Has a Market Reversal Happened?

The market action last week was very encouraging and optimistic. The fact that it moved up, ignoring all critical bad news, has given a lot of hope to market players. Many believe that a reversal has happened and that we are on our way with a recovery rally – a rally that signifies that the bottom made in November (in October in some markets like India) is now a significant long term bottom and that we shall now be moving on with a higher bottom kind of market movement.

I have tried to think through this process of a market rally in the wake of significant bad news and its interpretation that all major players who want to sell have done so. The bears therefore are now exhausted, giving opportunity to the bulls to come out and show their valor. But is there a case for inverted reasoning here? Let’s explore.

As the market tanks in value in a bear situation, after a significant fall the scope for bears making money becomes lesser and lesser as the buyers become scarce and bids for reasonable volumes come at much lower prices than in normal situations. This increases the risk for bears and the expected risk-adjusted returns may not justify further activity. The bears at this time start to withdraw and start to give bulls a sort of psychological advantage. In the current situation, if we assume that the forced selling is more or less done, then the bears have more reason to hold back as the risk-return equation is distorted even more. This means that the bears now need some reasonable up move for the risk-reward to shift in their favor.

But the question is - if the forced selling is almost done, what will give them the ammunition to fire? Just a technical position – overbought situations, or is there something else? If the play for them until now was forced selling or deleveraging and if it has been done (which I am still not too comfortable assuming) then where will their deliverance come from? Well, to me it is the global economy! As I see it, even if the forced selling is discounted in the market, the state of emerging global economy is not. While one may argue that it was economic news that was overridden, the prime reason for its neglect appears more technical - the bears wanting better and more blood.

This is also because I believe the forced selling is happening in different markets. For example it is reported that the sell-off in the leveraged loans market over the past month has been particularly bad.

The primary draw of leveraged loans for the pros: When a company defaults on its debt, holders of bank loans, which have certain of the borrowers' assets and/or stock pledged as collateral, are higher up in the capital structure and generally get paid before holders of unsecured debt and equity holders. And these loans can be bought at sharply discounted prices, around 65 cents on the dollar on average, say fund managers.

That's the main reason for the dramatic drop in prices for bank loans, which are down 20% to 25% in the last 120 days, loss rates not seen in 25 years, he says. "It is not reality-based in terms of what I focus on," which is mostly companies' ability to repay their debt and, if they can't, what the reasonable chances are of the fund recouping most of its investment.

"If 100% of the companies in our portfolio went bankrupt tomorrow, our historic recovery would be 70%, which is above where they're currently trading," about 65¢ on the dollar, he says. There's nothing about the companies in his portfolio that warrants their trading 25% down from where they were last summer, he adds.

One indication of the high level of risk involved in leveraged-loan investments: the growing possibility that a number of firms that go bankrupt will be liquidated instead of reorganized. (Emphasis added.)

Hedge funds, which now hold more secured loans than banks, have less incentive to see a company whose debt they hold restructured, and are more likely to push a company that defaults on its debt into liquidation, says Martin Fridson, chief executive of New York-based Fridson Investment Advisors. Those odds are even greater if hedge funds have shorted the subordinated debt and stand to make more money from liquidation. Liquidations require the approval of all classes of shareholders and creditors, however, and unsecured bond holders could vote to block it, he adds.

But Standard & Poor's said in an Oct. 23 report that "liquidation is becoming more likely in default and recovery scenarios, with market conditions making the financing needed for companies to emerge from bankruptcy as going concerns increasingly scarce." S&P drew special attention to constraints on debtor-in-possession, or DIP, loans, which typically are used to pay vendors and cover a company's ongoing operating costs.

Apart from the forced sales angle - this is really scary from an economic point of view – see the emphasized part of the excerpt above.

The current situation and the responses are unprecedented and much of what is theory is being tried out. I believe it is far too early for the market as a whole to be able to fathom the depth and possibility of outcomes of a series of measures being taken by various national governments/central banks and how these measures will interact to bring about global systemic changes. And there are quite a few pointers to this.

1. Given the enormity of global problems that the failure of the Big 3 can bring, more than the economic arguments it was the partisan north-south US politics that played a greater role. This also brings out the uncertainty of the current political process to address other critical issues in a timely, focused and result oriented manner. And imagine this political behavior across all the countries!

2. This is further buttressed by the way the much touted US bail out package (TARP) is being handled. The incendiary report to Congress has a lot to say.

Is the Strategy Helping to Reduce Foreclosures? What steps has Treasury taken to reduce foreclosures? Have those steps been effective? Why has Treasury not generally required financial institutions to engage in specific mortgage foreclosure mitigation plans as a condition of receiving taxpayer funds? Why has Treasury required Citigroup (C) to enact the FDIC mortgage modification program, but not required any other bank receiving TARP funds to do so? Is there a need for additional industry reporting on delinquency data, foreclosures, and loss mitigation efforts in a standard format, with appropriate analysis? Should Treasury be considering others models and more innovative uses of its new authority under the Act to avoid unnecessary foreclosures?

The point being made is that people handling the bailout seem to have very little idea or strategy and are ad-hoc at best. How will the results be? Again imagine so many packages being executed all over the world!

And it is not easy to execute packages with so much moral dilemma. As Jim Roger says:

"What is outrageous economically and is outrageous morally is that normally in times like this, people who are competent and who saw it coming and who kept their powder dry go and take over the assets from the incompetent," he said. "What's happening this time is that the government is taking the assets from the competent people and giving them to the incompetent people and saying, now you can compete with the competent people? It is horrible economics."

3. Now coming to the issue that mothered the current crises – the US housing sector. According to a Reality Trac report:

“Foreclosure activity in November hit the lowest level we’ve seen since June thanks in part to recently enacted laws that have extended the foreclosure process in some states, along with more aggressive loan modification programs and self-imposed holiday foreclosure moratoriums introduced by some lenders,” said James J. Saccacio, chief executive officer of RealtyTrac. “There are several indications, however, that this lower activity is simply a temporary lull before another foreclosure storm hits in the coming months.

“Delinquencies on loans not yet in the foreclosure process jumped to nearly 7 percent in the third quarter, a record high, according to the Mortgage Bankers Association,” Saccacio continued. ”And more than half of the homeowners who received loan modifications to reduce monthly mortgage payments in the first half of 2008 are already delinquent on their loans again, according to the U.S. Office of Thrift Supervision. Many of these delinquencies could turn into foreclosures next year.”

Why so many re-defaults? The questions being asked are:

“Is it because the modifications did not reduce monthly payments enough to be truly affordable to the borrowers? Is it because consumers replaced lower mortgage payments with increased credit card debt? Is it because the mortgages were so badly underwritten that the borrowers simply could not afford them, even with reduced monthly payments? Or is it a combination of these and other factors?”

That question “has important ramifications for the foreclosure crisis and how policymakers should address loan modifications, as they surely will in the coming weeks and months….”

4. Further it looks like the beach communities are likely to join the party soon with Jumbo Defaults. To quote:

Jumbo Prime are high-leverage programs that allowed borrowers to buy much more home than they should have. Because Jumbo Prime borrowers had better credit overall, banks were very easy on the qualifying.

…It goes hand in hand with the Moody’s downgrade of many Bank of America (BAC) Jumbo Prime deals citing a 13% delinquency rate. This represents a total meltdown in the sector happening right now that nobody is reporting.

…..Now that the raters are reporting such massive default rates, I am going to officially say that the ‘Jumbo Implosion’ is upon us. The sad part is (ex-Countrywide) BofA was one of the better lenders during the bubble years. In my opinion, it was much more conservative than Wells Fargo (WFC), Citi, Chase (JPM), Wachovia (WB) or WaMu (WM).

These programs offered by most of our nations largest banks allowed a considerable amount of leverage when purchasing or refinancing. These are the ultimate ‘walk away’ loan, as a household income of $85k per year could legitimately buy a $650k home with 5% down during the bubble years. With stated, no ratio and no doc available at a slightly higher rate, many didn’t even need $85k. Now that home is worth 25-70% less and borrowers are making the wise decision to walk away given most their after-tax income is going towards this massively depreciating asset.

Analysts are not taking into consideration how much trouble the American economy will be in across the nation when those middle to upper class home owners all over the nation see their prices fall as much as the lower end has. This will happen - it has to.

Looks like the key problem still remains and if these have been discounted, today’s price is anybody’s guess.

5. Talking about collateral damages I don’t know how many have figured this out. Says one report:

In its quarterly report, the BIS warned the US Federal Reserve, the Bank of England and other central banks that near-zero interest rates and emergency monetary stimulus may come at a cost.

By opening the cash spigot, the authorities risk displacing the money markets and may "discourage banks from lending to other banks".

The money markets are a crucial lubricant for the financial system, but they cannot function if rates fall too low. The sector can wither away, as Japan discovered during its "Lost Decade".
…[W]orldwide issuance of bonds and securities has also gone into freefall, plummeting 77pc from over a trillion dollars to $247bn in the third quarter…

The collapse in bond issuance reflects the near-total closure of the capital markets in the late summer as credit spreads surged. Bonds issued in Euros dropped by 94pc from $466bn to $28bn over the quarter.

6. The fact that the Fed is likely to issue its own bonds has its own collateral ramifications. Would the price start reflecting the way the Fed is performing? Would it be a call on its policies, execution capabilities and the risk in the assets it purchases using the proceeds? If this happens and if the past track record of Fed performance is any indication it would be a grand stage to watch.

Government backing may help but as seen now the yields on government backed issues of banks are higher than the Treasury securities.

7. China is emerging as a bigger joker in the pack than was previously imagined. According to this informed article:

But veteran Hong Kong economist Jim Walker, the director of the Asianomics research firm, believes investment cycles don't slow -- they disintegrate. Although Beijing will try to keep building public infrastructure, Walker's research indicates that a steep decline in private-sector demand from Europe and the U.S. will lop 7.5 percentage points off gross domestic product growth in 2009.

Walker thinks a crash in domestic consumption will lop an additional 2.5 percentage points off GDP growth. Thus Walker's best-case scenario is in the 0%-to-4.5% range, and he puts 30% odds on a contraction. "There has been an outrageous over-investment in property and factories, and much will be unwound," he says. The economist also believes that the growth in Chinese domestic consumption has been overblown and that despite a 50% decline this year, the Chinese stock market remains grossly overvalued.

Russia too is hearing the D word according to a Business Week report: “In comments cited in The Moscow Times, leading Russian economist Evgeny Gavrilenkov warns that if the latest government figures are accurate, they mean that Russia is now heading into a “severe depression”.

8. Are we looking at the death of OPEC? Many of the governments in these countries and those like Russia had national budgets at oil prices well above the current levels and are in deep trouble. It can only balance its current accounts and budget at around $70, according to its finance minister’s own estimates. Further highlights:

Politicians in oil-producing countries have gotten used to oil revenue providing the bulk of the national budget, enabling them to keep taxes low and expand services. In Iran, for example, oil revenue provides between 40% and 80% of the national budget, depending on which oil industry analyst you believe. In Nigeria, oil and natural-gas revenues account for 85% of government revenue.

According to PFC Energy a consulting firm the United Arab Emirates, Algeria and Qatar would be the only OPEC nations able to balance their accounts in 2009 with oil below $50. Saudi Arabia would need oil prices just over $30 a barrel, according to Merrill Lynch, or slightly more than $50 a barrel, according to PFC Energy.

In contrast, Iran needs a price of $90 to $100 a barrel to break even in 2009. And because of President Hugo Chavez’s soaring spending on social programs, Venezuela needs an oil price somewhere between $60 and $120 a barrel; the consensus seems to be somewhere around $90. On Nov. 24, Chavez told a news conference that $80 to $100 a barrel would be a fair price.

Makes you wonder if in the current economic turmoil the countries concerned will be able to reduce or cut expenditures when the call of the day is to increase them like never before. So the question then is how long before oil prices catch up for these countries to balance budgets - a 2mn. barrel per day cut could not help stem the prices. (It is well known that the compliance of these cuts by OPEC members is low.) Or will Middle East countries see taxation become an important tool? The internal dynamics of OPEC is changing rapidly.

And as far as oil demand and off take is concerned, Bloomberg reports that storage of oil in land is very tight and that producers are hiring tankers to store it.

9. As a fall out of the economic crisis and the mistrust the financial system and its guardians have created, Nassim Taleb the celebrated author of the book Black Swan talks of Capitalism 2 in which societies will not depend upon asset values any more! As one commentator to this talk points out:

Mr. Taleb has his mind around this present market morality play presented by the usual cast of self proclaimed financial charlatans... This tragedy Taleb correctly points out is another in a series of blow ups brought to us since he first experienced the 1987 incarnation of financial magical thinking in London...The Salmon Bros [sic] blow up that Warren Buffett helped mitigate at great personal risk seemed to be a remake or at least a knock off of 87 ... a ludicrous estimation of risk by people with PhD’s and fuzzy models... This same group of mathematical elves marched Hi Ho Hi Ho right into LTCM with the same lame theories Greek lettered disastrous result... Now a recent set of variants of that same sort of magical thinking has produced CDO's CDS's and a host of other alphabet soup sows ears... These seem have the potential of marching us all toward living in caves and bartering with loaves and fishes...

The importance of this, I believe, is that future risk will be profiled, giving a lot of weight to distrust on corporate reporting, assets and cash flow values which, when factored-in through PE multiples or discount rates, are not going to be very comparable to historical averages.

Disclosure: No stocks discussed - No Positions.

Comments

[softomic:]

I can hardly find anything optimistic in a market that ignores critical bad news. I think I heard the same pitch from a telemarketer trying to get me to put my money in oil a few months ago.

2008 Dec 15 06:54 AM

[who:]

Great summary, yes, i don't understand the bottom calls or ignorance of the bad news. Obama election has given the markets some sense of optimism but even he admits it may take more then one term of office to over the current difficulties. Given your summary more weakness is expected, even an oil price war may breakout as countries try to sell as many barrels as possible. Banks and balance sheets will never be the same.

2008 Dec 15 08:51 AM

[User 319796:]

The more the market goes up on bad news the harder it will fall when the reality finally sinks our consumer economy is screwed!!

Nobody wants to buy a house, because they are stuck in the one they are in. Nobody wants an American car.

And EVERY person i talk to is not interested in aquiring any more debt. This will destroy the bankers and their ponzi schemes!! Not to mention the rest of our consumer economy.

2008 Dec 15 08:55 AM

[Scott Sambucci:]

With regard to the housing and foreclosure market, there's also the activity on the existing home sales affected by the foreclosure rate. For example, check out Sacramento existing home prices vs. inventory levels:

Sacramento: tinyurl.com/Sacramento...

Even with a constant decrease in inventory, prices are still falling at a steady rate. We suspect that the fall in the weekly inventory numbers are simply properties going into foreclosure which then leave the existing home market's traditional channels (meaning represented on a one-on-one basis by agents/brokers). Once the banks take over the property, they're bundling and reselling at pennies on the dollar is asset packages.

Despite lower supply in the traditional resale channels, prices are STILL falling. Seems to illustrate the lack of buyers as the current price levels. More on this problem here:

scottsambucci.blogspot...

2008 Dec 15 09:35 AM

[fgd:]

Pretty much on the money. For sure there is going to be an oil crisis and none of the mentioned countries, especially South America and Russia, have any idea how to adjust to the falling prices. Only the United States and China have the ability to bring this world problem to a head. This is not going away in 6 months or a year, this is going to take a minium of 3-4 years and probably 10 or more. Remember, it took 25 years during the great depression and that was only solved because of WWII.

2008 Dec 15 09:55 AM

[happysoul77777:]

The article would be much better if the author provided with hard statistics.

2008 Dec 15 11:51 AM

[Daveson:]

The current Oil Rally is a suckers rally! After OPEC signals a reduction in production, the market will rise. Then the news of continuing demand erosion will hit.... and the shorts will have control. OIL and OIL stocks are headed for a big fall! Followed by a recovery, once the supply and demand equate. Further followed by a rapid rise as demand outpaces supply into the next 3 years. United States, China, and India. The real big three.

2008 Dec 15 02:40 PM

[john266:]

A rather confusing article, The number 1 reason people are defaulting on home loans is they are underwater and its getting worst, its easier to walk away than to hang on to a home that worth half what you paid for it.
Another thing that will start happening is people will start cashing out the 401k to pay bills after they loose their job. Creating more pressure on equities.

2008 Dec 15 04:45 PM

[prudentinve...:]

Excellent article. I agree with several of the comments posted that the fact that markets have been rising on bad news is not necessarily a positive trend. It could simply be a sign that bears are exhausted and waiting for a consolidation lull before the next leg down. It could also be a sign that there are still foolish people throwing good money after bad.

My own view is that there are certainly some very good values in today's stock markets, both domestic and international. However, many, perhaps most, stocks still appear overvalued considering their P/E, their yield, and their prospects for growth. Thus the recent mantra that the market as a whole is now cheap does not seem true from my vantage point of 30 years of stock investing.

2008 Dec 15 05:42 PM

[Socialism c...:]

Jim Rogers is SPOT ON. The government folks and the Fed have *completely* ignored the so-called moral hazard of their actions (which I call outright FRAUD of the American people!!) and plunged ahead with their bailouts, which Rogers rightly assesses as penalizing the competent, wise people to help those who were foolish!!

Having taken these wrong actions will not help the economy. What will is the one thing that has STILL not been done -- massive tax cuts, corporate and personal. THAT is how you save jobs. That is how the average American ends up with more of THEIR OWN money in pocket to pay down debt with, save, or spend...at OUR DISCRETION...since it is OUR money, to begin with!!

2008 Dec 15 05:51 PM

[Repsonsible...:]

Took Less then 16 business hours from the time he's arrested for Feds to step in and Cover losses of the Rich who invested with Madoff. They used a Obscure Old Law , so again Public Money for The Rich , but NOT A DIME for the Working Man at GM, F or C
workers. Im a Capatalist but this sucks protection for the RICH but NOTHING for the working people .

When the Investors were making 20% a year interest they where Happy , they didnt ask any questions , now that they got burned , there crying !!

2008 Dec 15 08:27 PM

[Son of Liberty:]

This mess is far from over. If someone tells you that wall street and the market has already discounted all of the bad new and we are at the bottom they are in denial or just talking up their book.

All of the big banks are using non GAAP accounting practices ala Arthur Anderson, Enron, Fannie & Freddie style (Referred to as SOP 03-3). They are using off balance sheet instruments that allow them to book interest income, hide loan losses, allow them to not account for loan loss reserves and even better yet...artificially raise their capital ratio to make them seem more solvent. Check for yourself take a look at BAC or JPM's most recent 10Q. Go look at the banks quarterly reporting to the Federal Reserve. Not that you will get all the data there...But what little is there is quite telling.

BTW, when you look at BAC's 10Q take a good look at what they expect to happen in 2009, 2010 and 2011 with their option arm portfolio that they "classify" as discontinued real estate under good ol' SOP 03-3. Well over 60% of that portfolio will be defaulting.

JPM is in an even more precarious position since they took over WaMu and all of their option arms...Can you say >60% default rate?

But the real gem of the group will be Wells Fargo...Currently trading at a premium...They bought Wachovia who wrote more option arm loans than any bank. The details of that "acquisition" has yet to hit their balance sheet. Wait until it does...

But wait it gets even better...When these banks do workouts with troubled borrowers they simply tack the past due payments onto the end of the term of the loan and then report them as current.

They all have also changed what they call a default. A default was once when a loan was 90 days late. Now they are using 120+ days. A rather convenient method to make their portfolios look better than they actually are.

You can only not pay the piper for so long. Once they have to foreclose the property must be reported on their balance sheet as real estate owned. Wait for real estate prices to drop more. Then the banks will have to take even more losses.

Then there is the unsecured debt/consumer credit in the amount of some $17 Trillion where some 20% of the borrowers are 90+ days past due and sure to default.

Next...Commercial real estate loans....Then corporate debt...

and then the mother of them all...the derivatives and credit default swap market.

I hear JPM is on the hook for some $90 Trillion...Oddly, according to the Fed's website they only have a little over $2 Trillion in assets...

Hmmmm, I wonder what the S&P 500 will be when the government has to fully nationalize all of the banks.

I have also heard that if the S&P 500 drops to 650ish most insurance companies will be insolvent as well.

Too bad Tobin's Q Ratio is calling for a 400 S&P 500....

2008 Dec 15 10:49 PM

[cayman:]

Phil Graham was right, you are a nation of whiners.
Where have all the cowboys gone ?

Of course it's bleak, but you have to see the positive and make it happen.....at least find a way to make it happen.

Markets rallying on bad news can mean there is good news in 6 months time, but for now the final crapper is coming through the pipe.

2008 Dec 16 03:10 AM

[Did U Think...:]

I have 2 pet peeves in this market:
1) Why do people insist in talking about "the bears this" and "the shorts that.? Bears and shorts are a tiny percentage of the investing population and we are not causing this or even controlling the show. It's the longs bailing on the market that is bringing it down.

2) We just had the greatest credit boom in the history of man. It has now gone bust. We all now know that dot bomb was not allowed to crash normally by Greenspan who opened the credit floodgates to stop it which had the unintended consequences (like all gov't meddling in the economy) of creating something even worse. So my question is why do people think that it is even remotely possible that the Dow will stay above its nasdaq bust lows? This bear market will end FAR lower than that, and we can just ignore anyone who says differently.

It really is that simple.

2008 Dec 16 06:39 AM

[bricki:]

Sons of Liberty, where do you get 17 trillion unsecured consumer debt? The numbers I've seen published are more like 2.5 trillion. The only way to get to 17 trillion is to include mortgage debt, which despite all the hue and cry has a pretty low default rate.

2008 Dec 16 01:41 PM