Powder Keg

Projection Update:

What happened: S&P 956 -> 865

Today, July 16: 940

Within 1 week: 956 retest

Within 4-6 weeks: 850 retest (25% chance), 1020 retest (75% chance)

Within 3-6 months: 870-1020 whiplash (75% chance), 1100-1200 retest followed by a guaranteed large crash (25% chance)

Stars: Financials, Commercial Real Estate, Commodities and Industrial Materials, Tech
Cash Cows: Home Builders, Mall Operators, CAD
Dogs: Gold, USD 

Analysis:

Back in early June, I was almost certain that 950 was the temporary ceiling and there must be a retracement to the 850 range. Well, we did retrace but only to 865. But being in a battle, you must begin to return fire with increasing intensity as the conditions move more in your favor. I was able to fill out 80% of my purchasing quota on the way down, the majority acquired at the 870 mark. I am currently 40% on the long side; the remaining cash is kept in CAD, which is indirectly a long position in commodities.

Two possible bullish scenarios were proposed from there.

First, 950 (956, exactly) will be retested. If this retest fails then none of the bullish scenarios will happen and we will almost certainly hit 850 or lower, retesting the low of Oct 2008, where the credit seizure began in earnest. But 950 has a high chance of being broken, with sentiment being a mixture of inflation fear and recovery greed, both of these bullish for stock. The earning season also could turn out very supportive of the bulls, since analysts set the earning bar far too low compared to last quarter actual earning, and we thought last quarter's bar was low! Now...

1) Reflation: we retest Oct 2008 high of 1020-1050, then trade in a range with a lot of whiplash between 870-1020, we will slowly make higher highs and higher lows though, and the stock market recovers painfully but sensibly, matching the economy's prospect. This is if inflation is tightly controlled (by the Fed) at a positive but small level. It's not easy to control inflation in this speculator-dominated battlefield, so it is a certainty that the best the Fed can do is to keep things in a range, and this make for a hard-to-trade but reliably trending up market.

2) Inflation: we break out from Oct 2008 high and then proceed to violently surge toward a psychologically important milestone, S&P 1200, the technical beginning of the bear market. This scenario will happen if inflation is allowed to go unchecked, either by a planning mistake, or indeed, by design, to induce a quick recovery at any cost. This retest, however, is guaranteed to fail (and may fail as low as 1100), and will then precipitate another crash that could bring us right back to the 800 range or lower. 

Scenario 2 deserves further explanation. If for any reason that there is the slightest hint at hyperinflation in the near future, fund managers and idle money (sidelined or new investors) will fear for their cash; speculative traders will act fast to raise commodity and material prices up; business managers will buy, build, and produce... anything to avoid keeping cash. The Fed had deliberately shut people out of Treasury, and Gold is a fool's investment, skirting a 40-year high. The only thing with the most potential to go up are stock, real estate, and commodities, which are technically low on the 1-year term. This is a volatile, mutually supporting, brew.

However, such a violent speculative rally will only end in disaster, since it will get ahead of the true state of the economy. The damage done to the wealth and confidence of the common people by downsizing will not heal within 3-6 months. Jobless data might improve but not nearly as fast as the price of gas and everything else going back up. A massive surplus of inventory and production capacity and price pressure on the household is another volatile brew, but this time for the bears.

The Fed's talk (but not their action) so far signified that they want a slow but sure recovery with low inflation. They are moderating their tone to guide the psychology of others to this direction and hinted at a possible rate raise by year-end, however, they are not toning down the quantitative easing. The chance that their *actual* intention is high inflation is small but still possible. More likely to happen is that they may make a mistake and trigger scenario 2 by underestimating the powderkeg nature of market sentiment at this point and the amount of power large speculators wield compared to other, longer-term players in the market.

We will operate under the assumption of Scenario 1, and expect the year to end at 1020-1050 range, but we keep our eyes peeled for any sign that scenario 2 may develop, and we must always have a portion of our portfolio allocated to the long side to hedge against inflation, just in case.