According to the Dow Theory, when the Dow Transports begin to lag the Dow Industrials, it is a significant event. This divergence signals that not all of the market agrees that the future is full of blue skies and sunshine.

In May 1999, both the Industrials and the Transports made new highs. But from that point forward, the Dow Transports declined and continued declining, even while the Dow Industrials rallied to a new high in January 2000.

Back then, almost no one trusted the "sell" signals issuing from the Dow Theory. Instead, almost everyone talked about how the "New Economy" was impervious to things like the business cycle, an inverted yield curve, and - especially - an antiquated stock-trading theory based on the Industrials and the Transports. I mean, how 20th century could you get?!

Despite all that, it wasn't long before the Nasdaq peaked in March 2000 and the bear market began. Looking back, all the signs were there for those who wanted to remove their blinders: The yield curve had inverted, there was a Dow Theory divergence between the Dow Industrials and the Dow Transports, and the rally into the 2000 high had become very narrow and concentrated in a relatively small number of stocks (i.e., market breadth had declined significantly).

Fast-forward to today, and we have many of the same market conditions - albeit on a smaller scale. The yield curve has been inverted for over a year. Since the high in July, the Dow Transports have failed to follow the Dow Industrials to a new high and instead have languished near their lows.

Market breadth on this advance has been poor. In fact, we have an enormous divergence between some parts of the market that have rallied to new highs and other more economically sensitive parts of the market that have not followed.

This divergence often occurs at the beginning of a downturn, which is why we suggested put options the Transports in last month's issue. We now have short positions in the weakest areas of the market - the financials, the Transports, and the home-improvement sector. Even if market indices like the Dow continue to make new highs, these sectors are likely to remain very weak, and could easily lead the rest of the market to the downside.

The weakness of the Dow Jones Transportation Average is not merely a technical divergence, however, it is also a fundamental sign that the economy is struggling. As the nearby chart clearly shows, there is a reduced demand for trucking. Coming out of the 2001 recession, shipments increased until 2005, then declined throughout 2006 and so far through 2007.

Supply Chain Digest is also reporting that inbound container volume growth has slowed dramatically at US ports over the past year, with May 2007 traffic down 0.2% from a year earlier. This confirms the slowdown we are seeing in truck tonnage, and also suggests the consumer-led economy is slowing.

Net-net, it's time to short Dow Transports. Here are six reasons why:

1. Housing has clearly stalled and shows no sign of recovery. With mammoth numbers of ARMs resetting between now and March 2008, things can, and likely will, get much worse. Shipping material for new construction will continue to weaken.
2. Shipping needs to furnish new homes will also continue to weaken.
3. Commercial real estate is poised to fall. Deals are collapsing as "people who can get out are getting out". The rate of increase of building new stores, as well as the merchandise required to fill those stores, will fall. That clearly means reduced shipping demand.
4. A weakening job market means less consumer demand. And falling consumer demand means fewer items need to be shipped.
5. Credit card defaults are rising. One reason is the housing ATM has been shut off. This is an ominous situation for cash-strapped consumers, who will be forced to cut back on purchases of stuff they do not need at prices they cannot afford.
6. Until recently, truckers have been able to pass on rising fuel costs, but that has changed in the face of falling demand.

The key thing to remember about avoiding a downturn in stocks is that by the time everyone realises a bear market has begun, it will be too late to do anything about it -because stock prices will have already declined. When the Fed began its rate-cutting campaign in January 2001, stocks rallied on the belief that the Fed would rescue the market. But only two months later, the S&P 500 was down 20%, and over the next year and a half, the S&P lost over 40%. You have to prepare ahead of time, when everyone is still convinced that everything is fine.

There is very little chance we will see another bear market like the 2000-2002 bear market again in our lifetimes - those come around only once every couple of generations. But an "average" bear market is certainly possible over the next year, especially given the housing situation and the market action we're seeing. Since the end of World War II, the average bear market has taken stocks down a little over 25% in a time span of 10-12 months. Certainly nothing to sneeze at, since it would take a gain of 33% from that low just to get your portfolio back to even.

So enjoy the rally while it lasts, but keep a very close eye on the Dow Transportation Average.

Mike Shedlock and Brian McAuley
for The Daily Reckoning Australia

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"He socked away US$521,000 from a lifetime of driving trucks, working overtime when he could, and playing the piano or accordion late into the evenings at weddings, hotel bars, and social clubs...

"The money was destined for his five children. But that was before more than half of the family nest egg disappeared on Feb. 2 as state banking regulators seized Metropolitan Savings Bank in Lawrenceville, citing 'unsafe and unsound' operations. When Mr. Przybilinski tried to take his money out, the man in charge of Metropolitan Savings' assets informed him that there was only US$200,000 left to withdraw -- the amount protected by the federal government through deposit insurance."

Here are some school-of-hard-knocks lessons from Raymond Przybilinski's misfortune:

1. If a bank is offering above market rate interest on CDs and deposits, there is a reason behind it. That reason is risk. And with excessive risk comes eventual disaster. 
2. With credit spreads widening, margin calls being issued, and absurd lending to build condos in Florida and other places smack in the face of record inventories, there are going to be more bank failures like this. 
3. Know and understand deposit insurance limits, or your life savings can be wiped out.
4. If you have money in a bank in excess of the deposit insurance, do something about it now, while you can. The above material was written on Aug. 8... Flash forward to Tuesday, Aug. 14, 2007: The USA Today headline reads "Sentinel Freezes Assets of US$1.5 Billion Fund".

What the headline does not say is that Sentinel is a money market fund. On Tuesday, Sentinel Management Group froze assets in a US$1.5 billion fund, saying too many investors are trying to withdraw their money. "We have never experienced a situation quite like this one," Sentinel Management said. "Liquidity has dried up all over the Street."

If you're looking for the source of the problem, here it is: "We have never experienced a situation quite like this one... Liquidity has dried up all over the Street." What happened is that Sentinel thought that just because it has not seen something yet, it could not happen. This is, in essence, the same thing that happened to the models at Moody's, Fitch, and the S&P, and various quant models. On Tuesday, Sentinel asked the US Commodity Futures Trading Commission for permission to halt redemptions. The request was denied...

Check out Sentinel's letter to clients:

"Dear Client:

"As you undoubtedly know, the credit markets, along with most other markets, have experienced a liquidity crisis in the past several weeks. Investor fear has overtaken reason and has induced a period in which most securities have simply ceased to trade. We've all read the stories about one hedge fund or another suffering losses related to subprime exposure and closing down or being rescued. This fear, while warranted in some cases, has spilled over into the rest of the credit market, and liquidity has dried up all over the Street...

"This liquidity crisis has caused bids to disappear from the market and makes it virtually impossible to properly price securities or to trade them. High-grade securities are trading like junk bonds as panicked investors dump names like General Electric at Tyco-like prices.

"We had previously thought that the market would return to some semblance of order and that our clients would not join in the panic. Unfortunately, this has not been the case..."

There were some interesting frequently asked questions on Sentinel's Web site.

1. "How can Sentinel consistently earn high yields on short-term investments without taking excessive risk?"
2. "How can I be sure my money is safe at Sentinel?"
3. "That is history. How can Sentinel ensure that such a record will continue?"
4. "Exactly what happens to the cash invested by Sentinel?"

Proposed New Answers

1. We can't. No one else can, either. That is what risk is all about.
2. You can't. Liquidity has dried up and we just got caught. That's why we halted redemptions.
3. Part of our original answer was: "Sentinel is registered with three regulatory agencies: the Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC) and the Congressionally chartered self-regulatory body, the National Futures Association (NFA)." You can easily see that now does not mean much.
4. "Sentinel clients have an indirect, undivided pro rata ownership interest in a pool of high-quality, liquid securities. Sentinel's Treasury Only Portfolio (TOP) consists of direct obligations of the US Treasury. The 125 Portfolio and Prime Portfolio consist of money market securities issued by US government agencies, corporations, or short- term bank time deposits, all of which meet Sentinel's requirements for liquidity and low risk." Those most at risk put their faith in the "125 Portfolio," and that's where the big problems are.

One part of the Sentinel letter complained: "We are concerned that we cannot meet any significant redemption requests without selling securities at deep discounts to their fair value and therefore causing unnecessary losses to our clients."

Excuse me, but doesn't the market determine "fair value"? Apparently, Sentinel thinks it knows what fair value is, but the market doesn't. Recall that Bear Stearns thought the same thing. Bear Stearns locked out clients who wanted to redeem all the way back in January. Those investors would have gotten something back, perhaps as much as 70 cents on the dollar. Bear Stearns locked those clients in, and the hedge fund went to totally worthless.

While Sentinel does not like the current offer for those assets, there is no guarantee (or even likelihood) that the market is going to think more of those assets tomorrow than it thinks of them today. Should Sentinel have seen this coming? I think so, or at least it should have been alert to the possibility. Instead, it stuck with a now failed model that offers these excuses:

• Investor fear has overtaken reason
• The market would return to some semblance of order
• Our clients would not join in the panic
• Securities are at deep discounts to their fair value.

Some may be shocked by this, but readers of the Survival Report were prepared. The difference between shocked and prepared is, of course, paramount. In preparation for a "liquidity crunch" and a continued housing tsunami, we recommended leap puts on Countrywide Financial (NYSE: CFC) when it was trading near US$36 and Lowes (NYSE: LOW) when it was trading in a range near US$31-US$32. Both options are doing extremely well as CFC is now trading near US$22 and LOW is trading near US$28.

Individual investors need not buy put options, of course. But they do need to examine the safety of the investments that they believe to be safe. They need to read the fine print on their "guaranteed" investments. They need to read (or, at least, to understand) the statements on their money market accounts that stipulate in their prospectus very clearly that they can LOSE money and that NAVs (net asset values) can fall below a dollar.

Unfortunately, most folks don't care about "the fine print" until it's too late.

Free Tips

1. Make sure you do not exceed deposit insurance limits in any account. Just ask Raymond Przybilinski about the consequences.
2. Do not panic over this. Just calmly make sure you know where your money is and that it exceeds no limits.
3. Also make sure that any money markets you are in are not heavily invested in "junk-rated" securities.
4. The higher the yield, the more excessive the risk is. Don't become another Sentinel victim.

Mike "Mish" Shedlock
for The Daily Reckoning Australia

Editor's Note: This article originally appeared in Whiskey and Gunpowder.  Register for their e-letter here. 

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A volume of seawater traveling at that speed is classified as a Tsunami - the biggest and most devastating of all ocean forces.

The seventh most devastating natural disaster is the 2004 tsunami in the Indian Ocean that killed 287,000 people.

Now imagine that the pattern of that tsunami's formation, its growth, and its ultimate destructiveness perfectly mirrors an industry in our country.

And the damaging effects of the industry to which I'm referring on the U.S. economy have yet to make landfall…

It is astounding how closely events of nature mirror events of business. It shouldn't be much of a surprise, really. Leaders in finance have used the physical world to help describe and predict the events of finance for decades. The most famous example of this in my mind is the Nobel Prize winning work of Fisher Black and Myron Scholes. They adapted a heat transfer equation from physics to explain and value options contracts.

And that's only one example…

MIT economics professor Xavier Gabaix, along with a team of physicists from Boston University discovered that the movements of the stock market follow a mathematical pattern similar to earthquakes.

These findings could allow traders to protect their investments by pinpointing periods when market volatility is likely to be significant.

"The frequency of crashes such as those in 1987 and 1929 follow patterns," says Gabaix. "Although that doesn't mean we'll be able to predict with certainty when movement will occur, or in which direction it will go, we can still predict - better than with other methods - whether it will be a big move or a small one. And that information can be useful."

The patterns that give us clues of huge equity market changes and devastating earthquakes are known as power laws. Power laws define mathematical relationships between the frequency of large and small events. Typically, the larger the event, the less frequently it happens. The importance of these power laws is in the way they describe nature as well as artificial constructs…

What I'm worried about, though, is something that will affect everyone in America, not just stock investors…

It will be the second wave downwards in the housing market that will catch everyone off guard and send the economy into a sharp, protracted consumer-led recession. And that second wave is about to hit.

The housing market peaked in summer of 2005 right along with the cover of Time magazine proclaiming "Home $weet Home - Why we are gaga over real estate". Since then home sales have fallen dramatically nearly everywhere and price drops in the bubble areas such as Florida, Massachusetts, Phoenix, Las Vegas have been as large as 25% or more taking into consideration incentives, interest rate kickbacks, and even "free" vacations and cars.

Building permits in November dropped 31% from the year earlier level. Note that seven out of the last eight times the annual rate of change on permits was negative 20% or lower, the economy went into a recession (not counting the current situation).

Furthermore it was a plunge in the annual rate of change on permits that preceded every recession that makes permits a strong leading signal. The only miss was 1987 where the annual rate of change exceeded negative 20% but there was no recession. There was also a recession in 2001 even though the threshold of negative 20% was not hit (but the number did at least get strongly negative). That likely explains why the recession of 2001 was not as severe as most. Indeed when housing is strong hiring is strong and people also tap into the equity on their houses and spend it.

In early December of 2006, in One on One with Robert Toll of Toll Brothers (NYSE: TOL). Toll proclaimed that things are "dancing a little bit above the bottom" and that "all the ingredients to have a very rapid recovery are in place and I suspect you will see a rapid recovery once the pent-up demand understands that if they don't buy now, they may miss an excellent opportunity to buy a home with a low mortgage rate."

Actions however speak louder than words as Robert Toll has personally been bailing on his shares at a tremendous rate. The key elements however, are land options and cancellations.

Nearly all of the homebuilders have had high cancellation rates and have also been taking big writeoffs on land. Here is a prime example: Lennar (NYSE: LEN) posted a quarterly loss after land writedowns:

"Market conditions continued to weaken during the fourth quarter and we have not yet seen tangible evidence of a market recovery,'' Chief Executive Officer Stuart Miller said in the statement. Lennar said it's taking a charge to write down land it doesn't intend to purchase. It's also writing off deposits and pre- acquisition costs for land it has under option.

Would Lennar or any of the homebuilders be dumping land if they really thought the bottom of the housing market was in?

It has now been over 18 months since housing peaked in the summer of 2005.

But the average decline in housing starts from peak to trough is about 46 months. By that standard this decline has a long ways to go yet.

Foreclosures are actually at a fairly low rate. It is the rate of change however that is alarming. Foreclosures increase 51 percent nationwide.

Foreclosures increased 94 percent last year to 157,417 homes in California, as homeowners struggle with fast-rising home payments and a slow-selling market, according to a Fair Oaks real estate investment advisory firm on Monday. California had the most foreclosures filed nationwide, while Nevada had the largest percentage increase at 175 percent last year compared to 2005, according to Foreclosures.com. Nationwide, almost 971,000 foreclosure filings were reported last year, 51 percent more than the 641,000 in 2005, according to the annual report.

There has been some excitement in the housing market as of late by a small bounce in homebuilder sentiment as well as a small bounce in new home sales. This is like looking for starfish on the beach during the trough that precedes the big wave of the tsunami.

For starters, new home sales do not take into consideration cancellations and cancellations have been soaring. The current methodology is to count "new sales" as soon as a contract is signed, but sales are not subtracted by cancellations. Thus not only are sales overstated but inventories are massively understated. Builders are now scrambling to finish projects and unload as much inventory as possible before the next wave hits.

That second wave will strike when massive layoffs occur as the current projects are being completed followed by a decline on a lagging basis of commercial real estate. Already we are seeing an impact in residential construction employment. But do we really need more Walmarts, Pizza Huts, strip malls, nail salons, grocery stores, Home Depots, Lowes, and restaurants that follow? I think not and historically commercial construction follows residential construction with a lag. That lag is anywhere from 8 to 16 months.

Commercial business hires people and lots of them. When that buildout ends, and we are at the beginning of the end now, there is going to be no source of jobs to replace those service sector jobs going forward.

Mike Shedlock
for The Daily Reckoning Australia

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"Soaring metals prices mean that the value of the metal in pennies and nickels exceeds the face value of the coins. Based on current metals prices, the value of the metal in a nickel is now 6.99 cents, while the penny's metal is worth 1.12 cents, according to the U.S. Mint...

"'The nation needs its coinage for commerce,' U.S. Mint director Ed Moy said in a statement. 'We don't want to see our pennies and nickels melted down so a few individuals can take advantage of the American taxpayer. Replacing these coins would be an enormous cost to taxpayers'...

"Under the new rules, it is illegal to melt pennies and nickels. It is also illegal to export the coins for melting. Travelers may legally carry up to $5 in 1- and 5-cent coins out of the USA or ship $100 of the coins abroad 'for legitimate coinage and numismatic purposes.'"

Note the irony in the mint for being concerned about those who would "take advantage of the American taxpayer," when the actual production cost for each penny is now up to 1.73 cents, according to the Houston Chronicle. Year in and year out, The U.S. Mint wastes money by coining pennies.

Notice that the Mint produced $78,612,000 worth of pennies at a cost of $135,998,760, thereby wasting $57,386,760 of taxpayer money through November 2006. Worse yet are the continued handling charges (and time wasted) by merchants and banks sorting and counting the damn things.

Following is an e-mail conversation I had with John Rubino at Dollarcollapse.com shortly after I wrote "Pennies, Nickels, and Dollars":

Mish: Oddly enough, it is quite likely that The Mint will bring upon the very conditions it hopes to prevent! Telling people 20 nickels are worth 40% more than a dollar can only invite hoarding.

Rubin Exactly! I told my 9-year-old about the nickel thing today (he's home from school with a cold) and he immediately got our change jars out and started picking out the nickels.

The Mint had to be crazy to announce that a nickel is worth 7 cents. I got to thinking about this a bit more, and a nickel is really 0.05 dollars plus a call option on the price of copper and nickel (the metals) in the nickel. If that option is ITM (in the money) enough, the mint cannot prevent people from hoarding them, which will in turn drive up the cost of producing them. In fact, the actual price does not even have to get high enough; the mere expectation that metal prices will get high enough could cause hoarding. Of course, the Mint tried to negate that call option by making it illegal to melt the coins, but that will not stop hoarding if the expected or actual price of copper and nickel gets high enough.

All the Mint really accomplished was telling everyone that a nickel is backed up by something useful, even if a dollar is not. Eventually, this is likely to force the mint to debase the nickel by replacing the copper and nickel in the nickel with steel or aluminum.

Recall that the Mint long ago replaced much of the nickel in nickels with copper, just as it removed the silver in silver dollars and replaced the copper in pennies with zinc. That is actually the process I was referring to when I suggested nickels would soon be confiscated.

In the short term, it is likely the value of a nickel drops to a nickel or less because of the falling price of copper. If there were as much nickel in nickels as there used to be, then nickels would be worth even more than today's copper nickels.

Many of you know that I have been bearish on copper for quite some time. I have been bearish on copper simply because so much of it is used in housing. I expected that symmetrical triangle to break down, and it did. Also note that I was lenient in how I redrew that triangle. The lighter blue line at the base was the lower edge of the previous triangle I was looking at.

We have since then seen a retest of support at the 320 level that seems to have failed, as well as multiple failed tests of the triangle (using previous lines). My target remains the 220 level, but 160-180 is not out of the question. Technically, copper is broken. Can it blast higher anyway? Yes, it can. I just do not think it is likely.

Exactly what are Dr. Copper and Lumber telling us? To me, it is obvious. This economy is in trouble.

Let's now return to my previous question: "In what time frame will the current (and probably soon-to-be confiscated) nickel be worth more than a dollar?"

Aaron Krowne gave a couple of possible answers to that question on AutoDogmatic.com:

"If base metal values continue to increase by 5% per year on average, and the dollar continues to depreciate by about the same, then in about 261/2 years, a nickel will be worth a dollar in inherent value. If the rates are 10% per year, then in a bit over 13 years, this milestone will be reached."

Some might think Aaron is asking too much, others too little, and in the short term, I am still calling for a pullback in copper prices. But what's to lose by hoarding nickels? Oddly enough, hoarding nickels is a hedge against both hyperinflation and deflation. If hyperinflation kicks in, a nickel might be worth more than a quarter (in metal content) in no time flat. If deflation kicks in as I suspect, cash will be a good thing to have. If you are going to hold cash (change), it may as well be in nickels.

Regards,

Mike Shedlock ~ "Mish"
for The Daily Reckoning Australia 

Editor's Note: Michael Shedlock (Mish) worked in the financial services industry for 20 years at some of the top institutions in the country including Harris Bank, the Bank of Montreal, Bank One, First National Bank of Chicago, and First Data Corp. He is a regular contributor to the free e-letter, Whiskey and Gunpowder, which covers resources, oil, geopolitics, military history, geology and personal freedom.

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