Wow, what a month, what a quarter, what the hell is going on? As February ended and March began the only escape from bad news and a declining market was a special blend of ice cubes and your favorite marinade to take the edge off. By the end of March we found ourselves in the midst of a powerful bear market rally that made it hard to remember that just 20 days prior the markets were making new lows with their nose pointed straight down. What caused the change? And more importantly, is it change that will stick or are the markets actions just a head fake?
Let’s first start with what stimulated the markets turnaround then address the bigger issue of whether this rally is a bear market rally or the beginnings of a new bull market.
On march 10th the S&P500 reached 666 (the devils bottom as it will be known), you will recall in last month’s letter we talked about the markets breaking the old lows of 740 on the S&P and how this now opened the door for the markets to go lower. The trigger on March 10h that caused the markets to reverse course was news from Citibank that January and February were profitable months. For us here at Quiver we snicker at this because if Citibank can’t make money in this environment with the ability to borrow from the government for essentially nothing and then turn around and loan that money to you and I for over 5% then they won’t be able to make money in any environment. None the less the news causes short sellers who were betting on Citibank to decline further to cover their shorts. Covering your shorts is not something you do after a dysfunctional sphincter accident (my kids call it a shart). To cover a short position you have to buy the stock which causes the stock to rise. When you have a large number of institutions all covering their shorts at once it causes the markets to jump higher. As a side note to show you how confident investors are in Citibanks ability to rise further you can’t even find shares of Citibank to short at this time. All the shares are already taken by others still betting on future declines in the financial stocks. Not a sign of support and belief for sure.
Citibank started the rally then Bank of America came out and reiterated Citibank’s comments causing more short covering as well as the quick traders moving in to buy financials for a quick buck (these are traders not investors, they tend to rent stocks not own them). Another side note is needed here as Ken Lewis the CEO of Bank of America commented in an interview this week that March was not as good as Jan and Feb. Also, we think it must be noted that just because Citi and BofA had good sales months doesn’t mean their earnings will be all that great since we don’t know how much money they need to write down due to losses on mortgages and derivatives which leads us to the next more substantial piece of news for March – changes in accounting rules.
After the Enron scandal there was regulation past which requires companies to price illiquid assets on their balance sheet to current market values. This is called “mark to market” and its intention was to create greater transparency. In the midst of the current financial crisis we have learned one of the unintended consequences of this policy as the derivatives and mortgage backed securities that the banks have on their balance sheets are considered worthless or very close to worthless. In the old days bankers would just put these investments in Al Capone’s vault and pretend they didn’t exist until the markets improved. With mark to market rules they must reprice these assets at current values causing them to raise more capital in order to remain within the proper guidelines of accounting rules. The issue comes to a head when the financials need more capital and there are no investors willing to give them capital.
The end result is insolvency or a broke bank. To avoid this from snow balling the rules have been changed to allow the banks to have more flexibility in how they price these assets on their balance sheet. Providing this leeway gives the banks some breathing room which in turn will help their earnings look better than they really are. While this doesn’t create a solution to the real problem it does prevent failures which would cause depression in the economy. Essentially this move takes depression triggered by failing banks off the table for now.
While the accounting rules are significant in fueling the rally (there are some that say at least 1000 points of the Dows decline could have been avoided if we changed this rule a year ago) the real whammy was the announcement from the Fed that they are going to begin buying 7 to 10 year treasuries in an effort to lower mortgage rates.
This move by the fed is called “quantitative easing” and you can read about it in our “How the Fed Works” letter on our website. This move by the fed is a direct shot at placing a bottom in the housing market as well as stimulate the economy by giving homeowners a chance to lower their monthly mortgage payments by refinancing to a lower rate loan. This creates a lower monthly payment which puts money directly in their pocket not to mention creating a lot of revenue for banks and mortgage brokers.
In a nutshell March was a game changer in many ways and all these new changes were necessary to prevent a complete collapse of our economy. However, the jury is still out as the fundamentals of the economy still look pretty dismal. As I write we have updated numbers on unemployment with the rate reaching 8.5%. You may recall in our market outlook we discussed the likelihood unemployment will reach 10% before the recession is over and it does appear we are still on track for that. In addition, to unemployment we still have pending bankruptcy for GM and Chrysler not to mention no one has come out and been honest on how big the crisis surrounding the banks and their “toxic assets” is. By some accounts the problem could be in the hundreds of trillions. By the way, if you ever wanted to know how much a trillion dollars is – if you woke up the same day Jesus was born and spent a million dollars a day and lived to now you still would not have spent a trillion dollars.
In last month’s letter we touched upon some positives in the market place. We did see additional improvements in March with some of the leading economic indicators improving slightly. We also began to see what might be the beginnings of a slowing in the pace of badness. This is very important as the big investors will start to put money to work when they see that there is a change in pace to the negative economic news and interpret that as the beginnings of a turnaround.
Now to discuss whether the markets go higher or lower from here. In every bear market you will find “bear market rallies” or countertrend rallies. They usually get started by investors covering their short positions. We know this because in bear market rallies it will be the most beaten up stocks with the worst fundamentals that lead the rally. We saw this in March as the financials, retailers and housing related stocks saw the largest gain. Bear market rallies are typically very fast and will last 2-3 months which means this rally could go til June and we could see the S&P 500 reach 900 or slightly higher. Inevitably if the economic news doesn’t begin to support the new prices stocks are at the rally will fail and the market will reverse course and head back down to the mid 700’s on the S&P 500.
The best case scenario and lowest risk entry point for longer term investors is to wait for the markets to pull back for this “retest” and if it holds we will have a successful bottom placed in the market setting us up for a great 4th quarter. However, if the economic news begins to deteriorate sellers will move in quick and fast pushing the market lower and a break below S&P 740 reopens the door for greater declines. I know there is a lot of numbers in that last paragraph to digest so I will put it in a nutshell for you. If you are retired and need your money for income and are still in the market start selling your investments as and if the markets move higher over the next month with the intention you may be repurchasing those investments in July or August. If you are like our clients and have missed most of the downside to the market put a little money to work with a stop loss where you sell if the S&P were to break below 800. If you are a long term younger investor who will not need his/her money for twenty years begin dollar cost averaging by buying a little now, a little in July and August etc.
As you can see this is a time where you need to be dynamic with your money and if you have no desire to be so you need to hire someone that has the skill set to read the markets.
For our clients – here is what we have been doing. We continue to hold a substantial amount of cash. However, we have put some of that cash to work by putting 15-20% of it in the S&P500 in an effort to gain from the current rally. In some accounts we have purchased some prosaic names such as Potash the fertilizer company, GE and Dupont. We like the commodity area of the market as the Feds actions will weaken the dollar putting a bid under commodities as well as any companies which export their products. We have also purchased a weakening dollar fund as well as the Australian Dollar which has served us well over the last few weeks. We made an attempt to buy Gold as it should do well in this environment and subsequently sold it quickly. We have learned that when all the stars line up for an asset to go higher in price and it refuses to do so it is best to step aside and reassess. We continue to like the rising rates funds even though the Feds actions gave it a kidney blow for the short term which we view as a buying opportunity as eventually rates will move higher with all the money the fed has printed. It is not a question of if as to when rates will move higher. The Markets had the worst 1st quarter since the 1930’s with a decline of over 12%. At the time of this writing our accounts are essentially flat for the year.**
Until next month I wish you and your family healthy and wealthy days.
**Mentions of account holdings and performance are generalities of an average in our client base. Please review your statements for specific holdings and performance in your account.
The opinions expressed are those of Colby McFadden and Quiver Asset Management as of 4-3-09 and are subject to change due to market and other conditions.