Daily Insight

U.S. stocks failed to even tease the plus side yesterday after Best Buy warned of a “seismic” slowdown in consumer spending and a Treasury Department press conference reminded anyone that may have forgotten we still have a housing downturn and delinquency problems on our hands. It’s tough to get past a bevy of negatives and as a result the market is in the process of testing the October 27 low.

Basic material, energy, consumer discretionary and financial stocks received the heaviest beat-down yesterday. Utilities and health-care were the relative winners yet still down 2.75% and 3.52%, respectively.

Looking on the bright side, bear market’s generally test lows after a quick bounce off a multi-year low (you may recall the 18.5% rebound that occurred over six sessions from that October 27 multi-year nadir). Assuming another bomb doesn’t hit, it is likely we’ll rally hard off of this level – sorry I can’t tell you when – but we may have to wait to see how the Senate race finishes. (Minnesota is quickly slipping away from the Republicans so this brings us to the Alaska recount and the Georgia run-off. One can bet that the Georgia race will be one of the ugliest we have yet seen with all that is at stake – whether there is some form of check and balance or the majority has free-reign to govern may very well come down to this contest.)

Another bit of good news is that while retailers are stating this is the most difficult climate in a very long time, it means desperate discounting is on the way. Further, while there are many headwinds for the consumer, the 65% decline in gasoline prices from the July peak won’t hurt either.

Risk Aversion

Yesterday we touched the current bout of risk aversion, again. We’ve been watching the TED Spread for evidence of some willingness from investors to step back into areas of risk, and indeed the spread has narrowed, which is good. However, this narrowing has largely been due to the significant decline in LIBOR rates, no help has come from a rise in T-bill rates – the other component of this spread. And that trend looked even worse yesterday as the yield on the three-month T-bill plunged 27 basis points to 0.15% -- illustrating inundation into the safety of the short-end of the Treasury curve.

We need to see that three-month T-bill rate rise before it shows investors are willing to take some risk again.

Trade Pacts

We talk a lot about the uncertainty over tax rates and trade pacts, but we focus more on the former than the latter. If we go down the road of increased tariffs and destroying trade pacts, it will come back to harm us to a much larger degree than we are currently witnessing. The stock-market is forward looking and participants within the marketplace are concerned over these issues.

Study of the Great Depression shows that that economic period began as a rough recession, but was made into a depression by the three T’s: Federal Reserve tightening, a massive increase in tariffs (via Smoot-Hawley) and an increase in tax rates. The first, (Fed tightening) we have no worry of right now; the Fed has injected massive amounts of liquidity into the system and pushed their target for fed funds down to 1.00% (the effective FF rate is below 0.50%). But trade policy and tax rates are a big one right now.

The WSJ ran a piece yesterday calling on President-elect Obama to encourage Congress to pass a series of trade pacts – initiatives that have been held up by the Congress in this election year – that could easily pass if the leadership would acquiesce before Republicans lose even more numbers by January. This would remove one major uncertainty currently in the marketplace.

Take the Columbia Free Trade Act (CFTA) for instance. Failure to approve this pact illustrates the nonsensical nature of what Congress is doing right now. Columbian goods currently flow into the U.S. duty-free, yet U.S. companies (such as Caterpillar and Ingersoll Rand) have to deal with 5%-15% tariffs when they sell machinery to Columbia – a country that has a robust mining industry. The protectionists have been blocking this trade pact as they remain beholden to union leadership, but the irony is that the current environment is making union shops less competitive.

By passing the CFTA, U.S. business will see activity rise as their goods will flow into Columbia free of tariffs just as Columbian-made goods flow into the U.S. free of charge right now – this is what we call free trade. It’s a no brainer and Congress needs to pass it. By doing so, and getting on with passing the various other trade pacts that are currently held up by Speaker Pelosi, we can very quickly remove one major uncertainty from the market.

It is then we can get to tax policy (even though we won’t see improvement here with the 111th Congress and a President Obama, we can at least fight to keep rates unchanged) and we’ll see this market soar. Until the, the protectionists and those that engage in class warfare get a clue, the economy and stocks will have a very difficult time here in the short term.

Focusing on the same topic over and over (housing and mortgage securities) – even if housing and certain mortgage securities are at the heart of the problem – is not doing any good, as witnessed by another stock-market decline.

Congress needs to focus on the other concerns that are affecting investor sentiment – like these trade pacts. We’re under no illusion that pro-growth advocates will have the votes to push tax rates lower – I mention it simply because this sort of policy would boost optimism and the uncertainty of which lowers after-tax return expectations – but we can get this trade issue accomplished and one-by-one knock down these impediments to progress.

The TARP

Treasury Secretary Paulson held a press conference yesterday explaining that the program would primarily focus on injecting capital into financial institutions rather than buying up troubled assets. This was a segment of the original plan, but the decision to abandon the erstwhile centerpiece of the program did come as a surprise – which we touched on yesterday as the WSJ broke the story prior to Paulson’s official address.

The shift isn’t a bad thing, and it is quite possibly better to inject capital to give institutions the time to hold these assets until the housing market stabilizes rather than the government holding auctions, or flat-out determining the price – besides this direction would have taken much longer to implement, which was another issue.

What was new from Paulson’s comments is a plan – along with the Federal Reserve – to develop a lending facility that would encourage investors to buy securities backed by credit cards, auto loans and student loans. This is where the overkill really begins.

Why is the world would investors want to buy these types of asset-backed paper in this environment? The Fed has put in place some really strong facilities, the most successful being the money market and commercial paper programs. The money-market plan will help confidence, which is extremely important right now, and the commercial paper facility is essential because this is a very important element of business financing. However, credit card and auto activity is not essential.

Some things must be allowed to run their course. We’ve entered an economic downturn and we’ve got to let the market do its things in this regard.

And on student loans, you can thank Congressional leadership for much of this problem when they decided to cap the interest rate on subsidized student loans in early 2007 -- this was part of the 110th Congress’ 100-hour agenda. The idea was well-intentioned but lacked understanding, which is quite dangerous. The result was many banks simply decided to pull-out of the student-loan market, as it was no longer worth the risk. So the current issues in the student-loan arena are not just a function of credit-market chaos and increased delinquencies, but an unintended consequence of well-meaning, yet benighted people. Remove the cap on rates and you’ll find much of the problem disappears in time. Unfortunately, there is about zero chance of this occurring.

Have a great day!
Brent Vondera, Senior Analyst