January 2009

"Yes, Virginia, There Is A Santa Claus" -Francis P. Church 1897 The New York Sun

Santa came to the rescue, as the market ended 2008 with its largest two day point rally in history and its largest percentage gain since 1941 (Lowry), but it hardly put a dent into what has been the worst market decline since 1938. The S&P 500 ended the month with a 1.06% gain, but for the quarter it was down 22.92% and for the year a rather depressing 37%. Please see our results on the performance page. On the surface, the rally from the November 20th low has looked impressive as sellers appear to have finally exhausted themselves, but the rather anemic buying pressure during this gain leads to the question: Is this a bear trap, or the start of a longer term cyclical bull market? I’ll be looking at the volume on advancing issues as well as the volume on declining issues for a clue in determining the path that the market will take in the New Year.

While it is difficult to predict the short term direction of the equity market, I do think there have been several overshoots that have occurred, and while there are no guarantees that these overshoots can become even further stretched, it is my belief that certain sectors and products within those sectors represent unusually good value. With much of the thought process coming from BCA research, I will attempt to outline below some themes and specific ideas that may work in 2009.

• The massive bubble in Treasuries caused by investors seeking safety has created what appears to be tremendous value in fixed income. I’d be looking at quality first and then at high yield as the default and recovery rates become more measurable.
• The dollar has been strong as it still represents the currency of last resort, but it has started to weaken and should weaken further in the face of massive monetary and fiscal reflation. This may well be a positive for sovereign debt and high quality corporates traded in local currency.
• Commodities and oil are overshooting to the downside, and with widespread cuts in supply, I would anticipate a rebound in prices. Additionally, a weakening dollar (commodities are priced based on the US dollar) and the potential for China and India to start ratcheting up production could fuel further gains.
• The discount on closed-end fixed income funds has widened dramatically this year (negative six to over sixteen percent); with stability coming back to the fixed income markets, these discounts should narrow rather significantly. Simply put, the discount increases the yield by sixteen percent, and if the discount closes, there is a built in capital gain.
• Equities are cheaply valued but it would be nice to see the leading indicators pick up before overweighting the class. I believe that emerging markets represent the best potential, as monetary stimulus alone should be enough to jump start these economies.

What could hurt this scenario would be a failure of the aggressive monetary and fiscal measures to offset the current restraint on consumer spending. What could be a positive surprise is that these measures lead to a quicker turnaround in housing than expected (the original source of all our problems). Hoping for positive surprises in the New Year.

-Joe

PS. If this should prove to be a reasonably accurate thesis, I believe our current portfolios are well positioned. We’ve moved some of the put roll down profits into fixed income and commodities, but still retain a significant amount of cash to deploy should the current equity strength prove to more than just a bear market rally.