Navarroââ,¬â"¢s Big Economic Picture

We may see a few more desperation rallies, but Iââ,¬â"¢m going to go out on a limb here and call the market top at no more than a few percentage points above the current 52-week highs.  This doesnââ,¬â"¢t mean Iââ,¬â"¢m going to abandon the long side altogether.  I will still take my occasional (not so long) shots.  But I will probably start laying on some more sector-level and market-level shorts.

Hereââ,¬â"¢s the way I see it: We had a lousy 2005 right up until November when we got the obligatory end-of-the year momentum rally fueled by desperate fund managers.  Once enough of them put up semi-respectable numbers, they pulled their dough off the table until the New Year ââ,¬â€œ which killed the Santa Clause rally.  The pent-up demand and cash piling up on the sidelines as these money managers swilled eggnog then fueled another wave of 2006 buying ââ,¬â€œ again driven not by economic fundamentals but rather by technical momentum considerations.  However, once the momentum wore off, traders raced for the exits ââ,¬â€œ and the markets gave away most or all of their gains.

The bottom line: more than a few traders got left standing and bleeding in this game of musical chairs.  Expect the numbers of walking wounded to swell in fits and starts over the next few months as the fantasy of robust economic growth driven by increased corporate spending and an only moderating consumer sector is bowled over by the reality of Fed rate hikes, oil price shocks, the closed gate on the home refi ATM, stagnant income, left week crazies in Bolivia and Venezuela, gangsters in Nigeria, right wing nuts in Iran, and a budding power vacuum in Israel. 

Here, then, is what to expect: Frantic rallies fueled not by confident buyers but rather short covering profit takers following by a resumption of what is likely to soon be a downward trend.  Look for an epic lurch down a la March 2000.

Of course, just so I have an escape exit should the bull rise in 2006, Iââ,¬â"¢ll say that the only way it can happen is if the Fed stops raising interest rates, oil prices subside below $50, sanity prevails in Iran, inflation remains under wraps, and/or both the budget and trade deficits get back down to reasonable levels.  Now thatââ,¬â"¢s hedging my bets!  Now letââ,¬â"¢s turn to Matt Davioââ,¬â"¢s as he hedges his own.

And by the way, Mattââ,¬â"¢s analysis had it EXACTLY right two weeks ago when he pointed out how investor bullishness had spiked ââ,¬â€œ an almost certain contrarian indicator.

Navarroââ,¬â"¢s Macroeconomic Calendar & Market Movers

The report calendar this week is exceedingly light with a very big heavyweight report (4Th quarter GDP) coming in on Friday which will keep traders on the sidelines starting mid-week.  Expect the Index of Leading Indicators on Monday to signal steady growth ââ,¬â€œ but thatââ,¬â"¢s old news.  The real payoff will be Fridayââ,¬â"¢s GDP report which analysts have coming at 3%.   If it is under that ââ,¬â€œ as Lehman Brothers is projecting -- look out below!!!  Both housing reports should put a little further damper on the housing sector ââ,¬â€œ buoyed now by the optimism the Katrina reconstruction but hanging on by a thread.

The real action is going to come with another round of earnings reports.  So far, the projections on guidance are bearish, with numerous companies guiding down.  If last weekââ,¬â"¢s bellweathers turn into this weekââ,¬â"¢s trends, it ainââ,¬â"¢t going to be pretty.

Hedging Your Bets With Matt Davio
 
We had two huge sell-offs last week and a huge snap back rally on Thursday while Friday featured the largest one day drops for both the S&P 500 and NASDAQ since October. Yes, there were Iran and Al Qaeda fears, but I just flat-out think the market is tired, and there are no good reasons to buy. Letââ,¬â"¢s look at some of the risks:

Housing - I donââ,¬â"¢t think it will take a housing crash to dramatically impact the economy.  As housing starts eventually fall back towards the historic mean (which we are seeing right now), cash refiââ,¬â"¢s will slow, and the long awaited consumer spending slowdown will appear.   Homebuilders, contractors, mortgage brokers, and construction suppliers such as Home Depot and Lowes will be the first ones to feel the pain in the housing market slowdown. 

Retail - Most retailers are priced for growth, not contraction.  I believe that heavy retail discounting during the holiday season and continued auto maker discounts will pressure future earnings.  With profits squeezed, any consumer slowdown will make these same companies seem very expensive.  Rememberââ,¬Â¦the consumer makes up 70% of the GDP.  I have discussed in the past, we have no real wage growth, which means it is a non-stimulus driven environment.  Consumers have been borrowing beyond their means and will not be able to take on more debt.  As strong as earnings have been over the last 14 quarters, the bulk of these earnings have come from energy sector.  High energy will eventually kill all sectors as it effects business across the board in a negative manner. 

Corporate Buybacks - The corporate buybacks are also misleading.  Not only have these buybacks impacted earnings positively (a temporary fix), but most of these companies are also issuing more stock at the same time as the buybacks.   It is possible that 1/3 of all earnings are due to these buybacks.  So, energy and buybacks constitute the bulk of the "so-called" earnings growth! 

These are big reasons why you have seen less and less buying interest over the past 3 years in the markets and why the markets have traveled more sideways than up -- even though earnings have grown and the markets have rallied.  What are some other catalysts that could really hinder the future of these markets. What if we have any or some of the following:  Flu Pandemic, US/Israel vs Iran War, US Dollar Crisis, More Obvious Inflation to the consumer, More Political Scandals inside the US, Fiscal Deficit Worsens, Fed Over-inflates Interest Rates, a worsening of the energy Crisis.

These are all very real risk scenarios to me and should be considered when looking at your overall portfolio risk.  Can you manage the higher volatilities that I think are around the corner?   We havenââ,¬â"¢t had a 10% correction in this market in over 4 years, and typically, we see one every 19 months.   Food for thought.

In this regard, I am a big believer in reverting to the mean. Thatââ,¬â"¢s always been a solid way to evaluate risk and performance in our portfolio.

Peter Navarro is a business professor at the University of California-Irvine, and can be contacted at pn@peternavarro.com. Matt Davio is a managing partner at the hedge fund, Red Rock Capital Fund, and be contacted for hedge fund services at redrock@peternavarro.com.

DISCLAIMER: This newsletter is written for educational purposes only.  By no means do any of its contents recommend, advocate or urge the buying, selling, or holding of any financial instrument whatsoever.  Trading and investing involves high levels of risk.  The authors express personal opinions and will not assume any responsibility whatsoever for the actions of the reader.  The authors may or may not have positions in the financial instruments discussed in this newsletter.  Future results can be dramatically different from the opinions expressed herein.  Past performance does not guarantee future performance.