Bullish Descending Wedge Formation?

Here is an illustration of what may be a potentially "bullish" development in the Dow Jones Industrial Average. The weekly chart shows what I think may be a descending wedge formation. This is occurring at a time when there is absolutely no "good" news being reported about our economy. Selling activity appears to have reached a point of extreme as shown by the Williams %R and MACD indicators, on decreasing negative volume. Everyone and their brother is calling for a breakdown to about the 5000-6000 level. If this pattern confirms and resolves to the upside, we could see the Dow rally back to above the 9000 level (40% retracement).

Does this mean our problems are over? Not necessarily, but from a technical perspective these are signs of which we should take note.

Disclaimer: The above information is not intended as investment advice. For specific investment advice consult your own financial professional.

Should U.S. Follow Suit with British Bank Deal?

Here is an interesting excerpt from the Dow Jones Newswire. The UK has its own idea of how to solve their banking problem:


(Dow Jones) Feb 22, 2009, Royal Bk Scotland,Lloyds Banking In GBP500B UK Gov Deal-Paper

"Royal Bank of Scotland Group PLC (RBS) and Lloyds Banking Group PLC (LYG) have submitted plans to insure almost GBP500 billion of assets as part of the U.K. Treasury's scheme to kick-start lending, the Sunday Telegraph reports.
Prime Minister Gordon Brown and Chancellor Alistair Darling will meet with Treasury advisers later Sunday to hammer out details of the program, which will involve the creation of a new class of non-voting shares to allow the banks to fund their participation, the newspaper reports...

The newspaper cited people close to the discussions saying that it would see a new type of capital instrument devised that includes a dividend entitlement. However, because the new shares would not include voting rights, their issuance would not be dilutive to existing shareholders...

The solution avoids the immediate prospect of outright nationalization for the two banks, which are both likely to be charged billions of pounds for their participation in the Treasury scheme, the newspaper said."

Could this be the answer Wall Street is looking for?

This Is Not Your Grandfather's Depression...Yet

This past week, several pieces of data came on the newswire which show we might not be headed for the Great Depression II. Whether or not you agree, it can be said that the U.S. Consumer plays a significant role in how deeply this recession will affect the global economy. That is why these retail data are so important:

1. Sales at U.S. retailers unexpectedly halted a six-month slide in January.

2. Sales at automobile dealerships and parts stores rose 1.6 percent, the first gain since August, after decreasing 2 percent.

3. Excluding autos, gasoline and building materials, the retail group the government uses to calculate gross domestic product figures for consumer spending, sales rose 1.2 percent in January, following a 1.7 percent decrease in December. Sales also rose for electronics, appliances, clothing and food and beverages.

4. Purchases at non-store retailers, which include online and catalog sales, rose 2.7 percent.

5. The inventory of existing homes for sale in 29 major markets covered by an independent research firm declined an average of 2.5 percent in January 2009, compared to December 2008 and down 13 percent compared to January 2008. For the housing market to recover, less inventory is good.

Maybe this is looking at the glass "half full." But definitely, this is positive news. All this comes as Washington continues to push for a whopper stimulus spending bill which everyone agrees is not perfect and will take years to see the full benefit.

Three Causes of our Current Financial Crisis, and One Helper

Over the next several decades many individuals, business schools, finance institutions, etc. will examine the causes of our recent Financial Crisis. Here is my take on three of its causes and one additional event that created the perfect financial/economic storm:

1. Consecutive Rate Hikes by the Fed. As an effort to quell “alarms” at the Fed to avoid inflation, a successive string of interest rate increases occurred from 2004 through 2008. Combined with our most recent real estate bubble, this forced mortgage holders to pay higher and higher rates as their ARMS adjusted upward. Corporations' cost of borrowing also increased during this period. As you can see Figure 1 illustrates a successive increase of the Federal Funds Rate have been followed by a recession 8 out of 11 times since the 1950s. Pay particular attention to the period from 2004 through 2008. During this period the Federal Reserve increased rates from 1.25% to 5.25%.

Figure 1

According to Moneyweek, Feb 7, 2007, an article on mortgage delinquencies reported that “The rise in delinquencies is unusual because it comes at a time when the economy is relatively strong. Even though job growth remains healthy, ‘the total mortgage delinquency rate is the highest that it's been since the depths of the (2001) recession,’ says Mark Zandi, chief economist at Moody's Economy.com. He attributes the increase in part to the weaker housing market and the widespread use of adjustable-rate mortgages, many of which now are resetting at higher rates.” Strange coincidence this parallels the successive Fed Funds Rate increases during this same period.

2. Repeal of the Glass Steagall Act. This removed the wall put up after the Great Depression to prevent banks from engaging in activities which exposed them to excessive risk. In 1933, in the wake of the 1929 stock market crash and during a nationwide commercial bank failure and the Great Depression, two members of Congress put their names on what is known today as the Glass-Steagall Act (GSA). This act separated investment and commecial banking activities. At the time, "improper banking activity", or what was considered overzealous commercial bank involvement in stock market investment, was deemed the main culprit of the financial crash. According to that reasoning, commercial banks took on too much risk with depositors' money. Consequently, to the delight of many in the banking industry (not everyone, however, was happy), in November of 1999 Congress repealed the GSA with the establishment of the Gramm-Leach-Bliley Act, which eliminated the GSA restrictions against affiliations between commercial and investment banks. Furthermore, the Gramm-Leach-Bliley Act allows banking institutions to provide a broader range of services, including underwriting and other dealing activities. The attached Figure 2 taken from an article by the Contrary Investor dated March 1, 2008 illustrates the explosion of derivatives exposure shortly after this event. When the underlying securities began defaulting, the growth of bank derivative exposure was like adding jet fuel to the fire.

Figure 2



3. Relaxed Policy of Lending by Fannie Mae and Freddie Mac to low income buyers. An article in the New York Times entitled “Fannie Mae Eases Credit To Aid Mortgage Lending,” which appeared September 30, 1999 reported how the quasi-government agency will “encourage those banks to extend home mortgages to individuals whose credit is generally not good enough to qualify for conventional loans.” The article further states that, “In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980's.” As the economy turned down, those marginal buyers could no longer afford their payments.

4. (Helper Cause). Bankruptcy of Lehman Brothers. This allowed a problem which was mainly restricted to the mortgage and banking industry to spread to other parts of our economy. This is according to a quote given by Noel Collins, Senior Investment Consultant at Mercer given September 17, 2008. Mr Collins noted: "The level of broad market disruption is a concern for pension funds currently involved in asset transitions or implementing changes to strategy. However, there also are a number of more specific knock-on issues, which will affect pension funds on a fund-by-fund basis, depending on where they are invested. This includes issues such as Liability Driven Investment portfolios, stock-lending programmes, and operation of Cash funds". Lehman commercial paper was held by most institutions as investment grade paper. This was eliminated overnight. After the bankruptcy was announced, pension funds, corporations, banks, etc. were all brought into the problem. Many of these institutions were holding 401(k)s and other investments for the common US worker, which then took a hit. The resulting further unwinding of derivatives ensued and the stock market plummeted as many investors (institutional and retail) moved to raise cash to cover their positions.

Sources:

1. "The Truth About US Mortgage Default Rates," Moneyweek, Feb 7, 2007
http://www.moneyweek.com/news-and-charts/economics/the-truth-about-us-mortgage-default-rates.aspx

2. Series: FEDFUNDS, Effective Federal Funds Rate; Economic Research Federal Reserve Bank of St. Louis http://research.stlouisfed.org/fred2/series/FEDFUNDS

3. The Far Too Simple Beauty Of The Promises We've Made, Contrary Investor, March 1, 2008 http://www.gold-eagle.com/gold_digest_08/ci030108.html

4. Impact of Lehman Brothers Bankruptcy on Pension Funds, Mercer newsletter, September 17, 2008
http://www.mercer.com/summary.htm?siteLanguage=100&idContent=1322320

5. Fannie Mae Eases Credit To Aid Mortgage Lending, New York Times, September 30, 1999 http://query.nytimes.com/gst/fullpage.html?res=9C0DE7DB153EF933A0575AC0A96F958260

6. What Was The Glass-Steagall Act? Reem Heakal, Investopedia http://www.investopedia.com/articles/03/071603.asp