2009 - RETURN TO PARITY

Going in to 2009 our return to parity analysis determines the most probable economic environment in the year ahead.  Again, our premise is the Investment Rate, so nothing has really changed.  However this process has been refined, and that could make the difference between good decisions and bad ones as the year progresses.  Instead of measuring the overall direction of the demand cycle as the Investment Rate does, our return to parity analysis is measuring immediate demand ratios instead.  From there, with an accurate assessment of today’s demand we can compare that to normalized demand trends from the Investment Rate.  For example, if today’s demand ratio is much higher or measurably lower than the normalized demand ratios offered by the Investment Rate an accurate assessment of future economic conditions can be made.  The observation would suggest that demand tends towards equilibrium over time.

In fact, this is always true.  Other economic models might erroneously suggest a return to equilibrium from time to time, but this is different.  Because demand is a natural occurrence, we can be sure that normalized demand ratios exist, and we can be sure that current demand ratios will trend towards equilibrium over time.

Although my original analysis was based on the premise of keeping it simple, the return to parity analysis I am offering here is a little more complicated.  Reasonably, this also satisfies the interest of modern-day economists.  Most econometric models include dozens of added variables which, on a broad scale, create more harm than good.  We have already discounted the majority of these and in doing so we have also weeded out the noise which might otherwise cloud the clear progression of our economy over time.

However, as we become more focused on these relative demand ratios additional variables need to be included in our model.  Therefore, the return to parity analysis which will be described here requires an added degree of insight.  Thankfully though, for those of us who have adopted proactive trading models this return to parity analysis just doesn’t matter.  Even if it is complicated, it will not have bearing on our proactive activities.

In other words, our proactive trading models dispel the need for this type of economic evaluation.  Proactive trading models adjust by themselves, so we don’t need to pinpoint interim direction.  However, this return to parity can help.  More specifically the conclusions it draws help us improve our efficiency.  The conclusions should also help us increase our confidence.  In every unique situation, if we have an understanding of the broad picture we are more capable of acting reflexively, and the return to parity helps with that.

Reasonably, this is a second step in our longer term analysis.  First, we painted the broad strokes with the Investment Rate.  That gives us an overall evaluation of future economic conditions and market direction.  Now we will be more precise.  Although that will not affect our proactive models, that will give us additional insight into immediate trends and in turn that will also help us stay on the path to the Comfort Zone.

Arguably though, the return to parity analysis will be extremely important to some investors.  This is especially true for new clients and brackish investors.  For those people who are continuously exposed to longer-term equity positions in the stock market, in real estate, in private business, or in any other asset class which will be affected by the findings of the Investment Rate, this return to parity analysis carries significant weight.  More precisely, it tells us if we can expect equity prices to improve over the next interim cycle.  My demonstration focuses on 2009, and therefore the conclusion provides an understanding of current demand trends and their immediate impact on equity prices.

That brings us to the root of this analysis, and the added variables which will be included in this equation.  In order to further our evaluation we must correlate demand ratios from all asset classes.  We need to know what the current level of demand is within the real estate market, or example.  We also need to know what the current demand ratios are for stocks.  And the same study needs to be conducted for every asset class which requires a steady inflow of money to grow.  Without question, this also includes bonds.  Reasonably though, as I will concede later, treasury bonds could be considered a detriment to the demand for other equity investments over time.

After carefully evaluating the demand trends which exist within each of these specific equity classes we are then able to combine that analysis.  Over time I have learned that a combined analysis is much more efficient than unique observations as well.  Therefore, a combined analysis paints a more accurate picture of immediate demand ratios.  For those economists who are interested in going to work, an evaluation of these demand cycles will pave the way to a lengthy study.  In fact, I will also gladly offer a detailed study of the return to parity at some point in the future, and that should support third party research which might be conducted today.

However, this analysis is a broad understanding of that concept.  Based on recent economic conditions, the findings should also be very easy to understand.

First of all, this return to parity analysis does not impact the overall trend in demand evidenced by the Investment Rate.  Demand ratios peaked in 2007 and a decline lasts for the next 16 years.  Nothing will change that.  However, during that 16 year span there will be occasions when demand ratios are lower or higher than the normalized trend of the Investment Rate.  The years leading up to the peak in the market were a great example.

Prior to the end of 2007, cheap money defined our economic landscape.  The most obvious reference was private equity.  Private equity was able to buy companies for virtually nothing.  With the issuance of debt at very low levels private equity was able to step in and by some of the most well-known names on Wall Street.

However, the influence of cheap money did not stop there.  Of course we all know that cheap money influenced investments into real estate which should not have happened.  Low mortgage rates and unregulated standards in the mortgage industry influenced monies that would not have otherwise been invested.  In other words, monies which would have otherwise been allocated to the market in 2008 or 2009 were allocated to the market prematurely.  The influence of cheap money increased the demand ratios prior to 2007 as a result, and current demand ratios at that time were far higher than the Investment Rate suggested they should be.

This anomaly broke the longer-term oscillation cycles defined by Fibonacci and the Golden sequence.  Investments were influenced into the economy which should not have been there.  That created an overshoot above the normalized demand trends offered by the Investment Rate, and in 2007 a clear return to parity set-up existed.

After the fact, we all know that demand ratios were extremely high late in 2007.  Arguably, growth fostered by debt assumption was commonplace.  However, with all arguments aside, everyone has accepted that universal demand for investments in real estate, in the stock market, and in private business, was extremely high.  The influence of cheap money on the flow of dollars was the obvious reason.  That overshoot suggested that a return to parity would come as the economy continued to cycle.  In other words, when normalized demand ratios broke higher the overshoot told us that those demand ratios would ebb down eventually.  In turn, that suggested that equity levels would fall too.  This time though, unlike 2002, those declining demand ratios impacted all equity classes.

Eventually, the economic conditions developed as I expected them to develop.  No one seemed to want to admit it in the middle of 2007, but a return to parity was necessary.

However, immediately afterwards another unique phenomenon took place.  Again, this was a direct result of the cheap money environment which existed in years past.  The misguided investments which were influenced into the economy prematurely eventually caused a reverse anomaly.  Immediately following the 2007 peak in the market the economy was hit with an immediate void in demand.  This time, instead of abnormally high demand ratios, in 2008 demand ratios were abnormally low.

Quite clearly, an overshoot to the downside occurred in 2008.  But let’s step back for a minute.  According to the normalized demand ratios offered by the Investment Rate demand peaked in 2007 and it trickles lower until about 2010.  From there, severe declines in normalized demand continue through 2023.  Barring abnormal circumstance, real demand should also trickle down until about 2010.  However, instead of trickling down along with normalized demand trends, our economy experienced an absolute void in demand instead.

Arguably, tightening credit standards were one of the main reasons.  Credit worthy borrowers simply did not exist.  Still, our government was more concerned with the supply of money than it was with the demand for investments.  Our government continued to satisfy financial institutions with hard money and until 2009 they failed to address the root of the problem.  The root of the problem in 2008 was demand.

Unfortunately, there was nothing anyone could do to change the economic landscape that existed in 2008.  A void in demand was real and true.  That was a direct byproduct of the premature investments made in 2004, 2005, and 2006.  Even if prices dropped significantly, demand just wasn’t there.  Clearly, immediate demand for investments in all asset classes had been completely exhausted because of the cheap money environment that everyone is now so familiar with.

So, instead of engaging prudent fiscal policy our government spent trillions of dollars trying to support the economy.  This indebtedness will come back to haunt everyone.  As time goes by we will need to repay all of the monies we are borrowing today.  Therefore, one of two things is going to happen.  Either our government is going to tighten the reins and engage prudent fiscal policy from this point forward.  Or, treasury will decide to print money and the value of our dollar will plummet.

Reasonably, this scenario will not pan out for a number of years, but when it does Social Security and Medicare are likely to be front and center as well.  Therefore, the irresponsible fiscal policy that we witnessed in 2008 and that seemed to be developing in 2009 will paint a picture for what will likely be a Greater Depression.

However, with those longer-term projections put aside for the moment, our immediate observation concerns the return to parity that may exist in the years ahead.  More specifically, what’s going to happen to the market and the economy in 2009?

Because current demand ratios have overshot to the downside, my return to parity analysis offers a bright picture for the immediate future.  Although nervous tension will almost surely still exist, and although immediate economic concerns may surface from time to time, overall demand trends should improve.  In turn, that should help our economy stabilize, and equity markets should increase as a result.

But that doesn’t give everyone the green light to go out and start buying and holding all over again.  Instead, that gives brackish investors and those persons nervously holding longer-term equity positions a final chance to get out.

 At 2009 progresses, the recovery in demand will only return to parity within a downward sloping curve.  In effect, the Investment Rate tells us to expect declining demand the ratios for an extended period of time.  Therefore, although a return to parity is a bullish indicator for the foreseeable future, 2009 may also turn out to be one of the biggest headaches of all time.  Investors have been accustomed to immediate recovery because longer-term demand ratios were increasing precipitously between 1981 and 2007; that has worked every time.  However, the playing field has changed.

Now, demand ratios are declining, and they continued to decline every year until 2023.  Therefore, the return to parity that I project will only be a return to declining demand ratios.  Reasonably though, this process may last through 2009 and slightly into 2010.  From there, however, the normalized demand ratios offered by the Investment Rate should prevail and substantial market declines should continue accordingly.

However, with this relatively positive immediate economic outlook understood, an additional caveat also needs to be recognized.  The flight to safety which drew big money into US treasury bonds in 2008 has also created a circular trap which is likely to impede the progress of our economy during this projected recovery.

More specifically, large amounts f money which would have otherwise been investable back into either the stock market or the real estate market are now tied up in US treasury bonds instead, and that’s where they are going to stay.

Early in 2009 I recommended that all of my clients strongly consider shorting US treasuries.  Yields were effectively zero, and there was little risk in taking this position in my opinion.  In addition though, if demand ratios do improve and if economic conditions stabilize accordingly, I also expect the flight to safety to dry up at the same time.  Based on Adam Smith’s resounding theory, if demand subsides and supply remains the same prices will decline.  Therein lies the circular trap I expect in US treasuries.

If prices of US treasuries begin to decline and the yields start to increase from near zero, those monies which have been invested in US treasuries will have lost value.  In turn, the expected safe haven that big money coupled with U.S. Treasury bonds may indeed turn out to be one of the worst investments imaginable.

Not only will those investments offer meaningless returns, but the circular trap and U.S. Treasury’s will also dampen economic recovery.  Investors will not have access to those monies and they will not have the ability to repatriate them into the stock market or into real estate until such time as maturity is realized.  By that time, it may be too late t make a meaningful difference.

Interestingly, we were already beginning to see signs of this in early 2009.  In January the volume of activity in the stock market dried-up.  I believe this was a direct result of the circular trap in U.S. Treasury’s.  From there, I expected volume levels to remain low for the foreseeable future.  Big money has opted for safety rather than allowing money managers and hedge funds to control their wealth.  Reasonably so, smart money has also identified the beginning of the third major down period in US history.

With that understood, my advice to my clients at the beginning of 2009 is as follows:

·         Expect economic stability after the first quarter, expect the stock market to begin to improve, and expect real estate prices to react accordingly.  But don’t expect a prolonged recovery, because it is not going to happen this time. 

·         Do not engage in any long term investments.

·         Instead, use the anticipated strength associated with this return to parity to liquidate any and all longer-term investments and revert to cash.  For example, selling real estate or longer term equity positions in the 3^rd or 4^th quarter of 2009 might be smart.

·         Begin using proactive strategies immediately if that hasn’t been done already, and start learning how to control risk at all times.  Use these strategies to manage current investment accounts, and create a game plan for emotional conditioning going forward.

After some early turmoil, I expect a good year in 2009.  However, I also believe this will be one of the most significant catch and shoot scenarios in our lifetime.  Some investors will get bitten by the bug, and they will not respect the economic weakness evidenced by the Investment Rate.  For those investors who fail to see the risks, they will still be prone to wealth destruction. 

However, for those persons who continue to control their risk every step of the way a much more rewarding life is achievable instead.  My objective is to provide that opportunity, and that is a function of our proactive strategies. 

My 2009 return to parity analysis lays the groundwork for some action strategies, but for most of us, it does not affect our proactive decisions at all.  This interim analysis is important, but more for those investors who still find themselves behind the curve.  Anyone who is still struggling with losing positions, and anyone who is still hoping for a recovery will find a greater benefit from this analysis than those who are already prepared for the third major down period in history.

Lastly, proactive traders should also find solace in knowing that the Market often flows higher for period durations within longer term down cycles.  However, eventually major setbacks will happen again.  Because proactive strategies are best designed for this environment, we continue to be in the right place, at the right time.

 Good trading.

Thomas H. Kee Jr.

President and CEO

Stock Traders Daily