The Dangerous Unknown

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In less than in a few weeks, more than $4.4 trillion was wiped off stock markets around the world. On Thursday, we had the biggest one day decline since October 2008.

The markets, the European crisis, and the political battles are wreaking havoc on our summer vacation.

Adding more fuel to the fire, the S&P just lowered their long-term sovereign credit rating on the United States of America to ‘AA+’ from ‘AAA’ and affirmed the ‘A-1+’ short-term rating. Let’s not forget, this is the same S&P that gave triple-A ratings to some of Wall Street’s riskiest packages of mortgage-backed securities and collateralized debt obligations that infused the crash of 2008.

Could things get any worse?

While I can’t sit here and confidently predict day-to-day events given the political climate, I can’t say I am surprised at what happened. For months I have been saying the markets are overvalued and that the US is in trouble – both long and short term. Does that mean the markets will continue to freefall?

The simple answer is no – the bottom for this summer drought appears to be forming.

P/E ratios are incredibly low and many stocks have now been battered so badly that even the mediocre ones seem like bargains. This isn’t a repeat of 2008. There is tons of liquidity in the system and the economy is nowhere near as bad as 2008. By the end of the year, we will look back at summer and wished we had more cash to buy more stocks.

That doesn’t mean you should go out there and dump everything you have into the markets. I continue to like gold, silver, and related stocks – especially over a longer period of time. However, we still don’t know what politics and what Europe has in store for us. Will the downgrade make a difference in the markets? Will Bernanke implement QE3? Maybe, maybe not. But if you remember during the debt ceiling debate, I said (see The Next Big Wave) the debt ceiling will be resolved in the eleventh hour, and it was. So while I can’t tell you what’s going to happen tomorrow, I can tell you confidently what I think will happen before the year is over.

Before I do that, I want to go back to a previous letter I wrote in June, titled, “Time to Feel the Pain.” If you already read it, it’s worth reading to refresh your memory. If you haven’t, I suggest you do so.

In the meantime, here is a brief excerpt:

While there will be bargains, that also means the overall markets may still have further downward pressure. Especially when Federal Reserve Chairman Bernanke looks so defeated.

Last week (June 5, 2011) I said, “With all of the money spent through all of the US’ loose fiscal policies, nothing has changed.” On Tuesday, Bernanke reiterated those statements causing the markets to fall even further down south.

In his Tuesday speech, he said that seven months after the central bank began a historic round of monetary stimulus, growth in the broader economy has been disappointing. But with the amount of money printed and no real results, Big Ben has planned to stay on course, ending stimulus on schedule this month and keeping monetary policy steady for the immediate future.

Bernanke has finally admitted what we already know. The recovery has fallen short of the central bank’s expectations by a number of different measures. Six out of ten leading indicators are bad and the other four appears to be getting worse: Unemployment is high, and anyone who has found work must accept lower wages than they previously earned. Home prices are falling at a newly accelerating rate (see The Greatest War in History), making homeowners more vulnerable to default and foreclosure. Manufacturing is down and oil is trading at levels reminiscent of 2008, when months of record-high fuel prices helped drag the economy into recession (combine that with OPEC’s recent objection of raising supply.) All obvious points that I have mentioned in previous letters.

The central bank’s ability to boost the economy, or its willingness to attempt to do so, has reached a limit. Or has it? Was the amount of money being spent really used to bolster the economy or was it used to bolster the wallets of the Fed by lending as much money as possible to the world’s most powerful nation?

Bernanke has made it clear that there will be no QE3…yet. But before we make any judgements, let’s not forget that after QE1, he hinted there wouldn’t be a need for QE2.

The truth is, the next QE, be called QE3 or something completely different, will eventually happen. But before it does, America will need to feel the pain. Without pain, there will be no political will.

That was written June 12, 2011. It is now August 7th. We’re starting to feel the pain.

America, like it or not, will have to do something drastic to keep things moving. In an exclusive interview with the Wall Street Journal, Donald Kohn and Brian Madigan – the last two directors of the Fed’s powerful monetary affairs division – said the Fed should consider a third round of bond purchases only if inflation slows from recent elevated levels and if the economy continues to underperform.

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The signs Kohn and Madigan speak of are here. This recent flash crash has caused the perfect storm for implementing QE3. The economy is underperforming. Inflation is moderating – commodities prices have eased and measures of inflation expectations have retreated a bit recently. The stock market is getting crushed. The US has been downgraded. And investors are fleeing. We’re feeling the pain.

While I think the S&P rating on US debt is a complete sham (Moody’s and Fitch have maintained US’ AAA rating), the markets may think differently. I go back to how ignorant a mob can become. Their panic selling will cause them to lose their shirts but it will also allow those who are calm to seize the opportunities.

I know next week can be scary but I don’t think the downgrade will mean much to the market. If you believe in value, taking some more risk during this time could prove very rewarding – as it did for those who purchased stocks after the 2008 crash. I’d be a buyer on dips next week.

Be fearful when others are greedy, and be greedy when others are fearful” – Warren Buffett

This coming Tuesday, the Federal Open Market Committee will convene and Bernanke will speak. What he says will undoutedbly have an effect on the market, so be prepared. While he may hint at QE3, this may not neccesarily be enough to satisfy the battered and bruised investors. For the most part of August, we still need to be careful.

If next Tuesday fails to provide anything, the focus will quickly shift to August 26 for Bernanke’s speech at the Jackson Hole, Wyoming Fed conference. And that’s where I expect Bernanke to really pump up the markets, as he did last year with QE2.

If you remember on April 11, 2011, I wrote the letter, “Beware the April Fool“:

Bernanke’s statements have a major impact on the markets. Earlier in the week, the Dollar rallied simply because he told us that “inflation must be watched extremely closely.” Imagine the consequences of an open press briefing.

In his August 27, 2010 speech at the Fed’s Economic Symposium in Jackson Hole, Wyoming, Bernanke signalled the possibility of QE2 (Quantitative Easing 2):

“I believe that additional purchases of longer-term securities, should the FOMC choose to undertake them, would be effective in further easing financial conditions,”- Ben Bernanke, Fed Chairman

A couple of months later in November, the central bank announced plans to purchase $600 billion in long-term Treasury securities by the end of June 2011.

The S&P 500 is up more than 25 percent since Bernanke’s speech at Jackson Hole.

If historical political events are any indication of what’s going to happen, expect Bernanke to hint at QE3 sooner than later. While it may not have as strong of an effect on the market as QE2, it should be more than enough to push the market into another short term rally. This will give us another opportunity to make some money and then begin our own selloff before May 2012.

The market mob has turned every investor into a day trader. If you’re not a day trader, don’t act like one.

Until next time,

Ivan Lo

Equedia Weekly

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Until next week,

Ivan Lo
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