Inventories Coming Down is Bullish

One of the things necessary to turn the GDP numbers is a change in production schedules of factories. At first, all that will occur is a cessation of the cuts in production schedules. This is probably already at work and explains some of the better economic statistics lately. The stats are not signaling growth but they are suggesting stability is seeping albeit at a low level of activity.

Stability in the GDP outlook is the first step required for a higher stock market. I think the rally off the March lowis moslty tied to a feeling that the economy is bottoming. To get another significant leg up will require less negative GDP growth followed by a return to positive growth. The stimulus bill and various Fed and Treasury initiatives will help with this starting in 2Q. Positive GD growth in 4Q is not out of the question. Investors will be hesitant to bid stocks up a lot further, however, until they see sings that economic activity is improving and this is where the low inveotires come in.

My favorite economist, Tony Crescenzi of Miller Tabak, has been hot on the trail of the potential improvement. Here is what he had to say about the inventory numbers:

"The combination of falling inventories and increased sales brought the inventory-to-sales ratio down to 1.31 months from 1.34 in January, although it is still well above the record low of 1.06 months set last June. The decline nonetheless represents progress, and U.S. companies have calibrated their output sufficiently to the new, lower levels of demand.

As I said, it is the direction of change that will get attention first, via the factory-laden economic calendar. This will rally riskier assets. Later, there will be focus on the magnitude of change and on whether the change in direction is enough to spark a change in the production cycle strong enough to take hold and evolve into a self-reinforcing virtuous cycle of increases in production, income and spending. There will be plenty of obstacles and plenty of doubts."

1Q earnings reports will be a good window on the stability argument. I think the commentary will be mixed, skewing negative. However, the stock market only needs enough of signs of stability to prevent the negative feedback loop and Armageddon scenario from developing again. I am hopeful that there will be enough stability signs which is why I brought down cash balances in Northlake client accounts in late March.

"Dow of Steve" Debuts at SNL Kagan

I am very pleased to announce that SNL Kagan, by far the industry leader in independent reporting and analysis on the media and communications industries is debuting a new blog authored by yours truly. The first post at the Dow of Steve should go up later today.

Kagan is a subscription site that comes at a pretty steep cost. It is designed for Wall Street firms and research departments of media and communication companies.

You should not expect any changes to Media Talk other than my having even greater resources now that I am associated with SNL Kagan. Those resources should accrue to the benefit of Northlake clients as well as other readers of Media Talk.

Trrying to Explain the Rally

In trying to explain the rally in the face of nothing but sensational negative news, I have tried to stress that all it takes is signs of stabilization in the economy and less negative sentiment to turn things around. A few weeks ago I was joking that if CNBC ran a headline that said "Guaranteed Bottom for Economy in 1H09" we would rally 1,000-2,000 points.

I believe more or less these things are what is driving the current rally but to focus more closely on the GDP debate, I think that Fed Governor Janet Yellen's comments from yesterday were overlooked. After noting that she is "strikingly more optimistic" than her friends in the business world, she went on to explain the difference between "growth rates" and "level." Wall Street is happy if growth rates stabilize regardless of level. Businesses and employees facing layoffs care more about level. But the best part of Yellen's comments are the following:

"Second, it takes less than many people think for real GDP growth rates to turn positive. Just the elimination of drags on growth can do it. For example, residential construction has been declining for several years, subtracting about 1 percentage point from real GDP growth. Even if this spending were only to stabilize at today's very low levels--not a robust performance at all--a 1 percentage point subtraction from growth would convert into a zero, boosting overall growth by 1 percentage point. A decline in the pace of inventory liquidation is another factor that could contribute to a pickup in growth. Inventory liquidation over the last few months has been unusually severe, especially in motor vehicles--a typical recession pattern. All it would take is a reduction in the pace of liquidation--not outright inventory building--to raise the GDP growth rate. In addition, pent-up demand for autos, durable goods, or even housing could emerge and boost demand for these items once their stocks have declined to low enough levels."

This is a crucial point for the bull case. Just three weeks ago no one believed this despite the fact that it was true. And no one bothered to remember that the Stimulus bill was going to add hundreds of basis points to GDP starting in 2Q.

I think the best time to buy aggressively will be on the pullback from this first real rally since the September breakdown. The character of the market has changed for the better. The downside risk is more manageable now and the outlook is bit more balanced. I think we have upside into early April and then a pullback that should be bought.

I don't mind not buying the low because the risks three weeks ago were greater than they are today now that some signs of stability have appeared in the economic and financial system outlook, investor sentiment has improved, and government programs are being given a chance to work.

In other words, even though the Dow has rallied 1,500 points the risk-reward trade off is better.

Dollar Weakness is Bullish

My friend and fellow money manager, Scott Rothbort, noted on SeekingAlpha.com that euro strength is bullish. I think he is right. The euro is over $1.21 today, the highest since mid-February. The euro is also at a multi-month high vs. the yen. A chart of the euro/USD looks an awful lot like the S&P 500 over that time frame.

Scott mentions the beneficial impact of currency translation but I think just as important, maybe more important is that euro strength (dollar and yen weakness) is a sign of lessening risk aversion which is in turn a sign of improved confidence in the global economic outlook.

And it is not just the euro. Emerging market currencies have rallied as well. The Mexican Peso has rallied 10% in the last two weeks and is now down just 2% on the year. Even Eastern European currencies have rallied led by more stable nations like the Czech Republic. Dare I note that even Ukraine's currency has rallied over 10% and is now down just 4% this year.

I see currency movements as investor sentiment on the global economic outlook. Right now currencies are improving which is a positive for stocks.

Position: No positions mentioned but client holdings, including my personal accounts, are positively leveraged to euro and emerging market currency strength including CETV and NIHD.

The Steelers Are Bullish

A good friend and client is a huge Steelers fan. Being a Buffalo Bills fan I don’t know how I can stand the guy as they are probably going to get their 6th championship and neither the Bills nor any other team from Buffalo has ever won anything, just lots of near misses.

I can't vouch for the following but my friend forwarded me an article from the Pittsburgh Post Gazette written by Len Boselovic which stated:

Memo to U.S. Treasury Secretary Timothy Geithner: The Pittsburgh Steelers may be the only stimulus package you'll need.

Stocks also have outperformed in years a team appears in the Super Bowl for the first time, which is the case with the Arizona Cardinals. But the edge in those years is much smaller than the gargantuan gains that Steelers appearances have produced.

I'll be cheering for the Steelers Sunday. Ben Roethlisberger and I share the same alma mater, Miami of Ohio. We don’t get too many stars in professional sports so I'll be waving a terrible towel on Sunday. Hopefully, the market will cooperate again this year with Steeler success and I won't have to use that towel to wipe away tears from another down year.

Latest Market Comments

The market has just been brutal. I have incorrectly thought the whole way down that stocks were reflecting a worse economic reality than was likely to occur. Obviously, this view has been proven wrong. I do believe that the market and the economic outlook are now in sync but that won't help until the economic outlook stabilizes. If we magically could declare that the economy will be "really terrible but we promise it won’t be worse than terrible" the market would stage a very big rally. It is the fear of unknown, which grows every day the market collapses, that is now driving the devastation in individual stocks.

There is a total lack of confidence in any forward looking estimate. Therefore, even when it is obvious that a company's business will not collapse the stock can be priced as though it will. For example, News Corp or CETV stocks are falling so rapidly that it suggests their revenues will collapse, down 50% or more. Yet, any realistic assessment of the likely demand for TV advertising or satellite TV subscriptions or subscriptions to the Wall Street Journal would show a worst case scenario where revenues fall 20%.

Maybe I am wrong and the downside is really as severe as the stock prices imply. One thing that makes it difficult for me is that I have an innate optimism. I have never believed doomsday scenarios. I just believe that things generally work out. The current market is telling me I am wrong.

There really seem to be just two things that can turn us hard upward. First, though it sounds stupid, we just need to go up. Investors are so scared and have been burned so badly with every buy since September that just a few days of upward momentum would remind us that you can in fact make money by buying. It may seem odd to those who don’t play in the market every day but what I am saying is that there will be many more buyers of a stock that has gotten destroyed at $20 or $30 or $40 than at $10. Right now, everyone is taking their signals from price. That needs to change.

Second, we need some good news. Either the macroeconomic outlook needs to stabilize or individual companies need to prove that the stock price is wrong compared to their ability to earn even in a severe global recession. I think lots of companies can do that. Just this week Dell and Hewlett Packard did that.

My optimism remains. This horrible period will pass. I know that Northlake's strategies and stock picking work. They worked in 2005, 2006, 2007, and until late September 2008. They will work again.

"They Just Haven't Seen It Yet"

Yesterday, late in the day upon returning from a tech conference my RealMoney.com colleague Bob Faulkner wrote, " Now the bear in me will say they just haven't seen it yet but, who knows?" in relation to solar demand at MEMC Electronics.

I've got a longer column coming up today facing up to the pain and trying to explain Central European Media Enterprises (CETV). I think Bob's comment is exactly what people would say about CETV's ongoing confidence in local currency ad growth in 2009 throughout the Central and Eastern Europe markets where they own TV stations. They first said it a month ago and reiterated it today at a Morgan Stanley conference in Barcelona.

But the point of this comment is not solely CETV. You can read my column later. Rather, I think this attitude/question that Bob raises applies pretty broadly. I follow lots of stocks where the stock price has to be discounting far worse in 2009 and 2010 than management is indicating or willing to admit to at the moment even if they have already guided lower (Disney would be a good example).

I think for the market to stabilize and have a big sustainable rally we need a sense that the outlooks are not a black hole. Right now, pretty much everyone assumes that even where earnings and cash flow estimates have been slashed they are going to be even worse (DIS again). Visibility is poor so there is little defense against this view. We need something in the macro story to hang our hats on because we are already expecting terrible results. If we could find something that tells us they will not be worse than terrible, we will get a big and sustainable rally.

I doubt I can predict what it will be ahead of the time but I think it is important to consider all possibilities as the news flows. The last few weeks especially have taught me that in this market it is OK to wait and react. I'll be watching.

Latest Market Comment

The market staged a big rally on Tuesday that looked quite similar to the one-day wonder on October 13th. Both rallies started from almost the same levels on the major averages. If we can hang onto to Tuesday's gains, you will see lots of commentary about a successful retest of the October 10th lows.

While the economic outlook has soured considerably since October 10th there are some signs of hope. On a purely technical basis, the chart patterns look better. As painful as the last week has been it looks like a trading range may be getting established between the lows (S&P 500: 840) and recent highs (S&P 500: 1000).

More importantly, the efforts by the Federal Reserve, U.S. Treasury and Central Banks and Governments around the world are beginning to thaw the credit markets. Inter bank lending rates are slowly falling and well off their highs. Commercial paper issuance by US corporations soared this week after weeks of meaningfully declines. Mortgage rates dropped a bit and statistics on housing sales, inventories and starts suggest the possibility that the initial source of the problems we face is losing downside momentum and could bottom in 2009.

The latest problem is in the currency markets. This was a problem I did not foresee that has significantly magnified the risks faced by the global economy and stock market investors. Last week currencies around the globe collapsed versus the dollar and yen. In some cases the drops were 20% or more and the carnage was not just restricted to emerging markets. The British pound actually fell 8 cents in one day last week. In recent years a penny move was considered volatile.

Many of the collapsing currencies in emerging markets are happening even though the economies of those countries have been performing well and the local banking systems are not unusually exposed to the credit market meltdown. But panic is panic and when the Brazil or Ukraine or Hungary or even South Korea loses control of their currency the blow back on their economies can be quick and severe.

Since emerging markets have been the backbone of global economic growth for several years last week's loss of confidence in those markets undercut the final hope of investors that the world could avoid a really nasty recession. A new downward spiral of collapsing currencies, stock market sell-offs, and rising risk premiums suddenly appeared. And it way too closely mimicked similar spirals in the credit markets that accelerated the downward trend in stocks from early September onward.

On Wednesday investors will be laser focused on the Federal Reserve expecting an interest rate cut of 50 basis points. I think that is the minimum required to prevent a sell-off in stocks. However, I think on a longer term basis we should keep on eye on currency markets. What we want to see is further weakness in the dollar and yen and a rebound in the euro and especially emerging markets. The euro has rallied 2-3 cents in the last few days. Emerging market currencies rallied 2-3% on Tuesday. An extension of these gains will parallel improvements clearly evident in the credit markets and set the stage for a period of greater stability for stocks.

While I find many stocks to be really cheap on a 2-3 year basis, I think the most helpful thing right now would be a period of stability. Even just a week of something that looks normal on my screens would remind investors that the world is probably not ending and that the decisions they make and the tools they use can still be valid.

I have been negatively surprised by the way the initial subprime problem spiraled out of control and seemed to randomly ricochet around the world of global finance and economics. The velocity and severity of the movement caught me by surprise and led me to make some incorrect decisions in the stock market – at least incorrect in the short-term. I am still learning but what I missed was how tightly connected global markets and economies were due to the use of derivatives and how much larger and less stable those derivatives actually were than I understood.

The market is actually higher today than it was on October 12th when I wrote my last market comment but it remains far below where it was when I wrote my initial comments in mid-September.

Throughout this period I have felt it was best to sit tight and ride out the storm. For the last two weeks that has been OK advice. I still think it makes sense even though my forecasting ability has proven no better than the nightly weatherman.

If we can stabilize in the next few weeks, I think we could rally another 10-15% before year end. After that I think we face a period of several months at least where we will see just how bad the economy becomes. Right now, I think a good working assumption is that the economy is growing again in 4Q09.

If that is the case and stock prices follow their previous pattern, a more sustainable upturn in stocks would occur next spring. I think stock prices are low enough today to warrant the risk that this forecast proves too optimistic. In the meantime, I'll have to make tough decisions on some of the losing investments. A few may be sold on a rebound while others deserve to be averaged down.

Unfortunately, the only thing I know for sure is that events will continue to move rapidly and responses will have to constantly re-evaluated.

Special Market Comment: October 12, 2008

Several times last week I started typing a market comment but each time events were moving so fast that my thoughts felt dated before I was done.

Now that the weekend has given everyone a chance to breathe, I wanted to offer a few thoughts even though I worry that when Asia opens on Sunday night, followed by Europe early Monday morning, markets and news events may make these comments look behind the times.

Since the market began its accelerated decline in mid-September I wrote several comments that have proved to be off base. I thought what is now the initial phase of the decline would put in a bottom to the year long bear market since stock prices finally appeared to be reflecting the magnitude of, and risks posed by, the credit crisis.

It turns out I was wrong. I never expected another stock market crash. I was already a five year market veteran in 1987. Those things are supposed to happen at most once a generation.

What Seems To Be Happening

The immediate problem for the stock market is that the issues in the credit markets appear to be overwhelming the government and central banks response. A vicious downward spiral has developed. A new problem emerges in the credit market. The stock market takes another big leg down. A financial institution's stock implodes. The implosion feeds back into the credit markets which tighten further. Stocks re-open and more financial stocks collapse. All of this is exaggerated by derivatives contracts on debt which have a value far in excess of even the balance sheets of the world's central banks.

A parallel cycle is at work for the economy and non-financial companies. Stocks collapse in response to signals from the credit market. Weakness in both markets leads consumers and businesses to freeze spending triggering worries that the economy will get even worse. Forecasts and budgets for 2009 drop. Fear that the economy will collapse grow. Credit markets tighten further. The stock market drops again.

2008 vs. 1987

In the short term, the most important thing is to break the downward spiral. We need to start with signs that credit market conditions are easing. If that occurs, stocks will have a huge rally. In 1987, the worst 9 days of the market crash saw a decline of 29%. On days 10 and 11, the market rallied 15%. So far, in the 10 days starting with the 778 point drop in the Dow on September 29th, the major market averages are down by 25%.

The 1987 pattern saw a slow decline after the initial bounce until the crash low was retested in early December, six weeks later. The retest held, the economy was not as bad as feared, and a new bull market began. From the low in October 1987 until the next major correction began in August 1990, the Dow rose 80%.

This pattern offers hope. However, I think there is a big difference between 1987 and 2008. In 1987, there were some developing economic problems due to a weak dollar and high and rising interest rates (10 year Treasury yields broke 10%). Stocks crashed which led to deep worries about the economy.

In 2008, the stock market is reacting to potential problems in the economy triggered by the credit market collapse. This time the worries are about the economy and a collapse of the global financial system. Stocks markets are where those worries are immediately priced, where investor fear about the future is reflected.

In other words, the credit markets and economic concerns are driving stocks instead of the other way around. This is a more dangerous situation.

Trying to Look Ahead

It is almost impossible to look ahead and make predictions with any confidence about the near future of the stock market. I firmly believe that if we can break the downward spiral for just one or two days, there will a huge rally, the biggest ever. We will not be out of the woods at that point as the severity of the declines in the last three weeks will lead to difficult economic conditions well into 2009, possibly longer.

However, if we get the relief that will come with a rally, central bankers, government leaders, consumers, and businesses will get a chance to relax. We will all realize that the world as we know it is not ending. Stocks of many companies are extremely cheap looking at their prospects over the next several years. Right now, no one cares because there is no reason to believe any forecast. That will change if we can break the downward spiral.

What will break the spiral? Honestly, at this point, I am not certain. The markets are in control. We just need an up day. The Federal Reserve, Treasury and similar institutions around the globe have thrown massive resources at the problems: unprecedented liquidity, coordinated interest rate cuts, capital injections, direct intervention in credit markets, the guarantee of bank deposits and money market funds. In a rational world, one not driven by panic and fear, this should be enough to stabilize markets.

Once the market stabilizes, people will remember that bull markets can still occur. They will look back at 1987 and see that from the low the market rallied 80%. We won’t rally like that right away but we will rally again.

Everything in my experience tells me it is too late to sell but I'd sure feel a lot better about my belief if we could get the relief that will only come from an up day.

What To Watch

This weekend the markets want a coordinated government response with specific details. Keep a close eye on Europe. There are signs that a specific plan to pump money directly into the banking system is taking shape. The plan is built on the UK strategy announced on Friday. The UK stock market and bank stocks have done badly but late last week the damage was not quite as bad as elsewhere which I think is a sign that the UK plan is something that global credit and stock markets will support.

In the US, look for the Administration to make a concrete step in the direction of the UK plan. Watch Morgan Stanley and Goldman Sachs shares. Morgan Stanley has a lifeline from a Japanese bank. It is important that the deal closes on schedule this week or another rescue plan for Morgan takes its place. Goldman shares reflect the financial system fears on a minute-by-minute basis. They only recovered slightly from their lows in Friday's final hour rally.

Other financial stocks need to recover. On Friday, some of the banks deemed secure like JP Morgan Chase had nice up days. Follow through is important. Technology stocks had an OK day lifting the NASDAQ into positive territory. Small cap stocks were up big as measured by the Russell 2000. Financial, technology, and small cap stocks are where investors will buy if we get a turnaround because that is where the biggest rebound will initially occur.

Another Market Update and Schwab's Safety

The activity in the financial markets and on the regulatory front is absolutely amazing. I've been managing money since 1982 when the Dow was well below 1,000, and I have never seen anything like this, not even the 1987 crash.

My operating thesis this week was that we had reached a turning point in the credit crisis as Wall Street finally accepted its magnitude and important initial steps were taken to stabilize it. The next step in my logic was that Wall Street would turn its attention increasingly toward the impact of the credit market turmoil on US and global economic growth. While my opinion is that the resiliency we have seen in economic growth here and abroad would continue, what is really important is that Wall Street can analyze and efficiently price a recession but it can't analyze and efficiently price a global collapse of credit markets.

An old saying is that Wall Street likes certainty. Before the extraordinary actions taken by the government yesterday and today the level of uncertainty had been reduced. This was the reason I decided to begin to invest client cash reserves during trading on Tuesday and Wednesday. I am only bringing reserves down slightly and still feel above average reserves are prudent especially as stock futures today are presently forecasting another 5% gain.

The actions by the government to guarantee money market funds and begin the process of establishing an entity to takeover bad mortgage loans throughout the system have dramatically reduced systemic risk and should put to rest concerns many have about the safety of their assets at various financial institutions. Nevertheless, I wanted to pass along some information I have received from Schwab regarding the safety of Northlake client assets....

....Schwab has not been implicated in the issues that got Lehman, AIG, Bear Stearns, and others in trouble. Schwab's business model is far different and does not include capital markets activity. Schwab's primary exposure is in its own mortgage lending to its brokerage clients and its money market funds.

Schwab does have one issue with a quasi money market fund which produced large losses for owners. The fund was not large enough that lawsuits would threaten Schwab's financial viability. According to the attached pdf on Schwab money market funds it does not appear that any other funds are in trouble. Of course, the government is now backing money markets so it should not matter if other assets they own are in trouble. As far as their mortgage lending goes, there is no way to know how many bad loans they hold but given that this is not Schwab's primary business it seems unlikely that losses would threaten the company.

Let's postulate, however, that Schwab got in trouble and declared bankruptcy. The other attached pdf on asset safety addresses this issue and should be extremely comforting. The presentation is long and complex. Here are the key points:

• Client assets are not commingled with Schwab corporate assets and Schwab creditors have absolutely no right to them in a bankruptcy.
• Client assets are protected via SIPC insurance and a Lloyd's policy.
• The primary risk to clients is that "assets go missing." This could occur because Schwab lends client assets – no w ay to stop that, it is standard industry practice.
• If client assets are missing, SIPC insurance kicks in and then the Lloyd's policy.
• Losses for any single client are shared pro rata by all Schwab clients. Schwab has $1.4 trillion in assets which means that "losses" would have to be in the hundreds of millions to cause any meaningful loss to an individual client that would not be covered by SIPC or Lloyd's insurance.

The pdf on asset quality contains 25 slides. The most important slides for you to review are 6, 7, 15, and 25. Perhaps the most assurance I can provide is the following quote from the SEC Chairman in April in testimony before Congress about Bear Stearns. This quote appears on slide 7:

"Despite the run on the bank to which Bear Stearns was subjected, its customers were fully protected. At no time…were any of the customers of Bear Stearn's broker-dealer at risk of losing their cash or securities…there is one thing we know to certainty: with or without JPMorgan Chase's acquisition of Bear, and with or without a bankruptcy, Bear Stearn's securities customers are and would have been fully protected from loss of cash or securities."

I guess if the total financial system melts down as appeared to be possible this week, these words may not have proved accurate. However, government actions the last few days seem to have eliminated that risk.

I hope this latest email is helpful. My intention is not to flood your inbox but these are extraordinary times for investors. If you have any questions or comments, please do not hesitate to contact me at anytime including this weekend.

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.

Fannie and Freddie Bailout

I think the biggest benefit of the Treasury takeover of Fannie Mae and Freddie Mac is that it will unclog the market for mortgage backed securities. With an explicit US Treasury guarantee, yield spreads on Fannie and Freddie debt should drop sharply. Inventory of MBS should decline. Banks should feel comfortable lending again to quality borrowers with the knowledge that they will once again be able to securitize the loans. The combination of falling yield spreads on mortgage-backed securities and renewed lending by banks should help stabilize the housing market.

If this scenario plays out, the economy is not out of the woods. Economic activity is weak for consumers and businesses across much of the developed economic world. The return of leverage to more reasonable levels remains a huge and lengthy headwind. However, the risk of something worse, like a really deep and long recession or a deflationary depression, appears to have been significantly reduced.

For stock market investors that should be a good thing as it improves the risk-reward tradeoff and reduces the level of uncertainty. How it plays in the very near future is less of an issue for me than how the market performs over the next six to eighteen months. I believe the outlook has improved considerably but I still believe we are in a low return environment until the deleveraging of the global economy is much further along.

The Credit Market Problem

Today's New York Times had a good article explaining why the lending availability is drying up in the US. This is a very important point for the near-term market and economic outlook. Our economy requires easily available credit to function near maximum efficiency. Credit availability went over the top in the past few years expanding debt levels well beyond reason. What I think happens next is a long period of unwinding where financial company, business, and consumer debt levels are reduced. This will create a great headwind for the economy likely leading to sub par economic growth for the next six to twelve months at least. Stocks can rise while this happening if investors can look beyond the sluggish period to the next growth phase. One of the key things investors will look at will be credit conditions. That is why this article is worth reading. When these indicators begin to bottom and then move in the right direction the stock market will do better. When they get better on a sustained basis the next bull market will begin.

Changing Demographics and Wall Street

AdAge.com posted an article analyzing census data from the perspective of marketers. The data was interesting although I guess not all that surprising once it was laid out. I think that the implications go far behind marketing. Here are the key conclusions: (1) the US is aging with the average age for the head of a US household almost reaching 50. For marketers this means that buyers are getting more risk averse. I'd say the same thing is true for investors. (2) There is growing behavior difference between online and wireless people and those still using traditional communication methods. Again, I think this translates to Wall Street. Well connected investors using online research and trading tools strike me as making far different investments with different time horizons than those who still rely on traditional brokerage accounts. (3) The US is not one nation but a collection of regions – the Northeast is old, white, and has few households with children compared to the multi-ethnic, young, and still child bearing West, for example. I'm not sure how this impacts Wall Street directly but it clearly is important for individual companies trying to growth their revenues and profits in the domestic market. (4) The younger segments of our population are much more diverse. Among those under 45 20% are African-American, Hispanic, or Asian vs. just 10% of those over 65. I wonder if this younger cohort will have the same saving habits as the older cohort. Will the younger cohort follow the traditional life cycle of investing or does their different ethnicity and cultural background mean they will go about their investments differently even if their assets and incomes are similar to the today's 45 and older investors? (5) 40% of US population growth in the last seven years has come via immigration. This fact feeds into regional differences as well. Immigration obviously is a big issue for the economy if for no other reason than its impact on labor rates and labor availability....

....Another interesting aspect to immigration is one recently studied by my daughter. Today's immigrants are much less likely to follow the traditional route into major urban centers living solely with other immigrants form the same place and at the same income level. More and more immigrants are heading straights to suburbs or exburbs where even among their own immigrant populations there is great diversity in incomes and job levels. I'd wager a guess that immigrants are proportionately less likely to use traditional Wall Street products and services. If so, is that gong to continue or as they assimilate will hey be drawn to Wall Street? If they are not drawn to Wall Street, will money flows to the capital markets change even beyond the issues faced by the aging of the baby boomers and their likely shift toward more conservative asset allocations. Just some stuff to think about if you need to be distracted from the bear market and crazy intraday action like yesterday.

Thoughts On The Market's Rally

This rally has been really impressive. The S&P 500 is off less than 3% this year as of Thursday's close, hardly a blip considering all the angst earlier this year and late last year. I think the largest reason for the rally has been that earnings have exceeded expectations. According to Ned Davis Research, the median gain in 1Q08 earnings for the 90% of the S&P 500 that has reported is 9.1%. It is true that overall earnings growth is negative, down more than 15% in fact. However, NDR tells me that according to Zachs Investment Research, financial sector earnings are off 80%. Thus, the median figure is a far better indicator of the health of corporate earnings in 1Q. Add in the facts that guidance has been decent, expectations for 1Q and the rest they year had been low, and the economic statistics while soft have generally indicated stronger than expected growth and you got the ingredients for this nice rally. Will it last? Will the rally push higher, above the recent top end of the trading range? I'm not sure but if it does, I don’t think it will be by much. I don’t see catalysts now that earnings are done and I think the bears will press if given the opportunity.

Could The Market Be Too Bullish Regarding The Impact of Private Equity?

There is no doubt that flood of money into private equity funds and the subsequent investment of these funds in buyouts of public corporations has contributed greatly to the 2006 bull market. Conventional wisdom is that private equity buyouts of public companies will continue at its recent pace, providing support to current public equity valuations despite the big increase in valuation multiples this year.

That is why I found this Reuters article so interesting. The theme is that private equity funds may run short of investor dollars because they are not exiting enough deals and returning funds to current investors. Reuters states that the value of private equity backed buyouts is over $600 billion this year but exits are only $177 billion. Furthermore, several major buyout firms including Carlyle, Warburg Pincus, and Blackstone are all trying to raise additional funds in the $5 to $10 billion range.

The article identifies two issues that could lead to a shortfall in funds raised by private equity, which means a shortfall in funds available for buyouts, at least relative to conventional wisdom. First, many large investors in private equity are at or close to their current allocation limits for private equity. Second, the lack of exits means that private equity firms are going to back potential investors without a track record when asking for more funds....

Even if this thesis proves correct, there are a couple of offsets. Banks and bondholders are willing to accept more and more leverage in recent deals. The $25 billion currently being sought by Carlyle, Blackstone, and Warburg Pincus can be leveraged at 9 to 1 these days compared to 6 to 1 a few years ago. That is an extra $75 billion in buying power. With private equity funds as a group raising a few hundred billion dollars a year recently, the incremental leverage ultimately creates hundreds of billions of additional buying power. Therefore a shortfall of fundraising of $10 to $20 billion might not prove much of an obstacle to the seemingly endless stream of private equity backed takeovers.

Additionally, I don’t see why the lack of track record will slow the flow of investment dollars into funds. At least among the major players, there is enough of a track record, Reuters quotes a 22.5% return in the 12 months ending June 2006, to convince current investors to up their allocations temporarily in anticipation of more exits in the next few years.

Despite my arguments that are sanguine for private equity funds, this article raises some important issues. Any shortfall in the ability of private equity funds to raise funds should set alarm bells ringing in public equity markets given the importance of deal flow to the bullish sentiment. Even more bearish would be a shortfall in available buyout funds at a time when private equity firms are looking to dramatically up their rate of exits. The IPO market is very healthy but the supply-demand balance for public equities would be altered dramatically if private equity buyouts peaked simultaneously with a surge in IPOs.

Reuters says that "The Blackstone Group is having a hard time raising the last chunk" of money for its latest fund. As my friend Doug Kass says, "Makes me say, hmmm."

A Look at October Market History

Despite September's history as the worst month of the year, September 2005 turned out pretty well. The S&P 500 produced a gain of 69 basis points and a total return of 84 basis points. The NASDAQ and the Russell 2000 did produce negative returns on a price only basis for September but both indices fell less than 10 basis points...

...In a Street Insight post about September market history, I wondered whether the fact that September was a bad month was too widely known and therefore a fade trade (go against the conventional wisdom) was in order. It turns out that it didn’t really matter one way or the other. As we begin October, I think the conventional wisdom is that Ocotber is a lousy month but history suggests otherwise as the following data from the Stock Trader's Almanac reveals:

• Over the last 33 years, the S&P has produced an average return of 1% to rank as 5th best month with 19 up years and 14 down years
• Over the past 33 years, the DJIA has produced an average return of 0.6% to rank as the 6thbest month with 20 up years and 13 down years
• Over the past 33 years, the NASDAQ has produced an average return of 0.5% to rank as the 8th best month with 17 up years and 16 down years

October also marks the end of the worst six months of the year. Stocks tend to put in their best performance from the beginning of November through the end of April. So October actually usually finishes off a bearish period and marks the launch of the seasonal rally. In fact, significant lows were made in 1987, 1990, 1998, and 2002 which launched major rallies. The seasonal trade is not surprising as Wall Street is normally an optimistic and bullish place. October puts the current year behind us from an earnings perspective and allows us to shift toward next year when we usually adopt a hopeful view.

Given the strong third quarter results for the market this year with the S&P producing a total return of 3.60%, it does not appear a major or seasonal low is at hand as we enter October. Most most managers and market strategists I know seem to have a cautious view as we begin the month. So maybe once again, conventional wisdom will prove wrong and October will be a positive month.

My own view is to look for a negative start for the month on the basis of earnings warnings with a decline toward recent lows (down 2-3%) setting up an excellent buying opportunity for a run to yearly highs to end the year. I have built cash up to my maximum levels at about 10-12% by taking partial profits in my winners. If my playbook is correct, I'll be looking to buy Japan (EWJ and JOF) and the NASDAQ where I can gain exposure to the historic seasonal trade that favors information technology in the fourth quarter.