This Two-Step Defines It All

 | Jun 18, 2013 | 12:36 PM EDT
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Look, it's like a blast zone. Initially it looks like no one survived. Then some people climb out of the rubble, many injured, but some, miraculously, unscathed. That's how you have to view this Fed event.

Now, let's face it. We know from the last go-round that the structure we stand on is a shaky one because, regardless of whether it is true, market participants just think that the edifice exists because of the Fed.

Fortunately it is the end of the quarter, so buyers will surface to protect their positions. Also, let's not forget that many companies are doing well and have not benefitted from the Fed as much as we think. They have refinanced, they have taken on low debt, but unless they are directly related to housing, the Fed has been a non-event.

But their stocks? As we saw from the real estate investment trust debacle, there are more people who want out of this stock market and into bonds then there are those who want to get out of bonds into stocks. So many people simply didn't understand what they owned or thought that we would be safe  because we are nowhere near the employment goals.

That means we have to deal with the reality of the stock market BEFORE we deal with the reality of the companies themselves. That two-step dance is what's going to define everything because, either way, if the Fed says it will keep buying or if the Fed says it will start tapering, interest rates should go higher, continuing to spoil the bond market equivalent plays that had been the refuge against low-bond yields coupled in the end with the greater fool theory that there would always be someone else buying your shares at a higher level because there will be someone else who needs to reach for yield.

Unfortunately this reach for yield concept became one of the most pernicious forces out there. We had people reach for yield with emerging markets in the 1990s, which led to catastrophic results as many of these markets defaulted or collapsed.

We had people reach for yield in the 2000s by buying collateralized debt, typically supercharged mortgages that turned out to be worthless or near worthless as housing prices cratered. Given that the reach for yield is typically done with borrowed money to enhance returns, the decline gets magnified and the stress to the system turns out to be more unfathomable than anyone thought,

That's what I think will happen with the bond market equivalents when the Fed is done buying bonds as the knuckleheads who use leverage to buy these securities are so wrong and so undercapitalized that they have to frantically hit bids, hence the decline that you see.

Fortunately we learned from the remarkable run-up in yields after the May Fed meeting that this reach for yield contingent is hard at work ruining everything for everyone again. We need to defend against that by staying in the shelter for tomorrow's blast zone and then coming out when the all-clear is announced. We come out with tech and with banks, as I mentioned before.

Why is it a foregone conclusion that there will be turbulence before stabilization? Because those who own bonds are now on the side of the need-to-tighten and they are going to vote with their feet to get out if the Fed is not restrictive and new buyers have to sell their bond equivalents first. These skittish owners used to be called bond market vigilantes because they would come after the Fed for not being tough enough.

The stocks, of course, take their cue from the rise in rates and once the rubble is cleared out we are able to figure out which companies have their stocks hurt, but their underlying business intact and which ones might be hurt. But we won't know for sure until we see their quarters. Those, for example, in the housing business get buffeted every day as we get numbers like yesterday where the homebuilders show great confidence and then numbers like today where housing starts are weaker than expected.

That's the same with autos. Yesterday Ford (F) said good things about the European market, but we got actual registration number for new cars and they were at a 20-year low.

Who do you believe?

The answer is that you believe what has historically worked at this point in the cycle, namely industrials, aerospace, banks and tech and the other you simply have to wait and see what they look like when they are pulled out of the rubble.

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