BEAR MARKET LETTER #9

ONE YEAR ANNIVERSARY OF THE LONE BEAR LETTER PLUS

THE LONE BEAR LETTER Or “WHO ME WORRY?

Carl M.Birkelbach

1/23/2015 Dow: 17,672; NASDAQ:4757: S&P 500 2,051

1/20/2016 (noon) Dow: 15,484; NASDAQ:4,328; S&P 500 1,816

IT’S NOT ABOUT BEING OPTIMISTIC OR PESSIMISTIC. It’s arithmetic!

It’s almost one year since I issued the now famous LONE BEAR LETTER! If you’ve been out of the market since I wrote the letter, you’re ahead of the game. I have been asked, what made me bearish so early? A simple answer is that I do not tell markets what to do, I let the markets tell me what to do. The decision is unemotional and mathematical and being optimistic or pessimistic has nothing to do with the conclusion. Let me give you an analogy. It is well accepted and understood that our planet earth’s Northern and Southern global hemispheres go through the cyclical seasons of Summer, Fall, Winter and Spring. If you are growing roses in Wisconsin, you know enough that in the Fall, you ‘cut back’ the branches, cover them in protection of winters freezing winds and uncover them when winter is over, so they can once again grow. There is nothing optimistic or pessimistic about your actions. So it is, with the markets!

It’s mathematics and arithmetic. Energy stocks represent approximately 7% of the S&P 500 and commodity materials stocks represent about 3% of the market. That’s only 10%. However, if the bonds held by these companies start to default; the eventual outcome could be another banking crisis. It’s kind of like A plus B = C and C plus D equals E and E plus D equals F for failure. In this case A stands for a global economic slowdown + B Chinese slowdown and mismanagement, equals or causing C lower commodity prices and deflation, plus D causing raw material and energy bonds and sub-prime auto bonds to decline or default, which equals or causes E causing banks to mark to market lower or defaulted bond prices, which equals or causes F investor fears and a Bear Market and possibly a banking crisis worse than 2008. Its arithmetic!  As US markets and world markets, break below August 2015 lows, don’t blame the messenger!

The markets, as explained below, were telling me that; ‘Houston we have a problem!’  If you have read my book Investment Strategy Handbook for Volatile Markets, (available as a post on our website for free ) you would have read THE FOUR NOBLE TRUTH OF INVESTING as follows:

 “Four Noble Truths of Investing

1) We do not control world events, the economy or the markets
(Life means suffering)

2) We can change our old investment habits and follow a strategy of going long or short and be flexible with our holding period. (The origin of suffering is attachment)

3) Investors are irrational in a predictable way. (The cessation of suffering is attainable)

4) Let the markets tell you what to do through our methodology.(This is the path to cessation of suffering)”

A journey of a thousand miles starts with the first step. Now is the time for you to walk the path that ends your suffering and eases financial stress. This journey will teach you a methodology and the metaphysical methods that will let the markets tell you what to do.” END QUOTE FROM THE BOOK

Why I wrote Lone Bear Letter!

1) My first clue that things were going wrong was that interest rates in European banks were below -0%. How could this be? I never imagined you would have to pay a bank to hold your money. Something different was happening. What was happening, I calculated, was that deflation and a lack of trust in banks was happening. At the time, January 2015, the world and US economy were very strong. What could be going wrong with the US and world economies? For the last twenty years all the income growth has gone to the top 1% in the US and in the World only eighty people own 50% of the wealth (they won’t stop until they get the other 50%). I concluded that on a worldwide basis, a consumer oriented and market oriented economy was unsustainable under these circumstances. Those that have an ideology of a libertarian and are saying they are pro-business, free markets, less taxes and less regulation, I believe are naturally motivated by greed and are causing  unstabilizing forces between capital and labor. Richard Fink, chief strategist for the Koch’s family, was quoted in a recent article in the New Yorker Magazine saying, “We want to decrease regulations so we can make more profits. We want to cut government spending so we pay lower taxes.” In my opinion, corporations are not individuals. If they are, they are sociopaths! I concluded, that the balance between capital and labor has been tilted in such a way, that it is unstabilizing US and world economies  and that all boats could sink.

2) My next clue was declining oil prices and lower raw material commodity prices. Why was this happening? A look at the Chinese markets showed me that their stock markets were in a downtrend at the begging of 2015.I concluded, that the Chinese communist government is highly corrupted, were denying any troubles. The Chinese markets actually rallied in the first five months of 2015. However, commodity prices continue lower, especially oil. This indicated to me that the Chinese were actually lying about their growth and were probably hiding a recession or worse.

3) In my thinking, lower commodity prices and below zero interest rates for banks in Europe, was indicating that we were possibly entering a deflationary period. In our modern era this would be unprecedented, as individuals, corporations and governments have always used inflation to pay back debts with inflated currency. This data was indicating that we would be in a deflationary, rather than in an inflationary period.

4) I reasoned that the outcome, could lead to another banking crisis. Why? The last banking crisis was caused by banks holding worthless debt in the mortgage bond market. If oil prices continue lower, as the charts showed, countries like Russia, Venezuela, Brazil, Mexico , etc. and even Saudi Arabia could have problems with their sovereign debt. In addition, approximately 10% of the S&P 500 are made up of companies that depend upon higher energy prices and natural resource prices. These corporations have issued hundreds of billion dollars of debt, which may default, if oil prices and commodity prices stay at these levels. The banks hold these bonds and more speculative derivatives than ever. This, in my opinion, would lead to a banking crisis larger than we had 2008. That is because in 2008, the government was willing to bail out the banks with trillions of dollars of taxpayer money. This time, Congress is in no mood or politically structured to save the banks and the Fed is out of bullets and hold trillions of dollars of high-yield bonds that they purchased during quantitative easing.

5) The one thing that we can be assured of is the denial from the financial industry that has trained investors like Pavlov’s dog, to ignore all setbacks, with the false assumption, that markets will always come back up. Jamie Diamond, from the Chase bank was interviewed at the Davos Switzerland world economic forum and said that we have nothing to worry about. What else could he say? At the end of the movie King Kong with Kong killed from a fall off the Empire State building, the question was asked, What happened? The answer from the promoter was, “it was beauty that killed the beast.” In this case it’s the greed of the top 1%, hubris of the public and the denial of the financial industry! See the movie the BIG Short or read the classic book THIS TIME IT”S DIFFERENT.

A NEW BEAR MARKET Today, 1/15/16, the S&P 500, on an interday basis, broke below its August low. With the Dow Jones Transportation Index already below its August low, this to me, confirms that we are in a New Bear Market. Other worldwide indexes that have also broken below their August lows are the Chinese markets both HSI, and SSE, the Russian stock market, the Russell 2000, the Emerging Markets index EEM,  OIL and the FTSE London index. If the Dow Jones Industrial s and the NASDAQ also break into lower August territory next week, this will confirm a Bear Market. Once again, I believe the Canary in the mine are bank stocks, particularly  Deutsches Bank, now, below twenty-one dollars a share, down from a high of 52.  Deutsches Bank has approximately $7 billion of sub-prime automobile loans, many on Volkswagen. The subprime automobile business has once again been packaged by Wall Street, similarly to the way they packaged collateralized mortgage bonds. Recent estimates show that there are $150 billion of outstanding subprime auto loans outstanding that banks own. So, you wonder why auto sales are up?  Just like with subprime mortgages, the banks will give an automobile loan to anyone. Packaging these subprime auto loans, does not make the security any more stable than the CMO’s of the 2008 debacle. Do you hear anybody else talking about this?

The analysts on CNBC have not yet caught on to the big problem of sub-prime automobile loans or that banks hold bonds backed by companies producing energy, and other natural resources. Analysts are still concentrating on the fact that lower oil prices should be beneficial to the economy. However, consumers are saving their money or paying higher prices for other inflated items. Consumers are hurting as Walmart is closing 267 stores.  The prices of many of these energy and natural resource bonds are already yielding some 20%, which means the prices are down severely. The next step will be the default of some of these bonds. Will the banks mark the price of these securities on their books to market? They didn’t with collateralized mortgages, until they were forced to do so. See the movie The Big Short.

There is an old Wall Street joke that is a parody on the situation. A technical analyst (charts) and a fundamental analyst (earnings etc.) are in a kitchen when a knife falls off the table and goes right into the fundamental analyst’s foot. The fundamental analyst asks the technical analyst ‘Why didn’t you grab the knife before it hit my foot?’ The technical analyst answered, “Never grab a falling knife,” which is an analogy to never buy while a market is falling. The technical analyst asked the fundamental analyst, “Why didn’t you move your foot?” To which the fundamental analyst replied, “I never thought it would fall that far.” Once markets break their uptrends and starred in their downtrends, there is no logical explanation to assume how far down a market will go down. If you remember, the NASDAQ index went from a high of approximately 5000 to approximately 1000. That’s an 80% drop. Wasn’t logical? Probably not, but bear markets are dangerous.

1/8/16 Calm, before another storm? Markets in China, Europe and the US, today have so far, (noon EST) steadied today. China took off at 7% breakoff point for closing markets, after the Shanghai market yesterday was only open for fourteen minutes before it was closed down with a 7% loss. Sanctions to restrict selling by large shareholders and no short selling, continues in effect. These restrictions will do nothing more than lead to further instability in the China markets. The jobs report today in the US was very positive. However, wages once again were reported as lower. Oil prices are once again lower at 32.88 a barrel. This price is well below breakeven prices most countries except Saudi Arabia. However, even Saudi Arabia is having trouble meeting its government’s budget with these lower oil prices. We continue to worry about default of bonds that are dependent upon the price of oil, which includes  various commodity product corporations around the world. Not only will the effect of low oil prices have an effect on these companies, but will also be detrimental to their bond ratings, which are held by banks, etc. This of course, could lead to another 2008 debacle that was caused by the defaults of mortgage bonds. George Soros said yesterday, that this economic situation reminds him of 2008. Only in 2008, Congress bailed out the banks. I doubt if they will do that this time, if this a situation occurs again.

1/7/16 Sorry, this is just the beginning of the Bear Market. Markets in China are falling apart as the Shanghai index was barely able to open before it was down 7%. In  2007 this index was at 5903, today it is at 3125, with an August low of 2927. It should break its August lows tomorrow. The China Hang Seng index today as at 20,333, and has already broken below its August low along with the China Large cap (FXI  31.95) below the Aug low of 33.22. If August lows are being taken out in in China, will the US markets be next? The Dow Transports index has already broken below its August low. Other markets that have broken below their August lows are The Russell 2000, Russia, Emerging Markets. the Commodity index and Deutsches Bank. Whereas US markets are well above their August lows today, we believe the deterioration of the Chinese markets and lower oil prices will eventually bring our markets down below the August lows. So far, US markets have been able to dodge a bullet with their relationship to a deteriorating China and the effect of  lower oil prices on supporting bonds. Don’t hang on. There is nothing to hang on to. Read last couple of Investment Strategy Letters below and our Lone Bear Letters.

1/5/16 Market Update. Markets throughout the world held up pretty well today considering the volatility of yesterday. The latest news from China is that they will extend their curbs limiting volatility for a little longer. This means that large investors and corporate insiders have not been able to sell their stock for seven months. In my opinion, this doesn’t decrease volatility, but will increase volatility and destabilization. Who knows what’s going on in China’s state owned corporations? Despite destabilization in the Middle East, oil is down eighty cents today at 35.96! If markets can hold above their August lows for the next couple of weeks, markets could once again begin going higher. However, I believe risks for a big drop are higher this year than last year. My forecasts for 2016 call for the Dow Jones Industrial average to be as low as 14,688, the NASDAQ to be as low as 4,506 and the S&P 500 to be as low as 1,560.

I continue to believe that the canary in the mine is the Deutsches  Bank stock. It has fallen from fifty-one dollars a share to 23.49 in the last two years, and has broken below its August low by far.

The other canary in the mine is the Dow Jones Transportation index which has fallen below its August low. My worry in the US continues to be bonds that are held by banks worldwide and that depend upon their income and debt payments on higher oil and commodity prices. Once again, as it was with the mortgage bonds,’ the Emperor has no clothes; but everybody’s afraid to say so.

Continued trouble in the Middle East

More than 85% of the world’s 1.5 billion Muslims are Sunni. They live in almost all the countries across the Arab world including Saudi Arabia, Iraq, Turkey, Pakistan, India, Bangladesh, Malaysia and Indonesia. Shiites are largely in Iraq and Bahrain. The Saudi royal family practices austere and conservative Sunni Islam known as Wahhabism and controls Islam’s holiest shrines in Mecca and Medina. The recent flare-up between Saudi Arabia and Iran occurred when a Shiite cleric was executed along with forty-seven others for inciting violence against the state. The terrorist group, The Islamic State are Sunnis. This is really a civil war that has been going on in the area for centuries. Troops on the ground will not help. As during the Iraqi war, the terrorists merely faded back into the population until we were gone. There appears to be no real solution unless the Middle East Muslims decide to solve it themselves. Until then, expect more trouble. In spite of this trouble in the Middle East which theoretically reduce the supply of oil and theoretically therefore increases the price of oil did not happen today. Instead, oil prices once again fell and are at 36.88. To me this indicates that the problem in today’s markets is not the Middle East, but the problem is China.

Forecasts for 2016 and why I am negative! Goldman Sachs is forecasting 2015 S&P 500 earnings at $109 down 3% from 2014 $113. Original forecasts in December of last year called for an 8% increase. They were wrong!  2016 S&P 500 earnings are forecasted at $130 down from $231 a year earlier. 2017 are forecast at $129 down from $241 a year earlier. I believe earnings for 2016 and 2017 will be lower than forecasts from Goldman Sachs. My forecasts call for the Dow Jones Industrial average to be as low as 14,688, the NASDAQ to be as low as 4,506 and the S&P 500 to be as low as 1,560. Goldman Sachs calls for markets to be up approximately 8%. I disagree

I am not a negative person. I understand, however, that there are two sides to everything.  I LET THE MARKETS TELL ME WHAT TO DO,NOT THE OTHER WAY AROUND! The hubris and the hype that has made America a very positive force in the world, can sometimes ignore the very obvious, as was done in 2008. One of the reasons I have become The Lone Bear is because I don’t see anybody else talking about caution or concerns. Believe me; I would rather be talking about how wonderful Americans are, how great our market economy is and how kind our people are to one another. However, there is a lot we have to worry about and somebody has to talk about it.

Additional Dangers in 2016 The dangers of 2016 are as I have stated in the Lone Bear Letter and the market letters. However, there are some additional things that I’m concerned about that are non-economic issues, but which could have a devastating effect on our economy. They are as follows: 1) Since the attacks in Paris, US citizens are frightened of terrorists attacks in public places. The Republican debate tonight, talked about unlimited war in the Middle East and even confrontation with Russia, without considering the repercussions. The radical terrorists, of the Islamic state, have put themselves in a position to radicalize the US voting public. If there is a major terrorist act, like 9/11 or worse, they could affect who becomes the next president of the United States. Remember, it was the burning down of the German Parliament building that brought Hitler to power. Of course,. In my opinion, a Trump nomination, and possible election could skew all economic and political forecasts into a reckless future. 2) There is also the possibility of a mass cyber attack on US that could come from other than the Islamic state, but which could paralyze our economy. I heard a statement from Ted Koppel, on Sunday mornings NBC Meet the Press that struck a chord with me. He said, “There are two kinds of companies, those that have had cyber attacks and those who do not know they have had a cyber attacks.” With banking online as common, a cyber attack into our checking accounts could paralyze the economy.

ADDITIONAL INFORMATION IS AVAILABLE UPON REQUEST
Mr Birkelbach does not offer investment advice, but merely his own personal opinion. This report has been prepared from original sources and data we believe reliable but make no representations as to the accuracy or completeness. Mr.Birkelbach , his affiliates and subsidiaries and/or their officers and employees may from time to time acquire, hold or sell a position in securities. Past performance is no guarantee of future success. Upon request, we will supply additional information. CarlBis@aol.com

 ADDITIONAL INFORMATION IS AVAILABLE UPON REQUEST
Mr Birkelbach does not offer investment advice, but merely his own personal opinion. This report has been prepared from original sources and data we believe reliable but make no representations as to the accuracy or completeness. Mr.Birkelbach , his affiliates and subsidiaries and/or their officers and employees may from time to time acquire, hold or sell a position in securities. Past performance is no guarantee of future success. Upon request, we will supply additional information. CarlBis@aol.com