"Maybe you don't like your job, maybe you didn't get enough sleep, well nobody likes their job, and nobody got enough sleep... Maybe you just had the worst day of your life, but you know, there's no escape, there's no excuse, so just suck up and be nice. "
Ani Difranco

For everyone who has been struggling to understand why the market (especially homebuilders and financials) rallied lately below is my skeptical capitalist opinion for what its worth... Remember, it's not wise to fight the Fed, regardless of what your opinion of the job Ben and Co could be doing- for example I think that they are behaving irresponsibly, but that doesn't mean I should be holding all cash!

Four main observations:

1. AAA ABX Indices which track the value of residential securities have recovered to the levels not seen since January, which is in itself an astounding fact... I am a little surprised about the scale of this recovery and think that a lot of it could be explained by the short covering rally and the improved liquidity driven by Fed's acceptance of some of the highly rated securities as collateral. Let's leave the discussion of whether the fact that only AAA and AA rated staff recovered, and that the securities rated below A have not really budged much, for a different discussion. But too me there are many signs out there that make it pretty clear that this rude Fed intervention (read inflation) is THE driver of this artificial market recovery and thus we are destined to pay for it in the future...

source: markit.com

2. I am also tracking various housing related web sites and data with an intent of trying to predict how far are we from the bottom in nominal prices... From what I am seeing so far- price declines have accelerated, but at a certain level- which seems to be related to the roughly the nominal prices at the actual level of sales in the second half of 2004 - buyers are willing to step in. I don't want to overload you with all the data and facts that support my conclusion but that's what I am seeing and hearing so far. Thus, I personally, expect prices to stabilize at level of around early 2004 (which is only 5-10% below most asking prices today) and stay flat for a while

source: Zillow- one of representative homes I tracked for 2 years...

3. Spreads on the commercial securities have also tightened dramatically (good for prices). Improvements again are concentrated in the higher rated tranches and point to substantial smaller risk of further write downs... What's more, there could be even some gains that banks will be able to recognize in the next few quarters if gains continue. Again, I think these gains might be temporary but would explain why banks are bouncing back...

source: Markit

4. Here is another opinion- commodities have topped out for the foreseeable future. I personally sold out even from my O&G servicing plays on Monday and now think that the correction is going to be extremely painful with many retail investors being too late to the game as usual- lot's of pain is yet to come on that front- including the super "hot" fertilizer stocks like MOS and POT

source: bloomberg

All-in-all, if I had to summarize the current situation- I would call it a "Fed" induced "artificial" rally with painful paybacks coming later this year. For now, buy tech, healthcare, industrials and sit and enjoy this temporary "green" color on your monitors :)

P.S. But if you are a retiree on fixed income or someone who has a lot of money in money market funds- you have a right to be really pissed off at the job the Fed is doing as your money is simply being INFLATED AWAY

Stay safe and cheers, Vad
Skepticalcapitalist@gmail.com

Banks and financial institutions that just yesterday were screaming that they were somehow "duped" into lending at outrageously low interest rates, are now once again willingly lending to many of the same players at rates, that not only do not compensate them for taking on the actual risk, but which are also in many cases even below the inflation level? Yes, you heard m correctly- the banks are that dumb!? Do they really believe that this artificial inter bank lending interest rate of 2% or "prime rate" of 5% is here to stay? How long could this really go on? Are we going to be in the same "credit crisis" boat 12 months from now when the rates are virtually guaranteed to be higher?

What does really change when you let the exact "same client X" refinance a loan he/she could not afford yesterday to a new, artificially lower "affordable" rate today? Remember, "client X's " income did not get any higher; the value of the underlying collateral did not go up and the only reason this whole "transaction" was made possible, was the fact that Fed "artificially" reduced rates to a level that was now temporarily affordable? So ok, what's wrong, you ask?

Let's fast forward 12 months from now- Fed Funds rate and with it Bank's cost of funds are now 2-3% higher, but this temporarily affordable "client J's" asset is now sitting firmly on the bank's balance sheet (no more selling it off in a "CDO") and still paying an "artificially low" interest rate that could now very well be even lower than what it actually costs the bank to fund it...?

How is that for a business model? So what's the solution- surely once again lower interest rates? Not so fast- how much lower could you really go- it's already below the inflation level...

In my opinion, if nation's economy can not function normally at a "growth neutral" Fed Funds rate of roughly 5-6% (real GDP 2-3% growth plus inflation 2-3%), than this economy is full of excesses that have to be worked out. Restoring some common sense and destroying the "low rate entitlement" of the financial services industry would go a long way towards making US economy safer, stronger and more balanced.

We simply can not continue to assign blame for the "asset bubbles" like "high oil prices" and "real estate mania" to everyone in the world instead of trying to look back into our own backyard. High food and oil prices are a not a direct result of "growing demand" from place like India and China, but rather simply a spillover effect of the completely incompetent monetary policy. Remember, inflation "always and everywhere is purely a monetary phenomenon"- I personally learned this first hand, when as a child I had to learn to quickly add up prices of my basic groceries first in single digits, than in thousands and finally in millions. May be now it's time for Ben Bernanke as well to actually make a trip to the past and learn that printing money is rarely a preferred solution...

But until that happens, as a rational "capitalist" I should probably go get another mortgage, borrow heavily against all of my assets and safely "diversify" into a few of these 20/1 leverage "all-or-nothing bets" on the continued "inflation driven bull market" for the next several quarters or so. Even if few of these bets "blow up", I am sure that some poor retiree from Indiana, will unwillingly help me out, with his/her negative "real" investment returns from a money market fund more than offsetting the excess returns I will earn on my money...

Please feel free to send me your comments at skepticalcapitalist@gmail.com, Vad

"The only real mistake is the one from which we learn nothing"
John Powell

Hopefully, anyone who read my previous articles or may be even my biography knows that I despise all and any form of socialism, and as a rule don't put any trust in government's ability to accomplish anything productive... But the scary part now is that I am now starting to believe the recent actions taken by Federal Reserve here in the United States are starting to resemble a very unique form of socialism that could be defined as simply dangerous or even borderline reckless, and this does not bode well for the long term health of our economy...

Consistently excessive government intervention in the form of aggressive unnecessary interest rate cuts, unnecessary bailouts of "private companies" and provision of implicit government guarantee for the "riskiest" players of the whole economy (investment banks), is simply outrageous and thus can not go unpunished in the long run.

It is also becoming very clear to me that the currently widespread belief in Federal Reserve's powers to magically "guide" the economy out of recessions is quickly starting to undermine the entire fundamental basis of our market based capitalism. In a true capitalist society, market participants should be expected to only receive a return on their capital that is directly related to the level of risk they are willing to take on. Excessive risk has to be punished by failure; otherwise the whole system fundamentally breaks down- period!

I don't know how could anyone say that this is still the case today? With short term "risk free" interest rate of 2% currently firmly below the inflation level of roughly 4%- most of the nation's "worker bees" savers are being severely punished by the negative "real" returns on their hard earned money. This Fed induced redistribution of "real wealth" from the poor retirees living on fixed income, and lower income and middle class workers who keep most of their savings in money market and other low yielding investments, to the "debt hungry" spenders of all income levels is not only unfair but also dangerous. I mean, why in the world would anyone "save" the money and earn a negative "real" interest, if it is easier and more pleasant to simply borrow all you can, and then enjoy the life style you never really deserved in the first place?

Why would one try to earn a "normal" return on your money in the stock/bond market, if you could add a 20/1 leverage, put up only a modest amount of your own equity at risk and go for the "all or nothing" bet at the expense of the "sucker" savers who might not even earn enough money to provide a "zero" return when adjusted for inflation? I mean, with this kind of leverage you can make twenty bets using the same amount of equity and thus even if one or two deals blow up, you are still guaranteed to make enough money to buy a new house in Greenwich every few years or so.... The only market participants who suffer in this case are once again the "sucker" savers who unknowingly financed one's "leverage" by investing into seemingly safe "money market" funds. What a joke...

For the first time in my life, despite being a ruthless capitalist I normally am, I feel that some of the "blame the Wall Street" media whining is actually somewhat justified... In the country that prouds itself on being the "mother of true capitalism" the "always low rates" entitlement mentality of the financial services industry is quickly becoming something of an incurable decease. I am not exactly sure how did we end up here in the first place, and who exactly is to blame for this nonsense, but this dangerous game of musical chairs is starting to look awfully scary...

Continued...

Once again my screener spit up a bunch of new names on both long and short side last week. Below is the list- consider it a list if ideas - do your own due diligence
P.S. For many reasons this list is dominated by healthcare and tech companies...

Long:

HMIN-Home Inns & Hotels Management, Inc., together with its subsidiaries, engages in the development, lease, operation, franchise, and management of an economy hotel chains in the People's Republic of China.

BVF-Biovail Corporation, a pharmaceutical company, engages in the formulation, clinical testing, registration, manufacture, and commercialization of pharmaceutical products utilizing various drug-delivery technologies in the United States and Canada.

FFIV-F5 Networks, Inc. and its subsidiaries engage in marketing, selling, and servicing products that optimize the delivery of network-based applications

EME-EMCOR Group, Inc., together with its subsidiaries, provides electrical and mechanical construction and facilities services worldwide. It engages in the design, integration, installation, start-up, operation, and maintenance of various electrical and mechanical systems,

CELL-Brightpoint, Inc. distributes wireless devices and accessories, as well as provides customized logistic services to the wireless industry. Its logistic services include procurement, inventory management, software loading, kitting and customized packaging, fulfillment, credit services and receivables management, call center and activation services, Web site hosting, e-fulfillment solutions, and other services.

WYE-Wyeth engages in the discovery, development, manufacture, distribution, and sale of pharmaceuticals, consumer healthcare, and animal health products. It operates through three segments: Pharmaceuticals, Consumer Healthcare, and Animal Health.

NCTY-The9 Limited, through its subsidiaries, engages in the development and operation of online games, and Internet and Web site related businesses in the People's Republic of China.

OC-Owens Corning, through its subsidiaries, produces residential and commercial building materials, and glass fiber reinforcements and other similar materials for composite systems.

MRX-Medicis Pharmaceutical Corporation, together with its subsidiaries, operates as a specialty pharmaceutical company in the United States and Canada.

CCJ-Cameco Corporation engages in the development and production of uranium worldwide. It operates in four segments: Uranium, Fuel Services, Electricity, and Gold.

BMY-Bristol-Myers Squibb Company (BMS) engages in the discovery, development, licensing, manufacture, marketing, distribution, and sale of pharmaceuticals and other health care related products worldwide.

SRP-Sierra Pacific Resources, through its subsidiaries, engages in the generation, transmission, and distribution of electric energy in southern Nevada. It operates in three segments: NPC Electric, SPPC Electric, and SPPC Natural Gas.

SEB-Seaboard Corporation operates as a diversified agribusiness and transportation company worldwide.

WLP-WellPoint, Inc., through its subsidiaries, operates as a commercial health benefits company in the United States. It offers various network-based managed care plans to the large and small employer, individual, Medicaid, and senior markets.

Stay safe, Vad

"The way to get good ideas is to get lots of ideas, and throw the bad ones away"
Linus Pauling

Some more ideas as promised earlier - now on the short side... Short description of my principles applied in the selection process are here-. Don't forget to do your own due diligence though.

P.S. A much larger number of ideas is due to my belief that short positions should be much smaller in size than the ones on the long side due to possibly violent short term volatility...

CWST-Casella Waste Systems, Inc. together with its subsidiaries, a waste services company, provides collection, transfer, disposal, and recycling services to residential, industrial, and commercial customers, primarily in the eastern United States.

CRWN-Crown Media Holdings, Inc., through its subsidiaries, engages in the ownership, operation, and distribution of pay television channels in the United States.

SUF-SulphCo, Inc., a development stage company, engages in the development and commercialization of technology for the upgrading of crude oil.

LGN-Lodgian, Inc., together with its subsidiaries, operates as an independent owner and operator of full-service hotels in the United States and Canada.

WSBC-WesBanco, Inc. operates as the holding company for WesBanco Bank, Inc., which provides a range of financial products and services.

PWER-Power-One, Inc. engages in the design and manufacture of power conversion and power management products.

LZB-La-Z-Boy Incorporated manufactures and markets upholstered furniture and casegoods furniture products in the United States and Canada.

OSIR-Osiris Therapeutics, Inc., a biotechnology company, commercializes stem cell products from adult bone marrow in the United States.

HOKU-Hoku Scientific, Inc., a materials science company, provides materials and components for the generation of electricity from clean energy technologies in the United States and internationally.

CORS-Corus Bankshares, Inc. operates as the holding company for Corus Bank, N.A. that offers various banking products and services.

FLE-Fleetwood Enterprises, Inc. produces recreational vehicles and manufactured housing primarily in the United States.

TVL-LIN TV Corp., together with its subsidiaries, operates as a local television and digital media company in the United States.

MAXY-Maxygen, Inc., a biotechnology company, engages in the discovery, development, and commercialization of protein pharmaceuticals for treatment of disease and serious medical conditions in the United States.

ABCW-Anchor Bancorp Wisconsin, Inc. operates as the holding company for AnchorBank, fsb that provides various financial services in Wisconsin, Iowa, Minnesota, and Illinois.

Stay safe, Vad

Markets as measured by ABX indexes are currently suggesting that most of the residential mortgage backed securities rated below single A, that were issued in second part of 2005 through 2007, are now nearly worthless. This in turn implies that financial sectors woes are not likely to all of sudden stop any time soon... However, pain is likely going to be concentrated in the companies, that decided to retain low grade debt hoping for an eventual recovery instead of selling it at what was considered "fire-sale" prices...

I personally believe that, for example, insurance companies have not yet disclosed the "real" write downs and thus would be very cautious on touching any of the insurers that hold any debt rated below AA. AIG's release last week is a case in the point...

Source: markit.com

VIX index has stopped declining which suggests that fear might be slowly entering investor minds again.

Source: yahoo

Fed rate cutting cycle is over- bonds are looking awfully unattractive at these levels with "real" yields negative across the entire time horizon. This could provide somewhat of a support to equities in the US- but hedging with short positions is an even better idea...

Source: clevelandfed.org

Inflation is clearly spinning out of control. I think that Fed will be forced to start raising rates prior to the year end, which would in turn undermine any short term recovery in economic activity that is now widely expected. For now they seem to be in denial focusing only on the "core rate" which is starting to look like one big joke...

The Consumer Price Index (CPI) rose at an annualized rate of 4.2 percent in March, returning to its recent elevated trend after a respite in February, when it increased only 0.3 percent (annualized rate). The CPI is up 4.6 percent over the past six months. Contrasting the rather sizeable increase in the overall CPI, the CPI excluding food and energy (core CPI) increased only 1.8 percent during the month.

Stay safe and see you at Money Show in Vegas :)
Vad - skepticalcapitalist@gmail.com

"Growth for the sake of growth is the ideology of the cancer cell"
Edward Abbey

Various modifications of "Is this rally for real?" headline are slowly becoming a staple in the mainstream media. Everyone and their mother is now asking this question and stating various reasons why it is or it isn't the case. Here is a simple fact to consider from the "un opinionated" skeptical capitalist- Dow and Nasdaq are up 10%+ since the market bottomed in March! Given the fact that this double digit gain is most likely significantly larger than the average annualized return passive investors should expect over the long haul, why in the world would anyone question if this rally is/was for real? Giving up a double digit return for any reason in my book is simply irrational.

This rally is exactly the reason why I have been arguing passionately for a while now, that successfully timing the market is quite difficult achieve over the long haul, and thus an average investor should never move a 100% of his/her holdings into cash. If/when unsure about where the market is heading - it could much more prudent to move your cash into index ETFs like VO, VV, SPY, QQQQ than into cash or money market funds that don't even earn a high enough return to compensate for inflation. And if you are a true active investor- consider hedge using short positions. Remember, there is nothing wrong with being negative about the stock- it is perfectly ethical to give management the run for their money by questioning their silly actions and voting your dissatisfaction by selling shares... I actually think that if/when the "negative stigma" attached to the cruel "short selling" practice disappears, average investors will be much better off because the market will become more efficient.

Just imagine how much wealth has been irrationally shifted from the unscrupulous investors' accounts into the pockets of newly minted "dot com" millionaires during the tech boom, just because speculative actions of the bullish investors went unchecked by the widely outnumbered and heavily criticized bearish investors. Same thing with sub prime lenders and homebuilders in 2006-2007...

If only investors out there finally realized that instead of listening to the "whining CEOs" blaming evil "short sellers" for manipulating their stock prices, they could do much better if they listen to what these "evil" hedge fund managers are actually saying. While obviously short sellers aren't always right, they are more often right than wrong and high short interest usually indicates either temporary overvaluation of the stock itself, or could even point to a fundamental flaw in the underlying business model of a company that seems to be doing ok on the surface...

The reason for this phenomenon in my mind is quite simple- in the world where investing is now easily accessible to anyone with a computer and internet connection, the real edge comes from doing what most regular investors are still afraid to do- shorting stocks. This in turn implies that investors who short stocks are on average much more sophisticated than the ones who do not and thus their advise is likely to be more valuable.That is precisely the reason why I personally pay a LOT of attention to one widely underappreciated "Vad's secret hedge fund recipe" indicator- short ratio.

This ratio represents a number of shares of a particular stock that are shorted divided by stock's average daily volume over a certain period of time (usually 30 days). I, for example, use it on both sides of my investing strategy. When searching for stocks to short- I simply avoid starting a full position until the short ratio moves above 7 days. It is only one of the factors I take into account when making a decision to short a particular security, but it is definitely one of the more important ones.

On the long side, after my mechanical screening process identifies the top picks, I go in and manually dig through all the available bearish information on each stock with a short ratio of over 7. If I can't figure why the stock is disliked- I simply don't buy it. On the other hand if short ratio is high and I think I know why- the pick becomes a part of my contrarian "conviction" bet group with the appropriate allocation of no more than 3-4 positions and 15-20% total maximum weighting for the high short ratio group.

As an example my original "conviction pick" FSIN at the time I picked it carried relatively high short ratio. But to me it was pretty clear why- investors simply did not believe that management could deliver on its growth promises and also questioned the rationale of the stock dilution required to complete the Copperweld deal. I, however, decided that not only the fundamental growth story was clearly intact with copper/aluminum ratio firmly into Fushi's favor, but also that management has not shown any reasons whatsoever to actually doubt their business acumen and thus shorts were likely to be wrong. It is not clear who is going to be right in the long haul but to me a 35%+ return in just a few months is nothing to sneeze at...

It is true, that I could have theoretically shown returns much better than 18%+ plus enjoyed so far by focusing on a small number of "conviction" picks, as I have now selected a very long list of 35%+ winners on both short and long side. But in my "actively hedged" strategy the main focus is risk adjusted returns, which by default means higher number of picks and consistently significant short position. This strategy has worked for me so far and I have no intention of changing it.

On another note- I have been relatively quiet recently as I am currently in the process of officially changing my status from the " amateur to a real "pro". Beginning June 1st I will finally combine all of my skeptical capitalistic ideas into one full fledged hedge fund launched with a "back office" support of my current employer. Hopefully, given the fact I can now focus a 100% of my efforts on the actual portfolio management; my track record will only get better as time goes by. In the mean time, I will also devote much more attention to building my blog www.skepticalcapitalist.com into a useful resource for any active investor who is looking for some good monthly long/short investing ideas and unbiased economic/investing educational commentary.

For now, stay safe and please feel free to e-mail me with any questions at skepticalcapitalist@gmail.com

"Don't wait for people to be friendly, show them how"
Author Unknown

I have received an enormous number of e-mails recently related to my posts here and at MSN- and I will take a few posts to simply answer them in as few sentences as possible:

1. What was the logic behind my portfolio rebalancing two weeks ago?
As I mentioned several times already- I am an active investor and I thus scan for new ideas every several weeks? Why so often? Logic here is very simple- I don't believe that major indices will close in the green in 2008- hence in my opinion is that the most recent rally, that took us almost to a breakeven point for the year, has pretty much exhausted the return potential for any passive investor out there for the next 6-12 months. So simply passively waiting for your existing positions to take you higher could very well lead to the opposite as higher beta stocks move faster in each direction... What does this mean for me?- it means slowly preparing for the next downside move and hedging using lower beta positions in healthcare and adding new shorts. Does it mean my portfolio is going to actually go up when Dow is going down? Probably not- but it could certainly help to preserve some of the excess returns...

2. Why healthcare?
During the most recent market scan - a surprisingly large number of healthcare stocks came up on one of my screens. So I did my homework and here is what I found- it is true that healthcare sector has been under pressure with a huge number of patent expirations, cost pressures across the board and potentially unpredictable consequences of democrats sweeping the elections in the fall. However, the truth of the matter is very simple- earnings for the sector as whole grew 13% and 7% y-o-y during the two most recent quarters, while the earnings for the market as a whole declined 56% and 29% respectively. Actually using the data from WSJ one can notice that healthcare sector earnings have grown faster than overall market for 6 quarters in a row...At the same time healthcare sector's stock prices actually lagged the market over the last 2 years as measured by VHT (healthcare ETF). So there is certainly a disconnect there, at least on the surface...

Source for original data: WSJ Market Data Group
Edited and graphed by SkepticalCapitalist.com

source: Yahoo

3. Am I bearish or bullish at the moment?
Anyone who read my last posts should have noticed that I have been deleveraging my portfolio for about two weeks now. Sold some of the riskier tech names for healthcare, added some new shorts and this morning actually sold off half of my FSIN and CHNG positions. That obviously implies that I am growing a bit more skeptical on whether the economy can actually avoid a recession in 2008. Here is why- based on several pieces of not widely publicized economic data, like growth in income tax withholdings published by US Treasury, the economy has slowed down markedly in late April and early May- which could now very well mean that payroll growth again moved firmly into a negative territory, and the GDP reading for Q2 could again come in lower than expected at flat or negative. FYI-this data came out yesterday and thus might help to explain the 400 point sell off in the Dow. Media does not really cover this too widely and only boutique research firms like TrimTabs and other sophisticated investors are actually tracking this data closely...

Anyway, enough for today -stay safe and cheers,
skepticalcapitalist@gmail.com

P.S. I have received a lot of information requests about my new hedge fund. Due to some serious legal limitations - I can not answer them publicly on the web site-

P.S.S. Before relying on the my opinions, you should always assume that Vad Yazvinski personally and other investors influenced by him have material financial interests in any of the stocks mentioned and hold or trade them contrary to those opinions.

Continued from Part 1

On the other hand, it is true that values of the widely followed ABX and CMBX indices have staged impressive recoveries, that not only imply that write downs in the financial sector could be over, but that we even might see some "write ups" of the previously marked down securities. However, it is also becoming increasingly unclear whether these recoveries in the values of credit derivatives are actually meaningful, or are they merely an indication of the continued imbalance in the derivative vs underlying security relationships that triggered a large portion of the last year's "credit mess" to begin with...

Putting it in simple terms- it now seems increasingly likely that some (or many?) of the hedges that Wall Street banks put in place after the sub prime fiasco, might actually end up exaggerating the problems, instead of fixing them in the short term... How bad could the things get? I don't think anyone really knows.

And that's precisely my whole issue with the financial sector valuation today- there is still so little certainty with what "real" balance sheets actually should look like, that investing into almost any investment bank or insurance company today, is almost like walking blind in the mine field- there is a certainly a good chance that one might end up making some outsize returns in the long run by buying into conservatively run "real" banks like JPM and WFC, but on the other hand chances of another "Bear Sterns-like" blow up are nowhere close to being remote either. Add to that- almost inevitably stricter regulatory guidelines from the Fed, massive simultaneous deleveraging, paltry returns from the asset management side of the business, still very nascent recovery in the mergers and acquisition volume around the world and any screams about the "historically low" valuations in the financial sector become quite silly...

"Lemming like" behavior of Wall Street still could, in my mind, trigger another "run-on-the-bank". One would assume that Fed's implied guarantee for the counterparty risk helps to virtually eliminate the chance that the likes of Lehman Brothers would repeat the fate of Bear Sterns. But with their bonuses and paychecks on the line, wallstreeters could become quite irrational in heart bit, and when it becomes a 100% clear that artificial shot in the arm in the form of below inflation interest rates is starting to reverse itself - all the bets are off.

That's exactly why I, personally, believe that staying away from financial sector and investment banks in particular, is still a rational move at this particular point- risk/reward balance is simply not there yet... But once again, my investing strategy is just as much about earning the absolute return, as it is about avoiding risk. Hoping for a speedy recovery in the financial sector at this point is still a pure gamble, so I'll take my chances and stay away...

Stay safe and please free to e-mail me any questions at skepticalcapitalist@gmail.com

"Be who you are and say what you feel, because those who mind don't matter and those who matter don't mind" Dr. Seuss

Trying to understand Mr. Market these days is certainly not an easy thing to do...Just when it seemed like Fed has managed to successfully inflate all the problems away, fear has once again managed to stage quite a comeback. I, personally, have been preparing my portfolio for the next downturn for several weeks now by investing into lower beta healthcare stocks and adding new shorts...

And it has not been driven by some mysterious hunch or educated guess, but rather by following a simple logic. As I mentioned before, I believe that the probability of major indices closing in a positive territory for the year, given everything we had to go through to-date, is so remote, that it's not really even worth mentioning, and thus the rally that took us to an almost breakeven for the year, has simply exhausted its full annual potential... Yes, it is certainly true that government's brute intervention in the form of the Bear bailout, rate cuts, "stimulus plan" etc has likely prevented the worst case outcome for the US economy and "nominal equity" prices in the short term. But it has also introduced a whole new "unexpected" variable for the bunch of cheerful Fed governors- inflation!

A significant part of last week's market losses could be attributed to the "unanticipated" changes in the Fed's economic projections for the remainder of the year. Always optimistic "lemmings" of Wall Street, seemed to have been genuinely!? surprised by a gigantic increase in "inflation" expectations and further reductions to the expected GDP growth... Heh?Dah? I mean, why they don't once again give us another "cheesy" story about the expected dramatic fall in prices just because of the slowing economic growth, lower housing prices, lower capacity utilization etc...

Haven't we all read the same economic books? How about the "inflation is always and everywhere as purely monetary phenomenon" mantra? Didn't we all listen to the same lectures about the impact excess "liquidity" makes on inflation? "We hope that inflation will moderate over time" line is just another way of saying - we are in denial for now- let's see if the problems could just go away somehow...

But remember, "Hope is not strategy!" It is always the excess liquidity and not the "evil speculators" or "unfriendly governments", what leads to higher inflation and asset bubbles. Higher oil and food prices are only the symptoms of the underlying sickness of current US/World economy- too much money in the financial system chasing too few opportunities.

And I think it finally became very clear last week for the "More rate cuts, please!" crowd -the party is finally over, done, finished- period. What's more, I am now willing to make another prediction- Fed could be forced to start raising rates even before the year is over. Inflation genie is now out of the bottle and getting him go back there might require a lengthy series of rate hikes. Unfortunately, that once again, makes it even less likely that stock prices could end the year in the positive territory. It should also help explain my steadfast refusal to add financial stocks to the long side of my portfolio.

Don't get me wrong, the currently very steep yield curve should theoretically make it a very attractive proposition to own financial stocks, but I personally just don't think this "friendly" environment is going to last. To me the write offs recently announced by AIG, are not just an exception, but rather an indication of a just of the "hidden" outstanding dangers still abound in the financial system. Conveniently missing from the headline earnings numbers "other comprehensive income/losses" and the true impact from reclassification of assets from "available for sale" vs. "held to maturity" categories, will have to eventually make it back to the where it really belongs- the income statement...

Continued...

"Wisdom is the reward you get for a lifetime of listening when you'd have preferred to talk". Doug Larson

About a month or so ago I read a very interesting article by John Bogle in the Financial Analysts Journal called "Black Monday and Black Swans"... Here is the link to a whole paper btw.

This article in my mind offers a few important points:

1. Concrete, quantitative justification for my conviction in the silliness of fund managers holding a ton of cash and trying to time the market.

"...The stock market has experienced relatively few of these extreme changes. And they are overwhelmed by the frequent--but usually humdrum--fluctuations that take place each day within normal ranges. For example, the Standard & Poor's 500 Stock Index has risen from a level of 17 in 1950 to 1,540 at present. But deduct the returns achieved on the 40 days in which it had its highest percentage gains--only 40 out of 14,528 days!--and it would drop by some 70 percent, to 276. Or eliminate the 40 worst days; then, the S&P would be sitting at 11,235, more than seven times today's level. A good lesson, then, about "staying the course" rather than jumping in and jumping out."

On the basis of the information above alone- investors should consider moving into an index ETF instead of cash whenever not sure about market's direction...

2. It is pretty well established wisdom in the financial literature that stock returns are composed of three components- dividend growth, earnings growth and multiple expansion/contraction with the first two being the major drivers... Very frequently you would hear "talking heads" on TV talking about "this time is different" or "this a new economy that requires a new valuation approach" mantra, but the reality is quite simple- numbers don't lie. In the long run earnings will grow roughly at the rate of the GDP- that's why I believe my focus on the overall economic overview is important.

"...Note that, with the exception of the depression-ridden 1930s, the contribution of earnings growth was positive in every decade, usually running between 4 percent and 7 percent per year. Total investment returns were only once (again, the 1930s) less than 6 percent annually, and only twice more than 11 percent. But if we recognize that corporate earnings have, with remarkable consistency, grown at about the rate of the U.S. Gross Domestic Product, this relative consistency is hardly surprising.

Speculative return is, well, speculative, and has alternated from positive to negative over the decade. But over the long-run speculation hasn't produced any Black Swans either. In fact, if P/E ratios are historically low (say, below 10 times) they have been likely to rise over the subsequent decade. And if they are historically high (say, above 20 times) they have been likely to decline (though in neither case do we know when the change is coming). Nonetheless, certainty about the future never exists, nor are probabilities always borne out. But applying reasonable expectations to investment return and speculative return and then combining them has been a sensible and effective approach to projecting the total return on stocks over the decades.

The point is this: Over the very long run, it is the economics if investing--enterprise--that has determined total return; the evanescent emotions of investing--speculation--so important over the short run, have ultimately proven to be virtually meaningless. In the past century, for example, the 9.6 percent average annual return on U.S. stocks has been composed of 9.5 percentage points of investment return (an average dividend yield of 4.5 percent plus average annual earnings growth of 5 percent), and only 0.1 percent of speculative return, borne of an inevitably period-dependent increase in the price-earnings ratio from 10 times to 18 times, amortized over the century. Despite the Black Swans of market history, ownership of American business has been a winner's game. "

So once again- key points- Markets go up in the long haul! So being a 100% short like some of the funds out there is in my mind a pure suicide. "This time is different mantra" is nothing but myth- earnings are virtually guaranteed to continue growing at the rate of nominal GDP growth and if we all believe that US GDP in the foreseeable future is going to be lower than in the past, stock returns will be lower as well. Here are my expectations for the next decade: real GDP growth roughly at 2-2.5% a year, inflation at 2.5-3% and dividend of 3% with negative contribution from contracting multiples of about 0.5% a year, which means the expected stock returns of roughly 7-8%... This in turn implies that if you expect 15% return- one likely needs to be an active investor...

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