Happy Days are Here Again – Briefly

by JDH on March 7, 2009

Well, that was a great week, eh? At least, according to CNN Money, the Dow Fights Back to close up on Friday. I guess a 32 point uptick is something to be happy about. The bad market performance could be because the U.S. economy lost 651,000 jobs in February, after losing 655,000 in January, and 681,000 in December. According to the government, the civilian work force is 154,214,000 (if I’m reading the tables correctly), so at this rate in less than 20 years no-one will be working. That’s not good.

There’s lots of bad news out there. GM shares are at 75 year lows. They are exploring their options, so expect a bankruptcy filing sometime in March. Citigroup shares are worth less than a buck. Even Trump Resorts has had to seek bankruptcy protection. And don’t get me started on AIG.

So with all of this doom and gloom, what am I doing?

Buying.

Yes, I like to do the opposite of what makes sense, so on Wednesday I closed out my short positions (like RSW – Rydex Inverse 2X S&P ETF) (one day early, as it turned out), and I went long, buying the RSU – Rydex 2X S&P ETF.

Have I lost my mind? Is everything good again?

No, of course not. We are in a depression, and we are in a bear market. But, all bear markets have bear market rallies, and it looks to me like it’s time for one here.

here’s a shorter term view:

Obviously the charts look overbought, since historically an RSI below 30 leads to at least a short term rally, and the RSI closed at 28 on Friday. Aside from the charts, is there any fundamental reason why the markets could rally?

How about this: Legislation introduced on Thursday night proposes to eliminate mark to market rules. You see, under mark to market accounting principles, the value of a financial instrument must be restated to it’s current market value. If I bought a share for $5, and it is trading today at $6, I would show it on my financial statements (my balance sheet) as $6. Of course if it’s only worth $4, that’s the value it would have on my balance sheet.

If prices are rising, the conservative accounting treatment is to leave the price at the lower of cost or market ($5 in my example above), on the theory that a gain should only be recognized when it’s realized on sale; a paper gain is not a gain at all. The opposite is also true. If the price has fallen, is it fair to show a $4 stock on your balance sheet as being worth $5, because that’s what you paid for it? In that case, market value is more realistic.

Test time: let’s assume you are a bank with a sub-prime mortgage portfolio originally valued at $100 billion, but today, because no-one is paying their mortgage and the underlying houses are close to worthless due to the real estate market crash, the portfolio is worth zero. What portfolio value would you like to show on your balance sheet?

Hmmm, let me think. If I have to write down my portfolio by $100 billion, my balance sheet is wiped out, and my company is worthless. If I can keep the portfolio at it’s original $100 billion value, my company is worth $100 billion, and everything’s fine. If I’m a banker, I pick option B. Or, to quote the AP story on this:

Bankers pressed the SEC to suspend the mark-to-market rules as an emergency measure. Congressional allies managed to get a provision into the law setting up the $700 billion financial rescue plan directing the SEC to study the issue. But the agency in December recommended retaining the rules while suggesting improvements to current practices.

The latest proposal may not gain traction or become law, but it opens a new window on the debate over the highly charged issue of mark-to-market, or fair value, accounting rules. It’s expected to figure in discussion at the hearing Thursday by the House Financial Services subcommittee on capital markets.

“Part of this is pressure from banking regulators and the banking industry,” Mercer Bullard, the head of a mutual fund watchdog group and a former SEC attorney, said Friday. “It’s really the same old-same old.”

The bill proposed by Rep. Ed Perlmutter, D-Colo., joined by a more senior Republican, Rep. Frank Lucas of Oklahoma, would create a new federal board to oversee how accounting principles are applied to the financial markets. The board’s members would be the heads of the Federal Reserve, Treasury Department, Federal Deposit Insurance Corp. and SEC.

That would put an array of banking regulators, who generally look less favorably on mark-to-market rules, in charge of a crucial province now overseen only by the SEC.

The new board makes sense “because a broader group of individuals with a view of the greater economy should be in charge of applying” generally accepted accounting principles, Perlmutter said in a statement. “As we work to stabilize financial markets and rebuild the economy, we must look closely at the regulatory structure to see what is helping and what is making things worse.

“Proponents of mark-to-market rules argue that suspending or scrapping them would weaken transparency in companies’ financial statements, hurting investors and the capital markets. Critics say the rules mandate onerous writedowns — sapping investor confidence in banks — that don’t reflect the true value of soured, mortgage-linked assets and the prices they may fetch in the future.

The Perlmutter proposal “represents much needed reform that will help address systemic risks that accounting standards can have on the economy,” Edward Yingling, president of the American Bankers Association, said in a statement Friday.

Brilliant. Allow me to summarize:

This is an emergency. Instead of showing mortgages as worthless, we will show them as being worth billions. Stock prices go up. Investors are happy. The markets go up.

Brilliant.

It’s even more brilliant because the new rules cost the government nothing. No increase in taxes. No bailout money. No increase in the deficit.

Even better, since the government now owns half the banks out there (okay, I’m exaggerating, but you get my point), the value of the government’s investment instantly increases. They can sell their shares at a profit, instantly lowering the national debt, and the deficit. At no cost to the taxpayers!

So, on Thursday, at 10:00 am, the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises will meet to discuss relaxing the mark to market rules.

(As an aside, do we really need a committee called the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises. Isn’t that an unusually long name? Couldn’t we just call it the HFSSOCMIAGSE? Or perhaps just get rid of the Committee altogether? But I digress).

Governments will do what governments do. They don’t actually fix things, but they will make things appear better. So here’s JDH’s fearless prediction:

On Thursday the government will make noises about relaxing the mark to market rules. The stock market will rally. Big time. Everyone will be happy. All will be wonderful.

Lest this little blog of mine starts to sound like a late night infomercial……………..Wait, there’s more! If you order now, for a limited time, not only do you get the mark to market adjustment, but you also get the great big beautiful Bad Bank!

Here’s the deal: the government uses a trillion dollars, or whatever, to fund a newly created Bad Bank. The Bad Bank then uses it’s trillion dollars in cash to buy up all of the crappy assets (bad mortgages, etc.) from the banks that exist today. Instantly all of the bad stuff is off the balance sheets of the banks, and their stock price soars! Happy Days are here again!

The newly created Bad Bank then hires the same idiots on Wall Street who got us into this mess to manage the portfolio of toxic assets. They earn huge fees to do this. The banking industry is saved, and everyone makes money!

Yeah!

So, to summarize, I am buying for two reasons:

  1. The charts are looking over-bought; we are due for a rally.
  2. The Powers That Be will not allow the stock market to tank forever. They will do whatever it takes to force a rally. Spending trillions of dollars didn’t work, so changing the rules of the game is the next step. And creating a Bad Bank to make things look great is a certainty.

As I mentioned above, I bought some RSU – Rydex 2X S&P ETF, which is an ETF that goes up, in theory, by twice the percentage increase in the S&P 500. I bought some on Wednesday, and I averaged down on Friday. If the market falls on Monday, I may buy more to continue averaging down.

Second, I also bought some call options. I bought the April 76 S&P 500 calls (the SPYs, ticker symbol SZC C APR 76.00). If the S&P 500 closes above 760 by the third Friday in April, I’m in the money.

Like the DOW, the S&P 500 is trading at an RSI of 28.47, which is not sustainable. I think a move into the 800 range is almost inevitable. That would still leave the down trend intact, and would not even get the index back to it’s 50 day moving average.

Has JDH lost his freakin’ mind?

So, here I am, Mr. Doom and Gloom. In Story Time with JDH I told you many stories to illustrate why the world was ending. Last week I talked about shorting the market and buying gold. (I was correct last week, by the way, and thanks, it worked out well).

So why, this week, am I going long? Buying call options? What’s changed?

Nothing has changed. The world is still ending. Consumers have too much debt. Unemployment is at record highs. The stock market is crashing. Gold is rising.

But, and it’s a big but, nothing happens in a straight line. The markets will not fall by 200 points every day, day after day. There are always bear market rallies.

And that’s where we are today. Or next week. Or within the next few weeks.

The Obama Administration knows it’s got problems. The Dow opened at 9,326 on November 3, 2008, Election Day. On Inauguration Day the market opened at 8,280. The Dow closed on Friday at 6,627, a drop of 29% since Election Day, and a drop of 20% since Inauguration Day. Yes, we all know that President Obama inherited a big mess from George Jr. But if one accepts the premise that the stock market is forward looking, it does not appear that the markets believe Mr. Obama can fix things.

But fix things he must. He promised to do great things in his first 100 days. A 20% drop in the markets was probably not one of those “Great Things”. He needs a rebound in the markets, and fast. If miniscule consumer confidence disappears completely, he’s done. He’s a one term president.

He will not allow that to happen.

He will make sure the Bad Bank is created, and Mark to Market rules are changed. And when he does, the markets will rally. And I will profit.

For a short period of time.

Changing accounting rules, or moving bad assets from one box to another does not actually change anything. And, once the market realizes that, the downward spiral will continue.

I predicted Dow 8,000 on March 31, 2009, and I’m sticking to that prediction. (To be honest, I thought the market would fall to the 8,000 level by March 31; I didn’t think it would fall to 6,500 and then bounce back to 8,000, but hey, whatever gets us there, I guess). I expect a big bear market rally over the next few weeks.

How sure am I of a big bear market rally?

Not very sure. I am only placing small bets. I am still holding a significant amount of cash (over 40%), and a significant amount of gold and silver stocks (around 50%) with the balance in my gambling bets RSU – Rydex 2X S&P ETF, and the April 76 S&P 500 calls, in which I have invested a tiny amount of money, since I will probably lose the bet and lose everything). If I’m correct, I make a few bucks. If I’m wrong, I lose a few bucks. Either way, it won’t be significant.

Doom and gloom is an opportunity, so for now, I’m buying. It’s very possible that within the next week I will also be selling again.

Time will tell, and the time to tell will be next week, so thanks for reading, and see you next week.