Friday, March 21, 2008

Have we made a bottom?

This truly is Good Friday. The market isn’t gyrating up or crashing down. It is a day of peace and reflection. Time to reflect on the market’s recent euphoria in celebration of the Fed rate cut, rescue of Bear Stearns, and retracement in commodity prices. Have things changed? Have we seen the bottom? Is it time to back up the truck and load up on equities?

I don’t think so. We may have plateaued as far as the impact on the major institutions of the “credit crunch.” Just as the institutions abandoned all of the historical lending norms to put volume on the books, the regulators have, or are about to, changed the rules so that the crisis will not be as severe and immediately painful.

Here are a few of the changes:
1. Investment banks can now access the Fed’s discount window for funding
2.The funding can go up to 28 days and be rolled-over and over
3.Collateral can be mortgage backed bonds and the margin is less than the market’s pricing
4.Fannie and Freddie are now allowed to maintain less capital which allows them to leverage their balance sheets an additional $200B.
5.Bear Stearns is shotgun married to J.P. Morgan with the Fed’s blessing. The common shareholders are essentially sacrificed to keep the bondholders whole and avoid a cascading of credit defaults in the derivatives market.
6.Margin requirements are changed on commodities futures with the aim being the a reduction in the inflation inferno.
7.Finally, this will happen soon. Under the charade of fairness, since all types of institutions are not required to mark to market their securities, regulations will be weakened allowing bond pricing at cost if the company says they are held till maturity. The market marks become a footnote item and the write-offs are rebooked and capital is replenished. Nothing changes except everyone is now happy and the losses will dribble out over time.

Regulators and Wall Street need to “put some lipstick on this pig” to calm the markets, but they also realize they need to de-leverage the economy and try not to let this crazed lending/securitizing happen again. So, losses must be taken. Who will they let fail? I think they are going to let the losses bubble up from the bottom of the credit heap which will hurt smaller companies and give the big banks a couple years of yield curve profits to help rebuild their balance sheets. The big guys won’t get off easily as the Fed’s will demand dividend cuts, new capital through rights offerings and expensive preferreds., and curtailing credit to make capital go further.

The last item is the economic killer. It’s already happening on main street. Community banks have lent too much, too easily to builders and developers and the delinquency numbers are growing rapidly. Losses will be large and lots of banks will be shotgunned. Individual creditors won’t be missed as they are too small to be noticed.We’ve already seen this in mortgage brokers, small builders, and real estate related service companies. Retail can’t be too far behind. Recreational manufactureres like boating and RVs are hurting and general freight movement is getting softer. The jiggling of regulations may keep big institutions alive for now, but it won’t stop a serious recession since big and small banks, as well as the CITs and captive finance companies, will need to curtail lending.

Not only will the banks reduceB lending now that they have realized that they’ve been stupid to sacrifice prudent risk rules for growth, but consumers have seen the dangers of spending and borrowing frivolously. Even when offered, many consumers will say NO. It’s going to be difficult to gin up the economy through debt.We, as a country, may have to start making things again that the rest of the world wants and export ourselves back to prosperity. But that will take years.

All this rambling convinses me that we aren’t near a bottom as the economy will continue to weaken and analyst’s forecasts will have to come down and with lowered future cashflows you will see lower P/E ratios. So I don’t plan to borrow a pickup anytime soon to start loading up on stocks.

For now make a list of all the stocks you would like to own and keep that at the ready. You’ll get your chance, but not now. Like Charles Barkley says: “I could be wrong, but I doubt it.”

Sunday, March 16, 2008

Let’s hope foreign investors don’t bolt

It wasn’t too long ago that Bear Sterns was trading at $100 and I was in the money about $20 on a number of put contracts. I took a very nice profit because I couldn’t really tell if BSC was broke or going to be fine. Joe Lewis had just invested 1B and the Chinese put in another 1B. They had access to the books and I only had my gut that told me that Bear was riddled with terrible risks that they didn’t understand. Today JPM bought Bear for $2 per share and Lewis and the Chinese have lost their B’s in a short 120 day timeframe.

Asia is tanking tonight and Europe will follow. The rapid BSC decline is scaring the beejesus out of investors. How can you tell who will be next. It could be JPM! I doubt it, but we don’t have a true picture of any financial institution. Financials will get killed and the talking heads that have told people to buy because the banks are so cheap should be shot. How can you recommend a purchase when the balance sheets don’t even tally all the risks? Managers, directors, accountants, investment bankers, and stock hypers have really done a terrible job. The only place to be near a financial is short the ETF’s.

The Fed will continue to lower short rates and target their financing. The lower short rates are necessary to allow the damaged banking industry to borrow short and lend longer at a decent spread and hopefully earn their way out of this mess. But this will continue to hurt the dollar and foster an eventual demand for higher rates on the longer side of the interest curve. If foreign buyers flee the US bond market as well as the stock market, we may get higher 10 year rates soon.

I’ve been hunkered down, should have hunkered more, and can sleep nicely at night. When the next Fed inspired rally moves stocks up I will continue to lighten up. As i’ve said before, I want to have the ability to buy as things get worse and it sure seems like they will. The bankers will continue to lead us downward.

Monday, March 10, 2008

The bottom isn't here yet

I’ve done almost everything right to protect myself and make money during this downturn. Almost. The part I didn’t get correct was the magnitude of my positions. I’ve kept too much still in long equities and they’ve hurt me. From the peak in October, I’m down 4%. That’s a lot better than the “market”, but it could have been much better had I not been so conservative. Even so I have “most” of my powder dry and can participate when the bottom is put in. Will I be able to recognize the bottom or will I be like many people and still bearish for far too long and miss the big opportunities that will develop?

I think we’ve got the better part of a year ahead of us before the market finds a bottom. The banks are actively curtailing credit and that will slow the general economy. A slower economy will lead to earnings disappointments and lowered guidance. That leads to lower stock prices. If I’m correct on rising inflation, like I’m confident I am, that will lead to lower P/E multiples to correspond with lower earnings. Over the next few quarters stock prices will go lower.

People are not vomiting yet, but they will as the above unfolds. Too many are counting on a quick reversal to good times. As that dream fades prices will drop. Make sure your portfolio is vomit proof. Allow for a few verps, but do not get killed before the low prices arrive. I intend to take more money off the table when the fed lowers rates and the market rallies. The goal is to have all your money when the prices get compelling. We aren’t there yet!
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