V-Shaped Bottom or Second Valley? The truth can earn you 79%.  Watching economists attempt to find consensus can be like watching a burlap sack full of cats – lots of sound and apparent action, but precious little benefit.

Unfortunately, you eventually have to open the sack full of angry cats to find out how it all comes out. And then there’s that part about going to jail (or hell) because you put cats in a burlap sack.

Not that I would ever do something like that. This is really just one of those mental exercises. But I do watch economists a lot. I guess someone has to.

The One Real Question

The big argument this week: “The V-shaped bottom” versus “The Second Valley.” I guess we should open the sack a bit and see who’s winning.

Adherents to the former believe that we have seen the worst that fate (or rather our own stupidity and credulity) can dole out. They connect the dots thusly:

1. Real estate crashed,
2. The banks crashed,
3. The market crashed,
4. We had a recession.

The Beginning of the End

Now they believe that the recession is drawing to an end. They know this because real estate is selling again (albeit at dramatically lower prices), the banks are being taken over by Washington, and American corporations are hemorrhaging just a tad less cash this quarter than they did in the last quarter of 2008 (or in the first quarter of 2008… or maybe the fourth quarter of 2007… whatever. It doesn’t really matter which, so long as the comparison makes the situation look less dire).

It’s kind of like the line from the old blues song: “I’ve been down in the gutter so long, the curb looks like up to me.” To these sunny-minded optimists, “a little less bad” is the new “good.”

They have even found a way to describe the bankruptcy of two-thirds of the American auto industry as “a good thing.” It’s all about “certainty,” you see. When we were only pretty damn sure GM and Chrysler were bankrupt, that was “uncertainty.” And everyone knows uncertainty spooks Wall Street.

Certain Losses

But now we are absolutely sure that bond and stockholders will lose billions of dollars, and that plants and dealerships across the country will close, destroying hundreds of thousands of jobs and evaporating even more billions in increasingly rare tax revenues.

Well, now we definitely have “certainty,” although perhaps not clarity.

And the conclusion the “V-Shaped Bottom” types draw from all this? Spring 2009 was the grand bottom. Now anyone who doesn’t buy shares indiscriminately will miss out on the chance of a lifetime.

The Ugly Truth

The “Second Valley” types are a hair less optimistic. As they see things, the victim of our little train wreck has stopped bleeding so much mainly because the patient is running out of blood. And all that is in that transfusion bag is plasma – a thin substitute for Type O.

Second Valleyers see the facts as somewhat more complex, and a good bit more disturbing. Here’s how they line up the dominoes:

1. For the better part of a decade, Washington pumped trillions of new dollars into the system. (Actually they have been doing that for several decades, but that is a different day’s rant.)
2. This made the market price for all sorts of things – stocks, real estate, oil, food, electricity and of course gold – go up. Not the value of any of these things, mind you. Just the number of dollars you might have to give up to get a unit of most anything.
3. Unfortunately, wages simply could not keep pace with this inflation without destroying Wall Street’s ostensible profits. Thus we see folks borrowing more and more, to buy fewer things worth even less.
4. Eventually folks began defaulting on those loans, be they credit cards, car loans or mortgages, beginning of course with the most vulnerable low-income types, with their “NINJA” loans (”No Income, No Job or Assets,” for those of you who missed out on this particular bit of accounting fraud) and such. For a while the middle class could act smug, but inevitably most all of the country proved to be somewhat over-extended.
5. Now we see the bubbles pop: Down comes real estate, down comes the banks, down comes Wall Street (whose delicate dollar-inflated profits were doomed after all), down comes oil and steel and pork bellies, the whole nine yards as it were.
6. And finally, to solve all this, in essence to re-inflate Wall Street’s bubbles, Washington proposes to pump trillions more fresh dollars into the system.

Highway Robbery

Second Valleyers tend to see that last item as a bit of a problem.

Okay, that’s an understatement.

Actually, they see it as a nigh-treasonous act of currency debasement, in essence, a secret tax on most every citizen who managed through common sense to avoid pouring their wealth down the toilet during this debacle. In the end, they warn that this sort of irresponsible pandering will lead to the collapse of the American economy.

Propping Up Zombies

What’s more, Washington’s dollars are propping up bad institutions that most probably ought to be allowed to fly or die on their own. Just look to the troubles Great Britain, Japan and South Korea had for decades when they refused to allow financial Darwinism to take its natural course.

But these are long-term issues, and the Second Valley theorem warns of far more immediate problems. It notes that more Washington dollars do not actually solve any of the endemic troubles that laid us low back in 2007.

In fact, it may even make many of them much, much worse.

Caught Between a Rock…

All those proliferating dollars are once again creating artificial new highs in all sorts of commodities. Cotton, copper, steel, and most especially oil are all hitting six-month highs.

Where once those same economists (you know, the ones we tied up in the burlap sack?) argued as to whether oil could beat $50 a barrel this year, now they are falling all over themselves to be the first to call for $70 oil next month.

The plain and simple immediate result? American business has yet to show a genuine recovery. Sales are still god-awful slow, and margins are stretched so thin as to be invisible. And now raw material costs are shooting up ahead of the curve.

… And a Hard Place

American families are caught in the same vise. Just as they figure “Maybe, just maybe we’ll pull through this,” their gas costs and food costs and who-knows-what-else costs are starting to climb right back toward the tipping point that put us all in the soup in the first place.

No wonder spending is down and savings are up. It’s the first rational act we’ve seen in over a decade.

The net result: next quarter’s profits are going to really stink. Probably worse than the previous quarter, and possible worse than most any quarter they try to find to make things look prettier.

Tipping Into the Second Valley

And when word gets out about it, you can just bet that stocks (at least the most vulnerable ones) will take it on the chin again too. Thus the sobriquet “Second Valley,” wherein both the economy and the stock market do a quick three-month gut check.

Now I must confess that I do believe in most all of the tenets of the Second Valley Theorem. But I am also a bit of a realist.

I don’t really know for a fact that the Dow will reach all the way back to 6,469 again. Perhaps it will just grind along around these levels for a month or three. I am even willing to concede that more than a few stocks will actually shine during this episode. However, I believe that they will be the exceptions rather than the rule.

Use the Pinch to Squeeze Gains out of Transports

And I certainly believe that certain companies are exceptionally exposed to downside during this period. For example, I asked my WaveStrength Options Weekly readers to purchase put contracts on FedEx (FDX:NYSE) last Tuesday, because the freight company is exposed on two fronts.

A slowdown this summer will reduce outright sales, while spiking oil will raise FDX’s chief costs – gas for local vans, diesel for long-haul rigs, and kerosene for jets – to untenable levels. We are looking forward to short- to mid-term gains of 44%-79% off this play.

I advise you to do something similar. Both FDX and UPS (UPS:NYSE) look like good short candidates right now. And if you are unwilling to short a company or speculate on downside with put contracts, at the very least, please purge any transports you may have picked up over the last few months.

Source: The Truth Behind the Second Valley Theorem