Mid-Year Review 2007
With the exception of equities, various markets have performed more or less as anticipated this year. The dollar has trended lower and sits at a critical pivot point. Bonds are showing signs of cracking, despite impetuous demand by those who believe the coming recession will impart a traditionally bullish environment on fixed income. Precious metals continue a mammoth consolidation period, and energy has bounced back sharply from an early-year swoon. Overall, traders seem to be positioned for more of the same... in a leveraged sort of way... but are likely to get anything but the expected.
Stocks have surged relentlessly higher in the face of slowing consumer spending, a withering dollar, a sickly housing market, and signs that the credit cycle is in the midst of a major turning point. The activity is no more perverse than in tech... an arena that is heavily consumer-dependent... where inventories are piling up and prices are imploding. Semiconductors shares have popped more than 12% since last month's lows, helping the Nasdaq 100 set 6-year highs. Broader indices are also popping to new, multi-year highs. I have no doubt that these price gains are running on momentum alone. In fact, last week's late surge feels very much like panic buying.
I suspect that a top for equities is very close time-wise, but price-wise, the terminal point could be significantly higher, depending on how many shorts need to be wrung out. Nevertheless, I maintain a Bush-like stubbornness in my call for much lower equity prices by the time we exit 2007. I will even stick my neck out a little further and call for a top to be in no later than early August. The Chinese market, which is now more than 15% off its high, may be the canary-in-the-coal-mine. Given that China's economy has been highly-dependent on U.S. consumption, weakness in a market tied to businesses higher up the production chain should be considered foreboding.
In my Outlook 2007 post, I stated that I would not be surprised to see fresh, all-time lows for the dollar this year. Despite two countertrend rallies since January, the dollar has coughed up another 5% of its value and is sitting right on top of the 2004 low, which is barely a point off the all-time low. Given the intense concern and emotion accorded the dollar at this juncture, a sharp move is very likely, though the move could just as easily be upward as downward. Therefore, dollar bears should tread carefully. Acquiring a straddle or strangle may be the most prudent approach to a near-term dollar play. Under duress, I would probably accord higher odds to a near-term rally than an immediate break-down, but long-term, there is little for the dollar to do but depreciate.
As evidence of a slowdown piles up, fund managers are buying bonds because their models tell them to do so. Historically, slower economic activity correlates to higher bonds prices. However, these near-term reactions in the bonds will prove to be blindly imprudent. Given the context of the current macroeconomic environment in which inflationary pressures are already running high, the eventual efforts by the Fed to curb the recession via lower rates (money printing) will only augment inflation further. The damage to the dollar is already being discounted as evidenced by its new lows this week. Furthermore, the U.S. is engulfed within record levels of debt... "saturated" would probably be a better word... making for circumstances which are inconducive to further absorption. In fact, the dollar's decline... or at least anticipation of the decline... will eventually trigger a larger sell-off in U.S. Treasuries as investors seek to limit dollar exposure.
Gold and silver have continued what appears to be consolidative action, and are hanging slightly positive for the year. While I am wildly bullish on PMs, I suspect that the consolidation has not fully run its course. As conjectured in the beginning-of-year Outlook, the fortune of precious metals will be closely tied to action in the dollar. Should the dollar slump into full meltdown mode, the consolidative period for metals would end abruptly. If the dollar manages a last-gasp rally (which I believe is more likely), precious metals would complete their consolidation in an orderly manner, thereby providing the buying opportunity of our generation. In fact, I suspect that the sluggish action in precious metals of late is foretelling the last-gasp rally in the dollar. After all, if the PMs can't break to new highs while the dollar is testing its lows, then further countertrend action is likely to materialize in both.
Naturally, the action in most markets is highly influenced by Fed policy, so it is important to understand the current motivations Bernanke and the rest of the FOMC. Publicly, the Fed has continued to express concern about inflation. This banter is all part of a concerted effort to talk the dollar higher. I have no doubt that the Fed would very much like to see a higher dollar... a strong dollar is necessary to convince foreigners to keep buying our debt. However, the Fed has neither the conviction nor the political viability to take action to support the dollar. Given that backdrop, along with Bernanke's inherent propensity to print, the Fed will likely jump on their first compelling excuse to turn short rates southward. A continued meltdown in the credit arena would provide such an excuse, and perhaps a sharp dollar rally will set the final trap by luring the Fed into a sense of safety.
After breaking sharply lower to begin the year, energy prices, particularly oil, have trekked steadily higher. The price rise has been supported primarily by continued demand from emerging economies, but has also received boosts from rising geopolitical tensions and anticipation of a nasty hurricane season. I suspect, however, that oil prices will hit a brick wall in the near future as the U.S. slips into recession and China continues to tap on the monetary brakes. Should we have another dud of a hurricane season, we could easily see a replay of the 2006 sell-off. Energy and oil service companies have seen their shares go vertical in recent weeks, and while the bull market in energy probably has years to go, I would not be a buyer at this juncture.
As we tread into the second half of 2007, developments in the housing arena continue to devolve. Furthermore, despite the best efforts of investment banks to sweep problems under the rug, signs of wear in the credit markets are burgeoning,. While macroeconomic events tend to unfold at glacial speed, the effects of gross misallocations of resources tend to hit markets in the form of sudden jolts. The markets are ripe for such a jolt and simply await their catalyst.