Friday, March 30, 2007

A Colossal Mistake

My goal is to post one comment per day. However, today's trade sanctions against China cannot go without a response.

Let me join those condemning today's reckless act of political expediency.

Whatever the US government thinks will be the benefits of its actions are far outweighed by the downside consequences of this regrettable step toward protectionism. Clearly, this is precisely one of the key risk factors that has been noted in prior comments made here and elsewhere.

Investment Strategy Implications

The initial knee jerk reaction by the equity markets was the correct one - down in a heartbeat. With next week being a shortened trading week and the start of an uncertain earnings season, the odds of the equity markets making a new low have increased significantly.

Today's political decision and others to follow in the form of protectionistic legislation have added to the already high degree of uncertainty that far too many investors so sanguinely dismiss. However, if, for liquidity reasons and the noted "Misalignment Triangle", investors choose to ignore this real economy disaster in the making, then I believe they will join the politicians in making a truly colossal mistake.

Try to have a good weekend. Going forward, it may not be pretty.

Weekend Reading: McVey’s “Misalignment Triangle”

In a very insightful analysis, Morgan Stanley’s Chief Investment Strategist, Henry McVey, has connected the dots between private equity’s low hurdle rates versus corporate America’s high hurdle rates and the big long-only mutual fund managers’ need for performance.

Henry sees “a perverse set of incentives…afflicting the capital markets”. He goes on as follows:

“...(the) lack of corporate oversight at the company level as well as portfolio managers’ mandates to beat their benchmarks, not necessarily maximize value, is allowing private equity firms to ‘steal’ trophy properties at less than fair value.”

“…CFOs still believe that the risk premium associated with their businesses is around 9.0%.” “…our work shows that the equity risk premium on the S&P 500 is currently around 3.75%.”

“The problem, or the disconnect, lies in the misalignment of incentives throughout the system, and in three areas in particular. Whereas private equity firms are paid to use leverage to recoup cash flow as soon as possible, corporate executives are ‘safest’ in a post-Sarbanes-Oxley environment if they run their businesses with high cash balances and lower-than-average risk profiles. The final piece of the Misalignment Triangle centers on the big long-only, buy-side shops, many of whom are willing to sell shares at less than fair value because the ‘pop’ from the deal announcement is more than enough to help them beat their near-term benchmarks.”

Investment Strategy Implications

While many investors tend to get tangled up in their underwear over cyclical issues, I try to identify the more significant thematic issues that cross boundaries and have larger secular impacts on the markets. McVey’s “Misalignment Triangle” joins Rich Bernstein’s correlation analysis as thematic perspectives well worth your time exploring and understanding.

Have a good weekend.

Quotes are from Morgan Stanley Strategy and Economics, “Revisiting the Misalignment Triangle”, March 16, 2007.

Thursday, March 29, 2007

“…no one knows which war the Fed is fighting.*”

Chairman Bernanke's performance yesterday may have earned him a passing grade but it was no A+ in my book.

First, kudos to the staffer for Republican congressman Jim Saxton for asking what I thought were the best questions. Probing into hedge funds, liquidity, leverage, and the economy, Bernanke’s replies were very telling.

On the downside of the Chairman’s testimony were his replies to the issue of hedge funds. In my opinion, Mr. Bernanke was way off the mark re the risks they pose. Moreover, he failed to acknowledge the interconnected nature of money. Is it realistic to believe that financial capital has no role in the real economy? Is it realistic to assume that the risks of liquidity and leverage are contained to the sub prime mortgage market only? Time will tell if his sanguine response is correct.

The upside to the Bernanke’s testimony was the Fed’s balanced approach to the risks of slow growth and inflation. Here he is right on the mark. Investors may clamor for lower short-term rates. However, excess liquidity and leverage, globalization, strong global economic growth, a weak US dollar, and rising US domestic inflation argue against cutting rates at this time.

Investment Strategy Implications

The sub prime mortgage fiasco has made clear to the Fed that unchecked liquidity and leverage has consequences. The balanced concerns of the Fed reflect the incredibly complex globalized world we live in. The narrow, self interests of some investors may support higher equity prices. But the larger, macro strategy concerns remain with the complex web of unintended consequences.

And now on to 1Q07 earnings results.

* London School of Economics professor William Buiter in his reply to Larry Summers’ Financial Times commentary “As America Falters, Policymakers Must Look Ahead”.

Wednesday, March 28, 2007

Faith in the Fed

It is remarkable just how strong faith in the Fed is. The belief that the Fed will work its magic under all economic circumstances is so ingrained in investors that it borders on the mythical. This is a mistake.

This is not to say that central bankers haven’t become more proficient in managing the world’s capital resources. They have. However, the fact that all economies function within the framework of a global economy raises the stakes considerably. And makes managing such an entity that much more difficult. Consider the issue of coordination.

When one considers the fact that there is not a world central banker, coordination between domestically oriented (and politically influenced) central banks cannot falter. Yet, central bankers are near autonomous entities*. They are subjected to the political dynamics of their respective countries. Moreover, there are diverse interests and needs within each economy that influence domestic monetary policy. Lastly, their individual missions are not exactly identical to each other. For example, the Fed’s dual mission of growth and stability is not the mandate of most central bankers. And all this doesn’t take into account the core of their capabilities – monetary policy.

There is a danger in a near blind faith in their powers. Forgotten is the fact that central bankers are limited in the tools at their disposal. The Keynesian levers of demand management have been replaced by a strong belief in market fundamentalism, globalization, and the capital management skills of the world’s central bankers. How long this trio can maintain global growth and stability remains to be seen.

Investment Strategy Implications

It is worth remembering that there was a time when economic downturns, absent fiscal deficit spending policies, revealed a key weakness in a central banker’s monetary powers. It was during the first globalization and it was called “pushing on a string”.

Faith in the Fed may be high among market participants. But it should not be a blind faith.

We know that the market hates negative surprises. With faith and expectations in the Fed so high (and risk premiums still so low), just how strong should faith in the Fed be?

A little something to think about as Bernanke speaks today.

*I say near autonomous as the power of persuasion from the Fed to other central bankers is considerable (Bank of Japan, for example), although not absolute. Nor permanent.

Tuesday, March 27, 2007

Technical Tuesdays: Failing Rallies

For the most part, I find chart patterns interesting but often have a low predictive value. There is, however, considerable contextual value to them.

The current pattern for most stocks and indices are such a case as they strongly suggest one of the infrequent but useful patterns - the failing rally.

The sequence goes like this: Market makes a new high; market experiences a correction phase but does not complete that correction phase (neither in time nor in depth); market rallies back toward the highs but falls short. (Market then goes back down to (or below) the correction lows.)

Using SPY as our market proxy, the chart on the left shows that we may be experiencing just such a pattern.

Investment Strategy Implications

Failing rallies are born out of unresolved market corrections. Failing rallies have two characteristics: they come off weak bottoms and they are accompanied by weak breadth and strength. The first part of that equation is true, the second is not (at least not completely).

However, on this second point, I think it is fair to argue that we are in changed times (see yesterday's entry below). And that liquidity and leverage in the hands of the numerous new players in the game (hedge funds, in particular) have distorted many traditional analytical tools as correlations and momentum have gone to extremes. In other words, synchronicity is the current market order.

If last week was a failing rally (and I would put the odds on it), then the second down wave is the likely next move.

Monday, March 26, 2007

The Times They Have a-Changed

Change, the one constant in life, has impacted the investing world in ways that many may not fully appreciate.

The primary source of change today is Globalization.

Globalization, in its full manifestation, reflects the free flow of goods, services, and capital. When coupled with the emerging dominant economic ideology - market fundamentalism - a world of change is the dynamic, the effects of which are yet to be truly understood.

Innovation, technological and financial, is the other element in the change equation. Technological innovation is the great enabler of Globalization. And financial innovation plays a vital role in capital – sources and flows.

An expression of change that should be of great interest to investors is the players now inhabiting the markets.

Hedge funds, private equity, and millisecond traders have moved in alongside the more traditionally oriented investors. Yet, the goals and interests of the relatively new kids on the block, not to mention their diverse valuation methodologies, must be a part of the investment decision-making equation for the larger, more traditional investor types. If not, for anything else than to exploit opportunities as they are presented.

When markets are moved by such players, relying on traditional analytical approaches is insufficient for today’s dynamic global markets. This is not to say that traditional valuation approaches do not play an important role. They do. But to ignore the new players, with their trillions of dollars at work, is to deny the change and its impact on markets.

Investment Strategy Implications

The danger for investors is in not appreciating that we are living in changed times. And not just from a geo political perspective. Market participants with trillions of very active dollars cannot help but alter the investment landscape. Investors who fail to add this to their valuation tools do so at their own investment peril. Conversely, those that do appreciate the change that has taken place will find themselves in an enhanced competitive advantage.

Friday, March 23, 2007

Market Forecast notes from the field: Austin, TX

Follow the money. Expect the unexpected.

Last evening, I had the privilege of moderating my ninth and final early 2007 Market Forecast event. And the comments and conclusions from my panel – Bartels, Roth, Freeman, and Bovino – reflected many of the same sentiments heard in the previous eight events – and a few new ones. Here are some quick notes from last night’s event:

• Volatility is here to stay (Bartels)
• It’s an aging bull and is showing it (Roth)
• We have entered a new leg of the bull (Bartels)
• US growth will slow but pick up in 2H07 (Bovino)
• Long-term Bonds are the most overpriced asset class (Freeman and Roth)
• Forget Large cap, the Smids remain the place to be (Bartels and Roth)
• Liquidity is abundant and a key driver to the markets (Bartels, Roth, and Freeman)
• Correlated market moves are a problem for alpha production (Freeman and Bartels)

Investment Strategy Implications

Areas of disagreement were heard and many insights were shared. However, the expression “The more things change, the more they remain the same” seems to apply, particularly in the areas of liquidity and unknown risks (credit derivatives, for example). This is to be expected, despite major and minor market moves. But, new and integrated thinking was also part of last night's event. For example:

• Market moves will tend to remain synchronized (and perhaps highly correlated)
• Most of the action by hedge funds is market following
• Hedge fund behavior is a reliable contrary indicator
• Sudden and largely unpredictable sharp market corrections are now the norm.

It will be most interesting to see just how much changes and how much remains the same at my next Market Forecast events in May (MTA) and August (NYSSA).

Note: I will be on CNBC Morning Call on Monday (March 26) around 10 AM. Hope you get a chance to catch the segment.

Have a good weekend.

Thursday, March 22, 2007


To begin, kudos to the Bernanke Fed as it took an important step yesterday in decoupling itself from the Greenspan bubblenomics era by rightfully stressing the need to focus on inflation (and by default excess liquidity). And, in the process, the Fed continues the global central banker strategy of draining liquidity from the system.

However, given the likelihood that earnings growth will decelerate to low single digits, US real GDP growth seems heads to the sub 2% level, and inflationary pressures remain stubbornly sticky, it is remarkable, to say the least, that equity investors would celebrate such a scenario in the context of central bank tightening.

Investment Strategy Implications

If anyone needed proof that the equity markets are liquidity driven, yesterday provided it - in spades.

Maybe my good friend Jason Trennert is right. Maybe we will experience a market melt-up. And perhaps he has it correct to suggest that private equity capital will be a major player in the melt-up.

Yet, if investors acknowledge that this Fed is as data dependent as it says it is, and if one believes that the equity markets are an important source of information, then yesterday’s equity-booyah is unlikely to be ignored by Bernanke and Company. With the economy precariously balanced between the rock of stagflation and the hard place of excess liquidity, yesterday’s loud equity hurrah may be premature.

Wednesday, March 21, 2007

Will Bernanke Decouple From Greenspan?

With more than a year under his belt and his first crisis underway (sub prime), Ben Bernanke has arrived at that moment whereby he can separate from the Maestro and establish his central banker vision. Or he can follow the path of his predecessor, bail out yet another bubble-induced economic sector (housing), continue to flood the world with even more liquidity, and send a signal to the world markets and economies that his Fed supports Greenspan’s bubblenomics. My bet is that we will witness the beginnings of a clear break from such a policy. In this regard, Bernanke does have a precedent – Japan.

When the Bank of Japan recently raised rates, it sent a signal (albeit a modest one) that global liquidity via the carry trade took priority over domestic needs. Bernanke needs to send his own signal that his philosophy is truly his own, that it is different than Greenspan’s, and that the markets cannot rely on the Bernanke-put to rescue reckless economic decision-making. There is, however, a big risk that comes with being his own man. He may precipitate unintended (and unforeseen) consequences by exercising what Harry Paulson calls the “market discipline”.

Investment Strategy Implications

With the S&P 500 parked at the top end of the correction range (1410), the market has erased nearly all of its oversold condition and now stands poised at a key price point.

The FOMC decision today should set in motion the next steps for the market – either breakout of the range (and possibly make a run at a new all-time high) or trade down through it (and probably set a new correction low).

If the Fed makes the right call by not lowering rates, and, most importantly, does not change its language to neutral, the market may be disappointed and head south. While painful in the near term that, in my opinion, would be the right decision. And it would send a clear signal that Bernanke has begun to decouple from Greenspan and bubblenomics.

If, on the other hand (had to slip in an economist phrase), the FOMC does lower rates and/or change the language to something less hawkish, the markets may celebrate and conclude that the liquidity punch bowl is not going anywhere anytime soon.

Either way, today’s decision matters more than most.

Tuesday, March 20, 2007

Technical Tuesdays: Using Technical Analysis for Profit (and Fun)

As a big believer in the additive value of technical analysis (TA), I have found that many (not all) tools of TA have a useful predictive value. One such tool combines momentum, moving averages, and the concept of divergences.

As the chart on the left shows, momentum and MACD plunged in the early phases of the current correction. Now, here’s where the fun begins.

To begin, take a look at last spring’s correction and first focus on momentum (first chart lines beneath price chart) . Big plunge, rally to neutral, followed by a secondary drop. During that second drop, note how the market made a new low BUT momentum did not. Divergence #1.

Now, look at MACD (second chart lines beneath price chart). It, too, plunged, rallied to neutral, then dipped again. Also, not making a new reaction low. BUT, and this is most important, it wasn’t until the moving averages of MACD (the moving averages of the moving averages, if you will) crossed and trended upward that the market began to stabilize, build a base, then make a run to new highs.

Investment Strategy Implications

Thus far, the current correction has followed the above script fairly closely. The argument I have made, from a TA perspective, is that the extent of the damage done by the first wave is followed by a second wave during which divergences hopefully develop (between price and momentum and MACD) which sets the stage for the rally to new highs.

If the current correction does not unfold according to TA Hoyle, then the most dangerous words in the investment language are in effect – “This time is different.”

Monday, March 19, 2007

The 4 C’s (and a D) of a Bull Market Cycle

Confidence, Complacency, Concern, Denial, Capitulation.

History teaches that bull markets go through five distinct phases: Confidence begins to build, invincibility then becomes the norm (Complacency sets in), Concern enters the scene (from time to time, typically when market corrections occur), then comes the Denial phase (as stocks foretell bad times ahead, which some might say creates a self fulfilling prophecy), and, finally, Capitulation - happy days are no longer here to stay (unless you are a perma bear).

Needless to say, these market phases do not have to be sequential. For example, markets may oscillate back and forth between complacency and concern.

So, where are we right now? I would say we are firmly in the complacency phase (with just a tinge of concern).

As I wrote in my blog last Wednesday, complacency about the bull has given way to complacency about the correction. The nice, neat, and tidy 10% correction.

All one has to do is watch and listen to see and hear comment after comment from the vast majority of professional investors and market strategists to hear the calming refrain, “it’s just a correction”. And it isn’t just the words, but the tone that comes across. Sanguine, to the last. Moreover, when you consider that correction analysis is more the stuff of technical analysis, at times it seems that most everyone has become a market technician. Yet, this has more to do than just technical analysis. It has to do with the fundamental driver of the current high levels of complacency – comfort with risk.

Risk measures are easy to find. In addition to investor sentiment surveys, credit spreads are also an excellent example.

While the recent market correction has widened credit spreads a tad, the following chart (see report) provides some sense of just how much further spreads have to widen before some semblance of normal, healthy risk aversion reasserts itself.

In particular, what should concern investors is how narrow the spread between emerging market and high quality debt is. It seems apparent that a belief in the emerging markets story has gotten way ahead of itself, distorting values, and providing even more liquidity to a world awash in capital.

Investment Strategy Implications

Every investor, including those unabashed fundamental types, will admit that investor psychology matters quite a bit. It is, therefore, useful to have some sense as to where we are in a market cycle. Since we are still in a bull market (having yet to form a market top), the likelihood that the current correction is anything more than that is to possess a perception of matters economic and financial that borders on the divine.

Yes, we are in a correction. But the “just a correction” mantra is just a little too complacent a term.

My view is that the correction will likely end as it did in the last correction (last summer) with concern overwhelming complacency. I don’t believe we have reached that point.

If risk spreads were to widen and investor sentiment were more bearish, then concern (and doubt) might dominate investor thinking. Perhaps, 1Q07 earnings disappointments will be the catalyst to take the market to new correction lows. And, that may be all it takes to move investor sentiment from complacency to concern.

Note: To download the complete report, please use the Blue Marble Research services link to the left.

Friday, March 16, 2007

Leveraging Your Knowledge About Leverage

Part of my work is to identify points of view that help illuminate our very complex world. Here are two interesting and insightful excerpts for your consideration.

Rich Bernstein on correlations:
“Since we first wrote on this topic eleven months ago, the correlations between our select asset classes and stocks have changed noticeably. Those searching for noncorrelated assets should focus today on Bonds (both Treasuries and High Grade Corporates), T-Bills, Commodities, Gold and Consumer Staples.

Since the deflation of the Technology bubble, many investors have searched for assets that are “uncorrelated" to the S&P 500. These asset classes, like hedge funds, non-US stocks, and commodities, seemed in 2000 to not only provide significant diversification benefits, but also offered higher returns. The persistent low returns of this decade have caused some investors to use additional leverage to boost returns in these asset classes. The theory was the risks associated with the leverage were immaterial, when compared to the significant risk-reduction benefits of investing in "uncorrelated" assets.

Whereas that theory was true seven years ago, our analysis continues to show that 2000’s non-correlated asset classes are now often highly correlated to the S&P 500, and their diversification benefits now seem to be greatly reduced, if not completely eliminated. Investors should realize that higher returns again now simply require taking more risk as many opportunities have been bid away.”

Harry Markowitz on leverage:
“The unlevered investor cannot go any further than point (0,0), at which his return is maximized. If an unlevered investor tries to compete with a levered investor for returns, he can only access higher yielding, risky securities. As a consequence, the presence of leverage for some investors drives down the risk premium for ALL securities, including the riskiest securities with worse risk-reward profiles.”

Have a good weekend.

Thursday, March 15, 2007

Why The Fed Won’t Lower Rates Just Yet

The chant for the Fed to lower rates is far more complicated than many investors either appreciate or are willing to admit. Today’s contribution to a stagflationary outlook for the US (PPI data) is one dynamic. It may not be the 1970’s, but slowing growth plus above acceptable levels of inflation = stagflation.

A second component is the conundrum that any one central bank has to deal with in a globalized economy. As noted in previous weekly reports, Martin Wolf has highlighted this issue quite clearly in his brilliant January 30th, 2007 commentary, “A divided world of economic success and political turmoil”. Another way to see this nation-state versus globalization issue is to consider the Bank of Japan and its recent rate decision.

Does the BOJ emphasize its national needs and help its domestic economy by keeping rates unchanged? Or does it acknowledge the global implications of the Yen carry trade and raise rates? The recent decision by the BOJ was to opt for the later. Future decisions will be most informative. I think you see the dilemma a domestic central banker has. Domestic needs versus global considerations.

A third piece of the equation deals with excess liquidity and unregulated money. I think Mohamed El-Erian, President and CEO, Harvard Management Company, said it quite well in his current interview with the Financial Times:

“I think that if this were normal conditions, the Fed would be looking to cut rates. The economy is slowing. The housing market is under pressure. The corporate sector is not spending. However I think that policy makers are increasingly aware of the source of endogenous liquidity, the liquidity that the market itself creates. Private equity is a perfect example, where a dollar that comes out of the public market, becomes $4 or $5 when it goes back in, through the private equity mechanism. So, I think that policy makers will wait for unambiguous evidence that the economy is slowing, before they move, lest they contribute to excess liquidity.”

Note: There is a related dimension to the Fed that I will touch on in a future commentary – the strong faith of many investors in the Fed’s ability to come to the rescue in times of crisis.

Investment Strategy Implications

Wait and see will be the operative policy for the Fed. Which, by the way, should be accompanied by higher long-term rates.

Wednesday, March 14, 2007

The 10% Solution?

Bullish complacency has given way to …correction complacency! Specifically, the 10% variety.

The more I hear expert after expert recite the 10% correction mantra, the more I get the sense that a 10% correction is the last thing we will experience.

The problem I have is with the single point number: 10%.

Since when did a single point number like 10% take on such mythological certainty? It’s just a number, picked out of the air. And, as with key price points (1,000, 10,000, etc.), it has no value beyond the psychological. 10% says nothing about valuation. Nor, in fact, is it in keeping with the discipline of fundamental analysis*.

Perhaps it is the tidiness of a nice round number like 10% that appeals to so many. I could understand that. Nice, neat, tidy. Gives one a sense that all is under control. The world is predictable. Time to be complacent, again!

Unfortunately, the problem with this thinking is that investing is a social science. And, like that other social science called life, things have a way being messy. Sometimes very messy.

Investment Strategy Implications

If this year has taught us anything it’s that when the crowd believes in something so strongly, the odds are against it happening. In the case of the 10% solution: Nice and tidy meets the reality of human nature.

My impression is that that the market will get nowhere near 10%. That it will either stop right around current levels (200 day moving average, modest improvement in MACD). Or, the markets will drive well below that 10% number (second down wave), and, in the process, scare the bejesus out of everyone. Given the technical damage thus far plus unrepentant complacency (from bullish to correction), my bet is on the later.

*Note: This second point is particularly disturbing as making price point calls is the domain of technical analysis and outside the bounds of fundamental analysis – the discipline of the majority of analysts and strategists. Additionally, it has a market timing feel to it, something that numerous studies have made clear just doesn't work. Finally, it is made all the worse by being so precise on the magnitude of the correction - 10%.)

Tuesday, March 13, 2007

The Artistic Investor

“It is not a case of choosing those [faces] which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.”

John Maynard Keynes, General Theory of Employment Interest and Money, 1936

A key, yet underappreciated, aspect of equity markets is the mind games played by its participants. It is not what I believe that matters but what others believe that matters.

Investment Strategy Implications

Valuation is 2 parts science, 1 part art. The Keynesian beauty contest quoted above captures that artistic essence.

Monday, March 12, 2007

1Q07 Earnings Outlook and Implications

Since last summer, there has been a sharp deterioration in earnings expectations for every economic sector for 1Q07 and the full year. Granted, analyst earnings expectations tend adjust downward as optimism fades and reality kicks in. Nevertheless, the downward adjustment, as noted on the following tables (page 2 of this report - see left side "services" link), is a rather large one, particularly considering the fact that all of the decline has taken place while stocks were making new highs.

If one steps back and recalls the logic behind the rally - soft landing mission accomplished, recovery mode in gear -, then the slide to low single digit land for 1Q07 and mid single digits for 2007 (and who is to say that number won’t be adjusted downward?) should suggest that all is not well in marketville.

Then there is the issue of correlations.

The right hand column of Table 1 (see report) is from Rich Bernstein at Merrill. And what it shows is rather striking. In just under one year, the homogenization of market performance is very apparent. Correlations of eight out of ten sectors show a rise, in many cases a very sharp rise. This data helps explain the synchronization of sectors that the markets experienced over the past 9 months. Specifically, in 2006 and now into 2007, sectors have risen, fallen, rose again, then fallen again, in near unanimity. What this suggests to me is that hedge funds, and increasingly mutual funds, are under greater and greater pressure to perform – even in the very short term.

Moreover, when one considers the explosion of hedge funds (in number and dollars under management), an investor has to wonder just how many great ideas and great 20 year-old fund managers are out there? It is, therefore, logical to conclude that my oft-stated comment re the pressure to perform is compelling the more short-term oriented players in this group to chase every twist and turn and dive into and out of sectors, industries, styles, and countries en mass.

Investment Strategy Implications

In the coming weeks, the market stage will be a shared one. Macro factors, such as sub prime loans (and the not fully appreciated link to credit default derivatives), will share the stage with earnings season. And tomorrow’s Goldman Sachs report will likely set the early tone.

With a 6.8% slide in 1Q07 S&P 500 earnings from last August to the present, I suspect the surprise may be to the downside. And that fact could easily be the major catalyst for the second wave of the correction, as both bring into question the bull case.

Friday, March 9, 2007


Now that the jobs report has joined the Bernanke testimony and FOMC January minutes release in yesterday’s news bin, 1Q07 earnings should slowly start to take center stage. The pre-announcement period (a/k/a the confession season) will kick in shortly and, based on my analysis (sector specific), I believe the risk is to the downside.

As the quarter has progressed, many research analysts have been ratcheting down their ever overly-optimistic earnings forecasts.

It is fairly well expected that 1Q07 will break the 14 consecutive quarters of double-digit earnings growth. And the full year should remain in the single digit range.

Many investors are, however, banking on a second half recovery as support for the bullish case. Hard to say. Given the dynamic nature of global economy and the markets, 2H07 seems a long time away.

Investment Strategy Implications

Caution remains the order of the day. Today’s jobs data was neither fish nor fowl. And its impact on equities was muted, at best.

The focus in the days ahead should be on the state of the economy and the Greenspan-inspired debate over a hard versus soft landing. 1Q07 earnings results will factor into this mix and help shed light on the strength of the economy. My bet is more toward a disappointing quarter, which in concert with other aforementioned items should act as a catalyst for the second down wave to the correction.

Have a good weekend.

Thursday, March 8, 2007

Heaven Can Wait

Probabilities and outcomes.

The probabilities are (overwhelming so, I might add) that a second wave to the correction that began last week is most likely. That doesn’t mean there is a 100% certainty that it will occur. However, the odds are clearly strongly in that direction.

Now, it isn’t just history that suggests a second wave is likely. Nor is it the added real world factors that I noted in yesterday entry below (1Q07 earnings, for example). There is also the issue of reliable market metrics, such as momentum and MACD, that strongly imply that powerful downdrafts, such as we had last week, are not the stuff of V-shaped immediate reversals. (Note: I will illustrate this point in next Monday’s weekly report.)

Investment Strategy Implications

In the movie, “Heaven Can Wait”, the novice angel pulls the football jock out before the accident, an accident that the jock’s superior reflexes would have helped him avoid. The angel, therefore, violated a cardinal rule: you assess the probabilities and wait for the outcome. Acting prematurely was his mistake.

Unfortunately, for us mere mortals we are compelled to act. Even the act not acting is still a form of acting.

The probabilities of a second wave are strong. The outcome remains to be experienced.

Wednesday, March 7, 2007

Double Dipping

As impressive as yesterday’s rally was, there are two factors that continue to argue for a two-wave correction to take place – history and upcoming events.

To understand the history part of the two-wave argument all one has to do is look back over every prior correction (even the milk-toast variety investors have become accustomed to in this bull market) and the pattern of decline, rally, and test (often making a token new low) is quite evident. The question then becomes, “why would this time be different?”

As for the upcoming events portion of the two-wave (which can serve as either a catalyst or justification), there are several items to be sensitive to.

First, I suspect that 1Q07 earnings season will contain far too many downside surprises for those who have become accustomed to the regularity of double-digit gains. Negative surprises are always unwelcome. And downward pre-announcements also fall into this category.

Second, the unwinding of the carry trade and the lingering effects of a bursting housing bubble (with all its accompanying issues such as the still to be worked off inventories, lower prices, and sub-prime loan problems, to name a few) should still fill the media and occupy the minds of many investors.

Lastly, an anticipated spring offensive by the Taliban in Afghanistan will likely bring bad headline news reminding everyone of a job that is far from complete.

Investment Strategy Implications

The damage done by the market plunge this past week always takes time to repair. That is unless you are willing to cite the four most dangerous words in the investment language, “This time is different”.

Tuesday, March 6, 2007

The Return of Stagflation

When the topic of a potential return of stagflation was raised by me in previous media appearances and during my Market Forecast events, you would have thought that I was speaking heresy. Yet, today’s revised productivity and unit labor cost data may help change some minds.

As noted in yesterdays’ commentary, the combination of slowing profit growth and rising inflationary expectations (if not outright pressures) may be the catalyst for the second down wave in stocks next month.

Monday, March 5, 2007

I'd Rather Be Right Than Consistent

During my latest appearance on Kudlow & Company last week, I briefly described how the market correction should produce a two-wave down cycle. Allow me to elaborate.

Throughout this bull market, there have been five advances of 10% or more. After each advance, a modest 5% or so market correction ensued. The common characteristic for each correction has been the number of down waves each took to complete the correction.

Of the five corrections thus far (not including the current one, which would be number six), four had two down waves of selling and one had three down waves (early 2004).

The amount of time for each correction ranged from as short as 4 weeks (last spring, if you don’t count a third wave, which came close but did not make a new low) and as long as 4 months (the three wave of 2004).

Presently, we are in the first wave, which should culminate with a rise in bearish sentiment and volatility. If I had to pick a price point, the 200-day moving average looks as good as any. That means for the S&P 500 the 1350 level. Time frame? I would suspect sooner rather than later, perhaps within a week or two. If the first wave plays out as outlined (from my lips to God’s ears), that should generate a sufficiently oversold market, which should then enable the market to stabilize and likely oscillate around that moving average or bounce off it (not unlike the first down wave last May).

Given the technical damage done, the highly volatile emerging markets, a Chinese government intent on cooling an overheated domestic stock market (and, thereby, decreasing the odds of a meltdown in next year’s all-important Olympics), the Bank of Japan’s deference to cool global liquidity (by taking the froth off the carry trade) over their domestic needs (a fragile Japanese recovery), and emerging concerns over 1Q07 earnings, stocks face many headwinds in the immediate days ahead.

The odds of a second wave to the correction look favorable. The negatives noted above will likely be joined by a new set of concerns centered on 1Q07 earnings and more bad news from the Middle East.

Next month earnings season kicks off and single digit gains are projected. A single digit earnings gain for 1Q07 will break the multi year string of consecutive double-digit earnings growth. Talk of a slowing economy should fill the media. Inflation, however, will likely not slow. And the two will likely produce some commentary regarding (are you ready) stagflation! Now add to this mix the anticipated spring offensive by the Taliban in Afghanistan and the likelihood for the second wave looks promising. I say promising because that should resolve the correction.

The issue of a price point for the second wave is much more difficult (not that picking any price point over the very near term is anything more than a fool’s errand). However, if the US equity markets are to incur its long anticipated 10% correction (thereby breaking that multi year string of no 10% corrections), then a price point would be in the low 1300’s for the S&P 500.

Investment Strategy Implications

History teaches us that the technical damage done last week takes time to repair. Given the dismissive comments of many commentators and strategists expressing their “it’s just a correction” point of view suggests, however, that it will take more than a garden variety 5% haircut to shake their confidence.

On Kudlow last week, Larry asked me what one single issue stands out re why I believe in my cautious view on stocks. My reply was complacency.

Complacency is a very broad area, one that I will elaborate on in future reports. However, being complacent sounds a lot like being consistent. And the alleged quote of Winston Churchill, “I’d rather be right than consistent”, expresses my sentiments.

Thursday, March 1, 2007


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