Fade the Rally

The market acted terrible last week and that was only seven days removed from a prior bad week that featured a mini crash! This is not your average correction that some are talking and writing about. The markets are broken and continue to break down.

The latest Investors Intelligence poll shows that the bull camp stayed positive, dropping only a small percentage, from 47.2% to 43.8%; while only 24.7% are bearish. Not many appear overly concerned, despite everything that has happened in the past few weeks from Greece, to flash crashes, to Euro breakdowns and possible government intervention.

As a money manager, I don't know if I am first and foremost supposed to be an economist, common sense bearer, political analyst, or realist, but there are many factors that are affecting the markets currently. Numerous investors are only focusing only on the recently better economic news and are forecasting that straight out into the future. Onward and upward.

It is the next market move that is important. Global governments are printing more fiat (fake) money to throw at every problem. For a while that has temporarily worked in the past, there is no certainty that it work again this time. If investors and everyone were to start to comprehend that more debt cannot solve a debt crisis, the house of cards will fall. It does appear that market participants perhaps are now starting to focus their attention to the growing debt predicament.

While I don't want our economy to fall off a cliff - I don't think printing more debt and moving it from the private sector (from the banks) to the public sector (the federal government) is a viable solution. Here in the US, we are at historically low interest rates; rates not seen since the Great Depression levels in the 1930's. Yet all these trillions of new debt dollars are being funded on the short end of the yield curve. The likely hood is that some time in the near future, interest rates will go up. The long term historical average yield on a 10 year US Treasury Note is around 7% - today that rate is 3.23%. So if interest rates just go to historical averages, the cost to finance our debt more than doubles and that is just to pay the interest. That money will do nothing productive like building roads, bridges, airports, etc., that will help our economy grow. This is a very bad idea. Everyone including global governments need to learn to live within their means. For now this credo is lost on the minds of the global decision makers.

Short term, markets are extremely oversold. There are many ways to gauge overbought and oversold conditions, but by almost every measure we are at extreme oversold levels. Therefore the market could stage some sort of rally this week. That would not surprise me, in fact last Friday, we covered all of our inverse ETF positions that we placed on the markets just a few weeks back for handsome profits.

If you are an average investor riding out this washout, don't. Use any rally as an opportunity to raise cash! Put your funds into money market funds or short term Treasuries. If the market takes out last Friday's low (May 21, 2010) without first rallying - I would suggest cashing out even quicker under that scenario.

Faith has been broken. I think we could see a rally back up to 1100 - 1135 on the S&P, but that may not happen. My first downside target is 940 - 950 on the S&P if we take out last week's low. I would reassess at that point so I do not suggest riding out the storm as it could get worse than that.

Here are some sobering statistics. In the past 130 years, whenever the Graham/ Dodd/ Shiller normalized P/E ratio goes above 20.6x (it's approximately 21x today), the market has experienced a correction of 31% on average over the next 16 months. It has never failed.

A couple of more stats courtesy of David Rosenberg of Gluskin Sheff:

-1 in every 10 American homeowners missed a mortgage payment in the first quarter (a record)
-1 in 6 Americans are either unemployed or underemployed
-Over 4 in 10 unemployed Americans have been out of work for at least six months.
-1 in 4 Americans with a mortgage have negative equity in their homes.
-There are 5 unemployed workers competing for every job opening (hence downward pressure on wage growth).

The markets are under pressure and could potentially crash. I don't want to sound like a gloom and doom sayer, but the markets dropped around 10% before it crashed in 1987. We just had a huge run-up in the markets since March 2009 and money managers will be much quicker exit this time. Most individuals, as well as many state, federal, and global governments owe more than they are worth. That is unsustainable. Debt to bailout prior bad debt and doesn't create anything, reminds me of the old saying, "Don't throw good money after bad!" Investing in today's stock market could be the same idea. Sell into any rally.