MOthers Take on the Recent Financial Activity

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Dear Friends,

Perhaps you will find this look at what is going on in the financial markets of some interest. Much of it deals with a presentation I gave a week ago last Monday to a group of financial professionals and some of it is a direct response to an inquiry I received from a client whose business is centered around multiple forms of metals. Because this business is located in California you will see references to CA and AZ by way of illustration.

As of today, August 16th, the stock market, or more specifically, the Dow Jones Industrial Average which measures the 30 largest capitalized companies in America has experienced a 10% correction. On a technical basis such a correction would fall within a normal corrective pattern in a bull market cycle.

It is my opinion that several things are taking place at this time:
1. excess is being removed from overheated sectors 2. a leadership change is occurring within the marketplace itself 3. a rotation from value to growth investments is in process and 4. global economies and financial systems are being strengthened.

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The Federal Reserve has maintained what would be considered an "easy money" policy since the events of 9/11. They lowered interest rates multiple times which injected money into the banking system. Once they had achieved a reasonable money supply level, they then began to raise interest rates but kept rates at historic low levels. They set a fed funds target at 5.25%, which is the rate charged overnight between banks. When the rate varies above that, as it did last week, the Fed "injects" money into the system, creating more liquidity, which lowers the rate. When the rate falls below that target the Fed removes money and that causes the rate to rise back to the target. While we were maintaining this target and this easy money policy, central banks elsewhere began to raise their interest rates...England, Australia, Canada, even Japan had a modest rate increase for the first time in nearly a decade. That meant that they were "removing" money from their economies and in a way using "our money" versus their own. That added pressure to our system. On a concerted basis, all the Central banks joined together last week and this week to add back money, increase liquidity, and keep interest rates from rising. So far so good. This process is actually a normal part of Fed operations, but the effort in concert and the dollar amount world wide was a bit out of the normal Fed operations function.

So, what caused the rates to rise? That is at the crux of the matter. First, oil hit $78.80 and that was an unsustainable price in relation to demand and supply. About 10% of that price was "normal market manipulation" and about 20% was speculation. The Fed did not like that. In February and last year in May, they took action to cool the demand in commodity prices by raising interest rates on commodity related transactions. So far, each time the Fed has decided to cool an overheated sector, it has worked. Gasoline prices at the pump here in Arizona have dropped 26 cents per gallon in the last week - an example of cooling an overheated situation. The metals and materials sector was also getting overheated again as well and the Fed action is removing the heat there, too. These industry sectors are involved in operations that "use cash", but do not create cash. So, as commodity prices rise, that sucks cash out of the system, and no cash is created because the cost of the operation rises along with the increased price. Therefore, no liquidity is created. Just one of many aspects of the "liquidity" issue.

Then a few hedge funds got themselves in trouble. Bear Stearns here in the US, a UBS Dillon Reed hedge fund, and 3 funds in France. One day last week, the French government refused to allow 3 hedge funds to open their doors (what that means is that they could not pledge any of their assets as collateral to buy more assets, and they could not therefore raise cash through selling to meet margin calls (interest rates rising, more collateral or cash needed to meet those calls), and the government in France was concerned that investors might want to redeem their holdings for cash and those redemptions could not be met. What might be known generally as a run on the bank, or in this case a run on the fund. So, the French shut down the operation. That sucked a little more liquidity out of the system.

In addition to all of that it is important to go back to the late 1980's and something called the mark to market rule established by the government. Hmmm? the Fed asked, are the assets being pledged as collateral being marked to the market daily at the real price or is the value inflated? When the answer that came back had uncertainty... "Well, we aren't sure if the price is real because we don't have any buyers at the current price" ...that caused the Fed to inject money in order to create a "real price" that would be considered valid...a floor if you will. But, without knowing the total size of the asset base, it was not certain that enough money had been injected and if the prices were going to hold at the floor. Again, something is only worth what someone will pay for it regardless of what the "it" is. So, if there are no buyers of milk at $3, to sell the milk the price has to come down...if no one is willing to pay $2 it has to come down further. No matter what the underlying thing is from cell phones to computers to collaterialized mortgage obligations to milk, something is only worth what it can be sold for...and no one was willing to buy any more mortgages because they were already awash in mortgage inventory.

Now let's look at this a little more close to home by considering two different asset classes: the price of shares of Coca Cola on the one hand, or all of the 30 Dow stocks, and houses on the market in several regions of the country. In the case of the price of shares, with the advance to 14000 prices on the Dow, the prices per share were pretty high, investments were trading at or very near the top of the 52 week price range, and in some cases at the top of a five year price range. Money managers were reluctant to take client money and buy those investments because most had done so in advance of the rise when they were undervalued, and did not want to keep paying "up". So, while people weren't "willing" to buy, people also weren't willing to sell. This created a bit of a stand off and that stand off reduced market liquidity. When a stand off occurs, prices on investments have to retreat so that buyers will come in again, believing that they can get a reasonable rate of return on the dollars that they invest going forward.

Add to this mix the Uptick rule change after 73 years that the SEC reversed on July 6, 2007. By making this change, the objective was to add liquidity. One measurement of liquidity is volatility. Volatility became clearly more visible within the markets. Now, investors did not have to wait for a buyer to go long before they could place a bet that the stock price would go down by shorting the stock (the rule change), which somewhat ensured that prices would go down as liquidity and volatility increased. Most money managers watching the change take place over began to increase their cash levels which also had an effect on liquidity. While not knowing "when" many money managers were anticipating a change in leadership away from commodities and other less liquid investment classes. The market was becoming a bit more defensive under the surface while the Dow Jones raced to an all time high over a five day period.

In the midst of it all the housing market continued its months and months of erosion. . Unsold inventory was rising, rising, rising without buyers. Prices of houses were coming down, because they had advanced way too far and were overheated. Many people were caught with owning a house they could not sell while at the same time closing on another home which they had already moved into. So in a place like Tucson, a less "hot" market than some, inventory rapidly went from under 2000 homes to over 10,000 homes. Lots of supply and shrinking demand...shrinking demand because the prices were too high. Well, all 10,000 of those houses had some form of mortgage...many of them had teaser rates which were now resetting to higher levels...and some of those homes were bought to flip or were bought by people who could not qualify for traditional mortgages because they did not have enough cash equity into the property when they bought it, heck, they were already underwater, weren't going to get the surge in price they expected for the quick sale, couldn't meet the payment level that the new rate was requiring, and so they began to have "trouble". The Fed did not like this either. So, they began to "reprice risk" by attempting to bring prices in line with what buyers would pay. As risk rose, prices on mortgage backed asset classes declined and that began to be felt by lenders across the mortgage loan spectrum.

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Is the Central Bank doing the right thing? In my judgement, yes. Their actions are much like treating a patient who requires a surgical procedure to remove a gall bladder or repair a ruptured appentix for example. Without the surgery the patient is not going to get better and may even die, but with the surgery the patient will hurt and be sore and and it will take time to recover, but the operation enables the patient to recover. No operation - most likely no patient.

There are obviously more factors than the ones that I have highlighted. But, the bottom line is the same today as it has always been:

The stock market, or investment markets, are never for the faint of heart. They rise for real reasons and they fall for real reasons and over the long term they provide a better rate of return than any other investment class in existence and always have. When capital or liquidity is sucked out of a liquid market to go into illiquid investments it has a negative effect. Real estate is an illiquid investment and has never been meant to be anything else. Commodities are costly to find, extract, ship, use, and they eat capital. They, too, are not meant to be speculative or liquid investments. When real estate and commodities, longer term "things" are moved around like consumer disposables, sooner or later a problem is going to occur. The Fed has been tweaking this problem for the last 18 months and finally they stopped tweaking. Now they are serious.

Like you, and everyone else, I love the good times. But, I hate the greed times. We are now in the fear times. Fear is better. It removes problems and imbalances, and while that may seem harsh, it leads to improved health and wisdom.
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I ask you to make real world comparisons. If you are getting 1% roughly on your money in the bank, but during that same 12 month time period you get 7% from the investment market, then the investment market is a better place to be. To get that 7% you will likely see your worth go up 14% and then go down 7%, but the net effect is still a better rate of return over the same period of time. Make sure the time calculation goes into your personal assessment, please. If you are asking if you are at the same place today that you were in February of this year, the answer is most likely yes. However, you are most likely farther ahead then you were 12 months ago.