Dec 27, 2009

Hello Santa Claus Rally

Hello Santa Claus Rally!

December 28, 2009

“Bankers and regulators have not come anywhere close to responding with necessary vigor” to the worst economic crisis in 70 years. There is a lot of evidence that financial weaknesses brought us to the brink of a great depression. The proposed changes are like a dimple.” -Paul A. Volcker, Dec. 8. at a conference in West Sussex, England.

Weekly percentage performance for the major indices
Based on last Friday’s official settlement...

INDU: 1.85%
SPX: 2.18%
COMPQ: 3.35%
RUT: 3.85%

Just when I make mention of how the seasonal trades have been so bad all year (think January effect, Sell in May and Go Away, and the summer doldrums to name a few, first year of Presidential Cycle), the Santa Claus Rally delivers with the reliability of a 400 pound elf riding behind eight reindeer. The last seasonal trade of the year working, albeit a bit early, after the rest failed seems an apropos way for a completely whacky year to end.

What has been working? Over the past month utility and industrial stocks have led the market higher. Technology continues to be strong. The only weakness can be found among the financials, which have lagged over the past month as the market has broken out to new post-crash highs.

The technicians are going nuts right now as the S&P 500 settles in around 1120. This level represents a roughly 50% retracement of the correction from 2007’s peak to the low in March. The technicians are now falling over themselves with the classic “if it goes higher, it will keep going, but if it can’t go higher, it will fall.” I’m not being critical of the technicians, just restating what I have read at least 20 times over the past few weeks. The chart below, courtesy, shows the S&P 500 from its 2007 peak. The blue, somewhat horizontal line is the 200 DMA, and might be just as important as the 1120 level. In next week’s 2010 preview I’ll discuss what I am expecting for 2010 (as well as reviewing all of 2009’s predictions).

As we exit the first decade of the new century, the question on most investor’s mind is whether the economy is recovering or not. Instead of going through the most recent week’s economic releases, I thought we’d take a page from Russell Investments and review some of the key economic indicators.

Corporate debt, as measured by the OAS, has improved dramatically from a year ago, although it is still elevated from long term historical levels. What does that mean? Typically a higher OAS suggests greater default risk and therefore higher risk premiums, while a lower OAS suggests greater availability of credit. Corporate debt issuance hit an all-time record in 2009 while the OAS declined throughout the year.

The VIX (measure of market volatility) is within its long term historical range at 24.5, moderating significantly from the peak of over 80 in late 2008. The VIX tends to reflect investor anxiety. I have found it to be a more effective indicator of short term market bottoms than tops.

The yield curve is the steepest in 30 years, reflecting some optimism regarding economic growth; concerns about inflation; and of course the heavy manipulation of the short end of the curve by the Fed. The amount of Treasury issuance is enormous and growing rapidly as someone has to pay for TARP, Cash for Clunkers, Job Creation Programs, etc. Wait until the healthcare bills start rushing in.

Mortgage delinquencies are off the charts and not yet stabilizing. This measure should continue deteriorating in 2010. Government efforts to assist borrowers are only exacerbating the problems and spreading the pain to all taxpayers, not just those who are delinquent.

Core inflation is low but worrisome, but as we have mentioned we don’t see a risk of a classic supply-demand driven inflation, but instead one created by a currency crisis.

Employment growth is non-existent. According to reader Jon Fisher, unemployment should peak at 10.4% and quickly fall to 8% by year end 2010. Where does he come up with that estimate? He cites a link between housing starts and unemployment, and feels that directional changes in housing starts lead to similar directional changes in employment. Jon writes “now that housing starts seem to have bottomed in April 2009, we should expect to see the completion of the cycle: A quick peak and decline in employment.”

Consumer spending is weak, but appears to be improving. This measure is heavily tied to consumer confidence and employment. If Mr. Fisher is correct regarding an employment rebound in 2010, then we would expect to see a similar improvement in consumer spending.

Economic growth (GDP) is improving but still heavily manipulated and fragile. The 3rd quarter measure was just revised down. Cash for Clunkers had a significant impact on the 3rd quarter. Fourth quarter activity could benefit from some very weak comparisons versus 2008. If the economy truly is on the road to recovery, why does the Fed insist on holding short term rates at zero?

Credit Conditions
The chart below, courtesy of Tim Iacono (author of “The Mess That Greenspan Made”), shows a reproduction of M3 and its moving averages. I say reproduction because the government stopped producing the M3 aggregate in 2006, which is too bad because it is/was probably the most complete measure of the supply of US dollars. During the ‘90’s we found that the 13 week moving average of M3 was a very accurate predictor of the stock market’s movements over the ensuing 13-26 weeks. Excess capital creation tends to find its way into the market until the economy needs or finds a way to utilize it. As you can see, M3 annualized growth peaked in late 2007/early 2008 at an unsustainable annualized rate of 17%, just before the credit crisis hit the red-line. What caused this acceleration in growth of M3? A new Fed Chief and an inverted yield curve.

How can the current growth rate be approaching or near zero while the government prints paper with reckless abandon? Because the banks are hoarding that capital to repair their badly damaged and in many cases insolvent balance sheets. If the banks were to start lending again, M3 growth would once again accelerate and inflation would be staring us in the face. The Fed would be forced to raise rates.

The Known Universe

The Big Picture published a great graphic via YouTube that shows the “discovered” portion of our universe.

Sovereign Debt
In my last note I discussed issues with Greece, Dubai World (I know, it’s technically not a sovereign issuer), Spain, and France, and said to watch out for the UK. Dubai has been thrown the expected life ring by Abu Dhabi, who generously agreed to provide $10 billion in aid to the Dubai Financial Support Fund.

What about the UK? Yields began spiking on UK debt (as well as Japan’s) as both those countries deteriorating fiscal conditions are actually making the US look like an economic super-power once again.

As a side note, PIMCO issued a thumbs down to US debt by reducing their US Treasury holdings and stashing the proceeds into cash.

Health Care
According to the Department of Health & Human Services, there were 16K fewer primary car physicians than needed in rural and inner city areas. As a way to control rising medical costs in 1997, Congress capped the number of hospital based residencies to 90K. Now, with millions of new people about to receive insurance, this shortage will only worsen. HHS is estimating a shortage of 159K doctors by 2025, without national coverage.

I’m sorry, but did they actually cap the supply of doctors in an effort to limit pricing? Wouldn’t increasing the number of doctors help to lower the price of medical care? More supply=lower prices.

Another instance of Congress not understanding the basics premise of supply and demand.

More on Health Care

In the first crucial test of whether they could hold the 60 votes needed to overcome solid Republican opposition, Senate Democrats voted unanimously in the middle of the night to press toward a final vote on legislation to overhaul the U.S. health care system. The final vote occurred Christmas Eve, and was passed after simply buying the vote of Nebraska Senator Nelson. The payoff? Offering to have the rest of the country pay for the Medicare and other healthcare related goodies for Nebraska residents.

“Any healthy system needs a way to correct error and remove waste. Nature has extinction, the economy has loss, bankruptcy, liquidation. Interfering in this process lengthens feedback loops. Error and waste are allowed to accumulate, and you ultimately get a massive collapse.

Capitalism is primarily attacked by two groups: utopians who wish to impose a more “compassionate” system, and political capitalists who want to enjoy the fruits of success without bearing the pain of failure. They use the coercion of the state to gain privileges, at the expense of everyone else.
As a country we’ve become less tolerant of economic failure. The result has been a series of interventions, such as meddling in the credit markets, promoting homeownership and creating a variety of safety nets for investors. Each crisis leads to an even greater crisis. The solution is always greater doses of intervention. So the system becomes increasingly unstable. The interventionists never see the bust coming, then blame it on “capitalism.”

-Kevin Duffy, Bearing Asset Management.

Crude oil jumped over the past two weeks as Iranian forces moved into Iraqi territory to take over a non-producing well. The timing is interesting as President Obama recently pledged Iraqi troop reductions and redeployments to Afghanistan. It seems the Iranians testing the resolve of our new President.

More Oil
After being pushed to the sidelines by war, Iraq, with its massive reserves, is again issuing licenses to foreign oil companies. This fulfills the conspiracy theory of the anti-Bush wing, who felt oil was the main reason for the war. This also puts a damper on OPEC as it reduces their control of Middle-East oil production. The catch is that they need Iraq to pump oil so the country can stabilize itself and counter the Iranians, stabilizing the volatile region.

Tax Give-Away
“The government is consciously forfeiting future tax revenues. It’s another form of assistance, maybe not as obvious as direct assistance but certainly another form. I’ve been doing taxes for almost 40 years, and I’ve never seen anything like this, where the IRS and Treasury acted unilaterally on so many fronts.”

-Robert Willens, an expert on tax accounting, commenting on the $38 billion or so tax gift given to Citigroup.

As Barry Ritholtz said “The looting of the Treasury, begun in panic under George W. Bush, continues in ignorance under Barrack W. Obama.”

Jobs and Elections
In prior notes we have demonstrated a high correlation between jobs and voter approval of the incumbent party. Lawrence Summers, director of the White House National Economic council, said that the Administration’s top priority is job creation and that the soaring budget deficit would be faced later, when unemployment is falling.

My interpretation is that re-election of the majority in the House and Senate is priority #1, and to achieve that job growth must be visible. The budget deficit not only isn’t the #1 priority, it isn’t on the radar because the Administration knows that the only way to stimulate any type of economic growth, and hopefully corresponding job growth, is by spending like crazy, not by showing fiscal responsibility.

More on Jobs
According to Business Week, Democratic leaders in the U.S. House said they want nearly $50 billion in extra infrastructure spending to stimulate job creation. The measure to boost housing and highway construction and the renovation of school buildings is a response to demand from rank-and-file Democrats for action to bolster the economic recovery and employment. When everything is added up, the plan exceeds $150 billion.

Left, Right, It’s all the Same

Ed Harrison---
“Don’t be fooled. Those who decry Obama’s policies as ‘socialist’ are doing so for purely political benefit. Are you telling me that Obama is governing in a vastly different way than George W. Bush at the end of his tenure? How exactly would John McCain have been any less socialist? Are you telling me McCain would have bankrupted Citi or BofA? It’s absolute nonsense. I would grant you that McCain would have sought to extend tax cuts for the rich. Otherwise, the cry of socialism is a purely political tactic using Obama’s dip in popularity in order to strip him and his party of any right-leaning independents he may have won in 2008.

The only difference between the established parties is the degree to which they believe in neoclassical laissez-faire economics. The right believes that markets are almost always right and see nearly no reason for government intervention except to lower taxes and promote free markets. The left believes that markets are almost always right too but they see more reason for government intervention in order to protect their traditional base of unions and the working class (think health care reform, taxes on the rich, and the auto bailouts).

However, in practice, those beliefs manifest themselves differently because of the political process and the power of lobbyists. It is what I have termed deregulation as crony capitalism. What the Obama Administration is doing has nothing to do with socialism; those who believe that are either political partisans or those hopelessly misinformed individuals falling prey to political partisans. The present policy is what Dylan Ratigan calls ‘Corporate Communism’ i.e. a pro-business status quo bias which favors incumbent firms over potential entrants, big business over small business, and corporate interests over consumer interests. It is no different than what we saw during the Clinton and George W. Bush Administrations.”

Queen Pelosi
OK, I know this is going to tick off a lot of you. I know the response lines are going to be on fire.

It seems that Speaker of the House Nancy Pelosi wasn’t happy with the C-20B Gulfstream III jet that comes with her job. She ordered a 200-seat, USAF C-32 Boeing 757 because of its greater range, which allowed her to reach California without refueling.

What’s the cost of this extravaganza? How about $120K per week in fuel, or $5.8 million per year in fuel costs, which doesn’t include the cost of the plane or crew. I have been told, but haven’t confirmed, that Newt Gingrich flew commercial when he was Speaker of the House.

Now, I’m not a tax expert, but I believe that when you use a company vehicle to commute back and forth to work, the value of that vehicle for that usage is considered taxable income. I’d love to see that tax bill.

I wonder what’s the impact of this trade on global warming?

I am hoping to get out a 2010 preview and 2009 summary next Sunday. If I am unable to get it completed due to the holiday schedule, I will have it out during the first week of January.

Happy New Year!


“A number of states are treated differently than other states,” Reid told reporters. “That’s what legislation is all about. Compromise.”


  1. Cash for clunkers may have caused a temporary bump in the third quarter figures, but it came at a tremendous cost to taxpayers, used car sales, auto repair shops and car donation.

  2. Thanks for your fine work. I found your comments most helpful in my investing activity. Happy New Year. Jim Lawson