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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                Life is complex.  From the moment we awaken each morning, a never ending cycle of decisions appears.  For most people, preparing for work, getting children off to school and enduring a morning commute offer increased stress levels.  By the time their workday begins, stress has become elevated, fatigue encroaches and then we realize our day has just begun.  To combat this repeating cycle, we simplify.  Taking mental short cuts that allow our choices to become easier and our stress level lower, we can better cope with life’s complexities.

                The average person’s morning rush serves as a microcosm of the financial markets.  When considering how international trade and monetary policy will affect the economy and markets, most people look for simple answers to complex problems.  While deciding to eat the same cereal each morning may simplify our daily lives, the financial markets do not provide the same ease.   As investors, mental laziness leads to quick, sudden losses.

                So how does one cope with the myriad complexities an investor faces?  Over the years, I have seen that Wall Street tends to accept some information while rejecting other.  This filter creates an environment where certain data does not matter.  However, it will matter in the future.  Within this shift is where a forward thinking investor can profit from pending market change.              

                As an example, consider the price of oil.  Five years ago, oil traded near $30/barrel.  Today, oil trades above $120/barrel.  During this price increase, various forecasters described how the price was disconnected from market fundamentals and would eventually return to prior levels.  It never did.  The next approach was to stress how higher oil costs would lead to inflation and constrict the economy.  While oil continued marching higher, these economic bears abandoned their viewpoint and adopted a stance that increasing oil prices would not matter.  But will they?

                When we consider the role that oil plays in our economy, escalating prices will eventually have a negative effect.  Rising energy cost directly impact all people who drive to work and heat their homes.  Further, energy is a key component in chemicals and plastics.  As input and transportation costs rise on goods we purchase, financial stress quickly spreads.  With a tank of gas costing almost $80, we have less disposable income and flexibility.  Since the consumer represents the majority of economic growth, it is clear the shrinking disposable income will translate to shrinking economic growth.  As always, the true question is when this shift occurs.  Eventually the high cost of oil will matter.

                Picking these turning points is always difficult.  After all, rising oil prices leading to constrained economic growth is a rational, straight-forward argument.  However, anyone investing on this thesis has done poorly.  As oil has increased 4-fold over the last five years, we have not seen the direct impact one would expect.  Does this mean the thesis is incorrect or that the market has not realized economic reality?  Unfortunately, the definitive answer will be provided after the profit opportunity has passed.

                The tendency of markets to act independent of visible facts leads some to believe that the market knows best.  Since many profit seeking investors spend their time and money attempting to determine the proper price of an asset, many people believe this collective wisdom offers the best prediction of the future.  In the current environment, bulls are seizing on the market’s discounting ability to determine that the future will be better and prices are going higher.  After all, the signs of economic malaise are clear.  Housing remains weak, credit remains tight and inflation pressure remain high.   The Federal Reserve (Fed) has indicated that they are finished reducing interest rate and that the next move in interest rates will be higher.  Banks continue to report massive credit losses that will continue into 2009 and actively seek expensive, dilutive capital.  The consumer is showing signs of fatigue as higher commodity costs reduce disposable income and the employment picture remains unsettled.  Despite all these facts, the markets push higher.

                Recognizing that the short-term trend of this market is higher, we must ask ourselves if the collective wisdom of the market has seen through a shallow recession, a brief bear market and is now ready to head higher.  While the argument is possible, I do not find it plausible.  As the past has taught us, markets can discount the future, but they can also disconnect from reality.

                Over the past twenty years, the US economy has morphed into a system that relies upon debt to fuel consumption.  During the past five years, easy credit was the jet fuel that allowed our economy to recover from the tech bear market.   However, the credit crunch has altered the landscape.  Prior credit cycles were characterized by an environment where counterparties where uncertain if they would be paid.  If broker A sold you a stock, he expects to receive cash in return.  If that cash is not delivered, broker A will be reluctant to offer his service to you in the future.  This counterparty risk has always been addressed by the Fed pouring money into the banking system.  The arranged buyout of Bear Stearns is an excellent example of how a compliant Fed will help prevent a counterpart default from rattling the system.

               Unfortunately, the current credit crisis is much different.  During the housing boom, banks made many loans that would have been deemed too risky in the past.  By requiring lower down payments and providing teaser interest rates, housing becomes affordable to a group who had been locked out of the market.  The result was higher demand leading to higher housing prices.  Banks felt the virtuous cycle of home price appreciation could continue indefinitely and therefore relaxed underwriting standards.  As the culture of securitization took hold, banks made poor loans, sold them to an outside party and then created more bad loans.  As these loans turned bad, banks are left with large losses, depleted capital base and less willingness to extend new loans.  The lack of new lending will make it difficult for consumers to increase their spending.  Lack of new spending will ultimately yield lower economic growth.

                 Given these mixed signals from a market believing the worst is behind us and economic environment that remains fragile, who do we believe?  As mentioned earlier, the battle between the market and the economy will eventually resolve itself with a definitive action.  Until then, we must invest in an uncertain environment and profit accordingly. 

                 Over the short-term, the trend is higher.  The markets have bounced sharply from the lows recorded in early March with the Dow Jones Industrial Average (DJIA) rallying 10% in two months.  Normally, I would consider such a move as a sure signal that we have come too far too fast and need to pause.  However, my timing model is 69% long (a relatively neutral reading) and other sentiment indicators do not show the markets to be overbought.  While this does not guarantee we move higher, it shows that a fair amount of strength remains.  Further, the markets have begun to ignore bad news and move higher on good news.  The ability to selectively filter news flow is another sign that the next move may be higher.

                Given the ability to head higher over the coming weeks, investors need to be disciplined.  Shorting stocks into a market pushing higher can eventually turn profitable, but may increase volatility and test your emotions over shorter periods.  Similarly, chasing a rally by buying stocks you are not willing to own for long periods increases the chance for loss if markets reverse.  Therefore, the best approach is to maintain your investing style, gain more exposure to the market to benefit from strength, yet own a portfolio of solid companies who you would be willing to hold through an uncertain economic future.  Simplification may work in our normal lives, but financial markets require we pay acute attention to all details.

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