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Wednesday, March 05, 2008


the bull case

you won't hear it summarized any better at this juncture than by jeff miller at dash of insight. deep fed rate cuts in an environment of viral negative sentiment, good corporate earnings and balance sheet cash position (ex-financials, of course) and potentially-overstated writedowns in the financials make for a potential bottom.

however, miller is balanced enough to mention doug kass, whom i think has it right at least where he's concerned with the financials -- lending and broad money supply are not going to expand significantly for so long as the banks are capital-constrained, and the banks will remain capital-constrained until either they are recapitalized or the prices in the real estate market (both residential and commercial) at minimum stabilize. the fed may or may not be "pushing on a string" -- i don't think it matters. the point is that their policy rate stimulation weapon is probably not optimally effective under the circumstance of a major bank-credit bust because fed funds cuts work through expanding bank lending. this is particularly so when consumer spending growth has been driven almost exclusively by expanded borrowing in recent years as real compensation has declined and consumer leverage grown into a low-rate-highly-permissive credit environment, resulting in record low home equity and high household debt service loading. we have not seen a similar situation in a long time.

but it's an open question as to whether the banks will remain quite as capital-constrained as they currently appear. kass examines the recent marks-to-market on credit instruments and concedes that things are probably overdone on some fronts, at least for the time being, and financial writeups may be on the way if credit markets turn north. even if a government recapitalization is not forthcoming, could the increased carry fostered by low fed funding rates and in-the-pipeline writeups work to repair the banks much more quickly than many now expect?

the housing market is going to continue to mean-revert on valuation in the near-term -- the prices seen in 2005-6 were a product of anomalous mortgage credit terms that have vanished and will not be coming back under any circumstances, including those involving relatively healthy banks. moreover, commercial real estate is now suffering under the early stages of a correction of similar origin (but perhaps slightly lesser degree) that will hit regional banks hard.

as such, even a dose of writeups on LBO loans would seem highly unlikely to restore balance sheet vigor in the main, even if it helps stave off further capital raising -- though it may help moderate the depth of any recession. economically, you can put still me in the bear camp.

the market, however, is another thing -- and the january 22/23 washout, now perhaps with a first successful retest and coming on the heels of high panic levels, may pave the way out of the momentary well of pessimism portrayed by ISEE option data (now at new dataset lows by some measures), the AAII survey and the risk appetite index. even against a dour economic backdrop and with the prospect of lower index lows in time, i continue to think that there will be a multimonth rally here.

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