Good Evening: Investors headed into this past weekend worried about bank nationalization and tea parties in Lake Michigan. There was a little short-covering on Friday afternoon when some market participants tried to limit their short exposure in case the Obama administration attempted to pull a rabbit out of its hat with regard to a sweeping announcement about our nation’s banking system. They needn’t have bothered, since what emerged from Washington was yet another trial balloon in the form of a proposal to convert Uncle Sam’s existing preferred equity stakes into common shares. While this concept may have merits, it was once again the lack of detail that hurt confidence and led to more selling in Wall Street. Investors are losing patience with what appear to be trial balloons and half measures, so the markets are likely to continue to sink unless Team Obama can offer much clearer and actionable policies going forward. It is it any wonder why gold is front and center in the discussion surrounding investments appropriate for the current environment?
With no economic releases on tap today, the pre-market action in stock index futures swirled around stories that would have the U.S. government up its ownership stake in Citigroup (see below). The form of semi-nationalization under consideration would supposedly involve having the U.S. government convert its preferred equity position into a common equity position. I say “supposedly” because, as with almost every proposal emanating from Washington during the past month, the details were as few as they were fluid. Still, it was nowhere near the sort of broad and radical nationalization that had been rumored late last week. As such, investors breathed a brief sigh of relief and pushed stocks higher at the opening bell today. When D.C. officials had little to say about the Citigroup story, however, the shorts who had covered on Friday afternoon took it as a sign to reinstate their negative bets. The surest way to wealth in recent weeks, unfortunately, has been to shoot down any trial balloons with a hail of sell orders.
After popping 1% or so at the open, the major averages proceeded to sink for most of the rest of the session. The only rally of note came when the S&P 500 held the 750 level on the first assault, but this price point gave way during the final 90 minutes. It may not be anything more important that a sign of our times, but an offer from American Express to pay certain cardholders $300.00 to close their accounts (now that’s stimulus!) certainly didn’t help investor psychology (see below). Though the S&P never did quite breach the intra-day November low of 740 or so, this important large cap benchmark followed the Dow in setting a new closing low without putting up much of a fight. By day’s end, all the averages were down between 3.4% (Dow) to 4.15% (Dow Transports). The action in other markets was quite muted by comparison. Treasurys were mixed, the dollar index rose 0.75%, and another slip in crude oil prices precipitated a 1% slide in the CRB index
Uncertainty and ever-changing policy prescriptions may not be the enemy of capitalism, but they do hurt asset prices because capitalistically inclined investors tend to demand a higher risk premium (i.e. lower prices) in return for shouldering said uncertainty. Swept into office by the hope for “change”, the Obama administration has given the American people exactly what they wished for by changing their policy proposals for combating the financial crisis on an almost daily basis. What has also changed since the days Hank Paulson felt the need to introduce constant revision is that at least Mr. Paulson was decisive. Team Obama has yet to settle on a plan, let alone display a spine steely enough to implement it over the voices of objection. I have no doubt President Obama wants to craft what he hopes will be a great solution for addressing the needs of our now dysfunctional financial system. But in awkwardly groping for the great, Mr. Obama and Treasury Secretary Geithner risk ignoring the good.
Since, as our sinking markets can attest, time is a very real enemy here, perhaps Team Obama could take a few minutes to peruse the latest “Global Central Bank Focus” from PIMCO’s Paul McCulley (see below). Mr. McCulley suggests that the whole government (Fed, Treasury, and FDIC) will have to go “all in” to save the banking system from itself. I won’t review all of Mr. McCulley’s ideas here, but he does lay out the problems and solutions simply enough that even politicians might be able to grasp what he’s saying. In short, according to McCulley, the U.S. financial system is continuing to delever its way out of the epic leverage accumulated during Greenspan’s watch. It makes sense for our banks to do so, but the rub is that when all the players (on a global basis, mind you) delever at the same time, then a systemically disastrous race to the bottom for asset prices is the result. This self-reinforcing set of negative feedback loops is called “the Paradox of Deleveraging”, and Mr. McCulley proposes that the only balance sheet large enough to lever up to help manage the messy unwinding of bank balance sheets belongs to Uncle Sam.
It’s not a solution that sits well with capitalists, especially those of us who hail from the unforgiving futures pits in Chicago, but it IS a plan. Properly implemented, it could even work, despite the foul socialist odor its exudes. If Team Obama has such a scheme in mind, then they best get on with it. At least Mr. Market will better understand what he has to price in when he awakens every day from yet another fitful night’s sleep. Do you wonder why the gold market refuses to pull back? It’s only one man’s opinion, but I believe investors in the yellow metal have seen the printing press solution coming for quite a while now. Like Mr. McCulley, I don’t like this plan or how it smells. Perhaps we should hold our noses and just deal with this residue from letting our banking system run first unchecked and then amok. This crisis is unlikely to even begin to end unless Uncle Sam shoves every chip into the pot — including the chips the Fed has yet to create.
— Jack McHugh