Friday, August 17, 2007


An economic turn is not a smooth corner three turn. It is a tricky turn where the central bankers of the world have to pay attention to what one another is doing and avoid a number of obstacles littered across the roads. Ben Bernanke, the current chairman of the FOMC, has done a fantastic job of navigating the hazards. This morning, he added what I believe will be the master stroke! He has lowered the discount rate by one half of one percent and loosened the rules. Financial institutions will, for the foreseeable future, be allowed to deposit subprime and other assets as the collateral for loans. THE FED WINDOW IS OPEN FOR BUSINESS!

Does this mean that all stocks will go up from here? NO! Does it mean the momentum players that were driving down weak stocks by short selling are caught in a noose, YES!

One key way to observe and understand the turn is to note that basic material stocks and financial stocks are on opposite ends of a "see-saw". This is a generalization because there are certainly many differed species of financial and basic material stocks. In other words, a regional bank that makes most of its money by lending businesses is very different from a mortgage broker. Still, again, it is generally true that at the turn, the basic materials will start to perform relatively poorly at about the same time that financials start to outperform.

Look at the recent action. Yesterday, the financials lead the market during a huge afternoon rally. The two day average of financials is a gain of 3.4%. The two day average of energy stocks is a loss of 1.3% and materials lost .5%. Over the past 4 days, financials were down .8% WHILE MATERIALS WERE DOWN 5.9% AND ENERGY WAS DOWN 5.5%. OVER THE PAST 21 DAYS, MATERIALS STOCKS WERE DOWN 14.8%.

Understanding the relationship between financials and materials requires just a little thought and a little common sense. Suppose the US economy is about to move into what is commonly called the "prosperity phase" of the business cycle. In this phase, businesses expand because profitable ventures can be easily found. Under this environment, the demand for business loans is substantial. Thus, cheap money, the type used to build million dollar ocean front beach homes is no longer available, but business rate money is available for borrowing. At an 8% prime rate, many a business loan makes sense in this environment as business might make one expansion after another where there is a 15% return on invested capital. The 8% loan is hard for a beach home owner to swallow.

With the demand for business money being high, real interest rates stay high. When real interest rates (the interest rate minus the inflation rate) stays high, those who have hoarded basic materials face a high cost of carry. In other words, during times of cheap money (when interest rates are close to or even below the inflation rate), it makes sense to hoard oil, gold, and other materials.

The other thing that has happened is that capacity to produce materials has soared over the past few years and new capacity is set to come on line again and again over the next few years. Put another way, when the price of gold soared from the $300 range to the $700 range a few years ago, the price went way above the cost to produce it. Thus, for the past several years, miners have expanded capacity as quickly as they can. The same situation exists with oil. Just a few years ago, it was widely known that Canada has more oil in tar sands than Saudi Arabia has in desert sands, but virtually none of this oil was being extracted. Today, refineries in Detroit and Illinois are being expanded to handle the new oil flows and a mega refinery is planned for South Dakota. In addition there is a new refinery under construction in Canada and others are being expanded. Tons of oil is being produced at a cost of about $35 per barrel. With oil likely to trade at more than $35 per barrel for many years, you can expect rational oil men in Canada to continue to expand production.

Does it make sense that the price of oil is showing signs of rolling down substantially? Does it make sense that energy stocks have taken it on the chin hard during the past few weeks while financial stocks that have underperformed for years are suddenly showing signs of life!


PLEASE FORWARD THIS EMAIL TO A FRIEND SO THAT HE OR SHE MIGHT UNDERSTAND THAT A MAJOR MARKET MOVE IS ABOUT TO GET UNDERWAY. As always, I cannot promise that there will not be more bumps in the road. Conditions are ripe and the FOMC has opened the gates in a major way. The FOMC did not break the damn. It did not lower the Fed Funds target rate and the discount rate is still one half percent higher than the Fed Funds target. Still, relief is there for a lot of problems. Valuable paper that has not been tradeable for the past week or more is now acceptable collateral for loans. Banks will be able to buy tons of loans at significant discounts. The discounts will be dramatically reduced quickly as the huge majority of all these mortgages are "good money". The borrows will pay every cent!