Market Commentary for the week of March 8, 2010

Turning cautious.
Stochastic (relative strength) indicators clearly show that our current global “mini-rally” in stocks is getting long in the tooth. I would ascribe this rally to exceedingly low interest rates, monetary reticence to play the “inflation game,” and a lack of suitable alternative parking places to stocks.

Although figures indicate a bottoming in the recession, the same cannot be said for the markets. We are not making new highs, and valuation lows are deteriorating with the completion of each short cycle.

The fact that sideline-players remain cautious is a good sign, as I would be more worried if everyone was in the pool. Net equity exposure is still quite low, which means the game is being played mostly by traders and speculators. I would categorize these bull rallies as short-cycle upswings within the existing secular bear trend. Until, or unless, profits start being built by unit volume growth, the markets should remain in a negative trend overall.

The only game?
The big variable in that hypothesis, however, is that low interest rates leave no other suitable alternative for investors. With few exceptions, high grade fixed income opportunities are few and far between. The only way to break the equity market’s cycle of inertia and worry is for interest rates to rise. Given the high level of debt globally, I see this as a possibility before year-end. All of this lays the groundwork for reigniting investment, inflation, and higher net-return on capital. More importantly, higher rates are either indicative of, or congruent with, economic expansion, which isn’t such a bad thing.

As we continue to struggle with the psychological after-effects of the financial market’s near collapse, the sectors which suffer most are Financials, Consumer Cyclicals, and Industrials. Their decline is so severe that should the economy reaccelerate, their lingering problems will be difficult to overcome, and likely lead to a continuation of laggard performance. Unfortunately, I’m not considered a “value investor,” so these sectors seem like losers in the near run to me.

What to do.
A skeptical public doesn’t care much about the machinations on Wall Street, only the net result on Main Street. Political pressure from the U.S. mid-term elections could be enough fodder to influence policy-making on social/moral issues such as Healthcare, Alternative (replenishable) Energy, Food (agriculture), Infrastructure, and Science. It’s no secret that the debate will be strong if not tedious.

International crises, such as those in Greece, China; natural disasters in Chile; and monetary imbalances in the EU leave little wiggle room for emerging market opportunity. Truly, this is a stock-pickers market, and less an asset allocation exercise. I would expect going forward that the U.S. might lag while the rest of the world accelerates. Based upon the intricate relationship between currencies, and the relative lack of restrictions upon lending for industrial production, the more risky (but most likely to outperform) bet would be outside the U.S. Such a set of contradictions is the climate in which we now find ourselves.

The net effect of all these various data is to heighten risk levels in stocks as we near upper range inflection points. My signals point to an above average exposure to cash in the short-term while waiting for a capitulation downwards in stocks, hopefully to be followed by a sustainable “next-upleg rally” late Spring.