MARKET RECAP:

What a week in financial markets with volatility in stocks driving traders on an emotional rollercoaster ride. Tuesday it looked as if the bottom was about to fall out but excessive bearishness and apparently relentless shorting from large speculators (CME COT data shows large specs to be net short the most S&P contracts a year) proved to be the catalyst for a short squeeze from Wednesday into the weekend that saw major indices make new all time highs. Bonds were equally as volatile as last week’s sell off was retraced before backing off in a flattening bias. The dollar remained under pressure hitting a new low on the DXY while commodities trended higher.

INTERNATIONAL INTEREST:

DXY traded within a fraction of the multi-year low and is approaching the trap door 80.00 level on concerns over sub-prime and consumer spending due to weaker retail sales. The euro and sterling continued to benefit from the weak dollar as traders seem to prefer the tightening cycles of the European central banks. Our favorite indicator, the euro/yen, traded to a new high this week and prevented us from becoming too bearish on stocks Tuesday as it recovered nicely and gave no indication that risk aversion or de-leveraging was taking place. We have been relatively agnostic on the FX market as we were not interested in chasing the speculative flows via yen carry trades nor were we bullish enough on the dollar as we expect the Fed will need to ease in the coming months. Our recommendation was to hide in sterling as we view the BOE to be the tightest and most hawkish. That position has faired well with GBP trading to new highs this week and since we expect some further downside in the dollar before a reversal, we continue to favor sterling until we are comfortable buying a dollar low or the BOE signals the tightening cycle is over.

Bottom Line: There is still risk of a lower dollar but we are looking for an entry point as we believe the excessive bearishness and tightening credit conditions could be a catalyst for a major reversal.

COST OF CAPITAL:

The bond market volatility continued this week as they retraced last week’s holiday sell off before reversing lower testing the rising trend line of the June low. The gap from the big puke is acting as resistance and a break of the trend line could be ominous as it may indicate another low is needed before a sustainable rally. The price action off the low has been corrective in nature thus we would remain in the front end of the curve while the dollar remains weak and the risk of further duration liquidation weighs on the lone end. Next week the economic calendar picks up with inflation data and FOMC minutes to keep traders on their toes. It will be important to watch the action in the dollar for direction. If the dollar falls apart and takes out the multi-year support we would expect the curve to steepen as the inflation premium rises. If the dollar can hold and potentially reverse off the extreme bearish sentiment that would be indicative of a lower inflation premium and thus a catalyst for a flatter curve. The TIPs breakeven spread will be another indicator to watch as the week’s economic data unfolds.

Bottom Line: The bond market is at a critical juncture as the dollar is on the brink of collapse. We will be watching how the dollar and TIPs spread react to this week’s economic data to determine the direction of the yield curve and thus the better risk reward curve bet.

BETA MAXIMUS:

What a week for stock prices as the big Tuesday sell off raised fears of soft earnings and slowing consumers had the market on defense and bears growling. In typical Wall Street fashion, the sentiment once again became too extreme and swung back to excessive bullishness with the even larger potentially short squeeze rally on Thursday that pushed indices back to new highs by the close Friday. The rally Thursday was the biggest one day rally since 2003. Our game plan that we have been following continues to play out and we are sticking to our strategy of using this late stage rally to raise cash as it is still our belief that this move from the 10/02 low is in the late stages. We were looking to see the market make a high as we believed the June sell off was simply a correction and now that we got it will look for any failure to potentially signal a larger top. We believe the next swing will be deeper than the 5/06 and 2/07 corrections and would target the 1360 cash area at a minimum (-12%). While we expect next week’s option expiration to see a premium burn consolidation before a small new high (Dow 14k sounds good) we remain very defensive and urge investors to continue to reduce their equity allocation.

Bottom Line: We were getting a bit nervous last week that the market was losing its grip despite our view that a new high was still needed for a turn. The various indicators we follow were not giving sell signals just yet and their guidance kept us in the game and prevented an aggressive short position. This is a critical week but they may take a vacation as option expiration sucks volatility. Nevertheless we must stay focused and stick to the plan that has served us well in this increasingly volatile market.

DUKE & DUKE:

The crude oil breakout we identified a couple of weeks ago remained in tack. We don’t believe the rally is being driven by an increase in demand but rather a combination of a weakening dollar and a higher risk premium due to the potential of a US withdrawal from Iraq. Gold remained in recovery mode as it continued to bounce off recent lows. No doubt the dollar and potentially better liquidity conditions supported prices.

Bottom Line: If crude is discounting a fatter risk premium it is hard to quantify that value and thus we are remaining on the side. A reversal in the dollar could take some pressure off all commodities during the 2nd half of 2007 (see below).

THE EX ANTE FACTOR:

Are commodities topping as the dollar is bottoming? My friend Dominick (www.tradingthecharts.com) has pointed out two potentially simultaneous ending diagonals in the CRB (see RSI diverged) and the Dollar Index, which if correct would be consistent with each other and a signal the credit cycle is reversing.

Since the Federal Reserve's massive easing campaign between 2001-2003, the dollar has been the main casualty in the global credit and asset boom. Having lost 30% of purchasing power since 2001, it has been in virtual free fall while every other asset class has appreciated. The 2005 bounce (wave 4?) that occurred once the Fed finally got the funds rate above the CPI corresponded with the top in public home building stocks and the flattening yield curve from a historically steep level around 250bps 2s/10s. This flattening of the curve drove risk spreads to historically narrow levels and transferred the leveraged speculation from real estate to private equity and activist hedge funds as they took advantage of a capitalization arbitrage (issuing debt to buy equity), in what could be considered the 5th wave of the credit cycle (just as some firms go public). The obnoxious Alcan - Rio Tinto - Alcoa love triangle we have been witnessing makes the possibility of a reversal all the more intriguing considering the CRB.

Under the radar, the M2 growth rate (non-seasonally adjusted) has been elevated since 9/06 as nominal economic growth is decelerating. We could assume this may be the main driver of the weakness in the dollar since then, as perhaps the FX market has not allowed Bernanke to pseudo-ease in the open market without consequence. The effect of this most recent excess liquidity on commodities and assets is very apparent when looking at the CRB rally to new highs.

M2 growth for May and June decelerated to -8% and 0% respectively, down from 15% in April. Gold, arguably one of the more sensitive assets to liquidity topped out near $730 in 5/06, but the most recent retracement high in gold at $695 occurred in Apr when M2 growth also peaked and the dollar bounced. This evidence of ebbing liquidity is likely responsible for widening risk spreads which possibly caused the BSC hedge fund blow up and a volatile correction in stocks.

With the resumption of the decline in the dollar towards new lows as the CRB makes a new high (gold diverged?) we could assume Bernanke is back at it and no wonder with the potential implosion of the collateralized debt market. However, with Dominick's long standing target of 1.40 EUR/USD within striking distance, coupled with the two potential ending diagonals in DXY and CRB we would instead be looking for larger reversals in these two indexes. This could be the writing on the wall as the liquidity/credit cycle that has been supporting asset prices for the past 5 years may be ending.

What is the discount?
The implied return discounted by the S&P 500 fell to the lowest level of the year and is now potentially 2% over fair value when annualized. The equity risk premium fell by 15bps from last week’s low level of the year implying a further removal of the capitalization arbitrage that has supported equity prices for the past couple of years. In other words, corporate spreads continue to widen as stocks get more expensive which does not bode well for the private equity “put”.

Bottom Line: We been on the lookout for many months to what is happening now. A reversal of the credit cycle and the implications on asset prices and risk premiums. The stars are getting aligned and we think the next couple of weeks will be crucial to the next couple of years. You are paid for liquidity and that’s where we are, awaiting reversals in the dollar, commodities, yen and stocks. We are not clear on the bond market due to yield curve risk and would prefer the short end due to liquidity issues and relative value. The markets will not make this easy on either party but we believe prudence and patience will be rewarded in the coming years. If we are wrong and the economy re-accelerates or credit conditions remain easy, the best case scenario for investors still points to limited returns from these levels.