STOCK MARKET CHOKE POINTS FOR 2008
by Brian Stoll
January 3, 2008

This is the first portion of our client report for January 2008. The remaining portion
with its detailed strategies is available upon request at www.TimingStrategies.com

I want to begin with the several significant components of the stock market, due to the fact that the stock market is perceived by many individuals and presented by the media as its own entity unto itself. Nothing could be further from the truth. For example, the approximate capitalization of the US stock market is somewhere around 14 trillion dollars. The approximate nominal dollar value of the US Government, Municipal and Corporate debt market is approximately 45-50 trillion dollars. The US Dollar currency market is somewhere around 100 trillion dollars and the over the counter derivative market is somewhere between 450 -750 trillion dollars. Get the picture?

Yet, the general perception or folly put forth by the financial and political media to the public is that the stock market is the barometer or gauge of health of the US economy presently and going forward, that if the stock market is up, than everything is fine. The truth of the matter is that credit, currency and derivative markets are the real candy bar and the stock market is pretty much just the wrapper sort of speaking.

To understand the source of all this credit, currency and derivative creation one needs to look no further than the financial sector of the stock market or basically the banking and broker dealer sector of the stock market. That is where all the exotic credit, derivatives, leverage and so forth is created primarily. The Financial sector institutions are dependant upon credit creation and its proliferation to maintain life. This is where the problem begins and has now come full circle back again.

Current totals are that there has been 90-70 billion dollars of credit write downs in the financial institutions thus far in 2007. The estimation is that there are approximately 250 billion further in total write downs yet to be realized in 2008-09. There are also approximations of at least 1 trillion dollars up to as much as 2 trillion dollars in subprime credit that is coming due to reset higher in 2008. This is what has been just one of the focus fronts of all the Government bailout cash being shoveled into the banking /broker dealer firms in just the last 3-6 months.

Companies like Boeing or Caterpillar and such, do not issue credit. When they need money or credit, they can sell their own stock, but they'll usually sell a bond which is underwritten by a financial institution like a Citibank or Bank of America or Merrill Lynch or JP Morgan etc: All types of credit must either continue to expand or it is contracting. An interesting part about the financial sector is that it makes up the largest percentage capitalization of the US stock market. Up until about June of 2007 it was approximately 35% give or take. Financials and financial institution credit has been expanding at an exponential rate ever since Alan Greenspan showed up at the Fed. This type of credit is now in contraction, I or in revulsion to be more descriptive.

So what this translates into is the fact that if this sector of our overall modern economy is having problems, than this will directly translate everywhere else. The concurrent fact of that same equation is that this sector of the economy is actually the precise cause of the same problem that itself is suffering from, this directly implies a much bigger than normal succession of negatives for everywhere else included. So let's just take a look at this financial banking sector using the banking index symbol BKX shall we.

Here we see what the performance of the Banking Index over a little more than a 3 year period on a daily basis. The thick horizontal dark blue line at the top is the Jan 1, 2007 starting date value and the vertical dashed blue line is the percentage drop from it’s peak. What is revealed here is that almost from the beginning of the 2007 new year, the bank stocks were sold aggressively, so what this also tells you is that the problems were already identified by late 2006 and pushed off conveniently until "next year" "next election" etc: What the dashed vertical line simply tells is the percentage magnitude of approximately a negative (-29%) and wipe out of approximately 3 years of its prior period, seemingly rather ugly, which is why everyone in the financial media keeps flapping about "is it time to buy these guys yet" ? (Hint: no!)

That's what "was" or has been Christmas past. Let's see what "potentially" lay ahead for Christmas future and I say potentially because there are always new variables entering into these types of equations. (Government bailout schemes, tax code changes etc) Here is a longer term monthly chart of that same banking index. First thing that comes to my attention is that the largest sector of the stock market is absolutely leading a charge lower. It has broken and closed below its longer term cyclical trend moving average (the white line) and two significant longer term support levels (blue horizontal lines) as well. If there is an early warning reason to be a seller of the overall stock market in general, this is as good of one as can made in my interpretation.

There is although some evidence for an argument which can be made though that a strong potential for a bounce is coming at just about 5% lower from current levels. Those elements are that it is approaching its historical secular trend line (the solid red line immediately below) and also its concurrent historical secular moving average (the green line immediately below) both at about 5% below current levels. Should this index break and close below these historical secular trend lines it signals a potential massive unwinding of the tens to hundreds of trillions of dollars of years and years of questionable credit proliferation, and thus the deflation of the stock and credit markets in the process.

What is the long term outcome of this scenario? I do not know and nobody else does either, especially if they try to convince you that they do. I do have an opinion but that's exactly what it is. What I can tell you are my best estimations as to what presents the highest probabilities for managing the most likely near term price behavior.

Should there be a continued sell-off to the trend in the BKX uninterrupted approximately 5% lower, the most likely scenario should be a bounce at about the 84-82 level. From that level there should show a min. 7.5 -10% or greater bounce. Should that sell-off be short circuited by more Federal Reserve and Government intervention before the test of these levels can occur, then when re-continuation of the trend resumes, probabilities are much greater that such test of those levels will be unsuccessful and a breakdown below those levels much more likely. Should the later of these two scenarios occur, as described previously, the downside implications to the stock and non-government credit markets are so significant that it would rival or exceed the 2000-2002 financial environment.

This trend in the financial/banking sector is not alone in the stock market. There are numerous other areas in similar structures. I will not go into their details, but for example purposes, just take a look at the retail sector of the stock market on its longer term weekly chart. Consumer retail has been primarily credit driven and marginally by disposable income. The credit element, again, comes thru this sector and right back full circle to the financial institutions in this area as well, then transmitting throughout the rest of the market.

How this all lays out going forward into 2008 and how to manage it, is again an exercise in probabilities. I can only provide my best estimations. The first part or half of the New Year 2008 I anticipate being almost a mirror opposite of the second. Some of the few positive upside drivers remaining are, as always, the Federal Reserve and their perpetual monetary profligacy and ability to intervene in financial markets when Wall Street billionaires beg and cry for more free welfare bailout money. That is what has been currently taking place since about June of 2007 and have been possibly the only supporting mechanism for the stock and credit markets since. The other positive is 2008 will be an election year, that said, it has notoriously been a positive tail wind for the last 100 years due to the political money interests of Wall Street and DC. A couple ancillary but much less significant ones are the Chinese Olympics and Emerging Market global growth. I do not put as much emphasis on these though.

These two primary positive catalysts will either exert their influence in the early part of the year for 2008 or obviously the later as we get closer to the election. I anticipate this type of impetus to be good for about a positive 10% if exerted early in the year. This estimation then translates into how to determine at what price level is that influence being gamed and discounted going forward. Will it occur early in the first quarter of the year or will it be after a sell-off first, then a force used in the seasonally weaker part of the summer going into the election. If it’s to be later in the year, the 10% estimate becomes less of a constraint.

There are any number of sophisticated ways to assign a value to where this price level influence would be occurring and I have gone over several in great detail but about as effective as any, is a simple price expansion above or below the current price range and short and longer term cyclical moving averages, which are almost perfectly aligned at the current level. I refer to attached chart SPY as a proxy for the S&P. Those moving averages and price expansion levels are all displayed within.

SPY

The coming year in my opinion will most likely be the most volatile year experienced since at least 2003. There are as many long term influences coming into alignment than over the last 30 years. Central Banks in Europe and the US are very much aware of this and have been printing money with craven desperation in attempts to maintain control of something they are loosing control of, which was created during the Greenspan era. Volatility is not to be feared, it is opportunity. We have every tool available to manage and accomplish this. Central Bank intervention in financial markets makes this more difficult, as their level of intervention has been totally opaque and hidden behind the curtain, but it is coming a time, where the global financial community has created an element that helps remove their curtain, greatly reducing Central Bank efficacy while holding them to a higher level of accountability than they are comfortably used to operating in.

© 2008 Brian Stoll
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Brian Stoll
TimingStrategies.com
Registered Investment Advisor
Newport, California
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