Definition of a Trend

In the market as in life, perception always trumps reality. In one year the mantra is that it doesn’t matter what you pay for the new paradigm Internet stocks – the next year many of those same names are out of business. One year the oil is going to $200 a barrel and the next year it trades in the 30's. For at least 5 years into 2003, US Steel Corp couldn’t catch a break and was close to going out of business, for the next 5 years it couldn't produce enough steel to meet demand. One year it’s all virtual and digital, a few years latter it’s back to basics and basic materials with brick and mortar outshining the net. Let us not forget that at one time Lucent, the spin off of AT&T, was the single largest owned name in the United States. A few years later it was trading under $3 and its technology virtually obsolete. Did the underlying fundamentals change that drastically and that quickly or did the underlying perceptions simply get discredited rapidly?

If you go on the assumption that perception trumps reality your decision making can be derived from the idea that it is the state of mind of the masses that determines the fundamentals rather than the other way around. Our world is the image our brain constructs prompted by neural relationships, i.e. patterns. We do not know how real the mental images are relative to the objects they refer to. All our memory exists in ‘stored’ form--in other words beliefs that are not currently being considered by the mind but stored in memory waiting to become an image or action. We construct these images in a constant flow of pattern-recognition and memory retrieval. This flow constitutes our consciousness. Basically, we think in images.

Past patterns in the stock market in price and time will tend to affect the mass of market participants whether consciously or subconsciously. We never experience the “present” as a unique singular moment; it is a flow of images in the context of the world around us and the world before us, literally, and figuratively. In the cognitive process, we endeavor to create meaning. Meaning gives us a sense of security and control. We constantly look for patterns to match them with something stored in our memory. Learning is pattern seeking - the constant up and down of the stock market is the supply and demand of trying to make sense on multiple time frames (i.e. short-term and long-term).

The interaction of perceptions and interpretations in the market creates a constant information flow which in turn changes forthcoming interpretations. Sometimes that flow is interpreted as meaning. The thing to consider is not to confuse information with enlightenment. We try to make sense all the time and communicate this to others. A single individual communicates to another individual, then to a group, then throughout society and the cultural dynamics that create what we call trend.

For example, the coincidence of Obama saying stocks ‘may represent a value’ and Bernanke saying he sees 'green shoots' within days of the beginning of the largest rallies in a decade. Subjective vision becomes ‘accepted’ by followers if there is a convergence or coincidence of the idea. Being ‘trendy’ simply means to comply with a present state of idea within the market place (or society). A market trend can also be described as a trajectory of constantly and dynamically changing ideas within an overall pattern of price and time. We look for a pattern and create a narrative around it.

A trend is perceived as a correlation of patterns. The longer a trend has persisted and the more force it has demonstrated in a change over what preceded it, the observed trend is obvious. Yet we are always forecasting. We build patterns into the future. If we did not continuously infer into the immediate future, we would be constantly surprised by the present. In life as in the markets in the process of making sense, we inevitably project our own beliefs and expectations.

Likewise, because we are innately pattern seekers, it is all too easy to see patterns and to deduct connections which are not there. To arrive at a strategy that is useful, it is necessary to see the big picture first and always see the big picture. Something that is difficult as we can all too easily get swept up by the momentary story and act on emotion. The driving force of every trend is an idea of a world which lies in the future. We imagine the future. The question we should stop and ask ourselves is: does somebody else imagine this future for us or do we imagine it ourselves?

Smart Money / Dumb Money Update

Below is the most recent update from the SentimentTrader.com website showing the latest spread between smart money and dumb money represented by the green and red lines, respectively. As the market continues to rally, the dumb money confidence continues to climb, while the smart money confidence has remained relatively flat. (Click on picture for larger image)

Roubini's Recent Comments

Nouriel Roubini was right. A few years ago, at a time when the likes of Alan Greenspan were dismissing concerns about excessive home prices and stating that banks were stronger than ever, Roubini warned about a bubble in the housing market and that the bursting of that bubble would cause much of the financial system to collapse. And so it has turned out, with even the most seemingly outlandish of Roubini's predictions matched or even exceeded by reality. He is one of only a handful of economists who saw the crisis looming. Of course, you are only as good as your last forecast. However, since he was correct about the financial crisis it seems prudent to pay attention to what he expects to happen in the future.

Roubini, whos dire economic forecasts earned him the nickname "Doctor Doom", recently told CNBC this past week that the economic recovery is going to be "very ugly." "The recovery is going to be subpar," Roubini said. "I see a one percent growth in the economy in the next few years. There will also be 11 percent unemployment next year and the recovery is going to be slow. It's going to feel like a recession even when it ends."

Asked about his comments in a speech last week about the recession ending in 2009, Roubini said, "I've been saying all along the recession is going to last 24 months. It started in December of 2007 and my view is that it won't be over until December of this year." Click on the video below for the full interview.

Mid Year Update 2009

As we pass the mid point of the year, many analysts and economists are predicting an economic recovery beginning sometime in the next six months. Whether or not this actually happens remains to be seen. These are the same people who have been predicting improvement in the second half of 2009 since the beginning of this year. Well, we are now in the second half of 2009 and each day that passes is one less day.

While we remain hopeful and optimistic about the chances for recovery, the economic data so far has been mixed; so we have to be realistic to the facts at hand. Stock price appreciation during the second quarter ending in June, which resulted in one of the best quarterly performances for the S&P 500 Index in the past decade, has basically discounted the expected improvement in the economy. In other words, everyone now believes the economy will improve sometime in the next six months and the stock market has moved higher in anticipation of that improvement. However, we believe there are several headwinds facing the markets as we move into the back half of 2009.

• The trajectory of economic growth could be weaker than most expect
• Savings rates (consumer and corporate) will probably remain high, curbing consumption
• Consumer expenditures could remain low for an extended period of time
• The likelihood of higher taxes in the future could impact any recovery
• Deleveraging of corporate and consumer balance sheets continues for some time.

Although the recession from a statistical standpoint is probably over, we should consider the possibility of a W-shaped economic recovery, wherein a brief period of positive growth over the few quarters (brought about by massive amounts of fiscal stimulus), would be followed by another economic setback sometime in 2010; given the headwinds above. This scenario seems more possible than a rapid V-shaped recovery. More importantly, we feel it is the unknown, not the known, that has the potential to move markets and in turn impact the economy. The biggest unknown is what will be the ultimate impact of deleveraging, new government policies/regulation, and massive fiscal stimulus all occurring simultaneously.

Just as an increasing of the money supply caused the stimulation in the economy and appreciation of asset prices earlier this decade, the destruction of money is causing a widespread global economic contraction. This contraction could last longer and impact an economic recovery more than most expect, perhaps into 2010. It should be understood that if money creation stimulates an economy then the destruction of massive amounts of money through deleveraging should have an opposite effect and diminish the hopes of a rapid and sustained recovery. Only time will tell.

According to some estimates, US households have lost over $13 trillion in wealth since the beginning of 2008; the worst decline on record. It is likely that this kind of destruction in wealth will have some lingering effects and undoubtedly influence consumer attitudes in the future. How does the government hope to replace over $13 trillion in lost wealth? The answer is simple - it can't. Time is the only instrument which will cure what ails us. Time is what will ultimately heal the economy.

As for the stock market, the economy is secondary to earnings. For the stock market it's all about earnings. Our current assessment is that the US market averages (based on S&P 500) are in the range of fair valuation based on current earnings estimates for 2009, along with the assumption earnings estimates increase this year. Our valuation assumes earnings estimates for the S&P 500 will increase to roughly $60 before year end; about where the consensus was at the beginning of the year. Current estimates for S&P 500 earnings for 2009 are roughly $56, a slight increase from one month ago. Earnings are just starting to be adjusted upward, which is a positive sign. If conditions continue to improve, we could expect upward adjustments to earnings estimates after second quarter earnings are released by companies this month. If earnings estimates increase, this will help support current valuations.

As we enter the back half of 2009, our hope is that the second half of this year is better than the second half of last year. We are sure you will agree!

State Budget Deficits Growing

One of the economic problems stemming from the housing/credit crisis is the impact on state budgets. The decline in revenue has resulted in many states trying to patch billion dollar deficits. Several factors could make it particularly difficult for states to recover from the current fiscal situation.

First, housing markets might be slow to fully recover; their decline already has depressed consumption and sales tax revenue as people refrain from buying furniture, appliances, construction materials, etc. This also would depress property tax revenues, increasing the likelihood that local governments will look to states to help address the squeeze on local and education budgets. And as the employment situation continues to deteriorate, income tax revenues will weaken further and there will be further downward pressure on sales tax revenues as consumers are reluctant or unable to spend.

Unlike the federal government, the vast majority of states are governed under rules that prohibit them from running a deficit or borrowing to cover their operating expenses. As a result, states have three primary actions they can take during a fiscal crisis: draw down available reserves, cut spending, and raise taxes. States already have begun drawing down reserves; the remaining reserves are not sufficient to allow states to weather the remainder of the recession. The other alternatives — spending cuts and tax increases — can further slow a state’s economy during a downturn which produces a cumulative negative impact on a national recovery as well.

The combination of Federal budget issues and State budget deficits could have a significant impact on any future economic recovery, especially if spending cuts and tax increases are enacted. The budget issues facing the various states bearing watching as it could be the fly in the oinment to a sustained economic recovery.

Below is a list of the top 20 states with the highest budget gaps as a percentage of the state's respective budget. Of course California is in a dire fiscal situation; but there are many states facing large budget deficits - all on the list have deficits in the billions of dollars. (Click on chart for full size)