WOULD YOU BUY THIS COMPANY?

There was once a company that needed some money to fund its operations. It had a core business that was plagued by pricing problems and management was simply trying to get financing in place to ensure that they could pay employees and meet obligations while the market sorted its problems out.

As you might guess, the company met resistance among its bankers and lenders as they were hesitant to lend money to a struggling business. As the bankers examined the books of the company they found that the company had some merit - there was tons of potential, great technology, an eager and talented workforce, and lots of capacity to grow. On the other hand, the financial evaluators found that the company had a habit of spending more than it made and over promising some employees benefits and perks.

As the sales of the product declined and prices fell due to poor demand, the company hardly changed any of its spending habits, in fact it actually increased spending to provide extra benefits for its workers.

Because the firm was a very large corporation, they often issued their own debt in the form of bonds. During the financial trouble, the firm's CFO and CEO noticed that the bonds that they sent to the market were often met with lackluster demand and therefore prices were low and (interest rates were high). The greater interest rates meant that the troubled firm needed to pay more every six months in interest costs for borrowing. The growing costs alarmed the CFO and CEO and they hatched a plan. As they sent new bonds to market, they would actually use other accounts and buy their own debt! In this fashion, they would actually bid for their own bonds and bid with lower interest rates to put a cap on the growing interest cost. For a while, the strategy worked great. By artificially buying the debt other buyers felt more confident about them and were willing to participate in the offerings. Soon though, the market participants began to question how wise it was to purchase the debt of a troubled firm at interest rates that were below the true cost of a similar risk. Once these participants realized this, they stopped buying altogether and suddenly the company had to buy almost all of the debt they were issuing. They essentially gained little additional money to fund operations because they were paying themselves. Incoming money was used to pay the old bonds.



SOUNDS LIKE A GREAT INVESTMENT RIGHT?

If you were a banker, would you lend money to this company? Would you feel comfortable buying the firm's bonds for 30 years at 4.5%? What if you knew that the company was not planning on reducing spending at all, in fact had plans to increase spending? What if the company had financial assumptions that projected that interest rates on their bonds would actually be the same rather than increasing over time?

If you answered no, you wouldn't lend money, I'm in total agreement. While I'm made a very simple example, you might have guessed that the imaginary company is actually our US government.

WHAT IS THE PRODUCT?
In my example I mentioned that the firm had one product. If you recall, Ben Bernanke and Hank Paulson told us that housing was so important to our economy that it had to be stabilized and bailed out. We had all sorts of failed efforts to save the housing markets, measures that included mortgage modifications, incentives to purchase houses, and even actions that allowed banks to delay writing off foreclosures without indicating their true value on their financial statements.

These steps may have had some stimulative effects in the very short run with a boost in sales in November, but ultimately we will see that intervention won't help as lenders and the government have realized that they must actually take lending standards to the level where only qualified buyers should be able to obtain financing. As standards are improved, fewer buyers will qualify and excesses in the quantity of homes available will then drive prices lower. In addition, foreclosures WILL be released from the inventory on banks balance sheets and this new supply will only add to this problem.

Remember, housing is the key to the reversal in fortunes for the consumer. Of course I don't believe this is the only product in the US, but our government knows that consumers have used our homes as an atm machine previously and the home truly was the only store of wealth for many. Without a reflation of the housing market, the US consumer has little ability to carry on under the past mega consumption binge that they used to. 70% of the US economy is based on what the consumer spends, not what we manufacture. If in fact there is a material shift downward in the consumer's level of spending, how might it impact growth in the US? Is it any wonder that our government wants the consumer right back where he was spending without regard for saving and assuming that home prices will levitate without end?



WHAT ABOUT THIS BOND MANIPULATION, DID THAT HAPPEN?

Of course it happened and is still happening. The Federal Reserve calls their manipulation "Quantitative Easing", just like the corporate example, the Fed is buying their own debt because they want to control the interest rates and thus are paying more than the market prices to keep interest rates low. Despite their best efforts we will see that interest rates will rise and this will hurt the US in several ways.



First, we will have to pay higher interest costs on all new debt. America is issuing huge amounts of debt because we are spending much more than we are making in the form of tax revenues. The impact of greater rates will be devastating.



Second, because market participants are smart they have stopped buying massive amounts of US debt in long term maturities, in other words they have anticipated that interest rates are going to go up and rising interest rates hurt long term bonds the most. To avoid these losses investors have shortened their purchases and are buying shorter term bonds, leaving the longer term purchases to the US Fed. Summing up, we (the Fed) has been buying all of its own bonds -- the very bonds that will decline in value the most as rates rise.



CAN THEY REALLY STOP?

Like all ponzi schemes and lies, we will see that the Fed's version will be difficult to stop now that it has been set in motion. The Fed has stated that they will attempt to extract themselves from Q.E at the end of March. This approach to removing the drugs from the junkie will come in several phases. First, the Fed states that they are going to stop purchasing treasuries. Second, they are stating that they will stop purchases of MBS or mortgage backed securities. They are the securitized mortgages that are the massive pooled mortgages of agencies like Fannie Mae and Freddie Mac. The Fed has been purchasing these agency pools in an attempt to keep mortgages rates low. The Fed's handiwork here is not small, in fact they now are approximately 80% of the securitized mortgage market. Do you think there might be a reaction in the market when the biggest buyer decides to stop spending? In addition, the Fed says that they are also going to increase the costs of borrowing overnight to banks. So, the $1.5 trillion dollar question is can the addict just quit cold turkey? The answer is no! We have a front row seat to see the impact on interest rates in treasuries and mortgages. I suggest that we all pay very close attention in the first couple of days in April and we'll need to watch interest rates to see how much they go up.



Many of you will say - yes, yes, we know all of this! I know, but frankly this is a summary of a conversation I had with a few friends over coffee. It is stunning to really document how brutal our country's leadership has been and how if it were a business we wouldn't just decline to purchase the stock, we would absolutely be shorting the heck out of it! The scary thing about our story here is that it really is happening! And the message we need to gather from this very simply example is that we need to construct an investment strategy that truly examines how risky US assets are and what the long term implications are for the US dollar.

TRADING STRATEGY
Given what we know of the situation above and the recent market correction, I believe that this sets us up perfectly for what we've mentioned quite often. We are looking for a move higher here, even to new highs of around 1175 on S&P500 and 11,000 on the Dow. This will extend the range we've discussed for 6 months. I believe this move will occur over the next 6 to 8 weeks, taking us through March and into mid-late April. At that point we will need to have exited trades according to my view that we'll begin to see a significant drop in late April and early May that will be as severe as anything we saw in 2008 and early 2009. Remember, identifying areas in a market range is tough, in fact I have noticed that my experience in trading has gotten better as I sell as we near the upper ranges I've identified - essentially paring my position as it moves up. In the same manner, I buy as I near the target lower range. I almost never reach the bottom range of a target so if I didn't have this discipline I would often never get the chance to enter a position.

One trading update - KSU neared $33.50 earlier yesterday and could have been a good exit at a 10% gain for less than a week. I do believe it will achieve that $33.50 - $34.00 range again and I would use that an an opportunity to sale 100% of the position or at least 75% of it. There is no reason to get greedy when I believe you'll have another chance to play that same range again. I like the company and I like the fundamentals, but you must stick to the levels we identified at entries and exits and be disciplined. You can move your stop up to $31.50 to ensure that you make a solid profit to protect your downside as well.

Continue to watch the fear index. As the market rallies, we will be watching this to come down significantly. If we see it in the 15 or 16 level this will be a signal to start selling long positions and perhaps even pick up VXX again. This would fit well if we get to those highs I talked about earlier.

I will post an update on a few more ideas I've identified, but want to make sure we have confirmation of this move before laying it out.

Beware as well, my friend Guy Lerner has posted an update on www.thetechnicaltake.com that suggests that folks were bearish as the market bottomed and now that the market has reversed, they are suddenly bullish again since the market has recovered a bit. I mention this because we all know that when everyone believes something, it is best to start betting against them. I like to add this piece of information because every trade can and sometimes does go wrong, you need to be prepared if it does.

Goatmug