Amoral Majority

“Party like its 1933!”

Even though ‘optimistic’ is not a word I would have attributed to my outlook of the last several months (“We’re Just Sitting Around Blowing Bubbles 2/11/09″ & “We’re All In, America 3/1/09″), it was obvious even to me that a global rally was quite likely as I mentioned in my most recent post (“Dirty Jobs” 3/8/09“).  Massive losses for almost 18 straight months were topped off by the straight line decline of 8300 to 6500 in the Dow Jones Industrial Average in two weeks at the end of February/beginning of March.  Pessimism had reached a breaking point.  Sure enough, it didn’t take much of a glimmer of hope to spark what by all means was the greatest rally ever seen.  U.S. equity markets closed Friday afternoon (4/3/09) with four week gains of 25% starting later in the week of 3/9/09 – you’d probably have to be almost 100 years old to have been investing in 1933, the last time similar (better) gains were seen.

Despite an array of – literally, in many cases – the worst economic data ever, global stock markets are acting differently.  Emerging markets are up over 25% as well during this period, commodity prices like copper and oil have rallied to, in some cases, 6 month highs; it seems like the world is starting to get the wheels turning again.  The Volatility Index (VIX) that measures fear through options volatility dropped to its lowest levels since January and February during the last rally attempt.  More telling, though, is that the short term peaks have been trending down since peak levels in November (click the Symbol to see).  This seems to indicate that there is progressively less and less panic.  At the current level of just under 40, it makes these coming weeks very interesting to watch.

We’ve had many ‘bear market rallies,’ as they are commonly referred to, but I would argue that each of them was sparked by something artificial (fake). Treasury/Congressional/Fed/Regulatory actions caused people to get overly optimistic in the short term despite the looming disasters and uncertainty surrounding banks.  Now lies the dilemma.  What sparked this rally?  Really, nothing – except the market tendency to seek equilibrium (as in, when prices get low enough, there is an excess supply and prices fall).  Banks came out and said they were making operating profits four weeks ago.  This is meaningless – if a bank weren’t making operating profits, it wouldn’t be running at all for very long, recession or not.  When we consider that almost all bank losses have been concentrated in other areas of the balance sheets, this wouldn’t by itself do much.

The market would’ve taken anything at that point, though.  Any glimmer of hope, or something less than the end of the world, and people would start buying bank stocks at the prices they were at.  With the Federal Reserve’s decision to monetize its debt (3/18/09) and the Treasury’s release of its long awaited Public-Private Investment Program – PPIP – details (3/23/09) that were very beneficial to Wall Street (perhaps at the expense of the Taxpayers?), financials, energy, and commodity stocks had every reason to continue the rally that began the week of 3/9 on essentially no news.  This is different from prior rallies that had started after plans were announced.

Four weeks later, it is tough to say with confidence where we go from here.  Stocks have every reason to pull back as people lock in their profits of recent weeks – this is the common wisdom.  Stocks don’t go up in straight lines just as they don’t go down in straight lines like those weeks of late February and Early March.  Yet I continue to hold strong into next week, however.  As I mentioned, the VIX is at a key technical level.  If it breaks through to the downside (signaling a lessening of the panic), that will be a great ‘buy signal’ for a market dominated by computer algorithm trading.  Not to mention, it probably means stocks are going up.  And stocks, too, are at key technical levels.  The NASDAQ is now positive on the year and above 1600.  The Dow is above 8000 again, and the S&P is right above its key 50 day Moving Average (840) at 841.  A breakout above that level will also signal a buy.  Banks are at these same technical levels, etc etc etc.

This Tuesday 4/7/09 kicks off a couple weeks of earnings announcements, when *anything* can happen.  Depending on expectations, it can vary as to how the market reacts to losses and gains.  In some cases, gains will be less than expected, while in other cases losses can be better than expected, etc.  I’m interested to see if the banks have improved earnings on write-ups that they are allowed to take in Q1 as of the FASB mark-to-market accounting standard adjustment.  Earnings are already expected to be BAD.  Very bad.  If they aren’t quite as bad as expected, or if many firms’ outlook is for better earnings in the future (than are currently expected), we may be pleasantly surprised this quarter.  Technology leader Research in Motion (RIMM) blew away the estimates Thursday afternoon, for example.  Another key signal to me is in the currency markets, which I watch somewhat religiously since I view it as a great indicator of global sentiment.  The Japanese Yen has reached its weakest level against the Euro and Dollar since January, which signals a lessening of global fear.  The Dollar has weakened dramatically (especially since the Fed announcement), which also signals investors are willing to take on more risk.  The USD/JPY is just over 100, and the EUR/JPY is just over 135, levels that are key.  Weekly closes over those levels were great signs from a sentiment perspective.

Basically, it seems like everyone is expecting a pullback and waiting to get in again near the lows so that they can take advantage of the gains we saw these past 4 weeks whenever ‘the bottom’ is reached.  From what I know of history, however, few people catch bottoms by default because they usually occur when things seem the worst.  In addition, they usually leave most investors in the dust looking back saying ‘what happened?’  It could be that kind of scenario.  When everyone is waiting for and expecting a pullback, it signals that there are still plenty of short-sellers, and plenty of people who may panic on upmoves either by covering their shorts (equivalent to buying shares) or regular buying to participate.

We have gone down so far still, that even 25% is nothing compared to the drops.  The Dow is still a long way from 14,000 – even if we get nowhere near it, which we probably won’t for many years, we still have substantial room to move to the upside.  Each dip seems to be bought in relatively short order, as opposed to the massive drops we’ve been seeing for so long now.  It just feels like investors (globally) are back to looking for opportunities rather than non-stop selling for days or weeks at a time.  Bond prices have continued to stay very high as well (further inflating the bubble), and I would bet that if stocks continue to rally, many investors will shift out bonds and into the more attractive asset in equities.

That is still a big IF.  I am being very cautious here, because I don’t know how likely it is that my scenario plays out.  If the market does turn back and start heading down big, I admit that I will be jumping ship.  I know there are problems on the horizon and that it’s only a matter of how much has already been ‘priced in’ to stock prices (since equities are always forward looking).  It’s hard to know what is priced in and what is not, so it’s wise to be careful.  Yet with the truly terrible economic data being shrugged off, I have begun to wonder if there is anything that can really scare this market so much so that the opportunistic investors waiting for the pullbacks won’t buy each time from here on out.  Everyone has seen the upward pressure that can ensue, so its unlikely that there will be nearly as many panic sellers as there were in the prior year.

So I’m partying like its 1933 and not ready to give up on this rally quite yet.  So many historic things have happened that I am not shocked at anything anymore.  As we have only seen historic things to the downside, I tend to think it is possible (probable even?) that one of these days we will see something truly historic on the positive front.  There are more people short-selling stocks than ever before, and with this week’s looming reinstatement of a modified Uptick Rule, we may see a further – and potentially much larger – short covering rally as we break through technical levels.

It’s definitely possible that things are not (and never were) quite as bad as we have thought…. I being as guilty of it as anyone.  There are still (arguably major) problems on the horizon, but stock markets cause global recoveries, they are not an effect.  As I said in my previous post (“Dirty Jobs” 3/8/09), “optimism can feed on optimism this spring.”  And we haven’t really seen any GOOD news yet!  Some glimmers here and there, but what do you think this market will do when it gets some POSITIVE economic data rather than better than expected bad data?  We could be weeks and months away from that, but it seems like a recovery is becoming all the more real.

I’ll admit it;  I’m more optimistic than I’ve been in at least 6 months, even from a short-term perspective – as indicated by the length of this post.  If this global (this is the key, since the US has built its debt to unprecedented levels) recovery in equities is sustainable, it will cause the recovery to begin since stocks are leading indicators.  As Yogi Berra said: 90% mental, and the other half physical.  Global sentiment had probably never been lower; while it is still possible for things to worsen, it seemed pretty hopeless there for awhile.  Just 4 weeks later, we have made substantial progress.  And I don’t mean our worldwide Governments (The G20 is laughable), I mean our mindset.  Pyschologically, I think we may be ready to take on whatever problems still lie ahead.

“Dirty Jobs”

The Bank Index is down 60% in 2009.  To be able to say that with a straight face is kind of remarkable, seeing as it is early March and 2008 wasn’t too kind to the industry either.  When you also consider that it’s down more than 80% since mid-2007, the magnitude of the crisis is put into perspective.  At the core of the problem is the mortgage market, which is completely clogged.  Since some mortgage securities had become worth less (in some cases much less) and there was no regulated open exchange of these securities, all the mortgages simply became worth zero as the downward spiral was exacerbated by uncertainty. Add to that the incredible problems this has led to in derivatives (AIG’s hemmoraging of money), and we get to where we are now.  Some would argue, though, that the housing bubble would not have collapsed nearly as quickly or as hard (maybe not at all?) if there was an open market for these securities with full information.

Of course, investors did not seem to care much about the information anyways.  They were more concerned with the huge returns and decided it wasn’t worth asking questions… but for now, let’s assume that this happens in all types of markets to some extent, which is probably true. It was kind of like musical chairs: When the music’s over (my favorite Doors song), who is the one stuck without a chair – in our case, who was stuck with large amounts of leverage in assets that were now worthless?

But, to continue the analogy – who decided to stop the music?  If there was more information provided through better regulation and/or open exchanges, not all the securities would have become worthless such as they are now.  Not to mention, everyone holding these certainly shouldn’t have been forced to assume that they will always be worth zero, as is the logic of mark-to-market accounting (M2M).  While the rule does make sense in normal market conditions, the current situation has become one where financial institutions have to mark the securities quarterly at much lower than they would ever sell them for in the future, which then causes them to have to raise more capital, which makes their stock price go down and credit default swaps blow out, so that they have no way of raising capital, etc etc etc.

What sense does any of this make?  If I’m not planning on selling my house, I don’t give a rat’s a** what the price of it is at any one specific time.  M2M is good for comparing companies within industries – it is supposed to help investors gauge what the value of a company is.  But we have strayed far from that goal. I have no doubt we should return to M2M in the future – again, for comparative purposes – but we need to stop this irrationality that has developed as fear has fed on itself.  “…nothing to fear but fear itself.”

This week, Congress will have a meeting to decide whether or not to call the plumber and have him look at unclogging our pipes. They (and the Fed) have been trying everything they can think of to fix the problem themselves with various unorthodox methods, but they should just stick to the norm.  When they decide at the meeting to call the plumber, we may get the water moving again.

By assuming for a minute that the banks would not sell their securities at zero (or 20, 30 cents on the dollar) just because the market doesn’t know what they are worth, why make them hold capital as if they were doing just that?  Why not instead try to get to the bottom of what the prices are of these assets and while we’re sorting that mess out, maybe for just awhile say that institutions do not have to have capital to back up a price they wouldn’t take for an asset?

Congress is having a meeting to discuss M2M this Thursday.  Despite the fact that this plumber has his work cut out for him since the clog in the pipes caused damage of unequaled proportions to our house (financial system), he can unclog this pipe so we can get our water moving again; then we can begin to repair the damage.

I have heard it argued that lifting M2M will cause more uncertainty as investors would know less about the assets on the books, but these have usually been people who are known as short-sellers.  While short-sellers have been right if you want to look at it that way (many do, including myself), it does not give any more merit to their opinion than anyone else trying to sell you on something.  If this huge burden was lifted off institutions’ balance sheets, you can bet that some of the massive amounts of money sitting in conservative investments will come pouring in.  Just as fear can feed on fear, optimism can feed on optimism this spring.  I bought stocks last week for the first time in months, and if nothing else, I think we’re due for a huge global rally.  Global markets have pretty much gone down in a straight line in 2009.  Just since the 2nd week of February, the DJIA went from 8300 to 6500.  Even at my young age I know that kind of thing doesn’t happen often.

We’re All In, America

The striking thing in Warren Buffett’s letter to shareholders (2/28/09) was not that his Berkshire Hathaway had its worst year in his career.  To me, it was striking that his words sounded like those of a 78-year-old man who wishes to warn the world about what scares him before his time has run out.  Never before has Warren Buffett sounded so emotional and forthcoming; nor has he ever sounded his age.  This year he seemed to be ‘spilling the beans’ as the popular phrase goes. In the letter, he warns that derivatives were very dangerous and that many firms had knowingly created this system stating,

“From this irritating reality comes The First Law of Corporate Survival for ambitious CEOs who pile on leverage and run large and unfathomable derivatives books: Modest incompetence simply won’t do; it’s mindboggling screw-ups that are required.”

The superstar investor continued, writing:

“In poker terms, the Treasury and the Fed have gone all in.  (emphasis added).  Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel.  These once-unthinkable dosages will almost certainly bring on unwelcome aftereffects.  Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation.”

He also mentioned a Treasury bubble – as described in my previous post – that may be as extraordinary as the internet and housing bubbles.

The Treasury and Fed are all in with our money. So, we’re all in.  The few who responsibly managed their budgets are now bailing out the majority who didn’t, albeit on an individual or a business level.  Moral hazard is now an extinct ideology.  There is no incentive to be responsible even if it were possible to overcome being soaked dry by ‘the “good” of the people.’  I know this:  I’m no good at poker, but if I had the hand America is being dealt, I sure wouldn’t want to go all in, especially if Buffett’s assertions are even partially true.  Our debt is in a bubble set to pop, we owe the world $10.9 trillion, and we plan to allocate an addition $3.7 trillion to the federal budget this year, which includes $1.75 worth of more deficit borrowing.  The only thing still holding this all together is that the rest of the world depended on our stupidity.  Their exports have fallen dramatically as we stop consuming so much.  It’s only a matter of what will happen first – will the rest of the world find other people to sell their goods to, or will our economy recover fast enough to where they still remain dependent on us in the future?

Warren Buffett said that he agreed with the government’s actions, because without them, we would have faced cataclysmic consequences.  So I guess maybe we look at it this way:  if you only have one chip left, maybe you do have to go all in.  So there you have it.  We’re all in, America.

The market watch for March doesn’t look too promising.  The Dow and S&P indices closed on 12 year lows on Friday.  That said, the government” hope bubble,” as described in the previous post, was alive and well this week.  Before a pull-back on Friday, when the government took up to a 40% stake in Citigroup, the index tracking the banking sector was on pace for the best week in history on hopes that government actions would be beneficial for banks.  With Warren Buffett’s disclosures on derivatives showing how much they were hurting even someone like him, it is clear that the government cannot and will not save the banks from mounting losses they don’t even understand.  At this point, it seems equally dangerous to be invested in Treasuries or equities.  If the financial sector sees a further break-down, the effects on all areas of the economy will suffer.  Precious metals like gold and silver seem to be the safest asset class as it is inevitable that inflation takes off at some point as countries all over the globe destroy their currencies.  Stocks seem cheap right now, but it is likely what’s known as a “value trap. “  There is a reason that stocks are at 12 year lows.  Future earnings for companies are very uncertain, repercussions of government actions remain unclear, and perhaps most importantly, people don’t have money to invest.  All asset classes are seeing heavy withdrawals and redemptions, which means that the deleveraging is far from over.  Commercial real estate is seen as a looming disaster, which means the economic woes are far from over.  It is not a bad idea to start buying some small positions in quality stocks and adding to them as the market declines in the next few weeks or months, but I would not be putting serious money into stocks right now just because they are ‘on sale.’  If you can get them for cheaper later, why buy now?  Don’t go all in like our leaders have done. It’d be one thing if those were my naive words but when they are the words of the greatest investor of our time, it makes you stop and think.

“We’re Just Sitting Around Blowing Bubbles…”

A few bubbles have popped. A housing bubble and various commodity bubbles have come and gone. Asset-class bubbles have burst as well with others soon to come; mutual funds lost 30-40% on the year while the hedge fund industry took its biggest losses in history during 2008 – in many cases, years worth of profits and retirement savings were wiped out. Pension funds (much larger asset class than hedge funds) and private equity funds have yet to deleverage and take realized losses as was so publicized in hedge funds in late ‘08.

Yet there are other – potentially more damaging – bubbles on the horizon. While the US Congress sits running around in circles trying to find out where the problems started (which really is a circle since they will only end up finding out it was themselves not to mention a whole host of other problems like the Ratings Agencies, but I digress), we are looking at bubbles in government debt not only in the United States, but in Europe and Japan as well. Interest rates have gone down as low as they can possibly go. Add to that an ever-expanding debt burden with each coming week’s worth of bailouts, stimulus plans, and backstops, and we have a scenario where inflation is inevitable when the global economy does start to recover. As with every past bubble, a collapse of the T-Bond bubble could mean a severe correction. This would lean more towards hyperinflation than inflation as demand for US debt dries up and the Fed is forced to print money to pay off even the interest rates on the *official* $10.7 trillion National Debt (see: fiscal gap which was calculated at $65.9 trillion even as far back in 2006 – I wonder what this would be now).

The “strong” US dollar as typically bubbles up in recessions is not very strong by historical standards, which signals that the lows for the dollar index in mid 2008 will soon be revisited and then some when the global economy corrects.

Gold is bubbling up as we speak, and this will likely continue to grow as uncertainty reigns king.

The most dangerous bubble has clearly shown itself this week (week of February 9), which you wont hear the pundits talking about. The government bubble is a new phenomenon, and it could probably just as well be named the Obama bubble (Obamubble?). There is an underlying theme lately that seems to be expecting the government to solve our problems. I myself fell victim to it at the peak of the panic. In retrospect, the government will not and cannot fundamentally solve our problems. They have done nothing but exacerbate many of the problems by throwing money at them. The leverage put on in recent years by pension funds, insurance companies, sovereign wealth funds, hedge funds, firms, and individuals was excessive and is now being removed. The government trying to salvage those that need to be removed does two things, neither of them good. First, it is a losing proposition, and the losses are placed on the future taxpayers. Second, it causes the good sectors where that money would have been used to become less safe, and potentially even pushes them into unprofitability as well. Since it is political season, it is clear why we as a populace have become so short-sighted.  Yet even if one concedes that public demand taking the place of private demand now nonexistent is not the worst idea in the world, in the long-term, there is no way out of this problem that doesn’t involve the US Government and populace saving more and spending less.  As it stands now, the Government is trying to plug the dam with (pun intended) bubble gum. Be careful out there!

US equities are likely to continue retesting the lows of late November in coming weeks as the global economy continues to deteriorate and hope in government plans falters. If the Dow breaks below 7450 and S&P 740, we could be setting up for another economic downwave and more bad news from stocks. There had been alot of bottom fishing at the year end as volume deteriorated and then became enthusiasm about the Obama stimulus plan. If the bottom fails, the money could just as quickly run for the exits. At 7000 on the Dow and 700 on the S&P, ride the wave back up before selling into the rally back near 8000.  These are large moves, and currency markets lately have been on edge as all the Yen crosses have made new lows in 2009 as have many major global stock indices. The US should be soon to follow as the government hope bubble is burst.