Sunday, May 10, 2009

Seven questions for me on the stock market.

What is going on with the stock market?

Why is that happening?

Most people do not take the time to read reports and analyze tables. They are largely guided by three emotions; greed, fear, and jealousy. The market spiraled downward because people were fearful that they would lose everything and just wanted out at any price. Now people are full of jealousy (of those who already bought in) and greed and don't want to miss out on the gains and just want to buy at any price. They read anything that says the recession is over and ignore everything else.

But what about the bank stress tests that say the banks are solvent? That the banks will earn their way out of their writedowns?

The bank stress tests were a sham. The purpose of the results was decided before the tests began -- the purpose would be to reassure investors. The regulators (term used lightly) produced optimistic, reassuring results. But that wasn't enough. They then allowed their subjects to negotiate with them because oversized financial institutions now have oversized influence on our nation's government. The government went along with this and severely reduced the amount of capital they claim the banks will need to survive.

But that wasn't enough either. Rather than actually needing to raise capital to cover all the writedowns, the government is now letting banks convert preferred shares into common to take care of most of it. This is financial alchemy which adds nothing to the real world balance sheet. It also, once again, screws the taxpayer who used to be first in line to be repaid in the event of bank failure and will now be last in line.

Yes, but won't this prevent financial stocks from falling anyway? Maybe they will just trade sideways for years?

No. There are still financial shocks to come to the system. There will have to be writedowns no matter how long the banks try to put it off. What's more, there is a lot of money that needs to be raised by an awful lot of banks. There are a lot of banks out there, and most of them are not the top 20 largest which have a lot of lobbying power. This is not financial Lake Wobegon. Many of these banks will not be able to raise the money they do need to raise from private investors, because PE investors know about the coming writedowns, and if these banks aren't too big too fail there is no desire on the part of Congress to grant more money to bail them out.

But what about all the fundamental economic data that looks like they are turning positive? What about the "green shoots" in the economy?

There are no green shoots. When times are bad and people are scared, they no longer view data on seasonally adjusted terms. They also do not view data on year-over-year terms, as they did when times were good. They only view things month-to-month and quarter-to-quarter, looking for any uptick.

It is important to know that essentially everything is still declining no matter what terms you use, but the reason why people are saying the recession is over is not because things have turned positive but because they are declining at a slower rate than before. It doesn't matter whether you pick imports, exports, manufacturing, retail sales, whatever. All of those things are still declining on every possible scale, just at a slower rate than before. But everything always gets better coming out of January, February, March, etc. These numbers need to be seasonally adjusted, and they need to be compared year-over year. They YoY declines are horrific.

So how long can this rally last?

See now we're getting into the CNBC-esqu crystal ball predictions that cause problems for investors and can get you into trouble. But just based on what I experienced in 2008 and the seasonality of most sectors of our economy, plus the temporary effects of immediate stimulus spending, I would accept Nouriel Roubini's estimate of late Q2 to late Q3 of 2009. So this rally can last a long time, but it will not last the entire year. The notion that the economy will turn positive by then end of the year is very hard to swallow.

I'm missing out on this enormous rally.

That is true, but you need to keep this rally in perspective. If you've been short since late 2007, this rally hasn't meant much to you. Consider how large it is in relation to the fall:

It is the nature of numbers that the bigger the fall, the bigger the rise - on an exponential scale - is needed to get back to the starting position. A 50% drop needs a 100% gain, but a 90% drop needs almost a 1,000% gain to get back to where it was. So you can see that Citi has risen nearly 400% from it's bottom, but after the loss it took it still isn't even back to $5 per share. If you know how to play a rally you can certainly make enormosu sums, but I don't know how to play short-term drops and rises. I can only look at fundamentals and think about where things will go long term.

1 comment:

Anonymous said...

I think you have the best strategy - why take needless risks?

Love, MOM