Bottoms Up!

Giving the devil his due, the bottom-up crowd has won this round, as earnings results are not disappointing as economists did for the third quarter. Therefore, in light of the recent market action, it seems more than productive to understand the nature of this important (but not dominant) segment of the market.

Most investors are bottom-up oriented. They buy and sell stocks with a passing reference to the sector and style tilt their portfolios produce. Like many sports teams, portfolios are populated with the best ideas. Sectors and styles are a by-product. Individual company earnings results, performance metrics (such as profit margins, growth rates, etc.), and valuation levels determine the buy/sell/hold decisions made. From that comes the action taken.

This situation is largely due to tradition and training: traditional among individual investors, training among the professional crowd (the CFA program, for example). It is what the financial media obsesses on while providing limited, yet sorely needed, education on what constitutes good portfolio management.

As one of the two essential elements that drive stock prices up or down (the other being financial market liquidity), earnings results can dominate the moment, as they appear to have done thus far this month. When good earnings results motivate investors to act positively, the momos (the real power in today’s market) join the party, as they are indifferent to the reasons that drive investors and are far more interested in an excuse to act. As long as money is abundant (financial market liquidity), the upside bias exists. Which brings us back to earnings results.

As long as companies deliver positive earnings results and financial market liquidity remains ample, the bottom-up crew can move markets (aided and abetted by the momos, of course) to a significant degree. Should earnings falter, however, then the dual impact of declining results and diminution of financial market liquidity (in the form of redemptions and withdrawals) can produce a negative feedback loop to the real economy (Soros’ “reflexivity”). Yet, more importantly, within this investing approach lie the seeds of its own destruction.

Bottom-up investing is aided and abetted by ivy tower fantasies about efficient markets, assisted with high-sounding phrases like “price discovery” and “capital asset pricing models”, and supported by economic methodologies that are anchored in traditional metric analyses. Such traditional economic methodologies do, however, come with two significant blind spots: the inability to forecast with any degree of accuracy and consistency (certainly commensurate with a practice that fancies itself as a “science”) and an inability to do global macro analysis particularly well.

The first point is self evident and saturated with historical fact. For example, one need only look at today’s consumer confidence miss to see just how off the mark these “social scientists” can be. The second point was made most evident in the debacle known as the Great Recession. Moreover, the inability to do global macro well also comes with an inability to incorporate contagion’s speed and source (real and/or financial economy).

This is a big part of how the world works in Wall Street. It is the dynamic reality that exists in the surreal world of finance. It is the state of denial that many who play the investing game occupy. And it is why it is so essential to step back and smell the global macro rose, which right now has a decidedly foul odor to it.

But, hey! “Who cares?”, say the bottom-up boys and girls. "Earnings are good and that’s all that matters to me."

DO Fight The Fed

Today, Wall Street's Professional Investor Class (PIC) waits with bated breath for the Fed to provide words of comfort so that one of Wall Street's revered axioms, "don't fight the Fed", will deliver much needed relief to the beleaguered warriors of finance.

One of characteristic of the PICs that is useful to remember is that they are highly reliant on heuristics - rules of thumb that help frame the world into bite-sized analytical pieces. One of the heuristics that has worked from time immemorial is 'don't fight the Fed". For example, last year, around this time, a well-known hedge fund manager advised investors and traders of this well-worn axiom to great effect and result (stocks rose from the fall of 2010 into the summer of 2011). Unfortunately, while the monetary elixir did work its magic on the PICs (they bought stocks), it had little effect on the real economy.

Never sated, the ever-thirsty PICs are back at the don't-fight-the-Fed troff for another hearty slurp of monetary ease = higher risk asset values. From the PICs and Fed's perspectives, the economic rationale for this view is rather simple: Easy money = an increase in the value of risky assets = a positive wealth effect = increase demand = higher GDP (which then = higher wages, increased hiring, etc, etc). Hence, don't fight the Fed ALWAYS delivers. Or does it? And when it does, is the effect always the same under all conditions? Or are the results a product of the economic and financial times?

It may be a risky thing to go against such a dogma. After all, the four most dangerous words in the investment language is "this time is different". And to assume that more easy money will not produce the above listed outcomes is the speak those very dangerous words. Yet, if one believes we are in times that are truly different, particularly in the post WW II era, then perhaps it's time from some fresh perspectives.

Going against such a well-established dogma of day is also especially dangerous given the changed structure of the market. For, when the momo lemmings (who could care less what the drivers are or what direction the markets are headed, just along as stock prices move) jump on the market trend du jour bandwagon, the wheels get turning rather quickly.

Investment Strategy Implications

If you are going to go against a revered heuristic it is useful to have your own heuristic to counter the revered one. My heuristic is this: in a liquidity trap, the effectiveness of monetary policy is limited, at best. Moreover, monetary ease becomes even more limited when fiscal policy is contradtionary (i.e., expansionary austerity). These global macro forces are strong, pervasive, and global in scope.

So, the PICs may rejoice in what they hear today. And risk assets may rise - for a while. But the global macro forces at work can, and I believe will, overwhelm the monetary elixir the Fed will provide. And the PICs don't do global macro very well. (More on this point in a future blog posting.)

Bernanke to Wall Street: More Cowbell

“I got a FEVER! And the only prescription...is MORE COWBELL!”
-Bruce Dickinson (Christopher Walken)

There are two reasons why the stock market is trading where it is. One deals with valuation levels. The other is liquidity. These factors are the most direct to stock market levels. From a stock market point of view, the larger macro economic, political, and societal (including cultural and demographic) issues matter only to the extent that they ultimately impact the inputs to the valuation levels – cash flows, growth of the cash flows, and the uncertainty (the risk) of receiving those cash flows – and liquidity, specifically liquidity to the financial system.

It is on this second factor, financial system liquidity, that many fast money professional investors (hedge funds, high frequency traders, prop desk traders) are paying the most attention to in today’s testimony by Fed Chairman Ben Bernanke. As the primary market forces that move markets at the margin, fast money types want to know that the Bernanke Put (rising prices of risky assets help produce the wealth effect, which helps the broad economic environment) is still operative.

Based on what they heard thus far, all is good. Or as the Saturday Night Live quote above suggests, the fast money crowd has a fever (they always have a fever) and generous Ben assures them that there will be more cowbell.

Investment Strategy Implications

Hang in there. A resolution to the sideways market is not far off. As noted on several recent blog postings, the clock is ticking and appears to be set to strike midnight very soon.

Will it ring a new day for the bulls or will investing Cinderellas themselves with pumpkins and not stagecoaches for transportation? Right now, it's anybody's guess.

The Stock Market, King Lear, and the Meaning of Nothing!

Apparently in saying nothing yesterday the Fed Chairman did say something. By denying more financial morphine for risky assets, the markets reacted as King Lear did when his beloved daughter, Cordelia, said the same to him. The moral of this story: When the truth produces the tantrum, sanity is surely in question.

Ben Opens The Kimono

If one took the time to sit and listen carefully, the Bernanke press conference was an excellent opportunity to understand not only the decisions made but the economic philosophy underlying them. For that, Bernanke should be applauded. Transparency is almost always a good thing.

You don’t have to agree with the decisions made. However, knowing the thought process that leads to the decisions will help much more than whether his voice sounded shaky (which, if you listen to his testimony to Congress, it always does) or if he appeared to be sitting behind a piano (I actually love that comment. The imagery of Ben crooning a tune is priceless. Thanks, to Matt Phillips at WSJ).

In a manner similar to what St. Louis Fed President James Bullard discussed at the NYSSA luncheon I moderated last fall, Bernanke lays out the thinking behind the decisions. Therefore, here are a few observations:

• First quarter slowdown is transitory. Economic pace will pick up over time. Accordingly, the US economy should achieve a sustainable expansion. Continued improvement is expected. (Key words "over time". Lots of wiggle room.)

• Concern re inflation and its impact on jobs. Inflation (and any deviation away from stable, low inflation, which, of course includes deflation, for that matter) will inhibit job growth and must be guarded against.

• Related to this is the issue of long-term unemployment, which the Fed can virtually nothing about beyond seeking to help the current conditions and, thereby, help facilitate a virtuous circle of jobs creation. The long-term unemployment problem is one for the political process and other areas of the US economy.

• The Fed holds a “stock view”, which is actually Soros' "Reflexivity" – the feedback loop from the financial markets to the real economy and back and forth over and over. In this regard, QE (1 and 2) worked because “easing financial conditions leads to better economic conditions.” This is exactly the same philosophy and view expressed by St. Louis Fed President James Bullard at the New York Society of Security Analysts luncheon I moderated last fall.

• As for the potential of more QE, Mr. Bernanke took that off the table when he noted that in the Fed’s view the tradeoffs of more easing versus the risks of inflation and inflationary expectations are not favorable. (Perhaps for the reasons John Hussman has been fretting about.)

• Fiscal cuts (austerity) at the state and local level are not a major concern and, therefore, no plans to respond monetarily. The Fed is ready to react but no worries right now. (Not sure how this squares with the previous point.)

• The first step that signaled the end of monetary easing is occurring at the end of June, when QE2 ends. The second step that will signal the end of Fed easing is when the Fed stops reinvesting the US Treasuries and the mortgage back securities it has on its bloated balance sheet. This will, in effect, lower the size of its balance sheet.

• Rogoff and Reinhardt have shown that recoveries following financial crises tend to be slower and less robust. Bernanke believes this is true, as the problems tend to be in the credit markets and housing. He also, believes, however, that the reason for the post credit crises below average recoveries is that policy responses were not adequate. In his and the Fed’s board view, the aggressive and extraordinary actions undertaken by the Fed should help lead to a better economic outcome for the US. That said, he did acknowledge that the US economy growth (and employment, for that matter) thus far has been sub par but, as noted above, the Fed expects “recovery continues to be moderate but the pace will pick up over time.”

So what can we take away from this press conference that is of meaningful investment value? Two main items come to mind:

1 – The Fed is driven to maintain stability at the price level. They are very concerned about inflation (for the employment related reasons noted above). They are, however, deathly afraid of deflation. A Goldilocks approach to inflation is the only porridge that will do. And that is a very difficult thing to accomplish indefinitely.

2 – In the current environment and now that, in the Fed's view, the deflationary dragon has been slain, inflation and job creation are joined at the hip. Rising inflation will impact job creation and must be avoided at all costs.

Everything described above assumes an private sector led sustainable economic expansion lies ahead, which takes us to my third and most important point:

3 - No one asked the one question that I would have asked (and the one I have been asking for months now), What if the US economy does not achieve the escape velocity of a private sector led sustainable economic expansion?

What will the Fed do? What can the Fed do?

How will the markets, the economy (US and global), the geo and socio political environment react to another round of monetary easing? Why would QE 3, 4, or 5 work when 1 and 2 produced such transitory (and some would argue negative) effects?

If the Fed is right and a private sector led sustainable economic expansion does emerge, then the outlook will improve but to what extent remains to be seen. If not, then what?

Is there a plan B? A plan C?

Bottom line: What Bernanke did is a terrific thing. Transparency is almost always an excellent thing. Moreover, I truly believe he is sincere, knowledgeable, hard working, and has little in the way of political agenda (unlike Geithner). That said, being a good guy is not enough if the actions taken lead to a bad outcome.

Herbert Hoover was a good guy and look at how that turned out.

The Fed, Sir Isaac Newton, and QE

In today's FT, Mohammed El-Erian discusses the PIGS’ (Portugal, Ireland, Greece, and Spain) resurgent credit spread problems*. Toward the end of his commentary, he references a phrase that all non economists should know as it helps in understanding the mind of the dismal scientists and the comments posted the other day re the US Fed’s thinking on the risks of a Japan style deflation taking hold in the US**. The phrase is "path dependency".

"The history of emerging economy crises also tells us that these worrisome dynamics are self-reinforcing, resulting in what economists call “path dependency”. Rather than snapping back to a better outcome, bad developments increase the probability that the next set will be even worse."

Newton To The Rescue

A path dependency that leads to a steady state equilibrium for inflation and interest rates (which is the central point of the chart posted on Wednesday**) is the great fear of the Fed. And in the mind of the Fed the only way out of that condition is to exert an external force on it, with that external force being QE. Or as Sir Isaac Newton advised: "Every object in a state of uniform motion tends to remain in that state of motion unless an external force is applied to it."

Push, Ben, push.

*"Irish crisis demands new EU response"
**scroll down to Wednesday's posting, "Why The Fed Believes QE2 Is Necessary"

QE2 Sets Sail

Here is the calendar for the first round of the Fed's $600B in purchases as QE2 sets sail. Anchors aweigh!

Here’s Why The Fed Believes QE2 Is Necessary

Monday’s NYSSA luncheon with St. Louis Fed President (and voting member of the FOMC) James Bullard was most illuminating (wish you were there). In addition to the somewhat heated give and take with attendees, Mr. Bullard provided a chart that captures the principal fear the Fed has re deflation. It is what is known as the steady state (equilibrium) of inflation and interest rates.

The accompanying chart is the one he presented (which was also provided in his recent commentary and presentation “Seven Faces of “The Peril’”). In it I have pointed (larger arrows) to the steady state for the US (boxes to the right), steady state for Japan (circles to the left), and in the middle the May 2010 current level for the US. You will note that the May 2010 point is the closest to the Japan outcomes.

The concern at the Fed is that the slide toward the steady state for inflation and interest rates (in a zero bound interest rate environment) renders interest rate driven monetary policy impotent (as it has in the case of Japan). Moreover, a steady state tends to become entrenched (that’s why it’s called a steady state). And economists will tell you that when it comes to deflation/inflation it is the entrenched, longer term levels (and not the shorter term, more volatile factors such as commodities) that matter most.

As the May 2010 point illustrates quite clearly, the US trend is not where the Fed wants it to be.

Here’s Why The Fed Believes QE2 Will Work

In a nutshell – because it worked the first time.

Time and again in the aforementioned heated discussions, Mr. Bullard consistently pointed to the financial markets rebound during QE1 and in anticipation of QE2 as evidence of the positive effects of QE. Moreover, since the economy has recovered and avoided further economic deterioration (Great Recession not Great Depression 2), QE was and will be (in his opinion) effective.

Conclusion

No doubt the debate over the Fed's QE policy will continue. But at least now you know some of thinking behind the actions.

Caveat: Mr. Bullard was speaking for himself and his opinions do not necessarily reflect those of the Fed.
Click image to enlarge

Appearances Can Be Deceiving

If there is one thing that the New England Patriots have in common with the stock market it’s that neither is quite all that they are cracked up to be.

Like the Patriots, the stock market has a certain amount of star talent supporting its run for success. The Pats have the skills and talent of Belichick and Brady that enable an otherwise mediocre team from drifting into the domain of the pigskin wannabees. In the case of the stock market, it is largely the skills and talent of the stimulus machine (monetary and fiscal) that enabled (emboldened might be a better word) investors to lift prices to above historical average P/E land.

Investment Strategy Implications

Quarterbacks know that handing off the ball to a solid running back makes their life that much easier. The stock market equivalent rests in the economic handoff from stimulus to sustainability. Thus far, that has not quite occurred. Yet, valuation levels strongly suggest that such an occurrence is not only inevitable but will be highly successful (as in earnings growth rates that a V shaped economic recovery makes possible).

Sorry Bill and Tom, this will likely not be your year of glory. Your skills and talent will likely not be enough to mask the weaknesses that underlie your team. As for equity investors, they are accordingly well advised to be sensitive to the economic weaknesses that are masked by huge sums of liquidity. In sport as in the markets and the economy, appearances can be deceiving.

What if…

…the Keynesian stimulus efforts of President-elect Franklin Delano Obama don’t work?
…credit spreads remain elevated throughout 2009?
…depression/deflation valuation levels come to pass?*

What you see listed above are the three areas I chose to focus on at last Thursday’s 12th Annual "Market Forecast" luncheon. They were selected by me to help frame the discussion among my six expert panelists (Bernstein, Janjigian, Reynolds, Steindel, Trennert, and Wyss)**. Based on the dialogue that ensued, it achieved its goal. Of the three items listed, it was the first, the most macro of the bunch, that generated the most conversation between the panelists and attendees and one that I wish to share in this blog posting.

It must be assumed that some form of fiscal stimulus package will be passed by the US Congress in the coming weeks. By all accounts, the package will have all the qualities of a camel – a horse designed by committee. This is to say tax cuts (for the Republicans) and liberal causes (for the liberal Democrats) will reside along side stimuli that Keynesian oriented economists prefer.

Whatever the blend, there are two larger issues that must not be ignored by investors. The first is embodied in the opening “what if” question – what if the Keynesian stimulus efforts fail to produce a sustainable recovery? At last Thursday’s NYSSA event, panelist David Wyss (Chief Economist, Standard and Poors) articulated what sounded to me like the best answer – the hope that the stimulus package helps unfreeze the private sector (banking, corporate, and personal) and, thereby, a multiplier effect begins to emerge in which a sustainable recovery gets underway. The scary part in this answer is not just the prospect that the unfreezing process does not occur as prescribed but also that the answers David and all five other panelists provided seem to always include the word “hope” – as in “who knows if any of this will have the desired lasting effect?” The second issue is what will be the economic philosophy going forward?***

Investment Strategy Implications

Relative to where things have been recently, the financial markets appear to have entered a somewhat quiescent period. The multi-faceted stimulus and stabilization programs should have their desired effect in the coming months. This is evident in the steady decline in key market metrics, such as the TED spread and the VIX. While still elevated, the direction for the next several months seems almost certainly to be headed in a constructive direction.

The big “however” in this view is what comes after the fiscal and monetary stimulus punchbowl begins to run dry. Then what? For investors, keeping a keen eye on the above and other market and economic metrics will be key to determining if the audacity of our economic hope comes to pass.

*As a point of reference, the valuation parameters noted have been posted on this blog twice in the past weeks (see Dec. 30 and Jan. 7). They provide a framework within which investors can draw their own conclusions re operating earnings for the year ahead and the appropriate P/E ratio.

**Without doubt, given these incredibly challenging times there are numerous areas to explore, many of which could be argued as being vitally important to the investment decision-making process. However, only the most dedicated bottom-up only investor would deny that the global macro climate is the overriding factor is front and center to the future of the markets and economies.

***This is a larger, related issue to the Keynesian stimulus question, one that contains an evolutionary aspect of the current economic crisis: Now that American-style capitalism, in place since the Reagan revolution, has imploded, what will take its place? For interesting and insightful perspective on this subject, see “Where Do We Go From Here”

The Real Risks of Deleveraging

The deleveraging process that is dramatically impacting the economy and markets has two very serious consequences to it. One deals directly with the insane process of mark-to-market of illiquid, opaque assets. The other pertains to the effects deleveraging will have on the real economy. Allow me to highlight the key points of each.

In terms of the financial economy, the process of deleveraging can be characterized as feedback loops gone wild. Virtuous circles (and their accompanying animal spirits) give way to vicious cycles, in which lower prices beget write-downs, which beget lower prices. And on it goes. In the process, bad assets become toxic, especially for financial institutions who, unlike other entities, have capital requirements that must be met.

There is nothing new in all this. Bubbles and panics have been around for centuries. And bad behavior is always punished eventually. The larger macro economic issue is the fact that the global economy is in transition (listen to El-Erian’s comments below). The dominant question in such a macro economic environment is whether the transition will be an orderly or disorderly one (ex. a declining US dollar). What is new, however, is the impact that the rule change made last November that has turned a difficult situation into the disaster the financial markets are facing today.

Thanks to the well-intentioned actions of FASB last November and the updating of the accounting rule FAS 157, illiquid assets must now be marked to the current market price (mark-to-market) in an attempt to reflect the true value of the asset. This is all well and good were it not for the fact that marks in highly illiquid, opaque markets can produce a highly questionable reading as to what constitutes "fair value".

Moreover, when such marked-to-market assets are owned by financial institutions operating with high degrees of leverage often reliant on short-term financing with mandated capital requirements, you have a recipe for disaster. But don’t take my word for it. Listen to Paul Volker many months ago or Steve Forbes on Fox Business News last night*.

Lastly, so much of the current investment climate has been co-opted by short-term momentum players, many of which are aggressive short sellers. Does anyone seriously believe that these players are interested in what the "fair value" of an asset is?

All this creates a toxic climate for toxic assets.

The second risk re deleveraging is how it will impact the real economy. One effect is already being felt – fewer loans are being made. Gone are the days when credit cards, auto loans, and no-doc, no-income mortgages literally flew out the doors of financial institutions. Gone, also, are the very generous covenants attached to junk bonds. In their place is an austere environment where liquidity is abundant but the risk appetite in frozen with fear. This is all bad but what makes this situation highly dangerous is the state of the US consumer.

The US consumer, the spending workhorse of the world economy has a personal balance sheet that is in serious disrepair. In the current economic environment, the need to reduce debt and increase their personal equity will only come about through a process of savings out of income. Say goodbye to your personal (home) ATM. Say hello to a higher savings out-of-income rate.

But savings out of income coupled with extremely low levels of borrowing means that the US economy is on for a period of depressed economic activity. The shop-til-I-drop, I-must-sustain-my-unsustainable-lifestyle US consumer is toast. A weakened economic climate coupled with the negative wealth effect (from real and financial assets) and a looming retirement calendar will do that.

All is not lost. There are pockets of strength that can help alleviate the financial crisis and perhaps help avoid a worsening contagion to the real economy. For example, there is a segment of the world economy that appears to be poised to emerge as the source of demand – the emerging middle class of emerging economies. Growth in their economies should remain positive and, given their generally solid balance sheets (not to mention fairly good policy processes), should make a positive contribution to global growth and stability. Not quite 100% decoupling but more than the pessimists believe.

By the way, speaking of solid balance sheets, most investment grade corporations have very solid balance sheets. The ability to weather a financially-inspired storm is quite favorable.

Then there are the large pools of capital around the world that sit waiting for the crisis to resolve itself. From sovereign wealth funds to money market accounts to central banks, liquidity is more than ample.

Lastly, Americans have a great capacity to adapt, to innovate, and come together in common cause**. All these factors should not be ignored as they represent a path out of the credit crisis quicksand.

There is one final point that I wish to make.

Rule changes matter. FAS 157 is a well-intentioned rule that is rooted in an antiquated principle known as the Efficient Market Hypothesis. For while investors in the long run are rational and risk averse, in the short run they are anything but. Modifying FAS 157 would one very easy way to reduce the vicious cycle of mark-to-market.

Investment Strategy Implications

The technical damage done to the equity market is sufficiently bad (but interestingly not terrible) that aggressively adding to positions should be done with great care. However, a prudent portfolio management policy of sector tilting coupled with a mindful regard that stocks have an upward bias (see prior blog posting on this point) is always appropriate, made even more so when panicky selling rules the day.

*FYI - Little ole me has written on this topic on several occasions on this blog and in reports. I encourage you to use the topics link for credit related issues to your left to explore the writings further.

**This point is contingent on a less divisive political climate. Therefore: Memo to McCain’s advisors – cool it with the Karl Rove tactics. You may win the election just like W did, but you will cause severe damage to the country in the process, just like W did.)

Beyond the Sound Bite: An Interview with Glenn Reynolds, CFA

"In my interview with the CEO of CreditSights we explored a wide range of factors related to the credit markets including rising corporate default risks, the difference between today's environment (economic and financial) versus 1990/1, confidence levels in the financial system, and an estimation of the credit crisis (we are in the 3rd inning).



All Beyond the Sound Bite postings can be found at beyondthesoundbite.blogspot.com
To listen to this week's podcast interview, click here

Mark-to-Market Madness

It’s March, which for college basketball fans means March Madness. In the financial markets, investors are experiencing their own version of madness – Mark-to-Market madness. The idea that nearly every asset that could be priced should be priced and that price represents its fair value is absurd. Let me illustrate with the following example:


Say a homeowner has a fixed rate mortgage. Now let’s say in the mark-to-market world the bank holding that mortgage is able (required?) to continuously determine the asset value of that home based on comparable sales in the area. Suddenly, due to weakness in the housing market, the comparable homes in our homeowner’s area decline in value. What if the bank were then able to go to the homeowner and demand more money as the loan to asset ratio declined below the bank’s requirement? Demand more equity capital for an asset that the market says has declined in value. Mark-to-market in action.

Apparently, the mark-to-market madness has infected the mind of Fed Chairman Bernanke. Consider the following two segments from a recent Bloomberg article, which includes an exchange between Senator Chuck Schumer and Bernanke:

Federal Reserve Chairman Ben S. Bernanke said in congressional testimony on Feb. 28 that accounting rules may be forcing banks to put artificially low values on little-traded assets when they mark them to market. The inability to value such assets on the basis of actual trades, Bernanke said, is "one of the major problems that we have in the current environment. I don't know how to fix it. I don't know what to do about it.''

Later in the article, this:

Bernanke was responding to a question from Senator Charles Schumer, a New York Democrat, who said he had heard "from many people'' that the valuations have been "artificially low.'' That leads to a vicious cycle, he said, in which the writedowns sap bank capital and "they can't do any more lending and everything's frozen up.'' Schumer suggested one response might be to have a six-month grace period on mark-to-market. "You really don't know the value of the asset, and if you undervalue it, you may be hurting things as much as if you overvalue it.''

Bernanke didn't buy that idea.

"The risk on the other side is that if you do too much forbearance or delay mark-to-market, the suspicion will arise among investors that you're hiding something,'' he said, adding, "This is really an accounting board responsibility.''

Frankly, I am speechless. I don’t know which is worse – to admit that you have no idea how to fix a serious credit problem or to pass off responsibility of asset valuation methods to FASB. No wonder equity values tanked after the Fed Chairman spoke.

Investment Strategy Implications

If you are unfamiliar with George Soros’ reflexivity principle, I strongly suggest you get acquainted with it. The self-fulfilling nature of reflexivity is the feedback loop between the financial markets and the real economy.

The real economy is set to experience a moderate recession at worst. However, due to reflexivity, should conditions in the financial economy continue to deteriorate driven in large part by mark-to-market madness (thereby generating a graveyard spiral in asset values) the real economy may be in for a deep recession, possibly global in nature, thereby turning the currently extremely undervalued equity markets into a fair value reading.

Unthawing the Deep Freeze

It seems logical that one way for investors to keep an eye on whether the credit freeze has begun to thaw is to track the Fed’s Term Auction Facility (TAF). The data to your left* shows the results for each of the TAF auctions.






Investment Strategy Implications

Along with credit spreads, the TAF results should provide useful data re signs that the freeze at the core of the banking system is beginning to thaw. An unthawing of the credit freeze will be an indicator that some semblance of normalcy is returning to the economy, which should be anticipated by the financial markets.

Based on the TAF data noted, there appears to be no sign that the thaw is underway.

*click on image to enlarge

Bye, Bye Sanguilla. Hello, Elmer FUD.

The flip side of investor psychology entering 2007 is now in play entering 2008. What was once confidence and complacency is now doubt and nervousness. As wrong as the sanguine crowd was entering 2007, ignoring the warning signs eminating from the black hole of credit derivatives, so, too, will time show that the angst so abundant in today’s equity market be as misplaced.

To illustrate, let’s look at one of the issues that is generating so much FUD (fear, uncertainty, and doubt) – mortgage resets.


The above chart comes from today’s FT Alphavile (a must read service). The data shows a seemingly mountain of resets headed the US consumer’s way. What should be noted is the fact that this is an election year, not just for a new US President but for the entire House of Representatives and many in the Senate. Therefore, unless our elected officials have an electoral death wish, it does seem reasonable to assume that money will be made available to help alleviate the real economy dangers eminating from this manifestation of the credit derivative black hole. Moreover, after the first wave of resets is dealt with in 2008, a reduction takes place making the management of the problem more, well, manageable - at least for the subsequent 12 months.

Investment Strategy Implications

The start of 2007 was happy time for many investment strategists. I was not one of them. And for a time (until mid year), I was on the wrong side of the trade. But all that changed as reality bit in mid summer (see relative performance chart of the Model Growth Portfolio from mid 2007 to year end).

The start of 2008 is a fear-laden period with real economy worries distorting the reality of abundant investment capital, the global growth story, and increasingly attractive valuation levels. It appears to be a matter of time when reality bites again, this time to the upside.

click on image to enlarge

A Delicate Balance

To reiterate the point made on this blog one week ago today, “This Fed is attempting to walk that fine line between the real economy effects of the credit squeeze, the moral hazard consequences of a bailout, and the risks that inflation eminating from the global growth story poses.”


This is the essence of the debate investors are having.

The most vocal say the Fed is not acting with a sufficient sense of urgency, that the economy needs more liquidity to avoid what in their view will be a certain recession, that the Fed is taking a far too aloof ivory tower/academic view of the economy and, in the process, is far behind the curve.

Others, the less vocal minority, believe that the Fed should not bail out bad business practices, that the moral hazard consequences send precisely the wrong message, and that the economy will manage its way through a sharp slowdown but not a recession.

And even less vocal and smaller (but slowly growing) minority believe that global growth combined with a weak US dollar will push inflation higher here in the US, which, when combined with weak US domestic growth, produces a stagflationary scenario.

What tends to be lost in all this global macro debate is the calendar.

2008 is not just a US Presidential election year, it is also the year when all members (so, that's what they are called!) of the House of Representatives are up for reelection and many in the Senate are as well. The balance of power is at stake. Well, you tell me – Will the US Congress sit idly by while the US economy rolls over into a recession? Or will earmarks and other pork barrel projects inject a fair amount of stimulus into a moribund economy?

Now, let’s also consider this issue – China. Will China sit idly by as its moment in the global sun (Olympics) becomes clouded as its primary export market, the US, slips into a serious recession? Or will they take central bank and sovereign wealth fund action to provide the necessary liquidity to ensure that its primary customer remains in decent if not excellent shape?

Investment Strategy Implications

There is every reason to believe that the Fed’s balancing act will work. However, the innovative approach taken by the Fed and other central bankers may not sit well with certain market players who want the game that was to be reinstated*. Frankly, that won’t happen. That game is over. A new financial innovation game is being molded, with several of the key components from the old game, namely lots of liquidity, as an integral part of it. To the extent that this creates uncertainty, as all transitional phases do, so be it. Uncertainty produces opportunity - for those who can see through the fear.

Bottom line: Stay fully invested. And be on the lookout for Lunch Money** trades.

*see blog postings "Squealing Away", December 12; “Searching for the Magic Formula”, November 29
**see Topics Discussed "Lunch Money"

Squealing Away

This morning's bold central bank announcement will be seen by some as a capitulation, by the Fed and its counterparts, to yesterday’s negative knee jerk reaction to the Fed’s ¼ point rate cut decision. To see the announcement as such is naïve. Picture the scene: the Fed members sat around last night wringing their hands in woeful lamentation wondering why Wall Street just doesn’t understand us? Nonsense.


The decision this morning is part of the next phase, a series of steps designed to create the game that will be, the Magic Formula*. Like a pig stuck in an investment fence, however, some “investors” want the game that was to be restored asap while this Fed wants the game that will be to emerge*. To understand the difference between the two is to understand the tug of war that erupts every time this Fed chooses not to go back to the game that was via a bailout of bad behavior.

The principal reason why certain “investors” want to reestablish the game that was has much less to do with their crocodile-tear concerns re the real economy and the threat of a recession and much more to do with one simple, logical fact of human nature: When many have made a fortune playing the game a certain way, when their trading systems and information networks have generated seven, eight, even nine-figured incomes, they will do everything in their power to restore what was using any and all means possible, including those like-minded shills in the media.

Investment Strategy Implications

This Fed is attempting to walk that fine line between the real economy effects of the credit squeeze, the moral hazard consequences of a bailout, and the risks that inflation eminating from the global growth story poses. Therefore, it is advisable that real investors, those interested in making investment decisions with a time horizon beyond the next media sound bite, try to best understand the global macro context that policy decisions are being made in. It is also advisable not to become consumed in the moment (what behavioral finance experts call the “availability heuristic”, also known as “recentness”**) at the expense of the larger context as noted in yesterday’s simple stock market balance sheet.

It may be upsetting for some to hear but this far from perfect Fed does know something.

*see blog posting “Searching for the Magic Formula”, November 29
**see blog posting “Just How Smart is the “Smart Money”, May 29

A Simple Stock Market Balance Sheet

Lost in the daily angst is the fact that there are counterbalancing forces pushing and pulling stocks up and down. Yet, many investors often get consumed in the single-issue story and forget to take a step back and compile the pluses and minuses that tilt the market up and down.


To help frame the subject, applying a simple balance sheet approach to the market should help identify those factors that matter most and, thereby, put the current fear in perspective.

On the asset side of the ledger:

High Levels of Investment Liquidity

                 Hedge Funds, Sovereign Wealth Funds, Private Equity, Mutual Fund
                          Low Redemptions, Net Cash Infusions

High Corporate Cash Levels
                   Strong profitability
                          Technological Benefits

Valuation

                  Expected Returns, P/E

Technicals

                 Mega Trend
                          Moving Average Scorecard

US Elections, Olympics in China

Global Growth Story

                 Globalization

On the liability side:

Slowing US Economy
                US Consumer Under Pressure

Credit Freeze
                Black Hole
                        More Shoes to Drop

Weak US Dollar

Emerging Markets Bubble

Inflation

Unresolved issues include:

Geopolitical Risks
                Pakistan, for example; Terrorism always

Decoupling

Investment Strategy Implications

It appears that we are now in the worst phase of the credit derivatives debacle. For this is the time, before the bean counters close the books and senior management has to sign on the personally liable line, when all that needs to be known will be revealed.

Interestingly, however, the big shoes are dropping but, beyond the very near term, the stocks aren’t. That should tell you something about the strength of the market and its near term direction.

Moreover, it’s also worth noting that the two ultimate measures of the market – valuation and the mega trend (as measured by the technicals) – are currently on the asset side of the ledger.

Finally, only if you believe in the deep recession scenario, which produces a substantial impact to the global growth story, as decoupling proves to be a myth, which in sum produces a large hit to corporate profits (>10%) should you chose to undervalue the asset side of our simple balance sheet. If, however, you are not in that camp, then fear should be tempered as there are many sectors and industries to stay invested in.

Hurry Up, Hank!

The search for the magic formula (see last Thursday’s blog posting) is running into serious roadblocks and the financial powers that be must resolve the re-engaged credit freeze asap. With each passing day, the failure to create the new financial order puts increasing strain on the core of the system – something that cannot be allowed to metastasize into the real economy. Dangerously, such a risk seems to be on the rise. Yet, at the same time, the excess liquidity sitting in the coffers of institutional investors (including hedgies) along with reasonable earnings growth suggests that the downside risk to equities is limited.


The two above dichotomous points are captured quite clearly in the following three excerpts from the must read FT Alphaville:

“The perceived riskiness of European corporate debt increased on Tuesday as traders in credit default swaps, worried the credit squeeze will ripple from banks to the wider economy, drove spreads wider. Concerns for banks’ balance-sheets were exacerbated yesterday when the one-month sterling Libor rate hit a nine-year high. There were growing signs that tightening credit was hitting consumer demand as restaurants, credit card businesses and property funds began to feel the strain.”

“Five hedge fund managers at London’s Marble Bar Asset Management will share at least $400m after agreeing to sell their five-year-old firm to EFG International, the Swiss bank.”

“Warren Buffett has rediscovered his appetite for junk bonds, buying $2.1bn in debt issued by the Texas utility TXU in a move that suggests value-seeking investors are prepared to step back into the troubled credit markets.”

So, there you have it in a nutshell. The core of the system has reentered the deep freeze with the increasing risk of spillover to the real economy while investment capital remains abundant, and abundantly rewarded.

Investment Strategy Implications

One week from today, the Fed’s interest rate decision will be a no brainer – another ¼ point cut. That will put the Fed 2/3s of the way toward the normal rate cut response (1 ½%) to a potential domestic economic slowdown. However, rate cuts alone will not do the trick. The magic formula must be found - and quickly - as there is little about the current situation that is normal.

As for equities, signs of a topping process increase. As noted in yesterday's weekly report (subscription required), the infantry is abandoning the effort as Small and Micro cap have significantly underperformed of late leaving only Mid cap standing. It is, however, far from being a done deal. Counterbalancing positive factors (valuation, global growth story, investment liquidity) provide support for higher equity prices, or at least limiting the downside risk. Yet, these positives can evaporate in short order if the magic formula cannot be found.

Time is not on anyone’s side.

Searching For The Magic Formula

To some, the powerful two-day stock market rally was all about the prospects of the Fed cutting rates. While this no doubt was a contributing factor, the larger issue that may have been lost in the noise of rate cuts is the attempt by the Fed and other interested parties to secure the core of the financial system (i.e. big banks). Those at the periphery of the system can break down (hedgies, private equity, mortgage bankers and brokers, even investment banks), provided their problems do not metastasize inward toward the core of the system.


What seems to also be lost in all the noise re rate cuts and traditional real economy stuff is the concurrent effort of the Fed and other interested parties in fixing what got broke. Specifically, the financial model that gave us the Great Moderation (lower rates, low inflation) and all the wonderful real economy benefits complements of Globalization.

Perhaps it is the street kid in me but I find it rather curious that earlier this week the Fed pumped $8 billion into the system followed by ADIA (Abu Dhabi Investment Authority) pumping $7.5 billion into Citigroup (a core of the system entity) at the same time Fed Vice Chairman Kohn gives a speech widely interpreted as communicating the Fed’s intention to do whatever it takes to maintain the monetary boat. Random events? Reactionary decision-making? Maybe not.

In my view, what is happening is an attempt by the Fed and other interested parties to find that magic formula that can both secure the core of the system and invent a new and improved financial model, one that will enable the Great Moderation to live another day.

The core of the system cannot break down. The Fed has stated as such many times over (read just about any speech by Bernanke and other important Fed heads and you will hear this theme stated explicitly or implicitly). Now, this is not to say too big to fail is part of the policy solution currently being orchestrated the Fed and other interested parties with its attendant moral hazard implications. However, failure in the core of the system has very different meaning as in a managed transition to another entity that can ensure the system functions effectively. Think ADIA and Citigroup.

Investment Strategy Implications

The big equity markets' hurrah of the previous two days was about more than a simple rate cut. It was about the perception that the Fed and other interested parties seem to be making progress toward reestablishing a secure core of the financial system and reinventing the magic formula of economic peace and stability to the system, the markets, and the real economy.

To be sure, more pain is headed the markets way. Yet, unless one believes that the mark-to-market pain will aid and abet a US recession, which will precipitate a global slowdown or worse, which will thereby produce a double-digit decline in corporate earnings (see the Expected Return Valuation Model in my reports*) while at the same time the Fed and other interested parties are too dumb and lack the innovative wherewithal to work their way out of this mess, the credit derivatives problems of yesterday and today are fast becoming old news. And old news does not move markets. New news does. And the new news is the progress made toward reinventing the magic formula.

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