How about that!

This past weekend, my long time trader friend, Ed, came to town to visit with the family and his hold friends - he lived in the northeast before moving out to Chicago to trade at the Chicago Mercantile Exchange. He was a trader in the pit at the 'merc and when i visited him years ago, the mini S&Ps were just in their infancy and the big contact of the S&P was the guide to the equity markets. Since then this thing called globex was created and grown and online trading took off - thus now he is out of the pit and trading mini S&P's for a living. So when we sit down and talk markets, two views clash - the one that has the trader perspective of the pit and emotions versus the analytical one of myself who has been behind a desk his whole like and uses spreadsheets and software programs to gain an insight into the marketplace. The most talked about topic is that of the economy and this once again comes down to what you see in reality versus what you see on the computer screen.

Ed's belief is that the economy is weak and getting weaker. He thinks the S&P, while cheap on a historical basis, can easily get cheaper because we are in an environment that features massive PE compression of multiples and low correlation. In short, valuation does not matter at the moment because of the continued risk in the economy and possible inflation spike that is probably coming thanks to the Fed's super easy policy. He thinks that Wheat is just the beginning on the spike side as the movement in corn and beans will be coming sooner than later to the upside joining already high crude prices and super high gold prices. While gold would be a logical buy, he thinks that the gold story might be limited to a trading range because inflation is priced into it at the moment. Lastly, he is of the belief that any incumbent this fall will lose in their reelection bid - not just democrats.

So how did I respond? Lets look at these piece by piece.

Valuation does Not Matter

My response was that I do believe valuation matters - at least on the Macro level. My valuation bands formula which essentially measures three types of markets (panic, normal, euphoric) basically bounced off the bottom of the normal valuation band which argues that the market should now bounce to the top of this valuation band. At the moment, the S&P 500 is hanging out around 9.4x forward earnings plus cash and the top of the range is 11x. While I agree PE deflation is occurring at the moment, while the economy maintains a sort of weak growth but no dive and unemployment does not get meaningfully worse, then I think we maintain this range. Thus I think on balance the S&P should make its way towards 1150 at some point this year. A break of the 9x range and then I need to change my story.

Inflation an Issue

I am divided on this issue. Within my Trimmed Mean and CPI models, I see inflation compression pushing towards deflation. Within the market I see the exact opposite. Does this mean the statistics are lying or that profit margins are being hurt? So far with all the layoffs in the corporate world combined with a cut back in salaries, the answer to this question is unclear. However, given my belief that the Fed is way too easy with current policy via the rate side of the equation, I think an inflation spike, at least within the asset markets, is now on the table. The CRB has woken up of late and crude has basically held in for the past 6 months. Now with the agriculture sector all waking up, food prices are about to see a sizable move higher since these are goods in demand - people have to eat!

Gold range bound

I share the opinion of my friend Ed in that gold is probably range bound. I am impressed again with the move though that took gold down through major support around 1180 and then back above it (and to the current 1220s levels). A break past the 1250 level would change the battleground in my opinion; in short, inflation within the asset markets would be confirmed with gold breaking out. Failure to do so and I would imagine the contact moves back down to the bottom of the range and then all the gold bugs rethink their premise...again!

Incumbents out!

Unique thought but I have to agree with it. Public sentiment versus Washington at the moment is just rancid. Good luck if you are running!

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