First Steps to Some Stabilization

Excerpt from Raymond James strategist Jeffrey Saut's latest essay, published Monday (October 20th):

...[W]e have always thought the credit markets are smarter than the equity markets and therefore have been watching various credit spreads intently. The credit markets, ladies and gentlemen, will be the first “tell” as to when things will stabilize; and Mr. Bernanke is correct, “stabilization of the financial markets is a critical first step.” Late last week looked to provide the “first steps” to some kind of stabilization. For example, the November Eurodollar contract was sharply lower on Friday, as was the 3-month LIBOR interest rate. Rumors swirled that a major bank was lending heavily in the inter-bank market and the credit markets took a baby step toward thawing. We are hopeful that notion will spill over into the equity markets this week because the set-up for at least a trading bottom looks promising.

Indeed, as mentioned in previous missives, the equity markets are massively oversold and our downside day-count sequence is VERY long of tooth. Moreover, the Friday plunge of October 10th had all of the characteristics of a panic “low.” If so, what typically occurs is a 1½- to 3-session sharp rally off of those “panic lows” and then the averages go right back down over the ensuing three to five sessions. Roughly 60% of the time the averages hold above the previous low. The other 40% of the time they make lower lows, but not by much and the bottom is completed.

Obviously, last Monday’s 936-point “Dow Wow” was a sharp rally that lifted the senior index some 1500-ponts above the previous Friday’s nadir (7882). That strength spilled over into Tuesday morning, thus completing the perfunctory 1½-day throwback rally. From there the DJIA went straight back down into Thursday’s panic low of 8198 in what may have been a three-session slide that retested the lows of 10/10/08. If I could script it perfectly the downside retest sequence would have “timed” out into the first part of this week, but they don’t run the stock market for my benefit.

Accordingly, ever since that ill-fated Monday (9/29/08), when the House of Representatives turned down the Paulson Plan, we have told participants that the main theme is “survival.” We have also suggested to “be the second mouse that gets the cheese” because the first mouse usually gets caught in the trap. Plainly, most folks who have attempted to pick the bottom over the last three weeks have lost money. Nevertheless, we have been readying our “buy list;” and last week Raymond James issued a comprehensive report titled “Securities For Uncertain Times” peppered with the best risk-adjusted ideas from our various departments, many of which have decent dividend yields.

And, we think the odds of a bottom have increased. From a technical perspective that view is reinforced by the bottoming sequence already discussed. However, there are more fundamental factors at work. Firstly, there is the noticeable improvement in the credit spreads. Secondly, the Fed is printing money at an unprecedented rate and money is the “oil” that makes the economic engine run. Thirdly, European leaders have taken the reins into their hands and crafted a rescue plan that makes much more sense than our ill-conceived reactive plans. Finally, there is tomorrow’s settlement for the recent Lehman credit-derivatives auction, which at nine cents on the dollar was a total bust. However, if tomorrow’s settlement goes off without a hitch it could soothe the markets and provide the “spark” that ignites a decent rally.

That said, even though the equity markets may stabilize and rally, as Mr. Bernanke notes, “even if they stabilize as we hope they will, broader economic recovery will not happen right away.” Manifestly, the falloff in the economic data has been dramatic. Consumer confidence has plunged to 57.5 this month from 70.3 in September for the largest decline in the history of the data. Meanwhile, retail sales tagged a three-year low and single-family housing starts slid 12% in September to a 26-year low. Not to be outdone, building permits skidded 8.3% on the month for a reading not seen since November of 1981; and industrial production, as well as the Philly Fed index, have come in well below forecasts.

The good news comes on the commodity front, where prices have crashed. That commodity crash has ameliorated some of the inflation concerns and should allow the Fed to continue to expand its balance sheet and begin to act like a loan clearing house for many of the credit-derivatives awash in the system. Interestingly, in theory the Federal Reserve can expand its balance sheet exponentially since it is a central bank with a sovereign currency that is NOT convertible into anything other than itself, a point Mr. Bernanke so eloquently made in his now famous “Helicopter Ben” speech of November 2002. We actual find this reassuring given the “toxic waste” that has infiltrated the country’s economic system.

The call for today: While we have not seen a crash, what we have seen is a series of crashettes that have left us with as good a chance for a bottom as we have seen since 55 B.C., which is why we told accounts in last Tuesday’s comments that the short-term lows were “in” and they could begin a buying program in the investment account.

We reiterated that stance on Friday, repeating that a bottoming sequence was at work and participants should act accordingly. Consequently, we’ll leave you with this thought from Cicero in 55 B.C., “The budget should be balanced, the Treasury should be refilled, public debt should be reduced, the arrogance of officialdom should be tempered and controlled, and the assistance to foreign lands should be curtailed lest Rome become bankrupt. People must again learn to work, instead of living on public assistance.”