There’s Something Happening Here . . .

There’s something happening here
What it is ain’t exactly clear
There’s a man with a gun over there
Telling me I got to beware

I think it’s time we stop, children, what’s that sound
Everybody look what’s going down

There’s battle lines being drawn
Nobody’s right if everybody’s wrong
Young people speaking their minds
Getting so much resistance from behind

It’s time we stop, hey, what’s that sound
Everybody look what’s going down

–Buffalo Springfield, For What Its Worth

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Life — and investing — is all about probabilities. We don’t know what is going to happen in the future — certainly not with any degree of confidence. What we can surely asses is a range of possibilities as to what might happen; we can also assign a range of probabilities to various outcomes.

This morning, we are taking a look at the shifting probabilities of various outcomes:

Markets: Following a 2 year rally that saw the indices double, markets this year have been unable to develop any upward momentum, gaining a mere 2.3% YTD. Experience has taught us to give a bull run (even a cyclical bull market) the benefit of the doubt, as they tend to go further and last longer than most people assume or is reasonable.

Alas, this bull cycle, after a screaming move higher, is starting to look tired. In terms of potnetial outcomes, this sideways phase could be a consolidation before the next move upwards. Or it could be a topping process setting up the next substantial drop. Prior to current action, I was more inclined to see the glass as half full. But here we are, a mere 5% from recent highs, and my probability is starting to shift. Whereas I was 70/30 consolidation versus topping, that assessment is now closer to 60/40 — and gaining speed.

The lines to watch are the 200 day moving average and the YTD start.

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click for larger chart

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Economy:  We avoided the double dip scare in 2010, as the data suggested a deceleration of growth rather than an outright contraction. The 2011 economic data series may be prtending something more serious.

Consider: Employment (watch layoffs ticking higher), retail sales (watch auto sales closely), GDP, industrial production and manufacturing: All are softening. The one bright spot is corporate earnings, but even they have an asterisk, with the lion’s share coming from cost cutting and overseas growth — not domestic top line growth.

Its the demand, stupid.

The probabilities of an ordinary business cycle recession are increasing. Its been terribly obvious that the bulk of the growth has been primarily Fed induced, not Federal stimulus spending. While the Austrians scream that Keynsian stimulus has failed, what they really mean is Friedman’s Monetarism has failed to magically produce a self-sustaining recovery (which does not disagree with Friedman at all).

Given that its now 2 years plus since July 2009, when the prior contraction ended, this would not be a double dip, but rather a stand alone 1938 type recession. My odds of a recession within 18 months went from 10%  to 30%.

Policy, Taxes, Regulation:  You can count on idealogues to do the wrong thing at the worst possible moment, and this time is no different. The Austerians are not satisfied with producing a government induced recession in Europe through severe cost cutting at a time of weak growth and low employment, they have brought their brand of lunacy to the States as well.

If the Federal Government accounts for 20-25% of the US economy, and we shrink that to 15-20%, guess what? You just reduced the overall size of the economy by 5%. The private sector will not magically create demand for that missing piece. Hence, an increasingly likely economic slowdown or outright contraction by philosophy.

I keep saying I am not a Democrat because I have no idea what their economic policy is, and I am not a Republican because I know EXACTLY what their economic policy is. That is our policy choices: Inept cluelessness on one side, and hapless fantasy-based lunacy on the other.

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Whoever would have suspected that Stephen Stills was a trader — concerned about the Fed (the man with the Gun), resistance levels, and contrary crowd beliefs (Nobody’s right if everybody’s wrong).

Yes, something is happening here. It is our jobs as investors to figure out what it is likely to be happening, and make adjustments accordingly.

The odds are shifting.