Tuesday, October 14, 2008


How desperate can one be for a major rally? The Volatility Index has been seeing levels seldom seen before. There has seldom been so much pessimism. Conditions are ripe for a major rally. Two strong up days in a row are worth talking about. These trades are "economic recovery trades".

Cyclical stocks, including energy and basic materials, are bouncing high in London again this morning. Economically sensitive stocks, such as airlines, that once traded inversely to oil are now trading with projections for economic growth. Gloom and doom have turned around to see that the world is not ending. Lest we forget, financial stocks are among the most cyclical of all stocks. Plot a ratio chart of the S&P Bank Index divided by the S&P 500 and you will see what I mean. Bank stocks dive into recessions but soar back out of them. For example, by the time the stock market took off on October 10, 2002, bank stocks had been beating the broad index for two years. If you don't believe that financial stocks have been beating cyclical stocks for the past three months, you should take a look at the resource based market in Russia. One day last week, it was down 19% in one day. The market was closed a couple of other days.

Today, in London, the financial index is up another 5%. Energy and basic materials, after being pounded over the past three months, are up around 9%. Yesterday, US energy stocks were up 18% while the average stock was up only 11%! The 11% move was bigger than all but 5 days in history.

For some weeks, I have said that if Paulson wanted to inject money directly into the banking system, he could do so with the stroke of a pen. Actually, Ben Bernanke has the authority to lower required capital ratios. Paulson went through a long drawn out vote as a stalling tactic, making it look like the government was doing something, before doing essentially the same thing. Today, he will announce investments of $250 Billion directly into banks. It sounds better to say that he is investing, even though the borrowed money being invested was invented by the stroke of a pen and is not really different than adding lending authority by lowering capital ratios. The main difference is in the timing and distribution of monies. The danger is that the government camel has poked its nose under the side of the bankers tents. Once a camel smells something tasty, it is almost impossible to keep it out. Had the distribution been made by a small reduction in capital requirements, all banks would have been treated the same and all banks could have seen relief weeks ago.

The big thing that happened between the big drawn out public vote and today was the market bottom that caused huge margin calls. The market was allowed to go down enough to force a lot of wealthy people to sell out at low prices. Of course, the closest friends of the most powerful got the wink to avoid margin, until the bottom was made. Did you ever wonder who did all the buying last week when some very wealthy players were forced to sell? Now that the bottom has been made and now that banks are being flooded with money, those burned by margin trading will be slow to take advantage.

While there are still a few trillion dollars of sub-prime paper stashed away by banks around the world, new accounting rules allow that paper to be valued based on cash flow. As these loans are gradually paid off, refinanced or brought current, the true value of the paper will become known. It should be considerably more than the lowest price reached at the bottom of the turn. Bank stocks fell sharply for more than a year (the KWE index of regional banks fell by more than half between February of 2007 and July of 2008). Again, these stocks are highly cyclical, they tend to make V bottoms early during recessions. They tend to have recovered most of the prior losses by the time the recession is over. They will continue to go up during the recovery years, after the recession, but at a slower pace than other stocks. Looking only at the bank index, we do not see the spikes in relative performance. Again, ratio charts show that bank stocks get killed going into recessions but they lead the way back out.

After an 11% surge, a day of rest would be in order. However, it sure does look like we are going to see TWO BIG UP DAYS IN A ROW!