History does not repeat but it rhymes. I am therefore writing up the exact same security that I recommended during the Lehman weekend, at almost the same price.

The American stock market is overvalued, has practically no upside catalysts yet multiple catalysts that could soon take it down to fair value, which I judge to be about 20% below current levels and perhaps much more depending on future interest rates, market stress and general trust in our financial system. I choose the small caps over the large caps because they have outperformed on the way up and I expect the volatility to be mirrored on the way down.

-----------Valuation-------------

Same argument as in September '08: historically a normal P/S range is 0.6 - 0.8 and growth stocks perhaps deserve a ratio of 1.00. There's no way IWO deserves the current ratio of 1.20 (it was slightly higher on Sept. 12, 2008 at 1.25) so it has a downside of at least 17% with additional downside if economic problems spiral beyond what we happened last week. The rest of the write-up discusses the catalysts.

-------- Catalysts---------

Valuation itself

A bubble of strained valuations can go on for longer than you can remain solvent but when the psychology turns it's all downhill; that's when the "valuation is a catalyst" argument becomes valid, is especially in a market like this where the rally was low-volume with narrow participation (driven mostly by Wall Street research + gambling using government financing and High Frequency Trading).

World Equity Market Leadership

A glance at world equity markets may be surprising to some readers: almost the entire globe made a top, NOT in April but in the winter: from the BRICs to the European markets to Latin America. Only in America and certain Asian markets did the momentum continue until late April. Note also that the world is a leading indicator because since this reflation started foreign markets led the way up in terms of capital flows (various real estate bubbles are notable). So the U.S. market is a follower.

Europe & Sovereign Debt Issues

So much can be said here - this is everyone's focus anyway. Where I might add value is to zoom out and notice the big picture. Remember 2003 when a bunch of crazies talked about how deficits and debt will matter one day? Remember early 2009 when the acronym PIGS was being thrown around but the discussions were about *future* problems? The future is now; we are here and this is the moment of truth. The main show to follow is European politics and the ECB. So far there have been 6 separate attempts by European officials (and then the IMF) to make promises in front of a camera and calm markets. Every time, markets resumed de-risking trades after a few days. We can conclude the following (1) Europeans are horrible at taking bold action (2) the Eurozone as initially designed is a unworkable (3) countries in the Eurozone are politically very far apart and cannot easily compromise. Even if they compromise, there will be a deflationary depression which can exacerbate the problem. (as GDP declines, upward pressure remains on the Debt/GDP ratio). Plus, there's no guarantee that the underlying problems will be fixed. The only way the Euro can survive is by members getting much closer to each other and having a union with a currency for which there is political willingness to inflate. I think the chances are better than a coinflip that a year from today there will be no such thing as a Euro but regardless, the transition period to whatever new arrangement is going to be painful for markets.

Then of course there's the issue of the big 3: UK, Japan, US. It is certain that these countries will have to deal with government debt issues. Notice, however, that this is increasingly becoming the consensus - it's not just Niall Ferguson and Nouriel Roubini. Trying to question the consensus, I suggest the following thesis: the timing could be way sooner. Most people say these 3 countries will face risks in 2-5-10 years but there's a larger than appreciated chance that some switch will go off MUCH sooner and trigger a run that will shock most people.

Rising Interest Rates

This is a related issue: there's been a downtrend of almost 30 years for interest rates. Fed funds is now at ~0% and treasury yields bottomed in December 2008 (though we might revisit these lows in the shorter term). In any event, it would be a very good bet that during the next 10-20-30 years they will trend up.

China

With all the European stuff going on, not enough attention is being paid to what I think is a giant additional setback: anecdotal evidence is emerging out of China that the high-rise property bubble is imploding. Mentioned in various articles: developers giving 15% discounts on condos; April sales volumes down 40-50% MONTH-OVER-MONTH in Shanghai and Beijing; people desperate to sell apartments. It sounds to me like what we saw in the U.S. from fall 2005 to winter 2006 compressed into 1 month! A deflation of this bubble will for sure take the bid under commodities. Some economies will suffer (Brazil, Australia, Canada and more). There will be a smaller chance of Yuan revaluation, which in turn means bad news for U.S. exporters. Also, all this pushes up the USD which leads to further carry trade unwinds which takes down stocks.

Government vs. Banks

Political appetite for bailouts will be more limited should another credit crisis occur. Banks are exposed to further mortgage stress, most notably with option ARMs recasting in 2010 & 2011. The GSEs are still on life support and they serve to keep the housing market elevated. Most importantly, housing inventory is still elevated and much of it is owned by banks. The big banks are also exposed to sovereign stress, some banks have large exposure to currency and interest rate derivatives which are now going to be relatively volatile compared to other financial instruments. The U.S. economy is still quite leveraged and we need banks to function well because they're attached at the hip to governments and are instrumental in implementing policy. Any cross-contagion between sovereign and bank entities can cause financial markets to panic and send equities downwards due to a lack of confidence. Over the past few weeks sovereign CDS and bank CDS in Europe have widened together.

Economic Recovery Too Weak

When we come back from a recession as deep as 2007-2008, economic growth is supposed to be stronger than what we've seen if this were truly a V-shaped recovery. There are a few reasons to believe in a 2^nd half slowdown other than the above issues: end of stimulus, end of inventory correction and disappointing developments in construction and consumption. Unemployment is going to stay stubbornly high according to any common-sense analysis. GDP will suffer from the continued misallocation of capital by the big banks (speculation + yield curve carry trade at the expense of useful business lending). The US economy going forward is projected to eventually pile up a 60% debt/GDP ratio which according to Rogoff and Reinhart is enough to shave off 1% from GDP growth. If the American economy will indeed permanently slow down, P/E ratios deserve to be lower than they were during the 20^th century.

High Frequency Trading

HFT is still around; investigations are still ongoing and slow. The HFT crowd is totally unrepentant for Thursday's "flash-crash" and there is nothing to suggest that it cannot happen again. And because markets are overvalued and fear has set in, HFT is essentially a free put option on stocks. And if HFTs gets banned in some way, it will remove volume from the market which is not great either.

Summary

Basically, as in September 2008, the stock market faces many imminent and potentially accelerating headwinds and practically no tailwinds other than the possibility that this is a well protected V-shaped recovery with sustainable earnings superior to those predicted by analysts. This is another one of those times where you want to short the market, at least to hedge. It's going to be scary because the ECB has come up with a very aggressive package now including extra IMF participation, ECB intervention in the secondary market and commitments by Spain and Greece, but if we follow the pattern since 2006 we know how it ends: they're always behind the curve and Europe will suffer if real fixes are not put in place.