Challenging Times

Oct 17, 2011 | 3:02 PM EDT
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The straight shot off of the October low compressed what might normally have been a two-month rally into less than two weeks. However, investors should not read an "all clear" message into the surprisingly powerful bounce. Pay little attention to the talking head perma-bulls who contend that this is true. The economies and markets are still fraught with risks.

We got here (crazy volatility, no net price changes) because of deteriorating macro yet still-OK micro conditions. The outcome of that contradiction remains to be seen. Deteriorating macro conditions are causing modest earnings estimates reductions, but no wholesale eviscerations. Poor macro is causing negative leading indicators such as orders/ backlogs and poor diffusion/ sentiment surveys, but not hitting retail sales, industrial production, or employment levels, which are coincident indicators. Both the bulls and the bears can support their respective cases with such mixed economic data.

My point is that markets can "say" anything with its price action, but that doesn't have to be correct. And market observers who ascribe infinite fundamental predictive capabilities to short-term gyrations in share prices are simply wrong.

Both bulls and bears have challenges to overcome for the markets to respond to their wishes. Zero short rates, still healthy profitability, record free-cash-flow levels, and strong mergers-and-acquisitions (M&A) activity at big premiums help the bull case. Deteriorating fundamental conditions, structural imbalances retarding normal growth, euro banking/sovereign debt issues, and a slowing China/commodity trade all combine to support the bear case. Throughout this battle' and despite the short term spikes up and down, share valuations on normalized profits have remained middling.

At this time of year and under correction/bear market conditions, I usually look to add equity risk exposure. I have done that again over the past few months, buying at the low end of the range. However, I have been buying starter positions in tech, energy, industrial, and telecom and haven't become comfortable enough to ramp them to normal-size long positions. I favor both dividend and speculative ideas, one for high income and the other for trading profits on oversold, stupidly cheap specs. However, I also continue to hold a large cash position. I guess that makes me neutral on equities, but I am still looking for selective long opportunities.

The battle between the bulls and the bears will come down to the macro. If the economy muddles through and Europe gets "rescued" for the fourth time, shares could extend their rally. If however, the 30/50-1 leverage of the European banking system and the bankrupt PIIGS (Portugal, Italy, Ireland, Greece and Spain) generate a seizure in the global banking system, all long bets are off. Shares would drop sharply on a severe economic decline or a significant systemic financial crisis.

Many strong thinkers, most of whom called the 2008-09 recession/bear market, are once again predicting economic and stock market downturns. This time, it's Europe and China and not the U.S. that is expected to take down the global economy. While I have been buying stock slowly and selectively, I also believe the risks to the economy and markets are to the downside. Maybe that's just the pessimist in me. I have not added anything after the latest surge.

To be fair, it's getting close to the "put up or shut up" point for the bears and the real economy. We can't have recession fears depressing share prices forever. A worst-case outcome is absolutely necessary in the short run for the bears to be correct. As the brokerage statement proves, it's challenging to be bullish. But it's also challenging to remain bearish with the micro conditions still so positive. There must be a fundamental resolution to this bull-bear battle over the real economy in the next quarter or two.



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