Here we go again. Ben Bernanke and Co last week delivered another strong message to the commodities bears all around the world- "we can't really tell if it was/is a bubble until after it blows up"... Unfortunately, it does seem as if my last week's prediction about Fed's inability to raise rates in the middle of the "political season" is actually becoming a reality.

Faced with a tough tradeoff between growth and inflation "Chairman Ben" and Co came up with a clever way, but also potentially dangerous way of solving the "Bernanke's dilemma"- "outsource" the inflation fighting role to other economies around the world instead of doing the dirty work themselves. In his speech last week, Fed's Vice Chairman Kohn delivered a message that seems to have not only borrowed major points from the stories of the "commodity" bulls, but also gave a pretty clear answer to "will they really raise interest rates in August?" question- "Not gonna happen!"

"The reasons for the trajectory and persistence of increases in prices of food and energy this year, as global growth has moderated, are not entirely clear.(VY-Heh?) The upward trend in prices of food and energy over the past several years, however, importantly reflects the pressures posed by rapidly growing demand in developing economies against relatively inelastic global supplies of commodities.

...Additionally, in those countries where strong commodity demands are associated with rapid growth in aggregate demand that outstrips potential supply, actions to contain inflation by restraining aggregate demand would contribute to global price stability"

The translation basically goes like this- "US monetary policy has nothing to do with ever rising commodity prices. These high prices are merely an indication of sky rocketing demand from BRICs. And because the US Federal Reserve and the US Economy have had nothing to do with this rise, they should not be obligated to participate in the clean up. The "new guys on the block" (BRICs) and stubborn Europeans need to fight the inflation battle on their own!- slow down economic growth engines using all means necessary- raise rates, further adjust currency exchange rates etc. US won't be raising rates any time soon." -Case closed...

Mr. Market's reaction?- Dow down 400 points or so, Gold up $50, new multi year low for the DJIA, new highs for Crude Oil and virtual death sentence for some/(all?) the Big 3 US auto and RV/Boat makers. I certainly admire the creativity of this "heads I win, tails you lose" interest rate logic- it is almost guaranteed to win some political points here at home. But it is also a very dangerous one for the world economy- relying on China and India to remove the excess liquidity from the world's economic system, is in my mind equivalent to a firefighter waiting on his colleagues to return from vacation in the other state, to help him put out a house fire that has been already been raging on for a while- it is very possible that by the time they come back, there won't be a house to save...

Continued...

So instead of already being out of what could have been a relatively minor recession absent the rate cuts, we are now possibly only one hurricane away from oil prices clearing the $150 a barrel barrier and with it GM, Chrysler, Ford and major US airlines rapidly entering the insolvency territory. But even with all US indices now closing fast on the "bear" market territory, stubborn Fed still refuses to do its main job of fighting inflation, and keeps arguing that their lax monetary policy has nothing to do with high prices?

Come on Ben, give me a break- M2 Money supply growth in double digits during the first quarter of 2008, got very close to that of China, country whose GDP is growing at 10 times the rate of the US. Where do you think this liquidity has gone? Dah?

Anyway, enough rambling- Fed has made its decision, and while I think it was not a very smart one, I have to now figure out how to profit from it. My healthy short position has certainly helped me to preserve most of my gains, and being some 15% plus ahead of the market is definitely a terrific result so far, but now I need to figure out how to resume the upward trend.

I don't know what it might be, but absent a rate increase move from the Fed- oil and other commodities could very well go higher and when/if that happens- US indices could possibly now go much lower- say another 7-8% lower?. Plus with US Fed outsourcing the interest rate increases work to the emerging markets and European Central Bank, these markets could actually fall faster and harder than anyone expect them. This sell off is also likely going to produce some terrific buying opportunities, and thus with capital preservation goal as a major theme, I'll for now buy deeper into the defensive utilities and healthcare sectors...

I hope that I am completely wrong, but it certainly does not look pretty out there- with VIX nowhere close to the "fear" territory, capitulation of the major indices looks likely to continue for a while longer, so stay safe out there, Vad - skepticalcapitalist@gmail.com

I guess I will never stop being amused by the investment related media headlines out there... One day we hear a story about the "major bubble" in oil, another day "about oil prices going to $250". Same divergence with interest rates, investment banks or for that matter with anything else that is a "soup du jour" of the moment- I guess it is an almost bullet-proof strategy- throw a bunch of things on the wall, make lots of extreme statements and then see what sticks, and at the end declare that you were right.

Recently, forecasting shapes of what seems to be an inevitable eventual recession has become a very popular topic of conversations. Here some of own views and opinions on the subject. I will try to describe them in the "media-like terms" hoping it won't be too boring ...

Some believe that the US Economy is in for a V-shaped recession- a quick and painless slump followed by a fast recovery; others think we might see a W- shaped one with one quick dip followed by a short recovery and then followed by another larger dip with an eventually inevitable upward move. And the last group, ("Elliot Wave" crowd) thinks that we are destined to live in the L- shaped world - with the US Economy entering a decade long Japan-like period of stagflation for the years to come...

I'll start by eliminating the third scenario outright- in my opinion the repeat of Japanese scenario here in the US is pretty much impossible, because we are 1.Nation of spenders, not savers 2.Are as far from the deflation as one could be- "have you seen the inflation numbers lately?"

On the other hand, I believe that the first two shapes of economic downturn are still very much possible- and the end result could very well depend on the next move of the Washington wizard called Ben Bernanke. So below is a hypothetical scenario planning exercise to make sure that my portfolio is ready for the eventual outcome whatever it might be.

Let's now introduce some core factual statements:

1. US Economy is going through a period of highest inflation in more than a decade- all the talk about core, non-core inflation is irrelevant at this point- you can only call high energy and food prices non-core and temporary if they indeed lasted for only a short period of time ...

2. Inflation is always a direct of excess monetary liquidity. High commodity prices are merely a symptom and thus are not likely to be cured until the excess liquidity is drained...

3. Healthy financial sector is a fundamental requirement for any well functioning growing economy- without normal access to credit- the economic system as we know it cannot function...

4. Banks are very unlikely to start lending in a normal fashion again until they become confident that the value of their collateral is no longer eroding.

5. Financial sector especially the investment banks are facing significantly more restrictive regulatory environment and lower leverage

6. It is very rare, however, when you see a combination of persistently high overall inflation and accelerating deflation of the core collateral in the financial sector (real estate) -simultaneously.

7. The longer the current restrictive credit situation drags on, the more likely it is going to spill over to new areas- Fed has to force the banks to start lending again

8. FDIC is now going to virtually force banks to raise more capital whether they need it or not in the short term- expect more capital dilution and dividend cuts...

9. Thus one stakeholder in the financial sector is going to suffer more than the others- shareholders

In addition to that Fed is now facing another trade-off- trying to protect as many banks as possible from the insolvency and buying them some more time with lower rates, and at the same time trying to contain the increasingly unstable inflation expectations from spiraling completely out of control.

11. In my opinion, achieving both objectives is at this point virtually impossible and thus Fed could either:

• Own up to its mistakes, raise interest rates swiftly, bankrupt many of the smaller and mid size banks, but kill the inflation genie and deflate the commodities bubble. In the process this will send the entire global economy into a deep but relatively short lasting recession - shape "V" as the media would say...:)

• Keep talking "big game" but not take any "real actions". Force banks to raise more capital by diluting existing shareholders and cutting dividends whether they eventually need it or not. Keep rates low and pump more liquidity in, until commodities or some other bubble, once again blows out of proportion. But inflation in this scenario is very likely going to enter the next stage of a usual cycle -with workers demanding higher wages in turn moving prices even higher etc... Eventually Fed will be forced to raise rates higher than in scenario 1 and thus will inevitably send the economy into a more severe recession- shape "W" as the media would say. (Inflating the housing issues away should allow for the headline GDP to contracts only slightly in the first leg of the cycle).

12. Neither one of the options is pretty at this point, but in my opinion while the first one is clearly the more logical, it is also very politically challenging- with election season in full swing- rates will be tough to raise without a republican "blood bath"... So Fed is going with the option two -which in turn means that because regulators are now going into a severely brutal "raise more capital at all costs" mode, even the healthy bank's shareholders are now bracing for more dilution.

13. Thus my decision to buy into financial sector last week even in a small way was not a correct one and I am reversing it. It also means that S&P and DOW could very well retest/ move past the January lows in the nearest future and thus adding a few more shorts and more defensive play like utilities might not be such a bad idea.

On the positive side, however- the corporate health outside the financial and consumer discretionary sectors still looks ok and income tax withholdings as released by the US Treasury http://www.fms.treas.gov/dts/ have actually picked up in the last few weeks of May and in early June. The most recent data in my interpretation is consistent with a GDP growth of at least equal to or may be even slightly higher than that in Q1 2008...

After playing with the data I have also found what seems to be an interesting correlation between the four weeks lagged S&P 500 index and growth in withholdings- it is by no means bullet proof, but certainly seems to point to a limited short term S&P downside (2-3%) with the next move up of roughly 5-6%.

And to finish off- here is one more opinion- I think that behind the all the "doom and gloom" noise out there, it is important to clear any disillusions and fears. In my opinion, 10 years from now- all major US indices will be trading at higher nominal prices than they are trading today, period. I am willing to make this bet with pretty much anyone-but I also doubt there will be many takers though as it is pretty much bound to happen for two main reasons:

1. In the world of "fiat" money inflation is not going away and thus while real stock prices might be higher or lower, nominal prices are simply destined to go up!

2. US Economy is still the most vibrant, flexible and productive one in the world and thus it will find a way to reinvent itself and will surely grow in the real terms again at some point :)

So with that in mind, I think that assuming one could weather some serious volatility in the next 12-24 months or so- pulling all the money out of stocks and reinvesting them in cash or money market funds is very likely to be the most counterproductive thing a passive investor could do. However, protecting the principal investment should be the most important goal of any investment manager and thus hedging with short positions is as usual a very prudent decision...

Stay safe out there, skepticalcapitalist@gmail.com

Rate hike chatter is getting louder every day... Futures are now pricing in a 25% probability of a rate hike in June and almost a 50% chance of a hike in August. What's more now even a 50BP hike is a possibility. One interesting thing about Bernanke's Fed so far has been the fact that futures have a been a solid predictor of their actions...

source: ClevelandFed

source: ClevelandFed

Now what does that all mean for the markets? I think that the severe declines of the last week are the answer. But as usual in any market there will be winner sectors and losers. Below are some excerpts from a research paper that studied the impact of Fed's actions on various sectors called "Sector Rotation and Monetary Conditions" by C. Mitchell Conover; Gerald R. Jensen; Robert R. Johnson and Jeffrey M. Mercer

"We focus on the efficacy of a particular timing-decision variable advocated in prior studies, that being a simple gauge of the stance of Federal Reserve monetary policy. In particular, our objective is to determine whether there are potential benefits associated with using monetary conditions to guide a sector rotation strategy. Our results show that, in general, using announced Fed policy changes as indicators of when to shift a portfolio to a more aggressive or defensive posture, would have allowed investors to significantly enhance portfolio performance. Specifically, performance is enhanced by shifting into cyclical stocks following Fed changes that signal a more expansive monetary policy, while the appropriate response to a signal of a more restrictive Fed policy is a shift into defensive stocks."...

... "One of our more interesting and potentially useful findings relates to the rotation portfolio's performance during expansive relative to restrictive monetary periods. As indicated, the rotation portfolio assumes a defensive posture during restrictive monetary periods, and it is during these periods that the most prominent improvement in portfolio performance is observed. During restrictive monetary periods, the rotation portfolio returns approximately twice the benchmark return, yet the rotation portfolio has considerably less risk. This result suggests that the primary benefit associated with using monetary conditions to guide an investment strategy is that the strategy can be used to improve the disappointing performance associated with bear markets"

Below is the table of results of their findings slightly modified by me... The punch line is that resources sector actually on average does quite well? A bit surprising, but math is math...Another clear cut message- Technology does not do well during restrictive cycles- I will have to think hard about being so wide open in the IT field...On the other side just as expected- financials have not done too well when rates went up, neither did discretionary consumer goods...

P.S. STD- stands for Standard Deviation...

I think my MSN Portfolio needs a serious rebalancing...
skepticalcapitalist@gmail.com

Becoming a successful "intelligent investor" is not something one should expect to achieve in a very short period of time... Too many of the very smart, well educated and successful people out there believe that picking stocks is just as easy as running their own business or that one can create a mathematical model that will tell them exactly what the stock is worth. Unfortunately, it's not quite that easy. As we all know, most of the professional managers out there fail to beat the market year after year, and number of those who have been able to do so consistently is so limited that you probably know them most of them by name.

Just think about again- every year hundreds of newly minted MBAs leave Top business schools around the world and join the asset management industry in their quest to become the next Warren Buffet or George Soros. Most of them are more intelligent and driven than an average person out there- but still the vast majority fails measurably... I personally always wondered why does this happen and how could I possibly avoid their mistakes? Finding an answer to this question is not an easy, but as with everything else, I have my own skeptical opinion...

After one of the many rereads of my favorite books about investing psychology "Reminiscences of a Stock Operator" by Edwin Lefevre, I realized that a large portion of this question might have already been answered almost a 100 years ago -

"... The desire for constant action irrespective of underlying conditions is responsible for many losses on Wall Street even among the professionals, who feel that they must take home some money every day, as though they were working for regular wages..."

Too many of us approach investing just like we would anything else-with great passion and determination to make it work- we plunge wholeheartedly into the "mysterious world" of stocks, spend countless hours reading about "magic, bullet proof formulas", listen and watch to Bloomberg and CNBC and dream about the next "Berkshire size" investing opportunity out there. But unfortunately, there lies our biggest flaw- we become so devoted to our new passion- that we let emotions drive our decisions, we let our affection for a particular stock to overrule the common sense and we deviate from what at first seemed to be our well thought out, "iron clad" strategy.

As if our human nature wasn't enough, the continuous and never stopping media flow of new tips, "important" information and "expert" opinions lead us to sell winning stocks when we should be sitting tight or force us to "fall in love" with a money losing stock and ride it all the way down to zero. And this emotional urge is frequently so difficult to resist that many finally give up, pull whatever is left out of the market, put it in the money market or some other cash equivalent account, where inflation slowly takes care of whatever is left...We've seen it happen over and over again and it is very unlikely to stop anytime soon.

That's' precisely why I think learning the behavioral/psychological side of financial world is as or may be even more important than the traditional quantitative one. And I am not talking about the technical analysis (TA) driven world of "self fulfilling prophecies", I am talking about good-old boring fundamental ones- like herding, group-think, loss aversion, mental accounting etc... The list is simply too long and obviously can't be covered in serious detail within one article- if you want to learn more on your own- the good place to start would be Wikipedia...

Continued in Part 2...

Remember, understanding the theoretical principles is just the first step- the most important part is trying to figure out how use it in action. Today I wanted to mention just one of the topics that deals with the question that I get e-mails about most often- how and why should one choose when to sell stocks?

In my opinion- selling strategy could actually be more important than the buying one. Remember, nominal stock prices go up in the long haul- pure and simple, and thus your diversified portfolio is very likely to go up regardless of when and what exactly you buy, if you just leave it alone for long enough period of time.

In my experience, however, the single biggest mistake investors make is selling out too early. Here is my advice and rule of thumb - NEVER sell stocks on the way up- sell them ONLY on the way down. Yes it might sound counterintuitive and make people question my logic, but that might be just the single biggest factor in why some people do better in investing than others.
Why does it work this way? Weren't we all taught that it is a better to set a target price and sell it when the stock reaches it? Before jumping to conclusions simply too quickly -consider these few findings of behavioral finance and try to apply them to the stock market:

1. "Loss aversion"-

humans have been found to strongly prefer avoiding losses to acquiring gains- it means that people, on average, refuse to admit that they made a mistake by buying a particular stock and thus end up sticking to losers when they should have been selling. Social Psychology Fourth Edition, Aronson et al., p. 175: "Once we have committed a lot of time or energy to a cause, it is nearly impossible to convince us that it is unworthy"

2. "Endowment Effect" -

"People place a higher value on a good that they own than on an identical good that they do not own" - by Kahneman, Knetsch, and Thaler (1990

3. "Disposition Effect"-

"Investors are unwilling to recognize losses (which they would be forced to do if they sold assets which had fallen in value), but are more willing to recognize gains". "Shefrin and Statman (1985) predicted "that because people dislike incurring losses much more than they enjoy making gains, and people are willing to gamble in the domain of losses, investors qill hold onto stocks that have lost value (relative to the reference point of thir purchase) and will be eager to sell stocks that have risen in value. They called this the disposition effect."Montier (2002) pages 23-24

4. "Post-purchase rationalization" -

"...common phenomenon after people have invested a lot of time, money, or effort in something to convince themselves that it must have been worth it. Many decisions are made emotionally, and so are often rationalized retrospectively in an attempt to justify the choice"

Now, these are just a few of the well researched human biases that affect investor's behavior when they make investment decisions - but all of them point us to the same conclusion- investors on average sell winners too early and hold on to their losers for too long... And if on average people make the same mistake over and over again- the smartest thing you could and should do- is take advantage of it and do just the opposite, hence my selling rules...

Anyway hopefully that helps to answer some of the questions, for now stay safe and please feel free to e-mail with any questions at skepticalcapitalist@gmail.com

Rates are go up before the year is over...

Excerpts from a great speech by one of the only few Fed Presidents ( Dallas' s Fisher) that seems to still get it- Unless inflation is brought under control quickly, US Economy might be in for a very long and rough ride...

"We know from centuries of evidence in countless economies, from ancient Rome to today's Zimbabwe, that running the printing press to pay off today's bills leads to much worse problems later on. The inflation that results from the flood of money into the economy turns out to be far worse than the fiscal pain those countries hoped to avoid

Earlier I mentioned the Fed's dual mandate to manage growth and inflation. In the long run, growth cannot be sustained if markets are undermined by inflation. Stable prices go hand in hand with achieving sustainable economic growth. I have said many, many times that inflation is a sinister beast that, if uncaged, devours savings, erodes consumers' purchasing power, decimates returns on capital, undermines the reliability of financial accounting, distracts the attention of corporate management, undercuts employment growth and real wages, and debases the currency.

Purging rampant inflation and a debased currency requires administering a harsh medicine. We have been there, and we know the cure that was wrought by the FOMC under Paul Volcker. Even the perception that the Fed is pursuing a cheap-money strategy to accommodate fiscal burdens, should it take root, is a paramount risk to the long-term welfare of the U.S. economy. The Federal Reserve will never let this happen. It is not an option. Ever. Period."

The good news for the long term health of the economy is that Fed Funds probabilities are now starting to slowly point towards an inevitable rate increase- 13% chance of a rate hike in August... I think we might see at least one hike before the year is over- hence financials are once again might not yet be cheap enough...

source: ClevelandFed.org

Want another confirmation of more trouble coming the Financial's way?- Bernanke's speech today- while pretty worthless and non informative on the inflation part, offered new details of what's in store for financials- if you still own lot's of banking shares- watch out- you could be saying "ouch, that hurts..." a lot more...

"Finally, we are taking action in our role as regulators. We have worked with lenders and servicers to encourage appropriate modifications of distressed mortgage loans, and we have proposed new rules to improve disclosure and to ban unfair or deceptive acts and practices in mortgage lending. We are also collaborating with other regulators, both domestically and abroad, to put in place changes that will help make the financial system less vulnerable in the future. Among the changes we expect to see are strengthening of capital and liquidity rules, greater disclosure requirements, an increased emphasis on the measurement and management of firmwide risks, and further steps to increase the transparency and resilience of the financial infrastructure. Our goal is to emerge from this difficult period with a financial system that will be more stable without being less innovative, with a more effective balance between market discipline and regulation."

Stay safe and cheers,
Vad skepticalcapitalist@gmail.com

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...

Stay safe and feel free to e-mail me at skepticalcapitalist@gmail.com

read this legal disclaimer after/before/during reading of all and/or any of my posts :)

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...

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

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.