Rumor vs. Reality

Did the market gyrations of the first quarter make your stomach churn? Does it feel like a scary world out there? Let’s first get the bad news out of the way, and then we’ll assess what, in my opinion, really happened in the first quarter of 2008. My article is a little longer this quarter since I’ve had some questions from clients about recent market behavior.

Here’s what the fear mongers (the title of last quarter’s newsletter) are telling us:

• The economy lost roughly 232,000 jobs domestically in the first three months of 2008.
• The markets have been in a sideways pattern since 1999. Sideways markets are tough to stay fully invested in emotionally because of alternating periods of euphoria and despair.
• The Dow suffered its largest first quarter point decline (1002 points) in the history of the index.
• The Dow has declined for five straight months for the first time since 1990.

Here’s my take on what the markets are telling us:

• The Federal Reserve (the Fed) has finally gotten a backbone and the markets loved it. Why is this important? Because, if we wait for Congress, legislation moves much slower than the Fed.
  
  The FED’s remarkable week in mid March:
  • a. They engineered a fire-sale of Bear Stearns with a $30 billion loan.
  • b. They offered emergency loans for securities dealers of the type that are normally reserved for regulated banks. Securities firms are not regulated by the Fed.
  • c. They slashed short term rates another 75 basis points (bps) to 2.25%
  • d. They pledged $200 billion in Treasury Bonds to cash-strapped banks in exchange for less-liquid (read: poor) paper assets. It’s important to realize these loans are only for 28 days. (Treasuries are always in strong demand during a liquidity crisis.)
• We began the second quarter with the best first opening quarter day since 1938— that’s seventy years!
• There is $3.4 trillion in money market funds on the sidelines waiting to be invested.
• Insider stock purchases, as published in Barron’s, have risen for six weeks.
• Reuters Consumer sentiment is the lowest since February 1992.
• Bottom line, the last eight months have seen a sharp rally in Treasuries and a sharp selloff in stocks. If the economy reverses, these two trends will both reverse.
• REITs, following a terrible 2007, delivered double-digit returns in first quarter 2008.
• I candidly believe that the risk of recession has already been fully discounted by the global stock markets. Remember, the stock markets are leading not lagging indicators.

Now, let’s review some current rumors vs. reality:

Rumor #1: All bond investments are in trouble. If we invest in bonds, we have a highly possible chance the bond issuer will default. What do we do?!

Reality #1: You have to drop to “B” ratings in bonds before defaults are much above one percent. In other words, BB issuers and above have a less than 1% chance of defaulting.

Rumor #2: What happened to Bear Stearns (hereafter referred to as “BS”) could happen to a dozen other Wall Street firms, and then our economy would shut down! Yikes!

Reality #2: J.P. Morgan stepping in to rescue BS follows a long tradition at that bank to rescue financial markets from crisis. We now know that this Fed is willing to take the same posture. BS traded at $158 a year ago. Interestingly, except for the financial sector, corporate balance sheets are stronger than ever, ahead of the APR earnings report season. What happened to BS is an example of fear versus substance. The $250 billion of capital that disappeared would have supported $25 trillion in lending capacity, at a typical bank leverage factor of 10X. The Fed is becoming the “owner of last resort” or “collateralizer of last resort” for all kinds of poor sub-quality paper.

Rumor #3: Ok, it’s this leverage that is scaring me! I thought leverage was only for commodity trades and gamblers!?

Reality #3: Investment firms like BS and others have basically morphed from investment banks into debt machines that heavily trade their own accounts. This is a riskier business model than was typical of these firms only ten years ago. Goldman Sachs uses about $40 billion of equity as the foundation for $1.1 trillion in assets. Merrill Lynch uses around $30 billion to control $1.0 trillion. You can see the problem: when markets rise, all is well. When the markets are in peril, a small shift in “real” (non-leverage) assets can wipe out shareholders. Just ask Bear Stearns’ stockholders…

Rumor #4: The Fed is over-reaching its authority. Their BS move was just a “cover up” for our really bad economy, right?

Reality #4: If history is any guide, a big scary event like BS is the signal of extreme panic and the bottom for the broad market. It just never feels good. There have been four failures of major banks in the past 25 years. Stocks have been higher 6 and 12 months later in every case. The toxic packaging of sub-prime loans into shaky securitized assets was concocted by elite bankers with the tacit approval of the three major rating agencies! The market is now doing the cleansing of the toxic mess. Sadly, BS shareholders suffered during this cleansing process.

Rumor #5: It is estimated the economy could lose $400 billion from the sub-prime meltdown. This will be catastrophic to the U.S. investors!

Reality #5: The S&P 500 gained 3.6% on April Fool’s Day, Tuesday 4/1/08. In one day, that was a gain of approximately $480 billion in market capitalization. That $480 billion is more than the total amount of credit write-downs on sub-prime-linked securities, expected to be $400 billion. One day of market movement exceeded the expected losses! Wow!

Moving onto another topic, starting in May, I will publish monthly online commentaries. You can subscribe to receive them automatically as they are published. Just look for the icon in the Educational Resources section on our website. I will still publish quarterly newsletters in print.

I assure you that Chris, I, and our team are watching your accounts daily as we evaluate how to best serve each of our client’s investment objectives. Please feel free to call or to email me (cbrown [at] weg1 [dot] com) with any questions or concerns.

With our focus on superior customer service, and the on-going growth of our company, we are continuing to expand our CB3 family. We have been fortunate enough to hire two very experienced new members to our administrative support team. Sue Gehm has stepped into the role of Projects Coordinator enabling Alice Brown more time to work with clients as a financial consultant. Lory Harris joins Nancy Osterberg to ensure our high administrative standards continue to be met. Robert Gehm has joined our advisor team as financial educator. He is currently working on securing his insurance and securities licensing. Please join us in welcoming our newest team members when you get an opportunity to speak to them.

Until next time,