They are losing money. As an investor, you should be selling," he says.

Even short-term bulls are conflicted and tempering their expectations. Registered investment advisor George Slezak says we are in the final leg up of the 2003 bull market and notes that the broad market is performing much stronger than the Dow.

Independent trader Art Collins was slightly long in late July, but bearish longer term. "It just seems like everything is falling apart," he says. "The pattern that started in 2001 is not going to play out until 2012," he says, and near term, the Dow is more likely to hit 10,000 than 15,000.

"The volume is all to the downside," says Larry Levine, principal of secrets of Traders. He says there are three big issues currently weighing on the equity markets: high commodity prices, international capital flows and current credit conditions. "That three-headed monster is a real reason for people to step out of equities and into futures. But there are not a ton of people willing to buy this stuff and push us into a trend higher any time soon," he says.

COMMODITIES

Record high prices for dollar denominated commodities, especially food and energy, are in large part the result of a remarkably weak U.S. dollar. The U.S. dollar index future, which measures the dollar against a basket of currencies, was 0.7267 on July 1, up slightly from 0.7105, its all-time low set on April 21. In addition, the extreme weakness in the U.S. economy is hitting Main Street hard, even as we arguably or narrowly avert the official definition of recession. U.S. consumers face rising unemployment, food and gas prices, and the negative wealth effects from the battered housing market and tight credit.

"While the U.S. economy has slowed, we are not seeing that in the Asian economies," says Michael J. Zarembski, analyst for optionsXpress Inc. "This is a new dynamic," and as the United States adjusts to these new higher prices, we are likely to see capital leave equities and chase higher returns in commodities.

Agricultural exports are likely to continue rising, not only due to the declining value of the dollar but because of worldwide shortages of soybeans, corn and wheat and demand driven by China's newfound appetite for red meat. "This is a genuine issue in tight com and cattle stocks that fails to get mentioned," and will continue eating into ending stocks, Waldock says. He is skeptical of U.S. dollar stabilization, and says commodities indicate more dollar weakness. "We could see a rally of 3% to 4% in the U.S. dollar index. If we do, that rally should be sold," he says.

Slezak is concerned about the potential bursting of what he sees as a "commodity bubble" and a resulting deflationary spiral similar to what Japan experienced in the 1990s after the collapse of the Nikkei/Dow. Japanese capital then sought refuge in real estate; that bubble burst and led the country to its decades-long deflationary economy. The Commitment of Traders (COT) report shows open interest in crude oil futures has increased to 1.35 million contracts from 500,000 contracts in 2002 due to investment interest. He says if the market returns to 500,000, a huge supply would hit the market, resulting in plummeting prices.

"This is going to be a world-wide unwinding," he says, adding that crude could fall to $20 per barrel, gold to $300 per ounce and the Dow to 9,000.

CAPITAL FLOWS

Despite recent stirrings, the U.S. dollar remains anemic. While this has offered some benefit for large cap exporters and helped the U.S. trade deficit, it also has created opportunities for non-U.S. buyers to snatch up U.S. dollar denominated assets.

"From March to April we have seen a total net outflow from U.S. securities of about $25 billion," Zarembski says, and at the same time we have seen a rise in non-U.S. purchases of U.S. government debt, which increased to $80 billion in April from $53.62 billion the previous month. "This money can shift on a dime when opportunities exist in other asset classes," he says, adding the money flowed from securities into government debt at about the same time the heart of the credit crisis was hitting. "We are going to see more of that as money tries to find what's hot at the moment. There's a fear factor."