U.S. stocks tumbled, mirroring Monday’s move, as the credit markets remain largely frozen. Problem is banks continue to hoard cash, as we’ve talked about for a couple of days now, and this causes the whole system to seize up -- we’ll touch on this issue more specifically below.
To no one’s surprise on a day of substantial decline, financial shares took the brunt of the beating – losing 8.94%. Although, the losses were widespread as utilities fell 5.33%, information technology down 4.9%, consumer discretionary shares fell 4.84% and industrial shares lost 4.77%.
On financial shares, we must put an end to what short sellers are doing here. I normally wouldn’t favor such action, but there are times when the authorities have to step up and take Machiavellian action (swift, effective and short-lived). This is one of those times.
The SEC has decided to actually – hopefully this time it’s for real – prosecute those engaging naked short trades (shorting stocks without having the shares to deliver). This will help. They must also reinstate the uptick rule, meaning one must wait for the stock price to tick up before selling short. This rule was eliminated on July 6, 2007. The SEC ran a one-year pilot program, eliminating the rule back in 2004 and all went well, which encouraged them to reverse the rule. However, this is not 2004 and it’s pretty obvious a rolling short is in play -- short one financial stock to zero and move onto the next.
Market Activity for September 17, 2008
For sure, it is the reckless behavior of financial institutions, encouraged by the Fed’s very terrible mistake of keeping rates too low for too long all the way into 2005 (fed funds was kept at 2.00% or below for three full years) even as the economy began to boom in 2003 and was hitting on almost all cylinders by 2004. This reckless behavior by the financial sector is ultimately why the short-trade even got rolling. But we can’t change that now. The raid must be stopped.
In addition, consumers -- specifically many home buyers -- were reckless as well, which is why we’re dealing with this “toxic” paper that no one wants to touch and firms are stuck in a continual write-down loop as a result.
There are people talking about creating a new RTC (Resolution Trust Corporation, which was set up to liquidate assets in an orderly way due to the S&L crisis 20 years ago) to buy up the “bad” paper – sub-prime, Alt-A mortgages etc. – and selling them off in a orderly way. This may be a good idea.
I’d bet a new RTC would eventually make large sums of money off of this because it seems very likely, to me, these assets that continue to be written down are worth much more than currently marked to. And that’s one of the problems.
The mark-to-market accounting seems deeply harmful in my view. Why in the world mark these assets to where they can be sold in a distressed market? In fact, that’s putting it mildly. There is no market for this paper, but the collateral behind it is worth much more than currently assessed. For heaven’s sake, the mortgage market looks ugly, but we’re talking about 93% of mortgage payments are on time. The write-down scenario would make one think this number to be more like 60%. The authorities will eventually get a clue and switch to net present value accounting these instruments that have 10-20 year lives.
That to me is the answer, the accounting standard change.
We’re seeing the farce of the supposedly sophisticated models used to value assets in this mark-to-market accounting rule. As financial firms try to sell distressed assets it lowers the price even more, which makes them even harder to sell – buyers will not step in until they perceive a bottom has been reached. As asset prices fall its causes banks, among others, to raise capital. It becomes self-feeding. And this is why financial institutions are hoarding cash and credit markets are frozen.
The accounting rules must be changed – as former Fed governor Larry Lindsey stated so well yesterday in the WSJ editorial page; I encourage anyone with a WSJ subscription to read it. We must either move to more stable capital adequacy rules – basing capital ratios on original asset values or net present value these longer-term assets. This will put a halt to the capital concern and unfreeze the credit markets. You can’t do this overnight, but changing the rule to take place over the next year will help immensely. As some smart guy from the past said (the name escapes me) the best time to plant a tree is 20 years ago; the next best time is now.
We see this morning that central banks around the world are coordinating to pump $247 billion into the system. This is one of the things central banks are tasked to due and it may help. Then again, it may be like squeezing Silly Putty -- squeeze all you want there will be other areas that stick out. The accounting rules must be changed; this is the ultimate solution for now, in my view.
There are people saying the Fed needs to lower rates – these types think just because the FOMC hasn’t pushed rates lower since March that rates are not low enough. Look, it is not appropriate to view the fed funds rate by itself, but against current levels of inflation (averaging the three major inflation gauges). By this measure, you’re looking at a negative fed funds rate of -3.00%; this is a hugely accommodative stance.
On the Bright Side
The events of late have presented an enormous multi-year stock-market opportunity, but things may very well remain jittery for several months and I am not at all calling a bottom here. Just pointing out that once we get beyond this the attractive nature of the major indices will allow for above normal returns.
The S&P 500 trades at an earnings yield of 7% based on the earnings forecast for the next four quarters, while the 10-year Treasury yields a whopping 3.38% -- even relative to the past 12 months worth of earnings, the S&P 500’s earnings yield remains 101 basis points above the 10-year rate.
The chart below illustrates this point. The series that offers a historic view of the S&P 500 earnings yield was discontinued in October 2007, but the calculation is simply the inverse of the p/e ratio so we can plot where it is today – as represented by the point on the right side of the chart. This presents the largest spread in favor of stocks in at least 30 years. The index also carries the highest dividend yield in 12 years. (Other indices also show favorable ratios as the Dow trades at 13 times earnings and carries a dividend yield of 3.07% and the NYSE Composite – which includes higher growth medium and small cap stocks -- currently trades at 15 times earnings and a 3.40% dividend yield.)
To no one’s surprise on a day of substantial decline, financial shares took the brunt of the beating – losing 8.94%. Although, the losses were widespread as utilities fell 5.33%, information technology down 4.9%, consumer discretionary shares fell 4.84% and industrial shares lost 4.77%.
On financial shares, we must put an end to what short sellers are doing here. I normally wouldn’t favor such action, but there are times when the authorities have to step up and take Machiavellian action (swift, effective and short-lived). This is one of those times.
The SEC has decided to actually – hopefully this time it’s for real – prosecute those engaging naked short trades (shorting stocks without having the shares to deliver). This will help. They must also reinstate the uptick rule, meaning one must wait for the stock price to tick up before selling short. This rule was eliminated on July 6, 2007. The SEC ran a one-year pilot program, eliminating the rule back in 2004 and all went well, which encouraged them to reverse the rule. However, this is not 2004 and it’s pretty obvious a rolling short is in play -- short one financial stock to zero and move onto the next.
Market Activity for September 17, 2008
For sure, it is the reckless behavior of financial institutions, encouraged by the Fed’s very terrible mistake of keeping rates too low for too long all the way into 2005 (fed funds was kept at 2.00% or below for three full years) even as the economy began to boom in 2003 and was hitting on almost all cylinders by 2004. This reckless behavior by the financial sector is ultimately why the short-trade even got rolling. But we can’t change that now. The raid must be stopped.
In addition, consumers -- specifically many home buyers -- were reckless as well, which is why we’re dealing with this “toxic” paper that no one wants to touch and firms are stuck in a continual write-down loop as a result.
There are people talking about creating a new RTC (Resolution Trust Corporation, which was set up to liquidate assets in an orderly way due to the S&L crisis 20 years ago) to buy up the “bad” paper – sub-prime, Alt-A mortgages etc. – and selling them off in a orderly way. This may be a good idea.
I’d bet a new RTC would eventually make large sums of money off of this because it seems very likely, to me, these assets that continue to be written down are worth much more than currently marked to. And that’s one of the problems.
The mark-to-market accounting seems deeply harmful in my view. Why in the world mark these assets to where they can be sold in a distressed market? In fact, that’s putting it mildly. There is no market for this paper, but the collateral behind it is worth much more than currently assessed. For heaven’s sake, the mortgage market looks ugly, but we’re talking about 93% of mortgage payments are on time. The write-down scenario would make one think this number to be more like 60%. The authorities will eventually get a clue and switch to net present value accounting these instruments that have 10-20 year lives.
That to me is the answer, the accounting standard change.
We’re seeing the farce of the supposedly sophisticated models used to value assets in this mark-to-market accounting rule. As financial firms try to sell distressed assets it lowers the price even more, which makes them even harder to sell – buyers will not step in until they perceive a bottom has been reached. As asset prices fall its causes banks, among others, to raise capital. It becomes self-feeding. And this is why financial institutions are hoarding cash and credit markets are frozen.
The accounting rules must be changed – as former Fed governor Larry Lindsey stated so well yesterday in the WSJ editorial page; I encourage anyone with a WSJ subscription to read it. We must either move to more stable capital adequacy rules – basing capital ratios on original asset values or net present value these longer-term assets. This will put a halt to the capital concern and unfreeze the credit markets. You can’t do this overnight, but changing the rule to take place over the next year will help immensely. As some smart guy from the past said (the name escapes me) the best time to plant a tree is 20 years ago; the next best time is now.
We see this morning that central banks around the world are coordinating to pump $247 billion into the system. This is one of the things central banks are tasked to due and it may help. Then again, it may be like squeezing Silly Putty -- squeeze all you want there will be other areas that stick out. The accounting rules must be changed; this is the ultimate solution for now, in my view.
There are people saying the Fed needs to lower rates – these types think just because the FOMC hasn’t pushed rates lower since March that rates are not low enough. Look, it is not appropriate to view the fed funds rate by itself, but against current levels of inflation (averaging the three major inflation gauges). By this measure, you’re looking at a negative fed funds rate of -3.00%; this is a hugely accommodative stance.
On the Bright Side
The events of late have presented an enormous multi-year stock-market opportunity, but things may very well remain jittery for several months and I am not at all calling a bottom here. Just pointing out that once we get beyond this the attractive nature of the major indices will allow for above normal returns.
The S&P 500 trades at an earnings yield of 7% based on the earnings forecast for the next four quarters, while the 10-year Treasury yields a whopping 3.38% -- even relative to the past 12 months worth of earnings, the S&P 500’s earnings yield remains 101 basis points above the 10-year rate.
The chart below illustrates this point. The series that offers a historic view of the S&P 500 earnings yield was discontinued in October 2007, but the calculation is simply the inverse of the p/e ratio so we can plot where it is today – as represented by the point on the right side of the chart. This presents the largest spread in favor of stocks in at least 30 years. The index also carries the highest dividend yield in 12 years. (Other indices also show favorable ratios as the Dow trades at 13 times earnings and carries a dividend yield of 3.07% and the NYSE Composite – which includes higher growth medium and small cap stocks -- currently trades at 15 times earnings and a 3.40% dividend yield.)
Unfortunately, there are some real disturbances, if I can call it that, in the credit markets, so patience is certainly needed in this environment. And possibly some areas may need to be avoided in the very short term if the credit markets do not improve over the next few days.
On the economic front, the National Association of Home Builders broke ground on fewer homes than forecast in August. Housing starts fell 6.2% to 895,000 at an annual rate.
Multi-family starts plunged 15.1%, while single-family starts fell 1.9% last month.
Also, building permits, a sign of future construction, dropped 8.9% to an 854,000 annual pace. Both of these figures remain at the lowest pace since 1991.
This illustrates the residential housing component of GDP will continue to weigh on economic growth. We were under no illusion that housing would magically begin to support growth again, but figures over the past couple of months did at least begin to show the level of decline had eased – in fact the latest GDP report showed this occur in the second quarter. But the past couple months of data are a pretty clear sign that residential fixed investment will subtract another full percentage point from real economic growth – marking the 10th straight quarter of drag.
Certainly, the degree of decline among multi-family units overstates the underlying weakness in housing; it nevertheless suggests that residential investment is going to be a large drag on third-quarter growth.
Based on the data we have at this point, we still expect the Q3 GDP number to come in better than most expect. The business side of the economy will offset some of the weakness consumer activity will show and export growth may more than offset the housing drag. However, this is based on the assumption export growth remains strong. I think it will for the current quarter, but it seems apparent this segment will slow next quarter based on the slowdown the European economy is now enduring. At that point, if housing doesn’t show a little life, the fourth-quarter GDP reading will likely be flat. One hopes the rise in homebuilder optimism is a sign the degree to which housing activity is declining wanes over the next few months.
Have a great day!
Brent Vondera, Senior Analyst
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