Thoughts For Friday, 12/17/2010

The one constant in 2010 (and in many previous years) is that optimism (on the part of strategists and investors) expands when share prices rise, and pessimism rises when share prices decline.

Case in point: the bond market.

Shorting bonds may be "the trade of the decade."

Susquehanna reiterates Yahoo!, with a $20 price target.

Over the past two weeks, our country's leadership has taken the easy route and has demonstrated that there will be no meaningful movement in cutting our burgeoning deficit -- once again, trading off near-term growth at the cost of intermediate-term pain. The bond vigilantes smell blood, recognize this inertia and are now exacting a price to be paid in much higher interest rates. (The rapidity of the recent rate rise is but one of the accumulating factors that will likely weigh on stocks in the weeks/months ahead.)

Higher interest rates are already taking a toll on the still-depressed housing market. Applications for new homes and refinancings are again heading lower (over the last three to five weeks), as the rate on the 30-year fixed mortgage has abruptly climbed back to seven-month highs. This rate rise comes at a bad time as mortgage-gate has delayed the foreclosure/sale process until early 2011, which will likely result in an outsized and steady supply of inventory for sale in the months ahead.

Rising mortgage rates and an avalanche of supply are a toxic cocktail for housing.

Meanwhile (consistent with rising stock prices), the bullish talking heads' chorus of smooth and self-sustaining economic growth has grown ever louder, ignoring the warning signs of worsening payrolls growth, the temporary nature of the stimulus, a continued buildup in household savings, a banking system that is still in a healing mode, the potential for "beggar thy neighbor" policy decisions, Chinese inflation out of control, the sinking ships (of Japan, Ireland, Greece and Spain), the specter of corporate profit margin erosion (evolving from higher input costs), rising tensions between Iran and Israel, and a worsening housing market.

To summarize, as 2010 concludes, I continue to maintain the notion that, in light of the many unresolved macroeconomic issues, selectivity, discipline and caution should still be an investor's mantra.

In the uneven economic environment I envision, stockpicking and a flexible and bolder opportunistic trading approach (based on shorter-term catalysts) seem to be the likely ingredients to superior returns.

We should all be mindful, however, that, with few exceptions, many (if not most) observers -- and that includes Ben Bernanke -- missed the 2008-2009 downturn, despite the clear and accumulating evidence of economic uncertainty and growing credit risks (and abuses). The analysis of multi-decade charts and economic series convinced most (along with other conclusions) that home prices were incapable of ever dropping, that derivatives and no-/low-document mortgage loans were safe, that there was no level of leverage (institutional and individual) too high and that rating agencies were responsible in their analysis. Importantly, they also failed to see the signposts of an imminent deterioration in business and consumer confidence that was to result in the Great Decession and credit crisis of the last decade.

Many investors seem to be similar to victims of Plato's allegory of the cave, a parable about the difficulty of people who exist in a world shaped by false perceptions to contemplate truths that contradict their beliefs. This is why so many investors were blindsided by the last downturn and, from my perch, continue to wear rose-colored glasses.

In the famous simile of the cave, Plato compares men to prisoners in a cave who are bound and can look in only one direction. They have a fire behind them and see on a wall the shadows of themselves and of objects behind them. Since they see nothing but the shadows, they regard those shadows as real and are not aware of the objects. Finally one of the prisoners escapes and comes from the cave into the light of the sun. For the first time, he sees real things and realizes that he had been deceived hitherto by the shadows. For the first time, he knows the truth and thinks only with sorrow of his long life in the darkness.

In all likelihood, the U.S. economy will muddle through, though that may not be the case in Europe) It remains my view that the anticipated anemic slope of domestic economic growth in 2011-2012 exposes the improving economic cycle to policy or exogenous surprises and influences.

Every cycle poses new challenges to growth, and the current cycle is (very) different this time. As I have frequently chronicled, so many nontraditional headwinds represent challenges to the U.S. economy and stock market. Most important, the weight of the structural disequilibrium in the U.S. jobs market coupled with a still-struggling housing market mired by an unprecedented shadow inventory of unsold homes are some of the more conspicuous and unfortunate byproducts of the credit crisis of 2008-2009 and represent important impediments to a self-sustaining domestic economic recovery that the crowd appears to see with increasing clarity.

Arguably, over the past few months, investors' "heads we win, tails we win" response to news is becoming increasingly reminiscent of the period approaching prior market peaks, providing to me (again) a clear reminder of the wisdom of Santayana, who once observed that "those who cannot remember the past are condemned to repeat it."