Author: Paul Franke, Quantemonics
Covestor model: Relative Value

The stock markets latest push higher in January and early February is starting to feel like the ending phase of a bull move.  Market participants are way too eager to ignore the deteriorating macroeconomic setup.

Whether it’s the highs odds of a war with Iran developing in the critical Middle East oil region, the still unchecked U.S. federal deficit spending spree, the sky-high U.S. trade deficit, a slowing economy in China, or the debt troubles in Europe there are many imbalances in the global economy in 2012.  Similar to 1987 or the late-1990s tech boom peaks, investors rushing headfirst into a market that is ignoring reality are asking for trouble and a major loss of capital at some point.

Most of the economic events taking place during 2011 and 2012 are late-cycle related, using historical patterns as a guide.  At this stage, a spike in oil/energy prices in 2012 will undoubtedly push the U.S. and global economy into recession, and such events are “late-cycle” by definition.

We are in a kind of “Twilight Zone” for the economy, where leaders are unsure how or unwilling to deal with all the imbalances that exist.  For sustained, real economic growth you need sound money as a foundation, and balance in a list of critical factors. Little is in free market balance currently.  Per our estimates, a 15%-20% reduction in U.S. GDP and real incomes is now required to actually balance the out-of-control federal spending deficit and the growth depleting trade situation we have with the rest of the world.  Basically, new and creative ways of money printing by the Federal Reserve Bank have completely debased the U.S. dollar. (It takes 170,000 pennies to buy a small ounce of gold).

No politician wants to be blamed for destroying incomes and the economy short run, to help U.S. change course from our long-term demise. The longer we wait to deal with reality, the greater the overall pain will be.  At this late stage, we may not be able to recover in quick fashion from any austerity push. Given a heightened and rising level of overall market “risk,” we have been reducing our net long exposure in the Relative Value portfolio the last four weeks. We now have plenty of options to buy stocks on weakness with current cash holdings, and exchange our short ETF hedges for regular operating companies.