Weekly Update from Puru

The Weekly Update sent out on 29 May 2009 discussed the 'green shoots' hype and noted the extreme bullish sentiment. Back then, we stated that we'd sold the strength and raised 50% cash in our clients' accounts. Well, the financial markets continued to rally for a few more days but they've corrected sharply over the past few trading days. Our technical and sentiment data suggests that the markets are extremely vulnerable to a sharp contraction over the summer/autumn months. Accordingly, we're cautious and our managed portfolios are diversified and hedged - 50% 'long' stories (emerging markets and commodities), 35% long-dated US Treasuries, 10% natural gas and 5% 'short' financials for our aggressive accounts.

At present, the investment community is positioned for immediate 'hyperinflation' and a further debasement of the US Dollar. We don't think 'hyperinflation' is going to occur in the next 12-18 months and when others come to the same conclusion, we are likely to see a fall in stocks/commodities and strength in US Treasuries, US Dollar and Japanese Yen.

So, why don't we believe in immediate 'hyperinflation'?

Look; much of the Western world is currently undergoing secular deleveraging whereby households and corporations are repaying debt. These people are stuck between a rock and a hard place and there is no way they are going to take on even more debt in order to oblige policymakers. So far, the stimulus has not caused a massive surge in inflation because this money is currently sitting as excess reserves within the banking system. And unless borrowers are willing to borrow and lenders are willing to lend, we won't get any hyperinflation. The fact is that (after years of excessive borrowing and consumption) American households are now paying back their debt; something which hasn't happened in over 5-6 decades! And in our view, it is extremely improbable that people will go deeper into debt. In the past, such debt contractions have occurred very infrequently and none of them resulted in 'hyperinflation'. Therefore, if our view is correct and we don't get an immediate economic recovery, there will be another revulsion towards risk and a flight towards 'safety'. So, our advice is to take some money off the table and stay hedged over the summer months.

The fact is that most stock and commodity markets are overbought from a technical perspective and sentiment is at a bullish extreme. In other words, market risk is currently high and we don't want to take any chances. And neither should you! The best outcome over the summer months would be a sideways grind and there is no reason why you should risk your entire capital in the hope of capturing minor additional gains. History has shown that market crashes usually occur in autumn and we're now approaching 'Disasterville'. Whether or not we'll see another crash this year is anybody's guess but our current investment position has prepared us for (almost) all outcomes.

Over the following weeks, we expect most stocks and commodity markets to correct or consolidate (best case scenario), so wait before adding to your 'long' positions. On the other hand, we expect strength in long-dated US Treasuries, so nimble traders may want to gain some exposure for a multi-week trade. As far as currencies are concerned, both the US Dollar and Japanese Yen will probably rally in tandem with a contraction in the credit markets, so keep your cash in these currencies.

Finally, gold and silver are correcting as per our expectation and long-term investors can start buying both at current levels. The downside in gold is much more limited here and real money should have an explosive rally over the following 10-12 months. Precious metals mining shares are still correcting and our recommendation is to wait before adding to your positions. Once the correction has run its course, we'll allocate a large amount of our capital to this sector which is poised to do extremely well.