The Stock Market - relative strength comparisons

1.Fundamental outlook

'Worse than expected'

There can be little doubt that current economic fundamentals are extraordinarily bad – the new stock phrase that accompanies almost every economic data release lately is 'worse than expected' – and this happens with expectations already lowered considerably. A good way of following the evolution of expectations are WS estimates for S&P 500 earnings in 2009. These have gone from $98,-/ share about a year ago to $42/share now. There have been numerous revisions along the way, and economists are similarly revising their guesses as to economic data about to be released.

It is generally agreed however, that knowledge of current economic fundamentals is not necessarily useful information with regards to what the stock market is about to do. The theory goes, not unreasonably, that the market tends to discount fundamentals ahead of their manifestation. However, as i have previously pointed out, this has generally not been true over the past decade or so. The stock market has most of the time acted as a coincident, and at times even lagging indicator, at least relative to official economic data.

Nevertheless, this does not change the fact that current fundamentals are a poor guide to market action over, say, the next four weeks for instance. There could be a rally in spite of a continuing deterioration in fundamentals, pinned on nothing but hope (the 'it's so bad it can only get better' thesis of investing), or pinned on a more reasoned approach that is based on the general idea that stocks are not merely a claim on earnings streams in the relatively near future – rather they are a claim on earnings streams into the far future.

Still, it would be good to have a crystal ball that informs us of future fundamentals. Can we make an educated guess? A large percentage of mainstream economists routinely disappoints in the economic forecasting department. One can certainly not rely on their timing, and neither can one rely on their general forecasting abilities. How many economists did in fact forecast the bust? Given that they have obviously a tendency to have too rosy an outlook even in the face of one of the worst contractions of the post WW2 era (thus the never-ending 'worse then expected' moments), why should one believe their estimates of when a bottom is likely?

A review of the known facts is in order.

1.we are in a secular bear market period, which will be marked by a secular contraction in p/e ratios, from the over-valuation seen in 2000 to an as-of-yet undetermined level of undervaluation.

2.Such a bear market is accompanied by recurring economic busts of increasing severity and duration – busts that are a mirror image of the preceding boom.

3.The current bust has a unique feature - the banking system appears on the brink of insolvency after having inflated credit willy-nilly for several decades (this is no exaggeration as the US total credit market debt / GDP ratio shows).

4.The authorities – fiscal and monetary, know only one recipe to counter the bust – inflate, inflate and inflate some more (in a combination of using the printing press and blatant Keynesian deficit spending; both methods have been thoroughly discredited throughout history in practice as well as theory, but are resorted to as a matter of course anyway).

If we only consider the above, it is clear that the current bust is of a different order of magnitude than its predecessors. While it was also precipitated by relatively tight (relative to the period preceding it) monetary policy for a short while (2004-2006) , its major feature is the sudden incapacitation of the banking system – the very system at the heart of the practical implementation of the inflationary policy of the modern day industrialized welfare/warfare democracies.

It is important to note that the final inflationary boom – the real estate mania, respectively mortgage credit bubble, already saw the stock market decline sharply in real terms, even during the cyclical, nominal bull market phase.
In other words, the only thing that drove the rally from the 2002/3 lows in stocks was the inflation of money and credit. This becomes evident indirectly by the expansion of margin credit and the enormous leverage taken on by hedge funds and investment banks during the period.

It was a levitation on hot air - based on the false confidence that everyone in the chain of credit that was extended during those years would be able to pay.
The plunging Dow/gold ratio indicated though that it was an entirely illusory boom.
Given how the authorities have reacted thus far to the bust – the central question then becomes 'will they be able to create another inflationary boom?' In other words, can reality be masked again by a new illusion of wealth based on the inflation of money and credit?

This seems a tall order – since there is a limiting factor in the real world that doesn't lend itself to eternal exploitation – the pool of real funding. It matters not how many pieces of paper or electronic chits the Fed prints up in its balance sheet expansion – the amount of real resources available to the economy can not be changed by that.

The reality of the banking sector's balance sheet implosion is currently partly camouflaged via the Fed's interventions, but it can likewise not be winked out of existence.
What the banks now lack is capital – as their existing capital has been eaten away by too many securities turning worthless, and too many debtors defaulting. The problem is that everybody else lacks capital too, or owns capital for which there is currently no use and that can not be profitably employed in its current incarnation (a number of car factories come to mind, for example).

We can conclude that the bust will be intense, and investment strategies will have to be adapted accordingly.

The time of 'buy and hold' has been over for ten years already, even though a surprising number of analysts still seems to cling to this mantra of the bull market. Perhaps they should have specified 'buy and hold t-bills', since those have outperformed the stock market by nearly a cumulative 40% over the past decade?
Likewise, it appears the 'money multiplier' has degraded into a 'money divider' as Bob Hoye has recently put it.

2. Technical conditions

In terms of the stock market's technical condition, it is surprisingly poor. Why 'surprisingly'? There are quite a few historical examples of a market crash in the fall, both in the 20th and 19th century. One common feature of all those crashes has been a subsequent rebound that went hand in hand with a lessening of credit concerns and as a rule managed to retrace at least 50% of the preceding crash wave. A notable exception to the rule was the 1987 crash that happened in the broader context of a long secular bull market – in this case, the rebound erased over 100% of the crash wave before running into temporary trouble.
The point is, it is unusual to see the market as weak as it has been so far in January right after an autumn crash.


The S&P 500 Index with Elliott wave labeling. Wave 4 is likely still in progress. click on chart for larger image

It is possible, even likely, that the expected rebound will still happen with a delay. However, given the unusual action up to this point, one must be prepared for the alternative as well – a further wave of selling. As previously discussed, the market lends itself to a relatively obvious Elliott wave count since the October 2007 high. The corrective action since the 'wave 3' low has been a bit more difficult to interpret, which is a common feature of corrective waves, as there are a great many variations possible.
From this standpoint, the main question is 'are we still in corrective wave 4' or 'has wave 5 down already begun'.

One of the arguments in favor of a rebound is the fact that a number of market participants are reportedly simply waiting for the current horrible earnings season to be over before committing new capital. The earnings season is regarded as being chock-full of the same event risk that is currently dogging economic data releases – the 'worse then expected' syndrome.

Ironically, an argument can be made that the market is actually not 'oversold' , as Carl Swenlin shows here in this 'chart spotlite' at decisionpoint.

From experience though it can be stated that the shorter term the time frame considered, the more difficult it is to forecast the likely outcome. If acting in favor of one outcome, one should always prepare a plan of action for the opposite outcome.

Assuming that the rebound will resume, the question of which sectors are most interesting comes to the fore. Below are a number of 'relative strength' charts. They show how different market sectors have performed relative to the S&P 500 over the past year – whereby their performance since the November low is what interests us here.


Airlines have outperformed the rest of the market since the peak in oil prices. Note however that this streak seems potentially endangered now, which may be a hint that energy prices are about to rebound. Option traders are optimistic on airlines. put/call open interest across the sector is the lowest in the past year, and short interest in the group's most prominent component stocks has declined sharply. click on chart for larger image


Banks have once again strongly underperformed the market of late. As can be seen here, the BKX-SPX ratio chart broke the neckline of a head-and-shoulders formation, but may already have met the target range, and is now deeply oversold. Near term, we would avoid this group from both the short and long side. There's no need to try to bottom fish given the industry's sorry state and the risk of a snap-back rally is too great to make it an enticing target for shorting. This sector is best left to those who want to play hero. Interestingly, the sector-wide p/c open interest ratio of 0,87 is actually very low compared to the readings over the past year.
Note: as the market cap weighting of financial stocks declines, their influence on the market-at-large declines commensurately. click on chart for larger image



The biotechnology index has outperformed the market since last spring. The sector-wide put/call open interest at 0,62 is fairly high compared to readings over the past year, which is to say, option traders are rather pessimistic on this group now. Good relative performance coupled with pessimism is a good omen for this sector. click on chart for larger image


The Broker Dealer Index has made no headway relative to the market since the November low, and remains in its longer term down-sloping channel. Short interest remains high, but option traders are curiously optimistic on the group. We see no reason to engage with any financial stocks, given that their outlook remains bleak. Financials should be watched for signs of getting overbought, at which point they will likely continue to provide shorting opportunities for nimble traders. click on chart for larger image


There's nothing remarkable about the performance of the Chemicals Index either, which is essentially also going nowhere relative to the S&P, following a streak of under-performance since the fall. As a cyclical sector it suffers from the sharp deterioration in the economy. click on chart for larger image




Due to containing a large weighting of Wal-Mart (WMT), the MS consumer index CMR has outperformed the broader market. The discretionary consumer ETF XLY may be the better gauge in this case – it has flat-lined relative to the broader market, which is to say, it has performed just as badly. In short, there are neither fundamental nor technical reasons at this time favoring this sector. click on charts for larger images



Disk Drive stocks have begun to outperform since the November low. It remains to be seen if this can be kept up due to the fundamental challenges faced by this industry. Still, storage is perhaps one of the better sub-sectors in the tech hardware world. click on chart for larger image


There is always a lot of worry about the pipelines of the large pharmaceutical firms, and the sector has for a long time been a downside leader (it was one of the first groups to break below its 2002 lows). However, strong balance sheets, high dividend yields and an intriguing streak of outperformance in recent months make this sector interesting. click on chart for larger image


Computer Hardware shows strong relative performance since the November low, mostly due to component stocks like IBM and HPQ. It remains to be seen whether this can be kept up – option traders are optimistic, and there are a number of fundamental reasons to remain wary.
click on chart for larger image



Internet stocks are helped by GOOG's less than horrible recent earnings report. There is however nothing especially exciting here. click on chart for larger image




The upcoming period of seasonal strength in energy could help both the XOI and OSX. XOI currently looks better on a relative strength basis, but the OSX is traditionally lagging, and usually has a higher beta, so it could play catch-up. click on charts for larger images


RTH's relative strength is helped by Wal-Mart (WMT). For obvious reasons, retail stocks should probably be avoided. The best thing that can be said for them is that most are technically oversold by now. click on chart for larger image


Networking stocks have been going nowhere in particular relative strength-wise in a wide channel. click on chart for larger image


The Semiconductor sector has recently strengthened as well, but the group remains suspect for fundamental reasons. click on chart for larger image


The relative strength chart of the telecommunication group is intriguing, as it is attempting a break-out. click on chart for larger image

The point of this exercise is basically, 'if you have to be long something, choose whatever shows good relative strength' . Two of the biggest reasons why I personally have become a bit more constructive vis-a-vis the stock market in the near term can be found below (please note, i remain medium to long term bearish):


The US dollar index appears to have built a bearish flag – a decline in the dollar would likely go hand in hand with rising stock prices. click on chart for larger image


The safe haven buying that supported the huge rally in T-bonds has subsided. The initial correction target has been met, so a rebound is increasingly likely. However, the bearish influence the bond market had on stocks has clearly lessened (currently, lower interest rates on long term government bonds are a bearish, not a bullish sign for stocks). click on chart for larger image

3. Gold and gold stocks

I'm looking at gold and gold stocks in a separate section because the gold stocks are currently the one market sector with the best fundamental and technical outlook.

Here is why:


Gold weekly, 3 years. this chart looks constructive click on chart for larger image


On the daily chart we can see that a big test lies just ahead for gold - the resistance in the 920-930 area that has stopped the previous rally attempt. It seems likely that this won't be overcome on the first attempt. Breaching this resistance would be a a very positive sign. click on chart for larger image


Gold keeps streaking higher against the S&P index. At the moment it is attempting a new break-out in relative strength terms click on chart for larger image


Gold has risen enormously relative to crude oil. Energy is a major input cost for gold miners, so this is a boon for their profit margins. Interestingly, Wall Street analysts are generally very lukewarm toward gold stocks. click on chart for larger image


Since the low was put in, the HUI has risen sharply vs. the SPX, but the relative strength chart is now running into short term resistance.

To reiterate something I have mentioned before: the gold sector will probably be the only major market sector to deliver earnings growth in coming quarters. In spite of this, it is strangely unloved by many in the Wall Street analyst community.
Let me name a few examples.

Newmont Mining (NEM) for instance currently sports 4 'strong buy', one 'buy' and 8 'hold' ratings ('hold' is the Wall Street euphemism for 'you should have sold it yesterday'). Put/Call open interest on the stock has soared in the past few months, from roughly 0,60 to about 1 now.

Barrick Gold (ABX) has 6 'strong buy', 1 'buy' and 7 'hold' ratings; put/call OI on the stock has also soared lately.

Goldfields (GFI) has 1 'strong buy', 2 'hold', and 1 'sell' rating. Note in this context that the price of gold in South African Rand is at a new all time high (!) , while GFI trades about 65% below its former all time high. p/c OI on the stock has doubled of late.

Harmony Gold (HMY) has 1 'strong buy', 1 'hold' and 1 'strong sell' rating. I'm not sure who dispensed the 'strong sell', but the company's balance sheet is stronger than it has been in years, it has 5 growth projects in the pipeline, and the fattest margins in at least 5-6 years.

You get the drift – Wall Street isn't exactly brimming with love for gold stocks. This is of course excellent news for anyone holding them, as it increases the chance for future upgrades.


Gold in South African Rand. This is a nice, steady bull market progression. The profit margins of South Africa's gold mines are soaring along with it.

Gold stocks and the stock market – an update

1. Gold Stocks

Since my last look at the gold stocks the sector has rallied sharply - along with the broader equity market, but with a number of notable differences, mainly in terms of leads and lags and relative performance.

As noted in the original post on gold stocks, a strange dichotomy had developed at the time, insofar as the gold/SPX ratio was rising, whereas, oddly, the HUI/SPX ratio was falling concurrently. Shortly after i pointed this out, this trend began to change again in favor of the gold stocks.

The HUI produced a divergent, higher low in November, just as the SPX broke to a new multi-year low in the wake of the previously documented collapse in commercial mortgage backed debt. Furthermore, the HUI has already managed to exceed its secondary late October high, a feat as of yet proving elusive for the SPX.
Since the low was put in, the HUI index has sharply outperformed the SPX, bringing the ratio between the two back to a less 'abnormal' level, although not yet to a level that would be justified by the concurrent multi-year highs in the Gold/SPX ratio.

The rational expectation would therefore be for the recent streak of gold sector outperformance to continue. This idea is additionally supported by the fact that the gold/oil and the gold/commodities ratio have kept rising vigorously as well.
As noted before, this is very important for the profit margins of the gold mining industry, due to energy representing its second biggest input cost factor after labor; other commodity input prices (for instance steel, timber and rubber) are also relevant to gold mining margins.
A large divergence between the current valuation of gold stocks, and gold's real price (which remains at multi-year highs) thus persists. Even if the nominal gold price were to remain static or were to soften somewhat, gold stocks would remain historically very undervalued at current levels.

Obviously the gold sector has crashed along with the rest of the stock market in October for reasons that have nothing or little to do with its fundamental outlook (an argument could be made that fear of deflation played a role in the HUI's relative weakness during October, but this doesn't satisfactorily explain the contrast between gold's relative strength and the relative weakness of gold stocks).
Forced liquidation swept everything along, regardless of relative values. Ironically, the fact that the gold sector is comparatively illiquid meant that it was undeservedly punished with extraordinary severity.
Note however that declines of similar severity happened during previous bull markets in gold stocks as well – the extent of the decline is per se not proof that the long term bull market is over – prima facie it just represents a large cyclical bear market that was unusually compressed in time.

No doubt the sector will continue to be buffeted by recurring deflation fears and the countervailing uncertainties introduced by the ongoing monetary pumping exercises of the central banks.
The markets clearly fear that a deflationary spiral could overwhelm the system, as credit creation by the commercial banking system has ground to a halt, at the same time though, the central banks and fiscal authorities are engaged in the biggest reflation effort ever attempted in the history of the recurrent crises of the modern system of irredeemable currency.
The attempt to recreate the inflationary phantom wealth of the boom is likely doomed to failure (aside from the fact that it makes little sense), but a properly determined central bank operating in a fiat money system can always devalue the money it issues – just ask Dr. Gideon Gono if you don't believe it.
However, regardless of whether these inflationary measures do or do not 'succeed', gold will likely prove to be a good hedge hedge against both outcomes – since both will be marked by 'monetary disorder'.

It remains to be seen if the gold sector is merely going to continue to mimic the larger stock market's moves with a higher beta , or if it eventually manages to decouple and go its own way again, as it did in the 2000-2002 bust. This likely depends on the intensity of prospective recurring liquidation periods.
In the heretofore grand-daddy of deflationary super cycle bear markets of the 1930's, gold stocks crashed with the market in the initial crash wave, but later decoupled and were the only market sector to produce large gains.
It has been argued that the at the time fixed gold price made this possible, but a similar argument could be made now, since the core of the argument is not about whether the price of gold is fixed, but whether gold actually gains in terms of purchasing power.

A note on the gold/CRB ratio: gold has literally exploded against the CRB. It is fairly typical to see gold's price in terms of commodities rise sharply during economic busts, but the extent and speed of this recent rise are indicating that the current bust is a secular one of a very high degree.

Bob Prechter argues it is in fact what he calls a 'grand super cycle degree bear market' – read: a bust that corrects the entire economic advance since 1720. This idea is based on the fractal nature of the stock market described by the Elliott wave system (all types of waves repeat at various cycle degrees – and indeed, one can look at a one minute chart of the stock market and detect up and down waves that have an astonishing similarity to the hourly, daily, weekly, monthly, etc. waves; the stock market clearly exhibits a fractal structure).

I for one think it is difficult to come to a firm conclusion about such extremely large degree waves, because one can easily be off by decades timing-wise, and will only ever know for sure in hindsight , provided one lives long enough.
Bob Prechter bases his view on his long term Elliott wave count of the stock market, but even at very large degrees, such a count can end up in need of revision at a later stage (it has already happened to some extent to his count – the 5th wave of the bull market kept extending).
Regardless though if his dire outlook is correct, we do know one thing for sure: it is a secular downturn, and as such at least of super cycle degree – for the stock market, it means a journey from extreme overvaluation (year 2000) to extreme undervaluation (by 2010 -2014 perhaps?).

This makes the gold sector very interesting, for the simple reason that while it often correlates positively with the rest of the market over the short to medium term, it has a proven negative long term correlation with the broader stock market.

Note though that in the near term, gold itself still needs to overcome a number of technical hurdles – namely resistance in the $830-845 area, and then the major resistance around $925-930. Gold's market structure (in terms of commitments of traders in the COMEX futures) looks quite bullish of late, as small speculators hold an exceedingly small net long position. From this standpoint, it should be easier to overcome resistance than it has been on occasion of the last attempt, but there is no guarantee it will happen.

Charts:


1. The HUI index and its divergent secondary low; several potential technical resistance points are denoted that may have bearing on short term trading tactics. Click on chart for larger image.


2.The HUI/SPX ratio has turned again in favor of the HUI, and is now in 'mid point' territory. Click on chart for larger image.


3.The gold/SPX ratio continues to cling to multi-year highs. Click on chart for larger image.


4.The gold/oil ratio has risen back to its long term average, at the same time a near 8-year high. Click on chart for larger image.


5.The gold/CRB ratio is yet another way of showing that gold's purchasing power has massively increased, in spite of the fact that its nominal price is a good deal below the all time high of March. Click on chart for larger image.


6.The nominal gold price must overcome two major resistance levels to confirm a new uptrend. Click on chart for larger image.



2.The Stock Market

I previously pointed out that the market was likely close to a low in terms of time, as during the last update, wave 5 of 3 was clearly underway. It appears now that wave 5 likely ended at the November 20 low, concurrent with the blow-off moves in mortgage and junk debt yields. In my opinion, it is quite worrisome from a longer term perspective that the market at one point sliced through the lows of 2002 as if they weren't there, but short term this slight undercutting of an old low followed by a reversal back above it is likely a positive sign – at least it should be given a positive weight when looking at the entire probabilistic gestalt.

After i posted the worrisome charts of Citigroup and the BKX, both continued to collapse , C for two more days and the BKX for one more day, whereby their moves down , while short lived, where absolutely astounding in terms of their severity. By the time the market closed on Thursday last week, it appeared as though we were once again on the brink of a true systemic meltdown. Everybody knew that someone had to be hurting big time from the plunge in mortgage backed and corporate debt, and it was equally clear that 'too big to fail' Citigroup was at the center of storm this time.

Friday then brought a late day relief rally that the financial press ascribed to president-elect Obama appointing Tim Geithner to the post of treasury secretary (certain sharp-tongued cynics who want to remain anonymous remarked that 'the nomination of anyone but Paulson would likely have produced a rally; even a block of wood would have done – at least one could be sure that it would remain silent').
This 'explanation' makes no sense however, since Geithner is closely associated with the bunch of nincompoops who 'never saw it coming'. 'It' being the current financial and economic disaster.
Besides, anyone who still believes that politicians matter in the face of this tsunami of a bearish social mood turn and collapsing credit bubble should best keep away from the stock market for his own good.

A more sensible explanation is actually that it was an options expiration, which saw market makers buy back their shorts in the last half hour (when option market makers sell puts, they hedge by shorting the underlying shares – once those puts expire, the hedges are lifted).
The Elliott wave explanation would be: wave 5 was likely finished, regardless of the technicalities surrounding the event.

However: whereas broader indexes like the SPX and the NYA have clearly made it back above their October lows, the BKX is actually still lagging - in spite of rising over 50% (!) from its intra-day low on Friday last week, it has yet to make it back above the broken neckline of the head and shoulders formation i pointed out.
If there is anything that makes me doubt the 'wave 5 is finished' idea, then it is this fact. It is the single most worrisome fact to my mind, in terms of the overall technical picture.

Yes, the interventionists succeeded in lifting a great weight off the market's mind in the short term, by first agreeing to backstop Citigroup with guarantees amounting to over $300 billion – a move designed to avert the growing danger of a run on the bank (of the total of $820 billion on deposit at Citi, a huge $554 billion was/is held abroad – and thus not subject to FDIC insurance. No doubt these foreign depositors were going to form queues at Citi branches worldwide come Monday, had the government not decided to bail the bank out for all practical purposes), and secondly by announcing an enormous additional monetary pumping exercise that appears to amount to an outright monetization of $800 billion in 'highly rated' mortgage backed and asset backed securities.

Consequently, CDS markets calmed down considerably, and credit spreads declined left and right. Most notably, CDS spreads on Citi's debt were basically cut in half (while this was no doubt a great relief to almost everyone, there are losers in this type of trade as well – and it is actually a bit infuriating that those who made the correct bet – namely that the creditworthiness of Citigroup was increasingly in doubt – were once again cheated of their winnings by a government intervention. I note that there is no great urge anywhere to make their losses good).

The fact remains though – the BKX index is still below its broken neckline. My advice would be to watch very closely what happens once it touches the neckline, which should be within a trading day or two. If it turns back down from there, we can go back to 'red alert' status in my opinion.

The second item that needs to be considered is the fact that yields on longer dated government debt continue to decline sharply. In part this is due to a technicality – the government's recently announced hoovering up of $800 bn. in MBS and ABS has created prepayment risk for mortgages – and that means that a number of MBS portfolios are likely to get a duration mismatch problem, or rather, the previously extant duration mismatch problem has been reversed in the opposite direction (rising mortgage rates lengthened the expected maturities and durations of MBS portfolios, falling mortgage rates will shorten them). Hedging against the eventuality of shortening or lengthening durations is done in the treasury bond and note markets, and currently this is driving yields lower.

However, t-bonds and notes have normally also a strong tendency to confirm stock market rallies by means of declining (i.e., yields rise) – in that sense, their recent action constitutes a non-confirmation.
Note also, with t-bill rates close to zero and other short term rates having declined precipitously as well, this recent move at the long end of the curve actually flattens the yield curve – this is can not be considered a good sign for the 'reflation' effort.

Lastly, on the potentially positive side of the ledger, we have the recent weakening of the dollar index (DXY), which has happened against a backdrop of technical divergences at the recent high. It may finally be due to correct, a fact that is supported by gold strength leading the subsequent weakness in DXY. A large correction in DXY would likely accompany a wave 4 rally in stocks, given their recent strongly negative correlation (a rising DXY and Yen are symptoms of deleveraging).

Summary:

While the recent rebound in stocks suggests the large wave 4 retracement may finally be underway now, there are still important non-confirmations extant. It is always possible that the confirmations will happen with a slight lag, however, one should keep a close eye on what actually develops. The previous warnings regarding the overall sentiment picture remain in force – however, there always comes a point when previously shaken fund managers go from praying for a rally to fearing they might miss one, and such a flip of the herd will eventually produce the retracement rally in self-fulfilling prophecy fashion.
The short term risks seem a lot lower than they were exactly one week ago, but they have by no means disappeared.

Charts:


1.The SPX is back in the 'zone' for now. Click on chart for larger image.


2.The BKX has yet to get back above its broken neckline, in spite of an enormous rally off the recent low. Click on chart for larger image.


3.The long bond is not yet confirming the rally in stocks. Click on chart for larger image.


4. DXY has recently weakened after a high with typical 'end of move' divergences in evidence. It may be a bit early to tell, but a larger correction seems definitely possible. This would be an important development for all risk assets. Click on chart for larger image

charts via stockcharts.com

The collapsing value of mortgage debt and the stock market

The stock market has recently been as 'oversold' as it normally ever gets – in fact, some of the market's internals have produced never before seen records (on one occasion in early October, new lows at the NYSE jumped to almost 2900 issues, which is almost thrice the previous record high; last Thursday the NYSE TICK at one stage in the early day sell-off was recorded at minus 1940, a new record low, to name two examples. It almost doesn't matter which indicators one looks at – they have either produced never before seen extremes, or extremes that were last seen in 1929-1932).

Many of these internals have recently 'eased off', and on Thursday's 'classic retest of the lows' we see numerous divergences (fewer new lows, a lower VIX, lower put/call ratios, a higher RSI reading, a higher MACD reading, etc, etc.) that would normally lead one to expect that some sort of larger relief rally is close at hand.

And yet, there remain a number of flies in the ointment.

Bulls and Bears

The first one is the apparent eagerness of traders wanting to 'buy the bottom'.

The second one is the fact that the bears have apparently capitulated. Yes, you have read correctly – it is the bears, not the bulls, that are doing most of the the capitulating. Consider the updated version of two charts i showed in the 'quo vadis' post a while back, the NYSE short interest ratio deviation and Rydex bear fund cash flows. By the looks of these charts, bears continue to abandon their positions, no doubt chastened by the huge one day wonder rallies that have recently, in illiquid banana republic market fashion , heralded at least two false dawns.


the NYSE short interest ratio deviation– it continues to hover at what is at least a 10 year low, deeply in bearish territory - click on chart for bigger image


the cumulative Rydex bear fund cash flow ratio remains at a multi-year low - click on chart for bigger image


In addition to the above, the net short exposure of CTA's , who are highly flexible traders, is now no larger than in November 2000. This is very little compared to some of the short exposures held by this same group during the bulk of the 2000-2002 bear market.

In this context , consider also the fact that most of the trading volume in stocks continues to occur during those times when stocks go up. Bob Prechter was the first analyst to point this strange phenomenon out – he asks, not unreasonably, how there can have been capitulation (of the bulls/long holders) when most of the trading volume is expended in chasing stocks higher (this was once again in evidence last Thursday in intraday trading. Volume began to expand as soon as the market streaked higher).


Mortgage Debt

The third problem for the market is a group of indicators that used to be widely followed for a time, but have lately not been mentioned much as other financial catastrophes took center stage.

I am referring to the ABX-HE and CMBX index products administered by Markit . The charts below show a cross section of the situation , presenting indexes on variously rated debt, from AAA to BBB. If you want to see regular updates of these charts, they have been taken from here(historical ABX-HE)and here(historical CMBX). These may be useful links to bookmark.

Keep in mind that ABX-HE are indexes that refer to the price of the underlying debt pools of residential mortgage debt(down is bad, up is good), while CMBX refers to the spreads of the underlying commercial mortgage debt (up is bad, down is good).





ABX-HE indexes of various residential mortgage debt pools, from highest to lowest ratings - click on charts for larger images





CMBX spreads for different ratings, again from highest to lowest - click on charts for larger images

As one can clearly see, these instruments show that extraordinary stress continues in the mortgage debt markets. It is no surprise that AIG's bail-out requirements have recently swollen to $150 billion from the originally envisaged $80 billion – many of the credit default swaps written by AIG reportedly were for CDO's backed by mortgage debt. Presumably many of these CDO's were once double and triple A rated – however, as we can see, even triple A rated mortgage debt pools continue plummeting in value at great speed.

This means that many bank assets will be subject to further write-downs. Even if a lot of garbage paper has been swept under the 'Level 3' rug, this further deterioration in prices and spreads will likely force a renewed wave of asset revaluations. ('Level 3' is an accounting term - it is where financial institutions house securities for which there is no market price input, hence they can not be 'marked to market' but are valued according to models, respectively are marked to 'reasonable stab' as the method was once described by a Citigroup spokesman. Some people have dubbed this also 'marked-to-fantasy').

Consider in this context the truly sorry looking chart picture of the BKX index below. Similar to the broader market, we can also detect a number of recent potentially bullish divergences, but it is the price chart itself that gives one pause. It does not inspire much confidence.


the BKX (Philadelphia Exchange Bank Index)- bullish divergences, but bearish price formation - click on chart for larger image

The same ideas regarding the short term outlook as outlined in 'quo vadis' still apply – the market is still within the recent trading range, and the direction in which it will eventually break is not yet certain. It is this latter point i actually want to make – while numerous divergences at the recent third 'retest low' seem to favor a rising market, there are still indications that the underlying stresses in the financial system continue to mount.

The Federal Reserve and other central banks have momentarily stemmed the increase in LIBOR with unlimited dollar swap agreements and revived commercial paper issuance by buying CP directly – but this particular hole in the dike - the plummeting value of mortgage backed securities - continues to grow. Arguably this remains one of the most important things to watch, as the ABX-HE indexes have often reliably led the stock market, and also due to the fact that at the height of the real estate/mortgage credit bubble insanity, a full 63% of all bank assets were tied to real estate financing.

One must therefore continue to keep an open mind regarding near term market direction. It is always possible that the bears who have covered their short bets are 'smart' and will get a better opportunity to re-short, and the oversold ABX-HE indexes may well soon bounce. However, there is considerable uncertainty given these data points, and the market lows of 2002 still beckon.

PS: A few words on the G 20 meeting

The recent G 20 pow-wow can hardly be expected to be a panacea for the ongoing crisis. This is merely a bunch of politicians getting together to 'fix' the economy and markets after all – expectations should be muted accordingly.

From what one hears so far, they are actually busy reinforcing the recent deflationary trend in the credit markets, by proposing – what else – 'more controls and regulations'. As i overheard in a German TV newscast, this control is supposed to encompass credit creation (a.k.a. 'credit dirigisme', as now practiced by Uncle Sam with Fannie and Freddie – the state will decide who is 'worthy' of getting credit and who isn't).
The press meanwhile is dishing out the usual pablum about this meeting representing a confrontation between 'US laissez faire' and 'European regulation' principles. Time Magazine lets loose with gems such as 'To optimists, the mere fact that Sarkozy convinced regulation-wary U.S. President George W. Bush to host and attend such a summit was cause for hope.'
There will be some generalizations about every government feeling free to implement a raft of Keynesian inflationary measures intended to counter the financial and economic contraction (expansion of fiscal deficits and even more interest rate cuts), and of course we are promised - more meetings! This is not surprising, as these get-togethers apparently are marked by lavish banqueting. As a warning sign to all supporters of the free market, 'French top officials have applauded the summit results'.
All that has so far been decided falls roughly under the header of 'how can we make sure of making things worse in the long run' - with the sole exception of a pledge to avoid a return to protectionism. The real reason for the crisis was - as was to be expected – not even mentioned in passing as far as i can tell.

Not a single word about the central banks' money price fixing scheme, or the proliferation of regulations and subsidies that has marked the growth of the post WW2 State everywhere – the colossal failure of the state's economic planning was not deemed worthy of debate. Anyone looking toward a government-mandated crisis solution will eventually find out that the interventionist dogma is at the end of its tether – as i have previously mentioned , the economy's pool of real funding is the limiting factor in all state-led inflationary schemes, and it appears that it is in grave trouble globally.

charts courtesy of marketgauge, stockcharts.com, decisionpoint and markit

Quo vadis, stock market?

Is the stock market a discounting mechanism?

If one looks back at market history, the idea of the stock market functioning as a discounting mechanism becomes very dubious, especially if one looks at the history of the past 10 years. The truth is, sometimes it is, but most of the time it isn't. Since the Asian/Russian crisis of 1998, the market has behaved as a coincident rather than a leading indicator – at times it even lags developments in the economy.

This has been quite obvious in the 2000-2002 bear market, when the market actually bottomed out well after the economic recession in terms of GDP contraction did (in other words, the market lagged the economy), and it has become glaringly obvious in the course of 2007 – 2008.

Consider for instance, that there was a roughly 500 point one day decline in the DJIA on February 27 of 2007, for which two immediate potential triggers could be identified at the time: one was a sharp overnight decline in China's stock market. This was the 'reason' hyped in the press, and can therefore actually be ruled out as a significant trigger – not least because Wall Street had never before worried about what stocks did in China. The second, more credible trigger event, was a sharp decline in a derivatives index product that most stock market traders had up to this point in time never heard about: the sub-prime indexes of the family of ABX-HE indexes , which are run and managed by Markit. Essentially these indexes represent certain residential mortgage debt pools and are used by banks, hedge funds, broker dealers, etc. to hedge mortgage backed debt , respectively speculate on its value.

The sharp decline in these specific indexes signaled growing distress at those mortgage lenders that had specialized in the sub-prime sector of the mortgage market – firms like New Century Financial , Novastar Financial, Fremont General or Accredited Home lenders, the stocks of which used to be market darlings but had been under some pressure for over a year already (in their case, the market actually did fulfill its discounting role), suffered large additional declines. Indeed, it didn't take long for these firms to go under.

However, the one day 500 point market decline remained a one day wonder. Not only that, the market went on to blatantly ignore the message from the then visibly growing distress signals emanating from anything connected with sub-prime mortgage lending, and went on to furiously bid up all sorts of financial stocks, so that several of the companies that by now have been reduced to a status of bankruptcy, zombie-dom or have been nationalized by the government respectively become subject of 'take-unders' by their former competition, reached either new all time highs in the summer of '07 or came close to reaching all time highs.

As examples, consider the charts of the XBD (broker-dealer index) , FNM (Fannie Mae) and ABK (Ambac). In spite of the by then well-publicized problems besetting anything that was involved with mortgage lending and associated derivatives, these stocks traded at very high levels as late as October of 2007.

What accounts for the market's apparent inability to spot even quite obvious economic problems in advance? One can't be entirely certain, but a John Kenneth Galbraith bonmot comes to mind: 'there is (now, was) too much money to invest, and not enough intelligence to guide it'.

The financial industry has grown by leaps and bounds in the just ended era of massive money and credit inflation – and it's a good bet that the amount of 'market intelligence' has not managed to grow at the same rate. To put it bluntly: anyone who was involved in bidding up FNM to almost $70 in October of 2007 was completely asleep at the wheel, and has probably been weeded out by now.

Be that as it may, the fact remains: one can not count on the stock market to 'discount' anything in advance.

(click on charts for larger images)







The Value Trap

The recent sharp decline in the stock market – which not surprisingly, has happened coincidentally with a sharp deterioration in all sorts of economic backdrop data – is best viewed as the 'point of recognition'. Finally, denial about the economy's prospects and the likely extent of financial and economic damage inflicted by the collapse of the biggest credit bubble in history has given way to a collective recognition that the stock market can not be expected to levitate through the ongoing disaster. Elliott wave practitioners are basically of one mind that the crash was a wave 3 down at several degrees - which in E-wave parlance is known as the 'recognition wave' – i.e. the moment when most market participants realize what the direction of the new trend actually is.

As mentioned in the brief report on the gold sector, due to forced deleveraging, many stocks have apparently become quite undervalued now. Several well respected value investors, such as Mr. Buffett (see here) or Mr. Hussman (see here) have advanced arguments to the effect that the panic has created a buying opportunity, irrespective of any further short term damage that might occur. It is certainly correct that risk is now smaller than it used to be; this is obviously a truism, since stocks have become much cheaper.

However, i strongly suspect that a problem with market psychology that i have remarked upon previously in conversations on e-mail lists and fora is still at work here: there has been, and continues to be, a general tendency to underestimate the current bust, both in terms of its likely duration and its likely extent.

Consequently, given the market's consistent failure to do any 'discounting', one should probably be very careful when evaluating this current 'buying opportunity'.
One thing one must keep in mind is that p/e ratios travel in secular cycles. They tend to move from extreme undervaluation to extreme overvaluation and back again, over fairly extended periods of time (20-30 years in each direction, sometimes even longer).

I still remember vividly how the extremely high p/e ratios in Japan's stock market anno 1989 were considered an 'exception to the rule', with countless rationalizations forwarded as to their likely imperviousness. These included assertions such as 'Japan's institutions must invest in stocks' (the 'wall of money' argument) , or 'shares in Japan are never really sold, they are merely passed around between long term holders' (the 'keiretsu' system of extensive cross-shareholdings was supposed to keep share prices aloft), or 'Japan possesses a superior economic model' (the interventionist Ministry of Trade and Industry was actually seen as a positive influence on Japan's economy), and so forth.
Unfortunately for those who believed all this, the Nikkei has fallen to a 30 year low this year, with its average trailing p/e ratio threatening to break below 10.
'Below 10' is actually precisely where p/e ratios tend to fall in secular bear market periods, historically. This puts the current trailing valuation of the S&P 500 Index into perspective – after all, the average decline in GAAP corporate earnings reported so far in the current earnings reporting cycle has been 40% year-on-year.

Lessons Learned?

Let me briefly return to the nature of the current bust. Many, if not most, market observers have for quite some time – in my opinion wrongly - believed that this bust is comparable to previous post World War 2 era busts. Often one has heard arguments to the effect of 'we have seen all of this before' , comparing the situation to what happened e.g. during the 1998 Russian/LTCM crisis, the late 80's/early 90's S&L crisis, the 1987 stock market crash, and recently, more pertinently, but still missing the mark, the mid 1970's bear market and recession.

Lately, comparisons to the experiences made in the 1930's depression have been voiced more often, but are far from having entered into the mainstream consensus. The consensus with regards to this type of comparison is that 'we have learned from the mistakes made in the 1930's, and they will not be repeated'. The current Fed chairman Mr. Bernanke specifically is thought of as a pre-eminent scholar of the 1930's depression, and therefore deemed to be uniquely qualified to avert a similar calamity. One should however realize that people believed the very same thing when the 1930's depression started. Back then, it was believed that the still relatively young Federal Reserve, with its modern 'flexible' currency system would not repeat the mistakes made in the bust and depression of 1873 to 1894. As an aside, in 1873 it was strongly believed that the powers of intervention then in the hands of the secretary of the treasury would surely avert any bad economic outcomes from following on the heels of the 1873 financial panic. Surely the mistakes made in the 1830's would be avoided. Every era shares this belief: namely, that the interventionist wizards at the top will somehow pull a rabbit out of their hat.

Apart from the fact that consensus thinking is apt to be wrong a priori, one can state with reasonable certainty that whatever lessons have allegedly been learned have actually been the wrong ones. While some of the mistakes that have been made in the 30's will likely not be repeated, new mistakes will be made in their stead, and the one, crucial mistake, is being repeated already. Readers of this blog know of course what i am referring to: the idea that fiscal and monetary interventions can avert the bust – this idea is as wrong as it can possibly be. Not only will they not avert the bust, they will make it worse.

Let's briefly look at the major differences between the 1930's situation and today. We know already what the similarities are: in both cases, a giant credit and asset bubble led to malinvestment of capital and capital consumption on a vast scale, laying the foundation for an enormous bust. In both cases, the government felt called upon to intervene in the economy and markets on an unprecedented scale in order to ward off the bust.

The differences are less obvious, so let me try and briefly summarize them: Today, we have 'more furniture to burn to heat the house'. Imagine the economic downturn as akin to a harsh winter (indeed, in the Kondratiev Longwave theory, a secular deflationary bust is referred to as the 'winter season'). If you decide to get through the winter by burning the furniture, having two desks to burn is comparatively better than having just one. Of course it would be better to go out and cut wood, store it somewhere dry, and use it for heating purposes. That is however not the path we are taking. The governments of the world have already decided that burning the furniture is what we're going to do.
Since we have more furniture – i.e., accumulated wealth – than we had in the 1930's, we will hold out longer, and it won't get quite as cold.

The second major difference is one of scale and complexity. For instance, we have far more debt relative to economic output than we had in the bad old days. A large amount of this debt is unproductive – it has either been used for consumption, or has been wasted on investment projects that will not generate any wealth, ever (many such projects only appeared to be profitable while the credit expansion was still ongoing). Both the financial system and the production structure of the economy are vastly more complex than they used to be – the global division of labor as well as global economic interdependence are far more advanced.
On the one hand, one can hope that this complex system will prove to be more resilient than its historical predecessors, on the other, it is this very complexity that makes it difficult to judge what the ultimate effects of the credit contraction and the many 'unintended consequences' of officialdom's interventions will be.
The bureaucrats are like the proverbial bulls in a China-shop – everything they do to plug a hole in the dike on one end immediately opens up new holes elsewhere, which then begets new interventions, and so on, in a never ending cause-effect chain reaction.

In terms of market volatility, size and extent of government interventions, the ratio of debt to economic output and the recent speed of economic deterioration, one really is forced to look back to the 1930's to find any remotely comparable events. We can therefore state: the current bust, regardless of the fact that it will most likely not become quite as bad, is at least of the same general degree.

The short term market outlook, considering technicals

It is always difficult to talk about the short term market outlook, especially when the market is in what appears to be a corrective formation. It often feels like a coin toss, so one is forced to resort to 'if...then' formulations. Anything else is a bit disingenuous – one may get a short term call right, but one can never be certain – it is a matter of probabilities.
Generally, this is easier when the market structure is clear, during impulse waves.
However, from a technical perspective, regardless of what system one uses, one must first and foremost consider the main trend. The main trend is the larger undercurrent upon which the smaller ups and downs play out, and it exerts an influence even during the counter-trend moves.

To make a long story short, in spite of the market's severely oversold status, it is just as likely to immediately break lower to for instance retest the 2002 lows as it is to produce a larger corrective rally first. Normally, one would expect a severe price crash to bring forth a sizable corrective rally, and from the point of view of empirical evidence this has to be regarded as the higher probability bet. The biggest problem with this is that almost everyone seems to agree, and the market tends not to reward consensus opinions. On the other hand, a rash of mutual fund redemptions, extremes in the Investors Intelligence bull/bear ratio, a seemingly – so far – successful retest of the early October low, all support the idea that a bigger corrective rally is now, or will soon be underway.

As can be seen on the chart below, prices will give us a decisive 'if – then' answer soon:



(click on chart for larger image)

The retest of the early October low has produced a number of divergences, that theoretically are short term bullish. However, the market is also closing in on a short term layer of resistance, with further resistance levels indicated by the Fibonacci grid in magenta.
So here is the short term 'if-then' proposition: the dotted blue support line must not break – if it does, then the 2002 lows become a likely target area (SPX 770-780 region). An obvious problem with the re-test is that it has come so quickly. Very little time lies between the two lows. This makes the 'double-bottom' weaker than it otherwise would be.
Noteworthy is also the 'flight of the bears' – consider the chart of the NYSE short interest ratio deviation below:



(click on chart,etc.)

A lot of short positions have obviously been covered. This can also be observed in the Rydex bear fund cash flow ratio, which has declined to a multi-year low (Rydex fund cash flows are a useful microcosm of sentiment):



(click on chart for larger image)

In short, the 'the low is in' consensus should be subject to some healthy doubt. The recent rally has been largely marked by short covering, and there will be less short covering buying power from here on out.

However, it is also quite clear that shorting an already severely oversold market is quite risky – if the market overcomes the layer of price resistance as per the chart of the SPX, then a larger retracement rally , likely toward one of the Fibonacci retracement levels (1040 or 1210) can be expected; this will probably happen regardless of whether or not the market makes new lows first.

The long term market outlook and its dependence on inflationary policy

The market's longer term outlook is to my mind a less problematic topic. A secular bear market started in 2000, and as such secular downturns go, it is highly unlikely to only last 8 years. To wit, Japan's secular bear market has made it to the ripe old age of 19 years as of 2008.
As Bob Prechter and others have remarked, in real terms it is as if the intervening inflationary cyclical bull market in the Dow/SPX of 2002-2007 never happened. In terms of gold (i.e., real money), the market just kept going down, and is now down by some 75%. This is to say, if not for a massive credit and money supply expansion having artificially supported nominal prices, we would be at completely different depths of bear market despair now.

To what levels the market will eventually fall in nominal terms is highly dependent on how 'successful' the central banks are with their policy of inflation, or 'reflation' as it is euphemistically called. It seems unlikely that a 'success' similar to the real estate credit bubble that has brought us to this juncture will be achieved – after all, what is there left that can be inflated? However, one must be aware of something very important here: the very real 'threat' of deflation that is now barreling down on the global economy, is first and foremost a political issue.

Similar to inflation, deflation leads to a redistribution of resources (see Huelsmann,pdf) , only it is a redistribution away from those who profited from inflation to those who were prudent, are debt free and in possession of savings – i.e. , the victims of the previous inflationary cycle. As Huelsmann correctly points out, the supply of money is irrelevant in terms of society's overall wealth – any size of money supply can fulfill the necessary functions money needs to fulfill (to put it differently, it matters not how much money is in one's bank account, what matters is what this money can buy).

If you consider who in society profits the most from inflation, and consequently stands to lose the most from deflation, it becomes quite clear that an inflationary policy will be pursued come hell or high water. The entire modern-day welfare-warfare state is crucially dependent on the inflation of money and money substitutes. The state would shrink without it. Also, the current elites would be replaced by new elites in case of a deflationary collapse of the system (these are also points made in Huelsmann's essay). In addition , we note that the debt expansion of recent decades has ensnared a large part of Western society – 'allowing' deflation to run its course unhindered is simply not politically palatable.

Due to the fact that the banking system is now extremely capital deficient and impaired, the traditional credit transmission mechanisms of the fractional reserve banking system are temporarily not working (it does not matter how many times the White House entreats commercial banks to 'start lending' – they won't do it, because they rightly fear that they will only add more future defaults to their tattered asset base).

However, central banks are already adapting their modus operandi to this circumstance, and can be expected to come up with more non-traditional measures as needed. The direct injection of money into the economy via buying of commercial paper at below market rates as currently practiced by the Federal Reserve is one way in which the banking system is bypassed, and we can rest assured that Mr. Bernanke and the Fed's board will come up with many more ideas in attempting to stem deflation as time goes on. It seems most likely that fiat money will be devalued further, i.e., the approximate 97% devaluation of the dollar since the birth of the Federal Reserve is likely to continue.

Could it be that the central banks will be overwhelmed by the sheer speed and scale of the deflationary contraction? At the moment this can actually not be ruled out completely. Remember what i said above about the 'general tendency to underestimate the crisis'. Even though central bankers have presumably more insight into the problems and potential exposures besetting institutions within their regulatory ambit (very likely the CDS market has already cost Heli-Ben a sleepless night or two), they have only very recently awakened fully to what is going on – which is exemplified by the Fed's balance sheet ballooning by well over 100% over the past 5 or 6 weeks alone. In addition, a large part of the financial system is outside of the regulatory ambit of the central banks – what is commonly referred to as the 'shadow banking system' could well develop deleveraging and default dynamics that will be comparatively difficult to contain.

Ironically, the little propagandistic trick that is used to ensure public support of the central bank system – namely that CB's pose as 'inflation fighters' although they exist primarily to pursue a policy of inflation, may be one of the things that has delayed their reaction. Remember, only a few months ago, the lagged effect of a previous tighter policy stance was not yet in full flower – commodity prices continued to soar, specifically the price of crude oil (as an aside, one can only cringe in despair when one hears central bankers declare that rising oil prices are 'exerting inflationary pressures'; a more thorough confusion of cause and effect is difficult to imagine).
So for a while, the central banks were worried that they might be in danger of losing their 'inflation fighter' reputation, and while they acted reactively and very much ad hoc to the ever more deteriorating financial scene, they were reluctant to pump all-out. Consider that reluctance a thing of the past.

The main point of the foregoing is the following: the historical experience with secular bear markets and secular periods of p/e multiple contractions tells us that the stock market will continue to decline quite a bit more in real terms (this is notwithstanding the fact that the secular bear market will be comprised of several cyclical bull and bear markets – it will be a sequence of lower highs and lower lows in real terms); how low the ultimate low will be in nominal terms will however largely depend on how determined and creative the central banks get in their 'reflation' efforts, or whether they will actually be overwhelmed by the deflationary credit contraction that is currently underway.

One thing that seems fairly certain is that the 'buy and hold' method of investing in stocks will remain a losing proposition for years to come. This should eventually lead to a large swing in the 'allocation pendulum' – institutional allocation percentages that have swung toward bigger and bigger portions of funds being allocated to stocks are likely to revert to much smaller stock market allocations, reaching their low point just in time for the next secular bull market's beginning. Note also that the demographic boost that the stock markets of the Western world received via the 'boomers' is turning into a demographic drag - as of now.

A final remark regarding the mutual fund industry: a more stubbornly bullish bunch is nowhere to be found. The mutual fund cash-to-assets ratio recently stood at a historically paltry 4,5% - considering a roughly 45% decline in the S&P 500 Index from the top, this slightly elevated number (the all time low hit in 2007 was just below 4%) can probably largely be ascribed to the decline in asset values. In other words, whatever selling mutual funds have engaged in appears to have been in reaction/anticipation of redemptions, and not out of fear of a declining market. This is in stark contrast to past bear markets, which have unfailingly seen the industry raise its cash on hand to much higher percentages. This is a fount of potential future selling pressure that one needs to keep an eye on.

Errata: in a previous post i mentioned that the Fed's base money expansion in 1929-1932 stood at 98% annualized; this was erroneous, it should have read: 'the total amount of the Fed's monetary expansion between 1929 and 1932 stood at an annualized rate of 98%'.

charts via stockcharts.com, marketgauge.com, decisionpoint.com

Gold Stocks

The recent stock market crash/deleveraging stampede has hit many stocks to the point where they actually represent value, mainly in terms of the replacement value of the assets held by the companies concerned (earnings are declining sharply, so most stocks are not yet cheap in terms of their p/e ratios).
Commodity stocks of all stripes have been hit especially hard - which is not too surprising considering the very large price declines in the commodities they produce, but to some extent the declines can no doubt be attributed to the fact that many hedge funds have held large positions in these stocks, so the need to delever has put additional pressure on the stocks of basic materials producers.

Interestingly, gold stocks have fared especially poorly - which is a bit incongruous insofar as the gold price itself, while certainly weak of late, has held up much better than other commodity prices. In short, gold has been rising relative to other commodities, which is exactly what is supposed to happen in an economic bust. Note that many of those other commodities represent a big chunk of the input cost for gold miners, with energy the most important cost item. The best explanation for the poor performance of gold stocks is probably that the sector has been more strongly affected by the indiscriminate selling that has taken place due to being relatively small and illiquid.

Recently several interesting things have happened, from a technical perspective.
For one thing, the put/call open interest ratio of all optionable gold stocks combined has risen to 0,64 (data by Schaeffer Research). This may not sound like much, but it is actually a 'pessimistic' reading when brought into the context of the readings that have been observed over the past year - only about 23,5% of all readings have been higher.
Furthermore, gold stocks have rarely been as cheap relative to gold as they are now. This is happening while gold mining margins are actually expanding (remember, input costs have been falling faster than the gold price).

The HUI index of unhedged gold stocks has plummeted to an area of support last seen in 2005, when the gold price was at around $450/oz. - note that this area of support was at the time the lower boundary of the HUI's trading range.
A number of mid tier and junior miners have seen their market capitalizations collapse to below the cash on their balance sheets, i.e. the market values their mining assets at zero now. Obviously this is unlikely to be sustained in the long term - it is largely a result of the above mentioned deleveraging process, and will be reversed once that process is finished.

A further remark regarding the fundamental situation - the best performing stocks in this sector going forward should be the 'pure plays' - i.e. producers that do not depend too much on by-product revenues from e.g. copper or other base metals, resp. also silver. Also, companies that are largely operating in countries the currencies of which have recently weakened sharply should enjoy a considerable advantage in terms of profit margin expansion.

Below are several charts illustrating the situation. A number of interesting developments can be observed; the recent decline has produced divergences with RSI, and the ratio of the HUI to the S&P 500 has gone into the opposite direction of the Gold/SPX ratio. Furthermore, the ratio of Gold to the HUI seems extremely stretched and due for a large pullback (i.e., the HUI and other gold stock indices should soon begin to rise relative to gold).

charts with comments (click on charts to see larger versions):