Energy shares led Friday’s advance as Middle East tensions heat up to drive crude prices higher. Basic materials also performed well with industrial and consumer discretionary shares helping the benchmark indices as well.
Market Activity for December 26, 2008
We were without an economic release on Friday, and absent one today also. Trading activity is also subdued as many take the final few days of the year off and have probably accomplished most or their end-of-year positioning and tax-loss harvesting. Nevertheless, there is still plenty to talk about.
Lending and FASB No.159
Government officials continue to state that they want banks to make more loans, yet they fail to pull the correct strings. The government’s unwillingness to suspend mark-to-market accounting rules with which to base capital adequacy ratios (officially FASB rule159 put in place November 2007) is one of the major reasons their pleas are being ignored.
Mark-to-market is a reason banks have halted lending as the accounting change carries elevated write-down risk. Make no mistake, we’re not ignoring the fact that falling asset prices and rising default rates are playing a role, but based on the former standard the seemingly endless write-down cycle would not be occurring and thus affecting capital adequacy is such a pernicious manner. (We’ll add, this rule is just as harmful in a rising asset-price environment as it would encourage firms to hold less capital.)
Another issue is how the Treasury has changed the TARP, using the funds to inject capital into banks, rather than buying up “troubled” assets. The original plan would have allowed the government to house those assets – removing them from bank balance sheets -- until the market returns to normal and can then be sold at prices that more closely align to intrinsic value rather than distressed price levels that currently have little if any bids coming in. Changing the plan was a big mistake in my view as the decision does not address that which has firms so fearful.
The idea to inject capital assumed that banks would increase lending activity as they would be able to withstand current asset write-downs with these additional funds. However, as banks increase loans obviously they’re taking on more loan assets, assets that are subject to huge write-downs even if the institution has zero desire to sell the asset and the asset is producing cash flows. This is what the capital injection plan misses. So long as mark-to-market instructs that banks continually write-down assets in this distressed asset-backed market banks will simply hoard the cash, as they are doing.
In the meantime, the Treasury and the Federal Reserve continue to target housing in a very circuitous manner. The various Federal Reserve facilities (while some have worked quite well) and Treasury Department programs that have been implemented make the government even more the Rube Goldberg machine that it always has been than and entity that efficiently attacks the issue – an endless cycle of write-downs and capital raises that cause banks to become increasingly cautious.
We must allow the housing correction to run its natural course, reverting to the mean after years of outsized growth – in terms of both credit and prices. What we must attack is that which has exacerbated the painful process of reversion – the accounting change. By eliminating mark-to-market, specifically with regard to basing capital adequacy ratios, and returning to the original cost model banks will not have this incessant capital-eroding write-down problem and lending, while remaining logically subdued, will increase from these very low levels of activity.
Gold and Oil on the Run
Gold prices have rallied 4% the past two sessions as Middle East tensions rise again. Concerns of an inflationary event over the next 12 months may also be playing a role as the metal has jumped 15% since December 5.
Normally gold has to compete with interest paying assets but with Treasury rates so low, in fact non-existent on the short end, we’ve got money flowing into the hard-asset safe-haven once again. The price of gold has been surprisingly held back considering all that has occurred.
Oil prices have also found some life, jumping 6.7% on Friday and up another 7.7% this morning as Israel attacks the Gaza Strip, which is where Hamas’ second favorite weapon, Katyusha rockets, are being fired.
This back-to-back rally in crude is pretty meaningless relative to the 75% plunge over the past five months, as the chart below illustrates.
Still, as things heat up in the Middle East especially if Iran gets involved via its proxy Hezbollah, the crude trade may have some staying power -- too early to tell just yet.
In any event, Middle East tensions are not going away and when you combine geopolitical risks with the massive liquidity injections via the Fed (causing an inflationary event when lending begins to increase) we find it hard to believe oil will stay at these levels for an extended period of time.
Friday’s Letter
I went back and read Friday’s letter to notice I rambled on there in the first half while talking about short-term equity-market trends – accept my apologies for the complete lack of brevity.
A much better way to deliver the point is to say we believe there’s a heightened potential for a strong bear-market rally to occur. Although, I’m not convinced it will happen in January as many seem to be predicting. The de-leveraging process has probably not yet played out, so we may have to wait until February/March for a potential spike.
Certainly, there are many concerns tugging at investor sentiment. Indeed, there are a number of issues on the horizon as well. However, as the de-leveraging process runs its course, a spike from these levels is likely in our view.
What’s more, rallies are typical after sharp dives in equity prices such as the two moves we endured in October in November.
Have a great day!
Brent Vondera, Senior Analyst
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