Wednesday, December 17, 2008

Much More Than a Santa Claus Rally!

We are at the time of year when investment people talk about the Santa Claus rally. This rally, which tends to start by mid December, is also known as the "January Effect". During the early days of the New Year, large contributions to pension plans tend to push the market up. While the history of seasons can be very misleading (sharp skews can result from histories of a small data sample), the current move should not be discounted as just another Santa Claus rally.

This rally kicked off on November 20. The average financial stock is up 11.6% in the last two days and up 31% since November 20. Technology stocks have also done well; they are up 14.9% since November 20.

It is worth repeating that the market cycle sequence is Stocks Down, Commodities Down, Bonds Up, Financial Stocks Up, Consumer Cyclical Stocks Up and then Technology Stocks Up. There are overlaps and retracements but the pattern is strong.

The rally in financial stocks is a result of the turn in real estate and both begin their recoveries several months or even a year or more before the end of recessions. Consumer cyclical stocks and technology stocks are the big movers once the market rally gets started and, yesterday, retailers were among the big winners. We should not jump to the conclusion that consumer cyclical stocks will take the leadership reigns tomorrow, next week or even next month but we are clearly seeing the bubble right at the Bonds Up point of the cycle. Crude oil, at $43 per barrel, might go lower but it does not have that much more room to fall. Treasury bonds are very expensive and have very little more room to rise.

If you own balanced mutual funds or life style funds or income funds you should sell. Small cap value stock funds will beat the pants off these hybrid bond funds over the next several years. Small cap financial stocks and small cap consumer cyclical stocks will likely soar. Years ago, I memorized the fact that in the 9 years after the 1973-74 real estate recession, the average small cap stock went up 1,579%!!!!!

A few days ago, there was a full moon. We have a full moon approximately every 28 days, so no big deal. This particular full moon was closer to the earth than at any time since 1993. Those who notice repetitive cycles can successfully predict future events. Astronomers can tell us precisely when the next moon perigee will occur.

The average real estate cycle is 18.3 years. The real estate cycle has a higher standard deviation that does the moon but the current bottom is similar to those of the past. There have been three of these bottoms during my life. At the peak of the construction boom in 2005, homes for sale were being built at the annualized rate of 1.2 million units. Last month, homes for sale were built at the annualized rate of 280,000 units. New construction starts are at record lows and the ratio of completions to starts is at the second highest level in history. Housing crews are focused on completing partially built homes and not on starting new projects. I expect a new all time peak in December.

The home absorption rate is a mean reverting number. The long term moving average is between 900,000 and one million units. With only 280,000 being built, it will not take long for inventories of unsold homes to return to normal. Long before the national numbers show normal, most markets will have below average inventories. The extremely over built resort markets are distorting reality. Inventories are already back to normal in a lot of markets and prices will rise shapely as demand begins to fight for supply. With mortgage rates ready to follow 30 year bond rates to historically low levels, the average worker can afford a much higher priced house than he currently realizes.

The process of correction was well underway before the dramatic FOMC announcement made by the FOMC Chair yesterday. Once again, it was fun to witness a dramatic announcement and all the discussion thereof only to note that the FOMC has already been doing what it announced for at least a couple of months. Still, the actions of the FOMC are powerful.

The FOMC formally moved the Fed Funds Rate target down 75 to 100 basis points. The new target is from 0% to .25%. This is where the Fed Funds have been trading since October. The FOMC also announced that it will buy long dated agency and treasury paper, however, in reality, the Fed balance sheet has soared over the past several months as a result of buying all sorts of paper, including long dated agency paper. The Fed added the statement about buying long treasuries in order to persuade bond traders not to dump long treasuries. In other words, the FOMC said "don't worry about the long term inflationary effect of pumping too much cash into the system, we are serious about moving interest rates down".

One of the guests on Kudlow's show last night expressed great fear of too much cash and thus hyper inflation. His fears are way off the mark, for several reasons. Two big ones are: 1) That when the FOMC borrows money from the Treasury to buy paper already on the market, only a swap of assets takes place, not a printing of money. It is the same as if I borrowed a $1000 from my Mother and purchased a Fannie Mae bond with it, Mom could get stuck if I failed to pay her back but no new cash was created, the FOMC owns the bond rather than the bank that sold it. 2) The money printing presses crank up when banks are quickly lending the same money over and over again. During an economic boom, money is "hot". A person that acquires money is quick to spend it and the bank that receives it as a deposit is quick to lend it again. During an economic slowdown, the "Paradox of Saving" takes hold to stop the printing presses. Banks, companies and individuals are more cautious about spending; businesses wait for their customers checks to clear before they produce another widget. The situation is similar to the rubber-necking that occurs when there is an auto accident. A few people are involved in the accident but the reason the traffic piles up is because every one passing has to take a good look.

Yes, a significant number of people have lost jobs (they are very involved in this accident) but most of us are suffering only because the speed of cash has slowed (gotten jammed in traffic). In this analogy, the action of the FOMC is like the action of the police when they arrive and start waving the traffic through. The tow trucks are currently pulling the wrecks away; by the time the people in the back of the traffic jam get to the accident site, there will be nothing to see and the speed of money will soar. The value of the Fannie Mae bonds will also jump, the banks will certainly want to buy there bonds back. The FOMC balance sheet will go down almost as fast as it went up. (Some of the TARP deals will take 5 years to unwind but only because the banks will want to enjoy the low cost funds for as long as possible, while they make high returns off them.)

NEVER BEFORE in your life has the FOMC done so much to push the economy forward. This FOMC traffic cop has just created an extra lane by directing traffic onto the shoulder for several hundred yards. The backed up traffic (financial stocks) is starting to get past the wreckage and is speeding down an unobstructed road.

When a line of cars stop at a traffic light, they follow a pattern of simple harmonic motion. Except for the idiots that run up hard behind you and stop in a hurry, the stopping motion is similar to the swing of a pendulum. When the light changes, the line starts to move, it slowly gathers momentum and of course, just as the traffic is moving rapidly through the light, it turns yellow and once again, the stopping process begins.

The market caution light was shining brightly in 2006 and very brightly by the summer of 2007. This caution light was the flat yield curve. I was the idiot who ignored the warning light this time, even when it flashed red several times by inverting. Today, we have come a very long way down the road. The Fed Funds rate at the time of the inversion was 5.25%. Today, the Fed Funds rate target is 0 to .25%! In the spring and early summer of 2007 the FOMC was standing on the brakes. It caused a multi-car pile up. Today, the FOMC has opened up new lanes and is offering to refuel cars that have run out of gas for free. Traffic is starting to move. You should catch a ride with a bank car, a real estate trust truck or a beach condo train.


Bernard L. Madoff made big news last week when his Ponzi scheme came crashing down. Investors lost an estimated $50 Billion. Mark Perry has asked an interesting question. Who built the largest Ponzi scheme of all time? The multiple choice answers are Charles Ponzi, Bernard L. Madoff or Franklin D. Roosevelt. Of course, Roosevelt is the correct answer. Ponzi schemes work for as long as they cash flow. Madoff was undiscovered for years because new deposits and partial refunding of principle disguised as principle were more than enough to meet withdrawals, until withdrawals increased during a weak economy. At the end, the customer accounts showed value of about 50 Billion Dollars but, when Madoff saw he could not meet redemption's, he gave piles of money to family and friends before revealing his deceit.

In the case of Social Security, the public has long known it to be a Ponzi scheme. It will continue to cash flow if and only if benefits are reduced or payroll taxes are increased, according to most experts. The hidden good news is that productivity growth will, after a very long time, repay loans from the treasury; provided benefits are not increased or that payroll taxes are not cut. The coming Obama tax plan is the equivalent of a massive earned income credit, where, in effect, $500 to $1,000 of payroll tax is refunded to the payer, out of general revenues. As usual, when the misguided take aim at the rich, the middle class is inadvertently shot. Despite the denials of Obama, under his plan, the $50,000 to $100,000 earner will pay extra payroll taxes to cover the additional deficit.

The answer to Obama is to do well despite the extra tax. Equity investors will do very well over the next several years. No matter what the percentage of taxes (less than 100%), it is wise to make high returns when they are available. Some day you will look back on these days and wonder why you were not more aggressive while the price of equity was so cheap!