Complex Outlook

We find ourselves in the midst of major crosscurrents of prices, trends, expectations and psychological effects. On one hand, we have a market which has rallied about 50% since its March lows. Credit spreads have tightened, LIBOR has stabilized, banks have been recapitalized, housing shows signs of bottoming out, cars are flying off the lots, and earnings season was a home run. Sounds like a new bull market to me. But as we look a little deeper into things, every area that has seen improvement has to thank the gov't for propping it up. Credit spreads (gov't guaranteeing debt), banks (TARP, TALF, PPIP, etc), housing (tax credits & mortgage modifications), cars (cash for clunkers), earnings (pent up demand & heavy discounting). Employment is still crumbling. The seasonal adjustments show signs of life, but many people are no longer being counted as a statistic because their unemployment benefits have run dry. This exacerbates delinquencies (credit cards), defaults (all consumer loans), and foreclosures (housing). That doesn't point towards any type of sustained recovery when an economy is 70% leveraged to the consumer.

Next, we have the markets biggest conundrum, China. The newly anointed leader of global growth is having its own problems. Can they be the anchor for the global economy? Seems as if our friends in the east are having a tough time shouldering the load. With commodity prices more or less following the lead of Chinese demand, any decrease in demand will have adverse effect on prices. Thanks to the gov't stimulus, Chinese banks have been lending out money as if were 2003 in the U.S.A. While this money was originally meant to be for infrastructure projects (real estate development, building repairs, roads, bridges, etc), a good amount of the money has leaked into the equity and housing markets, therefore sending asset prices up. Sound familiar? Just in the past two weeks we've seen two near 5% corrections (drops) in the Shanghai index...stability? We're also seeing dissension within the Chinese ranks. The vice finance minister said China will create an "internal mechanism" to stabilize the stock market while a deputy governor of the central bank, on the same day, said they won't consider asset prices when adjusting policies. As Ron Burgandy would say, "Agree to disagree". I guess that go in Hollywood, but in global central banking, it simply doesn't cut it. Add to that, the president of China Construction Bank (2nd largest in China) said they plan on cutting new lending by 70%. Maybe they're realizing it's not a great idea to simply lend out money to anyone who asks for it. Also, China's GDP growth has been due to accounting rules, which vary greatly from the ones we use in the U.S. Too much to go into at this time, but trust me on this one.

Next on the list is Europe. As I noted before, the European banking system is on the verge of demise. You'd think that the Euro would weaken against the USD, but this are no time for conventional wisdom. The EUR/USD has been ripping as of late. Eastern European banks are insolvent. Germany seems to be the only Western European nation that has its head on straight. Thank Ms. Merkel for that. The picture is pretty bleak in Europe as well, but they have seemed to fly under the radar as of late. The UK announced further plans to use quantitative easing and the Pound got beat up pretty good thanks to that. As I've said before, no economy can be healthy if the banking system is sick. The European banking system/model is sick...very sick.

This obviously comes off as a bearish outlook right? Well, those are my medium to long-term ideas. As for the current, I expect this rally to extend. We will most likely have a basing at the current levels while market participants digest the great earnings season and the better than expected news inflow on the economic front. There are two factors I'd like to bring into play. First is the large amount of cash still on the sidelines sitting in treasuries and money markets. If this money comes back into the market it could fuel a liquidity driven rally...simple supply/demand. Second is a psychological factor. With many portfolio managers being underweight equities, the fear of under-performance is setting in. Their "risk" lies in a further rise in the market. This completely changes their mindset. They are waiting for a pull back so they can jump back into a more neutral weight position and gain some ground which they lost from being underweight during the recent rally. They are buying the dips which means that any pull back could be minor at best. Between the cash on the sidelines and the portfolio managers waiting to get back into the market on any meaningful pull back, the likelihood of a short term run up to the 1100-1200 range is inscreasing.

I believe a lot of the markets confidence has come from China. I believe this past 5 month rally to be completely based on psychological and technical factors, nothing fundamental. The fundamentals are deteriorating. With China more or less propping up commodity prices, the market has used the basic material sector as a foundation for the rally. The perception that banks are "out of the woods" is also having an effect of investors confidence. This market is hinged on stabilization of commodity prices. China will stay strong until October 1, its 60 year anniversary of its revolution and founding of the People's Republic of China (communism). That is about 6 weeks away.

China has also been in recent talks with U.S. officials. Hillary has said that China is "comfortable" with its lending to the U.S. I'm glad glad we're taking cues from a communist gov't. If they weren't so comfortable, the Chinese could dump the USD reserves and kill the dollar. They'd be screwed because the money we owe them would then be worthless and their biggest export partner would be dead. They don't want this to happen, so they must have made some type of deal to keep funding the U.S. deficit in return for the U.S. to either raise taxes or cut spending.

There is still so much debt in the "system" still, it trumps the amount of capital available in the entire globe. This debt is going to be reduced or deflated. Debt reduction will strengthen the USD. This is going to go on longer than most people think. As I've said before, when the dollar goes up, equities go down. Actually, anything priced in dollars will go down.

The dollar strength will coincide with Chinese weakness (after October 1) pressuring commodities. When commodities drop this will trigger the rest of the market will follow. This is going then put more attention on the balance sheets of the banks and we'll have a deflationary spiral begin. I'm not saying this is going to get out of control, although it could, but we'll see a more than expected drop in asset prices. With investor psychology so fragile at this point, the change of attitudes is going to have a lasting effect on investment decisions (risk averse in the realm of losses).

Conclusion: Short-term bullish into September - October. Going into that time frame I'll be looking into going long the dollar, long select consumer non-cyclicals, short commodities, short financials, short retail, short China, short European banks.

Just one man's humble outlooks. Good luck today!