Rick’s Picks

Thursday, May 25, 2006

For investors who’d rather be smart than lucky 

My gut is telling me that we should short the bejeezus out of every rally that comes our way these days. Stocks feel like they are being held aloft, but only barely, as the smart guys prepare to bolt for the exits. Take the Dow Industrials. They’ve traced out a teepee in the last month and are now struggling to avoid breaking beneath its floor. Ordinarily, the consolidation pattern this has created in the last few days would be prelude to a short squeeze, or at least to the construction of a right shoulder within a larger H&S pattern. However, to achieve proper symmetry in time, that would imply that the impending collapse is still at least a few weeks away.

Can Da Boyz hold up the averages for that long? I seriously doubt it, especially with the bird-flu thingie threatening to touch off a stampede out of any and all stocks that will not somehow benefit from a global pandemic that kills hundreds of millions of people. Bird flu is not the only dark cloud on the horizon, either. There is also an imploding housing boom that threatens to turn our piddling consumer inflation into a catastrophic debt deflation.

Dreaming of 5%

This is notwithstanding recent assertions from Pimco that the upward trajectory of real estate prices is about to merely slow to a more sustainable 5 percent. In your dreams, maybe. Pimco is not the only formerly reputable bear that has made a 180-degree turn just in time to soft-peddle the housing bust. My friend Jas Jain has been keeping tabs on other high-profile pessimists who, though recently justifiably gloomy, now sport big “Smiley” buttons on their lapels.

Here’s Jas, eager as always to name names:

During 1997-98, when the U.S. stock market had exceeded all prior valuations and all historical signs of warnings were being ignored, it was clear to me that a new mood of carelessness had taken root among the America’s “educated” class; there was a widespread lack of cautious attitude, and an unhealthy lack of skepticism existed about the promoters and business leaders, including the Federal Reserve. I concluded then that whenever this ends, and it has definitely not ended yet, it would end badly.

At the time, I shared an insight with a colleague at Cisco, stating that the worst will not come until those who are cautious and issuing warnings either capitulate or are discredited, primarily because of the length of time during which they have maintained their negativity about the future. All this is part of human nature. The past ten years, especially, in the U.S., have been a period of extraordinary speculation among the middle class, first in stocks and later in housing, the two largest asset classes. All indications are that speculation in housing is coming to an end, very rapidly.

Time Running Out

It appears that we are now at a point in time when the worst that some of us doom-and-gloomers have been predicting might be near. The reason for this assessment is that something very important transpired during the past few weeks that has gone mostly un-noticed: to wit, four noted pundits -- two economists and two investment gurus -- employed by the most powerful and influential financial firms in America, who were cautious for a long time, capitulated. Two of them, Rich Bernstein and David Rosenberg, work for Merrill Lynch, and their capitulation could be taken as a result of a common conclusion. The other two, Stephen Roach of Morgan Stanley and Bill Gross of PIMCO, have given up their bearish outlook for the U.S. and the world economy.

All this happened over a period of 15-20 days during which the financial markets seemed to be signaling greater danger and uncertainty ahead than for quite some time. It began with David Rosenberg, interviewed remotely on CNBC. He said at the time, “We have raised our target on S&P 500” – that is, he and the firm have turned more bullish on the stock market. Mr. Rosenberg, the chief North American economist for Merrill Lynch, has been very cautious on the economy, a big believer in the Housing Bubble and its recent climax. He has also been a staunch deflationist, maintaining that the economic forces in play are deflationary, and that inflation is not a threat.

Merrill’s Deflationist

Only a few days ago I received an e-mail from a fellow bear and deflationist with the title, “Excellent report from Merrill's David Rosenberg, with a deflationary theme.” I had already read that report, and hundreds of others from Mr. Rosenberg over the past several years, and examined thousands of graphs and tables complied by his team. Most of them support a negative view of the U.S. economy going forward and a deflationary bias, as the Housing Bubble’s support of the economy unwinds and aggregate consumer demand goes down.

Almost at the same time, Mr. Roach, the most famous bear on the U.S. economy, threw in the towel with his now-famous “World-on-the-Mend” message to investors. In it he noted the following: “While an unbalanced world has yet to shake its hangover from global healing, I must confess that I am now feeling better about the prognosis for the world economy for the first time in ages.” The most interesting part of this newfound enthusiasm is his admission at the very beginning that the last time he felt this good about “global healing” was in 1999, and that he was proven wrong instantly! It appears that Mr. Roach is none the wiser seven years later. Is the recent run-up in gold price a signal of “global healing” -- or of the “global imbalances” blowing up, as Mr. Roach has feared for so long?

CNBC’s Pat on Back

As soon as the news of Merrill Lynch’s top economist/strategist turning bullish on the stock market reached CNBC, Rich Bernstein was invited to the network’s “world headquarters” on the morning of May 3, welcomed with open arms. Essentially, the team at Merrill Lynch, which had the most bearish allocation among the leading firms, had cut its allocation of bonds and simultaneously increased its allocation of stocks, turning bullish after a 15% relative out-performance of stocks over bonds over a six-month period! Thus far, it is turning out to be a very poorly timed change of heart.

Those with whom I communicate regularly know that I have held the two gentlemen from Merrill in the highest regard for their excellent analyses. It is obvious that those employed by Wall Street firms are under tremendous pressure to be bullish, and an analyst has to be very good indeed if he is to be bearish, or even cautious, for a long period of time. Bernstein and Rosenberg were undaunted in their cautious views because of the supporting data that they could provide. So, when I heard about their change-of-view, I smelled something fishy because their analyses had hardly changed. If anything, Mr. Rosenberg’s recent analyses are even more supportive of a weakening U.S. economy and deflationary pressures.

Pressured to Be Bullish

The rather lame excuse Bernstein gave for the allocation changes is that the Merrill team sees a lower dollar. However, if one examines the relationship between the dollar and U.S. stocks and bonds over the past ten years or so, one would come to the opposite conclusion. Moreover, the weakening U.S. economy, an impetus for lower dollar, can’t possibly be good for stocks and bad for bonds. If there is a pressure on someone to change his bearishness, though, I am sure a reason can be concocted.

The last one to capitulate, and the most influential financial guru in the U.S. in recent years, was Pimco’s Bill Gross. Just last week, he changed his forecast for the 10-year U.S. Treasury Note yield-range from 3.0-4.5% to 4.0-5.5%. This, after the rate had touched 5.2% and has been above 4.5% for more than three months. What was Mr. Gross’s excuse for turning more bullish on the world economy? What has changed over the last few months to justify that outlook? When the two biggest voices among bond bulls, Gross and Rosenberg, throw in the towel, who is left? A yield below 4.0% is very likely in 2006 now that Mr. Gross has given up on it. Has the “Bond King” called the top in the bond yields? Yours truly, the Bond Prince, thinks so.

The only people left in the bear camp are stalwarts of the underground, commentators who have a limited circulation via the Internet. Even they have suffered some credibility loss because people are impatient and demand a certain outcome in a short period. Those of us who focus on the long cycles know how long it takes for the imbalances to build up and be resolved. Let me quote Alan Greenspan: “Knowing that something will happen and when it will happen are two different forecasts. The latter is harder than the former.”

Only Question Is When

From the conditions that have existed in the U.S. for the past ten years, a Second Great Depression is unavoidable; the only question is: When? The time window has been narrowed down to this decade, I believe, and is dependent on how the unwinding of consumer debt plays out. The man who contributed most to this dangerous condition, Alan Greenspan, has manifestly ignored his own advice: “Debt is bad. Pay it down as fast as you can.” Also, he shared my distinction between private debt for consumption versus for productive investments: “…there is no limit to the size of private debt, provided it is used for productive purposes.”

I believe that the capitulation of the four noted pundits, over a very short time frame, can be taken as a sign of something big to begin in the coming months and quarters. If my prediction of the next recession to begin in 2006 were to come true, it would be preceded by a significant drop in the stock market before the end of August. For all we know, it could have begun already.

Another important signpost would be when Toll Brothers, a high-end home-/hopebuilder whose shares are currently trading around $28, falls below $20. When it falls to $15, we may have entered the recession, or be only a month or two away from one. (Economists usually inform us six to nine months after a recession has begun.) If the recession does begin in 2006, it is a safe bet that the world would be in a deep depression by 2008. Bust follows boom as surely as sunrise follows sunset.

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Australian Seminar? 

Quite a few of you have indicated you are likely to attend the hidden-pivot seminar in New York this October. I’ve also heard from about a half-dozen Australian readers and subscribers who said they’re interested but that it would be too far to travel. However, I’m willing to come to Sydney or Melbourne if I can fill a class, so let me please hear from you if that would work.

The New York session will be a no-frills version of the course that I gave in Denver, offered at a significant saving over the original price. After that there will probably be just one more session offered – in San Francisco, late in 2006 or early 2007 -- but that would be the last for a long while.

The course includes post-grad mentoring via a chat group that some of my former students have set up. If you’ve been impressed with the accuracy of my forecasts, this is an opportunity you should not pass up. Please let me know via e-mail if you are serious about coming.

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Information and commentary contained herein comes from sources believed to be reliable, but this cannot be guaranteed. Past performance should not be construed as an indicator of future results, so let the buyer beware. Rick's Picks does not provide investment advice to individuals, nor act as an investment advisor, nor individually advocate the purchase or sale of any security or investment. From time to time, its editor may hold positions in issues referred to in this service, and he may alter or augment them at any time. Investments recommended herein should be made only after consulting with your investment advisor, and only after reviewing the prospectus or financial statements of the company. Rick's Picks reserves the right to use e-mail endorsements and/or profit claims from its subscribers for marketing purposes. All names will be kept anonymous and only subscribers’ initials will be used unless express written permission has been granted to the contrary. All Contents © 2006, Rick Ackerman. All Rights Reserved. www.rickackerman.com