Weekly Recap - December 21, 2008

This past week was quite quiet, not to say plain boring. There was no rally, no deep dive of any of the indexes, nothing to keep us from doozing off while watching the ticker tape. If it wasn’t for Madoff, with his Ponzi scheme, there would be nothing to remember.
Speaking of Madoff, here is what Clarence W. Barron, the founder of Barron’s newspaper, said in 1920, when he denounced the original Ponzi scheme: “This neglect in our educational system leaves the people’s financial education to the sensational press, to socialistic propaganda and to designing politicians. It permits schemers to defraud the small earner and small investor through making him believe that capital accumulations and great fortunes are matters of speculation or public robbery.” Barron’s – the newspaper – wrote a skeptical note on Madoff back in 2001, questioning his secretive tactics.
So let’s take a yawn – sorry, look – at the major indices and how they fare this past week. The DJIA closed at 8579.11, down 0.59%, Nasdaq closed at 1564.32, up 1.53% and S&P500 closed at 887.88, up 0.93%. That’s it! So, with nothing to talk about last week, everybody turned to predict the outlook in 2009. And the opinions abound. After a 2008 which had investors on their toes, ready to throw in the towel, or the shoe, everybody is hoping for a much calmer 2009. It must be the exhaustion talking, because I read somewhere that 1929 looked just like 2008. Brrrr!!
Because optimism is the most important of the humanly traits, let’s cross our fingers and take peek into what’s expected from 2009. Tall order, no less! The economists expect a deeper economic slide, and traders are waiting for companies to report their messy fourth-quarter earnings starting in February. There are three powerful forces that will keep investors guessing and markets volatile: the ongoing and unpredictable government intervention, the process of deleveraging, and the impact of the economic contraction on corporate profits. As the volatility will come down from its peak, so is the correlation between stocks, which will allow for a clear differentiation between winners and losers. Some dubbed 2009 “the stock picker’s paradise”. As the expectancy for growth increases, the first beneficiaries could be the technology and small stocks – Nasdaq rallied 13% in four weeks.

The Cash Bubble and the January Effect
We are probably in a cash bubble, as investors paid the government to keep their money safe. The “cash is king” mentality is all the rage now, and it may soon join the list of bubbles that burst over Wall Street, including stocks, oil, agricultural commodities and subprime mortgages. A lot of traders are buying – or debating doing so – bullish calls on stocks and sectors. The more battered the security the better. They see options as a cost-effective way to balance the risk that the market could worsen in 2009, rather than improve, while ensuring they do not miss any rallies. They are selling richly priced calls, and using the proceeds to lower the costs of buying stocks. One Credit Suisse derivatives strategist, is advising clients to sell calls against Exxon Mobil (XOM), which he says is the “T-bill of equities”. Exxon has a free cash flow of $37 billion, the highest in the S&P 500. Many investors, in their flight to safety, have bought Exxon recently, and it appears to be overbought. Selling January 85 call against the stock may be a good way to cash in the exuberance. The economy gives us good reasons not to part with cash. Conditions will worsen if the consumers don’t start consuming again. Rising unemployment is also a major risk factor. However, it is difficult to find another point in the modern time when investor sentiment was more negative than today. Three-month realized volatility of the S&P500 Index was recently 71.86% surpassing the high of 68% set during the Great Crash of 1929. A short term swing on the optimist side will see a great deal of cash reinvested. Jon Najarian, co-founder of optionmonster.com, said cash is so high on the sides that it could stress the financial system when reinvested, saying that “it could be the biggest January effect ever”. Now that’s a good way to start 2009.

Still in the Bear Territory
The bear market doesn’t go away that fast. So while a retracement may be in the cards, looks for the exit points while the rally lasts.In this information age we are all inundated by data, forecasts and opinions. Some based their forecasts on life experiences, statistical analysis, historical references, or even just opinion. In the end some will be correct, and most will be incorrect. To pick and choose among the various resources is a matter of personal preference. Yet, to pick and choose too many resources will result in information overload. We can all agree, economically these are treacherous times. Banks are dysfunctional, credit lines are tight, businesses that relied on ever expanding credit are failing, unemployment is rising, and deflationary pressures are everywhere. We can all also agree that this is a cyclical economic downturn and not just an equity bear market. In the past century all cyclical bear markets have displayed similar characteristics. First, the equity market loses 50% of its value. Second, there is a 50% retracement of the entire bear market. Third, the final downleg. We label these three events are Primary waves A, B and C. The 1937-1942 cyclical bear market: lost 50% in a year, retraced 50% in a few months, and then took three years to retest the lows. The 1929-1932 bear market: crashed 50% in a matter of months, retraced 50% within a few months, and then continued to decline for the next two years until the market lost about 90% of its value. Technically, the main difference between the two cyclical bear markets is the 1929-1932 bear market continued to make new lows for the next two years after the initial 50% decline. While the 1937-1942 bear market went sideways for a few years, and only made new lows at the end. Our current cyclical bear market has already declined 50%, but has yet to retrace 50% of that decline. The retracement may be underway now, as the market has already rallied 24% off its recent lows. When the retracement does complete, Primary waves A and B will have completed, and then Primary C will be underway. Only then can we estimate the potential total damage to the equity market. Prior to these two events occurring, many forecasters are just making educated guesses. Should the bear market stall we'll enter a 1937-1942 scenario. Should the bear market start making lower lows, 1929-1932. The 1929-1932 bear market displayed some characteristics of its own. More on this should the need arise. When this bear market does complete its 50% retracement, to remain in equities would be a high risk venture.