Daily Insight

U.S. stocks slid in the final hour of trading yesterday as concern grew the credit-market situation, which tightened further, will spread into other industries, according to the financial press. I believe that was a concern already, if fact we all know it was the case. The sell-off was more a function of de-leveraging and growing fear, which drives things well-below justified valuations.

The fact that things fell apart to such a degree in the final hour likely suggests the plunge was due to hedge-fund deleveraging. Look at the most liquid stocks, many of which took the worst beating; those that had to sell when redemptions flooded in sold whatever they could. It’s quite likely in my view large-cap stocks will show the largest bounce when the indices rally again.

The Dow moved to the 8,000 handle, closing at 8579 for the first time since May 2003 – the index has lost 16% this week, which I believe is on pace for the worst weekly performance ever. The broad market, as measured by the S&P 500, has plunged 27.4% since September 19 – down 17.2% for the week.

First chart represents yesterday’s session; the second shows the last 18 months.

So much for the thought that removing the short-sell ban would push the indices higher, that was a moronic statement. (The logic was that hedge funds may come back to the market as they would now be able to put on the appropriate hedge – can scrap that idea).

Market Activity for October 9, 2008


I don’t know call me crazy, but maybe the charts below (pay-to-play odds on the election outcome) have something to do with the pummeling too. When investors, especially those of whom may not have a multi-year time horizon, fear that capital gains and dividend tax rates may be jacked higher, I’m going to guess it doesn’t exude a pleasant feeling to say the least.

I’m going to guess, with all that is occurring, specifically the credit markets shutting down and the economic contraction that is quite likely to ensue, investors probably aren’t getting a great feeling about a filibuster-prove Senate either.

The activity in the stock market over the past three weeks and specifically the past seven trading sessions, seems to be pricing in a serious recession. We’re are not headed for a downturn that is worst that anything we’ve seen in 30 years – the typical recession seems about impossible to escape though the longer credit markets remain this locked up; heck, the stock market activity alone will surely push spending lower, whether it be the consumer or business as caution is heightened. However, if the market is pricing in an Obama victory – and much worse an Obama/Reid/Pelosi run government – it means it is pricing in higher tax rates and tariffs (major changes in our international trade agreements). That would mean an economic coma in this environment.

And before any Obama lovers send me hate mail, I’m going to rip on the current administration below – this is not about whom I want to win in this election, it’s about policy and it’s about proper communication.

Another Treasury Proposal

The Treasury Department reported they may begin a program to inject capital into banks, much like the UK plan announced the day prior. The TARP plan includes the ability to do this – using some of the $700 billion to directly inject capital in exchange for currently traded preferred shares to protect the taxpayer. These positions must be sold back to the private sector once the crisis passes, that’s imperative.

As the Editorial Board of the WSJ stated yesterday, when the private sector won’t provide the capital in this current period of fear public-sector funds must be used to throw the life-preserver.

As we touched on yesterday, it is better for Hank Paulson to wait until something is put in place before making statements. The market could give a damn about talk, it wants action.

Besides, everyone knows that I believe a couple of the Treasury’s major plans will work quite well. But they have a problem with communication – a contagion within the Bush Administration. It’s quite likely poor communication has meant a 2,000-point swing in the Dow – instead of losing 1,000 from 9500 it very well should have rallied 1,000 to 10,500.

Take this capital injection, for instance. Do not state such a plan without specifics, the market will think they’re going to bring out the hatchet. Moral hazard? This is something many have worried about with all of this government intervention. Not with these guys.

This capital injection plan can work very well, but Treasury must make it clear that they won’t do what they did with Fan and Fred – destroying the preferred shareholder, many of which were the very banks that need help. Lay the plan out when you bring it, and it must state three things loud and clear with regard to government stakes in preferred stock:

• No voting rights
  
• Not senior to any other preferred series (so the currently held shares won’t be blown out – don’t penalize shareholders here; support them)
  
• Get out ASAP (as soon as this crisis has waned)
  

Commercial Paper

Total commercial paper (CP) outstanding fell $56 billion in the week ended October 8, which puts the total decline over the past four weeks at $264 billion -- total outstanding is $1.55 trillion.

Financial company CP fell $42 billion and is down $175 billion over the past month – financial CP stood at $825 billion a month ago, that $175 billion decline marks a 21% plunge. Non-financial CP outstanding rose $3.6 billion in the past week to a total of just over $200 billion, that’s the bright side.

The dark side is that financial and asset-backed CP continues to decline rapidly and signals the need for the Fed to get its Commercial Paper Funding Facility operating in quick order.

On the economic front, the Labor Department reported initial jobless claims fell 20,000 in the week ended October 4 – although, the figure remains elevated due to the hurricanes that tracked through the Gulf in September. The report showed these weather-related events added 17,000 in jobless claims so adjusting for this claims would have dropped substantially.

The four-week average of claims rose 8,250 to 482,500.

The hurricanes resulted in an increase of 50,000 in claims in last week’s data, but the overall figure only rose 2,000 – so plenty of distortions then as well. This is good news but we should be prepared for claims to remain elevated as small business in particular has been hurt by the credit market freeze up.

Continuing claims remain elevated, the highest level since June 2003 – which was three months before the labor market began to turn around coming out of the 2001 downturn. Thirty-five states and territories reported an increase in new claims, while 18 reported a decrease. These aspects of the data likely underscore the deterioration in the job market we’ve seen of late.

The G7 will convene this weekend and I’ll go out on a limb and say they’ll come back and have decided on two things:

One, they;ll state global governments will guarantee lending between banks.
Two, there will be a coordinated effort to suspend mark-to-market accounting for securities that currently have no market. (The U.S. has proposed this but I do not believe it has become offical. Besides the standard needs to be change on a global scale for conformity’s sake)

These two events should bring inter-bank lending rates lower and a willingness to lend to one another. At which point businesses, specifically small business, will begin to see capital and credit flow in their direction again. I’m still waiting for a tax-rate response as well, which would provide a big boost to confidence – to offer nothing in this regard is a major mistake in my view

Hang in there and have a great weekend!

Brent Vondera, Senior Analyst

Daily Insight

What a difference a year makes. It was a year-ago today the Dow Industrials Average and S&P 500 indexes touched their all-time high – 14,164 on the Dow and 1565 on the S&P 500. Nine-trillion dollars in stock-market value was created during the bear market that began in the spring of 2003 to that peak, as measured by the NYSE Composite – today that rise in stock-market wealth stands at 44% of that figure, 4.16 trillion.

U.S. stocks bounced around again yesterday – and the swings were significant – but we gained momentum going into the afternoon session and appeared poised to close strong. But then Treasury Secretary Paulson stepped to the microphone and…well, the same thing happened that occurs just about every time a government official open his mouth, the rally fizzled. (And no, I’m not being sexist here because the pronoun is correct; I won’t disparage the other gender because when FDIC Chair Sheila Bair speaks the stocks market does not retreat.)


I’ve been pretty hard on Paulson in the past – he’s weak on the dollar, failed to convene the G7 as the FOMC was digging a larger hole for the greenback and has offered zero with regard to a tax-rate response to this entire mess – big mistake.

But what he’s proposed with the TARP plan has a great shot of freeing up the credit markets – assuming the auction does not end up being rigged, can’t rule that out; this is the government we’re speaking of. Really though, you’ve got TARP passed and signed, please don’t step to the mic. again until you’ve got something constructive to say and your ducks are in a row to buy, buy, buy.

Market Activity for October 8, 2008 At midnight the short-selling ban expired, that ban pertained to something like 800 stocks, and conventional wisdom may assume this will result in more pressure for stocks. Not sure about that though, the indices may rally on the news as hedge funds come back in to buy now they have more freedom with putting proper hedges in place. These market participants may have sat out while the ban was in place.

IBM announced quarterly results earlier than expected, stating operating earnings rose 22% last quarter and margin growth was strong, widening to 43.3% from 41.3 a year ago. Revenue growth was a little light, surely the woes in the financial sector have caused some issues, but it was a good decision to pre-announce in this environment lest rumors take over and crush your stock.

Overall earnings will be weak for the quarter, no getting around that, but maybe tech-land will be stronger than most expected.

On the economic front, the National Association of Realtors (NAR) stated pending home resales unexpectedly rose 7.4%, as the median price of existing homes fell sharply in August.

One has to expect home sales to fall further, especially with how locked up the credit markets are, but mounting foreclosures are helping the sales data and this may help to offset the credit-market issues – pending home sales are an arbiter of the direction sales will take over the subsequent two months when these contracts close.

By region, pending sales were up 2.3% in the South, 3.6% in the Midwest, 8.4% in the Northeast and soared 18.4% in the West.

Digressing

I ran across an article Monday night that stated how the slide in home prices has left nearly 16% of homeowners with a higher mortgage than the home is currently worth. (I’m not sure all of this is because of the fall in home prices, as a decent percentage of these people have been in their current home for several years – and home prices are higher going back to mid-2004 --, but rather because they took advantage of home-price gains in previous years to refinance and take cash out. Others of course put no money down and so it doesn’t take much to go underwater – it is pathetic though to see so many just walk away, not even trying to make the payment – as if the price of the property will not rise over the longer-term)
Anyway, the article points to the need to offer programs to these individuals to keep them in their homes.

No. What we have here is a total neglect of obligations – complete irresponsibility.

These people must not be bailed out in a direct way – of course a series of government action will bail those that made really bad decisions in an indirect way, but it may also insulate the rest of us from going down with them. The Treasury’s TARP program will offer indirect assistance to those that made bad choices, but this program is essential so that those that have lived their lives responsibly are not harmed by a bevy of mistakes made by the Fed, Congress and individuals themselves.

The most effective solution to this situation is three-fold as I see it:

• One, TARP is essential. These troubled assets must be removed from bank balance sheets.



• Two, the SEC and FASB must at least modify mark-to-market accounting – and hopefully kill the wretched rule, that is FASB rule 157.



• Three, broad-based tax cuts are imperative. Reductions in capital gains, dividends, labor income, repatriated income and corporate earnings will spark growth, increase earnings and after-tax income, rally stocks, bring more capital home, boost tax receipts, and promote jobs.

Many continue to miss the fact that broad-based reductions in tax rates do result in more tax revenue – the evidence is there; one only needs to review what occurred in the 1960s, 1980, late 1990s and the current epoch, save the last year as corporate profits have been hurt by financial-sector woes, a rebate check scheme immediately added $175 billion to the 2008 deficit and everything that has occurred since.

But we shouldn’t forget that the three fiscal year running 2005-2007 saw the largest rise in tax revenue ever, jumping $785 billion in that three-year period. Let’s not forget, the 2007 budget saw the deficit narrowed to just 1.2% of GDP from 3.9% in 2004 after the downturn of 2001 and trillion dollar hit to the economy from the 9/11 attacks.

Cutting tax rates in a broad-based way increases revenue for two main reasons:

One, with regard to capital gains more investors are willing to pay the tax at a lower rate – we all know this story. Further the after-tax return expectations that result push stock prices higher, which results in additional gains – lower dividend tax rates have the same result.

Two, lowering income tax rates means higher after-tax income, which promotes growth. Also, and what many fail to acknowledge, is that two-thirds of the top tax bracket is made up of small businesses, and as after-tax profits rise for the largest job creator within our economy they hire more – thus increasing the tax base.

So lower tax rates are vital to growth, both for the private sector and in terms of tax revenue. We face many challenges over the next couple of decades and growth will be essential to meet those challenges.

Have a great day!


Brent Vondera, Senior Analyst

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

Daily Insight

U.S. stocks took a beating, even as they pared losses in the final hour of trading, as global equity indices were pounded the night before and that flowed into our trading session. Concerns that the credit market seizure will continue to spread and have larger ramifications than just the typical economic downturn continue to grow.

I’m not willing to share this belief just yet, but we have to get these troubled assets out of the way, or banks will continue to hoard cash. Personally, removing current accounting rules that make zero sense, and in fact results in a death spiral we’re watching play out, would do the trick but apparently not all share this view. As a result, the assets must be removed and housed by an entity that has the resources to hold these assets through the current crisis – and obviously that is government – I’m not one that normally embraces intervention, but in this case it seems very much necessary.

The broad market, as measured by the S&P 500 was down 8.3% at it worst level yesterday but stocks rallied 4.8% from that nadir in the final hour of trading. The NYSE Composite plunged 9.12% with an hour to go, but jumped 5.0% in the final 60 minutes – the index lost $760 billion in market value.


Market Activity for October 6, 2008

This latest decline has sent the Dow Industrial Average back to where it traded in the spring of 2005. The S&P 500 hasn’t seen this level since December 2003 – ouch!

Credit markets remain extremely frozen. As most readers know, the following charts illustrate this point. These graphs show the level of risk aversion in the marketplace – put simply all you really need to know is when they jump to this degree, it ain’t good.

For new readers, the TED Spread is the difference between three-month LIBOR rate (an interbank lending rate) and the rate on three-month Treasury bills. (Banks are charging more as they are unwilling to lend for anything longer than overnight and three-month T-bill yields have plunged as many run for the safety of the Treasury market.



And speaking of the credit markets, we’ve talked about how everything suddenly changed on September 15 when Lehman went down; this is the date credit markets tightened up, and outside of a two-day blip when the TARP plan was initially laid out, hasn’t eased.

For instance, business spending had been on a very nice upswing for three months, but came to a screeching halt in September. Firms obviously have the resources to continue to buy equipment, but a high level of caution has caused a respite.

A prime example of this is SAP AG’s latest earnings report. The software giant had offered bullish comments up until two weeks ago, but yesterday explained that things changed dramatically in the back-half of the month. The firm cited that customers have put orders on hold amid the global financial crisis. The good news is this is not for lack of capital, but credit markets have to free up or activity is going to remain subdued at best.

Another good indication of how quickly things have changed is news Bank of America cut its dividend by 50% after the bell. One can only trust these managers as far as you can throw them these days, but CEO Ken Lewis has been pretty straight up over the past year. The fact that he stated there was not reason to cut the dividend just a couple of weeks ago when they bought Merrill Lynch shows how quickly things have deteriorated within the financial markets

On Fed Action

One reason being given for yesterday’s dramatic sell-off – prior to that late-session rally – is the market had expected a coordinated rate cut by the various central banks and when there was not an announcement of such a plan by mid-day, the market came under intense pressure.

What the Fed did announce is that they will be doubling their TAF (Term Auction Facility) program to $900 billion. This is a new program put in place last December that allows the Fed to accept a wider range of collateral and provide increased liquidity. This is a good step, although it didn’t do much to unfreeze the flow of credit. It’s a step though.

On this topic of a coordinated rate cut by several central banks, I wouldn’t hold your breath. For one, our Fed has tried to bring the ECB (European Central Bank) along on this before and they’ve been obstinately opposed. Secondly, the Fed is now offering interest on deposits at the Federal Reserve – this is what many term quantitative easing. It’s essentially a stealth rate cut.

Banks must keep a required level of reserves with the Fed and sometimes there is an excess amount. Banks will now be paid interest on both required and excess reserves – interest on those excess reserves will be the targeted fed funds rate (2.00%) minus 0.75 on those excess reserves. So, what they have done is effectively moved fed funds down to 1.25%.

This serves two purposes. One, it gives the Fed greater scope to use its lending programs by expanding its balance sheet. They will have more firepower to shoot liquidity to where it is most needed. Two, it keeps a floor on fed funds. (During times of big liquidity injections, such as now, banks are left with excess reserves and thus are willing to lend this money overnight for an amount that is often much lower than the target the Federal Reserve sets – this is why we’ve seen the rate trade at 0.50% on occasion over the past three weeks. See below:


By paying interest on excess reserves at the Fed it sets a floor on fed funds – why lend it out overnight at 0.50% when the Fed is going to pay you 1.25%? Now the Fed is free to pump massive amounts of liquidity without pushing fed funds to levels that would spark inflation – well, at least not as severe as would be the case otherwise. I still believe we’ll have an inflation problem to deal with when things return to normal, but it is obvious that’s a secondary concern right now.

On a more optimistic note, there are some really compelling valuations and opportunities in stock-land – if anyone cares to hear about it in this environment.

There seems to be a marvelous opportunity in energy here; many names in this group are trading at lower multiples than they did in 1998 when oil was $10 per barrel.

Same is true for defense, industrials and medical equipment markers in most cases – awesome opportunities. Same can be said for technology shares.
Of course, we may have to wait a while for these opportunities to result in a sustainable upswing, but patience is key for stock market investing – a reality that has become obvious to all over the past several years.

While diversification is key – one must not abandon positions in many economic sectors and asset classes, stocks in the aforementioned industries may lead the economy once again. We are coming off of a 10-15 year period in which financials led the economy, now that leverage within the industry will move from 30 times to a level that is more appropriate and sustainable the more traditional industries appear positioned to lead the way

Patience will be needed though as locked up credit markets cause quick deterioration and some pretty substantial damage to both domestic and global growth has occured.

Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks dropped Friday after a wild ride that saw the broad market advance 3.4% during the morning session only to fall 4.7% from that intra-day peak – as the chart below illustrates.

The morning session’s euphoria was based upon the strong likelihood the TARP plan would pass the House, but once it did the benchmark indices fell sharply as the market focused on the September jobs report and the fact that there is no way to prevent a recession at this point. The effectiveness of the TARP plan, along with more traditional policy responses, will determine whether the downturn is mild or severe – more on that below.


The S&P 500’s performance last week was the worst since the 2001 terrorist attacks – the index lost 9.3%. The NYSE Composite – one of the broadest looks at U.S. stocks – fell 10.16% last week, also just slightly less than 11.24% decline the week stocks opened after the 9/11 attacks. People are beginning to realize that the TARP plan is not about “bailing out Wall Street” – as so many in the press have led people to believe – but about stopping the damage from spreading to everyone else, most of whom have lived their lives in a responsible way.

The credit markets remained locked up Friday, but we didn’t expect this to turn on a dime simply because the government’s rescue plan was passed and signed. It will take some time, but as the assets that are clogging things up come off of the balance sheets, things should improve. The extent of the improvement will determine the degree and duration of the downturn.

Market Activity for October 3, 2008
The Citigroup/Wachovia news got interesting Friday as Wells Fargo offered to pay $15.1 billion for Wachovia, or $7 per share. This gets tricky because Citigroup supposedly has an exclusivity agreement that forbade Wachovia from talking to another firm.

Wells clearly saw the TARP plan was on its way to passage and since they would be able to unload the troubled assets of Wachovia as a result, decided to throw in their bid – a far superior deal to botht he shareholder and the government. Under the Wells deal shareholders would get $7 per share (clearly still largely wiped out from where the stock had come from but a major improvement to the $1 per share from the Citigroup deal. Further, the FDIC wouldn’t be on the hook, which was not the case with the Citigroup workout.

Where it seems to stand now is some sort of split up between Wells and Citigroup based upon geographic lines.

On the economic front, the Labor Department reported 159,000 payroll positions were lost in September, which is a figure that is more in line with the typical labor market downturn – prior to this latest number, as most readers know, the monthly job losses had been mild from a historical perspective.

As the chart below shows, we normally see monthly jobs losses that move below the 200,000 level and while September’s data remained above this mark, it’s the closest we’ve come to that level of deterioration thus far.


Year-to-date, the economy has shed 760,000 payroll positions, or 9.5% of the total created since 2003. This is beginning to become significant and considering how locked up the credit markets have become over the past three weeks, one must expect this figure to get worse.

Basically every industry of last month’s employment report looked bad, except – as has been the case throughout this downturn in jobs --, education and health services. These segments have added 451,000 positions year-to-date.

Construction and transportation have been among the hardest hit as the unemployment rates for these two industries jumped from the year-ago period. For construction, the unemployment rate increased from 5.8% in September 2007 to 9.9% currently. The unemployment rate for the transportation industry increased from 3.9% a year ago to 5.8% last month.

The segments (not to be confused with industries) that have been hardest hit are teenagers – where the unemployment rate has risen from 16.0% a year ago to 19.1% and the self-employed – where unemployment has increased from 2.8% to 3.9%,

Overall Economy

In terms of the overall economy, everything has changed over the past three weeks – the turning point was when Lehman went down on September 15; the credit markets froze up.

We’ve gone from a situation in which things were significantly stronger than most had portrayed -- credit continued to flow (of course, less available than before but with much more appropriate standards), business spending had bounced back in strong fashion, factory activity remained upbeat and incomes were rising at a nice clip all things considered -- to an environment where most of these things have shut down. (Income growth remains on a nice trend – although flat in real terms due to high inflation --, but these other aspects have reversed course.)

Now we have job losses picking up to recessionary levels and what appeared to be shaping up as a 2.0% real growth quarter just three weeks back has changed to something flat or worse currently.

Government policy needs to go on the attack both from a perspective of dealing with the troubled assets that have led to the freeze up of credit distribution channels and purely from a framework of economic policy.

The TARP plan has now been passed and signed and if done right, and relatively free from Congressional intrusion, this auction process should work to create a market and pricing mechanism for these assets. We’ll note, while the government is pretty inept at managing just about everything, they are very good at holding auctions and have a good history of the type of auctions that will be held for these assets, from what I’ve learned about the issue. Moreover, they will be able to finance this plan at very low interest rates, increasing the likelihood Treasury will make money off of this plan.

Along with that plan, we must eliminate FASB rule 159 (mark-to-market accounting) especially with regard to the basis of capital adequacy ratios – and the TARP plan does have a provision to look at this and modify it. From here, we must net present value these assets. This will include in the valuation process the cashflows that run off of these assets, something rule 159 ignores.

(We see news broke last night that Europe is beginning to take action as well. They are now providing blanket guarantees on deposits and are looking at doing away with mark-to-market as well. Just to clarify, mark-to-market is used in many circumstances, what we’re talking about here is the appropriate basis with which to determine capital adequacy for financial firms. On this topic, mark-to-market is nothing but harmful.)

On the economic policy front, it’s time to stop playing around and drive tax rates down across-the-board. In basketball terminology, it’s time for “40 minutes of hell.” Cut fed funds further? Please. We’re talking about substantive action here and only tax policy can deliver the big-bang boost that is needed.

I do not express the urgency of this because of the 159,000 job losses for September, but rather because the frozen credit markets will cause this figure to become much worse. Small businesses will be eliminating many more jobs – there is no getting around this for now. What we must thwart is a spiral of job-market deterioration that will ensue if the flow of capital and credit is not freed.

In order to spark activity in the face of current caution with regard to large businesses and lack of short-term credit for the small businesses we must drive down the income tax rates – two-thirds of the top tax bracket is made up of small business – and the corporate tax. Drive these rates lower and you expand after-tax profits, which leads to more jobs and a larger tax base – more government revenue. (The benefit to the private sector would occur very quickly. In terms of government revenues, it will take a year to begin funneling in, but this will result in substantially more receipts that if we were to do nothing in this regard.)

Further, the repatriated tax must be eliminated. This will bring capital that is currently residing overseas to escape this tax to come back home. After a year or so we can get this rate back to 5% or so, but the 35% that is currently levied on these funds is not helpful.

The capital gains rate must at least be halved. Igniting the stock market right now is essential both from the standpoint of confidence and from an overall net worth scenario. It will take some time for the job market to improve again, but by igniting a stock market rally consumer activity will begin to pick up as both confidence and wealth are boosted. In terms of government revenues, this tax rate change will be felt immediately as investors unlock old investments – willing to pay this lower tax – and will move those funds into new investments.

If these actions are taken, we can thwart what a reckless monetary policy has wrought – particularly speaking of the FOMC’s decisions during the 2003-2005 period – and we can escape the worst of this situation. And once we get past this, tax rates and overall policy will be positioned to help the U.S. economy reach its intrinsic growth potential.

I realize this all seems unrealistic at this time. During this election cycle class warfare has hit a crescendo, but as more and more people see how this situation affects everyone, now is exactly the time to propose such measures.

Have a great day!


Brent Vondera, Senior Analyst