Bert Dohmen's
WELLINGTON LETTER

THE GLOBAL CRISIS RETURNS-FULL FORCE!

Excerpt from the February 7, 2010 Wellington Letter

While the perma-bulls in the media talk about a “V” shaped recovery and good times ahead, we warned in January that the enthusiasm in the markets and economies was due for an immediate reversal. We exited long positions and started to get positioned on the bearish side of the market. That switch has turned out very well so far.

Here is what we wrote in our SMARTE TRADER service of Jan. 22, 2010:

The bears are overwhelming the bulls in the stock market. The decline of the past three days has been the most severe since the 10 month rally started in early March last year.

The bulls are trying hard to dismiss the decline with comments like “the market deserves a pullback,” or “it just gives us another buying opportunity.” Although anything can happen in the markets, our work suggests that this decline is of much greater importance. Here is why we say that:

Since mid-October, volume of trading has been shrinking while the major indices rose grudgingly. The low volume shows that the bulls had little ammunition left, and those who did, weren’t willing to commit it. Such a configuration means that a demand vacuum has been created and that eventually prices will decline sharply until prices get so low that it finally attracts new buying. And that is more than 5-10% down in our view.

The fact that bullish sentiment the past several months has been near levels seen at bull market tops, such as in 2007, shows that everyone who was inclined to buy was already in the market. Mutual fund cash is at very low levels, indicating that buying is exhausted.

Selling is picking up instead of diminishing. That suggests that this decline is the real thing and will go much lower than the majority expect. First support is in the 1000 area of the S&P 500. That would mean a lot of damage for individual stocks.

As we said last week, every analyst in the media has technology as their favorite sector. This means that there is a lot of selling to be done.

The commodity sector has lost 5.3% the past two weeks as the dollar strengthened. Our subscribers were forewarned and are nicely positioned, short commodity stocks and long the dollar index.

Oil will go below $60, and eventually lower.

We called the downturn very nicely in all of our services. The trend is now down. That means rallies should be shorted. We said for the past month that the big trading outfits were closing out their stock positions and using rallies to sell short.

They will now want stocks to decline because that’s where their reward is.

In addition, the President’s virtual war declaration on Wall Street is not the fight he should have picked if he wanted the stock market to stay strong.

And the latest is heightening tensions between Beijing and Washington, while in Europe the dominoes of sovereign debt are starting to topple. This is a perfect environment for investment managers to pull in the horns, sell stocks, and raise cash.

IN 2010: DON’T CONFUSE MINI-BUBBLES WITH REALITY

Excerpt from December 28, 2009 Wellington Letter

The multi-trillion dollar infusion of credit and guarantees by the Treasury and the Federal Reserve in 2009 haven’t anything to produce an economic recovery. However, they have taken the risk out of speculations. Private debt has been transferred from financial institutions to the Fed, although for many decades the Fed was allowed to buy only AAA securities. Now they are being everything but the proverbial “kitchen sink.”

The efforts of the Fed have been geared to preventing a recurrence of the financial crisis. It’s been a very expensive effort. However, it has flooded the banking system with huge liquidity. That has produced one of the steepest yield curves in history, i.e. short term interest rates are far below long term rates. The Fed and government thought all this liquidity would be used for lending. But banks find it much safer and easier to borrow money at 0.25% and then buy US Treasuries yielding 3.5% or more. No loan exposure, no need to look at financial statements or take the risk of being accused of “discriminatory lending.”

As a result, the financial system is flush with cash which is not being used for economic activity. Therefore, the capital is used for speculation, similar to what produced the financial crisis in the first place. The carry-trade is a favorite speculation once again: cheap US dollars are borrowed at 0.25% and reinvested in governmental bonds of higher-yielding countries at perhaps 5-8% with great leverage, perhaps as much as 100:1. This is a great way to make money, until the currency trends change. If the dollar rate increases by just 1%, with that leverage all the equity would be wiped out. If the bank has those losses, the taxpayers will probably get the losses, while the banks’ trading operations got the prior profits.

With the declining US dollar in 2009, it was more attractive to buy shares in companies which at least have a chance to grow profits, even if sales don’t grow, then just buy money market funds. In effect, stocks became a hedge against the depreciating value of the currency. In 2010, investors may turn out to be wrong when profits follow sales downward and the dollar rises in value. A rising dollar would turn the tide for many currently most popular investments, such as commodities, emerging markets, etc.

Although a steep yield curve traditionally has meant a good economic recovery was ahead, this time there are many obstacles to a recovery. Higher taxes, and promises of even more taxes in the years ahead, make business creation a game of “hope over experience.” A flight away from the questionable policies of a U.S. Congress, which threaten to destroy the U.S. economic system, is already occurring. U.S. companies are moving abroad because the writing is on the wall. Success will be punished in the U.S.

The “trader tax” proposal, thought to be dead earlier this year, is gaining traction again as Washington desperately looks for new sources of revenues. It would impose a tax on every stock market transaction. It would destroy the U.S. financial markets. Trading would move off-shore. But politicians are usually oblivious to the reality of the market place.

BOTTOMLINE: The excess liquidity spilling over into the investment markets has produced the illusion of a new bull market. But it’s just plain speculation. Once the Fed starts reducing the stimulus, or the perception is that the Fed will act, reality will return.

The markets in 2010 will bounce between disillusionment about economic reality and liquidity injections by the Fed. Another crisis will be averted, but significant parts of the economy will be totally under the control of Washington. This suggests that there will be no economic recovery, just long-term stagnation, shrinkage of business enterprises, insufficient job creation, and continued loan contractions.

The Dubai and Greek financial crises are the “canaries in the mine” confirming that all the rescue efforts of major central banks around the world have been insufficient to stop the crumbling of the global debt pyramid. It will be important not to confuse new mini-bubbles created by the central banks with genuine, sustainable economic growth

Traders will have great opportunities, will the “buy and hold” investors will continue to face the same difficulties as the have over the past 10 years during which the major indices actually lost money. It has been the lost decade.