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*** Fleckenstein's Contrarian Chronicles ***


Game over for stocks and real estate

The big sell-off we saw in bonds, gold and silver last week is a signal the bull market in stocks and real estate is close to its end.

By Bill Fleckenstein
4/19/04

It's often tough to make sense out of Mr. Market. That point -- plus the need to have a risk-management plan in place -- was driven home Tuesday and Wednesday, when the cross-currents that whipped Wall Street resisted rational explanation. On both days, the stage was set at 8:30 a.m. ET when, respectively, the March retail-sales data "beat the number" and the Consumer Price Index report showed inflationary pressures.

The dollar jumped, while the metals (for reasons to be explained below) and a fixed-income market that fears a rate hike were thumped.

To me, the retail sales number jibed with what I've been discussing about the tax refunds. It's pretty obvious that the retail sector was the direct beneficiary of the recent tax refunds, but I think this strength is unsustainable. I would also attribute the outsized negative reaction by foreign currencies to the fact that the dollar has been moving upward (though we're nearing the end of its rally, in my opinion).

Turning white knuckles into green thumbs
Oftentimes at the end of a move, you see outsized price changes on news that's not that spectacular. Last week, the euro traded at $1.19 and change, quite close to the $1.18-to-$1.16 area I have been discussing for quite some time. The euro could still trade to $1.16 in the blink of an eye. We're not very far from the 200-day moving average, and if that cracks, there will probably be selling

As I mentioned last week, the pattern in the euro thus far continues to track very closely to its pattern of last summer. Though I have not done anything in the euro yet, I took advantage of last week's currency weakness to buy more Australian dollars. The central bank there seems to be the most legitimate of any major country, and one gets a pretty nice yield for owning Australian paper.

Turning to the metals, I'm sure a lot of folks were scratching their heads over the damage they sustained in the wake of the inflationary pressures noted in the Consumer Price Index report. The reason is that in the short term, momentum rules, especially in markets where there's leverage and/or hot money. The markets right now are home to so many leveraged operators and so many hedge funds (which themselves often use plenty of leverage) that, when things get in motion, they can stay in motion. And that motion can be exacerbated for no reason other than the fact that motion has begun.

I took advantage of last week's price breaks to buy silver, gold and gold calls. Because I was fortunate enough to have planned ahead, via my purchase of gold puts a while back, I was able to buy this plunge without incurring a great deal of risk. (Yes, I already had a gold position, but that is a position I don't plan on trading.)

ethought as the engine of opportunity
I don't describe this to call attention to my 15 minutes of modest success. Rather, I want to point out that in foreign-currency and commodity markets (and in short-selling), where trading is often required, it's very helpful to plan one or two steps ahead. I had bought puts so that I could aggressively buy gold. I have now bought calls so that once gold gets up to around $430 an ounce, I can sell part of my position, but keep the upside.

This is one of the ways that I try to manage risk for myself. It's meant as food for thought to help folks assess how best to manage their own positions in these volatile markets, not as a suggestion that others do the same. With silver basically having traded between $8.20 and $6.85 in the space of about four recent sessions, I think this is the first time many folks have seen how violent its moves can be. While silver went up in a steady, stair-step fashion, this 16%-plus plunge has been very white-knuckled.

That happens to be what bull markets do: They grind higher and higher and higher. Then, when they collapse, they collapse mightily to shake people out. This is one of the reasons why I had not been long silver bullion (until this week). I had not found the right juncture to get long where I thought I might be able to do so and have my risk somewhat under control.

best-case outcome for the economy: stagflation?
As for the implications of the CPI report, last Wednesday's sell-off in fixed income has convinced a lot of people that the Fed is about to tighten. I'm not sure the Fed will tighten, though as I noted a few days ago in my daily column, the market could tighten for the Fed. To me, the outcome of the Fed's policies, the insanity within the real-estate market and the speculation in the stock market mean that we are probably headed for a bust in both markets.

However, I suppose that the economy could somehow manage to hang on for a while, with inflation picking up as well. I believe that the best-case outcome for our economy is stagflation. Not that you'll see inflation in the government numbers, but I think that a muddling along of economic activity and more inflation would be the best that I could foresee from the circumstances that we have.

The more likely, uglier scenario would be that the economy simply runs out of gas now that the stimulus is behind us. As the stock market comes under pressure and the refinancing game ends, that will further weigh on the economy. If by some miracle the economy does do better than I expect, I would think that inflation would become very heated and interest rates rise pretty dramatically, since even this Fed would have to respond.

The refi game and government stimulus have been the only glue holding the economy together. If last Wednesday's move in the bond market has shut the door on (mortgage) refi activity once and for all, as I believe it has, then the Fed is basically trapped. It is my view that we have reached the inflection point -- where it's game over for stocks, real estate and the economy. That doesn't mean everything will stop on a dime, but we may look back at this period in time and say that it was an inflection point.

Lastly, to punctuate my claims about the prospective train wreck I've been warning about, in Thursday's Financial Times, Felix Rohatyn, the financier and former chairman of New York’s Municipal Assistance Corp., penned an article titled America: Like New York in the 1970s but worse." It reads, I should note, like many columns I have written:

Indebtedness spinning out of control, fueled by an unchecked increase in the deficit. An accounting system that indiscriminately mixes expenses with capital assets, ignores contingent liabilities, and makes Enron look conservative. A social structure sharply divided between "haves" and "have nots." An administration locked into denial on the assumption that "the markets will always be there for us." A political system paralyzed as public finances careen toward catastrophe. That was New York City in the early 1970s; it could be America tomorrow. America's out-of-control federal budget deficit, rapidly growing domestic and foreign debt, and off-the-books Social Security and Medicare liabilities look eerily similar to the fiscal situation that faced New York nearly 30 years ago.

Rohatyn went on to cite a couple of important elements that helped to resolve the crisis, in the spring of 1975: a bipartisan willingness to pull together on the part of all involved, and some assistance from foreign leaders, since the U.S. government chose not to bail the city out.

Next, he set the stage for how we've been able to live so far beyond our means:

So far, the willingness of the central banks of China, southeast Asia, Japan, and Europe to finance U.S. deficits has allowed the administration of George W. Bush and the Federal Reserve to pursue a policy of cheap money, low taxes, large deficits, and reliance on a speculative stock market and property bubble to create economic growth. This may not last forever, and either the willingness of the foreign central banks to carry U.S. debt -- or their capacity to do so -- could be impaired.

Some time before that moment is reached, the markets would begin to react: The dollar could fall further precipitously, interest rates would shoot up, and we would have to deal with a national crisis, which could develop into a global crisis.

(He also notes that given the current political situation, we may not be able to count on foreigners in a moment of crisis.) Even though this path is quite possible, it doesn't mean that we will indeed have a crisis. However, folks need to be aware of the risks.

Continuing on, he rebutted Alan Greenspan's contentions that basically all is well, noting the rot I have vapored on about so often:

Alan Greenspan, chairman of the Federal Reserve, said recently that the huge rise in consumer debt in America posed no risk, as it had been matched by a rise in the value of property and stock portfolios. However, those are just the circumstances that brought about the speculative bubble of the late 1990s and the stock market collapse that followed. The U.S. at that time was in a much stronger financial condition than it is in today. America was running huge budget surpluses instead of the current deficits; its sovereign debt was declining instead of soaring; the currency was strengthening, not weakening.

This litany of concerns is why I own foreign currencies, precious metals and precious metals stocks and am not willing to own stocks generically. We have a serious amount of trouble ahead. Trying to speculate our way to prosperity has only exacerbated the situation.

http://moneycentral.msn.com/content/P78279.asp