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September 17, 2008

Special Market Comment

I firmly believe that the stock market is way oversold. Current levels for the major indices and most stocks will be significantly higher within the next six to twelve months. Prices reflect a significant global recession driven by the crisis in the financial system. The near-term is being driven by emotional trading in thin and illiquid markets. It is difficult to predict when that will end. However, today's decline and panicky trading in all types of markets (oil up $6, gold up $83, treasury bills rates at one half of one percent) indicate that the pieces are falling into place for a major bottom. Complete panic and loss of confidence marks a bottom. Until today, I did not see that panic. Now that it has arrived a bottom should be much easier to put in.

My confidence level about an intermediate term rally is high but the very short-term is impossible to predict. I feel we fell far enough that I began today to invest a portion of the excess cash reserves I have been holding in Northlake client accounts. My near-term strategy is to lower reserves gradually but maintain higher than normal levels of cash. I view normal cash as 4-8% of an equity portfolio.

When I am making partial buys for client accounts, I complete a random sort of accounts to determine where the shares are allocated. For example, let's say I want to buy 10,000 shares across 40 accounts but the first day I only buy 2,500 shares. I will sort the accounts randomly and allocate shares until the 2,500 are gone. The next day the process starts again until all client positions are filled.

As for today's action, it is difficult to determine exactly what was driving the extremely heavy selling. The bailout of AIG is a positive. Had it gone into bankruptcy, today's decline would have looked mild given the insurance it provides for banks and brokers worldwide.

I believe what got people worried was that from the weekend until last night the bailout of AIG grew from $40 billion to $70 billion to $85 billion. Clearly, the problems were growing and much worse than even bears expected. The obvious conclusion is that if AIG is much worse than expected, and getting worse by the day, then all the other financial institutions, even the presumably strong ones, are in a much weaker position that we had thought.

I can accept that reasoning but this is where it gets complicated....

....The stock market was taking its cues today from the credit markets, in particular, the market for credit default swaps (CDS). CDS are a form of insurance: the higher the price to insure, the riskier the company. Today, CDS prices for leading financial institutions such as Morgan Stanley and Goldman Sachs exploded. Based on the pricing, these companies are in serious trouble. Gold soared on this and stock futures sank.

Also complicating factors was short selling. Short sellers are just doing their job, trying to make money for their clients. However, the rules are such that short selling is too easy and in a market where the collapse of the stock of a major financial institution can lead directly to the collapse of that institution, regardless of its actual health, shorts can overdo it. It only takes one person in a crowded theatre to yell, "Fire," and cause panic even if no fire actually exists.

The immediate question is whether the CDS market is correct. I am not so sure it is. The CDS market is unregulated, illiquid, and has a fairly small number of players. Thin markets lead to exaggerated moves and today that may very well have been the case.

Unfortunately, even if I am right, the ramifications of the massive declines in stocks today could endure. Financial companies need confidence and access to capital. Today confidence was lost and the access to and cost of capital rose dramatically. There is a risk that healthy companies can get in serious trouble as this cycle can be a self-fulfilling prophecy.

To get things turned around requires a break in the downward cycle. More coordinated government action, interest rate cuts by Central banks around the world, or even just a rally could do the trick.

Remember, we entered September worried about Fannie, Freddie, AIG, Lehman and Washington Mutual. Four of these have been dealt with. It's been painful but we are in a better place than we were two weeks ago as far as coming to drips with the credit crisis.

I have little doubt the credit crisis will lead to more difficult economic conditions all over the globe. But if we can get beyond the immediate fears on the credit markets, Wall Street can deal with the implications of a global recession. That is measurable, knowable, and investable.

I think we are far along in the process even though it has been far, far more painful than I ever expected or predicted. This why I think it is prudent to begin to invest cash reserves.

If you want to talk further about the markets or your particular investments or finances, please give me a call.

Posted by Steve Birenberg at September 17, 2008 05:49 PM in Stock Market