DRACH MARKET RESEARCH REPORT
March 13, 2009
On Tuesday the Dow Industrial Average gained 379 points, its largest daily gain of the
year. There was a direct correlation between the advance and comments made by both
Barney Frank (Chairman of the House Financial Services Committee) and Christopher
Dodd (Chairman of the Senate Banking Committee) when they joined a long line of
others voicing their support for reinstatement of the Short Sale Uptick Rule.
The Rule was placed into effect in 1938 to thwart knowingly manipulative short selling
that had artificially depressed stock prices (contributing to widespread economic
destabilization, hindering capital formation, destroying shareholder wealth and expanding
unemployment) in the early 1930s.
In the almost seven decades the Rule remained in effect, there was never a recurrence of
the destabilizations experienced prior to the Rule’s implementation.
In July 2007, the Securities and Exchange Commission (SEC) rescinded the Rule and in a
compounding pattern both the economy and the stock market have experienced a degree
of destabilization not seen since the early 1930s.
The other topic gaining significant congressional attention occurred on Thursday. In
direct correlation with the congressional hearing on modifying “mark to market”
accounting standards, the Dow gained 239 points. Congress wants modification of
disruptive rules implemented by the SEC and Financial Accounting Standards Board.
One of the reasons behind congressional concern is the possibility of manipulative
practices (including short selling to artificially depress prices) destabilizing a variety of
markets, many without any type of regulation; possibly relegating some “mark to market”
pricing to “mark to manipulation.”
This was addressed in comments by Senator Charles Schumer (Chairman Joint Economic
Committee) who also indicated his support for reinstatement of the Uptick Rule and
urged the SEC to “crack down on derivatives that have the same effect of short selling.”
Credit is due to the tenacious efforts led by Congressman Gary Ackerman (D-NY) to
legislate against abusive practices (rather than leave enforcement to lax agency
discretion) helped push these issues to public forum.
At the same time as last week’s congressional actions, most financial media attention was
focused on Bernard Madoff who formally pleaded guilty to some things and was placed
in the slammer with wide criticism of the SEC for not catching “Bernie” before he turned
himself in after stealing $50 billion or so over a couple decades.
Madoff is simply a thief who used a standard Ponzi scheme. All Ponzi schemes have a
core element; the schemer must have control of the accounting statements. If securities
are held by and account status provided by an independent third party (custodian), Ponzi
schemes cannot work. It takes no genius to know if there is an arms length custodian.
As to status of the aforementioned three SEC related events:
Bernard has yet to be sentenced and no others have been arrested (difficult to
comprehend how one elderly fellow who frequently traveled kept track of 4,800 falsified
accounts). He is appealing his incarceration until sentencing.
The SEC and FASB said they will provide plans to modify “mark to market” standards
less prone to manipulation on April 1. Makes one a bit uneasy that’s April Fools Day.
SEC spokesman John Nester said the SEC “may conduct a public meting as early as next
month to consider whether to formally propose reinstatement of the Uptick Rule, or
consider other measures relating to short sales.” Usage of the words “may” and “or
consider other” SEC imposed time delays are a bit suspect.
As the saying goes, “we’ll believe it when we see it,” but the directions are positive.
The point here is to emphasize, as clearly verified by a long list of correlations, the day
by day investment environment is very sensitive to political announcements/actions. The
effects are both psychological and fundamental.
Seeing Bernie being placed in a cage and congress finally addressing indefensible actions
by agencies and those who have pilfered corporations helps to instill confidence as well
as discourage naughty behavior by unsavory elements.
For well over a year the market has been plagued by a lack of clarity and tangible result s
from a string of stimulus actions. The removal of uncertainties related to competency
and directions of implementation have a fundamental effect on consumer and investor
behavior, i.e. more confidence enhances both spending and investing necessary to hasten
We are in historic times, but not without historic precedent to provide insight into what
can reasonably be anticipated. Among data sets, it is difficult to justify most media
hyped comparisons with conditions dating prior to the Banking Act of 1935 which
created the FDIC, i.e. the insuring of bank deposits effectively minimized the traumatic
effects of widespread bank runs which accompanied almost all major economic
dislocations prior to the Act. The same era produced the New Deal and Second New
Deal which changed socioeconomic structure via Social Security and other safety nets.
Over the past two years in a compounding pattern, a wide variety of historical and
statistical precedents have been repeatedly breached. Other than manipulation which had
never before been a major data set, all data sets have at least a few decades of history. In
other words, it is not the data sets that are new; it is the magnitude that has never before
Last week, the Dow Industrial gained 9%, the S&P 500 10% with far larger advances in
relatively discounted high quality issues. Normally, this type of compressed movement
would alter some data set status, but nary a significant budge. The reason is because of
massive pricing disarray between industry and quality sectors as well as among stocks
within the same sectors. Common sense and all historic/statistical precedent dictate that
pricing relationships normalize to fundamental merit.
The abnormal has been widely accepted and tablo id media reinforced as normal. The fact
is abnormalities in civilized economies return to normalcy and there is a relationship
between the degree of strain (deviation from norms) and rectification (return to norms) of
the strain, a sort of rubber band effect reflected in both magnitude and time duration.
There is no sane economist that can deny the elemental relationship between money
supply and demand for products and services. Money supply fuels demand.
Each of the nine credible data sets (psychological, media, fundamental, technical,
structural, professional positioning, nonprofessional cash reserves, macroeconomic,
Federal Reserve) always exist with varying influence. Each shares the characteristic of
measuring demand/supply relationships which are the core cause of stock price change.
The relative influence of any data set or combination via precedent can be observed at
any time. In the current condition, one Federal Reserve subset dominates all others,
additional money supply. The amount resulting from combined Federal Reserve and
legislated stimulus measures is huge, well beyond any precedent and expanding.
In last week’s report we presented the magnitude and acceleration graphically (can be
found on Federal Reserve web sites). The important aspect is recognition that, albeit
clogged, it exists. It is massive, expanding and will not go away.
With so much media fragmented and tabloid (the in depth reporter pools are gone), it is
easy to lose sight of time duration differentiations of what is being reported.
Intense competition for attention (expansion of news sources via additional cable
channels and ease of entry on the internet) has created a “news” environment dominated
by sensationalized headlines purporting fact when content is often opinions, assumptions
and presumptions with wide variance of historical/statistical validity.
As reflected in the historic strains among data sets, we are in the thick of the most
dramatic stock market condition in modern history. To avoid confusion and emotional
reaction to tangents, it is helpful to recognize core elements among established data sets
in the context of associated time durations and magnitude of effects.
Macro (overall economic) aspects are dominated by the additional money supply created
by stimulus actions worldwide.
Albeit clogged, the money has only two eventual pathways; funding productivity or
creating inflation. Whatever the division, the value of productive assets (including
corporate ownership = common stock) increases.
No one knows the potential productivity/inflation division because the implementation
(unclogging process) has not been clarified as to rapidity or sequential industry effect.
Anyone with a sense of economic history knows the amount is so huge that directional
money flows are going to create significant multi- year (mega-cycle) socioeconomic
Micro day by day aspects are dominated by political actions/announcements because the
initial directions of the money supply infusions are dictated or influenced by those
politically empowered to do so.
Sunday evening, Federal Reserve Chairman Ben Bernanke will be interviewed on the 60
minutes television program. It is rare for a Fed Chairman to be interviewed in this type
of public forum. Whether the questions/answers are canned or not, interpretations of
Ben’s comments will likely be a major influence on stock pricing Monday.
As evidenced last week, even a whiff of eliminating short selling trading abuses
(reducing selling supply) or other actions to add stability can spike prices. The list of
correlations goes on and on. The point here is that extraordinary sensitivity to the
political climate is unavoidable until actions in substance (not rhetoric) provide clarity as
to the timing and directions of additional money supply (stimulus measures).
We have had numerous requests to reprint the web site address to the Bloomberg video
on naked short selling.
http://video.google.com/ videoplay?docid= 4490541725797746038
This video is informative because it shows how elements, domestic or foreign, can profit
by aggravating economic disruption/hardship and weaken U.S. infrastructure. It is very
nasty stuff, especially during a time of economic instability and two wars.
The core question, as always, is adaptation. The macroeconomic data is clear. It is a
combined (Federal Reserve + legislated) monetary infusion (stimulus measures) cycle.
Via precedent and as has occurred (is occurring), additional money supply will be created
until the objectives (offsetting deflation and sparking economic expansion) have been
Most stimulus measures have established time lines before their full economic effect. For
example, the Fed interest rate reduction to nil won’t have full effect until next September.
As such, there is overshoot, i.e. the flow of additional money supply will still be coming
after the objectives are achieved; thereby magnifying outcome.
The stock market has invariably advanced (often very significantly) before recessions are
pronounced as over or most standard economic measures indicate recovery.
Basic elements creating this monetary infusion cycle are well beyond precedent, so
massive that there is no previous cycle to compare eventual magnitude of economic
expansion or stock market advance. The sheer amounts portend it will be huge.
Against this background and the most accommodative Fed in history (we won’t fight the
Fed) all Time Overlay applications are fully invested.
In micro adaptation, focus is upon internal pricing relationships because whenever
fundamental dislocations occur there is an eventual return to norms.
Because of extreme pricing dislocations in all sectors, probabilities have favored a
broadly based advance prior to significant relative strength shifts among sectors as prices
normalize. Relative discounting among quality issues provides the group advantage.
The 10+% up move of the past four trading days is more than the historical average
yearly move of popular averages, but did not significantly alter data sets or relative
discounting between industry sectors or issues within the same industry. To see this type
of movement relegated to a minor blip among data sets is exceptionally rare and provides
indication of both the internal disarray and potential magnitude of this cycle.
We know the macro condition; there is a growing tsunami of liquidity. We know the
micro condition; higher quality stocks in all sectors are historically low in both yield
relationships and against the background of additional money supply. The combination
is straightforward, be heavily invested with holdings weighted to quality.
We don’t know what is going to come out of Bernanke’s mouth Sunday or if Treasury
Secretary Geithner has a developed a plan to release money supply clogged in the
banking system or the legislative and executive branches will direct the infusions
competently. All of these folks will be in the news next week and all have publicly
blundered. Hopefully, they will now be constructive, soon find out.