The Grand Illusion
By James M. Carrillo
Sr. Broker, SATC
Aug 7, 2009

Perplexed about the markets today? How can stocks sustain a rally? Wasn’t this supposed to be the end of the world? Did Obama save us? Is the Fed a magician? What gives?

Referring back to my article in January the markets are playing out almost exactly as expected -- "the battle between the bulls and bears rages on." However, we are nearing a major crux.

As mentioned in (The Lag Between Cause and Effect) I use both technical and fundamental analysis to make decisions on where I put my money. Stock Market fundamentals are horrid, but short-term technical data was drastically oversold on the panic that occurred at the end of 2008 and early 2009. However today we are at a level of needing to make serious long-term choices.

Our banks received massive federal aid to increase lending, but instead have been using most of that money to invest, reduce their debt and become real estate investors. According to Realty Track there are some 600,000 homes missing from the market. It appears they are holding homes in their own portfolios to give the illusion of a shorter supply. This may backfire if sales don’t reverse dramatically because a massive number of ALT A loan resets, now underway, will continue through 2011. This is not good for real estate prices over the next 12 months.

Retail Sales Are Horrendous

In the last two years, investors have heard the words “bubble” and “crisis” to the point that they have become cliché. They are thrown around far too often. But investors should take a look at “the bigger real estate bubble” - commercial real estate, as I warned about in January. Commercial real estate’s decline is a very real issue facing the economy because it may result in more losses for the financial industry than we witnessed in residential real estate. Commercial Real Estate includes shopping malls, apartments, hotels and office buildings.

Insurance companies among others are going to be impacted greatly by the commercial real estate situation. Most leading insurance companies have invested in excess of 10% of their assets into commercial mortgages. As the value of commercial properties decline, the write-downs of these mortgage loans on the books of these companies will severely impact their shareholders and their customers. A recent article at Marketwatch: Commercial real estate new Achilles heel for banks written by the President of the San Francisco Federal Reserve Branch also supports this.

Unemployment is still increasing

Unemployment is still rising beyond the Obama forecast of 8% and there are no new jobs to replace the ones being lost. In the twenty most populous states, unemployed people outnumber advertised vacancies and range from a low of roughly 2 to 1 in Maryland to about 10 to 1 in Michigan.

Next is the basic supply and demand rate of jobs, in May (latest month unemployment numbers are available) was at 4.32, down slightly from 4.40 in April indicating that there are more than 4 unemployed workers for every online advertised vacancy. Among the states Michigan is at 9.95, or nearly 10 unemployed people for every advertised vacancy. Other states where there are over 6 unemployed for every advertised vacancy include Indiana 7.73, Kentucky 7.33, Ohio 6.54, North Carolina 6.49, and Mississippi 6.30.

Coupled with the Commercial Real Estate issues, this does not bode well for growth.

Market reaction

So how is the stock market rallying? First, speculation. Second and most importantly the banks are buying stocks with bailout money. This is really taxpayer money. Companies cut staff initially so profits do improve in the initial quarter(s). Banks are not lending the money to businesses and homebuyers, they are still contracting credit.

Ask yourself this, if the economy is turning around why are banks not lending this money to the people? They see risk, which is exactly the way we should see it. This rally is nearing technical resistance. The realities of joblessness, lower growth revenues and a slower U.S. economy will soon surface.

Remember, if the majority of companies, corporations and governments are cutting 10-20% of their employees for the sake of making the books look better with no new jobs to replace them, who will be buying the products over the coming months and years? Answer: Very few. The expectations of GDP growth are fantasy when 72 percent of GDP is consumption.

China and inflation

The biggest problem I see is that China is booming. Yes, I said problem. I liken the infrastructure build outs in China and India to that of a locust infestation on all raw goods and materials. The recent report of China having a $2 trillion-dollar surplus is alarming and should make us all shudder. They act like our friend and ally but are they really?

Unlike the US, China has a $2 trillion surplus to invest with relatively few obstacles towards long-term growth. China has wisely begun to diversify away from investing in foreign treasury securities by building on its emerging market plan expected to hit 7.2% GDP growth (The World Bank). It has been aggressively pursuing major acquisitions and investments in gold, oil, copper and coal commodity companies and other investments.

China has recently strengthened relations with Russia while both agreed to oppose trade protectionism. It has promised to support Russia's bid for membership of the World Trade Organization (WTO). China mainly exports machinery, light industrial products and textiles to Russia. Russia's exports of natural resources to China primarily include crude oil, natural gas and lumber.

Why is this a problem?

The Chinese population is 1,330,044,544; India’s is 1,147,995,904. The United States has 304,059,724 as of 2008. You should now understand what I meant by saying, “a locust infestation on all raw goods and materials”.

The problem here is simple to understand. We have printed over a trillion dollars of currency backed by nothing but the full faith and credit of the United States government. The U.S. is a debtor nation and we are now competing with mass surplus countries. Basic economics insists this could rapidly erode our dollar’s buying power as the currency loses value. Either way you look at it those dollars will buy less over time because there is a lag between cause and effect that must not be ignored.

Couple our dollar dilution/devaluation with the fact we are now competing with these growing mega-countries for raw materials already in short supply. They have a combined populace seven times larger than ours. Perhaps now you better understand why I liken Chindia’s size and growth to a locust infestation.

Beware of the Chinese banking and stock bubble. China is also creating its own banking bubble by printing Yuan like crazy, growing their money supply expotenentially. There is a serious disparity in growth of money vs. their economic build out. This all could easily fail especially since they hold massive amounts of U.S. Treasury debt. The Yuan will not be a solution to the world’s problems. This may ultimately lead to a one world currency.

The Treasury auctions held this last week of July tell a story far more disturbing than what we hear. The $39 billion auction of five-year notes (the largest such sale ever) wasn't bid heavily enough to prevent the Treasury from paying a higher rate on its borrowing habits.

Rising yields not only affect our government's borrowing costs, thus increasing the deficit, but also increase costs of borrowing to consumers and businesses, since the 10-year note is the most commonly used pricing benchmark for mortgages and corporate borrowing.

The international ratings agency, Standard and Poor's, has recently changed its outlook for the British economy from stable to negative because of soaring government debt.

Sound familiar?

The ratings watchers have also cast a huge shadow on the struggling US economy after a top investor warned America's AAA rating was in jeopardy as well.

Moody's Investors Service downgraded California's general-obligation bond rating to Baa1 from A2 this month. It was the second two-notch downgrade this month after Fitch Ratings issued an identical drop recently. California is the largest economy in the U.S. and would be the eighth largest economy in the world if it were a country.

Derivatives Disaster

Simplified, the term "derivative" refers to a "derived" wager, or bet, on the price of something. If you don’t completely understand these bets don’t feel alone, even the Fed Chairman, Warren Buffet, Bill Gates and the brightest financial minds in the world don’t fully understand derivatives, but this graph will give you an idea of the sheer size of this market.

Yes those are TRILLIONS. Why should we care?

"Derivatives are financial weapons of mass destruction," said Warren Buffet back in 2003. He knew it then and they have grown massively since then to over $600 trillion.

Buffet's concern becomes clear when you see what this total equates to. The dollar is the world's reserve currency, so the majority of all derivatives are transacted in U.S. dollars. These are trillions of dollars of worthless fiat transactions that dwarf the rest of the world. By comparison our debt, dollars and GDP figures seem small;

* $9 Trillion Total Monetary Supply of US Dollars, cash, coin, and banking accounts.
* $15 Trillion Total 2008 GDP, or the market value of all goods and services the U.S.
* $50 Trillion Total world GDP in 2008, per US Global
* $75 Trillion Total value of the world's real estate, per US Global
* $77 Trillion Total nominal value of world's ETD derivatives, per BIS
* $100 Trillion Total value of the world's stock AND bond markets, per US Global
* $684 Trillion Total nominal value of world's OTC derivatives, per BIS

The fact that we are only now trying to regulate this mess and curb trading may very well cause the collapse of this market. Now you understand why I say, “I currently do not trust paper assets in any form.”

Updated projections

The S&P 500

Technically, we most likely will rally over 1000 on the S&P500 upwards of 1080, but as stated earlier I choose to widely ignore this rally because it has zero fundamental support. It could turn rapidly and wipe out fortunes overnight. If you are still in the market you are most likely looking a gift horse in the mouth in my opinion. Look for a great selling opportunity above 9500 on the Dow and 1000-1050 on the S&P 500.

Nothing has changed fundamentally. The idea of flooding the markets with massive amounts of new currency will either work and we will come out of it in a massive inflationary spiral because too much money chases to few goods and services or it won’t work at all. Pray for the former. I don’t believe any middle ground exists.

The U.S. Dollar

The US Dollar is nearing a break point now. July’s monthly close below .7900 was a major sell signal to worldwide fund managers. It is currently trading dangerously close to the .7900 area. Fundamentals are in place for a free fall, lower employment, banking problems, real estate glut. Major issues within the commercial sector with poor auctions are forcing the Fed to buy back its own debt. This is like using your Mastercard to pay the Visa bill.

Technically we haven’t received the next U.S. dollar sell signal just yet. Fundamentally you can’t sell me on the idea that we can mass-produce world currency and U.S. dollars and make them worth more. The more there is, the less they are worth. Again, basic economics dictates this is going to be a long-term inflation spiral created by monetary inflation. It will require more dollars to buy the same goods and services regardless of what the talking heads want us to believe.

GOLD

Gold has done what I hoped for last January as the best case scenario, I quote “If we are lucky we will get a choppy sideways pattern until August with a moon shot move up into 2010.” My conviction continues to be that, “it is better to be a year too early than five minutes too late. Accumulate gold now before the dollar falls into the abyss.”

Gold is the anti-dollar because it moves in the exact opposite “a mirror image” to the value of the dollar. Buy the dips if we get any. The longer gold moves sideways the larger the move will be.

CONCLUSION

Looking at the above charts, I ask you: which market is stronger? Where would you have rather been over the past decade? What has changed? The world melted down in 2008 and early 2009. Gold stands firm and massive amounts of currency are being printed worldwide. Fundamentally nothing has changed and technically the long-term trend of stocks remains down, the dollar has re-established and triggered a new down trend, gold once again appears to be the major benefactor. The talking heads tell us one thing, but common sense, the numbers and the overall trends tell us that the stock, bond and real estate market rallies are nothing but a grand illusion. Remember, the best way to dump dollars is to buy gold.


Disclaimer: All of the facts and information is believed to be true, however errors are possible. All investments have risk and past performance is no guarantee of future performance.

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