Saturday, November 1, 2008

"Double, Double Toil and Trouble; Fire Burn and Cauldron Bubble"

From the Desk of Joe Rollins

Here I sit writing this post on Halloween day, which is coincidentally the last day of what will undoubtedly become a legendary month in the financial world. October is now on-track to end as one of the worst performing months in the history of the financial markets.

It hardly seems likely that the market will close at break-even today, but if it does, the major market indices will have suffered through the 11th worst month in history (as measured by the Dow Jones Industrial Average). This is the worst monthly loss in 21 years (the last devastating loss occurred in October of 1987). I remember that Black Monday as if it were yesterday. In October of 1987, the Dow Industrial Average lost a whopping 22% in one day. This loss was indisputably traumatic, although it didn’t seem as bad back then as the water torture that we endured this past month. It’s remarkable that the Dow wasn’t up two straight days at any time during the month of October, 2008.

As the indexes were dramatically down during the month, the daily news managed to get worse and worse. The average daily range from the high to the low for the entire month of October was 606 points. There were even a few days where the range exceeded 1,000 points in a given day. The Dow was down 16 (inconsecutive) days during the month of October, which is the most down days in any given month since August of 1973.

During 1973, we were dealing with the Middle East oil embargo. Relatively speaking the price of gasoline was high; but worse than that was that gas was not really even available. Due to the restrictions of imported oil out of the Middle East and the gross inefficiency of our government in distributing what oil we did have, there was just very little available at the pump. The country was in a severe economic depression and corporate profits were plunging. Inflation was running at about 12% and interest rates were exceedingly high. All of the negatives that were present in 1973 are not present in 2008, yet the performance this past October was just as bad.

Each of the major market indices – the Dow, the S&P 500, and the NASDAQ Composite – will end the month down approximately 15%. Each will also be down in excess of 30% for 2008. As incredible as it may seem, there have been 10 worse monthly performances for the Dow Jones Industrial Average. Nine of the 10 occurred during the Great Depression, from 1929 through 1940. It’s confusing that the month of October, 2008 would have a performance that would rival the carnage and economic destruction that occurred during the Great Depression.

The purpose of this post is to see if we can make some sense of this performance. Last weekend, I attended an investment conference in New York City just to make sure that great city is still in existence – it is. I can further report that I had a difficult time finding a hotel reservation due to the overbooking of hotels. Moreover, all of the flights were oversold and changing a flight reservation was impossible. It was difficult to walk the streets of Times Square because there were so many tourists on the sidewalks. And forget about making a reservation at one of the famous restaurants – that was nearly impossible! Tickets to many of the Broadway plays were also sold out. So, what’s my point? There are gross inconsistencies between reality and the volatility of the financial markets.

One of the biggest misconceptions of the investing public is that stock prices have something to do with a company’s performance. It’s presumed by many that when a stock price goes down, it affects the company itself. While there’s clearly a correlation between excellent performance and stock valuation, a decrease in a stock price doesn’t mean that the company is performing poorly. During this extremely volatile month, even some of the most profitable companies traded with wild, unreasonable ranges.

On Thursday, Exxon Mobil reported the highest corporate profits ever recorded by a U.S. corporation. At the beginning of October, 2008, Exxon Mobil’s stock price was $78.58. Twice during the month the stock dipped to around $56 before closing the month at approximately $75. This is just one example of how the most profitable corporation in American industrial history could trade in a market range of over 30% for one month alone.

The terrible performances of the indices during the month of October belie the actual progress that’s been made. I suppose Wall Street traders trade first and think second. The GDP was announced yesterday with a minor loss of 0.3%, which isn’t nearly as bad as the so-called experts expected. In fact, a loss this small could easily be argued to be an incredibly small rounding error in an economy that will top $14 trillion in 2008. The critics in the financial news argue that the amount could not be correct since things seem so much worse. We will know soon enough whether that number is right or wrong, but regardless, with the Fed’s actions we’re clearly closer to a turnaround than we were only a short 30 days ago.

While the U.S. indices were terrible during October, the indexes overseas were much worse. Many of the Emerging Market currencies came totally unglued during the month. It is always astonishing to me to hear the rest of the world criticize the United States for virtually every act, but when things become difficult for the rest of the world, they want to be in U.S. currency. Only the Japanese yen and the U.S. dollar receive this confidence from the world; all other currencies, including the Euro and the U.K.’s pound sterling, suffered major declines during the month. In fact, the currencies in parts of Asia and South America almost collapsed. If the U.S. Federal Reserve System hadn’t entered into currency exchange arrangements with Brazil, Mexico, South Korea and Singapore, those countries’ currencies would likely have failed. It’s a good thing the rest of the world hates us – except when they need us.

The freezing of the money funds enjoyed a spring thaw towards the end of the month. It’s true that banks decided not to lend each other money, and therefore, interbank credit seized up. On October 10, 2008, the very important three-month LIBOR interbank loan rate was an astonishing 4.82%. At this rate, virtually no bank would have been willing to borrow from another for overnight activities. Due to the intervention of the U.S. Federal Reserve and the British and European commissions, interbank lending was guaranteed. Only two and a half weeks later, this very important rate has fallen to 3.05% today. While this rate continues to be too high, it is a significant indication that bank lending is returning to normal.

It was also noted that the ability of major corporations to borrow money in normal bond refinancing had ceased. On Thursday, MGM Mirage was able to borrow $750 million in high-yield junk bonds. When speculative companies can make major bond sales, it tells you that investors’ appetite for risk has returned.

Commercial paper rose by $100 billion this past week. There is currently $1.5 trillion available in commercial paper. This is the first time in seven weeks that the amount of commercial paper has actually expanded.

Today, Ford Motor Company announced that they’re calling back 1,000 workers in order to build enough Ford 150 trucks to meet demand. For all we have heard this month regarding the incredible poor financial performance of the automobile industry, seemingly there seems to be ongoing improvement.

I’m not implying that the economy won’t be bad for a few quarters. I expect that we will see negative GDP growth in the 4th quarter of 2008 and in the 1st quarter of 2009. However, as I have written many times before, the cavalry has arrived.

All last week, I kept hearing in the financial press that whatever the government was doing to ease credit and push money into the economy just wasn’t working! I really believe a lot of the negative press being provided is from professional investors trying to influence the direction of the markets. The truth of the matter is that the major funding of the banks in the United States did not occur until Wednesday, October 29th, and the funding of the British and European banks has yet to occur. It is really hard for the actions of the Treasury to improve liquidity until something actually occurs.

Worldwide equity injections that are approximating $2 trillion have now been approved. Never in the history of U.S. and world finance has so much money been pumped into an economy over a short period of time. For those who are preaching the sermon of an upcoming Great Depression II, they will need to postpone the benediction. The U.S. economy will rebound quickly as this money makes it through the system in the coming six months.

I know these are difficult concepts for people to understand since no one has lived through it before. However, economic textbooks have long addressed these issues and the repercussions. Given the incredible influx of liquidity, this money will work its way through the system and will create jobs, construction and a better economy by spring.

As we end the earnings season for the third quarter of 2008, there was very little publicity about the earnings actually being quite good. Aside from the financial companies, the vast majority of the S&P 500 major companies beat their projected earnings. While earnings will undoubtedly come down, they certainly do not justify the incredible devaluation that has occurred in the equity markets.

It was interesting that the markets sold off last week when the U.S. consumer confidence was reported at one of the lowest all-time readings. These indexes reported to be a major destabilizing influence in the U.S. economy as well as around the world. However, I doubt few actually read the report and understood its significance.

A major component of the negative consumer confidence relates to the anticipated belief by consumers of future inflation. During the month of September, consumer outlook on future inflation was at 6.9%. I’m not implying that consumers are unaware of what’s going on, I just don’t think they’re very timely. With the price of energy falling close to 50% in the last 90 days and commodities literally falling off a cliff, you may rest assured that inflation for the next 12 months will be non-existent.

I simply wanted to provide you with a reality check regarding the ridiculous volatility and hyperbole of the financial press. While things are certainly not fabulous, they are clearly not desperate. The market should move up between now and the end of the year, but it will be volatile. Since my last post, "Let's Talk Turkey", the market has moved up, and hopefully volatility will be reduced, reality will be reintroduced and positive financial wealth will once again resume in the coming months.

No comments: