March Madness or The Big Dance?

I knew the stock market would rally this week because my foolproof signal of a market bottom was flashing like crazy. During my 30 years as a financial advisor every time time I have received multiple urgent calls from clients who want to go 100 percent to cash until things "settle down," it came at a time when the market had already been crushed and was about to bottom. I received five such calls and emails in a single day last week and the market has gone straight up ever since.

After plunging by more than 25 percent during the first 10 weeks of the year, a number of market watchers felt we were due for a rally. There is great disagreement, however, regarding whether this rally is just another head fake destined to break our hearts again as stocks plunge to new depths, or whether we have, in fact, put in a bottom from which prices will improve going forward.

Is this just more March Madness or have we arrived at the Big Dance?

As my clients and readers know, I have been saying for months that it is not time to be bearish nor is it time to be bullish--it has been and still is time to be smart. That may sound a little obvious, but it isn't always true.

The end of last year, for example, was time to be bearish. It didn't matter what you bought or how much or little sense it made--everybody lost a lot of money in everything. Stocks, bonds, oil gold, real estate--you name it. There was no place to hide. Nothing worked except cash. Period.

This year, although the broad market averages have continued to plummet, it has been a very different story. The financial services, retailing, and consumer sectors have been a horrible place to be. Even with their recent rallies, Citigroup, J.P. Morgan, and Bank of America are down between 30 and 70 percent in price this quarter. In addition, any company reporting disappointing earnings or announcing the need to raise capital in this environment has been hit hard as well.

But unlike during the fourth quarter, many companies and sectors have provided real opportunities for gains in recent weeks. There have been two major successful themes.

Companies that have introduced exciting new products or provide services that enhance productivity have done well. Apple, IBM, and Google are all up nicely for the year. Akamai Technology, which makes products that enable and support streaming video, is up more than 20 percent. Amazon.com, which has introduced the second version of its hugely popular Kindle book reader, is up more than 30 percent in price. These stocks were all down a lot during the final four months of 2008.

Second, most companies or asset classes that deal in hard assets and commodities have also done well. Freeport McMoran Copper and Gold is up almost 50 percent. Petrobras, the Brazilian oil company, is up by more than 20 percent. I continue to recommend a strong overweight in "stuff" since I believe paper currencies around the world will lose their buying power as countries print more and more currency that is backed by nothing to stimulate their economies..

A related investment that has done very well, the ETF that goes up and down in price along with the yield on long term U.S. Treasury bonds, is ahead by more than 25 percent this quarter as the yield on the 10-year treasury note has gone from 2.00 to 3.00 percent over the last 10 weeks. If rates continue to climb as I believe they will, then that investment should continue to do very well.

That's what I've been recommending over the last few months. But what about now? Are all our banks worth zero? Is the economy ever going to get better? Is that is short term bounce in the market or the beginning of the end of the worst bear market in 80 years? Will (as many of my friends now believe) the last one out get nothing?

Although the economy is terrible and getting worse, I continue to believe that this is a time of great opportunity as well as of great risk. That sounds like a cop out, but it's really not.

Take the banks for example. We now all know that many banks are in serious trouble due to the huge losses they are facing from bad loans and bad bets they made over the last several years. Many have already failed and others may have lost so much money during the last few years that they will not be able to survive.

On the other hand, it is hard to imagine a better operating environment for banks than the one we now have. They can take in deposits from the Federal Reserve and depositors at zero cost and turn around and lend money out to borrowers at rates of 6 percent and more. Their "spreads" (profit margins) are huge.

Citibank recently announced that it is showing its best operating profit in years. Its stock is trading at less than $2 because it may be too little too late. Citi may have so many unrealized losses that nothing can save it. But not all banks are in the same hole.

What about those banks that did not become hugely involved in sub-prime mortgage lending and did not invest on the wrong side of derivatives and credit default swaps? They may be in a position to mint money in this environment. It is interesting that the stock prices of Goldman Sachs and Morgan Stanley are up more than 100 percent since last November while most other financials have dropped sharply. Maybe the market is telling us that it makes a difference which financials you own. That not all companies are created equal.

Add to that the fact that many key government leaders are now calling for a relaxation of the mark-to market accounting rules and may reinstate the uptick rule that would keep short-sellers of stock from pounding prices relentlessly. Many hedge fund and ordinary investors are short the bank stocks and the whole market out the wazoo through short and ultra short ETFs. If they decide that the bear party is over and they need to cover, this could turn out to be a rally with some legs.

The stock market is like a dance floor. When everybody is out there doing the jitterbug, there is little upside because the dance floor is full and there's no one left to cut in. Conversely, once most people have left the floor they lose the ability to empty it further--they're already gone. All they can do is fill it up again when they decide to dance some more.

An investor who has sold all his or her stocks and moved to cash can't drive the market any lower than they already have. All they can do is move prices up when they decide to get involved again. That has never been easier than it is today since so much money is in self-directed retirement plans where a few clicks on the computer can move someone from all cash to fully invested in stock in five seconds.

These continue to be times of great risk and great opportunity where being smart makes a real difference. That is likely to be the case for a long time.