May 18, 2011

The Rally's Foundation is Shaking

By Andrew Mickey, Q1 Publishing

Thomas Kempis said, “The loftier the building, the deeper must the foundation be laid.”

More than 600 years the words couldn’t be any truer when applied to stock rallies.

Rallies have historically been built on foundations of improving earnings, widening margins, innovation, and economic growth. They are fundamental, solid, and deep foundations. As the foundation grew stronger, the higher valuations could be supported.

The current rally has been built on none of those. It has been built on cheap money – the weakest foundation of all.

Most investors at this point know it will end. They’re right too. Stocks will be fundamentally revalued at some point 20% to 30% below where they are right now.

Lately, there has been some serious shaking of the rally’s foundation and with the end of QE2 just weeks away, we’re seeing a few clues into the market’s next move.

Dr. Copper’s Poor Diagnosis

Copper is said to have a Ph.D. in economics. Copper prices have mirrored global economic growth over the last decade.

A pound of copper climbed from 70 cents at the turn of the century to a high of just over $4 before the credit crisis. It immediately gave back nearly a full decade in gains in the following six months. It has gained it all back and then some over since then.

It has been a wild ride. But it shows copper is still a good indicator of worldwide economic health. That’s why the latest move in copper prices is a serious concern.

After topping out in February, copper prices have started to turn down. The crest, which included volatile swings over a few months, is typical of medium term tops.

Clearly, Dr. Copper is signaling potential trouble ahead. That trouble could be the double-dip or simply reduced rates of growth in emerging markets. Either of which would be a significant headwind for stocks at this point.

But it’s not just copper indicating trouble ahead.

Jeremy Grantham Makes a 180

Jeremy Grantham is one of the great investors we watch closely. He’s usually right. He successfully called the tops of the tech and housing bubbles. He called the bottom in stocks in early 2009. Most big money investors listen to him. And his forecasts can often become self-fulfilling prophecies.

A few days ago Grantham changed his “float with the Fed” mantra.

In a recent follow-up to his quarterly letter to investors he wrote:

I do not feel the same degree of confidence that I did, which was considerable, that the Fed could carry all before it until October 1 of this year. A third round of quantitative easing would very probably keep the speculative game going. But without a QE3, there seem to be too many unexpected (indeed unexpectable) special factors weighing against risk-taking in these overpriced times…

Risk now should be more reflective of an investment world that has stocks selling at 40% over fair value (about 920 on the S&P 500) and fixed income, manipulated by the Fed, also badly overpriced…

Although the taking of some “extra” risk by riding the Fed’s coattails has been profitable for six months, I admit to being a bit disappointed: I really felt the market had the Fed’s wind in its sails and would move up deep into the 1400 to 1600 range by October 1, where it would be, once again, over a 2-sigma 1-in-44-year event, or, officially, a bubble. (At least in a world where GMO is the official)…

The market may still get to, say, 1500 before October, but I doubt it, especially without a QE3, although the chance of going up a little more by October 1 is probably still better than even. And whether it will reach 1500 or not, the environment has simply become too risky to justify prudent investors hanging around, hoping to get lucky. So now is not the time to float along with the Fed, but to fight it.

This warning is very similar to the ones Grantham issued at the top of the tech and housing bubbles.

He doesn’t cite a specific catalyst for the end of the party because no one really knows what it will be He, like most successful investor, focus on the odds. Right now, Grantham (and we) see the risks quickly outweighing the potential rewards when looking at the market’s overall.

The Dollar Collapse Rally

As remarkable proof that nothing can go down forever, the final market turning event has been the U.S. dollar rally.

Stocks have been inversely correlated to the U.S. dollar throughout the current rally. The dollar went down and stocks went up and vice versa.

That trend changed a week ago:

Now the dollar is drifting higher and stocks are drifting lower.

Although the current rally of a mere 4% in the dollar isn’t much. But if it’s a sustained rally is in store, there will likely be even more headwinds for U.S. stocks.

As we enter the summer, there’s a very good chance the dollar rally will continue. The Euro is about to get hit again. Debt crises in Portugal, Spain, Italy, and Greece (again) are going to require more intervention. Also, commodity currencies like those in Canada and Australia, recently popular safe havens, are poised to give back some of their recent gains if commodities continue to correct.

A return of the US dollar index to 80 or higher is going to likely spell trouble for stocks.

Just Say No…Sometimes

These indicators continue to reinforce our thesis that the markets are facing some serious headwinds.

The months and years ahead will not be like the last two years. Everything will not go up. Mistakes will be punished severely.

Rational investors should start with an eye towards safety instead of greed, undervalued assets, and wait – sometimes frustratingly – for significant corrections. Just look at silver. One day you’d have to pay $50 an ounce. Two weeks later you can buy it for $35.

Henry Kravis of Kohlberg Kravis & Roberts once said, “It's one of the most important things at the end of the day, being able to say no to an investment.”

Right now is a great time to say no to a lot of investments. But it’s always time to say yes to undervalued assets with significant upside potential.

Recently we look at the remarkable values in utility stocks. There’s also remarkable early stage growth in stop-start autos. In the Prosperity Dispatch, we’ll look at one of the few big growth sectors in a market that has been falling out of favor.

And right now, if you can find ideas with big growth potential and/or exceptional value, you will get excited by any weakness as an opportunity to buy even more a better price.

Good investing

Andrew Mickey
Chief Investment Strategist, Q1 Publishing