Poor Matthew's Almanac: Rally like its 1999...

Some quick back of the envelope calculations... If you took out a CD yesterday at 3.5% and invested an equal amount of money in the stock market at the same time... your losses today in stocks equal all of the interest you could hope to accrue in the next year from your "safe" certificate of deposit.

Touching 9300, a level its not seen since 1996, 1997, 2001, or 2003, the stock market is now ready to rally like its 1999.

(Unless it hits 7000 in which case we're back to 1966)

Why?...

I am beginning to feel pessimistic for the first time since Bear Sterns was rescued. Judging by the capitulation factor, this means I am wrong, since I am the most pessimistic guy out there. I was amongst the first to feel worried back when the Chrysler deal collapsed in the last week of July, 2007. But, I've been optimistic ever since Bernanke began to bend the rules this last March. . .If I am capitulating than we must have reached the bottom.

However the volume, the amount of trades done in a given day, has been extremely low ("dull"). This make me nervous.

Normally in a bear market, the situation is as Joseph Granville (see footnote) describes it, "Volume will be light on the early stage of the decline because the public believes that the decline is nothing more than one of the usual previous dips in the bull market and the result they expect will be another buying opportunity. The early selling is therefore done by the professionals. When the decline does not stop, the public becomes concerned and starts to sell stocks and the volume gradually rises on the accelerating decline.

As the decline becomes more rapid, the public gets more and more frightened and now stock are being dumped. This sends the volume still higher and a 'selling climax' results.

Recognizing this climax as a sign for a technical rebound in the market, the professionals start buying and the market goes into a technical rebound.

If the fundamental business background is showing some signs of weakening at this juncture, then such a rebound in the market would probably be considered as a selling opportunity, further declines are yet to come. This pattern can be summarized as: First phase of the decline on light volume- professionals are selling, and the public remains confident. Second phase of decline on heavier volume- professionals are selling, public disbelief over the decline causes them to lighten up. Third phase of decline on still heavier volume, l

eading to a selling climax- professionals finish their selling, and public confidence, now shaken, bring in a deluge of stocks. Fourth phase of decline- temporary technical rebound on professional short covering and general professional buying while the public continues to sell."

But I believe these rebounds have already happened in September 2007, April/May, and July/August of 2008.

"H.M. Gartley was a great technician in the 1930s. He did more work on volume than any other man. In 1933, he wrote:

'Bear market cycles begin on reduced volume. As the major (downward) phase develops, volume increases and this phase ends in a selling climax on heavy volume [March 18th 2008, July 15th 2008] The ensuing rally (corrective phase) is accomplished by declining volume, which dwindles until the rally loses momentum completely, and the major trend is resumed in a new bear cycle... Bear market rallies start out of active selling climaxes.'

Note that the first six bear market rallies, following the 1929 top, came out of heavy trading. But the rally in July 1932 came out of extreme dullness, indicative of a major reversal (a new bull market began on July 8, 1932 [granted it was down 90% from its peak]). The rationale behind the diminishing volume in bear markets is simply that the public loses interest as it loses money. Also, they have less capital to trade with, owing to those losses."
-Harry D. Schultz, "Bear Market Investing Strategies" 1968, revised 2002.

I think the difference between a crash today, or the crash of 1929 is the the government is coping with rather than exacerbating the crisis. So perhaps we will not have six bear market rallies, but more likely 4 or 5. We already had one in September 2007, April/May 2008, and August/September 2008, so maybe one more rally now and another in 9 months or so.

Or we will have six or more rallies but they will be not from declines like 1929-1932 but more like the gradual troughs of the 1970s. Basically the picture I see in my mind is the Federal Reserve, like a machine, trying to damp the vibrations of a violently oscillating string. In this picture the each fall and rally gets less dramatic as the crisis is solved.

Here is the reason why the crisis is not solved... Consumption is 70% of our 13 trillion GDP, about 9 trillion dollars. When a store takes on inventory, or in the service sector, borrows to meet its payroll in advance of its receipts, the store borrows in the commercial paper market. Doing an extremely crude back-of-the-envelope calculation, lets say half of that 9 trillion dollars needs to be borrowed every year to finance the goods we consume.

If this is averaged over 12 months, 375 billion dollars needs to be borrowed by companies, short term, every month. Right now this market is entirely shut down. (Quick check of the facts, the commercial paper market is actually 1.6 trillion dollars per week, because corporation evidently borrow more than I thought possible and it also includes bank's short term financing requirements, which I did not consider.)

"The Federal Reserve is working with the US Treasury on plans for a dramatic move into unsecured lending in the hope that this extreme step could help bring credit markets back to life.

As well as unsecured lending to banks, this could lead to the Fed directly purchasing commercial paper or funding a special purpose vehicle set up to do this.

Any unsecured lending would be a radical departure for the Fed. Central banks almost never make unsecured loans, and the Fed has never done so in its history...

It would allow the Fed to address two key problems in the financial system directly: the freezing of the term interbank money market, which covers all but overnight borrowing, and the rapid contraction of the commercial paper market...

The core of the problem in the interbank market is the lack of availability of term unsecured loans. Banks can get some term funding, but only on a collateralised basis, which helps explain the extreme demand for Treasury securities used for collateral purposes. Unsecured borrowing rates for any significant period of time - such as the three-month Libor (London interbank offered rate) - are sky high. In practice, most financial institutions are now unable to get term loans without collateral, and are funding themselves heavily in the overnight market." -Ft.com

"This hurts banks. Most [bonds/revolving lines of credit] are three- to five-year deals, agreed pre-crunch, at rates - typically Libor [pre-crisis, LIBOR was Prime minus 3%] plus six to 10 basis points for an investment-grade credit - that now seem extraordinary. Back then, these were barely break-even deals for the banks: they'd use them as a ticket to an M&A mandate or a big interest rate swaps programme. Now banks are funding themselves at much wider spreads. Whether they recover the notional amount is almost irrelevant - a drawn-down revolver means net interest margins are shot to pieces." -Ft.com

"This reliance on overnight money is dangerous for the financial system. It makes banks vulnerable to short-term market dislocations or loss of confidence, increasing the likelihood of failures and firesales of assets.

There are two reasons why banks cannot obtain term unsecured loans from the private market. There is a classic financial-crisis coordination problem, characterized as: "I won't lend you money for a month if I think that everyone else will only lend you money for a day, allowing them to pull out tomorrow and leave me stranded." This "roll-over" risk is a form of liquidity risk. The second reason is the credit risk of lending to banks, which has been elevated by the financial and economic turmoil.

The Fed's existing liquidity operations - ramped up again yesterday - reduce liquidity risk by providing a large backstop source of funds. But they are imperfect substitutes for unsecured borrowing, as they are only available on a secured basis. Unsecured term loans - for instance at 100 or 150 basis points over the federal funds rate for three-month money - would provide a near-perfect substitute.

The unsecured Fed term loan rate would act as a ceiling for Libor. Banks would be able to use these loans to reduce their reliance on overnight borrowing, making the system more stable.

Moreover, banks would in theory become more willing to lend spare funds to each other, reviving the private interbank market, since the borrower or lender could turn to the Fed for unsecured loans if it suddenly needed additional liquidity."-Ft.com

It is extremely dangerous to call market bottoms, but this unprecedented move by the Federal Reserve is almost the last trick in their hat. They have also announced they will start paying interest on overnight bank deposits with the Federal Government. This (which the European Central Bank already does) will allow the Fed to much more closely manage overnight borrowing rates. If this doesn't work, nothing else will. I suggest putting half of your money in the mattress and buying stocks with the other half.

For the folly of calling market tops, see the footnote on Joseph Granville below...

[Granville is probably best known for his bearish market calls during the 1970s, 1980s, and 1990s, when he claimed that the stock market was headed for imminent collapse. His overall track record, according to the Hulbert Financial Digest, is very poor.

The Granville Market Letter "is at the bottom of the Hulbert Financial Digest's rankings for performance over the past 25 years - having produced average losses of more than 20 percent per year on an annualized basis." ^[3]

Nevertheless Granville was known as a great showman ^[4] who would emerge from a coffin at an investment conference, or appear to walk across water (at a swimming pool) when meeting clients. According to Robert Shiller in his book Irrational Exuberance^[5]

His investment seminars were bizarre extravaganzas, sometimes featuring a trained chimpanzee would could play Granville's theme song "The Bagholder's Blues," on piano. He once showed up at an investment seminar dressed as Moses, wearing a crown and carrying tablets. Granville made extravagant claims about his forecasting ability. He said he could predict earthquakes and once claimed to have predicted six of the past seven major world quakes. He was quoted by TIME Magazine as saying "I don't think that I will ever make a serious mistake in the stock market for the rest of my life," and he predicted that he would win the Nobel Prize in economics. -Wikipedia]