Sunday, August 2, 2009

Weekend Musings

I got back from a much needed weekend of sleeping, reading, and thinking. I have been going for over a month straight and needed the catch up time. Of course, I spent alot of time thinking about the markets (I don't really know how to do anything else). I have said on this blog a couple of times that I believe the market will top in the next 60 days (by the end of September). If that is even right, that sounds like a much bigger statement than it actually is. Sixty days is a long time when the markets have been moving like they have been of late. 1200 on the S&P is basically only 20% away. We have covered that more than twice in the last few months. Incredible, right? So if I am right (that is a big if), there is a whole lot left open that impacts portfolio decisions. Shorting at 987 if the market was to have blow off top that propelled it to 1200 would be deadly.

This 60 day top is different than other "corrections" I have talked about and tried to navigate for the last several months. I have for months thought the inevitable top would be in August or September because of what I discussed below. I was looking for a correction in May into June which I never got (the market decline 9% at its greatest point) and because I never got it, it was painful. But that doesn't change my thoughts for the final top, similar to October of 2007.

So why do I think the market tops in the next sixty days? First, I am not a big believer in the market's discount ability. CNBC and others love to talk about how the market is way ahead of the actual economy. This is only partially true and I think way overblown. The market topped at basically the start of the recession in October of 2007. Great job leading there and the market bottomed after the true economic bottom which was December of 2008 (the greatest percentage decline in growth worldwide was occurring in December). I could give many more examples. I think economically we have just passed the top or will shortly (the difference is very important and makes a difference I think on if the market goes to 1200).

Below is a graph from Bridgewater (yes I am probably not supposed to have it)

This shows the net impact of the government stimulus spending on the economy. I saw this graph back in February. We are now on the otherside of where the government spending has the greatest impact on the economy. You need to be careful in reading this graph. It is the margin change. At first blush it looks like the government spending is declining because we are on the right side of the hump. No, it is the rate of change. So if the economy is $10 back in April the government was adding $.60 even as they private sector was pulling back say $.80 (you saw this in the last week's GDP report). Now the government is adding say only 2% above what it was adding but it is on top of the $.60 already added so spending is $.612. Well soon, that changes. The hope when all this was put back together 6 to 9 months ago is that this government surge (think Iraq surge) would shock the economy enough for the private sector to take off on its own and run. This shock and awe was only supposed to be in place for a short time. Later this year into next year the actual money being added starts taking away from GDP growth. Once again that doesn't mean the government stops spending, simply that it was just less to prior months, a net drag to GDP. This is of course assuming no additional stimulus packages which if the market does top and starts to head down in any meaningful way, the government is sure to start spending again.

We have been getting less bad for months. The proverbial "green shoots." I would not be surprised if July was actually positive. If that is the case, all these numbers get reported in August. There will be alot of "good" economic numbers that will be reported. The real question in my mind is how August will be. This means alot in the timing of how all this plays out. Is August a little worse than July or is there still enough of an umph that August continues to improve? I really don't think the market will move ahead "predicting" anything. When the economy tops the market will be topping or have just recently topped.

We are at critical levels in the markets. The best scenario for the bears is the market does not break 1000 in the S&P 500, rolls over moving back down to 940 to 960 eating up a week or two and rallies again up to 1,000. Fails again. If that were to occur I believe that would be it. If you break 1,000, and I mean a meanginful break say 1,020, you could have a market surge, blow off top that would send the market screaming (I mean absolutely screaming) higher in a very short amount of time. The reason is there are quite a few bears that would give up the ghost if 1,000 was broken. That isn't guaranteed of course but the probabilities are alot higher than anyone who is short the market would like.

The key is signals, divergences, to be able to adjust the probabilities on which way to market is likely to go. For example, China was down a little over a 1% last week while the U.S. markets were up. To the extent that China starts drifting down, pretty important. China has led in all of this. The dollar got slammed on Friday, down over 1% in a day. That has typically meant big surge in equity markets. Market finished basically flat with the NASDAQ down 29 bps. If the dollar would to start drifting higher and the markets were ignoring it moving up also, I would see this as pretty big. There was failed divergence last week also. Oil got completely pummelled on Wednesday before regaining all of it back and setting new highs for the week.

Other big signals is if the market actually sold off hard on good news. I would take that to mean that was the top of the good news, the market is predicting the next data set to be poor. This is what occurred in March. Like I said, I am expecting July (except for retails sales) numbers to be pretty good. To the extent the market starts selling off on these numbers, that could signal a peak.

Finally, you need to see the sentiment readings to become a little more extreme to the bullish side. This has started to happen but it needs to climb a little more.

Anyway, the net government impact of their huge stimulus game essentially becomes zero and starts going negative soon. That will be the first big test for the economy. Also, as I have mentioned before, I think we have seen the best of the earnings for banks. The closer we get to the year end audit, the fewer games they will be able to play. Housing issues under the surface will also start to cause a big problem.

It is possible of course (though I put a low probability) that the momentum guys are firmly in control and we will rally into the end of the year.

Time always reveals its secrets. The next 60 days promise to be interesting.

Until the market tops, basic corporate analysis seems pretty fruitless. Amazon should probably be trading sub 50. It is released horrible earning numbers, subpar guidance, and stock is firmly in the mid 80s. PALM is 16, probably should be below 8 but continues to chug away on its trend line (thank goodness I avoided that trap). JP Morgan should probably be closer to 30. I could go on and on. Until the market appears to have topped, the normal corporate analysis doesn't have the value it normally has.

No comments: