Michael Belkin

» Normxxx - Prepare for worst-- high-volatility dislocation

By Jon D. Markman | 5 May 2004

Six months ago, astride the great Nasdaq rally of 2003, just a handful of analysts raised their voices to express concern about the dangers of a stock market driven forward far more by highly simulative government tax and monetary policy than by fundamental business conditions.

One was Michael Belkin, an elite independent researcher based in Bainbridge Island, Wash. In an interview published here on Oct. 22, the former Salomon Brothers analyst argued that the 2003 advance would end in a fourth-quarter skid mark, as “bubble fuel” was drained from the system in an “involuntary de-leveraging” process. Its main victims, he predicted, would be technology and housing-complex stocks -- and particularly shares of semiconductor makers such as LSI Logic (LSI). Beneficiaries, he said, would be the shares of large consumer products makers such as ConAgra Foods (CAG) and energy companies such as Amerada Hess (AHC).

For the next three months, Belkin was dead wrong. The market continued to shoot straight up, and readers e-mailed repeatedly to ask why we had given him any credibility. And yet now, with the passage of time, his views don’t look so dumb after all. The Philadelphia Semiconductor Index ($SOX.X) is lower by 5%, though LSI Logic is down by 15%. And most of the large-cap tech and biotech stocks that make up the Nasdaq 100 Index ($NDX.X) have gone nowhere, with Intel (INTC) down by 18% and Amgen (AMGN) down 6%. Meanwhile, ConAgra has jumped 23%, and Amerada’s up 35%.

The recent setback is nothing, however, compared with what’s coming, he says now. In an update interview this week, he said his research suggests that the market will revisit its October 2002 lows, and he is sticking to his prediction of a “high-volatility dislocation” -- you might call it a crash -- en route. He still singles out semiconductors as likely victims, but has now added emerging markets to a long list of investment areas he expects to get clobbered; meanwhile, he still likes consumer products companies and energy as potential hedges, though he doubts they will provide positive absolute return.

The dawn of the ‘real’ bear market
His most interesting assertion is that it turned out that March 2000 was not the peak of the bull market that began in 1982: It was only the peak for the S&P 500 ($INX), Dow Jones Industrial Average ($INDU) and Nasdaq ($COMPX). The agonizing bear phase that followed in those groups over the ensuing 2½ years was counterbalanced by a steadfast rise in small-cap and midcap stocks, particularly ones categorized as value plays. In other words, agile money managers were able to sidestep the big-cap growth bear market by switching to, or hedging with, small-cap and midcap value plays.

When the S&P Smallcap 600 ($SML.X) and S&P Midcap 400 ($MID.X) indices reached historic highs in October last year and continued to make new highs through March of this year, bulls asserted that their success showed the bear market had ended and a new secular bull market had begun. But Belkin’s view is that the real bear market is only now set to begin, with all market capitalization, sector and style groups -- not to mention foreign markets -- pushed to extreme valuations by an imprudent monetary policy that set interest rates far below the inflation rate.

By allowing the official overnight federal funds rate to lag well behind the inflation rate, he says, the Federal Reserve made the worst of all possible central bank mistakes -- encouraging as much unproductive speculation in the past year as it did in 1999, when it flooded the world with dollars in anticipation of trouble from the Y2K bug. For this handiwork, he labels the men around the Fed board table “worse than the board of Enron” for their obsequious obedience to Chairman Alan Greenspan.

“They’re all total wimps; the board is all yes men, academics who just rubber-stamp their boss. And they’ve now given us the biggest bubble in everything that I’ve ever seen,” he said. “Through 2000 it was mostly the tech stocks, but now it’s everything.”

Belkin fears that emerging markets have the furthest to fall, because they attracted the most excess capital during the past two years. “When capital is fearless, when investors feel bulletproof, they put money into the riskiest areas,” he said. “That has pushed emerging markets into the worst extremes in my experience of about 20 years, including the periods preceding the big collapses in the ‘90s of Russia, Latin America and Asia. The Fed has essentially bubble-ized the whole world.” He estimates that the Nasdaq, S&P 500 and German DAX have about 42%, 30% and 45%, respectively, to fall to revisit their 2002 lows, but the Brazilian market could fall as much as 58%.

A rocky road ahead
Belkin depends on a model of the interconnected world market in equities, commodities and debt that he created at Salomon Bros., and updates every week with fresh data. Many of his measurements are proprietary, but in the big picture, his model sees all markets as big expansion and regression machines, always moving to extremes in one direction and then contracting to a baseline and shifting to the opposite extreme. His data show that the appetite for U.S. equities “has been rotting from inside all year,” despite tremendous inflows of cash into mutual funds from investors earlier in the year.

The peaks of inflow came in the first few weeks of the year, then tapered off, then hit a crescendo again the first week of April, and have since tapered down back to lows. His view is that when the market can’t make progress after that much fuel, investors inevitably get frustrated and slow or halt their contributions. And then the real trouble comes when fund outflows begin.

The analyst said he has been warning his clients, primarily large U.S. and European financial institutions “not to get caught up in the Fed con game and positivity,” and to prepare for the possibility of a “high-volatility collapse” that will see a return to the treacherous, unstable days of 5% up and down days in the Nasdaq. “The declines after bubbles are more violent and pronounced the more people are positioned wrongly, and I’ve never seen so many people on the wrong side of everything -- bonds, emerging markets, small-cap stocks, and techs -- just as inflation and interest rates are getting ready to explode,” he said. The Fed, he believes, can hold back interest rates only so long, and then the market prevails. In the past seven weeks alone, the market has pushed two-year and five-year Treasury bill yields up 90 basis points, which is the equivalent of almost four of Greenspan’s “baby step” 25-point moves. In addition to tech stocks, he believes the financial services group, especially brokers, will be hard hit.

10 large-cap leaders
Of course, not everyone is wrongly positioned. Even though the broad market is flat for the year, industry group rotation has gone exactly as forecast, with makers of personal products, food and consumer staples moving ahead as many major institutional funds have positioned themselves defensively this year. Earlier in the year, the list of NYSE and Nasdaq new highs had reached extreme historic highs, but they are now heading in the opposite direction, with the McClelland Summation Index, which measures market breadth, starting to turn negative last week.

Many of Belkin’s measurements only begin to matter when they matter, which is an existential way of saying that his work cannot be used to day trade. He’s paid to look far over the horizon and help major portfolio managers turn their battleships slowly. The last time he appeared here, it took three months for his views to come into the mainstream. Perhaps, with interest rates already rising, their turning radius is now shorter.

Fine Print
You can read my Oct. 22, 2003, column on Belkin, “Market prophet is battening the hatches.” All but one of the 20 longs he provided in that column were up through May 3, for an average gain of 11.7%; the shorts were up 7.2%. . . . He does not have an advisory service for private investors, but institutions can contact his representative, Mondiale Partners, via their Web site. . . . As mentioned last time, Belkin is not all-bear, all the time. In May last year, he advised investors to buy beta and predicted the Nasdaq would rise as much as 50% in the second half of 2003. Read Kate Welling’s interview with Belkin here.

-- posted by Normxxx

» Normxxx - The Best News is Behind

By Michael Belkin | July 14, 2004

As investors ponder the difference between current economic and market conditions and the utopian hype at the beginning of the year, they might well blame Wall Street for an intelligence failure and themselves for gullibly believing the hype. What is left to be discredited? The last remaining WMD (Weapon of Mass Delusion) is the cyclical and industrial economic recovery. While our model does not yet have a downward forecast for most industrial economic indicators, the slowdown in sales and rising inventories of goods such as autos and semiconductors suggest a cyclical slowdown is approaching.

We won't add much to the hyper over-analysis of the Fed's recent action, except to point out that the fed funds rate is 200 basis points below the CPI inflation rate – a more normal level would be at least 200 basis points above the CPI. The CPI rose 71 basis points last month (annual rate). So 25 basis point fed funds rate increases won't even keep up with the CPI rise that the Fed's negative real interest rate policy has created. What a mess Greenspan has created. Most things now celebrated by awe-struck investors wouldn't exist without ultra-low short-term interest rates (carry trade, zooming emerging markets, financial stock out performance, car sales, home sales, etc.). Investors are firmly planted in Fed-created bubbles that won't survive an interest rate up-cycle. Ironically, hardly anyone is calling this a bubble – when it is a bigger one in many ways than March 2000. That was just TelecomMediaTechnology – this is everything.”

The last thing anyone seems to expect is an economic slowdown in the US. But our model sees early signs of a downturn approaching. The best news is probably behind for home sales, auto sales, economic growth and inflation. The model has an early downward forecast for the ECRI weekly leading index and money supply growth. It has an upward forecast for core PPI, core CPI and initial unemployment claims. An economic slowdown accompanied by rising inflation is not a pleasant environment for consumers, employers or corporate earnings. We expect companies to lower guidance and knock share prices lower. So far, several major US companies have had disappointing pre-announcements or earnings; e.g., WalMart, GM and Washington Mutual. That is a broad industry range – retailer, manufacturer and home lender. Other disappointments are lurking out there. Stock indexes have been stuck in a trading range all year. 2004 highs (so far) were set months ago – but stocks haven't fallen much yet. It has been a frustrating environment for both bulls and bears, as short-term rallies and declines have both stalled out without much follow-through. Mutual fund inflows have dried up, but there hasn't been much on the fundamental side to motivate selling. As economic and corporate earnings news deteriorates, mutual fund outflows will probably increase, sending share prices lower. Weaker groups/markets that appear to be leading the broader market lower include semiconductors, securities brokers and emerging markets.

Semiconductors typically lead technology sector performance, tech leads the Nasdaq and the Nasdaq usually leads other US and global indexes. So semiconductor group performance is vital for other groups and markets.

Semiconductor stocks have been much weaker than the S&P500 and Nasdaq this year. The SOX Semiconductor Index is down 11% ytd – while the S&P500 is up 2% and the Nasdaq is down 1%. The SOX recently turned down again and is close to its early-May lows, erasing most of the May-June bounce. The SOX is also below its 200 day average. Are semiconductors leading tech and the broader market lower? Given the widespread celebration about economic growth and all things cyclical – it is ironic that the leading ‘smokestack tech’ group (semiconductors) is ailing.

Our model’s #1 underperformance prospect in the US and Japan is securities brokers. Brokers typically lead financials in the same manner as semiconductors lead tech. The XBD securities broker index chart resembles that of the SOX – below its 200 day average, back to its May lows – having erased the May-June bounce. The XBD Index has underperformed the S&P500 financial sector by 12% since late January.

The model forecast suggests that that theme will continue. Broker’s share prices are slipping, even while they scour the earth for new ways to keep the financial bubble going. The joke is on them.

The IFC emerging equity market composite index is down 15% from its early April high and has a big downward model forecast. Emerging markets are like balloons – fill them up with helium, release and watch them fly as the gas rushes out. Then watch them flutter back to earth, empty. Those 1% US interest rates generated big capital inflows into emerging markets (which zoomed) – but now the gas is gone and the flutter-back-to-earth cycle is underway.

Bottom Line
Three bull market leaders (semiconductors, brokers and emerging markets) are in distinct downtrends with downward model forecasts. This deterioration stands in stark contrast to the constant chatter about economic growth and stock market rally potential. Whoever is long semis, brokers and emerging markets isn’t buying the happy-talk consensus view – they are selling.

The content of this message is not to be construed as constituting market or investment advice. It is intended for educational purposes only. Individuals should consult with their own advisors for specific investment advice.

-- posted by Normxxx

» Jas_Jain - Re: The Best News is Behind

Thanks, XXX.

Jas

-- posted by Jas_Jain

» Normxxx - The Belkin Report: Stop Sign

By Michael Belkin | September 20, 2004

“The equity market rally of the past several weeks has reached the limit that our intermediate term model can endure. Because the short-term and long-term model forecasts both point south for equities -- and because most stock indexes have only bounced up toward their 200 day averages (no breakout), we are giving the market one last chance to conform to our downward forecast. But this is it -- no further rally or our long-standing short positions are closed. So here is a stop sign -- the short term rally stops or we are stopped out.

...Still, someone has bought every dip in the equity market. But someone else has sold every rally. So stocks have been squeezed in this downward trending trading range after the top of the big 2003 rally, in the context of a long term bear market. Our stop sign is out there because the market can always do crazy things. But getting squeezed into the death throes of an aging mini-bubble within a long-term bear market seems like a really dangerous strategy.”

[Normxxx Here:  Looks like we didn't have to use the 'Stop Sign' last week. ]

The contents of this letter/report does not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of this message is not to be construed as constituting market or investment advice. It is intended for educational purposes only. Individuals should consult with their own advisors for specific investment advice.

-- posted by Normxxx

» Normxxx - The Belkin Report

By Michael Belkin | Sept. 14, 2004

“The long-term model forecast is positive (in relative terms) for low-beta sectors like Utilities and Telecom Services -- and is negative (in relative and absolute terms) for the Tech sector. Given those forecasts, it is difficult to get excited about any tech-led rally potential. But markets can always do crazy things briefly before resuming the long-term trend. So we are wary -- still short stock indexes, but this is a testing point for our long-held scenario of a major equity market top and decline.

The forecast for the US economy is less ambiguous -- there is a distinct softening in the economic forecast. The recent downturn in retail sales growth is probably the beginning of a sustained trend. Higher fuel prices are absorbing a greater percentage of household expenditure by low and mid income consumers. Retailers are feeling the impact.

The retail sales slowdown should soon feed through to lower orders for manufacturers. That process is well underway with autos -- inventories are at an all time high and Q4 production plans at GM and Ford are down 7% year over year. Auto component suppliers like Visteon are beginning to feel the impact. This is a classic economic slowdown pattern. While we are not wildly bullish on energy prices, a collapse seems unlikely given rising global demand and Mideast instability. So pinched consumer expenditures and the retail sales slowdown are likely to be persistent themes. This sales slowdown should depress revenue and earnings results for corporate America.

If many companies are going to miss Wall Street's elevated revenue and earnings expectations – the equity market is not likely to be happy. So, while we are wary, given the conflict between model signals in different time frames, the recent stock market rally is probably just another bounce in a downtrend.”

The contents of this letter/report does not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of this message is not to be construed as constituting market or investment advice. It is intended for educational purposes only. Individuals should consult with their own advisors for specific investment advice.

-- posted by Normxxx

» avnerk - Re: The Belkin Report

Thanks Normxxx. I've been searching for the Belkin report everywhere.
Please keep them coming.
Thanks

-- posted by avnerk

» Normxxx - Re: Re: The Belkin Report

Hard to come by, for less than a few grand, so the updates are likely to be spotty.

-- posted by Normxxx

» Normxxx - "Play safe"

As faithful readers of this publication have no doubt realized by now, Michael Belkin, the keen-eyed and sharp-witted market strategist and publisher of The Belkin Report, is on the whole a most sober fellow, solid citizen and all that. Even if he did forsake the joys of Manhattan for the questionable charms of an even smaller island, off the left coast. So It was only natural to do a double-take and pick up the phone when this headline cropped up in his latest missive: “Do Drugs And Have A Beer. Not to worry”, I found him perfectly coherent. Then again, maybe that’s why we should worry!
KMW

It’s been too long since we talked, Michael, but I see that your antennae are quivering again. You’re calling another significant change in market direction?
A lot has changed since you wrote about me turning bullish at the end of ’02 and in the spring of ’03 [w@w 1/10/03 and 5/16/03]. Back then, gloom was thick in the air, but my forecasting model, which helps me determine whether we are at the beginning, middle or end of a move, and gives me the next direction, was in almost exactly the opposite position it is in today. Then, everything was pointing up. It was the beginning of something. Now, it is down—for the intermediate term and for the long-term, meaning for the next three months and 12 months.

Gee, not three days?
I still hear people claiming to “invest for 10 or 15 or 20 years.” But the reality is that most portfolio managers had better get it right in the next quarter, or their investors are going to want their money back. Which is why they focus so intently on the current quarter. And for the current quarter, my model points down.

And you’re predicting another insipid quarter for stocks?
Or worse. Not just for the equity market For everything that everyone has flooded into—every risky asset everywhere on the globe. It is hard to find exceptions.

So it would seem, glancing at your long list of shorts and short list of longs. Is there an emerging market you don’t see submerging?
The outlook is not good. Investors have been squeezed out the risk spectrum. They’ve been embarked on an increasingly risky quest for returns. Given little choice, really, for about a year now, given the negative real interest rates that Greenspan & Co. have been creating by setting official interest rates below the inflation rate. That is a surefire recipe for creating a boom that leads to a bust.

The boom part was intentional, clearly. But a bust…?
Well, that’s right. But you do get blowbacks from a policy like that, much the way that the CIA gets blowbacks from its policy errors. It sets up Osama Bid Laden to fight the Russians and, boom, we get airliners attacking our skyscrapers 10 or 15 years later. In this case, investors went looking for return in fixed incomes, junk bonds, emerging market debt, emerging market equities, shorts, puts, the volatility indexes (VIX, VXN), credit derivatives, European stock indexes. What’s different, as I see the market heading into this next bear leg, is the technology sector.

Are you implying that you’re now turning bullish on tech?
Don’t misunderstand, tech still is definitely on my underperform list. I see it going down in absolute terms, and also in relative terms. But I am really much more worried about financial sector.

The financials? Despite all the depth charges that have hit the group—there are headlines about new investigations or writeoffs daily, it seems—that’s a decidedly minority view—
That’s true. But in part that is because the financials have been such a good place for portfolio managers to hide for the last couple of years. If you look at the chart of the S&P 500 financial sector divided by the S&P, it is plain to see that the financials were starting their own relative bull market just when the bear market in the major averages began in 2000. But that relative bull market in financials has been kind of stuck on a plateau over the last year, essentially going sideways, relative to the index. And I think what is going to change the most in this forthcoming decline is that the financials will no longer be a safe place to hide.

Why is that?
Fundamentally, because my model points down for the financials, and the S&P financial group has just recently broken its 200-week moving average, relative to the S&P 500. But if you want reasons of the sort most investors call “fundamentals,” there are any number of things out there that we could point to. Just think about what has been happening. The financials are where the problems are. One headline blow-up after the other: Enron, WorldCom, Fannie Mae and Freddie Mac, AIG, now GM’s bonds, etc. In all those cases, you could tell that most professional investors knew ahead of time that something was wrong. It was clear, for instance, that Fannie Mae was piling a mountain of leverage on top of virtually no capital to keep inflating the housing bubble. That was just so obvious. Same thing with GM. “Buy one, get one free” is a bad business model. You can’t make money.

It doesn’t seem to work for Detroit, that’s for sure.
Sooner or later it has to catch up with you. If you are making money only in your mortgage finance subsidiary while losing money on health care benefits and on building cars, it just doesn’t work. But like in all of those cases, it didn’t matter, it didn’t matter—until, suddenly, it mattered. Boom. Some event triggered the depth charge. I think there a lot more situations like that in the financial sector that could go off. Probably—although this isn’t going to win me any more hedge fund clients—among the hedge funds. There’s been a huge proliferation of them, and my sense from a recent trip to New York, my first since the summer of 2001, is that they are all crowded into the same consensus trades, almost all of which are based on negative real interest rates. So they’ve all been pushed out the risk spectrum into all sorts of carry trades in Latin American debt and whatever. I fully expect that most of the hedge funds that are nothing more than disguised bets on negative real interest rates won’t survive global de-leveraging. And with widening spreads squeezing the hedge funds, I am worried about all the, shall we say, “prime brokers” financing the hedge funds. The providers of leverage will surely get whacked by global de-leveraging. There is probably going to be a bit of a shakeup of the investment banks and securities brokers.

In addition to the Morgan Stanley soap opera, you mean?
Exactly. Proprietary trading desk losses likely will become an issue. Everyone is not going to get it wrong. But I am sensing, after a first quarter in which performance numbers weren’t good, but in which the hedge funds saw enormous inflows, that the flood of money into the hedge funds just might start to reverse.

All that liquidity has to go somewhere—and why should hedge fund investors be any more inherently sensitive to bum performance than mutual fund holders have shown themselves to be?
Well, it takes 60-90 days for hedge fund redemption notices to kick in, but that might actually start happening in the second quarter. The people—and even the institutions—that invest in hedge funds are not paying premium fees for performance that’s mediocre or worse. That implies that the hedge funds will be de-leveraging. Which is not good. Leveraging has been the essential force buoying the world markets. If we now go into liquidation and de-leveraging, it will be like pulling the layers off the onion. That makes markets go down. It is like a gigantic global margin call. One that should puncture the bubbles in stocks, bonds, emerging markets, credit spreads and derivatives.

But why should even a gigantic margin call create such problems in a world awash in liquidity? All the mega-merger deals being announced speak volumes about very easy money—no matter how many times the Fed has hiked rates.
Correct. I am not much of an expert on private equity and M&A, but at the moment there does seem to be a surplus of willing buyers wanting to pay top tick. And plenty of lenders willing to find the wherewithal for them to do so. But that sort of liquidity can disappear in a flash. I concede that I am mostly outside the consensus in this forecast. But where I have been in the consensus recently—basically on the S&P materials sector and energy—those trades haven’t been working well in the last few weeks. They are fairly old signals and the trades have gotten crowded.

Everybody “knows” that energy prices are going up and materials getting scarce because the Chinese need it all.
Which is why I am getting more agnostic on those two sectors. There are fresher signals. Specifically, I see a turn decidedly toward the defensive side in sector and industry group rotation. With, as I said, the financials no longer playing defense.

What hiding places are left?
Some of the utilities, which are quasi-financials, I guess, though I wouldn’t rank them as my No. 1 outperform idea. The more traditional defensive outperform stuff, like consumer staples and maybe health care should do better this time.

Maybe healthcare?
I am no fan of the big drug companies, knowing that their real business model was to basically have their sales reps bribe doctors to prescribe their medicines. They still spend more money on marketing than they do on creating drugs. But that is for a whole other story. Besides, I don’t let my views on the ethics of various businesses influence my interpretation of my models. If my model says the pharma sector is going to outperform, then I go with it. And that is what it is saying. Then too, health care and pharma could bounce in relative terms, without necessarily going up in absolute terms.

Drug companies have been garnering lots of negative headlines lately, too.
That’s why I’d suggest a basket approach. There is loads of individual company risk in the sector, with the FDA waking up to all the drugs that are proving dangerous after they’ve been approved, on top of the uncertainty that has always dogged drug stocks with “promising” new products in clinical testing. But another way you could approach this sector is by putting on spread trades, shorting some of the over-owned health care equipment companies that have been outperforming the drug stocks for years, while going long some of the beat-up pharmas.

You didn’t sound terribly excited about consumer staples, either.
Remember, these are relative calls, not absolute. Consumer staples could be a place for long-only portfolio managers to hide—ones whose freedom to go to cash is curtailed by their mandates. For long-only institutions, I am recommending maximum defensive positions here. This won’t be like 2000, when you could short tech and buy value. Granted, Tiger got blown out of those positions right at the top, but all the trades they had on were the right idea, if they could have held on. They worked for several more years. That is what is so different today. Back then, the market wasn’t so thoroughly picked-over. There were groups that had not gone up in the bubble, that could go up in absolute and relative terms. Now, what hasn’t been picked-over? Small caps? Forget about it. Mid caps? Forget about it. Cyclicals? Nope. Gold stocks? Be serious. This stale rotation has cycled through virtually everything. I can find very few stocks that are negatively correlated in this market, so it is just a question of what is going to fall more and what is going to fall less over the next 3-12 months. The U.S. market now reminds me very much of the Japanese market, which has been in a bear market for 15 years now—

Which is why I have heard some people suggesting that the Japanese market might be a pretty good place to hide.
I just closed out my long position in Japanese stocks. I did have a buy signal there, but it’s not there anymore. Maybe, I’ll get another buy signal there, but I am following my model. The other place that could be an exception to the global bear trend is China. I am no big China bull now, but China hasn’t really gone through a big bubble yet. As you know, I don’t mind investing in bubbles, I just want to get into them cheaply, on the ground floor. The thing is, there are few prospects for that in China now, even though, given the population’s propensity for speculation, you have to assume it has bubble potential.

Why not now?
Their boom is fading and there are enough things wrong over there, with the stocks that are listed, in terms of state ownership and such, that I just don’t see it. Clearly, though, all those well-recognized problems mean that China’s rulers have a lot of room to make policy changes that would pleasantly surprise investors and get the juices flowing. So China is on my radar screen as something negatively correlated to every other investment theme in the world, but the timing is not now.

Isn’t there a silver lining somewhere in all this?
Getting back to Japan, if you look at a 20-year chart of the Nikkei, you see that it topped out on the last day of 1989 and it has since traced out 5-10 enormous declines within that long-term downtrend. If you were a buy and holder in Japan, you’ve been just constantly eroded. But along the way there have been enormous rallies. These were great trading opportunities, lasting 6-18 months, that would take the Nikkei up 4800%, before it got knocked back down to the bottom again.

So we’re on the Japanese plan?
Nothing is ever exactly like anything else. I have given up the habit of overlaying charts and predicting that this time is going to be exactly like that one. That always seems to work, until some point—when the trends completely diverge. Still, there are general patterns that long-term bull markets, as well as bear markets, follow. You get sharp and vicious rallies in bear markets, but when they top out, the market sinks back almost to its lows. The current positions of the U.S. equity market and the primary European markets (the DAX, FTSE, CAC,) remind me very much of the tops in many of Japan’s extended rallies over the last 15 years. They are rolling over and preparing to scrape bottom again.

How so?
While some stocks went to enormous new highs on this move, most didn’t. Most indexes are below their early-2000 peaks. In emerging markets, there has been a convergence play: Hungary and the Czech Republic and Poland are going to join the EU, so buy them. If you look at their charts, you see parabolic blow-offs and then some. To my eyes, that makes these emerging markets the Yahoos and Amazons of this cycle. Those three emerging markets have been rockets. But they are rolling over. I have been involved in emerging markets for 20 years now, ever since I started at Salomon, and my model has proven pretty good at spotting vulnerabilities before the crises hit, whether in Russia, Asia, Mexico, Argentina, etc. And I have to say that it is currently signaling, boy, just a really a powerful down move in emerging market currencies, debt and equities. As you know, capital has flooded into these often illiquid markets. Somebody has been just blindly allocating in and buying, buying. When things reverse, when a crisis or scandal surfaces, these markets have a tendency to go no bid in no time. My model’s signal for the IFC Composite Emerging Market Equity Index, (which is equities, denominated in U.S. dollars), is particularly powerful. So are my bearish signals for Latin America and Eastern Europe—not so much Russia, but Hungary, Poland and the Czech Republic. Meanwhile, my model sees the dollar strengthening, especially versus those currencies and the Mexican peso. As for the EMBI/JPM Emerging Market Debt Index, that is an accident waiting to happen. It represents a collection of emerging market high-yield bonds, another risky area that has been flooded with capital. But the index has broken down significantly in the last several weeks and it has a long ways to go, down. It’s not an asset class you want to be long in here.

Michael, has the sun shone at all in the Pacific Northwest in the last month or so?
That’s not it. This is not seasonal affective disease or something like that talking. I try to be impartial and objective about this. My forecasts are based on this probability model, I just follow where the statistics lead. If that were up, like in early 2003, I’d be bullish. But it’s not. Really, I try not to let my personal view of the fundamentals interfere with the model’s signals, because I have learned that it is better at timing market moves than my internal hunches are. Still, there’s a fundamental case to be made right now, alongside my probability model, that also says there’s a lot of downside risk in the markets because of this latest bubble Alan has created.

And very few places to hide.
Right. Now, I am no guru and institutions don’t index their portfolios to the Belkin model, but my recommendation is go to your maximum defensive position, whatever that is. For hedge funds, that means to go net short, sell the rallies. For long-only institutions, that means raise cash, shift into defensive sectors. And that very definitely doesn’t include bonds here. The long bull cycle in bonds is ending very typically, really, with rising inflation and higher interest rates—not just on the short rates that the Fed controls, but on the 10-year, the 30-year. Which is a big change. I have a preliminary forecast that the curve will steepen, which would be another de-stabilizing force in the financial markets, since everyone seems to have curve-flattening trades on. In fact, if long rates rise more than short rates, that could squeeze a lot of leverage out of the fixed-income markets and there’d likely be casualties. Anyway, what we are seeing is that setting interest rates too low lit a fire under inflation, so prices are rising, interest rates going up, the equity markets going down. Credit spreads are expanding. This is a classic end-of-cycle scenario.

Classic, perhaps. But not widely recognized as such. Practically everyone expected higher rates last year. When they didn’t materialize—
Right. There is no strong consensus on the fixed-income markets at the moment. Being bearish on bonds last year didn’t work. Now, sentiment is mixed. But I think Treasury yields go up. I don’t expect something like 1998, where you have a crisis and the Treasury market benefits from a flight to quality. There is some potential for that on the short end—I’m not as bearish on the price of short-term securities; I don’t see much rise in short rates; that move has pretty much run its course. My model’s strong signal is that long-term rates are going up and so are all the credit spreads against long rates—mortgages, the S&P speculative grade credit index, junk bonds. The signal on Moody’s BAAs is almost there, but not quite. Corporate bond yields are very close to their lows still and the three-year is still pretty close to its low yield—and these rates should not be there. I think they are going to go up. Ultimately, widening mortgage spreads will be another signal with ominous implications for this whole housing-led, “your house is your ATM, consume and buy a lot of stuff from China” economy. That whole economic model is going to get shaken. Maybe, after it is, and after the economy slows, bonds will be a buy again. But that will probably be a slow process. When housing plateaus, people tend to go into denial and keep asking top dollar for their houses, unless they absolutely have to sell. So very few houses change hands, because no one is willing to pay top dollar and no one wants to take a loss, if he can help it. But meanwhile, houses become increasingly unaffordable as mortgage rates rise. The upshot is that the housing market tends to take a long time to adjust, in sharp contrast to the financial markets, which adjust rather quickly to the bid and asked prices. In real estate you only get price discovery when the two-income family that stretched to take out a too-big adjustable rate mortgage gets hit with a job loss. That whole thing is a house of cards, and it will come down then. Believe me, I take no glee in it, but I think that will happen down the line. Creating the real estate bubble to replace the Nasdaq bubble was another very bad policy error on the part of the Fed. And now that financial asset inflation is finally leaking into real-thing inflation.

But not into wage inflation.
Not yet. But if you look at core PPI and CPI, the forecast is up. I don’t think this is the beginning of hyper-inflation. Although, when I ask myself where I might be wrong, a hyper-inflation is essentially the only fundamental scenario that I can come up with. If the Fed were to somehow decide to just try to inflate our way out of our deficits and we crossed over into a Brazilian style hyper-inflation, my forecasts would be derailed. But I do not assign a high probability to that scenario. It’s more likely that we finally get a slowdown that allows for some re-adjustments.

Gee, Greenspan’s parting gift won’t be yet another bubble inflated to replace the loss of wealth from the bursting of the housing and equity bubbles that the Fed fostered?
I doubt it. But if they are going to create another, I wish I knew where—because I would be buying whatever it is. Seriously, I wouldn’t want to be in the Fed’s shoes. It’s a joke to me that Greenspan is still celebrated and praised; that Congress wants to hear what he has to say about Social Security. He is the perpetrator of these bubbles, and yet somehow this guy has had nine lives. He has been able to escape the blame not only for creating these successive bubbles, but for pricking the previous ones. When this game ends, Greenspan will no longer be a hero, though it clearly will take time for people to recognize how irresponsible monetary policy became under him.

Irresponsible? Don’t you remember, it wasn’t all that long ago that the big worry was deflation? So Greenspan spiked the punch, big time? That lesson wasn’t lost on Washington.
So he’s a world-class pusher of monetary Prozac. But there’s a fundamental question about Fed policy that doesn’t get asked very much. Which is, why should anyone set interest rates? Hello? Don’t we believe in free markets? But that’s a whole other tangent. And we don’t want to go there. Your readers are already suffering through this interview, considering all of our happy talk.

If they’ve gotten this far, they must think you have something to say—and be hoping for some more ideas about how to insulate their portfolios from the wrenching readjustments you’re forecasting for the economy and markets—
Well, at some point there will be a great buying opportunity for an extended rally, but first we have to get to that point. And, no small matter, if we want to participate, we will have to have some available cash. That implies investors should shepherd their resources so that they are available when that big bounce potential materializes, even if it’s only a trading rally in a long-term bear market. But for now, besides the drugs, my model has outperform forecasts only on some of the typical defensive plays like household products and beverages—where the candidates are mainly brewers. So maybe it’s time to do drugs and have a beer, while hedging, shorting, whatever you can do. It’s not too late to get defensive for a potentially very long decline.

Well, that’s half of a good idea, anyway.

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The content of this message is not to be construed as constituting market or investment advice. It is intended for educational purposes only. Individuals should consult with their own advisors for specific investment advice.

-- posted by Normxxx