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Automakers on Watch

(December 4, 2008)

Dear Subscribers and Readers,

As subscribers may recall, I devoted the mid-week commentary to a write-up of Best Buy, Inc. a few weeks ago.  I have since updated Best Buy's valuation, investment thesis, and downside risks in a more formal write-up for my own personal use.  Attached is the latest version of that write-up.  Note that was written with at least a three-year investment timeframe – and in no way construes a formal buy recommendation for the company.  Comments and feed back are appreciated.

Note: The daily NYSE ARMS Index hit an immensely oversold reading of 10.16 on Monday – its most oversold reading since February 27, 2007, when it hit a one-day reading of 15.77.  Over the last 50 years, there have only been six days when the NYSE ARMS Index has exceeded a reading of 10: September 26, 1955 (the day of the Eisenhower heart attack), October 19, 1987 (Black Monday), October 26, 1987 (Black Monday's after shock), October 27, 1997, February 27, 2008, and December 1, 2008.  The 55-day moving average of the NYSE ARMS Index also rose above 1.5 last Monday.  Over the last 50 years, there has only been one other instance when the 55-day moving average rose above 1.5 – the day of the Black Monday's “after shock” on October 26, 1987.  We are continuing to make history in terms of liquidation pressure as we speak.

As expected, the Bank of England lowered its policy rate by 100 basis points, while the European Central Bank (thankfully) lowered its policy rate by 75 basis points – slightly more than what the majority of analysts were expecting.  As I mentioned before – in terms of geographically-concentrated risks – Europe (in particular, Western European banks, and the countries of Central and Eastern Europe) remains the most vulnerable, as the banks of the Euro Zone have lent a combined 4 trillion Euros to the many Central and Eastern European countries – many of which are running historical current account and budget deficits.  While the Euro Zone's latest interest rate cut will help, it is not sufficient in itself.  Already, the Bank of England (with its policy rate currently at 2.0%), is discussing the possibility of lowering its policy rate to 0%.  What is further needed is a Euro Zone wide fiscal stimulus of more than 200 billion Euros to jump start the region and to restore liquidity to the rest of Europe and its banking system, although we are not holding our breath at this point (Germany remains the lone holdout despite the fact that the country has done more than its fair share of sucking money from its neighbors and the rest of the world).

In the meantime, all eyes are now on the possibility of a federal government bailout of the “Big 3” automakers.  As of Thursday morning, things are not looking too good, as polls show that more than 60% of American are against a bailout and as Congress remains lukewarm to the idea as well.  While the UAW and the Big 3 executives have agreed to some important concessions (such as the elimination of the infamous “job bank”), my sense is that this is only the bare minimum.  More ominously, the idea of a debt renegotiation seems immensely (and legally) difficult to pull off unless the automakers file for a pre-arranged bankruptcy – which essentially allows the automakers to force their terms on the debt holders.  While the idea of a pre-arranged bankruptcy will probably do minimal harm to the real economy (if the automakers were liquidated, my sense is that we would see the US unemployment rate spike up to 10% sometime in the next 12 to 18 months), I would argue this would again rattle the financial markets. If either automaker does file, then the Federal Reserve and Treasury will need to implement theirs plans to buy more agency MBS, and for the former, longer-dated US Treasuries in order to pump more liquidity into the financial and housing markets.  Perhaps this is the major reason why Paulson has been floating the idea of targeting a 100 basis point decline of long-term mortgage rates by buying more agency mortgage-backed securities?  If any of the automakers does file for bankruptcy, then we will need more liquidity provisions, no doubt about it.

On the other side of the pond, the Bank of Japan has also been studying plans to pump more liquidity into its domestic economy.  In its latest move, the Bank of Japan is now accepting more risky collateral in return for central bank loans.  While this is a step in the right direction, more needs to be done.  As can be seen in the following monthly chart (showing the year-over-year growth in the Japanese monetary base vs. the Nikkei), the November 2008 year-over-year growth of the Japanese monetary base is still at a paltry 1.9%:

Year-Over-Year Growth In Japan Monetary Base vs. Nikkei (Monthly) (January 1991 to November 2008) - While the y-o-y growth in the monetary base (1.9%) is now at its highest level since 2005, the BOJ still has its work cut out for them, as the monetary base is still at near its October 2002 levels. More needs to be done!

While this is its highest growth rate since October 2005 (when Japan's policy of “quantitative easing” was being unwind), it is definitely not sufficient to combat the current global financial crisis – especially given the fact that many countries who are in trouble have borrowed a substantial amount of Japanese Yen.  At some point, the Bank of Japan will need to “open the floodgates” either by selling Yen (without sterilization) or by adopting a “quantitative easing” policy once again.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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