Issue 6 • January 7, 2009

A New Year Bull Market? Better Enjoy It While It Lasts.

After a gut-wrenching 2008, can investors look forward to a happier new year in 2009?

So far so good — the beaten down stock market rallied higher over the first few trading days of the New Year, although this morning’s sharp pull-back reminds us that whip-saw volatility is still with us.

The S&P 500 Index actually launched a fresh bull-market move at the end of last year, if you follow the conventional definition of a 20% rise from a recent low. The blue-chip index rallied a bit more than 20% from its November 20th closing low, to its New Year’s Eve closing high.^[I] Enjoy it while it lasts...

At Weiss Capital Management, we’re NOT convinced that the ultimate market bottom has been recorded just yet. But that doesn’t mean stocks can’t enjoy a spirited bear-market-bounce in the meantime.

In fact, history suggests that a short-term reversal of fortune for investors may be in store early this year. Since 1900, whenever the Dow Jones Industrial Average declined 20% or more in a year (it was down -33.8% in 2008^[II]), stocks gained an average of 4% the following January and had a positive bias the next year, according to data from Birinyi Associates.^[III]

Then again, plenty of bear markets in the past featured compound losing years (1973-1974; 2001-2002) with the worst string being the four year decline from 1929-1932.

Bearish Sentiment Sends Bullish Signal

To be sure, there are several sentimental reasons to expect a decent rally even within the overall bear trend, at least in the near term. Several indicators of market sentiment flashed extreme bearish readings during the closing months of 2008. Taken in a contrary way, such near-universal pessimism has, in the past, coincided with a reversal in financial markets.

Without doubt, one of the most remarkably pessimistic data points I have seen is the overwhelming pile of money sitting on the sidelines. In 2007 investors stashed a record $628 BILLION in cash into money market funds just through the end of November – even though yields are now hovering near ZERO. According to data from the Investment Company Institute, the total assets of money-market funds ($3.8 trillion) is now larger than all of the assets held in stock mutual funds ($3.6 trillion), an unprecedented sign of investor fear!^[IV]

In fact, there is enough cash sitting in money market funds to purchase 42% of the S&P 500 Index!^[V] Such a huge amount of cash on the sidelines could potentially fuel an explosive market rally, but a catalyst — or match — is required to touch it off. Without such a catalyst, money-fund assets may just continue to pile up in reserve.

Many Uncertainties to Overcome in New Year

Looking at the broad range of uncertainties facing the market in 2009, you could easily pick and choose among any number of reasons why investors may stay glued to the sidelines. But two key issues stand out in my mind: housing and banks.

In our view, a lasting reversal of fortune in the financial markets and the economy won’t happen until:

1.	The free-fall in real estate markets is arrested, and
2.	The MESS in the financial sector is cleaned up — or to be more precise — banks finally “come clean” about their own finances.

Let’s take a closer look at the second point (banks) first in this issue of Weiss Advice, and we’ll examine housing more closely in another issue soon.

One of THE BIGGEST contributing factors to the steep market plunge last year was (and still is) the issue of solvency (or lack thereof) among financial firms. The failures of Bear Stearns, Lehman, and AIG — to name just a few of the high-profile financial firms to fall dramatically from grace last year — triggered a systemic loss of confidence in the financial sector.

What’s in Your Bank’s Wallet?

Years of aggressive risk-taking by bank brokers and insurers, too much leverage, and too little regulatory oversight contributed mightily to the financial sector crisis. All it took was a dramatic decline in housing values to trigger a massive meltdown in mortgage-backed securities and derivatives, and voila — a perfect storm for the financial sector.

Losses and asset write-offs at the world’s biggest financial firms now total $1 TRILLION (and still counting) as a result of this mess and financial results set to be announced over the next several weeks won’t show much improvement.

Take Citigroup as a case in point. Citi’s share price has lost nearly 90% of its value, trading into the low single-digits late last year.^[VI] Like many other banks, Citigroup maintained all along that its balance sheet was sound with “very strong capital.” Yet, just one-month ago, Citi was forced to rely on a government bailout. In December, the bank received a new $20 billion investment by the Treasury Department, AND a government agreement to cover about $306 billion of Citi’s assets against more losses. This is over and above the $67 billion in losses already reported by Citigroup.^[VII]

What do Citigroup’s problems say about the solvency and financial stability of JP Morgan, Bank of America, Morgan Stanley...not to mention the hundreds of regional banks that are heavily exposed to potential losses in residential and commercial real estate?

This is the prime reason why credit markets froze-up last year, with banks afraid to lend to each other, let alone to consumers or businesses. So far in 2009, we’ve seen tentative signs of a thaw in the credit markets. Overnight bank lending spreads have come down considerably from their sheer panic levels of late last year – but are STILL NOT back to normal.

Over the next several weeks, the nation’s biggest banks and financial firms will reveal billions more in loan losses and “impaired” assets. “U.S. banks’ earnings will be hurt in 2009 by as much as $40 billion of further writedowns as asset prices continue to drop...” according to a story in Bloomberg this morning. The article goes on to say: “Banks’ credit ratings and capital ratios will be “of critical focus” in the first quarter.”^[VIII]

To truly restore lost confidence and credibility in the financial sector, what’s needed is for these institutions to come clean about the true extent of their losses and weakened capital state. Only then will private sector investors, rather than Uncle Sam, be interested in putting new capital to work to help finally rehabilitate beleaguered financial firms.

In an upcoming issue of Weiss Advice, we’ll examine the ongoing housing crisis in more detail, stay tuned.

^[I] Bloomberg Market Data, 1/5/09
^[II] Barrons: “What Will Light All That Dry Powder?”, 1/5/09
^[III] Birinyi Associates Ticker Sense: “Expect a Gain in January”, 1/2/09
^[IV] Investment Company Institute, Trends in Mutual Fund Investing November 2008, 12/30/08
^[V] Barrons: “What Will Light All That Dry Powder?”, 1/5/09
^[VI] Bloomberg Market Data, 1/6/09
^[VII] Bloomberg: “Citigroup Needs to Confess Its Writedown’s Now”, 12/4/08
^[VIII] Bloomberg: “U.S. Banks Need to Raise More Capital, Whitney Says”, 1/7/09