With the start of spring the markets may be showing signs of life as Green Shoots begin coming out of the ground. Will these Green Shoots blossom or turn to weeds? For this to be answered we have to look at the mechanics of markets and their relation with economic news as well as investor anticipations.
Markets are the ultimate predictor and discounter of things to come. As more and more investors anticipate a future outcome of the economy they place their money where their thoughts are and look for evidence that will either support or discount their beliefs. If their beliefs are supported they invest more and if discounted they sell.
For the past year and a half the only way the big boys on Wall Street have made money was betting that Financial, Real Estate and Consumer Discretionary stocks (as well as others) would decline and therefore short the respective companies. Because you can only earn byshorting a stock until it reaches 0 there comes a point where you have to exit the trade if the company you are shorting doesn’t go BK. We spoke about this in our last market update. One of the things we mentioned was in order to close out your short position you must buy the stock. When one big Wall Street firm begins to cover it’s short position it pushes the stock higher and as it does it will cause other firms to begin to cover their short positions causing more upward movement in the stock. Just like you can have cascading downward sell offs you can have the opposite to the upside as more and more firms buy stock to cover their shorts.
This is not investing – these are not purchases in the mind-set that the buyers are believers in the company’s abilities to thrive in the near term.
The price action in the market for March was mostly due to this mechanism which then extended slightly in April as the news on the economy gave the impression that the rate of decline in the economy was slowing.
We are beginning to see some benefits from the Feds moves in the past year of lowering rates and injecting money into the system as credit markets have shown improvement. We have said before that the problems started in the credit markets and will be solved in the credit markets. In addition to improvements in credit markets we saw continued increases in commodity prices which is typically a good sign as commodities are the raw materials that need to be purchased before anything gets made. Prices moving up represents an increase in demand. Granted this increase in demand can be short lived if the consumer stays in his cave and there can be an argument made that a two month improvement in commodity prices doesn’t necessarily begin a new trend.
Regardless, all this takes us back to the question of Green Shoots or Weeds. The signs we are seeing are encouraging. However, those green shoots will need additional water and fertilizer to blossom. Markets will require the same to remain near the current levels. For the markets to remain at the current values or move higher there will need to be continued evidence that not only the rate of economic decline has improved but is starting to plateau and reverse course.
Looking in the near future there are some obstacles the markets and economy must hurdle before we can feel that it is prudent to increase risk too much. The swine flu needs to go away and hopefully go down in history as just another overreaction. It is important to note that overreactions tend to get magnified when times are tough and societies are under stress. The swine flu is a left field event the markets have not priced in which makes the reaction up for grabs.
Chrysler and GM going bankrupt does seem to be priced into those stocks and bonds however I am not sure the systemic risk of them going BK as well as the economic effects it has on suppliers as well as commodities is currently calculated with markets at current levels. My gut says probably not.
And let’s not forget the release of the “Stress Tests” for the banks coming out the first week of May. Our feeling is the stress tests are a nice game to play when a government is trying to create confidence. However, the parameters of the test were not all that tough and didn’t appropriately represent what we think a worst case scenario would be.
With these obstacles on the horizon along with the continued change in consumer psychology to cut back and save Desi Arnaz comes to mind as the markets still have some splaining to do.
We feel there is a higher probability a pull back in the markets will occur over the next few months. The degree of this pull back will be determined on the news which comes out. On a technical basis the levels to watch are 830 on the S&P 500 (currently at 870) as a break below opens the door for the market to decline to 790 and a break there opens the door for a possible retest of the March Lows. The best case scenario would be a pull back into the 740-760 range on the S&P and then a move back up above current levels as we enter the end of the third or beginning of the fourth quarter. That kind of movement would bring additional buyers into the market as it would be considered a lower risk entry point for longer term investors and potentially set the markets up to have a good 2010.
We have recently moved a majority of assets to money market and in some accounts put 10% into the bear market fund to create some gains if the market does pull back in the near term. We are also investing for a short term decline in gold prices in the near term in our managed accounts. We exited our weak dollar, rising rates and Australian currency trades with profits and are considering whether we need to buy back our rising rates allocation.**
The markets and news will continue to be dynamic over the next few months. Dynamic is better than dismal and we will continue to monitor and adjust our portfolios as needed.
Until next month enjoy the beginning of spring and get out there and fertilize the economy.
The opinions expressed are those of Colby McFadden and Quiver Asset Management as of 5/1/09 and are subject to change due to market and other reasons.
**references of allocation and/or performance are not necessarily reflected in your account. Please review your statement for account specific information