Weekly Strategic Insight
Friday, October 10, 2008
It would be an understatement to call this market period unprecedented. All of the economic, fundamental and technical research cannot explain the current course of events. It is for this reason that celebrated money managers worldwide appear suddenly foolish. Market strategists carry MBAs, PhDs and CFAs, leaving them woefully unprepared for irrational periods requiring advanced degrees in political science and psychology.
The protagonists in today’s markets are not IBM, GE and Microsoft; they are Fox News and the government. Excesses in optimism have now turned to excesses in pessimism. This is reflected resoundingly in stock market valuations. At the top in 2000, the S&P 500 had a P/E of 30 times corporate earnings; the long run average is 15. After the close today, that P/E will be less than 10. The dividend yield today well exceeds yields on Treasuries. At the height of the bubble in 2000, it was less than 1%. The stock market risk premium is the highest it’s been in 25 years. The market is considerably cheap by nearly any measure. Is this market Crazy?
How We Got Here
The epicenter of this crisis is the decline in housing prices, now down 15-20% across the country. Housing foreclosures and delinquencies now total nearly 10%, because people who couldn’t afford houses bought them anyway, and banks happily loaned them money because they were simply selling the loans off to Fannie, Freddie and Lehman Brothers. These firms then packaged the loans together, paid the rating agencies to put Good Housekeeping Seals of Approval on them and sold them. Additionally, they added more borrowed money, created derivatives on top of them and sold them again. Imagine the fun of being able to sell your house to a dozen different buyers at the same time!
Once the collateral started to decay, the capital levels used to support the additional borrowings began falling, meaning that the intermediary investment banks became technically insolvent very quickly. The Fed resuscitated Bear Stearns, Morgan Stanley, Goldman Sachs and Merrill Lynch, but they experimented with the bankruptcy option with Lehman Brothers. In hindsight, this was the catalyst for the panic that has taken hold. Lehman had far too many interrelationships, creating systemic disruptions.
Recognizing their mistake, the government backpedaled quickly with the proposal of a $700 billion antidote. Markets celebrated this demonstration of personal responsibility with two very dramatic upswings, only to be embarrassed on Monday September 22nd when the House voted no. The failure of Lehman created a financial crisis, the failure of the government created a financial revolution.
Now to the core unresolved issue. “Too much leverage” is the same as saying “too little capital.” Due to the deterioration of the base collateral in the system used to fuel this version’s excesses, we now have a capital shortage. There are only two ways to fix this problem; either through the reduction of leverage (and we have all seen how painful that can be), or the introduction of capital.
Hank Paulson has a $700 billion checkbook. He has not cut a check. Ostensibly, he can spend it any way he wants to. He has one mission: stabilize the banking industry. If he can accomplish this, banks will lend to each other again, they will lend to you and me, and the economic engine will turn over. He can do this by buying the toxic assets caught in the financial plumbing system, and he can do this by taking direct equity stakes in banks. Supporting him, the FDIC may insure all banking deposits to restore account holder confidence, the Fed may guarantee inter-bank lending to restore healthy banking practices and governments around the world may respond in concert. There is a certain beauty in a global collaborative effort to fight this financial virus. That is what is happening right now. This will work.
Looking for the Exit
If you feel like you are in a dark room looking for a doorknob to turn, don’t look to the stock market. The path to redemption for investors will come through the bond market. Think of bond market spreads (simply the comparison of two different bond yields) as a thermometer of confidence. When spreads are high, we have fever, when they are low, we are healthy. The most important thermometers right now are the overnight inter-bank thermometers and the overnight corporate borrowing thermometers. The decline in these spreads will be the spark we need. The London Interbank Offering Rate, LIBOR, was 2.15% a month ago, peaked at 6.88% last week and fixed today at 2.47%. Why the quick fall in LIBOR? The British Government allocated $87 billion in fresh capital to the nation’s eight largest banks. Did you hear that, Mr. Paulson? In the corporate borrowing market, or commercial paper market, overnight rates dropped from 2.59% on Wednesday to 1.71% on Thursday. Why the improvement? Mr. Paulson announced plans to fund a facility to purchase commercial paper directly. This does not guarantee the market but it introduces a substantial buyer into a $1.5 trillion marketplace. So while the exit may still be sealed, light is finding its way into the room.
Stop this Depression Talk!
My final observation is this. When we went through the Great Depression in the 30s, unemployment was 25%, foreclosures were 50%, and the government denial phase was long and finally punctuated by significant policy mistakes. This is not the 1930s. We have a single digit foreclosure rate and a 6% unemployment rate. The government has asserted itself aggressively. Whether you agree with the tactics or not, smart people are working on this problem. We will resolve the credit crisis, we will survive the recession and we will expand again.
My friends, if this is not the end of the world, then it’s the best buying opportunity I have seen.
Happy Columbus Day!
David S. Waddell
Senior Investment Strategist