Saturday, September 20, 2008

The Week That Was

Stunning is a word that sums up this week's action. It fits because it can be used in proper context for all parties involved in the capital markets, regardless of whether they held short or long positions.

The behavior of stocks? Stunning. The behavior of Treasuries? Stunning. The behavior of commodities? Stunning. The behavior of currencies? Stunning. The behavior of the government? Stunning.

Recounting all that transpired with sufficient detail would make this wrap a rival to War and Peace in length. Accordingly, we'll spare you the nitty-gritty and will focus on the larger happenings.

To begin, the week began with a washout of sorts as the market dropped 4.7% in the wake of reports that investment bank Lehman Bros. was filing for bankruptcy, that Merrill Lynch (MER) agreed to sell itself to Bank of America (BAC) in a hastily arranged transaction, and that insurer AIG (AIG) might be headed for bankruptcy if it couldn't raise a large amount of capital in a hurry.

The focus on the financial sector on Monday was apropos since the Wall Street universe revolved all week around that area, which was both a black hole and shining star depending on the day, or even the hour, one looked at it.

All other developments, like a warning from Dell (DELL) about slowing demand, a disappointing earnings report from Best Buy (BBY), a reassuring report on consumer inflation, and a decision by the FOMC to leave the fed funds rate unchanged, were a distant second to the behavior of the financial sector and the credit market, which were inextricably linked.

After recouping a portion of Monday's losses on Tuesday, the market suffered another seizure Wednesday, dropping 4.7% in the wake of news the Fed agreed to a 2-year, $85 billion secured loan for AIG. Although that loan was structured on very attractive terms for the Fed, the major concern for the market Wednesday was that it failed to do anything to put the credit market at ease since it didn't fix the underlying problem.

Strikingly, the TED spread, which is a barometer of credit risk and is the difference between the 3-month Libor rate and the 3-month T-bill rate, blew out to 302 basis points. That level compared to a 135 basis point spread the preceding Friday and marked the widest spread since just before the stock market crash in 1987.

Other credit spreads also widened considerably, particularly the spreads on credit default swaps for investment banks Morgan Stanley (MS) and Goldman Sachs (GS). That widening reflected heightened anxiety about their ability to repay their debt which, in turn, reflected a pressing concern that those firms were at risk of going the way of Bear Stearns and Lehman Bros.
From their close last Friday to their lows for the week, the stocks of Morgan Stanley and Goldman Sachs plummeted 69% and 44%, respectively. Remarkably, that move occurred despite both firms posting better than expected fiscal third quarter earnings results.

Their losses were indicative of some of the panic selling that took place during the week as participants fretted about the government's inability to stem a collapse in the financial system (more on this in just a bit). That selling was exacerbated, too, by reports that the value of the Reserve Primary Fund, which is a money market fund, broke below $1.00 per share, an extremely rare happening for a money market fund.

The confluence of the disconcerting headlines surrounding the financial sector precipitated a massive flight-to-safety bid in gold and the U.S. Treasury market.

At their high on Thursday, gold futures were up $161.50, or 21.1%, from their close last Friday. Meanwhile, the yield on the 3-month T-bill hit 0.02% on Wednesday, marking a 149 basis point drop from where it went out last Friday.

The fear in the market was palpable. For traders it manifested itself in the VIX Index, commonly referred to as the fear gauge, which hit its highest level in six years Thursday.
Thursday and Friday, frankly, were two days for the trading ages.

Thursday began well enough as stocks initially reacted favorably to reports of a coordinated effort among central banks to inject more dollars into the global financial system. Those good feelings proved to be fleeting. Stocks rolled over upon seeing there had been no real improvement in the credit market and upon hearing more worrisome headlines about money market funds.

In an instant, though, the tone of the market again changed in favor of the bulls when the U.K. announced a temporary ban on the short-selling of financial stocks.

Sensing that the SEC might follow suit in the U.S., a short-covering rally ensued. However, it wasn't until a report late in the day that Treasury Secretary Paulson was entertaining the idea of a financial system fix equivalent to the Resolution Trust Corporation solution used during the S&L crisis that stocks really took off.

From its low on Thursday to its close, the S&P surged 6.4%.

Sure enough, Friday brought a tidal wave of news regarding government proposals to return stability to the financial system.

In particular, the SEC banned short-selling of 799 financial stocks until Oct. 2 and the Treasury provided a guaranty program for money market mutual funds. The big game changer, though, was a proposal put forth to have the government (er, the tax payer) take the illiquid mortgage assets off the balance sheets of financial companies.

Administrative officials and Congressional leaders intend to work over the weekend to iron out specific details of the plan, but it was clear in Friday's session that participants liked the implications of what was being discussed since it got to the heart of implementing a comprehensive and targeted solution to fixing the root of the financial system's problems, which is housing and mortgage-related assets.

By implementing a program that removes the illiquid assets from the balance sheet of the financial companies, the government is literally buying the time that is necessary to turn the illiquid assets into liquid assets again through a more rational price discovery process.
The cost of the program won't be cheap. Secretary Paulson estimates it will run into "the hundreds of billions of dollars" since it has to be sufficiently large to have a maximum impact. However, the cost entails buying actual assets which can deliver cash flow, possibly in excess of the amount of the price the government will pay.

Time will tell, but the thinking that this plan can succeed in stabilizing the financial system and the housing market translated into heavy buying interest Friday. In fact, Friday's session, which also happened to be a quarterly options expiration day, saw the most volume (2.98 bln shares) ever traded at the NYSE.

For some perspective on the magnitude of the rebound over the final two days, consider the following: from their low on Thursday to their high on Friday, the Dow, Nasdaq, S&P 500, Russell 2000 and S&P 400 Midcap Index surged 9.8%, 12.0%, 11.6%, 13.2% and 12.0%, respectively. As an aside, the stocks of Morgan Stanley and Goldman Sachs rebounded as much as 189% and 69%, respectively, from trough to peak.

If two lessons are to be learned by investors from this week's action, it is that panic selling isn't a recommended portfolio management strategy and that you can't try to time the market. Neither works in the ongoing effort to build long-term wealth by investing in the stock market.

--Patrick J. O'Hare,


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