Sunday, March 23, 2008

What a week!

This past week was undoubtedly one of the most schizophrenic in recent memory -- given how 2008 has unfolded that's saying a lot! I have been calling for a break of the January lows before moving higher. Now that the first part of that prediction has come true, the pressing question is "How durable is this low going to be?" I had thought before that we would have an intermediate term low. My thinking has been wavering in view of the broad sell-off in commodities this week.

While the financials have made a tradable low based on extreme negative sentiment, I'm not sanguine about the long term prospects of this sector at least in terms of its relative weight in the S&P. This week's Economist has this to say about the leverage employed by investment banks:

This process has turned investment banks into debt machines that trade heavily on their own accounts. Goldman Sachs is using about $40 billion of equity as the foundation for $1.1 trillion of assets. At Merrill Lynch, the most leveraged, $1 trillion of assets is teetering on around $30 billion of equity. In rising markets, gearing like that creates stellar returns on equity. When markets are in peril, a small fall in asset values can wipe shareholders out.

Looking at it this way, Carlyle Capital's 32x leverage was none the least extraordinary. In the current environment, one can safely say that the securitization business won't be the same for a long time. In contrast, the commercial banks have brightened their earnings prospects in theory due to the steeper yield curve, but unlike the investment banks, they have not been as aggressive in marking down assets. Another concern is whether they can find any worthy borrowers to take advantage of the yield spread. Lastly, the asset management business may provide some long term growth prospects, where the two E's, emerging economies and the elderly, should provide a growing flock of sheep to be sheared client base. But that growth will take time. In conclusion, besides trading profits and some asset mark-ups (by no means certain despite we hear on CNBC), I don't see a lot of positives for the balance sheets of financials as a whole. I certainly don't see them leading the charge into a new secular bull market.

As mentioned at the start of this post, I have grave concerns about the decline in commodities, should it progress further from here which would suggest something more sinister than profit-taking, hedge fund margin call, or a concern with broker liquidity. Some would character it as sector rotation, but to me sector rotation occurs within the framework of the existing market trend, which is bearish. Commodities/materials have been the last pillar of this market, if they were to fall, should there be a renewed concern with the financials, absolutely nothing could prop this market up.

Precious Metals
In the last post, I mentioned the possibility of a post-FOMC decline in the PM complex, but its ferocity still amazed me. Gold lost about $115/oz in a span of four days! Gut-wrenching this drop may be, gold and silver have merely fell to the bottom of their respective up trend channel as shown in the two charts below. Assuming those trends remain intact, this is another buying opportunity.

The HUI declined from a high of 520 to a low of 425 in less than four days. Looking at the bull leg from May'05 to May'06, there was a drop of similar magnitude in March'06 (albeit over a longer time period), the HUI subsequently recovered and went on to peak in May. Although the current decline took place much more quickly both declines were wave 4 corrections in their respective 5 wave advances by my count (see the last chart for my EW count for the current wave). The best case scenario is sketched in red in the next chart where the HUI traces out a triangular abc wave 4 correction pattern making a new high. Another argument here is that while the gold stocks have come a long way since their August bottom, there has yet been a parabolic type move that punctuated earlier uplegs. In summary, I believe there is still some ways to go in this PM bull leg yet, and I've been taking positions accordingly.