Nov 5, 2011

Equity markets have rebounded sharply since early Oct. But underneath the hood, all markets are showing increasing volatility, lack of equilibrium, and stress. US equity markets aren’t really looking toppy right now but how much upside is there.

Seems to me there are two conflicting forces at work. Headline risk – re Europe, Asia, and financials/credit/currency – is really high with the potential for “crash-like” (read 1987 or the 2010 flash-crash) conditions. Not so much because the news itself will be a disaster but because the market makers themselves are under stress and will pull bids and the markets will cease to function.

Absent those headlines however, the forces have a slight upward bias. Corporate profits are strong. They aren’t particularly leveraged nor exposed to short-term credit issues. The US consumer is spending their future income freely and will apparently shop til they keel over. I don’t see a huge new wave of layoffs and, for better or worse, those who have jobs can keep the economy going at a slow growth rate. Long-term, this can’t work. The gulf between those who are doing OK and those who are completely screwed is widening — and those who are being screwed have less chance of improving their economic conditions than a Third Worlder digging around in a garbage dump. The only thing keeping a lid on violent social upheaval – here or in Europe – are the various social welfare bribes/trinkets. And sovereign debt issues everywhere will force the conflict eventually. But until then, its delusion time.

Overall, a relatively low probability of an extremely big downside — and a relatively high probability of steady slow creep upwards. So — avoid financials and other things that are most vulnerable to headlines – and avoid the heavily cyclical stuff like basic materials. Defensive sectors seem a bit pricy in here.

One stock to watch that got hammered this week is Jefferies – JEF. A financial that avoided the whole bailout mess in 2008 – but NOT a “too-big-to-fail”. Is now the target of shorts questions (probably emanating from the Squid or other TBTF who want to get rid of competition) re its market-making exposure to European sovereign debt. The company is being very transparent about its holdings and their exposures make perfect sense for a market maker. If the end-game here is that market-making in European sovereign debt is deemed “too risky” in this credit environment; then batten the hatches for something far worse than 2008. And by “batten the hatches” I mean guns beans and gold.

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