FMX | Connect – www.fmxconnect.com - (Reported 10/25/2010)

TOP OF THE RALLIES!  A Dollar Rally will cause Trend Reversals

Source:  Bert Dohmen’s Wellington Letter

TWO SHOCKERS, SAME DAY!

On October 19, the bulls were briefly shocked by two news items:

1. China hiked interest rates for the first time since 2007 (that was the global bull market top),

2. Several of the largest bond investment firms, together with the NY Federal Reserve, are asking Bank of America to buy back from them the defaulted mortgage obligations, about $47 billion. The DJI plunged over 200 points intraday. What are we to make of this?

Here is what we wrote later that day in our SMARTE TRADER service:

Today the People’s Bank of China announced a small interest rate hike. It shook all the markets, from commodities to gold and silver, to stocks. Here we can see how much China has to do with the global investment markets. Once the bursting property bubble becomes known, it will be a Tsunami across the globe.

The slightly higher rates in China strengthened the dollar, which caused a 3% decline in gold. The latter is a knee-jerk reaction. Actually, this move confirms the inflation problem in China, which means that more Chinese money will flow into gold. Of course, that has no influence in preventing a technical correction.

The China move will significantly increase the hot money flowing into the Yuan via the “carry-trade.” Inflation in China is now a big problem. The official rate is 3%. The actual rate in our view is 2-3 times higher as food and housing prices have soared over the past year. (On Oct. 22, the CPI came in at 3.6%).

Interest rate hikes only increase inflation pressures, contrary to what economists believe. That produces a cycle of higher rates, higher inflation, more imbalances, and eventually a crash. China is now on the road to a serious inflation problem, which will eventually turn into a financial market problem…possibly next year.

The second problem came from the U.S. mortgage market. In our opinion, this is a potentially very serious for banks. Many foreclosures by the banks have been done using fraudulent and falsified mortgage documents. Investment firms who bought mortgage backed securities are now trying to get the banks to buy them back. Here is what we wrote in SMARTE TRADER:

Now some major financial firms, together with the Federal Reserve of NY, are teaming up to get Bank of America (BAC) to buy back mortgages that had improper documentation. That’s about $47 billion, which were packaged into pools. It’s a potentially big problem for BAC.

According to www.bloomberg.com, banks’ costs from repurchases of mortgages in securities without government backing may total as much as $179.2 billion, Compass Point Research and Trading LLC analyst Chris Gamaitoni estimated in August.

The letter written by these financial firms to BAC says that Countrywide also hasn’t met its contractual obligations as a servicer because it hasn’t asked for repurchases itself and is taking too long with foreclosures, either because of document or process mistakes or because it doesn’t have enough staff to evaluate borrowers for loan modifications, Patrick said. If the issues aren’t fixed within 60 days, BNY Mellon should declare Countrywide in default of its contracts, she said.

The bulls say this is a small problem. However, in our view it could just be the first of many suits to have the mortgage originators reimburse the buyers of mortgage derivatives compensate them for losses. This could be several trillion dollars. We may be wrong, but that could be proverbial “camel’s nose under the tent.”

As you know, until 2007 these bad mortgages were packaged into pools, and sold around the world as CDO’s. They imploded, and unsophisticated investors such as villages in Norway and Savings banks abroad bought them because of the AAA rating. They didn’t know that these ratings were “bought” by the issuers of the CDO’s. What if those buyers decide to ask for compensation through the courts?

That’s the real problem. The wheels of justice grind slowly. But they do grind. And then there is the situation where these mortgage pools were assembled containing the worst mortgages with the advice of the hedge funds who planned to profit from the plunge in these securities. It is called “built to fail.” Tranches of these pools were sold to investors as CDO’s.

These hedge funds would then buy Credit Default Swaps on these pools, and made billions as they imploded. Of course, the unsuspecting investors who bought tranches of these pools lost all their money. Doesn’t it seem logical that there must be a law firm already working on a class action suit?
And those are the risks of investing in U.S. financial institutions at this time.

THE U.S. STOCK MARKET: CAUTION!

The election of November is approaching. This coincides with the market giving technical caution signals. The indices are at or near very strong resistance levels. Sentiment is approaching bullish extremes normally seen at important tops. Remember late April?

And storm clouds are forming at an accelerating pace. Investing is a always a matter of probability, not certainty. When the potential obstacles to a trend continuation become more numerous, it’s time to reduce or eliminate exposure.

Note everything is what Wall Street wants you to believe. Take Caterpillar (CAT), which has been hyped by numerous analysts visiting the media. The stock is up about 50% since early June. But here is what the company said in a meeting on Oct. 21:

"We know it is tough to understand why sales of CAT machines are up so much. And new machine sales in the United States are a good example that illustrates the point. Here is what is happening. First, sales to users peaked in 2006, then declined in 2007, declined again in 2008 and then declined even more significantly in 2009. From the peak quarter in 2006 to the bottom in late 2009, dealer machine sales to end users in the US declined nearly 80%. Today, we are seeing improvement from those low levels as customers are buying some machines to slow the aging of their fleets. In addition, dealers have increased machine purchases for rental fleets".

In other words, after a sales decline of 80% over the past 4 years, there is a rebound in sales because of aging equipment. The stock is now back to the level of 2006 when sales were about 5 times greater! Could you conclude that the stock is way ahead of fundamentals? In our view, this is typical of many stocks.

THE CHARTIST’S VIEW

We are getting warning signals from the markets. If you are positioned on the bullish side of the “reflation” trade, which has been the correct side for the past weeks, then you may want to take some profits. Or if you want to be really cautious, close out all those positions.

The preliminary signals are warning of potential reversals ahead, similar to late April this year. Once the trade reversals become more evident, there should be a rush to sell as everyone wants to lock in profits. The second wave of selling will come from the implementation of new shorts, and the purchase of the bear ETFs.

The chart of the DJI on Thursday reached the high of the year made in late April, which was followed by a plunge. That is normally very strong resistance. All those who didn’t sell at the high in April will now be getting out, using the old method of “I will sell when I can get out even.” The indicator below has just gone to a “sell.” These are all sufficient for us to issue a “sell” all stocks at this time.

The chart of the ETF for the S&P 500 INDEX (SPY) (weekly) shows that the index is now in very strong resistance. Part of that resistance comes from the April high this year. A previous high is usually a strong resistance area. The most important resistance comes from the start of the 2008 crash. It means that all those who wish they had sold just before the start of that crash will sell now that the market is back at that level. The market has memory.

The ETF for the hot Brazilian stock market, EWZ (daily), is giving “sell” signals. When the leader of the emerging markets looks bearish, you better get out of the emerging markets sector. The chart shows the gap down this week, when China hiked interest rates. After a one day bounce, the ETF exceeded the low of two days earlier. The indicator below has now given a sell signal. This should not be ignored. We are getting similar signals from the hot Hong Kong market.

The chart of the DOLLAR INDEX (weekly), which is the dollar versus a basket of currencies, shows that contrary to popular opinion, the dollar is actually up since early 2008, when some of the high profile billionaires sold billions of dollars short.

The dollar is up even over the past 12 months and over the past 2.5 years. However, virtually everyone believes that the dollar is plunging into the abyss. Eventually it will, but not now. The chart shows that the uptrend line, which is support, has just been reached. Together with our other work this suggests that the dollar is now ready for a good year-end rally. This would have extremely important implications for all the markets.

That brings us to GOLD and the precious metals. We remain long term bullish. However, a dollar rally will certainly cause a reversal of the virtual record bullish sentiment. As you know, when everyone is on one side of the fence, markets reverse. And the precious metals have a history of violent reversals.

Above you see GOLD and below that, the chart of the GOLD MINERS ETF (GDX) which is a basket of gold mining stocks. Note that gold has been making new highs over the past year, while the GDX has not. That’s called a negative divergence. It’s a warning of a correction. Even more important, the brief upside breakout to a new high in the GDX from our last issue had no follow-through. It now looks like a “false breakout,” which is usually followed by a sharp correction. Add to that the new “sell” signals we have on our indicators (not shown), and you have very strong reasons to lighten up or get out.

Long term investors always ask, but I am in it for the long term. Should I sell? That’s a decision every person has to make for themselves. Ask yourself, will you be sorry you didn’t sell when prices are down 20% from the peak?

CONCLUSION: The above charts show that the rallies in the various markets are ending.
We always pay attention to the weight of the evidence, although that isn’t infallible. Nothing is. However, using solid analysis brings a lot better results than using hope as an investment tool.

This weekend the finance ministers of the G-20 countries meet in Korea to discuss “rebalancing the world.” Currencies and trade balances will be addressed. When 20 bureaucrats try to control the world, it usually doesn’t turn out well. We prefer free market forces.

A GLOBAL CURRENCY WAR?

The big news of the last two weeks, prior to the news discussed above, was a potential, global currency war, or competitive devaluations.

SINGAPORE:

Singapore’s central bank announced a strong tightening move of credit which included an aggressive upward shifting of its trading band against a basket of currencies. This was a surprise, and it caused further selling of the U.S. dollar. Singapore is seeing a big inflow of capital from its surrounding neighbors. It’s the “island of safety.” I just spent over a week there. What a clean, well organized city-state! Other countries around the globe should try to emulate it.

Although Singapore’s moves are geared to increase the value of the currency and perhaps discourage inflows, the end effect will be the opposite.

How is Singapore’s economy doing? It’s a roller coaster, because the economy is small. Singapore's GDP expanded by 10.3 percent on a year-on-year basis in the third quarter of 2010. But on a quarter-on-quarter basis the economy contracted by 19.8 percent. The prior quarter it had soared 27.3%.

The Ministry of Trade and Industry (MTI) expects the Singapore economy to grow 13 to 15% for all of 2010. That’s a blistering pace. The reason for the sharp decline in the last quarter was a decline in biomedical manufacturing. However, the construction sector contracted by 12%, compared to an expansion of 29% in the preceding quarter because some major projects had been completed. However, looking at the skyline of Singapore, you see a multitude of cranes. It seems that the cranes of Dubai were moved to Singapore.

REST OF ASIA:

Expected further loosening of monetary policy in the U.S. will cheapen the dollar further. However, as you know from our last issue, the dollar index is getting closer to technical support levels. After the November election, we should see a good dollar rally.

Traveling through Asia, the primary conversation is currencies. The U.S. is pressuring a dramatic rise of the yuan, China’s currency. In the media, China is resisting. It says it fears a sharp decline in exports. In the end, a stronger yuan will immensely benefit China, but the U.S. politicians don’t realize that.

CHINA: THE INVISIBLE CRISIS

Don’t you just love a good dictatorship? A Chinese dissident, Liu Xiabo, who is in a Chinese prison, was just awarded the Nobel Peace Prize. The Nobel Committee in Norway said they had awarded him “for his long and non-violent struggle for fundamental human rights in China."

He is currently serving an 11 year prison sentence for drafting Charter 08, which called for multi-party democracy and respect for human rights in China. Any reference to China’s first Nobel Laureate has been deleted from the China internet, as has any reference to “Nobel Prize.”

The China bulls are still talking about all the great growth of China, the large demand for commodities, the huge stimulus from the government, etc. But all these positives will now turn into negatives. The bubble is popping, but so far the casual observers haven’t noticed.

As longer term subscribers know, we have been warning of the bursting of the China real estate bubble since early this year. Our work shows that this has been in progress since late April. Similar to the bursting of the U.S. bubble in 2007, it takes months until the serious problems are recognized. The first phase is when speculators realize they can’t sell any of their properties. At first they consider it’s just a “soft patch.” When it persists, they become worried. They start lowering the price, slightly at first. Still, buyers don’t show up. Then the speculators panic.

When the much lower volume of sales starts hurting developers and real estate brokers, the worry becomes a serious concern. Banks stop making real estate loans, speculators are no longer interested in buying, but only want to sell. And that’s how the bursting bubble produces an avalanche downward. It takes many months, a decline of 30% or more before reality hits that it is indeed not a “soft patch,” but a serious decline. Even a loosening of credit policies can’t reflate a burst bubble.

According to hedge fund manager Jim Chanos: “There is currently 30 billion square feet of Chinese real estate in the works, would work out to a 5.5 (ft) cubicle for every man, woman and child in the country.”

That is in addition to several billion square feet of existing, completed real estate being empty. Here is photo of a giant, modern shopping mall. It looks beautiful, but its 99% empty.

It was just reported that China’s property prices in 70 cities rose 9.1 percent in September from a year earlier. Note that they didn’t report the price plunge over the past 6 months. All the numbers you see show “year-over-year” comparisons, which masks recent weakness. Actually prices in September were a mere 0.5% above those of August. It was the first increase since May. That number is more revealing.

Our view is that China’s economic growth peak over the past two years was in April of this year. Eventually, perhaps in a year or two, economists will agree that the big contraction started in May. But so far, very few people have noticed. Look at these numbers.

GDP growth (y-o-y) in Q1 was 11.9%, and in Q3 had declined slightly to 10.6%.

However, now look at electricity production: In Q1 it was growing at a 22.7% rate y-o-y. By Q3 it was down to 11% y-o-y. To us that suggests that in Q3 electricity production was down substantially from Q2. Electricity production is one of the best indicators of economic growth. It’s similar to the number that 64 million housing units in China have not had their electric meters turned on. In other words, they are empty.

The Chinese government’s economic numbers are even more suspect than those coming out of Washington.

China is hiking property tax taxes, first in some major cities, then to the whole country. Commercial banks were told to stop lending to buyers of 3rd homes, and require a 30% down-payment for first time buyers. The Chinese government has no choice but to try to get property prices down because housing has become unaffordable to the average Chinese. The negative is that speculators and real estate developers will experience great pain or bankruptcy. But doing nothing risks having several hundred million people protesting in the streets.

We remember well when in early 1990, the Ministry of Finance in Japan announced that its new policy was to tighten money until property prices had declined 30%. That was our signal to sell and sell Japan short, predicting that Japan would experience a 10-year period of recession/depression. When the announcement was made, a member of the media asked if that wouldn’t cause a lot of developers and speculators to go bankrupt. The answer was: “Easy come, easy go.”

We believe that “Easy come, easy go” will now be the attitude of the China government. They will give party officials time to get out of their properties before severely tightening up on lending. The vast majority of the speculation has been by officials. They always got first crack at new projects.

As we reported previously, the government wants banks to conduct a “stress test” on their financials, assuming a 50-60% decline in real estate values. Are they expecting that big of a decline? It may be an important signal of how far the government’s anti-inflation efforts may go.

CONCLUSION: The China “boom” is a credit boom. They always end very badly with great pain for those who thought it was a new paradigm.

THE US ECONOMY

The EMPLOYMENT REPORTS continue to be great disappointments for the optimists. There is one bright spot: in the September report 159.000 jobs were lost in government. Maybe the only way to reduce the size of government is a good depression.

Politicians say that governmental jobs “create stimulus” because they spend their salaries. That’s false. They add nothing to the production of the country. But they absorb valuable tax revenue,s which have to be paid by all of us. That’s deflationary.

Here is a great chart from www.shadowstats.com on employment without the distortion of the temporary census workers. There is a benchmark revision from the DOL, which adjusts the number of previously reported employed people down by 550,000 (red line).

Do you see any evidence of a “V-shaped” recovery here? It’s more like a “dead cat bounce.”

One economist we like, perhaps because he shares our more pessimistic view, is David Rosenberg, formerly the chief economist of Merrill Lynch. He has recently changed his forecast from “recession” to “depression.” Regarding housing, he writes:

“So let’s get this straight. Mortgage rates have tumbled nearly 100 basis points in the past year to a record low of 4.42% for the 30-year rate, yet existing home sales collapse a record 27% MoM (month over month) to an all time low (data to 1999) of 3.83 million units at an annual rate…”
Yes, if record low mortgage rates can’t stimulate housing, what can?

“PROOF:” About 400 years ago, the great philosopher, mathematician, and physicist Rene Descartes “proved” the existence of God. We will now “prove” the absence of intelligence in the U.S Congress.

U.S. companies doing business abroad have over $1 trillion in cash in their off-shore companies. If they bring that $1 trillion back home, to invest in the U.S., it could fuel economic activity. But to repatriate those earnings, they will have to pay a tax of 35% on that. If they keep it off-shore, and invest it in any other country, no U.S. tax!

Obviously, a CEO could be considered incompetent if he brought that money back to the U.S. The U.S. is the only industrialized nation that does this.
The Wall Street Journal writes that “almost every major developed economy, including Germany, Japan, the United Kingdom, France, Spain, Italy, Russia, Australia and Canada” tax such repatriated earnings “at a tax rate of 0%-2%. That's because those countries realize that choking off foreign capital from their economies is decidedly against their national interests.”

Keeping that $1 trillion away from the U.S. economy where it might be used to create jobs is absolutely stupidity, or some say, insanity. The White House, or the Congress, could change this very easily. They don’t. Instead, they are considering another $1 trillion stimulus, which won’t work, and eventually will require steep tax hikes, which will kill economic growth.

There is your “PROOF” of the stupidity of Congress. As if we really needed more evidence!

Traveling throughout the world, and seeing so many poor countries, as well as some of the incredible exceptions, you can easily see that the only cause of poverty is their governments. Bad governments prevent the natural entrepreneurial spirit of individuals from working with hundreds of bureaucratic impediments for starting businesses. I suggest your read Hernando de Soto’s book on the subject, THE MYSTERY OF CAPITAL.

If you go to Singapore and Hong Kong, you see two countries that have no natural resources, and even import the water from their neighbors. Yet, their economic prosperity over decades should be the envy of the world. The reason is so obvious, yet totally ignored by other countries, even their immediate neighbors.

WHO WILL FINANCE THE UNSUSTAINABLE DEFICITS?

We have written since the health care plan was passed by Congress that the U.S. deficits will not be financeable. There isn’t enough money in the world.

Total world-wide money supply is around $60 trillion. The U.S. accumulated deficits and liabilities are around $70 trillion, conservatively. Thus, even if you take all the money in the world to pay the U.S. deficits, it would be insufficient.

Foreign central banks who have been buying U.S. debt are starting to wise up. One of their favorite investments until the meltdown was U.S. agency debt. You know, like Fannie Mae, Freddie Mac, etc. The Fed’s part of the bailout plan assured these central banks they would not lose money. Yes, you have to keep your banker happy. But now they may be getting nervous again. Here is a chart from our colleague, Jim Sinclair, which shows the loss of appetite for U.S. Agency debt.

It starts in 2004 and goes to the present. Very recently, there is a plunge of $57 billion in the agency debt held by foreigners. That’s huge. The problem is that once the selling of U.S. agency and Treasury debt starts, it’s like an avalanche: unstoppable. You can’t predict when it will happen. But you can predict that it will happen.

Senator Gregg said on Fox News that the U.S. is facing a situation similar to Greece. The show’s host asked if it will happen in her life time. Gregg answered “for sure,” possibly within 5-7 years. For a Senator to make such a blunt statement is refreshingly honest, but scary.

In addition to the Federal deficits, there are the states’ deficits. Bond market wizard Jeffrey Gundlach (Double Line Capital) spoke of a meeting he had in Illinois recently. He was told that even if the salary of all public employees in the state dropped to zero, the state would still run an annual deficit of over $5 billion. How is that possible? Pension benefits!

Pension obligations will bankrupt many municipalities unless the politicians show the courage to cut the pensions.

We now hear doctors and health industry officials say that the health care system is bound to collapse. For the first time, the number of uninsured has soared over 50 million people, since the health care bill was passed. Insurance is now unaffordable for many people. Furthermore, why get insured, if you can buy insurance on the way to the hospital when you need it. The insurance companies cannot deny you for “preexisting” conditions.

We believe that health insurance will double in price over the next five years. That will bring a clamor from the public for governmental insurance (single payor), which the liberals originally wanted. You see how it works: overburden the system to the point where everyone becomes a dependant of government. Russia did that for 75 years. It didn’t work very well.

Get ready to wait for a doctor’s appointment for six months. And for surgery, start looking into good hospitals abroad. Clue: Singapore would be my choice. It’s called “medical tourism.” It will be a booming industry.

THE GLOBAL SLOWDOWN NO ONES SEEMS TO SEE

As you know, the most important factor in our analysis is “the change in credit.” If you look at that, you don’t have to look at all the other economic statistics. When credit contracts, it means the economy is contracting, when credit expands, the economy is expanding. It’s that simple!

Well, all the credit aggregates are either contracting or not expanding. Much of it is not voluntary. For example, consumer debt has declined almost $620 billion. But almost $590 billion of that is due to defaults. It’s not a matter of “not wanting” to borrow, but instead of “not being able” to get credit. This U.S. problem is being replicated in other countries around the globe. And that’s what is so frightening about the current situation.

The facts about the debt problem of Greece are slowly leaking into the public media. The debt to GDP ratio is now a huge 130%. It is expected to grow to 150% over the next two years. Experts are already quietly commenting that the only solution is a “rescheduling” of the Greek debt, which is basically like Greece saying “we can’t pay you.”

Ireland has a huge problem with one of its huge banks, Anglo Irish. Standard & Poor’s cut the country’s credit rating to AA-, saying the state may have to inject as much as 35 billion euros ($44.5 billion) into Anglo Irish “over time.” That’s a lot of money for such a small country.

Canada’s GDP grew at about a 6.1% annual rate in the first quarter of this year, making it one of the strongest growth rates in the world. That growth was revised down slightly now to 5.8%. Canada is a beneficiary of the resource play. However, the Q2 GDP number is now out, shrinking sharply to 2% growth. That’s the first estimate. That will most probably be revised downward in subsequent months.

This is more evidence that the global economies, especially one of the most important customers of Canada, i.e. China, are slowing rapidly. Therefore, we should not get too excited about the current “reflation” bullishness.

EUROPE:

The real story of the hidden losses in the large European banks is starting to surface. We knew it was only a matter of time. In September we heard that Germany's largest bank, Deutsche Bank (DB), is in talks to raise equity by selling as much as $11 billion of new stock. You see, the Basel III rules, still being formally issued, would force disclosure and write-down of much of these underwater securities. DB apparently wants to be the first one to raise capital, just in case the window closes.

Germany's 10 largest banks may need to raise about $133 billion (€105 billion) if these new rules are enacted. Just imagine how much other European banks may have to raise! Unfortunately, we don’t have that estimate.

SAUDI ARABIA:

There is trouble in “paradise.” Saudi Arabia’s inflation is at 6% and rising. Unemployment at 10.5%. University graduates are protesting that they can’t find jobs. Amongst youth, the unemployment rate is 40%.

Such conditions are great for Al Qaeda. All that’s missing now is a sharp decline in the price of oil because of global weakening economic conditions and the ruling family is in trouble.

Perhaps this would be a good time for the Catholic or Lutheran church to try to build a church in Riyad. Or how about a Jewish Temple? Of course, the government would never allow that. Would an official rejection get the mayor of New York to reconsider his position on the controversial mosque project in Manhattan?

OUR EARNINGS BELONG TO GOVERNMENT

The White House (WH) budget deficit projections are far too low, as estimated by various organizations, such as the Heritage Foundation. The chart below shows the difference in the estimates.

The bottom line (blue) is the deficit estimate from the White House. The top (red) line is that from the Heritage Foundation. It estimates annual deficits to hit the $2 trillion mark, twice the estimate of the White House.

Now the issue becomes “tax cuts.” The politicians say that because of the horrendously high deficits, which they have created, the government “cannot afford tax cuts.” Have you noticed that whenever politicians talk about “tax cuts,” they always say “this costs xxx billions of dollars.” In other words, they go from the basis that 100% of our earnings belong to the government. If they let us keep more of that, it’s “a cost to them.”

I will have to read Karl Marx’s Communist Manifesto again. I think he made similar assumptions.

Greetings,
Bert Dohmen

Source:  Bert Dohmen’s Wellington Letter

Website:  http://www.dohmencapital.com/

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