Did I Just See a Dead Cat Bounce?

Sorry to be a party pooper, but I don't buy the sustainability of the recent market rally. 500+ points in two days? Give me a break. Market prognostication is not one of my specialties but I simply have to speak. It doesn't take a rocket scientist or the Amazing Kreskin to see that things suck out there. In the real economy. Being excited about lower rates is only part of the equation. Sure, you are discounting back future cash flows at lower rates and therefore increasing the present value, but what exactly are you present valuing? I'll tell you what - lower future cash flows. So many market participants get all excited about the prospect of the Fed dropping rates, but I think a few questions need to be asked:

1. Why are they dropping rates, and what are they seeing that we aren't;
2. Does the Fed really have the power to stimulate growth simply by monkeying with the short end of the yield curve; and
3. What are the knock-on effects of the Fed lowering rates that could work against a rosy outcome, i.e., a weaker dollar that chokes off domestic demand and causes long-term rates to rise?

I personally don't like the answer to any of these questions right now. The Fed is scared, that's for sure. They see the dislocation in the credit market persisting, and perhaps getting worse. All we need is the failure of a single monoline insurer or (another) 10-figure write-down by a major bank to toss the financial markets into a complete panic, which would be good for precisely nobody (except perhaps Bill Ackman, Jim Chanos and a few others). So in light of these risks, they may well tilt towards an accomodative stance. However, if they do this, will this really stimulate growth in the real economy and meaningfully loosen up tight credit markets? Debatable. There are likely more direct steps they could take to provide banks and other financial intermediaries with the liquidity to bridge the gap and to address the tightness in the mortgage markets, steps that maybe wouldn't have such an adverse effect upon the dollar. And what if they continue to push down short term rates, and the real economy doesn't react as hoped? In the absence of real growth and in light of lower rates, the dollar will fall further, only exacerbating an already difficult situation. This could have the effect of causing foreign capital to flee and long rates to rise, making it more costly for firms to raise stable, long-term capital (not to mention the US Government).

So market rallies are great, and I am an optimistic person in general, but the trading action of the last few days doesn't fool me. I just saw a dead cat bounce. And it will soon fall back to earth.

Comments

[Sherman McCoy]

You're right this is mostly dead kitty short covering. BUT, lowering Fed Funds DOES matter. The Fed bailed out the banking system in the 90's by getting every bank to buy 2 years and fund it in the Fed Funds market. IT DID WORK. If banks can borrow at 1% and invest at 3% in zero risk weighted assets, they can earn their way out of this problem. Knowing this, everybody and their brother is buying Treasuries. have you noticed that Treasuries have rallied in the face of a declining dollar? That's why the dollar won't collapse further near term.. Now is a great time to be SELLING euro's, because ultimately, the ECB can't afford a strong currency. If you can't stomach dollars, buy Gold.

[Dave]

David Harper,

I think you are conflating two issues here. One is the complexity of individual companies' financial statements. The other is the need for (most) investors to build a diversified portfolio. I acknowledge that even well-educated people may not fully understand the financial position of a large, complex firm such as AIG. Just recall all the stories in the press of doctors not knowing what business the dot-com companies in which they invested operated.

Just because you're an educated person does not mean you can understand every company. All of this, of course, argues that most people, per Warren Buffett, ought to buy index funds.

But it is still true that there are two major groups of investors for whom a crashing market is bad: those looking to book capital gains to finance their debts and those looking to retire soon. Even if these people are savvy enough to buy index funds, they should not, if only because of the volatility inherent in the equity markets.

Again, to my thinking, this is a matter of education. And it has nothing to do with modern portfolio theory, efficient market hypotheses, matrix algebra, or any other topic favored by the D.E. Shaws of the world. Rather: for those for whom equity investments are appropriate, owning a broad basket of stocks offers more protection in a down market than does exposure to a single stock.

[David Harper]

If I might connect Yaser's and Dave's points, I went to take a look @ AIG and my problem is, I would need to go on a sabbatical to analyze AIG. And the financials, for that matter. Is it a matter of education, or dizzying complexity and volumne? I teach FinStatement analysis and i can price credit derivatives, but still, how much time would it take to analyze AIG to, say, compute AIG's intrinsic price (and, believe you me, I have reason think Roger believes AIG has an intrinsic price).

I'm in tech mostly because i can get a handle on them, how can you possible value these financials with subprime exposure from the outside? And, btw, this is before Basel II kicks in, which, as a bedrock assumption (Third Pillar) relies on "market discipline" (knowledgeable investors) to sort out what will be an incredible volume of additional disclosure around portfolio risks...

That's the other reason i feel the gist of Roger's post above must be correct: even anticipated Fed moves bode well for something fundamental, I don't believe the market can be repricing the complexity on a daily basis - it's more like bouncing from one overreaction to another based on tidbits and wild extrapolation

[Dave]

Roger, all fair points in your response to me. I fully concede that there are many unsophisticated investors involved in the market, but I still contend that it is incumbent upon investors to understand how their personal financial situation should affect the extent to which they take on risk.

To me, this is a problem of education. Perhaps this is simplistic. Perhaps the concept that one who is about to retire, or who is in debt up to his eyeballs ought not be invested heavily in the stock market, is one too complex for most to discern.

[wallbang]

Sentiment of hedge funds is apparent. Institutions lightened up on 11/08 and the past few days we've seen intervention induced covering.

But the following news, as it propagates. will add to the turmoil.

"Florida freezes $15 billion fund as subprime crisis hits"

http://tinyurl.com/3yqc4n

[Yaser Anwar]

A good name to look at in all this mess is AIG. AIG avoided writing protection on what is turning out to be the worst credit turmoils (06 & 07) related to subprime exposures.

In addition, the total 06 & 07 subprime exposed RMBS investments held on AIG's balance sheet is only $26 billion, of which 98% is rated AAA and AA.

Given the decline in market value, the market has more than written this entire portfolio to 0. Finally, AIG's level of disclosure dwarfs that of other banks/insurers et al + the incremental $8 bn buyback program, suggests that the mgmt believes that its mortgage exposure is very manageable.

[David Harper]

Great points, Roger. I don't know macro (to save my life) but obsession over the Fed's power to impact fundamentals escapes me. All the Fed commentary, my eyes glaze over.

My read is the Fed has good intentions: they are really scared banks, in classic 'procyclicality', won't (already aren't) make good loans as they smart from the hurt of the bad ones. Big concern but, alas, Fed isn't a cure all. I like Bernanke as a good old-fashion inflation targeter. It seems to me the Fed should just avoid doing harm by seeking price stability (and free up some newsprint for actionable commentary?) - there is a nice track record for errors when they overreach. Dave seems reasonable that cheap assets are good for some, but headless masses blow bubbles with cheap assets. And, btw, price reflation might exacerbate volatility (?). I pay so little attention that I only recall Greenspan's 'conundrum' remark a few years ago, which felt like the start of a diminished Fed, where they've all but admitted they don't have a grip on long rates (and indirectly, haven't they hinted that they don't *really* stimulate the economy?). To chase quick fixes feels good temporarily, but it's like a car careening out of control in oversteer, you fix the credit liquidity problem only to steer into the other rail (i.e., dollar, other mini asset bubbles). I guess there problem is they are the business of damage control (which damage to control!) but the MSM seems to imbue them with superpowers,

[Roger]

Michael, I get the technical stuff, too. But merely saying "it's technical" doesn't fully address the issue at hand because (1) it's not all technical; and (2) tone and sentiment have shifted in light of recent Fed comments. Tone and sentiment are not strictly technical phenomena, and will impact investors fall beyond those applying technical strategies to their trading. So while I agree to a degree, I think it is an important but insufficient point.

[Roger]

Dave, yes, I have heard of buy low/sell high. I also understand that cheap assets are good for anyone that has a head. Unfortunately, by your definition, we a nation of the headless masses. This is the reality. We are not a nation of hedge fund managers, regardless of how it seems. It is those non-managers whom I'm concerned about, Dave. As an investor with market knowledge and some dough I am not at all freaked about the goings on for me personally, but for those not in a similar circunstance. You can call those people foolish, uneducated - but maybe "human" is the appropriate moniker. In any event, I get your point which I find interesting but not relevant to the thrust of my post.

[Michael]

Nowadays mutual fund and hedge funds routinely use spy, qqqq and iwm, plus index put options to hedge their equity exposure. With the market oversold during the last 2 weeks, it doesn't take much to get people to unwinde their short hedges. This is especially true when the downward index momentum slows down, VIX comes down. As the long put optons get unwound in a panic, the option market makers unwind their short hedges as well. Result: big retracement moves.

Pt is, all these movements are technical in nature, and hence appear incomprehensible and irrational from a fundemental point of view. When in reality, there are good reasons for it.

If you try to analyze these movements from a fundemental pt of view, you will go insane.

[Yaser Anwar]

Forgot to mention, keep buying the FXE eurotrust. It has a good yield and given the fed fund futures market expectations, 98%, of a Dec 11 fed cut, FXE will likely benefit further.

I've been long FXE for my school fund alongside GLD, and believe their is more upside to the trade given the Fed's destructive policies.

However, it's always good to have some insurance. With the market betting heavily towards a Fed cut, having a small position in favour of a no-cut will yield substantial upside. That said, in light of Fed's most recent moves, not comments!, the market is right to bet the way it is.

[Yaser Anwar]

Spot on! Great post.

A few observations:

a) The 3-month T-bill yields are testing support at 3%, while rates on ABCP/Swap Spreads instruments continue rising. The widening spread warns of further turbulence in financial markets.

b) Look at a chart of DJ Industrials. From October to November, almost 3 times the market moved upwards and then lower, in technical jargon, making lower highs. If it doesn't break to the upside of 133, we're headed to August 07's bottom of around 126.

c) According to Bespoke IG, since 1945, there have been a total of 45 corrections, defined as a 10% decline from peak to trough. Post-correction history (day after each 10% correction) shows that:

i) equities faced avg additional declines of 7.8% over 68 days following the correction

ii)11 times the total declines led to a bear market (24% chance we go bear)

iii) 9 times equities bottomed at the 10% decline levels and rose thereafter (20% chance Tuesday was the bottom)

[Dave]

Why do you say panicked financial markets are good for nobody save Ackman et al? Cheap assets are good for anyone who has a head.

Ever hear "buy low and sell high"? Clearly a market crash causes pain for the short-term investor, or the investor looking to book capital gains to crawl out of debt But those are precisely the people who should not be exposing themselves to the risks inherent in volatile equity markets.

The equity markets are a tool; they can be exploited for gain when prices are cheap, and they can be the road to penury when assets are dear. But a crash in the markets is neither inherently good nor inherently bad--it just is.

What is good or bad is a person's individual financial circumstance. Those that husband their capital wisely will take advantage of a decline in prices and those that are foolish with their capital will suffer losses.