All best-case market scenarios depend on a very rosy assumption – the long-run extrapolation of some very short-term circumstances.

Here at Taipan Daily, we believe in editorial freedom. Nobody is told what to write (let alone what to think). We’d rather let you make up your own mind when viewpoints diverge (as opposed to constructing an artificial unified front).

I mention this because, when I saw Kent’s piece arguing for S&P 1,200 yesterday, I nearly spit out my coffee. Needless to say, he and I bring different perspectives to the equation.

I think it would be great if Kent were right, by the way. And I think his arguments are reasonable as far as they go. “Earnings” alone do argue for a sunny perspective, given the impressive “beat” rate of 72% this past season (as compared to a long-run average of 61%). If one extrapolates the current path of earnings, and further assumes a sustainable path of economic recovery, then S&P 1,200 is not out of the question.

To put it bluntly, my concern amounts to this: If we get a double-dip recession, then corporate earnings projections are going to take a frying pan to the face. All best-case market scenarios depend on a very rosy assumption – the long-run extrapolation of some very short-term circumstances. All in all, I see low odds of this “current path” being sustained. It’s possible, just not all that likely in your humble editor’s point of view. And if investor sentiment turns south again... that is to say, if “greed” morphs back into “fear”... then broad valuation multiples will once again be compressed.

Of course, there will still be high-quality investment opportunities to choose from, even in the event of a ferocious double dip. After all, there were companies that did well – and saw their share prices go up – in the midst of the Great Depression!

Like U.S. Gypsum, for example, which saw sales increase more than 500%, and earnings go up more than 2,800%, between the years of 1930 and 1940. Homestake Mining, a gold stock, also did amazingly well in the early years of the Great Depression, delivering more than 500% capital appreciation (not including dividends, which were substantial!) between October 1929 and December 1935.

No matter how ugly things get, there will be new Gypsums and Homestakes this time around too. But that doesn’t mean we should be complacent about the overall economic picture. The top-down headwinds we face are very, very strong.

Watch Out for the Bend

A few quick words on trends (sources unknown, or at least not recalled by your editor at this time):

• “The trend is your friend.”
• “Trends are like roses and young girls, they last while they last.”
• “The trend is your friend till the end when it bends.”

That last one, taking note of the “bend,” is the kicker as we ponder this chart (via Société Générale) of the ECRI leading indicator, a favored tracking device of general conditions.

As SocGen further opines in their weekly strategy commentary,

We monitor a variety of such indicators [like the ECRI chart above] and until recently they have all been giving an unambiguous green light to participate in risk assets. That has now changed... the OECD leading indicators for China and other emerging markets have now topped out. But also in the US, some leading indicators have started to dive quite sharply, albeit from very elevated levels (see chart above). In Japan too, we note a topping out action...

If you enlarge the chart, you can clearly see the sharp “dive” SocGen refers to. The question is, what happens next? Do we continue powering higher, thus rendering the “dive” a mere correctional squiggle? Or is this the beginning of the end as far as stimulus-driven euphoria goes?

Again, these are questions of a “top down” nature. If we knew for certain that the economy would continue to recover, then it would be no trick to buy stocks in anticipation of the perpetually rising cash flows that followed suit.

The risk, though, is that the happy trend “bends,” or breaks entirely, as Wall Street’s bottom-up picnic gets ruined by the top-down equivalent of a full-force gale.

Expected Surprises

Last week your editor wrote of a “Pinball Wizard Market” – one in which hopeful expectations would drive the market up, only to see share prices get smacked down by macro-level wake-up calls once again.

That is pretty much exactly what happened on Tuesday, as the market puked (if you’ll pardon the uncouth term) on news of consumer confidence plummeting to its lowest level since 1983.

For some, this kind of thing counts as a negative surprise. But really, given the broader economic backdrop, it’s more like an “expected surprise.” When things are bad on the whole, one should not be “surprised” by bad news! What else would you expect when The New York Times is running headlines like “Millions of Unemployed Face Years Without Jobs.”

This further goes back to the disconnect between planet paper (Wall Street) and planet real (Main Street). In October of 2009, we posted the following table (you can read the full piece here).

The trouble continues to be a major-league disconnect between planet paper and planet real – or, if you like, Wall Street versus Main Street.

The trouble is, much as Wall Street would like to permanently divorce itself from Main Street, it can’t. Consumers and small businesses are the backbone of the U.S. economy, accounting for more than two-thirds of spending and more than half of all business activity respectively.

So when consumers and small businesses are sick, Wall Street can ignore that for a time, especially with the help of taxpayer-funded bailouts. But it can’t ignore Main Street forever.

Companies Get Lean and Mean

Ford Motor Company (F:NYSE) offers a classic example of the current troubles we face. On many levels, Ford is a great American success story. It’s the scrappy homegrown company that could. Ford refused bailout cash, fought its way back into the black with CEO Alan Mulally at the helm, and now has a shot at even bigger and better things with the mighty Toyota stumbling.

That’s all well and good. But consider this from Bloomberg:

After cutting 47 percent of its North American workforce since 2006, Ford isn’t ready to resume adding employees even as it upgrades factories and grabs a larger share of U.S. sales, Chief Financial Officer Lewis Booth said in an interview. One analyst estimates Ford may not hire for two years.

In large part, public companies have improved their earnings through cost-cutting. That means axing lots of full-time jobs... loading up on temporary workers with limited hours and benefits.... and putting a freeze on hiring.

This is all well and good for the balance sheet. From a shareholder perspective, it’s the right thing to do. But what does it say about the future unemployment picture?

Paolo Pellegrini, one of the few Wall Streeters to make a fortune in the subprime crash, further believes that corporate cash piles are vulnerable. With deficits and broken budgets as far as the eye can see on both the federal and state level, it’s only a matter of time before corporate taxes will have to rise.

Oh, and not to mention interest rate concerns... or unsustainable sovereign debt loads... or the still unresolved housing bubble…

The Boy Scout Motto

So what should you do? First and foremost, remember the old Boy Scout motto: Be Prepared!

The first aspect of being prepared is focusing on scenarios instead of forecasts. Would you own a home without fire insurance? Would you run a business without emergency backup plans?

For traders, being prepared amounts to fluid flexibility and the ability to adapt as environments change. If the charts say bullish, we roll bullish. If the charts say bearish, we roll bearish. (And if they say “muddled confusion,” we keep our powder dry and stand aside.)

Long-term investors have a little bit trickier proposition, relying as they do on balance sheets, business models, and estimated valuations moreso than charts. (This can be a great way to go – just look at Warren Buffett.)

A key element on the investing side, then, is taking into account the potential macroeconomic risks to one’s portfolio. Barring the trader’s ability to use a stop-loss and get out quickly, the investment “stress test” becomes that much more important. Some investments are directly dependent on a rosy economic outlook in order to do well. Others are more like Sherman tanks. Certain companies have fortress balance sheets, bulletproof business models, and cash flows robust enough to survive a panzer attack.

I should add that these bulletproof, “Sherman tank” style investments are just the kind that my friend Kent likes to uncover for Safe Haven Investor readers. The letter is most appropriately named with him at the helm – which is why it’s easy enough to take our “macro” disagreements in stride. If he turns out to be right, the charts will show it... and as a trader I’ll be long. If the gloomy scenario prevails, on the other hand, the robust nature of the Safe Haven portfolio should stand investors in good stead.

Other Related Topics: Justice Litle , Macro Trader , Stock Market Analysis , Wall Street

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