The search for the magic formula (see last Thursday’s article) is running into serious roadblocks, and the financial powers that be must resolve the re-engaged credit freeze ASAP. With each passing day, the failure to create the new financial order puts increasing strain on the core of the system – something that cannot be allowed to metastasize into the real economy. Dangerously, such a risk seems to be on the rise. Yet, at the same time, the excess liquidity sitting in the coffers of institutional investors (including hedgies) along with reasonable earnings growth suggests that the downside risk to equities is limited.
The two above dichotomous points are captured quite clearly in the following three excerpts from the must read FT Alphaville:
The perceived riskiness of European corporate debt increased on Tuesday as traders in credit default swaps, worried the credit squeeze will ripple from banks to the wider economy, drove spreads wider. Concerns for banks’ balance-sheets were exacerbated yesterday when the one-month sterling Libor rate hit a nine-year high. There were growing signs that tightening credit was hitting consumer demand as restaurants, credit card businesses and property funds began to feel the strain.
Five hedge fund managers at London’s Marble Bar Asset Management will share at least $400m after agreeing to sell their five-year-old firm to EFG International, the Swiss bank.
Warren Buffett has rediscovered his appetite for junk bonds, buying $2.1bn in debt issued by the Texas utility TXU in a move that suggests value-seeking investors are prepared to step back into the troubled credit markets.
So, there you have it in a nutshell. The core of the system has reentered the deep freeze with the increasing risk of spillover to the real economy while investment capital remains abundant, and abundantly rewarded.
Investment Strategy Implications
One week from today, the Fed’s interest rate decision will be a no brainer – another quarter point cut. That will put the Fed two-thirds of the way toward the normal rate cut response (1 ½%) to a potential domestic economic slowdown. However, rate cuts alone will not do the trick. The magic formula must be found - and quickly - as there is little about the current situation that is normal.
As for equities, signs of a topping process increase. As noted in yesterday's weekly report (subscription required), the infantry is abandoning the effort as Small and Micro cap have significantly underperformed of late leaving only Mid cap standing. It is, however, far from being a done deal. Counterbalancing positive factors (valuation, global growth story, investment liquidity) provide support for higher equity prices, or at least limiting the downside risk. Yet, these positives can evaporate in short order if the magic formula cannot be found.
Time is not on anyone’s side.