Friday, February 02, 2007

Counter currents in the market

Lately, the sectors that I’m overweighing, namely precious metals and energy stocks, especially CanRoys, are doing well. Even the two specific names featured here recently are pulling their own weight.

ITA is benefiting from a blow-out quarter by Boeing; while NAT has broken above the $35-36 level with enough still left in the tank. I never tinker with things that are working, so it leaves me some time to ponder the bigger picture. But be forewarned, what follows is a synthesis of what I consider the major currents underlying this market. Those looking for a clear conclusion will be disappointed, as I have none to offer.

In October of last year, I wrote about my bearish bias based on a housing bust. If we re-examine that premise today, we’ll find some pretty awful news from that front:

However, you won’t be able to tell by looking at the stocks of major homebuilders and mortgage lenders. The Philly homebuilders index ($hgx) has been trending up since last summer’s low, and I won’t even go into what happened in CFC and LEV this week.

Some are quick to point to the “whack-a-short” game played by institutions. It’s plausible but the question no longer interests me after closing out my shorts there some time ago. On the other hand, the $64k question remains, “Is the weakness in the housing sector going to spill into the rest of the economy?” Without going too much into the details, I list the bull/bear arguments in the table below.

Bear caseBull case
- Subprime mortgage implosion
- High housing inventory, vacancy and foreclosure rates
- Price reduction in former “bubbly” housing markets
- Anticipated reduction in MEW and RE related jobs - Rebounding homebuilder stocks
- Strong overall stock market
- Q4 GDP and consumer spending
- REITs strong
- Fed on hold
- Rabid money supply growth

With the exception of Q4 consumer spending that was made possible by deep discounts during the holiday season, items in the Bear column are based on developments on the ground, whereas items in the Bull column are related to money supply, credit and the stock market. In other words, we’re witnessing a dichotomy of the “real economy” and the “financial economy”. Note that I’m conforming to the common usage of these two terms but there is nothing unreal about the “financial economy”, or as they say at the Contrary Investor, in this country the “financial economy” is the real economy. Too often these two terms are used with the implication that the “financial economy” is the wayward son that eventually must converge with the “real economy”. Let me invoke the name of this blog here and say that we make no such distinction.

In the Bull column, perhaps the most powerful force is the rate of money supply growth.

Money power
We cannot talk about the “financial economy” without talking about money supply growth. Steve Saville made this very astute observation on the yield curve inversion:

A prolonged and substantial contraction of the spread between long-term and short-term interest rates, such as we've seen over the past three years, will generally LEAD to a less-liquid financial environment. However, the yield-spread contraction itself is typically a response to INCREASING liquidity because it stems, in large part, from the eagerness of speculators to 'borrow short' in order to either 'lend long'…

My understanding here is that the inverted yield curve that had a perfect track record in predicting recessions WAS a warning sign of shrinking liquidity. However, in today’s world of yen carry trade and global reflation, it is more of a sign of excessive liquidity. [The latest number from NowandFutures shows reconstructed M3 growing at over 12%; M3 in the Euro area is growing at 9.7%; all the while the BoJ caved into political pressure by standing pat on their 0.25% lending rate in the most recent meeting.]

It is also true that the rapidly swelling M3 is not making its way into M2 or Mish’s M’. Again, nothing surprising since M3 is better correlated with the war chests of punters.

Technical picture
The major indices did well this week, making it a positive January. The transports made a new. The Nasdaq which has been the weakest of major indices managed to pull itself up by the bootstraps. It was up six sessions in a row since last Thursday. Coupled with the upbeat Q4 GDP number and a Fed content with the short term rate at 5.25%, it’s goldilocks all over again.

After all this, in my heart of hearts, I still can’t shake off my bearish bias. Don’t get me wrong, I’m fully long with a tiny number of covered call positions, but my moments of introspection tell me time is ripe for a capitulation of the bears. The 8.6 year cycle tops out in at the end of this month. The housing inventory situation for next spring is another big unknown.

What to do
Let me say again that I don’t have the answers. I can only talk about which way I’m leaning for my own account. One thing last September taught me was not to short early, as least not short big. I’m also constantly reminded of one of Gartman’s trading rules: “think like a fundamentalist, trade like a technician”. I don’t see myself initiating short positions until there is a clear breaking of near term support/trend line. I will do it with more conviction if there are signs of the yen carry trade unwinding or yield curve normalizing as Saville suggested (i.e., the 10 yr breaking down). Precious metals and PM stocks will do well in a dollar crisis, although the probability of that is remote. I can’t predict how PMs will react in other scenarios, but then again they are the least of my worries.

The last thing I want to mention is Sam Zell’s musical Christmas card which has been circulating around the net. You know, the one that starts with “Capital is falling on my head” to the tune of “Rain drops falling on my head”. One of its themes is the need for capital to chase after yields as the western world ages. It makes a lot of sense to me and I’ve been picking up CanRoys (oil bottoming didn’t hurt either), tankers, as well as some high yielding close-ended funds.

In conclusion, the market is in fine technical shape and I’m poised to take advantage of rallies as I sense a possible bear capitulation. However, I remain wary of the housing situation and the impact of possible high inventory levels in the spring.

Best of luck and be safe!