Wednesday, April 30, 2008

What Now?

Are we near an inflection point in markets? I have heard numerous talking heads on CNBC recently saying that markets are near a turning point. The mantra goes something like this: the dollar is near a bottom, therefore commodities are topping out and stocks will move higher. While all this may come true, I think there are reasons to be skeptical.

The dollar has rallied from the lows against the Euro as well as gold, but the trend is still intact.

The idea behind the dollar has bottomed meme is that the Fed is done with interest rate cuts and the ECB may have to start cutting rates. While I don't disagree with the Fed pause, I have serious doubts about the ECB cutting. Here's Axel Weber, ECB Governing Council member on April 26 in an interview with a German newspaper:

"I am concerned that, with regard to the conduct of wage and fiscal policy, the recent temporary heightened inflation rate could be consolidated for longer than is necessary above the tolerance level of the Eurosystem," Weber said.

"Should indications of this increase, we must react with interest rate policy," he added in an interview with Germany's Welt am Sonntag. "We are therefore observing the current wage agreements and finance policy decisions very closely."

And here's Christian Noyer, another Governing Council member (via Bloomberg)

``Our big problem is to make sure that inflation falls back below 2 percent next year,'' the Bank of France governor said in an interview on RTL radio. ``We'll do what it takes for that,'' he said, adding, ``If needed, we'll move rates.''

I could go on, but you get the picture. One may be tempted to think that these two are the ECB equivalent of Richard Fisher and Charles Plosser who both dissented on today's rate cut by the Fed, but remember, the ECB hasn't cut rates during the credit crisis. They have preferred using their lender of last resort status to provide liquidity where it is needed. Oil probably wouldn't be almost $120/barrel if the Fed had followed the same policy. So the idea that the ECB is on the verge of cutting rates in Europe seems more hope than probability.

That doesn't, however, rule out the possibility that the dollar is due for a rally. Certainly, it's the Rodney Dangerfield of currencies; even supermodels don't want Uncle Sam's money. The sentiment against the dollar is pretty extreme and any good contrarian has to consider the possibility that the bottom is in. But we need more evidence; until then, the trend is your friend.

Commodities may be in a topping process, but again we don't have enough evidence to make that call yet. My guess is that we are in for some kind of correction, but the bull market will remain intact:

Commodity prices are, in my opinion, inflated a bit, but the long term trend is for higher prices. As long as the Fed keeps real interest rates negative (Fed funds 2% with inflation at least 3.5%) I don't think we need to worry too much about commodity deflation. I have reduced our commodity positions somewhat recently (and I may reduce some more), but our positions had grown and were over our allocation target. Furthermore, if commodities do correct, I will be more inclined to buy than sell more.

The trend in the stock market hasn't changed yet either:

There are hopeful signs about the market, but reality is that the trend has not changed with the recent rally. The major indices are trading below their 200 day MA and until we get a close above that, the trend is still down. Again, understand that I'm not saying that the trend can't change or that it won't soon; we just don't have enough evidence yet to make that call.

I'm actually pretty optimitic about the market and the economy. Earnings have generally been pretty good outside the financial sector and the economic stats are not nearly as bad as they've gotten in prior recessions. Consumer sentiment is awful, but sentiment is not a good predictor of future economic activity.

Notice that consumer confidence fell during most of 2002 when we were most definitely not in a recession. Notice also that consumer confidence bottomed ahead of the stock market in 2003. Consumer confidence hit bottom in early 2003 but the market didn't make its bottom until October. That would argue that we are still some ways from re-establishing the bull market. That could mean a prolonged period of base building or it could mean testing the lows again. I don't know, but the conservative thing to do is not get too excited about stocks just yet. If you are a trader, you might consider taking some profits here (and I'm sure there are a lot people thinking that way so a correction seems natural here), but long term investors should probably ride out any short term price corrections.

So, while everyone else seems to think, or hope, that we are about to reverse some long standing trends, I can't make that leap just yet. Things could change quickly and if they do, I'll make changes but for now, I see no reason to believe that things have changed that dramatically just because the Fed has tired of cutting rates.

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