Scared Straight

The events of last week were astonishing! Two men, both pro free markets and anti moral hazard, travel to Capitol Hill to meet with Republican and Democratic leaders, who are normally divisive, especially six weeks prior to a presidential election. What they said essentially was that, if a major plan to restore confidence in our financial markets wasn't approved immediately, commerce in this country would grind to a halt. The looks on the faces of the participants coming out of that meeting were as if the Congresspersons had just seen "Jaws" and were told they had to go scuba diving the next day. Talk about fear! And apparently, the plan, which involves purchasing the toxic debt instruments from financial institutions, insuring most money market investors from loss, and restricting short selling in the financial services industry, has a very good chance of being approved quickly, of course with some modifications and add-ons.

What led to this? One event was an unintended consequence of the Lehman bankruptcy. A highly regarded money market fund held some Lehman paper, which was worthless, and as a result the fund's price fell to "under a buck". This led to a fleeing from this particular fund and money market funds in general, with the money pouring into Treasury bills. In fact, I understand at one point the Treasury bill yield was below 0 percent! A buyer was paying the U.S. government to hold his money! Since commercial paper financing is essential to the liquidity of major companies in the U.S., a freezing up of this market would have dire consequences unless something were done quickly.

Another event which occurred Thursday was the unraveling of the common stocks of Morgan Stanley and Goldman Sachs, the two large investment banking houses left standing after the collapses of Bear Stearns and Lehman, and the announced merger of Merrill Lynch with Bank of America. This happened after both banks reported better than expected earnings. If allowed to continue, Morgan Stanley, in particular, would have had to link up with another entity, and still may have to do so. The waterfall decline of these stocks, if writ large to encompass the entire market, would have produced the long awaited capitulation phase. More about that later.

And finally, Paulson and Bernanke had been fighting this financial contraction on a case by case basis and probably realized that some major policy change had to be in place to stem the downward spiral.

Will this plan work? If by "work" one means averting a depression by restoring confidence in our financial system, I believe the answer is yes. I applaud what Paulson and Bernanke did. And the cost to taxpayers may not be as much as the pessimists expect. It depends on the prices at which the Treasury purchases the toxic debt. However, the deleveraging of this country's balance sheet will continue, although this plan will help move this process along. And home prices haven't yet started to climb again. The financial companies still must raise equty capital to replenish their balance sheets. In short, the plan avoids a disaster but doesn't avoid a continued recession.

Was last week's low of 1156 for the S&P 500 Index the low of this bear market? It is my sense that, had the meeting among Paulson, Bernanke, and Congress not occurred, the stock market was heading toward a classic selling climax, which I have discussed ad nauseum in previous postings. We will never know. However, while last week's action didn't fit the precise characteristics of one, particularly because the decline and rally didn't occur all in one day, from peak to trough, the S&P 500 Index declined roughly 9%, then ralled back to almost even. And the volume of trading was at record levels. The CBOE volatility index, called the VIX, reached 42, an unusually high level that only occurs near major turns. While this index has been reliable, it has not existed for very long. The I.I. percentage bears indicator has been around for more than forty years. The lastest week's figure will be out Wednesday. However, the survey is taken on Fridays, so the sentiment of advisors would have been measured after the rally on Thursday afternoon and won't be representative of the fear levels immediately prior to that.

The good news is that even if last week's bottom were THE BOTTOM, there is almost always a test of it in future months. If that test is successful, that would be an opportunity to put more money to work.