Requiem for a Heavyweight


“And be these juggling fiends no more believed…that keep the word of promise to our ear, and break it to our hope.” Shakespeare (Macbeth)

Up 400, down 300, up 300. Lose an investment bank, but gain the biggest IPO ever. Throw open wide the Fed window. Ah, did we say prime collateral? For special friends of the Fed, we take not-so-prime collateral. Loan? Oh no sir, we don’t lend money anymore. That’s the Fed’s job. Takeovers? Oh no sir, those 2007 takeover bids have all expired. Yes sir, you see we were out of our minds when we made those bids. We’ve invoked the sanity clause. Yes sir, there really is a sanity clause. Just ask JP Morgan (JPM), or the New York Fed. They’re standing right over there in the gift-wrap section.

So passes another week of the strange and weird in the U.S. markets. The best bet on the Street right now may be that nobody knows what may happen next week. Nobody, maybe, except those guys who were loading up on tens of thousands of out-of-the-money Bear Stearns (BSC) puts ten days before expiration. Those puts were way, way out of the money, they ended up way, way in the money, and the SEC is way, way interested.

The Bear Stearns rescue (the operation was a success, but the patient died) was certainly the talk of the Street. Questions will linger on for months if not years, and there is still doubt about the outcome. Investigations we can be certain of (e.g., the puts), as well as lawsuits (JPM has reserved six billion or so against litigation) and I’m quite sure at least half a dozen very large hardcover books.

Another thing that appears certain is that JP Morgan has made out very well. It’s a bit difficult for them to be keeping a straight face right now, claiming that $236 million was a fair price on the one hand while pretending that the $12 billion increase in its market capitalization was just the market’s way of saying thanks.

We are witnessing a historic change in finance these last six months. The Fed has opened its window directly to non-deposit-bank primary dealers for the first time. It seems inevitable that in return that the investment banks will find themselves under Fed supervision. The recent crescendo of leveraging led to a spiral of margin calls that still poses a threat to the financial system. The move to cash in on real estate turned into a frenzy: judgment was put aside, and a price will have to be paid. There will be more than one probe.

Predictably enough, the Bear debacle has launched waves of finger-pointing, posturing and misinformation as different groups grapple with the issue. The regular press struggles to understand it (they haven’t), the ideologue high priests thunder from their pulpits (too much regulation, not enough regulation, too much/not enough money and so on), while business columnists look hard for the book angle that could mean buying a Manhattan co-op from a laid-off banker.

We’ll try to deal with some of the misinformation. For example, the notion passing around that the Fed has already used up half of its balance sheet, or may run out of money. The Fed’s balance sheet is in fact unlimited, and it cannot run out of money. But it isn’t anxious to start printing it, either. The goal is pragmatic: keep the system going without overdoing it.

The Bear Stearns resolution was not a bailout of Wall Street robber barons, nor does it encourage moral hazard. No investment bank ever wants to suffer the fate of Bear Stearns. The employees, who own one-third of the company’s stock, have suffered devastating financial losses. The biggest losers in dollar terms are senior management. Investors in Bear Stearns stock have suffered huge losses as well.

The Fed acted to prevent the system from going into a full-blown panic. Letting a large investment bank fail in the current circumstances would have been the worst kind of negligence. One can argue about the price, and further scrutiny of Bear’s last days will probably turn up some embarrassing revelations. But candidly speaking, the average person will never know what a huge bullet we dodged. The repercussions could have gone beyond recession to as far as a general depression. The Fed’s actions go to the heart of the reason it was created: to keep the financial system from imploding during panics.

We can expect more pushback from ideological purists, the same sort who would tell you that the Titanic sunk because it was weighed down by its lifeboats. But there may be some good to come out of the current crisis. One is that having gone through two extremely unpleasant bubble collapses in ten years, the calmer heads on the Street may want to work out a more stable system. The Street wants to make money and so do we, so we shouldn’t stifle financial innovation or adopt excessive regulation. But nobody wants to give all the profits back every five or six years.

We need a system that more explicitly addresses the changes in the U.S. economic system. When the United States was more of a manufacturing-based economy, business cycle swings tended to result from over-production of inventory that eventually led to a glut and then a contraction. Eventually manufacturing gave up on trying to predict turning points and took advantage of technological advances to switch to more flexible production systems with lower stocks. The manufacturing cycle is smoother now.

The financial sector is now the dominant one, and is repeating the mistakes that manufacturers used to make: over-producing during good times and suffering painful contractions. The solution isn’t obvious, because we had regulations in place that might have prevented the last bubble. The problem is that the political will to enforce prudence tends to vanish during a boom. Adding more regulators may do nothing more than leave us with the same reliance on timely judgment, a system that hasn’t produced great results.

We have some automated risk-limit systems. After the 1987 stock market crash, the exchanges adopted rules to limit and even suspend trading based upon specific market moves. The answer may lie in some sort of mechanism that can kick in when balance sheet growth and leverage ratios reach certain levels.

It won’t be easy, because for one thing we have seen how clever financial engineers can be at developing off-balance sheet schemes. For another, one can expect all the players to try to maneuver any remedy to the benefit of themselves and to the detriment of their competitors, all cloaked behind a screen of free market spin-babble that proclaims itself the champion of growth and employment.

We shouldn’t handcuff the Street, or lending, or home ownership. But we’ve got to do better at managing production levels. We can’t repeal the business cycle, but we can certainly live without these wrenching bubble collapses every few years.

With that out of the way, let’s turn to some more immediate observations on the state of the financial system. While the Fed’s actions should hold stem the panic, a lot of institutions are still too frightened to do much more than breathe – and rather quietly, at that. CIT Group (CIT) had to draw down its entire $7.3 billion line of backup credit when its other funding sources stopped returning calls. There is still some work to be done.

Two parallels from the 1987 crash come to mind. One is that on the afternoon of Black Monday, over-the-counter (e.g., Nasdaq) traders and market makers literally stopped answering their phones (things were less electronic then). They were afraid to provide bids. The regulatory authorities were not amused, and the Street found itself on the receiving end of massive changes in the trading business. Let’s just say it isn’t as profitable as it used to be.

Now the investment banks have stopped answering the phone on auction-rate securities that they promised to backstop. They’ve stopped answering the phone on calls from the boards of companies that were slated to be taken over. So have their private-equity counterparts. Deals are being busted at an unprecedented rate. The Street is terrified that homeowners are going to do exactly what they are trying to do – walk away from investments that have gone underwater, rather than try to stick it out. There is going to be fallout. I’m afraid the private equity shops haven’t woken up to it yet.

Another parallel is portfolio insurance. This clever concept was designed to protect portfolios against downside volatility, as its name implies. The idea was that when the markets were falling, one would sell index futures contracts to offset the decline (the seller of an index future profits if the index declines). The futures market makers, though, sell stocks to hedge against a decline in the contracts. On Black Monday afternoon, automated programs began churning out massive amounts of orders to sell futures contracts. So the market makers sold more stock. So the programs sold more futures. So….oops.

Now we have credit default swaps (CDS), devised as a way to protect against default risk by bond issuers. Now they’re used for all manner of hedging and speculation. As the markets sink, panicky investors and aggressive traders bid up CDS to absurd levels. Risk managers and margin clerks see the CDS price and demand more collateral from bondholders. The holders have to sell into a down market, which drives the price down further, which drives the price of the CDS higher, which….oops.

So while financial stocks are bottoming, thanks to the Fed’s action, we’re not out of the credit crunch yet. A week ago, I had thought that the markets might have reached its bottoming phase, but last week’s rally suggests that we’re not there yet. The markets were relieved last week that the results from the major investment banks beat estimates and produced no new horrors, but S&P – which didn’t take Friday off – put Goldman Sachs (GS) and Lehman Brothers (LEH) on negative credit watch at the end of the week.

The outlook from economic barometer FedEx (FDX) on Thursday was grim. One line that stood out was its characterization of the last five years as “the largest transfer of wealth in the history of the world, $2.5 trillion from the OECD oil importing countries to the oil producing countries.” I wouldn’t put that into the bullish category.

Yes, the Fed lowered rates by another big chunk (100 points in all) and that sure is going to help. So is widening the borrowing window and the types of collateral it will accept. It also lowered its growth forecast and raised its inflation forecast. That last part doesn’t sound like a recipe for growing stock prices to me and by the way, bear markets don’t end in relief rallies.

Line of the Week: “You have the stupid money coming into the market now, and I think the smart money is beginning to get a little frightened about what the stupid money will do.” Jeffrey Christian of the CPM Group commenting to the New York Times on the commodity markets. Gold suffered its biggest one-day drop in twenty-eight years last week.

Happy Easter to those who observe, and Happy Spring to all.

The Economic Beat

The week led off with the New York Fed’s manufacturing survey doing the bass line to the Bear Stearns tenor. Basso profundo, because it was the lowest reading the survey has produced since its inception in July 2001. It wasn’t all bad, as there was some modest uptick in new orders (though still contracting overall) and employment was steady. It’s a survey, not production data, but a look at the chart isn’t comforting:

New York Fed Survey

Source: NY Federal Reserve Bank

The Fed’s industrial production report that was released shortly afterwards continued in the same register. It showed a decline of (-0.5)%, versus expectations of (–0.1)%. Utility output accounted for much of the difference, but generally conditions were soft. The monthly production numbers are somewhat choppy, and even in boom years will produce a couple of down months, so one shouldn’t rush to judgment over one down month. But it doesn’t look good sitting next to the NY and Philadelphia Fed surveys.

The National Association of Realtor’s Housing Market Index was unchanged, and housing starts were somewhat better than expected. That is to say, February didn’t decline as much as expected, and January’s decline was revised to a gain. But permits were down, indicating the still troubled nature of the sector.

The PPI (Producer Price Index) came in at an expected 0.3%, though in an unusual twist the overall number was actually lower than the core number, which came in at 0.5%. The year-over-year rate declined from last month’s twenty-five year high, but the Fed couldn’t have been happy about the jump in the core rate. By week’s end traders were interpreting the FOMC inflation stance in the most favorable light. Be careful of the market’s built-in tendency to wax euphoric.

Retail sales and mortgage applications are showing little life, while initial unemployment claims rose strongly. The latter suggests another disappointing jobs report may lie in store. The Philly Fed’s employment indicator turned negative, and its overall number was also quite weak with a reading of (-17.4) (zero is breakeven). The markets, being the emotionless, rational decision makers that they are, rallied because it was better than the consensus estimate of (–20). Sure, new orders, production and employment are all declining while prices are rising, but hey, it beat consensus.

The leading indicators fell again and last month’s reading was further revised downward. Investors should keep in mind that that although the Fed’s actions should help the economy recover down the road, there is likely to be considerable near-term pressure on earnings and guidance. As Peter Lynch was fond of saying, in the end it’s the E (earnings) that matters.

Next week will get off to a slow start with existing home sales on Monday and one of the consumer confidence readings on Tuesday. Neither reading is likely to suggest anything new, but in its current over-excited state the market is apt to over-interpret anything and everything. Wednesday will bring new home sales and durable goods. If the latter holds to form, it should tick up again mildly after last month’s sharp decline.

I suppose if new home sales are one hundred units better than the consensus it’ll be another occasion to jolt the homebuilder stock zombie, but widespread evidence of multiple and impending bankruptcies amongst private builders keep me from believing in the sector. It may be less competition for the lions if the other carnivores in the jungle are dying of disease, but that will be of little comfort to the lions that catch it themselves.

Thursday will bring a final reading on last quarter’s GDP, a look at aggregate corporate profits, and the first occurrence of the Fed’s new Term Senior Lending Facility auction. That’s the schedule, anyway, as the Fed has been quite nimble lately and one hardly knows these days where the next panic may come from. Friday will bring the personal and income spending data, which should be the most revealing data of the week. But reports are nothing next to rumors these days.

StockWatcher’s Corner

Got shoes? If you’re interested in a retail stock these days, you might want to have a look at Foot Locker (FL).

Start with Friday’s price of $11.53. That’s about 75% of book value, and about a buck less per share than what the CEO paid when he bought over a million dollars worth ($1.25mm) four months ago. With a little patience, you could probably pick up the stock in the current market environment for under $11. The current range is the lowest for the stock since 2003.

The company has over $3 a share in cash and $1.77 net of all debt. It generates strong operating cash flow and recently raised its dividend to a current yield of 5.2%.

Operating results suffered last year along with the rest of the mid-priced retail environment. The company was doubtless distracted by its takeover competition with Finish Line (FINL) for Genesco (GCO), a battle it was indecently lucky to lose. It appears that the management is refocusing on running lean and mean, and that sales may be at trough levels. Nike (NKE) is the company’s biggest supplier, and the former reported strong results last week. It seems that people still want to own shoes. Foot Locker operates stores in North America, Europe, Russia, Asia and Southeast Asia.

Although the current retail environment is difficult, this may prove an opportunistic time to build positions in retailers with good balance sheets and strong cash generation. Retail stock prices usually turn up well before a downturn or recession ends.

share this blog post
Facebook Twitter Plusone Linkedin Digg Delicious Reddit Stumbleupon Tumblr Posterous