As The Market Turns?

February 19, 2008...."A reasonable person cannot simply abandon equities. Once the market turns, it will turn with a vengeance." - Clear The Mist

In response to the Timothy Geithner plan for a partnership between the federal government and private capital pools to purchase "toxic assets" from banks, the stock market soared today.

The DJIA closed at 7776, up more than 497 points, or 6.8 percent. The broader S&P 500 Index closed a tick below 823, up more than 54 points, or more than 7 percent. Even the tech heavy NASDAQ closed at 1556, up more than 98 points, or nearly 6.8 percent. All in one day.

Since reaching its bear market lows earlier this month, the U.S. stock markets are up about 20 percent.

Don't get too excited yet. Equities indices remain close to 50 percent below their 2007 peaks and all-time highs. So if you think the train has pulled away from the station, or the space shuttle has already zoomed away, relax.

A couple of things about the new Geithner Plan ("Plan"). Will private capital show up for the dance? At what prices will banks - if at all - be willing to sell their currently unpriceable assets? AND, perhaps more concerning to taxpayers and our international trading partners, while private investors have the possibility of earning big profits off this scheme, they are protected by the Treasury against big losses. Why? Because the way the current Plan is proposed/structured, you and I, as a taxpayers, stand to absorb the vast majority of any potential losses.

I am not proposing an alternative solution, mind you. And I am happy to accept fault for criticizing the Plan while not proposing one myself. It's very Republican of me, isn't it.

But I must remain skeptical about this Plan. While I believe that bad mortgages represent a relatively small percent of mortgage-backed securities or CDOs (collateralized debt obligations), given how complicated these instruments are, I'm unsure how you accurately price them - even if you are a so-called expert. It all bears further patience.

Regarding the current bear market rally, let us keep in mind that we've been there before. I hate to bring it up, but during the calamitous bear market of 1929-32, investors - what remained of them - experienced no less than 9 rallies of 15 percent or better. In fact, one rally was some 40 percent! The ultimate result, though, was an overall stock market decline of about 86 percent.

Now bear markets do not announce their ends with fanfare. They do not end simultaneous with the end of recessions. I think we all know this. Conventional history shows us that markets bottom some six months before the economy. So the question remains: when will the economy bottom?

Many pundits are pointing to the "fact" that many stocks that are reporting disappointing earnings and other events are not responding with further declines. They suggest that we see this when investors have "priced in" pretty much all the bad news. This may or may not be the case. I hate to be the cynic. But when investors have sold as much out of equities as they have over the past six months, clearly some feel the urge to reinvest en masse, especially when we see daily gains of 4, 5, 6 percent or more. We just hate missing trains, especially after so much money has been lost.

I, for one, need to see more clarity on the Plan. When and how will investments actually be made? I, for one, need to see some tangible evidence of an improving economic world. I don't even mean increasing corporate profits. A leveling off of unemployment trends would be very nice for starters.

Clearly, as I have stated in prior postings, many many stocks are cheap. It doesn't mean they are as cheap as they can possibly get. But as I have also said, averaging your investments is only prudent, especially given this market's volatility. There is a sense in the air of a change in psychology. But again, we've experienced that before during big rallies in prior big bear markets.

And The Day Isn't Yet Over

So alright. On February 19, I reiterated my commentary regarding yet deeper declines in the stock market. So, sadly, this morning's decline to lows not seen 1997 is no surprise.

We have yet to see the worst of the bad economic news. Safe havens, such as healthcare stocks, dividend yield, etc. in the equities markets, are pretty much as weak as all other sectors. Sure I can make the argument that long-term investors should take advantage of these declines and average down. But I can just as easily make the argument that people should simply take advantage of any semblance of rallies to sell equities and just wait out the ongoing financial carnage.

In recent months and weeks, so-called professionals have been arguing for investment in corporate bond and other fixed income sectors, including U.S. Treasury securities. I have to admit. After spending more than forty years investing, not to mention my educational and professional training and experience, that strategy in this climate leaves me scratching my head.

Managed corporate bond funds, in particular, do not have a great history of investor returns. Sure, you can find and/or develop portfolios of "high quality" bonds - whatever that still means - that produce "respectable" current yields. However, at some point in the not too distant future - and as usual before naive investors see it coming - those yields will be more than offset by an environment of rising interest rates and declining principle values of those wonderful bonds.

As far as the safety of U.S. Treasury securities, a few voices in the media have been cautioning about a developing "Treasury Bubble." Yields are too low and not reflecting risk, but rather reflecting the relentless flight to safety, nor are they reflecting the real possibility of damaging inflation...once we conclude the current deflationary spiral. The only "Treasury" investment strategy that seems to make any sense is to keep maturities short. And I mean short.

A 90-day Treasury bill currently yields less than 0.25 percent annually, six-months 0.4 percent, a ten-year maturity yields an anemic 2.92 percent. Any glimmer of strong inflation, oh perhaps driven by multi-trillion dollar federal deficits and record expansion of the money supply, will drive those yields higher by orders of magnitude. An increase in 10-year yields to say 8 percent - not out of the unpredictable - would drive the principle value of those 10-year Treasuries down by 64 percent. Sound familiar?

We've seen it all before. Well, some of us did. Some of us simply read about these cycles in textbooks, too often in academic passing. Perhaps fewer of us managed investors through these cycles. How many fixed income fund managers were actually managing these instruments, say in the 1970s and 1980s? How many were preparing to complete high school or college in those years? How many were trained at the same "B" schools that produced the very same management geniuses that have led us to our current circumstance?

PERSPECTIVES

For years, I've retained a yellowing newspaper article in my desk. Dated July 3, 1998, it's an Associated Press story titled "Study: Blunders kill new airlines."

Subtitled "Big carriers' tactics not to blame, institute says," it was based on a study conducted by George Washington University's Aviation Institute. In short the article points directly at the recycling of senior management in the airline industry, with "famous names" ans "properly educated" executives moving from one failed airline to another. The study examined 129 airline bankruptcies from 1979 through February 1998. It found that more than 97 percent of the 39 airline bankruptcies in the 1990s had senior executives who had been involved in a previous Chapter 11 bankruptcy - in the same industry! Further, the study found that "more than 75 percent had executives who had been involved in at least TWO Chapter 11s, 50 percent had top officials in at least three bankruptcies and 15 percent had executives who were involved in at least four bankruptcies."

Past is precedent. Today's "airline" industry is the financial industry, is it not?

Universities need to drastically rethink how they "construct" business leaders. Businesses need to rethink how they retain and hire future business leaders.

Now is this simply sour grapes coming from a former business executive who graduated from Michigan State University rather than the University of Michigan, or Harvard Business School, or Wharton, etc.? That's for my readers to judge, of course. To preempt your judgment, however, I'll simply say no. But the Ivy League of "B" schools has "educated" us to where we are. Corporations have supposedly sought out the "best and brightest" from these fine institutions, as government has sought the same "rocket scientists" from Goldman Sachs and Morgan Stanley, et al to lead us out of this generational catastrophe. We are caught on a hamster wheel, are we not?

Someone needs to begin thinking outside the box, or at least reflecting very seriously on financial and economic history. Are we doomed to condemn the entire U.S. economy to the fate of the airline industry? Seems like that is where we are navigating.


WHITHER THE STOCK MARKET

So many stocks are "cheap" says the conventional wisdom of the financial establishment and CNBC talking heads crowd. General Electric (GE - NYSE) at less than $8.00 when it was happily trading at more than $30 less than a year ago? That list is inexhaustible. Price in a vacuum does not reflect "cheapness." Price must be based on earnings power. And no one, I repeat no one, is in a position to estimate corporate earnings power over from here for the next two to three years. There may be some good guesses. But will you base your financial future on guesses?"

Let's look at the S&P500 Index, shall we? Last fall, I suggested downside risk to 700 on the S&P500. Depending on when you caught up with me, the S&P500 was trading at somewhere between 1,000 and 900, anywhere from 20 to 30 percent ago. On February 19, well a possible "bottom" looked more like 650 - 600 than 700. But all of that is based on earnings declining to perhaps a core of $60, with a price/earnings multiple (P/E) of no more than ten.

When the market last traded at these levels - bordering on 1996 - the S&P500 Index traded at a P/E of about 17 or so. Earnings were a mere $40 - 44. Assuming that earnings collapse to those levels - which is not unreasonable - would you pay 17 times those earnings in light of all the economic uncertainty? Or would you be more willing to pay something closer to 10 times?

450 on the S&P500 Index? Keep in mind: 10x multiples were far from uncommon in the 1970s and first half of the '80s. By the way, that period followed a fairly lengthy market earnings valuation in the teens and greater during the 1960s and early '70s. What goes around comes around? History repeating itself?

The stock market has nothing to grasp onto at this point. As I have been writing this piece, the market has declined from 720 to 704, the DJIA around 100 points. Oh it may rebound somewhat before the end of the day. But that'll simply be short sellers taking profits, not necessarily bargain-hunters.

Myself? The thought of earning less than one percent annually disgusts me. But it just may be reality for most investors for the next year, or two, or three, at least until the giant cloud of uncertainty is resolved.

CONSUMER SPENDING

Our economy has been dominated by consumer spending, driven by debt accumulation, for well over a decade now. You can blame people for being imprudent, for living above their means, yada yada. But the truth is that business has driven people to become consumer animals rather than production engines or, god forbid, savers and conservative investors. Jobs are disappearing as business contracts, leaving us consumer animals either with less money to consume with or greater fear that their ability to consume will just evaporate.

The Harvard MBA crowd has shipped job category after job category overseas to take advantage of lower costs, creating higher profits - profits for the few. How many good paying manufacturing or product development jobs have we created here in the U.S.? How much of those higher profits from cheap foreign labor has found its way to higher wage rates for our fellow Americans?

When the economy turns, and it surely will, how much of that next round of higher profits will find its way into the pockets of workers here at home? As opposed to yet fatter profit margins for the few?

General Motors prays that $40,000 (god! $40,000!!!!) Chevy Volt plug-ins will save it. Forget about the absolute lack of economic rationale for paying $40,000 for a Chevy Volt for a moment. But the greater question to ask is how many Americans will be able to afford - let alone qualify to finance - that Chevy Volt?

The Chevy Volt represents the lack of genius that has created this mess. Is this the business management that we want to lead the nation in the future? In business or government? They don't get MY vote. It's the airline industry all over again. Only this time, the airline industry represents the entire economy.

Whine Whine Whine

Today, the Dow Jones Industrials Average (DJIA) fell decisively through its November 2008 low, reaching its lowest level since October 2002. The broader S&P500 Index is not far behind, though it has yet to test the November 2008 low. Don't bank on that one holding much longer.

For what it is worth, Merrill Lynch has revised its estimate of earnings for the S&P500 down to $42 for 2009. The most pessimistic Wall Streeters that make their livings guessing about such things have been comfy cozy with $60 - $70, as have I.

Back in October, I estimated that we would see market lows in the range of 7,200 on the DJIA and 700 on the S&P500. The basis was a dramatic decline in corporate profits - to that $60 - $70 range on the S&P500 range. While we are only in February, and therefore premature to "accurately" guess about these things, it seems that the likelihood of Merrill Lynch, of all institutions, being close to the mark for corporate earnings estimates is increasing.

7,200 on the DJIA? That's pretty much a "done deal." 700 on the S&P500 Index? That's only about ten-percent lower than the current level. And if corporate earnings on the S&P500 plunge below $60 this year - or are least expected to - well look out below. 600 - 650 on the S&P500 is more likely.

A reasonable person cannot simply abandon equities. Once the market turns, it will turn with a vengeance. But short of equities - high quality ones - cash remains king and queen. Corporate bonds? Forget about them. Just when you aren't expecting, interest rates will begin rising and bond prices will begin falling. It is a losing proposition. I, for one, am avoiding them like the plague.


Now to the whining.

Wahhhhhhhhhhhhhhhhhhhhhhh! To all the politicians - primarily Republicans - and those among us that oppose just about anything that stands even a snowball's chance is limiting this Great Recession, especially Obama's recently revealed mortgage/housing plans, get over it. Yes, there are irresponsible people that irresponsibly took out unaffordable mortgages and purchased larger homes that they really didn't need. There are people that bought rental homes, be it one or ten, betting as businesspeople that they would generate profits. But they bet as businesses, not as prudent homeowners. The current Obama plan does nothing to assist them, and I believe rightly so.

Sure. I'd love to be able to refinance our home at a lower rate and save some money. But I'm not sure that my neighborhood has been hit as hard as others, many others. But if one of my neighbors needs assistance and this program makes it available, hallelujah! Take it. I won't lose any sleep just because someone else is being helped.

Honestly, where is the compassion? There seem to be some folks that have money, are quite comfortable, either have secure jobs or sufficient assets to survive protracted unemployment, have no problem spending $700 a month on a Lexus lease, and they begrudge those that have less a little assistance. They fail to see the greater picture. Every foreclosure negatively impacts the housing market and eventually, if not now, their own neighborhoods.

They complain about government interference in the housing market when, in fact, the government's been there all along. Do they honestly think that home ownership would be as broad-based as it has been for decades if it was not for the tax deductibility of mortgage interest, for example? Talk about a subsidy. Government involvement in housing is nothing new.

We live in extraordinary times, and these times call for extraordinary compassion and action. My fear is that Obama's current plan may simply not be sufficient. But neither is the Stim, round one.

We Have Met The Enemy...and It Is Us.

First the stock market...

After the stock market stumbled to the best test yet of the late November 2008 lows, traders experienced a major bounce off today's lows to close largely even for the day. If you're a technician, however, the afternoon bounce wasn't all that significant, with still substantial volume in the day's declining stocks. Yes, the technology-heavy NASDAQ market saw a much greater proportion of its volume in higher trading stocks. However, this is all "technical stuff" and reflects less the current or even future status of the economy.

Market analysts continue to lag reality with their rosy forecasts for corporate earnings, so many stocks look inexpensive. But, as usual, aren't they missing the greater picture here?

Now the broader outlook and the "Enemy"

3.6 million jobs lost over the past 13 months, about half of those in the past three months. There is no evidence that the rate of job losses has reached bottom. And the employment picture does not account for the even greater numbers of part-time workers that want full-time work but cannot find it. Nor does it account for the millions that have simply dropped out of the workforce over the past several years...OK, over the past eight years.

Yes yes, economists will tell you, with significant justification, that employment is a lagging indicator of economic growth - or lack thereof. So no, we won't see the end of the "Great Recession" (I did not coin that name myself.) when we see the end of the current unemployment trend.

Here's the thing. Now follow me on this. Businesses lay off - fire - workers for two general reason: 1) demand for their products declines or is projected to decline; 2) a business' profits are declining or predicted to decline.

It is the latter that is so troublesome. We are caught on a seeming perpetual motion machine. Businesses respond to reduced demand, actual or projected, by firing workers. Firing workers further reduces potential demand for products. Firing workers places more mortgages and credit cards at risk. Increasing the pool of risky mortgages continues the pressure on home values. Increasing THAT pressure increases the risks of credit card delinquencies and defaults. All of this circles back to the banking and business communities, resulting in yet more firings. The downward spiral puts pressure on commercial real estate markets as a result of store closings and other business "downsizing," putting even more pressure on the banking system.

Now certainly, none of this is news to many readers. But it is to some.

So how do we get off the gerbil's treadmill? Hmmm?

Historically - well we do not have a lot of precedence for messes like this - governments intervene and spend money in an effort to a) maintain and create jobs, b) maintain or strengthen social safety nets, and c) stimulate the availability of capital for lending and investment.

President Obama will shortly sign into law "The Stem." While we can point to many aspects of it as "better than doing nothing" as the Republican Party would have us do - what else would you expect from them; they have a lot of experience doing nothing, going back to Herbert Hoover.

The Stem is loaded with ineffective tax cuts. Obama bought three needed Republican votes with those. The Stem is light on infrastructure investment. Yes, there is money for energy, roads, dams, yada yada. But is it sufficient to really make a difference? This commentator would love to believe so. But we need lots more than $789 billion, considering that more than $250 billion of the Stim is tax cuts. Any credible economist agrees that we get far more bang for the buck with actual spending as opposed to tax cuts. But Republicans are not very good students of facts. Hence the ridiculous magnitude of tax cuts in the Stim.

Oh, did I mention that if you are unemployed, you can look forward to receiving $25 a week more in unemployment benefits? $25? That just might pay for your gasoline while searching for those disappearing jobs, not to mention the ones that the Stim will not create thanks to the tax cuts.

If you are employed, you can look forward to $400 a year in tax cuts ($800 if you file a joint tax return). $400? Oh, that's about $14 a week. Heck, we can all return to Starbucks.

If you are receiving Social Security benefits, smile when you receive that one-time $250 extra super-duper bonus check.

And the latest? The rumors / news that rallied the stock market this afternoon? Our government is considering a plan to finally help struggling homeowners. While the details have not yet been formalized, it looks like the federal government may be going into the mortgage subsidizing business, not to mention credit card financing. As it stands at this hour, the Treasury may use part of the remaining TARP funds to subsidize those good ole' banks and reduce interest rates on deteriorating loans. They may even cram down principal values on those loans to reflect the collapse in home values. Oh all of this will be "standardized." So all banks will conform to the same set of standards when evaluating mortgages - assuming all of this comes to pass, of course.

Now I am all for FINALLY helping homeowners. Something in this regard is long overdue. You didn't, however, expect that George W. Bush and his pals would help anyone, did you? It was always up to Obama.

The problem is, sadly, this type of government-subsidized assistance - which could run into the hundreds of billions of dollars even if they are currently talking about $50 - $100 billion - can only serve to place an artificial floor on home values. When would it stop? Beyond the folks that will meet the standards for the program initially, we still have two issues. First, when does the flood of qualifying people end? Second, if you fail to qualify by just a skinny little hair of an actuarial formula, what then? Does the government modify its "standards" downward? And when does THAT stop?

I am not suggesting that I have a better solution. Fact is, no one does. We are swimming in uncharted waters.


One thing that does occur to some of us that think about these issues, though. What if, what if businesses that could actually afford it, public and private, maintained higher levels of employment even if it meant lower profits for their owners? Why do profitable businesses find it necessary to "downsize," to "rationalize their size," to "adapt to new economic realities?" More employment maintained, fewer mortgages and credit cards at risk, less stress on stressed health care and social services systems, more folks actually able to buy stuff.

So OK, my company (well not really mine) generates profits of only $100 million in 2009 instead of the possible $200 million - which, of course, is down from 2008's $400 million. But that $100 million keeps lots of folks employed. And there's a multiplier effect in all of it, as I think I've tried to outline.

And before I forget, I sure did get a chuckle out of those large bank CEOs testifying on Capital Hill the other day, largely suggesting that few, if any, people have had their credit card interest rates explode or credit lines cut since those very same banks took tens of billions of dollars from the TARP.

There is ample evidence that they, indeed, have done that, and done it indiscriminately. This becomes another perpetual motion machine. Slash lines of credit on folks, even if they are strong, consistent payers, and guess what? Their credit scores go down, making them appear to be higher credit risks. So they do not qualify for that new lower-cost mortgage or a new car loan. All thanks to the banks. The banks that our tax dollars are saving from insolvency.

Now not all business owners or managers are cruel. Some people do step up and work overtime to preserve jobs. But many, and I'm mainly talking about large employers here, just don't get it.

We Have Met The Enemy...and It Is Us.