GSE Honeymoon Is Over

Jack McHugh writes a wonderful daily wrap up on the Markets. Here is his take on the trading action Tuesday:

Whether this outcome (the nationalization of the GSEs) can save the housing market or stop the recession unfolding before us is another matter, but let’s save those issues for another day" (source: end of yesterday’s comment).  Well, the honeymoon the capital markets enjoyed with the GSE bailout lasted a mere 24 hours, so I guess we have to address these issues today.  More trouble at Lehman Brothers, poor pending home sales results, and a virtual collapse among natural resource stocks all combined to smack the U.S. stock market.  The violent down moves in financial stocks and in commodity-related equities left many wondering if this type of action could soon spread to the rest of the tape.

Tuesday started innocently enough.  Equities opened modestly lower, with the usual assortment of downgrades (PG, WB, & Homebuilders) taking some of the blame, and falling oil prices taking the rest.  Lehman opened just more than $1 lower on reports that its talks with the Korean Development Bank had ended (but with no word on its final decision).  The major averages rallied back into the green just as the pending homes sales index figures were released.  Coming in weaker than had been expected, this leading indicator of future home sales immediately put a damper on stock prices.  The retreat was turbo-charged just before 11am eastern time when the news services reported that the KDB decided NOT to invest in Lehman Brothers.  LEH was quickly clubbed, dragging down the rest of the financial universe with it.  Bottoming around $8/share (down 40%), Lehman then stabilized, as did the major averages. 

But when LEH sprang another leak in the afternoon, the rest of the tape followed, pushed along by a savage beating in shares of oil, gas, steel, and metals names.  S&P added insult to injury by putting LEH on creditwatch for a possible downgrade (see below).   At the closing bell, LEH was hit for a 45% loss, the KBW bank index gave up 6%, as did various energy indexes, and the XAU (gold & silver index) was caned until it shed nearly 10%.  The XAU is now down 45% in just seven weeks — a crash by almost any definition.  The indexes comprised of energy stocks are down 30% since June, and we’ve all previously witnessed the more than 60% drop in the bank stock index into this past July.  As for today’s damage, the major averages all fell between 2.5% and 3.5%.  In this nervous environment, Treasury securities were the vehicle of choice.  Yields fell between 10 and 14 basis points as the yield curve steepened.  The dollar was mixed, but its ambivalence did nothing to help commodities (see below).  Energy, precious metals, and even orange juice were all hit hard, leaving the CRB index down just shy of 2%.   

With the S&P, Russell 2000, and Dow Transports all hit for 3.5% losses today, many investors now wonder if the sector volatility described above can translate into the type of price action that could dislocate the broad market averages.  Having been on the front lines of a few bear markets myself, including 1987, I must say that while such an outcome is against the odds, it certainly wouldn’t shock me.  The final article you see below is one potential catalyst.  Though the New York Post is not my preferred source for financial information, its story about hedge funds cutting risk and raising cash is just the latest in a batch of stories like it. 

In my opinion, hedge funds aren’t just raising cash to cushion themselves from the vagaries of volatility, as the article suggests.  The hedgies are managing more than just market risk; they are girding themselves for an expected torrent of redemption letters this month.  Most funds have a provision that requires clients to let the fund manager know, in writing, if they would like to redeem all or part of their investment by year end.  The most common cut off date is September 30, so we could easily be in for a very challenging market environment until that date passes.  Additionally, many individual investors are aware that long term capital gains rates have nowhere to go but up next year, so there may be extra incentive for them to cash in long term gains (in both stocks and in hedge funds) before 2009.  By themselves, these factors wouldn’t mean too much if our economy was strong, but it’s not.  It’s sinking, as are those in much of the rest of the world.  Thus, the answers to the questions posed at the outset of this comment are "not yet" and "not quite" respectively.  In an ever-shifting environment like this one, perhaps it’s sensible to make like a hedge fund and raise some cash.   

–Jack McHugh

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