U.S. stocks ended mixed on Friday as the S&P 500 gained some ground, yet the NASDAQ Composite failed to close on the plus side as shares of RIMM, Apple and Google weighed on the index. The Dow Industrials jumped 121 points as shares of Bank of America and JP Morgan – well-run institutions that have been able to buy assets on the cheap – propelled the move. Those two stocks accounted for nearly half of the Dow’s advance.
Well, what we’ve all been waiting on – passage of TARP – appears ready for a vote today and we should get the plan signed over the next couple of days. The equity markets don’t seem to be interested in applauding the development though as index futures are down big this morning.
The stock market has been very patient as Washington plays politics with this plan. The fact that this plan is focused to deal with some very serious stuff – credit markets that are very clogged up and threaten to do serious economic harm – it’s too bad we have this game playing. Maybe this is what stocks are finally sending a signal over. Maybe the weakness is simply a result of quarter-end window dressing by mutual-fund managers to give the appearance they were heavy cash in this weak market, or to reduce their positions in what was hot, and certainly now is not – energy and commodities. Maybe it’s over the Wachovia development. I don’t know. What we do know is the market is going to open down according to futures.
Market Activity for September 26, 2008
What I really love though is how McCain and Obama are acting as though they bolted over to the Capitol to save this whole situation and forced Congress to pass a better bill. That’s a joke.
Then we have Speaker Pelosi and Congressman Frank. Listening to their comments yesterday was also entertaining, although sad, as they don’t seem to really get the magnitude of the situation. Apparently, they chose to play up for the election and blame this entire event on de-regulation. We’ll point out that the two industries that have been hardest hit by this mess – housing and financial services – are among the most regulated industries out there.
Want to place blame? It is about time we begin to focus at the origin of this situation – Federal Reserve monetary policy mistakes – and that which has exacerbated the problem – FASB Rule 157, “mark-to-market” accounting. You can also add on bad legislation such as the Community Reinvestment Act and Congress hauling banking executives up to Capitol Hill in the 1990s to all but call them bigots for not providing loans to lower income/poor credit score individuals. Now these same politicians castigate the financial industry for doing just that – hence much of the sub-prime problem.
In terms of the proposal, it increased from the four pages that Treasury Secretary Paulson laid out 11 days ago to 110 pages by Saturday night, which is why we’ve been arguing for some speed here as time only gives Washington time to stuff the bill with a bevy of social programs. I will say though it could have been much worse. The executive compensation provisions for those participating in the plan are not austere and House Republicans forced the elimination of a provision to devote 20% profits from the plan to an affordable housing fund. This means ACORN would get that money – and those familiar with this group will understand the importance of this elimination.
Public Angst over the Proposal
We keep hearing how the public is so against this plan. Well, of course they are as it has been presented in exactly the wrong way. When Paulson and Bernanke use terms like “bailout” and figures as large as $700 billion it’s no surprise taxpayers grab their wallet to make sure it’s still there. But this is not a bailout. It is an investment in assets that have a higher intrinsic value than the currently distressed market for these securities is valuing. In fact, there really isn’t a market for much of this stuff anyway, which is why a plan to remove these assets from balance sheets will help to unfreeze the credit markets.
For now, anyone with a 750-plus credit score can access credit in a heartbeat. You want to finance a care purchase? Done. And the cost of money is close to zero. Want to buy a house? No, problem. But the risk is if the credit market remains this clogged – banks continue to hoard cash for fear additional write-downs will affect their capital adequacy ratios – even these top–tier borrowers may be affected. And more importantly, there are many small businesses out there that use credit lines to meet payroll, or buy inventory. These credit lines are in jeopardy of being squeezed and of this credit situation persists, even those who have managed their lives responsibly will be harmed. These are some things that should have been explained.
Further, the entire $700 billion may not even be necessary, as maybe $350 billion is enough to stabilize the market. And even if it takes the entire $700 billion, over the next 5-7 years the Treasury will likely net money off of this deal.
Moving on
On the economic front, the Commerce Department reported real GDP was revised down to 2.8% at an annual rate in the second quarter from the previous estimate of 3.3%. The reason for the lower revision was because personal consumption and net exports (the two catalysts to Q2 growth) were revised down. Inventories were also a larger drag than the previous estimate showed.
Looking to the current quarter, it was shaping up to give us a 2.0% growth quarter (that’s in real terms at an annual rate). Consumer activity was going to be weak, but business spending had rebounded very nicely and the production needed to rebuild low inventory levels looked able to offset this consumer weakness. However, with what has occurred of late – specifically the credit market bottleneck – business spending has reversed the encouraging trend of the past three months and residential fixed investment (housing), which looked much better in the second quarter, will be another big drag to growth for the July-September period.
It is still too early to call current quarter GDP, but if the credit markets are not unlocked quick, it will be quite negative.
For several quarters now we’ve heard from the financial press that consumer activity has been weak – the consumer is “tapped out” as they love to put it. Well, we’re headed into a period where the press will see what weak consumer activity actually looks like – the press is so clueless – and if the business side (capital spending) doesn’t show the August figures to be just a respite – the third-quarter GDP figure will not be a good one.
We’ve got a lot of challenges facing us – both endogenous (domestic economy) and exogenous (geopolitical risks) – the latter was true before the credit market locked up; the former really was not.
The only way to meet these challenges is through growth. I know tax-cutters/supplysiders are gun-shy right now with all that is going on but they shouldn’t be. Proponents of lower tax rates should invite the argument from all of those that want to blame the current situation on lower rates, those with the facts can crush this flawed belief.
The best way to revive things right now, outside of doing what is necessary to free up the credit system, is by reviving the stock market. The quickest way to accomplish this is to drive the capital gains rate down to 5% and the corporate tax rate to 20%. This will spark a renewed optimism and confidence, two things that are desperately needed right now, and we can avoid a downturn, maybe a deep one, as a result. We have people proposing higher tax rates, this will not boost tax revenues – kind of difficult for tax receipts to rise when the economy is held back by lower after-tax profits and returns. Lower these rates and tax receipts will boom. Investors will unlock investment they have been unwilling to sell due to capital gains confiscation and increased after-tax profit growth will funnel right to jobs, increasing the tax base.
Looking Ahead
Stocks will have to endure a period of intense uncertainty, and some of this uncertainty may result in a negative outcome.
However, the housing market will eventually flatten out and then slowing return to normal. The question over tax policy may be answered over the next month as the election takes place – assuming it is not too close and thus dragged out for a month as we count and recount votes. The TARP plan will help the economy avoid a crisis situation and if the operation of this plan is not damaged by political meddling the Treasury will be able to pay back what it borrows and then some.
As these issues wane, stocks are set to provide very nice returns over the next several years. No, we should not expect 15% annualized returns. Those days are gone, and it is a good thing because those levels are not sustainable and lead to years of weakness as the market regresses to the mean. But we’ve got a really good shot of 10% annualized returns over the next several years once we get the realities that follow years of poor risk management behind us.
We believe there is a strong likelihood industrial and technology shares present some great long-term opportunities – don’t mistake this for a walk from diversification; everyone must remain diversified and participate in each of the major sectors and asset classes, I’m just laying out where the potential looks the brightest.
The financial services sector has led the economy for more than a decade, but as independent broker dealers have either been gobbled up by commercial banks or the market forced this upon them as internal funding via deposit bases is the way of the future, leverage is going to move from 30-to-1 to something closer to 10-to-1. This means less growth for the industry, but a more responsible and sustainable growth. As this occurs, the more traditional forms of growth will once again lead the way and this means industrials and technology.
Have a great day!
Brent Vondera, Senior Analyst
Well, what we’ve all been waiting on – passage of TARP – appears ready for a vote today and we should get the plan signed over the next couple of days. The equity markets don’t seem to be interested in applauding the development though as index futures are down big this morning.
The stock market has been very patient as Washington plays politics with this plan. The fact that this plan is focused to deal with some very serious stuff – credit markets that are very clogged up and threaten to do serious economic harm – it’s too bad we have this game playing. Maybe this is what stocks are finally sending a signal over. Maybe the weakness is simply a result of quarter-end window dressing by mutual-fund managers to give the appearance they were heavy cash in this weak market, or to reduce their positions in what was hot, and certainly now is not – energy and commodities. Maybe it’s over the Wachovia development. I don’t know. What we do know is the market is going to open down according to futures.
Market Activity for September 26, 2008
What I really love though is how McCain and Obama are acting as though they bolted over to the Capitol to save this whole situation and forced Congress to pass a better bill. That’s a joke.
Then we have Speaker Pelosi and Congressman Frank. Listening to their comments yesterday was also entertaining, although sad, as they don’t seem to really get the magnitude of the situation. Apparently, they chose to play up for the election and blame this entire event on de-regulation. We’ll point out that the two industries that have been hardest hit by this mess – housing and financial services – are among the most regulated industries out there.
Want to place blame? It is about time we begin to focus at the origin of this situation – Federal Reserve monetary policy mistakes – and that which has exacerbated the problem – FASB Rule 157, “mark-to-market” accounting. You can also add on bad legislation such as the Community Reinvestment Act and Congress hauling banking executives up to Capitol Hill in the 1990s to all but call them bigots for not providing loans to lower income/poor credit score individuals. Now these same politicians castigate the financial industry for doing just that – hence much of the sub-prime problem.
In terms of the proposal, it increased from the four pages that Treasury Secretary Paulson laid out 11 days ago to 110 pages by Saturday night, which is why we’ve been arguing for some speed here as time only gives Washington time to stuff the bill with a bevy of social programs. I will say though it could have been much worse. The executive compensation provisions for those participating in the plan are not austere and House Republicans forced the elimination of a provision to devote 20% profits from the plan to an affordable housing fund. This means ACORN would get that money – and those familiar with this group will understand the importance of this elimination.
Public Angst over the Proposal
We keep hearing how the public is so against this plan. Well, of course they are as it has been presented in exactly the wrong way. When Paulson and Bernanke use terms like “bailout” and figures as large as $700 billion it’s no surprise taxpayers grab their wallet to make sure it’s still there. But this is not a bailout. It is an investment in assets that have a higher intrinsic value than the currently distressed market for these securities is valuing. In fact, there really isn’t a market for much of this stuff anyway, which is why a plan to remove these assets from balance sheets will help to unfreeze the credit markets.
For now, anyone with a 750-plus credit score can access credit in a heartbeat. You want to finance a care purchase? Done. And the cost of money is close to zero. Want to buy a house? No, problem. But the risk is if the credit market remains this clogged – banks continue to hoard cash for fear additional write-downs will affect their capital adequacy ratios – even these top–tier borrowers may be affected. And more importantly, there are many small businesses out there that use credit lines to meet payroll, or buy inventory. These credit lines are in jeopardy of being squeezed and of this credit situation persists, even those who have managed their lives responsibly will be harmed. These are some things that should have been explained.
Further, the entire $700 billion may not even be necessary, as maybe $350 billion is enough to stabilize the market. And even if it takes the entire $700 billion, over the next 5-7 years the Treasury will likely net money off of this deal.
Moving on
On the economic front, the Commerce Department reported real GDP was revised down to 2.8% at an annual rate in the second quarter from the previous estimate of 3.3%. The reason for the lower revision was because personal consumption and net exports (the two catalysts to Q2 growth) were revised down. Inventories were also a larger drag than the previous estimate showed.
Looking to the current quarter, it was shaping up to give us a 2.0% growth quarter (that’s in real terms at an annual rate). Consumer activity was going to be weak, but business spending had rebounded very nicely and the production needed to rebuild low inventory levels looked able to offset this consumer weakness. However, with what has occurred of late – specifically the credit market bottleneck – business spending has reversed the encouraging trend of the past three months and residential fixed investment (housing), which looked much better in the second quarter, will be another big drag to growth for the July-September period.
It is still too early to call current quarter GDP, but if the credit markets are not unlocked quick, it will be quite negative.
For several quarters now we’ve heard from the financial press that consumer activity has been weak – the consumer is “tapped out” as they love to put it. Well, we’re headed into a period where the press will see what weak consumer activity actually looks like – the press is so clueless – and if the business side (capital spending) doesn’t show the August figures to be just a respite – the third-quarter GDP figure will not be a good one.
We’ve got a lot of challenges facing us – both endogenous (domestic economy) and exogenous (geopolitical risks) – the latter was true before the credit market locked up; the former really was not.
The only way to meet these challenges is through growth. I know tax-cutters/supplysiders are gun-shy right now with all that is going on but they shouldn’t be. Proponents of lower tax rates should invite the argument from all of those that want to blame the current situation on lower rates, those with the facts can crush this flawed belief.
The best way to revive things right now, outside of doing what is necessary to free up the credit system, is by reviving the stock market. The quickest way to accomplish this is to drive the capital gains rate down to 5% and the corporate tax rate to 20%. This will spark a renewed optimism and confidence, two things that are desperately needed right now, and we can avoid a downturn, maybe a deep one, as a result. We have people proposing higher tax rates, this will not boost tax revenues – kind of difficult for tax receipts to rise when the economy is held back by lower after-tax profits and returns. Lower these rates and tax receipts will boom. Investors will unlock investment they have been unwilling to sell due to capital gains confiscation and increased after-tax profit growth will funnel right to jobs, increasing the tax base.
Looking Ahead
Stocks will have to endure a period of intense uncertainty, and some of this uncertainty may result in a negative outcome.
However, the housing market will eventually flatten out and then slowing return to normal. The question over tax policy may be answered over the next month as the election takes place – assuming it is not too close and thus dragged out for a month as we count and recount votes. The TARP plan will help the economy avoid a crisis situation and if the operation of this plan is not damaged by political meddling the Treasury will be able to pay back what it borrows and then some.
As these issues wane, stocks are set to provide very nice returns over the next several years. No, we should not expect 15% annualized returns. Those days are gone, and it is a good thing because those levels are not sustainable and lead to years of weakness as the market regresses to the mean. But we’ve got a really good shot of 10% annualized returns over the next several years once we get the realities that follow years of poor risk management behind us.
We believe there is a strong likelihood industrial and technology shares present some great long-term opportunities – don’t mistake this for a walk from diversification; everyone must remain diversified and participate in each of the major sectors and asset classes, I’m just laying out where the potential looks the brightest.
The financial services sector has led the economy for more than a decade, but as independent broker dealers have either been gobbled up by commercial banks or the market forced this upon them as internal funding via deposit bases is the way of the future, leverage is going to move from 30-to-1 to something closer to 10-to-1. This means less growth for the industry, but a more responsible and sustainable growth. As this occurs, the more traditional forms of growth will once again lead the way and this means industrials and technology.
Have a great day!
Brent Vondera, Senior Analyst
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