Daily Insight

U.S. stocks endured another harsh session yesterday after beginning the day up 170 points (for the Dow), but plunged from that intra-day peak by 680 points. We talked about a coordinated rate cut by various central banks yesterday, many seem to be blaming yesterday’s weakness on the fact that this did not occur.

Well, literally as I type, the Fed, Bank of England and ECB (European Central Bank) have just done so – all cutting their benchmark rates by 50 basis points, or one-half of one percent. Frankly, I’m not sure what a rate cut does, if banks are unwilling to lend credit spreads will not ease. As I look, these spreads remain wide and in fact the TED Spread, three-month LIBOR and LIBOR OIS are all wider, or higher in terms of 3 mos. LIBOR, than yesterday.

However, stock-index futures have turned around nicely; let’s hope we can hold onto those gains as the actual session progresses.

Market Activity for October 7, 2008

Another Fed Facility

The Federal Reserve continues to add liquidity and shoot it to where they see its most needed. Yesterday they announced creation of the Commercial Paper Funding Facility (CPFF) in which to purchase commercial paper (CP) and create a liquidity backstop for U.S. issuers. The facility will directly purchase three-month unsecured and asset-backed CP through April 30, 2009.

Outstanding CP has shrunk to a three-year low, interest rates on this short-term funding used by businesses has risen substantially and an increasingly high percentage of outstanding paper must be re-financed daily, according to the Fed.

The CPFF should help to improve confidence in this very important segment of the credit markets since CP investors will know the Fed stands as the purchaser of last resort in event an issuer has difficulty rolling paper.

Yields on top-rated overnight CP dropped 0.74 percentage point to 2.94% on the news – this is used to finance day-to-day operations.

On the economic front, the Federal Reserve released their minutes from the September 16 FOMC meeting. These are things we talk about each day, and since the minutes pertain to what occurred largely in July and August it’s a bit outdated, but worth mentioning nonetheless.

• Economic activity decelerated considerably in recent months.
  (Actually, I would re-phrase this. The economy was rebounding pretty nicely. Consumer spending was weak, but the business side of things looked very capable of offsetting this reality – business spending was on the rebound. However, business expenditures came to a halt in the back-half of August after three-months of nice gains. September, even though we do not have the data yet, will surely prove to be very weak as credit conditions locked up and firms either became cautious or saw funding dry up.)
• The job market declines accelerated, according to the Fed.
  (And it got worse in September, which the Fed minutes did not cover. Prior to September the job losses were mild, but moved to a level that is more in line with the typical job-market downturn.)
• Consumer spending has weakened.
  (And we can expect this to remain the case for a couple of quarters. The numbers may appear flat, but adjusted to inflation they will very likely remain soft).
• Inflation rose rapidly in July, but edged lower in August.
  (The Fed has bigger problems right now, but they should be careful with these comments. Inflation remained elevated in August by a variety of measures. The PMI and ISM surveys (factory-sector indices) and consumer level gauges remained high – even if down from extreme elevation. Plus, despite a dramatic decline in energy prices, producer prices rose 9.6% year-over-year in August (latest data) and core intermediate goods – goods excluding energy that go into producing finished product -- accelerated in August to 12.5% year-over-year).
• Credit conditions deteriorated
  (We know this all too well).

And speaking of credit, the Fed reported that consumer credit declined in August for the first time since 1998 – the previous period of credit-market chaos.
Credit by this measure, which includes both revolving (credit cards) and non-revolving (auto loans) fell $7.9 billion in August, or 3.7% at an annual rate. (This data does not include mortgages or home-equity loans).

This reduction illustrates the credit crunch that truly began that month, one wonders how much the figure will contract when the September data is released. Some of this isn’t all that bad as certain aspects of debt need to come down, as consumer credit growth has outpaced the rise in disposable income by eight percentage points since the end of 2002. Not a terribly big deal, but you really don’t want credit outpacing income growth. I think it’s safe to say this game is up for a long time.

Further, in light of all that has occurred, it is safe to say it’ll be a long time before investors take on substantial levels of risk without correctly pricing it in. This of course is a result of monetary policy mistakes as a lot of investors sought extra yield as Fed policy was recklessly easing even as the economy was hitting on darn-near all cylinders – we’re talking about the mid 2003-2005 period. When the history is written the Fed will bulk of the blame for this one.

Downward Pressure

The downward pressure on stocks weighs heavily on everyone. Since hitting an all-time high a year ago tomorrow, the broad market is off 36% -- 20% since September 19.

A couple of things on this:

One, we’ve got to suppose that many understand things have shot well too far to the downside. One looks around and sees an ocean of stocks that offer healthy-to-strong earnings growth (this comment is not based on expectations but on many years of bottom line growth) and trade anywhere between 8-12 times earnings. And look at the indices here and the dividends yields that are offered. The S&P 500 carries a yield of 2.99%; the NYSE Composite carries a yield of 3.92% at yesterday’s closing price; the Dow Average yields 3.36%. These are not only strong yields for entire indices to offer in a very very low interest rate environment, these yields help to boost annual returns for those interested in looking past the current mayhem.

But most do not seem willing to remain invested – and I’m talking about money managers; it’s difficult to explain to clients why they shouldn’t be at 50% cash in this environment; it’s much easier just to sell – as they worry more about their jobs than doing what is right for clients’ long-term perspective. But this is a sprinter’s view; investing is a marathon.

Two, the S&P 500 is back to its October 2003 level, yet the index is still higher by 24% since March 2003. The NYSE Composite is back to its August 2004 price, yet up 43% since March 2003.

You see where I’m going here. This points out that when stocks swing back they do so in a dramatic way. Even when the S&P 500 hit its peak a year ago -- it was up 95% from when the market turned around in March of 2003 coming out of the tough 2002 period – half of that gain occurred in the first 11 months of the new bull market. And I can tell you from memory even well into 2003 there were a lot of people hesitant to step in. Point is you wait for when it feels good and you miss out on a lot.


You don’t sell on panic here; you remain invested, and for the current situation it does make some sense to wait and watch for what the credit spreads signal – when they narrow, that should be a green light to step in with money on the sidelines.

Of course compounding the market’s issues are two presidential candidates that find it easier to castigate capitalism – as if distortions are never supposed to occur – than to offer fundamental solutions. Instead, they should lay blame with the Fed, government policies that demanded more sub-prime lending, individuals that made poor decisions and insane accounting rules and offer solutions such as growth-inspiring tax rate responses, as we touched on in Monday’s letter.

Hang in there and have a great day!

Brent Vondera, Senior Analyst