There are going to be two results of the above condition.  First, all of those holding U.S. treasuries and bonds will have to continue buying if they don’t want to lose substantial amounts in their current holdings.  This makes for a slow and gradual migration into higher yields as older securities are redeemed and new ones bought.   Second, as the global economy experiences the slowdown in growth, we will also see another leg down in valuations of most stock markets around the world.  There will be few places to hide other than short term cash and Treasury Inflation Protected Securities or TIPS.  There is already a growing interest in these types of investments.  Unfortunately, there are not enough being offered to meet the growing demand. 

    I have to point out that since October 19th, the U.S. stock market has only briefly advanced and then has been trading in a range of plus or minus 3%.  It is proving to be a good call to eliminate market risk, stay in cash, and wait until the current crises play themselves out.

       Second, I have made mention of the U.S. Gross Domestic Product or GDP and how it needs to be above 3% -4% to indicate any sort of economic recovery.  In the 4th quarter it was reported that the number was 5.7% for the quarter.  The market has seen through that horse shit.  Gene Epstein of Barron’s explained that the part of the GDP that reflects recovery is the Domestic Final Sales element or the DFS which reflects consumer spending plus business and investment in plant and equipment.  The DFS needs to be substantially higher than the 1.8% in the 3rd quarter and 1.9% in the 4th quarter.  So GDP is nowhere near where it needs to be.  It might benefit from the increase in spending to rebuild inventories (or so they say).

     Third and probably most important is the alternatives available for investors to put their money in.  The vast majority of it is going into U.S. Govt treasuries and now German Bonds are starting to draw assets.   The problem is U.S. Govt  treasuries have become another asset bubble that will burst down the line.  Think about it.  If everyone is demanding U.S. Govt bonds, the price goes up and the yields go down.  At some point, the massive U.S. Govt debt issue is going to begin to weigh on investors minds and they will begin to wonder how in the world the U.S. is going to pay down that debt.   Keep in mind that as long as the interest rates that the U.S. pays is low, it is a manageable problem.  But, global  investors, as soon as the rest of the world starts to look better in terms of total returns,  are going to start selling bonds and moving toward more attractive alternatives that have inherently less risk.   When that happens, rates start to climb,  the U.S. Bonds begin to loose value and then all hell breaks loose because all the Retirees that are holding those bonds mutual funds are not expecting to loose their principal and will start reading their quarterly statements and those losses will begin to register.  As long as the interest rates are on a par with the GDP growth rates ( 3%-4% vs 4%-5%)  running up a national debt can work.  When those ratios get out of whack, watch out.  That’s when you want acreage, ammo, and isolation.

      In the context of a market that is fairly or fully valued, the above points can only have a negative impact on the market.  We are 800 points into the 1,000 to 1,500 point drop I wrote about on Jan. 22nd and not far from a DOW 9,000 to 9,500 level which will be the 15% correction I wrote about.  The market mentality has changed from one of bullish euphoria to doubt and concern.  Any good news is now looked at with scepticism.  Any bad news is emphasized such that the pundits start to referr to a possible end to a bull market that never really was.  We simply recovered from a major panic in the markets and it took on a life of it’s own.  We witnessed an overreaction to the upside.  It is entirely possible that we may witness another overreaction to the down side.  But, don’t count on it.  There are way too many anxious money managers chomping at the bit to jump at what may look like another leg up.  

       Just consider that if you followed my opinion and went to cash, you avoided a nice slide.  Don’t worry about whether the market will keep going down after you get back in.  Rest assured it will.  It just won’t be as painful as it could have been.  And wait for the next oscillation in the market.

    I would like to mention that the re-confirmation  of Fed. Chairman Ben Bernanke is at risk due to political reasons.   If he is not confirmed (which would also be classified as another Black Swan Event) then the markets will respond negatively.  I find it incredible that Republicans can find fault with someone who successfully navigated a world wide financial crisis and want to replace him because they are, ironically, claiming he is at fault for the crisis in the first place.   The legislation that created the crisis was passed by those same legislative representatives back in the 90′s.  Granted there is fault to go around, but you don’t  fire the one person who succeeded in performing his job for political reasons.  He has demonstrated that he knows how to deal with the issues.  Why would you replace him with someone who has not been tested by fire.

   I’m starting to wonder how many market factors are going to turn against the market.  There is a group of European Union members that combined have acquired the acronym PIIGS.  Each of these member countries (Portugal Italy, Ireland, Greece, and Spain) has major Soveriegn debt problems that combined are beginning to convince the international markets that the Euro might actually fail.  If that does come to pass, there will be a mass exodus into the dollar and yen.  If that happens, our markets may take a 1,000 – 1,500 point dive for fear of commercial and consumer market demand collapsing and impacting corporate earnings.   Mark my words,  this period is going to experience more historical world financial events before it is over.

   It is earnings season and we are getting mixed results.  Top line (sales) growth rates are still not increasing as was hoped.  Without it we cannot achieve expansion in earnings.  So, let’s see how this pans out over next couple of weeks.

   Ok.  So, what I have been trying to point out over the last couple of months is that all these factors were eventually going to catch up with what investors are willing to pay for stocks and bonds.  I suspect that that we are about to reach a confluence of these factors and we will see a stair step down to market levels that are more reflective of the amount of risk that should have been recognized months ago.  The Dow Futures as of today are already 100 points down.  Should be interesting.  To be honest with you, I’m a bit relieved that the correction is finally  starting.  Takes the pressure off a bit.  We should get better visibility on these risks and their effects over the coming months.  In addition, if these risks are mitigated, then we might even find a re-entry point.  Watch that Risk Factor Scale.  It might just surprise you.

         It is challenging personally and requires courage to have to wait for confirmation that my call is correct.   But, I am seeing those confirmations.  Check out ”The Economist” magazine cover (www.economist.com ).  ” Bubble Warning; Why assetes are overvalued”.  Saturday Jan. 9th, 2010, Bernard Condon of the Associated Press writes that Main Street is not buying the rally.  American Association of Individual Investors survey results are 49% bullish, 15% are bearish, the highest since Sept. 1987 and very contrarian.  72% of investment advisors are bullish.  Also, very contrarian;  contrarian because when everyone is positive about the markets, that is when it is the most dangerous.

     If these sources are indications of market overvaluation, it begs the question, why is the market continuing to increase?  One possible explanation is  ’Market Momentum’.  History tells us it is generally not a good idea to fight momentum,  until it turns….  Another factor, it is the end of one year and the begining of another year when tax sales and portfolio repositioning takes place.  There will be some rotation from one sector, or group of stocks, to another as well.  But, volume has been very thin which indicates a lack of conviction.  So, this increase is not as solid or pronounced as it appears.   There has also been a massive amount of money market funds going into bond funds driving bond prices up and yields lower.

    Last week the job losses report came out.  It was expected to be a net of -11,000.  It ended up -85,000.   All the talking heads, analysts and strategists have been rolling this number about trying to understand it.  What they don’t realize is that many small businesses were waiting for the end of the year to close their doors and lay off the remaining employees.   The reason I know this is my contact at a major payroll company told me that this is common knowledge with payroll processing specialists who are on the front line talking to these business owners weekly.  This is not good news.

      Let’s review some assumptions.  There is limited near term earnings growth in stocks.  Long term interest rates must eventually rise.  The Gross National Debt cannot continue to climb and government stimulus has to end.   Current market valuations are considered to be fully or fairly valued.  Any increases form these levels are purely speculative.  If these are all true, then should one continue to be in the market?  If so, for how long?

     As I see it there are 3 choices.  First remain on the sidelines in money market funds, risk losing out on the short term gains, and avoiding the excessive risks.   Second, stay fully invested and let the market volatility churn your portfolio values and emotions.  Third, diversify into bond funds and attempt to reduce the risk and volatility.  The last approach incorporates the very real and, in my opinion, far more dangerous interest rate risk.  This could impose losses as high as 25-30%.  Interest rate risk, if you are not clear on it, is the risk of existing bond values declining as current long term interest rates increase.  If investors have to be offered higher interest rates to entice them into tying up their cash for 30 years, then the existing bond values will have to decline in market value to equate to the new rates being offered.  This is almost guaranteed to happen.  It’s just a matter of when.

   In summary, as long as 1) we continue to get weak but positively trending economic date dribbling in,  2) they continue believe in the rally momentum, and 3) nothing manifests itself to the contrary, this market will continue to edge up.   In my opinion, the excessive risks are great and the first option is the most prudent.

    The past year the market has been one of the most volatile in history.  We experienced a decline of over 25% only to regain that and then capture a 23% gain on top of it.  But, we are still almost 30% below the market peak of 2007 and not expected to get back to those levels for years.     A lot of press has been given to 63% gain from the market lows in March, as if there were actually someone who captured that gain.  You can rest assured that there is absolutely no one that sold at the 2007 high and bought at the March 9th low to capture those numbers.  The best one could have expected to get is to have done nothing at the beginning of the year, having a 100% stock portfolio, not reacted to the market as it tanked in March, and then watched as it recovered to it’s present level for a total 23% gain for the year.   Experiencing that kind of volatility, it is almost impossible to remain detached. 

     One of the natural concerns of most analyst at this point is that we have had such a fantastic recovery without a correction.  2010 is expected to be a year where market performance is between plus/minus 5%.  All sorts of technical data (chart fairy fodder), economic statistics, international factors, etc, are being bantered about.  What I find interesting/irritating are prognosticators that draw similarities with some of the years past like 1938 and 2004 without regard to the vast background differences and drawing conclusions that suit their agenda and support their industry.  This market and economic recovery is being described using adjectives and phrases like slow and steady, fragile, new normal, and flattish year.  Do these make this investing environment seem encouraging?  I continue to see otherwise. 

     In my  research, I’ve looked at a broad spectrum of information.  I don’t want to bore or overwhelm you with data.  But, I think you should know at least a quick summary of some important points.  I also want to share with you something that no one is yet talking about.  But, first the data.

      Again, it’s all about earnings and growth.  GDP measures economic growth of the country.  2% is OK but we need 3% or more to justify these market levels.  This is where a lot of attention is being focused and why analysts are so interested in inventory and production levels,  initial jobless claims, the unemployment rate and other data points that provide early insights as to the direction of the economy.  I am expecting 2%.   January 29th is an important date when production and inventory reports are made known.   Consider it a jump-off point for the rest of the quarter.   Other items of interest are the prices of copper, oil,  the yields on 30 year government bonds and then the strength of the dollar itself. 

       The price of copper, often an early indicator of industrial production demands,  has been rallying over the last few months.   This time around it is a false signal for several reasons I won’t go into.  It should be dropping around 30% over the next couple of months. 

        Rising oil prices also indicate rising industrial demand and overal economic growth.  But, world inventory levels have been rising and OPEC is having a hard time getting participants to reduce production.  So, prices probably won’t be going much above $80 per barrel.

       The dollar has been weakening over the last several months due to the Federal Funds rate being almost zero and U.S. Treasuries and Govt. bond yields dropping.  Investors have been selling the dollar, buying U.S. securities for safety and investing in commodities as they became more desireable.   The federal government has been injecting stimulus money for liquidity to improve the financial markets.  That will be concluding in the near future.  As a result, yields have begun to  increase.  This is going to cause existing bonds to decline in value and the dollar will begin to strengthen.

     I haven’t even addressed the collapsing commercial real estate market, the loans that are coming due on those depressed properties, and the resulting financial losses.  

      When you combine these factors, the market rally will have met it’s end.   But, what analysts are not talking about is the effect this will have on foreign markets and international holdings; i.e. emerging markets, Europe, Brazil, Russia, Asia.  All will decline in value relative to the dollar.  Those markets will have a a brief pullback but their growth rates should continue independent of  U.S. economic factors.

   The bottom line is I continue to believe that our markets are still at risk for a significant pullback.    Risk management is prudent still and their are few safe havens other than money market funds.

   So, we have problem commercial debt, reduced earnings expectations, the dollar strengthening, and gold selling off.  All of these have been addressed here and they are all becoming problems at the same time.  It is time to watch the markets closely over the next 2-3 weeks to see if the 15% pullback happens before the end of the year.  There is no where to go for a flight to quality except for the protection of the strengthening U.S. dollar.  That means that to make any money, one has to go long the U.S. dollar.  For the 401k investor, money market funds are a safe haven.  But, keep an eye out.  The market may provide a surprise entry point if it takes a quick dive under 9,500 or 950 on the Dow and S&P respectively before the end of the year.  Stay tuned to WWW.FUNDSWITCHERS.COM.