by Dan October 30, 2011 6:09 pm • Commentary

Last week was just one of those weeks where you had to join the herd, cover your eyes and put blind faith in generally in-effectual European Policy makers to make money from the long side. Unfortunately for me those are 3 compromises that I am generally not willing to make in most facets of my life. It might have been the obvious trade, but that is not how I tend to run my investment/trading strategy or my life for that matter…I take no pleasure in doing what everyone else is doing and generally don’t believe in anything that I can’t see with at least one eye wide open.

As Bruce Springsteen so aptly put it in his intro to the song “War” on his album Live 1975-85,

“Blind Faith In your Leaders, or Anything will get you killed”.

Well in this instance, that obviously wasn’t the case for longs in this market, but going forward, as the markets determine the lasting affects of last weeks compromise to fix the Euro-Zone debt issues, it is gonna take a heck of lot more than hope and faith to get those sorts of equity returns going forward.

EU Plan:

Drilling down a little on last week’s plan announced by the EU to ring fence Greece’s debt obligations and recapitalize European banks, I am hard pressed to see that this wasn’t exactly what the markets weren’t expecting. The markets reaction the world over clearly tells a bit of a different story, but if nothing else I guess it bought the financial world as we know it a little time, and enough time for Greece now to meet their near term financial obligations.

European Central bankers and political leaders were obviously working from our 2008 financial crisis playbook in an effort to haircut bond investors, increase leverage to expand sovereign balance sheets, but in my mind they have merely kicked the can down the road, and not attacked the root of the problems.  Friday’s Italian bond auction, which saw 3 year bonds fetch yields up more than 25bps in a month, and north of 6% for 1o years (the highest level since joining the EU in 2000), shows the continued challenges of the PiGS’s ability to borrow and the future constraints of paying back this debt at record high levels.

Glass is Clearly Half Full for the Moment:  

As for the stuff that we could see with only one eye open, economic data and U.S. corporate earnings, most were generally fairly decent. Of the almost 200 companies in the S&P 500 that reported earnings last week, almost three quarters of them beat estimates (albeit recently lowered expectations). Additionally Q3 reading in GDP that came in mildly better than downbeat views and slightly better consumer confidence data all suggest that our economy is doing slightly better than most feared only recently.

Cross-Currents remain abundant though, this week we will continue to get data on 2 pillars of the economic recovery that refuse to budge, jobs and housing…. mortgage application data and than the all important Jobs number this Friday…..But all eyes will clearly be on the FED statement at the conclusion of the FOMC meeting this Wednesday……the rate decision is not likely to be a big mystery as they have already give the world a sense that real rates will be negative for the next however many years necessary to stimulate growth……..but there has been much debate about recent rhetoric out of some Fed officials who have been calling for QE3……If the Fed hints to this in their statement in a more direct way than the “we will leave all options open” sort of thing than that could be the the final nail in the coffin for the shorts this year.

Price Action and the Charts:

Since Oct 4th world equity markets have staged a historic comeback from multi-year lows earlier in the month and now sit at 2 month highs which take us back to the break-down levels from early August. Month to date the S&P500 and the Nasdaq are both up about 13%, while the DAX is up 15% and the Shanghai Composite is up close to 5%. Our major equity indices are now up anywhere between 2-5% year to date while the DAX is still down a little over 8%, Brasil down 14% and Shanghai 12%. While the lows are clearly in for the year in the U.S., emerging markets don’t appear to be out of the woods yet.  This is significant to me as their appears to be a raging debate about the health of China and whether or not they are in the process of a soft or hard landing from the massive economic expansion they saw since the end of the global financial crisis.

The Gazillion $ Question….sorry not answered here…..

As I have spoken about in this space on a few occasions, the gazillion $ question for your portfolio for the balance of the year and into 2012, is whether the market cycle we are in is more reminiscent to 1998 than 2008…..at this point with holiday shortened months left in the year and a plan in place to avoid Greek default, we have likely avoided financial Armageddon this year…..a look at the chart of the SPX from July 1, 1998 to Dec 28, 1998 shows a fairly similar pattern to our early summer late October period:

[caption id="attachment_5788" align="aligncenter" width="300" caption="SPX July1, 1998 to Dec 28, 2011 from Bloomberg"][/caption]


When You look at the chart below of the SPX this year from July 1, 2011 to Friday’s close you see an eerily similar pattern of a July peak, followed by a 20% plus draw down culminating in a panic low followed by a fierce reversal in the same month equal almost to 20% and then much further gains..….

[caption id="attachment_5789" align="aligncenter" width="300" caption="SPX July 1, 2011 to Oct 28, 2011 from Bloomberg"][/caption]


So I guess for all my bearish skepticism above I think it has become very clear that the fix is in for the balance of the year, barring 1 big thing, some sort of reversal of the Euro bail out plan.  Much like 1998, this year’s main cause of volatility had less to do with the soft patch in our own economic data in late spring/early summer, and more to do with the risk of a foreign debt contagion much like the situation back in the summer/fall of 1998.  If this has in fact been put off ’til next year then we will likely close within 5% up or down from here…..

SO what to do now after such a massive run?

While all signs point to up for the balance of the year I think the prudent thing to to is wait for a bit of a pullback in the range of 3-5% to get long for the holiday year end mark up rally that could drive our markets back to the highs of the year. I think these are the sorts of rallies that couldn’t be more artificial in nature, but they can be powerful nonetheless.  If this happens we will have the opportunity of a lifetime to short the closing tick on New Years Eve……