In Barrons recent cover story (see Barrons article), roundtable members were once again interviewed about their thoughts on the economy, the markets, and select stocks. While there was varying opinion about the short-term outlook, many believe that the market has gotten ahead of itself, with some expressing longer-term concerns - even if the a short-term rally continues. As a hedge against the recent government spending spree and potential coming hyperinflation, some have stressed their continued interest in gold (one analysts with a $850/ounce entry point). The short-term stimulus / long-term worry perspective was articulated by Felix Zulauf, stating that:

"The U.S. economy will look a little better in the next two to three quarters, due to inventory restocking and fiscal stimulus. But the improvement won't continue after mid-2010, when the economy turns bumpy again."

Zulauf goes on to state that:

"The market undershot into March, and will probably overshoot in the first half of next year. The first rally is just about done. The market might climb into July, but it will correct in the fall, with stocks retracing maybe 50% of the recent advance. That will provide an opportunity to buy for a rally next spring or summer. That's the whole mini-bull market. Economic conditions won't support more than that."

Fred Hickey goes on to mention that while there are similarities to the 1930s, the current situation is different in that by adding liquidity, we may be recreating the very problem we were trying to solve. As mentioned by Hickey:

"The situation is reminiscent of the past 14 years, when the Fed primed the pump and created bubbles everywhere."

In a different Barrons article (see second article), Michael Darda, chief economist at MKM Partners, is more optimistic short and long-term, and expects the market to bottom this summer. As evidence, Darda points to the money base, measuring currency-in-circulation, bank reserves, and vault cash (see second Barrons article). The money base is now near a record high of around 2.9 times the stock market's value, a value that is slightly below a higher value in February (right before stocks took off), but below the average of 1.5 over the last 20 years. As Darda points out, the value was below 0.9 times as the stock market peaked in 2007. And while rising yields on the 10-year Treasuries have reduced refinancing, and threaten to lower home prices, Darda points out that what is important is the spread of the yield curve. The current slope is signaling strength, and not giving an inverted slope recession prediction.

But Darda does concede that while futures are pricing in a 50 bps increase in short-term rates by the end of the year, he expects unemployment levels and politics will keep the Fed from raising rates - in what could be a choice of risking a "repeat of the 1970s than a repeat of 1937-1938." This perspective of short-term moves followed by long-term concerns is in line with Arthur Laffer's recent higher inflation / higher interest rates op-ed piece in the WSJ (see previous post). In the article, Laffer highlighted that in:

"shorter time frames, the expansion of money the expansion of money can also result in higher stock prices, a weaker currency, and increases in commodity prices such as oil and gold."

Of course, over the long-term, such effects are much more negative, not only for the economy, but the market as well. Therefore, while good economist seem to vary somewhat on the short-term outlook of the economy and market (not unexpected), most agree that the longer-term consequences of the 2008 credit crisis and subsequent spending will provide a challenging environment at best going forward, especially long-term. As mentioned before (see previous post), plan accordingly.

According to the recent TIM (Trade Ideas Monitor) report, over the last five trading days institutional brokers have switched from being bearish to being more bullish on equities (see previous post or youDevise website for additional information on the TIM report). For the five trading days ending June 11, the number of long ideas as a percentage of new ideas sent to investment managers increased 73.66%, compared to 58.65% one week earlier. Longs represent 67.03% of ideas in June.

The TIM Long-Short Index, measuring the total number of long ideas compared to the total number of short ideas sent to clients, increased 97.2% after recently falling. As for individual securities, JetBlue (JBLU), Intuit (INTU), and Gymboree (GYMB) were the stocks most recommended as longs by institutional brokers.

On the surface, the TIM Report appears to be an interesting idea and new source of data. While I am not yet sure if the data will be too lagging for investment/trading purposes, I am interested to learn how this new source of data can be used, and will therefore be tracking it while available.

Hedge funds had a nice May, up 5.2 percent on average. While the recent market rally no doubt helped, hedge funds also appear to be benefiting from less competition (see Economist article), with approximately 1,500 funds liquidating last year. This follows a similar trend observed in the late 1990s when less competition for trading opportunities helped those funds that survived after the LTCM failure.

But as reported in the article, not everything is rosy. After poor performance in 2008, many investors are requiring a more fair fee structure, one that is either closer to 1-10 (instead of 2-20), or that phases in fees over a longer period, after the fund has outperformed a benchmark - with the benchmark closer to the general market, and not simply zero, or a non-negative return. Investors also seem to be asking for more managed accounts where they can see where their money is being invested, and can also withdraw it quicker (and without gate restrictions). If that was not challenging enough, one cannot forget the added government regulation is coming down the pike. Possibly the biggest loser will be the funds-of-funds, which tack on an extra level of fees for the expertise of picking the best funds. Their failure to outperform enough to compensate for the extra fees, along with the benefits of cheaper hedge fund replication clones (see previous posts here, here, here, and here), are also making their services less cost effective.

Canada posted a trade deficit of $179 million in April. Economist were instead expecting a surplus near $1 billion (see Financial Post article). Both prices and volume fell, with exports dropping 5.1%. Lower exports of industrial goods, materials, energy products, machinery, and equipment drove the number lower. The Canadian dollar, which has been strengthening against the U.S. dollar, is also not helping the situation for Canada. The U.S. is the largest Canadian trading partner (76% of exports and 65% of imports to and from the U.S., 2007 data, wikipedia; about 1/3rd of U.S trade). The numbers, while bad for Canada, also highlight issues for the U.S. While the weak greenback may have helped U.S. exporters, imports into Canada were also down 1.5%. As a result, the larger decrease in exports from Canada illustrates the double-edge sword of a weak dollar. While it makes U.S. exports more attractive, it also makes international goods more expensive for U.S. industries that rely on imports of raw materials. The impact of this was seen in 2008 as higher crude oil prices, driven up in part due to a falling dollar, put a strain on the economy that trumped any benefits from increased exports. The figure below shows how U.S. - Canadian trade has fallen off a cliff over the last six months (figure source, U.S. Census Bureau), and why the recent "Buy American" provisions received so much interest and debate in Canada and the U.S.

Source: U.S. Census Bureau

According to a recent Wall Street Journal article, the SEC is being deluged with letters supporting the return of the uptick rule. Pressure for the rule has been building since the market melt-down last fall, generating additional interest this spring (see previous post). Let me state upfront that I believe when regulators interfere with the natural flow of the market, as they did when banning the short selling of financial stocks last fall, it does more harm than good - primarily by reducing market efficiency and increasing volatility when temporary restrictions are lifted. Besides the irony of helping to reduce risk management opportunities, adding an uptick rule seems ineffective for liquid markets, for which it is not all that hard to find a plus tick. Nonetheless, I understand and appreciate the arguments on both sides - primarily that we did fine with it for near 70 years. I am also not sure it will make much difference one way or another. Yet the current debate seems to expand the argument, and fall into the trap of assuming correlation implies causation. This is apparent in the following quote:

"Isn't it coincidental that right at the time the uptick rule was abolished, the sharp spiral downturn started."

While we can debate whether the market began falling July 6, 2007, or later that year, does it really matter? Could it also be argued that the rule was artificially propping up a market that should have long since fallen under the weight of a housing bubble? Is it the rule change that caused the market to crash, or did it simply get out of the way of the inevitable pent-up selling? Is there any difference? Was something else at play? One current argument goes on to say that not only should the uptick rule come back, but that naked short selling should be banned, capital ratios should be increased, the CDS market should be regulated, and leveraged ETFs should be examined. All worth examining. But if the CDS market becomes more regulated (a near given), current naked short selling rules are enforced (not such a given), and leveraged ETFs are restricted, is the uptick rule even necessary? Should we require a little more evidence?

As an additional reason for changing the rule, another advisor mentions that the repeal of the rule "drastically changed the outcome of many stocks this past year." Last I saw, so did greedy banks and home owners, yet we seem to be forgiving many of their problems, and even making it easier for them to become whole, but I digress. Yes, when bad companies are sold, they tend to go down. Maybe the market needed to drastically change. Was there overshooting, sure, but markets have a tendency to overshoot, in both directions.

Maybe the real point of contention is given by another advisor quoted in the article, stressing that reinstating the rule will help "investor psychology." Possibly, but is this a reason for bringing the rule back? And which investors are they talking about? Will the psychology of short-sellers or hedge funds be better off? Probably not, and maybe that is the point. Many blame the hedge funds and short sellers specifically for destroying their nest eggs. It only seems natural to want to punish them, but does it solve the problem? Once again, I don't think it does.

We have to be careful when assuming that one thing causes (or doesn't cause) something else. In fact, I know that some will argued that I am falling into the same trap. I agree. In fact, that is the point. When we interfere with and observe one outcome or property, and try to describe what we are seeing, the less we know about the other paired property, not unlike what Hiesenberg observed over 80 years ago. Controlled studies are needed, but as with quantum physics, this is difficult for dynamic markets. Maybe the next time the markets begin to fall we should spend less time assuming it is only caused by a structural flaw in the system, and more time understanding if something fundamental to the market started the selling. The market may be telling us something early on. If we had listen a little earlier, maybe we would be months and years into the next recovery ....... and figuring out when and how to short the next bubble (which if the uptick rule is reinstated, may be more inevitable).

There is an excellent opinion article in the Wall Street Journal today by Arthur Laffer (see WSJ article). In the article, Laffer discusses the increase in the monetary base, and how in the past 95% of the monetary base was composed of currency-in-circulation. Even with the recent unprecedented increase, cash-in-circulation has risen only 10%, now making up less than 50% of the monetary base, whereas bank reserves have increased nearly 20-fold. Granted, an increase in bank reserves was needed as a result of the liquidity issues of 2008 in order to make it possible for banks to begin lending again, but the balance has shifted too far. Laffer points out that banks will no doubt continue to make loans until they are once again reserved constrained. Currently, as banks make more loans and put more money into the system, the growth rate of M1 (currency in circulation, demand deposits, and travelers checks - see wikipedia article) is now around 15%. This of course will result in higher inflation and higher interest rates. As mentioned by Laffer,

"In shorter time frames, the expansion of money can also result in higher stock prices, a weaker currency, and increases in commodity prices such as oil and gold."

Does this market situation seem familiar? Unless the Fed acts to reduce the monetary base, which appears unlikely anytime soon given that there is no easy approach or outcome (see the Laffer article), it appears likely that the Fed will continue to lose control over rates (see previous post), and the markets will continue to tip towards inflation (see additional previous post). Plan accordingly.

Once again we have a weak dollar helping to push the price of crude oil even higher (see Bloomberg article, see first WSJ article on crude, second WSJ article on the dollar). In the CNBC video below, the technical analysts Nicole Elliott is absolutely beside herself, and even giddy at times, regarding the absurdity of the move in 2-year U.S. Treasuries. She eventually comes to the conclusion that the central banks have lost all control of the setting of interest rates, not to mention the long bond and interbank loans which have been outside of their control for a while.

Source: CNBC Video
Yet the 44.4 basis point move between June 5-8, along with the recent move in the Fed funds rates, are being dismissed by some firms that trade directly with the Fed, implying that it is simply speculators that are driving rates up (see Bloomberg article). Many dealers go on to predict that the Fed will hold tight well into 2010. Maybe so, but does it matter? While the Fed has recently retreated from seeking debt-issuing power to help control inflation (see Bloomberg article), the markets certainly are nervous about what they are seeing, regardless of the policy and wishes of the Fed. The TIPS market has also been active (see previous post).

Of course, what many traders are seeing and are nervous about begins with the unprecedented amounts of cash that is flowing into the world economies, much of which will eventually trigger higher inflation, higher taxes, and lower profit margins. To make matters worse, there is a feeling that much of the spending and printing is not necessary, and even worse, that no one at the Fed is really even minding the store. For instance, in the YouTube video below, one politician questions the Inspector General of the Federal Reserve. During the questioning, the Inspector General seems to have no idea where the trillion-plus dollars the Fed has put into the system actually ended up, or who received the money. There also seems to be no postmortem or investigation on the impact of not bailing out Lehman Brothers, or auditing of any off-balance sheet transactions.


Source: YouTube
Given the market reactions, the inflation-driven moves are beginning to appear a little more obvious (see excellent Michael Pento greenfaucet post), even if the size and timing are still under debate. Yet the moves can happen quickly. Just ask those trading the 2-year Treasury, or those who were looking to lock-in to a 30-year mortgage under 5 percent just a few weeks ago. This certainly seems encouraging for commodities long-term, and even short-term, regardless of the current rallies. Just think if demand actually catches up?