Remaining Skeptical Amidst This Rally

The markets burst out in a rally last week on the news that the Fed thinks the housing downturn and the resultant economic slowdown will be much worse than they originally anticipated. A rate cut appeared more likely as Chairman Bernanke expressed his concern about turbulence in the financial markets. In fact, the mortgage situation is getting so dire that the Bush administration is working with major financial institutions to broker something of a bail-out scheme. Clearly, anyone can see that such a flood of good news should send the markets soaring. Are we that desperate?

Perhaps I am oversimplifying somewhat, but the market seems a touch too ready to grasp at any straw. This is strangely comforting; the contrarian streak in me was growing rather concerned that the bearish corner was becoming too crowded. This sudden stampede to the upside shows that plenty of "irrational exuberance" remains and thus there is still room to the downside.

The bulls may be right and things may quickly improve; however, it could very well be that things will continue to get worse. The credit crunch has not been resolved -- short-term interbank loan rates are still climbing. The mortgage problem is expected to peak in 2008, with interest rates on $362 billion of subprime loans due to be reset, though even after that there will still be a large overhang of mortgages that will have their adjustments in 2009. In recent years, during an incredible bull market, we have been conditioned to buy the dips in anticipation of a quick return to the upward trend. Unfortunately, that is not quite a law of economics and doesn't work as well in bear markets -- how well would one have done buying the dips in Countrywide Financial?

One cannot pick the bottom, but I suspect that this story has further to run before things change for the better. We seem to be doing our best to downplay the bad news and have not yet been able to fathom the full impact these various crises will have on the economy and the market.

At the same time, I am by no means arguing that all is gloom and doom; some aspects of the economy -- exports, for example, helped by the weak dollar (which could get weaker still) -- are doing quite well. Overseas, especially in Asia, the news is even better, though these markets would not escape totally unscathed by a US downturn.

Though I am maintaining my long-term core holdings, I am not ready to go on a buying spree. In an environment such as this, I am tempted to buy puts in order to take advantage of bearish opportunities. I expect volatility to increase, but so do many others and consequently much of this is already priced into the option markets, making many of those plays significantly less attractive.

Therefore, I look to proceed cautiously, continuing to work the two major themes I introduced earlier -- the negative impact of the mortgage and credit crunch on home builders, mortgage lenders, bond insurers, and financials as a whole and the positive growth story in Asia and other emerging markets. Unfortunately, both of these spaces are becoming more crowded, giving even more cause for caution. I have spent the last few days re-examining my holdings in this light. Over the course of this coming week, in the subscriber portion of my blog, I will review the rationale behind my current positions.