Is the Rally Just Window Dressing?

07/04/2011 8:30 am EST

Focus: MARKETS

Jack Adamo

Editor, Jack Adamo's Insiders Plus

There are some good numbers out there and signs of strength, but there are also some real challenges that remain, writes Jack Adamo of Insiders Plus.

The Pollyannas out there say the economy is improving, and the weakness we’ve seen in employment, housing, and other metrics amount to nothing more than a soft patch on the road to recovery.

Maybe, but I don’t feel the ground firming yet, and there are other factors to consider besides domestic ones.

Every few days we hear news about how the EU or IMF has agreed to bail out Greece again. Then, a few days later, there’s still some hurdle to overcome.

Moreover, anyone with any credibility left says Greece will default sooner or later. The EU would just rather it be later, after the European economy recovers more. That’s not much comfort.

What does all that European stuff have to do with us?

As I’ve talked about for years, all the US stock-market gains of the last decade have come for a weakening dollar. In terms of any reasonably stable currency, the stock market is flat to down.

John Mauldin mentioned this week that he recently paid $12 for a small Diet Coke in Switzerland. Granted, it was at a hotel, and hotel prices are always high, but not that high. We’re paying with Weimar Deutsche Marks.

If Greece pulls out of the Euro, or the European countries refuse to bail it out any longer, the Euro is going to take a big hit, and the US Dollar will rise concomitantly, as a “safe haven.” I don’t think that’s imminent; it would probably take too much political change to happen in less than six to 12 months, and probably more.

Longer term, the dollar will resume its downtrend regardless, and gold will be our salvation. But a stronger dollar in the short term could really blast the market.

When the International Energy Agency announced that its 28 member nations agreed to release 60 million barrels of oil from strategic petroleum reserves, in response to the ongoing disruption of oil supplies from Libya, the move had an immediate effect on oil prices.

WTI (Light Sweet Crude) fell to $91, after successive sharp drops that started a few days before the announcement was made. The CFTC is investigating the pre-announcement moves for signs of leaks and insider trading.

That issue aside, WTI is down 20% in the last seven weeks, in what is normally a season of rising prices. The first cracks appeared around bad economic statistics in early May and have continued to grow. The fact that the IEA decided to go ahead and release this oil while oil was falling tells me that everyone is more concerned about the weakening world economy than they are letting on.

Lower oil prices in theory should stimulate the economy, since most consumers will have more discretionary income. Whether or not they’ll spend that money—and whether that spending will prompt companies to hire workers and gear up the virtuous cycle—remains to be seen. But it’s a good try.

I want to add a little protection here, but I don’t want to go out on a limb, given that we haven’t had an outright sell signal yet. Here’s my plan:

After taking a hit following the earthquakes there, Japan’s market has been stronger than ours over the last few weeks. The reason for that is that the rebuilding process is stimulative for the economy, just as we saw post-Katrina a few years back.

In addition, Google (GOOG)—which is very, very down year-to-date—has hit a technical point from which it almost always has a nice rally. I want to add a little exposure to Japan and Google at the same time I hedge the overall market.

If I’m right, the strength in these two investments should cause them to gain more than our hedges will lose if the market rises, and lose less if the market falls.

If the market starts clearly moving one way or the other, we will let go of the hedges or the “longs” as appropriate. Then we’ll consider what to add. Right now, it’s too tough to call.

Subscribe to Insiders Plus here...

Related Reading:

Related Articles on MARKETS