I hate the overused “catch a falling knife” phrase and given that Chinese knives are more like giant cleavers, I thought chopsticks would be more appropriate (and less harsh.)  I heard Ed Keon suggest that people should start buying the stocks that got hit the hardest today and I almost jumped out of my skin.  As I wrote in my previous post, if you want to buy something, please think about the stocks that held up the best today.  Catching falling chopsticks is a losing proposition.

Some trees stand up tall on windy days while all around them - limbs, branches, trunks and even some roots are suffering.  Before the storm, many trees look majestic and healthy and it’s only when the strong wind blows that we find out what they are really made of.  On days like that, I admire the trees that seem unaffected by even the strongest gust and because they stick out in the worst moments, they are easy to remember when things calm down.   Today is one of those windy days where a lot of hidden weaknesses are being exposed and it’s discouraging to see what we have been ignoring.  Hopefully you are not panicking, but are taking care of your most urgent needs.  When things settle down, do not pass up this great opportunity to find the stocks that held strong.  They’ll be pretty easy to spot and you should really spend some time getting familiar with them and why they did so well on such a bad day.  Many of these are probably worth looking at as buys.

“Trading Curbs are in.” Wow - I haven’t heard line that in a while. I have been working on a post about program trading so I’ll keep this one short, but I just wanted to mark the moment. After having to watch CNBC’s annoying “number of points below record close” banners for the past several months, I thought it would be fair to have fun with the Trading Curbs announcement. Just remember that while curbs limit the sell programs, they do not eliminate them. HL Camp specializes in program trading research so I’ll provide this link to their explanation of Trading Curbs. It’s been so long that I thought you might need a refresher on them.

The US stock market open has been Shanghaid by China’s 9% decline overnight.  That’s a substantial decline but it should not have been a Shanghai surprise.  I have already written on this topic earlier this month so click here to read my earlier thoughts (they still apply.)   I am not convinced that last night’s Asian problem is any more important than the slide a month ago, but it appears that this one MAY call attention to the risk associated with the returns in emerging markets like China.  Investors have been dumping huge money into these markets with a massive dislocation between risk and reward.   Hearing that China’s selloff was due to “profit-taking” was laughable at best.  If it’s false, then we should be looking for the real cause.  If it’s true, investors should be thinking long and hard about how a little bit of profit-taking can precipitate a move like that.  Instead, I fear ignorance and blind hope that this will just blow over and we can go back to a singular focus on how wonderful the returns are in emerging markets.   I was worried about the risk in International ETF’s (click here) last spring and was told that I was panicking.   I expressed my concern last month and it was ignored.   I don’t know what is worse - denial or ignorance but the effect is not on me, it’s on the investors that are going to lose some money.  The fact is that China’s government has been blatantly telling people for months that they are going to slow down the economy and slow down the markets.  I’ll be watching to see whether any selloff in the US is met with buy programs or whether they are going to let this play out.

I am not a fan of the smart money debate given the performance of active portfolio managers versus the indices, dartboards, and monkeys for that matter. However, for the past few weeks, buy programs from institutions have been there at the end of day to buy into weakness. Believers in the smart money theory were encouraged and it has gone a long way to extend this rally. But smarter money sells too and I’ll be watching for signs that programmed buy trades stop working or start switching to programmed sells. Until then I am just going to assume the institutions are still bullish and putting all their cash to work on the long side.

Here is my monthly look at key factors that affect stocks:

• US Dollar - I am still bearish on the USD and think we will slide lower towards 82.50 on the index. I am paying close attention to foreign investments and key central bank shifts in their reserves away from the dollar. Coupled with slower US growth, I fear that we are in a tenuous spot here given the need to maintain higher yields to attract the foreign capital and the simultaneous economic pressure pushing down rates. Dealing with the Yen carry trade and its effect on currencies is a huge area of interest for me but I’ll leave that for a longer post.
• Rates - After the 10-year yield hit my previous target, we have drifted lower and I expect that to continue toward 4.55% during the next month. Last week’s problems in mortgage backed instruments due to the subprime component pushed a flight to quality and furthered the downward pressure on the 10-year yield. Given Greenspan’s concerns over a recession this year and a slower growth / lower GDP forecast, I don’t expect longer term treasury yields to head meaningfully higher in the near term. In fact, I am a bit concerned about a worsening of the inverted yield curve.
• Commodities - The broader basket of commodities represented by the CRB has become more bullish than I expected and we are getting to lofty levels in the short term. I am still bullish but am watching these levels very closely.
• Gold - The bounce off my anticipated support around $610 per ounce was steeper than I expected in December. Now that we are heading back into the peak levels seen in 2006, I am expecting some moderation in the short term. I am still bullish so I hesitate to post a new short term support level, but my current view is that the next pullback will challenge $650.
• Oil - I am still bullish on oil, but the technicals and fundamentals are making this one tough to call. Last month, I hadn’t expected to break through $60 this time around but here we are above $61. If I had to rely on technicals alone, I would be looking for a trade down towards $55, but the Iranian nuke issue will likely hold off selling pressure. I don’t like handicapping the weather or geopolitics, so I’ll just readjust my outlook if either of those become more dominant.

Overall, the picture I get from all these market forces is weakness in the United States. That may encourage the “Fed Rate Cut Hopefuls” to get excited but I remain very fearful of the fine line we are walking.

Seinfeld just joked around on the Oscars that moviegoers are entitled to throw their garbage on theater floors. Apparently, he believes the small print on the back of the ticket contains a contract to get back at the theater for ripping us off with the $5 popcorn, candy and soda. Personally, I am not a fan of those prices either and I know he was just kidding (kinda). But if you take a look at the financial history of theater chains such as RGC, you’ll see a bunch of bankruptcies. Regardless of the $9 ticket prices and expensive snacks, it hasn’t been easy to make it in the movie business - at least not for the theater owners. Attendance is down and trends are not promising. Maybe our society is changing, maybe moviegoers are being too critical and maybe, just maybe, the movies are often not that good. It’s no wonder that theaters are trying to make money on their expensive megaplexes and make us overpay for food that is terrible for us anyway. However, sometimes the biggest garbage at the theater is the movie itself. At least you know the quality of the Jujubes and Raisinets will be the same each time. The movies are not so predictable. Unlike Seinfeld, I pick up my litter whether the movie is garbage or not. When actors are getting paid millions to put out some of this stuff, it’s a bit much to expect a minimum wage worker to pick up garbage left in protest.

When the last bull run ended, many burned investors looked back in their rearview mirrors and said how they will never make the mistake of accepting high PE ratios on the S&P again (yeah right!). But when I look back at 1999, I reflect more on the growth rates that were in existence back then. Those are the things that really sunk the market (not PEs on their own) and explain why the Nasdaq has only recovered 50% of its peak while the Dow and S&P are fully recovered.

In 1999, investors were justifying high stock prices by focusing entirely on forward PE’s, rather than historical ones. That’s still true today and whenever I tell people that I give equal weight to trailing 12 month PE’s, I probably lose some respect. Oh well - past earnings are truth (excepting errors and fraud like Enron). Future earnings hope to be true and when they are overly optimistic, it’s painful. But it wasn’t just the forward 12 months that caused the problem - it was the 5-year estimates. Eight years ago, analysts seemed to be in some odd competition to pump up growth rates and GARP investing was made possible by relying on PEG ratios to make excuses for ridiculously high PE’s. As you know, one of mathematical problems of PEG ratios is that a small downward percentage change in “G” has a negative multiplier effect and as a result, I deemphasize PEGs in my work.

Today, I don’t see the really obscene growth rates slapped on almost every stock and on standard valuation metrics including historical and forward earnings multiples, the market does not look overvalued to me. But I am keeping a very close eye on 5-year earnings estimates because of their ability to cause a rapid change to fundamental valuations. The earnings season that just ended was good (not great) and analysts are starting to lighten up on growth rates for 2007. When you do your analyses, please make sure that growth rates are not overstated for the individual stocks you are considering.

15 years ago, I was in a friend’s office on a Friday and noticed that his staff was wearing jeans and other casual attire. For a buttoned up guy, it was weird to see jeans and tennis shoes sitting at desks. In a show of support, he dressed down too. I couldn’t pass up the observation and questioned why he had finally given in to his employee’s requests for a relaxed environment. He smiled and proudly told me he should have done it sooner and based upon his analysis, the office was about 20% more productive on Fridays in the past two months. I laughed and said, “If dressing down a little makes you that more productive, imagine how much more work you’d get out of them if they were naked.”

If a little is “good,” then shouldn’t taking something all the way be great? If a little private equity is good, then how about if they just bought all the public companies. Of course that wouldn’t be good. The other day, I saw a quote somewhere that suggested Private Equity would do about $1 trillion in deals this year, up from about $400 billion in 2006 and $135 billion in 2005. I think a trillion may be a bit of an exaggeration but you never know, it might turn out to be too low. Considering the amount of cash that is flowing into Private Equity firms and high leverage ratios that are available, their buying power sits at about $2 trillion, not even ten percent of the total market cap of global equities. So I guess there will be public markets after all, at least for now!

“Everything in moderation” is another saying and if Private Equity could just be measured on the deals it does, I would say that the current market has a healthy amount of Private Equity. But that is not the case. Over the past year, the markets have been inflated by rumors of acquisitions that never get done as well as sector-wide extrapolations for deals that do get done. For example, just look at the REITs and how they have risen on a few deals in the sector. EOP was the biggest LBO ever, but it was one deal. Placing a premium on the whole sector as if all the companies would be taken private is just nuts. You cannot measure the effect exactly, but if I had to guess, I would say that the market has run up about 3 percent due to M&A speculation in the past year. PE expansion was supposed to mean Price-to-Earnings expansion not Private Equity expansion. A lot of investors are hanging their hat on market multiples expanding this year to make up for slower earnings growth expectations. I suggest that we had quite a bit of that already due to acquisition rumors.

I have no problem with Private Equity funds, especially since HEDGEfolios is visited by quite a few of them. But my admiration for Private Equity is equal and opposite to the market’s pricing in anticipation of that next deal. Sooner or later, the liquidity provided by this group will slow down or dry up. When that happens, Private Equity will likely find a way to keep making more money, but I doubt that will be true for the market.

When it comes to concerns over leveraged equities, I am “On the Margin.” Over the past few days, many market commentators have called attention to the record levels in Margin Debt, especially as it relates to the levels in the year 2000. I don’t like taking every market statistic and comparing them to any one point in time and I think it’s rather dangerous to do so with the year 2000. But that doesn’t stop other people - bulls are busy explaining why margin debt doesn’t matter and bears are exaggerating why it does matter. What a surprise but the truth (according to me at least) lies somewhere in between the two extremes. Like all statistics, it’s important to do more than look at nominal values. Mind you, I am not fond of spinning every number with its inflation-adjusted value, but the bulls who have taken it upon themselves to suggest margin debt is irrelevant make some good points. They want you to evaluate Margin Debt in light of the dollar value of trades, short interest, and differentials in margin interest rates, etc over time. I leave it up to you to do that analysis. But the bears are not in error for calling attention to this matter. All it really shows to me is the increasing risk tolerance and leveraging that is consistent with other aspects of our economy inclusive of mortgage debt, household debt and the re-leveraging of corporate balance sheets.

I look at margin debt primarily in two ways: 1) The nominal value and 2) its relationship to the Free Credit Balances. While the current levels are high and increasing, they are not abnormally high relative to the credit balance. In fact, when you divide the combined NASD and NYSE Margin Debt by the Free Credit Balances - the result is 1.00. So while the Margin Levels are at or slightly higher than the peak of March 2000, the ratio was 1.8 back then and from December 2000 until now it has hovered between 0.75 and 1.04. Until I see a meaningful and sustained increase in this ratio, I am not overly concerned by Margin Debt. The real pain from Margin Debt is not felt until stockbrokers start making margin calls every day and that has not begun. When it does, you’ll know because those calls and the forced selling to meet margin requirements are about as painful as you can get.

The market is full of indicators like Margin Debt, inverted yield curves and the VIX. If you get hung up on any one of them, you are in trouble. When I look at all of them together, the odds are stacked against the bulls no matter how much spinning they do with any one statistic. But don’t fall into the trap of believing that any individual reading or even a simultaneous event of every bearish market indicator hitting extremes would signal the ringing of the market top bell. And one more thing, it is very unlikely we will have a pyramid top in this market. The bull - bear debate has become so ridiculously polarized that it appears both sides are fighting over a precipice. A decline in this market does not guarantee the end of the 4-year bull run and the start of a move like 2000 to 2003. More likely, the first real pullback will result in renewed buying and we will have to go through these iterations several times before this bull market is officially over.