Friday, November 30, 2007

10, 9, 8, 7, OOPS....6, 5, 4, OOPS....3, 2, 1 BLASTOFF

Summer before last, I wrote that I had decided to "ride through the mid cycle correction". I reported that I had purchased bonds in my most aggressive accounts to provide a little cushion but I would hold my stocks. Since that time, the price of bonds has soared and the mid cycle correction has taken three times as long. The market moved up prior to the correction so the average stock has only done a round trip, making new highs before getting hit hard.

In hindsight, I should have sold all stocks, used all money to buy bonds and only switched back to stocks three days ago. Of course, with perfect hindsight the market would trade as "smooth as glass" because all of us would have perfect vision. The good news is that the mid cycle turn has finally been negotiated. While there could still be fallout from companies hurt the most by the draw down of liquidity in the past, the present loosening by the FOMC will gradually solve most ills. Those companies that have been contemplating drastic actions to survive can now see that all they need to do now is hang in there for a little longer. The situation is like the lady that swam the 22 miles between a California Island and the mainland coast only to quit in the fog about 50 yards from shore. Had she only know how close she was, she would surely have found the strength to complete the task.


Prior big drops in interest rates at mid cycle turns show the power of interest rates. Interest dropped hard from August 1984 until October 1986. The market climb started soon after the first drop and continued through the summer of 1987. The interest rate decline beginning in February of 1995 continued until the first FOMC response in February of 1996 and the market climbed until March of 2000. The decline that started in August of 2007 is gathering momentum. Big Ben seems to be ready to follow the 90 day t-bill down which implies a cut of at least 100 basis points even if the flight to quality ceases and the 90 day rate bounces 50 basis points. Ben will probably not do all 100 points at the next meeting but the market is ready for all the relief it can get as soon as it can get it. Congress now has a self imposed deadline of December 14 to complete the budget. Negotiations over recent days indicate that the congress will actually cut taxes! Surprise, surprise, surprise, a democratic congress forced to cut taxes!


There are literally hundreds of indicators that the economy has made the turn. Some of my favorite ones have been posted by Don Hayes. To provide order, I will include Don's indicators among others, including a few from Brian Wesbury and a few from Martin Capital.

The ratio of the CRB futures index to the Bond Futures index dropped from April 1996 to November 1998. This big "drop in inflation" was during the fun days of the 1990's BIG BULL. This indicator peaked in May. The decline in sensitive metals such as copper, aluminum and zinc has been underway for a while, over the past several days it appears that the oil is starting to get flushed down the same hole. Last week, traders were doing their best to push oil over 100, now they are holding on for dear life at $89. In the previous oil crunch, it took a massive discovery of oil in Alaska before the tide was turned. This time the most massive of discoveries was in Brazil. It will take a few years for the new oil to flow from Brazil but, so far, without the oil from Brazil, non OPEC producers have increased production by a couple of million barrels per day since 2003. Much more will come on line over the next few years.

Construction Spending bottomed in 1995 long before the big move in stocks. Despite the reports you hear in the news about the housing market taking several more years to get going again, the momentum in construction spending has already turned. Current monthly home sales are greater than home sales at the bottom in 1995. Recent declines in mortgage rates combined with wage increases have made millions of homes affordable to millions of consumers.

WAGES AND BENEFITS: The 12 month increase in wages and benefits just set a new all time record. The increase in total compensation in one year was $475 Billion. Yes, almost a half a trillion dollars in additional pay. It is highly likely that this $475 Billion will be paid again next year and the next and the next. At a time when readers are sending me stories about predictions of bankruptcy and disaster, unemployment is low and pay is high. Despite what politicians like to say, the average person in America has benefited greatly by the combination of free trade, technology and immigration. The big money made in this country is the money made as wages. About 70% of our GNP is paid in salaries, wages and benefits.

INSIDER BUYING: Company executives are buying shares at levels not seen since the summer of 2002, right before the big, big move. This is a strong indicator. I cannot remember the exact details of this indicator but it is rare for the insiders to buy so heavily and when they do the market is set for a BLASTOFF!

LEADING INDICATORS: In December of 1995 the leading indicators went negative and TV talking heads said a recession was near. All the problems of the world were hashed over on talk shows and in news letters. At the time, lagging indicators, such as inflation were still high so they too were discussed ad infinitum. The scary topic of stagflation raised its ugly head. Does this sound very familiar? The leading indicators went negative in September of 2007 while the lagging index was still at 3.7, down significantly from the 5.8 reading in December of 1995.

THE BIG FIX BY THE BIG HERO: In case you have not noticed, the Central Bankers play the game of seeking cover for their foot dragging by citing lagging inflation indicators. By dragging their feet, they increase their importance while allowing their investment banking friends to position themselves for the next great profitable market. The 90 day t-bill has shown that the FOMC needed to cut interest rates for months. If the FOMC allowed the fed funds rate to float with the t-bill, it would seldom need to act. The situation is like that of congress, if the congress set a few rules and allowed the free market to work, the congress would only need to meet a few weeks each year. The congress must purposely create big problems if they want to earn big dollars when it is time to fix them. There are all kinds of tricks used. For example, legislation that never expires or legislation that does. The two recent examples being the AMT and the Capital Gains Tax. The AMT was passed in 1969, as I recall, and was not indexed to inflation on purpose. Thus its bite grows and grows and grows relative to the economy. In 2003, major tax cuts were passed, including the reduction of capital gains taxes but these were all set to expire in 2010. Again, a train wreck was set up that will have to be fixed.

CONSUMER SENTIMENT: Bottomed in November 1995 just as the big move in stocks was ready to start. Recent consumer sentiment numbers were below the levels seen in 1995 but retail sales have lifted off. There is a chart on the Carpe Diem site that shows the left off in Internet retail sales. Consumers are leaving the gas in their tanks and buying on line. On line sales are running at about 24% higher than a year ago!

NET EXPORTS SOARING: The biggest factor in the increase of last quarters GNP from the solid number of 3.8% to the fantastic number of 4.9% was soaring exports. Exports jumped by the biggest increase since 1996! Again, do you recall the great fun it was to be in the market in 1996 or did you wait until the big run was half over before you jumped in?

SMALL TO LARGE TO SMALL TO LARGE CAPS: About 18 months ago, I strongly encouraged readers to move their 401-K's out of small cap funds and into big cap funds. A good call. The small stock rally was huge from 2002 for several years and it died slowly in 2006. Big stocks have out performed small stocks since that time. Over the next few weeks, small stocks will probably out perform large stocks, however, one would need to be nimble to take advantage. On lift off, the more speculative stocks, including "white chips" and small stocks will do well. However, we are now in the second half of the economic cycle. The further we go into the second half the more concentrated the best performance. Within two or three years, it will be only the biggest of companies and the most defensive of stocks that will be holding up. I suspect the drug stocks will be included in the final big run that could last two or three years after the initial surge. When I called the mid cycle correction, I did so because the normal cycle is slightly over 9 years. The market lift off on October 10, 2002 is now more than 5 years old. We may have 5 more years in the cycle.

The first half rally has taken the S&P, the Russel 2000 and the Dow back to new highs. Even the NASDAQ fully recovered if you forget about that last crazy bubble spike in 1999. The NASDAQ 100 is composed of big stocks. It will continue to do well during the second half.

ECB BANKERS PLAYING THE SAME OLD SONG: The European central bankers are talking about the lagging inflation indicator. This is almost like Nero fiddling while Rome burned. The "economy of Europe" is getting slammed hard by the steep climb in the euro relative to the dollar. Arthur Laffer made the point well on Kudlow and Company last night when he asked Larry if he would buy all of Europe for $1. Of course, if recent trends were to continue, in a surprisingly short amount of time, Europe would be able to buy America for only one Euro. There is a limit to how low the dollar can go and as was mentioned earlier, US export growth is now on a parallel with the growth that occurred in 1996.

LIFTOFF: So far, the countdown has been interrupted several times. Last night, Big Ben started the countdown again. The FOMC meets on December 11. OPEC meets on December 5. OPEC does not want Europe to fall into a recession ditch. Current trends would put Europe in the ditch in 6 months or less. The US could be dragged into the same ditch unless there is relief. Lower oil prices would help. Lower prices for oil and for money take a while to boost the economy but, of course, stock markets would anticipate the resulting economic boom.

3, 2, 1 ......BLASTOFF!