Dazed and Confused

The last few days I've been taking a step back to try and get a clear perspective on things. I've never had such a lack of conviction about where I think this market is headed as I do now. The conflicting cross currents are making my head spin out of control.  Ok where to begin...let's start off with the viagra induced boner run the market has been on. Is it just a bear market rally or was that the bottom and it's upward and onward from here? I've always believed the best rallies are the ones that don't give you much of a chance to get in without having to chase it and that's the kind of rally this has been. Unfortunatley though, often times bear market rallies look likes these types of moves if the majority of the advance has been done via a gap up and run and that's what happened here. Now, it's actually not uncommon to see the first "real" rally out of a bottom start with a gap up...that happened in March '09, July '09 and Sept '10....but after that intial gap and run day you don't see so many follow up gap and run days like we have been seeing.... that's indicative of a bear market rally behavior as weak shorts (and most shorts are indeed weak) cover one after another toppling each other over like dominos. To make a long story short, I think this is indeed a bear market rally and not the beginning of a new bull run and if a LT bottom was made, some sort of major retracement of it is eventually going to happen.

With active fund managers still very underweight equities (current NAAIM shows they are 0% net long)  there is still room for this market to run higher sentiment wise perhaps after the current ST overbought condition is cleared. If earnings continue to come in good, some sort of positive progress is made in Europe and Greece is given their next tranche of bailout funds, we could very well see fear of losing money turn to fear of being on the sidelines missing the boat. Plus you have positive Nov-May seasonality kicking in soon which would give these underweight managers yet another excuse to say "fuck it, I'm getting back in. I can't miss the boat and miss my chance to make up for losses before year end".  Ultimately, such naive emotional based buying would fall flat on it's face.

But forget about sentiment and the ST. What about LT....the thing I care about the most? Well, the issues in Europe have not been resoloved, ECRI has reconfirmed their recession call and China is slowing. It's quite possibile that we may not feel the impact of these potential storm clouds until q4 or q1 of 2012 and the market could stay afloat or go higher till then. You might say "isn't the market supposed to be forward looking?" To that I say yes but it can appear downright dumb and shortsighted at times. Just take a look at what happened in October of 2007 when even though it was crystal clear that subprime had imploded creating ripple effects in the economy and leading indicators had rolled over, the market rebounded from a sharp sell-off in August of that year to make an ALL TIME HIGH! Why? Because just like now, sentiment had become very negative and bears pressed. Then the fed came in and cuts rates. At the time, subprime had only impacted the financial institutions that were directly exposed and so earnings for the broad market were still good. There was this belief by many that subprime would be "contained"  and with the fed to the rescue,  fear of a collapse turned to fear of missing the rally.

So, if the bear case end up being played out, we may very well have to see "proof" in the form of a material decline in earnings before the market breaks down to a significant new lows because as of right now, the European debt crisis, the China slowdown and other storm clouds appear not to have impacted broad based earnings or guidance of future earnings in a material way. Therefore the market still looks "cheap" on a forward p/e basis especially with ultra low interest rates. Call the market stupid or whatever you want for being so naive but that's the way it can be....deal with it.

So the big question is obviously this. Are we going into a big recession or not? You know I have respect for the ECRI but I also don't like how they are becoming so popular these days....but as I said before...I'll give them the benefit of the doubt. I've been talking about the bear case lately so let's talk about the bull case.

To sum of the bull case from my perspective it would be this...the fears/concerns in the market are either not going to come to pass or will turn out to be a lot less damaging  than feared because the dumbest of the dumb money is quite negative about the economy. I've said here before many times that the dumbest of dumb money is the public and mainstreet media. In my opinion they are displaying massive negativity and despair that matches what you see at major market bottoms. On just that basis, it suggests that the recession either is not coming or will be rather muted and so the market has already discounted it and more. I said myself last week that to believe Europe would be handled well with minimal fallout, China to have a soft landing and ECRI to be wrong would mean you'd have to be wearing rose colored glasses and I stand by what I said. However, the thing that's driving me crazy is that there is such overwhealming negativity from the public and media that to bet alongside with the bears means that the dumbest of dumb money is going to be correct and I just can't fathom that happening because they never are. Let me give you some examples of what I'm seeing out there.

I think it was Wednesday night when by fluke I happened to be watching the Jay Leno show. He was making jokes about how bad the economy is. In fact, after doing some googling I noticed that the other talk show hosts like Conan are doing it too and it's been going on since at least September. In the past this has been an excellent LT contrary indicator. I remember these types of jokes in late 2008 and early 2009. I also remember Jay Leno making jokes about the economy in July of 2002 just days before the bear market bottom. Now, keep in mind, these types of anecdotal contrary indicators take time for them to bear fruit. Take for instance what happened near the July 2002 bottom when Jay Leno made jokes. After a big rebound the low was retested twice, once on October and then finally in March of 2003 before the new bull market began. Same thing in late 2008 when the jokes started coming....the market had not yet completed the bottoming process...the market actually still went down quite a bit more but in all of the above instances if you bought stocks and held for at least a year when the talk show hosts make their economy jokes, you would be laughing.....but for a different reason. It should also be noted that in July 2002, October 2008 and just recently, Warren Buffet had been making significant buys into the market. So you had 3 times in the recent past when dumb money was quite negative while one of the best investors of all time was bullish. So far Buffet is winning 2-0....although it should be noted Buffet had been a bit early.

In addition to the talk show indicator, I also noticed a couple of my friends on facebook who never bought a stock in their life say "looks like a reccession in comming".  My soon to be sister in law who never once talked to me about the market asked me how I have been doing given that the market crashed. When you have people who don't even know what p/e means show any kind of attention toward the market or the economy like this, in my experience this has told me the trend was in the late innings. And it's not just main street folks that are gloomy....even the seasoned trader types appear to be. Back in late September I made note of the "Death of Equities" rant I saw on realmoney.com by trader Alan Farley. You can also add me to this list since I've been gloomy as well (but certaintly not to the degree of permabears like Farley and the most others).

Then you have rock bottom consumer confidence numbers that match what we saw in March 2009 and the occupy movements around the globe. If this is not proof of extreme b main street pessimism then I don't know what is. I suppose you can look  at the occupy movements as  having the potential to be the beginning of massive upheaval and social unrest which in that case would suggest we haven't seen anything yet in terms of pessimism.....it  could indicate we're in for a period of sustained, structural pessimsim due to an economy that is terminally sick. While such a thing can certainly happen such a notion would be the complete opposite of the one in late 90's whereby many believed we had entered a "new era" of permanent prosperity.....we all know how that turned out.

The bull case can be summed up as follows. History shows over and over that you will do very well LT in the markets betting against the dumb money when they are are pessimistic as they are now....on some measures pessimism rivals what we saw at the March 2009 lows yet the market is well above those lows - a positive divergence. Meanwhile you have smart money i.e. Buffet, buying and you have bond yields collapsed to lows that were seen during the depths of 2008 which signals extreme risk aversion and therefore a  LT buy signal for equities.  It usually requires a leap of faith to buy in an environment like this because during such times it appears as though things are utterly hopeless but that's what you see at bottoms and that's why most people don't buy low. What ends up happening is that somehow someway things end up turning out much better than what people feared. Maybe it's because fear motivates authorities to find solutions for the issues that are concerning everyone and it motives people to work harder and smarter and some sort of new growth industry comes along as a result. Earnings are still high, corporate balance sheets are solid and there was no greed or reckless behavior near the latest top in the market which is what you typically see at the start of big bear markets. In fact, there was still quite a large amount of skepticism at the latest peak of the market and that to me made me believe that any downturn in the market would not be the start of a serious bear market.  Even if earnings where to decline somewhat, when you compare the alternatives (bonds, money markets) stocks still look compelling. Earnings would have to collapse like in 2008 for the case to be made that stocks have serious downside from here given how low interest rates are. As a result, the market may be able to handle any future negative setbacks in the global economy without making a major breakdown to new lows.

The bear case can be summed up as follows.  The situation in Europe is just getting started. We still have not yet seen all the bankruptcies, restructurings and haircuts that are likely to happen. To believe that the bankruptcy of Dexia will be the only one would be quite very naive. There will be more bankruptcies and they will be larger and like in 2008 they will catch people by surprise.  Prior to the market peak in the summer the yield curves of Emerging markets were inverted signalling a sharp slowdown in growth was immanent for these countries and since Emerging market growth was probably the largest driver of the bull market that began in 2009, the global economy is in big trouble. These economies are only just beginning  to show weakness and so the worst is yet to come.  China, one of the important saviors of 2008 will no longer be in a position of strength because they are showing signs of a debt hangover themselves. The reputable ECRI is confirming a recession will be unavoidable and betting against them in the past was not wise. All bearish sentiment can do at this point is result in bear market rallies. You can't just simply "sentiment your way" out of this. The condition is terminal and the authorities have ran out of the traditional monetary and fiscal bullets to respond to the coming crisis because rate are already at 0% and austerity in now embraced. We have finally reached the "endgame".  Analyst expectations for future earnings are still high and do not reflect the storm clouds brewing. Finally, the market is behaving like bear markets behave - huge volatility with a downward bias.

I think I made a good case for either side of the market and that's why I'm torn as to which side of the market is going to be proven right in the LT. One thing that I'm somewhat sure about is that if the bulls are going to be proven correct, it's still probably going to take more months of base building even if we saw the low last week. The " talk show host joke indicator" and the actions of Warren Buffet (who tends to be a bit early) confirm this. If authorities make a "decisive response" to the crisis, it would be naive to assume everything is going to be hunky dory immediately following it and naive to think that there will be no additional responses required and no more economic fallout. That too would keep a lid on the market's upside. We also likely need to see Emerging market countries slash rates and their yield curves to be upward sloping again before the market is ready for bull market take off.

I have respect for the bear case but only to the point where I'd be inclined to sell longs into strength and remain in cash and not to the point where I'm looking to go short on a longer term basis.  I have a hard time doing that because of where sentiment conditions are right now. But even if you believe the bulls will ultimately prevail, at this point in time, as I pointed out,  I don't believe you are in danger of missing the the next bull run by staying on the sidelines aside from ST market moves. Keep in mind though that the ST moves could end up being quite powerful (for example, after the bottom in July 2002 the market rebounded 25% before giving it all back). So, go ahead and try to catch them if you can but odds are you won't be able to as you'll likely get whipsawed or stopped out prematurely.  There will be a time when the market will be a lot easier to trade/invest in....and that time is not now IMO....at least not for me.

We need to respect the possibility for the "endgame" that bears talk about. I realize bears have been like the boy who cried wolf calling for it over and over throughout the past 15+ years to no avail, but if there was ever a time for it to happen it would be now when you have no potential boost from rate cuts (in developed nations), high government debt levels and little tolerance for increased spending and the type of bailouts we saw in 2008. It's now up to the BRICs to be the world's saviors. Will they or can they do it?

Let's try to keep an open mind about what's going to happen and the most important way to get clues about that is to observe the market itself and not just whether it goes up or down but the way it does so.
I've done a good job protecting gains this year by largely sidestepping the crash but I can't remain in cash forever. For 2 years my strategy was to simply buy and hold small cap stocks for months at a time. That's the way to go in bull markets but until I'm confident to believe the bull is back I  need to change strategies and adapt to these market conditions figuring out a way to make money with an edge because I can't stay in cash forever....but if it turns out I can't find an edge or have any serious doubts I'll remain in cash for as long as it takes.

Defense first offense second.