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Long-Term View: Rally May Not Have Much More to Go

By    |   Thursday, 03 February 2011 03:55 PM

This certainly isn't one of the easiest of times for long-term investors.
For the S&P 500, for example, the line of least resistance still seems to be upwards, even if this rally is fast approaching six months in age and registering a 20 percent gain.

Cumulative breadth is also still rising even if there are some signs it may be weakening as, since late December, the Value Line has finally lost some ground to the S&P 500, the Small Cap to the Mid Cap, the Mid Cap to the Large Cap, and the Nasdaq Composite to the Nasdaq 100.

The Volatility S&P 500, or VIX, has had a little blip along with the equivalent for a still relatively subdued oil market, but “swaption,” which are options granting their owners the right but not the obligation to enter into an underlying swap, volumes remain calm; foreign exchange or “forex” volumes are what we could call “unremarkable;” basis swaps are at ease, and junk and Baa/Treasury spreads are testing “crisis era” lows while we see a very modest widening in the Emerging Markets (EM) bonds.

All this, at least in my opinion, are signs that pricing, once again, of mainstream macro is misleading everyone when it persists in its delusion that there can be no sustained price rises, at least of anything else than in the shops, while we still have a little bit less than 10 percent “full” unemployment, idled factories, and business reliant on “corporatist” life-support. So far, however, this has translated into, albeit a modest, sell-off in back month Eurodollars, which are U.S. dollar denominated time deposits at banks outside the United States.

Until now, the game has been to buy “growth” players, equities, non-PM (precious metals) commodities, with a move out of safe havens, governments and gold. To me, it’s like, after residing three years in a gloom and doom territory, the herd is once again spending its “customers’” money to prove to itself that, yes, the U.S. will fully recover; and, yes, once again, Europe will avoid a meltdown; and, no, China will not endure a hard landing, nor will any really “serious” inflation hit the West.

Whether or not such optimism will turn out to be justified, for now at least, the speculative “Gestalt” (Gestalt psychology represents the study of perception and behavior from the standpoint of an individual’s response to configurational wholes with stress on the uniformity of psychological and physiological events and rejection of analysis into discrete events of stimulus, percept, and response.) is eager to hold onto it, and will do its best to ignore any cognitive dissonances. Believe me, you can bet on it.

So, it may be prudent for the long-term investor to question ourselves on where the limits are of such thinking? I think we can put the limits at about 10 to 15 percent above where we are now, and here is why:

  • Wishful thinking alone will not forestall hard statistical evidence of what in fact every person in the West already knows, which is that the cost of living is going up at an increasing pace.

  • The input-output lag continuous its feeding through to equity margins and their pricing.

  • As already mentioned here before, when we observe the issue of “breadth,” which I’d prefer to call the “indiscriminate beta,” comparing the Value Line with the S&P 500 index (SPX), it now seems, at least to me, that the last decade’s exuberant times of easy money are approaching a major turning point.

  • The Emerging Markets, with the BRICs in particular have become unequivocally engines of growth but have also become at the same time serious breeding grounds of inflation and we already can see them starting to struggle against that phenomenon. We should take notice of the fact that the BRICs have started breaking down versus the broader Emerging Markets Index basket and the broader commodities indexes, both of which rotations, over the last couple of decades, have tended to be good precursors to a more widespread weakness.

  • While the latest move in crude oil, and here I take Brent crude because it is a far better reflection of the global oil market than the U.S. WTI as it dominates world oil trading and Asian markets continue their growth, is pointing to the $115 mark. Also copper could yet see, why not, $11,000. And here I’d like to warn investors I think it could be wise to start considering to discipline their “stops” on both of these commodities as both are in “maturing” bull moves and have what I’d like to call “uninspiring” fundamentals.

  • The recent relative “underperformance” in precious metals is not a stand-alone phenomenon. It is related to, but not limited to, the classic Risk On-Off movements, because there is also clear evidence developing that, as bond yields will rise, there is no doubt about that and please don’t misunderstand me as I here mean in relation to the last three decades, gold loses ground to non-PM commodities. Yes, this is not just a phenomenon arising from gold’s implied insurance premium, but also due to the coming changes in its associated opportunity cost.

Bottom line: Even if it’s difficult to most prudent investors to admit we should accept, at least that’s my opinion, that even when bond yields aren’t rising fast enough, yet, nor have they reached a level high enough to impede risk asset prices, or these of real goods and services, gold is likely to prove an ever less-effective preserver of purchasing power, especially since it is coming off a historically rich relative valuation.

That said, I think we could see a last kick up of another 10 to 15 percent, but then, and again that’s in my opinion, it should be over. Not only do the charts for crude and copper point that way, but also the overall commodity indexes adjusted for changes in the crude oil benchmark West Texas Intermediate (TWI) seem to be at the point to will deliver us that noteworthy “double top” before it’s over, at least for the time being.

If this plays out as I think it could, which doesn’t mean it should, then I think the moment for cashing in profits and move to the sideline for a short time isn’t that far away.

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This certainly isn't one of the easiest of times for long-term investors. For the S P 500, for example, the line of least resistance still seems to be upwards, even if this rally is fast approaching six months in age and registering a 20 percent gain. Cumulative breadth...
Thursday, 03 February 2011 03:55 PM
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