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Jeff Saut: Wall Street's "Naked" Little Secret

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Short selling now under SEC control.

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"He that sells what isn't his 'en must pay his debts or go to prison" is an old stock market axiom that has stood the test of time. Loosely translated, it means that if you sell a stock "short" (betting that it's going down in price), you're responsible for ANY loss incurred if that stock rallies. And, last week that old market "saw" took on new meaning when the Securities Exchange Commission (SEC) changed the rules on "naked" short-selling.

Clearly, "naked" short-selling has been a "dirty" little secret on Wall Street for years, but that has now changed with the revelations from the SEC. Indeed, last week the SEC changed the rules and required that "naked" short-sales, in certain securities, be settled like the majority of stock transactions. To us, this was the "lit match" for the already gasoline-layered environment in the equity markets.

Manifestly, the selling-stampede was already "long of tooth" since most such stampedes rarely last more than 30 sessions. Recall that selling-stampedes tend to run 17–25 sessions with only 1-3 day countertrend pauses, and/or counter-trend attempts, before they exhaust themselves. In fact, the longest "buying stampede" chronicled in my notes was the 38-session upside-stampede into the October 1987 "crash," while the longest selling-stampede occurred between May and July of 2002 and encompassed 44 sessions. Consequently, for the past few weeks we've been looking for some kind of "throwback" rally since July 1 was session 30 from the DJIA's May 19th high. As stated in my firm's July 7th missive, "It's not that we are turning aggressively bullish, but we think that unless the markets are in 'crash mode,' it is time to consider a corrective stock market rally."

Additionally, our proprietary oversold indicator was more oversold than it has been in a very long time, so the stage was set. And when the SEC changed the rules on "naked" short-sales, that "spark" lit the "gasoline" and the rest, as they say, is history. The result was an explosive rally, especially in the Financials, that began last Tuesday, lifting the Financial Select Sector SPDR (XLF) an eye-popping 13% by Thursday's close. According to one savvy seer, that was an 11 standard deviation event (for comparison purposes, a 4 standard deviation event is an event that is supposed to occur only once every 31,000 years). Given the SEC's mandate, it was not surprising that the highest shorted stocks rallied the most (+15%), while the lowest shorted stocks rallied only 2%. It will be interesting, therefore, to see if last week's "short covering" rally can sustain and broaden out this week. Whatever the outcome, my firm thinks the selling-stampede has ended. How far the rally will carry is unknowable, but we believe the equity markets have further "upside legs."

Does that mean I think this marks the end of the stock market's and economy's consternations? Well, not really, for while "things" may not get a whole lot worse from here, I have a difficult time believing "things" will get materially better either. Indeed, my firm's longer-term thoughts were best summed-up in an email exchange with one particularly bright Raymond James financial advisor who emailed us last week stating:

"I started out in this industry near the end of one of the most devilish parts of the S&L crisis. I can remember my boss at a small IM&R branch saying 'We can't make payroll this week and maybe next.' I was 22 years old and just cutting my teeth in this business. What a wake up call! We got through it, but my question to you is what is worse. The $200 Billion loss in market cap of Citigroup (C) and $2+ trillion market cap losses in Financial Sector over the last year, or the $160 Billion taxpayer bill due to the S&L implosion of 747 thrifts in the late 1980's? Can you compare the magnitude of these events and is this worse?"

The response read:

"I started out my career 38 years ago as an analyst and this is the worst credit market environment I've seen. First, consumers are over-borrowed and their net worth is now in decline from lower residential real estate values and declining stock portfolios. Mortgage rate resets, and higher rates on credit card debts / personal loans, are squeezing the consumer even more. Therefore, consumers are getting increasingly squeezed; and retirees are even worse off. A recent Ernst & Young report (see nearby bullet points) states 77 million Americans will retire over the next several years and that three out of five of them will outlive their retirement benefits. Consequently, most working consumers, and the vast majority of retirees, are being severely squeezed by declining asset values, rising prices of energy, food, medical costs, insurance, etc. and have inadequate, or insufficient, retirement benefits...

Ernst & Young Report (highlights):

  • Three out of five middle class retirees can expect to outlive their financial assets if they attempt to maintain their current pre-retirement standard of living.
  • Guaranteed income is projected to cover a decreasing share of retirement income, leaving households with increased responsibility for their retirement and at increasing risk of retirement vulnerability.
  • Middle income Americans entering retirement will have to reduce their standard of living by an average of 24% to minimize the likelihood of outliving their financial assets.
  • Those Americans seven years out from retirement are even less prepared and the study estimates that they will have to reduce their standard of living by an average of 37%.
  • Those Americans with Social Security as their only guaranteed income have a 90% chance of outliving their financial assets during retirement.
  • The very real possibility of living to age 90 or 100, combined with the volatility of inflation and investment returns, means that the risk of outliving one's assets is quite high. Without additional guaranteed lifetime income streams, such as income provided by an annuity, middle-income Americans are at high risk of outliving their financial assets and living their final years in poverty..


...I can't compare today with the S&L crisis, but I think the risks today are potentially greater because the amount of debt being carried by the average consumer is so much greater. A report I read late last year (I can't remember the source) said that in 1994, 50% of average consumers' annual household cash flow came from borrowings (the rest from salaries, wages, bonuses, commissions). By 2006, however, the borrowings component was up to an astounding 86% of average cash flow. Americans have taken down a lot of second mortgage debt, credit card debt, and personal loan debt to buy cars, boats and other high priced items; and, they are now unable to deal with higher interest rates being charged on adjustable home mortgages and credit card balances. I'm fearful that this could be the worst squeeze on consumer seen in the last fifty years."

So where do we stand? We think we are the middle of the envisioned "W" shaped economic pattern. To wit, the economic "slide" began in 2007, which is the downward-sloping left side of the "W." Said slide freaked out the politicos, as well as the Federal Reserve, causing them to take Herculean efforts in an attempt to stave off a recession. Those efforts have caused the economy to enter the upward-sloping middle part of the "W" whereby the stimulus gives participants the feeling that the worse has been averted and the economy will accelerate from here with an attendant rally in the equity markets. Unfortunately, we doubt that will be the way things will play. My sense remains that with the over-stimulation comes higher than expected inflation, which will eventually lead the Fed to raise interest rates and cause the economy to slow again (the downward-sloping middle right side of the "W"), or the fabled economic doubled-dip. Nevertheless, aiding our near-term positive outlook was last week's price breakdown in crude oil.

For months my firm has suggested crude was likely putting in a top. That "call" was driven by our sense the politicos were going to propose legislation to force the price of crude downward in front of the elections. While we think such proposals are wrong-footed, in the near term such rhetoric can be impactful; and last week oil broke below its rising trendline in the charts. If the slide continues, and it breaks below $120/bbl, "hot money" will think the top is "in" and act accordingly. This is the reason we have been shy of the energy complex for the past few months, as well as why we have recommended rebalancing ALL energy stocks in the portfolio. Rebalancing (read: sell partial positions) allows long-term capital gains to accrue in the portfolio, and causes cash positions to rise, giving investors the "ammunition" to take advantage of new investment opportunities as they present themselves. For the last few weeks we have suggested, "At such a potential short-term downside inflection point, what you need to buy are those companies/indices with the best relative strength characteristics and those with the worst relative strength characteristics. Since we already own those with the best characteristics, we have concentrated on those with the worst characteristics. Consequently, my firm's vehicles of choice were financials and real estate."

The call for this week: If the decline in crude oil continues to play, it should be bullish for stocks. Indeed, just as in horseshoes and hand-grenades, all you have to be is "close" when attempting to "catch" a bottom in the stock market to make a lot of money if you adopt a scale-in buying approach, which is what we have attempted to do over the past few weeks! As stated two weeks ago, "What a great time to be an investor" for if you are a well prepared investor, volatility breeds opportunity.

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No positions in stocks mentioned.
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