Daedalus would have made one helluva portfolio manager during these troubled times.
He was a man of moderation, caution and ingenuity. It takes all three to succeed, or at least not lose, in this environment. King Minos had imprisoned Daedalus and his son, Icarus, in the Labyrinth as retribution for a number of heroic acts. With escape routes by land and sea impregnable, Daedalus used his ingenuity to fashion a set of wings for he and Icarus out of wax and feathers. Before taking flight he cautioned his son to not fly too high lest the sun would melt the wax nor should he fly too low for the sea would dampen the feathers. Moderation, mid-level altitude, was the best course for escape and survival.
As the myth goes, Icarus had quickly mastered the use of his new wings. He would soar and dive, soar and dive, each time extending the upper and lower levels of his flight path. Alarmed, Daedalus repeated his warnings but the words were lost in the vacuum of the skies. Having in his mind successfully tested the boundaries of flight, Icarus decided that soaring into the skies was much more exhilarating than maintaining a steady path. He flew higher and higher, unaware that the sun was beginning to take its toll. The wax melted, the feathers floated down and Icarus crashed into the sea. As he was drowning, he could be heard to say: “Damn, if I had only gotten out just before the top. Next time…”
This is an Icarus Market. The rallies, the feelings of euphoria, suck people in and they ignore the risks, as their focus turns to the exhilaration of higher highs, a new trading range, much like Icarus extending upward his flight path. They focus on the positives, not the negatives. Like Daedalus, I am suggesting a moderate path, not net short and not all in long. While I believe that the risk may be to the upside, there are too many unresolved, potentially devastating issues for me to throw caution to the wind. My exposure remains light. I like defensive stocks or stocks not dependent on the economy. WLP (despite issues from the Super Committee), QCOM, value plays – my Ahmadinejad stocks as I like to call them because they are so hated (small positions in RIMM, HPQ which I shaved a bit and CSC), short EURO -long USD and of course, yield equities. Coal continues to act like garbage and steel had no basis for rallying.
Near as we can tell Europe has not meaningfully progressed toward a workable solution to the crisis, announcing a less than suitable framework for resolution. What was missing from the Merkozy plan was a ring-fence for Spain and Italy, the two major trouble spots, and funding. From the recent headlines, they are no further along to increasing the ESFS than they were then, with France still looking to the ECB in order to preserve their AAA rating, while Germany wants no part of bailing out the Icarus like French banks that assumed much too much risk. France’s AAA is gone – the S&P fat finger flub reminding me of newspapers that have already written the obituary of dying celebrities in advance of them taking their last breath.
And Europe’s recession will spill into the US, directly, and indirectly, through China. US multinational earnings will of course be hit by recession in Europe so look for the S&P estimates to decline. China’s major end market will also suffer, continuing to pressure their exports. And, while on China, is anyone still hanging onto the laughable hope that this bastion of self-interested opportunism is going to bail out the EU? They won’t even do the easy stuff such as sanction Iran. They have their own issues to contend with.
Before moving onto actual data, here’s where I am. I fly to the underbelly of Daedalus. As I weigh the pros and cons, I am encouraged by the US economy while expecting some moderation of corporate enthusiasm as seen in the recent reporting period. I do not believe that we can use historical measures for determining that the market is compellingly cheap since we are in a low growth environment. European troubles concern me the most and I would rather wait for a legitimate solution to be announced than get in front of it. Thus I don’t see significant downside to the market because each day the bar gets set lower and the bad becomes the not so bad. If I had told you a year ago that Spanish and Italian bond yields would be just below and above 7%, respectively, you would have ventured a target on the S&P of 1000. But the market has shown a tremendous capacity for resetting its threshold for bad news. So we will wallow in this extended trading range and likely not revisit the lows. In fact, more money can actually flow into the US equity markets as it exits Europe but I fear that is a wish and not reality. I would potentially turn more positive if I thought that more European Prime Ministers were poised to resign; each of the last two was worth a decent market rally. There are 15 more PM’s in the Euro that are candidates with relative value S&P points of 5 to 15. And even though there are no working monarchies, if say a King Juan Carlos abdicated, I would be willing to throw in a mid-afternoon rally for that – what the heck.
And the IMF will not be the answer even if they toss more chips into the pot. I offer these charts from JP Morgan’s strategist, Michael Cembalest, showing that promises by the IMF have not yielded a great result in the past.
And while I’m in a plagiaristic mood, here is a chart from my friend David De Luca that I had sent out last week along with some commentary. It shows the fear in equity markets. If you are one of those who believe the credit markets are leading indicators of the direction of equity markets then its time to head for the hills. Within the past week almost $45 billion was taken out of the banking system and placed at the Fed, matching the move last seen in September 2008. Surpassing the $108 billion peak post-Lehman, $125 billion is now being held at the Fed representing funds for loans that won’t be loaned anytime soon. As the chart below indicates, this size withdrawal usually leads to a steep decline in the equity markets but that has not occurred yet as I do not believe today’s decline in the futures has anything to do with this. My point is that a whole lot of bad news is being obscured by other bad news or worse, bad news that is perceived as good news such as when a major corporation (read: country) loses its CEO (read: Prime Minister) without any replacement.