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Last summer I did alot of digging around and calculating and adding and dividing and pondering and plotting on the valuation of the S&P.  I concluded then that about S&P 1100-1200 would put us at roughly historical valuations.  We've been at roughly the low end of that range now for months, and that is about where the market rally stalled. 

I know that the louder, more yappy bears llike to say, every day the market is up, that the rally "never ends" and all of this.  The fact is that the Russell 2000 is scarecely up in 5 months (a percent).  The S&P is down over the last 3 months and scarcely up in 4.  The DOW and Nas have faired a bit better, but lets face it, as in early last summer, we are in an extended period of a flat market.  

We will eventually break out of it.  A question of course is whether we break out to the upside or the downside.  I tought I'd take a stab at identifying and offering my $0.02 on some potential catalysts that could send us up, or down.  


continued improvement in conditions and profits for business:  companies have rebounded quite well from the brink.  balance sheets are largely shored up, business conditions are improving at basically all of the companies I follow, and the widespread cost cuts and efficiency measures lever many businesses to an improvement in top line etc.

Strength of catalyst:  medium to good.  The reason that I don't think this is an excellent catalyst for market growth is that if overall economic conditions are crappy, but businesses remain reasonably profitable, I think we'd probably see multiple contraction.     

probability of happening:  good.  Businesses have made great strides towards a sustainable return to profitability even if econmic conditions don't significantly improve.

continued improvement in economic conditions:  job growth, another quarter or 2 of significant GDP improvement, or a sustainable meaningful recovery.  

strength of catalyst:  medium to good.  I say medium to good, not good or excellent, because I think alot of this is basically priced in.  

probability of happening:  good.   The large contribution last quarter of inventories to GDP wasn't from restocking, it was from a slowdown in the rate of destocking.  Restocking will have to eventually occur.  Also business spending was slaughtered as part of the almost universal cost saving measures taken by businesses.  A rebound there would be huge for the economy.  And according to, only about 1/3 of the stimulus money has been spent so far.   I think there is still some gas in the recovery tank. 

 ongoing low itnerest rates. self explanatory.

Strength of catalyst:  low.  Probably already played out.  

Probability of happening:  we'll have low rates for a long time, extremely good probability

post-earnings-season happy period:  remember Q3 earnings season late last year?  The market was quite negative for a great deal of it despite generally positive reports.  GNW, a holding of mine, returned to profitability (analysts expected a loss) and promptly sold off 20%.  ASH, my largest holding at the time, reported in-line and promptly sold off 25%.  HIG blew it up and promptly sold off.  Etc.  However, in December for a period of several weeks the market rallied, with the companies that had reported well in Q3 recovering nicely.  Will we see the same thing now?  A March rally if for no reason other than earnings season is over?

strength of catalyst:  medium to high, but fairly short in duration

probability of happening:  medium to high in my view.  This earnings season has the market down and sentiment in the toilet, yet across the board companies reported favorably and beat expectations.

The Bipolar Monkeys that are wall street just get happy for a while.  One must never underestimate the capacity of the raving pack of monkeys to change mood, no reason for the mood change is necessarily required.  Markets just bounce or tank at times, and that could happen here.

Its a straight coin flip, and fairly transient in duration.  Could happen anytime over anything in either direction.

That the markets remain below average valuations of recent history.  I know, I know, I know, dear permabears, I know.  I've heard it all before, I've seen that p/e of the S&P chart.  (rolls eyes and vomits in his boots, just a little).  However, the fact is that stocks as a whole are reasonably priced and many stocks remain very cheap compared to historical valuations.  Doug Kass, certainly far, far from a permabull and a guy with an overall bearish lean, says this:


In my view #1 and #2 are reasonably likely for the next quarter or two.  I do think that there is some chance that the rise in efficiency at US businesses is structural / permanent and not cyclical.  The fear imparted from the crisis will not fade quickly, and I would guess that businesses will considerably use the increased profitability from their cost cutting measures to de-lever and get themselves in a solid financial position, or rock solid position.  Dividends and business spending may be slow to recover...



The Bipolar Monkeys that are wall street just get sad for a while.  One must never underestimate the capacity of the raving pack of monkeys to change mood, no reason for the mood change is necessarily required.  Markets just bounce or tank at times, and that could happen here.

Its a straight coin flip, and fairly transient in duration.  Could happen anytime over anything in either direction.


Employment numbers don't resume their path of improvement.  They haven't been good lately.  4 week moving avg of new claims has risen recently, January figures dissapointed.  I can see a situation where ... where this trend continues (claims never drop significantly from current levels for an extended periodof time) where the market sputters sideways to down, I can't see it causing a monster crash.

Strength of catalyst:  medium

Odds of happening:  low to medium in my view.  I think alot of corporate payrolls are stretched pretty thin and at least some net hiring will need  to happen in the near future.

Growth dissapoints going forward, double dip, etc.   I can see this causing a long side or side/down slog.  Or if combined with a period when the monkeys get sad, a sudden correction.  But...  I don't think this gets us the huge correction many people are yapping for  unless (see below) we have a surprise or a full blown panic or a significant double dip.  

Strength:  medium unless a significant double dip occurs, then strong

odds of happening:  low to medium

Stretched valuations cause a correction.  Bears love, and I mean they love.  Not love like I love pie, but love like Sampson loved Delila, like Don Gorske loves Big Macs, like hedge fund managers love profits.  They LOVE that thing! Everywhere one turns permabears are calling for a monster correction, if not a drop to S&P 300, based on that chart. 

Strength of catalyst:  low.  Valuations aren't actually stretched.  See my posts from this summer on the topic which showed that historical price/book and price/sales, etc etc blah would be roughly average at S&P 1100.  As conditions improve that level will rise (stayinga t the historical average valuations).  Also, sayeth Doug Kass, he of bottom-calling, hedge fund, and fame...  a noted bearish-slanting (even as described by himself) fellow and noted short-seller says, just this week:

 I continue to recognize that stocks are not meaningfully overvalued and that downside risk is limited. Stocks, unlike other assets classes (e.g., fixed income, private equity, residential and nonresidential real estate and commodities), have not had their valuations stretched. Most already expect a relatively shallow economic recovery. Also, inflation and inflationary expectations are subdued, and an elevated unemployment rate and large output gap are among the many reasons why the Fed will be on hold and the curse on cash will be intact for most of 2010.

Of late, there has been an increase in optimism with regards to profit growth based on better sales, improving margins (lower-than-expected unit labor costs) and rising cash flows, which are leading toward more aggressive share buybacks. The consensus for 2010 S&P 500 profit forecast is now moving toward (and even over) $80 a share, and the 2011 consensus is leaning toward the view that profits will exceed the previous 2007 record level of $92 a share.

Indeed, given low interest rates, benign inflation and reduced inflationary expectations, stocks, at under 13.5 times, remain statistically cheap against consensus 2010 S&P profit forecasts, far less than the historic P/E multiple of 17.5 times under similar interest rates and inflation readings.

Odds of happening:  low.  If valuations aren't stretched, and if anybody cares to debate it lets go over it on a stock by stock basis...    how can this lead to a correction?  IMO the best values exist at a variety of market caps (not just large cap "quality", which has become what "everybody" knows lately, and in the financial sector).

Continuing dollar strength causing a plunge.  Steve Leuthold has suggested that a STABLE OR STRENGTHENING dollar is needed for the next leg up in the markets.  We have seen, to an extent, decoupling of the markets from the dollar in recent months, and every commodity inflation cycle in history has eventually seen the markets decouple from weakening currency and rise without currency falling.  I think that while some people would be surprised, ...  the time for equity markets to decouple from currency may be reasonably at hand.

strength:  medium, but falling

odds of happening:  low to medium

Commodity price plunge leading to another deflationary shock.   Why would commodity prices plunge anew?  I can see several potential catalysts including:

1.  China stopping their stockpiling efforts.  China is buying more than its using, and a variety of china bears from Hugh Hendry to Jim Chanos worry about the commodity space for this reason.  

2.  Hedgies and speculators leaving the playing field.  Alcoa said late last year that "most" of the aluminum inventory was being held as an investment and not by users.  Oil prices are almost without a doubt being supported by speculators and not by actual demand.  The extent to which "commodities as investments" -vs- "commodities as things used in industry or society" isn't something I know, but from various indications its huge and at all time highs.  If the whole world goes long oil because oil is going up...  it creates a self fulfilling prophency, but what happens when they try to cash out?  Are we just going to store thousands of tons of aluminum forever?  

3.  Double dip, slowing of economic activity, etc.  I'm not in the double dip camp.  The most likely catalyst for a double dip, in my view, is a commodity price crash shock hitting commodity producers hard.  

The big deflationary shock of late 2008 saw basically all asset classes falling in tandem.  Commodities plummeted (probably partly due to selling by imploding hedge funds), stock prices plummeted, all types of debt and bond markets plummeted, save Govt debt.  Private equity markets plummeted, everything but government debt.  

If commodity prices crash anew, will it be an instant replay of 2008?  Probably not.  The money coming out of commodities will have to go somewhere, for one, and true genuine terrifying panics are rarely, if ever, spaced as close as 2 years.  Look throughout history, find one example of an epic market crash just 2 years apart from another one?  

Also, per Keynes, the market can stay irrational longer than you can stay solvent.  Even if this IS going to happen,t hat doesn't tell us when...  or how severe it would be.  

So I pose as a question:  what if the dollar rises, commodities plunge, but the equity markets don't plunge, or actually rally?  (at least rally outside of commodity related shares)?  That would be something close to a "least expected" situation.  Those who expect falling commodity prices assume that plunging markets will accompany them.  Those who expect commodities to rise via inflation and so forth don't tend to be market bulls.  

I think this situation - the not-real demand for commodities experienced currently in many markets - is one of the riskiest ones out there right now.  A crowded trade can unwind in a hurry.

Geopolitical instability.  War, etc. 

odds:  low to medium.  war is reasonably rare, but its certainly not impossible today

impact on markets:  probably fairly transient, but probably fairly dramatic when it sets in.

China implosion or instability or financial crisis.  China has a real estate bubble?  China cooking the books?  False economy from building cities for nobody and bridges to nowhere and capacity nobody needs?  Hendry thinks so, Chanos thinks so.  Many others are at least wondering. 

odds:  I haven't any idea

impact on markets:  probably noteworthy

European debt situation.  Bailouts will probably happen, problems will probably exist.  They will probably get baind-aided, life will probably go on. 

odds: good, but I think people are basically ready for it

impact: low, because I think people are basically ready for it


This post was written over sevearl sitting spanning all day as I wandered to and from my trusty 'puter.  I hope it is organized enough in its final form to be of some use.  

All in all, more plausible downside catalysts exist than upside.  Probably, that is usually the case.  Valuations are no longer extremely cheap and while I can't say I'm bearish on equities, I am mildly bearish on commodities as that trade is a bit crowded. 

For me my cash levels are higher than they have been since last June and my portfolio is meaningfully hedged.  Overall my position is defensively mildly bullish on US equities.  I intend to raise more cash, and, thought I shall disclaim first, I will offer a thought on the future of markets.

Disclaimer:  I suck at predicting near or medium term moves in markets, that has been proven again and again in my blogs here on the CAPs game.  I almost never get timing right, and when I do its probably as much luck as skill.  I am no macro economist, nor even a micro drunken economist.  I am just good at realizing when panic has gotten to irrational levels and capitalizing on it...

Prediction:  We will, sometimes in the reasonably near future, see a second wave of commodity price deflation.  Whether this comes in a rush or as a slow trickle, I don't know.  

That in and of itself isn't that interesting...  but I'll go out on a limb and say that equity markets don't crash alongside commodities.  The basis for that is partly that nobody expects it, partly that equities offer significantly better value relative to historical trendlines and historical valuations than commodities or bonds ...  and a deflating commodity mini-bubble leaves a great deal of money that needs to go somewhere.  And with negativity building around bonds...  decreasing levels of confidence about emerging markets clear superiority to mature economies...  that leaves equities as the last man standing.  

What would nobody expect?  Commodity price deflation + rising equities + falling gov't bond markets + rising dollar + falling debt and other bond markets + good economic recovery.  That is a combination that I have not seen anybody predict.  It would possibly be the outcome that would frustrate the highest possible number of people.  

As commodity stocks already feature crowded trades and premium valuations relative to other sectors, and as I think a second wave of price deflation in commodities is a feasible possibility, I am trimming commomdity stocks over the next month.  

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