"Geithner Gotcha"

Investment Strategy: "Geithner Gotcha"

By Jeffrey Saut | 25 November 2008

"In short, it comes down to a simple bet: Either markets are correct, policy easing will prove to be ineffectual and we are looking at a deflationary depression (in which case a broad spectrum of economic thinking is wrong— from Keynes to Friedman). Or markets are wrong; the reflationary policies of the world’s financial leaders will mitigate the credit crisis and put the global economy on the road to recovery (by mid-2009 if past indicators are correct). Our readers know that we bet on the latter. However, that does not necessarily mean that we advocate piling into stocks. There is simply so much money to be made in the credit markets that the risk/reward scenario in equities cannot compete. Indeed, in credit markets you do not even have to bet whether we are facing a deflationary bust or not— you just have to believe these companies can repay their debt. And, excluding financials, there are still a lot companies that remain cash-flow positive with strong balance sheets and whose likelihood of bankruptcy is very small." …GaveKal

As the astute GaveKal organization notes, "Either markets are correct, policy easing will prove to be ineffectual and we are looking at a deflationary depression, or markets are wrong (and) the reflationary policies of the world’s financial leaders will mitigate the credit crisis and put the global economy on the road to recovery. Our readers know that we bet on the latter." Obviously I agree with GaveKal’s views, and while there is no question that the current financial fiasco is likely the most serious since the Great Depression, this is NOT the Great Depression. To be sure, the economy is nowhere near as impaired as it was back in the 1930s, as the following quip from Merrill Lynch makes clear:

"This is not the 1930s all over again. The government and the central banks are not sitting idly by as banks fail this time around. We have automatic stabilizers in place like welfare and unemployment insurance. Back in the 1930s, 40% of Americans lived in rural areas— a dust bowl today wouldn’t exactly have the same impact on today’s highly urban economy. Today’s labor market is far more flexible and productive. Back in the 30s, GDP plunged 27%, real private investment collapsed 87%, consumer spending contracted by 41%, industrial production plunged 54%, personal income fell 25%, the unemployment rate soared to 30%, and half the nation’s homeowners defaulted (not 10%), and 10,000 banks failed; and as over-saturated as we may be today, we don’t have that degree of excess capacity in the financial sector. Not that we are trying to sugar-coat the situation, but we need to put the current situation, which is an outlier, into perspective. It may be something more than just a garden-variety recession, but it is not the Great Depression II."

While not the Great Depression, we do think there will be a whiff of deflation over the coming few quarters. Recall, however, what Chairman Bernanke said in his 2002 speech about fighting deflation, as reprised by Merrill Lynch:

"Checking against Chairman Bernanke’s playbook for dealing with deflation we see that in 2002 he noted that the Fed could 1) target long-term yields, 2) purchase Agency debt, 3) offer direct loans to banks using a wide range of collateral, 4) purchase foreign bonds and municipals and, as a last resort, 5) use foreign exchange rates. Given that he has done numbers 2 and 3 and that 5 would not seem to be helpful in the current environment, it is important to consider the possibility that the Fed might choose to explore, as he put it, ‘A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceiling for yields on longer-maturity Treasury debt.’"

Plainly Ben Bernanke is using, and/or considering, all the tools in his "toolbox" to dissuade the economy from plunging into a deflationary depression. Still, it appears that a pretty severe recession is in the works with 4Q08 GDP tracking toward a negative 5% reading; and, GDP is unlikely to turn positive before the second half of 2009 [[that "infamous second half" again…: normxxx]]. Adding to the deflationary, and recessionary, environment consumer prices (CPI) registered their largest monthly decline in the 61-year history of the data, ditto the PPI, unemployment claims leaped to their highest level since 2001, housing starts sank to their lowest level ever, permits for new houses also tumbled to their lowest level ever, and all of this caused the LEI (Leading Economic Indicators) to slide 0.8% in October. All of these indicators are setting the stage for an abysmal holiday selling season, telegraphed by last week’s -4.1% (year/year) collapse in nominal retail sales. In fact, according to Ed Hyman’s ISI organization:

"The single best correlation for holiday sales has been the stock market in the months leading up to the Christmas season with a 61% correlation. With the severe global recession, intense competition, and the halving of commodity prices already, we are probably entering a period of deflation. This is setting up the weakest NOMINAL GDP since 1954, something we worry the country’s businesses haven’t prepared for."

Meanwhile, the dour economic backdrop has caused analysts to lower their earnings forecasts on companies to the point whereby only 222 companies in the S&P 1500 have seen their earnings estimates increased. Obviously, this decline in earnings expectations has a caused a recalibration of P/E multiples with an attendant "hit" to stock prices. And last week that "hit" caused the S&P 500 to fall to its lowest closing level since April 1997, while other U.S. indexes set 5½-year lows. Moreover, the Wilshire 5000 index, the broadest measure of the U.S. markets, has now fallen by more than 50% since its peak 13 months ago; and Treasury yields also fell to record lows with the 30-year U.S. Treasury bond declining to lows last seen in the early 1960s.

Interestingly, the combination of lower stock prices and higher Treasury prices caused the dividend yield on the S&P 500 to exceed the yield on the 30-year Treasury bond for the first time since 1958. That means that a shareholder of the S&P 500 needs NO capital gains to outperform the holder of long-dated government bonds. And maybe, just maybe, those valuation metrics are what caused Vivan Watsa, CEO of Fairfax Holding (FFH/$276.68) and one of the few investors who have played this downturn to a tee, turning $500 million into more than $2 billion in the past year, to remove all of his downside stock hedges. Specifically Mr. Watsa stated:

"Given the unprecedented decline of the equity markets during the past several months, we felt it was prudent to promptly inform our shareholders that we closed out our equity index total return swaps this week and effectively eliminated our equity portfolio hedge. While we believe the recession may be long and deep, we also believe that stock prices may have already discounted the worst of the economic decline. As value investors, we are finding an incredible number of investment opportunities across the world."

For the past four weeks we too have spoken about finding numerous investment opportunities, citing things like The Wall Street Journal story that stated there are currently one in ten listed companies trading for less than the value of the cash and marketable securities on their balance sheets, as well as a list of companies that have increased their dividend every year for the last 20 years. And then there was this email of two weeks ago from one particularly bright portfolio manager, "I now have over 100 stocks on my watch list that are trading at, or below, book value and with superior fundamentals. Stocks, therefore, are too cheap and I am starting to buy for the first time this year".

Despite such investment opportunities, last week the DJIA slid below its October 10th low of 7882 that I had expected to mark the short/intermediate "low," thus activating downside targets between 7200 (approximately the 2002 low) and 7500 (50% retracement of the 1982 to 2007 Dow Wow). And, on Thursday and Friday of last week the DJIA traveled well into that target zone, leaving only 13 stocks in the S&P 500 above their respective 200-day moving averages, and extremely oversold, as can be seen in the charts. The Wednesday through Friday morning swoon lopped 1000 points off of the senior index, leaving participants in "crash mode," but Friday afternoon ushered in the "Geithner Gotcha".

For the last few weeks we have suggested that President-elect Obama could either adopt the FDR model, which would be disastrous for the economy and the markets, or he could step-up and provide leadership to fill the current leadership vacuum. Again as the GaveKal organization opined:

"Probably most important economic transformation which is about to occur is the transformation in personal leadership. Suppose you believe, as I do, that the financial meltdown triggered by the bankruptcy of Lehman Brothers was not a divinely ordained retribution for decades of greed and profligacy, but simply a bizarre accident, caused by the [[usual: normxxx]] incompetence of the Bush Administration, particularly of Mr. Paulson. In that case, the arrival of a credible new economic team in Washington, led by respected figures such as Messrs Volcker, Summers and Geithner, could transform psychology in global financial markets. With house prices stabilizing and an inspiring new leader replacing the doltish President Bush, American consumer and business confidence could enjoy a similar resurgence."

And, that appears to be precisely what happened late Friday. Hopefully, that mindset will continue this week.

The call for this week: We still think October 10th represented the capitulation "lows," as can be seen in the S&P 500 charts that shows the RSI and MACD indicators at their most oversold levels since the 1982. As Barron’s notes,

"For a bullish spin, though a weak one, the market has not made a significantly lower low since Oct. 10th. The word ‘significantly’ is important because some major market indexes, including the Nasdaq, have indeed been setting new lows. But the trend, if we can call it that, has been more sideways than decidedly down. A better, but still weak, bullish angle comes from trading volume, or the amount of money committed to either the bull or bear side each day. All of the higher volume days that have occurred since Oct. 10 have come on days when prices rose. Theoretically, when prices are going up and volume increases, it means that investors are chasing the market higher. That’s a sure sign of demand. Subsequent declines occurred with lower volume, so we can conclude that the desire to sell was not quite as strong as it was before Oct. 10th."

And don’t look now, but cold weather has crept into the country, which should be positive for the energy stocks we have been recommending.

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Normxxx    
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