At times, investing is easy.  Identify the primary trend, position your portfolio and wait for the returns to flow.  Other times, we are left with many unanswered questions that only resolve themselves over long periods of time.  While I prefer a simple, trending market, that is not what we are facing.  Instead, investors are left trying to determine if this most recent rally is real or a large bounce in a longer downtrend.

                My long-term concerns about this market are many.  For weeks, I have expressed concern that increasing commodity costs combined with limited availability of credit would eventually crimp consumer spending.  As oil races toward $130/barrel, agricultural commodities continue pushing higher.  At the same time, the precious metals have rallied with gold nearing $920/ounce.  Combined, rallying commodity markets foretell two problems for the equity markets.  The first is in the real economy and the other in the financial markets.

                In the economy, rising commodity cost will limit the amount of disposable income.  While temporary relief measures (i.e. - tax rebate checks) can stall the effect, ultimately consumers are left with less ability to spend.  Less spending equals lower growth.  Lower growth will cause company profits to shrink and expansion plans to be delayed.  Eventually, companies will act to reduce costs and eliminate portions of their workforce.  The net effect will be further pressure on spending that leads to more job losses.  As this vicious cycle repeats, our economy loses potency.

                The effect of inflation on financial markets is also severe.  With inflation increasing, bond investors will demand higher interest rates to compensate for the additional risk.  Higher interest rates will increase the discount rate equity investors require and lead to lower multiples.  As people are willing to pay less for each unit of profit, stocks will drop.  When you factor in a deceleration of earnings, the drop in the major stock indices could be deep and troubling.

                So if the future is so bleak, how has the Dow Jones Industrial Average (Dow) rallied 9% since early March?  This is the question I have wrestled with for some time.  After all, markets are known for their ability to look past the current environment and discount the future.  Isn’t it possible that as the Federal Reserve (Fed) takes action to rejuvenate the economy and increase liquidity, we will start to see growth resume?  While I hope this is the ultimate outcome, I fear it will not be.

                If we examine the bullish argument for the market, it rests on a few key assumptions.  They are the belief that the Fed will cause the recession to be mild and short-lived, that commodity markets are experiencing an irrational bubble that will soon deflate and that all the excess liquidity created by central banks around the world will search for a home and find its way into the equity markets.  While past experience justifies this outlook, I question the logic.

                Looking at each assumption, I am wary that the process will develop as hoped.  Concerning the recession, all agree that the housing and credit markets have experienced severe damage that is without modern precedent.  With a miniscule savings rate, our economy has morphed into a mechanism that relies upon credit and borrowing to drive consumption.  During the late 1990s, an escalating stock market provided the capital to fund one’s lifestyle.  As the dot-com bubble burst, housing became a key source of disposable funds.  From cash-out refis to home equity lines, millions of Americans used their home as an ATM to fund consumption.  As housing cooled during 2006, many turned to credit cards with low teaser rates to continue spending.  If there was a source of borrowing, the consumer could continue this game of musical chairs of borrow to consume.  This game is ending.  As banks realize their credit losses and race to strengthen their balance sheets, lending has slowed.  Banks are now more cautious and less willing to extend credit to all who desire it.  With this source of funds gone, Americans now must rely upon savings and income to drive consumption.  Over long periods, the return of financial discipline will be better for all.  Over the coming quarters, the negative effect on economic growth will be sharp.

                The commodity bubble argument is one that has existed for years.  Whenever commodity prices increase, arguments quickly begin that the price is unsustainable and destined to correct.  Is it?  Commodity price increases can be tied to two key events.  As ETFs and mutual funds have made commodities available to new investors, demand increases.  Since commodities are negatively correlated with equity markets, a commodity position offers diversification and reduces risk.  At the same time, emerging markets need raw materials to develop.  As India, China and the rest of the world develop, we witness an unprecedented level of demand.  This demand has not been with enough supply.  As demand grows from both investors and emerging markets, supply remains stagnate and prices escalate.  While I will not argue over whether $130 oil is too high or too low, the long term trend of commodity prices is higher.

                The final argument is that excess cash will be used to buy equities and drive prices higher.  Perhaps it will.  Or it could be used to drive commodity prices higher.  Or it could be used to reduce debt.  Or it could remain risk averse and stay on the sidelines.  Simply, we do not know where it will go.  What we do know is that excess cash eventually increases prices.  Another name for this is inflation.  As mentioned earlier, increased inflation wreaks havoc on the economy and financial markets.  Excess cash in the world economy guarantees it occurs.

                So the question remains, with such a terrible outlook how has the market rallied over the last two months?  Even more important, can it continue?  As history has taught us, markets can act in unpredictable, irrational ways.  I continue to view the most recent move as a sharp, bear market rally.  Weeks ago I expressed my view that the markets could push higher in coming weeks.  Since then, we saw a series of small rallies that stalled near the 200 day moving average.  Within this price action, my timing model remained 65% long.  Knowing that we have not reached extreme euphoria during this move, I remain optimistic that prices can push higher in coming weeks. 

                At the same moment, we need to address today’s 200 point drop of the Dow and what I may tell us about the future.  With this drop, the Dow quickly approaches 12,800.  For months, the Dow traded in a range of 12,000-12,800.  For this market to remain short term bullish, we need to avoid falling back into that range.  Doing so would provide investors a reason to take profits and push us yet lower.  Therefore, while one day means little in the scope of the markets, today’s price movement pulls us closer to a key technical level. 

                Given the uncertainty over the short-term movement and my dire long-term view, what does one do?  From a trading perspective, I do not think this rally has exhausted itself.  For an aggressive trader, today provides an opportunity to buy stocks for a quick recovery.  If you do so, watch 12,800 on the Dow.  If we close below that level, expect more downside and quickly exit your position.  Personally, I would use the Ultra Dow30 Proshares (DDM) as my trading vehicle.  If I am correct and we quickly rebound, gains will be swift and meaningful.  If I am wrong, your stop loss is close and the damage will be limited.

               For long-term investors, little change is needed.  By committing your capital, you should have a view about the companies you own and why you own them.  Unless the specific story has changed, there is no need to alter your view.  No one can anticipate each market movement and profit.  Those with a long time horizon are best suited to allocate capital in the direction of companies whose stocks are cheap and prospects are bright.  Doing so ensures success over time.

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