Saturday, March 19, 2011

Issue XXV - Japan S&P500

Dear Readers,

Over the course of the past month, several headwinds have formed for markets around the world. The political uprisings in the Middle East and the ongoing natural disaster in Japan have brought the S&P 500 down nearly 8% off its late February highs and sent oil back over $100/barrel, although it has fallen back below that level in the wake of the Tōhoku Earthquake in Northern Japan. Precious metals and oil could experience significant pullbacks, particularly Silver. For example, Silver stocks such as Silver Wheaton (SLW) are being affected by both the S&P 500 pullback and Silver falling from its highest levels since 1980. Even before the events in Japan, technical indicators on the S&P 500 signaled that a mid-term top may have taken place, and in the days following the earthquake several key support levels have been breached to the downside. The events that have taken place could continue to put downward pressure on world markets because the market’s momentum and technical indicators have been reversed. In this issue, I will briefly summarize the situation leading up to the earthquake and a few ETF’s that can be used to capitalize on the correction in Oil, Silver, and the Equities market.

To begin, it should be noted that what will ultimately transpire in the three markets covered in this issue will be determined in part by the performance of the US Dollar. Indeed, the dollar’s steady decline since July 2010 is one reason that Silver, Oil, and the S&P 500 have continued to move up. The dollar appears to be oversold, perhaps putting in a technical double-bottom on its longer-term chart. Of course, the Federal Reserve could announce a large third round of Quantitative Easing and send it even lower, as it did when Bernanke announced the possibility of QE2 in August, 2010 and formally announced $600 Billion of additional bond purchases in November. However, with the sovereign debt situation in Europe continuing to flare up, most recently a few weeks ago, and Japan injecting what may reach $500 billion in emergency funds into their economy, it is probable the dollar will trend higher over the next few months. A rebound in the Dollar Index in the near-term could take the Index back to the low 80s.

For all the tragic devastation that occurred in a matter of minutes during the quake/tsunami and could result from the Fukushima Daiichi nuclear fallout, a currency crisis triggered by the simmering Japanese debt crisis could hit just as quickly and would be much more destructive for the future of Japan and subsequent generations. Many analysts are commenting about how this disaster will be positive overall for the Japanese economy because of the future robust rebuilding program. While that could work, the fact is that Japan is on the cliff of a man-made debt disaster, and this natural disaster could prove to be the breaking point. Even before the earthquake, in January Standard and Poor’s downgraded Japan’s sovereign debt to the AA- rating. Another Japanese recession as a result of the quake would cause an increase in the cost of welfare and unemployment payments, combined with continuing unfavorable demographics. When added to a costly rebuilding and relief program, it wouldn’t be surprising at all to see Japan’s credit rating reduced to “junk” levels within a few years, maybe even sooner.

Some commentators are pointing to the 1995 Kobe earthquake and its aftermath for guidance about how the Yen will perform in the short-term. The yen rose in the aftermath of that quake, and while the yen has risen against the dollar in the immediate aftermath of the March 11 quake, in 1995 Japan had not yet resorted to nearly thirteen years of Quantitative Easing and over a decade of near-zero interest rates, a policy begun in 1997. With a 200% Debt/GDP ratio fifteen years later, if a flight to safety occurs it will likely not be to the Yen. The repatriation of funds back into Japan in the aftermath of the quake has taken the Yen to all-time highs against the Dollar on March 15-18, but each time the Bank of Japan has taken emergency measures to stem the tide. The G-7 has joined in this fight over the past several days, as well. Since a stronger yen is the last thing that the export-driven Japanese economy needs in the wake of the earthquake, it is all but guaranteed that the BOJ will continue intervening in conjunction with the other G-7 Central Banks. This marks other key difference between 1995 and 2011; the intervention is happening right away. In 1995 the yen rose relentlessly until the BOJ intervened nearly a month after the Kobe earthquake. Compare that to the immediate response of the BOJ and G-7, along with pledges from all the players to keep the Yen/Dollar ratio above a level of 80.

I have been an unabashed bull with respect to precious metals since late 2008 when the US Congress, Treasury and Federal Reserve chose to bail out the banks, and precious metals were trading at beaten-down levels. While the prices recovered in early 2009, it was the onset of the Fed’s Quantitative Easing program that set Gold and Silver ineluctably on the path upward. I believe these patterns will continue to play out over the remainder of the next few years and perhaps even longer, until the United States and other western nations fundamentally fix their budgets and get spending under control along with raising interest rates to more normal levels. At the same time, the events of the past month may have caused a mid-term top in the price of non-food commodities, particularly with Silver. After the robust advance of Silver over the final months of 2010, the price level of the metals suddenly has become risky, as mentioned in the issue sent out right before the New Year. Silver was about $30.50 at that time. While a pullback did occur in January, the onset of the Middle East crisis and rampant internet rumors about a shortage in Silver pushed the white metal to nearly $35 in February and early this month, much to the surprise of many commentators. With tensions beginning to subside and the events in Japan, markets around the world are responding with a correction.

After dropping nearly 15% in January, Silver came roaring back in tandem with Oil as tensions flared in the Middle East. In addition, the allegations about Silver manipulation that were mentioned in the August 4, 2010 edition of this newsletter have grown, and are currently rampant throughout the financial blogosphere. This rumor and additional untrue rumors of a pending shortage in Silver have reached the mainstream media, for example a column last week by William Cohan of the New York Times (You can read the column here). Despite the alleged manipulation, the fact is that no market goes straight up or straight down. The market shock that is being caused by events across the pacific could be the impetus for Silver to correct downward to its 200-day moving average. Such a pullback would be typical of the way Silver has tended to correct since its current bull market began in the early 2000s. It has always corrected to the 200-dma after large, breakout runs in which it often doubles in price. As can be seen in the chart below, the upward breakouts typically last 6-8 months, and are then followed by 18-24 month consolidations. This is what happened in 2004, 2006, and 2008. The financial crisis in 2008 caused the price to fall more than 50% from its early 2008 high, providing the best buying opportunity in years. At its current price, Silver is currently farther above its 50 and 200-day trend line that it has been at any point in this bull market. Simply put, the risk far outweighs the reward of investing at these levels, even more than at the end of December. If you are currently long Silver, an easy, liquid instrument to hedge a long position is ZSL. It is a Double-Short ETF, so if there is a pullback, ZSL will make up for some of the losses on silver mining equities or bullion. If Silver drops below its 50-day moving average in the coming week, look for further correction to take place.

Third, Oil and the S&P 500. Two weeks ago, Oil surpassed $100 for the first time since 2008. Obviously, the threat posed to oil supplies due to the revolutions in the Middle East were the main driver behind this. With the easing of tensions, the near-absence of violence in Saudi Arabia and the Tōhoku Earthquake, Oil appears to be heading back toward $90 per barrel or even less if the dollar continues to strengthen. As is the case with Silver, there is a Double-Short ETN to capitalize on this, the ticker symbol is DTO. Interestingly, DTO was issued around the time oil peaked at $147 a barrel in July 2008. Issued at $20, it was over $200 by early 2009 as oil crashed. I’m not suggesting that will happen again, but the point is that it is a good way to capitalize if the price of crude continues to decline.

Finally, the S&P 500. Since the Fed announced the second round of Quantitative Easing, investors have cheered as the S&P 500 surpassed its pre-Lehman Brothers bankruptcy high, and just two weeks ago the Dow Jones Industrial Average reached a level 100% above the March 2009 low. The onset of the Middle East crisis sent oil prices higher, and the S&P 500 responded by pulling back from what could be a midterm peak on February 22. Currently, the effects of the Tōhoku Earthquake are sending markets tumbling around the world, and the S&P 500 and Dow Jones Industrial Averages broke through their 50-day moving averages (one of the least-complex technical signs of a correction) in the past week. Unless the US enters another recession, we’re not facing a repeat of 2008, but more likely a 10-20% correction in the equities markets. On March 15, the Federal Reserve announced no change in interest rates or the current round of Quantitative Easing. Unless an expansion of the program is announced that sends the dollar lower in the short-term, this correction could take the S&P 500 to its 200-day moving average or below. To capitalize on this and/or limit the downside on long positions, the Double-Short S&P 500 ETF is SDS. For the inverse S&P 500 ETF which is not leveraged, the ticker symbol is SH.

Respectfully Yours,
Matthew R. Green
March 19, 2011