Is the Market at a Pivot Point?

A bullish investor would likely argue that the US economy is improving and should continue to improve without additional stimulus. A bearish investor, like myself, argues that the recent improvements in the market are more a result of monetary stimulus than real economic improvement. This week the markets faltered somewhat on the perception that the Federal Reserve may not provide additional stimulus. Was this weakness a momentary blip or a pivot point?

Clearly I have been wrong to date on the markets. While my strategy of maintaining a relatively neutral balance between long and short has avoided any catastrophic losses, my edging towards more weighting of short positions by the end of the quarter clearly hurt the performance of my IRA. For the month of March my IRA declined 1.2%. For the quarter I managed to squeak out a small gain of 1.9%, largely due to healthy performance by my high yield bond positions. This performance has under-performed the markets by a fairly wide margin. On an annual basis, my IRA increased 15.2%, aided immensely by my weak performance during the first quarter of 2011. I guess I am just a slow starter.

So, pivot point or bump in the road?

The job data released on Friday of 120,000 net new jobs created in March was another conflicted data point. It was well below the expected number of over 200,000 and potentially portends declining job growth, and thus weakening economic growth. But, does the number increase the likelihood of additional monetary easing, floating the market higher? So, the question in my bearish mind is: Over the next few months, is the market driven by weak real economic activity or excessive liquidity? Longer-term, I believe the market must ultimately succumb to fundamentals, it is just a matter of how long the Fed allows us to keep digging a deeper hole.

The question, in my mind, is somewhat misleading. To me, the trends of Sagflation continue to act on the economy and markets. Weak real economic growth and more volatile prices is not a friendly investing environment. Debt levels in Europe and weakening economic activity (and political stability) in China may continue to weigh on the markets. The Federal Reserve can inflate the economy for a while, but we are in trouble when the markets begin to question the "realness" of the economic strength. Does this play out as accelerating inflation, falling employment, or both? For now I plan to pursue three steps:

Step 1 - Continue to move the net balance of my portfolio towards short positions.
Step 2 - Opportunistically invest in treasuries, non-cyclical commodities, and consumer staple stocks.
Step 3 - Look for attractive themes, like the aging car fleet in the US and potential rising demand for US natural gas.

The first quarter was surprisingly tame, I doubt the next three quarters can offer the same tranquility.

Natural Gas Prices Near a Bottom?

Today I established a couple positions to increase my exposure to the natural gas market. The natural gas market has sold off significantly, dropping from over $5 MMBtu to under $3 in the past year, recently hitting the lowest level in over ten years of $2.32. Over production has been the primary cause of the price decline, but a warmer than usual winter has also contributed to lower demand during the typically seasonably stronger demand winter months.

Numerous producers have started to cut production, including Chesapeake Energy Corp., ConocoPhilips and Occidental Petroleum. While more production cuts are likely needed to balance supply and demand, I believe the price of natural gas likely begins to stabilize and may even bounce back above the $5 mark during the next year. The reason for my optimism includes the production cuts, the potential for either a colder weather pattern in the next month or a hot summer, and the likely increasing use of natural gas at lower price points. At under $3 I believe natural gas becomes a much more attractive fuel alternative for companies able to switch between natural gas and higher priced coal. Longer-term, the low natural gas prices should attract new uses for the fuel, including transportation, heating, electricity and industrial production.

So I have established the following positions:
~3% position in Penn Virginia Corp. Sr. 7.25% Notes 4/15/2019 (CUSIP 707882AC0) - This company is having difficulties and its stock price (Ticker PVA - $4.76) has dropped significantly. Lower natural gas prices have obviously not helped but the company has been investing in oil production, increasing revenue from oil relative to gas. Management does not instill confidence with a lawsuit outstanding for over-paying the previous CEO and CFO. In addition, the company has slipped a bit on production relative to guidance, calling into question execution. That said, management is out talking to investors, which is usually a good sign of their confidence about the future of the business. The company does not have any significant debt due until 2016 and has adequate liquidity. While the stock may ultimately prove a better bet, I decided to establish a position in the senior debt at a yield north of 9%, a more comfortable risk/ reward balance in my view.

~2% position in ProShares Natural Gas ETF (Ticker BOIL) - This is 2x leveraged ETF that tries to track movements in the natural gas futures markets through derivatives. This position is purely focused on the price on the natural gas. Because it is leveraged I have purposely kept the position relatively small.

Also, yesterday I reduced my position in silver slightly after a significant increase in silver prices due to the remarks by the Federal Reserve yesterday. Basically, the Fed stated its intent to keep interest rates low for multiple years and has not ruled out additional quantitative easing, both reducing the value of the dollar and increasing the value of precious metals. I plan to put money back into silver if the price retreats again.

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.

Stocks are Rising but What about Economy?

Stocks have been floating higher as investors bask in a relatively healthy summer earnings season and slower summer markets produce a less tense view about the world. I guess the recent beach weather has mellowed investors.  Just like the recent shark sightings off Cape Cod, I feel a need to raise a flag of caution. A couple recent data points are warning us about potential treacherous times in the fall, likely October if the market keeps rising and history is any guide.

Slower growth for new factory orders in July, as reported by The Institute for Supply Management, suggest the recent health in the economy was due more to replenishing inventories than a more sustainable recovery. The index was 53.5, still in expansionary territory but declining from levels recorded earlier in the year. The August data point to be published at the beginning of September likely is the first data point investors focus on post summer vacations. Anything below 50 likely gets an immediate downward response in the equity markets, 50-55 likely produces a bit of fear going into October, and above 55 provides investors with some measure of relief.

The Federal Reserve is now apparently considering re-investing money back into the bond market once previously purchased mortgage and treasury bonds mature. These investments in the bond market over the past couple years were unusual and were originally an effort to stimulate the economy. The program has ended and thus a potential re-investment strategy is a change in outlook. Considering many investors consider the bond market somewhat over-priced (relatively low yields) this potential action seems to register a little higher on the desperation scale of monetary stimulus. As mentioned in an earlier post, I would not be surprised to see the Federal Reserve take more non-traditional actions as it attempts to stimulate the economy. Assuming the slowing new factory order data is foreshadowing a slower economy, I would expect the Federal Reserve's action to continue to move up the desperation scale. These efforts likely result in more volatility.

On a positive note, having spent the last few weeks outside of the U.S., I have been pleasantly surprised by the relative health of other countries. At this point I think investors should be focusing more on South American economies, Canada, and a few emerging markets in Europe and Asia. In addition, silver appears interesting at this level, if for no other reason than a more inexpensive way to diversify the portfolio without buying historically high gold prices.