Oh Happy Day, Money Makes the Mare Go!

reprinted and redacted from Friday, November 30, 2007

In keeping with my tra-di-shun of sharing a happy thought or two at TG's blogsite when I can, I offer the following little ditty. (If I keep having all these happy thoughts up, I may just become one of the Peter Pan's Lost Boys. So Bangerang, to all the Peter Pan's of Wall Street out there!)

Money Makes the Mare Go!
Cash infusions work wonders on the psychology of the stock market. Besides financial companies like Citigroup, Freddie Mac, and E-Trade receiving substantial cash infusions to shore up badly depleted capital on their balance sheets this past week, the primary catalyst to last week’s jubilant romp in the stock market has by far and away been Helicopter Ben “priming the pump.”

On November 26, the Fed said that “heightened pressures in the money markets" would prompt the Fed to begin injecting liquidity into the system through year end. The first injection would be $8 billion on Wednesday November 28. That was the very same morning the stock market gapped open higher over 1%. Bull gaps over 1% that do not fill are quite significant. In four short days, the SP500 has risen 6% this week, thereby recouping about half of what it lost during the 32 day 11.3% decline from Oct 11 to November 26.

In the back of our minds, investors must be aware that the credit crunch in the money markets this November has worsened considerably since August and September. But improvement in the 90 day US commercial paper markets can be noted as of November 30th. More improvement in the US Commercial Paper markets is expected in the coming weeks, even if tensions are grudgingly slow to ease. Were conditions not to ease measurably by year end that will be a problem. The situation remains serious enough to bear close monitoring in the coming weeks.

Ostensibly, the easing tension in the USCP market as of November 30 is a direct result of the Fed stepping in to liquify the money markets this week. Traditionally, this is called “priming the pump.” When the pump is being primed, certain sectors of the market tend to do exceedingly well.

What first comes to mind is the 95% jump in the Nasdaq index back in Oct 1999 when the Fed primed the pump in response to the Y2K scare that never materialized. In short, as the bull market of 1982-2000 came to an end, the last blast of money flows into the broad stock market became concentrated into the growth and momentum stocks. Many value stocks simply did not participate in the final leg or worse, they even languished as valuations simply did not matter. In many ways, the stock market became bifurcated as breadth narrowed to its final zenith. The narrowing of market breadth as a bull market matures is not unlike the game of musical chairs. Every time the music stops another stock or market sector loses its chair.

Eventually all that is left are the high flying momentum and growth stocks that have become excessively over-valued. Once that happens, value stocks instantly come back into a vogue as money flows out of excessively overvalued stocks into extremely undervalued stocks. Investors should also bear this in mind too as the stock market evolves towards what may be its final stages in the coming quarters.

Stock prices are ultimately driven by earnings growth, and where earnings are still growing, money should flow even as the economy falters and possibly slips into a recession. The link between economic growth and the stock market exists, but we would do well to remember the stock market is largely a discounting mechanism that tends to be six to twelve months ahead of the economy.

The stock market correlation to monetary ease and priming of the pump by the Fed is a far stronger link. Marc Faber illustrates this key point beautifully in his book “orrow’s Gold.” As they liquify the money markets, that new money tends to go to work mewhere, even if with a lag. Investors are quick to follow that money to whatever sectors of the economy that it spills to – and infar as it spills into the stock market, those money flows should be towards companies still experiencing either strong earnings or earnings growth over the next few quarters.