Charts: It is time to remember that technical indicators are the least important of the three categories that we follow here at DMU. With that said, the charts are very bullish right now. The last big indicator to fall in line was Dow Theory, which charts the advance of industrials vs. transports. If industrials zoom up but transports lag, Dow Theory says that a rally is shaky. And this has been the case until recently. My focus on the S&P 500 vs. XLF is a variant of Dow Theory, i.e. both indexes must be strong for a rally to have legs. I’ve been calling this rally extended or overbought for a while. Bear in mind, a rally that keeps rocketing up when it looks extended doesn’t necessarily mean everything is wonderful, often it means the rally is getting even more extended. In any case our other two categories are far more important than charts.
Fundamentals trumps charts and geopolitics trumps everything.

Fundamentals: 71% of the companies in the S&P 500 that have reported so far have beaten analysts’ estimates. This is the biggest percentage beat ever and it is the reason for the second big rally in the embryonic bull market. Earnings surprises have been the main reason for stock price appreciation throughout the Great Moderation era (1982-present). The market’s reaction to today’s beats even though fundamentals are weak indicates that we are still in the Great Moderation and this makes the current lofty valuations a bit easier to swallow. Still, the beats are based almost entirely on cost-cutting. Revenue is coming in weaker than expected. What strength there is in the top line is mostly based on inventories being rebuilt. After Lehman Brothers collapsed inventories were slashed at a record pace, worse than the Great Depression, worse than anything. Now inventories are being rebuilt. Fine, but the inventory cycle is about 6 months long and the rebuilding started in March, so we are nearing the end of this boost. Tech has been strong and within this sector chips are stronger still, leading the whole group, which in turn is leading the entire market. But chips are levered to inventory rebuilding more than other tech companies. Long story short: the consumer must start spending more aggressively for the rally and the recovery to continue.
This is the picture in Europe and America. In Asia it looks better. China, Vietnam, Singapore, and South Korea have reported strong Q2 GDP growth. These countries are no longer in a recession. China and Singapore experienced freakishly strong double-digit Q2 growth. South Korea had the best growth in over 5 years, still in the low single digits, stout nonetheless. Consumers are beginning to spend more in Asia. Never before have Asian consumers pulled the world out of a recession. Can they do it this time? All of Asia (including dinosaur-like Japan) has roughly the consumer purchasing power of America. Europe and America seem to be moving in lockstep, together they are twice as big as Asia. In the Euro-zone, France and Britain are beginning to report softer numbers. Germany is reporting stronger numbers. Germany is much more levered to Asia than other European countries. So the global economy is at an inflection point. The infant recovery is in fact going to have to get at least some help from the American consumer. The 21st century will be the Asian century but this first decade is still too close to the 20th century for America to not play a significant role in the recovery. As we’ve seen American consumer sentiment surveys have weakened lately. This probably has a lot to do with oil shooting up. Since we can’t just endlessly ask questions and scratch our heads in befuddlement, let’s distill the outlook down to this key indicator: energy prices.

Geopolitics: A while back I wrote that the US Marine’s Battle for Helmand Province in Afghanistan is about like the Marine’s Battle for Fallujah in Iraq in 2006. It turns out that many of the Marines in Helmand are battle hardened veterans from the campaign in Fallujah. The New York Times asked these veterans how Helmand and Fallujah compare. Their answers are sobering. Al Qaeda in Iraq (2006) was not as tough as the Taliban in Helmand (present day). The Taliban is tougher and much smarter. The Taliban employs tactics nearly as sophisticated as the Marine’s own tactics. Ambushes, flanking maneuvers, supply lines, all work at a world class level with the Afghani Taliban. On the other hand, the Taliban has inferior equipment compared to Al Qaeda in Iraq. The Taliban is forced to make crude bombs out of fertilizer while Al Qaeda in Iraq had access to old Iraqi Army stock piles. The Marines say that if the Taliban had gear as good as the Iraqi bad guys, then they would be in for a world of hurt. Again, let’s distill all this down: The war will last another three years and investors will have to perceive that America and NATO are winning for this entire length of time for there to be a bullish effect.