Its Nice to be Squeezed Except if you’re Short

March 9, 2010: Today we celebrate the bottoming of the market crash of 2008-2009. With Dow Jones Industrials Average index up 60% from that low, the experienced observer of market price appreciation in a recession is becoming wary that the underlying forces working in our economy like: The Government Stimulus($780 Billion most of which is questionable and is yet unspent), Open Market Strategy(buy all the mortgges any generator offers pumping money into economy) by the Federal Reserve, potential consequences of Federal and State fiscal policies(Spend more than we have) leading to huge deficits as long as the eye can see, and a prospective mammoth government health care plan (a couple of $Trillion of new debt over ten years) being passed by Congress may put the brakes on the recent pace of GDP growth in our economy. Yet there continues to be active demand for stocks and bonds by institutional and private investors. Pundits talk about how the stocks in the Dow Jones Averages seem to be fairly priced given their recent earnings and PE multiples. Bond prices are inching up in a period when even the most ardent “bull” says that by 2011 interest rates should begin to rise reflecting the huge amounts of investor capital that is going to be required to finance and service Federal and State debt thereafter. Furthermore, this year we will probably see the end of benefits from the afore mentioned 2009 stimulus. Fed Chairman Bernanke says that the Federal Reserve Bank will stop purchasing mortgages by the end of this month and that suggests they will or should become a seller thus sopping up some of the excess liquidity out there now. Our biggest creditor, China, is making noises about diversifying their reserve investments away from the Dollar and today we heard their National Bank Director complaining about Obama-Bernanke politicizing our currency. So what is the problem?

The American securities market looks pretty robust but is it really? After previous recessions, like 1980-83 we started with inflation at 15-20%, interest rates in the teens and tax rates in the stratosphere. All it took to get the economy zooming was a principled President, lower taxes, consistent pressure against hyper-inflation and disciplined money policy by the Federal Reserve Chairman Volker. Then fueled by new and dynamic high technology, the economy generated 23 million jobs in the 1980-1990 decade. Hit with financial excesses in the junk bond markets and the residue of our ejecting of Saddam Hussein from Kuwait, the Hillary Health plan, and the passage of severe tax legislation, we had a minor recession in the early 1990s. But once again after the Clinton presidency turned right and the Republicans took control of the house, spending became subduedand tax revenues started to grow again. Then, after targeted business tax relief, firm control of the money supply, commercialization of the Internet, an explosion in consumer buying of real estate and other hi tech goodies, etc. the economy settle back into a solid growth pattern creating 14-15 million more jobs while producing higher tax revenue from lower rates. So what is different this time?

We start out with interest rates being artificially very low, The corporate, dividend, capital gain and income tax rates are the lowest since 1986 (except for the effect of Alternative Minimum tax), little or no inflation, and as a matter of fact, this period is more deflationary since the housing and commercial real estate sectors are still deleveraging.

This background looks like the toothpaste may already be out of the tube and the Bear opinion that we should have a retracement of at least a third of this rise in stock prices looks reasonable. Short term traders and hedge fund managers have accumulated large short positions in stocks and commodities in anticipation of that happening.

They are expecting a “Double Dip” decline reversing the rise from the lowsof 2007-2009. But the market refuses to go down so they can’t cover their short positions (Having sold securities and borrowed them to deliver to buyer and later expecting to repurchase the borrowed security at lower price). There is nothing more uncomfortable than being short in a rising market. More big money investors are riding the systematic periodic investment strategy by those planning for retirement and the huge amount of liquidity provides the ammunition to do dirt to the short positions. This can squeeze the courage out of the short seller to stay fundamentally correct but practically wrong in their position. So what will happen?

Other than a major event occurring, we could see the short seller capitulate and cover their positions causing a brief but sharp rise in the market. It would be an opportunity to adjust one’s investment strategy to hold positions consistent with a more subdued long term GDP growth rate expectation.

One Man’s Opinion – Bud Brewer