Friday, October 10, 2008

Current Status of the Markets

From the Desk of Joe Rollins

I took a few days off from posting to the Rollins Financial blog since my “Third Quarter Analysis” post because I have been waiting for more pronounced news regarding the stock market. There’s no question that the markets have been frightful over the last six or seven trading days, and that’s undoubtedly due to nothing other than panic. As the front page of the New York Times indicated on Wednesday – “Forget Logic; Fear Appears to Have Edge.” I think you’ll find the article to be very interesting.

In my last post, I referred to Rip Van Winkle’s 20-year sleep when discussing how I felt after the complete upheaval of the markets – it felt like the financial world as I knew it had completely changed. I decided to review all of the financial news as of late to figure out where the market really should be based upon the facts. Looking at only the facts and excluding all of the emotions, I would have assumed that the stock market would have been up several thousand points. The fact that it has been down several thousand points only reflects that fear – not investing fundamentals – is controlling this market.

Let’s take a look at the movements by our government and the Federal Reserve over the last four days:

  1. On Friday, the U.S. Congress passed and President Bush signed an historic $700 billion bill to buy distressed assets from banks and other companies. It also allows the government to make direct investments in banks, and it authorizes the Treasury Secretary to purchase troubled mortgage loans from individuals.

  2. The Federal Reserve and the Treasury moved quickly to stabilize from the fallout caused by average citizens who were removing their money from banks to buy Treasury bills. The FDIC guarantee on bank accounts was moved up temporarily from $100,000 to $250,000 (higher FDIC limits apply to retirement accounts). Additionally, the government guaranteed all commercial money market accounts to essentially make all of them risk-free.

    By taking these extraordinary actions, they saved smaller banks from runs on their accounts. Now, local and small regional banks have the same government protection as many bigger and much more financially sound financial institutions. Due to the flight to safety, U.S. government guarantee bonds are paying almost no interest. For a time, the one-month Treasury actually had a negative rate of return. As I write this post today, the one-year Treasury is paying an annualized rate of 0.15%.

  3. On Monday, the Federal Reserve doubled the allotment of money they would sell into the banking system. This enables commercial banks to take assets to the Federal Reserve and obtain direct loans to supplement their daily operations.

  4. On Tuesday, the Federal Reserve notified their member banks that they would pay interest on their excess cash reserves held at the Federal Reserve. This step had never been used by the Federal Reserve before. By agreeing to pay interest to the member banks, the Fed allowed the member banks to use their excess cash to put it back in the system and not purchase Treasury bills. This action creates significant cash assets for banks to loan.

  5. Also on Tuesday, the Federal Reserve exercised its right to lend cash directly to corporations to fund their commercial paper needs. This action by the Federal Reserve had not been utilized since the 1930’s – almost 80 years. Since the commercial credit markets had seized up in the United States, banks weren’t loaning to each other. Therefore, companies that fund their operations based on short-term commercial paper were unable to borrow needed cash for their operations. But on Tuesday, the Federal Reserve changed all of that. By putting money directly into the economy, the Fed circumvents the need to force banks to make loans that they are either unprepared or unwilling to make.

  6. Early on Wednesday morning, there was a coordinated global interest rate cut. Nearly all of the major economies in the world simultaneously cut their interest rates by at least one-half of a point. Even though there had been coordinated cuts in prior years for minor amounts, such a large cut had never been accomplished in the history of modern finance. Additionally on Wednesday, Great Britain indicated that they would inject capital directly into their national banks. By depositing £50 billion ($88 billion U.S. dollars), the British government secured their national banks and created liquidity and working capital for their operations.

  7. Additionally, while all of the above was occurring, the Federal Reserve and the archaic accounting profession has proposed a major change to the ridiculous and totally unwarranted “mark to market” accounting rules, which I have discussed before. By the SEC’s insistence that assets be marked down to a market value that doesn’t exist in the current environment, this governmental agency has destroyed over $500 billion in bank equity and reduced lending capacity by almost $5 trillion. These actions have hurt America by creating a risk to our financial system for no good reason. The President should immediately repeal these provisions.
If I had pulled a Rip Van Winkle and woken up to the events described above, I would have thought that the stock market would have reacted very positively. Unfortunately, that is not the case. To continue to watch the market trade in wild swings of 200 points in either direction is very discouraging. Once again, the market is trading strictly on fear and not on financial fundamentals.

The most fundamental aspect of stock market investing analysis is evaluating the effect that the Federal Reserve System has on corporate profitability. The adage that I’ve used time and time again, “Don’t Fight the Fed,” is particularly meaningful in this regard. As illustrated above, the actions of Federal Reserve Chairman Dr. Ben Bernanke have been extraordinary over the last several weeks. In fact, his actions are so decisive that all Americans should feel comfortable with his job performance.

Dr. Bernanke is reportedly the world’s leading expert and academic on the Great Depression, on which he has written extensively. The Great Depression primarily had more to do with the actions of the government than with the actions of investors and companies. As you know, the 1920’s are often referred to as “The Roaring Twenties.” The economy was hot and the government was loose (with the exception of the Prohibition on alcohol); money was seemingly everywhere and prosperity was growing at an accelerated pace. In spite of Prohibition, alcohol, flappers and good times ruled the economy. Of course, the party came to an abrupt halt in 1929 when the stock market crashed due to its own excesses.

The actions taken by the Federal Reserve during the Great Depression are vastly different from what Dr. Bernanke is doing now. In 1930, the Federal Reserve began draining the cash flow from the banking system. Their perception was that, due to inflation, they needed to slow down the economy and squeeze out all the excesses that had occurred during the 1920’s. In doing so, they basically forced 25% of the banks in the United States out of business and reduced credit to companies, causing many of them to fail or to lay off employees. Virtually everything they did was wrong.

It should never be forgotten that during the 1930’s, unemployment in the United States was over 25%. Today, even with all the negative talk regarding the economy, unemployment continues to be at a very controlled level of 6.1%.

All of the examples itemized above illustrate that the Federal Reserve is taking a completely different approach today than during the 1930’s. It is clear that the Fed is flooding the U.S. economy with money. Everyone is now flush with cash; this includes the banks, corporations and even – due to the financial effect of the Fed’s actions – investors. There is currently over $3.5 trillion sitting in commercial money market accounts, which doesn’t even include bank CD’s, checking accounts and other types of investments that are in near liquid form.

What we have today with all the uninvested cash is exactly the fuel for a stock market rally. However, what the markets are experiencing is truly due to a lack of investor confidence. There is more than adequate cash on the sidelines waiting for an opportunity to invest. It’s only a matter of time until that money works its way back into the markets.

The timing of the recent sell-off is somewhat coincidental. At the beginning of almost every quarter, investors typically have reservations about taking positions. The end of September through the first two weeks of October is historically a blackout time for corporate news. Since almost all corporations report their earnings on a quarterly basis, they are not allowed to make any comments regarding their expected results during the first two weeks of a quarter. It’s fairly clear that the economy has shifted from a robust GDP growth of 2.9% in the second quarter to a projected negative GDP for the third quarter, and that explains the hesitation regarding the expected earnings of the corporations.

It is unknown to nearly everyone how good or bad the earnings will be for the third quarter and how the negative economy will affect those earnings. However, IBM’s early earnings report released on Wednesday night was a good sign, especially since they beat their estimates. As a general rule, if earnings were going to be terrible across the board, we would have already heard many announcements to that effect.

The very positive actions taken by Dr. Bernanke are directly opposite of the actions taken by former Federal Reserve Chairman Dr. Alan Greenspan when he was in office. I think you would be interested in reading the lead article in Thursday’s edition of the New York Times, “Taking Hard New Look at a Greenspan Legacy.” The article raises many concerns regarding the actions and inactions of the former Fed Chairman. Those of you who have read my work in the past know that I have been very critical of Dr. Greenspan over the years. I actually wrote a similar article well over five years ago; I guess the New York Times is finally catching on.

The other major event that occurred during the third quarter was the significant liquidation of positions by the hedge fund industry. During 2007, the new hot purchase was commodities. It was reported that many endowments and pension plans were establishing an asset class in commodities equal to 5% or 10% of their total assets or higher. Many thought of commodities as a true asset class as important as cash, bonds and equities, and that commodity prices would rise forever and would never significantly decline. I guess they were wrong about that!

Now that the price of oil is falling from $148 a barrel to $84, it is obvious to see why hedge funds are being liquidated. The cost of almost every commodity has been cut by 50% or more. Some of the losses in these commodity-driven stocks are absolutely staggering. Share price reductions of 75% to 80% are the norm. Obviously, the fundamentals do not support this level of decline. However, in a liquidation mode the baby is always thrown out with the bath water.

Hedge funds were facing serious and material liquidations, which generally only occur in hedge funds at the end of a quarter. There was a massive deleveraging and liquidation of these positions over the last few weeks, but all of this selling should be wrapped up within the next week. Perhaps that is when we’ll get back to a normal trading environment.

When it comes to stock market evaluation, the fundamentals have almost never been stronger. While it’s true that we’re facing a decline in earnings due to a recessionary economy, the decline is certainly not severe. No one is forecasting a deep recession; it’s negative – but not severe. Interest rates are extremely low, giving rise to a definite preference for equities over fixed-income investments. CD and money market rates are low and going lower. Mortgage rates are incredibly low and it appears that they will continue to be low for some time. Cash is abundant and becoming even more available to virtually every corporation. If you evaluate stock market valuations based upon fundamentals alone, the market should be 30% to 40% higher today – even with lower earnings.

I don’t know exactly when we’ll experience a snap-back rally – it could be any day now. The traders on Wall Street couldn’t care less about the direction of the market. They can make money on both the upside and the downside. Volatility must exist in order for them to benefit from the market. On Wednesday, the market swung up 200 pointS and then down 200 points in a matter of minutes. That is reflective of professional stock trading activity, not the general public…

We will continue to see massive volatility until some sort of stabilization occurs. When the new buying occurs, it will be explosive and dynamic. The only way to participate in that upward movement is to be invested in advance. You will never be able to move quickly enough to participate if you are in cash. There have been exhaustive studies done on market timing, and each and every one comes to the same conclusion: market timing for professionals is impossible, and for the public, it is inconceivable.

I’m often asked why I do not sell during these types of declines. Whether you realize it or not, watching the market decline on an almost daily basis is excruciating for me and my staff. The easiest things for us to do would be to sell the portfolios to cash, which would alleviate the pressure and minimize the risk. However, if we did that, we would be doing a disservice to our clients. We must invest based on fundamentals; we cannot invest based upon external events that no one could have predicted.

I believe the market is dramatically undervalued at this point and that a major rally will occur sometime soon. I don’t know how long the rally will last or what levels it will reach. In any event, fundamentals today do not warrant the current low levels of the market. I highly recommend that if you have money to invest, now is the time to get positioned for this rally. If you don’t have additional money to invest but you are invested right now, I highly recommend you be patient and let the professionals do what they do on a daily basis until fundamentals once again dominate equity investing.

I’m often asked why we do not move the investments to more conservative and safer accounts. The investing environment during 2008 has been strange, to say the least. During the sell-off that occurred from 2000 through 2002, the market bifurcated into two separate investment worlds. Anything related to technology was sold-off dramatically; however, other funds invested in traditional businesses did very well during that period of time.

In 2008, there’s not a single asset class that has made money except government guaranteed bonds. Even so-called “conservative bond funds” are down double-digits in 2008. In all honesty, there’s been nowhere to hide in the investment world. This is unusual, unprecedented and not reflective of investing fundamentals.

It’s also interesting to see projections of the economy going forward. Never in the history of America have we seen such a massive injection of cash into the economy over such a short period of time. On almost a daily basis I hear commentators say that the $700 billion to buy distressed assets is not working. I guess they haven’t quite figured out that it was only approved last week and not one asset has been purchased at this point. Everything we know about economics dictates that when you flood the U.S. economy with such a massive amount of cash, you will receive an enormous stimulus which should prevent a deep recession, or hopefully, a snap-back in early 2009.

Another interesting aspect of this tremendous sell-off has been the incredible strength of the U.S. dollar. The Federal Reserve System had to provide U.S. dollars to other banks around the world. Even though all of these economies enjoy criticizing the U.S. and our way of doing things, isn’t it interesting that the currency preferred by the entire world in a time of crisis is the U.S. dollar? For that reason, international investing has lost a lot of its luster and cannot be counted on for consistent returns until the dollar begins to weaken again.

As information, we have sold out of some of our international positions and created cash for virtually all of our clients. This provides some safety and takes some of the volatility out of the accounts. Our intent is to reinvest when it is appropriate so that you benefit from the expected rally.

- An Aside Regarding Tuesday’s Presidential Debate –

It was kind of the Presidential candidates to mention both the Manhattan Project and John F. Kennedy’s “Man on the Moon” pledge in Tuesday night’s debate. You may recall that I mentioned both of these initiatives in my “Energy Crisis Resolved!” post on August 15th. It’s good to know that my posts are widely circulated – even to the politicians I so often criticize. While they didn’t directly plagiarize my posts, I still found it humorous that these two projects were brought up. I’ll just give myself a pat on the back for bringing those things to their attention. Maybe I should tell them how to balance the Federal budget…

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