Sometimes Technical Analysis Sounds Like a Foreign Language

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The task of today’s Daily Reckoning is to figure out if asset prices can rise a world of reduced leverage where investor attitudes to debt have changed from indifference to revulsion. Also up for discussion is the psychological effect of the last 18 months on Baby Boomers and their willingness to stay in invested in both stocks and houses now that they’re closer to retiring.

Now, to the markets. You may remember that yesterday we asked chartist Gabriel Andre to confirm or deny the claim by Chart Partners Group that the S&P ASX/200 could rise by another one percent-and then fall by 19%. It turns out Lord Swarm had published his own forecast yesterday in our sister letter, Money Morning.

“What is the target then for this current rally,” he asked. ” Well, as we anticipated a few months ago (see Money Morning dated May 14), it is likely that the next significant objective will be around 4,550 points. That is 300 points ahead, or 7% higher [than yesterday’s open]. The Bollinger bands are widening, the volatility is up. The target could be reached soon.

“Two key points argue for an exhaust at this level of 4,550 points. First, the Relative Strength Index (RSI) clearly shows that the index is already overbought. You may know that a stock or index or any other asset can remain overbought (or oversold) for some time. However a high valued RSI usually means that the countdown has started for the trend in place. Here the RSI is valued at 74, above the overbought level of 70.

“Second, the level of 4,550 points corresponds to the 38.2% Fibonacci retracement ratio of the decline occurred between November 2007 (point A) and March 2009 (point D). It is likely to be a resistance area where investors and traders will take profits.”

There you have it. Expect a rally to 4,550 then profit taking. You heard it here first. Or second, if you read Money Morning yesterday.

Sometimes technical analysis sounds like a foreign language. In many ways, it IS a foreign language. It makes the claim that the best way to understand and trade the market is to be fluent in the vocabulary of technical variables and chart patterns. It’s a big claim.

Your editor does not pick up foreign languages easily. But just for grins, we asked Gabriel to try his technical speak on the CRB commodities index. It’s been up, then way down, then back up. We wondered-all the fundamentals of supply, demand, growth, and recession aside – what the index looks like to trader with an eye for patterns and mind full of oscillators. We showed him the chart below, on to which he put the lines you now see.

CRB Targets 265

His commentary was to the point: “23.6% Fibo (the very first retracement level) hit on last June 11 (point C), is likely to be the immediate target, around 265 points. A correction had followed then a rebound on a support level (green horizontal line) valid since last March. I expect the resistance at 265 points to trigger profit-taking. It should hold, as many commodities are a bit overbought on short-term basis.”

Speaking of commodity prices, the RBA published its commodity price index yesterday. It was, in the spirit of the season, less bad than expected. The RBA said the index was flat in July after being down 3.8% in June. Coal and wheat were down, but beef, veal, and iron ore were up.

Source: Reserve Bank of Australia

Like all other investable asset classes, commodities are trying to find a natural price floor. That floor would be based on the long-term demand in the real economy for tangible assets. And with commodities, you at least get predictable cycles where overcapacity in production leads to falling prices. Or, as we saw in 1999, years of underinvestment in productive capacity coincided with a surge in demand, creating a huge gap that led to spiking prices.

Now things are levelling off at a higher equilibrium. But what about other asset classes? Specifically, returning to the question we began today’s letter with, can asset prices make new highs without new leverage in the system? And exactly who is willing to take on leverage now anyway?

This is the question that we think the markets are working through right now. You get the sense that people feel better about the economy. And they feel like the worse of the financial crisis is over. At the very least, investors feel that systemic risk-the chance of a total meltdown-has been averted. There are still risks, but perhaps not as grave as the risks faced once Lehman Brothers collapsed in September of last year.

One reason investors feel better is that governments have now stepped in and made clear they won’t let any systemically important firms collapse. That’s been a messy process. But it seems to have reassured people that the worst case scenario is impossible.

We’re not so sure. If anyone has learned anything in the last two years, it’s that the improbable is still possible. It only has to happen once, and it only has to happen to you for an event to derail a lifetime of planning. We reckon investors will bear the lessons of the last two years in mind as they approach markets today.

But it sure doesn’t look like that’s happening now, does it? So what, really, is happening? We reckon one explanation is that the financial system has simply doubled down on itself. Banks and institutions have partly shored up their balance sheets by selling new shares or, increasingly in Australia, bonds. They’ve taken the rest and made financial bets which generated paper profits and the false dawn of an earnings recovery, which has been priced into stocks.

You wonder though, how much of the liquidity made possible by central bank policies and government fiscal stimulus has simply found its way right back into speculating on higher asset prices. Is this a recovery in asset prices that simply duplicates the speculative excesses of the credit bubble peak last year? Hmmn.

If the entire financial world-institutions and retail investors alike – reverts back to the bubble era thinking, then you can almost guarantee further losses. This is the debt-deflation scenario. But it’s a scenario where the losses are taking grudgingly, drip by drip, in the face of furious attempts to releverage the system.

We were going to say that recommitting to the bubble could guarantee a retesting of the 2003 lows on stock markets. But this time, it may be a bit different. Because the monetary authorities will not allow a large firm (or sovereign state?) to fail-and because people believe there are no firms whose failure is big enough to take down the system-you’ll get a very different kind of crisis in phase two.

The credit bubble cannot be reflated. But the rate at which asset markets grind lower (in real terms) can be drawn out if there are no catalysts to cause a panic and if liquidity efforts by central banks remain in place. For example, we reckon that Aussie banks and fund are carrying hundreds of billions of dollars in unlisted assets on the balance sheet that are probably worth a lot less. But those assets don’t have to be re-valued continuously (marked to market). We reckon there are serious problems with those assets.

For one, there is the composition of them. Are they infrastructure funds? Listed property trusts? Commercial real estate loans? And then, don’t forget, there are the listed assets, which also include commercial and residential property.

Our main point is that asset values are probably much lower than investors would like to admit. But because of changes to accounting rules, no one has to realise any losses on these assets which would require more capital or, in some cases, force a firm into solvency once the value of the asset was written down.

So the zombie assets slumber on the corporate balance sheets in the hopes that everything recovers, the bubble is reflated, or excess bank reserves make their way into the economy to inflate asset prices (although in real terms, investors will lose ground).

In any event, you can be sure the “authorities” would like you to believe that a gradual reflation of housing and stock prices means there is nothing to fear any longer. But they may be underestimating one major change in investor psychology over the last two years: fear.

It is all well and good for the financial industry to turn Fed credit into asset price speculation. But at the household level, how are investors going to behave? We reckon most investors who expect to retire in the next ten years cannot afford to have another year like last year. The entire investor class that has seen stock and house prices rise for most of their adult life is counting on those assets to live off of in retirement.

Now they have a choice: stay in the game to make back some of what you lost and benefit from government reflation policies. Or cash out, hope you have enough to get by with, and adjust your expectations for a less lavish retirement than you had hoped for.

No one likes downsizing his expectations, of course. But as was discussed last Friday at our Debt Summit, attitudes towards wealth and debt may also move in cycles. Those cycles are informed by the unique experience of each generation. If you’ve experienced nothing but prosperity and rising stock and house prices, you’re happy to take on debt and you tend to discount risk.

But one good wealth-destroying recession is the kind of thing to temper both your expectations and your attitudes toward risk. We would not be surprised at all to see investors begin with holding liquidity from the stock and property markets. They are eighteen months closer to needing that money than they were when the crisis began. We suspect this will modify some behaviour.

Maybe it’s not all that complicated. We’ll see. But it could be that a permanent feature of this recession-and of globalisation for that matter-is lower real wages and income for Western workers. For Western workers to become retirees, then asset prices will have to bridge the income gap. However, as Glenn Stevens himself admitted a few weeks ago, the credit bubble created an exaggerated expectation about the rate of return you can expect from stocks and houses.

We reckon those investors who are first to realise this new reality of expectations will profit best. That is, they will modify their asset allocation plans accordingly. They won’t liquidate entirely. But they will probably (and prudently) risk much less of their capital, while putting the rest to work buying tangible assets at a good valuation. More on this subject tomorrow!

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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Comments

  1. Dan, you’re assuming that boomers have a clue. Some do, but plenty that I know think that all their investments will always go up in the longer term.

    I think it is the generation before them that realises the problem. Boomers are too used to seeing markets boom in their adult lives. Gen X’ers too, although many X’ers and Y’s realise they haven’t been around long enough to think they know all the ups and downs of markets yet.

    IMO.

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  2. Can’t sit in cash through 20 or 25 years of retirement with inflation continuing on its merry RBA targetted way. Without even a little recession or major job losses or a bit of a correction in housing prices to give Oz punters caution. But super and stock losses making them desperate. No, all I’m waiting for now is to see what investments Ken Henry decides to tax advantage in our brave new world.

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  3. “I’m waiting for now is to see what investments Ken Henry decides to tax advantage in our brave new world.”
    Ned 5/8/09

    Same here, Ned. As one of the really thick Boomers Pete refers to above, I’m always interested to learn how the coming generations are preparing for retirement, especially those experts who have experienced major losses, yet see the writing on a distant wall far more clearly than the rest of us…! ;)

    Biker Pete, New Brunswick, Canada
    August 6, 2009
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  4. And my $24k question is:

    What exactly are these “tangible assets at a good valuation”??

    By the way, can ‘assets’ also include: potential wives? ;) cause I’m in the market for a woman with a small dowry and can actually run a house.. Now that’s what I call a tangible asset.

    First Home Buyer
    August 6, 2009
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  5. Bugger. I almost forgot the fact that I still need to buy a house first..

    First Home Buyer
    August 6, 2009
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  6. I’m with you Ned. Waiting to see what the tax review says and sitting in cash till then. Was going to buy property but am hanging off that now. Still think things hang in the balance. If unemployment goes up a lot and interest rates too, you may see either a stagnation or fall in prices in property. Skittish on shares too. Actually, I’m off to Vanuatu for 18 months to do some environmental work so will transfer it over there as any interest is tax free (So is the income yahoo!). Am really sick of having to pay the tax office thousands every 3 months as well as income tax. Better off being in debt.

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  7. My experiences agree with your view Pete, many baby boomers are not financially literate.

    My parents in-law built up a good portfolio of residential properties and bank shares. In early 2008 I (gen Xer) urged them to sell their bank shares and take a profit. I was condescendingly told: Banks profit from mortgages and there is strong long-term demand for house in Australia, ergo they are a sure thing.
    Unluckily they also borrowed a very large sum of money and invested in shares via their super fund weeks before the big stockmarket crash.
    I recently went through the same fruitless exercise in urging them to sell their commercial property trust investments while they were still in the black.
    It seems that their investment strategy is to do the opposite of whatever I suggest.

    In contrast my Dad took a most unusual approach to saving for retirement. He was suspicious of most forms of investment as there were so many ways of his money being lost, easten up in fees etc.
    So he kept all his retirement savings in the bank. He lost nothing in the recent market downturn.
    In the country where he lives there are no tax incentives for super, and a murky share market, and higher interest rates, with low inflation.
    He is now (very cautiously) eyeing up assets he can buy at discounted prices.
    I wouldn’t have suggested that strategy, but it has outperformed mine.

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  8. Understand what you mean there Richo.

    I practically begged my own mother not to invest in shares. But she did anyway. Bought high. Sold low. Blamed the market, even though that was not the actual problem. She thought that all ‘blue chips’ would always go up.

    Then, convinced that the share market was not for her decided to purchase property instead. After I very much encouraged her to reconsider. She says she just wants ‘a stable income stream’. Well, I think that some people forget that ALL investments have risks.

    I encouraged her to wait a while, even though bank interest is pitiful, because in an environment where no-one has any money (credit dries up), a person with money has a lot more options and power. However if all your money is locked up in property like everyone else, then you are all in the same losing boat.

    Sometimes liquidity can be your friend. Try selling a house quickly, for the price you want, when the market is turning downwards…virtually impossible. And if you want to know what that feels like, ask anyone trying to desperately sell a house for more than 500K at the moment.

    I always get the same argument from the boomers I know (most of them): “over the longer term, things always go up”. I think that is because for the last 3 decades they have had things pretty sweet (in general, there were some hiccups) and things have generally gone up. It’s always the same mistake, take a trend, extrapolate it into the future and assume that is how things will go. Thats like seeing three reds in a row in roullette and expecting the rest will be red forever. Sure-fire winning strategy that.

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  9. Well I am a boomer about to retire and my DIY plan focused on three areas; 1 remove equity, 2 minimize risk and most important 3 no financial advice!
    OK…I am fortunate that about half of our required retirement income is guaranteed – indexed pension from a defined-benefit fund.
    The rest will come from our SMSF, interest earned on term deposits with a regional bank. Combine the two and apparently we will be a “comfortable couple” as defined by the Westpac/ASFA retirement standard – LOL
    Having made it to here an even greater challenge awaits us in retirement – wealth protection. The Government’s ongoing mission is to deter/prevent people passing on their wealth to others in particular family members.
    They need to do this to ensure future (working) generations are reliant on our superannuation system. And the super cycle starts again…think long term and accept the fact that others require your dollars today.
    The Government has ensured your participation via your SG contributions. Cheers

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  10. Ned S, Annie there is another alternative…move some funds offshore?

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  11. Any suggestions Greg? Was thinking of Vanuatu…

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  12. Another approach might be to put it where the majority of the voting public have their investments – hence govt will get nervous plundering it as it will see them kicked out of office. The danger is that investing with the herd is likely to result in losses.

    Or alternatively invest it where the most influential Australians do, the ones with lots of influence over politicians. In the UK for example the house of Lords ensures that tax havens are never outlawed by voting down legislation.

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  13. I think demographics has something to do with the Baby Boomer psyche.
    With the a bulge in the population and currently of the wealth, economic trends are strongly influenced by the baby boomers.
    They were buying their first houses, having children, saving for retirement, investing all together.
    IMO this creates two dangerous outcomes. Baby boomers thinking that their decision making is brilliant because so many others are doing the same at the same time (groupthink). The second danger is that the timing of their investment decisions creates demographically driven bubbles.
    Net investment in financial assets of all kinds has been rising for decades due to baby boomers saving for retirement. What will happen when they switch from net investors to drawing down of their savings together.
    How will the world economy cope with two decades of net withdrawals and asset sales?

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  14. Annie..Vanuata sounds nice :) Being in Japan I hedge my bets by owning assets in Japan and cash in Yen. If inflation picks up in Oz then sitting here in Japan where they are fighting deflation seems to be a good bet. Since I can only guess how world economic events will unfold (just like everyone else) I simply try and be spread everywhere and work on the assumption that at any one time there will be something for me to sell and bring in some income.

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  15. Richo – Boomer drawdowns on assets? The government plan seems to be to keep everyone working by the sounds. More immigration would help as well. But I suppose we have to be careful to not really overdo that or we could just recreate the problem two generations down the track.

    I don’t know of any precedent in a developed country that has played out yet. Japan is ahead of us in that regard as I understand it. Although differences in the structure of our economies and even cultural factors could mean that lessons from there aren’t directly relevant?

    It probably isn’t hard to imagine a worst case scenario in Oz in that regard. Although a best case scenario might say that India and China and other parts of Asia continue to grow strongly for 30 years or more and piggy back us through. Just maybe a bit of a muddle of a bunch of things perhaps?

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  16. “The second danger is that the timing of their investment decisions creates demographically driven bubbles.”
    Richo, 6/8/09

    We’ve predicted that many Boomers will downsize… and the GFC does seem to have accelerated this in Oz, although the half-dozen cases we’ve witnessed may not really be enough to call a trend. It’s interesting to note that this may also be happening in the Maritime provinces of Canada. Interesting because, as our hosts commented last night, “…there has never been a boom here… ever…!”

    Groupthink doesn’t merely apply to property, of course. Wherever a group of very enthusiastic individuals congregate to discuss and promote an(y) asset class, their mutually supportive feedback tends to reinforce belief in its superiority. (If this applied to realty, one might expect to hear cries of “Go Housing!” or “C’mon Property!!” as though spectators believed this might positively affect an outcome. Can’t say I’ve seen that level of desperation from ‘property bulls’, yet…! ;) )

    Biker Pete, New Brunswick, Canada
    August 6, 2009
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  17. I think Oz property is real safe Biker. And your boy’s stocks should continue to make him a fortune over the next few decades.

    I accept I’m a financial moron. But that said, my reasoning follows:

    Asia is real important to Oz. And especially the bits that have the most future growth potential.

    So I ask myself the question Just what could stop those countries being the juggernaut of the future? Will China fold and go away for a few millenia if America should diddle them out of a trillion or two? (After they get over their hystrionics – Smile!) Will developing Asia suffer irreversible financial damage because America is too irredeemably broke to buy their stuff anymore – As a really worst case scenario? Will China suddenly see riots in the street that they are too compassionate to put down? I actually doubt any of those things are at all likely. (Not the bit about the US doing it tough just maybe – But the bit about it causing Asia irreversible long term pain.)

    Oz is looking OK. Most boomers might even get to eat protein fairly regularly – Smile!

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  18. Ned I think we also have that appreciate that Asia is more than just China. The growing middle class of Asia spreads all the way across to India and so even if China was to stumble there are plenty of other economies (and people) in the region to take up the slack.

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  19. I’m convinced that Australia is well-placed to take advantage of Asia’s resource needs, Ned and Greg. Despite that, I’m a little surprised that the ASX has remained so resilient during what seemed to be a growing confidence crisis back home. We hadn’t predicted that… . Yes, Son1 is OK, being in for the long term. We view energy stocks as very promising, but our position tends to be somewhat (perhaps a little too) defensive, with retirement so close. We’re still building, with plans for more homes to follow, but we’re exploring a different niche, based on a perception that if the bears prove even _partially_ correct, demand will be higher in the $350 – $380K market. Strangely, rents aren’t all that different to those we’re getting in the $380 – $450 K niche! We think that says more about the housing shortage in a very desirable location, than it says about the rental market. Rents in Australia still appear to relatively cheap, compared to those in the northern hemisphere, but that may be more about population pressure than anything else… . As we cross Canada, with forays down into the states, we’ll gain a better perspective.

    Biker Pete, Fredricton, Canada
    August 7, 2009
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  20. The thing that I find fascinating (and potentially SO different) about China is that through not being a democracy, they have controls over their economy in ways that others very obviously do not. And an ability to respond very quickly. I know nothing about the mindset of the people but get the impression that they are actually quite happy with the existing arrangement – So much for fears about “riots in the street”. And the whole arrangement seems to be very good for Oz.

    “Communist Capitalism” – Who would have thought that would stand up well in comparison to “Democratic Capitalism” – But it is logical enough I suppose – Here are the good bits of capitalism – You will embrace them; These are the bad bits of capitalism – Embrace them and you get a bullet! And all totally free of any democracy enslaved need by pollies to give the mob lots of luxuries like we se in the West.

    Any idea that Oz would be OK because “China” had decoupled significantly from the US is obviously false. But one has to expect significant decoupling to be actively encouraged over time now. Again, not a bad thing for Oz at all regarding reducing risk. And in many ways it is just possible that emerging Asia could benefit from more cost conscious and somewhat spendthrift American consumers continuing to pile into Walmart longer term anyway – Which again is still good for Oz.

    But we have our own internal issues. With housing being the real big one – It is all anyone here really seems to care about in relation to the RBA and interest rates. Glenn Stevens comment about the desirability of ensuring more housing gets built rather than just more expensive housing, lined up too nicely with a bunch of my previous thoughts on housing to not just reaffirm that the Ken Henry tax review is the obvious place to tax advantage some forms of investment and tax disadvantage others to ensure that Glenn Stevens preferred outcome results.

    Buffett says don’t bet against America – Fair enough. But one of the constants you can bet on is change Warren. It is actually very possible that we are seeing the beginning of a realignment in global financial power bases – Which is way more exciting stuff than watching man land on the moon! Especially given where Oz sits in it.

    One thought regarding why this is not the 1930s Great Depression II – Back then the US was the up and coming juggernaut. And it was the US that got itself in trouble with debt. This time emerging Asia is the up and coming juggernaut. And emerging Asia is not in trouble with debt.

    Could the US go protectionist? It would seem smart. Any ideas anyone?

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  21. and again

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  22. Gazzbag, settle mate! Greg is an active poster, but it’s probably a testament to the fact that he has more free time than most people – something I personally aspire to!

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