Be on red alert for US market chaos

By Bill Fleckenstein

Folks want to believe the economy in America is doing better than in other countries around the world. Wall Street has acted as though that is an indisputable fact -- i.e., the decline in the S&P 500 Index ($INX) this year is less pronounced than the drop in Asian and European markets.

Granted, weakness is now being spotted in many countries, even those in Asia. Recent comments from Samsung Electronics, Corning (GLW, news, msgs), Novellus Systems (NVLS, news, msgs) and Dell (DELL, news, msgs), as well as many other companies, have corroborated this.

And, of course, some folks feel good about the prospects for U.S. growth, as well as the dollar, because second-quarter gross domestic product (aided by those government rebate checks) was recently reported to have risen 3.3%.

However, that assumed a rate of inflation of less than 2%, when in fact inflation is actually somewhere between 5% and 7% or even higher. Thus real economic growth in the U.S. is either nonexistent or negative. (For more on this topic, read "Why all roads lead to inflation.")

I strongly disagree with the view that our economy is doing better at all. Rather, I believe that earnings reports in the upcoming months will bear witness to our economy's weakening.

I don't know when the reality of our hobbled economy will dawn on the "denialists." But when it does, I anticipate chaos in the stock and currency markets.

In fact, that process of recognition may have begun last week, when a large rally early Tuesday reversed itself and Wednesday and Thursday saw further declines in the S&P 500. Those were followed by Friday's weak action in the wake of a large jump in the unemployment rate. I don't want to make too much out of a few days of market action, but I do think folks should be on red alert for a rapid change in psychology and its ramifications.

Debunking the stocks-are-cheap chirping

As for those folks who are continually making the case that stocks are no longer expensive, it's worth noting that because of pressures on profit margins, earnings losses, etc., the S&P 500 is now trading at more than 25 times earnings, a multiple previously exceeded only in 2000. That's another point that gets overlooked by bulls: Earnings estimates can be too high, and stocks can be more expensive than first appears.

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And in the "be careful trying this at home" department, Dwight Anderson just announced the closure of his Ospraie Fund, which is down about 40% for the year. For those of you who don't know, Anderson had a great track record (and reputation). The fact that a wipeout of this size could happen to him -- he is calling it quits -- should be a warning to folks about how difficult it is to trade commodities (and commodity-oriented equities). Though I suspect his problems were complicated by the size of Anderson's fund.

Nimble is better

One fallacy that has emerged in the past couple years is that bigger hedge funds are better. In almost all cases, I think that smaller means more nimble, which means better performance.

These multibillion-dollar hedge funds are more likely to produce outsized losses than outsized gains, unless they're inclined to more or less roll Treasury bills and collect the fees.

It's my view that the hedge fund industry has made an enormous top, as have funds of funds, which are derived from hedge funds in the first place and hold a collection of other funds.

Turmoil such as we've seen -- and quite likely will see more of -- can only make life more difficult for these giant organizations. And that would mean more chaos for the markets and thus for all investors.

At the time of publication, Bill Fleckenstein did not own or control shares of any company mentioned in this column.