Tuesday, September 22, 2009

Is This a Sign of a Top?

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September 22, 2009

Changing Sides?

Several times recently we have warned about investing with the herd. More often than not, it is disastrous for your investments. But what do you do when one of the loudest contrarian voices jumps ship?

James Grant is often referred to as a "perma-bear." Reporters ring him up when there is a downturn in the markets. A glass half empty kind of guy.

For years he has warned of market corrections, including the most recent collapse. But it is his recent article in The Wall Street Journal and newly bullish stance that has contrarians abuzz.

"With regard to the recession that precedes the recovery, worse is subsequently better," Grant writes. "The deeper the slump, the zippier the recovery." He later adds, "I promised to be bullish, and I am (for once) – bullish on the prospects for unscripted strength in business activity."

Is a tiger changing his stripes a sign of a market top?

It is certainly one of them. When a famously bearish analyst joins the chorus of bulls, we take note. Grant claims his position to be contrarian. "The world is positioned for disappointment," he writes.

But not the way we see it. We see way too many media hacks on their knees examining "green shoots." And far too many investors drinking the government's Kool-Aid that the recovery has arrived.

This rally has not been built on the foundation of improving fundamentals. There is still too much wrong with the economy to hope that a new bull market is beginning just yet.

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The market is behaving like it always does…

Sharp rallies are the rule in a bear market, not the exception. It is common for the market to rocket upward in an overall downtrend, relieving bearish sentiment and making investors forget their fear.

Take a look at the following chart (provided by Elliott Wave International) of the Dow Jones from 1929 – 1932. During that time, there were seven major declines and six major rallies.

The rallies ranged from 19% to as high as 101%. And in every case, investors probably thought the worst was over and a new bull market had dawned.

In our private newsletters, we're not recommending that subscribers sell and exit the market. This rally could run much higher, the fundamentals be damned. Instead, we let the market tell us when it's time to get out – when our trailing stops are triggered.

Flight to safety…

When over half of all corporate bonds carry a "junk" rating, it is only a matter of time until default rates start increasing.

According to a Bank of America study, the number of junk bonds outstanding at the end of 2008 that could default by 2013 approaches 40%.

And the rates are already increasing. According to Standard & Poor's, the default rate in 2007 was around 1%. The latest figures from August put the U.S. junk bond default rate at 10.2%. The past two high-default periods have averaged 30%.

With low interest rates, companies (just like consumers) went on borrowing binges. In 2013 and 2014 alone, $361 billion in junk bonds will mature.

Bank of America expects that 40% of these companies won't be able to refinance their debt. That means these bondholders (and certainly the stockholders) would be left with virtually nothing.

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This just re-enforces the importance of buying the right bonds. That is why our own Steve McDonald only recommends investment grade corporate bonds to subscribers of The Bond Trader. "No junk!" says Steve.

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Look who's holding the bag…

The government and the media have claimed "Cash for Clunkers" a success. While, auto sales certainly spiked in August, this was simply the result of future demand pulled into the present.

Now, word is coming that the program could be the death of many dealers. Why? Rejected rebates. Of the roughly 700,000 "Cash for Clunkers" transactions, around 60,000 have been denied by the government.

The dealerships have already credited the $3,500 – $4,500 toward the sales price. If the claims are denied, the dealerships will have to absorb this as a loss.

Some of these could be due to clerical errors that can be fixed. But anything that keeps dealerships from getting paid could be a kiss of death. Many are already operating on the edge.

And because the vehicle that was traded in had to be destroyed, these dealerships can't even try to recoup some of the loss by selling the "clunker."

And this won't be the only thing haunting us from this disaster of a program…

Here is what IDE reader KB from Oklahoma has to say about Cash for Clunkers:

"Thank goodness this disaster is over! And we will notice the following details about the car manufacturers:

  • The hiring of workers to fill the assembly lines will be temporary;
  • There will be (already is) a severe shortage of cars on dealer lots;
  • New production will soon reach these dealer lots;
  • No one will have money they want to spend on new cars because:
    • No more stupid tax rebates;
    • No certainty about their own economic future;
    • No money to spend.

"We can then expect a reversal of the past few months, as consumers who over-spent for new cars (when they would have preferred a less-expensive but operable car they already owned) will not be able to afford the payments on their new buggy and will end up losing it back to the lender.

"If this consumer still needs transportation, they will not be able to find any at their newly-adjusted price threshold, since all these "affordable" cars were destroyed. This may cause them to make adjustments in their own employment due to inability to commute. The dealers will soon be taking on inventory based upon stupid projections created during the false boom months, resulting in excess supply of now-overpriced cars on their lots. The manufacturers will have to cut back production severely to save money that consumers are no longer spending. And the new hires will be back out of a job again.

"What kind of fool would have dreamed of this? Only a fool educated in government theory, the kind who never sees the unintended consequences, but feels their deeds should only be judged by their original intentions as seen by them."

Good Investing,

Bob Irish
Investment Director
Investor's Daily Edge

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Market Window

Bob Irish - Investment Director
Andy Gordon - Editorial Contributor
Jon Herring - Editorial Director
Ted Peroulakis - Editorial Contributor
Christian Hill - Managing Editor
Dr. Russell McDougal - Editorial Contributor
Steve McDonald - Editorial Contributor
Michael Masterson - Consulting Editor

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