Twilight Zone Investing

by: John Dalt

Earnings season starts next Monday when Alcoa (NYSE:AA) reports after market close. We expect earnings to be relatively good and reinforce the recent market strength, maybe even push the indices to new highs. The horizon for investors is farther in the future. We have our eyes set on the summer. We see problems. We ask, "Why would I chase the market here, only to sit on losers in a few months?" Let me explain.

Sometimes our memories can be too long. Other times we can be caught in a "Twilight Zone" where living in the present is the only reality. We believe now is the time to search our memories to understand the future.

Last March the Fed ended the first round of monetizing debt otherwise known as quantitative easing or (QE1). Seven weeks later, the market started down. All the optimism of the previous twelve months was wrung out of traders and investors as the S&P fell from 1217 on 4/23/10 to 1010 on 7/01/10

We lost positions in our long-term portfolio as stocks hit our trailing stops. Some great companies, sold at a loss. Good paper gains gone, and reversed to turn into recorded losses. It was a tough two months.

This year the Fed is playing the same game, but we are supposed to believe it is different this time. They would have us believe the training wheels won’t come off, this time. The economy is recovering, they say. Corporate balance sheets are getting stronger.

Are they really? Have all the bad Mortgage Backed Securities disappeared? Are balance sheets at the biggest banks better or just inflated with all the cheap money the Fed has pumped into them?

We wonder about other corporate balance sheets too. How many companies have profited from the inflation trade set off by all the money sloshing around in the system. One of the lessons your editor learned in the 1970’s era stagflation was that inflation covers up a lot of bad decisions.

Rising prices will help you work your way out of mistakes. What happens when prices quit rising? History and experience remind me of Harold Hill in "The Music Man:" "Folks, we’ve got trouble … right here in River City."

The Fed is preparing the stage to take away the "punch bowl" of easy money after June. They have put $80 billion dollars a month into the economy for a total of $600 billion, on top of the $1.5 trillion in their first round after the credit crisis.

We have $110 crude oil rather than $30 crude oil, cheaper housing prices with more foreclosures and a stock market that is double the low in March 2009. The big question, and the premise of the Fed taking away the punch bowl of QE2; "Is the economy self-sustaining?"

If the market responds to the end of QE2 the same as it did QE1, we could be in for a difficult summer. As an investor, it is better to be careful rather than brave. If you have some good profits in energy, commodities or precious metals think about where they could be five months from now if the world economy is slowing, again. We like having cash to capitalize on opportunities.

The hardest part of investing is to know when to sell. Discipline can help you buy, but selling is a completely different kind of discipline. All of us must fight greed and the urge to be in the market all the time. Long-term investors may want to sell some of their biggest winners, or reduce their position sizes. This summer could be a good time to have some cash. This summer you can be like a vulture waiting on stock prices to fall into your "kill zone."

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.