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Tharp’s Thoughts

Market Update for July

Market Condition: Quiet Bear

by
Van K. Tharp, Ph.D.

I always say that people do not trade the markets, they trade their beliefs about the markets. In that same way I'd like to just point out that these updates reflect my beliefs. If my beliefs and your beliefs are not the same, then you may not find them useful.  I find the market update information useful for my trading, so I do the work each month and I'm happy to share that information with my readers. 

However, if your beliefs are not similar to mine, then the information may not be useful to you. Thus, if you are inclined to do some sort of intellectual exercise to prove one of my beliefs wrong, simply remember that everyone can usually find lots of evidence to support their beliefs and refute others. Just simply know that I admit that these are my beliefs and that your beliefs might be different.

These monthly updates are in the first issue of Tharp’s Thoughts each month. This allows us to get the closing month’s data. These updates cover 1) the market condition (first mentioned in the April 30 edition of Tharp’s Thoughts), 2) the five week status on each of the major stock U.S. stock market indices, 3) our four star inflation-deflation model, 4) tracking the dollar, and 5) the five strongest and weakest areas of the overall market.

Part I:  Market Commentary

August has largely been a sideways month, although it shows up on our classification as a bear month because the 13 week change continued to be large and down.  However, in my opinion these are some of the worst market conditions that I have seen since I’ve been a trading coach.  The last secular bear market was 1966 to 1982, and I think the conditions today are much worse than that.  It’s probably more like 1929 to 1949, which encompassed the Great Depression and World War II.  Why do I say that?  There seems to be no investment opportunities whatsoever.  All of the world markets look bad.  No country’s equity market looks strong.  And when that happens, you can usually find other areas that look good such as gold, commodities, oil, etc., but all those areas are also headed down.

Normally, even that wouldn’t be bad because there would be good markets to short.  But down markets all tend to be so volatile that it’s very easy to get stopped out, so the safest place to be right now is in cash.  But with 113 banks on the FDIC warning list, and FDIC reserves being very low, I begin to wonder if cash is even safe.  However, I’m sure the Federal Government, through the printing press, will bail out bank depositors for the FDIC.

Part II: The Current Stock Market Type Is Quiet Bear 

I have now substituted my new market type for the 1-2-3 model.  The reason I’ve done this is that as soon as the 1-2-3 model goes below a certain PE ratio (which it is poised to do) another component will turn bullish.  However, I expect us to be in a secular bear market until the PE ratios of the S&P 500 reach single digits.  Thus, the 1-2-3 model doesn’t really fit my current beliefs.  For those of you who are still interested, it is in red light mode (unless the S&P 500 PE ratio is now below 17, which could happen any time and that‘s the reason I stopped using the model).

The one thing that is suddenly clear is that the volatile markets that have characterized most of 2008 for the S&P 500 have now shifted to quiet markets.

Let’s look at what the market has done during the month of August. 

While all three indices were up and down during the month, all three still stand at double digit losses for the year.

I’m also listing the strongest and weakest areas of the market in this update. The ratings give the most weight to what has happened recently so they can sometimes change rapidly.  However, I’ll only list the strongest areas if they are up for the year and not just strong recently.  The relative strength of each component is given in parenthesis. 

Part III:  The Strongest and Weakest Market Components

Five strongest components, in order:

1)  US Long Term Treasuries (86)

2)  Small Cap Value US (83)

3)  Small Cap Blend US (83)

4)  Small Cap Growth (83)

5)  Real Estate (76)

None of these are really worth investing in right now. You should probably just be in cash.

Five weakest components:

1.      South Korea

2.      India (which was on the weakest, strongest and again on the weakest)

3.      Malaysia

4.      Singapore

5.      Sweden (31)

These are also very dangerous to short right now.  As I said, you should probably be in cash.

Part IV: Our Four Star Inflation-Deflation Model

As I’ve stated many times in these monthly updates, we are in an inflationary bear market.  Well, PERHAPS NOT.  When Steve Sjuggerud and I wrote the chapter on the big picture in Safe Strategies for Financial Freedom in 2002, I presented arguments that we could have a deflationary period ahead of us and Steve presented the inflationary picture.  And with our huge debt and a Federal Reserve that could print money at will, it was hard for me to see this scenario as being anything but inflationary.  How could the U.S. tolerate having such a huge debt in a deflationary time (when money is worth more).  Sure enough, the central banks of the world are printing money like crazy.  M3 for the United States currently stands at $13.8 trillion and M3 for the European Union currently stands at $14.1 trillion (converted to US dollars).  These data are as of May 2008.  These represent one year increases in the money supply of 18.8% and 10.5%, respectively.  Now that sounds like real inflation. 

But what I didn’t consider were the impacts of defaults.  When credit (which is one of the major ways money is created) collapses, it is a major deflationary factor.  How is that happening?  First, house prices in the US are down about 10% over the same time period.  In major markets the situation is much worse.  California real estate has dropped about 40% over the last year.  That value of US real estate is bigger than M3, which offsets about 60% of the money supply.  On top of that, you have to consider write-offs of derivatives and junk debt.  So far, $540 billion of junk mortgages have been written off the books and there is a lot more. Freddie Mac and Fannie Mae are now estimated to have a combined net worth of MINUS $50 billion; however, they still have assets (stock value and the mortgages).  But if the Federal Reserve has to bail them out those assets would become worthless.   Much of those assets are owned by regional banks – many of which are on the FDIC danger list – and that value would be wiped out.  In addition, China owns $376 billion in US agency debt – most of which is in the two FMs.  If the Fed has to bail out the two FMs, then that would also be wiped out and China would not be repaid.  Imagine the international consequences if that happened.  In addition, the credit squeeze is also showing up in the M2 money supply – in which there is now actually a net decrease. 

Thus, the 18.8% M3 increase over the last year could easily be wiped out and be a net decrease.  And that means there is less and less money to invest.  And when that happens prices go down.  That, my friends, could lead to even more deflation and deflation combined with large debt is big trouble.

And by the way, GM had a $15.5 billion loss in the second quarter.  Ford had a $8.7 billion loss in the same quarter.  The auto industry, which has long been the giant of American industry, is about to collapse without a big loan from the government.  My understanding is that Ford and GM are currently asking the government for a $50 billion loan.

Richard Fisher, president of the Dallas Federal Reserve, says that US unfunded liabilities now total almost $100 trillion and that doesn’t include the official debt of the US that has with a current ceiling of $10.615 trillion.  When the Fed published a study saying that the US was bankrupt, it estimated our total debt to only be $67 trillion – but that was in March of 2007 when that study was published.

The US Treasury’s only response to all of this is to spend, spend, spend.  Last month alone, US spending hit a new record.

So with that in mind, let’s now look at our measure of inflation/deflation.

We’ll now look at the two-month and six-month changes during the last six months to see what our readings have been.  Notice that Gold is now flat for the year 2008 and commodities are only up slightly.

For the first time since I’ve been calculating these figures, they are showing the potential for deflation.  Even energy prices are now going down.

Meanwhile at www.shadowstats.com, John Williams tells us that the government is increasing the money supply, (M3, no longer reported by the government) to over 15%, unemployment (the government doesn’t count people after their benefits run out) is at 14%, the CPI is running at over 13% (the old CPI the way it used to be calculated), and all that means is that we are  in a severe recession with the inflation adjusted GDP growth and -2%+.  And banks are folding with 113 currently on the FDIC warning list.

Part V: Tracking the Dollar

Okay the Tharp effect on the dollar showed is first contrary indicator that I can remember.  The dollar went up almost the entire time I was in Europe.

Notice that last month, most of which saw me in Europe, the dollar rose to a value higher than at the end of January this year.

Until next month’s update, t