Looks Like It's Going to be a Rough Week

It is striking how the market trades in patterns. I remember being very frustrated in late January when the market was rebounding off that dramatic selloff, but nothing I was holding was rebounding - it was all concentrated in the worst off sectors - financials, homebuilders, retailers; while the real strength was being hammered daily. I wrote a long piece [Feb 1: Is it Time to Adjust Strategy?] and frankly after re-reading it, I feel exactly the same today. But the fund had some rough weeks in that time frame (lagging the indexes severely) while the market jumped - so it appears we might be going through a similar patch here - my favorite groups get hit, the worst sectors rebound and everyone calling for a "rotation" into new leadership. Last time around that "rotation" lasted for a whopping 2 weeks, and then the "new leadership" went on to get absolutely pummeled. Eventually there will be a rotation but I still believe far too early. But judging from what is selling off and what has relative strength, it looks like we are going to have some similar performance to those rough weeks in latter January. Some excerpts of what I wrote in that post:

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.

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.

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%.

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.

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.

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?

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.

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.

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Since that post a lot *has* changed - the Federal Reserve is now essentially a backstop for financials; Lehman Brothers and Goldman Sachs already tapped the discount window last night - etc. But the underlying problem (housing prices continue to fall, and more people walk away each week) has not changed. And the recession (regional) still looms. So from time to time, we are going to have this "sector rotation" and people will ask "is the commodity boom over?" "should I be jumping back with 2 feet into the early cycle plays?" Well certain financial media pundits told you to do that about 7 weeks ago, and if you followed that advice you had your head handed to you on a platter. I still think it is way too early but I do expect this "rotation" talk (and action) in stocks to happen in cycles over the coming months. At some point they will be correct, but I don't think yet. That doesn't mean the stocks won't rally for a few hours/days/or weeks. But with a longer term horizon in the mutual fund positions, I don't make wholesale changes to ride a trend that might last 7 trading sessions.