We are BP

“We are about to embark on a momentous experiment to discover which of the two stories about the economy is true. If, in fact, fiscal consolidation proves to be the royal road to recovery and fast growth then we might as well bury Keynes once and for all. If however, the financial markets and their political fuglemen turn out to be as “super-asinine” as Keynes thought they were, then the challenge that financial power poses to good government has to be squarely faced.” - Lord Robert Skidelsky, FT, “Once again we must ask: ‘Who governs?’”, June 15, 2010

The transitional nature of this stock market fits perfectly with the transitional nature of the global economy – are we headed for the virtuous circle of sustained economic growth or will the decision to withdraw fiscal stimulus advocated by the G20 members result in a double dip (or worse)? The answer to this question will not be found in the present but in the near future – specifically the third quarter of this year.

Once we get the at to slightly above consensus 2Q10 earnings results out of the way, most of the focus will shift to the third quarter. Early into the third quarter, macro economic reports will provide an advance notice of what lies ahead for 3Q10 earnings. If the traditionally trained economists are correct, 3Q10 economic results should present no problem and come in at or above consensus expectations thereby ensuring that 3Q10 earnings results will meet the current optimistic projections.

If, however, third quarter macro economic data issued week after week produce below consensus results, then 3Q10 earnings results are nearly certain to come under expectations.

Stock Market Signals

All this would coincide with stock market action that will reflect a resolution of the sideways action exhibited since the fall of last year. This resolution will present itself in the all-important Mega Trend. If the Mega Trend* reasserts itself with price moving back above both key moving averages AND in the process reverses the recent bearish Mega Trend signals from Europe, then the trading range of the past 8 months has been a consolidation range, the bull market is back in gear, and the real economy will likely not suffer a double dip (or worse).

If, however, the Mega Trend in the US and Asia follows the lead of Europe and produces a bearish reversal signal, then it’s game over – the real economy outcome will likely be something far worse than a double dip.

Investment Strategy Implications

Going into the third quarter, investors who subscribe to the above have two choices: Bold or Cautious.

Bold would recommend a 100% exposure to equities. Cautious would suggest a 60 to 80% equity exposure. For good or ill, I am in the latter camp.

I believe there are two advantages to choosing the cautious stance. First, any near term decline would generate alpha, while any near term advance would produce a positive return but negative alpha. A form of portfolio insurance, if you will. Secondly, and perhaps most importantly, a cautious approach keeps the mind focused on the worse case scenario and will help facilitate rapid action once the below consensus economic readings start filtering in and the bearish Mega Trend signals are generated.

Chill Until

Stocks do not trade in a range indefinitely. A resolution to the upside would say that the trading range was a consolidation, that the bull market will resume, that global markets that had been weak were temporary, that the economic handoff of government spending to private sector sustainable growth has been successful, that the virtuous circle has taken hold, and that earnings and other key inputs into the valuation process will be better tomorrow than they are today.

Alternatively, a resolution to the downside would declare that the trading range was a distributional top, that global markets that had been weak were a warning sign, that the economic handoff of government spending to private sector sustainable growth has not fully occurred, that the virtuous circle has not fully taken hold, and that earnings and other key inputs into the valuation process point toward a tomorrow that will be worse (I would argue far worse) than they are today.

Alfred E. Neuman Would Be Proud

If there is anything to learned from the recent crises it is that incremental thinking to rapidly deteriorating situations produce catastrophic results. Here’s a partial list:

• It’s only a subprime mortgage problem

• The banking crisis is contained to the financial sector

• Greece is a very small part of the European economy

• It’s just an oil spill, a leak

With virtually no margin for error, any economic deceleration or decline could snowball rather quickly. The wrong thing at precisely the wrong time. Partying like it’s 1937.

All That Jazz



The quote from Lord Skidelsky above says it well - we are about to embark on a grand experiment, we will improvise as we go along, we are confident in our experts, we have faith in our meritocracy, we are BP.

Will this work? We will find out soon enough.

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