Is This Market Just Amateur Hour or Something More?

The most difficult aspect of trading beyond understanding what is going on in the market is timing. And it works both ways – when one’s view is wrong, is it simply a question of getting in too early, or is it a question of misunderstanding what is going on in the market? In other words – is it time to hold ‘em or fold ‘em, in poker parlance?

I have been wrestling with that latter question here in the first few days of 2012. What if we are wrong to presume that the perfect storm coming? Have we overlooked something in our analysis, some significant driver that will continue to drive markets higher for a time?

Not surprisingly, my earlier conclusions remain the same - not out of conviction in my own abilities, but rather from the data and a simple, but critical rule of trading that one of my early trading and analysis mentors taught me: the first week of any new year has too many amateurs and too much hot money, he would have lectured me.

Why? His theory was that when profit and loss tallies are reset to zero as a new year got under way, there were a number of proprietary traders who felt like they had a free option to put on significant risk, since they were starting with a clean slate and had the entire year stretching out in front of them.

That theory still applies, but now the old school prop-traders are replaced by underfunded banks that are buying underfunded government debt with money provided for free and with no down-side risk by a central bank (the ECB) which accepts lower and lower quality collateral to keep the game going.

The risk free game has been going on since the 1950s, when leveraging started in earnest. The financial crisis in 2008 did not stop it - it merely changed the major players from banks and its proprietary traders to governments and the EU Council of Ministers. The game is still the same: unlimited socialization of risk with no potential for personal/corporate downside.

Meanwhile in the land of reality the economic data is getting worse. Spain's new government just announced that it expects the budget deficit for 2011 to run closer to 8% of GDP rather than the earlier estimated 6%.The technocrat governments of Greece and Italy are having a hard time getting anything done, thus failing to provide the promised improvements to the Troika of ECB, IMF and EU Commission. In Greece the new government can't even agree on divorce legislation!

EU is de facto in recession, with its negative spiral of bigger budget deficits, higher financing costs, higher unemployment, lower growth, and deflation.

Yes the LTRO and 'borrow as much as you want' promises from FED, ECB and Merkozy personally could mean there is enough 'new funding' in Q1 - but what about Q2, Q3 and Q4? From a timing perspective, the one real change we need to make to our outlook could be that the peak of the storm may come at the end of Q1, rather than in the beginning. It actually makes sense from a historic and time-line perspective.

Our Q4 Outlook was called Maximum Intervention and represents the final attempt by policy makers to extend-and-pretend. While our preferred scenario was for maximum intervention to fail and lead to The Perfect Storm, our niggling suspicion at present is that timing dictates that Q1 may need to be a 'transition quarter’ that sees the storm brewing rather than immediately breaking out.
If we’re to reduce what is going on to a metaphor – it’s a bit like a big party that progresses through all phases from reception to formal dinner to drinks and dancing. In this scenario, the party is effectively over for some (Greece, Portugal and Italy) who are getting too blind drunk to stay on their feet, but don’t realize it yet. Others (France, Belgium and Austria) are still looking around for someone promising to dance with before the music stops but the likely partners are running out, because the best prospects (Germany, Netherlands, Finland) decided the leave the party relatively early and relatively sober because the debauchery was getting too ugly..

Meanwhile, the bar is running a huge deficit and there’s about to be one nasty argument over who will pay the bill.

So who should pay? Those who don't drink? The ones that always overindulge? The ones who are always looking to hook up with someone? I don't know but everyone will have an argument why they should not be the ones to pony up. That's always the case when the party doesn’t have a host!
The EU is advancing through the transition from final phases of extend-and-pretend and is already arguing over the bill. What about the US? There, the economy is throwing off stronger than expected data – and the operative word in that sentence is “expected”. The US data has a history of perfectly mean-reverting between the extremes of no hope and too much hope. It is not like the US is creating the 350K jobs per month that are needed to seriously reduce the unemployment level.

It is not like the 2012 fiscal austerity tightening is not going to happen (most people forget that the US budget runs from October to September not January to December!). Yes, they will most likely extend pay-roll tax reductions and other small details, but do not forget that the 100% capital expenditures tax deduction ran out at the end of 2011, so while the US has been investing recently, it is a function of tax arbitrage rather than belief in organic future growth. Our preferred US consumption indicators from Consumer Metrics Institute continue to lose momentum and its most forward-looking indicators suggest a slowing US economy relatively to consensus.

Worldwide, PMI's are deteriorating (China’s blipped higher in December, but this is probably due to an early New Year in China starting already on January 23), but the bulk of OECD PMI's are well below 50 (the threshold growth number) and closer to low 40s rather than high 40s.

Add to this that I am very skeptical about corporate earnings considering the macro backdrop and their already very fat profit margins. So the conclusion has to be that the market is challenging our timing, not our read of the situation. In other words – let’s be patient. It’s dangerous to fight negative economic gravity and the worldwide approach of addressing debt problems with ever more debt – the continued policy response of extend-and-pretend.