How To Use Your Analysis
With the summer breezes
flowing and much of Wall Street frolicking in the Hamptons, there is
not much to write about each day as it relates to really robust trading. Sure,
as always, there are a few set-ups each day, but nothing that requires a full
page description. So, rather than beat a dead horse, let’s take a look at the
market from a decidedly different perspective, the remaining half of the year
and what conclusions we can draw and what that potentially means for us as
traders.
There is little doubt that the polarization
between bulls and bears is quite evident. Each side makes articulate arguments,
and for me, at least, it is easy to see the validity of both sides. However,
unless you are “straddling” the market, you do need to decide which
argument/analysis makes more sense and plan accordingly. Until recently, the
bear case resonated with me, and in fact, still does. However, in the spirit of
staying flexible, I recently have changed my viewpoint slightly. It now appears
that higher levels are possible, but not for the reasons so commonly viewed.Â
Sure, earnings are getting better, but more as a result of cost cutting that
actual improvement in business. Secondly, increases in productivity (although
there is data that suggests productivity was higher 10-15 years ago) adds right
to the bottom line. So with earnings expectations in the toilet, beating them
seems somewhat of a lay-up.
The question that I believe is really giving the
market a real challenge is the longevity of the recovery. This is where I am
beginning to see the picture become much clearer. In the research and reports I
read (ask my wife, I read everything!) the commonly accepted forecast is for the
massive amounts of liquidity flowing into our economy will likely produce some
sort a recovery, the data is already supporting that. However, the flip side is
that without a more solid underpinning –Â ie utilization rates inch
higher, employment edges higher, GDP output gap narrows — we are essentially
putting yet another band aid on a still sick economy when looked at under the
hood.
Recent developments in the bond market are
certainly not what the Fed had in mind. So while they can control short-term
interests via open market policies, they cannot reverse the blunder created
after the Fed meeting whereby bonds have been spanked and many a fund manager
and “carry traders” have been beaten up brutally. Credibility is a hard thing
to regain. The thought here is that if long rates continue to go higher, it may
begin to slow up one or both of the strongest sectors, housing and consumer
spending. This would not be good.
My point is, don’t get bogged down in the
analysis, but rather to use it to frame a reference point and evaluate possible
outcomes. Personally, I think the amount of contradictory economic data has
many professionals avoiding risk altogether until a clearer picture develops.Â
The chart below may depict this exact scenario:
The other potential outcome, which has garnered
little to no discussion, is one of stagflation. The quote below from Sir Alex
Bridport, of Bridport and Cie is rather
interesting:
“When it comes to wealth
destruction, the recent fall in bond values must rival any thing that happened
to the stock market when the bubble burst. For this contribution to mankind,
investors can thank Alan Greenspan for an operation we might call the “Greenscam.”
It involved him allowing investors to believe that the overwhelming risk was
deflation and that all means would be used, including the Fed buying long
T-bonds, to keep long-term yields low and support the “carry trade.” Then
Greenspan pulled the rug and investors all fell down, taking off the carry
trade.
“We admit to being as much a
victim of the Greenscam as anyone else. At least we all know whom never to trust
again. Beyond the half-truths, the inherent contradictions and unproven optimism
about the rolling “recovery in six months,” our task is to weigh up the likely
developments in the US economy as the starting point to what will happen there
and elsewhere. Until last week we had “swallowed” the Greenscam line that the
economy could only recover or deflate. Since recovery with such a debt load
looked impossible, we went along with deflation being the more likely scenario,
although, in fairness to ourselves, we saw it as only a short-term phenomenon,
as a weakening dollar would offset deflationary pressures in time (we
overestimated the amount of time in making a “wild guess” of one year).
“As of last week, because of a
little publicized report that producer prices were rising at a 4.8% annual rate,
we began to think of the third possibility: stagflation. Given our view that
recovery is impossible until the US imbalances have been corrected (a view we
hold despite volatile stock market rallies), we see the debate as deflation vs.
stagflation. The latter is understood to mean slow growth (only slightly above
growth in working population), increasing unemployment, and rising inflation and
interest rates.
“A major question for the
outlook in this stagflation vs. deflation competition is the future of the
dollar. Bridgewater points out that, in past periods of high twin deficits, the
dollar fell but bonds did not. They see the Fed producing “whatever liquidity is
needed to shift some of the downward pressure on bond and stock markets to the
US dollar” – hoping to attract foreign capital because the dollar is cheap
(presumably with a view to its appreciating again). Up to that point we agree
with Bridgewater’s analysis, but we have to part company with them when they
continue to see the deflation model and falling yields as the most likely
scenario.
“Our view is towards the
stagflation model, because of the force of argument from the indices and because
the dollar looks likely to fall again. Despite our now leaning towards the
stagflation model (yes, we changed our minds over the last few weeks – but the
facts changed, too!), it would be inappropriate to recommend maturities other
than those close to the bond index. Yields overshot on the way down and may well
do on the way up. Besides the Greenscam may not have run its course. New cash
should wait on the sidelines or be used to buy instruments to counter a further
rise in yields and inflation.”
Perhaps this is the reason that job growth, while
better as of last weeks report, still seems to be rather elusive. A story in
yesterday’s Financial Times alluded to the
problem of a recovery with no employment growth and the electoral implications
for President Bush.
At any rate, those are my thoughts and
observations regarding the market as we slug through this trading range.Â
Remember to keep it light and be selective, there are simply no marginal trades
worth taking at present.
| Support/Resistance Numbers for S&P and Nasdaq Futures |
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As always, I welcome your comments and feedback.Â
If you found today’s piece interesting, let me know, I am happy to include more
of the macro stuff in the daily commentary as it comes about.