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The second quarter began just like the first quarter ended. The market rose on low volume despite numerous geopolitical and domestic challenges. It has been one heck of a run since the Federal Reserve turned on the printing press for round two of quantitative easing.

Since Bernanke foreshadowed the continuation of this program at Jackson Hole during the summer, the market is up over 25% and now sits above where the market stood before the events of the summer of 2008. Given the state of the economy, unemployment, the deficit, the European sovereign debt situation, etc….that in itself is hard to fathom. Given the Fed still has $200B left to soak up the continued excessive spending of the Federal Government until QE2 runs out until the end of the quarter, the market should continue to grind higher on low volume in the second quarter. However, it is feeling more and more like this is an unsustainable rally that will end soon thereafter. I believe we will soon hit an inflection point that will trigger a selloff of at least 15% - 25% by the end of the year. I base this on a myriad of factors.

Consumer spending: Job growth is slowly improving but wages are not. Gas is fast approaching $4 a gallon, and given the incoherent energy policy of this administration and the rapidly spreading revolutionary fever in the Middle East (which will not turn out well for American interests in the region), I don’t see gas prices falling significantly for the rest of the year, at a minimum. Consumer sentiment just posted its lowest measure of the year, which shows how much these factors are already impacting consumer psychology. All of this paints a scenario where consumer spending is unlikely to provide major support to the market in the near future.

State's budget situation: The Federal stimulus allowed states to put off the hard decisions for the past two years. It did little to increase jobs or economic growth and the stimulus has already slowed and will run its course by the end of year. States are now dealing with their still perilous situation in a variety of ways: Raising corporate income taxes by 50% in Illinois, furloughing or laying off state and municipal employees, raising various fees and personal taxes, and reducing/eliminating programs. These examples do not bode well for government spending’s contribution to the local and state economies. However, combined with the curtailing the power of state/local employee unions, they are all necessary, if painful adjustments.

Federal deficits/politics: Although the mid-term elections of 2010 reduced the business uncertainty of the previous two years and provided a nice boost to the market, the rising acrimony around the Federal budget could roil the markets at some point this year. Given that we can’t agree to cut even 5% of the total amount that the federal budget has increased over the past two years, nor have an adult discussion around the recommendations of the Simpson-Bowles Deficit Reduction Commission, I don’t see this situation resolved before some sort of shutdown or crisis forces it to be. This can’t be good for the markets.

European sovereign debt: I think it is getting pretty obvious that Greece and Ireland will not get through this crisis without some debt restructuring in the long run. In addition, Portugal is likely to be forced to take a bailout from the European Union before the end of summer. Given the slow growth in the whole of Europe, the austerity measures being implemented and the accelerating inflation throughout the region; it is hard to see Spain getting through the end of year without a bailout as well. These developments will not be good for the markets.

Middle East: Tunisia and Egypt’s rulers have been overthrown. Libya is close to civil war and protests are expanding in Syria, Yemen, Oman, Jordan, Bahrain, and even to Saudi Arabia. In addition, the United States has a totally random and poorly thought out strategy for dealing with this “Arab Spring”. The strongest and most organized entities in these countries are those belonging to radical Islamists. As such, it is hard to imagine a scenario where this end ups being a positive for the markets or Western interests. In the short term, it also puts a high floor under oil prices. If either Saudi Arabia or Nigeria experiences disruption, the markets and the West will have a major situation.

Federal Reserve: There is dissension in opinion coming from various Federal Reserve governors, a change in Congress, and the rising specter of inflation. Given these factors, it is hard to see a QE3 occurring. If one does materialize, it will not be received well by the bond or equity markets. QE2 did little to help the overall economy. However, it did a great job in inflating all assets, especially commodities and high beta stocks, as well as let the inflation genie out of its bottle. The potential for a significant market selloff once this program ends is great.

Given these factors, I am keeping a substantial portion of my portfolio in cash awaiting a much better opportunity in the near future to deploy my dry powder. I also have a good portion of my non-cash holdings in the TBTs. It is hard for me to imagine a scenario where long term interest rates do not rise substantially, given the withdrawal of support that QE2 provided, the inflation that's now in the pipeline and the lack of seriousness in tackling the budget deficit at the Federal level.

Disclosure: I am long TBT.

Source: 6 Reasons I Am in TBT and Cash Now