Market Update

Markets are down this morning after yesterday's FOMC announcement failed to provide any significant changes to current monetary policy. Bernanke did suggest increasing concern over deflation, which suggests increased dovishness (hence the temporary pop in the markets yesterday following the statement).

Also driving the markets lower this morning was weak guidance from ADBE (Down ~20% this morning) yesterday after the close and a tremendously poor earnings report from Jefferies Group that showed principal trading revenues of $74.3M down from $338.6M in 3Q09. Trading volumes were terrible all summer, and it follows that the investment banks will post very weak revenue in 3Q. With GS still trading near $150, one must wonder if there is a case to be made for going short the banks into earnings season.

Portugal's bond offering this morning closely mimicked that of Ireland's yesterday in that risk premium increased 100 bps on both the 4 yr and 10 yr bonds.

0.45B Euro of 4 Year bonds at a 4.695% yield vs. previous at 3.621%
0.3B Euro of 10 Year bonds at a 6.242% yield vs. previous at 5.312%

Today's POMO had little effect on the markets. The Fed purchased $2.07B 3 year bonds.
Interestingly, some of the high beta tech names (AMZN, AAPL) are going up despite the Nasdaq being down approx 1%, lending some credence to the blogosphere belief that POMO is providing primary dealers with levered funds to purchase high-beta equities in the hope that tech can lead us higher.

The probability of a trade war in Asia increased this morning as China Premier Wen Jiabao threatened more retaliatory action unless Japan "immediately and unconditionally" releases the fishing captain detained by the Japanese two weeks ago. As Japan is China's #2 trading partner after the U.S., and China is Japan's #1 export market, it bears watching this development as increased trade sanctions could lead to a gigantic selloff in global markets. China has also been seen increasing its Naval presence in Myanmar ahead of elections there, and we don't have any resolution in the continuing conflict on the Korean Peninsula.

The Euro is flying this morning to 1.3368 vs. the dollar. This is the high end of its summer range. I don't believe that the Eurozone is recovering, and think a long position in the EUO should be built at these levels. (Zapatero's announcement that Spain's troubles are over doesn't impress me...). Youth unemployment in Spain still hovers around 40%. Social unrest is not altogether unlikely. Also this morning, Eurozone Industrial orders posted the sharpest montly drop in 19 months, led by a drop in orders for capital goods. German GDP will begin to drop off if the ECB doesn't intervene to stop the strengthening Euro. Action on this front is all but certain as the race to competitive devaluation continues.

On that front, Tyler Durden at Zero Hedge provides an excerpt from perma-bear Albert Edwards' latest report in which Edwards asks, "What do devaluation, high unemployment, inequality and food prices spell? C-H-A-O-S." Edwards also goes back to a speech given by Bernanke in November of 2002. This is truly terrifying in its implications for the future intentions of the Fed.

"...A striking example from U.S. history is Franklin Roosevelt's 40% devaluation of the dollar against gold in 1933-1934, enforced by a program of gold purchases and domestic money creation. The devaluation and rapid increase in the money supply it permitted ended the U.S. deflation remarkably quickly...and by the way, 1934 was one of the best years of the Century for the stock market." WOW. No wonder gold continues its march higher.

Another interesting observation this morning comes from Philip Davis. He notes that after the past two Fed meetings, the stock market proceeded to lose 5% in the 10 day following the announcement.

With bullish sentiment much too high and mutual funds holding just 3.4% cash (lowest level in the 60 year history of this measure) there isn't a lot of plain vanilla institutional firepower left to lead us higher. Lists of the most overvalued stocks are being sent around this morning, and it appears that the shorts will be able to finally get back to work. I personally think that names that gapped 25% higher on no news over the past two weeks provide a nice entry point on the short side (especially some consumer discretionary names such as ANN and BC, both of which I hold short positions in at these levels.)

Finally, we must look ahead to earnings. Consensus expectations are still much too high and we will likely begin to see downward revisions. Consensus for 2011 stands at $95 and consensus for 2012 is still $108 despite falling GDP estimates. As we see more guidance disappoint, expect these numbers to be revised lower, thus making the bull case that the market is historically cheap based on forward earnings a little less robust. Analysts tend to be overly optimistic at the top (and overly pessimistic at the bottom). A reversion to the mean (if rational/truthful estimates are possible in a world in which the banks and brokerages must fight to keep outflows and low volumes from destroying their business by being as bullish as possible ('Occupationally bullish') would quickly show that this market is overvalued.