Daily Insight

Rejected!

U.S. stocks plunged yesterday – marking the steepest one-day decline in the S&P 500 since the 1987 crash – after the House rejected the $700 billion plan to unlock the credit markets and keep this situation from becoming an all-out seize up of the financial system. The NYSE Composite Index lost twice that amount yesterday -- $1.5 trillion.

Many wondered what would occur if this bill were blocked, and we’re finding out the market didn’t like that decision very much. We got a sense of this after allowing Lehman Brothers to go down; we now know it would have been better to put them into Conservatorship as well. The day Lehman went down is when the credit markets locked up, and led to AIG’s demise. Fact is the entire financial system is intensely interconnected due to the $60 trillion in derivative contracts. Mark-to-market accounting exacerbates the situation as troubled assets are written down further as these derivatives fall in value – hence the cash hoarding by financial institutions.

While the stock market gets all of the attention, and days such as yesterday are certainly unpleasant events, a decline of this magnitude is not significant over a longer-term perspective – besides this is what markets do on occasion. What is occurring in the credit markets is the main issue at hand; besides, until the credit markets normalize the stock market cannot stage a sustained upswing. The bill to take troubled assets from balance sheets, replace them with capital and sell these assets off in an orderly way is pretty vital to the financial system right now. I assume the members of Congress are getting this message as we speak. I assume all of those calls demanding not to support this bill have reversed course after yesterday’s market message.

Market Activity for September 29, 2008

And allow me to stop for a moment just to put these types of down days in perspective. While I say this is more about the credit markets than the stocks market, the latter is the one that gets the attention and has the most affect on individuals as 60% of the country owns a 401(k) account. Not that it may register very well on a day like yesterday, but we find it appropriate – after a one-day decline of 8.8% -- to illustrate what a one-day shellacking that is nearly three times worse (the 1987 crash) looks like from a long-term perspective.

Below is a 25-year look at how diminished a 20% crash becomes over time. (As an aside, nice double-top there by the way. This is what occurs when stocks go gangbusters as they did in the latter-half of the 1990s, it takes a while to revert to the mean. But over the past several years after-tax corporate profits have significantly outpaced the increase in share prices – up 109% for profits vs. 40% for stocks -- and this sets up for a strong multi-year run.)


And if 25 years is too long for some, here is what the same decline looks like over a 10-year period – the 138% rise over this period does minimize what was a chaotic day back in 1987.


Back to the bill though, it is unacceptable that Congressional leaders on both sides do not have the clout or ability to persuade lawmakers. Of course, the market has taken over as the lead negotiator.

One-hundred and thirty-three Republicans voted against the measure and 95 Democrats shot it down as the bill was blocked 228-204. One has to assume that the TARP is dead, you never know, but that’s what I’m assuming. To get more Rs to g for it, you’ll lose Ds. To get more Ds you’ll lose Rs.

I wouldn’t be surprised to see the Democrats come back on Thursday and pass their version of the bill. Of course this will include another Keynesian-style rebate check scheme, cramdown (allowing bankruptcy court judges to determine loan interest rates) and demanding union members be included on the boards of firms that participate in TARP – these are the things they tried to push into the bill last week. That’s a no go. And for the Republicans, they want to set up some insurance fund for these troubled assets, which I believe would be ineffective for the current situation.

On the bright side, maybe it was saddled with too many restrictions that may have been met with limited participation and we’ll get something better as result. I will state though we didn’t see much good that could come from dragging this bill out – not with these people around, and now we see how the game-playing certainly did not help things.

Moving to the credit markets, the Federal Reserve announced a large increase in its size of the 84-day TAF (Term Auction Facility, or one of the Fed’s tools to inject liquidity that we would prefer over jacking fed funds lower) to $75 billion from $25 billion. This increase will raise the supply of 84-day TAF to $225 billion from $75 billion. Total TAF credit (both 28-day and 84-day) will be increased to $300 billion from $150 billion.

The chart below is one indication that banks are hoarding cash and thus effects credit availability.


The yield on the three-month T-bill hit 35 basis points (one-third of one-percent) yesterday; nothing else explains more clear the level of fear – the massive move to the safety of the Treasury market has been stunning. In fact, the 10-year Treasury note yields just 3.63%. Too bad Congress failed to pass TARP. They could have borrowed the funds needed at sub-4% and over time paid back the Treasury at least what it cost. And this doesn’t even take into account the cashflows that run off of these assets.

Enough of that though; we must get serious. Didn’t like the $700 billion TARP, hey? Ok, here’s the solution. The president needs to come out and say we are moving forward by eliminating the mark-to-market accounting rules that were implemented in November 2007. The new standard will be to a net present value basis that discounts the cashflows of these assets. Or, at the least a five-year rolling mark-to-market – as some have suggested. Hand the SEC Chairman a pen and tell him to sign it. Done.

At the same time eliminate the repatriated tax (the 35% tax levied on foreign income made by domestic institutions when this capital is brought back into the U.S.). It’s an economically inane law anyway. This will bring an enormous level of capital bank into the country. Further, if needed, eliminate the capital gains tax on assets that currently find no bids, such as these CDOs that are clogging the system – this is an idea we raised six months back.

The elimination of mark-to-market (FASB rule 157) does not depend on Congress. This will buy time, as it’s a game changer, for banks while Congress fights it out over the repatriated tax and capital gains tax on troubled assets.

Moving along to yesterday’s economic data

On the economic, the Commerce Department reported personal income rose 0.5% last month and spending was unchanged. The personal consumption expenditures (PCE) index -- the inflation gauge tied to the personal spending report -- showed inflation remains sticky even with energy’s huge move lower. For those readers that understand inflation is a monetary phenomenon you’re surely not surprised.

Let’s look at this data one by one:

The 0.5% rise in personal income last month is a good reading as it was propelled by wage and salary income – a very nice thing to see. Rental income, dividend income and interest income also posted healthy results. Proprietor’s income showed a 0.8% decline last month and this corresponds with what has been hurting the jobs figures of late – after several years of big gains in self-employment we’re seeing the persistence of the housing downturn take it toll on this segment.

From a year-over-year perspective, incomes are holding up much better than we had anticipated. They are being harmed by current levels of inflation, but with the labor market weakness – even though the monthly job losses are relatively mild as we keep discussing – these figures are quite remarkable. Total compensation is up 4.1%, wages and salaries are up 4.2%, dividend income has grown 8.1%. Personal income as a whole is up 4.6% and disposable income (after-tax income) is up 4.8% since August 2007.

On spending, it came in unchanged for August after rising 0.2% in July. The level of real personal consumption (referring to the segment of consumer activity that shows up in GDP) stands 2.7% below the average for last quarter. As we’ve mentioned a couple of times now, consumer activity will remain weak for a couple of quarters and this data backs that up. A decline in employment and lower asset prices are just too much and are affecting the consumer.

On the inflation gauge, again the PCE index, this corroborates what other inflation indicators have suggested – inflation remains sticky and has at least become partially embedded.

The PCE rose 0.2% in August, and from the year-ago period barely budged, coming in at 4.5% after a 4.6% reading for July. The core rate, which excludes food and energy, actually accelerated to 2.6% from 2.5% in July.

The Fed has based their inflation expectations on two things – both are flawed Keynesian models.

One, their Phillips Curve-type analysis tells them that simply because the unemployment rate has risen that inflation must come down. This is not a tautology just as the view that inflation must rise simply because the unemployment rate dropped to a certain level is not a given.

Two, they bet that the price gauges would decline along with energy prices. This has not occurred either. Money supply – whether we look at MZM (money zero maturity) or M2 (which includes bank demand deposits) is growing much faster than output, or nominal GDP. This is inflationary. Now, the growth in these money supply measures have eased over the past three months, but one cannot expect this to effect inflation on a dime. Hopefully it will help to ease price pressures a few months out.

For now, the Fed obviously has other issues and providing liquidity to mostly frozen credit markets is their chief priority currently.

This morning we get the latest manufacturing survey from the Chicago region and the S&P Case-Shiller Home Price index.

Have a great day!


Brent Vondera, Senior Analyst