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January 14, 2009 — Issue #406
  
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2009 Market Outlook by Van K. Tharp

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Volatility: The Real “Back Story” in Today’s Market, Part IV by D.R. Barton, Jr.

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Feature

2009 Outlook

by 
Van K. Tharp, Ph.D.

Let’s look at what the media is saying about the market. Barron’s had its annual forecast for 2009 and 10 out of 10 experts predicted that the US stock market would rise between 10 and 20% in 2009. I think it’s possible that we could easily have one day in which we see that kind of performance (as we did in 2008), but I sincerely doubt that 2009 will be an up year.

The media is mostly saying that stocks bottomed on November 21, 2008 (with the S&P 500 reaching as low as 740). As a result, they are also saying that an economic recovery will start in the second half of 2009. In my opinion, there is no way that will happen. The media doesn’t even understand much of what is going on. 2009 was nice to us in that the first week in January became our first indication of a volatile sideways market in some time. In fact, given that the market was down 18% on the worst week of 2008, which is about to disappear from our 13-week rolling windows, we could even start signaling a volatile bull market. But that would be a statistical fluke in my opinion. We probably need to change our market type to depend on a 13-week exponential moving average so that big down or up weeks dropping out don’t have that much of an effect on the overall average. 

Let’s look at a chart. Different chartists could find all sorts of interpretations of what this means (i.e., the market displayed between the two red lines)—a flag, a pennant, a head and shoulders bottom (although it’s a v-bottom) or a simple sideways (but highly volatile) consolidation with a 200 point range. The market could either go up or down from this sort of range. But since the media is unanimously proclaiming Nov 21st as the bear market bottom, I would guess that we’ll be going down from here.

The media is also saying stocks are cheap. But my response to that is “Cheap compared to what?” Compared with other bear market bottoms we have a long way to go because we are no way near PE ratios in the single digits for the S&P 500. But compared with early 2008, yes, they are cheap.

The media also says that corporate bonds are a buy. But before you jump on that one, wait until you read more about the last great bubble that is ready to pop.

And lastly, the media is saying that stock market is discounting all future bad news. Let’s see what else could happen in 2009:

  • Another 140,000 retail stores could close as in 2008.

  • Factory production in almost all areas is below 75% of capacity and many factories start to close at 70% capacity.

  • What happens if people refuse to buy Treasury bonds and notes with the current low interest rates?

  • What happens if the dollar is officially dropped as the U.S. world reserve currency?

In my opinion, all that is possible in 2009 and some of it is likely. Is the current stock market discounting all of that?

In 2008, the world lost about $70 trillion of its value. At the start of 2008, the world GDP was at about $US52 trillion, so we had to absorb more than the entire production of the world in losses. And 2008 could just be the beginning.

2008 was the second worst decline in the U.S. stock market history (with the worst being in 1931). At the Nov 21st lows, we were well below the 1931 levels. For many countries in the world, such as Australia, 2008 was the worst year in recorded history for the stock market. The MSCI World Index dropped 42.4% in 2008 with China falling by more than 65% in 2008.

2008 saw major declines in equities, real estate and commodities. The S&P Shiller 20 city real estate index was down 18% in October over the last 12 months and down 23% from its peak in June of 2006.

Finally, the commodity collapse in 2008 was unparalleled. Oil went from making new highs at $147/barrel to hitting just above $30 around the end of the year. U.S. Steel output plunged 50% since September. And the CRB index of 19 raw materials, after hitting a record high of $147.27 on July 11, plunged to 229.54—the biggest plunge in the history of the index.

The U.S. Institute for Supply Management’s factory index fell to 32.4. Furthermore, its new orders measure reached the lowest level on record—falling 22.7% in December.

Lastly, international airlines saw a huge plunge in traffic cargo in November (13.5%). This was due to the fall in the shipment of last minute critical components that now very few companies seem to need. Combine this data with the fact that global shipping demand has fallen 94% since its high last May, and you can begin to see what’s ahead for both the United States and for the world. Our economy and the world’s economy, in my opinion, have not begun to see the impact of this global drop in shipping goods worldwide.

So What’s the Big Picture?

Expect a Debt Crash Eventually. First, although equities, commodities and real estate fell dramatically in 2008, there is one area of the economy that didn’t fall. It’s the fourth bubble that could burst in 2009: debt instruments.

When the Federal Reserve effectively lowered its interest rate to 0-0.25%, it marked the end of a great bull market in bonds that started in the 1980s. When interest rates go down, bond prices go up. Three days after the Fed’s decision, the 10 year note hit an all time high of 142.20. It’s gone down since that time, but with Fed rates at effectively zero, the bull market has ended. There is only one direction interest rates can go now, and that is up. And when interest rates go up, bond prices go down. 

Obama has inherited a trillion dollar deficit. His plans are to spend another trillion. And state governments are also in big trouble, so expect another trillion dollar deficit to go into bailing them out—all in 2009. And with interest rates at zero, who is going to pay for this? The Federal Reserve is printing money to pay for it. But this is a big change. In the past, other countries bought our federal debt. But why should they do so now when they get very little interest for it? Who is going to pay for that $3 trillion in 2009?

It is almost inevitable that the Federal Reserve will have to print the money to pay for that debt because who wants to buy Treasuries under these conditions? Do you?

Expect an Escape from the Dollar Eventually. The U.S. dollar has been the world’s reserve currency since 1944 (when it was backed by gold and even since the 1970s when it was simply back by nothing more than the printing press). But how long can that last? Who wants to hold Treasury debt or dollars when U.S. interest rates are so low? The answer is no one. Money flows to where it is treated best—a stable currency with a strong interest rate behind it. Right now that is not the U.S. dollar.

The only thing keeping the U.S. dollar strong is the fact that there is not a better substitute. So many countries hold dollars as their reserves that a U.S. dollar crash hurts everyone. But there is NOTHING right now that is attractive about the U.S. dollar.

And What Can We Expect the Economy to Do?

I read three year end summaries of people I respect to get some idea about this one and I got three different answers. The logical answer is to stay in cash and let the market tell you. But the government, with interest rates at effectively zero, does not want people to stay in cash. If you are a money manager and you don’t know what the market is going to do (logical right now), you go to cash. Right now the interest rate is about 0.2%, but the manager is charging his clients 1-2% in fees, so the clients lose money. Thus, the manager feels that he/she must do something, but what?

John Mauldin says we’ll have another “Muddle Through” type of year—expecting a rally at some point during the year in equities. His forecast is gloomy, but he says that he’s really optimistic.

John Williams, the economist who tracks real inflation (i.e., the 1980's CPI and real unemployment) says that we are going to have a hyperinflationary depression. This is fine because you would expect “things” to do well as the dollar inflates out of existence. This is certainly what our politicians want. You certainly do not want deflation (money is now worth more) when you have high debt as we do in the U.S. And if you knew this was going to happen, then you’d want to purchase gold, commodities, real estate and take on lots of debt.

However, what’s happening is that people are not spending. They are paying off their debt. This is causing a massive credit contraction, which is the opposite of what the government really wants to see. When the world GDP is 52 trillion US dollars and the world loses $US70 trillion in value from real estate, equities, and commodities, there is a massive contraction in the economies of the world. Keynesians want to stimulate the economy. Our government is dominated by Keynesians and Obama is bringing in more of the same. Economists say “Give the economy a massive stimulation. Don’t save! Spend, borrow, spend, borrow, spend‼‼” But that’s not what is happening. People are trying to save and pay off debt. People are scared. (According to Keynesian economics the state, (i.e., public sector) should stimulate economic growth and improve stability in the private sector through, for example, interest rates, taxation and public projects.)

The net result, according to William Buckler (another economist I follow), is that we are having a massive deflationary depression. Here cash is king and debt is bad. But you only get paid less than 1% on your cash, of course, because the government wants you to spend.

So what’s my opinion? I actually don’t know what to expect…. inflation or deflation. I just know that the markets can have very fat tails and what we are seeing on a global basis could be unprecedented. So let the market tell you what is happening and right now that is a highly volatile sideways equity market, a massive bear market in most commodities, and a massive bear market in real estate and probably a top to the bond market.

What’s My Advice?

  • Monitor the market type.

  • Only trade systems that fit the current market type. (See the Definitive Guide to Position Sizing to really understand this concept).

  • Short term systems are probably much better than long term systems in this climate. For example, if you actually expect the stock market to be up 10-15% in 2009, and you can get a move of 10-15% in a single day in something, then why wait a year to see if you are going to still be profitable?

  • From time to time, you could see immense bargains. Make sure they make sense long term, and even if the are very long term positions that seem like no brainers, don’t commit more than 3-5% of your equity on those positions. 

a. As an example, when oil hit $30/barrel, Ken Long suggested a position in oil that would be equal to 1% of your portfolio that you held onto for many years.

b. When the U.S. government got behind mortgages, then an investment in some of the virtual banks (NYL and HTS) was a no brainer at 20-25% interest. And within a short period of time, you also had an equity rise of about 25%. Here, because of the return, you might have invested a lot more.

I expect more of these opportunities to be available in 2009, so be patient.

Overall, the picture is rather gloomy, but there will always be good opportunities. Know how to find them and be patient.

I don’t trade currencies, but I keep getting a lot of “thank yous” from people who have read the Definitive Guide to Position Sizing and are making profits in currencies. 

On a personal note, I begin my around-the-world travels this month on the 24th. My wife and I are traveling to Dubai, UAE, from the 24th to the 28th, then to Bangkok, Thailand, from January 28th to February 3rd. Then we'll be in Sydney, Australia from February 4th to the 19th. Hopefully this schedule will minimize the jet lag!

About Van Tharp: Trading coach, and author, Dr. Van K. Tharp is widely recognized for his best-selling book Trade Your Way to Financial Freedom and his outstanding Peak Performance Home Study program - a highly regarded classic that is suitable for all levels of traders and investors. You can learn more about Van Tharp at www.iitm.com.

 

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Trading Tip

Volatility: The Real “Back Story” 
in Today’s Market, Part IV

by
D. R. Barton, Jr. 

 

Have you ever known any of those people who are true math geeks?  I’m talking about folks that see everything in a mathematical way.  They "mathematize" a way to many things—things that “normal” people would think about in terms of formulas.  My daughter, Meg, and my son, Josh, both go to a great high school—the Charter School of Wilmington (Delaware).  It’s consistently ranked in the top 50 high schools in the country.  And being a math and science magnet school, it is chock full of math geeks.

So, when I needed a math geek reference, I asked my progeny for one.  Meg piped up, “This morning, I heard some kids talking about Eulerizing their route between classes.”

Pause for effect.  I’m hoping that you, like me, didn’t know what this meant the first time you heard it.  Let me explain (and then we’ll get on the volatility goodies).

Leonhard Euler was an 18th century Swiss-born mathematician and physicist.  To be brief, his contributions to math and science are manifold and legendary.  The one my daughter was referring to was the Eulerian circuit.  It is the same math that is used to determine the routes for mail carriers, etc.  Indeed, Meg’s pals were just trying to determine the most efficient path from homeroom, to all of their classes, and back to homeroom at the end of the day…but in a very math geeky sort of way.

I’m far from a math geek.  In fact, since I was a junior in high school, I had to beat myself about the head and neck just to force myself to study to get through math classes.  

Yet I persevered.  In fact, I was only two courses away from a math minor in college because of all the stinkin’ math courses my chemical engineering curriculum required.

What I really do like, though, is the useful application of math (and science, for that matter) to everyday life.  And this brings us back to VIX as a volatility measure.

Don’t worry, though, we’re not going to dig into the math equations.  But we will talk a bit about what VIX is trying to accomplish.  Understanding this foundation makes it a much more useful indicator.  If you want to dig into the math (for all those lovely self-professed math geeks, and the closet variety as well), you can go to the CBOE website.  They have a whole subsection on the VIX with white papers that will take you as far into the weeds as you’d like to go.

Math Geeks Unite: VIX Really Is Useful

The stated goal of VIX is to represent expected volatility for the next 30 days.  From its inception in 1993, VIX did this by measuring the variation between put and call prices in indexes.

That general concept still applied after significant changes were made to the calculation in 2003.  In that year, the following major revisions to the calculation were implemented:

·   S&P 500 options are now used instead of S&P 100 options.

·    A full range of active strike prices is used instead of just the at-the-money strike.

·    Black Scholes option model is not longer used to calculate an implied volatility.  Rather, expected volatility is derived by averaging the weighted prices of out-of-the-money puts and calls.

Back in 2003, some of my analyst friends were up in arms about the changes in the VIX.  Admirably, the CBOE did historical calculations for both the new VIX (symbol $VIX) and the old VIX ($VXO) so that data is available for comparison back into to 1986.

So here are the main questions that traders and investors have:

1. Is VIX useful?

2. Has the 2003 calculation methodology change made it more or less useful?

Let’s look at a weekly chart of the markets that DOES NOT include the Fall of ’08 meltdown.

Sorry for the busy chart.  To keep you from squinting, the top symbol is the S&P 500 cash index, the next one down is $VIX, below that is $VXO and lastly, ATR.  This is a weekly chart.  In short, on a weekly basis, the difference between $VIX and $VXO is pretty small.

Also notable is that the $VIX is much more useful in identifying intermediate and longer term bottoms than it is for finding tops.  However extended periods of moderate to low $VIX activity are useful for identifying up trends that are likely to plod onward.

Now let’s look at the recent market activity, but since moves have been so severe, let’s look at the action on a daily chart.

As we mentioned in our last volatility article (two weeks ago), VIX has been effective in identifying the increase in volatility. As you can see from the chart, it has also been at its intermediate extremes when the market hit intermediate highs and lows.  But in this market environment this has really been more evident in hindsight than at the hard right edge of the chart.  For example, was anyone screaming that we were at a top on 11/4 just because the VIX dipped down to 44.25?

The last item of note is that the VIX vs. VXO is really not that important.  I’ve shown two spots on the chart (above) where they were a bit different.  But in general the two give very similar information.  Only if you’re using them as part of more in depth calculations for options pricing, etc. will the differences matter much at all.

Next week we’ll look at more tools to add to the volatility toolbox.  Until then…

Great Trading,

D. R.

About D.R. Barton:  A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena.  He is a regularly featured guest on both Report on Business TV, and WTOP News Radio in Washington, D.C., and has been a guest on Bloomberg Radio. His articles have appeared on SmartMoney.com and Financial Advisor magazine. You may contact D.R. at  “drbarton” at “iitm.com”. 

D.R. is presenting the upcoming How to Develop a Winning Trading System That Fits You Workshop, January '09.

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