It’s Hard to be a Bear

On any give day the stock market posts a big triple-digit gain it’s almost natural to want to jump aboard and commit fresh funds. That’s how I feel going into this morning’s trading after Tuesday’s 260-point gain for the Dow. But I won’t commit to the urge.

My portfolios are now sitting with their lowest equity exposure since 2001 and their highest allocations to cash, reverse index funds, gold and gold stocks, and a host of other investments that zig when the market zags. That’s been the right strategy all along this year – until July.

A major trend reversal is occurring this month. Some of the biggest losses are impacting hedge funds, now suffering their worst month in eight years with an average loss of 3.5% heading into this week’s trading.

The macro hedge funds or managers that assume big directional bets with leverage across global asset classes have been riding commodities this year and shorting financials. It was a superb trade until July.

Bank stocks have been rallying this month while everything commodity-related, including coal, potash and energy has been getting massacred. Spot gold prices have remained virtually unchanged in July from June’s closing price but the mining shares are down over 10%, inflicting damage across bearish portfolios.

The XAU Index, or Philadelphia Gold & Silver Index is down about 13% in July and now trades well below its important 50-day and 200-day moving averages. This suggests more selling lies ahead.

Coincidentally, the pathetic U.S. dollar is actually firming in July despite more bad economic news, including housing foreclosures, massive budget deficits, consumer confidence at 17-year lows and deflation destroying portfolio wealth since mid-2007.

As goes the dollar, so goes the commodities markets. This historical relationship has been one of negative correlation. As the dollar rallies, commodities tend to decline, and vice versa. Though I believe most of the dollar’s decline is behind us, I do think we have one more leg south. The market is wrong assuming the Fed will tighten anytime soon; there’s no way Bernanke will tighten when unemployment is rising, credit is contracting and housing is still hemorrhaging.

Oil is triggering a major trend reversal this month.

The price of crude oil is now correcting heavily off its July 11th all-time high of $147 per barrel and now fetches just $122 per barrel. Since oil and the rest of the energy complex is the largest constituent of commodity benchmarks, the CRB Index and other raw materials indices are down more than 10% in July. It’s pretty ugly if you’re long commodities right now.

But let’s put this somber mood for the bears into perspective…

The U.S. economy is not bottoming. I expect the economy to get worse as the year progresses with a bottom forming sometime in mid-2009, possibly sooner. Since stocks tend to discount a recovery in advance, it’s still too early to buy stocks. More bad news is coming – and not just in the United States. Earnings in Europe and Asia, excluding Japan, are still too optimistic and will be revised lower.

Lowry’s (Paul Desmond), which measures buying and selling volume trends, has not peaked. This index was correct in identifying weak buy-side volume as early as last August and warned a bear market was in the cards. On days the stock market posts a big advance, like Tuesday, investors are not aggressively accumulating equities; in fact, they are still selling. Lowry’s tells me that the point of maximum selling has not arrived.

Finally, and most importantly, the state of the credit markets is not improving.

Some segments are rallying, including the LBO market or leveraged loans. But most deals are not clearing and banks still have a massive back-log of paper they can’t sell. Furthermore, banks are reluctant to lend as battle scarred balance sheets are committed to rebuilding equity. Banks are struggling. Capital is scarce. Lending volume has fallen off a cliff since last fall and it’s not improving. LIBOR rates remain elevated, junk bonds are still declining in value as defaults rates rise and most credit indexes are at all-time lows, meaning stress is at extreme levels.

The only bullish component supporting the stock market now is lower oil prices. I’d have to see oil trade south of $100 a barrel to get really excited about stocks again. In the absence of an economic crash in China, I doubt we’ll see $75 or $80 oil again.

Also, a federal bail-out or nationalization of Fannie Mae and Freddie Mac is short-term bullish following its passage in the Senate; I assume investors love this arrangement since it thwarts systemic risk. But what a disaster in the end; this bail-out will result in much higher inflation as the government prints like crazy to nationalize half of the housing market. Taxpayers, naturally, will pay for this mess.

The bears are right. The U.S. economy and the dollar have not bottomed yet. If you’re a bear, then stay the course because stocks don’t make historical bear market lows during the summer. Market lows usually arrive in the fall.

The bear is still alive and kicking and just wants to sucker more investors into believing the worst is behind us. It’s not.

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