OK, Here’s the Situation…

November 16, 2009

Good Morning. Another strong week for the major averages, with the SPY closing at 109.62. That is up 2.3% from last Friday’s close of 107.13, and now up a full 63% from the low of last March. The VIX was down 3% on the week, from 24.19 to 23.36. A lot of the rally seems driven, and is for sure being credited for the advance, by the continuing weakness of the dollar. It goes something like this. Dollar drops, which we all know is favorable for precious metals and oil, and is favorable for those multinational companies that do significant business overseas. So the rally starts with raw material and gold stocks and carries over into the likes of CAT, UTX, IBM, etc. It is a difficult rally to trade, because a lot of the gain is in roughly 50 of the largest stocks benefiting directly (or thought to benefit) from this unusual situation. Those stocks appear stretched, and are therefore a tough buy, and any attempt to buy other stocks that seem a relatively better buy seem to not participate as well.

The current economic situation, and the various governmental responses to the problem (coupled with economic numbers that have become less reliable on purpose over time), make for a situation unique to anything I have seen or heard of in my study of economic history. In one sense it is similar to the Japanese situation of the last 20 years, where the Japanese government maintained a virtually zero interest rate for a long period of time in an effort to shore up zombie banks (sound familiar). That created a situation where investors around the world borrowed money in Japan at cheap rates and invested elsewhere, the so-called “carry” trade. That policy has been credited with being a contributing factor to both the Asian monetary crisis of 1997 and the rise of the sub-prime and other CDO issues in the US and elsewhere. There is no question that the current virtual zero interest rate policy by the Fed is creating a new “carry” trade where people are borrowing in the US and investing elsewhere (and some here). We also have recent history, in 2000 and 2007, that “extra” money finds its way into the stock market, driving it to unsustainable levels. The problem obviously is that the US is bigger than Japan by a huge magnitude, and that really no one would opine that this policy benefited Japan while it surely contributed to problems elsewhere. I also would not think that a U.S. “carry” trade lasts the ten plus years the Japan one did.

A second issue is the amazing growth of the money supply versus the performance of the underlying economy. Since June of 2008, roughly the last seven quarters, the GDP (using the actual governmental economic releases with all their tricks to minimize the real situation) has contracted by roughly a full 2% (taking an average of the annualized quarterly numbers). The Fed has increased the money supply (M2) a total of 8.8% over that same period. That is an amazing gap of 10.8% between money supply growth and economic growth; a spread very few would say is healthy or proper. Again (and I have said this many times in the past) the economic reason for the Great Depression was that the then Fed allowed (questionable if they had the tools to do much else) the money supply to contract roughly 24% in a short period of time. So every junior economist knows not to make that mistake again, but what is the proper number? The business cycle has not been eradicated, and an attempt to throw too much money at an economy that is in some structural contraction (for instance the stagflation of 1974-1981) seems to be fraught with peril. Yet we are hell bent on pursuing this policy to an extreme that seems to benefit only a few. Every notch down in the dollar, brought upon by too many dollars, increases the price of raw materials like gold, copper, and oil. Those of us who use those commodities are hurt by those increases, in addition to the fact that every notch down decreases the net worth on a world basis of anyone holding dollars, pawns like you and me.

The third piece of this puzzle is the debt load of the US Government, as well as states and the various local governments. The October deficit of the US was a worse than expected $176.4 billion for the month. Mind you October is the first month of the new fiscal year, and the deficit for the just completed 2009 came in at a hearty $1.42 trillion. Dig deeper and it gets even worse (how could it?). That deficit of $176.4 represents the gap between total revenue of $135.3 billion and expenditures of $311.7 billion. That is an amazing gap, and the interest cost for the month came in at $22.8 billion, or almost 17% of revenue. That is with interest rates on federal obligations at almost record lows, what happens when those rates go up? These numbers should be catching someone’s eye other than mine. Current estimates are for this year’s deficit to exceed $1.5 trillion. That is $26,300 in debt for every household in just two years, or a quarter of the gross income of the average household over that same two years. We are way past any kind of comparison about how if we ran our business or private finances like the government we would be in trouble. These people (and somehow the supposed beneficiaries seem the same under Obama as Bush) are taking some very narrow view of how much the rest of us need to pay to save the few, with some added fixation on mid-term elections thrown in. It is almost like a poker game where the government just went all in with our money. Those benefiting will, in my opinion, be long gone from this country when this debt comes due for the rest of us.

The other night my significant other (real estate owner and sales lady) was telling me how she felt the new latest plan that not only gives $8,500 to first time buyers but $6,500 to just regular people trading from one house to the next would really help sales next year. I, of course, asked if she could think of any sane reason why I (or anyone else) should send a $6,500 check to someone who does not need the money just because they decided they needed new digs. I like the fact that it will be good for her, but it is insanity for a government in the fiscal shape outlined above. You can surely make the argument that it will be good for realtors, mortgage brokers, maybe even Home Depot, but at what cost? It was always true that if you sent someone somebody else’s money, he or she would spend it, and the places it was spent would benefit. Where is the genius there? The fact is it is going on the tab of other people, and borders on outright insanity. At least make it even, I am a renter, where is my check? I promise to spend it, I can be real good at spending, and would get better with more practice. You know what is even worse? In the last two weeks I have been accused of being a Republican twice. Twice! I don’t really know what that means, I think numbers should add up the same way on both sides of the aisle, and I think they do for the right people. Some are really going to benefit by these absurd policies, and the rest have a problem.

So how do we trade it? Even more important, how does someone like me whose research indicates we might be creating a house of cards stay with this strong advance? It is very difficult; for reasons other than just concern for the rally itself. The rally is steep but it is also relatively narrow. The rally a couple of years ago made it possible to identify stocks that were relative laggards, and even a late investment in those stocks allowed the investor to catch up. This time, that has not worked nearly as well. Financial stocks, where a lot of the money is going, have not participated. Infrastructure stocks, like FWLT, CBI, JOYG, FLR, and IR, have all lagged tremendously, even though they were the first to be recommended after the new stimulus package was passed. Hard to figure how a stock with a 7.4 P/E like Foster Wheeler, actually targeted by the stimulus, is dragging, while a stock like AMZN is gunning towards a 75 P/E on the strength of some wild idea of infinite global growth. Like I said last week, I think you have to be a little long to participate in an undeniably strong market, but stay protected in light of the narrowness and seeming peculiarities of the reasons for the rally. It is hard to do both, for sure. Towards that goal a lot of you have seen me putting on long positions in the SPY in addition to the basic PIP Strategy, and I will continue to try and stay ahead and participate somewhat. Keep in mind that the SPY is still down 23% from this date two years ago, while the PIP is down only around 5% from the same date, without virtually any of the volatility. The trick now is to participate in any further rally while not giving much back if the market turns. I am confident we can walk that fine line.