Behind These Down Days

As we wait for indications that the bottoming process is working through, we had another bad week.  The Dow fell 473 points over the week ended last Friday, more than erasing the 401 point gain the prior week.  And international equity markets started out this week badly, with Hong Kong’s Hang Seng equity index down 12.6%, Japan’s NIKKEI 225 index down 6.4%, the FTSE index down 1.7% and so on.  Emerging Markets have really been hammered, especially equity markets in countries that have a heavy reliance on energy, materials, or precious metals production and sales. In Brazil, for example, the Bovespa stock index fell 6.5% and is down 64% in dollar terms so far this year.

 

With the carnage overseas, U.S. equity markets finished with the Dow dropping “only” 2.4% today.  There are some grounds for this better relative performance.  We are energy and commodity importers, so those price declines will benefit our economy down the road.  Also, while the dollar exchange rate has been rising, it remains well below the 2002 peak and still offers, in my opinion, a solid competitive advantage to U.S. companies that export and compete with foreign companies.  Finally, Federal Reserve and Treasury programs aimed at restoring our financial system are starting to kick in.  Today one, in my opinion, very important program started – the Federal Reserve’s Commercial Paper Funding Facility (CPFF).  This program will provide a backstop to qualified issuers of commercial paper (CP), giving these issuers the ability to get three-month CP loans from the Federal Reserve at near-normal rates.  CP borrowing had fallen by $366 billion (25%) over the last six weeks, another credit area that seized up after the AIG/Lehman failures and that has created much stress on many traditional borrowers.  There are more programs coming.  It is nice to see that not everything barreling around the corner at us is bad news.

 

So why have equity markets continued to have so many bad days?  There are a whole host of factors, but two now stand out.  First, the swift fall in oil and other commodity prices has had an immediate negative impact on the producer economies and stocks, but the benefits to consumer economies and stocks, importers or users of energy and commodities, tend to show improvement only after a lag of six months or so. Second, a new source of downward pressure on markets appears to have come from hedge funds. 

 

Hedge funds that actually hedge risk and thereby reduce risk have generally done relatively okay (though most are still down).  However “hedge” funds that were actually using leverage to make long risky bets on all sorts of things, like troubled debt, long energy, and other commodity bets or risky positions have been hit very hard by the credit crisis, and now their investors are reported to be fleeing in droves.  No one has a full view of this market, because it is yet another unregulated part of the global financial system that will likely have to be completely rebuilt and subjected to significant regulatory oversight. However, for now I, among others, am guessing that there has been a lot of forced selling.

 

These leveraged “hedge” fund portfolio price declines coupled with investor demands for redemptions have delivered a double whammy to equity and fixed income markets around the world.  It appears that managers of such troubled “hedge” funds have had to throw everything not bolted to the deck overboard to keep their funds afloat.  One problem is that the stuff bolted to the deck is likely to be the really risky junk assets, the “illiquid” assets that cannot be sold (or liquidated) easily. Meanwhile, the relatively good or “liquid” assets are being sold.  These managers appear to be selling all sorts of securities without, in my opinion, much regard to price.  AAA municipal debt securities, equities with low valuations, investment grade corporate bonds, etc. have been dumped at what look to me like fire sale prices.

 

And while we have heard from bunch of hedge fund managers that they are okay and have raised a lot of cash, there is no way to know for sure, and given the lack of regulatory oversight, in the main I tend to distrust much of what is said.  I have heard way too much from way too many financial institutions over the last year that just was not true.  One important gauge I am watching here is, strangely enough, the Japanese yen exchange rate.

 

Many “hedge” funds used something called the “carry trade” to borrow money to lever up their portfolios.  The idea was to borrow in Japan at a very low interest rate and use the yen denominated proceeds to buy assets anywhere in the world for their portfolio.  This process in effect put the funds in a short yen and long some other currency exchange rate position.  So, as they have been selling stuff out of their portfolios, they have been eliminating the short yen exchange rate positions.  As a result, the yen has soared since the beginning of September, rising 17% against the dollar and 37% against the euro.  A slacking in the yen appreciation may mean hedge fund selling is tapering off.  So far, that has not happened.  And, hedge funds still foolish enough to have that carry trade on their books are getting hammered by the appreciating yen.  Good grief, another bad movie script!

 

All of these bad movie plots we have seen play out over the last few months have common themes: high prices (housing, energy and other commodities) followed by a price crash, very bad security selection with very high leverage, hidden problems, deep flaws in the financial system, and a lack of regulatory oversight.  Alan Greenspan, in testimony last week, said he was astonished at how bad things were at many large supposedly sophisticated financial institutions at the heart of our financial system.  While I deplore the lack of regulatory oversight on his watch as Fed chairman, I have to agree with his astonishment.  So, is there more bad news likely to come barreling around the corner at us?  Almost certainly.  But there will also almost certainly be good news as well.  And we just have to deal with what the markets have already priced in.

 

I know that, in this global financial market meltdown, fundamentals do not matter to many investors, but I do think that fundamentals will become important once again when forced selling and panic selling subside.  For example, by my calculation, the stock market value of all U.S. non-financial corporations is now down to about 44% of their aggregate net worth.  The municipal debt market appears to be pricing in widespread defaults on AAA general obligation bond defaults.  Meanwhile, despite facing huge new issues of Treasury debt that will be coming to finance the Treasury and Federal Reserve programs, the yield on the two-year Treasury note is only 1.5% and the 10-year Treasury note has a yield of only 3.75% (compared to a 10-year AAA general obligation yield of 4.5%).  While I do not think it is time to step in and buy more risk, I also do not think it is the time to be a seller of risk either.  With a longer-term view, “risk free” securities look overpriced and therefore actually more risky, and “risky” securities generally look increasingly underpriced, therefore becoming less risky as their prices fall.

 

I will continue to try to offer what insight I can into what is driving the markets, and where we may be in the bottoming process, how long or deep this recession will be, and how well or badly government agency efforts to return our system to better functioning are working. As always, please contact me with any questions or concerns.

 

 

LPL Financial

100 North Point Center East

Suite 530

Alpharetta, GA 30022

(770) 995-7101

 

 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult me prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

 

 

Tightening up for the Recession

Equity markets around the world continue to experience high volatility as investors deal with a great deal of uncertainty about just about everything.  Although we still face a long list of unanswered questions, volatile markets, and yes, a recession, some of the right answers are starting to come in.

 

The ongoing list of unknowns is daunting: Are we in a global recession?  How deep will it be?  Are government and central bank actions sufficient to deal with the banking crisis?  Is OPEC likely to stick us with an oil production cut in an attempt to push oil prices back up again?  And so on. Yuck. 

 

Here in the United States, the Dow gave back all of Monday’s gain on Tuesday and Wednesday, but managed to close above the closing low set on Friday, October 10 and then closed up 172 points on Thursday—roughly flat.  International markets fared as badly, or worse, pretty much across the board.  It looks to me as though developed country equity markets are moving up and down trying to decide whether we’ve seen the bottom yet or not.  Also, while energy and materials stock prices took the immediate negative impact of the sizable drops in oil and commodity prices, the positive net effects of lower prices for the economy will take a while to show up in other stock prices.

 

Now that, in my opinion, we are in a global recession, I expect mostly negative economic news for the next three to nine months.  Consumers are tightening up, adjusting down spending in response to the economic uncertainty and lost net worth in housing and financial markets.  In aggregate, the tax rebates in May, June and July from the Economic Stimulus Act of 2008 did not deliver the desired impact on spending.  While consumer spending stayed relatively flat, personal saving increased by quite a bit more than the tax rebate, leading to a record decline in consumer installment credit in July.  I am actually happy to see that; it is a rational response to tough times.  However, I think that response does point to a fairly sharp downturn in consumer spending starting this quarter and extending into the first half of next year.  Home construction is already at deep recession lows, and banking is in recession.  But U.S. exports are booming, and I do continue to think that in aggregate U.S. non-financial corporations are pretty well positioned to weather a recession with well contained costs, low inventories, and capital spending programs under pretty tight control.  These companies’ biggest problem continues to be the decline in prices of goods and services sold. So much for fears of inflation.  So, while there is legitimate uncertainty over the magnitude of the recession, I still believe it will not be a deep one.

 

There are some positives.  The dollar exchange rate, while still low has been moving sharply higher, and the price of crude oil, while still high at about $68 a barrel today, is down sharply from that horrible peak of about $146 we hit in mid-July.  The high energy prices earlier this year took a while to damage the global economy, and lower prices now will, with a similar lag, help repair the economy.  It sure is nice to see gasoline prices below $3 a gallon again.

 

I continue to believe that the Federal Reserve, the Treasury and other federal agencies are headed in the right direction to repair the damage done by the meltdown in banking.  For example, bank reserves, which normally total about $44 billion, now total $180 billion and are likely to increase far more under announced programs.  And over the last four weeks, as non-bank borrowers exercised their revolving credit lines, bank lending has increased by about $300 billion, double the previous record four week gain.  So, it looks as though both bank and non-bank companies are awash with cash.  And households are piling up personal savings again.  In the short-run all these positives don’t help the economy or financial markets as everybody sits on this cash, but longer-term they should begin to ease the credit crunch and restart economic growth.

 

It’s clear to me that consumers, businesses, and investors alike are now tightening their belts and that we are entering a recession. There is plenty of pain in recessions; even a short and shallow recession means that some people will lose their jobs and some businesses will not survive. Once consumers and businesses are assured that the economic stimulus programs put in place are making real progress to their goals and can see positive results, the magnitude and the duration of the recession will become clearer and confidence should improve. Meanwhile, we will continue to see very volatile markets as investors react to every positive and negative indicator. As always, please contact me with any questions or concerns.

 

LPL Financial

100 North Point Center East

Suite 530

Alpharetta, GA 30022

(770) 995-7101

 

* There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not ensure against market risk.

 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult me prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.