GOING DOWN? SELL SMALL! SELL METALS!

Over the past 3 days, the Russell 2000 Index (RUT) is down 3.5%, the NASDAQ is down 3.1% and the S&P 500 Index is down 1.97%.

In the past 9 days, Phelps Dodge (PD) is down 9.35%, Newmont Mining (NEM) is down 6.44% and the $XAU Gold and Silver Index is down 5.48%. At major turns, small caps and metals often turn together.

Yesterday, the one day declines in the $XAU was 6.79%, the Mexico sector ETF (EWW) 3.36% and the Industrial Metals Index ($GYX) a whopping 7.3%. See the charts of the GYX posted last week, which showed the Metals had risen to extreme levels. Crude oil prices rose 4.25%, short interest rates rose 3.99% and Airlines took a 5% fall.

In recent days, I sold shares of PD and NEM short. I liquidated retirement account shares invested in RUT and have purchased put options on NEM.

Why all the sudden gloom and doom?

Ironically the answer lies in too much relative strength in the US economy. At a time when the German unemployment rate is at the highest level since the 1990 recession (10.8%), when the rest of Europe is in a funk and when China is restricting government spending in order to slow excessive growth, the US economy is showing signs of accelerating growth.

US statistics show that US layoffs are at the lowest level since 1999. Unemployment is down in 259 Metropolitan Areas and is up in only 63. The jobless decline is in 42 of 50 states. Federal reserve reports manufacturing was up 1.2% in November, completing a four month run. The ISM index was up a strong 58.6% marking the 19th consecutive month of increase!

The strong manufacturing and job gains spooked the Fed according to the December 14 FOMC minutes (released today). Several board members expressed concern about rising inflation. This information startled the markets as the Fed is still in stimulative mode. Indeed the fed funds rate of 2.25% is only .7% above the PCE deflator. One must assume after the significant declines we have had in the US Dollar, that the inflation index will rise by at least a couple of hundred points over the next few months. If the fed continues to crank up short rates by .25% per month, it will take several months to get ahead of the interest rate curve. Once inflation gets a jump on the fed, it usually takes a while to catch up. Oil prices are likely to trade up again significantly by the summer driving season.

Right on cue, the Euro Dollar just made its biggest decline in 7 weeks. Clearly the market is discounting the strong US economy, our rising inflation and the likelihood of further short-rate increases.

No one knows for sure what is next. However, the up-trends in small stocks, metals and developing country stocks have broken down. Earlier, I mentioned the Mexico ETF and could have used other examples such as the Brazil or Argentina Funds.

I sold my developing country funds too early, held some small cap funds a couple of days too long and missed the top in the metals by a week or two. One should never worry about hitting exact tops and bottoms.

The important thing is to preserve principle in the tough times. My short sells and puts on the metals hedge my long-term long stock positions. Selling short is an aggressive approach. Other aggressive investors may want to move other funds to cash, particularly in retirement accounts.

Based on current long-bond rates, the S&P 500 is cheap. The most recent moves by the fed have actually brought long-rates down. The market is currently spooked by the fear of inflation. Until most recently, economic indicators were showing a strong US economy but not an over-heated economy. Should one decide to be aggressive and raise cash, one should be prepared to reinvest at a moments notice. Those that sell small cap funds or emerging market funds should plan to re-invest in larger cap funds after the storm is over.