One of our best short term trading indicators moved to a sell signal for Nasdaq on Friday and even a modestly positive day on Monday (equating to a slowdown in momentum) is likely to usher in a sell signal for both the NYSE and SPX versions.  Thus, we have good reason to believe the rally is in the process of putting in an imminent end.  We note the ample draw down in bullish sentiment by investment advisors in the last few weeks, but previously excessive bullish sentiment for two full months was evidence that money was put to work from the sidelines, meaning less firepower should be available to fuel hopes at this stage.

The news for the few months ahead is grim.  Unemployment benefits for as many as 5 million unemployed will expire by June. As well, mortgage rate resets are slated to begin soaring imminently and will continue into the summer, providing the environment for a double dip into recession.  While there is small window for price improvement, the downside risks appear to be significant.  Add to the mix the continuing prospect for derivative disasters and you have the recipe for a 20% decline in prices.
 

A relatively small news item on Thursday, February 4th really caught our attention, catalyzing a gut response and the following commentary.  It seems stocks and bonds were crushed in Portugal as credit default swaps (CDS) climbed to record highs.  The stock market was down 4%, equivalent to a 400-point Dow move.  Concerns were shifting from Greece to Portugal and Spain, where deficit reduction plans have been less ambitious.  So really, how big a deal is this?  After all, Portugal is a relative non-entity with a GDP less than 2% of the U.S.  This is a very big deal.  In recent years, we have seen concrete evidence that all kinds of securities can fall victim to concerted short sale efforts, even ensuring bankruptcy or oblivion.  Government debt can be similarly impacted.  We have no doubt that Portugal can be shorted into fiscal oblivion.

Although there has always been widespread recognition that the upside can be sponsored by unethical and illegal activity, there has been precious little recognition by our major financial media that the same potential exists for a downside sponsored by the same kind of unmitigated gall.  Trust us, the hype that short sellers are the good guys is inane, self serving and blatantly false.  To begin with, it just doesn’t make any sense at all.  Bad behavior exists in all walks of life and the profit motive is far stronger than altruism.  If your portfolio stands in the way of dedicated short sellers, it will not stand in the way for long.  

The fact is, more than ever before, our broken system makes it far easier for concerted efforts to take down securities through the rumor mill, downright unethical and illegal activities, or simply by piling on to ensure the outcome.  It’s not only stocks.  It is an easy matter for mathematicians to devise financial constructs, a/k/a derivatives, such as credit default swaps, that later break down under stress.  We may attempt to “model” human behavior but predictive models ALWAYS carry the possibility of failure, perhaps massive failure, and this is why these constructed products can be abused or manipulated for profit.  

Thus, we also must consider the many possibilities of improprieties perpetrated by the largest and most influential bankers.  Did Goldman bet against its own clients? See Louise Armitstead’s UKTelegraph article and http://tinyurl.com/yb2mvjk and then read Gretchen Morgenson’s & Louise Story’s NYTimes column at http://tinyurl.com/y8hjj27, then speculate how easy it would have been for Goldman to push AIG into the abyss.  In particular, please refer to page two of the Times column and the portion headlined “Longstanding Ties.”  If Goldman traders who had “really very negative views” of the housing market were structuring deals that would profit Goldman if the housing market collapsed, why would Goldman do anything to prevent such a collapse?  And how in heaven’s name could this NOT be one of the most glaring conflicts of interest of all time?

Make no mistake, if you are concerned, you must widen your focus.  It’s not only Goldman’s chairman Lloyd Blankfein who is doing “God’s work” (see http://tinyurl.com/ybrkg72).  Others include those leading the continuing charge into the world of structured financial products (read derivatives) and those who are able to take advantage of the horribly broken mechanics of our financial system and the propensity to short everything in sight.  

Monthly mortgage rate resets are going to increase substantially in the months dead ahead (see http://tinyurl.com/5r76f3).  Thus, the groundwork has already been laid for another bout of portfolio misery.  Former Fed Chairman Paul Volcker’s argument (see http://tinyurl.com/yfqzecr) that the proprietary trading arms of banks and brokers have “insolvable conflicts of interest with customer relationships” is not only valid but crucial to understanding that tremendous risks still lie ahead.  The system is broken and must be fixed.  In Volcker’s own words, “We need to face up to needed structural changes, and place them into law. To do less will simply mean ultimate failure.…,” a point we have made repeatedly.  Hedging via credit default swaps and other derivatives cannot in any way, shape or form reduce systemic risk, which remains inviolable.  Indeed, the evidence of the last few years is startlingly clear; reliance on models that assume systemic risks are reduced are just plain wrong. 
   
Lord help us but we’re not done.  Laurence Fletcher’s Reuters story (see http://tinyurl.com/yjwng5p) points out Goldman’s alarming view that quant funds must adapt to the new environment, apparently by avoiding value of all things!  Isn’t it bad enough that a significant portion of transactions are now wound and unwound in milliseconds?  Is the key to success, as Goldman states, to further “…exploit shorter-term opportunistic and event-driven types of phenomenon?”  At bottom left, we first showed this chart in our recent Pictures of a Stock Market Mania update (www.cross-currents.net/charts.htm) and the more we view it, the more the chart stands out.  Total stock market capitalization (a huge aspect of our national wealth) has gone nowhere as trading regimens have gone haywire, totally obscuring the theme of investment.  Stocks are now held an average of 11 weeks, one-seventh as long as when value was the overriding consideration to buy.  What does the public get for its money nowadays?  Nothing it can get a grip on.  

Below, a recent snapshot of insider activity at the top ten constituents of the Semiconductor HOLDRs (SMH) exchange traded fund.  These stocks comprise 88% of the ETF and given today’s reliance on chips in so many products that use electronics, this may be one of the best snapshots we have of the potential for economic expansion down the road.  The logic is simple; if insiders see the road ahead paved with growth, they will tend to hold on to their shares.  If not, they will be quite happy to part with them.  At very worst, insider activity should give us a very clear picture regarding the value of SMH constituents.  

Interestingly, our thesis seems to have worked.  Just over six years ago, we registered our worst SMH insider tally ever, 3 buyers and a resounding 239 sellers.  SMH shares then traded at $40.70.  They last traded at $26.70, lower by 34%.  Our new tally shows 2 buyers and 78 sellers, clearly no better than our August ’09 tally of 1 buyer and 55 sellers.  If anything, the current tally most resembles the February ’07 tally of 2 buyers and 85 sellers.  The SMH is down 25% since then. 

More caveats; we’d love to give you an overall P/E ratio for the group but only six currently have earnings.  The group’s price/sales ratio measures a lot better than in the past as chips have become more of a commodity business, but at 3.5, the P/S ratio is no bargain.  Clearly, the insiders know best.     

ABOUT ALAN M. NEWMAN

Alan M. Newman has been the Editor of CROSSCURRENTS since the first issue was published in May of 1990. Mr. Newman is also a member of the Market Technician's Association and has been widely quoted for years by the financial press, media, and other newsletters and has written articles for BARRON'S.

The newsletter is published roughly every three weeks and focuses on economic and stock market commentary, often covering controversial subjects. Several proprietary technical indicators are usually featured in every issue accompanied by current interpretation.  Broad samples of our work can be viewed at http://www.cross-currents.net/. 

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