Sunday, June 7, 2009

UPDATE: THE OBAMANABLE DOLLAR’S RECENT IMPACT ON INCOME INVESTORS AND THE MARKETS

1. SUMMARY

While recent news on US economy, especially the non-farms payroll data, as been positive (OK, more like less negative than expected), in the past weeks, a number of powerful long term market trends have continued in currency and commodities markets and should continue over the coming months, albeit with the usual short term counter moves.

In sum, these include

• The weakening dollar against all major currencies

• The ensuing up trend in commodity prices (commodities are priced in USD) and their related currencies, the CAD and AUD against other major currencies.

However, we remain skeptical that the multi-month rally in equity markets will endure. Thus we do not recommend new long positions in them, and await shorting opportunities.

Here are the details.

2. What's Killing the Dollar

The biggest single story is the deterioration of the long term fundamentals of the USD. Why? In short, President Obama has no choice but to continue to expand the money supply at rates that will badly damage its value.

A. Why Washington Must Continue to Print Dollars

Washington has no real choice but to continue inflating money supply at unprecedented rates, because it is faced with a virtually unprecedented situation.

1. The Immediate Threat: Lack of Liquidity Causing Financial Collapse

President Obama is like an emergency room doctor dealing with a patient who has just been shot in the heart and will die in minutes if the heart can't be repaired and the blood circulation restored. The bullet was the subprime crisis and ensuing collapse of the housing and credit markets.

Thus he must first keep the heart going and stop the bleeding. The heart here is the financial system, particularly the largest institutions like Citibank, Bank of America, and those that insure their huge debt portfolios. It these bleed out liquidity, they will stop beating out available cash to depositors and credit to businesses, the lifeblood of the financial system depends. The heart, the banks cannot stop beating out blood, cash and credit, or the patient, the US economy, dies on the table.

So the printing of new dollars and expansion of money supply must continue.

2. The Underlying Disease – Excess Debt+Money Supply = Weakening Dollar

Unfortunately, the patient is already suffering from potentially fatal cancer of a weakening USD caused by massive debt, government bailouts of the financial sector, and expansion of money supply to pay these. There is no historical precedent for a country inflating its way to prosperity. While many argue massive spending saved the US from the depression, others would argue that the real cure was that WWII left the about half the world's production destroyed and the US as producer of about half the world's goods and services. But I digress.

To cure the immediate threat to the patient/economy, the doctor must continue to create new money/blood, which worsens the long term cancer of a weakening USD and inflation. If left unchecked, this cancer of a weakening USD will ultimately force up interest rates and may choke off the liquidity/blood supply from the heart/financial system.

Oh yes, major organ failure is continuing, with the bankruptcies of GM and Chrysler, plus a slow but steady rise in bank failures. These in turn threaten another spike in unemployment, ensuing residential foreclosures and reduced consumer spending. These in turn could cause further declines in:

• Overall business activity

• Values of banks’ commercial real estate and mortgage portfolios with further oversupply

• Banking income and balance sheet health and more commercial real estate foreclosures

• Local tax revenues and ensuing credit worthiness of local governments etc.

"Doctor Obama to ICU, STAT."

What's that loud beeping sound? Better fix the heart quickly!

3. The Results of a Weakening USD for Commodity Markets

Because they are priced in USD, commodities and their related currencies (AUD and CAD) are expected to continue their long term uptrend as the dollar weakens, even if relative supply and demand remains unchanged. Additional long term reasons for rising commodity prices include:

• Upward pressure on oil prices due to both the relatively inelastic long term demand, and the continued solid growth of the Chinese economy.

• As the USD's position as currency of last resort fades, demand for gold (and silver) increases because they're seen as safe stores of value.

• As China, other export economies, and other large holders of the USD lose confidence in the USD (public statements to the contrary aside), they buy commodities both to hedge (there is no obvious liquid substitute for the USD at this time) their wealth and to ensure a relatively cheap supply to support their production at lower prices.

4. Equity Indices

The multi-month trend in equities, however, appears far less durable.

Since March, major indices continue to rally despite minimal signs of true turnaround in the underlying fundamentals of their economies. Consider:

• Most of the positive news on which markets have risen consists of slowing contraction, not growth.

• The apparent return to profitability by the financial sector was the cause of the stock markets' latest rally. There is significant evidence that the prior quarter's results were not sustainable. In addition to evidence of outright manipulation of those results (beyond the scope of this article) consider:

· Recent problems in commercial mortgages like the failure of GGP, one of the leading mall operators.

· Coming interest rate resets in the next 2-3 years and resulting possible increases in foreclosures and erosion of bank residential mortgage portfolios.

· the continued deep problems in industries that employ the largest numbers, like construction and autos, and the effects of their decline on the values of the financial sector's residential and commercial lending portfolios.

The continued rally in the US stock markets has been more of a low volume, low credibility rise based more on short-covering by quant funds than a believable rally supported by real fundamental and technical evidence.

Could the rally continue for a while yet? Sure, especially with Washington and Wall Street cooperating so, ahem, intimately. But how many are willing to take new long positions after a 30% rise in stock prices without real improvement in underlying fundamentals beyond merely a slowing contraction?

5. Ramifications for High Dividend Stock Investors

In sum, we appear to be at the upper end of a trading range, with the overall trend continuing down. Continue to invest only with funds allocated for longer term investment that you don’t need for the next six to eighteen months at least. What you buy now may well go lower.

1. Consider a Partial Hedge with Selected Ultrashort ETFs

Thus, in addition to collecting your high yields, those seeking a more active hedge may wish to consider taking measured positions some of the Ultrashort Proshares ETFs as a partial hedge. For the unfamiliar, these are ETFs that move at twice the inverse of a selected sector of stocks. Thus for example if the S&P 500 index falls 1%, then SDS, its Ultrashort ETF, will rise by 2% (and vice versa).

The time is ripe to consider some of these. While by nature these are volatile, you want to buy these only as a partial hedge at strong support when the market has just stopped feeling very optimistic, as a rally begins to show signs of fading.

This looks like the time. Consider taking partial positions in the following.

· UltraShort S & P 500 Proshares (SDS) – Buy under $60, Strong Buy under $55

· UltraShort Financials ProShares (SKF) -- Buy Under $50; Strong Buy below $40

· UltraShort QQQ ProShares (QID) – Buy Under $40, Strong Buy under $35

· UltraShort Real Estate ProShares (SRS) – Buy Under $30, Strong Buy under $20

· UltraShort Russell2000 ProShares (TWM) – Buy Under $50, Strong Buy under $40

If you look at a chart for these, you’ll note my buys are very conservatively low. There is a lot of cash on the sidelines now, earning virtually nothing. Big players and insiders continue buying stocks we’ve been mentioning, because they’re clearly cheap and excellent long term values. As the past few months have shown, any glimmer of positive news brings buyers as everyone is waiting for the sign to jump in. Lots of cash on the sidelines will provide lots of fuel in the tanks for a rally.

If that happens, these ultrashorts can plummet fast, so you only want to buy them at strong support, so that if these levels don’t hold up you’ll know quickly and can get out before taking a big loss. Thus place sell stops no more than 10% below the Strong Buy levels to protect your capital. There are other Ultrashorts for other sectors, like the Ultrashort Oil and Gas DUG for shorting oil and gas. This one has been popular, but betting against energy and other commodities is dangerous and strictly for short term traders with expertise in these, so avoid this one.

2. Continue to Take Partial Positions at Our Recommended Strong Support Levels

Beyond the Ultrashort ETFs if you can earn reliable dividends from 8-12 percent or more while you wait for recovery, ongoing investment makes sense. You just need to find the best bargain priced quality high yield stocks, and collect your income while waiting for the market to improve and offer additional options. As noted above, with a confirmed downtrend and good evidence for a further 20% overall drop, refer to our past recommended buy levels, which are at strong support levels.

Since prices are up and thus yields are down, many of our stocks are above recommended buy points. Do not chase them, though taking partial positions above these prices is acceptable for those with lots of cash lying fallow. This is particularly so with the energy producers.

Remember our key criteria for new stock purchases: In sum, we’re seeking stocks of strong companies that mostly earn and distribute a high dividend in a non-USD currency and have a dominant position in a market for an essential product or service. Ideally, the stock’s fortunes should rise with those of commodities and other hard assets that remain in demand, like residential real estate, power generation and distribution, etc.

That’s my focus at http://highdividendstocksguide.blogspot.com .

3. Use Sell Stops?

While our emphasis is buy and hold as long as the distribution is safe and fundamentals hold steady, some may want to hedge their bets, especially if they may need the cash within the next year or so. Those in that position should consider using sell stops around 15% below the Strong Buy price as partial principle protection, though you risk getting knocked out of your positions, only to see them come back soon and possibly rise higher while you miss the dividend. It’s a judgment call, though not a bad one for at least some of your holdings given the current pessimism (which of course can change, fast).

Again, our focus is on getting high yields from healthy businesses whose price will recover while we earn outsized returns, and we don’t try to time the market too much.

6. Conclusion, Disclosure & More Info

Bear market rallies are a normal part of bear markets, and they can indeed last for months. While they are driven by positive news, what distinguishes them from market bottoms is the lack of evidence of long term improvement in underlying fundamentals. Slowing contraction is good, but it doesn’t necessarily mean a bottoming.

Thus we continue to warn, “beware the bear.”

Opinions presented are strictly those of the author and of those disseminating these articles or otherwise associated with the author.

The coming articles will examine individual categories and stocks in greater detail.

Disclosure: I have positions in most of the above mentioned investments.

Interested in learning more about investing in stocks that provide reliable high dividends with better transparency, appreciation potential, and liquidity than bonds? Visit http://highdividendstocksguide.blogspot.com

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