Shelter from These Storms in the Distance

Money Morning Article of the Week

by Michael E. Lewitt

In South Florida, we call the dog days of summer the “mean season“, as vicious thunderstorms move over the Everglades every afternoon and attack the east coast with lightning strikes and blinding downpours. We keep our fingers crossed that the storms won’t morph hurricanes that can sweep the ocean over the land and cause catastrophic destruction.

After a period of intense hurricane activity in the early 2000s, it’s been ten years since we’ve been hit by any serious storms, and we are being told that strong El Nino conditions will likely protect us again this season. But we know that sooner or later our luck will run out, and we will be back in the eye of dangerous winds and storm surges. And, at least for a moment, we’ll wish we lived somewhere other than in paradise.

Stock market investors are experiencing similar feelings after a six year hiatus from reality, courtesy of the Federal Reserve. Paradise is starting to give way to a very mean season…

The Dow Jones Industrial Average experienced its longest losing streak in four years, falling for seven trading days in a row. The Dow lost 1.79% on the week to close at 17373.38 and has lost 1,000 points since its May 19 high of 18,312.39. The Dow is now down 2.52% on the year. Other indices are holding up better. The S&P 500 lost 1.25% to close at 2077.57 and is now up 0.91% on the year while the Nasdaq Composite Index lost 1.65% to close at 5,043.34 and is up 6.49% year-to-date.

Effervescent Stocks are Losing Air

Two of the stocks that have powered the markets higher started to lose significant altitude for the first time, last week. Apple, Inc. (Nasdaq: AAPL) continued its recent slide to shed another 4.8% to end the week at $115.52, down 12.8% from its May 22 level of $132.54.

The Walt Disney Company (NYSE: DIS) lost 8.9% on the week after reporting that its ESPN unit lost subscribers. This started a sell-off in other media stocks including Time Warner (NYSE: TWX), Viacom (Nasdaq: VIA), and Discovery Communications, Inc. (Nasdaq: DISCA). Media stocks have been hedge fund darlings and added to the pain of those perpetual underperformers, who had already been struggling to produce returns for their investors.

Biotech stocks, which have been in bubble territory for months, also started taking on gas last week but remain egregiously overvalued. The iShares Nasdaq Biotechnology ETF (Nasdaq: IBB) lost 3.5% last week and is now down 7.4%, since July 20. But it is still up about 20% year-to-date. Sooner or later, investors in this sector are going to get their heads handed to them. The smart ones will sell now and avoid that fate.

While the Dow Jones Industrial Average has dropped 1,000 points, the S&P 500 index is still trading near its all-time high. Since the S&P 500 is weighted based on the market capitalization of the stocks in the index, the performance of the largest stocks – such as AAPL, Google, Inc. (Nasdaq: GOOG, GOOGL), Amazon.com, Inc. (Nasdaq: AMZN), etc. – in 2015 have allowed it to remain upright in the wake of considerable deterioration in sectors such as energy, other commodities and now media.

But under the surface, the internals of the index are terrible. Numerous stocks are trading in correction territory (down 10% from their highs) or in bear market territory (down 20% from their highs). But such terminology doesn’t begin to describe what has happened to energy and commodity stocks, many of which are down as much as 80%. It also obscures what is likely to happen to bubble stocks in the social media, Internet and biotech sectors once the spell cast by the current bull(crap) market mentality breaks.

Last week, some of the poster children of overvaluation started to get hit hard including Tesla Motors, Inc. (Nasdaq: TSLA), Twitter, Inc. (NYSE: TWTR) and Groupon, Inc. (Nasdaq: GRPN). My advice to those who are clinging to the illusion that this bubble will last forever is to sell these stocks before you end up having to eat out of garbage cans. The party is coming to an end and it is going to end in tears – not beers.

Currencies will Keep Commodity Prices Down

The broader markets are starting to show the strain of the collapse in the commodity complex. In its August 10 edition, Barron’s published a cover story urging investors to pile into commodities, calling it a contrarian value play.

The problem with this recommendation is that commodity prices are likely to move much lower before they recover based on the fact that most of them trade in dollars, and the dollar is likely to strengthen significantly before the current economic cycle concludes. The Fed is now poised to raise interest rates for the first time in years in September, which is likely to put upward pressure on the U.S. currency. Furthermore, there is no sign that European or Japanese central bankers have any intention of terminating their epic easing moves (despite the fact that their policies are going to fail).

This divergence in central bank policy should also lead to a higher dollar. The Euro weakened slightly last week but is still stuck at close to $1.10 while the Yen ended the week at ¥124.21. Both currencies have considerable room to weaken further with the Euro likely to end up below $1.00 (and likely below $0.90) eventually and the Yen at ¥200 or lower. Such moves would lift the dollar significantly and place enormous pressure on global commodity prices, regardless of how much commodity producers are able to cut production.

Investors heeding Barron’s advice better be prepared to suffer mark-to-market losses for an extended period of time before seeing any gains. The commodity bear market has a long way to run. Currencies are the often overlooked driver of commodity prices. Oil prices continued to tumble last week with WTI Crude closing at $44.31 and Brent Crude hitting $48.

Before the rout is over, I expect both to trade in the $30s, and possibly lower, if the dollar really takes off. Being a contrarian for the sake of being a contrarian can be very expensive. It’s better to look at the facts and understand what’s driving commodity prices.