6/9/2009 3:43:42 PM

Introduction

This week we focus on the Flow of Capital and its effect on the markets. Of course, we continue with a watchful eye for an Epic Bull Bear clash and report on our outlook for the markets.

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The Flow of Capital

I am growing uncomfortable with the movement of the market, in that the fundamentals don't actually support this move. Now, don't get me wrong. I think the market often moves without correlation to the fundamentals in the short term. It also regularly does this in the intermediate term. In fact, it can take a year or longer for trading of a given stock to align with the fundamentals that should support those moves. Notice that I say "should" because that is what subscribers to the efficient market theory believe.

It is when the market gets ahead of itself over a longer time frame and the fundamentals don't jibe with that move that I become concerned. I also understand that the market is anticipatory and that equities aren't valued at what earnings are today but rather what they are expected to be in the future. That is all well and good but I would like to share with you today my observations on the flow of capital and its effects on the market.

The last time I had the same sort of uncomfortable feeling like I am having now was in 2006. From the middle of 2006 until February 2007, the Dow Jones Industrial Average moved relentlessly upward without as much as a 2% correction. I was amazed and had never seen anything like it. As it turns out, neither had many other people as the market hadn't moved up for eight months straight without so much as a 2% correction in fifty years! The reason behind this move was cheap money. There was so much liquidity from low interest rates that there was just too much money chasing too few stocks and the market continued to move higher.

We'll take a look at some of the reasons there was so much money sloshing around shortly, but it is probably more important to understand why there is so much money sloshing around now and the ramifications for the markets.

One clear aspect of this is the money flowing from bonds to equities. As investors worry about inflation or see greater potential returns in equities, bond money flows to equities. Given that the fixed income markets are about ten times the size of the equities markets, a small percentage of bond money flowing into equities really has a significant effect on equities demand.

Another factor in liquidity is the ultra-cheap interest rates that credit can be secured for. If you have access to Fed Funds, you can borrow for 0.0 to 0.25% overnight rate. Of course, very few institutions can borrow at these rates but the institutions that can are being asked to make credit available, and in fact, if they received TARP funds, being measured as to the progress of that lending. That means there is a lot of cheap capital out there that is making its way into the hands of investors who are looking to make a return that is higher than they have to pay for the "cheap money".

Equities look attractive now, although with long term bond prices continuing to drop and inversely, yields continuing to rise, the focus could eventually shift back to bonds. In a rising inflation and interest rate environment, investors tend to avoid bonds as the absolute returns are reduced by rising inflation, so I would suggest that bonds won't be seeing significant inflows for awhile and, in fact, are likely to continue seeing money move from bonds to equities. If company profits are rising, which occurs generally when the economy is expanding, the equities will be more attractive if inflation is rearing its ugly head. Of course, this presupposes that the economy will move from a slowing contraction into an expansion phase that the Fed is predicting for the second half of this year.

Earlier this decade, sovereign wealth funds soaked up the long-term bonds and eventually began buying equities. At the same time, private equities firms went public given that they could turn their private holdings into cash by selling shares in the public markets. Several private equity companies went public and cashed in at the top of the market. This was a defining moment that illustrated just how much capital there was chasing a limited supply of securities. It marked the beginning of the end as the housing market topped in early 2006 and financial institutions that were in the home loan business realized belatedly that the party was over. All those loans written at 100% or even 110% of LTV (Loan to Value) were unlikely to be repaid as the property they were written against was falling in value.

That might not have been so bad, but the interest rates that allowed the homeowners to qualify were started at teaser rates which were often below market. When these loans adjusted to market rates, the homeowners wouldn't be able to afford the payments and there was no way to refinance because there wasn't any collateral in the homes. That source of liquidity dried up in a matter of months. The extra cash that homeowners received in the form of home equity loans stopped flowing and, in fact, had to be repaid at higher interest rates.

Summing it up, it was a perfect storm. Cheap money that was flowing from sovereign wealth funds, the Bank of Japan's low rates (known as the Yen Carry Trade), flowing out of the bond markets into equities, flowing from the ATMs known as equity loans, etc. All of this money supply was cut off.

Realize that the housing market had topped by early 2006 and there was significant evidence of this as to have become a downtrend by mid-2006. This is the same time that the equities markets began an eight month relentless move upward, even as housing toppled. Money just kept on flowing into equities and they moved relentlessly higher.

Fast forward to today. Let's try to determine what the Fed will do in terms of interest rates. To do that, we have to state some assumptions, look at some data, and then project what we think will happen. We'll start by taking a look at inflation, and attempt to understand what the Fed has done to deal with that in the past.

I borrowed a table that you can find at www.inflationdata.com.

Here is the link: http://www.inflationdata.com/Inflation/Inflation/AnnualInflation.asp

You will note that from August to December 2008, we experienced deflation, which means that prices for a like bundle of goods actually went down. In fact, the prices were dropping pretty significantly late in the year, which was the Fed's worst nightmare. It is very difficult to break out of a deflationary spiral, which is why the Fed increased the money supply so much.

The Fed, however, doesn't focus on the monthly change in interest rates, but rather focuses on the annual rate of inflation which can been seen in another table which shows inflation when compared to prices a year earlier. This table also comes from www.inflationdata.com and may be found at the following link: http://www.inflationdata.com/inflation/inflation_rate/historicalinflation.aspx

You will note that the annual rate of inflation is currently showing deflation and will likely continue to show deflation through June or maybe even July of this year. We want to understand what the Fed did in the past to combat inflation. What they did was they raised the interest rate until they curbed a rise in the inflation rate, at which time they waited to see if the interest rates would slow the economy too much.

Taking a look at the annual rate of inflation in 2006, you will note that it continued to rise until June. During this timeframe, the Fed continued to raise rates with the last raise occurring in June 2006 with a Fed Funds rate set to 5.25%. When the July and later month's showed inflation had eased, they elected not to further increase the Fed Funds rate.

Take a look at the table below:

It shows recent Fed Funds rate actions as posted on the New York Fed's website, http://www.newyorkfed.org/markets/statistics/dlyrates/fedrate.html.

Note that the Fed didn't begin to actually lower interest rates until September 2007. Looking back at the annual rate of inflation, the Fed's action to raise the Fed Fund's interest rate to 5.25% in June 2006 worked well to reduce inflation from 4.32% in June 2006 to below 2.0% by August 2007. It was then that the Fed decided that they would begin to reduce the Fed Funds rate. Remember that the housing market was in serious difficulties by this time but equities markets were still moving higher for the most part. Market participants hadn't grasped the magnitude of the impending collapse in the housing market and its ramifications on the broader economy.

By the time the Fed began to ease rates, it was too little too late. The financial sector, which had grown to nearly one quarter of the market capitalization of the S&P-500 had already peaked in May of 2007 even while the broader market moved ever higher, mostly on inflation feeding energy stocks. By October 2007, the market had peaked with the S&P-500 forming a double top, even as the Fed lowered interest rates at every meeting in an attempt to stimulate the economy. Now, take a look at inflation during the same time frame. The inflation rate moved up to the 4.0% to 5.0% range!!! The Fed's main tool to combat inflation was to raise interest rates but here they were lowering interest rates in order to try to stimulate the economy in the face of the collapsing housing market. The Fed was caught between a rock and a hard place and wasn't going to be able to engineer a soft landing. Inflation wasn't licked until the economy ground to a halt, equities markets collapsed, a collapse in commodities markets occurred, and everyone became aware that the housing market had collapsed and was taking a lot of others with it.

This had precipitated a collapse in interbank lending which posed a liquidity crisis. The Fed opened the spigot on the money supply and even though the Fed had set the target Fed Funds rate to 1.00% in October, it actually traded down to 0.0 to 0.25% due to a quirk of the abundant supply of money. There was so much supply the Fed couldn't manage the Fed Funds to stay in the range near 1.0%. So what did the Fed do? They dropped the official rate to the rate it was already trading at, essentially putting lipstick on the pig that it was a fact that they couldn't control the interest rate.

Fast forward to now. The Fed Funds rate is still officially at 0.0% to 0.25%. The interbank credit market is functioning normally. Other credit markets are not yet operating normally but the Fed is taking steps to ensure that they get there. The flood gates are still open on cheap money and all this cheap money is looking for a home. It is currently supporting the rise in equities as the risk/reward ratio appears favorable to market participants who believe that the economy will move from contraction to expansion in the second half of the year, as scripted by the Fed. Inflation looks set to rise but is currently pretty tame which could allow the Fed to delay taking action on raising rates as the economy gains traction.

What does all that mean? That means that cheap money will continue to power the equities markets higher. In a rising inflation and interest rate environment, long-term bonds are a bad investment which means more money will move from bonds to equities. It is too early to believe that the real estate market is a good investment. The residential real estate market is less than three years into its collapse and I believe it will be around six years before we see price appreciation for housing. I do think that prices will stabilize in another year or so but the huge inventory of existing homes has to be worked off as more homes go into foreclosure further swelling inventory. That will put a lid on economic expansion for awhile which means that all that money going into equities betting on an economic expansion will actually sit there for awhile looking for a better investment, but with no where to go.

Remember I said I am growing uncomfortable with the way the market continues to power higher. I will repeat that statement, "I am growing uncomfortable!" I get that much more uncomfortable when I read articles in Baron's Magazine that are are about doom and gloom. The most recent edition had Alan Abelson write the feature article on, "No Bottom in Housing." Abelson has a knack for presenting dry or negative material in a humorous way so much so that you may realize you should be upset even as you are chuckling.

After I was done reading the article, I mused about what the market reaction to such an article might me (Baron's is widely read by market participants). The article suggested we are in for more downside yet (at least another 5 - 10%) in the housing market according to one source. That source suggests only two of five waves of downside have yet hit the housing market. What is yet to hit? We haven't yet seen widespread defaults on prime loans, jumbo loans, home equity loans, and commercial real estate loans.

The second source cited in the article paints an even more dire scenario with a "falling off the cliff prediction". Similar to what happened to lower to lower middle-range housing in 2006 to present and which directly affected sub-rate and Alt-A loans, the mid-to-upper-end housing market is on the precipice of that same cliff.

I am not an expert on waves of failures in the real estate market. I haven't looked at all that data but I am familiar with a lot of reports I have digested that make it clear that a recovery in housing is far from imminent.

Given that I am full of doom and gloom about housing, what does that mean for the broader economy? I think housing will continue to be a drag on the U.S. GDP for several more years. That, however, doesn't mean that GDP had to continue to collapse. In fact, I do think that GDP will move back into expansion later this year as the Fed predicts. I am concerned about two things, mainly.

First, I am concerned about jobs. The official rate of unemployment moved from 8.9% for April to 9.4% for May. That is a huge jump. That doesn't take into account all the discouraged workers who are no longer looking for a job, nor the workers who have only been able to find temporary work when they are interested in full-time positions. I believe that unemployment will top 10%, even with the Obama stimulus package taking hold.

This brings up my second concern. I am concerned about another crisis in the banks that are actually not prepared to weather a 10% unemployment rate. The Fed's model was for unemployment of 8.9% for 2009. Since we are already higher than that, this presupposes that unemployment will drop significantly later this year. I don't think that unemployment will drop until 2010. That means that the models used to stress test the banks to ensure they had adequate capital reserves are not adequate. The banks will have to have larger capital reserves to weather the storm. The government has OKed the repayment of $68B in TARP funds from ten large financial institutions and smaller financial institutions have already indicated they will repay $2B. That is $70B out of nearly $700B laid out that is being repaid. The capital reserves of the companies paying back these funds may not be sufficient to weather the storm of a higher rate of unemployment and the government may have to provide the necessary funds yet again.

Does this mean that I am a pessimist and that we should batten the hatches and we shouldn't attempt to trade the market for profits? In fact, we have done rather well in trading the markets with our portfolio. If you had heeded our market calls on the market bottoms, you would have been able to amass gains of more than 100% like we have.

The point is, I believe there will be another shake out. The problem with predicting this shake out is the abundance of capital that must find a home. The supply of money is dwarfing the supply of investments, so the investments are being bid up in U.S. dollar terms. This will inevitably lead to inflation, etc.

I take my job to understand the economy (as best as anyone can do so) and share that understanding with you. I also attempt to analyze the markets and present what is happening and what is likely to occur in various timeframes. As you have by now surmised, the economic outlook is often different in the short/intermediate timeframe from the market outlook. With that said, let's take a look at the markets themselves to try to determine how we will profitably trade them.

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Market Outlook and Conclusion

On Friday, the TED Spread closed at 0.455. The "normal" range for the TED Spread is 0.10 to 0.50, so it is clearly in the normal range. Given that the credit crisis of interbank lending looks to have passed, we will only come back to the TED Spread if it moves outside of the normal range in the future. While there are other areas of credit to be concerned with the primary credit marked of interbank lending has normalized.

Recall that the TED Spread is the difference in interest rates between 3-month (T)reasuries and 3-month LIBOR rates. LIBOR is the London Inter Bank Offered Rate denominated in (E)uro (D)ollars.

When we look at U.S. treasuries and bond rates, we see interest rates rising and the prices of bonds falling. In the last week, the yield for the 10-year note rose thirty-nine basis points to close at 3.86%! That is a big move for one week. This leads me to believe that one or more of the following are surfacing as concerns for fixed income investors:

1) Investors are concerned that inflation is likely to be a factor in the near term
2) Investors are concerned over the credit-worthiness of the U.S. government and are therefore demanding more yield due to higher risk
3) Investors are moving funds from fixed income assets to other asset classes, such as equities
4) The front-running of the Fed-Trade (expecting the Fed to buy up long-term treasuries) is unwinding because it was overdone an the Fed won't be able to buy up all the supply on its own.
Any way you slice it, we have been expecting the long bond to fall in price. We shorted the long bonds in the McMillan Portfolio and continue to believe the long bond will decline further in price with a rising yield.

As we suggested in our Predictions/Forecast for 2009, the price of crude oil continues to rise. On Friday, the near month futures price of a barrel of crude oil closed at $68.44, which is an additional $2.13 from a week earlier. I expected oil to trade up to $70.00 per barrel and we are uncomfortably close to that level and not even half way through the year. I believe we are going to see either a significant breakout in the price of oil or an immediate correction. If there is a significant breakout, I believe that this will have significant negative connotations for the world economy going forward, vis-à-vis inflation. If there is an immediate correction in the price of oil, that would indicate that traders are getting nervous or demand has been satiated. I'll have more on that in another issue.

This week, we will discuss what we see occurring in the markets. You have already read our take on the massive amount of capital sloshing around looking for a home. Until the Fed and other central banks decide to tighten up on the money supplies, we have inflation to look forward to. This includes inflation of dollar denominated assets, such as commodities and equities. It is only when market participants view the risk of downside rising that they will exit these inflated assets in order to preserve capital.

We need to judge when we should take advantage of such a move to the downside. We have been predicting a local market top to occur shortly. In fact, we believe it will occur within days. That would be good time to take some profits or ensure you have backstopped your long positions by selling covered calls, etc.

In looking at the Dow and without throwing a bunch of charts up at you, we are looking at several things:

• The Dow closed 2008 at 8776.39.

• The Dow closed Friday at 8763.13

• The 200-Day Exponential Moving Average (DEMA) for the Dow closed Friday around 8820

• The 200-DEMA for the Dow will move below 8800 by the end of the week

In addition to the specifics on the Dow, we have been watching the VIX, which is the measure of implied volatility for the S&P-500. The VIX continues to move downward in an orderly manner, and for about a month we have suggested that it would likely break that downtrend around now. We have been counting down week-by-week and we are now monitoring the VIX to see of the trend will be broken. Since the VIX tends to move inversely to the S&P-500, it would be a sign the broader market is headed lower.

You don't have to use charts in your trading, but you have to realize that all of the Wall Street firms use the charts and essentially all of the professional traders use them to varying degrees. There is widespread monitoring of the charts for the major indexes which causes trading, based on price action. Again, I will reiterate, you don't have to use the charts, but if you understand that the majority of the money in the marketplace is being traded with input from the charts, then you can use that to your benefit.

Last week, we suggested you lock in some of your gains or at least to protect your long positions. We didn't suggest you short the market, but we took action to protect profits in our porfolio. As it turns out, that was probably good advice. Unless the markets head straight up from here without any significant pull-backs for months, then it was the right thing to do. Even if the markets head ever higher, you can always enter trades on a pull back for individual stocks that you still believe will head higher. If you don't protect your portfolio's gains, eventually, you won't have any because no market goes up forever.

Repeating what I wrote last week, while I am not ready to aggressively short the market yet, I am near that point, even if the short trade might not last a long time. I am waiting for the bears to battle with the bulls as the Dow and S&P-500 cross the 200-Day Exponential Moving Average (DEMA).

We have been featuring semiconductors and said that an abrupt halt was likely. That occurred last week. A number of trading services are coming out bullish this week on the semi-conductors as they break out. That is a momentum trade and it is a good one, if the economic expansion continues without a hiccup. If the markets decide to pull back later this week, it could easily stall semiconductors as their index approached a double top.

In the week ahead, we will be monitoring the market for a break-down. If we see the probability of a break down, we will be entering trades in the short/intermediate term portfolio. If not, we will begin to cautiously enter some momentum trades to see how long this uptrend can continue.

We believe that you can use this bull/bear clash to your advantage. To see how we will play this actively, you should consider a subscription to the McMillan Portfolio.

Our long term portfolio currently holds an average gain of over 88% per closed position. Our unrealized gains on open positions are up nearly 130% and we have ample cash to enter new long-term positions as well as short/intermediate term positions.

I hope you have enjoyed this weekly article. You may send comments to mark@stockbarometer.com. Please don't be shy in expressing your opinions of what you would like to see covered.

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