The reason we are so excited about Fund King’s quantitative system is that it allows us to wade through the conflicting datapoints that wash across our desk every day. The rally is a year old and in the case of the US has been good for a 70% rebound (more in select emerging markets). Anniversaries are a good time to reflect on where we are heading in the coming few months.

The broad answer is that we are not going anywhere quickly.

The Central Banks and their political masters are committed to pumping enough liquidity and credit guarantees to keep the markets from falling dramatically. They are collectively known as the Plunge Protection Team or “PPT”. The net result of their actions will be the largest transfer of debt from private to public accounts in modern history and that will reshape investing in the years to come. The “Greek Tragedy” is only the first episode in what promises to be a long running series. But for now, “PPT” actions put a floor of support under the markets.

The resistance in the markets comes from a lack of growth combined with a risk of inflation. The lack of growth comes from the US consumer and China tapping the brakes on its wild stimulus program of 2009.

The US consumer has started to spend again but will not reach the heady levels of 2007 for several years. While that is good news for the Consumer Sector ETFs (VCR & XLY), the momentum readings are not strong and we would advise watching these new positions carefully. A strong recovery in consumer spending will coincide with an economy that is adding jobs. Last week’s jobs report was better than expected but it would be imprudent to extrapolate a strong uptrend from here.

As for China, it is really a question of how well it can fine tune its stimulus withdrawal. Historically, the implementation of cooling measures has overshot the target.

In debt markets, the room for maneuver is tight. The main game globally is an insider’s game between the Federal Reserve and a select group of large banks who enjoy favorable access to nearly free short term money. The bet in the market today is borrow at nearly 0% interest rate, buy short term treasuries at 2% interest rates, earn the difference and hope that interest rates fall further to 1% as economic growth remains weak. What about inflation? Very little of this money is actually finding its way into the private sector (unless you count government contractors). This is a program for recapitalizing and reliquifying the banks. At this point, there is not enough leaking out of the closed loop to stem private sector job losses.

That said, not all inflation stems from overly strong demand. Zimbabwe did not tip over into hyperinflation (04-09) because of overly strong economic growth. The same can be said of Argentina (75-91), Brazil (86-94), Weimar Republic Germany (early 20’s) and Hungary (46) when each of those economies suffered hyperinflation. The root cause in each case was aggressive use of the printing press. Today, money is created by credit creation at the tap of a keyboard. The massive explosion of high powered money at the Fed has been contained inside the program to rebuild bank balance sheets. However, if the Fed is not aggressive about withdrawing that credit when the market actually starts to pick up, we could face an uncomfortable debasement of the US dollar. For residents of dollar linked economies that will feel very much like inflation and bond vigilantes (who are sharpening their skills in Greek paper today) will make sure that interest rates rise to compensate. The steep yield curve is not without logic…but it may not represent “free money” for too long.

What to do this week?

Emerging Europe still looks good with Russia (RSX) as the strongest prospect. Biotech has bubbled up once again in some of our portfolios but Pharmaceuticals (XPH) and Healthcare (XLV) might prove a bit more reliable. Investors are betting that Healthcare 2.0 will be more favorable to these sectors, especially considering the financing needs some members of congress may have for mid term elections.

Asia actually looks pretty quiet. Taiwan (EWT) comes out on top of the long only portfolio and China (FXI) at the top of the long short portfolio but neither have particularly strong momentum behind them for now. There is a big Asian broker conference in the US but that is unlikely to generate more than a blip in the short term.

The Euro (FXE) has bounced with France’s announcement of solidarity with the Greeks. However, Germany is still very cold to the idea of a bailout so it would not be surprising to see the Euro slide once again. As we noted in our mid-week flash, several Scottish investors are calling for the British Pound (FXB) to drop significantly on an unsustainable fiscal position and an unclear election prognosis.

On the commodity side, Oil (USO) and Gasoline (UGA) are showing some short term strength but we would wait a few weeks to see if a trend develops.


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