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Weekly Market Commentary, March 18th 2008
Posted by Sean Hannon
March 18, 2008 at 4:00 pm
Financial markets can be very complex. As we have learned over recent months, the financial engineers on Wall Street have developed a toxic brew of leveraged investment vehicles which have led to massive losses, the disappearance of a prominent investment bank and grave uncertainty. Even if one ignores the structured finance market, the choices for the average investors are daunting. When creating a stock portfolio, there are countess choices among many industries. There are over 8,000 mutual funds who apply a variety of strategies. How about buying bonds for your portfolio? A Bloomberg search on Proctor and Gamble returns 40 different securities denominated in four different currencies.
Given the limitless investment choices and complexity of financial products, it is natural to simplify. In order to convey a message, strategists adapt easy to use monikers. For years, the bulls have referred to the economy and stock market as “Goldilocks”. Since things were not too hot, not too cold, but just right, volatility remained low and growth was both steady and predictable. The natural byproduct of Goldilocks was increased leverage and disregard for risk. After all, the slow, steady growth witnessed led many to believe that any selloff in asset prices should be bought as the predictable uptrend of the economy would cause prices to rise in the future. For years, these investors were correct as anyone who bought the dip in a bull market was rewarded with higher prices in the future.
The only problem with consistently buying dips is that eventually the expected rally does not materialize. As the markets began unraveling during the summer of 2007, the bulls have found themselves grasping for answers. With housing weakening, financial companies facing massive margin calls and hedge funds facing redemptions, it has become difficult to justify the rosy Goldilocks scenario. This does not mean the bulls have abandoned hope and changed their views. Instead they find themselves searching for a new moniker to explain owning positions in a deteriorating market.
Luckily I have a recommendation. Long standing bulls that refuse to alter their view can begin referring to this as the “Little Orphan Annie” market as their justification of staying long in a deteriorating market is that the sun will come out tomorrow. Despite a mountain of contrary evidence, the unbending view that things will indeed be better tomorrow is noteworthy. While I admire the optimism, I question the wisdom.
So why am I so glum about the prospects for a quick change in economic conditions? Has not the Federal Reserve (Fed) and US Treasury stated that they will do everything they can to sooth investors and ensure that markets function properly? Isn’t Ben Bernanke ready with his printing press and helicopter to drop money to all who need it? Won’t this massive rush of liquidity save the economy as it has before? Why won’t the sun come out tomorrow and things be better? Why shouldn’t we bet our bottom dollar on a rebound?
These are all reasonable questions that can be answered with one response. Why should we expect this outcome? Since August 2007, the Fed and Treasury have launched a program of monetary and fiscal stimulus aimed at jumpstarting the economy, calming the financial markets and returning stability. The Treasury has been involved in a number of strategies that range from rebate checks for consumers to moratoriums on foreclosures to creating a super-SIV to buy bad assets. The Fed has injected nearly $1 billion dollars of cash into the banking sector, reduced their target Fed Funds interest rate by 300 basis points, financed the bail out of Bear Stearns and decided to begin lending directly to Wall Street firms. Combined, this is a massive stimulus policy that should forestall economic weakness, bolster the financial markets and usher in the return of Goldilocks. After all, Bernanke and Paulson have taken the dual role of the benevolent Daddy Warbucks and have done all in their power to make investors happy.
Thus far, they have failed. While today’s 420 point rally in the Dow Jones Industrial Average (DJIA) is impressive, we need only look back to last week to see how quickly a 400 point advance can be erased. Last Tuesday, March 11th, the DJIA staged a similar rally as the Fed pumped more liquidity into the system. Three days later, half the gain had been erased.
Since monetary stimulus began with the Fed’s emergency interest rate cut on August 17, 2007, DJIA has dropped nearly 8% from the summer low and 15% from the bull market peak. Housing remains weak with certain states seeing more foreclosures than sales. Credit remains difficult to obtain as financial firms are wary of lending against depreciating assets. All in, the policies applied by the Fed and Treasury have had clear outcome - the dollar has weakened and commodity prices have soared.
Going back to mid-August, the CRB commodity index has soared 30%. Select commodities have shown stronger gains with gold returning 53%, oil 47% and wheat 72%. During this same period, the US dollar has lost 17% versus other major currencies. This combination of rising commodity prices and lower purchasing power of the US dollar is deadly. With a small and shrinking manufacturing economy, we rely upon imports for many items we consume. As the dollar declines, these imported goods become more expensive. As commodity prices soar, the cost to heat your home, commute to work and feed your family increases. As the value of assets drop, the ability to extract equity from your home or to use capital gains to supplement your income declines. As companies reduce their dividends and raise new equity, existing shareholders see their income decline and their ownership position deteriorate. As the Fed continues reducing interest rates, retirees living on a fixed income see their interest payments drop. Together, a policy that was aimed to ease the market concerns, stabilize asset prices and return a sense of normality has been disastrous. From the average American’s perspective, what should be down (i.e. - commodity prices) is up and what should be up (i.e. - asset values and current income) is down.
So we return to Little Orphan Annie. Annie, as an optimist, believed things would eventually turn positive. Through the bad times and uncertainty, faith and hope prevailed. When she began living with Daddy Warbucks, her hopes were answered and she obtained a better life. It appears bullish investors have taken the same direction. Blind faith in policymakers to reignite the economy, shorten a recession and lead the stock market higher has allowed some to retain hope. However, each move by the Fed has failed. More troublesome, recent action has led to shorter, unsustainable rallies. Many of the ideas espoused by Treasury never materialized. The only evident outcome of the current policy has been a decline in the average American’s quality of life.
While the constant news flow can overwhelm anyone, this whole issue is fairly simple. If the eruption in the credit markets has been caused by bad loans, the pain will continue. In this scenario, all the Fed has accomplished is to delay an inevitable correction in asset markets. However, if the borrowers and collateral underlying these loans are strong, the loans are inherently good and once we pass the panic phase of the credit crisis, markets will rebound. Over time, it will become clear. For now, bulls can believe the credit markets have been too pessimistic, watch as the Fed continues dumping money into the system and keep hoping the sun will come out tomorrow. However, on Wall Street, hope is a four letter word.
Great read Sean. I am with you on the skepticism. No point in being bullish when we can’t even hold a rally for more then two days.
Volume yesterday was hardly anything to jump for joy about, and there is still some major resistance that needs to be broken.
I agree with Jim Rogers, is that what we’ll see, is a 1970’s like recession. Eventually, all of the ammo will be spent in the Fed’s arsenal. They’ll have nothing left to do. Save one thing. Exactly what happened in the 1970’s.
Bring in someone with the guts, to raise interest rates to 15%
And just like the 1970’s? Then the real pain begins.
It does lead to recovery. But the Fed and leveraged items that Wall Street has been using has made the road to recovery, much, much, much longer than it needed to be.