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July 13, 2005

Post 4th Fireworks

It seems the bulls threw a veritable party while I was in New York around the weekend. Starting with a strong rebound off the initial London-blast sell-off, equities continued upwards through today. The Nasdaq Composite scored a 4.8% gain off the Thursday low, and the S&P500 posted a 3.4% gain. We are now a modicum of points off the March high on the S&P. If we break through that top, the bulls will surely pop the champagne corks.

Back in 2002 I mentioned to a friend my belief that the Nasdaq would see 1,000 before it saw 2,000 (the Composite was trading around 1,700 at the time). Although the index fell precipitously, it never quite made it to 1,000 before launching itself upwards and eventually across the 2,000 mark. When my friend took the opportunity to point out the failure of my prediction, my response was that I underestimated the willingness of the Fed to artificially inflate the economy with its money pump.

Bears, including myself, need to be careful not to make the same mistake today. If history and fair valuation are to be given any weight, equities… and especially tech stocks, which sport PEs in excess of 40… should be heading downward presently. However, history has more than one lesson up its sleeve. Should the Fed open the spigots once again, we could see a 1980s Latin-America style inflation where equity prices do fall in real terms, but skyrocket in absolute terms. Short sellers can be absolutely right in this situation, but end up absolutely broke. The monetary policy of the United States is run recklessly. The constant monetary inflation instilled upon the system produces gross distortions that are difficult to navigate, thereby destroying the productive capacity of our system.

My conclusion is that short sellers of equities have to be hedged. They cannot control or predict the Fed’s actions. Therefore, it is only prudent for short sellers to own long-dated calls and/or precious metals (preferably the latter, in my opinion) which can provide a hedge against such profound sabotage.

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