Exceptional Bear

Exceptional Bear’s 2010 Outlook

Market Crash in reaction to QE2

Not just another ugly girlfriend

In his recent Collective2 newsletter, Mathew explains the benefits of an ugly girlfriend; the girlfriend is analogous to a trading system that takes calculated risks to earn a modest, steady return, contains a great deal of wisdom. On the contrary, the average investor is always chasing the latest hot trading system, only to find that last year’s winner becomes a loser as soon as he invests his money. Meanwhile, the system he fired ranks near the top again this year.

From this we might deduce that choosing the recent losers with a winning past under similar market conditions, might be the best of all possible choices. If you take a look at our half year 2008 to March 2009 in Exceptional Bear closed, you will see that we had exceptional returns in that declining market, what’s more if you compare this time period with any other system, you will be highly surprised. Although 2008 only shows a half year’s results, you might deduce that the Timertrac return of over 240% for the full year in unlevered funds, is well within reason, given a 62% return in December alone on Collective 2, would mean only 148% was required of the previous 11 months to equal 240%.

As Benoit Mandelbrot, the father of fractals, made clear, there is no random walk, but instead “Noah effects” and “Joseph effects”, while stats only measure the Joseph effects, it’s the Noah effects that make or break investors. Just such a cataclysm as the flood is now the stock market crash.
We are at the same juncture as mid-2008 with a steep drop the next in the market.

Why must the Market Plunge?
1)According to the American Association of Individual Investors cash holdings are at their lowest since the April 2000 market top. Likewise the proportion of bullish investors is the highest since February 2007, another market top. These contrary indicators of market tops signaled by the “dumb money” are even more accurate a predictor of a market top than “the smart money” – insiders who have disproportionately sold shares at 30:1, 40:1 and 50:1 in the last 18 months.

2)Despite the Fed, the market is a self-correcting mechanism; the primary reason for a Crash now is a backlash to the Fed’s continued meddling. In order for recovery to begin, the Fed’s entire credit creation, artificially low interest rates and money supply expansion must be completely withdrawn first. A Crash effectively accomplishes all three in a flash.
3)On a basis of its average 10-year earnings multiple, and in relation to corporate assets the stock market is at least 50% overvalued and over 96% of the S&P is trading above its 50-day moving average. But rather than dropping back to merely fair value, the market always overshoots from highly overvalued to highly under-valued.
4)According to Russell Napier’s Anatomy of the Bear, at market troughs stocks sell at a 60% discount to replacement value and a P/E ratio below 6. At the March 2009 low, stocks were still selling at 13 times earnings - more than double that. Meaning a drop far below the March 2009 low is assured - S&P 300 is likely the minimum, from the high of 1220 equals a 75% plunge.
5)Carmen Reinhart, co-author of monumental work, This Time is Different, in a paper delivered at the Jackson Hole Banker’s Symposium in August, provided a glimpse of the future. Distilled from her research studies of 15 crises over three-quarters of a century, including the Great Depression. Referring to 2008’s market plunge, she concludes: “post-crisis, credit contracts by an amount equal to the pre-crisis surge”. But with the Fed continuing to pump out liquidity, the only way credit can efficiently contract is through a Market Crash, where trillions of dollars vanish into thin air virtually overnight, severely constricting the money supply and reversing previous credit expansion. According to Reinhart, who reiterates the principles of the Austrian School, “Quick (Keynesian) fixes, grasped by political leaders impair, rather than improve the situation, by their unfortunate interventions, and turn the crisis into a persistent malady of our own making.” The dust has not begun to settle. Instead the shock from this crisis will likely be deep and persistent.
6)The dollar is in the process of strengthening, almost as much as it has dropped from the post-Greek crisis high in June. Given the current record volume in dollar shorts, the only thing that could cause such a surge is a knee-jerk “flight to dollar safety” that accompanies a Market Crash with its sharp contraction of the Money Supply. What’s more, the dollar is oversold and should climb back up to 88 on the dollar index from ~74.
7)Technically speaking in terms of Elliott, two colossal Diag II’s, which compound each other, signal the beginning of a long move down to complete the c wave of the larger 5-wave Diag II. The minimum likely downside of ~S&P 300, retraces the Diag II which marked the pre-crash 1987 high. As you may know, Diag >s indicate dramatic reversal ahead, back to at least where the lowest Diag began.

Although we employ levered funds, you can create a synthetic non-levered vehicle by setting aside half the capital in cash thus backing out the leverage. The reason for the levered fund is simple, the non-levered inverse funds are very thinly traded. If we attempted buying those, we would be constantly moving the market without filling our orders. The levered funds on the other hand, are used primarily by institutional traders and investors, so there is great liquidity and small spreads, and in most cases market orders provide excellent executions.
What’s more, we manage risk by scaling in and out, that is we sell a ½ the position when the stock becomes overbought and buy it back when it back cheaper, when it drops back down. If it goes higher still, we may sell the rest, if we think it will drop back after an extreme, temporary move. In this way we maximize returns while minimizing volatility.
Better to choose an ugly girlfriend who is likely to get very pretty soon, than one that will only get uglier and perform like the housing market - 30-winning years only to be reverse into huge losses. Compare our results to March 2009 in Exceptional Bear closed, you won’t find any better.
"Make no mistake, the next 6 months will be profitable beyond your wildest dreams”
Since markets plunge many times faster than they rise, you can earn more in one year of a Crash, than you’ve made cumulatively in the last ten (assuming you’ve made a profit, since this has been the absolute worst decade for stocks in all of recorded history.) What’s more, as the money supply contracts, the dollar’s purchasing power increases dramatically, further compounding your earnings in relation to others. At the bottom, you will be able to buy virtually any asset for ten cents on the dollar of its 2006 high: houses, boats, jewelry, art, watches and collectibles…whatever your heart desires. But you’ll need to pay cash, as a credit crunch will virtually wipe out all credit. Shortly afterwards another blockbuster rally begins back to the top in 5-7 years.
(Revised Nov. 8, 2010)