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May 22, 2006

The Best Game in Town

Stocks and recently hot commodities resumed their tumbles today as attitudes over rising interest rates continue to get priced in. Base metals were hardest hit in the commodities arena with huge losses seen in nickel and aluminum. Precious metals were very heavy in the early going, but managed to rebound almost back to parity. In a repeat of Friday's performance, mining stocks fell heavily and then put in strong reversals. I'm beginning to think we've seen a short-term bottom in the miners, but I have chosen to defer from trading the idea for now. Though my reticence may mean I eventually buy at higher prices, I prefer to wait for a more obvious entry point.

Stocks attempted a recovery late in the day, but again failed in the final half hour. I'm not sure how much weight to put on this late weakness given that momentum indicators are swinging positive. My gut feeling is that we are due for a violent counter-rally, and I prepared myself for such an event by paring my put option exposure. I prefer not to elaborate on which options were sold since the trimming was done simply to control risk and take profits, not because I think the story has changed for any of the underlying stocks.

One of the hardest-hit sectors in today's session were the semiconductors, which fell a little over 4% as a group. Intel coughed up 2%, more or less negating its late-Friday bounce, but the shares did not violate Friday's low. We'll learn soon if this means anything near-term.

The homeys were also hit, shedding almost 2%. Building Materials Holding was hit for more than 3% and has now slumped about 22% since the beginning of April. It is interesting to see this group suffer even as bonds rally because quite the opposite was true up until the last Fed meeting. The bond rally itself brings up another interesting point. Several readers have written to me in recent month asking how I can simultaneously be bearish on bonds and bullish on metals. In a typical economic cycle, these assets have a positive correlation. My response is that it's all about what dominates current psychology, and what currently dominates is the dollar. If the dollar is being panned, people will not want dollar-based assets. They will sell Treasuries and look for another safe haven. Real assets, especially precious metals, are an easy choice.

Recent developments help illustrate my point. Since the last FOMC meeting, people are suddenly fretting over a tough Fed. The dollar has been rallying while stocks and metals are tanking. The cash freed by these sales is being confidently placed into bonds, and such confidence is bestowed by a rallying dollar. This situation will not last. The macro picture, which I have outlined many times, will eventually force the Fed's hand on stopping rate hikes and even cutting them. At that point, we will see current asset price movements reversed: the dollar will tank and metals will explode. Unfortunately, U.S. stocks will not recover because they will fall into the category of dollar-based assets and will be panned.

As you may deduce from this discourse, I believe the gig is already up for stocks. Metals will rally sharply at some point, but that point is, as of yet, unknown. However, I believe stocks will, with the exception of the occasional heart-wrenching counter-rally, continue to tank. I am therefore focusing most of my efforts on shorting equities until conditions allow me to step back into the metals game with more confidence.

Disclosure: Short BMHC; Long BMHC Puts

 

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