Over the last 2 weeks we have masqueraded as a bull because we saw a few good reasons to buy US stocks; those reasons have now faded and we are retiring the bull suit.
The first reason we zipped up the bull suit was an anticipated move by the Federal Reserve – our view was the Fed would target its balance sheet and keep the yield curve steep. The steep yield curve would fuel a rally in the financials (which had lagged) and serve up some juicy opportunities to put out the shorts at higher prices. The Fed did target its balance sheet but has decided to buy long dated Treasuries (up to 30 years) which has caused the US yield curve to flatten and will squeeze bank profits. The counter argument is a flat yield curve will force banks to lend. This assumes a demand for credit and good investments with credit worthy borrowers, both of which are lacking.
The second reason for the bull suit was high dividend yields coupled with low option volatility. Many stocks could be bought and the dividend used to pay for an option hedge to get a “free look” at stocks. While the dividend yields are still high, option volatility has increased making the hedges more expensive.
Finally, the third reason for the bull suit was the pc/server refresh that was to be driven by the Windows 7 (Office 7) release this fall. After Cisco’s (NASDAQ:CSCO) earnings and depressing guidance, this catalyst appears to be fading.
The trillion dollar question is whether the current market weakness will simply take us to the bottom of the range (SPX 1010 – 1040) or is this the start of something bigger. In our view this could be the start of something bigger.
The entire recovery effort is based on the assumption that governments can borrow without limit and prop up the economy. The sovereign debt crisis in Europe was the first warning sign that the assumption is false. Therefore, if we see signs of further sovereign troubles, we will certainly bring out the claws.
Over the last few days European debt spreads have begun to widen again, with Ireland at the center of the action. Market chatter has suggested the ECB has been a buyer of Irish debt to calm any fears. Once again the implicit assumption is the ECB can buy debt without limit. We are not that confident the political will exists to fully support this assumption. Politics and policy will be the key to determining if this shall turn into something bigger.
For now, we have significantly lightened up on our long positions and have begun to position the portfolio for continued downside.