Markets Shrugging Off Bad News

by: Alhambra Investment Partners

The markets last week were dominated by the tug of war over the auto industry bailout and the arrest Thursday of Bernie Madoff on charges of fraud. Lost in the noise of the Madoff fraud was the arrest of a prominent New York attorney, also on fraud charges. Absent Madoff’s alleged $50 billion fraud, Marc Dreier’s alleged $380 million fraud would have been the major story.

Madoff is accused of operating a massive Ponzi scheme disguised as a hedge fund. Madoff, facing $7 billion in redemption requests, confessed earlier this week to his family that his business was a fraud. Madoff has been a prominent broker on Wall Street since the 1960s and was a past Chairman of the NASDAQ. His brokerage firm was a large market maker and is not accused in the scheme. His sons turned him in to the FBI.

Madoff’s clients include many prominent hedge funds, European banks and wealthy families, many with connections to South Florida. Norman Braman, the well known auto dealer with operations in Miami and Denver, said Friday he was among the investors in Madoff’s funds. Madoff’s funds were marketed mostly by word of mouth and had supposedly produced steady double digit returns for years. He had only reported 6 down months since the mid 1990s, which should have been a red flag. No investment strategy is that consistent.

The fight over the auto bailout continued this week with the House of Representatives voting to throw money at them while the Senate balked. Senate Republicans got some political cover on Friday when President Bush and Treasury Secretary Paulson said they would consider using the remaining first tranche of the TARP funds for the auto industry. No one can accuse those two of harboring free market principles.

The economic news this week was almost uniformly negative. Pending Home sales were down 0.7% in October which actually doesn’t seem that bad. Prices are still falling but at least buyers seem to be stepping up. We’ve still got a long way to go to clear out the inventory though. Jobless claims jumped to the highest level since 1982 as 573,000 filed new claims. Continuing claims jumped 338,000 to 4.429,000. The trade deficit rose slightly as both imports and exports fell. Retail sales fell 1.8%, but that isn’t as bad as it sounds. Gas station sales were down almost 15% due to falling prices and auto sales were obviously down. Excluding those two items, retail sales were actually up. The numbers could be skewed because of the timing of Black Friday (Thanksgiving came late on the calendar this year), but I’ll take any good news I can find at this point. And last but not least, Producer prices fell in November for the second straight month. Excluding food and gas, prices were up 0.1%.

Considering all the bad economic news, the auto bailout tussle and the Madoff revelations, the market performed pretty well this week. Stocks were basically flat on the week; the DJIA was down just 5.74 points and the S&P 500 managed a small gain of 0.42 (click to enlarge images):

The market’s ability to shrug off bad news is a good sign, at least in the short term. I am optimistic that the rally off the bottom can continue for a while. A short term target is the initial rebound high from the October lows of around 1000 on the S&P 500 and around 9700 on the DJIA. Here’s a six month chart (click to enlarge images):

If the optimism over the new administration continues into the new year, the rally could even carry further. Past bear markets have tended to track the 200 day moving average which right now is around 1200 on the S&P 500. Since the moving average is falling and it will take time to reach it, a very preliminary, very optimistic target would be around 1100. I know it seems odd to be looking for stocks to rally in the face of bad news, but markets tend to move on sentiment in the short term. And while the sentiment is not good, it is improving from awful to just merely bad. And the market can rally on that change.

The most significant change this week was the dollar. As the crisis unfolded over the last few months the dollar rose against most other currencies, the yen being the major exception. That was due to two factors. First, the dollar and Treasury bills were the safe haven. Second, was the de-leveraging which has been going on. Hedge funds had borrowed dollars to invest in a wide variety of assets, many of them denominated in foriegn currencies. With markets falling and lenders demanding more collateral, the funds had little choice but to sell and repay the dollar loans. That helped to drive the US dollar higher against currencies such as the Brazilian real, Australian and Canadian dollars.

So, last week, the dollar fell pretty hard against the euro. The graph below shows the rise of the euro against the dollar (click to enlarge image):

The falling dollar is also apparent when viewed on a trade weighted basis (click to enlarge image):

The falling dollar affects other markets, primarily in the commodity complex. Gold rose 9% on the week:

Oil was up as well:

Non dollar denominated bonds were also up:

These moves were also reflected in the stock market. The best performing stocks in the week were all resource based with coal, metals and oil stocks leading the way. This can be seen in the materials index etf:

And the Energy Index ETF:

And the Gold Mining Index ETF:

Even with a falling dollar, foreign markets didn’t do much better than the US market this week. The EAFE Index ETF was up slightly:

If the dollar continues to fall, and I think it will, foreign markets should start to outperform. The conventional wisdom is that the US economy will have to recover first and therefore US stocks should too. That seems unlikely to me though. The US economy is the one deeply in debt and we are about to add to it by trying to borrow and spend our way out of recession. Asia, and China in particular, would seem to be on the opposite side of that equation with little debt and lots of cash to spend. I suspect that over the next few years Asia will be a more favorable place to invest than the US. China’s market may have already made a bottom:

My expectation is that the US economy, even when it recovers, will be growing only slowly over the next few years. It will take time for us to work off the debt load we’ve built up. The recovery from the last recession (which was very mild), was weak (remember the jobless recovery?) and we now have even more debt. It seems likely that any recovery will take a long time to return to anything resembling robust growth.

Another theme that I expect to emerge is inflation. Certainly it isn’t the topic du jour as deflation takes center stage, but at some point, the Fed’s expansion of its balance sheet seems likely to show up in the form of a weaker dollar (maybe much weaker) and higher inflation. I wouldn’t attempt to predict the timetable, but based on what we saw with the dollar and gold this week, it could already be starting. Maybe it is finally dawning on the world that we have limited ways to get out of this mess and printing dollars is the easiest path. With all the spending the politicians are planning, we will be issuing large amounts of debt over the next few years. If you were a foreign central bank, would you buy them? If there isn’t enough demand and interest rates start to rise, the likely solution will be the Fed buying them. I see no way that can end except in inflation.

Next week brings a Fed meeting (which has been expanded to two days) and a plethora of economic news. The major releases for the week:

  • Tuesday - Building permits and the Fed decision/statement
  • Wenesday - Crude oil inventories
  • Thursday - Jobless claims, Leading Indicators and the Philly Fed Survey

Next week will also bring some important earnings annoucements with Goldman Sachs (NYSE:GS) on Tuesday, Morgan Stanley (NYSE:MS) on Wednesday and Oracle (NASDAQ:ORCL) on Thursday. It should be an eventful week so strap youself in and hang on.