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Wednesday, May 30, 2007

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"Natural Causes" 5-30-07

What was the catalyst that actually popped the “dot com” bubble? Does anyone remember? Amazingly, there is no consensus of what the actual event or catalyst was that sent the market spiraling to hell in a hand-basket. Do not suggest valuations, rampart speculation, or dubious metrics that were used to calculate valuation of the so called “new economy”. Those greater fool games persisted for quite a while before all of a sudden on one day they seemed to matter. The reality is that there is no one dramatic catalyst that derailed the greatest bull market of all time.

When reflecting back to those days, few will remember when President Clinton and Prime Minister Tony Blair jointly stated that the tremendous benefits derived from the mapping of the human genome needs to be made available to the public for little if any cost. Believe it or not, the NASDAQ started to become unglued just after their public remarks despite the fact that the biotechnology sector was not leading the NASDAQ at that time. Apparently, sentiment towards speculative stocks finally began to be questioned in earnest. Mind you, there were many times before in which speculation was seriously questioned. For some unknown reason, the speculative trend abruptly changed on or around that exact time. Was that the catalyst?

When looking at today’s market, bullish sentiment is pervasive. Sure, there are many skeptics who have not fully embraced the market, but we challenge you to find anybody willing to aggressively short this market. The bulls have been taking comfort that the bear case is too widely understood which is the reason that it fails to translate into lower stock prices. The theory is that too many have already taken defensive action due to the obvious concerns that the bear case lays out. Therefore, there is sufficient sideline money to keep the market drifting ever higher. While that certainly may have contributed to the relentless rise in the DOW over the past several months, it now seems reasonable that the bull case has become equally apparent. Ultimately, the sentiment will change, resulting in sharply lower prices. The problem is that identifying the specific catalyst is next to impossible.

Here are five areas of concern that Kcap believes can magically serve as the catalyst that reverses the uptrend:
1. The market is being largely fueled from private equity firms insatiable appetite. Therefore, nobody wants to short even a Bad Company (hey, wasn’t that a rock group in the 70’s?). Unfortunately, the major private equity players are starting to feel a little dizzy at these heights. Should their access to capital fall into question, the market would not take it kindly. The risk of the spigot being abruptly turned off due to higher interest rates and tighter credit standards from financial institutions is very real. After all, it is the major financial firms that are shouldering much of the risk in this latest episode of leveraged buy outs.

2. The slowing U.S. economy is indeed a serious threat and growing more alarming every day. Major retailers such as Lowes and Staples are showing no signs of bottoming with their dismal forward guidance. The housing sector is also showing no end in sight in its deterioration. Interest rates are starting to creep higher on a global scale which will further dampen the beleaguered housing sector and worn out consumer. Financial institutions have a historically large 38% of their loans secured by real estate… not a pretty site for this potentially ugly vicious cycle. Furthermore, gas prices are at all time highs and hurricane season has only just started.

3. Most importantly, the U.S. is catching a tremendous positive spillover effect from the out of control Chinese Index. The Chinese stock market has almost quadrupled in the past couple of years and is due for a very nasty correction. A dramatic pull back in that market will have serious consequences for the world’s growth forecasts. Even Allen Greenspan sent out a warning beacon which was largely ignored primarily due to his poor timing of his irrational exuberant speech in the mid 90’s.

China’s recent one day correction of 10% a couple of months ago are now a forgotten memory as that index has soared over 70% since then. The Chinese public is literally picking stocks based on numerology and astrology verses fundamental analysis. There are over 300,000 new brokerage accounts being opened in China every day.

All actions to date from the Chinese government to slow the assent of the speculation have failed. If the Chinese economy and its financial market are the primary engine of growth, what will replace them when they abruptly stall… especially when the U.S. economy is riding in the back seat of the Chinese racing car? Picture yourself sitting in the back seat of this car with an inexperienced Chinese driver as he zooms ahead at over 180 miles per hour. Also imagine that one of the wheels on the car is missing a few LUGNUTS! That is what the current market environment feels like to us.

4. Much is being made about the “shrinkage” in the equity markets these days. Buy backs and private equity firms have been removing available shares for purchase. While this is another excuse for momentum players to bid stocks higher, we must never forget how quickly and in unison market participants act. In other words, these momentum bulls will not be willing to buy even ONE share of any company when the $#!~ hits the fan. The decrease in outstanding shares in the overall market due to shrinkage will not cushion the fall. In fact, it may actually fuel the drop as traders actively search for shares to short that are no longer plentiful.

5. Many people are drawing comparisons to today’s market to the mid 90s. We take exception to that analogy due to the fact that GDP averaged 4% during 1994-1998 while inflation fell from 2.5% to 0.7%. Today, GDP is averaging 1.25% while inflation stubbornly persists around 2.5%. The threat of recession is on the horizon with even higher inflation due to commodity prices. Clearly the fundamental backdrop is different compared to then.

If You Held a Taser to Our Head:
When an old person who sufferers from many ailments finally dies, people ask what was the actual cause of death. The answer often comes back that he died from “natural causes”. Today’s bull market is old with many ailments. Ultimately, the media will state that the rally which commenced in the summer of 2006 died of “natural causes”. The only problem is that their conclusion will be broadcast AFTER the market suffers tremendous dislocations to the downside. All profits and more will ascend to money heaven. Everyone will talk about how a market that looked sooo good suddenly looks sooo bad; and no one will want to buy even one share.

Dangerous times ahead.

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