THE

ELDER

EPORT

Published by Felder & Company

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JULY, 2010 We have spent a fair amount of time in these pagesdiscussing the merits of investment fundamentals and valuations and also looked at a good number of charts.Clearly we see the value in both methodologies andstrongly believe that success in the markets depends uponone's ability to implement both.There are times, however, when both fundamentals andtechnicals agree and yet an investment based on thesefindings is unsuccessful. The company may be doing very well financially and be trading at a reasonable valuation.The chart suggests that the stock price is making a bot-tom. Still there is something unaccounted for and thestock price continues to decline.Conversely economic fundamentals may be very poorjobs hard to come by and debt and deficits out of control.The stock market displays a very clear topping pattern.Stocks defy these indicators and trade higher.Obviously there is something unaccounted for in thesetypes of situations and that is sentiment. Just as Bob Dy-lan said 40 years ago quoting Abraham Lincoln over 140

years ago, “all the people can't be all right all of the time.”

And when the fundamentals and technicals are so obvi-ous as to lead the crowd in a certain direction investorsshould be very skeptical.This is exactly the case with the stock market over thepast couple of months. The major stock market indexes,most notably the S&P 500 index, have formed clear headand shoulders patterns, one of the most popular technicalpatterns in the business.Recently it looked as if these patterns predicted immi-nent doom for stocks. In addition, economic indicatorshave been weakening suggesting an increasing possibility of a double dip recession. The only reason that stockscould not break down decisively, we believe, is that toomany traders were counting on just that possibility. A recent article in the Wall Street Journal provides evidence to validate this theory:

Half of the people can be part right all of the time,Some of the people can be all right part of the time,But all of the people can't be all right all of the time.I think Abraham Lincoln said that. -Bob Dylan

The Infamous „Head and Shoulders‟ Pattern

"In decades of market analysis, I can't remember a timethat I've heard [so] many analysts quoting some support orresistance level as being critical for the market," John Huss-man, president of Hussman Investment Trust, wrote in his weekly commentary. "The object of discussion has increas-ingly turned to the implications of this particular chartformation or that, as if some magic number or anotherabsolves investors from having to think about the big pic-

ture.”

The recent focus on technical analysis has "really ham-mered home how the volatility is getting so extreme," saidRyan Detrick, senior technical strategist at Schaeffer's In- vestment Research.The Standard & Poor's 500 index narrowly fell on Wednesday, snapping a six-day winning streak in which ithad gained more than 7%. But those gains came on theheels of a bigger losing streak in which the index fell innine of the previous 10 sessions and dropped 8.5%."When the market goes down, people turn to the chartsbecause it gives them peace of mind," said Katie Stockton,chief market technician at MKM Partners. "They wantanswers, and if they can't find the answers in the funda-mentals, they turn to technicals."The S&P 500 dipped below 1040 during the losingstreak, level considered the "neckline" for what chart watch-ers call the index's "head-and-shoulders" formation. Thehead-and-shoulders pattern consists of two smaller rallies,considered shoulders, that sit on each side of a larger rally,the head. It is typically viewed as evidence of the markettopping out and a precursor to a larger reversal.

But the index has bounced back in the past few days…

...to the tune of 6% in less than two weeks. Technicianstrading the head and shoulders breakdown have had littleopportunity to cover their shorts as stocks have marchedsteadily higher over that time. For now, the head andshoulders pattern has failed to work.The predictability of these types of patterns may just becompromised by the fact that so many traders have be-come technicians but that is a question to explore in an-other issue. For now, we can simply recognize that thepotential breakdown for stocks was broadly anticipatedand failed for this very reason.Last issue we discussed removing our market hedges. Inthe meantime we actually used the negative sentimentcreated by the popularity of his head and shoulders pat-tern as a buying opportunity (see Jesse'sMy Back Pages for the play-by-play) and it has paid off.Things aren't so clear though today. Economic funda-mentals are indeed very poor; leading economic indica-tors are rolling over; job growth is nonexistent and theeconomy is displaying none of the signs of the typicalrecovery. In addition, the head and shoulders pattern ispopular because it usually works. These signs can't beignored.Still we believe there is too much talk of deflation to-day. Early this year you'll remember us discussing atlength the prospect of Japanese-style deflation here in theUnited States. At the time very few were discussing thispossibility. Today it is on the minds of nearly every econo-mist and financial commentator and it has clearly seepedinto public consciousness. Over just the past monthGoogle searches for deflation have surged 300% andTreasury yields have plummeted to record lows in somematurities.It is much easier for us to take a position in the debatesuch as the current one regarding deflation when it is lesspopular as it was earlier in the year. Now that tradershave put on the deflation trade (long treasuries and shortstocks) we find ourselves much less comfortable with theposition. We are admittedly poor trend followers, a flaw we read-ily recognize (see our TLT trade in recent issues for anexample of selling too early). We simply believe it is betterto position oneself closer to the beginning of a trade andget out near the middle than to get in closer to the end of a trend and suffer consequences similar to what new short-sellers experienced trading the potential breakdownof the recent head and shoulders pattern.

Technology Stocks Battle the “Death Cross”...

...But FinancialsHold the Key

We still believe in the deleveraging thesis over the long-term, however, we now have little conviction in regards tothe near-term direction of the stock market. The headand shoulders pattern may eventually work for traders,especially if most soon abandon the idea. The fundamen-tals still line up with the technicals and if this currentrally flips traders to the bull camp you can be sure we will,in the very least, be putting our hedges back in place.Certainly, we have not given up hope that an end tothis epic bear market of the past decade may soon be athand. There are signs that investors, disillusioned by in-creasing volatility and persistent poor performance, con-tinue to abandon the equity market.The Wall Street Journal recently ran anenlighteningpiece:

Small investors' faith in stocks, which surged in the1990s, has collapsed since the technology-stock debacle andthe Enron and WorldCom scandals of 2000-2002. The2007-2009 financial crisis only made things worse. Now,the pullback among ordinary investors means they are adeclining force in a market that is increasingly dominatedby professionals.Some were tantalized by equities during the 70% rally that began in March 2009 and ran through April. But mu-tual-fund data and other clues suggest that that brief in-fatuation has ended.In 2002, investors withdrew more money from mutualfunds that invest in U.S. stocks than they put in. Thenfrom 2007 through 2009 they withdrew money for threeconsecutive years. That marked the first three-year periodof withdrawals since 1979-1981, according to the Invest-ment Company Institute, a mutual-fund trade group.

Ironically, early 1982 marked the end of a long periodof stock market malaise and the beginning of the biggestbull market in stocks on record. Sadly most investors hadjust thrown in the towel and missed out.

The article profiles the Potyks, “a comfortably retiredcouple in San Antonio,” who have a soured on the finan-

cial industry in general. "In the military, you learn that you want people you can respect, trust

—

who have integ-rity," Mr. Potyk says. "Over the last five years or so, I findthat our financial institutions have no shred of the char-acter I describe." Those who have read our recent issues will know that we vehemently

agree

with Mr. Potyk.

We can‟t, however, endorse his reaction: the Potyks

have sold all of their stocks and are now 100% investedin fixed income. The problem with this relates back tothe sentiment issue we discussed earlier. Getting out of stocks today is very likely to mean selling nearer to thebottom rather than the top (give or take a few years). Like- wise, buying bonds today, after a thirty-year bull market is very likely to mean buying nearer the top than the bot-tom (give or take a few years).Turning to the bond market, its recent performancesuggests the Potyks are not alone in their sentiments asinvestors have increasingly come to favor the long bondover more volatile investments like stocks. The yield onthe 10-year Treasury is now below 3%. In stark contrast,fully half of the stocks that make up the blue-chip Dow Jones Industrial Average pay a dividend yield that ishigher than the 10-year Treasury note.This means that investors would rather be locked into aguaranteed 2.95% return (the current yield on the longbond) over the next ten years than own a portfolio con-sisting of Verizon, AT&T, Pfizer, Dupont, Kraft, Merck,Chevron, Johnson & Johnson, Coca-Cola, Home Depot,

McDonald‟s, Proctor & Gamble, Intel, General Electric

and ExxonMobil that yields over 4%, or about 40% morein income!Only during a devastating deflationary collapse wouldthis bond investment outperform this hypothetical port-folio of equities (more evidence that the deflation trade is

THE

ELDER

EPORT

Jesse Felder, Editor Erin Felder, Copy Editor The Felder Report

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