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Real Action Should Come After Labor Day Weekend

(August 30, 2007)

Dear Subscribers and Readers,

The U.S. stock market was up strongly earlier today, with the Dow Industrials gaining 247.44 points (+1.90%), the Dow Transports 104.44 (+2.21%), the Dow Utilities 10.86 (+2.28%), the NASDAQ Composite 62.52 (+2.50%), the S&P 500 31.40 (+2.19%), and the Russell 2000 19.49 points (+2.54%).  The strong upside breadth is also evident given that 1) it was a Lowry's 90% upside day on the NYSE (for my readers who do not recall, a 90% upside day occurs when both the advancing volume and the number of advancing points equal or exceed 90% of the total volume and the total number of points, respectively), and 2) All ten sectors of the S&P 500 closed positive, with energy the strongest and health care the weakest sector.

The $64 billion question remains: How likely was Tuesday afternoon a sustainable bottom?  In a posting on our discussion forum on Tuesday afternoon, I stated that – at 2:51pm EST – the NYSE ARMS Index had just surpassed 2.5 (it would eventually spike higher to close at 3.22), and that probability suggested that the market should at least stabilize at the then current level.  In other words, the market was severely oversold in the short-run, and so a bounce (even a bounce like yesterday's) was definitely not inconceivable at all.  That's right, dear readers, I am still not convinced that the stock market has made a sustainable bottom yet, and that the window for a further decline is still open during the September to October timeframe.

While it is anyone's guess on why the stock market rallied so much yesterday, this author would guess that the cause was a combination of 1) a bounce from the severe one-day decline on Tuesday, 2) lack of further bad news within the markets, and 3) a sudden realization by the market that the Federal Reserve will no doubt cut the Fed Funds rate by 25 basis points during the next scheduled Fed meeting on September 18th.

While buying at the end of Tuesday for a possible bottom (especially if it was a short-term trade) was a shrewd move, the only reason for doing so – at this point – was the short-term oversold conditions that were in place in the stock market at the close on Tuesday.  For example, in a post on Wednesday morning, I highlighted the fact that after the Labor Day Weekend, many auditors and bankers alike would be scrambling – not because banks such as Goldman Sachs, Morgan Stanley, and Bear Stearns still need to liquidate positions or further deleverage (although I would not be surprised if there still a need to), but because many of these banks will be forced to properly value their losses in light of the recent markets and do substantial write-downs.  Moreover, the SEC has made it clear that they are constantly monitoring activities at the largest investment banks to see make sure that CDOs and other vehicles with little liquidity are valued and accounted for correctly come August 31st.  For those who are looking forward to the latest quarterly earnings announcements of the big investment banks, Goldman is currently the only one with a firm schedule – they are due to announce earnings before the market opens on September 20th (Briefing.com consensus of $4.34 EPS).  Meanwhile, Lehman, Bear Stearns, and Morgan Stanley should all be reporting during the September 10th to 25th timeframe. 

During the same timeframe, many hedge funds will also be looking to further deleverage or sell their existing holdings, in order to meet the September 30th deadline for investor redemptions.  At this point, it is impossible to tell how much redemptions there will be, but given that most of the popular hedge fund strategies (with the exception of “dedicated short bias”) were clearly not working during the two weeks leading to the notice deadline (August 15th), my guess is that there will be continued deleveraging going on during the next four weeks – right up until the September 30th deadline.

Indeed, as I have mentioned before, the window for further declines in the stock market is still open.  To the above list, we can also add the fact that approximately $300 billion in junk bonds and leveraged loans are still waiting to be dumped onto the markets at the earliest opportunity – and despite everything that you hear about on how “the stock market is cheap,” many managers are opting to put their money into the corporate bond market instead.  Note that on a day-to-day basis, liquidity in the leveraged loan market is still relatively dismal, as represented by the following chart (courtesy of Markit.com) showing the latest rise in LCDX spreads over the last few months (click on the following link for a primer on the LCDX index):

LCDX Price/Spread (May 2007 to August 2007)

As for potential Fed Funds rate cuts down the road, there is now no doubt that the Federal Reserve will cut by 25 basis points at the next scheduled meeting on September 18th.  The likelihood of a Fed Funds rate cut on September 18th is also reinforced by the latest readings in the Fed Cleveland Median CPI.

Before we go on and discuss the Fed Cleveland Median CPI, let us first refresh our memory on what is and why we believe it is important.  We first discussed this topic in our April 23, 2006 commentary (“The Message of the Fed Cleveland Median CPI”).  In that commentary, we stated:

As the title suggests, the Cleveland Median CPI is an inflation indicator which attempts to measure the price change of the middle observation of the goods and services that are contained in the CPI-U basket.  Quoting from the Cleveland Fed: “In effect, the median consumer price change is the CPI less everything but the price change that lies in the middle of the continuum.  Since only the order, not the values, of the various price changes is used in its calculation, the median is a central tendency statistic that is largely independent of the data's distribution.  The median also has the intuitively appealing property of lying close to the majority of price changes than does any alternative measure.”

The Cleveland Fed claims measurements such as the Consumer Price Index measures “only” the “average price of an array of goods and services purchased by households, but because it is constructed as a weighted mean of all consumer prices, it does not discriminate between relative price changes and inflation.  Indeed, the CPI may rise when the price of just one commodity increases.”  The Cleveland Fed claims that the traditional CPI may not be a good measurement tool of inflation, as “an increase in one price relative to others is the signal that directs resources and rations consumption [in other words, this does not take into account the “substitution effect” by consumers that can ultimately depress prices of the good that has gone up].”  Meanwhile, inflation is “a monetary phenomenon that determines the underlying level of all price changes; it has virtually nothing to do with the transmission of market information.  Indeed, one fundamental problem with inflation is that it can be confused with relative price movements, obscuring the transmission of market information and reducing market efficiency.”

That is, the Cleveland Fed claims that certain non-monetary events can “at least temporarily, distort reported inflation statistics … during periods of bad weather, for example, food prices may rise to reflect decreased supply, producing transitory increases in the CPI.  But since these prices do not constitute monetary inflation, monetary policymakers may want to avoid including them in their decision-making.”  In his book, “Inflation Targeting,” current Fed Chairman Ben Bernanke outlines precisely such a scenario (one that will involve the Fed stopping or even easing as opposed to hiking).  I will repeat the relevant quote from our last commentary: “In general, there is no conflict between output and inflation stabilization when the precipitating shock is an unexpected change in aggregate spending; using monetary policy to offset an aggregate demand shock is nearly always the correct response. However, an aggregate supply shock, such as a sharp increase in oil prices, may cause a conflict between stablizing output and employment in the short run and stablizing inflation in the long run. Targeting a price index that excludes the first-round effects of common supply shocks can, as we have seen, ameliorate this conflict to some degree. But a supply shock that is great enough, or that arises from some unanticipated source, may justify missing or changing a previously announced inflation target.”  The Cleveland Fed claims that such an evaluation can be done more precisely by using the median CPI, as opposed to the currently-popular method of the “core CPI” – which is basically the CPI excluding food and energy (together, they constitute more than 25% of the CPI).  Says the Cleveland Fed: “One commonly used technique for measuring underlying or core inflation is to exclude certain prices in the computation of the index, based on the assumption that these prices are the ones with "high-noise" components. This is the rationale behind the commonly reported CPI excluding food and energy data. However, economists Michael Bryan and Stephen Cecchetti have found a measure that forecasts inflation better than either the CPI excluding food and energy or the all items CPI: a weighted median of the CPI.”

Put more simply, the Cleveland Fed claims that Bernanke can do a better job of evaluating such “supply shocks” by looking at the readings of the Cleveland Median CPI than solely relying on anecdotal information. 

The latest July median CPI reading was released two weeks ago – and for the first time since May 2006, the latest year-over-year increase of 2.9% in the Fed Cleveland median CPI declined to below the 3% mark.  Following is a monthly chart showing the year-over-year increase in both the median CPI and the “16% trimmed mean CPI” from January 2000 to July 2007, courtesy of the Cleveland Fed:

FRB Cleveland Median CPI and the FRB Cleveland 16% trimmed mean CPI (January 2000 to July 2007)

Interestingly, the median CPI had actually continued to rise after the final Fed rate hike on June 29, 2006.  This – along with stubbornly high resource utilization in both the manufacturing and labor sector – was the primary reason why the Federal Reserve had been reluctant to not only cut the Fed Funds rate, but to adopt a more neutral bias in their official policy statements for the last 14 months.  However, given the latest downtick in the Fed Cleveland Median CPI as well as the latest “dislocation” in the financial markets, the Fed definitely has now gotten the “all clear” to cut the Fed Funds rate on September 18th.

While any upcoming Fed Funds rate cuts should be welcomed in the financial markets, it is not a given that the stock market will immediately rally.  Sure – on a historical basis (post World War II) – the stock market, on average, had put in strong performances after the Fed started cutting rates.  But keep in mind that this is also what the bulls counted on when the Greenspan Fed first started cutting the Fed Funds rate in January 2001, and the stock market did not bottom until 19 months later.  While I still believe we are in a cyclical bull market, it is not a given that the stock market will immediately make new highs after the Fed starts cutting – as 1) the number of rate cut campaigns post World War II is not a statistically large-enough sample to make any conclusions from a probability/statistical standpoint, and 2) as I mentioned in our commentary last weekend, this is one area where we should utilize deductive/logical reasoning in our analysis, as opposed to using inductive reasoning, i.e. coming up with a conclusion based on a limited set of historical experiences (which both the mainstream media and many money managers are currently doing).  For example, in the great majority of cases after World War II, the Fed had only started easing after a substantial decline (20% or over) in the Dow Industrials or the S&P 500.  That is, the stock market – in the majority of cases – was already ready to rally, and the easing of the Fed Funds rate only gave the market a bit more of a push, so to speak.  Should the market remain at its current level on September 18th – given that we are only 7% from the highs – it is not a given that the stock market would start making all-time highs again and never look back.

Finally, at this time, there is good reason to believe that both the major central banks and investment banks of the world still don't have a clear view of where all the subprime or leverage exposure is, even though all their risk books are, for the most part, consolidated.  Remember, as of the end of June, the total amount of money controlled by hedge funds around the world amounted to a range of US$1.7 to US$2.0 trillion.  Utilizing a leverage ratio and an annual turnover ratio of 4-to-1 (which is very conceivable since half of all trading on the U.S. stock exchanges and more than one-third of all bond trading are done by hedge funds), the amount of hedge fund “efficiency capital” rises to a whooping US$27 to US$36 trillion, or nearly three times U.S. GDP.  How could the world's central banks make policy (or even more of a stretch, provide specific solutions) if they (and their contacts at Goldman, Morgan, etc.) have no idea what half of the financial system is doing?  In the Fall of 1998, many folks in NYC know that the problem was LTCM – today, not only has the problem gotten bigger, but it has spread to many more, heterogeneous, participants as well.  In this way, the current crisis is analogous to the “Panic of 1907,” as during the “Panic of 1907,” much of the crisis had initiated in and spread around the NYC trust companies, as opposed to the national and NYC banking system, who were members of the New York Clearing House.  Indeed, the Panic of 1907 was one of the most serious liquidity squeezes in US history, mainly because of 1) the explosion in NYC trust companies and assets in the 10 to 12 years prior to 1907, 2) the fact that they were not members of the New York Clearing House, and thus no legal or regulatory responsibility to hold sufficient reserves in order to stave off a general run, and 3) members of the New York Clearing House, who were lenders of the last resort in 1907, were reluctant to “bail out” many of the trust companies since they had never disclosed their books.  Moreover, while trust companies were relatively conservative at first, they gradually evolved into more speculative institutions as the owners of the trusts “discovered” that they were able to invest in more risky assets, such as real estate and stocks, unlike banks who were strictly prohibited from doing so.  The hedge fund industry today is analogous to the trust companies in 1907.

Following is a table (courtesy of this paper from the Atlanta Fed) showing the increase in banking and trust assets from 1896 to 1907:

Total Assets of National Banks and Trust Companies in New York City (1896 and 1907) 

In 1907, the final panic/bottom did not take place until the “Big Six” and JP Morgan himself had finally seen the books of many of the trust companies, in order to decide which trusts were worth saving and only if it was in the bankers' interest to do so (it is interesting to note that James Stillman had to personally convince JP Morgan that the Trust Company of America was worth saving, as the man himself did not want to risk his own assets to bail out an imprudent financial intermediary).  While both the Fed and the ECB are certainly more benevolent than their predecessors are when it comes to “doling out money,” there are – at this time – still too many skeletons in the closet in the hedge fund world, so to speak.  Chances are, we will not get a clear idea of how bad it is in the hedge fund industry until after September 30th, or at least after more hedge fund liquidation and deleveraging has taken place over the next few weeks.  For now, we will just sit tight and wait.

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