Navarro's Broad Market Outlook: A Rally or Range Bound?

"[i]t makes some sense to ask whether, with hot-money types in unwinding mode, it's nearing a time when cool-minded traders should be readying their buy lists.  What's pretty clear is that the ingredients are slowly coming together for some short-term extreme in anxiety that could turn into another tradable rally, albeit one that could hit a wall before stretching to new highs."

--Michael Santoli, Barrons

With the market heading down, there is a lot of rally monkey chattering going on.  If this happens, it has to be more of a technical bounce rather than any realistic appraisal of the economic data.   There just isn't sufficient evidence to support the notion that the economy's soft patch isn't really a downward trend.  Just witness the whipsawing of signals between a higher than expected retail sales last week and a fall in consumer sentiment to its lowest level since March 2003. 

Accordingly, until the yield curve starts to steepen again, the stock market is likely to remain range bound or, far worse, continue its downward slide.  And of course as the yield curve flattens, the 9-lives housing sector and mortgage market is getting one more revival.  But get this: housing stocks are no longer responding and from a technical perspective, they are on a downward slide.  That's more evidence that the economy is in trouble.

The good news last week was, however, both a fall in the price of oil and a smaller than expected trade deficit.  Both helped to give some buoyancy to the dollar, which has been rallying against Euro.  While that helps with inflation, it does not, however, bode well for bringing about further export-driven declines in the trade deficit.  

Meanwhile, one of my bond market mavens is totally convinced the 20-year bull market in bonds is over and that the Fed is now key on pricking the speculative bubble in the housing market.  As evidence, Greenspan's very aggressive attacks on Fannie Mae and Freddie Mac only continue to escalate - and watch this coming Thursday for some more Greenspan-speak on this issue.  Looking for the exits, Mr. Maven is getting ready to bail on a huge real estate empire - preferring cash to risk at this point.

Market Movers of the Week: Watch the PPI news on Tuesday and the CPI news on Weds.  Analysts are calling for fairly tame numbers, but it you want something that could really roil the markets, these numbers are it.  So be careful.

Hedging Your Bets With Matt Davio: Convertible Arbs & Water on the Brain
This week I want to focus on an obscure form of trading called “convertible arbitrage.”  It's a strategy in which a hedge fund manager will typically go long the convertible bond of a company while shorting the underlying stock.  While this business doesn't directly affect most investors, it has the potential for seriously roiling the markets. 

The story begins with the fact the Dow Jones Convertible Arbitrage index is down 7.5% this year.  That's hardly enough to cause a hedge fund to turn off its lights.  However, these funds are designed to limit volatility by hedging against interest rate risk and market risk and all kinds of other risk; and the problem now is that the fund-of-funds managers that were tossing dollars into these so-called market-neutral pools of money to protect against risk are not used to watching the pool evaporate, even slowly.

This is especially true when there doesn't seem to be a very good excuse for the shrinking pool. No collapse in the Thai Baht, no Russian default…not even an Argentina currency crisis.  So they are getting anxious.

At least that's how it sounded to me on last Friday's Merrill Lynch conference call�"even though I didn't understand more than three sentences in the Merrill analysts' presentation or in the question and answer session that followed.   Yes, being an old-fashioned equity guy, I don't measure alpha or beta or theta, or even the covariance of the delta. So I don't have a clue when it comes to this black-box stuff.   But what I did understand is that the questions all had a single underlying theme: Where the Hell is the exit door?

Now here's the irony: The convertible arb guy who had it so good for so long buying converts and shorting the underlying equities attracted enough capital to finally make the business unattractive.  Consequently, volatility got compressed so that managers had to put on more leverage to get the returns they'd been accustomed to getting. Plus, as the hedge funds grew in size, they began trading more with each other rather than with the funds that actually own convertible bonds for a living.  The end result: There's nobody left to buy!

Now, a few people are looking for their money back. And the question becomes where to sell this paper to raise the money to give back to the investor now that the inflows into the pool have reversed flow and become outflows.

These situations are not fun. They are not fun for the guys stuck with the paper.  They are not fun for the investors stuck in the fund.  They are not fun for the brokers stuck with relationships that are starting to come apart.  And most relevant perhaps to you, they are not fun for innocent bystanders caught in markets that start to come apart when everyone rushes for the exit at the same time.

Matt's Portfolio Musing -- Water on the Brain:  Since I first mentioned a bevy of water stocks, GE has bought out Ionics (a pure water play) and Friday it was reported that 3M is buying Cuno (a company with significant water-related operations.)  

In both cases, the deals were struck at healthy premiums to where the stocks had been trading.  Evidently the large industrial companies are agreeing that there is potential in water - witness the buyouts. 

In fact, GE has pinpointed the water industry as one of its growth engines for the future.  This being the case, I would not be surprised to see more acquisitions by someone at some point in the future.  And even absent buyouts, the fundamental picture - given the need that exists for more and better water -  looks promising.

In this regard, legislation introduced in 2003 identified a need for something like $7 billion a year in low-cost loans so cities could upgrade their water and sewer systems.   A  survey of  water and wastewater systems operators by Water World Magazine showed that  30% said they planned to upgrade the filtration systems on their drinking water systems, 45% planned to upgrade their storage systems, 45% their pump systems and 53% their pipe systems.  So drink up!

Peter's Portfolio: CPTC Update
CPTC continued its recovery to get me back to even so I trimmed back my holdings to a few thousand shares.  Will add to position or cut losses following Rain in Brazil money management rules.   Holding ZILA and ARDI and sitting on a pile of cash waiting for inspiration.  Never was any good at picking tops or bottoms.  Trade the trend!

Peter Navarro is a business professor at the University of California-Irvine (www.peternavarro.com).  Matt Davio is a managing partner at the hedge fund, Infinium Partners, and be contacted for hedge fund services at infinium@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.