Monday, October 22, 2007

Entry for October 21, 2007

Investors eye chance of another Black Monday-click here
I agree with Paris in the fact that is indeed “a question of market psychology,” I knew from the start that a .50 cut in the Fed’s Fund does not solve any issues but provides temporary relief and adds to more of a superficial bullish sentiment among institutional and non institutional investors. Previous chatter in Wall Street said that a strong drop in domestic equities would have to occur before people started following fundamentals again. Though to the extent in this media driven age this sell off is indeed superficial. But to the extent of who ever buys into it. In other words, in a traditional sense Monday would be a great buying opportunity, but as we proceed media will wait along with investors to further assess weather or not indicators will be more bullish or bearish to be reported and over played. In deed great parts of this sell off is the focus in news, adding to negative sentiment values, priced in the market. I must note though however, due to these factors and many more, that the chance of recession has increased from 50% to 35-40% back to 50% to around 50-55% over the past 3 weeks or so (by my gauge). This extreme volatility can be attribute to the fact that it is indeed media driven. The past week and half or so, I would say fundamentals only significantly changed. This change spurred on primarily by the falsely bolstered lagged affect of a .50% preemptive fed funds rate cut. From the summer of 2007 similar conditions persisted with slight variation as seen in steady rises in domestic equity markets, as to clarify a steady conditions of mixed financial and economic factors, as one must always separate the two since they never are directly correlated. Similar conditions such as a constant drag in housing, which up until recently could have been negligent due to fact that housing drag will persist for a few years 1 – 3 or more, but non negligent now due the significant drop in housing fundamentals such as drop in home sales and housing starts (housing reports go here), in terms of the beginning boom in 90’s to slight prick, of financial conditions going from a over reaction in extreme bearish conditions on the surface of sub prime mortgage problems, to neutral to moderately improved view on sub prime, to uncertainty in that the crisis was not over tied in with the credit problems, and lastly to falsely improving bullish sentiment with the Feds cut,

Another contribution to this slide are emanated from earnings reports, though from my perspective, not totally surprising on a whole, but on the scale of significance more than I had expected. Key bench market such as conglomerates United Technologies cooperation and leading financials, Citi group, JP Morgan chase, Bank of America, all exposed to credit risk and exposure in sub prime. With current oil prices another aspect of industrial sector in the economy weakened due to oil prices, leaves technology left as support as presented in the article. Though I can’t the significance lies in primarily affecting the financial sector and probably hinges more on lower end higher credit risk consumers. United Technologies speaks more of world wide industrial aspect, but only slow growth in a few of its 6 segments.

From an investor standpoint there is no doubt that technology poised to rebound sooner or later, obviously the million-dollar question is when… Following trends within technology there is much compelling evidence for this. For a long time that I can recall from around 2004, the ^soxx which has been a trading range of 200-250, and many other technology stocks have been trading flat, stale or in a range, comparatively the Nasdaq has been a constant laggard of the other indexes. As any technician will tell you, the longer the sideways trend the greater the break out. I would say it is the resilience of technology, but the truth is that technology can only go down if society decided to stop using everything that makes an industrialized nation exist. Especially with future strong growth abroad in emerging markets, technology will be huge. The fact that technology also does not go do is in the fact that there will always be a constant demand for some form of technology, hence the resilience, or the natural underlying fundamentals of it.

Oil and consumer inflation

I would like to point out that the consumer is not as weak as it may appear, though on a whole retail is down, a large part of the consumer in the past months were driven by teenage consumption, one can say trends this year as we transition to winter will cause slower affects, and as though I cannot speak with 100% confidence, stores have not been mass campaigning for this winter though as soon as weather decides to settle on what it wants to do we will see a pick up in soft good retail side. Now point to hard goods and big box, this side of consumption is indeed something that is strong within the economy, look to Costco earnings, best buy earnings, and all electronic stores, also which ties in to technology who has buoying the markets in a sense form all the lack luster performances in industrials.

Though I must stress the significance of inflation risks. Brought on with the weak dollar, now extremely high oil prices, and volatile commodity prices. The bullish aspect to the dollar being that domestic production occurs, growth spurring on inflation, bearish is that exports are more expensive and thus again brings on inflation. Though this affect has not yet been seen and is to be reported soon as, as all economic reports are lagged, as I have proved this consistently with the prediction of revised cpi and ppi, though on large only brought about by the food and energy side, which is more massively significantly now considering the prices of two. On a whole some may argue the only slight revisions with in core cpi and ppi, but again I say this will change as with current economic conditions which will be reflected in later reports, On the oil aspect with now prices hovering around 90 a barrel, this will certainly have an added drag affect on the economy as consumption will again once rely on the mid to upper and middle class to drive consumption, eventually though, there will be a slow growth in the upper consumer too considering I can’t believe that myself or many consumers will be driving with gas prices increase that much. I would like to say that the bulls in energy are going to pushing for the 100 barrel mark more of a psychological factor, as soon as 100$ is approached gains will be taken and oil will eventually re retreat to the lower 90s to mid to high 80s’. (confirm with technicals). Slowing consumption further, though as again, the consumer is not really that in bad shape over all as seen in growth in technology and peoples willingness to buy racey expensive gadgets iphone, tv systems, etc.. (again reflected in big box hard good sales). The slow growth consumption is a temporary affect which is related to the volatile prices in energy and food. This is not to negate the fact that inflation still exists and may be perceived already by the Feds as they are the ones who receive first hand results from their advisory councils across the 12 regional banks.

Interest rate:

This inflation will definitely have a significant shorting opportunities in the bond market, as recent yield moves, it is only natural to see this significant downward pressure on the yields. As everyone in the bond markets are pricing a rate, cut and matches the tradition relationship between inverse moves of the domestic equities and bond market ( A sell off to an increase in bond prices). This is where my scenario of inflation comes in, with prevailing inflation to come in the upcoming months, short positions would be most advantageous, though properly hedge if the core is within expectations, and I would expect expectations to be slightly higher in the core, though and slight deviation of this expectation in the upward moves in % inflation, will spur on a great selling opportunity. Though again this is to say the necessary fundamentals are in place, so if economic conditions do persist, or further worsen in economic conditions, the bond market will experience a significant rally, as the feds continue rate cuts.

People will still love to talk about the inverted yield curve and its traditional meaning of recession, I just say one can toss it out the window. For two straight summers the yield has been inverted with bears chiming recession recession recession time over time again. Now this shows me two results or explanations, one being the resilience of our economy has fended off a recession and will continue to do so while contrasting as a bear would say, it is only a matter of time before we start pricing in recession or it becoming an actuality, since resiliency can hold for only so long. A more bullish viewpoint is that the vigilance of the Feds will fed off the recession, though I would argue that, buy doing cuts it will not solve any fundamental or structural integral problems. Though with enough cuts, it will take a longer time to work out but eventually would prevail under those assumptions.

Policy and trends on cuts: Closely tied to the last statement can be reflected in chairman policy. As Greenspan would show, Greenspan policy has led through the longest expansion in economics history and brought us through, as the trend of 2001 the consist preemptive cuts spurred from 9/11 and .25 cuts for 3 years shows us policy trend in terms of crisis. The question is how is Bernake going to act, on the magnitude of 9/11 is hard to compare the two completely different crisis though related to the fact that they are crisis’s. Bernake has already showed a preemptive stance as he surprised the bond markets September 18th with a .5 cut opposed the commonly priced in .25 cut. Though the scales of the two crisis are different, it would not be surprising to see another .5 cute when people again are leaning towards a .5 cut, if one were to graphically represent this trend, currently I would say we are on a downtrend, and significant downward momentum persist.

Again confirmation exist within the bond market, on the last Fed decision, the bond market and Feds finally were in accord. Through out the summer and number holds, there was significant divergence, of the sound fundamentals and the bonds wanting to cut rates, now that there is convergence, a confirmation in the bond market is legitimized, and considering the significance in this recently rate with only a few days of using the benchmark 10 year note, you have around 5.05 in mid July 19th, with a move to 4.40 now, the fluctuations are more significantly scene from 4.68 of September 21, to 4.40 now. All these are indication of another price cut with more harmony existing between the feds and bond markets.

Political Paulson: On a political perspective, recently Paulson has been portrayed as weaker and lacking in leadership, due to the recent credit and sup prime problems, and weaker dollar with softer economy, because of this is said to be affecting his power to negotiate on equal terms economic policy. As this is been lead on by media, which has forced Paulson to save face. Which lead to his comment on a problem that has been persistent and blatantly obvious, which he commented on how housing will continue to be a drag. This is not to negate the fact that housing indeed has been weakening, but was an already obvious fact that had been reported in lower home sales and starts, which was reflected in domestic equity markets, which goes to prove this is much of a psychological factor also.
This only relates to the fact that 1. Housing is obviously more of a negative aspect as stated by secretary Paulson, and that this puts significant pressure on Bernake since the health in the economy is tied to his reputation also, with political pressure and the job of the feds to prevent appeared or apparent systemic break down if you will, which leads more towards a cut stance.

Proof in the fact that Paulson is losing negotiation power can been seen in the weakness of the dollar. Slowly one of Japanese oil companies has an agreement with Saudi Arabia OPEC to trade yen on the spot market opposed to the usually vehicle currency the dollar. This move for diversification in assets has been seen through the 2000’s with the rise to the European Union, which obviously will bode more negatively for them.

All this can also be reflected in the trade balance, in terms of the United States the trade deficient has benefited from the weaker dollar, as seen a decrease in deficit spending while may in the future decrease the usual European Union surplus

In terms of currency and interest rates, growth:

1. Benefit of this weaker dollar, this boost consumer demand from abroad, while maintaining strong domestic consumption, which can sales of us cooperation in the midterm or upcoming months, by means of more jobs and more spending. Also tied into increase production and manufacturing.
2. Foreign Investment can benefit in many ways. Foreigner investors have been significant buyers in the real estate market for the past few years. As shown by the NAR, nation Association of Realtors, about 1 and 5 Americans sold a second home to by the end of April 2007 to a foreign buyer. 1/3 from Europe, ¼ from Asia, and 16% from Latin America. As prices of housing and the US dollar converge. And how can this relate, one can argue soundly, that this is the support the housing market will be looking for to bounce off a bottom. Another support can be that foreign investors, primarily equities, are constantly seeking undervalued companies out. Both of these factors, I must highly stress, are dependent on the stabilization of the weak dollar (show technicals here). Though as not yet to occur yet with its continued downtrend. Another factor that is bullish for a weak dollar is that, a weaker us dollar makes more companies more attractive as buyout targets, many countries will excessive wealth (Dubai) looking for a solid investment. (Great buy opportunities with the current weakness).

Bloomberg article-click here
3. This weak dollar also bodes well for employment and adding to the tightness in the labor market. This is possibly by means or tourism as a it is an industry that supports 5.4 million workers, and generates over $550 billion in annual revenue. Canadians by far are the largest group of tourist in the United States, Now the the Canadian dollar is trading at parity with the Dollar, we can expect a greater increase in travelers. There has been a 15% savings increase between cost of hotel cost between Canada and the United States, and Europe will experience a 5%-10% savings in travel cost. Tourism always a plus for economy.

On the other side-

1. The obviously and immediate affect of a weaker dollar is the higher cost of imports. Canada being one of the largest countries the US imports in can be seen as inflationary (this in with politics) and healthcare higher taxes on middle class hurt consumer). Because of this strength in the dollar Canadian drugs may not be as much as a bargain as they used to be. This is also true of high-end European items. Luxury goods, handbags etc…
2. Weaker currency will lead to tighter monetary policy. As oil prices are sky rocketing around 90 a barrel, Feds will only naturally have to aggressively cut the funds rates. Again you can relate these to other crisis such as the Asian and Russian currency crisis of 1997 and 1998. The fact that these weak fundamentals in the economy warrant a cut, inflation may keep the Feds at bay if it rears its ugly head. This inflation may prevent the necessary cuts to buoy the economy.
3. From a consumer level, though the possibility it cutting into business not as much, makes foreign travel more expensive. For example, in foreign countries like Europe and Australia. Since the beginning of the year, the Australian dollar has appreciated over 10% against the us dollar, primarily due to currency fluctuations this increase has occurred. The same case is true with Europe on a smaller percentage basis.

In relation to these last 3 points, there is still some leeway and room for continued Fed cuts, as inflation will be reported as lagged.

Carry trade:
Adding the carry trade aspect to this you get an even more interesting picture. Many Yen traders came to buoy the US dollar around October 8, you can see the 10 year note around 4.63, the dollar was searching for a bottom, but brown below support continuing its downward momentum with the slew of weaker economic data. This will only cause other countries such as Australia, New Zealand, and Japan (though BOJ has key rates on hold of .05) has continued support of higher interest rates. Favorites of Carry trade are probably more focused in Australia and New Zealand as the disparity interest rates are greatest, and probably Europe next as economic growth is looking more safe as we experience this flight to quality.

Labor markets:

I would have to argue that the Labor market is a bullish aspect still in the economy and is in part a large driver in consumption. And is a large reason why GDP has not dipped below the 2% level. Unemployment as perceived to lower in the month of July revised up as bullish. Though on a whole, due to weakness in the financial sector and tightness in the energy sector, it is possible to see weaker than expected employment reports. In general the labor markets have been stable due to the prevention of the spread of systemic break down. With the Vigilance of the Feds, I see it to continue as so, with slight revisions more to the downside, though obviously more positive repots will good trading opportunities if one can see a future disparity.

GDP trend: Recent GDP trends are been relatively static with slightly lower revisions down ward for two straight quarters. It is in my opinion that a continued downtrend is possible though barely significant as housing conditions are slightly worsened, and tighter credit still remains a large problem. Over 1 to 2 years I before for significant strength due to fundamentals am seen.

Government spending and war political consequence: Tied in with GDP growth, though I don’t have exact percentage, but Government spending due to the War efforts is very significant (defense stocks). With the continued war efforts may have been another contributing to buoying of the GDP just above 2%. It is very possible now with a more liberal bias existing in politics that Government spending will significantly decrease in that area, and will reflect in a weaker GDP. Though that’s not to say it will be direct correlation considering depending on whatever candidate wins for Presidency can use the money in a way to benefit the economy, which obviously is dependent now on the democratic primaries in my opinion and their platforms.

Liquidity relief: no the Wednesday of reserve requirements: Recently, the Feds has been adding in over night reserves (Open market operations, buying of us treasuries). This is significant in my position as it is the Feds are testing market conditions. As the domestic equities show, despite this all indices still reflected negatively. This can be seen as a measure and test as to much the next Fed Cut will need to be. Despite more liquidity perceived problems or actual problems still exist and need to be addressed.

For buyers in Domestic equities: Tomorrow does not appear to be a buy day, as technicals indicate increased downward momentum over the next 3-4 week weeks as back tested. Though considering the difference in scenarios 2 weeks is more possible. Tomorrow will be on a watch and wait policy for everyone and will be proceeding with caution. Obviously in this market your non-cyclical stocks are always what is commonly expected to be strong. A continued short position is suggested with a hedge on with written calls on S&P 500 futures.

In terms with interest rate derivatives; as 110.5 to 111 is approached, I suggest thinking about setting up short positions as I don’t think the economy will significantly tank further. Again another written call would work as a hedge. Or go long in the short term interest rate derivatives, if holding for short positions in accord with your short positions in longer interest rate derivatives.

Oil: though oil is seems like it is retreating I believe there is still some upside momentum, as volume slows down long positions should be taken earlier as higher marks are made to play it safe.

Currencies the dollar: Traders should be looking for improved fundamentals in US domestic equities, and looking to follow where foreign capital is moving too, carefully watching interest rates of other countries to keep up with carry traders. Significant buying opportunity exists as dollar approaches a bottom. Though I would wait a by the end of this week to reassess, it is possible that it will continue to drag lower through into next week, as indicated by volume.

For the Feds Decision: I can see a .25 cut with no surprise with another preemptive .50% cut with a series of smaller cuts to come, as inflation will not allow all the necessary cuts to fix the internal structural and integral parts of the financials that need to be worked out themselves. I would say it is necessary to let them feel the effects of their mistakes but global capitals markets cannot sustain such extended periods of illiquid markets, as there for necessary for the feds to keep providing relief through adding reserves, and cutting rates to provide more liquidity as the problem sorts itself out over a longer term.

Bullish Aspects to economy: Durable good strong, Consumer is not as dead as appears, growth and demand from abroad, technology, and other strong earnings reports will be solid, and weak dollar.

Bearish Aspects: Housing situated has slightly worsened but not that significant, as the wealth affect may take a slight hit but not significant to kill GDP. GDP growth is in decline, Inflation is prevalent, credit problems, illiquid markets, industrials are weaker along with financials, weak dollar possible, political pressures, job of Fed to maintain system risk.

I say the fundamentals overall have changed to the downside, but the cut will be more of a political pressured and media driven move; though also necessary to help the financials, and housing. Though already with the low interest rates housing may improve from spurred refinancing, as interest rates are significantly lower from the past 2 months.

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