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The Back Nine


One thing is for certain: discipline over conviction will serve us in good stead as we ready for the back half of 2007.

"It's easy to grin when your ship comes in and you've got the stock market beat. But the man worthwhile is the man who can smile when his shorts are too tight in the seat."
--Judge Smails, Caddyshack

Carl Spackler once said that in order to conquer an animal, we must learn to think like an animal. For bulls and bears around the Street, truer words have never been spoken.

The first half of 2007 is officially in the books as we tee up the other side of the hump. While the last few holes highlighted the hazards of higher rates and sub-prime contagion, the scorecards were fairly impressive as players headed into the clubhouse.

With a conscious nod that the most important marks have yet to be seen(they're buried under a pile of CDOs), the bovine have momentum as we ready for a battle on the back nine.

Still, as the game is far from over, I wanna use this quiet holiday stretch to circle back to the ten themes I laid out at the beginning of January and see where we stand.

Theme 1: Dollar Debasement: While a near-term rally in the dollar is possible as a function of negative sentiment, the broader trend of nationalization should continue as foreigners, particularly petrol-nations, look to denominate assets in local currencies or Euros.

The greenback (as measured by the DXY) began the year with a 2.5% rally before reversing 5% lower to challenge decade lows. Meanwhile, seeds of nationalization continue to be sown from Venezuela to Bolivia to Ecuador and Russia.

Ironically, through the lens of "dollar devaluation vs. asset class deflation," a weaker greenback may be necessary to buoy asset classes around the globe. Displacement risk remains, however, if holders of natural resources continue to tire of dollar-denominated returns.

Theme 2: Leadership Shift: Large cap should outperform small and mid-caps, on a relative basis, and energy and metals will take the leadership baton from tech and financials.

Large cap (S&P) narrowly beat their small-cap brethren, as measured by the Russell, 6.1% to 5.8%. Energy enjoyed a strong first half, with crude surging 18% and the drillers up 38%, while metals were mixed and the XAU was flat. Tech (NDX) was up 7.5% and slippage in the banks offset relative strength in the brokers.

It remains my opinion that investors will benefit by skewing their portfolios towards things needed to power, feed and educate the world while steering clear of high-multiple, subjective valuations and rate-dependent industries.

Energy and metals over tech and financials is a long-term secular thesis.

Theme 3: The Elasticity of Debt: It's no secret that debt has powered the most recent leg of our economic "expansion" at the expense of savings and wage growth. That tipping point may come to bear as upwards of $2 trln in adjustable rate mortgages reset in 2007.

The wheels on the wagon have started to wobble as housing continues to take it on the chin. That, coupled with the specter of higher global rates, has the U.S consumer, many of whom are tied to adjustable rate mortgages, in a pretty pickle.

The conditional elements of a debt unwind have been in place for some time but we've lacked a catalyst. That may arrive in the form of CDO "mark-to-market", which could conceivably start a downside domino effect. If and when that manifests, the easy money used to finance the merger and acquisition mania will tighten in kind.

I expect this issue to remain, cumulative albeit intermittent, with periods of relative calm masking growing disconnects. It is yet another reason to steer clear of the financials, which is a loaded proposition in a finance-based economy.

Theme 4: The Hump Back Market: The market action was fantastic into the home stretch of 2006 as positive data points were embraced and bad news was shrugged off. That momentum could continue into the front end of '07 before giving way to the weight of an unsure world.

The momentum from the back of '06 indeed continued through the front end of '07. Now, the bulls must stand up and claim their fame, juggling an uncertain rate backdrop, cracks in the housing foundation, smoke in derivative land and continued global acrimony.

All eyes will soon shift to corporate earnings as investors look for reassurance on growth rates and outlook. S&P 1540 is an important level, through a technical lens, and the financials remain a key sector to watch for guidance.

Theme 5: The "Haves" vs. "Have Nots": We've seen this dynamic proliferate in societal circles and can expect it to manifest in the hedge fund community. If I were trading hedge funds as an asset class, I'd be long the quality and short the quantity.

Blackstone, Fortress, GLG, Och-Ziff, KKR: the IPO parade has only just begun as smart money looks to cash out. Yes, the rich are getting richer and yesterday's millionaires are today's billionaires.

We've been monitoring this progression closely, drawing attention to the dichotomy between good companies and good stocks. That seems to be an intuitive distinction, given the inherent conflicts. The more pressing quandary is as follows:

Is this the last bastion of liquidity, one that could potentially spark a blow-off phase or echo-bubble, or is this a clarion call that those in the know are beginning to bottleneck at the last remaining exit?

Theme 6: Commodity Consolidation: Merger & Acquisition activity should pick-up in the hard asset space as smaller niche players are absorbed in a global effort to scale.

This continues to play out, highlighted by the Freeport-McMoRan's March takeout of Phelps Dodge. We've also seen a number of smaller alliances, which I expect to continue, as players grasp for share in this underinvested arena.

Theme 7: Life Stage Marketing: Just as social networking was the catch phrase of '06, look for life stage marketing within sector verticals to emerge as the media play in the coming year.

All's quiet on this front but I figured I was gonna be early with this one. Still, it is through this lens that we're building Minyanville. By the time we're recapping 2007, we'll have already planted seeds in each stage of financial vertical, from the ABC's to the 401(k)'s.

Theme 8: Rate Reversal: While the equal-weighted commodity index continues to tickle all-time highs and there is pressure from abroad to raise rates, look for the FOMC to lower interest rates this year to offset ARM resets and a slower growth environment.

It's clear that the FOMC has become reactive in their rate policy directive. They want to lower rates to spur growth (and keep liquidity flush into sub-prime concerns) but face headwinds from foreign holders of our debt and higher-than-reported inflation pressures.

As a result, we wait. And watch. And hope.

If the Fed does indeed lower rates, investors might be well-served to ask "Why?" before acting.

Theme 9: The Real Real Estate Market: As most folks monitor homebuilders as a proxy for real estate, expect the broader commercial and residential markets to accelerate their softening phase.

The slippage in the residential market has been somewhat bifurcated, with the "haves" keeping a persistent bid to the high-end as the "have not's" struggle to make ends meet. Still, as anyone who traffics in the homebuilders will tell you, there is persistent supply in the space.

The commercial side of the equation has remained surprisingly strong, although Sam Zell's sale of Equity Office Properties raises a wary eyebrow. If the smartest guy in the space is cashing out, I certainly don't want to be the person on the other side of his trade.

Theme 10: The Return of Volatility: The flush of global liquidity has dampened the relative momentum of individual stocks as reflected by implied volatilities. 2007 should see an uptick in overall market volatility.

True dat, to the tune of a 44% rise in the VXO (volatility index). This is the other side of a very crowded trade, one that should continue to trend higher for the foreseeable future. It's the result of cumulative compression, furthered by a rash of premium sellers across the equity space.

I like to use a very simple analogy when discussing volatility. Investors chasing an illiquid stock will run the price, creating volatility. Conversely, a flood of liquidity will naturally dampen overall market volatility.

Thus the obvious question is begged: if volatility is back, what are the implications for the broader market liquidity? And if liquidity abates, what will that mean to asset classes of all shapes and sizes?

It's a lot to digest and something to chew on as we round out the holiday celebration. One thing is for certain: discipline over conviction will serve us in good stead as we ready for the back half of 2007.

Good luck-and be the ball!

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