Welsh Investment Letter – February 2010

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THE INTERPRETIVE FACULTIES OF THE HUMAN MIND

A mirage is a naturally occurring phenomenon in which light rays are bent to produce a displaced image of distant objects. A mirage is a real optical phenomenon which can be captured on camera, since light rays actually are refracted to form the false image at the observer’s location. What the image appears to represent is determined by the interpretive faculties of the human mind. In economics, a mirage is a naturally occurring phenomenon in which economic statistics are bent to produce an image of a desired outcome. An economic mirage is a real phenomenon that is captured by the media and projected into the consciousness of the human mind. Most often, interpretation of the economic data is limited to a superficial and cursory glance, about as long as it takes a camera’s shutter to open and close while taking a picture. A headline here, a headline there, one snapshot after another. This is why most economists and investors look, but do not see.

On February 17, President Obama gave a speech marking the one year anniversary of the $787 billion “American Recovery and Reinvestment Act.” President Obama proclaimed “One year later, it is largely thanks to the Recovery Act that a second depression is no longer a possibility.”

GDP grew 2.2% in 2009’s third quarter, and ‘surged’ 5.7% in the fourth quarter, the best in six years. The headline in the New York Times read, “Economy Grew At Rapid Pace in Last Quarter.” The largest contributor came from a dubious 3.4% gain in inventories. Dubious because only as $33.5 billion of inventories were liquidated in the fourth quarter, down from the $160 billion that were slashed in the first quarter of 2009. Had the increase in GDP come because demand forced companies to increase production and inventory accumulation, rather than less liquidation, the 3.4% inventory contribution would have been real and significant.

Consumer spending grew at an annualized rate of 2.0%, down from 2.8% in the third quarter, which was goosed a bit by the “Cash for Clunkers Program.” Consumer spending in both quarters was supported by government income transfers, primarily unemployment benefits, which amounted to a record 17% of disposable income. Income transfers can be helpful in the short run, but are no replacement for the sustainable income provided by a job. While GDP was rising 2.2% and 5.7% in the last two quarters of 2009, another 1,090,000 workers lost their job, with 310,000 coming in the fourth quarter when the “Economy Grew at a Rapid Pace.” Since September, the percent of the unemployed that have been out of work for more than 26 weeks has climbed from 33% to 41%, the highest since World War II. The lengthening in the time so many people are unemployed has led to discouragement and a decision by

some to simply give up looking for a job. This is understandable since there are 6 workers vying for each job opening. The shrinkage in the number of unemployed workers actively seeking a job has enabled the unemployment rate to fall from 10.2% to 9.7%. The improvement in the unemployment rate isn’t because more unemployed workers found a job, but instead from a rising tide of despair.

The 15.02% of loans that were in foreclosure or behind at least one payment at the end of the fourth quarter was the most since the Mortgage Bankers Association began keeping records in 1972. According to the National Association of Realtors, the median price for single family home resales was up from a year earlier in 67 of 151 U.S. metropolitan areas in the fourth quarter. The national median home price was $172,900, down 4.1% from the end of 2008, and the smallest decline in more than two years. Since peaking the second quarter of 2006, the Case/Shiller Home Price Index had fallen 33.5% by April 2009, and was 30.0% lower through November 2009. The chart below compares the severity of the Savings & Loan inspired home price decline from 1989 to 1997, and the current cycle. A number of statistical factors have contributed to the modest price improvement between April and November.

The Case/Shiller Index is not seasonally adjusted, so the normal pick up in activity between May and September is not accounted for. In 2009, this prime time period was further boosted by the first time home buyers tax credit, which increased home buying of lower priced homes. In the fourth quarter, sales of homes in the foreclosure process represented 32% of sales, down from 37% in the fourth quarter of 2008. Fewer sales of foreclosed homes would mean less downward pressure on home prices. On the surface, this would appear to be a modest positive. Unfortunately, it is the result of banks holding back on selling foreclosed properties. In California, the number of homeowners delinquent on their mortgages has doubled over the last year, but the amount of foreclosures on the market has declined. Of the 7.7 million households behind on their payments, about 5 million houses and condominiums will eventually become foreclosure sales, according to a recent study by John Burns Real Estate Consulting. Some of the homes that banks are sitting on are loans the banks are trying to modify. However, a recent analysis by Standard & Poor’s Financial Services LLC suggests that 70% of modified loans will eventually re-default.

Over the next eighteen months, the number of Alt-A-and option ARM mortgages that are due to reset will increase significantly. This is likely to push another wave of homeowners into the foreclosure pipeline.  Sooner or later, the banks will be forced to unload their growing inventory of foreclosed homes. Counting the homeowners who are currently behind on their mortgages, along with existing foreclosures for sale, it will take almost three years to sell all the foreclosed homes at the current sales rate. At a minimum, foreclosure activity will continue to be a weight on home prices, and likely cause prices in the mid and upper end to fall further. Of the $1.6 trillion in existing mortgages that were packaged into mortgage-backed securities by the geniuses on Wall Street, roughly $425 billion are extremely late on their payments. These figures do not include the likely surge in foreclosures from option ARM and Alt-A mortgages. These losses will force banks to set aside more money for losses and curtail future lending.

As noted earlier, home values as measured by the Case/Shiller Home Price Index have plunged 30%, and are now back down to 2003 price levels. This means that almost anyone who purchased a home after 2003 has seen the value of their home fall below their purchase price. It is estimated that almost 25% of all homeowners are underwater, meaning they owe more than their home is worth. Unless a homeowner is able and willing to make another ‘down payment’ to eliminate the gap between the current value and their mortgage balance, they will not qualify to have their mortgage modified. According to S&P Financial Services, LLC, loan servicers have “nearly exhausted the supply of plausible candidates for loan modifications.” And if, as I expect, the coming wave of foreclosures cause home values to drop further, more homeowners will find themselves desperately underwater, and more will simply stop paying.

New research suggests that when a home’s value falls below 75% of the mortgage balance, owners begin to consider walking away, even if they have the money. Oliver Wyman Consulting used Credit Bureau data to calculate how many borrowers went from being current on their mortgage to default. Their estimate was that 17%, or 588,000 owners chose to default. As of September 30, 2009 an estimated 4.5 million homes were below the 75% threshold, according to First American Core Logic. It would cost $745 billion to restore homeowners to break even. In a further sign of how this stress is affecting choices, a study by Tran Union found the percentage of Americans who were current on their credit cards but behind on their mortgage, rose from 4.3% in the first quarter of 2008 to 6.6% in the third quarter of 2009. This cultural shift is driven in part by practicality. Most people need a credit card to function in our society. Miss a couple of credit card payments and the credit card company pulls the plug. Stop paying the mortgage and the bank may take a year or more before they padlock ‘their’ home. In the meantime, the homeowner has extra cash flow to pay down the credit card balances, and maybe take a nice vacation!

State spending represents 12% of GDP, and over the last 30 years has averaged an annual increase of 6%, adding about .7% to annual GDP. It would be an understatement to say that legislators in state capitols have been living large. Since January 2007 through 2009, total government employment climbed 1.6%, with 355,000 new jobs created. Over that same three year period, private-sector employment dropped by 6.625 million jobs. According to the Bureau of Labor Statistics, state and local governments paid their workers an average of $39.83 per hour ($26.24 wages and $13.60 for benefits). Private industry workers averaged $27.49 per hour ($19.45 for wages and $8.05 for benefits). Although the compensation of government workers is a paltry pittance, when compared to Wall Street bonuses, government workers make 45% more in total compensation than private sector workers. The generosity of state legislators has also created a $1 trillion funding short fall in public sector retirement benefits, according to a new study by the Pew Center on States. The $1 trillion short fall is about $8,800 for each American household, and will be paid over coming decades by you know who.

The Nelson Rockefeller Institute of Government estimates that states receive 81% of their revenue from personal and corporate income taxes, sales taxes, and real estate taxes. In the first three quarters of 2009, the tax receipts from these sources were the worst since at least 1963.  The states’ budget gap for 2010, which began on July 1, 2009, is projected to be $145.9 billion, equivalent to 9.2% of spending in 2009. The weak tax revenue problem is compounded by the fact that spending is driven higher during recessions as more people line up for state unemployment benefits and health care through Medicaid. According to the Kaiser Family Foundation, between June 2008 and July 2009 every state experienced an increase in Medicaid enrollment, and another 3.3 million people began collecting Medicaid benefits, bringing the total to 46.9 million.

As mentioned earlier, 41% of the 8.4 million unemployed have been out of work for more than 26 weeks. The chronic nature of unemployment is going to take a long time to unwind. Since 1990, the number of new entrants into the labor market has averaged 113,000 per month. In order to reduce the ranks of unemployed job seekers, monthly job growth will have to average more than 113,000. Anything less than 113,000 does not represent true job growth, although any month with positive jobs will be proclaimed as manna from heaven. If 313,000 new jobs were created every month, it would take almost three and a half years before employment recovered its December 2007 peak. The protracted recovery in jobs will continue to suppress states personal income tax receipts. It will also dampen sales tax revenue, as the unemployed and the under employed are forced to maintain lowered spending. This trend is already in place. More than 100,000 million Americans show at Walmart every week because Walmart saves the average weekly shopper more than $2,000 every year. Walmart benefits from a weak economy as price conscious consumers shift their allegiance from Sears, JC Penney and the Targets of the world in an effort to save a few bucks. Walmart was founded in 1962 and for the first time in its 47 year history, same store sales in the United States fell 1.6% in the fourth quarter. Yeah, the same quarter the U.S economy was forging ahead at a rapid 5.7% clip.

The 30% decline in home values means that states’ real estate tax receipts will recede back to their 2003 level, as homes are sold and existing homeowners petition for reassessment. At a minimum, the overhang of foreclosures will keep a lid on potential appreciation and will likely push prices lower in the states where foreclosures are concentrated. Real estate tax receipts are headed lower in coming years. In the last 45 years, states have never experienced anything like the plunge in revenue they are now dealing with, as this chart illustrates. Prior to the recession in 2008-2009, the 1982 recession was the deepest post World War II recession, which now looks like a walk in a park. The 2001 recession was amplified by a huge swing in capital gains from the Dot.com bubble, which first boosted tax revenue and then evaporated. This exercise has been repeated during the housing bubble and subsequent bust. The difference this time is the economic damage is far more pervasive, which will make the recovery far more protracted. The liberal Center on Budget and Policy Priorities estimates that states’ 2011 budget deficit will total $142 billion, and that’s after receiving $38 billion in aid from the Federal government.

Given the magnitude of the deficit problem, state legislatures have no choice but to raise taxes and fees, cut services and jobs, and issue bonds so it appears they have balanced their budget as mandated by state law. For the handful of FUBAR states, (California, Illinois, New York, New Jersey), issuing bonds will increase their interest expense for decades to come, as buyers will demand a higher rate to compensate for the poor management by prior elected ‘leaders’. Services account for 65% of consumer spending, yet they aren’t taxed by state and local governments. To politicians desperate to raise tax revenue, taxing services looks like a luscious green field they are ready to plow.  As of 2007, only 7 states taxed services provided by doctors and lawyers, according to the Federation of Tax Administrators. Hitting lawyers with a sales tax sounds like fun, until one realizes any new sales tax will be coming out of consumer’s disposable income (us!), almost every state is considering substantial cuts in Medicaid, even as democrats push to add 15 million people to existing Medicaid programs. Since states are barred from reducing eligibility, states are cutting ‘optional benefits’ like dental and eye care, and reducing payments to doctors. In Nevada, the governor has proposed to reduce the number of diapers provided monthly to incontinent adults from 300 to 186. It is expected to save Nevada $829,304 annually. (As an indication of my maturity, I will resist the temptation to make any number of scatological jokes.)

Higher taxes and lower spending by state and local governments will shave .5% to .7% off annual GDP over the next two years. More importantly, the cuts in services will truly hurt many needy citizens, and inconvenience the freeloaders. Most legislatures will finalize their 2011 budgets in June, since their 2011 fiscal year begins on July 1, 2010. As the news of all the planned tax and fee increases become known and the scope of the service cuts are highlighted by the media, there are going to be a lot of angry citizens. This whole process will be an even larger spectacle  since 37 governors are up for reelection in November. I don’t think many people understand just how ugly this is going to become over the next two years. Marches on state capitols? Absolutely. Riots? It’s going to feel like the 1960’s.

The shambles state budgets are in is nothing when compared to the mammoth mountain of Federal indebtedness that will spiral toward the sky in coming decades. The lack of true leadership from both parties over the last 50 years, and the culpableness of the American people have brought us to the point where there are no painless solutions. In the majority of elections, less than half of eligible voters participate. We may proudly sing the national anthem at sporting events, but can’t be bothered to exercise our freedom to vote. We’ve gotten the government and ‘leaders’ we did and did not vote for, and now the bill is coming due. In recent decades, the approval rating of Congress has generally been below 50%, and often less than 25%, irrespective of which party held the majority. Despite this deep seated dissatisfaction, incumbents are re-elected 97% of the time. How can this be? Although the “We don’t like Congress, but our Representative or Senator is OK” explains a portion of this dichotomy, it glibly overlooks a critical factor. Both political parties have redesigned voting districts to resemble Rohrshock test patterns. The use of computers to custom design voting districts virtually guarantees victory, even the most mediocre incumbent. In this respect, the very foundation of our country, “By the People and For the People” has been bastardized. The illusion that we have free elections persists, though most elections are decided even before the first vote is caste.

On January 25, President Obama announced he would call for a three year freeze in spending on many domestic programs in an effort to trim our trillion dollar deficits. This bold proposal underscores just how dysfunctional and inflexible the budget process has become. If enacted, this proposal will shave the projected $9 trillion deficit over the next 10 years by $250 billion, or less than 3%. The primary problem with the federal budget is that 85% is mandated by law, with projected baseline increases in spending for the next seven years. In order to avoid the looming catastrophe that will occur, the unfunded guaranteed spending imbedded in Medicare and Social Security programs must be lowered. If our leaders think that we can somehow grow our way out of this, they are delusional, as the nearby graphic clearly illustrates. If our leaders lack the courage to make the necessary changes, the explosion of debt will ultimately lead to a dramatic increase in interest payments on our ballooning debt. Over time, interest expense will consume an ever larger portion of the annual budget, like a flesh eating disease. And if our leaders rely too much on tax increases, they will stifle the very economic growth they need to increase tax receipts. As Winston Churchill said, “For a nation to try to tax itself into prosperity is like a man standing in a bucket and trying to lift himself up by the handle.”

Since last March I have expected the economy to give the appearance of a V-shaped recovery and it has delivered, at least in terms of GDP. What has not yet developed is the transition to a self sustaining expansion. The majority of economists and investors have gained confidence from the 5.7% increase in fourth quarter GDP, the modest decline in the unemployment rate, and the apparent improvement in housing. On the surface, these factors have formed an economic oasis, with the promise of real growth and better times fixed on the horizon. In coming months, there will be job growth and inventory accumulation, which will sustain and even sharpen the image of better times in the minds of economists and investors. Unfortunately, the reality we face will keep the mirage of better times on the horizon. So real, but always just beyond our reach. After all, it was an image created by the interpretive faculties of our mind and the need for the desired outcome.

CHINA

The one investment theme that garners widespread advocacy is that China will continue to grow far faster than any of the developed economies, and for that reason deserves a place in any well diversified portfolio. Year after year, China cranks out annual growth that consistently hovers near 10%. With over 1.3 billion people and the need to build the infrastructure that will create enough jobs to keep the current politicos in power, China is almost forced to pursue a breakneck growth policy. In response to the global financial crisis, China adopted the most aggressive stimulus policies of any country in the world. In 2009, the Chinese government ordered their banks to ramp up lending and they did, increasing lending by almost $1 trillion. Since China’s annual GDP is just over $4 trillion, this lending binge amounted to more than 20% of GDP, an extraordinary statistic. In addition, the Chinese government initiated a $570 billion stimulus plan. To say that China overloaded their economy with stimulus is an understatement. The strategy worked, as China’s economy is forecast to expand between 10% and 12% in 2010.

Comparing how the Federal Reserve and the People’s Bank of China responded to the financial crisis is instructive. The Federal Reserve expanded its balance sheet from $900 billion to $2.2 trillion. This has caused concerns, some of it bordering on hysterical (not the funny kind) that a surge in inflation in inevitable. This reaction is grossly simplistic, premature, and displays a fundamental lack of knowledge of credit creation. The Fed may have expanded its balance sheet impressively, but all that money is not creating new credit in the U.S. economy. Over the last year, commercial and industrial loans by commercial banks have declined by more than 18%. Although large investment grade companies have been able to access credit in the corporate bond market, medium and small companies are gasping for credit. This is doubly significant since upward of 70% of all new jobs are created by small business. Consumer spending, which represents 70% of U.S. GDP, is weak, as consumers cut back on borrowing. In the fourth quarter, borrowing decreased at a 4.75% annual rate. Consumer borrowing has fallen for eleven consecutive months for the first time since 1943, according to the Federal Reserve. Some of this is voluntary, as consumers cut spending and boosted savings. Personal savings as a percent of disposable income was 4.6% in 2009, up from 2.7% in 2008.

A healthy portion of the contraction in credit though is involuntary, after banks and credit card companies raised lending standards and slashed borrowing limits on even credit worthy borrowers. Even measures of money supply have been falling, and monetary velocity has not rebounded. The Fed may have significantly expanded its balance sheet, but the impact in the real world to date is deflationary, not inflationary. I don’t see how the Fed can drain reserves meaningfully, until bank lending and credit expansion revives.

In contrast, The People’s Bank of China (as if the bank really belongs to the people of China) pushed money into the real economy. As a result, lending exploded, economic growth accelerated, and real estate prices are higher now than were before the financial crisis. These are all signs of rising inflationary pressures. On February 12, the National Bureau of Statistics of China reported that producer prices had more than doubled in January from December to 4.3%. Housing prices in 70 cities have increased 11.3% from a year ago, the fastest in 19 months. In the December letter I quoted, Mr. Wang Shi, who runs China’s biggest property developer, “In individual cities, and in some of the main cities, there is clearly a bubble. I’m very concerned.” Collectively, central banks and governments have applied enough stimulus to stabilize the global financial system and markets. To say, they have won the war against deflation and prevented a second depression is premature and presumptuous.

China and India are at a different stage of development, with different battles, and different monetary priorities and challenges. Their goal is to maintain economic growth, so living standards are raised, and a broad middle class emerges over time. This is essential for China, since 35% of its GDP is derived from exports (exports are 12% of U.S. GDP).  Average annual income in China’s major cities is $2,500, and far less in rural areas. There are not enough middle class consumers in China to offset China’s current dependence on exports. And there’s the rub. As I have noted previously, the developed countries comprise 71% of world GDP, while China contributes less than 9%. If developed countries grow as slowly as I expect in 2010 and 2011, Chinese export growth will slow relative to pre-recession levels. Pegging their currency to the dollar has provided a trade advantage since mid 2002, as the Dollar Index fell from 121 to near 74 last November. But the 8% rally in the Dollar Index since November is eroding some of this trade advantage. In addition, trade protectionism against China is on the rise, and not just from the U.S. and E.U. Officials from Indonesia, Brazil, Thailand, and Russia have publically expressed displeasure with China’s trade policies, with India filing more complaints with China than any other nation last year.

The Chinese lending binge not only boosted real estate activity, but also increased industrial capacity. There is no doubt in my mind that China will experience excess export capacity problems over the next year, and possibly domestic issues, if the Chinese economy slows later this year.  In 2006, China’s bank reserves to deposit ratio was 7.5%. By the end of 2007, it had been raised to 15.0%, which was one of the reasons I thought the decoupling theory in late 2007 was hogwash. The reserve to deposit ratio peaked at 17.5% in mid 2008, and was lowered to 15.25% by the end of 2008. Since early February, China’s Central Bank has twice increased the ratio, which will rise to 16.5% on February 25 for large banks. There will be more increases in coming months that will ultimately lead to a slowdown in the Chinese economy, and a decline in real estate values. One of the early warning signals in 2006 of the coming housing downturn in the U.S. was a decline in the volume of transactions. In real estate, volume precedes changes in prices. In January, the number of transactions in Shanghai’s residential property market fell 46.4% in January from December, according to Sou-fun, a local research firm. As I said in the December letter, “I don’t think Chinese bankers are smarter than American bankers. After all, boys will be boys, and bankers will be bankers. There will be loan losses. It’s only a question of when.”

The coming slowdown in China’s economy later this year will probably surprise most economists and investors, since the long term China growth story is so compelling. If I’m right, it will have a profound and negative impact on commodity prices, since Chinese demand for ‘stuff’ is seen as unquenchable. It will also have a deleterious effect on equity markets around the world, as investors have come to consider the Chinese economy as the locomotive of global growth.

My analysis approach combines economic fundamental data and technical analysis. The synergy of both of these disciplines is superior to simply relying on just fundamental analysis or technical analysis. In the August letter, I discussed at length, “How Technical Analysis Can Improve Fundamental Analysis”, and showed how the combination helped identify the top in the U.S. stock market in October 2007, and the low in March 2009. It is noteworthy that as the stock market in the U.S. and all the other developed economies in the world were making new recovery highs in January, the Shanghai Composite, the China Shanghai 50, and the DJ-CBN China 600 were all making lower highs.

FEDERAL RESERVE

The Federal Reserve raised the discount rate on February 11, which probably appeased the inflation hawks on the FOMC, and inflation worry warts in general. I will be surprised if the Fed doesn’t throw them another bone by raising the Federal Funds rate from 0% -.25% to .25% -.50%, before the end of 2010. The Fed didn’t see the crisis coming, underestimated its magnitude when it was on its doorstep, and is likely overly optimistic about economic growth in 2010 and 2011. I certainly hope they wait to drain excess reserves, until lending and real sustainable growth emerges, rather than responding to the recovery mirage seen so far.

DOLLAR

There is a monetary and economic schism growing within the European Union, between economies which are very weak, Portugal, Italy, Ireland, Greece, Spain,(PIIGS) and Germany and France, which are doing better. This tension is going to lead to more weakness in the Euro in coming months, which will benefit the dollar. However, in the short term, the dollar may have made a peak, after it spiked up on news of the Fed’s Discount rate hike last week. In the fall, I was bullish the dollar because sentiment toward the dollar was incredibly negative. That has changed. There may not be many bulls on the dollar, but the extreme bearishness has diminished. In the next two weeks, Greece will attempt to float a bond offering of $7 to $8 billion. Greece is the G in PIIGS, and I can’t imagine that Greece, the ECB, and the IMF will not try to put on whatever lipstick is necessary to facilitate this upcoming auction, since it is in everyone’s interest that it goes at least OK. If it goes as expected, the Euro will get a lift, and the dollar will correct lower, possibly into a range of 77.75 – 78.70 cash. I expect the dollar to trade higher after this correction, which could last 3 to 5 weeks.

On February 5, I advised in a Special Update to lighten up on the dollar positions. At the time of the Update, the March Dollar futures were trading above 80.40, and subsequently traded as high as 80.82 on February 5. We were long the March futures from 76.75, and the Dollar ETF UUP from an average of $22.40. UUP was trading at $23.65, and traded as high as $23.77.

GOLD

We were short the gold ETF GLD from $107.94, and long the short gold ETF DZZ from $14.88. In the February 5 Special Update, the stop on GLD was lowered from $107.94 to $104.50, which was touched during trading on February 5. The Update suggested selling half of DZZ, and the other half if GLD traded at $104.50. At the time of the Update, DZZ was trading at $15.10, subsequently traded as high as $15.42, and was trading at $14.82 when GLD hit $104.50.

Establish a 50% short position in GLD, if it trades above $113.59.

BONDS

Not much has changed since last month. I still I don’t have a clue, and Treasury bonds are still locked in a directionless trading pattern. A close above 3.92% on the 10-year Treasury bond would be a negative short term, while a close above 4.02% would be an intermediate negative, and open the door for a move to 4.5%.

STOCKS

As I discussed in the Special Update on January 30, “The decline in the S&P below 1,080 is clearly a short term negative. However, the more important level for the intermediate and long term is 1,030. Since the March 2009 bottom, the S&P has marched progressively higher with each ‘technically oversold’ low (July, November) being higher than the previous low. Based on a number of momentum indicators, the market has reached an oversold level, comparable to readings at the July and November lows. Any additional weakness will get the market even more oversold, and stretched, laying the foundation for a rally. The odds favor the S&P bottoming above 1,030, and sometime in the coming week.” The S&P made a low on Friday February 5 at 1,044.50, which is the same day gold made its low, and the dollar made its first short term peak. This higher low is important for the intermediate outlook. As long as the S&P holds above it, the intermediate and major trends are up.

I also discussed in that Update what it would take for the rally I expected to take hold. “Two pieces will have to fall into place for new highs. The overseas issues will have to settle down. China is not likely to make additional tightening steps in coming weeks, and the problems with Greece and the EU will also have to recede. And the economic data points in the U.S. must continue to support the recovery story. If so, large institutions will shift back to the buy side, after it becomes apparent the correction has run its course. A self sustaining recovery is far from a sure thing, but that doesn’t mean the illusion of one can’t be sustained for another 2 or 3 months.”

The EU gave Greece 30 days to get their house in order, which has stabilized the Euro, and the majority of U.S. economic reports have supported the recovery story. The back bone of the rally since July has been a lack of selling pressure, rather than a surge in buying conviction. The low level of volume during this move up supports this conclusion. This isn’t the most healthy technical action, but as long as selling pressure remains at bay, the market can move higher. At some point in the future, the market will come to a crossroads, where the economy does manifest a self sustaining recovery, or it doesn’t. Barring surprises from overseas, most economic reports will continue to notch modest improvement in the next few months, and one of these months will record at least positive job growth. Although the upside is likely limited to modest new highs, any substantial market decline will be postponed until a secondary phase of the financial crisis erupts overseas, or institutional money managers are confronted with a series of economic reports that severely challenge their recovery thesis. The market can’t sustain itself on an economic mirage indefinitely.

E. James Welsh