THE COMING STORM / BARRON´S MAGAZINE ( A MUST READ )

Up and Down Wall Street

SATURDAY, JUNE 26, 2010

The Coming Storm

By ALAN ABELSON

The bulls are ignoring the economic realities.

SOME GOOD SAMARITAN—or if there wasn't one handy (they're pretty scarce in Afghanistan), just about anybody at Goldman Sachs would do fine—should have informed Gen. Stanley McChrystal that a rolling stone gathers no gloss. Because no one volunteered to tell the general that trash-talking about the chief and his staff before a Rolling Stone reporter is like confiding in the town crier, he wound up shorn of his epaulets.

That the war Gen. McChrystal was in charge of hasn't been going well lately wasn't exactly calculated to mollify the president's ire. One could argue, we suppose, that the jocular tone of the general's subalterns in their references to the vice president and other members of Mr. Obama's retinue was simply a case of boys being boys with aspirations of becoming wits. The quality of their remarks suggests they're half-way there.

To put it mildly, it wasn't the best of weeks for the president. Besides having to sack Gen. McChrystal, who was, after all, the architect and executor of the strategy being employed in Afghanistan, the latest Wall Street Journal poll made dismal reading for him. For the first time since he took office, more people gave his performance a thumbs down—48%—than a thumbs up—45%.

And if that weren't enough to put a grimace on his face, 62% of the respondents griped that the country is on the wrong track. (Since investors are both of the day-trader and long-term persuasion, we regret for their sake that the pollsters neglected to inquire whether the track was express or local.)

Taking a big bite out of the president's ratings is that poor excuse for an economic recovery, whose most prominent feature has been an intractable paucity of jobs. And, alas, it now emerges that GDP growth in the first quarter, initially reckoned at 3.2%, was several notches lower at 2.7%, as consumer spending was less exuberant than reported.

It's true that Mr. Obama wasn't the agent of the calamitous credit crunch or the Great Recession that it helped spawn. But not the least of the reasons he won the presidency is that voters thought he would get things cracking again, and, much to his and their chagrin, apart from a monster rally in the markets, the economy is still having trouble putting one foot in front of the other.

Such expectations, fair or not, come with the territory. He and his official chatterers had more than enough time before they got to Washington to get their ducks in a row, and you needn't be blessed with extraordinary insight to realize that front and center should have been the economy and jobs. Instead, they apparently found other tasks more interesting.

If Gen. McChrystal's failure to rein in some silly wiseacres on his staff was reason enough for giving him the boot—and it probably was—logic would suggest that the capos in the Obama gang who gave the novice president the bum advice to leave the economy adrift while he and they tended to other business ought to be made to walk the plank as well.

THE FINANCIAL REFORM bill finally cleared the congressional labyrinth late last week and is slated to get the OK from both houses this week so that Mr. Obama can put his John Hancock on it by July 4. Response predictably ran the gamut from the usual bomb-throwing bloggers snarling that it was shamefully weak, to Wall Street and button-down business types moaning that it was fearsomely onerous. So our immediate take is that it could have been worse.

Incidentally, it took the Senate and House negotiators 20 hours, working through the night, to hammer out the final measure. We can only conclude that the eats and the Scotch must have been really great.

According to the astute Washington watchers at Ed Hyman's ISI Group, the measure will hit the mammoths in the financial sector where it hurts most—their bottom lines. "Rarely," exclaims ISI, "has federal legislation so substantially reduced the profitability of major U.S. companies."

The succinct analysis singles out as particularly bad news for the big banks the impact of the severe limits imposed by the Volcker Rule on trading for their own accounts, how much they can invest in hedge funds and private-equity funds and to what extent they can dabble in derivatives.

Since this is an election year and the banks and their kin are still the public's enemy No. 1, the only surprise here is that anyone not comatose should be surprised.

THE STOCK MARKET COULDN'T make up its mind precisely how to react to reform rearing its ugly head not merely as a threat but as the real thing, so it just shrugged and retreated into the comforting embrace of confusion. It could be, of course, that it was Friday and the people at the big trading outfits who are paid obscene salaries to decide whether something is bullish or bearish had snuck off to the Hamptons for a long weekend. But then, the stock market has been in something of a dither anyway.

As we unfortunately have had more than one occasion recently to observe, bugging the market is the increasingly obvious disparity between what the Street's incorrigible cheerleaders see and prophesy and what's actually happening in the real world. Especially noteworthy is that the bulls have been counting on the consumer to abandon his newfound caution and, come hell or high water, they adamantly refuse to recognize the poor soul lacks either the will or the means to do so.

The great burst upward by equities, speculative bonds and commodities from the March '09 bottom lent a certain credence to the anticipation of a dramatic and sustained rise in the economy. As a forecast, that is proving a big, fat dud. The double dip in housing may or may not be a template of what's in store for the economy as a whole. But at the very least, it is a precursor of other serious disappointments destined to feed the unease among the jittery populace, which most emphatically includes investors.

To Dee Keesler, that could well spell disenchantment big-time with all the mournful consequences that might entail. Dee runs Boston-based SDK Capital and he's one smart fellow, with the record to prove it.

He has made two appearances in this sacred space. The first was in June '08, when he warned there was plenty of room on the downside for markets everywhere, and the second in September '09, when he ventured it was time to take something off the table in the U.S., but still favored some emerging markets. (In between, to his great profit, he did some judicious buying after prices fell off the cliff.)

Dee perceives the spanking move up from the lows—as do we—as a cyclical rally in a secular bear market. Now he thinks that rally may be topping out in preparation for the return of the beastly bear. And because he's a seasoned global investor, his negative view extends just about everywhere.

He's concerned that the massive fiscal and monetary stimulus so liberally applied in 2008-2009 is starting to run out of steam, with financial conditions tightening and leading economic indicators pointing to a stretch of "anemic activity." He takes note also of "structural headwinds," such as public and private deleveraging, higher taxes, greater regulation and trade tensions.

And Dee cites the well-publicized woes of the European bloc, which accounts for 20% of the world's GDP, as further evidence that the global economy, as he puts it, is downshifting.

The period of easy comparisons in corporate results, he says, is coming to a close, and that could be a significant turn-off for investors. The most vulnerable stocks, Dee believes, are those that benefited most from the "huge rally in credit and recovery in global growth." But he admits he's hard-pressed "to find areas of the world that will not be dragged down."

"Although the fundamentals in the U.S., Europe and Japan are worse," Dee spots plenty of downside in emerging markets and doesn't fancy the notion of decoupling. As you somehow may have gleaned, he currently has what he dubs a "short bias." And he's put his money where his mouth is: His shorts are in steel, copper, iron ore, metallurgical coal, oil services, autos, casinos and house furnishings.

In a world weighed down by debt and low nominal GDP growth, with deflationary pressures mounting, it's a no-brainer that risk assets aren't likely to fare well.

Dee points out that "we are sailing into these choppy waters without a life preserver; fiscal and monetary levers have already been pulled." That means that come another financial crisis, "the only policy response left will be to print money." Which, of course, is what the gold bugs are counting on and why bullion has glistened so brightly.

He sums it all up this way: What we've had since May is a nice bounce by an oversold market. "The rally, however," he cautions, "has been ragged. I think it's very timely to sell those tired longs and short anything in the way of the coming storm."

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