Saturday, January 22, 2022
League of Power

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Prepare for Gridlock…or Worse

Tomorrow night the polls will close. There will likely be a change in the leadership of the House of Representatives and maybe the Senate. If change does occur in just the House, then the order of the day will be gridlock. Up until now the Dems have been able to push their agenda through Congress with only token opposition. That will change, as the Republicans will want to hamper the Democrat agenda in hopes that they can take back the Whitehouse in 2012. If they win control of both houses, expect mayhem, as they will try to reverse the policies of the past two years.

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Under scenario one, a change in control of the House of Representatives, the market should react mildly as it is all but priced in. Under the second more radical scenario, the markets may react negatively as it spells uncertainty. What the market is keying in on right now is enough opposition to the change in tax regimen that has been promised by the Democrat party. Reversing the tax changes set forth by the Bush administration would negatively impact the market since it affects capital gains and dividend taxation law directly. Whatever happens on Tuesday, one thing is for certain – the markets will be volatile for some time to come.

The Volatility Index or VIX has come back to life in recent sessions after heading in a straight line downward. If this reversal continues, look for a sharp correction in the market as the “gap” that is needed to be filled on a technical level indicates a correction of around 10% or more is in the cards. With the level of quantitative easing promised by the Fed, any sharp correction should be viewed as a buying opportunity as easy money is the best catalyst for market out performance.

Back in the Real Economy

The real economy still stinks. Job creation is still benign at best, median home prices nationwide have corrected a whopping 35% since the top and in places like Florida, the median home price has corrected by more than 50% from the top. This type of correction in the housing market is unprecedented. It is also creating unprecedented opportunity.

I recently spoke to a top realtor in South Florida and for him, business is booming as money is flowing in from South America, China and Europe to take advantage of a weak US currency and a weak housing market. Bargains abound and if you have cash and patience you can score the deal of a lifetime. Not unlike the stock market in 2008/2009, the housing correction has reached its zenith and the downside is quite limited from here. However, it is also when the bottom is near that most people tend to shy away the most from opportunity. It is the ‘herd mentality” at its best.

Recently I had the opportunity to invest in some income producing real estate in South Florida. It was a rental house with an additional apartment. My partner who put the deal together bought the property for $26 per square foot. It needed about $20 per square foot in renovations and refurbishment; bring my total cost to about $46 per square foot. Both the house and apartment are now rented and producing excellent cash flow. Opportunities like these are everywhere and it takes effort and due diligence to find the right one, but the rewards are quite plain to see.

QE II

The Federal Reserve once again has stated that it is in favor of even more quantitative easing (QE). Goldman Sachs believes that the stimulus to the economy needs to be something in order of $4 trillion dollars in order to get the employment engine going again. That is a whopping 30% of GDP. If that is the real number, we can expect the dollar to tank further and the price of gold and equities to soar. However, Goldman is known for its exaggerated price targets during times of crisis. About $1 trillion in stimulus is already priced into the market as it stands today. The wrong place to be is US Treasury obligations, which are close to their top in terms of low yield and high prices. Additional issuance, which is the source of stimulus funds, will create less demand and higher supply as investors lose faith in the greenback. While it hasn’t happened yet, the laws of economics have not been repealed either. The resulting higher interest rates could have severe consequences on the market especially if the early results of any stimulus continue to show tepid growth.

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Gold prices have declined in the past week despite the talk of additional stimulus. I believe the decline is due to a normal correction in an asset class that has outperformed. More perplexing is the performance of senior gold mining shares. They are still trading at 2009 levels for the most part not reflecting the performance of the underlying metal at all. If priced in, these shares could jump 20% to 50% in the months ahead and still be considered undervalued. The best way to play this move would be through the purchase of LEAP options, or long term options. Why? Because they give you greater leverage to the price of gold shares and require an investment of just 15% to 20% of the underlying share price for control over the shares for a period of two years.

The final two months of 2010 should prove to be the most exciting and maybe most volatile months in the market this year. Be sure that you are ready for some wild swings as investors digest the results of the election. And, always be aware of the fact that this market could correct 10% or 20% in one week…it has already shown us that the only predictable aspect of the stock market is its ability to be unpredictable.

Regards,

Kevin Raymond


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