Divergence in equities

Everything that can be said here about the market has been said in the few posts before now. The divergence between the U.S. markets and the rest of the industrialized world is now being accentuated. Anyone can pick up the numbers of the European, Asian, and Emerging Markets stock indexes and see that they are far outperforming the U.S. over the last three years. That is now accelerating.

The interest rate give up in the U.S. is not necessarily bad for U.S. stocks in the near term. It could also be good for folks with the wherewithal to have 30% or more of their assets in foreign stocks and the S&P owners who have on average an exposure within those stocks of 48% international in their revenues.

All of this can be neutral or even positive for someone who can and has the insight to invest globally. It is not good for locals, meaning most Americans. Even all but the most aggressive out of nine asset allocation portfolios suggested by Wachovia had an international component suggestion of around 12%, and that might be too much in the minds of the generation of savers now in their 70's and 80's. And of course there is now the concern that one could come in too late, after the party is over.

That's unlikely and investing globally should be part of any asset allocation approach. If international stocks go down, it seems that the U.S. will as well. And the upside is apparent today. Look at the facts--Singapore, Malaysia, India, mainland China funds, Brazil--continuing their 30% plus returns over the last three years. Not sustainable, that's a possibility and I feared that two years ago when I white knuckled an investment in an Emerging Markets fund and loaded up on a Singapore ETF(see December 21, '05 post). It worked out ok.

At least the Fed was clear

The Fed's 50 basis point rate cut was thankfully clear. 25 basis points would have been muddled while no cut would have also have been clear, a line in the sand. The Fed chose to rescue short term market liquidity, the long term be damned. That may be the right thing to do, we'll see, and the equity markets certainly welcomed it. Indexes broadly, from the S&P to mid cap to small cap to international were up between 2.8% and 3.1%. Who can not like that. The dollar, however, did fall further and is certainly on the way to $1.40 per Euro and the bond market reacted modestly with the major investment grade U.S. bond indexes up around 18 basis points.

Whether the Fed move is of any lasting consequence or not is uncertain. The equity markets will likely continue to rise short term as concerns about commercial paper rollovers and other short term liquidity issues have been allayed. The dollar and the bond market will tell the story over the next few months.

The Bank of England this morning reversed their strongly stated opposition to emergency bank lending and began three month auctions to fund bank needs for liquidity. That's interesting as it was reported last week, just as an interesting sidebar, that Bernanke and Bank of England Governor Mervyn King had adjacent offices at MIT many years ago. That they moved together should perhaps not be a surprise.

No easy choice

In a few hours the Fed will announce its decision on the fed funds rate, same or lower, 25 basis points or 5o basis points. Holding firm will disappoint the market and send equities down. 25 basis points is a meaningless wimp out. 50 basis points is a short term solution that is incredibly dangerous for long term financial health given what it will do to the soundness of the dollar. It would sow more seeds for future inflation and higher interest rates.

As a new Fed Chairman it may be impossible for Bernanke to not lower rates. That's too bad because it is an option that should be considered seriously. The language of the Fed's comments could show extreme awareness of the difficult situation but still not capitulate with an interest rate cut. That would shock the market but perhaps create a foundation for responsible risk taking and, after a pretty awful short term sell-off, put an end to this creeping credit and market sickness. Sooner or later we'll need to pay up. It may be best to get it over with and go on from here with a chance of restoring the credibility of our currency.

Unlikely.

Check out those balance sheets

Some equities beyond financials have been trading significantly lower due to concerns about credit access. That's not news in the sense that companies that formerly had premiums built in on the expectation of a potential buy-out now don't have them, or have much less. Now, however, there is pressure spreading to companies with financial structures that have above average credit reliance.

Here are two examples. Alliance One International(AOI) is down 35% in two months, 50% in three months. There has been no visible change in the business to the observer relying on publicly available information. What is likely driving this is that the short term portion of long term debt is 80% of shareholders equity(that should be scary right now) and long term debt is 3X shareholders equity. Level Three(LVLT) is another case. This company has a much much stronger set of assets than AOI(no comparison there at all) but it has a long term debt to equity ration of almost 30 to 1. The stock price is down 25% in two months, and even though two months ago it was a stock viewed by many as oversold and ready for an upturn as soon as the weak holders were cleaned out. So much for that.

The allure of debt by choice as a way to enhance shareholder value is a lot less attractive at the moment. Going to the markets for a big rollover or refunding now will be very expensive. Renegotiating needed short term debt with banks will be a nightmare.

I don't remember the last time that I looked at balance sheets first when contemplating an equity investment. Oh yeah I do, all of them: '98 LTCM Russia; '97 Asia; '90-'91 recession/bank stress; and before that it was simpler. I just wanted my checking account to be in a place that stayed open.

The dollar's dangerous decline

In posts here the decline in the value of the U.S. dollar has been frequently mentioned as an issue of concern. Over the last five years the dollar has declined in value against a basket of foreign currencies by more than 30%, and by quite a bit more than that against the Euro and the Pound. For every ten commentaries by politicians and the media about either interest rates or stocks there may be, at best, one about this issue. It's a bigger issue than that suggests. Here's the deal.

It is not news that our economy is global. More than half of the total U.S. treasury issues afloat are held by foreign investors. Imports fill our car lots, our clothing stores, toy stores, electronics stores, Wal-Marts, Targets, even appliance stores and on and on. They also fill at least half of our gas tanks. Eventually a dollar decline will not be a good thing.

When the dollar loses value, purchasing power goes down. We don't see it yet, for the most part, because many imports are produced at cheaper costs and as the import substitution has grown and grown it has not been inflationary even with the weaker dollar. At some point in time this import substitution benefit will end, and with a continued decline in the dollar many products will eventually cost more. It will happen first in more sophisticated goods like cars from highly developed countries(and this will finally give U.S. automakers who have been slimming down by necessity a chance to raise their prices) and will spread down the value chain of products. The congressional pressure on China to revalue the yuan could accelerate the pressure, and there will be that "tipping point" at which the U.S. consumers will feel the pressure of higher prices in a meaningful and maybe painful way. Instead of waiting for this eventuality they could just go spend a week in Europe and see what it's like.

The counterargument to this is that a weaker dollar strengthens U.S. export industries, and therefore creates jobs and wealth. This is absolutely true and it has in recent years been a huge benefit to many major companies and to the aggregate economic statistics. Two issues though, at least two. Much of the benefit is in the translation of foreign currencies back into U.S. dollars rather than a surge in good job growth and more importantly wages and benefits in the U.S. And, much of the wealth created will be for the professional and investor class, which does not include the majority of U.S. consumers. "Trickle down" is not a term without meaning but if that "tipping point" arrives, a trickle will not likely do the trick.

Then there's the question of interest rates. The Fed will likely need to cut interest rates in the near future to stabilize financial markets, help borrowers and guard against a slowing economy. The irony is that an interest rate cut could lead to higher interest rates. How's that again? An interest rate cut will put pressure on the dollar. With foreign investors holding so much U.S. debt, they will not stand by idly watching their return diminish when their maturing bonds translate back into fewer pounds, yen, euros, dinars, or yuan. They will demand a higher interest rate to compensate. So a rate cut would lower short term interest rates and initially lower rates across the yield curve. In this crisis style market a flight to quality, meaning to the major currencies, could delay an impact, but in the near future it is likely that medium term and longer term interest rates would increase, and increase to levels above those before the cut.

Inflation in prices, inflation in interest costs, what else? Maybe inflation in words about the dollar's decline as this post might suggest. At some point doesn't this become an important national issue, a dent in reputation and a sign of weakness in the global economy. Or does it just mean that some Americans will get to play on another level at a global pricing structure while the great majority goes to the table with a beggared currency.

A few questions about the Iraq issue this weekend

---How did the Congressional Democratic leadership allow or the Republican executive branch arrange for General Petraeus to give his congressional testimony on 9/10 and 9/11. Coverage of the Monday testimony will be in Tuesday newspapers that will understandably have coverage of memorial events and related human interest stories, and Tuesday's television and radio will be filled with the same. Is this accidental, or could it be some kind of cynical use of this meaningful day of remembrance.
---Why did the Democrats choose to rebut the testimony on the Sunday news shows before it was delivered, and why in the world did they choose John Kerry, Ted Kennedy, and Joe Biden to be their spokesmen. There are very few leaders in Congress who can totally wash their hands of Iraq and this is the old image of the party. They of course could not choose the three leading candidates for the nomination to take this role for fear of showing favoritism, but where is Jim Webb or some of the other new faces.
---And are the Republicans serious when they put Bush's Homeland Security Advisor, Frances Townsend, on Fox News Sunday to say that Bin Laden is impotent, living in a cave, and can only come up with an occasional video. In the same interview she underscored the need for a continued military campaign in Iraq by saying that intercepts of Al Qaeda intelligence showed that they followed the situation in Iraq very closely and were using the country as a major recruiting ground. Is this consistent?
---Bill Maher noted that in Bin Laden's video statement he referenced the mortgage crisis in the U.S. According to Maher that's because of Bin Laden's experience in the real estate business in Afghanistan where he worked for Century 12.

Buying low, selling high

IN THIS MARKET YOU CAN DO BOTH. More than ever it seems that now is the time to look at the equity market. It is very likely that there are significant values right now. At the same time there could be gains to protect, positions to shave. Staying reasonably calm is different from sitting on your hands. And what the heck. In a calamity nothing is safe(your mattress money may seem safe but if it could buy a Volkswagen today and half of a Volkswagen next year...) so it seems like the right thing to do is be normally active, whatever that is. And real calamities rarely happen.

Market moves

On Friday the market told us what it had wanted---a rate cut for market reasons, not economic ones. The usual bad news equals good news response to an economic report(jobs) that could foreshadow a rate cut definitely did not happen. Stocks were down sharply and the dollar took a tumble as well. The markets were saying, "Oh no, we don't just have credit excesses to clean up, it's more than that. But we wanted liquidity without pain".

This is beginning to look very much like LTCM in 1998, August, September and early October 1998 coincidentally. This is worse you say. Past crises seem contained in hindsight because they are. In 1998 it did not feel contained at all. In fact it was more frightening, and hopefully it stays that way in comparison. Credit markets seized up, and big financial institutions were all suspect as everyone tried to figure out who was a counterparty to whom and on what. The time line is interesting. In mid August an immediate crisis developed and investors were looking for the billions of losses. Where were they. The Fed huddled with banks on a rescue plan, central bankers reassured, market spokespeople tried to put things in perspective, but uncertainty was rampant. Every other day in September was up or down, but fear continued to grow. It was October 7 when credit markets had almost stalled out completely. And then in just a few days Fed actions, a stabilization of LTCM, and then the beginning of earnings reports that were better than the markets feared, and it was over. Rally.

If there is any basis for comparison, just in terms of the time it takes to get through a market crisis and how bad it really has to feel before it can pass, then we still have more of this turmoil to come. If layered on top of this there is actually a real economic downturn the crisis may pass but the market could just flatten out. No Rally.

Baffled about the market, join the club

It appears that everyone is waiting for something, some news, some insight, to tell them what to do in this U.S. equity market. Trading volumes are low. The summer vacation season is done, there has been more than enough news in recent months, and yet trading is far below normal. Even the market pros seem to be sitting on their hands and wondering what to do.

Today at 2pm major liquid stocks like GE, MSFT, JPM, PFE, AIG, MO, etc. are on course to have trading volume at about half of their three month average. Stocks with significant market news around them like AAPL, COST, and LVLT will have volume just modestly above their average. Real estate stocks are down for the most part, except for favorite JOE, and all have low volumes as well. Small caps are just hardly trading. PESI has an average volume of 123,000 shares and at this point has trades of 3000. PATK has average volume of 9000 and has no trades.

Is this bullish or bearish. Is there no interest in buying, or no interest in selling. Take your pick. My bet is that buying is underway, big buying orders, that are being handled carefully so as to keep the prices low for as long as possible. Accumulating positions at the right price requires finesse for the big players. They need to be invested in stocks, and this is an opportunity. That of course does not insulate them from any more bad market news, if it comes, and at some point the opportunity to accumulate at an even lower price becomes painful.