Continuation Point

For the bulls, the events of the past several days have marked a major turning point for the U.S. equity market.

Share prices staged their first weekly gain in a month. The Federal Reserve pulled out all stops to save the banking system. Financial shares bounced hard. And inflation fears eased as commodity prices fell back to earth.

In other words, the ducks are all lined up: it’s time to buy.

Upon closer inspection, however, recent developments are less than reassuring. History suggests, for example, that major upside reversals are rarely anticipated before the fact -- or at the time. Often, they are not even acknowledged for days or months after a rally has begun.

Yet there was plenty of talk this week about "bottom-fishing," "buying opportunities," and the likelihood of a "bear market bounce" in share prices. Analyst Richard Bove proclaimed that “the financial crisis was over.” A Merrill Lynch survey revealed that money managers were itching to buy “undervalued” equities.

Not exactly signs of excessive pessimism.

There hasn’t been much “capitulation” by weak hands, either. Apart from the quick downdraft that occurred in mid-January, apparently spurred by hedge fund selling, the decline from the October record peak has been fairly orderly.

Yet the absence of a washout doesn’t seem to phase the bulls. One pundit even went so far as to say that a lack of panic-type selling like we saw last Monday was “another sign that we could be near a bottom.” That takes the cake as far as bullish rationalizations go.

What about the fact that financials were at the head of the pack during this past week’s recovery? Was it because investors were taking advantage of what Bove characterized as a “once in a generation opportunity to buy,” or did it have everything to do with the fact that the most heavily-shorted shares were being squeezed the hardest?

Otherwise, is it actually good news that Fannie Mae and Freddie Mac can now operate with even smaller capital cushions than they had before? Or that curious financial footwork helped some brokers to beat Street estimates, even though their outlooks remained dicey? Or that the Bear Stearns “rescue” could only be solved with the help of $30 billion in non-recourse Federal Reserve loans?

Many bulls also took comfort from the sharp decline in commodity prices, which was seen as a sign that inflation was no longer a concern. Reports indicate, however, that “de-leveraging” by hedge funds and proprietary trading desks played a major role in the unwinding. Instead of being good news, the slump probably means that bursting-credit-bubble deflation is gathering force, which is bad news for share prices.

Of course, what really got the bullish juices flowing recently are the actions of the Fed. From helping to orchestrate a Bear Stearns bailout, to cutting the discount and federal funds rates, to opening up new sources of liquidity for an ever-widening array of institutions, Bernanke & Co. are doing anything and everything they can to try and save the day.

Unfortunately, there’s just one thing missing: good results.

“‘He has taken extraordinary measures, things that we haven't seen since the Great Depression,’ said former Fed vice chairman Alan Blinder, a Princeton University professor,” in a Bloomberg report. “‘He's working overtime, literally and figuratively, to get this panic under control. But so far, it's not under control.’”

Arguably, the Federal Reserve is actually making things worse. For instance, rather than bolstering confidence, the central bank’s seemingly reactive and seat-of-the-pants, secretive, and unusually forceful response suggests that policymakers are desperate and behind the curve.

In addition, new liquidity facilities that allow a broad range of unnamed counterparties to swap unknown amounts of mis-rated and overpriced mortgage-backed securities for U.S. government bonds only adds to uncertainty about valuations and the extent of the problems that like ahead.

Finally, people are being led to believe that things are under control, so instead of doing whatever is necessary to prepare for the worst, they are setting themselves up for an even bigger blindsiding than before.

In sum, while bulls believe that share prices are poised to reverse and move sharply higher, the facts suggest otherwise. In reality, what they are seeing is the set-up for the next leg down. Some might call that a continuation point.

Comments

[roger pasa]

Objective reality is to much to bear for most people at this stage of our financial problems resistance is at its peak despair & confusion are turned are turned into a make believe world BE happy don't worry

[Jon McIntyre]

It is quite clear that we will continue to see violent swings in the equity markets. As the full force of the Federal Govt. and U.S. banking system pushes back against the unfdolding crisis, one day may be cheered by the beginning of the end by the bears, only to be followed by a rousing cheer for the bottom in equities and the end of the credit crisis by the bulls the very next day. The challenge is to navigate between reality and the manufactured reality of the fed/banks and make some profit while the markets ultimately sink lower. This may or may not come with a resounding and cathartic wash out but surely we're headed lower. There are undeniable problems and massive losses in the banks and credit system as a whole that have yet to be accounted for. As far as I remember, losses equal less profit and less profit equals less value in stocks.

[Truesincerity]

With the fbacking of the FED and the gov't have they not put a floor under the banking system?? Furthermore, you can see that the GREAT Housing Bailout is coming. They will not let Housing Prices continue to fall, they will attempt to put a floor under housing prices as well. I think this is what WallStreet is betting on, they will not let the system fail.

[David Pearson]

We might take the Fed's liquidity actions seriously if they addresses the underlying problem: leverage.

Think about how many financial institutions are borrowing from the TAF Fed and yet still paying out hefty dividends? How many continue to insist that their liquidity situation is "strong"? How many -- and this on takes the cake -- are actually buying back shares?

What the Fed should do is declare a simple requirement for TAF/TSLF/Window borrowings: any borrower should cut the dividend, suspend buybacks, and issue shares totalling, at a minimum, 10% of capital.

That the Fed doesn't exact this price means they are truly in panic mode. They simply cannot stomach a decline in equity prices at this point, as they fear it would further impact confidence.

[Rocky]

If you are one of Jimmy Cayne's rich neighbors, you might want to read Barton Biggs new book "Wealth, War and Wisdom". It makes for interesting reading, even if you are not rich enough to take all the advice.

[Jimbo]

Hurricane's a-coming. Best to have your kit ready.

Here's an interesting tidbit: empirical evidence from hotspots around the world shows that, since WW2, in any situation where lawlesness and lack of everyday necessities prevails, the most readily tradeable item (and therefore the one that acts most like money) is 22LR ammo.

Go figure.

[Jon McIntyre]

If a floor is put in under housing prices then the floor beneath the entire economy will fall. Maintaining house prices at their current levels results in too much disposable income going to pay the mortgage and not enough left to be a consumer and support the hyper consumption model of economics we've been "enjoying" for the last twenty years. Something's got to give. For all the rhetoric about putting in a floor under housing prices, prices are heading down right now at this very moment and the downward move is gaining momentum. If they don't, there's nothing left over for plazma televisions and new cars. Don't listen to the rhetoric, look at the numbers. No one is putting a floor under housing prices. All that is happening is an attempt to put a floor under the losses realized by everyone who gambled on housing and are now losing big. This is an attempt to minimize the losses in structured finance while simultaneously trying to convince those who are easilly convinced that its about stabilizing the real estate market. Stabilization will only occur when prices fully adjust to reflect the purchasing power of those who want to buy a home. We've got a long way to go to get to that point. This is basic economics. Everything else is smoke and mirrors.