Who should you believe?

As you know, I've been dazed and confused about where the market and economy is going longer term because there's a strong case to be made for either a bullish or bearish resolution. We're at a major cross road here and if you take the wrong path you're either going to get hurt in a big way or miss out in a big way. It all hinges down to the reccession debate. In this post I'm going to flesh out all of the things running through my mind that is causing me such conflict. Hopefully this catharsis will help me get a better feel for what probably lies ahead. Some of this will sound repetitive given my recent posts.

Last weekend Hussman made a convincing case to support the case for a recession. Here's a crucial except from his lengthy commentary...

Since 1963, when the ECRI Weekly Leading Index growth rate has been below -5 and the ISM Purchasing Managers Index has been below 54, the economy has already been in recession 81% of the time, and the probability of recession within the next 13 weeks was 86%.

If in addition, the S&P 500 was below its level of 6 months earlier, the economy was already in recession 87% of the time, and the probability of recession within the next 13 weeks climbed to 93% (and then to 96% within 26 weeks). Under these conditions, once the PMI fell below 52, the probability of recession within 13 weeks climbed to 97%.

That simple set of conditions (WLI < -5, PMI < 52, SPX < 6 months earlier) has been seen in every postwar recession for which the data is available. Though we've seen recessions without a drop in the WLI much below -5, when a WLI below -7 has been coupled with a PMI below 52 and an S&P 500 below its level of 6 months earlier, the economy has been in recession within 13 weeks, 100% of the time. This is the combination, incidentally, that we observe today.

Now, here's some convincing points from James Stack that totally refute the reccession call

the four-week moving average of weekly jobless claims had hit a six-month low. How often has the economy fallen into recession after such a development? Trick question. It has never happened in 44 years of claims data, he said. The Index of Leading Economic Indicators just hit an all-time high. When has that occurred in the six months prior to or in the early stages of a recession? Never in the 52-year history of the LEI data.

So, you have Hussman arguing that there's a 100% chance of a reccesion according to historical data and Stack who says there's a 100% chance of no reccession according to a different set of historical data! lol! WTF!!!! Well, somebody is going to be wrong....obviously.

Do you see folks why I am so fucking frazzled? Ok, let's get back to the the ECRI recession call. I mentioned how I don't like the fact that they are so popular amongst the masses which in my experience makes it more likely that the guru in question will soon be wrong in a big way.  It's interesting to note that the previous 2 times the ECRI made official recession calls were in March 2001 and March 2008. In both those cases, leading indicators, coincident indicators and reported earnings had all already decidedly turned down from their peaks. That has not happened this time around with their call. Also, when ECRI made the previous 2 recession calls, the stock market had made its peak several months prior and was in a well established downtrend - undeniably in a bear market. Therefore, the ECRI was a little "late" in making their official recession calls from a market timing perspective in 2001 and 2008 (but in their defense, in the months leading to official recession call, ECRI was strongly warning about the negative things brewing in the economy).  This time around, with earnings still elevated, leading indicators still making new highs and the stock market not off it's highs as much relative to when the last 2 recession calls were made, could it be that ECRI is jumping the gun with their recession call?  And isn't it funny how bears love the ECRI now but didn't mention jack shit about ECRI's bullish calls in March of 2009 and November of 2010? In fact, the media mentioned fuck all when ECRI turned bullish. And where was Hussman when ECRI was bullish?  Did he make mention of this? Of course not. He was wallowing in his dogma. That's permabears for you folks and that's why you need to have a balanced approach when reading commentaries from these guys. It's still worth reading what smart guys like Hussman have to say though because they can provide facts and studies that can help you form objective opinions.

Aside from issues with ECRI's latest call, a couple of other things are making me suspicious of a recession and a big bear is forthcoming. I mentioned a couple weeks ago how dumb money thinks one is coming, in particular, a few of  my friends on facebook and the late night talk show hosts making jokes about the economy. You have consumer confidence plunging to early 2009 levels where historically it's a great time to buy LT  and again, all of this is happening in the face of still strong earnings that are poised to make all time highs this year which makes the gloom appear unjustified. If you look at the crash of 1987 and 1998 earnings were still strong and hadn't rolled over thus the crash was simply a severe correction in a bull market (or a short and sweet mini-bear market....whatever tickles your fancy) while many believed it was indeed the start of a big bear market.

The media both mainstreet and financial are quite sour and that bodes well for an eventual bullish resolution to this crisis and we never did see any signs of giddiness from them near the peak either. Sure, you had Wall street strategists bullish and equity inflows were coming in, but that's to be expected in a bull market and those inflows were just a drop in the bucket compared to the outflows that occurred from 2007-2009. And now, those inflows have been completely reversed and then some and so any kind of budding optimism has been completely undone. Bull market tops are usually characterized by giddiness and corporate greed and it's the unwinding of this greed that fuels the bear market that follows. We did not see such greed at the latest peak. The only case where a big bear market occurred under the above circumstance was in 1937 and admittedly, as I pointed out in a recent post, there some important similarities with today's conditions vs. those in 1937.

Lastly, if you look at how severely oversold the market got after the crash in August, the statistics matched what you see towards the end of bear market not the beginning of them and I mentioned  back in early August how we were as oversold as we were in October of 2008. That to me again gives me reason to believe this is just a severe correction and not a new big daddy bear.

Now, let's exam the bear case.  I have concerns aside from Hussman's work that concludes a recession is pretty much guaranteed. My instincts tell me that untill we see a complete restructing of all troubled PIIGs debt this market ain't out of the woods. This situation reminds of me of late 2007 and early 2008 when toxic MBS was really starting to wreck havok. I remember telling my co-worker at the time that in the end the government is going to end up buying all this toxic shit from banks before this is over and that's what ended up happening but not before the markets went down a lot more.  MBS was a cancer to the system just like PIIGs debt is and until this cancer is removed once and for all, at the very least I don't think this market is out of the woods and a major retracement of this latest rally at the least, is inevitable.  Bond markets for PIIGS are saying loud and clear that it does not end with Greece. The potential fallout from this European debt debacle could be just as serious if not worse than  the MBS meltdown. And this time around government authorities have their hands tied a lot more to intervene given already low interest rates and pressure to embrace austerity.

Next you have yield curves in the BRICs - the number one driver of the bull market still flat overall suggesting a serious slow down lies ahead for them. It's likely that they will end up having to cut rates but with oil back to the mid 90's, they may have their hands tied as inflation concerns will remain given that food and energy account for a lager portion of overall inflation compared to developed nations. It seems that the only way for easy monetary conditions to be possible for them  is  if there's a global downturn sharp enough to take the air out of commodities and that translates to lower stock prices.

A rather obscure but historically quite effective indicator that I keep tabs on is OEX option data. Unlike the traditional put/call ratio, the OEX put/call ratio is a smart money indicator, therefore a high put/call  ratios is bearish for the market and low ones are bullish. It doesn't always pinpoint major tops and bottoms to the exact day....it can be early upto a few months, but's effective in signaling an immanent change in  IT/LT market trends in the weeks ahead. It's worth paying attention to only when where there's a bullish or bearish extreme. Look at the chart below and you will see that when the market was close to making it's bear market bottom in March 2009 and during the aftermath of the flash crash, OEX option traders were aggressivly buying calls pushing the 10 DMA below 0.75. OEX traders then became quite bearish during the spring and early summer of 2011. The bearishness unwound only modestly after the crash in August and it's now deep into bear territory again.

Unlike what happened in the months following the flash crash of 2010, wherby OEX traders became aggressivly bullish, they only got so far as being less bearish for a while before going back to deep bearish territory which is where we stand now. This supports the thesis that the market isn't through with this deep correction/bear market. Would I bet the farm on this one indicator? No! There have been some false signals over the years (not evident on this chart) but this indicator clearly favors the bears and suggests at the very least a major retracement, if not a full retest or worse in going the occur in the months ahead.

Next, I want to mention Lester - the worst trader in the world.  I discovered this guy posting on blogs 3 years ago and I kept tabs on him because he is bar none, the worst trader I have ever seen. His major achievements include switching his 401K from equities to cash in November of 2008 and then blowing his entire $300,000+ IRA using option trades in about 18 months wherby practically every single trade he made was the wrong trade! He trades purely on impulse and emotion. Do you know what Lester did this year? He switched half of his 401K back into an SPX equity mutual fund in March when the SPX first hit 1300. Usually he panicks during sell-offs but this time around he actually doubled down on his bet by averaging down into equities about 2 months ago (at around 1200).  He then later went even more aggressive by switching half from the SPX fund to his company stock! This is not a good for the bulls medium/longer term! Bulls need him to flip flop and go back to cash but that's not going to happen until the market goes down in a big way and given Lester's track record that's likely going to happen! I realize you shouldn't base your investment thesis on just one man's behavior but I gotta tell you if I was forced to, I would pick this guy hands down. He is the absolute worst!

Finally, there's the action of the market itself. Although the market rally has been impressive with what still appears to be plenty of doubters via the frequently  high put/call ratio and only modest equity inflows, the rally has been done primarily via gap up behavior. Also, volatility is still high which is not the characteristic of a new sustainable advance coming out of a correction that's going to last several months and make new highs. Take a look at how the market behaved off the July 2009 bottom and the September 2010 bottom. It grinded higher with small but frequent up days temporarily interrupted with sharp but short dips which were few and far in between. That's classic bull market behavior. The upside we've seen so far has been erratic characterized by large gap up and gap down days because most of the movements in the market as of late has been happening after hours or before the bell driven by headlines. That tells me the market is still broken without a solid foundation of true buyers.  It's the chronic shorting/hedging that has been keeping it afloat but that can only go so far. Once the shorts eventually give up (as the always end up doing) the market will  be very vulnerable to an abrupt drop. Admittedly, this short squeezing could potentially last for several more weeks but it can just as well last for a few more days so you better be careful if you try to go long playing the game of chicken with these bagholders.  Look for the VIX to drop to the low 20's to signal  potential true bear capitulation.

So there you have it....a complete info dump from my brain as to my thoughts and observations about this market. I'm going to take some time to review what I just wrote and let it sink in. Hopefully this will help provide me a better understanding as to were this market is headed and what actions I need to take with my account which is still primarily in cash.