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The Market Nears The Precipice

Jun 29, 2010

To All Clients,

The market is near the precipice of serious trouble.   The Dow is trading below the psychologically important 10,000 level and the S&P 500 has fallen almost 15% in the last 2 months.  Although the short-term oversold market conditions may provide a good setup for at least a brief rally, I’m not too confident that stocks will find lasting traction.  The major indices have not reversed the uptrend that began in March of last year, but a break much below current levels would signal a key reversal and the beginning of a new intermediate-term downtrend.

Over the past year, government stimulus programs successfully pulled demand from the future and spurred temporary improvement in business activity.  At the same time, corporations momentarily resurrected their profit margins by shedding employees.  Stocks reacted accordingly by staging a very large rally. But the last of the stimulus programs expired in April (namely the home buyer tax credit) and the economy must now limp along under its own power.  The prognosis doesn’t look encouraging if the employment situation is any gauge.  A close examination of the recent employment report reveals an extremely wounded and cautious private sector.  While 431,000 jobs were added to the economy last month, the preponderance were temporary government census jobs – low paying at that.  Private employers added only 41,000 to their payrolls.  Hello! There are many millions of unemployed people in this country. Those numbers won’t make a dent.

Since last summer, “predictive,” or otherwise known as “leading” economic indicators have pointed to recovery. However, real or ”coincident” economic indicators have been telling a different story, having merely flattened-out at record low levels.  As an aside, certain sectors and pockets of the country have fared better than the overall economy.  For example, some anecdotal observation suggests that business may be better in Texas than many other regions.   Just remember that the New York Stock Exchange is not a regional or local market.  It’s global.  It reacts to circumstances in California, the gulf coast, Greece etc.

Anyway, the leading economic indicators, one of which is the stock market, are now showing signs of retrenchment.  Yet most economist will not lend any credence to a double-dip recession scenario, nor will the general public.  Of course any unwillingness to consider this possibility is akin to an ostrich burying his head in the sand, because the evidence of real and present danger is available to any observer who cares to look a tad further than the evening news.  Denial is an effective coping mechanism, but Charles Darwin would not consider it an effective survival instinct.  In my judgment, the stock market, like many other leading indicators, over-reacted on the upside and could react adversely to a more sobering economic reality.   The bottom line, if the S&P 500 ultimately falls much below 1040, the next visible target would be around 948 – approximately 10% below current prices.   Beyond those levels, I will not comment.  Many traders are carefully watching this general price level. If the floor doesn’t hold, traders may sell stocks with abandon.  If it holds, expect a short snapback rally.

As you probably know, I have remained defensive with portfolios anticipating a relapse of volatile markets and difficult economic conditions. A few weeks ago, I used market weakness to add a few select stocks to the portfolios bringing our total equity exposure to about 15%. These companies are less vulnerable to slower commerce and have performed better than the broad market.  However, the timing of these trades proved premature and the markets have convulsed and ultimately continued to slide.  So, I promptly reduced our equity exposure to about 5% by selling a couple of tactical positions in index funds.  In addition, I have been in, out, and back into, an investment vehicle that essentially bets that dollar will appreciate against a basket of foreign currencies including the Euro.  Those trades have been profitable.

A “sell on strength” mentality rather than a “buy on dips” mentality could be developing.  If this pattern is confirmed, I will change our posture from relatively neutral to bearish.  In the meantime,  I’m trying to add value by pursuing alternative strategies that promise returns under any market conditions.

Incidentally, the S&P 500 is still down -33.8% from its high in 2007 and down -31.3% for the decade.

Best Regards,

Greg

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