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Is This Rally for Real? And Other Thoughts

by Michael Nystrom
January 10, 2006
Cambridge, MA

"The tape moves in mysterious ways, the multitude to deceive"

- WD Gann

2006 - Year of the Bear

As most of you are aware, there are a number of bearish omens hanging over US economy and stock market for 2006. Here is the list, off the top of my head:

  1. Rising short term interest rates
  2. Inverted yield curve
  3. Housing bubble slowdown / pop in the works (See this excellent article by Gary Schilling)
  4. Massive slowdown and/or bankruptcy at GM and/or Ford on the horizon
  5. Rising unemployment in home building, financial services, and manufacturing due to 3 & 4
  6. Rising energy costs
  7. Corresponding slowdown in consumerism due to 5 & 6
  8. Stock market's four year / presidential cycle pointing down
  9. Rising trade deficit
  10. Rising budget deficit
  11. Rising national debt
  12. New Iranian oil bourse in the works to price oil in euros this spring
  13. Falling dollar as a result of most of the above, but especially #12
  14. New guy on the job at the Fed to deal with all of the above.
I won't belabor these points; I think we're all well aware of them. Anyone with eyes and a brain knows what they mean. All the evidence is lined up against the economy and the stock market.

But just when things are looking the most bearish, when we all expect the market to start the year off with a loud thud and keep on going, what does it do? It confounds everyone with new highs. So no matter how bearish one may be (and I am pretty bearish for 2006), there is one thing that bears cannot argue with right now, and that is new highs. And that is exactly what we've seen so far in the new year on all the major indices. The Dow is perched above 11,000 for the first time since 2001, just 8% away from a new all time high.


Click here for full chart


Gold likewise put in a new closing high today, over 550. A number of commentators have already pointed out that these gains have been accompanied by huge increases in M3. That money has to go somewhere, and it looks like for the time being it will continue to flow into stocks, gold, and other commodities. This means inflation as long as the Fed keeps pumping. But have you noticed that everything seems to deflate after they lay off the gas just a little bit?

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Nystrom's Scenario for 2006 1Q

From a long-term perspective, things look pretty dismal for 2006. Most mainstream analysts seem, if not bullish, certainly not bearish, while most internet commentators sense trouble ahead. Count me among the the second camp. In the short term however, we've got a little rally on our hands in the stock market. While I have no idea how long this current rally could last, it appears fairly clearly correlated with M3:
M-3 has been launched into outer space, up another $56.3 billion last week, up $92.4 billion over the past two. This is some real horsepower. Over six weeks, the meaningless figure, ahem, is up $177.8 billion. These annualized growth rates are 28.7 percent, 23.6 percent, and 15.3 percent respectively.
I doubt the Fed is going to abruptly shut off the spigot, and this pace should be enough to keep the rally going at least through most of the first quarter. From a technical perspective, the SPX (futures) looks to have around 60 - 80 points of rally in it, the NDX around 150 points and the Dow around 600 - 800. Bull or bear I think we'd all like to see the old Dow make a good run at its all time high, if just for nostalgia's sake. Wouldn't it be nice to cheer it on for one last run, like the Rocky Balboa of old? Of course if the Dow does beak to a new all time high, the psychological boost to the markets could be much greater, and prices might move much higher. But we will cross that bridge when and if we come to it.

What I would like to caution bears on is not to underestimate the possible extent of this rally. Think back to last year at this time and how just about everyone was bearish on the dollar. The Economist had a cover that showed pictures of paper airplanes made of dollars, crashing from the sky. Warren Buffet went short the dollar, and Bill Gates was quoted as saying, "the ole' dollar - its going down." (As if he knew.) But while the "fundamentals" said it should be in for a fall, instead it did the exact opposite. For the whole year. That's how markets go sometimes. As the old saying goes, "the market can stay irrational longer than investors can stay solvent." And so it is with the stock market as we start this new year. I wouldn't take this rally lightly if I were a bear, but I wouldn't take it too seriously if I were a bull, either.

The Reason the Most "Conservative" Investors Get Caught Buying at the Top

I know that a lot of bears out there can't believe their eyes, can't believe that this market is still going up, not with the deteriorating economic picture, and not with that 14-point list up there. But the market has confounded just about everyone of late, because that is part of its job. So let's imagine that the market has a nice run over the next several months, and the conservative investors on the sidelines see others making money while they're missing out. Then those "conservative" investors will start to get a little antsy. Every day the market moves higher they'll get more uncomfortable. By the time they're finally convinced that the advance is real and they buy in, the top will be in and the rally will be over. The prime point for this to occur would be as the Dow approaches its all time high, looking like its going to bust right through it without looking back. The other prime point would be tomorrow morning.

Please note, all of this is pure speculation, but it is the best way I can imagine for a bear market rally to fool the maximum number of people. So if a first quarter rally does materialize, keep your eyes peeled for signs of economic weakness and recession. The factors on that list above are real, and barring some kind of miracle, they are not going away. The first quarter is when Iran's oil bourse comes online, it is not unprecedented for markets to peak in the spring. The Nasdaq's all time high came on March 10, 2000 as investors started to look ahead to first quarter earnings and decided they didn't like what they saw. Oil is rallying again, and whether it makes a new high or not, I think the damage has already been done to the economy -- we just haven't seen it yet. If oil makes new highs, then forget it - recession is practically inevitable.

Changing of the Guard at the Fed

Greenspan's last meeting as Fed Chairman comes on January 28, and I suspect the huge increase in M3 has something to do with ensuring a smooth transition between himself and Bernanke. If you recall, Greenspan also flooded the pipeline just before Y2K. He is a cautious man. He wanted to make sure to stem any potential panics, so he did what any banker would do - throw money at the problem in the hopes that it would go away (and we all know what that did to the market). The changing of the guard at the Fed will likely go smoothly -- everyone will be on their best behavior -- and the markets will politely welcome in the new guy. At least for the first few days.

Greenspan took over Chairmanship of the Fed on August 11, 1987. If memory serves me correctly, the market peaked around August 25th of that year, but waited a full two months before the big welcome party in the form of the October 1987 crash. Bernanke takes over February 1st, 2006, and his first meeting as Fed Chairman comes on March 28th, 2006. We're all expecting him to have a trial by fire, but who knows what will trigger it? Maybe he'll spook the market with his overly direct manner of speaking, in stark contrast to what Jim Grant called Greenspan's "central banker Esperanto." Or maybe he'll disappoint the market by continuing with the short term rate hikes in an attempt to live down his inflationist reputation. Whatever the case, by the time the market peaks, most people will be so intoxicated by the rising stock market that they won't notice the deteriorating economic conditions. Or if they do notice, they'll do what they always do - they'll ignore them and say that this time they don't matter. The market always climbs a wall of worry, but when prices diverge massively from underlying reality, the stage becomes set for a crash. Bernanke won't be the cause of it (if it happens), but if he doesn't fix it, he'll certainly get the blame for it!

The Credible Threat

Last night I reread the text of Bernanke's Fed speech on deflation (Deflation: Making Sure "It" Doesn't Happen Here). I remember the first time I heard his printing press remarks -- I was blown away. I didn't know who this guy was, other than that he was a new guy and that I thought the line about the printing press was an extremely irresponsible thing to be saying. I was sure that he would be fired, or at least reprimanded for his remarks, but look where he is now. Shows you how much I know.

This is what I gleaned from the speech last night: Bernanke tells a story, that if an alchemist invented a way to make gold in unlimited quantities, then released this news to the world and said he was going to start making and selling unlimited amounts of gold, the price would drop immediately, before the Alchemist made or sold a single ounce. He goes on to compare the Fed to that alchemist. He talks about the printing press, then says, "By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services."

Then it struck me - this elimination of M3 in March is the credible threat.. It's a bluff. First they juice M3 like it is the end of the world (or 1999), and then they turn the lights out on the statistics. Since we're all in the dark, the only thing we can assume is that the Fed is inflating like there is no tomorrow. But they really don't want to do that -- monetize debt, that is -- it is not good for their balance sheet -- so instead they engineer this bluff. Everyone believes it, and they (we) act accordingly, bidding up stocks and gold.

If you don't think the Fed is that clever, I encourage you to read Bernanke's speech. It is a long treatise on stimulating demand and causing inflation in the event that interest rates fall to zero. After reading the speech, you may find that they are beyond clever. They are insane.

The Presidential Cycle

A recent report on the US Presidential Election Cycle notes that during secular bear markets (such as we are currently experiencing), the second year of the presidential term tends to be quite bearish. The report, from Hendrickson Financial, states that "caution will be of the utmost importance over the next 12 to 14 months. On average, from the start of year one to the low of year two (expected in the fall), there is an 18% drop."

As time goes by, the bearish picture should become clearer. I can imagine that the catalyst for declines this year may have something to do with growing political scandals in Washington, but I'll save that for next week. Whatever happens with the current rally, I feel pretty certain that stock prices will be lower at the end of the year than they are now.

Your Investment Garden

In closing, tend your investments as you would your garden, with special attention and care. Be patient. Pull the weeds, plant more of the good stuff, and watch out for plagues and pests! Keep your sense of humor, stay focused on your family, the good things in life, and do what you can do to help those less fortunate than yourself. Stay in the moment of now, and remember that all this money talk is interesting but it is not everything. The best things in life are free, but not cheap. In fact, they are priceless.

I would love to hear your perspectives. Post them to the blog, here: http://www.bullnotbull.com/blog/?p=27

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