The markets greeted the first trading day of the New Year with a sharp sell off, which picked up even more steam towards the end of the week caused by yesterday’s chilling jobs report. With all major indexes (Dow Industrials, S&P; 500, Nasdaq, Wilshire 5000, Dow Transportation), including our own international Trend Tracking Index (TTI), now positioned below their long term trend lines, the question is whether the tide has turned on the markets.

While it’s still too early to tell, many signs are pointing in that direction. Before I jump on the bear band wagon, we need to get confirmation from our domestic TTI, which so far has remained in positive territory, but is showing signs of weakness.

To look at the big picture, I found this article, written last month titled “Stock market ‘winter’ is moving in.”

Here’s an excerpt with an opinion from Paul Desmond, who heads the demand-analysis firm Lowry’s Reports, based in Florida.

Desmond observes that bear markets have occurred over the past two centuries every 52 months or so, roughly every four and a half years. Although they seem like rare events, they’re actually as regular a part of the market cycle as winter is part of the seasonal cycle. Past market lows in just the past half-century include 1957, 1962, 1970, 1974, 1978, 1982, 1987, 1990, 1994, 1998 and 2002. Surely you recall at least a couple of those.

Desmond generally recommends moving portfolios to cash and selected shorts at the start of a bear phase, since virtually all groups of stocks tend to move down together at first, and waiting to see which groups of stocks emerge as countertrend heroes. In the early 1970s, the heroes were energy stocks, while in 2000-02 they were value and small-cap financial stocks. He guesses that energy, health care and utilities may buck the trend this time, but it’s too early to say with certainty.

I have to agree with Paul’s assessment, but I will let my Trend Tracking Indexes and momentum tables guide me as to the timing of either getting into or out of certain investments. I also believe that energy, health care and utilities have good upside potential and the momentum figures in our weekly StatSheet confirm this fact. This is why we own selected positions in all three of these areas.

As usual, I will implement our sell stop discipline should it turn out that we were too early, or simply wrong, with our investment decisions.

My latest No Load Fund/ETF Tracker has been posted at:

http://www.successful-investment.com/newsletter-archive.php

The bears beat the bulls by a wide margin this week with all major indexes ending sharply lower.

Our Trend Tracking Index (TTI) for domestic funds/ETFs has moved to +2.79% above its long-term trend line (red) as the chart below shows:

The international index dropped to -5.46% below its own trend line, keeping us in a sell mode for that arena.

For more details, and the latest market commentary, as well as the updated No load Fund/ETF StatSheet, please see the above link.

Reader Tom submitted the following chart which shows the economic output from all U.S. states compared to the rest of the world. While I can’t vouch for the accuracy it nevertheless still confirms that the U.S. is still the big dog on the block; it’s an interesting way to look at the globe (click on graph to enlarge):

“In the midst of a housing collapse and credit crunch, the impending doom of the U.S. economy is taken as gospel. But look behind the headlines, and the numbers tell a different story. The U.S. economy grew by 3.9% in the credit turmoil-ridden third quarter — following a 3.1% jump in the second quarter. That means that the United States added the equivalent of a new Saudi Arabia to its economy just since the beginning of April. And the fact that the World Economic Forum ranked the U.S. econom y the most competitive economy in the world last week got little press. And even when it did, the #1
ranking of the United States was explained away as a statistical
mirage.

This is not to say that the U.S. economy is in ship shape. But with all of the talk about China and India dominating our economic futures, it’s worth reminding ourselves where these new economic challengers stand in comparison to the United States today. Despite the high
economic growth rates of developing nations, the United States is by far the world’s wealthiest nation as measured by GDP — the broadest measure of economic wealth. And the rest of the world isn’t even close. This year, U.S. GDP is projected to be $13.22 trillion. That means that the U.S. economy is as large as the next four-largest economies in the world — Japan, Germany, China, and the United Kingdom — combined.

The map above — originally published here — puts the size of the United States’ global rivals in perspective. On the map, the name of each U.S. state is replaced by a country, whose GDP equals approximately that U.S. state’s GSP (gross state product.) A quick glance at the map leads to some fascinating — and unexpected comparisons.

Standing alone as a country, California would be the eighth-largest economy in the world and approximately the size of France. Texas’ economy is half the size of California’s and its GSP compares to that of Canada. Florida’s GSP is approximately the size of Asian tiger South Korea. Illinois’ economy is approximately the size of Mexico. Ohio’s economy is roughly the size of Australia’s. Tennessee’s GSP is the size of Saudi Arabia; Nevada, the size of Ireland; Alabama’s economy is the size of Iran. Bill Clinton’s home state of Arkansas, one of the poorest states in the United States, is approximately the size of Pakistan’s economy.

And what about the United States’ nearest rivals? Germany and China — #3 and #4 on the list of the world’s largest economies — are smaller than the economies of Texas and California combined. India’s $800 billion economy is on par with Florida. Brazil, as we see on the map, is comparable to New York. Russia’s economy is about the size of New Jersey (or Texas).”

Reader Nitin submitted an article from the NYT written by Floyd Norris titled “Credit Crisis? Just Wait for a Replay.” It tries to look beyond the Subprime debacle by trying to answer the question “What if it’s not just Subprime?”

It’s an interesting read and makes you look at other potential problem areas. This is not meant to dwell on negatives but to simply be realistic as to what else might be in store. To me, this view is more important for those who simply buy and hold their investments, and disregard any change in trends; because they will be exposed to an indefinable risk should the markets drift toward bear territory.

“As 2007 ends, it seems that the financial world shakes every time a company reveals some new exposure to the disastrous world of subprime mortgage lending.

But just how different was subprime lending from other lending in the days of easy money that prevailed until this summer? The smug confidence that nothing could go wrong, and that credit quality did not matter, could be seen in the many other markets as well.

That was particularly true in the corporate loan market. Loans were cheap, and anyone worried about losses could buy insurance for almost nothing. It was not an environment that encouraged careful lending.

“The severity of the subprime debacle may be only a prologue to the main act, a tragedy on the grand stage in the corporate credit markets,” Ted Seides, the director of investments at Protégé Partners, a hedge fund of funds, wrote in Economics & Portfolio Strategy.

“Over the past decade, the exponential growth of credit derivatives has created unprecedented amounts of financial leverage on corporate credit,” he added. “Similar to the growth of subprime mortgages, the rapid rise of credit products required ideal economic conditions and disconnected the assessors of risk from those bearing it.”

There are differences, of course, and they may be critical in averting a crisis. To start, there are virtually no defaults in corporate lending now, and even if Moody’s is accurate in its forecast that defaults will quadruple in 2008, the default rate on speculative loans and bonds would still be below the long-term average. That hardly sounds like a crisis.

And there is no reason to think that fraud was a big factor in the corporate loan market, as it seems to have been in subprime.

But the history of junk bonds provides a warning that defaults start to rise a few years after credit gets very easy. By that standard, says Martin Fridson of the research firm FridsonVision, a new wave of defaults is overdue. Already, even without defaults, he says, about a tenth of high-yield bonds are trading at distress levels — levels that provide yields of at least 10 percentage points more than Treasuries.

If a recession does occur, one can easily foresee a wave of defaults in junk bonds and their bank-loan cousins, leveraged loans. With highly leveraged structures supported by some of those loans, the surprises could be greater. It is sobering to realize that the issuing of leveraged loans set a record in 2007, even though the market contracted sharply late in the year.

If this was the year that many readers — not to mention financial reporters — learned what C.D.O., M.B.S. and SIV stood for, 2008 could be the year of C.D.S. and C.L.O. (For those who came in late, those abbreviations from 2007 are shorthand for collateralized debt obligations, mortgage-backed securities and structured investment vehicles. The new ones are credit default swaps and collateralized loan obligations — a special kind of C.D.O. backed by corporate loans.)

We have learned in the last month that credit insurers took big risks in backing C.D.O.’s and other exotic things. Some are scrambling to raise more capital to stay in business. One, ACA, may well go out of business.

But if the credit insurers turn out to have had inadequate reserves, what are we to make of the credit default swap market? Mr. Seides calls it “an insurance market with no loss reserves,” and points out that $45 trillion in such swaps are now outstanding. That is, he notes, almost five times the United States national debt.

Many of those swaps cancel each other out — or will if everyone meets their obligations. The big banks say they run balanced books, in which they sell insurance to one customer and buy insurance on the same borrower from another customer. But if some customers cannot pay what they owe, this could be another shock for bank investors. As it is, financial stocks have underperformed other stocks by record amounts this year.

One of the more remarkable facts about the subprime crisis is that total losses to the financial system may be about equal to the amount of subprime loans that were issued. On the face of it, that appears absurd, since many such loans will be paid off, and those that default will not be total losses. But, Mr. Seides said in an interview, “the financial leverage placed on the underlying assets was so high” that the losses multiplied, as the profits did when times were good.
“When there is more leverage” and things go wrong, he said, “there are more losses.”

The corporate credit market is vastly larger than the subprime market, and there are plenty of dubious loans outstanding that probably could not be refinanced in the current market. If some of those companies run into problems, defaults could soar and fears about C.L.O. valuations and C.D.S. defaults could spread long before there are large actual losses on loans.

There are other areas of potential weakness in 2008. Commercial real estate is one area where some see disaster looming. Others worry that some emerging markets could run into big problems because many borrowers there have taken out loans denominated in foreign currency and could be devastated if local currencies lose value.

It was the greatest credit party in history, made possible by a new financial architecture that moved much of the activities out of regulated institutions and into financial instruments that emphasized leverage over safety. The next year may be the one when we learn whether the subprime crisis was a relatively isolated problem in that system, or just the first indication of a systemic crisis.”

2007 was the year where most investors became acquainted with a variety of new terms created by Wall Street, some of them which by now have reached infamy. CDOs, RMBSs, SIVs and many others made it to the front pages of every financial newspaper and web site.

The better known ones are CDOs (Collateralized Debt Obligations), which have been around since the 1980s, but only more recently have been applied to mortgage backed securities. According to the WSJ, they were designed to provide investors with greater diversification and disperse the risk of mortgage lending. But so called mezzanine CDOs such as Norma actually served to magnify and concentrate the risk.

I like to thank the anonymous reader who provided me with the link to the WSJ that takes you through the five steps and explains how those CDOs were made. It’s a fascinating concept and will help you better understand the process of how your loan, along with millions of others, got sliced and diced and sold to institutional investors around the world.

It also makes you realize that the risk that comes with owning these CDOs has spread to many countries and it is unknown who holds how much of these now severely discounted or even worthless instruments. In a way, it’s time bomb because you simply don’t know who is next in line to come clean and admit losses that they can no longer absorb.

In the face of only negative real estate news for most of this year, as a result of the Subprime/credit crisis, the National Association of Realtors (NAR) managed to dispense any kind of information related to the topic with a positive undertone. I am not sure if that was out of sheer ignorance or a motivation to rally the troops.

Minyanville’s Kevin Depew had this to say in “Five things you need to know (item 4):”

In 2005, National Association of Realtors Chief Economist David Lereah released the book, “Are You Missing the Real Estate Boom? Why Home Values and Other Real Estate Investments Will Climb Through the End of the Decade – and How to Profit From Them.”

2007: “Why the Real Estate Boom Will Not Bust and How Foreclosures are Technically Part of the Continuing Real Estate Boom, In a Way.”

2008: “Why the Real Estate Boom in Distressed Properties Will Not Bust (except in certain local markets) and How You Can Use Leverage to Profit From It.”

2015: “Why Can I Maybe Borrow a Couple Dollars Off You Until the Real Estate Bust is Over?”