Stuck in the Middle

Sold my positions in financial and industrial companies this morning. This including Morgan Stanley (ticker MS), Goldman Sachs (GS), Citigroup (C), Prudential (PRU), Brookfield Asset Management (BAM), General Electric (GE), and Eaton Corp (ETN). Also sold my positions in Base Industrial Metals (BDD), Inverse Long Treasuries (TBT), Computer Associates (CA), Ferrellgas (FGP), and Huntsman (HUN).

This leaves me over 50% in cash and positions in precious metals (Gold, Palladium and Silver), and larger high quality companies like DOW Chemical (DOW) and General Electric (GE).

I find myself stuck in the middle on the future direction of the market, and thus uncomfortable being fully invested. The rising yields for European sovereign debt are highlighting, in my view, that credit markets are beginning to breakdown. This could result in a significant deflationary event, especially if Germany remains opposed to the European Central Bank intervention. On the other hand, if the ECB does actually step in and begin printing more money to offset the growing liquidity crisis, accompanied by actions by the Federal Reserve, we likely continue down the path I outlined in my previous post of a couple months of rising equity and commodity prices followed by a violent re-balancing of the market. Germany has a bad history with inflation that makes them anti-inflationary and they seem determined not to pick up the tab for everyone else. Fair enough, but it means the end game may be closer than I have been anticipating.

The bottom line is that the markets are increasingly moving towards a re-balancing of valuations to reflect the unsustainable debt levels in the world and my positions were increasingly relying on a "Hail Mary" from the central banks. As a wise boss once told me, "once you start hoping for something to happen you're screwed."

Easy Money Now, Hard Times Later

Following up on the last post, "Freight Trained," I wanted to highlight an article in Barron's that outlines quite well the expansionary monetary policies by most large central banks in the world. I agree with many of the concerns outlined in the article and believe these monetary policies, coupled with the fiscal austerity in many countries, lead to the following in 2012:

(1) Rising commodity prices into the first half of 2012, driving up prices for gas and food,
(2) Higher equity valuations into the first half of 2012 as liquidity inflates the stock markets,
(3) Rising interest rates on longer-term bonds due to inflation concerns and rising stock valuations,
(4) Declining wages as companies control headcounts to offset higher material prices, and
(5) Rising CPI by mid-2012 as companies pass along higher costs to customers,

All this leads to a potentially violent reset of the markets in the middle of 2012, in my view, in-line with my expectations under my Sagflation thesis of slow-to-negative growth combined with more volatile prices. During this phase of Sagflation there may be rising fear that we are entering a period of Stagflation, or high inflation, high unemployment and slow economic growth. I suspect this potential period of Stagflation may precede a period of negative growth and deflation in 2013 and 2014. While worrisome, I also believe the years 2013 and 2014 enable the political and economic re-structuring required to set-up for healthy growth in 2015 and beyond.

Returning to 2012, the potentially violent reset during the middle of the year may occur due to:

(1) Consumer spending falling due to a squeeze between rising food/gas prices and declining incomes,
(2) Debt stifling growth in European countries and with US consumers,
(3) Social unrest stemming from economic hardship in Europe and the US (Occupy movement),
(4) Additional austerity measures legislated in the US and enacted in Europe to reduce debt, and
(5) Diminishing impact, or even reversal, of expansionary monetary policies that appear to hurt growth.

These are my opinions and I lay them out in order to refer back to them in the future in order to track how my perception of the future evolves as unexpected events occur.

With all this in mind, I may exit a few positions that do not benefit from the anticipated rise in commodity prices and steepening of the yield curve. My portfolio currently includes the following:

Weight	Name	Ticker
~16%	Proshares Ultrashort 20+ Yr Treasury	TBT
~11%	SPDR Gold Trust	GLD
~4%	Base Metals Double Long	BDD
~4%	Rowan	RDC
~4%	Boardwalk Pipeline	BWP
~4%	Eaton Corp.	ETN
~4%	DOW Chemical	DOW
~4%	Huntsman	HUN
~4%	Prudential Financial	PRU
~4%	Brookfield Asset Mgmt	BAM
~4%	General Electric	GE
~4%	Vale SA	VALE
~3%	iShares Silver Trust	SLV
~3%	Tyson	TSN
~3%	Goldman Sachs	GS
~3%	Ferrell Gas Partners	FGP
~2%	ETFS Physical Palladium Shares	PALL
~2%	Citigroup Inc.	C
~2%	Morgan Stanley	MS
~2%	Pepsico	PEP
~1%	Teva Pharmaceutical Industries	TEVA
~1%	Computer Associates	CA

Twelve Month Outlook - Investors May Get "Freight Trained"

Freight Trained - (Rodeo Term) Being run over by an animal that is traveling at top speed.

Investment Conclusion
I believe the equity markets and commodity prices perform reasonably well, albeit volatile, through much of the fourth quarter due to the recent monetary stimulus injected into the world economy. I also believe the significant sovereign debt outstanding results in each round of monetary stimulus having a diminished impact, reducing its impact in both duration and strength. Therefore, I believe there is a risk that investors move back into the market over the next few months chasing the monetary-driven valuation increases, only to become exposed to a significant correction in 2012 once the monetary stimulus diminishes. To put it more colorfully, investors potentially get run-over when a perceived bull run turns on them.

More specifically, I believe the equity and commodity markets peak at some point in the next 2-3 months and then begin to reverse. Without additional significant monetary stimulus in the first half of 2012 I expect the equity and commodity markets to move sideways to down during the first two quarters. Around mid-year I expect a violent correction in the markets due to one or more of the following causes: (1) decelerating growth associated with austerity, (2) accelerating inflation associated with monetary policies, and/or (3) major sovereign debt defaults associated with excessive debt levels. After this correction I expect equity markets to continue downward for an extended period of time before bottoming with the S&P 500 around 700, consistent with my previous views within my Sagflation thesis.

The following are four points supporting my argument that inflationary pressures move the markets over the next few months:

(1) ECB Switches to Monetary Stimulus
The European Central Bank, ECB, cut rates to 25 bps to 1.25% in a "surprise" move. The takeaway, in my mind, is that the ECB is prepared to aggressively stimulate the European economy through rate cuts over the next few months to offset an economy that is slowing due to the debt crisis. This moves likely drives commodity prices higher and possibly stocks higher due to more liquidity in the world financial markets. The change of course also likely weakens the Euro, although the US dollar also likely continues to weaken relative to a basket of foreign currencies due to the Fed's low interest rates and monetary stimulus.

(2) Europe Appeases Markets in Short-term 
My takeaways from the European Greek debt agreement were: (1) Over $1 trillion may be injected into the market, adding inflationary pressures, (2) market activity was perverted, setting an ominous precedent, (3) maybe contagion has been avoided stemming from Greece but what about Italy and other countries, and (4) a short term solution was created that may or may not accomplish its goals, if implemented at all. In short, the agreement pushes these issues into 2012 and likely amplifies their negative impact next year.

(3) The Federal Reserve Remains Expansionary
While the Federal Reserve did not announce any additional quantitative easing programs, it did say it "is prepared to employ its tools to promote a stronger economic recovery." I believe this wording positions the Fed for further quantitative easing. The Federal Reserve also expects to maintain the low interest rates. While the Fed obviously doesn't want to jump into action at the whim of the markets, it appears more focused on driving growth in the economy. My takeaway is that the outlook from the Fed's position is inflationary since they appear to be shifting to more worry about growth than inflationary.

(4) Japan Focused on Healthy Exports
Japan's central bank is focused on weakening the Yen to aid its export-driven economy. The central bank has agreed that the future purchases of financial assets may be warranted, setting the possibility of a sort of quantitative easing in Japan, adding liquidity and inflationary pressures to the world markets. This implies that each of the three major world currencies are implementing an expansionary monetary policy, increasing the likelihood of inflation building in hard assets, like gold, copper and other commodities. It also likely pushes stock valuations higher, until inflation pressures accelerate above 3-4% in the larger developed economies of the world.
 
My current positions I expect to let run until one of the following occurs: (1) the stock price approaches its 52-week high, which for many of my holding represents over 50% upside; (2) the S&P 500 climbs over 1,375; (5) worries about a sovereign nation defaulting begin to dominate the market; (4) inflation concerns begin to dominate market movements in the US; (5) the yield on the 30-year treasury tips above 4.5%; or (6) 1Q of 2012. Once one of these criteria are reached I plan to begin executing my exit strategy. I suspect the market may move up aggressively through much of the fourth quarter as portfolio managers who are under-performing their benchmarks attempt to make-up the difference, but the last week may prove a much more volatile quarter.