2008, 2009, and the Madoff Legacy

Good Evening: In an attempt to finish a strong second quarter on a high note, investors began this holiday-shortened week by pushing stocks, bonds, and commodities higher today. Ex the Madoff sentencing and another rally in crude oil, market participants focused their waning attention spans on word from China that it was unlikely to radically change the mix of its reserve assets — for now. The statement provided a somewhat positive backdrop for asset prices, enough so that complacency has now risen to post-Lehman highs. With more claims of “the worst is over” being made these days, it may be wise to revisit some of the lessons learned after similar claims were made in 2008.

“Our foreign-exchange reserve policy is always quite stable,” Zhou told reporters at a central bankers’ meeting yesterday in Basel, Switzerland. “There are not any sudden changes.” (source: Bloomberg article below)

Grabbing everyone’s attention during the early going, the statement you see above is what helped support U.S. markets today. People’s Bank of China Governor, Zhou Xiaochuan, may or may not have meant to commit the PBC to an unchanging mix of sovereign reserves at his bank, but U.S. investors chose to interpret his message as a sign of “stability”. Central bankers are notorious in their desire for stability, but just what does “not any sudden changes” really mean for U.S. Treasury prices? Today, like last week, it meant “higher”, especially in the context of the previously less than bullish statements by Chinese officials with regard to U.S. fiscal policy. Longer term, however, this statement could mean anything — from continued buying of Treasury securities to a gradual shift away from them. Given the massive borrowing needs the U.S. and other Western governments face in the quarters ahead, we need China’s appetite for our debt to increase, not stabilize.

The major stock averages opened near the unchanged mark and traded lower before Zhou’s quotes helped spark a move higher. 90 minutes into the trading session, the Dow and S&P were both up 1% before they settled into a narrow sideways range. Treasurys also popped on the statement by China’s central banker, as did the dollar. Crude oil and its products raced ahead as well, but this move was probably attributable to more turmoil in Nigeria than to more sightings of green shoots here in the U.S. The various cable outlets then spent far too much of their time covering the sentencing of one Bernard Madoff. The fraudster from New York received the maximum sentence, but many of his victims were left feeling unsatisfied. I sensed many of them wished for Bernie to serve every one of those 150 years in Promethean fashion, with his liver being eaten by an eagle every day, only to have it regenerate every night to be eaten again the next day. Unfortunately, such a sentence would probably be deemed cruel and unusual punishment — for the eagle.

The Madoff story, a lack of hard economic news, and some early summer vacations contributed to what ended up being a fairly listless trading day. The Dow and S&P managed to hold onto their 1% gains by the time the closing bell rang, but the Russell 2000 and Dow Transports each finished with small losses. Treasury prices were on the firm side, with yields falling between 2 and 6 bps as the yield curve flattened. The dollar, which had perked up after Zhou’s comments, gave back most of its gains to finish mixed. Crude oil and its products were the only real winners among commodities, and it was their strength alone that carried the CRB index to a gain of 1.4% today.

See if you can place this time period: A venerable investment bank had disappeared, stocks had set a major low in March before rallying smartly, the VIX had fallen by more than 50% off its March peak, and both Wall Street executives and Washington policy makers were claiming, “the worst is now behind us” Though it seems like a lifetime ago, the moment in time to which I refer is the end of 2Q 2008, but it could just as easily be Q2 2009. During May and June of last year, I wrote ceaselessly that the financial crisis was not “contained” and that the worst was still ahead of us. In so doing, I took the risk of opposing such luminaries as Warren Buffet, Sam Zell, Ben Bernanke, Hank Paulson, Lloyd Blankfein, and John Mack. I wrote then that housing had yet to bottom and that Wall Street firms were issuing more of their own shares that spring even as they claimed their troubles were over. The key was to pay attention not to what these firms were saying, but what they were doing.

A year later, things don’t appear all that much different. Housing is still on its backside, and Wall Street is still touting its prospects while issuing newly minted shares (as JP Morgan did today — see below). Interestingly, the level of complacency among investors is almost as high now as it was a year ago (see articles below). Consumer confidence readings (even in Europe) are levitating; the vast majority of stock market participants feel the bear market lows have been seen; the VIX is back to pre-Lehman levels, and options traders are selling volatility whenever it rises. Even the primary bond dealers are now confident enough to puff out their chests (see below). And now, just as in the spring of 2008, we have CEOs saying the crisis is “behind us”. GE’s Jeff Immelt today joined his contemporaries in making such a claim, though his words were aimed as much at Congress as they were at GE shareholders. GE Capital may be facing the legislative knife if lawmakers determine it is “systemically important” enough to be spun off and given closer scrutiny by regulators. Perhaps I’m wrong, but Mr. Immelt’s words look less like an economic forecast and more like lobbying when viewed in this light.

Given the similarities between June 2008 and June 2009, should we have the same concerns for a white knuckle ride in our capital markets again this autumn? It may surprise some readers who think I’m one of the “permabears”, but I have to say such an outcome — while possible — is not likely. Events this spring are not the same as they were in 2008, and while securities prices are nicely higher than they were three months ago, they are nowhere near as elevated as they were during the second quarter of 2008. While I fully expect the confidence we see today get tested in the second half of this year, it’s just not a slam dunk to say this test will include the March lows in the S&P. Plus, all the bailouts and debt monetization represent a mountain of money large enough to obscure the landscape of even the most far-sighted prognosticator. I feel a decline is somewhere ahead, but an all out bearish stance right now is just as dangerous as an all out bullish one. Patience and flexibility will be important during the balance of 2009, but a healthy respect for due diligence and risk management will be the lessons of 2008 that we should always remember. It would be the only positive aspect of Bernard Madoff’s otherwise shameful legacy.

— Jack McHugh

U.S. Stocks Rise, S&P 500 Extends Best Quarterly Gain Since ‘98
Zhou Says China Won’t Change Reserve Policy Suddenly
Bond Dealers Say Worst Over as Demand Soars at Sales
VIX Drops to Lowest Level Since Lehman’s Collapse as Fear Ebbs
GE’S Immelt Says Crisis Period Over, Sees 2010 Growth
European Economic Confidence Rises More Than Forecast
JPMorgan Tightens Grip on Equity Sales by Selling Own Shares

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