Turning Point?

Good Evening: It was simply getting too easy. For most of the past 10 weeks, market participants have been able to profitably sell every bounce in the stock market. Shorts were starting to print money almost as fast as our Federal Reserve. But once the S&P 500 took out its 2002 lows on Thursday afternoon/Friday morning, selling rallies became more hazardous. Now that our government has (again) fortified and back-stopped (the polite way of saying “bailed out”) Citigroup, and now that the 2007/2008 bear market has destroyed more capital than has any since the Great Depression, the old question of whether stocks have found a lasting bottom is being asked anew. The answer can’t be known beforehand, but to me, decreases in equity prices call for increases in the flexibility of one’s portfolio.

The major U.S. averages retreated last week in the wake of what seemed to be an unending stream of negative economic news, culminating with Thursday’s huge uptick in jobless claims and a correspondingly large downtick in leading indicators. Concern for the global economy became so pervasive that the word “deflation” was being bandied about as often as the term “booyah” had been during the up cycle. The S&P 500 breached its 2002 lows on that same Thursday, leaving this benchmark index down more than 50% from the all time high it set in October of 2007. Friday brought no new economic data, but it did bring an option expiration-related bounce. Enough money was drawn in off the sidelines on Friday that, instead of experiencing another harrowing late day drop, equities soared more than 6% into the closing bell. Friday’s fireworks even overcame persistent weakness in Citigroup and other financial names.

The situation at Citigroup must have been as dire as its sub $4 share price implied because the Fed, Treasury Department, and FDIC worked overtime this weekend to craft yet another rescue for the beleaguered financial giant (see below). The details and appropriateness of this latest plan will be debated for weeks to come, but what is not in question is the size and scope of this bailout. It’s massive. Washington’s obvious intent is to let the markets know that Citigroup will survive. And it’s not just Citi, either; the whole financial system will be backstopped, if necessary. Officials hinted that other large institutions needing similar help would indeed receive it. If so, Mr. Paulson’s fabled bazooka will itself need to be rescued (from overuse).

Reactions in various markets to these latest actions by the President’s Working Group on Financial Markets (a.k.a. the plunge protection team) were both swift and decisive. Shares of Citigroup soared more than 50%, and financial stocks in general jumped some 25%. Today’s advance was able to overcome another weak piece of housing data, specifically a larger than expected drop in existing home sales and a record drop in home prices (see below). By putting together the strongest back to back up days since 1987, however, perhaps Mr. Market is trying to tell us the bad economic news has been discounted — at least for now. Despite a notable dip in the final hour, the major averages posted gains ranging from 5% in the Dow to 7.5% in the Russell 2000.

Away from stocks, Treasurys were dumped almost as fast as they had been accumulated last week. After the 10 year note sported a “2 handle” on Thursday, yields rose across the curve on both Friday and today. Citi’s rescue and a poor 2 year note auction led to a back up in rates and left the 10 year note yielding 3.33%. TIPS fared even worse, and benchmark issues at 10 years and beyond all now promise real yields of greater than 3%. Investors looking for residual deflation fears after the rally in equities can find them still on display in the TIPS market. The dollar also reversed course, as the euro, Aussie, and Canadian dollars had their best days in quite a while. Our Fed’s continued promise to print all the dollars necessary to ward off deflation helped cause a 2% decline in the U.S. dollar index (see below). Commodities basked in the heat of the dollar’s drop and went up across the board. Led by large jumps in crude oil and precious metals, the CRB index gained nearly 5.5%.

Today I was asked if a stock market rally of 13% in two trading days was too fast to be characterized as anything other than a bear market rally. My response has two parts, one which will not surprise constant readers and one which will shock them. Yes, this move has all the hallmarks of a classic, bear market rally. It has been both breath-taking and brief. I put the odds of Friday’s intra day lows as being the ultimate lows as being no better than a 50/50 proposition. Just about the only certainty is that the economy has yet to hit bottom.

But the lack of follow through to the downside on Friday, coupled with what seemed to me to be a bearishness that bordered on despair (conversely, the shorts looked to be getting complacent), led me to purchase some shares of two names I have refused to touch for years. I bought a little Citigroup just south of 4 and some Goldman Sachs just north of 50. There is a non zero chance many market participants will look upon the Citigroup rescue as a signal of at least a short term bottom. Plus, with all the financial guarantees and promises of further money printing, I also added to some of my favorite mining positions. I wouldn’t be surprised if Charles Schwab himself called me to ask just what the heck is going on with my account.

No, I’m not a raging bull, and no, THIS IS NOT INVESTMENT ADVICE. I’m trying to show how the investment climate can change and how investors must be able to adapt to incoming information. These moves represent only small shifts at the edge of my very conservative portfolio and do not represent a change in my philosophy. As our government becomes increasingly committed to fighting what Merrill’s David Rosenberg fears is imminent deflation (see both pieces below), it makes sense to me to be at least somewhat prepared for different outcomes. What if, for example, our government “succeeds” in resuscitating our economy by debasing our currency? Stocks might fall in real terms, but they might also stop going down in nominal terms.

Home prices have been declining, stock prices have been dropping, commodity prices have been sinking, and economic activity has been waning, so there are indeed deflationary winds blowing in from the north. Consider also that he Treasury is bailing with all its might, Congress is ready to fire off another stimulus package, and the Fed is literally throwing money at our problems, so potentially inflationary breezes are building in the south. These are titanic forces are work, and the collisions they generate in our capital markets may lead to, in addition to the occasional tornado of volatility, consequences that are both unpredictable and unintended. Since I honestly don’t know how whether this storm will intensify or start to blow over, it’s sensible to prepare for either outcome. Hence the short term changes to my portfolio. As one of my friends from Georgia says, “it’s good to have a dog in each hunt”.

-Jack McHugh



U.S. Stocks Post Biggest Two-Day Rally Since 1987 on Citigroup

Citigroup Gets U.S. Rescue From Losses, Cash Infusion

Citigroup Bailout Charts New U.S. Course for Rescuing Banks

U.S. Economy: Home Resales Fall, Prices Tumble Most on Record

Recession’s Grip Forces U.S. to Flood World With More Dollars

Download Your Report: Negative nominal.pdf

Download Your Report: Pushing on a string as banks h.pdf

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