Thursday, March 12, 2009

SIGNALS FROM THE MARKET.


"Finance is art of passing money fromhand to hand until it finally disappears."--Robert Sarnoff

Signs Of Stability Or A Sucker Rally. As of today (Thursday, March 12) the Dow Jones Industrial average has increased 576 points or 8.7% from a week ago. While it is likely too early to tell if this represents a real reversal or a major rally within a bear market, there are some signals that indicate that the market is potentially nearing a bottom. Obviously, no one knows; however, there are some interesting signals.

1. Mark to Market. This is an accounting rule that has played havoc with financial services companies that invest in relatively illiquid assets. These companies include, but are not limited to some banks, business development companies, and real estate investment trusts (REITs). The rule states that assets owned by corporations must be carried on the books at the fair market value as if sold in the open market. While this sounds logical, at times markets for these illiquid assets are limited (that's why they're called illiquid assets). Marking these assets down to the price available in a non-existant market makes it necessary for banks to add massive amounts of capital. It also makes it difficult for REITs to use leverage to finance their real estate purchases. There is now a congressional committee meeting to evaluate the possibility of relaxing these rules for some assets. This would be a tremendous benefit to the markets and make it unnecessary for banks to keep asking for government money.

2. Return to Profitablity for Some Banks. Both Citigroup and Bank of America have stated that they have been profitable for the first two months of the year. We will have to wait awhile to find out just how profitable these institutions may be but even a small profit would be a shot in the arm for the market.

3. Less Fear In The Market. This is measured quantitatively by the Vix, a statistic published by the Chicago Board Options Exchange (CBOE). Although it is not a totally reliable index, that value has dropped from a previously unheard of maximum of 80+ to just above 40. This is at the upper end of the historic range but it does signal a reduction in volatility which is usually associated with fear.

So What Does It All mean? I definitely believe there is more upside than downside in the market right now, particularly in financial institutions. If Citicorp and Bank of America return to profitability and if realistic changes are made in the mark to market rules, we can expect a major rally in bank stocks, although not nearly to previous highs. Caution is definitely the watchword and, while it is definitely too late to sell, it may also be too early to buy aggressively. A small bet in the financial and energy sectors could be appropriate; however, a larger than normal allocation to cash is probably still prudent.

What About Real Estate. Single family home prices in the Denver Metro area dropped 10% or more from last year and unsold inventory is still too high to predict a rally. Rental rates are also dropping. One sign that predicts a recovery is the reduction in housing permits issued. These have gradually dropped from 38,000+ in 2006 to 30,000+ in 2007 and just over 19,000 in 2008. If this trend continues, it is only a matter of time until the surplus in inventory turns to a shortage as it did in 1991. Unless you are in an area in which prices have held relatively steady, you probably don't want to sell unless you are forced to. If you have to sell, remember that the market pays for houses that are clean and well staged. If you just throw it on the market, remember you are competing with foreclosures and short sales which usually have to be sold at a discount to market value.

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