Is it Time to Adjust Strategy?

One must be constantly flexible, and staying married to any one viewpoint is, in my estimation, a way to lose money. The question is, with the flurry of changes over the past week and a half, is it time to change focus in the fund? This is something I have been thinking about a lot the last few days.

Let me give you my thoughts from a macro economic/strategic view point. I have a lot of new readers, and based on the fund performance the past month where things have stalled I'd like to go over a 40,000 point of view.

On the economic front my predictions have been just about dead on since August. Everything is playing out as I envisioned, and in fact even more accelerated than I thought. I saw a weakening US economy, distress in financial system, and a reactive Federal government on all levels. Things have moved even faster than I predicted - back when the first discount rate cuts came in August I said inflation concerns will be thrown out the window as the cockroaches came to the surface - so ignore all pundits who tell you the Fed cares about inflation - we are going to 3% by Spring 2008. It's already happened. In my 13 Outlier 2008 Predictions I revised that to 2.5% Fed funds rate (this was when we were at 4.25%). We seem to be headed there, and it might be by next meeting considering how putrid these unemployment numbers are.

Now we are at an inflexion point, much like in mid August after the Fed began their rate cutting actions. It is very easy for popular pundits to now say "don't find the Fed" - and to buy the early cycle names especially retail and financials.. These were the same guys who said it in August (and they were right for 8 weeks after the market went on a Kool Aid rally). But they were wrong when they said it in October. (November was a 10% correction). They were wrong in December on the next cut. (January 10%+ correction at its lowest). And anyone in retail, financials, homebuilders lost far more than 10%. Many names were down 40-60%. So I find it a bit ridiculous they crow now. But so be it. The more important question is what now?

In my 13 Outlier 2008 Predictions I wrote

#7 After over 2.5 years of not suffering a down 2% day dating through early 2007, volatility in the stock market takes over as the theme of the year, 2% daily increases and drops become a weekly occurrence. The market suffers its first 20% drop (from Oct 9, 2007 peak) in the first half of 2007 as consensus emerges that "a major slowdown" (which dared not be called a recession due to elections coming), is happening. The first half of 2008 is marked by major downward revisions in 08 estimates and a 'cheap market' doesn't look so cheap.

So far so good. Daily volatility has been off the charts in January (do you realize we went 2.5 years without a 2% correction in the market during 2005-2006? It was an amazing time) We had a 19% correction in the Dow and more than 20% in the small caps.

Later in that point I wrote

Markets make a dramatic rally off these lows as all the worlds banks coordinate to flood massive infusions into the system (all this money needs to go somewhere) - and in combination a massive wave of foreign investment hits US firms (non financial), driving up equities late in the year. Investors are giddy before realizing a 10% return in equities marked with 9% inflation really only means 1% return, but they clap like seals anyhow. Pundits will claim how resilient the economy is without realizing we are selling off large pieces of it... The market ends the year only down 2.78% as economic based bloggers throughout the world wonder what it takes to make the market ever go down?

I still think this is a very likely scenario - but the question is of timing. Is everything moved up now since the government actions have been even more aggressive than I envisioned? I'm still not convinced.

What will change my mind is the next round of write offs and foreign capital inflows in the coming 4-8 weeks. What's that? You thought we were done with that? No, I don't think so. It has just been pushed to the side the past 2 weeks. But back to my point above - what will change my view on financial is the next round of writeoffs and foreign capital infusions. If the financials begin to rally HARD off of announcing $8 B in losses - then I will believe the bottom is in. Because folks... we will have more losses. And more foreign infusions. The thing to note is not the "news", but the "reaction to the news". So the next 4-8 weeks will tell me whether to join the Kool Aid crowd or not. If $12 B write offs at Citigroup are rejoiced over - than its time to ignore all economic reality and buy financials hand over fist. If we sell off on this news, then it's still not a bottom.

I referenced earlier this is a very similar time to August after the first emergency cuts. Why? Because we began to drink Kool Aid in large swigs. The conventional wisdom at the time was the Fed will save us and almost no one was talking about recession - this was a financial issue and the Fed could fix the banks and things will continue as normal. Not one investment bank was talking about recession. Very few bloggers were. That all changed within 3 months. As for the markets - they raged upward on "trust" in the Fed... the same investors who now berate Ben everyday for being behind the curve. Funny how things change eh?

I had a lot less readers in August but do you know how I was positioned? Very similar to how I am now. And the fund suffered - I was losing money daily on the Ultrashorts... because banks were "saved" by the Fed. This was before even the first foreign capital infusion. I kept saying this is just the beginning and whatever disclosures the banks were making (they were calling these kitchen sink quarters) was nothing. We had a whole house of sinks to go through. And we have seen this was true. But PERCEPTION IS REALITY. And PERCEPTION at the time was, "the banks will be FINE once we get over this rough patch" and "recession? laughable". So the market ramped for 2 months into mid October.

What did I do with the portfolio? After suffering some losses for about 3 weeks and just being step for step with the market (no outperformance at all) since my gains in longs were constantly eaten up by losses in Ultrashorts (talk about a true hedge) I said (and I repeated this almost daily) - I don't know why the market is going up because the economic background is degrading and the financial situation is just beginning. But I said, even though that is true, it doesn't matter. Because all that matters in the stock market is the current belief system. And the current belief system at the time was the Fed was all powerful and any economic slowdown was a blip. So I could of continued with my viewpoints for 8 weeks and continued lose money (I would of been proven correct over the long run, but much poorer). Instead I plugged my nose, went heavy long and just prayed every day that the next shoe would not come to wipe out us all. I kept typing (for those who were around) "it does not matter. Until it does."

Then it began mattering again in November. Then it really mattered in January.

So that's the past. Where are we now? Well I find the same viewpoints now everywhere. The Fed will save us. I am looking at what is rallying and I have to ask an open question. With a flailing employment situation ... and folks, we won't see the truth of the employment situation until the summer in the "government numbers"... how do you justify a bullish move into retailers, homebuilders, and financials? Perhaps I can understand financials, but a distressed customer won't buy Macs (see Apple performance of late) but will buy shoes, clothes, housewares, home improvement products, etc? Logic? None. A distressed consumer cannot afford hambugers (see McDonald's performance of late) but will buy homes? Cars?

Very interesting logic. But nonsense. But PERCEPTION IS REALITY. Further, I think (and I don't stress this enough) people need to understand the power of computers in the market. Computer trading is 70%+ (and probably increasing by the quarter). It's based on models. When models see Feds cut so aggressively they go to "early cycle" plays.... rightly or wrongly. This is why "scientists" or "logical" people get frustrated with the market. Right brained people. I myself have been gritting my teeth. 10 years ago I'd sit here and say what the heck is going on - none of this makes sense. Today, I say - none of this makes sense - but I realize why it is happening. This is just the "playbook". And the computers are driving up these stocks.

So the open question going forward is where do we stand? I wrote in the late summer/early fall people are underestimating our issues. They think there will no real slowdown and the financial system will be fine in a few months. SO the market went up. I think the same is going on now.

We have 2 risks (a) systematic financial risk and (b) recession risk. What has made this market scary to me is having both risks at once is not something I can recall - nothing in 98 or 01-03 was similar. Perhaps 1990 was the same, but that was before my time in the market. If this were simply a recession story I could "game that" a bit easier. But both at once? Much harder to game. Now with that said, we are beginning to work through the systematic financial risk... i.e. the bond insurers won't go out of business and bring down the system. But we still have other new financial risks that people are now glossing over in their drive to run up the financials. Those have been discussed at nauseum here - mortgage risks in Alt A, prime. Car loans. Student loans. Credit card borrowing. I still believe almost none of this is discounted in the market. But all people care about now is that we don't have a global collapse due to bond insurers and that's good enough for a hell of a financial rally. But that doesn't mean we don't have many more shoes to come. Shoes I don't think are being discounted at this time.

Employment is the key here folks. I don't care what the government statistics are. Follow the market - follow the job cuts. Retailers are beginning. Mortage companies already have done some but the greater financial services cuts have yet to come. And just like on the way up, this "fake economy" based on overextended housing market created ancillary jobs throughout the system, the exact opposite happens now. For each 20 less construction workers, is 1 less barber, 2 less mortage bankers, is 2 less realtors, is 1 less dog groomer, is 1 less grocery clerk, is 1 nail technician, is 1 less bartender and so on and so forth. It's a major ripple effect and it takes time to work through the whole economy. Does it mean people don't need to cut their hair or groom their dog or go to the bar to drink? No. But they cut back. And when consumers cut back, business owners cut back. They cut jobs. (80% of jobs in America are small business - business suffering through same inflation the UPS, the Fedex, the airlines, the food producers are going through - coupled with higher health care costs, coupled with slowing consumer). Almost our whole non export (15% of GDP) economy is now based on housing - not 4.5% as "they" would lead you to believe. Through housing comes jobs; through housing comes equity; through houses comes spending. So if you are on the fence of housing is coming back this fall in a big way, you need to ignore this entire thesis, because I will be wrong. And we are at the bottom.

I will say - Main Street and Wall Street are 2 things. For long periods of time they can disassociate. What I see coming is a period of serious hardship on Main Street but a time of potential pleasure on Wall Street. And people will be shaking their heads again. A tidal wave, an absolute flood of liquidity is coming to the world through the US Federal Reserve... and next UK... and eventually EU. Those in the right places and in the right time will benefit enormously and asset classes will rise as we have limited supply of equities, commodities and the like. Those who own those properties will be enriched. (Foreign capital will also flood US markets) At the cost of massive inflation, and the common man on the street who must pay for goods day to day. All these new dollars will circulate the globe adding to inflation and hurting Main Street. But enriching Wall Street and those who hold assets. So I do believe we will be entering an era where I will be writing about a lot of bad economic things happen to the common man, while the very same day writing about some massive gains in the stock market. Pundits will say "well what's good for Wall Street is great for everyone" because 70% of America is now the investor class. All those working folks with $3800 in their 401k ... right. Meanwhile job losses will magnify, foreclosures will increase, people will find it increasingly harder to pay for households goods (Procter & Gamble raising prices 6% across the board - Procter and Gamble tells analysts it plans to raise prices six percent or more on many of its household products, including Iams dog food, Cascade dishwasher detergent and Zest soap.), energy and food.

I do believe my stagflation thesis still holds, and there will be a lot of suffering among the non investor class. But we can cheer our Ameritrade accounts going up to offset it.... John Edwards "2 Americas" will become even more magnified in the coming years...

I'm already on record as making my first 2009 Outlier Prediction - that yet another government rebate will be coming to Americans as they struggle to pay day to day bills in food, energy, and anything Procter & Gamble makes.

Lost in today's unemployment numbers is this simple fact "Average hourly earnings for jobholders rose to $17.75 in January, a 0.2 percent increase from the previous month. It was half the pace logged in December. Economists were predicting a slightly larger gain of 0.3 percent. Over the last 12 months wages went up by 3.7 percent. With high energy and food prices, though, workers may feel squeezed and feel like their paychecks aren't stretching that far."

Again, wages are not keeping up with inflation. They haven't in years. It's been masked by the home equity ATM. Inflation is ramping, not stabilizing. And pressured business are going to squeeze laborers to please their investors (the stock market) - they want to keep margins high to keep stock prices high. How? Reduce costs. Fire. Those that remain - limit their wage increases. In an inflationary environment no less.

So am I changing strategy? Nope, not until I see financials ramp hard on their next round of write offs and capital infusions.. I do think the "perception is reality" trade will push me into financials, and homebuilders as the year goes on (I've already written about this). Retailers scare me in this environment where the US consumer is falling behind inflation on a daily basis, but "perception is reality" so they can go up to. Again I need to stress - Main Street is not Wall Street. When 5700 people lose jobs, the stock goes up. But I don't think much of what I've written above (which can of course all be incorrect) is priced anywhere in this market.