One Traders Conundrum

The capital markets have arrived at a potential trend reversal juncture, and I have a conundrum. Mine is do I want to be a trader, or 'investor'? I use the latter term pejoratively. You see, investors buy to hold, whereas I like to hold with a time frame in mind. I'm more interested in performance over time than I am about controlling something or enjoying something.

After all, stocks are merely prices. They are not our children, or some corporation we run, where control is necessary. Besides, nobody can control stock prices (unless they are penny stocks, which is why advise against trading them). All we can do is try to stay on the right side of trend.

As you know, my forecast is bearish for U.S. equity markets, with a long-term cycle bottom for the Dow 30 to be established at about the Dow=9200 level. Moreover I believe that long-term traders, i.e., those with a greater than one-year time horizon for equity purchases, ought to be 80 pct in cash.

I also believe that four years after the next cycle bottom, the Dow 30 index will rise to a record high in the 14000-range. That's because the global economy is growing at a +3 pct clip, and the Dow 30 corporations are in a mindset to buy back shares and raise dividends, so share price growth rates will be well ahead of +3 pct. Ergo Dow 14000 in four to five years.

One conundrum is, of course, the possibility for global inflation, which brings rising interest rates, which at some point could severely damage the real estate market (and discourage the millions of homeowners enjoying the Wealth Effect). If interest rates get too high, the usual economic growth would be curtailed. There could be recession or possibly even depression.

I don't think in those terms, but I don't totally discount the possibility.

My problem is an ages old one: do I buy equities and bonds now if prices are going lower and yields higher? I really don't want to use my ammunition now, and then get stuck with negative returns for a year or more. Moreover, if that scenario plays out, my performance after the eventual cycle bottom would be significantly less than possible, or that I expect for myself.

But this was a strange week to make decisions. For the Dow 30 alone there were some very strange trades: MO, HON, CAT, and MMM, for instance, confused me.

As for the full Dow this week, 15 were up and 15 down. And this week even the Dow (and S&P 500) went south as the Nasdaq went north.

And as for the ten U.S. ETF's I follow closely: five were up and five down.

Also confusing to me: while XLE and XLU went south, XLB (Basic Materials) went north; and Consumer Staples (XLP) went north, but Consumer Discretionary (XLY) went south.

Moreover, XLF and the consumer lending stocks went north as the yield spread on the U.S. 30-year-3-month Treasuries dropped to a cycle low of just +93 basis points, which indicates that there is almost as much risk in holding fixed income securities over the next 26 years (the remaining term of the 30-year T-Bond) as there is in the next 13 weeks. It also indicates that lenders are going to have a tough time making money on their usual carry trade, but traders don't seem to mind.

I don't know why.

I have to know why.

Otherwise, how could I know which side of trend to position my holdings? Whether you are an Intra-Day Trader or an Extra-Year Trader that is truly the ONLY important concept in trading.

So I spent Saturday trying to resolve my conundrum, and I came to a few conclusions. Very few!

I decided that the trend is still bearish; that stocks and bonds are still going to go south. As to the Dow 30, the cycle bottom could in fact be 9800 (which is -4 pct lower) or 9200 (-10 pct lower).

As for the U.S. Sector ETFs, my recommendations are unchanged (i.e., 80-pct cash, with the balance as follows):

• Energy: Over-weighted: lower PE's (XLE -4.8 pct) but growing value
• Basic Materials: Over-weighted: waiting on China to revalue, lower raw material costs
• Industrials: Minimally over-weighted: export manufacturers will like lower USD
• Consumer Discretionary: Market-weighted: still no money for Fords or Maytags
• Consumer Staples: Market-weighted: defensive stocks fall less in a bear phase
• Healthcare: Market-weighted: also defensive, but with some promise
• Financials: Under-weighted: troubles with narrowing yield spread, rising yields
• Technology: Under-weighted: weak unit growth, but signs of promise
• Telecom Services: Under-weighted: negative issues may go away in time
• Utilities: Under-weighted: debt service worries (XLU -1.7 pct)

As for the rest of the capital markets:

• Bonds: Late-in-week bull trap; real estate market still in doubt as interest rates go higher
• Commodities: Pullback but still high, means high raw material costs still exist
• Oil & Gas: Prices dropped again but will stay strong from storm damage/winter's approach
• Gold Bullion: Central bank sales cannot match foreign buying; USD is depreciating faster than "real wealth" is growing
• Goldminers: Still buying dips, and looking to buy smaller caps as Gold headed for $500, but two steps forward (maybe) for one back
• Forex: Termination of the USD's short-term bullish phase? Not happening yet as international holdings being sold and capital repatriated. Flight to safety
• International Equities: EWJ (Japan), EWU (UK) and EWC (Canada) were down -3.24 pct, -2.94 pct, and -2.10 pct W/W respectively; international traders are showing their nervousness, and sending capital back to the U.S.
• U.S. Equities: Dow 30 Index is down to 10215, but loss this week was just -0.70 pct (and S&P 500 -0.59 pct) vs gain of +0.84 pct for the googlified Nasdaq

Sitting back to see the big picture:

Inflation and inflation-fighting interest rates are the capital markets' biggest fears at this time. Both stocks and bonds are being affected.

Interestingly, both the Dow 30 index had my 10-ETF monitor were totally mixed this week: the Dow had 15 up stocks and 15 down, and my closely-watched ETF monitor was 5 up and 5 down. But when you look deeper into the individual components, both the Dow and the Equity ETF's had much bigger losers than winners.

I continue to believe that any bump that occurs in U.S. equities here is from short covering. After an individual bump (say like UTX on the 19th) there doesn't seem to be any follow-through. The Relative Strength Index (RSI) seems to go quickly negative again, which is an indication of 'pump and dump'.

As I pointed out a week ago, an intra-day trading event will not likely impact on the more important trends in the Daily, Weekly and Monthly price series data.

The Bulls are spinning the economic data on inflation now as a positive ("we've passed the peak!"), but the truth is clearly the opposite. The global inflation that America is importing in the form of much higher import prices is a fact. There were spectacular rises in U.S. Month over Month import prices, and PPI/CPI data, which are being exacerbated by record high trade deficits.

These figures would have been worse had the USD not been so strong based on investment flows. But government spending and fiscal deficits are going to worsen the outlook for the USD sooner than later. This issue remains outstanding.

The U.S. Twin Deficits picture did look not so bad for a time based on higher taxes being collected earlier this year, which came from +4 pct economic growth, and taxes on extra dividends and capital gains in the equity market (helped along by share buybacks and excessive trading in the Googles).

But at economic growth that is now below +3 pct, and less trading this month and perhaps into November, the growth in taxes will likely fall away, but the trade deficits will continue (as American capitalists outsource manufacturing jobs to India and China where there is cheap labor and no healthcare/environmental protection costs to worry about).

So the repatriation of USD that occurred this past week is likely to be short-lived because traders are soon to be worried the USD is losing its value at home.

One new factor that may come into the mix is the attitude change of Americans with respect to fighting wars abroad. This is one topic I intend to avoid because it is so emotional (I grew up during the painful Vietnam years), but I'd point to the weekend news-type shows on Dateline and CNN that is now focusing on homeland support for the U.S. Administration that appears to be rapidly dissolving.

I recall too, from my youth, the huge surge in inflation in the post-Vietnam years, which is likely being repeated at present. And that is the Bulls greatest fear: slowing economy and rising inflation. That's why they try to tell you the exact opposite is happening.

All in all, this week is harder than most to figure out the market's direction. I may still be bearish, but I'm also calling it a conundrum.