Credit Extreme Emotion
By Paul J. Lamont
Oct 17, 2006
Sentiment
Update
For the last 11 days, MBH Commodities’ Daily
Sentiment Indicator (DSI) has recorded a 90% or higher bullish reading for the
S&P500 index. This is the highest 10 day average ever recorded in the 19
year history of this indicator. Investors are now more optimistic towards this
index than they were at tops in late 1987 or early 2000, which led to falls of
35% and 50%, respectively. The NASDAQ’s sentiment is also at extreme levels. For
the last 10 days, an average of 92% of investors surveyed believe the NASDAQ
will go higher. What makes this even more amazing is that the S&P500 and
NASDAQ indexes are not making new highs. With extreme optimism levels not seen
in over 19 years in these equity markets, it would be wise to prepare for a
historic sell off.
Why So Extreme?
Since,
sentiment surveys are only recent phenomena, we do not have measurements for
manias in the 1830’s or 1920’s. However we do have another method that gives evidence
as to the size of the sell off that we believe will soon occur. According to
the Elliot Wave Principle, the first echo of a major top coincides with higher
sentiment among market participants than at the initial peak. It is similar to
an emotional gambler with a “double-down” mentality. Odds (or economic
fundamentals) are against the gambler but emotion overrides rational
probabilistic thinking. The “I have to make this back or my spouse is going to
kill me” mentality. Even mutual fund managers are bound by it. “I have to make
performance…or my investors are going to sell out of my fund.” This prevents participants
from exiting the market even when extreme valuations occur. Today’s investors are
guilty of this as well. They are “hoping” for stellar returns like those in the
late 1990’s to make back their losses. Of course, odds are against them. The
same market emotion fooled investors in the bear market peaks of 1968 and April
of 1930. Most continued to hold through the following declines that lasted longer
than a decade. How large could the future sell off be?
When The Music
Stops
Robert Prechter used the chart below in his October
edition of The Elliot Wave Theorist to compare the bounce in the S&P500
since 2002 to the rebound after the 1929 crash. This chart shows just the first
two waves after each major peak.
Most investors do not realize that the stock market
moved in three phases after the 1929 peak:
the initial crash, grinding bounce, and then the final downdraft.
“Paul came over to say hello. ‘It's a great change,’
he said sadly. "We do about half the business we did. So many fellows I
hear about back in the States lost everything, maybe not in the first crash,
but then in the second.”
- F. Scott Fitzgerald’s
“Babylon Revisited”, 1931.
Here is the third wave or ‘second crash’ that lasted
from 1930-1933:
The down wave that started in April 1930
corresponded with three banking crises and a fall of 85% in the DJIA. It is unfortunate that our banking system has
again been weakened, this time by unscrupulous mortgage lenders in the recent
housing boom. We believe that we are apt to repeat history’s mistakes because
‘emotion to participate’ (greed) overrides rational thinking. While most may
initially dismiss the comparison to the beginnings of the Great Depression,
they would also have trouble with the next chart also provided by Elliot Wave
International in 2002.
Unfortunately, as you can see, price action from 1974-2000
corresponds quite well with the ‘Roaring Twenties’. During the 1920’s, margin
and credit expansion moved stocks to record levels. Similarly, our boom has
been based on credit, especially consumer debt.
More recently,
home equity extraction (shown in chart below) and loose mortgage lending
practices have added fuel to the boom.
As a result, financial institutions will come under
severe strains as the credit bubble bursts. The rise of mortgage defaults will signal
the beginning of this deflationary spiral.
Unfortunately, interest rate markets are setting up homeowners for this exact
scenario.
In the Short
Run: Higher Rates
Recently, leveraged speculators have piled into long
term bonds driving down interest rates. The
Commitment of Traders reports that the bet by ‘Large Speculators’ in the decline
in interest rates is the greatest in over 10 years of data. Historically, ‘Large
Speculators’ extreme leveraged positions have led to losses against better
capitalized ‘Commercial Hedgers.’ With sentiment also at high levels in the 10
Year Treasury Note market (88.7% bullish- 10 day DSI, MBH Commodities), history
implies that the peak in bonds is near or already has occurred and higher rates
will be in store for at least the next six months. Higher rates will prevent
many from refinancing out of their adjustable rate mortgages. Reports from
Fannie Mae state that over $1 trillion dollars in mortgages will reset at
higher rates in 2007. Many
Protecting
Value
Our analysis shows that owning stocks, mutual funds,
real estate, and long term bonds will lead to losses in the future. Given this
outlook, holding 3 month U.S. Treasury Bills directly in your name at a
financially healthy institution is currently the best option for investors. If short-term interest rates climb, investors
will benefit from buying new T-bills at higher rates every 3 months. However, if
asset values fall as the credit crunch begins, total principal will be protected
by the full faith and credit of the United States Federal Government. At Lamont
Trading Advisors, Inc. we specialize in the preservation of wealth. Please contact us to open your
U.S. Treasury Bill account and protect your portfolio against volatility.
***No
graph, chart, formula or other device offered can in and of itself be used to
make trading decisions.
Copyright
©2006 Lamont Trading Advisors, Inc. Paul J. Lamont is President of Lamont
Trading Advisors, Inc., a registered investment advisor in the State of