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Confused
Seas
By
John Riley
Chief Strategist
06/26/08
According to
Dockside Reports, Confused Seas are defined as follows:
“These
are among the worst conditions, and don't necessarily have to involve
large waves to be dangerous or make life at sea miserable. Confused
sea conditions are best avoided since there is no getting around
them… Confused sea conditions occur as a result of major shifts
in wind direction that occur quickly. This causes waves coming from
differing directions, resulting in waves that are irregular and
unpredictable.
So called
rogue waves are caused by two waves from differing directions coming
together at oblique (very wide) angles. Like two boat wakes coming
together, the net effect is to create a yet higher wave, up to two
or more times the height of the originals. These can be downright
dangerous due to their unpredictability.
When caught
out in confused seas, one needs to be particularly alert for those
big ones that suddenly pop up out of nowhere. With a bit of experience
one can come to anticipate them soon enough in advance to take evasive
action.
We often
hear reports of skippers describing boats "falling off a wave."
…A situation occurs that is the opposite of a rogue wave;
instead of two waves coming together to make a taller wave. It happens
that undulations from confused seas can create exceptionally large
troughs. The boat hull can be on a hump and suddenly that hump just
disappears out from under the boat. What happens is that the undulation
moves away, the boat is left with nothing supporting it and it simply
drops.” - David Pascoe, Rough Water Seamanship
Confused
Markets
Today’s markets are like Confused Seas. Information is coming
in from different directions and markets are acting wildly in response.
What is up big today is tomorrow’s loser.
And rogue waves
are everywhere.
Never before
have the markets been so interdependent. No longer can a strategist
look solely at the US without considering foreign economies. You
can’t look at the stock market without considering the commodities
and housing markets. The Fed’s actions are being driven by
economic, financial, foreign and political concerns.
Can't
go this way, can't go that way
The Fed is supposedly at the helm of the US economic ship, but they
seem to be getting tossed around by waves coming in from several
different directions.
The housing
market stinks, and is getting worse, the economy is on the verge
of recession and unemployment has popped up. It is obvious that
they need to lower rates to give the economy a kick.
Source: Federal Reserve; Format: CIS |
| Unemployment has been trending
upwards for the past year or so, but the recent pop up took
everyone by surprise. Raising rates before this comes under
control could make things worse |
But the Dollar
is sinking, commodities are racing and inflation is heating up.
It is obvious they need to raise interest rates.
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| Commodities have been racing, maybe too fast.
A 50% increase since last summer should be a warning. No,
commodities are not in a bubble, because to have a bubble,
you would also have to have deteriorating fundamentals. Fundamentals
are continuing strong. Global consumption keeps growing for
many if not most commodities. But, to see a wave up like this
collapse quickly would not be surprising. It would not mean
an end to the commodity bull market, just a buying opp. |
This
month Lehman Brothers almost rolled over like a certain other big
name brokerage a few months ago. Merrill, Goldman and several others
have tapped the Fed’s new emergency fund indicating they have
potential problems. Citibank just announced a $9 billion write-off
and their need for cash. The mortgage market is getting worse and
shows no sign of bottoming. So the Fed obviously has to lower rates
to bail out the financial and housing industries.
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| As we anticiapted in our last update, Banks
have gone on to new lows and Brokers look poised to follow.
This doesn't bode well for the Fed's bailout a few months
ago. It looks like there will be more problems, more writeoffs,
maybe a failure or two and more Fed intervention. |
But the Congress
is about to approve a mortgage bailout plan for homeowners, flooding
the market with more debt and liquidity, putting more downward pressure
on the Dollar, so it is apparent that the Fed’s next move
is to raise interest rates to protect the Dollar.
Waves
are high and troughs are deep
It doesn’t end there. The stock market is reeling from a wave
of factory closings from the few manufacturers still in the US.
There are daily announcements of major layoffs, and investors are
bracing for the big one - the long awaited and much delayed recession.
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Well, we are just about
20% below the all-time highs for the Dow. I don't hear Wall
Street telling investors it is a bear market yet. What are
they waiting for? As you can see from the P&F chart
above, there have been repeated sell signals since the first
failure at 12700. The trend is down. The only question is
- how fast? |
The
economy is saddled with a mountain of debt worse than before the
Great Depression. The real estate market is in full crash mode with
foreclosures piling up and prices dropping at record rates. Overseas
consumption of commodities is pushing oil, gas and food prices here
higher and higher. We all know there is inflation, even if the government’s
numbers don’t show it yet.
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| Despite continual claims to the bottom is
in, housing keeps heading lower. New home salesare down almost
66% from the highs in 2005, and Housing Starts, which didn't
start to decline until well after new home sales started lower,
are down over 60%. Higher rates won't help either of these
areas recover. |
And the commodities
markets have been acting like Dot-Coms. The populist views of oil
is that the big oil companies are pushing the price up to rip off
the little guy or that the Arabs are hiding vast reserves of oil
for themselves just to give the US a hard time or that big Wall
Street brokerages are pumping up the price to make big profits for
themselves.
None of them
are correct. Consumption is outstripping demand. It is as simple
as that. If the oil producing countries could produce more, they
would. But it isn’t just about production. There isn’t
enough global refinery capacity, there aren’t enough tankers
to move oil around the world and there is a scarcity of qualified
employees. Top that off with decades of declining new finds and
you have today’s situation.
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| The top chart is oil. Just like
the commodity chart above, it is unlikely that oil will be
able to maintain a moonshot trajectory. A major decline should
be expected. How swift the decline will be is the only question.
Oil stocks, the middle chart, already shows signs of tiring.
While oil is hitting new highs, it is declining. The same
goes for Oil Services, albeit to a lesser degree. |
Rogue
Waves
They can come from anywhere at any time. Israel attacks Iran, food
riots in India, terrorism at the Olympics, another major bank failure
in the US, a collapse of the Dollar.
All of these
are possible and probable, to different degrees. How might they
effect the US markets? And these are the just Rogue waves we are
looking for. What about the one that comes in and surprises us,
like a collapse of a sovereign government or a credit crunch. These
are also possibilities much higher probabilities than you might
think.
Should the Fed
bail out the next big bank or brokerage failure? If they do, what
does that say about their credibility? What does that say about
those that take risks? Will the Fed bail out every one?
Waves
from different directions
And what about the stock market? As the recession picks up steam
and is pushed longer and deeper than most economists expect, thanks
to the heavy debt burden on its back, how long will the bear market
last? Will the Fed have a quick fix for the recession? Can they
lower rates to mitigate a recession without sparking hyper inflation
and the Dollar’s collapse?
And if the Dollar
does collapse and inflation does pick up, where does the housing
market go? In a very friendly, low interest rate environment, housing
has been a total mess, what will happen when things get really bad?
If the Dollar does collapse, you would expect to see higher long
term interest rates
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The top chart
is a long term view of the 30yr Treasury rate. It shows
that after decades of decline, the next major move for long
term interest rates is likely to be up. The lower chart
is a shorter term view of the 30yr Treasury rate. It shows
if the rate goes above 4.90, it is likely to head higher,
up to maybe 5.50%. A breakout above there has a target of
6.10% A break above 5.50% would indicate that the long term
chart may have reversed. A break above 6.10% would confirm
it. |
Or if the Fed
raises short term rates, they could protect the Dollar, fight inflation
and push the economy quicker and deeper into recession. As rates
rise, the economy would likely continue even faster into recession,
housing would likely get worse and the stock market would fall back
into a long lasting bear market.
In what
direction do you point the ship?
Under normal circumstances, the captain points the ship into the
waves and rides out a storm. It may be a bit rocky, but they navigate
through the ups and downs and usually come out okay on the other
side.
The Fed steers
with interest rates. They are either rising or declining. Their
Monetary World View won’t allow for anything else. They can
only point the economic ship in one direction at a time. And under
normal circumstances, that works.
But not in confused
seas. A skipper has to work his way through the waves and troughs
and be ready to turn the boat this way or that way, depending on
the seas. If they choose wrong, they sink. This article has shown
that in Confused Markets, like Confused Seas, there is no single
direction to point the ship.
Unfortunately
for most investors, most money managers and Wall Street, they have
a Monetary World View, like the Fed. They can only point portfolios
in one direction and hope that it doesn’t get too damaged
in the economic storm.
Answer:
Point the ship in several directions at once.
We have a huge advantage over the Fed in that we have many more
tools and ways to navigate through these dangerous waters. The Fed
has only interest rates. We utilize a variety of investments and
strategies. Our portfolios can be pointed in several different directions
at once.
Worried about
rising inflation? We own commodities and gold.
Concerned the market could collapse? We own hedges on the market.
Scared there could be another banking collapse? We own a hedge on
Financial services.
Think the Dollar is toast? We own foreign bonds and stocks.
We don’t
suppose to have all of the answers, nor do we know when this or
that will happen. But our portfolios are built in such a way that
we are flexible enough to take what the markets give us and navigate
through the Confused Seas.
When faced with
Confused Seas or Confused Markets, you want a skipper at the helm
that isn’t limited in what he can do. You want a skipper that
has seen it before and is already prepared for what is coming.
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