In last month’s letter we discussed the recent “Green Shoots” that many Wall Street Pundits have been citing as signs that the economy and markets are beginning to turn around. As May progressed we had little evidence in economic data that would confirm whether the green shoots will blossom or whither into weeds.
Most of the economic data throughout the month of May was marginally better than prior months. Unemployment claims remained roughly at the same levels as the prior months (which is not good but not getting worse), housing prices showed additional declines after showing a slight uptick in April and the savings rate has now reached 5% a level not seen since 1995. I mention these 3 categories as I feel they are 3 of the more important indicators which will shape the economy.
Housing being the largest asset of most individuals as well as the industry with the greatest affect on the economy needs to see stabilization before confidence will come back into markets. Employment is the back bone of any economy as it is difficult to spend when you don’t have a paycheck. And the savings rate shows how our mentality has shifted quickly from spend spend spend with a negative 2% savings rate in 2007 to a positive 5% today. While this increase in savings is good news for the future it makes the near term tough as people are obviously cutting back and spending less. It’s tough to get an economy stimulated if its participants are in the mindset of saving and bargain hunting.
The biggest moves in the markets for May were observed in treasuries with interest rates spiking radically higher and the dollar dropping dramatically in value compared to other currencies. Both moves we talked about earlier in the year in previous market recaps. The overall stock market traded sideways with no significant gain or loss (just a lot of noise).
Moving forward there are some interesting behind the scenes events unfolding which should make June and July fairly interesting. Since the March lows the markets have seen a powerful rally which has all of us in a debate as to whether this rally is the beginning of a new bull market or a bear market rally which will eventually end like the previous rallies by rolling over and losing all the gains it created. I propose that it may not be as cut and dry as one or the other, rather a mixture of the two which will play out over the next six months.
There is no doubt in my mind this current rally began with short covering (a subject we covered last month and the month before). This month however there were some interesting undertows which have my concern antennas up. In the first week of May the government released the results of the “Stress Tests” for the banks which told us that Bank of America, Wells Fargo and Citibank as well as others needed to raise billions of dollars in capital to remain in business. The stress tests where based on the assumption that unemployment would peak at a rate of just over 10%. We are currently well over 8% and we have yet to see the repercussions of how the bankruptcy of GM and Chrysler will affect unemployment rates. This is concern 1 for me as I wonder how the markets will react if it begins to look as if unemployment will not only reach but exceed 10%. Will that force banks to have to raise more capital at a time when capital is not available?
This is a concern that keeps me up at night as the banks were successful in raising large sums of money in May through selling their stock in what is called secondary’s which means the banks issued more stock and sold it to large institutions. As this was happening we were seeing large early morning manipulations in the futures markets which caused the overall market to appear stronger than it may actually have been. It is not uncommon for central banks to play in futures markets to help their own currency stay strong as well as create values within markets in order for the central bank to get something accomplished.
What I am eluding to here is the possibility of the central bank (The Fed) pumping up the futures market during a time the banks needed to sell large sums of stock. By doing so this would help the banks get the right price needed for the amount of money they were required to raise. I know it sounds a bit like a conspiracy theory however in this world nothing can be ruled out.
I note this as a concern because what happens when this manipulation stops? The only probable answer is a decline in markets as there aren’t regular investors to replace the funds that the central bank was using to manipulate markets. In addition to possible market manipulation we have seen a significant change in long term interest rates with the 20 and 30 year bonds dropping in value pushing interest rates higher. The move in interest rates was one of the biggest moves I have ever seen and will work directly against the Feds efforts in lowering rates to stimulate the economy. Typically a move this dramatic in interest rates is a negative precursor to stock markets as it tells us there is something happening in credit markets which have people nervous. Coupled with the dramatic change in rates was a significant decline in the value of the dollar. Typically a decline in the dollar helps the US stock market which I believe was the case in May. However, the combination of the dollar falling rapidly and interest rates spiking higher is usually a sign of concern ahead. For these reasons I have been building our position in the Bear Market fund * or remaining in money market as I believe the markets are due for a selloff in June and July. I’ll be the first to acknowledge that this can be a risky move if I am wrong and on a day like today when the market is up 200 points after GM’s bankruptcy announcement I am nervous and willing to reverse course if need be. However, almost every bit of homework I have performed leads me to the belief that this year will be like a W with the March lows being the first low end of the W and the S&P500 around 950 (which we are very close to) being the widows peak of the W and the summer months being the second lower part of the W setting up the last part of the year to have another significant rally to the upside.
On the positive side there has been continued improvement in credit markets even with the bankruptcy of GM and the change in interest rates noted earlier. In addition, we continue to see commodity prices remain strong as well as the economic news has stopped deteriorating and has stabilized and in some cases seen small positive changes. All this leads us to the belief for now that the March lows will not be breached for quite some time and longer term investors that are sitting on cash can begin to get the cash to work on market dips. I believe the concerns mentioned earlier will provide us a window in the next few months to get our cash working harder. As mentioned earlier we anticipate the market to pull back through the summer months possibly setting us up for some good buying opportunities as long as there isn’t an increase in the pace the economic deterioration.
As always we will continue to monitor and keep you informed.
Bear Market Fund is not available in all accounts. Please review your statement for specific allocations within your account.
**The opinions expressed are those of Colby McFadden and Quiver Asset Management as of June 1st 2009 and are subject to change due to market and other conditions