The Federal Reserve achieves its goals through its member banks which require all chartered banks to contribute capital to the Federal Reserve as well as co-operate with reserve requirements, the amount a depository institution must deposit to the Fed as a percentage of assets. The money contributed to this pool is used to backstop the financial commitments of all member banks and, more generally, the financial markets as whole. At the time that the Federal Reserve System was created, much of the world’s liquidty flowed through commercial banks and, as a result, monetary policy changes enacted by various Fed means would typically flow through the rest of the markets.

Unfortunately, with the Gramm-Leach-Bliley Act in 1999 and the resulting intertwining of investment banks, insurance companies, and traditional depository commercial banks, our financial system has become that much more complex and has fored the Fed to act in ever expanding ways. As we’ve seen over the last few months, the Fed has now begun using its funds to backstop prime brokers and buy out insurance companies. But, how is it doing so? With the contributed capital of the nations banks. Money that anyone with a savings account is contributing. It’s being put to risk, not to provide liquidity to the system of commercial banks in the US, but to create a market for risky assets and prop up financial institutions that ought never to have been able to wreak so much havoc on the average citizen.

The question going forward now becomes, where do we go from here? Is it really right that the commercial depository institutions of this nation are lending their money to hold up the whole system? Will we see an expansion of the Fed system to include prime brokers and insurance companies and maybe even hedge fund in the future? And, if so, will this come with increasing government oversight in our supposed free markets? What we do know is that the system as it was created cannot continue as it was.

Free markets, unfortunately, are prone to excess. In the end, we’re all speculators at heart. Most of us can remember pretty clearly what our most recent recession – mostly caused by the internet bubble bursting and exacerbated by 9/11. Outside of the bursting of a bubble, that market correction could be chalked up to natural business cycle more so than our current market turmoil which was created by the poor decisions of a handful of investment professionals. To find a true parallel, we have to look further back to the Savings and Loan Crisis in the late 1980s.

During the late 1980 more than 1000 savings and loan institutions failed, the crisis contributed directly to the recession in the early 1990s and threatened much of the banking system as we know it. What caused so many institutions to fail? Well, the same thing we saw unravel over the last few years – the popularization of a new breed of security, increasing leverage, realization of unaccounted for risks in the security, and rapid unwinding of positions.

In the 1980s, Michael Milken started the cult of the junk bond. Prior to Milken, bonds with junk status were typically fallen angels. These were good companies which had come upon hard times and had their credit ratings marked down to junk status. Not surprisingly, despite being labeled junk, default rates on these companies weren’t as horrific as expected as by the time these companies hit junk status their troubles were beginning to bottom out. Milken parlayed this phenomena into the creation of a market for junk bond originations. That is, underwriting bond offerings for companies initially trading as junk. Not surprisingly, the risk characteristics of these companies was profoundly different from the risk characteristics of fallen angels. These were companies which never had good balance sheets or strong credit ratings for whom a singe mis-step might result in a late payment or, worse yet, a default. Somehow, this was overlooked as the craze took hold. New metrics were designed to value junk companies with negative cash flow. And, junk bond prices skyrocketed.

Savings and loans institutions, hungry for yield now that Treasuries were trading at lower and lower rates, began to look at junk bonds as an option. They were convinced by Milken and the other devotees of the junk bond that such securities were not as risky as they seemed. Unfortunately, by the late 80s, default rates on junk bonds were rising and, by 1989 despite the high yields these bonds claimed to pay, return on junk bonds as an asset class turned negative. Savings and loan institutions, insurance companies, just about every large investor in junk bonds began to exit, sending the market for junk bonds crashing down and those who couldn’t unwind fast enough were stuck holding nearly worthless pieces of paper with little hope of waiting out coupon payments let alone principal repayments. In the end, the government was forced to step in and bailout a crumbling market. At the peak of the storm, the California Insurance Commission was forced to take over Executive Life, one of the largest insurers at the time. In addition, since the crisis hit many savings and loans and commercial banks which had deposit insurance on their consumers’ accounts, it is estimated that tax payers paid upwards of $124 billion as a result of the poor money management and speculation in the financial industry.

Sound eerily similar to what’s happened in the mortgage backed securities market? Well, it just goes to show you that though times may change, people don’t.

Basically, the Super Bowl Indicator works like this. After the NFL-AFL merger in 1967, if a team from the original NFL wins the Super Bowl, then the Dow is likely to go up during that year. If a team from the original AFL wins the Super Bowl, then the Dow is likely to fall that year. Basically, this boils down to NFC teams being bullish and AFC teams being bearish. Notable exceptions include the Indianapolis Colts (BOO!), Pittsburgh Steelers, and Baltimore Ravens (the original Cleveland Browns) which were all NFL teams prior to the merger but which now play in the AFC.

There are a number of expansion teams not covered by this theory: the Tampa Bay Buccaneers, Seattle Seahawks, Carolina Panthers, Jacksonville Jaguars, and Houston Texans. Furthermore, there’s some controversy over which Cleveland Browns incarnation, the Ravens or the current Browns, counts as the true original NFL team.

Despite these discrepancies, expansion teams haven’t really factored into Super Bowl outcomes with the exception of 2003 Super Bowl where the Buccaneers won. Excluding this Super Bowl, from 1967 to 2007, this indicator has been right 32 of 40 years. It was right 28 of 31 years from 1967 to 1997. Hit an 0 for 4 skid from 1998 to 2001. Then, rebounded by going 4 for 5 from 2002 to 2007 (the 2003 win taken out).

So, what’s this all mean? Well, as with most stock market myths, I wouldn’t suggest trading on it. While it’s surprisingly more accurate than most stock market experts could ever hope to be, always remember this little tenet, “correlation does not equal causation.”

But, if we are to believe in the Super Bowl Indicator, the silver lining to the Patriot loss to the Giants may be that the market is set up for a pretty good rally. The Giants are an old NFL team and the last two times they won the Super Bowl, 1987 and 1991, the Dow was up 2.3% and 20.3% respectively. The last two times the Patriots lost the Super Bowl, 1985 and 1997, the Dow was up 22.6% respectively. Given the current sentiment about the economy, we probably need any kind of good omen we can find.

So, does the Super Bowl Indicator mean that the Patriots do deserve to be hated (especially by investors)?  I don’t think so. The one time the Super Bowl Indicator was incorrect in the last 5 years was 2004 when the Patriots won and the Dow was up 3.6% by the end of the year. Furthermore, in 2005, when the Patriots won again, the markets only fell .6%. So, here’s to next season and hopefully another dominant Patriots team. (One that won’t fold in the last game…) And, here’s to the Giants helping to bring that bullish sentiment back to my portfolio.

Keynesian economics was first postulated in 1936 and became widely accepted by the 50s and 60s. Since then, the government either through the Federal Reserve and monetary policy or the President/Legislature and fiscal policy have been very active in trying to influence the direction of the economy.

Furthermore, we all know how important it is for an outgoing President to attempt to leave office while the economy is chugging along. It gives him the best shot at winning another term or being able to leave a favorable legacy and pass control to his party.

So, does this usually work out? Is the government really so able to create cycles in our economy centered around election dates? Well, an article written by a Pepperdine Professor, Marshall D. Nickles, claims that there is some truth to this idea. He analyzed the returns of the S&P 500 on a monthly basis from 1942 until 2004 and found that there does seem to be a roughly 4 year cycle of peaks and troughs in the S&P returns. Of the 16 four-year terms there have been from 1942 to 2004, it was found that 15 of the 16 market troughs fell in the first or second year of a presidency and one (the 1985-1988 term) fell at the end of the third year of a presidency.

If one were to define bear markets as a draw down of 15% or more in the S&P 500 in a one year to three year period,  it was found that most of these bear markets occurred within the first two years of a new presidency. On average, the market has reached its worst point 1.87 years into any new presidency. It was also found that investing in the market during an election year more often than not proved to be quite lucrative.

So, here’s the question, can we really depend on this data? Truth be told, the analysis done in this paper is not rigorously statistical. There are some interesting patterns, but it’s hard to say whether or not 15 trials is sufficient enough to declare victory on the subject of investing based on election cycles. After all, look at the economy this year? Could this be another “anomaly” like that of 1987 where the market crashed in one of the latter two years of a presidency?

In fact, a little more rigorous paper on the subject examining market returns using the Fama/French factors (a modification of CAPM which takes into account the risk/return anomalies found in low P/E and low P/B stocks) found that there is a statistically insignificant change in expected returns of the market over the 12-month period before and after an election. Though, they did find some correlation to presidential elections in the quarter prior to and after an election. In fact, they went as far as to attempt to use market performance to predict potential winners of presidential elections (albeit only in years where an incumbent is up for re-election… i.e. not this year). Check out the paper here if you’d like to try a little heavier stuff.

What is the Santa Claus Rally? It is a phenomenon discovered by Yale Hirsch and published in The Stock Traders’ Almanac and it describes a year-end rally in stocks from the day after Christmas until the first two days of the New Year. Well, going back 100 years in the Dow Jones Industrial Average, this phenomenon does exist. In fact, it happened over 65% of the time even during the bear market in 2000, 2001, and 2002.

Source: InvestmentU.com

Will it happen this year? Well, if the 200 point run up in the Dow this Friday (December 21) is any indicator, this market curiosity may be making yet another appearance. Just in time to pad our year end results. Actually, if Eddy Elfenbein of Crossing Wall Street is correct, the Santa Claus Rally can actually be extended from December 26 – January 2 to December 21 to January 7. In fact, his numbers crunched on the last 111 years of the Down Jones Industrial Average confirm both the Santa Claus Rally and the Halloween Indicator. The Dow, on average, rises 7.79% from October 29 until May 6 with the most impressive short term gain of 3.39% between December 21 and January 7. Most importantly, the period between the end of October and the beginning of May typically encapsulates over 93% of the Dow’s annual returns.

So, why might the Santa Claus Rally exist? Other than that it might be a self-perpetuating market curiosity, there are some structural reasons for its exists. First and foremost, year-end tax loss selling will begin to alleviate itself around this period. Also, most people ranging from retail investors all the way to institutional investors like mutual funds tend to fund their strategies at the beginning of the year. Heck, a lot of people just like to invest on a calendar year to calendar year strategy. I know I purposely started my investing on and around January 1 when I first decided to open a stock account.

This year, we have the added bonus of rate cuts and huge additions of liquidity by the Federal Reserve for the last four months ostensibly priming the pump. Could Santa just be waiting to deliver a nice little surprise at the end of the year?