Dozens of stocks come to mind that were sold down to insanely cheap levels as hedge funds scrambled for cash. That scramble is probably not over, so we may be in for more turbulence. Plenty of stocks come to mind that are still trading too high relative to their earnings potential. We’ll be looking to bet against those in 2009. Plus, many companies will not make it out of 2009 without going through bankruptcy. I expect to find a few more “short to zero” stocks — like Fleetwood Enterprises (NYSE: FLTW) — in 2009. We sold Fleetwood short in March at $4.43 and covered in October at 27 cents, for a 94% gain.

When asked by family and friends over the holidays what I think about the 2008 stock market and economy, my response has been, “I expected a nasty bear market in 2008, but the carnage since September took me by surprise. The economy will remain weak, but I think the worst of the widespread market carnage is behind us. Future damage should be concentrated in sectors with horrible fundamentals. Thankfully, 2009 should be a year when fundamental analysis should start to matter once more.”

This will be a welcome development, because 2008 was a year when the following strategy worked best:

1) Sell short any stock or ETF, without bothering to do any fundamental research
2) Invest the proceeds in Treasury bonds, preferably with as much margin as possible
3) Repeat Steps 1 and 2, over and over.

Clearly, this “deflation trade” strategy is not sustainable over longer time frames — not in an era of worldwide paper money standards. In fact, I’d expect that such a shotgun-based investment strategy of short S&P 500/long Treasuries could lead to big losses in 2009.

I think the key to approaching 2009 markets will be to view everything form the perspective of the Treasury and the Fed. Everyone knows that the real economy stinks and that America is overly indebted. But I doubt everyone realizes just how extreme Treasury/Fed will be in using the deficit and the paper money system to stop the Great Depression II scenario. Theses tactics will be inflationary at some point.

The U.S. banking system became destabilized because its core collateral – houses and mortgage-backed securities – collapsed in 2008. While the authorities may not be able to re-inflate old bubbles in these assets, I’m betting they can employ cheap Treasury financing to cushion the decline. This involves refinancing homeowners out of toxic mortgages into conventional mortgages. They’ll also find some way to deal with the problem of negative home equity, even if it involves highly inflationary tactics like Treasury assuming losses from principal reductions via Fannie and Freddie. And even if foreigners balk at absorbing new Treasuries, the Fed will monetize them – i.e., buy them itself. Again, these tactics would be highly inflationary.

So let me enumerate a few predictions for the New Year:

1) It’s far too easy and popular to be bearish on everything but Treasury bonds, so odds favor a sharp rally in early 2009 — a rally in the S&P 500, led by stocks with the most sustainable fundamentals, including energy, commodities, and infrastructure. Stocks with weak fundamentals may participate, but quickly roll over as economic reality sets in. Many will go to $0 in bankruptcy.

2) The SEC will suspend mark-to-market accounting, or at least modify it to allow more management discretion in marking values of securities. The era of wholesale shorting of financial stocks is likely over. A massive wave of refinancing is also a backdoor way to recapitalize the banking system; perhaps the most efficient way to increase the value of exotic mortgage-backed securities, (and bank capital) is for many of the mortgages backing these securities to “prepay” upon refinancing. Bankers will re-emerge from their bunkers and look to make new loans to creditworthy borrowers, since a sub-1% cost of funds courtesy of the Fed is too low to ignore.

3) Oil will rebound to $80 per barrel on lower than expected production, despite weak demand. If demand rebounds, oil could go to $120.

4) Gold will rally beyond $1,200 on weakness in the U.S. dollar, unprecedented Treasury bond issuance, and tepid foreign demand for U.S. dollar assets. Weaker foreign demand for Treasury bonds will prompt the Fed to step in as buyer of last resort and monetize debt. In its December policy statement, the Fed signaled that if foreign lenders look to sell Treasuries, it would step in as a buyer to keep rates low. If this happens, more savers and bond fund managers will look to invest in inflation hedges like gold and energy.

5) Many more hedge funds will fold in 2009, but this is good for the long-term health of the market. Most of the new funds should not have been started because they just went “long” everything on margin. Their closure will result in a more efficient – and less volatile – market.

6) 2009 will be a “stock picker’s” market. Nothing worked consistently in 2008 other than indiscriminate shorting of stocks and buying of Treasuries. The worst of the wholesale liquidation of stocks is likely over, so 2009 will offer lots of opportunities to buy and sell short individual stocks using fundamental analysis.

That’s the good news…So let’s end on that note.

Regards,
Dan Amoss

January 12, 2009

Stock Strategies: Random Predictions for 2009 was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

According to Mark Hulbert at CBS Marketwatch, 1958 was the last time the yield on the S&P 500 exceeded the yield on the 30-year bond. 1958? Are you kidding? Elvis joined the U.S. Army in 1958. Eisenhower was in the White House, Khrushchev in the Kremlin, and Menzies was elected for the fifth time in Australia.

The world may have lived on the edge of nuclear holocaust in 1958, but at least some things were more certain. You were better dead than Red. What was good for GM was good for America. And everyone liked Ike.

The world is much more confusing today. The yield on S&P stocks was 2% this time last year, a 74% increase in the last twelve months. We reckon stocks will start to look even more appealing when the yield reaches 5% or 6%, which would also mean lower stock prices first.

But there’s a bigger story going on, too. It’s what we call the Fed’s war on cash. You see, the Fed is driving down yields on government bonds and notes of all maturities quite deliberately. More on what it’s up to below. But it’s not just the Fed that’s pulling out all the monetary stops to float the world on a sea of credit.

It’s a now a race to the bottom for central bank interest rates. New Zealand’s central bank cut its main interest rates by a whopping 1.5% overnight. But the Kiwis have some work to do. Short-term rates across the Tasman are still at 5%, 450 basis points above Ben Bernanke’s Fed.

You don’t normally see such aggressive rate cutting in an economy until unemployment levels are much higher. It’s the classic Keynesian trade-off between inflation and unemployment. You can keep prices stable by keeping the rate growth low and savings high.

But slow, steady, prudent growth doesn’t create jobs fast enough for politicians. So rates are lowered! This leads to lower unemployment rates, but higher inflation. The big change in the last thirty years is that higher inflation was tolerable for most workers in the Western world because it seemed to come with some juicy benefits.

The first was asset price inflation. Houses and stocks went up too! Real wage growth was flat (or even fell). But the value of things you bought went up! On paper, everyone got wealthier.

Then, when China came along and started churning out geegaws and widgets faster than you could slap down a credit card, the apparent virtues of a little bit of inflation seemed limitless. Stocks and house prices went up, but consumer goods, durables, and electronics got cheaper.

This so-called “Great Moderation” suckered people into a dangerous financial strategy: asset-based saving and debt accumulation. And why not?

In a way, it’s perfectly rational. If credit is cheap and asset prices are rising, why not borrow to buy stocks and houses? The debt service is low, employment was pretty easy to find, and capital appreciation in your assets would smooth out any rough edges to the strategy.

Well, now that strategy is coming unhinged. In fact, the larger implication is so scary that only people like Robert Shiller dare to mention it: asset price appreciation is not a retirement strategy. It was a good run, from 1982 to 2000. But the idea that the stock market is society’s way of managing the risk of old age is now showing its own age. Investors are skittish.

“Fortress Investment Group LLC fell 25 percent to a record low,” reports Bloomberg, “after the private-equity and hedge-fund manager halted redemptions from its Drawbridge Global Macro fund, which had lost value this year.” Investors are seeking redemptions of over $3.5 billion from Fortress.

The run on the hedge funds is only restrained by the lock-up periods most investors agree to when turning their money over to a fund manager. But time takes care of that. Investors will continue asking for their cash back if they believe the market is either too risky or too mediocre.

This move to cash must distress the Fed and other central banks. It wants banks to lend, businesses to spend, and consumers to borrow. But the exact opposite is happening. So now we see the Fed doing its best to punish those in cash and force them to spend, or at least get out of government bonds and buy stocks.

Banks are content for now to build up a war chest of excess reserves. In fact, there’s been a surge in excess reserves held at the Fed by banks, and not just since the crisis began last October (the same is true of cash held at the RBA by authorised deposit taking institutions, see column K).

In other words, banks are happy to borrow from the Fed, but sad to lend to anyone. So what do they do? They deposit their new borrowings right back with the Fed, where they earn 1.5% interest (in excess of the target Fed Funds rate).

According to Fed data, U.S. financial institutions had just $60 billion in excess reserves held at the Fed at the end of September. On October 5th, the TARPenstein was passed. By the end of October, excess reserves held at the Fed had grown to $267 billion. By the end of November, it was $610 billion. Don’t fight the Fed! Flee to it!

Even a Congressman should be able to figure out what’s going on here. Correlation is not causation. But it sure looks like a lot of TARP money has gone straight to banks and financials, who’ve then put the money hard at work…on the Fed balance sheet, where it’s safe, secure, and earning 1.5%.

Maybe that was the whole point of TARP anyway. To beef up bank capital positions and not increase lending and spending. But the Fed is busy elsewhere in the bond market trying to get investors out of cash into something (anything!) else.

In a march that would have made General Sherman glow with joy, the Fed is systematically decimating the yield on U.S. government bonds and notes. It is blitzkrieging its way through the U.S. yield curve, buying, or threatening to buy U.S. bonds and notes in order to lower rates.

Don’t believe it? Bloomberg reports that the yield on 90-day Treasuries is .01%, while Ten-year U.S. notes yield 2.66%. Both yields, as you can see on the chart below from the Dallas Fed, are down.

By buying up securities with different maturities the Fed lowers interest rates. Investors crowd in looking for safety and, of course, rising prices. But what is the Fed really up to? Is it really trying to reduce American savers and those on fixed incomes to a state of pauper hood, where a lifetime of savings is consumed in a firestorm of inflation?

That is no way to treat your grandparents. So let’s give the Fed the benefit of the doubt and say that the ultimate objective of the policy is to drive interest rates on government bonds so low that savers and more importantly, banks, begin to loan out some of their excess reserves, or better yet, use them to buy distressed assets from each other.

If you want to use a military metaphor, the Fed is dropping big rocks on safe houses from its EZ Money helicopter battleship. One basis point at a time, it is methodically destroying any rational reason for investment advisors to put their clients in Treasuries.

And so if you’re not going to be in ultra-safe Treasuries because they are really no better than cash, then what will you do with your money? You have to do something with it. You will spend it. Or invest it.

Either way, you will get rid of it. There is no value in holding it, at least rationally. Emotionally, it feels safe, which is why ten-year yields are back at Eisenhower levels.

The risk here is that once everyone is crowded into the Treasury market, everyone gets too scared to leave. Safety in numbers, etc. On the one hand, it puts a lot of concentrated capital at risk in a great inflation. On the other, it sets up U.S. interest rates up for a massive spike if investors fear an inflationary spike and flee U.S. bonds to stocks or commodities. Talk about an interest rate shock.

Any way you look at it, the plunge in ten-year yields is impressive by historic standards. What you’re seeing is major dysfunction in capital markets. Capital is fleeing entrepreneurial risk for government bonds. Pressure is building. Something is going to give.

Regards,
Dan Denning
www.dailyreckoning.com.au

The Fed’s War on Cash was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.