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June 7, 2005

Topping Patterns

We saw a significant failed rally in the Nasdaq Composite today, which, having rallied 1% early in the day, closed nearly a half percent in negative territory. The index was lead down by solid slumps in several big names such as Yahoo (down 3%), Texas Instruments (down 1.5%), Research in Motion (down 2.4%), XM Satellite (down 2%), and Intel (down 1%). AMD also broke $18 today, capping a nearly 30% run in the passed month, before falling back 3% from its high.

Many bulls have characterized the passed two days as “healthy consolidation” in what they expect to be a continued run. However, given the scope of today’s failed rally, I think the odds are higher now of resumed selling. The next few days should be telling.

Bucking the trend, the home builders had a solid rally day with the likes of Centex and Toll Brothers both up over 1%. The recent rally in the homeys can be entirely attributed to the rally in the 10-year Treasury. Given Dr. Greenspan’s testimony today that long rates are unlikely to change soon, they almost certainly will change dramatically. In which direction is anybody’s guess, but we will guess that rates will continue to fall until the Fed finishes its current series of rate hikes. This statement may seem counter-intuitive based on historical behavior of rates. However, hiking rates is the prudent action for the Fed to take, and investors probably feel more confident buying U.S. bonds while this is happening. When the Fed starts cutting rates, holding U.S. dollars becomes very risky (given the amount of inflation that has been enacted in recent years), and investors will flee from dollar-based assets. It’s rather ironic that, short of outright hyperinflation, both rate hikes and rate cuts could be interpreted as negative for equities.

Back to the homeys… there is much talk about “the bubble” these days. Even the AP is picking up stories about the housing bubble. There is so much talk about it bursting, that I’m fairly well convinced that it is not about to burst. I have no doubt that there is a bubble and that it will burst in a way that will cause widespread panic, but I believe the timing is not now. “When?” you may ask. There are two factors that fuel bubbles: excess money and psychology. It is excess money that starts bubbles. Both money and psychology inflate them, and a shift in psychology is what bursts them. Usually an external and sometimes seemingly unrelated factor causes the shift.

In the case of the Nasdaq bubble, I believe the shift was simply Y2K… not the professed computer glitches, which were a non-event, but simply the year. Everyone was euphoric with the party leading up to the new millennium (I know it technically started in 2001), and when the big number was upon us, the party was over, and things returned to reality. In the case of the housing bubble, I believe the psychologically significant event will be Greenspan’s retirement in January. The general public has great faith in Dr. Greenspan’s ability. Their faith reveals great ignorance of economics and economic history (pick up a copy of Murray Rothbard’s “America’s Great Depression” for a revealing parallels between the 1920s and present day Fed policy). Besides, there is a better than even chance that Greenspan will ratchet rates down before his tenure is up in order to protect his legacy. Such a move could provide the fuel for the blow-off top in the housing market bubble.

In any case, I remain short some home builder stocks. I expect the homeys to start slumping well before the actual housing market burst, as stocks tend to presage changes in the economy.



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