Posted by Joseph Y. Calhoun, III

The stock market finally rebounded today, rising roughly 6%. While it was a good day, it does not as yet qualify as a reversal of the predominant trend. It is encouraging though that the rally was built off of genuine good news. Previous rallies have been technical in nature and had no fundamental underpinnings.

I know the last few months (and especially the last few weeks) have been very disturbing for our clients, as it has for me. I want to emphasize though that the theoretical basis for our strategy has not changed and that I am confident that our portfolios and the economy will recover.

Our investment strategy is based on the truism that in an economy with a fiat currency (no gold standard constraints) and a central bank, there can never be a period of extended deflation. The central bank (The Federal Reserve) will always be able to create more money that will find its way into the real economy and cause some kind of economic activity. In periods of a rising dollar, this inflation will generally manifest itself in stock prices while in periods of a falling dollar the inflation will generally manifest itself in real assets (real estate, commodities and consumer prices). The problem facing an investor is that one cannot predict in advance the course of the dollar and therefore cannot predict which asset class will rise during the inflation. Therefore, we construct our portfolios so we have exposure to all those assets. As trends become more apparent we can then shift our emphasis to the rising asset class. This strategy over the last 30 years has proven very successful.

We have just come through a period where we had a deflation of asset prices which was much more severe than anything we’ve seen since the Great Depression. All asset classes fell during this period with the exception of government bonds. We have had periods during the last 30 years when that happened but not a period of such intensity or duration. I believe the deflationary episode is now ending and it will become evident over the next few months which asset class will lead us out of this period.

Today’s rally was initially sparked by an internal Citigroup memo filed with the SEC in which the CEO told his employees that the bank had been profitable during the first two months of the year. He did emphasize that the profit did not include the effects of capital provided by the government or the writedowns of bad assets, but it does show that the current environment for the banking industry if quite favorable. In an interview yesterday, Warrant Buffet had this to say about the banking industry:

The banking system largely will cure itself.

What he means by that is that the Fed’s monetary policy is working. Right now a bank can basically borrow for nothing (either from the Fed or by selling extremely low rate CDs) and lend that money out at a large spread. That is how banks have always made money and the environment right now has never been better. Interest rate spreads are at historic highs. If Citigroup can make money in this environment, then the banks that are actually run well must be doing much better. Contrary to the popular caricature, the banking system is not in trouble. There are a few large banks that got into trouble while the vast majority of banks are doing just fine. It is unfortunate, in my opinion, that the bad banks were bailed out. The bailouts, and then the non bailout of Lehman Brothers, produced a level of uncertainty about government policy that paralyzed investors, businesses and consumers. Furthermore, the well run banks who would have benefited from the failure of the larger ones were not allowed to reap the rewards of operating prudently. The point though is that the banking system is healing and an extended period of low interest rates will allow them to rebuild their capital base.

The other news today was that the SEC is re-evaluating and may reinstitute the uptick rule for selling stock short. This rule was put in place in 1938 to prevent what were then known as “bear raids”. Short sales allow an speculator to speculate on a falling stock price by borrowing shares from an investor and selling them in the open market. The speculator then wants to repurchase those shares at a lower price and return them to the investor from which he borrowed them and thus book a profit. The uptick rule required that the last trade before a short sale be an “uptick” in price. That prevented coordinated shorting of a stock which could drive the price down with no relief. The rule was suspended in 2007 and market volatility has risen almost since the day it was repealed. While I don’t have a problem with short selling (it adds liquidity and can add information to the market), repeated, uninterrupted short selling does not give investors time to consider the reason for the drop in price. Investors tend to panic when stock prices are falling fast and they don’t know why. Most assume that someone must know something they don’t and feel they must sell before the bad news comes out. I have been writing about the uptick rule on the blog since last year and now finally someone at the SEC has awakened. It hasn’t been reinstated yet (good lord government moves slowly), but at least they are considering its effects.

Another piece of good news came from Ben Bernanke this morning. In a speech before the Council on Foreign Relations, Bernanke said:

The ongoing move by those who set accounting standards toward requirements for improved disclosure and greater transparency is a positive development that deserves full support. However, determining appropriate valuation methods for illiquid or idiosyncratic assets can be very difficult, to put it mildly. Similarly, there is considerable uncertainty regarding the appropriate levels of loan loss reserves over the cycle. As a result, further review of accounting standards governing valuation and loss provisioning would be useful, and might result in modifications to the accounting rules that reduce their procyclical effects without compromising the goals of disclosure and transparency. Indeed, work is underway on these issues through the Financial Stability Forum, and the results of that work may prove useful for U.S. policymakers.

I know for a lot of you that is gobbledegook but this is another item that I and others have been screaming about since last fall. The accounting rules he refers to are called mark to market and they have devastated bank capital in the downturn. Basically, mark to market rules say that assets have to be marked on the balance sheet at the prevailing market price. When the price of assets are stable or rising in a normal market that is fine. In a market that is impaired, it is financial suicide. Many of the losses that are being written down now are on loans that are current but must be marked down because the market price has fallen in an illiquid market. If the bank intends to hold the loan to maturity and it is current, there should be no reason to mark it down. I would also note that FDR suspended a similar mark to market accounting rule in the 1930s. While we don’t know yet what the changes will be, if any, at least they are finally looking at the problems with these rules. It is no coincidence that mark to market accounting was fully implemented in 2008 and that is the point when all the banks started taking writedowns.

In the shorter term, the actions of the Federal Reserve will have a positive effect on economic activity. The recently passed stimulus bill, while very poorly designed, will also have an effect on activity. These coordinated actions will likely show evidence of success soon, especially the Fed actions. This will show up first in higher asset prices and later in the economic statistics. My concern is for the longer term. Neither of these actions can be sustained in the long term and are actually just more of the same policies that got us in this mess to begin with. I feel sure though that these policies will lead to inflation. Again, from the Warren Buffet interview:

The current efforts to help revive the economy are likely to produce inflation that could be worse than what the country suffered in the late 1970s.

I said above that we can’t predict in advance which asset class will lead us up, but if inflation is coming, it is likely to be real assets again. Oil prices which fell to $35 in December are nearing $50 again. Copper has risen from $1.25 to almost $1.70. The commodity indices we use haven’t moved up much yet, but they are also acting better than stocks. The rate of decline for the Goldman Sachs Commodity Index has slowed considerably and is now roughly 10% off its lows. It isn’t yet time to increase our exposure, but it is a lot closer than the stock market.

I believe the economy and the markets are hitting their nadir now. It has been a much rougher ride than I anticipated but I think it is nearing an end. In retrospect, I wish I had done more selling last year but our strategy has always been long term in nature. As things develop over the next few months I will be making changes to take advantage of the new trends.

I have also developed a new, more active strategy for those who are interested. I have spent a lot of my time over the last few months doing research. In the course of that research, I wanted to see if there were more active trading strategies that would have allowed us to avoid the majority of the bear market. In reading through the academic research, there are some strategies that can be employed utilizing moving averages and other technical trading rules. I have formalized the research into a set of trading rules and will be implementing the strategy soon. This trading portfolio still uses the same assets as our long term portfolios but is much more active. Of course as with anything there are positives and negatives. While the strategy avoids large bear markets, it tends to underperform in bull markets and also involves a lot trading in and out which produces short term gains and losses. Because of the trading activity I will be implementing the strategy at the online trading firm FolioFN (https://www.folioinvesting.com/). This firm’s trading platform will allow me to manage the trading across multiple accounts ensuring that the accounts are uniform. In addition, they charge a flat fee for trading which will allow me to offer the new accounts for the same fee as the less active accounts. If you are interested in the new trading strategy, please send me an email (jyc3@alhambrapartners.com) or call me and I’ll share the research and track record.

Regards,

Joe