"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...