Investment Strategy Turns More Cautious, Existing Home Sales, Record Auctions This Week, Galleon Grief

Stock Market Investing: The Equity markets were down across the board Friday as the week ended. Last week was a week of churning and distribution, two actions I hate to see during a market advance as they often mark the end of a rally. To make matters worse the churning occurred at key areas of resistance on all three major averages: 10,000 on the DOW, 2,200 on NASD and 1,100 on the S&P 500. Investment Strategy: Turning more cautious.

With this negative week still fresh on the mind it seems appropriate to evoke the immortal words of Andy Grove, "Only the paranoid survive." and discuss three possible developments that could derail the bull.

Development One: Economic numbers that suggest recovery begin to outpace negative economic news. This leads to the perception -- or possibly, the reality -- that the Fed will reverse its stance on easy credit.

If you are a new reader I strongly advise the perusal of past posts before you begin your protest. Those of you who are familiar with my work will know the well documented relationship between bad economic numbers, easy credit, weak US$ and strong equity markets. As long as the Fed remains committed to easy credit in all its forms the bull market can continue.

However, I have witnessed a disturbing trend over the last few weeks. Good news on the economy leads to selling. This suggests to me a real fear pervades the markets with regard to the continuation of easy credit. The equity markets are trading at these lofty levels because of liquidity not reality and if the Fed-controlled gravy train of easy credit stops, then trouble will ensue. When the gravy stops dog will eat dog. What the distribution of the last few weeks may be telling us is that the big dogs are smelling trouble and are preparing.

Today's trading offers a perfect illustration of Development One. First, good earnings numbers out of Microsoft & Amazon were not able to move the markets higher. Instead, the excitement was used by the big players to distribute their holdings. Second, the following "good" economic report hit the news wires this morning, but the equity markets sold off almost immediately after the release:

Existing Home Sales Exceed Expectations
Existing home sales jumped 9.2% to 5.57 million units in September. The increase followed an unexpected decline (-2.9%) of sales in August. The consensus was expecting sales to rise by a much more modest 5.1% to 5.35 million units.

Beyond the headline sales numbers, there was another good piece of news from the data release. Distressed properties, which accounted for almost 50% of sales throughout the spring and summer, have declined significantly to only 29%. Sales of non-distressed homes make it more likely that consumers will start looking at more expensive properties as homeowners move up the pricing ladder. The increase in sales helped push the total available supply down to 7.8 months.

Development Two: A funding crisis unfolds.

Will the US$ decline in value to a point where long rates must increase aggressively for our government to continue funding its debt? How long will China and others tolerate the ruse of quantitative easing before demanding higher rates?

We obviously don't have the answer to these questions. However, this very real possibility must be respected. There has always been a high correlation between long rates and the equity markets. I can think of no better example than the crash of 1987. For four months the bond market was collapsing (rates rising) before the equity markets infamously followed.

Of course, in '87 bonds sold off because the Fed was tightening. If, however, bonds sell off even in the face of Fed easy credit policies then I hate to see the ensuing equity market response.

Record Auctions Announced...euro 1.5001...yen 91.5060 (3.411% -07/32)
Treasury will sell a record batch of bonds next week with $44B 2-yrs Tuesday, $41B 5-yrs Wednesday and $31B 7-yrs Thursday. The record levels show an increase of $1B on the 2-and-5s, and $2B on the 7-yrs. There will also be $7B reopened 5-yr TIPS going off Monday along with $29B 3-mos and $30B 6-mos. The market may get some relief as the news is over, but the high end of expectations had been for closer to $115B versus the $116B announced, so any relief may be brief.

Development Three: The high profile SEC take down of Galleon may cause a ripple effect leading to hedge fund unwinds.

Galleon had over $3 billion and now according to DJ: "Galleon is winding down all hedge funds."

Last year we all witnessed what happens when hedge funds are forced to unwind. Many of the big funds are often involved in the same trades and one unwind leads to another. There will be many denials along the way but the equity markets will speak the truth.

I will also respectfully submit to you, the readers, that the derivatives crisis is far from over. The individuals who created the credit crisis are still running the show. If you believe this statement is incorrect or feel President Obama promised you change so his cabinet must be full of new thinkers, I suggest you view the PBS Frontline documentary entitled The Warning.

The Warning brings to mind two obvious questions:

1- What will cause the next derivatives crisis? Could it be the take down of a major hedge fund that ignites the next collapse?

2- Why isn't Brooksley Born a major member of the Obama administration? If Obama was truly an agent for change wouldn't she be a must in the cabinet?

Consumer Sentiment Dismal, US$ and US Treasuries Reaction A Head Fake

Today's consumer sentiment numbers offer immediate confirmation that the issues I raised in yesterday's post are clear and present dangers to the continued recovery of the debt and equity markets.

As of this post, equity markets are down about 1.5% across the board, which is not surprising.
However, the rally in the US$ and the US treasury market are in my estimation a head fake. The US$ has rallied a bit in the last week or so due to belief that a recovery will allow the Fed to shrink it's balance sheet. US treasuries have rallied because participants believe the economic recovery will pave the way for less stimulus and debt issuance.

Clearly, this sentiment data along with the dismal July retail sales data and awful initial jobless claims data paint an altogether more ominous picture. This picture does not bode well for the US$ or the Treasury market.

ECONX Some Sobering Sentiment Data
The preliminary report on consumer sentiment for August from the University of Michigan caught the market by surprise and not in a good way. The index dipped to 63.2 from 66.0 in July. The consensus estimate was 69.0. The current conditions index dropped to 64.9 from 70.5.

The August reading here is unsettling considering it is below the level seen in February when the stock market was much lower and the unemployment rate wasn't as high. The economic outlook index fell to 62.1 from 63.2. That is the lowest reading since March when this category measured 53.5...

Ultimately, it is income that drives spending, but the weak confidence measure is a sobering reminder of the psychological (and real) effects of a weak labor market that has been accented by a growing mass of workers (1 out of every 3 unemployed) that has been unemployed for 27 weeks or longer. The economic data overall might suggest in the months ahead that the recession is over, but this confidence report goes to show it will feel like a recession for a lot of people a lot longer than some production data says it should.