Is Asset Price Targeting the Solution?

Good Evening: After Wall Street’s recent winning streak, I guess it shouldn’t be too surprising that stocks took a tumble less than 24 hours after I had warmed to them. Whether it was earnings, economic data, or persuasive attacks on the “bad bank” concept, the news flow was pretty poor. There are plenty of people around with suggestions of what NOT to do in trying to solve the financial crisis, so it will be interesting to see what course of action the Obama administration finally settles upon. PIMCO’s Bill Gross has a thought or two to share on the subject in his latest, “Investment Outlook”, but first let’s review what happened today.

U.S. stock index futures were under pressure starting last night on earnings concerns, and those worries only intensified this morning. Allstate, Dry Ships, Illinois Tool Works, Qualcomm, Starbucks, and Textron all reported disappointing news of varying degrees. Dry Ships, just to pick one company, has been on a tear since the November lows, quintupling from just over 3 to more than 16 earlier this month. DRYS announced this morning that it had breached a debt covenant and now needs to issue $500mm in new stock. The company’s shares sank 30% today. The economic releases weren’t bullish, either, as jobless claims, durable goods orders, and new home sales were all very weak. New home sales for December fell so far that they easily set an all time record (see below).

Given the above, the stock market could have been forgiven had it dropped even more than it did at the open, but the resulting 1% to 2% declines posted by the major averages elicited few smiles. The indexes then tried to bounce, but a decent undertow soon developed that never really did relinquish its grip on the markets. Meredith Whitney, Oppenheimer’s ace bank analyst, opined that the “bad bank” concept would do little to restore bank lending (see below). Then George Soros sent his regards from Davos with much the same message (see below). Even the usual port for any equity storm — Treasurys — keeled over when a 5 year note auction went poorly. I doubt the following analysis from Citigroup helped bond prices much, either. The Citi team could have been reading from one of Jim Grant’s recent speeches when they said:

“This may sound a bit ridiculous, but we think we have begun a full-blown bear market in fixed income,” wrote Tom Fitzpatrick, Citigroup’s New York-based chief technical analyst, and London-based strategist Shyam Devani. “The commodity that is going to be the most in demand as far as the eye can see is capital. As a consequence, the cost of capital can only go one way — up.” (source: Bloomberg article below).

Stocks never did spend much time wearing the rally caps I spoke about yesterday and the averages closed right near their lows for the session. Holding up the best was the Dow (-2.7%), while the Russell 2000 (-4.2%) took on the most water. Treasury yields rose smartly, with the long end taking most of the punishment due to curve steepening trades. Yields were 5 bps to 18 bps higher, and if they keep heading northward they will become a complicating factor down the road. The dollar enjoyed a nice, 1% rally, but the strength in the greenback didn’t have a large impact on commodities. The CRB index was off a mere 0.4%, and it was interesting to watch gold head higher along with the dollar. It’s way too early to call this a trend, but if they continue to rally together, it may be a sign that investors are starting to view both of them as a flight to quality play.

With so many people taking turns to pummel the concept of setting up a “bad bank” to remove toxic assets from bank balance sheets, I thought it might be interesting to consider another possible solution, one that’s fresh off the desk of Bill Gross, head honcho at PIMCO (see below). Like many of us, Mr. Gross thinks the government’s efforts to date have been “attempted in numerous, seemingly uncoordinated ways”. Mr. Gross believes the focus should be squarely on supporting asset prices, whether via the TARP, a “bad bank” plan, or some other mechanism. Supporting the banking system alone is not sufficient, in his view, since the broken machine once known as securitization is at the core of the financial mess we’re now in.

Mr. Gross acknowledges that we “can’t bail out everyone”, but he advises policy makers that the focus going forward has to be on sectors orphaned by the lack of securitization (in his words, “the shadow banking system”). If we ignore for a moment that PIMCO has a limited advisory role with Treasury, Mr. Gross’s choices for governmental asset purchases are commercial mortgage-backed securities, credit card receivables, and municipal bonds. I’m not sure whether his plan is better than any of the others, and I’m very sure I don’t know more than Mr. Gross does about fixed income and how best to navigate that market for clients. But I do know that asset price targeting makes me uneasy. After all, didn’t the Maestro, through his frequent picking of generously low interest rates, target first the stock market and then the residential real estate market back in the day? An impartial observer would tell me to get over my queasiness and admit that almost every “solution” on offer represents a form of asset price targeting. Mr. Gross might be right, and we need all the good ideas we can find these days, but I still can’t shake the notion that targeting certain asset markets helped land us in this mess in the first place. Jack McHugh

U.S. Economy: Sales of New Homes, Durable Goods Orders Tumble

Treasuries Headed for Full-Blown Bear Market, Citigroup Says

‘Bad Bank’ Will Not Boost Lending, Whitney Says

Soros Says Bad-Bank Plan Won’t Help Increase Lending

BEEP BEEP — Investment Outlook, February 2009, by Bill Gross