It has been a long day, but I want to add one note to Thursday night’s piece: I would not sell the market immediately.? The summary of my recent research is that market moves from undervalued to overvalued, to more overvalued.? At more overvalued, momentum of the market slows down.? This is the time to exit before the correction occurs.? Momentum is still strong enough, but when momentum gets average when valuations are high like today, it would be a time to exit.? We are not there yet.

As for what is weak, there is housing.? Dark supply.? Many investments in housing are pre-planned losses.? Probably better to be in money market funds.

Gains and losses are not purely random, they tend to streak.? Here’s my stylized view of how an equity/credit cycle works:

1. After a washout, valuations are low and momentum is lousy.? People/Institutions are scared to death of equities and any instruments with credit exposure.? Only rebalancers and and deep value players are buying here.? There might even be some sales from leveraged players forced by regulators, margin desks, or “Risk control” desks.? Liquidity is at a premium.
2. But eventually momentum flattens, and yield spreads for the survivors begin to tighten.? Equities may have rallied some, but the move is widely disbelieved.? This is usually a good time to buy; even if you do get faked out, and momentum takes another leg down, valuation levels are pretty good, so the net isn’t far below you.
3. Slowly, but persistently the equity market rallies.? Momentum is strong.? The credit markets are quicker, with spreads tightening to normal-ish levels.? Bit-by-bit valuations rise until the markets are fairly valued.
4. Momentum remains strong.? Credit spreads are tight. Valuations are high, and most value-type players have reduced their exposures.? Liquidity is cheap, and only rebalancers are selling. ?(This is where we are now.)
5. The market continues to rise, but before the peak, momentum flattens, and the market meanders.? Credit spreads remain tight, but are edgy, and maybe a little volatile.? This is usually a good time to sell.? Remember, tops are often a process.
6. Cash flow proves insufficient to cover the debt at some institution or set of institutions, and defaults ensue.? Some think that the problem is an isolated one, but search begins for where there is additional weakness.? Credit spreads widen, momentum is lousy, and valuations fall to normal-ish levels.
7. The true size of the crisis is revealed, defaults mount, valuations are low, credit spreads are high.? A few institutions and investors fail who you wouldn’t have expected.? Momentum is lousy.? We are back to part 1 of the cycle.? Remember, bottoms are often an event.

You could call part 4 of my stylized cycle “borrowed time.” But it is borrowed time that can last a long time.? At the end of the bull cycle, the equity market catches up to the credit market, creating a situation where the valuation of the equity can no longer be sustained by further increases in leverage (part 5 leading to part 6).

Note to readers

I will be sending part 1 of my Impossible Dream research to clients this coming week.? In the next week, those that have asked for the research will get part 1, and clients will get part 2.? The week after that, those that have asked for the research will get part 2, and I will publish part 1.? The week after that, I will publish part 2.

When I was a corporate bond manager, I was relatively open about my ideas, because I knew that imitation was a lot more difficult than it seemed.? That is still true now.? But out of honor to my clients, they get the first look, and requesters get second look, and casual readers get third look.