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Monday, July 30, 2007

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The Beginning of the End? 7-30-07

Has the Market finally cracked? Are the Bears finally going to be vindicated? The ursine views have been plentiful but completely ignored for sooo many months. Time after time those dip buyers have managed to step in to save the day taking the market to new highs. No amount of negative news has deterred them despite the overwhelming evidence that a nasty pullback was tremendously overdue. The question now is whether the recent downdraft constitutes the beginning of a change to the uptrend.

After such tremendous success that the bulls have enjoyed for so long a change in trend can only materialize from very specific price action. In other words, Traders would be unwise to place too much emphasize on actual news content as the underlining reason for the beginning of a Bear rout. This is due to the fact that the ursine arguments have been around for quite a while. In essence, we must defer to the actual price action within the market and key underlying securities to help us determine if there indeed is a physcological change.

In our prior post, we outlined several areas of concern that might serve as the catalyst for bearish action. The first one that we mentioned described the ramifications of a credit crunch for private equity players and associated balance sheet risk for large financial institutions. Apparently, this concern seems to be the straw that is in danger of breaking the Bull’s back. However, even this catalyst is not as important as the actual price action that we must pay careful attention to in the coming weeks. The market is just as likely to fluff off this credit concern as easily as it has disregarded so many negative developments in the past. On the other hand, the market can choose to extrapolate this credit crunch to the global economy and start to simultaneously heed all the other Bearish arguments as well. Oh my, not knowing is so UNBEARABLE! What is a Trader to do???

The market is entering an oversold condition this week. In addition, end of the month window dressing may provide a decent excuse for the dip buys to reemerge. Should a rally occur (and we expect it will), it will be very important for the beleagered financial sector to lead the rally. Furthermore, the internals such as breadth and volume need to be at least as strong as they were weak during the recent decline. Favorite stocks that helped define the bullish psychology such as Apple Inc. need to assert themselves in a leadership role. If the bulls can put these key attributes together, then there is still a chance that the Bears will go back into hibernation. On the other hand, if the rally is lacking ANY of these key ingredients, than the danger of a horrific Bear attack will become very real. In fact, your friendly neighborhood KCAP team has been long preaching that the Bear attack (when it finally gains traction) will be utterly gruesome. Unfortunately, this has caused us to sound the defense alarm way too early.

Simply put, there is only one way to know if this is the beginning of the end. We will need to judge the makeup of the reflex rally. Regardless of its internals, traders and investors would still be wise to protect their capital by raising more cash or hedging. We are also not opposed to shorting the major indices at this juncture with loose stops to allow for increased volatility. We acknowledge that KCAP has sounded the Bearish alarm prematurely over the past several months; however that does not mean that we have been incorrect in our assessment of the tremendous downside risk that this market has been carrying for quite some time.

There are times in the market when the downside risk is mild or moderate. Impeccable timing during those times will not save our readers significant money from losses. However, there are other times when the downside risk is severe and we are often premature when we send out the warning. The benefits of heeding that advice are usually much appreciated AFTER much patience is exhibited. Remember, those who called a premature top in 1999 but stayed with their convictions were ultimately more than vindicated.

On a more fundamental note, we have been feeling very concerned about the underlying message that is coming out of the Fed recently. After studying recent minutes and various testimonies from Big Ben , it has become evident that the Fed sees itself in uncharted waters. They have recently signaled that the use of the Philips Curve will be even less helpful in their quest to balance inflation and growth. They have also signaled their concern about a systemic slowdown in productivity. Unfortunately, they seem to be groping for a methodology to accurately model future Fed policy. Recent Fed remarks about the utilization of “expected inflation” as a tool to target and adjust policy are indeed disconcerning. The uncertainties surrounding such a methodology will lend itself to significant adjustments and second guessing by the Fed as well as the financial markets. This will significantly add to the volatility to Global Fixed Income and Equity markets in the coming years. Furthermore, an uncertain Fed raises credibility issues and translates to uncertainty in the financial markets.

Most professionals have learned the hard way that uncertainty is far more damaging to financial markets then even severe and prolonged negative news flow. What is even more shocking to us is how little commentary there seems to be from market professionals about the Feds apparent plea to the academic community to help it model future inflation expectations and growth implications in the new global arena. We find the Feds state of confusion to be quite distressing. Expect to hear more chatter about this topic from market gurus in the not too distant future. However, the market is preoccupied with issues of credit for the time being.

If You Held A Taser To Our Head:
We are still of the mindset that the risks out way the rewards on the long side in the current environment. While we believe a reflex rally is in the cards, the chances for failure are quite high. Importantly, should that failure materialize, there’s a long way to FALL… and we’re not talking about autumn. We are cognizant of the stubborn nature of the dip buyers and how they may save the day yet again. Regardless, the market holds a higher level of downside risk than most people are aware of…. even the Bears. Although this has been true for some time, and has made anyone with a defensive posture look downright silly, the day of reckoning will be at least as ugly as the rally was beautiful. In other words, play defense regardless of the internals of the expected reflex rally.

We understand that many readers are frustrated with our almost non-existent posting schedule. Perhaps we will beef it up again sometime later in the year. However, our fee paying clients are receiving tremendous personal attention. Those of you that wish to join should give us a call at (732) 617-9001.

Hope you are doing well.

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