Q2 Tuesday – Ending With A Whimper, Not A Bang

What happened to our great rally?

We started the quarter off well enough, with the Dow at 7,522 and S&P at 787 on April 1st, we flew right up to 8,000 on the Dow and 840 on the S&P the next day but then it took us the rest of the month to gain 200 more points and the last day of May we finished at 8,500 Dow, S&P 920 – nothing to write home about on the whole.  June 1st was very exciting as we made all our gains for the month that day, flying up to Dow 8,800, S&P 944 but that's where we called a top and cashed out and it's been pretty dull ever since as we've bounced up and down between 8,800 and 8,300 on the Dow and 940 and 900 on the S&P, waiting for a breakout one way or the other.

It's dull to stay in cash, it's like going to the track and not betting on any races.  We really thought we'd get a proper indicator by now and we had fun betting the downturn from the middle of June but even that fizzled and left us back in cash as we head into the holiday weekend.  On the bright side, the VIX has come down substantially and we are now able to pick up long options again at reasonable prices.  This will be fantastic and give us some great leverage but we still need the market to pick an actual direction. 

At least now we have earnings coming so we can evaluate various sectors and place some bets for Q3 but index buying has ruled Q2 and the performance of individual stocks has been washed away as a factor as machine trading has yanked the broader market up and down on a daily basis.  It used to matter how IBM or INTC was doing as an individual company, now the entire Nasdaq can fly to the moon and take PALM, AAPL and RIMM with it, even though it's not very likely that all can do well in the same space for very long (remember MOT?).  We are no longer deluding ourselves that 2Bn people in Asia and Africa will be sporting the newest smart phones on the beach next summer yet the pie in the sky valuations persist, as if there is infinite room for all competitors to sell in the global marketplace.  In fact, emerging market valuations are are back over 40 on a p/e basis so who says we can't have another "dot com" boom?

Commodities are trading like .com stocks, where no business plan is required as long as you sell something that can be traded on the ICE or the CME, where EVERYTHING is valuable to somebody.  Not since YHOO was priced at $300 a share has the greater fool theory been more evident with more and more investors chasing fewer and fewer commodities as the reality of production shutdowns due to low demand meets the unreality of a speculative bubble that is fueled by wave after wave of new buyers, who can't find anything else to put their money into so they chase the only "performing" sector and that's commodities.

It doesn't matter that global demand is down or that supply is plentiful.  Arguing logic with a commodity bull is like trying to tell a Pets.com investor that people aren't going to overpay for pet food on-line just because a sock puppet told them to – they just don't want to hear it.  That sock puppet is going to make them rich and there's nothing you can do or say to make them think otherwise until the bubble bursts and they realize none of the profits that were projected ever materialized and that the sock puppet was, in fact, a sock puppet and couldn't even be sold on EBay.  Just yesterday, despite the IEA telling investors there is no growth in the energy markets and won't be for 5 years, oil and gasoline had their best day in a month.  There is no point discussing fundamentals with these people, they just NEED to have their bubble burst – just like last year, they won't believe it can happen until after it happens and, even then, they'll be back less than a year later to do it again….

The UK economy posted the largest decline in 50 years this morning with output down 4.9% vs down 4.4% expected by our "green shoot" spouting economists.  A sharper than expected decline in construction output as well as declining service output led the declines.  Overall GDP was off 2.4%, revised down from 1.9% (25% worse).  James Knightley, U.K. economist at ING, said the figures were "much worse than expected" but added that they "should only provide a temporary knock to sentiment."   This is, indeed, JUST like the .com days when a company would lose $100M in a quarter, drop 25% in value and call it "a temporary knock to sentiment."  Household expenditure dropped 1.3% in the first quarter on a quarterly basis, the biggest decline since 1980. Real household disposable income fell 2.4%, also the largest since 1980.  Oh yeah, 1980 – good times! 

Asian stocks were led higher by the Nikkei, who jumped 1.8% led by energy stocks as oil was pushed up to $73 in overnight trading (now back to $71.70 at 9 am).  Despite the party thrown by the commodity pushers, the Nikkei failed to hold 10,000 and finished at 9,958 after a 200+ point gap open failed to close the deal.  It was far worse on the Hang Seng, where a better than 300-point gap open on very excited pre-market trading turned into an all-day route where the market gave up 500 points and finished the day down 149 at 18,378.  "Investors expect that after the recent window-dressing activities, the market will enter a phase of correction," said Ben Kwong, chief operating officer at KGI Asia, referring to purchases made by institutional investors recently to shore up the value of their stock virtual portfolios.  Meanwhile, unemployment in Japan hit a 6-year high.

Europe is trading flat ahead of the US open and my big fear for the week is:  What if this IS the windown dressing?  Euro-zone CPI posted its first drop ever this morning with French PPI down 6.7% from last year and Italian Producer Prices down 6.1% from last year as the economies remain stuck in the mud.  Bloomberg published an article this morning warning that a crisis in the Pound is brewing.  “The probability of a real sterling crisis is around one in three, and the probability of major tax hikes and cuts in public spending is roughly one in one,” the Harvard's Niall Fergusun says.

The US economy got some relatively good news as Case-Shiller showed homes "only" declined 18.1% since last April.  This is up from down 18.7% in March and is the first month-over-month improvement since January 2006 so nothing to sneeze at although home prices were UP 16% year-over-year in 2006, as opposed to down 18% now.  In general, housing prices are now back to mid-2003 levels, wiping out 6 years of home wealth-building and we MUST hold it together here or the majority of US homes with mortgages could end up underwater, which will lead to another massive round of bank write-downs. 

So it's green shoots or bust in this economy and we'll do our best to ignore pesky little facts like New York City Business Activity contracting in June with a massive fall from 61.3 all the way back to 44.8, a disaster that is being swept under the rug by the MSM on this last day of the quarter celebration.  Also getting little attention today is Redbook's Retail Report, which is showing June sales down 4.4% from the first 4 weeks of May.  I wonder if that includes gasoline sales as gasoline is up 28% for the month….  Yes it's still a scary market out there and, annoying as it is not to play – we still love our cash at the moment.