Friday, September 21, 2007


When US Fed Funds Rates hit a peak on February 1, 1995, the dollar began a blow off plunge. Record lows were made in March and April. Suddenly, on July 6, 1995 the FOMC had to change directions. The FOMC cut rates by .25. Each cycle is a little different. The second .25 cut did not come until December 19, 1995. For the next 5 years, the dollar index and the stock market climbed while real estate agents searched for a bottom in housing. Does this sound somewhat familiar?

The market climbed, inflation stayed tame and commodity prices rolled over. New production of commodities overwhelmed new demand.

Part of the reason many investors stay in a confused state around major turns is the J curve effect. The J curve is one of the "normal" paths that numbers take. For example, the relationship of blood pressure to the incidence of cardiovascular disease follows a J curve. There is a good chart of British Pound Sterling posted on the internet that shows the J curve that took place at the mid cycle turn in 1995. A good way to understand this phenomenon is to think through the process when there is a turn in a trade balance. When a currency is devalued, the higher cost of imports hits hard. Take gasoline as an example. When the price jumps, everyone does not go out and buy a new fuel efficient car the next week. Indeed, even though they may cut back on total miles driven, their total gas bill goes up. However, if the price stays high, more and more cars are traded and eventually the total fuel bill goes down because the reduction in the volume used eventually is bigger than the increase in price. We all know this to be true. We all understand that the laws of supply and demand dictate that the higher the relative price of a good, the less of it is used. Economists talk about the process in terms of elasticity of demand. Their point is that it may take more or less time to adjust to price swings for certain goods but the law of supply and demand still holds.

The accumulated effect of the decline in the dollar has put US exports growth on a solid growth J curve. Indeed, because the Yuan is linked to the dollar, the growth of Chinese imports has been spectacular. Indeed, a clearing price is near. The "blow off rally" has hit in several markets, including the Euro Dollar, the Canadian Dollar and Crude Oil. We are talking about a "capitulation rally." What's happening is the investors, including any hedge funds, that were on the wrong side of this market have gotten so tired of losing money that they are closing out positions. Specifically, those who were short oil future contracts are buying oil at all time record levels.

Congress has the responsibility of passing the 12 massive spending bills by September 30. One of these bills includes big tax increases on the oil industry. Of course, those who put the tax increases in the bills like to talk about how they are closing loop holes granted to the oil industry (by many of these same politicians). One of the ways the Democrats want to increase spending is by adding middle class children to the government health insurance plan. Bush says he will veto this "Trojan Horse" which is designed to build a European style government health plan.

Bush has said he is prepared to veto 5 of the 12 spending bills as they are currently written. He and Congress will grin and pretend to enjoy the signing ceremonies on the other seven as both sides will be holding their breath to avoid the stink of compromise. The Dems will probably go all out to force Bush to veto the children's health bill. As we all know, the jockeying for the best position in the 2008 elections is the point of this health bill. We all know that major healthcare reform is needed. In the mean time, points will be scored by two sides. Solving an issue is often not the best path to being elected to office. Politicians need an issue to run against to be successful.

The markets are to some extent hostage to this political process. Investors cannot be sure about what congress will do about the "BIG BILL". The BIG BILL is in regard to AMT (alternative minimum tax). Something must be done! Neither Congress nor the President would want to be responsible for 23 million middle class families to pay extra taxes this year.

The bottom line is that the deadline is due in 9 days. A continuing resolution could drag the deadline out another week or two but the pressure is continuing to mount. While I do not believe that the oil industry has manipulated prices at the pump, the timing of the blow off rally in oil seems to be about perfect for the industries political purposes. Of course, it makes all the common sense in the world for the industry to reduce investments when under the gun of a Congress bent on taxing the one industry in order to subsidize others. As usual, whenever politicians try to "drive the markets" they make very expensive wrong turns. The American people need an education in economics. They all should understand that the invisible hand of Adam Smith will lead to efficiency whereas the heavy hand of government will lead to excessive costs.

Once the bills are passed, a lot of uncertainty will have been washed away. Conditions are ripe for a continuation of this great bull market. Since the market bottom in October of 2002, big returns have been realized. Even in this seemingly tough year, the average stock is up about 10%. There has been a J curve dip in a number of areas but the staff of the J is going to be climbed over the next several years. Hold onto the bucking bronco and ride like the wind! BUY, BUY, BUY STOCKS, SELL, SELL, SELL LONG BONDS.