Sunday, March 04, 2007

Weekly Look Ahead

Last week was a very rough one in the market, with a 4.2% drop in the dow and most other indices. If you followed my lead and sold your broad market holdings when I said to you wound up 2-4% ahead of the market for the week (personally my average sell price put me ahead 2%).

I still recommend holding most of the Finance Wonk Portfolio (with the possible exception of AAPL, depending on your tastes for volatility), as those stocks are picked to profit over a full economic cycle.

Everybody wants to know where the market will go this coming week. As usual I am going to put my opinion on the line in no uncertain terms: I believe the market will go down.

Why do I think this? I have been crunching numbers like mad and let me first tell you what will not be at fault. Earnings are not crashing any faster than expected, although next quarter should see much lower growth than before. The market P/E ratio is not completely out of control, only about 16, versus 24-50 at the height of the last bubble depending on how you sample and calculate. [As a note for us hardcore value analysts a 16 P/E on the market is actually rather high for current growth projections - so this must dampen the market in the longer term.]

Inflation has not yet exploded, although there was disturbing data last week that suggested inflation was going up. Consumer sentiment was also down.

So what is the main issue I see damping the market? Declining Liquidity.

Hedge funds and various investing pools have been borrowing money like mad recently in the low interest rate environment and investing it to juice returns (see for example the carry trade primer in Bond Investing 101). The main enemy of this sort of leverage is volatility and last week saw major volatility indexes jump up 50% or more. Shortly thereafter the Japanese yen exchange rate with the dollar went nuts as hedge funds tried to unwind their carry trades. With lots of hedge funds deciding risk has returned to the market something like $ 100-500 Billion could be pulled out of the market, which is equivalent to all the upward buy side that one might expect during a trading week. That is why I expect at least another week of declines.

To quote James Awad, of Awad Capital Management; "What you're having is a reality check. The market is being fueled by liquidity and some of the liquidity is drying up. Fear is in the marketplace. You're probably going to have a noticeable correction."

For the longer term we'll have to see how the market adapts to lower growth.

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