The Eye of the Hurricane

Putting today's pullback aside, equity markets have continued their tear over the past several months with the S&P sitting comfortably above 1,000. The dollar index has fallen another 2% since my June post, providing additional support for equities. Although the rally extended further than I originally anticipated, as I was early calling for investors to short cyclical stocks, my original premise remains intact. The fundamentals have only gotten worse over the past quarter, and it's only a matter of time before equities begin to price in the actual economic state, not projected recoveries or wishful thinking. Below are the main drivers underlying the recent stock market run-up as I see them:

Government Capital Market Manipulation
The mainstream media has the general public convinced that equities are simply reflecting the improved economic state and inevitable rebound that is destined to take place over the next several quarters. The reality, however, is a little more sinister. Market observers agree that trading volume has been anemic over the past six months, so the rally is not as broad based as they would lead you to believe. Low volume makes the conditions ripe for government manipulation of the market. This is accomplished through open purchases of futures contracts in the open market with the assistance of large investment banks.

The chart below perfectly illustrates my point. This represents an S&P e-minis futures daily one minute chart for Friday, May 29. It was a sleepy Friday with no news released and very low trading volume throughout the day as depicted by the volume bars below the main line graph. In the last few minutes of trading, enormous buy orders hit the market with over 200,000 contracts purchased right before the market close. This volume spike immediately pushed the S&P up roughly 10 points for no valid reason. I am not a conspiracy theorist by nature, and I'm well aware of the program trading that often takes place near the end of the trading day, but this pattern has continuously repeated itself over the past several months. Downside volatility has disappeared while the major indices often closed right at the highs of the day. Even during the market meltdown in late 2008 and early 2009, equities experienced vicious upside volatility through short covering and government bailouts.



With a large percentage of Americans having seen their 401Ks decimated, I am not at all surprised to see the government try to restore confidence in the economy. It is also no accident that consumer confidence has risen with the stock market, but this correlation will prove short lived as unemployment continues to soar.

Massive Government Stimulus Programs
I underestimated the short term impact that the coordinated response of governments around the world would have on equities and economic activity. I am a strong advocate of free market capitalism and tend to analyze such programs from a longer term perspective. Long-term, debt based government spending adds no value and only serves to increase the national deficit. Although in the near term, such policies act as stimulant, akin to an addict getting his fix. The euphoria will wear off leading to a more violent crash once participants realize that despite the government's best efforts, the long term contraction has only been slowed.

The cash for clunkers program is a perfect paradigm for our current economic state. Some analysts have gone as far to suggest that the four year decline in auto sales may have reached a turning point with the success of the program. The government of course allocated billions it doesn't have to fund the program, representing yet another example of taking from the taxpayer (or borrowing from the Chinese in this instance) to artificially create an increase in auto sales. Even with the deep cuts made by the auto manufacturers over the past several years, the sad truth is that there are still too many dealers and too much excess capacity still remaining in the system. As a result, auto sales showed a nice bump over the past several months, but this only shifted future sales to the present.

I've had many people come up to me over the past several weeks pointing to the stock market's recent performance as an indication that the worst has past and we are on the road to recovery. They also point to the housing uptick and question my long term bearish stance on the economy. I have two words for these individuals.....just wait! The FHA is providing mortgage loans with as little as 3.5% equity that has resulted in 50:1 leverage on their books. Although this is better than the 100:1 leverage sported by the Fannie Mae and Freddie Mac, the risk has only been shifted from the private sector to the tax payer.

A brief note on my investment strategy. I do not buy or sell individual stocks but instead sell deep out of the money naked call options on stocks, commodities and broad-based equity ETFs. Through time decay on these options and proper risk management, I have not had one losing trade in 2009. However, it has taken me longer to realize my profits as a result of the market run-up. The early cyclical names that I highlighted in my prior post represent excellent shorting opportunities if you have the patience and the wherewithal to profit from the coming collapse in consumer spending. Consistent with my prior posts, I fully expect the S&P to drop below 500 by the end of 2010 with the only risk to my forecast being a weak dollar that artificially inflates equities.

Ask yourself these two questions: If the equity rally was for real, why is gold trading over $1,000/oz? Second, how in the world is cheap credit and increased personal spending going to lead us out of this "recession" when these were the primary drivers leading to the excesses in the first place?