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“THIS IS THE END, MY FRIEND”
July 6, 2005
*April 2003 low: 7,603.76
*- See March 31 &
NB: Due to the effects of evolving industry regulations, whereas SKC publications had previously occurred on the first weekend of the month, final copy may only be ready for transmission 2 – 3 business days thereafter.
They’re not far off.
In any event, in deference for a possible decline in the Dow to 6500, our last report surmised:
“2006 could be preceded by a decline in the Nikkei, while also providing a lifetime investment opportunity. It would remain to be seen what the effect of such a decline would actually be on Domestic Demand Oriented Value Stocks (DDOVS).”
We therefore concluded:
“A Nikkei rally toward the mid-11,000’s, could be used to lighten positions, in deference for the possible negative implications for equities, for the next year.”
The Nikkei has indeed rallied to just over 11,600, with stocks rallying into a seasonally weak period. This is consistent with the Yen’s recent peak, from which a 7.5% correction very quickly ensued. The Yen has tended to precede the Nikkei’s activity by about two months.
title borrows from the first words of Jimmy Morrison’s “The End”, a piece that
was subsequently and appropriately popularized by the film, “Apocalypse Now”. The
song described that soul’s sinking into the sunset, a conclusion that took
In the first quarter of 2004, the US economy saw peak leading indicators and a top in stock prices, when denominated in foreign currencies (at the Dow’s October 2002 low, SKC had forecasted February 2004 to be the Dow’s next major peak). Therefore, SKC has held the view that the past 18 months’ “Last Tango in New York” could only spell an eventual precipitous decline, as the markets had experienced in 2001 – 2002 and 1973 – 1974, when the Dow also held up in the clouds, only to then decline, reflect and come into line with deteriorating fundamental, valuation and technical indicators, “all at once”.
Finally, then, we have come unto the one market that SKC is so profoundly bearish on: New York, with respect to which, for good measure, Desjardins Securities has reported on June 20, 2005 that nine of the last twelve leading US economic indicators reports were negative, as have been the last four.
Along with the divorce from the activity in the price of oil (see last quarter’s special Desjardins Securities study), the above fundamentals bolster and support eerily bearish valuation and technical arguments, all of which are consistent with SKC’s view that the Dow has an appointment with 6500 in 2006, with a “fair-value-stop” at 8000. Of course, “not inconsistent with” is not the same as “consistent with”, but SKC’s views are well known and clear, as is our open-ended promise to review forecasts as time progresses.
The key right now is that the risk over the coming six to nine months is extremely high, against a background of extremely cheap long-dated puts that serve both as contrary indicators, as well as vehicles that provide extraordinary gains potential, or significant efficiency in hedging, for those who will have held equities despite the prevailing landmines.
VALUATION: The Dow’s PE multiple is at a premium to forecasted earnings growth rates. Those forecasts are not even being contested here. The reader is merely being reminded that the reason given for the new paradigm that allowed for premium multiples were that interest rates were headed toward zero. With the underpinning of that new paradigm argument gone, the Dow’s fair value is at 7,900, or so, based on a PE that reflects those consensus forecasted growth rates. Bye the bye, do markets ever stop at presumed fair value, or do they then discount the future’s negatives, to the extent that they had previously ignored basic valuation criteria?
FUNDAMENTALS: According to my interpretation of the above referenced Desjardins oil study, the Dow’s coming into line with oil’s activity could take that index down to 8000 fast.
TECHNICALS: Long term stochastics join other indicators in also supporting the analysis that the Dow’s decline to 8000 could be speedy, taking volatility indicators up, just as fast. The combination would spike put prices in stunning fashion.
Due to recent market events, the May 7, 2005 report is quoted below, largely to seek benefit from similar circumstances as what prevailed then:
“The two-year puts doubled, due to a spike in the volatility index and falling market. Puts benefit from higher volatility and a lower market. Puts expiring one year before the contemplated two-year options, rallied to the level of the two-year puts, thereby allowing put holders the opportunity to turn their long put positions into a spread, by selling the shorter dated put, thereby recouping the entirety of their initial investment, if they so wished, while still holding the initial position, which enjoys a full additional year. From the April report, then:
“Meanwhile, all this occurred with the Volatility Index rallying back to what can only be referred to as washed-out levels, historically! This is why such very long term puts provide the leverage today that approximates what was available via 9-month put spreads a year ago. The last time I saw such incredible relative risk-averse leverage was in the 2-year European traded Nikkei put warrants in December 1989.
“This is why capital recuperation and profit maximization is so easily achieved in a falling market against such long term puts. Simply, put prices are driven by market levels (the lower the better) and Volatility Index levels (the higher the better). When the Dow declines - and it should again do so speedily, to slam the door shut on the bulls - the Volatility Index spikes up, as we just saw in March.
“The effect is the ability to sell shorter term puts against the outstanding long term puts, thereby recuperating most or all of the initial investment in the longer term options, which are held to take advantage of the time owned, so as to capitalize on a greater crash into 2006. The ability to track option (volatility) prices will figure greatly into the larger performance picture, which SKC believes will exceed 1000% per cent anyway, from desired and recently seen prices, based on the here anticipated move in the Dow……without contemplating time premiums!
“In 23 years, I have never seen a greater leveraged long term opportunity and when things are this stretched, it tends to spell violence ahead. One must be positioned in advance, since the nature of such bull moves is to lull everyone to sleep, as hedgers and speculators await a confirmation that would dramatically appreciate very long term puts.
“Remember: Leverage is established/achieved on the buy side!”
CONCLUSION: Here too, we find our conclusion as having been well-expressed in the April report.
“The Dow is … highly susceptible to a 2000-point drubbing at any time, to get the ball rolling en route to 6,500 in 2006. Multi-year, low risk (for options) puts are here expected to return over 1000%.”
The following two paragraphs and quotes are taken from recent issues of “Bullion Buzz”:
"Sooner or later, the world's investors will realize that neither the US, nor the EU, nor the yuan, can offer what they promise - and people will figure out that the Chinese were right to advise their citizens to accumulate gold bullion (which by the way is a first in the history of modern government, to my knowledge). Consequently, investors will start accumulating gold bullion themselves very soon."
"There is a growing realization that gold, commodities and commodity derived products offer far more stable investment prospects than European or US financial products."
James Moore - TheBullionDesk.com
While the above pertains to fundamentals and valuation, the
following technical summary is taken from the last issue of SKC (
“If this is in fact the scenario that is playing out, it may indeed be correct to conclude that exchange-traded gold funds have siphoned off some otherwise available cash for gold investment. As equities are well into a still young bull market, and as they may be discounting a re-test of gold $410, their underperformance versus the metal since gold hit that level weeks ago, is giving this bull market a bad name. Of course, that’s good for buyers.
“With gold stocks trading at levels last seen at definitively lower gold prices, risk is to the upside, as the equities contain a lot of leverage to the metal from here. Gold stocks have a history of shaking the tree to dispose of weak holders, who doubt the only legitimate North American equity theme that I see.
“CONCLUSION: SKC had correctly forecast $410 for gold, though that made no money for stock investors. That level is still seen as a worst-case scenario and the view is maintained that one should be 100% long the metal from that level. Gold and silver equity investors should be 50% long, prepared to increase to 100% around gold $410, if it does actually get there, with an intermediate term view to reduce positions to as little as 33%, on a spike to $460 in gold. I suspect that we’ll have opportunity for revision.”
Gold did attempt to re-test $410 but savvy investors got out in front of it and caused a slightly higher low. Precious metal stocks, meanwhile, flushed out to new lows. Therefore, within the context of the preceding paragraph, investors went 100% long, according to their experience (talent and inclination). As for reducing positions “…to as little as 33%, on a spike to $460…”, forget it?
CONCLUSION: The metal shot up to $440 very quickly, while breaking out versus the Euro. Investor apathy and ignorance of precious metal stocks suggests that a rather unheralded low has again been seen. This will again yield extraordinary profits. The sharp downward spikes are typical of BULL markets. Tree-shaking (headlines that cause retail investors to back off or sell) doesn’t occur in a bear market. Rather, the latter was marked by slow multi-year erosion.
There is no change from recent commentary or asset allocation.
Careful and prosperous investing to all,
LEGAL NOTICE. On this 17th day of December, 2005, Mr. Sidney Klein has donated
market letter to the public domain.