On September 30 in this blog, I suggested that perhaps there was a Bull market lurking somewhere because there was so much bearishness.

Sure enough, the market has rallied about  8.7% since the October 3rd low.

This begs the question of whether or not this is just a rally in a bear market.  Many smart investors, from Geoffrey Gundlach to Hoisington Investment Management, believe we are already in a recession, and the fourth quarter will actually show negative growth.  For now, we are erring on the side of conservativism.

As we have said many times on these pages, until we see the political will to make sweeping and constructive changes in Europe, as well as in the U.S.,  we will be mired in a recession like economy for the time being.  And, the markets will reflect this by being stuck in a trading range.

Listening to CNBC this morning I heard Bob Pisani talking about how bearish all the long/short hedge fund managers are.  And, they are not the only ones.  It has been an incredibly difficult market, and for good reason.  There are a lot of real problems out there, and a lot of reasons to be nervous.

China is slowing, in part due to their own strategy designed to contain an inflation problem.  Europe still can’t come up with a comprehensive plan to solve their debt issues, and Greece is on the brink of a default.  Here in the U.S. we are still struggling with too much debt, a lousy housing market and unemployment that is over 9%.  These are the big issues, and we could add to that a plethora of other challenges as well.

For the time being we will continue to be in a volatile and difficult market environment.  However, with sentiment so low, and many of the aforementioned problems on the table, I keep wondering if there may be a better market lurking somewhere in the near future.

In this week’s edition of Barron’s,  an interview with portfolio manager Dan Chung at Fred Alger Management, reminded me that highly correlated markets can make for good opportunity.  If of course, you have the stomach for it.  My partner Marilou and I call it “the big whoosh”.

The “big whoosh” is what the market feels like when all stocks, regardless of valuation, market share, or profitability, get taken down in a big market decline.  When fear is the overriding emotion, and no one wants to own stocks, and it feels really bad to buy anything, that can be where real opportunity is created.

We don’t know when or if that will happen, but if it does, it could be an opportunity to buy companies that may be thrown out with the bath water.

The Ted spread, which was once largely ignored, became a closely watched indicator during the financial crisis in 2008.  The Ted spread represents the difference in yield between the interest rate a bank demands to lend money to the U.S. Treasury, and the rate it demands to lend money to another bank.  An increase in the difference between these two interest rates indicates that fear is rising.

For the past year or so the Ted spread has been mostly stable.  However, it pushed much higher in August hitting a one-year high this week.

While this indicator is still far from the panic high of 2008, it is definitely heading higher, pointing to some erosion of confidence in the banking system.  As a result, we will continue closely monitoring the Ted spread, and the potential warning signal it is sending to investors.

We have had a slew of economic numbers released in the past week.  Housing, manufacturing, and employment data, to name a few, have all pointed to an economy on the brink of recession.  That is, if we are not already there.

Wednesday’s durable goods number was one bright spot, but still, not much to hang your hat on.  Many traders are waiting to hear from the Fed Chairman, Ben Bernanke, on Friday to see if he offers some reason to become more positive on the market.  Many are even waiting for QEIII.

The hard numbers are telling us that there is no growth right now in the economy.  However, there is one sentiment number that could be positive for the near term outlook for the equity markets.  Bears currently outnumber Bulls, in some cases by a wide margin.  That could bode well for stocks.

As the effects of the S&P downgrade of U.S. sovereign debt to AA+ are being felt across global markets, we wanted to give you our assessment of what the downgrade and recent market volatility means for your portfolios.  As we’ve discussed with you often since the financial crisis, deleveraging is a slow and difficult process whether for individuals, institutions, or nations.  Europe is several years behind us in dealing with all the bad debt in its banking sector, and the ongoing turmoil in the EU was one of the main factors leading to this summer’s market decline.

 We have had much higher than normal cash levels since the spring when we began to get stopped out of some of our equity positions.  In addition, we have not been  comfortable with either the market action or the macro-environment  surrounding Europe and the debt ceiling battle here at home.  The downgrade by Standard and Poor’s was signaled for months, and the fact that it actually happened is the explicit realization that our political decision making process is deeply flawed.  S&P even stated that they needed to see $4 trillion in cuts in order for the U.S. to keep its AAA rating.  From the press release issued by S&P on Friday:

The political brinksmanship of recent months highlights what we see as America’s governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed. The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy. Despite this year’s wide-ranging debate, in our view, the differences between political parties have proven to be extraordinarily difficult to bridge, and, as we see it, the resulting agreement fell well short of the comprehensive fiscal consolidation program that some proponents had envisaged until quite recently. Republicans and Democrats have only been able to agree to relatively modest savings on discretionary spending while delegating to the Select Committee decisions on more comprehensive measures. It appears that for now, new revenues have dropped down on the menu of policy options. In addition, the plan envisions only minor policy changes on Medicare and little change in other entitlements, the containment of which we and most other independent observers regard as key to long-term fiscal sustainability.

There are three main effects of the downgrade; two are negative and one is positive.  On the negative side, market volatility will increase over the near term as risk gets repriced.  Also, the chance of the domestic economy sliding back into recession has gone up since corporate managers may further delay spending decisions that have already been postponed due to regulatory, political, and taxation uncertainty.  On the positive side, this is the first time in our lifetime that both political parties have acknowledged that continually increasing government spending and funding it with debt is not prudent or sustainable.

Our primary goal as always is to protect your portfolio while positioning it for future growth.  High cash levels and low equity exposure combined with the bonds in balanced accounts helps the portfolio during periods of market volatility.  However, we do not think that this is a similar period to the financial crisis of 2007-2008.  Our domestic banking system has been recapitalized, corporate balance sheets are strong, rates are low, and falling energy prices will help the consumer and businesses.  If both Congress and the Administration can focus on creating jobs rather than name calling, our economy may be able to get through this period of low growth without slipping back into recession.  We would also like to see stability in European sovereign debt spreads in order to become more positive on the market.

While I was listening to some traders yesterday on CNBC, I was again reminded that the equity markets are forward looking.  

There is certainly a lot of negative news to be processed around the world between Greece, the PIIGS’ debt problems, and our debt and political challenges here in the U.S.   So much so in fact,  that the tendency for analysts and money managers to be bearish is well founded.

However, as one savvy trader put it yesterday, the market action, coupled with some recently reported positive economic data, cannot be ignored.   Right now that action is telling us that the second half of the year could prove to be quite productive for equity investors.

Yesterday the ADP and Challenger employment data were disappointing.  In addition, the ISM number was weak, including new orders.  These numbers, coupled with the weak housing data one week ago have investment pundits wondering whether the economy has hit a soft patch, or is presaging a steeper slowdown.

The markets are also trying to digest the problems in Europe, and how the possibility of a Greek debt default, and weakness in some of the other EU countries will affect global growth.

We think the economy has hit a soft patch that will improve later in the year.  If Congress could agree on and enact some real, and meaningful cuts to runaway entitlement costs, the market could actually start another leg of the bull market.  Of course the corollary to that, is that more of the same, equals an economy and markets, that will hit more than a short term soft patch.

Yesterday reported inventories for oil dropped more than expected which sent the price down below $100 per barrel, and caused a sell off in the Dow and the S&P 500.

This seems to be a knee jerk reaction to what is probably good for many sectors of the market in the near term, including energy stocks.  Several reasons for this include:

1.  Lower oil prices are better for the consumer and probably consumer discretionary stocks.   2. Oil/Oil Service companies continue to make good money even if oil drops to $85 per barrel and, in addtion, it hinders demand destruction. 3.   Input costs should drop for Industrial companies that use energy to produce their products, enhancing margins. 

As long as the drop in oil inventories/price does not reflect underlying economic weakness, this pullback in price could be good news for many sectors of the market in the coming weeks.

This morning in our research from Ed Yardeni, he discusses his dismay at the inability of Democrats and Republicans to agree on $61 Billion of budget cuts.

“The Republicans, led by Paul Ryan(R-WI) are proposing a plan that would cut the $10 trillion of deficits projected over the next 10 years by the Obama administration, under current law, by a whopping $4.4 trillion.  The only problem is that they can’t seem to agree with the Democrats on $61 billion in spending cuts for the current fiscal year, which is half way over.  This raises the possibility that our country is politically incapable of restoring any fiscal discipline whatsoever.”

If the market begins to perceive that this is in fact the case; the gains we have enjoyed since the November election could quickly evaporate.