Daily Insight

U.S. stocks took their expected beating yesterday, pushing the S&P 500 1.8% below the July 15 mark – thus making a new multi-year low; a two-year low to be exact. By mid-day it appeared the market wanted to hold above that level – 10,962 on the Dow -- but it was not so as half of the day’s damage was done in the final 90 minutes of trading.

The Dow Industrial Average lost 504 points Monday, just four points shy of the October 19, 1987 crash. The difference is that in percentage terms the decline meant 22.6% was shaved from the index back in 1987; today such a drop amounts to 4.4% -- although you wouldn’t know it by the way its getting reporting.

Market Activity for September 15 2008

Financial shares got clocked, falling 10.4%, largely driven by AIG shares, but BAC also pushed the financial index lower due to the Merrill purchase premium. Worries over AIG pressured the market all day as questions rose over their ability to raise capital; however, after the market close the company received approval to access $20 billion of capital in its subsidiaries to free up liquidity to buy time for that capital raise. Now they have other issues due to ratings downgrades that were issued late last night – this is the news of the day and we’ll touch on the topic a bit more in a moment.

All 10 major industry groups were hit hard yesterday, but along with the financial group energy was the other major decliner, losing 6.87% as oil prices fell 5.41% to $95.71 per barrel.

This morning crude is down further, off another 2.85% to the $92 handle. I guess people are thinking these companies will have trouble making money at $90 per barrel, or they fear crude will move to $70. If so, energy-company profits will still post strong results and in the meantime it effectively removes a major burden from the consumer. I’ve even heard people state that the drop in energy will help those that bought more house than they could afford pay their mortgage now. That obviously is taking things too far.

But back to AIG, the ratings agencies downgraded AIG last night which may trigger another $13 billion in collateral calls. AIG needs capital and they need it now as they also were sucked into the leverage trap, big time. The Treasury and Federal Reserve were in discussions last night – bringing JP Morgan and Goldman Sachs in to round up these funds.

The authorities must not be that worried about it though, since they have not chosen to tear down the regulations that keeps mountains of private equity out of the available capital pool. To my understanding current regulations state that anything larger than a 25% stake in an insurance company means the private equity firm is now treated like a bank; regulated like a bank. You can forget capital to the rescue from this group so long as this is the case. According to reports though, without this regulatory hurdle private-equity capital wants in.

Credit Markets Increasingly Jittery

The rush to find, or keep capital was evident by the action in the effective fed funds rate, which jumped to 6.00% at one point yesterday until the Federal Reserve engaged in operations to bring the rate lower -- this is the rate at which private banks lend balances to other depository institutions overnight. As you all may know this is also the rate the Federal Reserve targets to set their monetary policy agenda. But that is just a target, as the chart below illustrates, the effective fed funds rate had jumped as there is both a scrambling for liquidity and an occupying (unwillingness to let it go) of liquidity for those that currently have excess. The target fed funds rate stands at 2.00%.

The TED spread also shows the state of risk aversion yesterday as the index jumped – not unlike during other events during this period of credit-market chaos. For new readers, this is the spread between three-month Treasury bills and LIBOR. Bottom line, when the spread widens it indicates investors’ and institutions’ increased desire for safe investments. When it narrows it illustrates a willingness to take on more risk as default risk, or the perception of which, decreases

The Press

I don’t want to make light of what is occurring, this is serious stuff – as the above graphs help to illustrate, but the way the financial press, along with the rest of the media, is playing this thing has gotten way out of hand. The concern is that it drives people to think their bank accounts are not safe.

What the media is doing right now even stuns me. Terms like “horror” on Wall Street and these developments “shake individuals to their core” were used yesterday and last night.

Horror? Shaking individuals to their core? Only if these ignorant media participants tip off a panic will people be shaken to their core. Heck, CNBC is running a “special” each night – all night – entitled “Is Your Money Safe?” Beyond the headline of this “special” the mood and alarm exhibited by these people is astounding. One must realize though that they are receiving the best ratings in their history; then you understand the alarmism, which of course causes more people to tune in.

Capital

We’ll also point out something else that is hugely important right now, and gets zero attention. The economy, the system as a whole, is stuffed with capital. There is no shortage of it, but there is an unwillingness to use it in the current environment, or large amounts are being blocked out by regulation as we touched on above.

Let’s run through some numbers. Huge amounts of capital has been created and re-built over the past few years.

The New York Stock Exchange Composite has seen its market cap grow more than $7 trillion over the past few years – even with the latest 20% decline on the index.

Another $900 billion has been created via after-tax corporate profits since 2001. And this figure is adjusted for inventories and capital consumption so there’s no chicanery in this number. (It’s tough to read but the graph shows an increase of $888 billion.

Another $1.2 trillion has been added in real disposable income – that’s inflation adjusted. This is not all counted as capital, as most of this money gets spent, but we know that a decent percentage has been added to the markets and is likely available on the sideline right now.

In fact, money market accounts currently stand at $3.1 trillion – as of the latest data – which is enough to buy 27% of the S&P 500.

Point of all of this is things could be much worse. At some point the smog of uncertainty and worry clears. In time, the housing market will stabilize – household creation and demographics will make it so on its own – at which point the write-downs will cease. (What isn’t helping things in this regard, and is actually exacerbating the situation, are rather dumb accounting rules in my view that make firms mark assets to market when in fact there is no market for much of this stuff. Why mark to where it can be sold in a distressed market? Better to net present value this stuff that have 10-20 year lives)

And this is what investors should be thinking about. No, it is not a time to be a hero, the market is in a tenuous state, but this is when longer-run opportunities present themselves for those who can look past this all – it’s tough though, I know.

I’ve bifurcated the letter again, feeling the need to touch on the current state of things and we’ve gotten long. Read on if you care about yesterday’s economic data.

On the economic front, the New York Fed reported that manufacturing activity (as measured by the Empire Manufacturing index) contracted in September after bouncing to back to expansion in August. The index slipped to negative 7.41 from positive 2.77.

Still, there were some positives as the prices paid index came down big time, new orders accelerated and shipments were positive.

This rise in new orders shows the Empire’s decline in August was not a marked deterioration. Further, the index for business conditions six month out jumped to 43.11 from 34.58 in August.

Also, keep in mind that nation-wide manufacturing activity remains right at the point that separates expansion from contraction – point is it is holding up remarkably well during this period if economic weakness and credit-market troubles. The New York area has been hit hard by the credit troubles, which helps explain why factory activity in the Northeast region looks worse than for the country as a whole.

In a separate report, the Commerce Department reported industrial production fell a large 1.1% after two months of increase. The drivers were a 11.9% plunge in auto production and a 3.2% decline in utility usage – due to extremely mild weather. These two segments account for 15% of total industrial production.

Overall, every segment declined in August, save information processing. It was a pretty miserable report, but the large decline was vastly due to the auto and utility realities. Auto inventories have been trimmed substantially and this segment should provide a boost for the current month. (Auto sales remain weak from a historical perspective, but we did see sales bounce in August as automakers’ incentives were successful.)

This morning we get the Consumer Price Index for August and the FOMC (Federal Open Market Committee – the group that sets monetary policy) meeting, which should be interesting. Odds are the FOMC will cut fed funds down to 1.75%. The minority view is that they’ll leave it at 2.00% and use other ways to inject liquidity.


Have a great day!


Brent Vondera, Senior Analyst