Delisting of GSEs Looms Large

The day of reckoning is coming for both Fannie Mae (FNM) and Freddie Mac (FRE). The first time delisting of these companies was discussed, on September 8, 2008, the NYSE notified FNM and FRE that they'd have to increase their share price over a dollar or the stocks would be delisted from the exchange after six months. The two previous times that the stocks fell below $1 the government was able to bring them back above the minimum.

While being delisted isn't the end of the world for most companies, these government entities rely on the confidence of the markets to move forward after being seized. If the government has plans for the structured reorganization of mortgages in conjunction with the latest bailout package then being delisted would be a final nail in the failed bailout coffin.

Look for a boosting of the share price to ridiculous levels (anything above $1) or go literally to zero in the next delisting notification process. I believe that the prospect of delisting is going to wipe out these companies and possibly the banking system. Touc.

Sources:

Spicer, Jonathan. "Fannie, Freddie Facing Delisting Threat." Thomas Reuters. September 8, 2008. Accessed February 21, 2009.

When Paper has no Value

The time will come when governments of the world realize, by force in some cases, that more value and confidence can be gained from using gold as the last resort bailout mechanism rather than paper or digital money. However, the gold option is very much the financial equivalent of the nuclear option. No nation wants to actually resort to this feature first because as one nation dips its toes in the water all subsequent nations will follow in its path at ever higher gold prices. It is only the last nation in the pool, with sizable gold reserves, that benefits the most from using gold as collateral. The first nation in the pool becomes the sacrificial lamb. Unfortunately, desperate times call for desperate measures.

As an example, in 1974 the official rate of gold was at $42.22 an ounce. However, the free market price of gold reached $180 an ounce. The free market price of gold increased the borrowing power of bankrupt Italy, which had 2,500 tonnes of gold, from $3.7 billion to $15.8 billion. On September 1 1974, West Germany lent Italy enough money to stave off complete collapse of the nation using the free market price of their gold holdings as collateral. Most interesting in this deal is that West Germany never collected on the gold. It was accepted on faith that if the loan could not be repaid then the gold would be shipped to West Germany. However, as long as Italy was able to make their payments on the loan then there would be no question of whether or not they would ship the gold in the event of default. This gave every incentive for both West Germany and Italy to hope for the rise in the price of gold.

We often hear about how governments would rather not have gold compete with their currency or that gold has no master. Then why are central banks filled with the stuff? The case of Italy in 1974 provides a perfect example of the reason why.

Gold acts as the last resort to combat the global competitive protectionist policies of coordinated rate reductions and domestic stimulus packages that we're seeing today. When a nation is on the brink and there is talk if a loan agreement based on the value of gold then, and only then, can we be assured of the turn in the tide for inflation, interest rates, stocks and the price of gold. Touc.

Sources:

• Lee, John. "German-Italian Deal ignores U.S. Policy." New York Times. Sept. 2, 1974. p.21.
• Hofmann, Paul. "Bonn to give Rome A $2 Billion Loan in Financial Crisis." New York Times. Sept. 1, 1974. p.1.
• Russell, Richard. Dow Theory Letters. June 26, 1974. Letter 601. p. 4.

Volume Observations in Bear Markets

The charts below reflect the peak in the Dow Jones Industrial Average from the week of October 8, 2007 (yellow) and February 7, 1966 (green). We're 72 weeks into the current bear market and all systems are go.

Notice that volume is generally rising in both instances. This indicates that we're still in the early stages of this bear market. This bear market will indicate that it is near the end by having a flat or declining trend in overall volume. Unlike the bear market of 1966, which began rising in the 35th week, the current bear market hasn't seen a sustained rally.

The overall trend in volume is quite fascinating. In both bear markets there is an early above trend volume pattern however, in week 17 and week 12 there is a spike down. There is also a surge in week 47 and week 48 from below trend volume to above trend volume.

All this means that while we may be at the bottom cyclically we're still in a secular bear market. Touc.

Misinformed Market Observations

The information that is being provided on the website dShort.com is top notch. So good is the information on this website that it should be the beginning course for every investor. However, there is a disservice being done by those who take this information but don’t put it in its proper context. The information that I’m referring to regards a Bull and Bear Market Rally Chart that depicts the performance of the Dow Industrials, S&P, and the Nasdaq indices during major declines in history compared to the most recent decline. The reaction to this chart, if you’re a stock market bull is a glazed over, panic-stricken stare. If you’re a stock market bear you’re probably salivating with eager anticipation and excitement.

The problem with this chart is that it is being used by “bears” as a cautionary tale of what is to come (i.e. 1929 to 1932-type decline). However, these indices, while similar (they're all traded in the U.S), are not the same and should not be compared to each other, especially when we have data on the Dow all the way back to 1896.

More important than what is shown is what it doesn’t show. The chart doesn’t show the periods in history when the Dow declined by 40% or more in one move as has occurred since October 2007. In every instance that the Dow has fallen 40% or more in one fell swoop, as it has recently, the market rebounded 50% to 100% every time.

• Jan 19, 1906 to Nov. 15, 1907 decline of 48.3%
• Nov. 15, 1907 to Nov. 19, 1909 increase of 89%
• Sept. 30, 1912 to Dec. 24, 1914 decline of 43%
• Dec. 24, 1914 to Nov. 21, 1916 increase of 107%
• Nov. 21, 1916 to Dec. 19, 1917 decline of 40%
• Dec. 19, 1917 to Nov. 03, 1919 increase of 81%
• Nov. 3, 1919 to Aug. 24, 1921 decline of 46%
• Aug. 24, 1921 to Oct. 14, 1922 increase of 61%

All of these declines and increases occurred within the bear market of 1906 to 1924. This was a period when the Dow started 1906 at 100 and didn't close permanently above 100 until after July 1924. While I understand the dire nature of the markets and the financial system a sucker's rally has to start soon. Every 17-25 year period of bear markets has had similar action and reaction. This means that either we're going to get a sucker's rally or this is really the bottom in the market.

Some could accuse me of being selective but the facts and truth are consistent. 100% of declines in the Dow of 40% or more result in a reaction of 50% or more. If you can find a period that doesn’t meet this criteria then pass it along since I need all the information that I can get. By the way, if you want to school me on 1929-1932 then please read my breakdown of this market decline in my Big Picture Observation and 1929 article.

It is likely that "this time is different" and I'll be proven wrong. However, I feel that a little perspective is necessary on this topic. Touc.

Convergence of Extraordinary Forces

Most people contend the current economic malaise that we're experiencing has something to do with the housing sector of the economy. I believe this notion is an adept recognition of the symptom rather than an acknowledgment of the true problem.

My views is that the banks are the problem and have been since the beginning. After all, homes could not have been bought if the easy financing wasn't available. Furthermore, homes could not have been built if it were not for the financing provided to the homebuilders through the capital markets and the banks. This lead me to the conclusion that the ebb and flow of bank deposits would be an indication of the overall pulse of the economy and the stock market.

To this end I have conjured up the Demand Deposits at Commercial Banks provided by the Board of Governors of the Federal Reserve System. In the chart below the increase in the Demand Deposits indicated a general instability in the banking system. The decline in the Demand Deposits indicates a high level of confidence in the banking system. While these ideas seem useful there seems to be an attempt to show correlation as causation which can be just as dangerous as mistaking the symptom as the problem. We forge ahead regardless.



The chart above shows that since September 2006 there is a parabolic increase of demand deposits at banks. This reflects part of the "flight to safety" that many are describing in the financial press. Flight to safety occurs when savers realize that investments carry unforeseen amounts of risk. According to David Marantette, parabolic moves up or down can only last for so long. The exhaustion of such moves can be attributed to entropy or the second law of thermodynamics.

Entropy is the change of energy from an orderly state to a state of dissipation or death. The parabolic rise in the last two years will have to break down at some point. In the case of Demand Deposits, what we should expect to happen is for the index to dramatically decline in an equally violent fashion. A good example can be found in the low of December 2000 until the peak of September 2001. That parabolic move was followed by a violent decline in the index from October 2001 until September 2002. The September 2002 bottom was offset by a violent rise until August 2003. After the August 2003 peak we see an "orderly" diffusion of the energy expelled during the period from December 2000 until August 2003.

If the stock market is a leading indicator for the economy then it would appear that the Dow Jones Industrial Average anticipated the end of the volatility in the Demand Deposits by hitting bottom in October 2002. From October 2002 the Dow Jones Industrial Average increased from the level of 7286. 27 to the high of 14,164.53 in October of 2007, an increase of 94%.

Not only does entropy seem to be at work with the Demand Deposits, cycles seem to be playing a prominent role in the action of this index. Of the last cycle bottoms since 1959 the average cycle lasted about 5.6 years. Half of the cycle bottom, to find where the top would occur, is equal to 2.8 years. If projected from the September 2006 low, we would expect the most recent rise to peak around June of 2009. The next bottom in the index projected to take place around April 2012.

Finally, seeing this index nearly triple it's move beyond the normal peak from periods past leads me to think reversion to the mean. At the very least this index should fall to the level of the previous high. The current level is at 59% year-over-year percentage change while the previous peak was at 13.6%, a decline of 76%.

The impact of all this information is that starting in June 2009 the stock market will either hit bottom and go higher or trade in a wide range until April 2012. Afterwards the market would head lower in a fashion similar to what we've seen in the last 2 years. Touc.

Six or Half a Dozen?

As I have demonstrated in my October 2008 article and was later confirmed by BloombergMarkets magazine in their Jan. 2009 issue, the old administration (republicans) had doled out at least $8.5 trillion in support of the financial markets. Of this amount, only $700 billion was put before Congress for a vote which was rejected the first time (as it should have) then rejiggered and forced down our throats the second time.

Now, the minority party (republicans) in congress wants to stand opposed to the very thing that the old administration (republican) vehemently said was needed in order to save the economy. The current administration (democrats) is doing everything the old administration espoused (the opposite of change) by using fear tactics and is getting no love from the same republicans who supported the first bailout package back in October of 2008.

What really grinds my gears is the fact that $7.8 trillion never went up for a vote and now the republicans are saying that Obama's $900 billion is going to bankrupt this country. Where were the critics when the $7.8 trillion was going down the drain? Don't misunderstand me, I think that the only money that should have been provided was by the FDIC for bank failures. I knew the bailout was a scam when only $73 billion of the $8.5 trillion was used for FDIC insured instititions. Now there are no bullets left for the very things that were supposed to be government insured.

These politicians, both republican and democrat, are gaming the system and the citizenry. Why are we allowing this, because if we don't then, "the whole financial system would collapse." As I showed on October 2008, the $1.8 trillion that was spent didn't stop Wachovia, Lehman Brothers, AIG, Freddie Mac, Fannie Mae, IndyMac, Washington Mutual, Merrill Lynch, Bear Stearns and a whole host of other institutions from collapse. After the $1.8 trillion an additional $6.7 trillion was thrown into the fire to no avail. Historically, bailout don't work and now we're being gamed right and left.

Don't worry though, if the economy recovers within the Obama administration the three card monty operators, republicans and democrats, will claim that they are responsible for the outcome. All the while they will be bankrupting our country. Touc.

Bank of Hawaii Update

As a follow-up to my earlier research recommendation of Bank of Hawaii there is news that three days afterward, on January 15th, Bank Director magazine ranked Bank of Hawaii as number 4 among the nation's top 150 banks. Bank Director says that,

"Honolulu-based Bank of Hawaii, No. 4 on the Scorecard, has $10.4 billion in assets, making it the largest in asset size of the top five financial institutions. Its impressive 23.24% ROAE is the highest of any large bank or thrift during the four-quarter analysis period. 'They are a much more traditional bank with a good mix of commercial and retail customers,' says Aaron Deer, a San Francisco-based research analyst at Sandler O’Neill, who follows western banks. 'They’re well rounded and they’ve avoided a lot of the pitfalls that many other banks have stepped into.'”

It is nice to know that we might be looking in the right places when it comes to investment opportunities in the banking industry. So far, BOH is up by 3.79% in 26 calendar days. Good luck on your investment research of this quality bank. Touc.

Dow's Theory

Dow's theory is supposed to be the barometer of the market. In general the market doesn't care about one single statistic or policy implementation by the government. The market is the all encompassing knowledge of what the future will be. What does Dow's theory tell us about the prospects for the near term?

Dow's theory is telling us that the markets have hit bottom and are headed higher from here. However, this prognosis has one huge caveat. Only if the Dow Jones Industrial index continues to stay above the low that was reached on November 20, 2008 will the bear market rally remain in effect. Already the Transportation index has fallen below its Nov. 20th low as recently as Jan 20, 2009. Normally a re-confirmation of the bear market would have been signaled if both the Industrials and Transports fell below the Nov. 20 low. The fact that the Industrials hasn't confirmed the Transports by falling below the previous low and the rising volume since December 24th indicates that the markets are poised to move higher.



The risk to my outlook for the stock market is that both the Transports and Industrials fall below the lows of Nov. 20th at the same time. Falling below 7552.29, the Dow Industrials would have 4132.17 as its next resting point. This is not a wish on my part, it is only an observation as part of Dow's theory.

As an investor we need to approach this market with caution. As it stands, the news is very negative and there are more and more layoffs being reported. How are we supposed to commit our remaining investment funds (as opposed to savings) to the market after the painful experience of last year? Such a challenge is best answered by hedging your position by focusing on the strongest dividend paying companies that are out there. This way, if you're wrong about the stock going up at least you could hold and compound the dividends. Compounding only becomes necessary for those unwilling to sell after a certain amount of loss has been experienced. Take a look at my recent research recommendations on February 4th. These companies offer the best hedge against the prospect that the market could fall much lower.

Remember, the Industrials are either going back to 10836.11, a gain of 31%, which would still be within the context of a bear market or the Industrials are headed down to 4132.17 a loss of 50%. Touc.

When was it said?

"...the oil stocks are already the 'whipping boys' of the energy crisis, and Washington is playing the 'windfall profits' theme for all it's worth."

-Richard Russell. Dow Theory Letters. December 5, 1979.

The preceding comment was found in the Dow Theory Letters at or near the peak in oil prices. It seem that politician at the time were doing the same thing that they were doing during the congressional hearings with oil executives back in 2008.

The beauty of all this information is the fact that unlike other types of history, financial history does repeat itself. Of course there are minor difference in the names of the people but economic history points to the direction that things are headed. To me this means that the response by the government to the current economic malaise is only going to extend the pain rather than solve the problem. Touc.

Income Investing in Hard Times

According to the National Bureau of Economic Research, and backed up by the Federal Reserve Bank's Industrial Production Index, the economy officially went into recession starting in the month of December of 2007. Since then, we have seen the economy and the stock market decline in unprecedented amounts never before seen. As the chart below demonstrates, not even the "Great" Depression has seen such a year-over-year decline on a percentage basis.

When it comes to investing in the current economic environment we have to consider the worst case scenario. Below I have included a spreadsheet that considers Dividend Achievers that are close to or within 10% of the 1 year low. These stocks are ideal for consideration as your next research and potential purchase candidates.

What I have done is assume the period which these stocks have accrued the lowest quarterly earnings since the recession began then projected those low earnings to determine if the company can sustain the dividend payment over the coming months and years. Stocks that have a negative number in the column titled "cash remaining" are the least likely to be able to increase their dividend in the coming year. While this does not condemn the stock it does warns us of the danger that might exist. Also, stocks that are highlighted in red are those whose lowest quarterly earnings since 2006, if projected into the future, could not sustain the current dividend payout. These stocks (DBD, PII, KO, PPG, TRH, UVV) are still good companies however, if the recession continues or gets worse then we could see the dividend increase put on hold as well.

My recommendation is that stocks with the lowest payout ratio and the highest cash remaining (based on the lowest quarterly earnings since the recession began) are the best companies to start your research. Don't forget to verify the dividend history before buying these stocks. Touc.