Market Timing: Should You Attempt It?

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Top 346. Nov 15, 2005 4:46 PM

» Normxxx - Year-end rally for no good reason

Contrarian Chronicles
A year-end rally for no good reason

by Bill Fleckenstein

The much-anticipated year-end rally may happen, but it's merely the calm before the storm. As the housing bubble dissolves and the economy slows, watch out in 2006.

As 2005 winds to a close, I have been wrestling with a question: Whether or not the market can hold together for the rest of this year— leaving the serious business of "the next time down" an issue for 2006. In the face of that unknown, I must look to seasonal market psychology for clues.

Bulls have been feeling pretty bulletproof due to the combination of the "calendar" and what I refer to as the "no-news period." Let me explain the latter— and how it works into the equation of what the rest of this quarter and calendar year might look like.

Lifecycle of the corporate-spin cycle

Most companies in America are on calendar quarters. In the case of the third quarter, by the time October was finished, we had heard from pretty much all of them. We won't really hear anything further until early December, when we get the mid-quarter updates. Next, we get whatever preannouncements are going to occur. Then in January, we hear from the companies about the fourth quarter.

So in essence, the news period starts roughly with the last month of the quarter and runs through the first month or so of the new quarter. Said differently, the no-news period is the month in the middle of the quarter. (Obviously, this is not precise. Sometimes, due to the way the quarters have aligned vs. expectations, the no-news period can be longer. Also, it isn't strictly a no-news period. It's just a diminished-news period.)

Vaporing thrives in a vacuum

Why does that matter? Because even though most people who operate on Wall Street are adults, they seem to want to believe in childhood fantasies— witness them describing the economy as a Goldilocks economy and planning for the Santa Claus rally and assorted other dreams.

When I got into the business in the late 1970s, this sort of brazen naiveté would have wiped you out in short order. By my reckoning, individual stocks figured out (or discounted) the news long before they seem to do so today. I attribute this to the fact that people have made so much money basically ignoring all forms of bad news since roughly the mid-1990s that they have invented new rules. (Yes, we did have a nasty 18-month period after the bubble burst. But, as one can see by the craze that's shifted into housing, that sell-off seems mostly forgotten.)

In any case, combine the no-news period (which November essentially is) with folks' belief in the Santa Claus rally, and you have the dynamic for a big rally— if there is the money to do so (meaning that folks haven't already made the bet) and if what news there is cooperates.

The writing on the drywall

Last Tuesday was an example of the news not cooperating, as Toll Brothers (TOL) was forced to take guidance down for next year. The company's stock declined about 14%, with every other homebuilder hit for 5%, plus or minus. (It is worth noting that since last summer, insiders— continuing to wax poetic about their business prospects— sold more than 3 million Toll shares, at an average price of approximately $51.)

Anyone who's read the Contrarian Chronicles for any length of time knows that this is just another data point signaling the demise of the housing ATM and, as a consequence, the consumer and the economy running out of gas. What we don't know is:

At what rate the process will unfold.

When it will be recognized and acted on in the stock market.

A potential sign of that recognition: last Tuesday's 3% decline in the shares of Best Buy (BBY), a prominent beneficiary of consumers' spending spree, financed by you-know-what.

I may be making way too much of the dots being connected. But dots will have to be connected about what the demise of the housing ATM will mean before it can collectively mean anything. So, along the lines of what I said earlier, one of the things I'm looking for are signs, outside of the housing stocks themselves, that folks are figuring out what the demise of the housing ATM means.

End-of-year rally or trap?

Back to my original question about the market's path into year-end: I still find it hard to believe that all the people who've made the calendar/no-news bet are going to get paid this year— though the weight of their sentiment may suffice to keep serious downside action at bay until next year. If so, we might just see a giant flop-and-chop for the rest of the year (with the averages finishing plus or minus a couple percent).

Of course, even if something like that scenario did play out, it doesn't mean there wouldn't be a handful of stocks that might go up a bunch and a handful that might go down a bunch. Again, this is only a near-term scenario, as I continue to be completely convinced that the next move of any consequence will be lower. However, when you're speculating on the short side, as I do, getting the timing right is crucial.

The Next Time Down

I have been in the money-management business since 1982. Since 1996, I have run a short-only hedge fund, been a director of Pan American Silver, and written a daily market column on the Internet. That column, and a copy of this talk, can be found at Fleckensteincapital.com. As I clearly state on my Web site, my personal motto is "Often Wrong, Never in Doubt." With that disclosure out of the way, I can get started.

Today I have a trifecta to share with all of you: a macro theme which I call "the next time down," a specific idea to profit from that theme, and, in the interest of evenhandedness, an idea that those of you who conclude I am dead-wrong can use, to express your negative opinion of my opinion.

I believe that the four years which have elapsed since the stock market peaked have essentially been one massive exercise in denial. Initially, folks were in denial about the fact that stocks had peaked and that we were in a bear market. Then, all of our economic and stock-market problems were blindly pinned on the attack of September 11, even though that attack wasn't the economy's true problem. The next excuse was pre-Iraq war fears.

Finally, the combination of the fall of Baghdad, 13 rate cuts (which heretofore had been not good enough), two tax cuts, two rounds of tax rebates, and the recent tax refund was potent enough to give us the year-long rally that recently ended, as well as a big bounce in the economy. However, from a stimulus standpoint, the government is out of bullets. No more tax cuts are coming, no more rate cuts are coming (though I think no more than a couple 25-basis-point hikes are coming, either).

But most importantly, the "use-your-house-as-an-ATM-to-live-beyond-your-means" stimulus is finished, thanks to the recent de-leveraging/crackup in the bond market. The refi game and the bull market in housing it created postponed the consequences of the largest stock market bubble in history. Though the Fed and the rest of the government succeeded in postponing the fallout from the massive misallocation of capital that took place in the mania, they have also succeeded in compounding and exacerbating those consequences. Even more leverage was created in the system, as we attempted to speculate our way to prosperity.

In short, the excesses from the bubble have not been cleared away, but they will be, along with the recent excesses from the refi bubble. I believe the economic rebound has peaked, the economy will slow down in the second half, and we will ultimately slide back into recession. I believe we are headed for a large slide in the stock market, as well as a resumption in the decline of the dollar. These developments will tend to be self-reinforcing, and especially damaging, if and when housing prices join the decline.

If that weren't bad enough, in addition, the Fed is finally trapped. Easy Al can't cut rates when trouble starts, because he has already created a decent-sized inflation problem. As this scenario unfolds, in whatever variation, we will experience the "next time down." The realization that the market is going down again, and with it the economy, will force people to come to grips with the fact that the interlude of the last year was just that. This will deal a crushing blow to confidence, causing the public to finally comprehend that the Fed can't save them. Once the business of clearing away the excesses begins again in earnest, your guess is as good as mine as to how ugly it all gets.

Though I run a short fund and recently became fully invested for the first time since 2002 (as I was fortunate enough to see last year's rally coming), my specific idea to capitalize on the debacle I see brewing is a long— not a short. I decided to go with a long idea for three reasons: (1) Managing a short position requires a lot of monitoring. (2) While you may make 50% to 70% on a short, you can make 200% to 300% on a long. (3) This long idea should also protect you when the dollar weakens.

My idea to protect yourself, or to profit from the potential damage I have just described is— buy silver or silver equities. One month ago, I was struggling to come up with an idea to suggest today. But the recent 35% collapse in the silver market created a topic for me, and an opportunity for you, as silver's downside from the $5.50 level is small and manageable.

The fundamentals of the silver market are briefly as follows: About 600 million ounces, or $4 billion worth of silver, are produced each year, while 800 million ounces are consumed. The market has been in deficit for 13 years in a row now, reducing above-ground stocks by some 1.35 billion ounces. (These stocks are currently estimated to be approximately 500 million ounces, or $3 billion.) Photographic demand comprises about 25% of consumption and has remained fairly stable, in spite of digital cameras, thanks to other photographic uses. In fact, Photofinishing News projects that more silver will be used in 2008 than in 2000!

However, the supply and demand data are not reason enough to own silver, though they do suggest what could happen to the silver price if investment demand picks up. The price rise could be truly explosive, especially when one considers the inelasticity of silver supply. Pure silver mines are rare, as roughly 70% of the silver produced is a byproduct of other mining. The bottom line: If demand heats up, there will be only a limited amount of new silver for quite some time— and, the central banks don't have any, unlike gold.

So what will create the investment demand? A change in psychology regarding the superiority of paper assets, precipitated by the ramifications in the financial markets of "the next time down." The demand for paper assets and dollars that we have witnessed in the last decade or so has been an expression of total confidence in the central planners at the Fed. If that confidence cracks, as I expect, and the dollar begins to be viewed as the Bernanke confetti it has become, demand for silver and gold will increase. Warren Buffett has eloquently articulated his bearish point of view of the dollar (and backed it up with $18 billion), so there is ample reason to be concerned about the dollar, even without the change in psychology precipitated by "the next time down."

Okay, so how can a guy who doesn't want to buy silver itself implement this idea? Since silver is a small market, and silver mining has been so difficult for so long, your investment choices are limited to about five companies, which all have different characteristics. One has serious base-metal exposure, one has serious gold exposure, one is pretty speculative, one has the most horrendous management I have ever seen, and then— bearing in mind that everything I have to say is 100% biased— there is Pan American Silver.

Since I am a director, it is not appropriate for me to be as opinionated as I otherwise would like to be. What I will say is that after being on the board for seven years, I believe it is an extremely well-run company. I don't know how many of you know Michael Larson, who manages Bill Gates' money, but he has been on the board for five years now, and he shares my opinion of management. John Doody, the best independent mining analyst, says that PAAS is the "best pure silver producer; with six mines soon, its profits will benefit most from a silver rise, as all others need two to three years to build a mine."

Earlier, I promised an idea for those who disagree with my analysis. For those of you, I would suggest shorting CDE, of which John Doody has written: "CDE stayed alive, issuing shares for debt, but despite diluting original holders by 90%, the company still cannot make a profit. Management continues self-aggrandizing ways, as 2003's corporate overhead works out to 87 cents an ounce produced! No wonder management owns few shares."

I thought I would conclude this brief analysis by comparing a few data points about PAAS and CDE (but for anyone wishing more detailed information, read John Doody at http://www.goldstockanalyst.com, or listen to Pan American's most recent conference call at 877-519-4471. The pin code is 472 6403.)

If all goes as planned, by the end of next year, both companies will produce in the neighborhood of 15 million ounces of silver annually. In eight years' time, Coeur d'Alene's production will have grown 60%, Pan American's about fivefold, with shares outstanding having increased nearly tenfold at Coeur d'Alene, versus 2.5 fold at Pan American. In other words, Pan American will have delivered almost nine times the growth in production, with about one-quarter of the dilution.

Meanwhile, the chairman and founder of PAAS owns almost 10 times as much stock, while getting less than 25% of the salary received by CDE's chairman. Yet, Mr. Market has valued PAAS at 50% less than CDE ($800 million, vs. $1.2 billion). For all you market-neutral people in the audience, perhaps a pair trade is in order. The next time down for stocks may be the next time up for silver. But even if you disagree with that, then you know what to do.

______________

The contents of this letter/report does not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of this message is not to be construed as constituting market or investment advice. It is intended for educational purposes only. Individuals should consult with their own advisors for specific investment advice.

-- posted by Normxxx

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