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What Next?

As uncertainty reigns supreme amidst these volatile/choppy markets of today, investors and traders alike are trying to assess whether we are on the brink of a “double-dip recession” or merely just a experiencing a blip–or correction–in the recovery from the throes of the 2008 deflationary spiral.  The answer to this question opens the door for vast opportunity; however, it’s increasingly difficult to deduce exactly where we stand on the road to recovery.  With the markets sitting just above their breakdown levels, the rhetoric and tone are increasingly bearish.  Each attempted rally gets sold with increasing force.  Yet still, the market remains above what many investors perceive to be a solid “value”/breakdown level for the market–S&P 1,040.   I want to “dumb it down” and focus on just a couple of metrics to watch for each side and simply offer some of the competing arguments as food for thought (but inevitably, I’ll give my brief personal conclusive thoughts in the end).

The Bear Case:

Without getting into too much detail about Europe, I want to focus on some key indicators at home in the US that do not bode well for the sustainability of the recovery (I am not altogether ignoring Europe, as the indicators I will discuss account for Eurozone risks).  First, let’s look at a weekly chart of the 20 year Treasury Note (as reflected by TLT) dating back to late 2006.  This has been my personal favorite risk-sentiment gauge during the course of the crisis and in its wake.

The Treasury market is a great risk sentiment indicator.  When the notes spike and the yields drop, we know that investors are more risk averse and looking for a liquid source of safety.  Over the course of the last month, Treasuries reached levels not seen since July 2009’s failed head and shoulders breakdown.  This is a significant sign, considering that thus far in 2010, Treasuries traded consistently in a tight range.  So long as the TLTs remain above the highs of their early 2010 range, the markets will be in “flight-to-safety” mode. Demand for US sovereign debt is to many “irrationally” high considering the increasing budget deficits the government continues to run; however, in the zer0-sum game of global finance, this is the most liquid market in the world and is the natural source of safety when things are hitting the proverbial fan.

Along with the rallying Long Bond came a stronger US dollar.  This both poses risks to the recovery in increasing the prices of US exports and is reflective of decreasing risk tolerance on the part of investors.  A strong dollar means that there is increasing demand for dollars in the global economy, and such a move is deflationary (I’ve written about this several times in the past).  Considering we are in the dawn of a recovery from a major credit crisis, such deflationary signs are scary in light of the troubles in Europe and the lack of monetary and fiscal policy ammunition as tools to place a bid under snowballing selling pressure in global asset prices.

Moreover, the Gulf disaster generates economic risk in its own right.  As the destruction of one of our nation’s important ecosystems and economies continues, the unquantifiable nature of the damage makes it difficult to gauge the overall impact.  There will be significant job losses from the seafood and travel industries which rely on the Gulf as their source of livelihood.  Additionally, companies who rely on offshore drilling will face increasing scrutiny, regulation and diminished earnings in the near-to mid-terms.

The Bull Case:

This arena holds what I believe to be one of the more surprising and optimistic indicators seen emerge over the past month: the recent rally in the Baltic Dry Index (BDI).  Click on this link to check out a Bloomberg chart of the index.  For those unfamiliar, the Baltic Dry Index is an index that tracks the prevailing rate on global shipping.  Strong up moves in the index are reflective of increasing demand for shipping, and vicariously, increasing global trade.  Surprisingly, this index marched steadily higher despite the deterioration in the Eurozone.  Now this uptick may be demonstrative of a desire on the part of resource owners to clear out inventory before wave 2 of the crisis widens, yet for some reason that seems unlikely.  Consumer confidence also checked in nicely higher in May despite the growing Eurozone crisis and this move seems more consistent with the positive developments in the BDI–consumption is making a strong recovery.

Furthermore, the Eurozone’s troubles can become the US’s strengths.  The crumbling Euro has come hand-in-hand with cheaper commodity prices, thus lowering the cost of important input goods such as oil and copper.  A stronger dollar helps boost America’s purchasing power on the global level, leaving consumers with excess wiggle room in their budgets with which to save.  Savings will go a long way towards strengthening the awful balance sheets of America’s households and businesses and this is THE critical step in moving from a stimulus induced recovery to self-sustaining private sector growth.  The rising Treasury rates that go hand-in-hand with Euro troubles  help keep the cost of financing US deficits much more manageable.   These are tangible long-run benefits.

In the words of Rahm Emanuel, “never waste a good crisis” and the Gulf situation should be no exception.  There are important lessons to learn out of this that can lead to long-term improvements and real economic gains.  Yes this comes with a hefty cost; however, rarely is there progress made without some sort of accrued cost.  This disaster clearly highlights the nature of negative externalities when dealing with resource expropriation and provides a much clearer picture of the true supply/demand equilibrium of oil in our economy.  We now know with a higher degree of certainty that alternative energies come with a fairer price-tag than original closed-ended calculations projected.  This is the catalyst that should help lead us to reconsider how we generate energy for consumption.

In Sum:

There you have it.  The key points at the moment for both sides of the coin.  Ultimately should the S&P break the 1,040 level, everything will change and technical selling pressure will highlight and lead to further fundamental weaknesses; however, should that level continue to hold this could be an actionable “long and strong” value level to use as a line in the sand for a portfolio.   Personally I am a believer in the longs, but will quickly change my stance should 1,040 break.  This is so because I give much weight to the improved consumer confidence and Baltic Dry Index numbers despite the multitude of negative sentiment and indicators swamping the headlines.  If today’s rally can hold, and the S&P can once again retake 1,100 this impressive rally off of the March 2009 lows will/should take another leg higher.

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