A Doozy

This is the toughest juncture I have ever had to navigate in my investment career. On one hand the market is no longer overvalued. Based on normalized earnings multiples and normalized profit margins the S&P 500 is a little less than 10% undervalued. Trying to bet against an undervalued market is the definition of dancing between raindrops.

However, in the past two secular Bear Markets, markets did not bottom out until the market was 40% undervalued. In addition, the imbalances due to a decade of bubbles have not been dealt with. Balance sheets are in disarray and there is a gaping trade deficit. Chances are that this Bear Market is not over yet.

To make matters more complicated the government is trying to force people to take risk by printing money and bringing rates down to zero. Even if one believes that the government plan will work there will be a trillion dollar deficit next year. One can only hope that foreigners will be willing to fund ever growing deficits and accept our newly minted dollars.

The question before me is do I buy stocks, even though the foundation for this recovery is shaky, and hope that I could get out before the wheels fall off. Or do I remain patient and risk sitting out a monster recovery. To me, the greatest risk is losing money. There is pain in missing out on a rally, but that is not a reason to invest. There will be opportunities during 2009 even if one does not take a strong directional bias. Hopefully, I will be able to spot them and share them with you. Have a happy and healthy new year.

NYC Real Estate

There is more proof that the NYC Real Estate will suffer from this downturn. An article in today's New York Times says Manhattan office rents have fallen by as much as 25%. I know someone that negotiated 30% off the asking price of prime Manhattan office space.

Question: What does someone who bought an office building in Manhattan with a 3% cap rate do now that vacancy rates are way up and rents are down by 25%?

Answer: Lobby for a bailout.

Running Out The Clock On 2008

Good Morning. 2008 is a year that most investors are glad to see gone. Unfortunately, when everyone returns to work next week the calendar will change but the issues facing us will not. I am happy to let the clock run out on 2008 as the tape is too easily pushed around in this holiday thinned environment.
  • This morning oil is giving back all its gains from earlier in the week. If tensions in the Middle East can't help oil I am not sure what could. Oil bulls better hope that the move lower is tax loss selling or portfolio repositioning into the New Year.
  • The Federal Reserve announced that they will begin to buy mortgages next month. This will be done with freshly printed money. That is the wild card for 2009. Will the new money be used to buy risky assets or will banks just use it to reduce leverage? Will the freshly printed money cause a dollar crisis at some point? When?
  • In the new Investors Intelligence survey Bulls and Bears are dead even at 38.5%. This is the first time in months that Bears have not outnumbered Bulls.
  • While sentiment surveys are showing improving sentiment, they are not showing the extreme sentiment that the option ratios are showing.
  • Many have told me that the extreme in the options ratios might be due to the lower volume. I agree that it is a possibility. While that might stop me from shorting the market, I would still not go long.
  • I hope to be more active in individual stocks in the New Year. Right now I am uncomfortable investing in individual stocks because the effect that the recession has had on earnings is not clear. The recession did not hit hard until the fourth quarter. Fourth quarter earnings reports will be coming out in a few weeks.

By Hook Or By Crook

It looks like this market is getting marked up into year end by hook or by crook. With Cox at the head of the SEC they could all sleep well. Have a good night.

Whats Wrong With Bailouts

Bailouts are keeping companies alive that should have failed. Aside from the fact that taxpayers are funding these bailouts, they cause distortions in the economy that are of greater consequence.

GMAC has been giving out loans that are uneconomical, resulting in their current predicament. Now that they have been bailed out they are free to continue to give out bad loans. It is even being reported that they will be lowering their credit standards. Other banks that were more careful about their lending either need to step back from auto lending or try to compete with these uneconomic loans. The same thing is happening in home mortgages. Fannie Mae, Freddie Mac and FHA are giving out mortgages that no private institution can compete with. Thereby putting banks in the mortgage business in a similar situation.

If the government bails out all the bad lenders in every industry that causes a dilemma for institutions that were disciplined. They have a choice of making uneconomic loans or holding on to cash. The Federal Reserve is making sure that holding on to cash is not a viable option by bringing rates to zero. In the short run these ploys might work but in the long run this weakens healthy companies and will cause further damage to the economy.

Failure Is Not An Option

  • The ducks are starting to line up for an intermediate term top sometime in the next week. The market will be long term overbought early next week. The seasonally strong period ends early next week. In addition, there seems to be a sense of giddiness in the market that is confirming the heavy call buying we have been seeing.
  • The Obama inaugaration seems like a more logical turning point for the market. But the indicators are pointing to next week.
  • Ben Bernanke punishes savers by reducing rates to zero and debasing the dollar, so that those that over levered themselves can borrow cheaply. The Treasury rewards buyers of GM/GMAC toxic debt, while punishing taxpayers who were wise enough to stay away. That is the dictionary definition of socialism.
  • In a world with Bernard Madoffs is it so hard to believe that managers might use this holiday thinned trading environment to push up some of the stocks they own?
  • Credit spreads continue to improve.

Another Bailout

Good Morning. The futures are higher on news that GMAC will be bailed out. Volume will once again be thin and we might need to wait until next week before we can get a better sense of where this market wants to go.
  • The Obama plan is to spend money on infrastructure, which creates domestic jobs. This requires borrowing money from other countries. I understand why the Chinese lent us money to buy their products, but I don't understand why they would lend us money for infrastructure projects. Not at 2%.
  • Earnings warnings have been quiet during the holiday season. Expect them to heat up after New Years.
  • Per my piece yesterday on the options ratios, the market still has room to rally until early next week.
  • It would not be difficult to mark up stocks in this thin environment.

New York City Real Estate

  • There is still a large group of people that I speak to who believe Manhattan real estate will not be effected too badly by the current turmoil. Their arguments always come down to the fact that New York City real estate has been resilient throughout the years. Aside from the obvious flaw in that argument there are many reasons why I disagree.
  • There is no city that benefited more from our finance based economy than NYC. It stands to reason that no city will suffer more from its downfall.
  • Complicated financial products will be shunned for years to come. Other financial services are largely commoditized businesses. In a commoditized business cost control is of the utmost importance. New York City is the most expensive area in which to operate.
  • SL Green, the NYC REIT cut its dividend in more than half, showing that NYC is already suffering.
  • At 2:00 bonds reversed lower hard, while commodities reversed higher. This helped the S&P cut its losses.
  • The market continues to frustrate both the Bulls and the Bears.
  • Have a good night.

That Was Quick

  • Just like that the hard earned gains of the Santa Claus Rally from last week have been taken back and then some.
  • Even though the market is taking a beating, investors continue to purchase calls at an alarming rate. I can't recall a time where investors bought so many calls in a declining market.
  • One could write off the call buying to the low volume but it is difficult to spin it as a positive.
  • What happens if those playing for a year end rally start dumping stocks into this low volume market?
  • I want to become more constructive on this market as it is down so much. But the facts keep getting in the way.

Not All Bah Humbug

  • While my Weekly Strategy focused on the warning signs from the options market, other indicators are not confirming its negativity. That puts me squarely in the neutral camp but on the lookout for more cracks.
  • Rohm & Haas (symbol:ROH) is down 20% early on fears that Dow Chemical will not be able to close its cash takeover. Broken deals act as supply into the market as arbs sell shares back to investors. While this is not a broken deal yet, it potentially can become one.
  • The good news is that if this deal breaks there are no more large deals that can break.
  • Apple, BIDU, GOOG and GS are showing early strength despite the slightly lower open. A positive sign showing that there is some appetite for risk.
  • Trading should continue to be thin into New Year's.

Business As Usual

"It is difficult to get a man to understand something when his salary depends upon his not understanding it"
-Upton Sinclair
Paul O'neill was George W. Bush's first Treasury Secretary. In 2001, President Bush introduced tax cuts in order to stimulate the economy. Secretary O'neill opposed the Bush tax cuts because he did not believe it wise to borrow money in order to pass tax cuts. Normally, a president is supposed to seek advice on economic affairs from his Treasury Secretary. However, in this case Bush sought a new Treasury Secretary with advice that was more to his liking. Paul O'neill was soon out of a job.

I have little doubt that if Secretary O'neill were able to keep his job that he would have done a better job than those that replaced him. It is even possible that he might have been able to help avoid many of the excesses that have led to our current dilemma.

President Bush was not looking for advice from his advisors. He was looking for cronies. He appointed a Chairman to the SEC who made the SEC toothless. In addition, the SEC allowed investment banks to increase their leverage from 12 times to 30 times, setting the stage for our current financial crisis.

President Bush appointed Ben Bernanke as head of the Federal Reserve. While Ben Bernanke is not a crony, his stated beliefs made him just as good. Ben Bernanke believed that markets should be left alone when all was well but that the government should step in vigorously to avoid recessions.

It is not a coincidence that our current leadership is clueless. It was a job requirement. But before we blame our leadership for all our problems, we need to look inward.
Paul O'neill was well hated by the public. Few were sad to see him go. The major criticism was that he was not fighting the downturn hard enough. Paul O'neill did not get it.

The downturn earlier this decade was one of the shallowest receessions in history. Paul O'neill understood economic cycles and understood that with time the recession would pass, setting the stage for the next expansion. But Secretary O'neill was out of office before that time arrived. A public that that wants all gain and no pain ended up with a similar leadership. We reaped what we sowed. The way forward depends upon looking inwards before looking to assign blame.


Weekly Strategy

My favorite measures of sentiment have always been the option ratios. Sentiment surveys measure what people are saying, but option ratios measure what people are actually doing. Currently, the option ratios are saying that we are much closer to the end of this rally than the beginning.



The chart above is the 21 day moving average of the ISE Sentiment Index. The higher the line on the page, the more calls are being bought. This measure of sentiment is now sitting at a 52 week high. The three other times that sentiment reached these levels were shortly before major legs down in the market.

This does not mean that the market must go down soon. In Bull Markets sentiment can go much higher than current levels. This only means that unless the underlying character of this market has changed, we are currently at a point where the market has run into trouble in the past year.



The chart above is the 30 day moving average of the CBOE Put/Call ratio. The lower the line on the page, the more calls are being traded. This sentiment index is approaching a 52 week extreme which is another warning signal for the market (although the line is likely headed lower for the next six trading days).

This coming week is a seasonally strong period and there is still room for the CBOE 30 Day MA to go lower. The market still has a window in which to rally but that window is closing quickly.

The S&P 500 currently trades at approximately 15% below its fair value. At times like these I prefer to look for reasons to buy, but the extreme in sentiment is too glaring for me to ignore. There are some differences between now and the past few times these sentiment indicators were flashing red. Sentiment surveys are not confirming the bullishness of investors and the Federal Reserve was not engaging in quantitative easing the past few times as they are now. However, it is troubling that investors are getting bullish even though the market is just churning. I am treating this market as being guilty until proven innocent.

iPhones in Aisle Three

  • iPhones will officially be going on sale this Sunday at Wal Mart. This is a tacit admission that even the best are suffering during this recession-depression.
  • It is hard to argue that this will improve Apple's brand name. I suspect the hope is that it increases sales without harming the brand name.
  • Apple trades at less than ten times next year's estimates net of cash. The stock may have already priced all this in.
  • Amazon is now up less than 2%. It seems that there are fewer people willing to play games. That is a long term positive.
  • Once again we are seeing call buying.
  • I am starting to see the signs of a top forming. Normally, I would start planning my short strategy around this time but given that the market is fairly valued I will probably just stay on the sidelines.
  • Did I just say I see a top forming with the S&P at 870?
  • I will be on the road for the remainder of the day. Have a great weekend.

Amazon's Play On Words

Amazon is currently trading 5% higher based on saying they had their "best ever" holiday season. Analysts are currently expecting revenue growth for the fourth quarter to be 14%. Through Amazon's cryptic press release all one can infer is that revenue was up year over year. Since expectations were for 14% growth this should not come as a surprise to anyone. They basically said nothing. However, in this holiday thinned session it seems the lunatics rule the asylum.

Our Fearless Leaders

  • Good Morning. "Retail Sales Plummit" is the headline in this morning's Wall Street Journal. The good news is that few had high expectations for retail sales. The futures are higher, shrugging off the bad news.
  • Can you guess who is described in the following passage from this morning's New York Times, "In March 2005, a low-key Princeton economist who had become a Federal Reserve governor coined a novel theory to explain the growing tendency of Americans to borrow from foreigners, particularly the Chinese, to finance their heavy spending. The problem, he said, was not that Americans spend too much, but that foreigners save too much."
  • Answer: Ben Bernanke. The sad part is that this is not even the worst of his cockamamie theories. He seems like a polite, well intentioned man but he is clearly in over his head.
  • Judging by the price of oil and holiday sales, deflation currently has the edge on inflation. However, I have no doubt that the Federal Reserve will eventually be successful in debasing the dollar. The key to investment success will be to figure out when we have crossed to the other side.
  • The Madoff talk is having a profound psychological effect on investors. Everyone is talking about it and it greatly reduces investor's appetite for stocks.
  • If oil goes any lower than its current price there will be few new exploration projects, which will reduce the supply of oil. That is a longer term positive, but presently momentum rules the day.

Enjoy The Holidays

  • Once again we are seeing an abundance of call buying. Sentiment is growing more positive but that might not matter during this seasonally strong period.
  • Starbucks stopped matching employees 401k contributions. Other companies might follow. If this practice gains steam it might slow down inflows into the market.
  • By next week we should start hearing results from the holiday shopping season. Nobody is expecting good news but the reaction to the news is what will be important.
  • Betting on two cockroaches racing across the floor is less of a gamble than trying to trade this market.
  • Enjoy the holidays.

Half Day

Good Morning. Today is the first day of the much anticipated Santa Claus Rally. Historically, the next 7 trading days have shown higher than average returns. I would be more enthusiastic about this setup if other factors were lining up for a rally. My main concern is that sentiment is over enthusiastic despite the fact that the market has been edging downward. The market closes today at 1 PM and volume will be thin all day.
  • I read an article this morning titled, "Consumers fall deeper into debt: Equifax". All I could think about was that Bernanke's plan to get us out of this mess is for us to increase borrowing.
  • Corporate debt has been improving for over a week now. I believe the worst is over in that market.
  • An area where I believe there will be more pain is private equity. Private equity shops and hedge funds are valuing their private equity investments at prices far higher than what they could receive in public markets. My guess is that they are aware of this but hoping things will turn around. Reminds me of a fellow named Bernie.
  • Corporate debt and mortgage debt have improved. What do these hedge funds that imposed gates own?

Madoff Is A Bad Man

  • Madoff has done more damage through deceit than anyone on death row has done with a gun. Charities have lost billions of dollars, retirees have lost everything and today a fund manager invested in Madoff commited suicide.
  • I don't know if the Madoff deceit started innocently. But at some point he had to realize that he was stealing money from charities and retirees.
  • When the Madoff scandal broke I decided that I wanted nothing to do with this market. I believe considerable damage has been done to the psychology of investors.
  • The QQQQ traded less than 30% of its normal volume today. Trading will only get lighter as the week wears on. Getting an early start on the holiday season may not be a bad idea.
  • Have a good night.

What If ?

What if I told you that in a three week period:
  1. The Federal Reserve said it will do whatever it takes to keep the markets up, including printing money to buy securities.
  2. The Treasury bailed out the automakers.
  3. There was heavy call buying, showing that investors have grown more optimistic.
  4. The VIX imploded, showing that fear has subsided.
In the situation described above shouldn't the market be up? In reality, the market has gone sideways for the better part of three weeks and more recently has begun going down. What does that say about the underlying strength of this market?

On a separate note here is a link to a chart of the median returns for the Santa Claus Rally from The Big Picture.

Yesterday's Late Day Strength

Late in the day yesterday, the market saw a sudden burst of strength which seemed to have come out of nowhere. I believe I have solved the mystery of why that happened. The Ultra Double Short exchange traded funds like SDS and QID went ex-div this morning. These leveraged ETFs typically rebalance at the end of the day. In order to pay a dividend these ETFs had to reduce their market short exposures at the end of the day yesterday, which meant a large buy program. The late day buy program that shot the market higher at about 3:20 has these guys fingerprints all over it. For once, I agree with Jim Cramer. The leveraged ETFs are a menace.

Call Buying Extreme

As of 10:30 call buying is at extreme levels, both on the ISE and CBOE. Sometimes a large trade can skew the readings, but it is hard to spin it as a positive. Overly positive sentiment is still this market's largest obstacle.

Positive Seasonality

The market will benefit from positive seasonality starting tomorrow and lasting through the second trading day of the New Year. The last 5 trading days of the year plus the first two trading days of the New Year are the actual period of the Santa Claus rally, where stock market performance has historically been above average. Volume will be very thin so anything could happen.

Speaking Chinese

Through a newspaper editorial, the Chinese have put the US on warning that they will not continue to finance US deficits indefinitely. The only reason that we are able to fund our bailouts and stimulus packages is because foreign central banks are willing to absorb our Treasuries. If that changes we will either need to cut spending or watch the dollar spiral lower. We are now beholdent to the Chinese. From AFP, China says lending to US will not go on forever:
China warned Wednesday it would not keep lending money to the US economy indefinitely, even as new data showed it had consolidated its position as the top buyer of American government bonds.

"China's increased purchase of US Treasury securities should not be interpreted as an endorsement of the assumption that the US can borrow its way out of the current financial crisis," the China Daily said in an editorial.

The warning from the state-run newspaper, an English-language daily that mainly addresses a foreign audience, came after the US Treasury Department reported a steep increase in Chinese holding of US Treasury bonds.



Road To Nowhere

Good Morning. The policies of the Federal Reserve and Treasury have been reactionary at best. They are aimed at putting back together a broken system rather than solving the underlying problems. There is too much debt in the system. Instead of allowing the excess debt to be destroyed, the policies are aimed at trying to prop up a failing system.While I am reasonably sure that the policies have almost no chance of working in the longer term, there is a chance that they will be able to give a temporary adrenaline boost to the market and the economy.

In recent days the market has shown signs of fatigue, no longer able to rally on good or bad news. Additionally, it seems that sentiment has gotten ahead of the market as the group of bottom callers grows louder. A weak market with overly optimistic sentiment is not a market friendly combination. While the market seems susceptible, I am hesitant to go short. Valuations are reasonable and Ben Bernanke has a printing press and has threatened to utilize it.

The Pros and Cons

  • The largest positives that I see is that credit continues to improve (LQD, JNK), albeit off of very depressed levels.
  • The largest negative is that there is continued call buying despite today's weakness.
  • Lower oil and lower mortgage rates are incremental positives.
  • Companies are not repurchasing shares. The LBO market is shut. Hedge funds can't raise enough cash to return to investors. Who will the incremental buyer of stocks be?
  • For the past few weeks the market has gone up no matter how bad the news was. In hindsight, the fact that the market did not rally on Friday despite an auto bailout package and good news from RIMM and ORCL was a hint that something had changed.

Interesting Times

The Federal Reserve will continue to print trillions of dollars while the Obama administration is planning a record stimulus package. There is a debate as to whether the deflationary forces will be stronger than these inflationary forces. No one has ever lived through anything resembling this so I am allowing for both outcomes.

However, there are some outcomes that do seem obvious to me:

1. The US dollar will suffer. It does not take a giant leap to conclude that deficit spending funded by a printing press will cause the US Dollar to decline.

2. Treasury bonds will not be a good investment. Even if deflation does emerge victorious, a 2% a year return on 10-year Treasuries is hardly a coup.

3. The underlying causes of this crisis will still need to be dealt with at a future date. Both the money printing and stimulus packages do not deal with the causes of this crisis but the symptoms.

Eject Button

  • Many managers have beefed up their portfolio for a year end rally. At what point do they hit the eject button if a rally does not materialize?
  • Shouldn't Apple have rallied on Friday, given the "good" news from RIMM? Not being able to rally on good news is usually a sign of supply. However, given that Friday was option expiration the signal is not as clear.
  • I spoke to an engineer for oil companies over the weekend. Most of the projects he is currently seeing require oil to be over $35 in order to be profitable. Under $35 most new projects don't make sense. I will keep that in mind in case oil dips below $35.
  • In Forbes, Charles Biderman rebukes the assertion that there is a lot of money on the sidelines. He sites evidence that much of the money that has been withdrawn from the stock market was used to pay down debt or for daily needs during these hard times. In addition, much of the money has been put in CDs, which ties up the money.

Is Santa Claus Coming To Town?

Good Morning. There has been increasing chatter of a Santa Claus rally in the past few weeks. Given the almost unanimous expectation of a rally the contrarian in me can't help but suspect that investors might end up with a lump of coal instead.
  • The gubmint bailed out the automakers on quadruple witching option expiration. They bailed out Citigroup to ensure a Happy Thanksgiving. Do they have something in store to ensure a Merry Christmas?
  • If markets were allowed to function on their own, I believe the Madoff scandal alone would have been enough to ensure no Santa Claus rally.
  • In the actual world we live in quantitative easing plus a lot of money on the sidelines could still equal a big rally.
  • I was shocked to read a document where Harry Markopolos outlined prophetically exactly what Bernie Madoff was doing three years ago. This document was ignored by the SEC.

Alpha Plus Advisors Cyclical Bull

Marvin V. Bolt and Frank Ramsperger of Alpha Plus Advisors lay out the case for a cyclical Bull Market within the secular Bear Market we are currently experiencing. They use an abundance of historical data and graphs to make their case.

The Capital Observer will return Monday.

The Hex

I know I am supposed to be going on vacation but I couldn't help but share this. Alan Greenspan might have just put a hex on this market by saying it will go up. This is the same man who backed the "new economy" in 1999 and encouraged ARM mortgages in 2003. From Bloomberg, Greenspan Says Financial Markets May Rebound in 6 to 12 Months

Financial markets, which have been depressed by “fear” not seen since at least the 1930s, are likely to rebound in the next six to 12 months, former Federal Reserve Chairman Alan Greenspan said in a commentary published by The Economist online.

Observing The Capitol

The Capital Observer is heading out to the nations capitol for the next three days so this will likely be my last post of the week. I will be posting the case for a cyclical Bull Market courtesy of our friends at Alpha Plus Advisors tomorrow.
  • The movements between now and Monday morning will be largely expiration related. By next week we should find out where this market wants to go.
  • It looks like volatility buyers are going to get crushed this month. The market has gone sideways for the past three weeks and volatility prices were close to record highs.
  • GE's rating deserves to be downgraded for stupidity. Why does a company with capital issues continue to pay a 7% dividend. At the same time they are paying Buffett 10% + options to borrow money. Not to mention that they are issuing taxpayer backed debt.
  • The dollar just had its biggest 6 day drop in history.
  • The 30 year Bond trades close to 40% above its 200 day moving average. To put that in perspective stocks bottomed a few weeks ago about 40% below their 200 day moving average. The difference is that Treasury bonds are not supposed to move like stocks. If you thought the action in the stock market was crazy, the Treasury bond market makes it look tame.
  • What makes the move in Treasuries even more amazing is that it goes against all common sense. The Treasury is printing money and is running a trillion dollar a year deficit.
  • I am hugging the sidelines as being on the wrong end of one of these historic moves could be career ending.
  • If I were bullishly inclined I would be buying on weakness instead of chasing on days when the market is strong.
  • Have a great weekend.

Credit Improving Again

Credit is improving again today as seen in the two credit ETFs, JNK and LQD. Spreads on Fannie, Freddie and municipal debt have been improving as well. Much of hedge fund woes have been tied to credit markets. If this improvement continues will hedge funds be able to post positive results this month? Would that break the vicious circle of liquidations?

Call Buying Orgy

There is a call buying orgy thus far this morning. Today the CBOE is confirming the action we have been seeing on the ISE the past 3 days. The option indicators can't be looked at in a vacuum. Some call buying is healthy at turning points as it shows a change in sentiment. However, this is too much for me to be comfortable with. I would want to see the call buying back off if I were to buy here.

Not Great Expectations

The futures popped a little when the weekly jobless claims came in at 554,000. That goes to show how low expectations are right now. Stocks don't go down on monstrous earnings warnings. Madoff did not matter for more than a few minutes. Low expectations are the best thing this market has going for it right now.

The Most Anticipated Rally

Good Morning. The futures are shrugging off a bunch of earnings warnings this morning. Primarily, Ingersoll Rand's earnings will be less than half of what analysts are currently expecting. Investors are solely focused on Santa Claus and the rally he will bring. Normally, I would say that such a widely anticipated rally could not occur. However, investors have moved to the sidelines to such a large degree in the past few months that there is room for a rally. While I believe the odds still slightly favor a rally in the next few weeks, I am not comfortable investing in such a widely anticipated event.
  • The Japanese have threatened to intervene in the foreign exchange market as the Yen has soared recently. The dollar continues to plunge against the Euro.
  • Given US interest rates are so low and that the Fed will be printing dollars, what reason do foreigners have to hold the US Dollar? Who will fund our deficits? It seems that Foreign Central Banks will, for now.
  • Why do I still have all of my wealth in US Dollars? I feel like a deer in the headlights.

A Story From The Internet Bubble Days

When I started working at Goldman Sachs in 1998 I sat next to a friend who I will call Stan for the purposes of this story. It was right after the Fed slashed interest rates to bail out Long Term Capital and the market started taking off. Stan was holding on to the most speculative internet stocks there were at the time. Stan prodded me to buy internet stocks and the conversation went something like this:

Stan: Why don't you buy Yahoo or Amazon? They are going to go through the roof. The Fed just goosed the market.

Me: They trade at 500 times next years earnings. They don't even earn any money. Its a bubble. I can't buy it. It will go down eventually.

Stan:Look at these stocks. They go up 40 points a day. When will it go down?

Me: They always go down after earnings.

Stan: So, what you are saying is that since earnings are in January these stocks will probably go up for another 2 months.

Me: I guess so.

Stan: So why aren't you buying?

With that I decided that even though I knew I was buying an overpriced stock, I would hold my nose and buy Yahoo until January. The day before earnings, I sold Yahoo for more than double what I paid for it.

The current argument for buying the market seems strikingly similar to me. The Fed has goosed the market and chances are that until Obama gets inaugurated the market will rise. The difference is that we have suffered through an 8 year Bear market and I am not sure people will be as gullible this time around.

Annaly Running For The Roses

Annaly Capital Management has been making a run for the roses. I have sold calls against my position, so I am essentially out. I own the Annaly Capital Management 7 7/8% preferred shares. At 18.50 the preferred shares yield close to 11%. I believe that they offer a better risk/return than the common shares at current levels. The only downside is that the shares are very thinly traded and not easy to trade in and out of in size.

Call Buying Alert

  • We have been seeing very heavy call buying on the ISE the past 2 days. The CBOE readings have not been as extreme. If the market fails this will have been the proverbial canary in the coal mine.
  • Bloomberg has an interview with Jim Grant in which he opines that the Federal Reserve's actions will backfire. Intellectually, its always good to know that Jim Grant is on my side but he is not known for his market timing skills. He started pointing out the error of Greenspan's ways in the early 90's and it took over a decade for the rest of the World to realize. I suspect this time around it will not take that long.
  • Another good point from the Jim Grant interview is that while the SEC was busy attacking short sellers who were pointing out the problems in the system, Madoff, Enron and Worldcom bilked investors. He says the presence of the SEC is counterproductive as investors don't do their own due diligence because they wrongly believe the system is being policed.

Unnatural Forces

There are unnatural forces at work in this market. I have never traded through a market where there was quantitative easing. As such I plan to be much more careful than I would normally be. I hear the argument that says that one might as well join the party if the Federal Reserve has spiked the punch. However, I am sitting this dance out until I can get more comfortable with the environment.

Dollar Beatdown

The Federal Reserve's policy will have many unintended consequences. There is one that we may already be seeing as the dollar continues its free fall. Gold, the Euro and the Yen have exploded higher since the announcement. Our trade deficit is not funded by private profit making entities, but by foreign central banks. How long will they continue buying dollars when the Federal reserve is trying to debase the dollar. The market is speaking loudly as to the direction of the dollar. Eventually, foreign central banks will hear it. At that point our only choice will be to confront our problems head on.

Credit Improving

Credit is showing improvement. LIBOR is down big today. In addition, a number of credit products I look at are showing improvement. Exchange traded funds LQD and JNK have rallied substantially since the Fed announcement. The Fed is clearly having the desired short term effects on the market.

What can stop this rally?

One thing I believe that could stop this rally is corporations issuing new shares. United Technologies and Honeywell both announced recently that they will contribute shares instead of cash to their pension fund this year. CIT Group is swapping shares for debt and doing a follow on offering.

While the amounts being spoken about are small potatoes, as the market rises more companies will look at issuing new shares. This is a far cry from 2003 when companies were buying back shares. In 2003 GM borrowed 10 billion dollars to put into its pension plan. That is the equivalent of buying on margin.

Someone Is Wrong

  • Currently, Treasury rates are where they were at the depth of the Great Depression. At the same time the stock market is screaming higher. Someone is wrong.
  • A major difference between now and 2003 is that companies were buying back stock furiously at that time, while today there is little capacity for buybacks. Even the major company that is arguably benefiting most from this recession, Wal Mart, has suspended their buyback.
  • Where can buying come from? Asset allocation.
  • News that Mac sales were down 1% in November had no effect on Apple's stock but news that Steve Job's is not presenting at a trade show takes the stock down 5%?
  • Will everyone who is "playing" a rally be able to find a chair before the music stops?

All Clear

Good Morning. Printing money and devaluing a currency have never led to prosperity. The solution does not deal with the underlying problems but the symptoms of the problem. Arguably, it might even exacerbate the problems. Bernanke's solution is to lower rates so we can borrow more easily. However, borrowing too much is the reason we find ourselves in this spot.

In the long run I am quite certain that Ben Bernanke will fail miserably. However, in the short run that does not matter. While things might have gotten too heated yesterday and the market could use a rest, it seems that the market wants to rally into the Obama inauguration.

For my part I still have very small positions. I was planning on getting a bit more aggressive for a year end rally but cancelled those plans when the Madoff scandal broke. I hate to chase a rally, especially when it seems like every bear suddenly turned bullish yesterday. For now, I am sitting this one out.

Turkish Millionaires

I was on the road all day and come back to find equities and bonds lifting off, while the dollar is once again getting decimated. The Federal Reserve is promising to print as much money as is necessary and Wall Street is celebrating as they did in 2003 when Easy Al lowered rates to 1%. In the past 5 trading days the S&P is up 2%, while the dollar is down 9% against the Euro. Pretty soon we will all be Turkish millionaires.
  • Is printing as much money as is necessary the long term solution to our problems?
  • Apple is another stock that does not want to go down on bad news. Yesterday, NPD reported that Mac sales in November were actually down by 1%. That was a clear disappointment as many were saying Apple was going to buck the negative retail trend. Apple closed the day higher anyway.
  • Stocks not going down on bad news is the main reason I would not want to short this market. However, it is not reason enough for me to buy.
  • Was I crazy for thinking a 50 billion dollar scam would slow down this market or is everyone else crazy?
  • Is everyone trying to get into the market before Obama gets into office? Does it make sense to just play along?

Could Be Worse

Good Morning. The market was bracing for bad news from Goldman Sachs and they did not disappoint. A loss of $4.97 a share was worse than expected. Goldman is up in the pre market as the bad news was well telegraphed. Recently stocks have been able to rally on bad news, which is a positive.
  • The Fed might unveil plans for quantitative easing today. That would mean the Fed lays out what assets it plans to buy with money fresh from the printing press.
  • I don't believe Bernanke will buy Treasuries. Yields have already plunged since he threatened to buy longer dated Treasuries a few weeks back.
  • While analysts estimates were off on Goldman they were not that far off. Analysts were estimating a loss of about $4 and the loss was only a dollar higher. Given the 800 billion dollar balance sheet, which only management knows the contents of, its amazing how anyone can even come up with an estimate, let alone be so close. I suspect their were some winks and nudges from management to get analysts so close to the actual number.
  • Speaking of analysts, yesterday Goldman's oil analyst lowered his price target on oil to $30 after calling for $200 oil. Why does that guy still have a job? Where do I sign up?

Risk Free 30 Year Bonds Paying Below 3%

  • Goldman Sachs reports earnings tomorrow. Earnings estimates have been coming down all quarter. It is hard to imagine anyone being surprised negatively tomorrow.
  • The Federal Reserve will announce the Fed Funds rate tomorrow. Fed funds already trade well below the target so there will be no real effect by the rate change. The only effect will be psychological. Once psychology was the Fed's greatest weapon but given their loss of credibility the effect is marginal.
  • The Fed might release details of their quantitative easing plans. That is where there might be some pertinent information.
  • Intraday volatility seems to have come down to more normal levels. Its hard to frame that as a negative.
  • Every day that the market does not fall apart is a positive as the market is becoming less overbought.
  • Ask anyone who was invested in Treasuries during the 70's if they are risk free.
  • Have a good night.

Once In A Lifetime Everyday

  • The Euro is moving up against the dollar in a way that currencies don't usually move. In any other time this would be shocking.
  • Will we look back in a few years from now and ask ourselves how we could have owned US dollars?
    The government's plan is to run a printing press with no real strategy except to buy anything that is failing.
  • Or will debt destruction lead to deflation and the purchasing power of the US Dollar rise?
  • Whatever occurs, in hindsight everyone will have seen it coming.
  • What is the upside in Treasury bonds with the ten year yield below 2.5%?
  • Can Treasuries go down with everyone calling it a bubble?

If You Can't Beat Em'

  • Barring the Madoff scandal I would be bullish for a Santa Claus rally. The market does not seem to care about Madoff, so why am I dwelling on it? While a year end rally is probably the better bet, I am looking for easy trades and I believe the Madoff scandal complicates matters.
  • Why does the little voice inside my head keep whispering, "If you can't beat em' join em''"
  • I always cringe when people try to sell me an investment based solely on the fact that someone rich or smart is doing it. It is that type of thinking that allows a tragedy like this to happen.
  • Keep in mind that this week is options expiration. Much of the action will be expiration related.
  • I am hearing that many car dealerships are going out of business regardless of an auto bailout package. Sales are just too low. I was told that brand new cars were being offered for 50% off sticker price from some of these dealerships. The automakers will take large hits as they finance the inventories of their dealers. My understanding is that the dealerships going out of business plan to default on those loans. This is another blow to the auto industry that has not yet been factored in.

Weekly Strategy

"There's a sucker born every minute"
-P.T. Barnum
The market currently has a positive technical setup. We had a major overbought reading a week ago. The short term implications of an overbought reading are negative. However, a very high overbought reading has positive medium term implications, especially when it comes after a large decline. I believe the reason for this is that after such a long decline the fact that the market can get so overbought shows that the selling pressure is gone.

Despite the positive technical setup I am hesitant to make a big bet on this market. There are two issues that are bothering me. The first is that it seems that everybody is calling for a Santa Claus rally. This alone would not have been enough to dissuade me from investing, as some optimism after a large fall is not necessarily a bad thing.

The Bernard Madoff story makes me very hesitant to invest. It is still unclear what the losses are but they appear to be between 17 and 50 billion dollars. This is possibly the largest scam in history, larger than Enron and Worldcom. If I were fleeced by Madoff, the first thing I would do is liquidate some other holdings and make sure I had some cash. Then I would look a lot more deeply into everything I was invested in. Hedge funds and other fiduciaries are sure to see more redmption requests. In this environment it is hard for me to see them chasing a year end rally. Even investors who were not fleeced by Madoff might become more careful as a result of hearing this story. This will only increase risk aversion.

I see the positive technical setup and I see that bad news does not seem to matter. However, following the largest investment fraud in history I just can't bring myself to bet that it will not have any negative implications.

Just Wow

  • The technical setup of the market remains positive. I thought in this case fundamentals would trump the technicals but I was clearly mistaken.
  • The biggest lie ever sold is that a GM bankruptcy would mean the end of GM. The main thing that would change is the owners of the company, from stockholders to debt holders. That would leave a lean company free of debt. Additionally, the company would be rid of their UAW contract. Those are the people that are so desperately trying to distort the issue.
  • Debt destruction would be a positive. The debt burden of the economy is too high.
  • Its never the right time to take our medicine.
  • I will be on the road for the remainder of the day. Have a great weekend.

Treasury Safety

Treasuries don't seem to be rallying today despite the market sell off and the horrible news. This is a change from the past few weeks where everything was a reason to buy Treasuries. Maybe I am looking too deeply into things but just putting it out there.

Checks and Shmalances

  • The Treasury was given TARP money to buy bonds. The voters don't want a bailout for automakers. Congress doesn't want to pass a bill. The Treasuryknows better and is planning on using the remaining TARP money to bail out the automakers. Let's hope nothing else comes up in the next month.
  • A friend told me, "It would be easier to understand a menstruating woman on crack than this market". Its hard to argue with that statement.
  • This Madoff story makes hedge funds and other fiduciaries unlikely to commit new money to this market. If there is a rally it will need to be driven by individual investors. Not a bet I am willing to make.
  • When in doubt, sit it out. That is my game plan.

Hedgeron

  • If you were burned by Madoff yesterday, what would you do with the remainder of your holdings today?
  • In case it is not clear, I am putting on hold my plans to buy today. The grinch might have stole Christmas.
  • Under normal circumstances I would buy into a plunge caused by a GM bankruptcy. This hedgeron scandal is a giant wild card though.
  • More than a few people bought in anticipation of a Santa Claus rally. The longer the market stays down, the more likely they are to sell.
  • Its better to be lucky than smart. The only reason I am not caught in this mess is because the market stayed stubbornly overbought and did not give me a chance to buy.
  • Anyone who has operated in the markets for a few cycles can attest to the fact that returns are not smooth. Mr. Madoff claimed to have only 2 losing months in over a decade.
  • Expecting high, smooth returns is the financial equivalent of having your cake and eating it too. Isn't that what so many hedge funds promise?
  • If this market was a person, would it have been committed to a mental institution by now?

Too Good To Be True

Good Morning. It was revealed last night that one of the most respected investors, Bernard Madoff, with over 17 billion dollars under management was running a "giant Ponzi scheme". A lot of investors are in the process of being informed that their money is gone. The Worldcom fraud was 10 billion dollars. If the details are correct, this dwarfs it. Confidence was running thin but this might be the knockout punch. I expect hedge fund redemptions to pick up steam, which will result in continued volatility in the market.

In addition, it is becoming likely that we will see a GM and Chrysler bankruptcy in the next few weeks. The entire market cap of GM is 2.5 billion dollars, so the actual damage should be minimal. 2.5 billion dollars is the equivalent of a 50 cent move in ExxonMobil. GM bonds already trade as low as 17 cents on the dollar. The bonds are already priced for bankruptcy. The company would likely continue to operate with the bondholders becoming the owners, unencumbered by a mountain of debt and union contracts. However, this market is all about emotions and a high profile bankruptcy will likely shake some people.

Ponzi Fund

My words do not do this justice. From the SEC website:

The Securities and Exchange Commission today charged Bernard L. Madoff and his investment firm, Bernard L. Madoff Investment Securities LLC, with securities fraud for a multi-billion dollar Ponzi scheme that he perpetrated on advisory clients of his firm. The SEC is seeking emergency relief for investors, including an asset freeze and the appointment of a receiver for the firm.

The SEC's complaint, filed in federal court in Manhattan, alleges that Madoff yesterday informed two senior employees that his investment advisory business was a fraud. Madoff told these employees that he was "finished," that he had "absolutely nothing," that "it's all just one big lie," and that it was "basically, a giant Ponzi scheme." The senior employees understood him to be saying that he had for years been paying returns to certain investors out of the principal received from other, different investors. Madoff admitted in this conversation that the firm was insolvent and had been for years, and that he estimated the losses from this fraud were at least $50 billion.

"We are alleging a massive fraud — both in terms of scope and duration," said Linda Chatman Thomsen, Director of the SEC's Division of Enforcement. "We are moving quickly and decisively to stop the fraud and protect remaining assets for investors, and we are working closely with the criminal authorities to hold Mr. Madoff accountable."

Andrew M. Calamari, Associate Director of Enforcement in the SEC's New York Regional Office, added, "Our complaint alleges a stunning fraud that appears to be of epic proportions."

According to regulatory filings, the Madoff firm had more than $17 billion in assets under management as of the beginning of 2008. It appears that virtually all assets of the advisory business are missing. ...


Hedge Fund Enron

Madoff Securities, a firm with 17.1 billion dollars under management was described as a "giant Ponzi scheme" by the founder. The details are unclear but according to The Wall Street Journal there are a few hundred million left. His investors are mostly hedge funds, banks and wealthy individuals. These people are about to find out that their money is gone. If there was a crisis of confidence before, this will really get the ball rolling. I expect hedge fund redemptions to really heat up now.

Pullback Time

  • We are finally getting a pullback off of the overbought reading I have been harping about. Another down day tomorrow would probably be a good place for those bullishly inclined to build some positions.
  • I will likely do some buying tomorrow into further meltage. The issue I am having is that it seems too many people are calling for a Santa Claus rally, present company included.
  • Can hedge funds fuel a Santa Claus rally given that they have to worry about redemptions?
  • The decisive turn in the dollar and commodities are large positives. It likely means that the liquidations in those arenas are over.
  • Can you believe we are back where we started the week on the S&P?
  • Have a good night.

Won't Back Down

  • Humongous earnings warnings. Eye popping unemployment. Insolvencies. Is that all the Bears got?
  • The dollar is being decimated and commodities have broken out. It seems that the reflation trade has moved from the stock market to the commodity and currency markets. This is a short term positive for the Bulls.
  • There is a thin line between reflation and inflation.
  • How long will foreigners fund our 60 billion dollar a month deficit while we print money?
  • Is studying the fundamentals a hindrance in this market?
  • There was a time when one could ignore the economy and make money on pure stock picking. I yearn for those days.
  • The worst part about this environment is that so much depends on gaming what politicians will do.

Lasting Rally

Good Morning. I am feeling increasingly confident that we are in the middle of a rally that will last into the beginning of next year. The market is currently overbought but has been working off the reading by going sideways. The window for the market to take a hit is still open. I would be a buyer on that dip if and when. However, it is starting to seem like the market might not make it that easy and force those who want in to pay up.
  • The sharpest rallies occur in Bear Markets.
  • The vast majority of mortgages get done through Fannie Mae, Freddie Mac or FHA. The mortgage industry has been socialized. The banking industry has been socialized. The auto industry is about to be. Who's next?
  • If the market does pull back I will be dating it, not marrying it.
  • Shorter term credit measures continue to improve. I have been looking at senior bank loan closed end funds and they make new lows every day. At the prices they are trading at, if half the companies defaulted, one would still not lose money. I am strongly considering them for purchase.
  • The fundamentals have not changed since a few weeks back where people could not sell fast enough. Emotions have changed.

The Market That Could

  • There are two ways a market can work off an overbought condition. By going down or by going sideways. The latter seems to be the case as we are seeing some sector rotation but very little giveback by the market as a whole.
  • I don't understand how Barack Obama was bad for the market a few weeks ago and is good now. Or just maybe every little market move can't be explained by who the president is?
  • While I am having a hard time buying into this overbought market, I am having no thoughts of trying to short it. There is a lot of money on the sidelines and a pile on could ensue.
  • Can someone explain to me why the double short financial etf, SKF, is flat on the year while the financials are down by 50%?
  • I have no interest in leveraged ETFs. If I lose my money, I at least want to understand why.
  • Have a good night.

Central Planning

"Capitalism without failure is not capitalism at all"
-Jim Grant from Grant's Interest Rate Observer
Alan Greenspan and Ben Bernanke both claim to be proponents of free markets. But in reality they only believe in free markets when markets are rising. The reason we find ourselves in such a predicament is because they fought off recessions for so many years. Recessions bring important adjustments that ultimately make the economy healthier.

Recessions are an important part of the business cycle. Lenders and speculators that over reach fail. This discourages the type of unhealthy activity they were engaged in. Unproductive businesses either become more productive or die during a recession. This frees up capital and labor from these unproductive businesses so that they can be used productively somewhere else. That sets the stage for the next expansion with a leaner and more productive economy. In economic terms this is known as "creative destruction".

This country has not had a real recession since the eighties. The early nineties recession was one of the shallowest in history. Alan Greenspan furiously lowering rates and the S&L bailout forestalled a serious recession. Later in the decade the Fed lowered rates and added liquidity during the Asian Crisis, Long Term Capital and Y2K. Failure was not an option. After the technology bubble burst the Fed lowered rates to 1% and kept them there even after a deep recession was averted.

During this two decade period recklessness was rewarded while prudence was punished. While a deep recession would have been painful at the time, we would not find ourselves in the mess we are in today. The entire banking system would be insolvent today if it were not for its nationalization.

The greatest damage done by years of easy money has not been to the banking system but to the economy itself. We find ourselves in an economy that is asset based. Nothing is created in this country anymore. The best and brightest all work in a finance or real estate related field. Do we really need all the astro physicists working at hedge funds? Shouldn't some of these people be creating something instead of shuffling money from one place to another.

People made logical decisions. The money was in finance and real estate so that is where they went. Now we have massive over capacity in those industries with little talent in others. The rewards were being distorted by the Fed interfering in the natural economic process.

Stay tuned for part 2 of this article

Still Impressed But ...

  • I am still impressed by the strength of this market but now that the market is overbought and we are seeing excessive optimism in the option ratios I am not interested in buying. I want to see a pullback and some skepticism from investors before I buy.
  • LIBOR has started to improve again. Improvements to the debt market are spreading somewhat but still not reaching the high yield arena.
  • Oil is outperforming today for the first time in recent memory.

Three Chears For A Bailout

Good Morning. The futures are higher on news that a compromise was reached on the auto bailout. This market must have rallied ten times already on this auto bailout news. Normally, I would expect this news to get sold pretty quickly as it is news to no one. However, this market has used any and every excuse to rally so I would not rule it out.
  • Lower rates for mortgages and lower energy prices will act as a large stimulus.
  • Gas purchases were up year over year last week for the first time since April, according to Mastercard. In addition, the Chinese are lowering gas prices (in China gas prices are controlled by the government and change infrequently). It is becoming mighty tempting to try and pick a bottom in Oil.
  • Oil stocks have not been making new lows while the commodity has. That is a positive divergence.
  • Yesterday, I mentioned that the fact that the market was able to get so overbought was a positive. Jason Goepfert of SentimenTrader.com via Minyanville explains why.
  • The Federal Reserve is seeking the authority to issue its own debt. Ben Bernanke has already pushed the limits of his authority under the Federal Reserve Act without explaining exactly what it is he is doing. Since we are socialist now I guess checks and balances are not all that important. He knows what he is doing and the ends justify the means. Its not like he cultivated the debt bubble the economy is crumbling under.

Not Bad

  • Large cap tech (QQQQ) was a big outperformer due to the semiconductor companies. I like large cap tech because the companies tend to be unleveraged and they generate free cash. Trying to figure out what Citigroup is worth is above my pay grade.
  • Thus far the pullback looks healthy. If this continues I will be looking to do some buying later in the week. I still believe we will go lower longer term but for now Santa Claus is coming to town.
  • The people I speak to in a wide variety of industries say that business is miserable. People who have been in busines for decades are just closing up shop. This is why they call it a depression.
  • The fact that the market was able to get so overbought is a positive. The fact that the market is overbought is a negative. Got it?
  • Wal Mart cancelled its buyback program. You know times are tight when the hottest company in the country can no longer afford a buyback.
  • Have a good night.

Bear Market Rally

  • Bear Market rallies are the most vicious. This market is not even pulling back to allow Bears to cover or renters like myself to get in. While its painful to see the year end rally I have been calling for go on largely without me I am remaining disciplined.
  • Cyclical stocks generally bottom on bad news. Last week Freeport Macmoran bottomed on their warning. Today, semiconductor companies Broadcom, Texas Instruments and National Semi are bottoming on their announcements of lower earnings.
  • I still am expecting a pullback this week.
  • There are many companies in need of capital. As this rally progresses I suspect we will start seeing overleveraged companies issuing shares. Longer term that is a positive but supply in the short term is a negative.
  • We are seeing heavy call buying today. That does not mean we will go lower but shows that sentiment is no longer overly negative.
  • The banks are not participating in today's rally. That marks a change as the banks have been leading since the bottom.
  • Tribune bonds are trading at 13 cents on the dollar. While areas of the bond market that the government is supporting have improved the effects have not spread to the junk market.

All News Is Good News

Good Morning. The market is once again trying to shrug off a number of earnings warnings but I suspect that it will take a long overdue rest. I am impressed with the resiliency of the market but don't want to buy into an overbought market. A few down days should relieve that condition.
  • The most surprising warning last night was Fedex. Lower oil prices should have been a boon but business is that bad. Fedex is considered a good indicator of business activity.
  • What will P/E ratios look like once earnings outlooks are adjusted?
  • How long will Barack Obama's honeymoon last?
  • Housing and real estate related activity took us out of the last recession. What will take us out of this one?
  • Tribune declared bankruptcy yesterday and defaulted on twelve billion dollars worth of debt. Bankruptcies are normal in every downturn. What is different this time around is that companies were lent so much money that recovery rates will be much lower than ever seen. I would be surprised if Tribune bondholders recovered 25 cents on the dollar.
  • I believe all this bad news will be dealt with next year. After a brief pullback I expect a Santa Claus rally.

Animal Spirits Back

The animal spirits are back. How quickly people forgot that they were soiling their pants a few short weeks ago. Now they want a piece of the action. There is a lot of sidelined money so a rally can probably carry further than most would believe. I continue to believe we will see a Santa Claus rally but am waiting for a pullback to add to my small position. I suspect we will get one some time this week. Have a good night.

Why So Bearish

I have been asked by a few people why I am bearish. I am not bearish. I actually have a couple of small long positions which I bought much lower. I am just not willing to chase the market higher by buying while we are overbought. I believe we will get a Santa Claus rally but I am hoping to be able to buy in on a pullback. If I miss it, I miss it. Nothing lost.

Weak Links

  • Bonds, commodities and Morgan Stanley are reversing direction. Might the stock market follow?
  • The Euro is rebounding strongly, which augurs well for risky assets. The Euro and risky assets have been falling in tandem.
  • The Chinese have recently depreciated their currency, the yuan, against the US dollar. Since we run a huge deficit with China it is likely that the Chinese had to acquire a huge amount of dollars to achieve this. That was probably done through the acquisition of Treasuries and is possibly another reason why Treasuries have been rallying.
  • Given the timing of the Chinese on Blackstone, what does that say about Treasuries?
  • By devaluing the yuan, the Chinese make their goods cheaper. The issue is not that their goods are too expensive but that we simply don't have the money to buy them.
  • Much of a deal was made about the Hartford Financial and Met Life announcements. These companies don't have to mark to market their bond portfolio. The way they are showing investment gains is likely through the selling of their Treasury positions while holding on to their losing positions. Accounting hocus pocus.

Primal Instincts

Two short weeks ago when the market was 20% lower "sophisticated" brokerage firms were sending around graphs and theories about why the market is going to go a lot lower. Recently, I have been receiving graphs on why the worst is behind us.

At any given time there is a graph or indicator that can corroborate a bullish or bearish case. What drove people to be bearish two weeks ago was a primal instinct to follow the herd. The same primal instinct is now making them bullish. They justify this instinct by finding a piece of evidence such as an indicator, graph or story. The vast majority do not realize that this is what they are doing.

My advantage is that I realize that I am a primate. I try to make sure that I constantly look at all the facts and not just the ones that corroborate what I am feeling. I always look at the same indicators, so that I can't be fooled by my emotions.

This market can go higher as we are not at extremes. However, my discipline does not allow me to chase overbought markets. In the long run this will help me protect myself from my primal instincts even if at times it does not allow me to profit. This is a trade off I am willing to accept.

The Question

Good Morning. The economy has been deflating at a rapid pace for the past six months. The Fed has been combating this deflation by printing money. Thus far it has not been able to stop the deflation. However, if Bernanke is hell bent on printing dollars until he beats this deflation, I believe that he will eventually succeed. The key is to figure out when we reach that turning point.

There are two markets where the government cannot interfere. The exchange rate market and the commodity market. Those two markets might offer clues as to when the Federal Reserve has succeeded. One would expect to see a lower dollar and higher commodities if the Fed is successful. This morning we are seeing that but one day does not make a trend.
  • The earnings warning parade continues with Illinois Tool Work and 3M. A lot of bad news seems to be priced into this market already. If I were a Bear I would be sweating. What would it take to bring this market down?
  • A big gap up in an overbought market is not the type of setup I like to buy into. Even if the market is going to extend its gains today, I would expect a test lower beforehand.
  • Late Friday bonds tanked while stocks soared. Could that have been an asset reallocation?
  • Are there a lot more portfolio managers severely underweight stocks because of the sharp rally in Treasuries and and decline in stocks? Will they rebalance?

Weekly Strategy

"After considerable thought and deliberation I have decided to make a major change in my life: I am going to close my hedge fund. I have several reasons for no longer wishing to run a short-only fund as I have for the past 12 years. First, my original reason for starting the fund was because of developments I saw occurring in the late 1990s that I wanted no part of. I felt that Greenspan was fomenting an environment that would lead to disaster, as consultants, financial advisors, and the public at large were losing all respect for risk. Of course, the reckless behavior carried far higher and lasted much, much longer than I ever imagined it could. However, the recent carnage in the stock market, real estate market and the financial system (as well as the job losses) has washed away those excesses to a large degree and it has violently demonstrated the risks associated with investing.

... Second, though I think that the stock market still has unfinished business on the downside, I believe that 2009 is the year to prepare for a return to managing money in a more balanced fashion, with longs (and some shorts), as there are currently plenty of interesting ideas that appear to offer a margin of safety. On the flipside, compelling opportunities on the short side are not as abundant as they were just a few months ago"
-Bill Fleckenstein from Calculated Risk
Legendary bear, Bill Fleckenstein, is shutting down his short only hedge fund and will return to managing money on a more balanced basis. I share Mr. Fleckenstein's thoughts on the market. With stock valuations now reasonable it is hard to justify taking an aggressive short position. However, after overshooting by so much on the upside there is a good chance that the market will overshoot on the downside. It is probably too early to take an aggressive long position.

Throughout history burst bubbles have led to markets overshooting on the downside. That leaves us with a resonably priced stock market that will likely go lower. At that point we will be at a generational buying opportunity. The question before us is what to do between now and then. Bill Fleckenstein is taking time off to prepare and that is the course of action that would be prudent for most.

While the market is likely to go lower I would not recommend taking a short position for a number of reasons. Being that the market is trading at a below average valuation the cost of being short and wrong can be immense. There are no guarantees that the market will overshoot to the downside. In addition, Bear Market rallies can be vicious and I suspect we will get a Santa Claus rally this year.

The reason I suspect we will have a Santa Claus rally this year is that recently the stock market has had a change of character. Generally, when bad news is highly anticipated it does not have a negative effect on the market once its announced because it is already priced in. Sometimes it even has a positive effect in that once the event passes there is nothing left to fear. However, for the past few months no matter how anticipated a news event was it would take down the market. In the past two weeks that has changed. We have had floods of earnings warnings and negative economic data and the market has gone up. In addition, we are seeing vicious short squeezes and some sector rotation. Also, characteristics of a more normal market, if not a market that wants to go higher.

My main goal is to preserve my cash so that when we get to that generational buying opportunity I have money to deploy. That means being very careful between now and then. The reason I am not buying aggresively for a Santa Claus rally is because I want everything to line up before I buy. Currently, the market is short term overbought after a two week rally. Short term overbought has not been good for the market in the past year. While it may be different this time I am playing very tight and am willing to miss the rally if everything is not perfect.

I'm Impressed


  • Stocks have managed to claw their way back despite being overbought (on a short term basis) and the horrific news. I continue to be impressed with the recent change in character but am unwilling to buy in to an overbought market. I will be looking to buy if we get oversold.
  • Suppose the Fed's plan to print money succeeds in lifting the economy short term. Does it make sense to try to play along for a while and try to get out before the music stops?
  • I can't remember a time when so many companies warned and the market has pretty much shruged it off.
  • The shorts continue to get squeezed in Sears and RIMM is actually up since it warned.
  • Is Christmas spending less bad than feared?
  • This mess is far from over but the market rarely goes anywhere in a straight line (except for the past few months).
  • Have a great weekend.

Sell The News

  • It looks like traders are taking a sell the news approach to the Employment Report with stock futures climbing back. Markets do bottom on bad news but I would have more confidence in this setup if the market was oversold.
  • Bonds are also trying to reverse direction while crude oil is taking another beating.
  • In the short term the plan to buy GSE debt is acting as a stimulus as mortgage activity is heating up. In addition, lower gas prices are acting as a huge tax cut. Tighter lending markets and fewer jobs are the headwinds.
  • Will the GSEs offering mortgages at such low rates crowd out other lenders from the market? How will everyone else make money?
  • I will be out of the office for the majority of the day so my posts will be scarce.

Free Lunch For Helicopter Ben and Hank The Tank

Last week the Treasury announced that it would purchase 600 billion dollars in Fannie Mae and Freddie Mac debt. Generally, the Treasury would need to borrow money by issuing bonds to finance such a purchase. However, the Treasury announced that the purchases "will be financed through the creation of additional bank reserves." The English translation of that is they are printing money in order to buy GSE debt.

In large part that is why Treasuries have been rallying. They are buying long term debt without issuing any long term debt, reducing the supply of long term debt on the market. There are two schools of thought on what the consequences of this will be. Some say that during the next economic expansion we will have hyper inflation as a result of the money printing. The other school of thought is that the deflationary forces are so strong that this will not make a difference.

Both outcomes sound logical and I am yet undecided on which side I agree with. However, there is one outcome that I don't believe in. The one that Hank "The Tank" Paulson and "Helicopter" Ben Bernanke are betting on. That they will get this exactly right and be able to remove the stimulus before it causes inflation. They are playing with a type of fire that has never been experimented with in this country. They have proved themselves inept at dealing with more mundane issues. Bernanke oversaw the creation of this bubble as the regulator. Paulson is the one that convinced the SEC to allow the investment banks to go to thirty times leverage as CEO of Goldman Sachs. I am no monetary expert but I don't believe that the answer to this crisis is to simply print money and buy assets with it. Is life that simple? Is there such thing as a free lunch?

Tiger Steepening

Julian Robertson got on CNBC a few months back and said he had put on a curve steepening trade. That means shorting long bonds while going long short rates. From my understanding this steepening trade was a popular trade among hedge funds. It is blowing up in a big way right now. This is likely contributing to the volatility in the bond market.

While Julian Robertson navigated well through the credit crisis until this point he did not count on Bernanke and Paulson interfering in the market. How do you game stupidity?

I am calling it a day. Have a good night.

Unintended Consequences

The action in the Treasury market looks a lot like a short squeeze. Who is short Treasuries? Many buyers of mortgage backed securities and corporate bonds hedge out their interest rate risk by shorting Treasuries. There are various reasons why financial institutions might put on interest rate hedges. This action might have negative consequences for these institutions as increased volatility increases the cost of hedging. Or there might be outright losses on these hedges.

Maybe this is healthy and for once the Fed and Treasury know better than the market. However, I would not be surprised if a body or two surfaced as a result.

BCE Becoming A Bargain

The Canadian communications company, BCE, is looking attractively priced. It has gotten pummeled as its takeover was cancelled. It trades at less than ten times next years earnings. Verizon trades at twelve times next years earnings, putting BCE at a 20% discount to its American counterpart. I believe that the Canadian economy is much healthier than the US economy and this type of discount is unwarranted.

I am not yet interested in buying the stock because the discount is likely to become larger before it improves. The company is likely to see the pressure of arbitrageurs exiting the stock for a few more weeks. If BCE reinstates its dividend the yield will be close to 9%. This is likely once the takeover litigation ends. We might also need for the litigation to end before the last of the arbitrageurs throws in the towel.

Change Of Character

There has been a change of character to the market recently. Stocks have been going up on bad news, showing that much has been priced in. Retail sales were bad and retail is up. Merck warned and the pharmaceuticals are up. Another change is that we are seeing short squeezes. Just look at the REITs or Sears Holding. This is more normal trading than the one way market we have been seeing the past few months. The market is currently overbought so I am not buying, but I am filing this in the back of my head in case we get oversold in the next few weeks.

People Never Learn

One of the things that has confounded me over the years is that people don't learn from their mistakes. After the tech bubble burst, the lesson that people took was that stocks are bad and real estate is good. I remember in 2003 reading an article by Paul Mcculley suggesting that a real estate bubble would take us out of the malaise of the tech bubble and thinking he was crazy. After just being burned by a bubble there is no way people will flock to another one I thought. Sure enough, we proceeded to have the largest real estate bubble in history.

The lesson being taken this time is that nothing is safe except for Treasuries. With ten year notes yielding 2.6%, what is the upside? The lesson that should have been learned from the tech bubble and reinforced from the real estate bubble is that flocking to the hot product of the day is a sure road to ruin. Today's hot product is Treasuries. The two prior bubbles went much further than anyone could have imagined so I suppose this can go further. Caveat emptor.

Nowhere To Hide

Drug maker, Merck announced a 10% reduction in its 2009 profit forecast. People are cutting back on anything they could, even items that were thought to be recession proof. Nokia warned on cell phone demand as well.

Fourth quarter earnings and outlooks should give us a better idea of what earnings will look like in this recession. It is the first full quarter where we were in a deep recession. This should help to build a worst case scenario. It will be much easier to make investment decisions at that point.

Much Improved

Good Morning. The market is showing some signs of improvement. It responded well yesterday to some earnings warnings and grim economic news. In addition, it has been responding well to good news such as GE's announcement two days ago. Unfortunately, the market is now overbought. It is a positive that the market is able to get overbought after staying oversold for so long. However, I would like the setup much more if we pulled back a little in the next two weeks and the market became oversold.
  • The astounding rise of the 10 year bond continues with the rate being quoted at 2.5% pre market.
  • The Treasury is floating a plan to give out mortgages at 4.5%. Houses need to fall to levels where they are affordable. Distorting the market only prolongs the problem. What happens when they stop giving out these loans? Hank Paulson should take a page out of his trading days and cut his losses.
  • Why is it that the same people who never saw this crisis coming and in some cases helped create it, are the ones that are being trusted to solve it?
  • We will get through this but it will take time and some pain. There is no such thing as a free lunch.

Hugging The Sidelines

Despite my more constructive view of the markets I am still on the sidelines for the most part. If we get oversold in the next few weeks I will use that opportunity to build some positions. If not, nothing gained, nothing lost. I took a decent hit last month. After a loss I become much tighter and only invest when I see a home run. Have a good night.

Once In A Lifetime

There have been numerous once in a lifetime moves in the markets lately. So much so that they have probably lost their shock value. The chart below is the five year chart of the TLT, which is the tracking stock for the long bond. For five years it traded in a 15 point range. In a little over a month it has gone up by 18 points. I suspect that at this point it is becoming self feeding. From BigCharts.com:

Annaly Book Value

I purchased Annaly Capital Management because it was trading at a large discount to book value. I estimate that in the past week the book value has grown to over $13.50 as there has been a huge rise in the price of Fannie Mae and Freddie Mac securities.

Zero, Zero, Zero Financing

  • Freeport McMoran Copper & Gold (symbol: FCX) warned on earnings. Commodity companies are notorious for bottoming on bad news but thus far it has not helped them.
  • The heavy put buying I mentioned this morning has turned into heavy call buying. Its amazing how higher prices make people more bullish. I would be a little more cautious as optimism and this market don't mix well.
  • GM will survive even if the company goes bankrupt. The debt holders will become the equity holders while the equity holders would be wiped out. The government should then provide guarantees to the new entity. A bailout makes no sense but this is politics.
  • I have spent the past few days trying to get comfortable with some deep value stocks. However, I keep running across the same problem. A company is not a true value if it is leveraged.
  • Remember when 30 on the VIX was considered high?

Opening Observations

I am seeing some encouraging signs at the open. There is heavy put buying and the market is holding up relatively well. In addition, RIMM is barely down on their earnings warning. I am holding tight until the market gets oversold but these are encouraging signs.

Mortgage Applications Soar

I mentioned this morning that newly lowered mortgage rates have helped spur some activity in the residential market. This morning it was reported that mortgage applications soared by a record in the past week. From Bloomberg:
Mortgage applications in the U.S. surged by a record last week as lending rates plunged after the Federal Reserve pledged to buy mortgage-backed debt.

The Mortgage Bankers Association’s index of applications to purchase a home or refinance a loan jumped 112 percent to 857.7, the highest level since March, from 404.4 the prior week. The group’s refinance index skyrocketed 203 percent, while the purchase index rose 38 percent.

RIMM Rocker

  • Good Morning. Yesterday, I pointed out the curious action in RIMM, which was down hard all day despite the broadly higher market. Last night we found out why as they warned. They are down 10%+ in the pre-market.
  • Oil prices are down $100 a barrel from their high. This acts as a stimulus for the US economy.
  • My contacts in residential real estate have told me that the large reduction in mortgage rates have helped push through some deals that otherwise could not have been done.
  • The combination of these improvements has me considering the possibility that the economy might not be as bad as some fear. That said, I am waiting until the market is oversold before I consider purchases.
  • Treasury prices are down for the first time in a week. Between all the rescue packages, stimulus packages and lower tax collections the deficit is going to explode. How could buying a ten year note yielding 2.7% turn out to be a good investment?

Another Day, Another Dollar

There is little rhyme or reason to what goes on in the market these days so I will not try to explain today's action. The wild moves are probably scaring out all but the true long term holders. Eventually, that will be a positive. I am patiently waiting for the easy trades. I will let you know when I find them. Have a good night.

Treasury Fever

  • Could Ben Bernanke's plan to buy long dated treasuries backfire? Why take risk when one can invest in a riskless asset with knowledge that the government will be buying it?
  • Ben Bernanke's plan is to force those that don't want to take risk to do so by lowering rates (thereby making riskless assets unattractive). Punish those that act prudently. Isn't that how we got into this mess?
  • Treasuries had every excuse to go down today. The higher stock market and the the fact that they are very extended to name a few. Momentum rules (for now).
  • Sears Holdings announced a new share buyback today and the shorts are feeling the pain. Even if this move works out for Eddie Lampert, CEO of Sears, was it worth the risk?
  • Is this an act of desperation?
  • What is going on with Goldman Sachs and RIMM?

GE Rally

  • A few months ago GE swore up and down that all was well, then dropped a bomb on the market weeks later. Given that history, why does anyone trust their ability to forecast a year out in this environment?
  • Why is the fact that GE is giving a dividend good news? If you were running a private business that was in need of capital, would you be paying out dividends? Isn't that like taking a subprime second mortgage to pay for a vacation?
  • The good news is that the market is responding well to the GE announcement. It has been a long time since we have seen that.
  • Crude oil hit new lows today. A sign that global growth is still slowing.
  • Money actually went into US equity mutual funds last week.

Cautious Trading

  • What would it take to get me buy? I want to see the optimism from the Thanksgiving rally completely disappear and I would want the market to get short term oversold. Yesterday, went a long way to alleviate the optimism, but the market will not get short term oversold until the latter part of next week at a minimum.
  • Does that mean we can't rally? I would not be surprised if we rallied, but it has not paid to bet on this market unless it was oversold. My ultimate goal is to live to play another. My secondary goal is to profit.
  • The good news is that expectations are very low. The bad news is that the economy will probably get worse before it gets better.
  • Recognition of a problem is the first step to recovery.

Coming To Grips

The bull market in debt and borrowing that started in 1982, when interest rates started coming down from the high teens, ended a little over a year ago. For the greater part of this period asset prices have risen as well, supporting the bull market in debt. There were some stumbles along the way that almost brought the bull market to an end. Michael Milken's junk bonds, the S&L Crisis, Long Term Capital and the internet bubble to name a few. However, the government was always there to lend a helping hand, ensuring that the bull market continued.

We have now reached the point where the entire system is loaded with debt. Individuals, who used to save more than 10% of their pay went to a negative savings rate. Instead of paying off mortgages people took out second mortgages. On the corporate level, companies followed fancy formulas and computer programs that optimized their capital structure. In the past this was known as leverage. As a country the deficit is expanding at its fastest pace ever.

Yesterday, Ben Bernanke announced that he was planning on buying US Treasuries even though the ten year note is yielding 2.7%. In addition to owning toxic mortgage assets, AIG and Citigroup the US taxpayer will now own government obligations paying close to nothing. Ben Bernanke is hoping to lower rates further so that people borrow. However, the problem is that people borrowed too much. The debt burden has become too large to bear.

The solution is for debt to be destroyed. Ben Bernanke does not realize that something has changed. The old playbook from the Greenspan era no longer works. It seems like Bernanke does not want to do nothing, so he is doing anything. He is like a chicken running around without a head. Just like the bill finally came due for all our borrowing in the past two decades, the bill will come due for all these bailouts. The most unfortunate aspect is that the bailouts are not helping our issues and might even be exacerbating them.

When In Hole, Stop Digging

  • Ben Bernanke is now saying that he might use unconventional measures to deal with the economic crisis, like buying long dated treasuries. He wants to solve a problem caused by low rates with lower rates. After his one term as the Fed president he can follow in Alan Greenspan's footsteps with a multi-million dollar book deal. The working title is, "When In Hole, Keep Digging"?
  • I could have sworn that a few weeks ago Ben Bernanke found religion and admitted that the Fed policy of cleaning up after bubbles was not ideal. Old habits die hard.
  • Judging by the bond market in the past few days there were some loose lips at the Fed. Do you think the bond rally was a coincidence now that we know Bernanke's genius plan to save the World?
  • Can you blame the general public for thinking that the stock market is rigged?
  • Anyone who bought the indices last week is now under water. Just like that a record week's gains are gone.
  • Might the volatility in the Treasury market have some unintended consequences?
  • Have a good night.

Holiday Hangover

  • Selling when sentiment gets positive continues to be the trade of the year, despite the positive seasonality.
  • Were bonds the canary in the coal mine last week? Does it make sense to wait for bonds to turn before buying?
  • How quick will everyone turn bearish if we break through a few support levels? Would that lead to the the ultimate year end setup?
  • A good shakeout is what I would want to see if I am going to build a few long positions.
  • Betting against Treasuries with such low yields seems like a no brainer. No brainers scare the hell out of me.

Cyber Monday

Good Morning. The US market is begrudgingly taking a breather on the back of lower World markets. US interest rates continue their run towards zero with the ten year note yielding 2.83%.
  • In speaking with individuals about stocks over the holiday weekend all anyone wants to talk about is bank stocks, especially the more speculative ones. What happened to once burned, twice shy?
  • There will be consequences to the current bailouts. The million dollar question is figuring out when.
  • Some very smart investors believe we will face the consequences of these bailouts via inflation during the next expansion.
  • We have only been off of the gold standard since the 1970's so I am not sure this period is comparable to any other. In a World where money could be printed it is hard to see how a deflation could last. Although Japan is exhibit A.
  • I am very eager to see first quarter earnings and the outlooks. It was the first full quarter where we were in a deep recession. It will be easier to invest in individual equities once we can build a worst case scenario.

Weekly Strategy

"No one makes money in a bear market, not even the bears"
-Old stock market saying by unknown
The market just had its largest one week advance since 1974 and there were only three and a half trading days in the week. The sharpest rallies occur in the context of a Bear Market and the rally we just had certainly fits the mold. Bear market rallies can exceed 30% in size and can last as long as three months. Few Bears can survive such an assault. No one who has been involved in markets the past few months needs an explanation of what can happen to Bulls in Bear Markets.

There are two occasions in a Bear Market when one can be profitable without taking unacceptable risk. Buying when the market is deeply oversold and pessimism is extreme and shorting when the market is overbought and investors are optimistic. The consequences of being wrong anywhere in between the extremes can lead to unacceptable losses. The key is to be patient and wait for the extremes even if it means staying on the sidelines for months at a time.

At present, the odds favor a continuation of the current rally as the rally is only a week old. However, the market is no longer deeply oversold and sentiment has improved somewhat so the protection that is required to take an aggressive stance is no longer in place. In addition, there are some conflicting forces at the current moment. Seasonality is positive through Tuesday, while the market is also short term overbought arguing for a pullback.

In the current context, it is best to stay out of the way for all except the most risk seeking individuals. For my part, I have very small exposure (mostly debt related) but for the most part am squarely on the sidelines.

Irrational Treasury Exuberance

  • The action that continues to catch my eye is in the Treasuries. The ten year bond is now yielding 2.937%. They call it a flight to safety. Seems more like running into a burning building to me.
  • There is a tug of war going on between oil and equities on one side and Treasuries on the other. It is highly unusual for equities to bottom and bond yields to continue to sink.
  • Are the same people who were long CDO's, subprime debt and overpriced stocks the ones who are driving up Treasury prices?
  • Have a great weekend.

Black Friday Observations

  • Chesapeake Energy may sell as much as 1.7 billion dollars in new shares, as they are too leveraged. There are many companies in their position. If enough companies come forward to sell new shares this will put an end to this rally.
  • Markets will close early today and after the first hour, trading will probably slow to a crawl.
  • Bear market rallies typically last at least three to six weeks. This one is less than a week old.
  • The market has seasonality on its side until Wednesday, when it becomes more neutral.
  • What a difference a week makes. The crowd went from scared of losing everything to scared of missing a rally.
  • The government can make money cheap but it can't force people to borrow and lend.
  • Is more debt the solution to our problem?