The Coming Collapse

Given the path we are on (high levels of debt, unsustainable deficits and the promise of massive unfunded future liabilities), it is not a matter of if, but when, the current structures and institutions that comprise the existing international monetary system (actually that is bit of a misnomer because there is no actual system, but a loose assortment of institutions, rules and accepted norms) collapse under the weight of their own imbalances and corruptions.

2008 was a shot across the bow, but it doesn't look as though we are paying heed to the warning. As such, in the absence of courageous change and honest leadership, we are still on a path to reckoning. You can pay the piper now, or pay the piper later (with interest). That is the choice when you stretch beyond the laws of economics.

But let me be clear. It is not likely to be a collapse in a catastrophic sense. Rather it is likely to be over a long period, punctuated by short periods of crisis, and with the consequent dismantling of whatever structure, institution or norm is ailing us at that particular point in time.

We will awake at some point in the future, and in looking back, will see that all the institutions, structures, rules, and norms that guided us, have been replaced by a new set of rules, structures, and institutions.

A phrase that really irks me

It irks me when people refer to hedge funds as a catch-all.

There is the hedge fund as a distinct legal entity in some offshore haven - a really bad investment vehicle for investors in my opinion (high fees, lock-ins, side pockets, minimal transparency, and limited regulation...need I say more).

There are also hedge fund-type investment strategies - these usually differ from the traditional mutual fund-type strategies by incorporating such other investing elements as leverage, shorting, futures, options, other derivatives, alternative assets, greater theme orientation (event driven, global macro, etc.), etc..

There is also the euphemistic use of the phrase hedge fund to describe the actors behind the markets machinations. In the absence of anymore Long Term Capital Managements, it is most likely that the "hedge funds" implied by this use are probably large bank prop desks.

As with most industries, power is concentrated, with 80% of the assets residing in 10% of the hedge funds (industry has roughly $2 trillion in assets, spread among 5000 odd hedge funds).

Roger Hodgson & Supertramp

Came across a blog the other day talking about songs that make life worth living and the guy there referenced a couple of Dan Fogelberg songs and a bunch of Supertramp songs.

Now I love Supertramp and grew up listening to my brother listening to Supertramp (as he made tapes from Casey Kasem and the American Top 40 off the radio), but I have a hard time hearing lyrics and it is usually the sounds and choruses that I identify with. When I went back and revisited some of those songs, I was taken aback by their spiritual depth and philosophical speculations (from some so young), and it also provided greater perspective on their other songs. And so I looked up Supertramp on Wikipedia and that led me to Roger Hodgson and a desire to find out more about the guy behind many of the songs and the music.

A good time of personal introspection.

P.S. The songs mentioned were lessor known signatures: Fools Overture, Even in the Quietest Moments and Lord, Is it Mine (look 'em up on YouTube). I pretty much like most of Supertramps stuff and think Crime of the Century is one of the greatest albums ever (but I need to get Breakfast in America).

The Key to 2010

Q. Will we go up by more than 10%, or down by more than 10% from current levels in 2010? Ans. Yes.

The key to having a really good 2010 will be picking which comes first. I'm pretty sure both will happen, but if you get the call right it can make for a much more enjoyable year. Despite my skeptical bias on the longer term outlook, it seems to me that the odds are stacked toward an upward move of 10% first.

Reasons supporting that contention: growing confidence in the economic recovery; increasing signs of an economic recovery; current market trends and momentum are supportive; investors coming out of their bunkers; cash at 0%; big money is positive; still large amount of skepticism and risk aversion (sentiment is supportive); continuation of the carry trade; the optimism of entering a new year and a new decade; ongoing relief that catastrophe has been averted; the scramble to get back in; the confirmation bias; recent market consolidation sets us up for the next move higher.

Factors mitigating that contention: market needs a break after a 65% bounce; the psyche is fragile; signs of reversal in the trend; investors pulling in their wings and putting money in the bank after a good 2009; focus moving to fiscal/monetary exits and outstanding systemic risk factors; growing risk aversion; a crowded reflation/carry trade; increasing doubt in the sustainability of the recovery.

I Want to Repent of My Sins

I want to repent of my sins, but I am not sure it will change who I am.

The main sin I want to repent of, is the sin of tardiness. Or, more specifically, the sin of being too slow in changing my opinion. I have this nasty tendency of being way too slow in adopting a new outlook. It means that I am late to the party, and therefore miss a decent portion of the fun. It also often means, that I am so slow in changing my opinion/outlook, that I am actually ahead of the consensus. As such this tendency plays havoc with my convictions, but it also plays into my contrarian nature.

The biggest issue I deal with when considering a change in opinion/outlook is the fear of regret due to anchoring. Regret that I'll change my outlook just as the consensus comes around to my position.

All of which is to say, that I am currently doing my next year review and am seeing a lot of things pointing to a more constructive environment than where I am presently at.

This is serious

The stunning rise of gold over the past 8 years is serious. It is signaling an end to the existing monetary and economic order. Now that might be quite some time away, but it's rise reflects concern over the value of paper currencies.

I have completely missed this run-up. I am a market child of the 90s. By the time I entered the industry, gold had already been falling for 10 years and had another ten years to fall. My first boss was a persecuted goldbug from Switzerland. He had sailed to New Zealand on a yacht and decided to stay and play in the newly deregulated financial markets (nothing like cowboy markets to attract punters). I took a look at gold at the time and dismissed it for the same reason Warren Buffett dismisses it (as a quaint historical artifact with limited intrinsic, and economic value). To add insult to injury, the case for gold was often being touted by "the end is nigh" folks on the fringe. Their arguments were reasonable, but in order for their predictions to come to pass, massive social and economic upheaval must occur. A collapse of the fiat monetary system couldn't happen! Could it? The longer gold underperformed, the further it fell from favor. Alas, if only I had listened to those prophets from the wilderness (aka the Austrians) and taken a little gold on board (just for insurance sake).

But, as with most things in the markets. There is nothing new under the sun. What comes around, goes around, and it is presently the time for gold to shine.

Hopefully I've learned a lesson here. But I wouldn 't count on it (can you say hard headed). I still don't buy the economic argument for gold, and don't see why gold, as compared to many other goods, is "the chosen" store of value. But what I think doesn't matter. It is what the market thinks, that matters. And gold is definitely the asset du jour.

Complacency and Comfort

My sense is that there is a growing feeling of complacency and comfort among market participants with the market's level and rise.

The previous pushback associated with the market's historic rise (both speed and magnitude), has increasingly been lulled to sleep by a certain familiarity and increasing comfort with present levels.

This is dangerous for the simple reason that when you put your guard down, you are more susceptible to a negative surprise. But it is also paradoxical because the more you have your guard up, the greater the chance the market goes higher - climbing the wall of worry is all about drawing the skeptical in from the sidelines.

The Cash Dilemma

What do you do as an investor if you have cash sitting in the bank gathering dust, the markets are running, and you see inflation in the outlook?

What do you do if you are a corporate with cash burning a hole in the balance sheet, shareholders demanding a return on investment, and you see inflation in the outlook?

You deploy your cash.

ZIRP forces cash from the sidelines into the market, almost irrespective of the fundamental outlook.

Investors are scarred and highly skeptical of the markets, and are not surprisingly reluctant to leave those sidelines. But many have no option. That cash is slowly but surely getting squeezed back into the markets.

What happens if/when that cash is redeployed and the market fesses up to reality? A potential disaster waiting to happen.

Tiger! Tiger! Tiger!

Quite apart from the media frenzy over the car crash, salacious revelations, and gross invasions of privacy (sadly, a grotesque reflection of our modern culture).

What were you thinking!

Eliot Spitzer (and every other high powered guy messing around with flouzies) comes to mind.

What are these guys thinking? I'm not sure I want to go there.

It isn't the first time, and it sure won't be the last. I don't really think anyone is surprised. Just disappointed. There are plenty of high powered folks who have led lives of honesty, integrity and fidelity. That does not mean they are perfect, only that their weaknesses and indiscretions are "normal."

Dead Man Walking

Globalization v 1.0.

Disaster exhibit no. 1: Japan

Cause: selfishness

I don't think we're at the point of no return (even in Japan), but the "writing is on the wall" for the developed nations of the world. They have lived beyond their means for too long, have made too many promises they are unlikely to deliver on, and are currently bailing as fast as they can to avert the piper. Unsustainable debt levels, unrealistic standard of living expectations, too many unfunded future promises, the need for massive infrastructure investment (water, power, transportation, alternative energy, carbon reduction), a failure of political leadership, the changing balance of global wealth, rising taxes/interest rates, and the demon of demographics are all leading us closer to a point of no return. The developed nations of the world are on notice. Now if they and the current system go down, then the developing nations will also suffer correspondingly (but because they are coming off much lower bases, their recovery will be faster and greater).

The ultimate result will be a reordering of global and domestic institutions (legal structures, governance structures, political structures, financial structures, economic structures, security structures, labor structures). China will experience a very severe recession (it is a 10 year bubble waiting to burst), but will arise stronger. India takes advantage to play catch-up.

Time frame: anywhere between 5-30 years.

P.S. Life will go on. People will work and play, love and enjoy life. New technologies will enhance our lives. For most, we will only cursorily be effected by these monumental shifts. I would also add that this doesn't necessarily imply terrible markets over the whole period. Just as always, there are likely to be periods of significantly positive returns and periods of negative returns in equity markets. The trick will be correctly understanding, interpreting, and navigating the winds of change.

An important article on deflation and hyperinflation

Here is a link to an article I found very useful in describing the relationship between deflation and hyperinflation.

The article is titled, How Deflation Creates Hyperinflation and is by Eric deCarbonnel.

What I found most interesting was the description of how hyperinflation takes hold, and how the accelerating velocity of money signals not animal spirits, but increasingly fearful spirits. We could do with a little increase in the velocity of money right now to unclog the system. But, be careful what you wish for. I doubt that we will undergo hyperinflation here (hyperinflation is generally only associated with failed states), but the possibility of heightened inflation (10%-15%) is not out of the question. Much depends upon the strength, the courage and the independence of the Fed, and its commitment to fight inflation. On the basis described in the article, I would say that Japan is a potential candidate for hyperinflation at some point in the future (although the demon of demographic deflation will serve as a counterweight...much will depend upon whether all those seniors retain their faith in the existing order).

Note: Somewhat strangely I think it could be argued that the American penchant for cynicism toward big government makes it a greater candidate culturally for hyperinflation compared to the more conforming Japanese culture. Only time will tell.

2010 - A Year of Reckoning

2010 figures to be a year of reckoning.

It was the best of times and the worst of times in 2009, but 2010 will be a time of transition, a time of honesty, a reality check. A time where the rubber meets the road. Gains will not be so easy. Cracks in the system are likely to be tested. Risk increases as expectations increase.

Govt's will try and pass the economy back to the private sector, while central banks will try and extract themselves from the market, all the while hoping they don't upset the applecart, or have their bluff called.

Fear and trembling dominated 1Q09, while hope and relief characterized the last half of 2009. Unmitigated reality awaits the market in 2010.

Partying like it's 1999

The market is a little like a drunk heading out and having one last hurrah, before giving it up for good.

Partying like its 1999...except it is 2009 and 2010, the year of reckoning, awaits.

We're not in Kansas anymore Toto

I've written about this before, but I think it bears repeating.

The market and the environment in which investment decisions are made and investors interact has meaningfully changed over the past fifteen to twenty years or so.

The advent of new players (bank prop desks), new investment vehicles (hedge funds, SWFs, private equity), new investment instruments (ETFs, fixed income related derivatives), new quant strategies (HFT), increasing computing power, access to and the manipulation of voluminous mountains of financial data, and the willingness to use leverage, all combined with evolving academic support for momentum strategies has changed dramatically the nature and complexion of investment markets.

The best way I can think of to describe the market these days is either like a run and gun engagement, or as a game of chicken. Either way, it usually ends badly for someone.

I would also point out that these changes to and in markets, parallel in many ways some of the changes to our society and culture.

The future hinges on...

To a relatively large extent, the future hinges on whether banks return to a more normal lending environment.

If they fail to do so, then deleveraging and deflation will weigh down the growth outlook. If they do come through, then the recovery will receive a much needed capital underpinning.

Supporting the "yes, they will return to normal" camp are improving balance sheets, strong operating profits, a supportive fiscal and monetary environment, cyclical tailwinds, growing investor confidence, and the present low cost of funds.

On the "no they won't" side are an already overly indebted consumer, high unemployment levels, tightening lending standards, secular headwinds, and vestigial bank fears of another run.

Fish out of water

I feel like such a fish out of water.

I have essentially been fighting this move since the end of June. It doesn't make sense to me, it doesn't feel right to me. But there it is, another 30% on top of the initial 35% move off the low.

I am typically slow in getting with the party, which is a terrible trait to have in modern financial markets that are dominated by momentum and trend following strategies.

When I looked at the market a few months back I could see that the market had its gander up and that 1200 was within its sights. The problem was I just couldn't buy into it. I was fearful that at any point, the market could lose faith and crater again...and I didn't want to chance that. To make matters worse, I have been especially out of position in the energy, materials, and consumer cyclical areas.

At everypoint, one must re-assess ones conviction, and determine whether it makes sense to change tact.

I think I'll hang tough to see whether it'll break 1200 (but that could change tomorrow).

Riddle me this

What is risk? Risk is kind of like art. Its meaning resides in the eye of the beholder.

We use the word "risk" to refer to many different scenarios, situations, and outcomes. For example, "risk" for a soldier in a combat zone is very much different from "risk" for an investor in the markets, or the "risk" of making a marriage commitment*. As such, "risk" is dependent upon how the word is defined and the context in which it is framed.

Risk for an investor is generally market risk, and relates to the chance of loss and the potential magnitude of a loss. Prospective loss depends upon the investors position and the directionality of the market (ie. it relates to whether you are long or short). Risk is also highly time dependent.

"Real" investment risk however, is very much a function of the long run, and relates to return on investment after taxes and after inflation.

*Most people would probably consider getting killed a much greater "risk" than losing money, but also a different type of "risk" to committing your life to someone else for life - death and marriage have a certain absolute to them.

Hedge Funds. Huh!

I could have sworn that "hedge funds" were toast last year. Their business model was being seen to be the fraud that it is, and their performance was not living up to expectations (that is if you had any confidence in the performance they were reporting).

But by referring to "hedge funds" perjoratively we are doing most hedge funds a gross injustice. Now to be sure, the business model is a complete scam (2/20 with lock-ups), but the idea of taking a holistic investment approach has its merits. Of course, hedge fund investment strategies come in different shapes and sizes, and so it is an oversimplification (if not disingenuous) to refer to "hedge funds" as if they were all the same.

The hedge fund industry is like most other industries. The top 10%-20% of funds hold 80%+ market share. Most hedge funds that put their shingle out are small asset managers pursuing some specialized investment strategy. They use a little leverage here and there, but on the whole these are not organizations or strategies that can bang the market around. The real "hedge funds" are the major bank proprietary trading desks. When people refer to "hedge funds" euphemistically, this is who they really have in mind.

That does not compute

Saw an article today proclaiming that the long term avg. PE ratio based on trailing earnings is about 14-15, while the long term avg. PE ratio based on forward earnings is about 11.

I'm not disputing these claims (I actually think they reflect generally embedded expectations), but something does not compute here.

A forward PE of 11 relative to a trailing PE of 15 implies 36% expected earnings growth.

Obviously long term earnings growth is not 36% pa, and so I think we can read something about the positive bias of the market into this.

The "free market" paradox

Now there is no such thing as a pure free market system, just as there is no such thing as a pure egalitarian system.

The capitalist system as we know it is an amalgam of different markets, industries and entities generally constrained by a system of market-based rules, laws and institutions, all of which is married to a social-democratic safety net. The emphasis and balance between free market institutions and govt based redistribution networks varies a little from country to country, but the basic framework is the same across most developed nations.

I find it amusing that some of the most vocal supporters of the TARP, central bank bailout measures, and government stimulus were also some of the greatest proponents of free markets. The belief that you need to abandon the market to save the market is ironic on its face. This speaks to a crack in the free market ideological armor (it will be interesting to see where this leads).

Taking a step back from the bailout, I just find it strange that we generally don't give two thoughts to the irony of a central bank in the midst of "free" financial markets. Faith springs eternal, and the human ability to sustain incongruent positions is pronounced.

Back at it again

No sooner had we rallied 60%+ off the bottom than the bulge bracket boys were back at it again...you just can't wean them off cheap money.

Goldman Sachs, JP Morgan, Credit Suisse, Morgan Stanley, Merrill Lynch, Biggs, Wien, et al - they've all declared it safe to get back in the water. These are firms and guys who have never known an asset they didn't want to buy (or sell to someone). Whether out of habit, or simply because it is in their best interests, they are back playing the same old tune.

"All is well. We love equities. We love commodities. We love bonds. We hate cash."

The "buy" bias that pervades the street is understandable, but reprehensible. It pays scant regard to those traumatized by the financial market implosion, and the possibility that they may be leading them back to slaughter. It wouldn't be so bad if they got the turn right, but the fact they are only now coming out with the "all clear," is a recipe for disaster (we're now at the stage of the sucker rally).

Given the still strong negative sentiment shrouding the market, given the momentum in the market, given the recovery in the economy, given an open monetary faucet, and given the big boys all marching their clients back into the market, the rally still has legs (1200 here we come...but we're coming around the end turn).

Where did we get our stomach for risk

It amazes me the gutsiness of the guys who sit on prop desks, or at hedge funds making market bets with 20x-30x-40x-50x leverage. I don't know how they do it! One wrong move and it all goes poof.

Is it ego? Is it hubris? Is it bravado? Is it incentives? Is it stupidity? Is it madness? Is it skill? Is it luck? Is it greed? Is it insecurity? Is it peer pressure? Is it culture? Is it ambition? Is it hope? Is it faith? Is it the will-to-power? Is it immaturity?

The one thing they invariably have in common is that it is someone else's money.

This penchant for risk among our financial superstars has slowly, but insipidly made its way through the system. To the point where modern Anglo-Saxon economies are a mere shell of their former financial selves.

One way or another change is coming. It may be through enlightened cultural norms (don't count on it), more likely it will be through enlightened self-interest brought on by economic necessity.

The choice is ours (if only there was leadership to help navigate the waters). We can either take our medicine now (manifest in a deep recession) or we will experience something a lot less savory later.

The M&A Dilemma

For an acquirer the time to buy is when prices are cheap. Like after the tech bubble bust, or post the recent financial crisis. Unfortunately, no one wants to sell then.

And so, the dilemma for an acquirer (one of many actually, including the problem of buying a lemon due to asymmetric information) is that they generally can only get a deal done once the target has appreciated in value (and consequently ain't worth buying).

Acquirers purchase anyways, mainly because they are personally incentivized to do so (ego, personal gain, etc.) and it is hard to sit with underutilized assets (whether cash or unused credit).

How About That!

Barack Obama given the Nobel Peace Prize.

Be interesting to see how the burden of expectation plays out internally, externally, and in US foreign policy.

I sure hope we can look back in hindsight and concur that he was in fact worthy of the honor.

There again, the awarding of the honor came before honor was due, thereby devaluing the honor. Bet the Nobel committee has its fingers crossed.

We need a pullback, BUT...

In my opinion, the market needs a pullback, BUT this is a buy the dip market.

I don't think we're going to see a 20%+ decline, however much this would cleanse bullish ardors. If we're lucky, we'll get a 10%-15% correction, then it is off the races again (maybe not quite the races, but a 1200 target on the S&P 500).

The time to sell this market will be when the authorities try to pass the baton from the public sector to the private sector. That is not likely to happen before the middle of 2010 for monetary authorities and may never happen on the fiscal side of the ledger (just a little tongue in cheek). The critical point will be to anticipate when the market is going to get antsy about the transition (it may be six months beforehand, it may be longer or shorter).

Note: Geopolitical uncertainty brought about by an attack on Iran by Israel, a large terrorist attack on US soil, or heightened trade tensions could throw a spanner in the works.

The Problem With 'New Normal'

The problem with the 'new normal' meme is that history is against it. Essentially, the argument for a 'new normal' is an argument for 'this time it is different.' And as we all know, 'this time is different,' is a dangerous position to take. Now, I happen to have a lot of sympathies for the argument and think it pretty reasonable (mainly because we're still overlevered and heading into delevering headwinds [higher taxes, lower consumption, structural deficits, structural unemployment, rising rates, etc.]). But, the problem with the new normal (and all the well considered bear cases of the past [and future]) is that they typically discount the resilience and dynamism of the economy. And it is only with the benefit of hindsight, that we see how it was we escaped the myriad of obstacles encountered and imagined. I don't know how we're going to escape the scythe this time around (as I said, I have my doubts), but the trendline of history reveals bumps, large and small, that are overcome in the course of time. Perhaps, this time is different (and we go through a period similar to the 'heisei malaise' or even something resembling the double-dip of The Depression), but it takes a brave person right now to discount all the market factors flashing green:
- Upturn in M&A (indicates pro-cyclical bias and confidence of boards and management),
- Rejuvenation in the IPO market,
- Significant recovery in credit markets,
- A benign bond market and low interest rates,
- Large fiscal stimulus still to come,
- A strong and resilient stock market,
- Increasing confidence among consumers,
- Economy showing rebound,
- Housing moving off the bottom,
- Resolution of healthcare reform,

A Game of Chicken

Since the mid-80s, playing the stock market has essentially been a game of chicken. The market's normal condition is one of overboughtness and overvaluation. Naturally there are times when it is more overbought and more overvalued than at other times, but the game has been to stay long and stay the course (and hope you can get to the exit before the music stops). This was logically underpinned by technological revolution, a generally robust economic environment, and the ideas of free market liberalism. Unfortunately, the period was also marked by a significant increase in leverage among governments, corporations and consumers. All good things must come to end, and it would appear that the financial crisis, sweeping electoral victory of Barack Obama, and coincidental recession of 2008-09 mark the end of that era. It remains to be seen what the future holds, but the early money is upon higher savings, lower consumption, higher taxes, increased govt spending, and greater regulatory constraint. Not a particularly exciting mix. But companies will still grow and make money, and investors will still be able to derive a decent return on investment (a 60% mark-down in asset prices does wonders for long term expected returns). However, the transitional pains of recalibrating from one state to another imply greater dislocation within and among economies, with a concomitant increase in volatility effecting asset prices and asset markets. Welcome to the new game of chicken.

Chicken vs the egg

Q. Are banks not lending, or borrowers not borrowing?
Ans. Both.

The money base has expanded rapidly, but falling monetary velocity has offset that expansion. During this period, banks have tightened lending standards (falling consumer lending), and credit worthy borrowers have been reluctant to take on more debt (more interested in paying debt down and repairing their market ravaged balance sheets).

The result has been buoyant asset markets as banks have redeployed their excess reserves to proprietary trading activities.

This can't continue ad infinitum. At some point, credit markets and the economy will normalize.

The Trigger

The problem bears face at the moment is one of timing. Economic tailwinds and improving sentiment look unsurmountable, at least until the Fed starts tightening. And given that most bears either don't expect the Fed to tighten, or don't see it happening until mid-2010 or later, it could be painful watching this juggenaunt from the sidelines.

That having been said, we have been on easy street for so long now that any vestiges of caution are castigated as something "quaint." As such, it is hard to know what might trigger a reversal in sentiment and equity fortunes. If we continue to rally into quarter end, then earnings could end up being a classic "buy the rumor sell the fact." But even with improving expectations about earnings, a positive outlook and strong momentum could blunt any retracement as folks "buy the dips."

Beyond upcoming earnings however, there are any number of amorphous economic, political and geopolitical factors that could arrest the rise. Unfortunately, in the absence of 20/20 foresight, the best you can do is monitor the conditions and look for any signs of a break in the weather.

Small-Mid Caps lead the way in US

The S&P 1000 peaked at 5275 on 7/17/07. It fell to a low of 2225 on 3/6/09. As of today it is currently around 3879.

Peak to trough fall of 58%. Rally from low of 74%. Index currently 26% below peak.


The S&P 500 peaked at 1576 on 10/11/07. It fell to a low of 667 on 3/6/09. As of today it is currently around 1054.

Peak to trough fall of 58%. Rally from low of 58%. Index currently 33% below peak.

The S&P 1000 hit an airpocket around 4300 in late September 08 (falling quickly to a low of 3000 by October 10). My sense it that it will test the 4000-4200 range, but fail.

One step forward, two steps back

It seems to me that we have entered the final phase of this rally. One which could take us one step forward and two steps back.*

As it stands, it is hard to see much standing in the way of the market continuing its rally right now. Economic data is supportive, trend data is supportive, sentiment indicators are supportive, flow data is supportive, breadth is supportive, monetary policy is supportive. For those who haven't participated in the rally to date, I can't help but think that they are playing a dangerous game.

*The one step forward could be another 10%-15% move on the upside (ie. take us to 1140-1200), while the two steps back could be a 15%-20% correction on the downside (ie. 900-950).

It All Depends

We are perched on a knife-edge and it all depends upon whether interest rates rise, or not, as to whether we crash and burn (aka relapse), or continue to dig our way out of the hole.

A deflationista would argue that there is no inflation and deflation is the true bogey. As such, they are probably highly conflicted because their view would support a low level of interest rates, and large amounts of monetary and fiscal stimulus. And, we have already seen what that does to asset prices. But rising asset prices is unlikely to comport with their view that a deflationary environment reflects falling demand which should translate into falling asset prices. Conflicted or confused. I'm not sure what they are.

On the other hand, an inflationista would argue that inflation is the true bogey, lying in wait around the next corner. The hydrant of low rates, and large amounts of monetary and fiscal stimulus is creating fictional money that will morph into inflation. They would point to the rapid rise in assets and the quickly reflating economy as support for their contention. At this point, the inflationistas seem to be winning the war, although inflation has yet to show itself.

Irrespective of whether you are a deflationista or an inflationista, we are sitting on precarious gains both in asset prices and in economic recovery. Should interest rates rise for whatever reason (inflation scares, reversal in monetary policy, funding concerns, liquidity constraints, currency crisis), all bets are off. The consumer is up to their eye-balls in debt (and would be hammered by re-setting and re-casting mortgages), the govt is up to their eye-balls in IOUs (and would be hammered by higher funding costs impacting the deficit/debt), and financial institutions, who are already skating on thin ice, would have less cushion to work with and be hammered by falling asset values.

We better hope the deflationistas are right, so that the inflationistas can continue to take the day.

Towels Flying Everywhere

The melt-up is entering its last phase.

You can just feel the flutter of towels flying into the ring. The relentless march of the market is squeezing out the last of the mohicans.

As confirmation, I present exhibit 1 - Bob Doll, the perma-bull CIO of BlackRock, bought out of hibernation to co-host CNBC this morning.

How much further can we rise. Can't see us going through 1200. That to me is the maginot line.

How much longer will we rise. No clue. It feels like a pretty strong tailwind. People are getting much happier, and much more comfortable with the economic outlook. This happiness is not going to evaporate anytime soon.

Of Golf Scores and Flight Logs

CEO's have a new scourge to deal with.

Golf scores* and flight logs.

Not only can folks make fun of your score, more importantly it can be used to track your whereabouts. This, of course, can be especially embarrassing when you have responsibilities and priorities elsewhere. Flight logs can be used much in the same way.

I guess credit card and phone records would also be pretty revealing. Fortunately, they are a little less accessible. But there is a moral in there somewhere.

* A recent dealbreaker post reminded me of this issue.

Look on the bright side

Okay. I feel like a real scrooge. After talking about revolutions, red flags, and policy mistakes, how about something a little more positive.

The economic data is almost unambiguously pointing to a recovery. Historically, this indicates it is time to loosen up and hit for the fences. I'm a little more circumspect than that, but at least I know I'm running uphill.

That having been said. Whatever way you look at it, the numbers have stabilized and in many cases are turning positive. Whether it is...
Leading Economic Indicators (0.7%),
Philly Fed (4.2),
ISM (48.8),
Existing/New Homes Sales (3.6% &11%),
Initial Claims (< 600K),
Consumer Confidence (46.6 and rising),
Industrial Production (0.5%),
Empire Manufacturing (12.08),
Mortgage Apps (5.6%),
House Price Index (0.9%),
NAHB Housing Market Index (18),
Personal Spending (0.4%),
Unemployment Rate (9.4%),
Domestic Vehicle Sales (8.4m),
Nonfarm Productivity (6.4%),
Factory Orders (0.4%),
Avg. Hourly Earnings (0.2%),
...the numbers are generally moving in the right direction (retail sales, durable goods, consumer credit, chain store sales, personal consumption are still stuck in neutral).

And it is not just here in the States. Germany and France produced shockingly positive economic growth, house prices in England have turned the corner (can't quite work that one out), China appears to be going gang-busters (with an emphasis on busters), and South America seems to be doing well.

A recovery would be good for everyone. Economic dislocation brings pain and suffering. It isn't just numbers, real lives are effected.

I'm just not sure we have purged our excesses from the system.

We Need a Revolution

Just as Jesus threw the money changers out of the temple, so to do we need to do a purging of US political, legal, and economic institutions.

The system is weak, decrepit and bereft of integrity with various parasites feeding off the host. Money talks, and when you're talking about the wealthiest country in the world, there is a lot of money at stake. And it is precisely this money and the power surrounding it that will continue to eat away at the foundations of society.

Sadly, as with any unsustainable imbalance (think healthcare inflation, tertiary education inflation, rising debt levels, oil consumption, disproportionate military spending, etc.), nothing will be done until a catastrophe occurs. And even then, if the current response to the financial crisis is any indication, we are unlikely to achieve true reform. It is a bad position to be in, to be a Jeremiah, when you have no clue as to when the walls will come down. But the writing is on the wall, and history shows that when something is corrupt, economically unsustainable, and being eaten away by parasites, the result is foregone.

The current healthcare debate is just another symptom of the rottenness in the system. With it so hard to create good policy, is it any wonder that we can't get true reform until it is too late.

Red Flags In Surprising Places

I screen a lot looking for quality companies. Quality companies are not hard to identify. They are companies with above average growth rates, above average profitability, expanding margins, positive earnings surprises, low debt levels, high operating leverage, etc., etc..

I was watching William Black's presentation "The Great American Bank Robbery" and it reminded me of some thoughts. Namely, that the naive process of screening for "quality" companies often throws up a number of duds and dupes. These are companies that look good on paper, but are rotten beneath the surface. Black refers to red flags related to companies exhibiting huge growth rates, monster margins and always beating the number. He argues that the growth rates and the "always beat" are often hallmarks of an environment where bad ethics is driving out good ethics. The weapon of choice for white collar crime is accounting fraud. Sometimes, when it is too good to be true, it is too good to be true.

Foreign companies (especially Chinese companies) often exhibit these characteristics, so it is always buyer beware. However, the measure I have come across to cross reference the quality of a company is the level of short interest. The short guys (at least those who specialize in it and not necessarily the hedge guys who simply run long/short portfolios) always seem to sniff out accounting fraud, or a broken business model, or a company/industry in secular decline, or fads. They do their homework and have a healthy dose of skepticism.

Black, to his credit, also holds no punches when he calls the Big Four accounting firms and the credit rating agencies failures - ouch!

It takes a brave man to...

...call a double dip.

The 'new normal' thesis is both eloquent and reasonable. But it takes a brave man to call a double dip. Originally the bears were calling for some sort of mega-recession. Now that we're showing signs of bottoming, they've had to revise that to a double dip. That makes some sense, but it is a big call.

History and current economic signs weigh against the thesis. We have seen very few double dip recessions in history. Usually they are caused by some sort of policy mistake (which I think has a greater than normal chance of happening - both monetary and fiscal). Probably most likely is some sort of muddle through in which the economy struggles to find traction, but doesn't actually go down again.

Time will tell, as they say. But the future seems more murky than normal.

We're Almost Guaranteed A Policy Mistake

The Fed is walking such a tightrope that we are almost guaranteed a policy mistake.

Will it be staying at the party too long, or will it be taking the punchbowl away too soon?

Either which way, it is highly unlikely they will maneuver successful through the minefield.

For my money, it seems to me they have given every indication that they will stay too long at the party. But with so much slack in the system, I don't see CPI-type inflation coming through anytime before mid-2011 (at the earliest). With the pedal to the metal, this means bank reserves will continue to leak out into asset prices.

The Problem With Being a Perma-Bull

The problem with being a perma-bull is that there isn't much room for reflection, or introspection, within one's countenance.

Conditioned by the modern phenomenon of economic growth, perma-bulls have never met a dip they didn't like (the positive skewness of the market leads to a certain complacency). There isn't much pause to consider the value of an asset, or the underlying health of an economy. They are generally dismissive of anything negative, and fail to understand that they operate within an industry that has every incentive and predilection to being bullish. They also tend to be practitioners of momentum (some would say herd followers), and contra to their stated economic worldview (free markets), are great believers in the value of the central bank (emperor with no clothes) to bail them out (they have spent their whole careers succoring on the teet of monetary stimulus).

Interestingly enough, practitioners of this science tend to be American and/or equity managers, while practitioners of the counter-stance (perma-bears) tend to be British and/or bond managers.

I spoke a little about some of the traits of a perma-bear the other day, but in the wake of being so harsh on perma-bulls, it would be remiss of me not to expand upon those thoughts here. Let me just add that the positive skew of the markets has killed perma-bears over time. It is one thing to identify and talk about structural flaws or imbalances in the system, but it is a totally different thing to get your timing right in acting upon those concerns. Markets and economies get out of whack periodically. Minsky rightly pointed out that imbalances build over time during periods of general stability. He also pointed out that markets and the capitalist system are inherently unstable. In this environment (and especially after a crash), it will generally pay to have a bullish bias. Besides, people like a positive person over a naysayer anyday. At this point I don't see any repudiation of the phenomenon of economic growth, and so that adds to the case toward a positive skew. Having said that, I am of the opinion that the general growth outlook for the future will be more muted than what we have seen over the recent past (1980-2007). As usual, there will be winners and losers in that environment. The trick will be to pick the winners and avoid the losers.

Surely the Market is Smarter Than That

Are we going to make the same mistakes that we made from 2000-20007? Surely not!

Surely the market is smarter than that. Surely it knows how this is all going to end. Sadly, the market doesn't think in terms of smart or dumb (and apparently it also struggles with foreseeable long term consequences). It is more properly a place where people come to place their bets on the next 1 month, 2 months, 3 months or, heaven forbid, 6 months. How else would you explain an avg. portfolio turnover rate among professional money managers of 125%, or the growing attraction of short term momentum strategies. The myriad of market actors - all with different perspectives, all with different incentives - are collectively conditioned by one pavlovian treat. Money. Most market participants know that we haven't solved our long term structural problems, and that major issues loom. But, they have to play the game. And so long as the game is going up (because the Fed and govt are providing the treat), they've got to go along with it. Once again, it reduces itself to a game of musical chairs with everyone betting they are quicker than the other guy. We know how that ends.

It is therefore not surprising that I am really conflicted. On the one hand, I can see the market wising up to the false signals and artificial imposts, and after attracting the last of the bears in, taking us down to a real gut-check level. On the other hand, it also wouldn't surprise me if we simply had a little consolidation, before taking the next leg up in another upcycle (ie. business as usual). I think both scenarios are about equally possible, with a slight nod to the latter because of the current momentum in the system.

The Problem With Being a Perma-Bear

The problem with being a perma-bear is that there is no joie de vivre.

When one is always looking for disaster to hit, every little twitch, every little movement from the market or the economy signals impending doom. It is hard to believe that the market might actually go up when one's underlying belief is that disaster is just around the corner.

All the foibles of behavioral bias manifest within one's outlook and actions. As such, it is hard to see the trees for the forest.

It seems to me that we are committing the same mistakes in the present that we have committed in the past. All the signs are there that we will reflate again, only to have to deal with the same problems again in the future. It is the timing of the "again in the future" that is so hard to forecast.

Now, where have I seen this before...

...oh, that's right.

2000-2007. Tech bubble bursts==>Cascading decline in global equities==>Economy in recession==>Fed stimulates with historically low rates==>Govt. provides its share of fiscal stimulus==>Proportional recession averted==>Markets rebound strongly==>Economy gets back on the growth path (although unemployment lagging)==>Global equities continue to demonstrate strength==>Housing and increasing debt become backbones of the recovery==>Energy and commodity prices skyrocket==>All is well with the world.

Fast forward to 2007-2009. Housing bubble bursts==>Cascading decline in global equities==>Financial crisis ensues==>Economy in recession==>Fed stimulates with historically low rates==>Govt. provides its share of fiscal stimulus==>Proportional recession averted==>Markets rebound strongly==>Economy stabilizes (although unemployment lagging)...Increasing debt becomes backbone of the economy==>

I wonder how this ends! The only question is what asset class/area will become the investor's bubble of choice? Stay long until they take the punchbowl away.

Cyclical Tailwinds Dominating Secular Headwinds

The current cyclical tailwinds of stimulative monetary and fiscal policy, and the natural turn in the cycle have transformed the markets disposition and created a more hopeful outlook.

Beware the Ides of March.

Lying in wait are significant secular headwinds (higher taxes and regulation, ongoing deleveraging, structural unemployment, higher savings/lower consumption, greater govt. involvement in the economy, rising inflation, higher energy & food prices) which when combined with the reversal of the current monetary and fiscal stimulus pose a serious problem for the markets recovery and the economy's long term health.

How Overcrowded Is The Short USD Trade?

I don't know how overcrowded the short dollar trade is, but if the seeming consensus is anything to go by, the dollar is good for nothing and heading into the bowels of hell. Does it deserve to be trashed? Probably. Is it a one-way trade you can't lose on? I wouldn't be so sure about that.

The US has certainly done its best to debase the dollar, and the outlook sure don't look too pretty. But you've got to remember that the dollar is a unit of relative value and that it tends to run in 5-7 year cycles (and we're closer the end of this cycle than the beginning). In that context, the USD doesn't look all that bad. Throw in the fact that the current account is moving in the right direction, the Fed will raise rates sometime, the Chinese will likely revalue at some point, "hard currencies" are not so hard, the Europeans and Japanese are begging for relief, and it doesn't take too much imagination to see the dollar moving higher.

On second thoughts, I think I'll keep my dollars.

Where Is The End Of Rally Mania Going To Come From?

If momentum is the strategy du jour, then an end of rally blow-out in the large cap space is likely to come from Materials, IT and Consumer Discretionary. But with those sectors already up 32%, 36% and 20% YTD respectively, there is a chance we won't get much more juice out of them, and it'll be left to some of the laggards to equalize this turn. Prime candidates are Industrials, Telecom, Healthcare, and Energy (2.75%, -5.03%, 3.98%, and 1.9% YTD respectively).

What is interesting is that when you drill down into the small and mid cap space, you get slightly different sectoral leaders and laggers. Leading sectors in the mid cap space have been Energy (43%), Consumer Discretionary (36%), IT (35%), and Materials (31%). Laggards have been Telecom (-5.9%), Financials (-0.11%), and Utilities (3.09%). In the small cap space, leading sectors have been Consumer Discretionary (37%), IT (33%), Energy (28%) and Materials (26%). Lagging sectors have been Utilities (-6.17%), Telecom (-40%), and Financials (-12%).

Defensive strategies have been crushed this year, while being leveraged to cyclicals would have knocked the ball out of the park.

"Rallying because we're rallying"

Just heard a classic quote from a guy on CNBC.

"We're rallying because we're rallying. People are jumping in because they can't afford to miss this move."

Talk about exuberant irrationality.

I'm sorry to break it to those folks "jumping in," but they have missed the move and there is only more pain for them if they think they can time their entrance and exit to the last leg of this move.

Attention Shoppers - Standard of Living Adjustment in Progress

It seems reasonable to believe that the US (and a number of other developed countries) will be undergoing a standard of living adjustment over the next 10-20 years. The adjustment will probably be effected through a combination of stagnant real incomes and faster relative growth outside the country. And, the impetus for change comes from the need to get the consumer's economic house in order and the general indebtedness of the economy. The deleveraging of the economy will manifest itself in many ways and in many areas, but there is a good chance that the USD will play a very pivotal role.

Stagnant to falling real incomes will be underpinned by relatively high unemployment and high underemployment, as it relates to productive overcapacity. It will also be interesting to see how quickly the private sector rightsizes itself to these realities. American management is ruthless, so this transition may happen more quickly than thought. The government is going in the opposite direction, and so will serve as a counterweight to the private sector's improvements.

Controlling The Hydrant

Will the Fed act quickly enough to reduce bank reserves when the velocity of money normalizes? If they are like anyone else in the market, they won't. The problem is not a lack of knowledge or vision related to the risk (they are fully conversant of the risk). The problem will be a failure of timing due to human nature and political pressures. Just as most market participants failed to time their exit from the market with a crisis looming (and their entrance back into the market by the looks of things), the Fed is likely to fail in its attempt to time the withdrawal of reserves from the system.

The Fed is playing a high risk poker game. One that they have demonstrated little aptitude for based on historical precedent. The problem is compounded all the more by the ongoing decline in the duration of government liabilities and the split personality of balancing inflation with employment. The result is, they have a smaller window of opportunity to get things right before the the market dings them, and the costs of failure mount.

Why The Big Beats?

Company earnings are coming in way above consensus expectations. Why the many, and why the big beats?

Couple of thoughts. (1) When the economy was in freefall nobody had any clue what the future looked like. In the panic that followed, companies erred on the downside and set us up for the current round of big beats [managed expectations]. (2) It appears that companies have a lot less operating leverage than we give them credit for [earnings have fallen less than topline declines would imply]. (3) We are borrowing earnings from the future to win in the present [accounting manipulation]. (4) Companies were pretty quick on the trigger to fire workers [lots of fat in the system].

Several implications. Analysts are playing catch-up by raising forward estimates, but they'll soon be getting closer to reality, and that means the lowered expectations game will be tougher to play ["we're onto you"]. If it was too much fat in the system, then we are likely stuck with high level structural unemployment [dead weight costs to economy and one-off gains for company earnings]. If it was simply management hitting the panic button, then we are on the mend [operating leverage will propel future earnings but be counterbalanced by rehiring costs...highlights the short sightedness of some managements]. As far as I am concerned, management is always suspect with regard to their accounting policies, assumptions and treatments, and their attempt to manage and massage earnings [that is a gross generalization, but probably not far from the truth]. This time is no different, and it will be interesting to see how and where they try to manage earnings going forward [lots of moving parts on this one].

Two Things You've Got To Get Right*

As an asset manager there are two things you've got to get right.

(1) Where is the money coming from?
(2) Where is the money going?

If you have your finger on (1) and (2) then you have a good chance of getting the trend right. And if you get the trend right, then you can make a whole lot of mistakes, and still be a genius.

At a big picture level, the money seems to be coming from Asian Central banks, sovereign wealth funds, and big bank prop desks (with perhaps the prop desks being the most important player).

In the current environment, there are two subtexts. The first is the USD as the engine of the carry trade. And the second is the use of ETFs and commodities as the preferred vehicle and store of value.

* You've actually got to get a lot of things right. But one of the other things you've got to get right is having the acuity of mind to change position should you be wrong. The trick, like most things in life, is having balance.

Looking For The Panic

I'm looking for the panic buying of the "I've missed the boat brigade" diving into the market on the back of the new consensus sounding the "all clear" to keep pushing this market up.

There may be good reasons for this market to go up over the long term, but we are fast getting to a point where the reasons for the market to continue its meteoric rise are getting thin. I don't know where that point will be - it could be 1050, it could be 1100, it could be 1150, or even 1200 - but as this market continues to march higher, I think it would be wise to sell into it.

It wouldn't surprise me if the peak of this move marks the top of a longer term trading range, from which the market consolidates its gains and periodically tests the range over the next couple of years. If I had to put a floor on the market it would probably be around 800 or so.

RIP WSJ

Is it just me, or has the Wall Street Journal really gone downhill since Rupert Murdoch took it over.

I used to love reading it. The quality of its content and the breadth of its coverage was magnificent.

Now, it is just a fancied up daily with color pictures of sensational events, lousy writing, and crappy editing.

I figured he wasn't stupid enough to mess with an institution when he bought it. How dumb was I! Lesson learned. Thanks alot Rup.

RIP WSJ.

Filling The Cascade Gap

I am a little surprised to see the market running so hard, so quickly after enduring the shock and awe that hit us in October and November of 2008, and the numbing malaise that laid us flat in Feb/March 2009. I can understand a big bounce off the bottom, given the magnitude of the decline, but then I would have expected the market to consolidate its gain and move forward in a more measured manner (especially given the cloudiness of the future). Strangely, this does not appear to be happening. Which leads me to think, maybe we haven't learnt anything from our recent brush with pure, unadulterated risk.

In trying to interpret these movements, the thought occurs to me that maybe as the Feb/March cascade was anomalous (and I think it was), perhaps the cascade move below 1200 in Oct/Nov was also anomalous (I'm not so sure about that). If that were so, then in essence, the market made not one, but two really big mistakes in risk assessment. And if that were the case, then we could possibly see a super spike back to 1200 to backfill the market's mistake. Such a thought is a red rag to the bulls, and a repudiation to anyone concerned with market efficiency and conservatism.

A Little Economic Reality

What has been achieved by this recession? What problems/issues/imbalances have been resolved by the crisis/recession? What has changed in the system/institutions/market as a result of the financial crisis and recession?

My answer to those questions, is not much. Not much has changed. For all intents and purposes, the stimulus and emergency monetary measures have failed to allow the economy to clear (markets cleared, but are now showing strong signs of amnesia). The instability of the economy and the financial markets is greater now than prior to the onset of the financial crisis and recession.

As far as I can tell, the legacy of this crisis is heightened moral hazard, heightened financial risk and heightened economic risk - not to mention higher taxes, greater regulation. We have compounded our problems. We haven't resolved anything. As such we have simply deferred our day of reckoning...again.

For the time being, the market is flashing the all clear sign. This is going to be interesting. We'll all bowl back into the market, only to find out we were chasing ourselves. And should have known better.

Don't Get In The Way Of A Charging Bull!

The market has got a head of steam up.

You could throw any piece of news at this market right now, and it'll devour it through rose-tinted lenses. It ain't thinking right. Will cooler heads prevail? I doubt it.

We're scaling that wall of worry, sucking in all those who are bearish and skeptical (and there are alot of them). Recovery is the only thing in the sights and minds of investors...until it isn't ("Got to get with the program or be left behind").

At what point will economic reality smack the market in the face? Hard to tell. It looks like pretty clear sailing through to the end of the year - generally positive economic data, stimulus monies and monetary stimulus hitting the economy.

More on that economic reality in another post.

Exuberant Irrationalism...And How Far It Can Run

Market up and running. Got to cover. We're nearly 12% off the 875 support floor on the S&P in less than two weeks.

Number of technicians point to 1020 or somewhere around there as the next resistance point. That's only 4.5% from where we are.

The fundamental underpinning to this rally, which is gaining momentum, is the palpable sense that the recession is over. Whether you believe that or not, and whether you believe the future is bright or not, is not factoring into the equation right now. You've got to get with the crowd or be crushed.

Earnings are generally better, but they are still very mixed. But the market has decided it is willing to take a leap of faith.

My sense is that most investors/traders are going back to their 2002-03 experience, and using that as their playbook.

P.S. If it turns out that we are genuinely on the road to recovery, I can't help but think we are now more likely than ever to repeat the mistakes of the past AND in much shorter order. In other words, the illusion of growth will return, the market will go up, and we'll come asunder again - probably within the next five years. The reason is the foundation is rotten and we haven't addressed our underlying problems.

So What Is The Right Proportion?

So what is the right proportion? WRT "proportion," I am referring to the appropriate fall in asset prices given the decline in fundamentals. To answer that question, I think it is somewhat helpful to reverse engineer a fair market value for the stock market based on the fall in corporate revenues (and profits), and the fact that the market was overvalued at the peak (ie. risk premium was way too low).

To do this I work off the following assumptions. Public company revenues have fallen somewhere between 20%-30%. Public company profits have fallen somewhere between 15%-25% (stripping out financial write-offs). If I adjust for the undervaluation of risk at the peak of the market, and multiply those declines by say a factor of 1.7x, then I think a case could be made that S&P 500 fair value is somewhere around 1040. Peak S&P 500 = 1576. Decline in profits = -20%. Multiplier applied to decline in profits given the undervaluation of risk = 1.7x. Calculation: -20% x 1.7 = -34%. 1576 - 34% = 1040. All this is saying is, that the market should probably have only fallen about 34% given the decline in fundamentals. The fudge factor, of course, is the risk adjustment multiplier, and its level all depends on how overvalued you think the market was at its peak. And, of course, markets overshoot (both up and down).

The tricky task is in our business is marrying the economic fundamentals with an appropriate multiple for asset prices, adjusted for a reasonable risk factor. Previously, I looked at fair value for the market from a bottoms-up perspective (looking at normalized earnings) and put it somewhere around 900-950 ($60 normalized earnings x 15x = 900). What is confusing me at the moment, however, is determining whether to apply a higher or lower risk factor to the future (ie. what multiple to apply). In many ways I can see where a higher risk factor should be inputed (greater chance for fiscal and monetary policy error, higher taxes, lower consumption, structural shift, etc.), but in other ways I can see where a lower risk factor is warranted given that we have overshot fair value.

All of this speculation is independent of what actually happens in the future, which will tell us (in hindsight) what side of the risk factor I should have fallen on.

I've Got To Confess...

...all this talk about "the failure of capitalism"* and the "need to reinvent capitalism", etc., etc. seems to me pure gibberish. One, it doesn't need to happen. And two, it isn't going to happen. We may get a little regulation here, a little limitation there, but I doubt very much we have a wholesale reinvention of the global economic system.

What we are seeing, in this financial crisis and the markets response to it, is capitalism in action. To me, the beauty of the capitalist system is that the laws of economics are allowed to operate somewhat freely (by the way, the laws of economics operate within all economic systems). Given that the system is predicated upon self-interest (not a great moral foundation I might add), it also needs reasonable safeguards and constraints to protect consumers, and ensure that bad apples and bad actions have consequences. But if you live beyond your means and you get swept up in the euphoria of the masses (and fail to assess risk appropriately), then there is an inevitable price to be paid. No system can stop you from making dumb decisions. But the capitalist system seems most reasonable from the perspective of economic efficiency and wealth creation. Issues of wealth distribution and equity are generally best dealt with through the political system.

*The discussion about capitalism is full of hyperbole and ridiculous assertions on both sides. Things such as, "if you believe in capitalism you believe the market is always right and should be given free reign," and "capitalism is morally bankrupt and the cause of all evil," etc. Such comments are ridiculous on their face, and should be treated with the contempt they deserve (by ignoring them).

When Will China Explode?

A country, especially one the size of China, can't grow at an average rate of 8% for 30+ years, and not create some imbalances. I'm talking here about a country bubble (not a stock market bubble). China has already had a stock market bubble, with the air coming out in 2007 and a recovery beginning in March of this year.

Everyone knows the future is China's, and that is true. But the path between point a. and point b. on the economic development timeline is not always smooth (as in 8% growth every year!). China reminds me of one of those old movies where the steam engine is racing along the track going faster and faster as the train driver continues to stoke the furnace, and even as it keeps going faster, more and more things are falling off the wagon. Eventually, it goes beyond the point of no return and blows apart at the seams. That, I am afraid, is the economic destiny of China. It is on a collision course with history. I don't know when that day of reckoning is going to come, and I don't know what will push it over the edge.

Hopefully it won't lead to social disorder or anything like that. But there is a price to be paid for defying the laws of economics.

Taking A Step Back

Sometimes it is helpful to take a step back, and view the action from above the fray.

Economy
The economic future is clouded. This uncertainty feeds market uncertainty. Signs of stabilizing abound. Signs of recovery are not quite there yet, but the market has rallied in response to the postponement of Armageddon and some expectation of recovery. Further market movements are likely to be based on future data points (the proof is in the pudding).

Valuation
Valuation based on forward expected earnings and normalized earnings infer the S&P is probably pretty close to fair value. If you believe in a normalized recovery story, then the stock market is probably pretty attractive (and you ought to be fully invested). If you believe in a less than normal recovery outlook, then you ought to have a decent lick of equity exposure, but you may also want to keep some of your powder dry (as you wait for data confirmation).

Flow of Funds
Deleveraging means higher savings, paying off debt, reduced consumption, and more money for investment. The critical thing for a money manager is anticipating where the sources of funds are going to come from (US savers, Asian central banks, European doctors, Middle Eastern SWFs) and where they are likely to go. My suspicion is that the rapid rise in US savings will become a more prominent feature of the market in time to come. Anticipating where those savings go will be critical. The collective deficits of the world economy poses as a substantial black hole for savings.

Stay tuned.

Set-Up To Climb A Wall of Worry

I think an argument can be made that the market could be positioning itself to climb the proverbial "wall of worry."

We've come through the crisis and there is a palpable sense of relief that the worst is over, which is translating into a growing optimism.

That having been said, you don't climb the wall of worry by "getting happy." You climb the wall of worry by having the market move upward on negative news. We saw two examples of that today - the ADP Employment Report and mortgage applications.

Perhaps the strongest thing going for the "wall of worry" thesis is the idea that many market participants are still recovering from the psychological and wealth battering they took from the 60% market drawdown.

The disbelief and skepticism that all could be better again so soon, will increasingly draw these folks back into the market if it continues to climb. Stay tuned.

The Fear Of Being On The Wrong Side

There is an ever-present fear of being on the wrong side of the market. This, of course, assumes one has taken a position.

The fear comes from having been wrong many times in the past (and knowing that getting on the right side of the market trend is the most critical thing you can do to increase your chances of success), and hopefully leads to a healthy respect for the market and a risk management framework that minimizes the size of ones potential mistakes.

I'm caught in the middle right now, and have a wager either side. I have a healthy cash position should the market experience a retracement (which I am looking for), but maintain a reasonable equity exposure should the market chose to continue moving higher. With a significant lead over my benchmark, I am afforded the luxury of this strategy and position.

Having had good exposure to the beta trade off the bottom, bottoms-up issues are increasingly influencing my investment perspective and portfolio management positioning. As holdings run and hit my target levels, I am happy to let them go. And as prospective targets fall and look more attractive, I am happy to add them to the portfolio.

Michael Jackson Died

I, like everyone else who came of age in the 80s, have the beats from his music, the sound of his voice, and the images of his videos ingrained on my mind.

I was sad, but perhaps not surprised to hear of his passing. And it saddens me to think of his life. It has to be hard to be a famous person. Whether a rock star, movie star, or a President. Most famous people have a time in the sun, then recede to the shadows. But some continue to occupy a place in the public mind. Michael Jackson was one. This is a day you remember, much like when Elvis died (I was only 10 at the time, but remember it distinctly).

And let's not forget another icon from a period. Farrah Fawcett died on the same day. Charlie's Angels and the Six Million Dollar Man, almost defined my youthful tv viewing (can't forget Dr. Who either...and many others as I come to think on it).

It's Just That Easy?

The bullish case is predicated to some extent upon the unprecedented amount of stimulus being injected into the system (what I call an artificial impost). I am presuming that the case also extrapolates to a point in time where the stimulus puts us on a self-sustaining track where the govt can hand the economy back to the private sector (but I haven't heard that espoused too much).

I've struggled with the seemingly cavalier way in which some analysts and strategists take it as granted that the borrowing of money is an unmitigated positive. My sense is that they see it this way because the immediate cause is positive and the long term effects somewhere in the future. Similarly, they see it this way because they have been conditioned to this cause/effect throughout their careers. When a problem arose in the past, we simply doused it in money (whether fiscal or monetary, or preferably both), and voila the problem was solved.

If it were only that easy. Something seems wrong about this to me. But I'm not smart enough to fully articulate why. I guess the best response I can make is if it were so simple to goose growth by simply spending and borrowing money, then why don't we do this all the time. If there are no costs/consequences to such an action, why not do it always and at every time. The answer, of course, is that there are limits to such activities.

However, as John Mauldin said last week, saying "this time is different" is a very precarious position to take, and will generally be wrong (except when it is right...wasn't last year a "this time is different" case and didn't all the lemmings fall off the cliff together).

Increasing deficits when the balance sheet is already stretched and the income statement looks terrible (just ask the states and local governments) does not seem like a free lunch to me. The economic optimists seem to be only focusing on the positives (stimulating demand), while failing to factor in the effects (greater debt burden, greater pressure on currency/inflation, a short term fillip, rising taxes).

Is the market that dumb that we can pull the wool over its eyes by simply creating money? I don't think so. So there is something else to the markets strong rise. Me thinks it was the simple overshoot of the market in Feb/March in the face of great fear and uncertainty. But with the armageddon factor diminished, we now have to work out what is a reasonable valuation given the fundamental outlook...and that is where it gets interesting.

Thinking the Unthinkable

What if all the monetary and fiscal stimulus fails?

What do we do then?

Talk about staring into the abyss.

Hitting The Pause Button

My sense of things is that companies hit the pause button at the end of the first quarter, and are taking a wait and see attitude with respect to the economy (the market looks as though it is doing something similar).

If we lose confidence, there is a good chance we will see a second wave of lay-offs with concomitant, negative flow-on effects to the economy.

Are lay-offs the tail wagging the dog (the economy), or the dog wagging the tail?

What A "New Normal" Might Look Like

I'm a 'new normal' kind of guy and I was just musing what a 'new normal' might look like. Here is what it might look like from an investment perspective in a generalized example:

T-5 T-4 T-3 T-2 T-1 Reset T+1 T+2 T+3 T+4 T+5
Revs ($m) 80 85 90 95 100 70 80 83.5 87 91 95
Profit Margin (%) 20% 20% 20% 20% 20% 5% 10% 10% 10% 10% 10%
P/S multiple (x) 2.5 2.5 2.5 2.5 2.5 1.5 1.8 1.8 1.8 1.8 1.8
Firm Value ($m)* 200 212.5 225 237.5 250 105 144 150.3 156.6 163.8 171
Return 6.25% 5.88% 5.56% 5.26% -58.00% 37.14% 4.38% 4.19% 4.60% 4.40%

*Firm value = Revs x P/S multiple

The table above assumes a 'new normal' world, ie. lower growth rates, lower multiples (higher risk premium), and lower margins - much of the 'new normal' hypothesis depends upon growth rates failing to return to normal (due to consumer deleveraging and increased taxes). Here are a couple of takeaways: (1) We experienced a 58% asset reset last year, reflecting an 80%+ decline in reported profits (I consider that the first wave of deflation), (2) We get a bounce gain of around 37% after the reset (already had it), (3) Firm value will take a long time to recover (hard to get back wealth losses if we're going into a 'new normal'), (4) To reduce the damage of the asset reset, you absolutely needed to stay in the market to capture the bounce.

I was astounded by the implications of the 'new normal' world wrt the loss of wealth (or firm value), but the biggest takeaway from this example is the fact that when you reset asset prices by 58%, long term expected returns are pretty good.

I could have used PE instead of PS for valuation purposes (I prefer PS, especially in a period like the present), and it would have conveyed the same sense.

P.S. Sorry the table looks bad. You'll have to bear with me on that one.

A Leap of Faith

I don't think I could have articulated it any better than ISI strategist Francois Traha:

"The market pullback of the past week or so has rattled the conviction of many investors. This is not surprising to us since the recovery in stocks is really about hope rather than concrete evidence of an economic recovery. Thus far, so-called "green-shoots" have been concentrated in indicators that tend to be anticipatory of economic growth (i.e. leading indicators). It always takes a leap of faith to buy into a rally at an economic low since it begins about six months or so before coincident indicators of growth recover. We believe the evidence is overwhelming at this stage, but the "bullish" call on stocks will not become the mainstream until investors see actual growth, which will probably occur later this year."

I don't necessarily agree with his conclusion, but I think he captures the essence of a view.

Where Is The Corruption In The System?

Perhaps the most perverse manifestation of the corruption in the system shows through in the area of executive compensation.

Whether it is absolute levels of remuneration/inurement or relative levels (vis-a-vis avg. compensation within a business), executive pay is out of whack with any sense of reasonableness. This is, of course, a broad brush to be painting with, and there are obviously many exceptions, but on the whole executive compensation is bananas.

Who's fault is it? Is it the government for not regulating such activities? Is it society/culture for tolerating such inequity? Is it greed and entitlement among the executive class? Is it the consultants who facilitate the game? Is it a principal-agent relationship gone AWOL? Is it boards stacked with management cronies? Is it institutional shareholders who have abdicated their stewardship responsibilities? Is it regular mom and pop shareholders who are too apathetic and complacent (or powerless)?

I dunno. I think everybody and everything contributes to the problem. But boy, does this description not also look and sound like the problems that led us into the financial crisis.

The failure of monetary authorities, perverse incentive structures imbedded in the system, facilitation by ratings agencies and regulators, greed of the investment banks and bankers, "all care and no responsibility" among mortgage brokers and securitizers, failure of moral courage among borrowers.

All of which begs the question, where is the outrage? or better yet, where is the shame?

Confessions of a Conservative*

Ok. I admit. I have a conservative bias.

Oh, it hurts to admit as such, but it is true.

My conservative bias is, of course, the tendency to hang onto my view for too long, and only slowly adjust it over time. In the trade, it is a sibling to anchoring, overconfidence, and regret, and a cousin to ignorance and arrogance. Those banes of any good investor. None of which makes me happy of course!

Anchoring refers to our tendency to grab onto the irrelevant when faced with uncertainty. Overconfidence relates to the illusion of knowledge (a situation where we think we know more than everyone else) which translates into an illusion of control. Regret is what happens after you have bought or sold an investment (kind of like buyer's or seller's remorse).

*Was inspired to plagiarize these thoughts from James Montier's piece "The folly of forecasting: Ignore all economists, stategists, & analysts"

The Doldrums

Market is listless and directionless.

Not sure how long the doldrums will last.

Reasonable cases can be made that we will breakout to the upside, breakout to the downside, or stay in the doldrums.

I'm wary of the market tanking a week or so before quarter end, and dashing a lot of peoples hopes for a good quarter.

A Problem, an Issue, or a Conundrum

Actually it is probably more an issue and/or a problem, rather than a conundrum.

I am referring to the fact that financial markets like gold and oil are relatively small compared to traditional markets like equities and bonds.

The changing face of market players (the rise of hedge funds, SWFs, and ETFs), along with changing perspectives on asset allocation and investment strategy, has led to the prospect of significant demand/supply imbalances.

In other words, the flow of funds can unhinge a market from its fundamentals, aka bubble.

Speed wobbles

Just re-visiting the good ol' eyeball of the SPX over the last 5 or 6 years.

Could have used any benchmark to make the point, but SPX is The Benchmark, so why not.

Market returns were smooth and stable with a nice positive skew over most of the period (ah...for the good old days). We then hit a pothole in Feb 07 (first shot across the bow - China and the first subprimes), recovered and got going again at a faster pace, hit the Bear Stearns hedge fund closure in July and the Cramer rant heard around the world (second shot across the bow), over-corrected into October, and then lost control in 2008 (too many shots to innumerate).

We finally crashed and burned in October, and have been in purgatory ever since, but there is nothing like a few indulgences to give us hope.

Title inflation

Just an observation.

Has it ever hit you that everyone is a Vice President, a Managing Director, or some other hoity toity title.

Once upon a time, those titles actually meant something.

It reminds me of grade inflation.

Overshoot

Just eye-balling the SPX over the last five years or so.

Looks to me as though we overshot on the upside by about 12% in 2007 (SPX hit 1575, but fair value was probably around 1400)...even assuming the massive build-up of leverage in the system was "normal (remember, no one worried about it then).

We then had a significant overreaction with overshoot on the downside with a low around 666, but it should probably have been about 800 (16% overshoot).

Assuming 1400 should have been the top, then we are presently down about 33% from the high, and the move up to 940 being a 17% bounce from 800.

I don't know what all this means, but I mention it to try and gauge a little perspective under more normal conditions.

Did We Simply Imagine This?

The thought has occurred to me, and I imagine there are a number of others also wrestling with it.

Is all that we have just experienced over the past 20 months simply an existential crisis of confidence that led to a liquidity crisis, which begat a financial market implosion, which led to panicked firings and a related economic cliff dive?

In other words did we simply imagine this and all will return to normal?

Even if we did just imagine it, it is hard to believe that we will simply return to normal. The reason is because we now have to deal with the consequences of the reaction to the crisis, ie. decline in wealth, lost jobs, heightened insecurity, massive govt interventions in markets and economy.

What Is The Market Telling Us?

Interpreting the market is pretty easy. You just look at the recent price action and extract the rationale behind those moves.

Last year it was telling you doom, gloom and utter destruction.

This year (at least since early March) it is telling you cyclical recovery (discretionary, IT, emerging markets), inflation (materials, energy, gold), funding concerns (weak dollar, rising rates), and skepticism (short covering and sidelined cash).

The trick, as always, is not getting blindsided by a reversal. And that is problematic because the market has already staged an historic rally, and it is unclear whether the cyclical recovery/inflation thesis will turn out true. Of course, by the time the data comes out, the market will be somewhere else (I'm just not sure where).

P.S. By rallying more than 40% straight up from the lows (with perhaps more to come), the market is telling you that it made a mistake last year (or maybe more precisely at the beginning of this year).

Squaring the Circle

It's hard to buy this market right now. We're up 40%+ from the lows, we haven't seen a decent retracement, and the outlook is muted (at best).

Conversely, it's hard to get too bearish. Downside looks like 10%-15% max, the bears are trapped and getting squeezed into the market (flow of funds), momentum and sentiment is positive, green shoots dominate mindspace, and there is plenty of govt "news" likely over the next 6 months.

The tough thing for me is reconciling a less than upbeat economic outlook with positive long term return expectations.

Getting the big trend right is the most critical thing. And it seems like the long term trend will be for a recovery in equities. I hate that because it doesn't necessarily square with my fundamental outlook (a likely cyclical lift no doubt, but significant secular headwinds). It translates into buying equities on hope. That has been the right strategy many times in the past, and is likely to be the right strategy in the future (not because I believe in the fundamental case for such, but because history has shown it is a fool who underestimates economic resilience).

The one thing that could really upset the "hope applecart" is if the market mirrors the Japanese experience (because we are snookered and have few options). And that is what keeps me up at night. The lessons from that experience are to be nimble, be prepared to buy and sell more often, don't get wedded to any stock(s), and be disciplined in trading a range - hardly a description of a long term investment strategy (or maybe it is).

Markets Acting Badly

The market is such a baby.

Right now, especially, it seems to be acting like a spoilt little brat.

Everytime Bernanke, or someone or something, highlights that things ain't so good, it throws a hissy fit.

As if only tax payer dollars, or central bank printing, or jawboning will solve its problems. Like a petulant little brat it requires much hand holding and spoon feeding in order for it to feel good.

P.S. While we're at it, did everyone get the same "trade of the day" email? Seems like everyone is rushing in and out of the same trade at the moment. I guess they all got sold the same model...now where have I seen that before!

Cliches for the time

After a big move up, it always baffles me that people want to join the ride.

The main premise behind this action is the idea that the market is now signaling that it is safe to get back in, and the adage the trend is your friend. This is momentum investing at its best.

But if you flip it on its head, you end up with the disastrous situation we had last year. Investors selling the market late and eventually quitting at the bottom.

What is interesting to me is not only that momentum investing fits a certain psychological disposition, just as contrarian investing fits a certain psychological profile, but that you can make good money on both sides of the divide.

My guess is that really good investors manage to mix the two perspectives within a fairly flexible investment framework.

Mean Reversion Man

Mean reversion man says sell that which is overvalued, and buy that which is undervalued.

Thanks mean reversion man, you're a great help!

What is overvalued and what is undervalued? I dunno. But to garner a little perspective on that issue, I analogized that just as the global economy had significant structural imbalances, so to the domestic economy has probably got a few sectoral imbalances. We heard from Jim Chanos last week that he thought tertiary education, healthcare, defense and financial services had grown at growth rates greater than what was sustainable and so they were probably candidates for some sort of mean reversion (predicated upon govt intervention of some sort).

That got me curious. Does that thesis play out in the national accounts? The answer is yes, no and dunno.

I took a mosy on over to the US Bureau of Economic Analysis and dialed up the numbers for GDP by Industry from 1987-2007. I compared the current proportion of the economy for each industry with its long term average and sort to identify anomalies by seeing which sectors were outside of their one and two standard deviation ranges.

Interestingly, Mining was running 2 std dev above its long term average, with much of that change coming in the last year of the data. Perhaps not surprisingly, Petroleum & Coal is also running 2 std dev higher than long term average, as are Information & Data Processing and Management of Companies & Enterprises. I can see a little mean reversion going on in some of those sectors.

On the flip side, Agriculture, Forestry, Fishing & Hunting is running 2 std dev below its long term avg. contribution to the economy, along with Electrical Equipment, Appliances & Components and Retail Trade.*

And yes, education, healthcare, and financial services were all running one standard deviation greater than their long term average contribution to the economy. Defense was lumped into the govt spending category which wasn't, as of the date of the data, much different from its historic average.


* That one surprised me. I'm not sure of the definition of Retail Trade but I'll have to look it up.

Why Are We Rallying This Thing?

It's the way of the market.

As Al Funt would say, "when you least expect it, expect it."

The market is rallying on hope and history. Hope that we will see a turnaround by the end of this year, and history associated with the idea that stock markets typically bottom about 6 months before the economy bottoms.

If the recovery is real, then the rally will be supported, if the recovery is premature, then there will be insufficient economic substance to support the market.

Inflation v Deflation? Yes!

Is it possible that we could get inflation in "hard" assets, and deflation in consumer prices?

I guess so.

It is hard to reconcile these two contrasting effects, but it may be possible. After all, all things are possible, but not all things are probable.

That having been said, a case could be made that monetary profligacy needs an outlet, and hard assets appear to be the place of choice. Conversely, it is also possible that a deleveraging economy based on a crippled consumer could lead to declining consumer prices.

We've already seen significant asset deflation (a 60% haircut is not much fun), but not much of an effect in consumer prices (stripping out energy and housing if you follow the core numbers...which I think is a joke but it suits the argument I am making here). With the market having bounced 39%, that looks like a correction to an overreaction, but we are still to see the follow-on deflationary effect on consumer prices take hold. I think its coming though. Rising unemployment, rising foreclosures (across the credit spectrum), less access to credit, rising savings all point to lower consumption.

Lower demand points to lower prices. After all it is still a competitive economy (just).

Worst Case Scenario

How is this for a worst case scenario.

Rising prices among the food, energy and commodity groups underpinned by a collapse in the dollar and rising interest rates.

Declining prices for labor, consumer goods and anything discretionary (predicated on falling incomes, rising savings and increasing unemployment).

Greater govt dead-weight cost associated with weak stimulus multipliers, major policy mistakes, rising tax burdens, increasing regulation, crowded out private investment, clueless monetary authorities, and the reintroduction of trade warfare.

Instead of global stagflation, global flat-lining.

Chanos is onto something

Just saw some notes on a presentation Jim Chanos gave at an investment conference.

They reflect a thought I have had for sometime, but of course he puts it much more eloquently and identifies the underlying impetus for change.

I am referring to the idea that when an industry derives excess profits, this attracts the govt to increase its share of the take. Chanos puts his finger on the impetus for change coming from the cultural and political acceptance that health and education are rights and not privileges (and this changes how they should be viewed and treated by govt).

Chanos talks about a 30 year deregulatory boom in education, healthcare, defense, govt services, and finance. The govt has a stake in these sectors either directly or indirectly, whether because they are deriving outsized margins (against the public good) or the govt subsidizes them. Bottom-line: there is payback to be had. He is particularly focused on the potential for change in healthcare and education.

Cash on the sidelines...

So how much cash is there on the sidelines?

I dunno. Probably lots (but maybe not as much as people think).

Asian central bank reserves are pretty big (about $3.5 trillion between China and Japan).

US money market stats show about $3.78 trillion in total money market assets presently compared to assets of $3.15 trillion in January 2008 (and $2.5 trillion in June 2007).

US bank excess reserves are about $877 billion.

Mutual fund cash levels have been rising since 2007, but are still only at 5.5% or so (and have no doubt been drained by investor withdrawals).

Much of this liquidity is going to either stay on the sidelines or be drained from the system. How much stays on the sidelines is hard to tell. With all the secondaries, short covering, and bond issuance going on, it won't take much to hoover up $500 billion or so, which would leave about another $500 billion to enter the fray.

Relative Performance Performance

This has been a very good week in the relative performance stakes for the SMID strategy (added more than 350bp vs benchmark).

It seems that the relative performance of this strategy goes in spurts. Sometimes there are periods of underperformance, and sometimes there are periods of outperformance. Meanwhile those bursts are punctuated by periods of pretty much par performance.

I don't really know, nor can I explain, why that has been the case. But I find it interesting.

Ones main hope is that there is a positive skew to that measure (:>)

Financial Technique

How I approach a stock depends to some extent upon the present market environment.

For example, in the current environment the first thing I do when looking at a company is to go to the balance sheet and see what its debt load looks like and what its liquidity situation looks like (I love nice cash cushions in this environment). Next I venture to the cash flow statement and look at how well the cash flow generator is working (this also gives me a peak at quality of earnings). Finally, I'll mozy on over to the income statement and look at the company's cost structure and see whether there are any funny things sticking out of the accounts.

After a quick review of those factors, it is then onto the business of digging deeper and getting a handle on operating leverage, debt schedule, cash conversion cycle, etc., and marrying those with future growth and margin cycle implications. The trick is then to condense that into an expected present value of the company and to compare that (with an imputed risk factor) to its current market price.

What Is Truth?

Philosophically I think it reasonable to believe that every asset has an intrinsic value (an objective worth). The only problem is that no one knows for sure what that true value is.

And so at any point in time, the task of an investment manager is to ascertain (1) whether current market value is above or below intrinsic value, (2) determine at what point in the future market value will converge with intrinsic value, and (3) anticipate whether there will be some overshoot on the reversion back to intrinsic value.

In some ways the search for truth in investing, is like the search for truth in life. To borrow from the ancients, you are always in the process of Becoming and never quite arrive at the point of Being.

The Future - Unknown Unknowns

My sense is that there are plenty of folks still on the sidelines. Many of those folks have watched a 37%+ rally pass them by, and many have sold into the rally and are now sitting in non-producing cash. The skepticism is palpable, and as such will only continue to support the rally, as people are drawn into the rising market. When the last bear has been forced back into the market, then it will be time to reverse thrusters.

What I don't know is how much farther this rally can go (it has the potential to go 40%-50%), nor how long it will take (I've got no idea on this one but it could go through the end of 2Q09 and who knows maybe even 3Q09).

I'm skeptical, and that worries me. Anytime the market doesn't do what I think it should, it worries me. It worries me because I could be wrong (it won't be the first time and certainly won't be the last). Being wrong is an integral part of the occupation. How you manage that uncertainty will determine whether you separate yourself from the crowd, or simply get caught out.

I've raised a little cash, to bank some profits from the run off the bottom, and am faced with the decision whether to get fully invested, raise additional cash, or to run with what I've got and see where this market takes us.

The difficulty in navigating this market (and any market really) is in tapering your view/conviction on the fundamental outlook with feedback from what the market price action is telling you.

Regret revisited

I usually own an asset because I believe it has value over and above where it is currently trading.

It may be because it has a great outlook and I expect the business to do better than what the market is expecting.

It may be because I see some value within the business...could be intellectual property, cash on the balance sheet, hidden assets, ie. land, possible takeout, etc.

Whatever the case, whenever the stock takes a hit, I always struggle with determining whether my original investment thesis was faulty...admitting one is wrong is never easy. Not only that, but assuming I still believe in the asset, then I am left with knowing that it is obviously going to take a lot longer for that thesis to play out. What to do? What to do? That is the question.

Oh, the story to be told

The story to be told will be of the carnage and destruction wrought by the private equity firms.

This business model is disgusting. It appears toward the mid and late stages of a credit cycle, feeds on the old and enfeebled, and then retreats to its lair until the next time. It is predicated entirely upon low cost debt and how quickly they can extract their equity from the deal. Cov-lite loans and the like were the most crazy (and telling) sign of the apocalypse.

By the time they are done, there is nothing left but the bones.

What really roils me is that even when they get it wrong (and they usually do by staying too long at the punchbowl...the greed of man), they still manage to extract their pound of flesh. They buy old, mature companies/brands with 10% down, lever them to the gills, pay themselves a huge dividend (get their original equity out and then some), and then feast on the carcass with any additional dividends being money for jam (and if they are really lucky they might find another dupe (the public through an IPO) to flip the business).