Stock Market: On the Precipice or the Launching Pad?

by Steven M. Cohen  •  Mar 15, 2009 at 4:51 pm

http://www.buyselljump.com/2009/03/stock-market-on-the-precipice-or-the-launching-pad

With last week's four out of five positive days resulting in a 9% boost to stock prices, the market appears poised at some kind of crossroads, perhaps even an inflection point at which positive prospects can begin to at least compete with the steady stream of awful economic news that has pervaded the investment environment for the last eighteen months. Bullish analysts and traders maintain we have seen the bottom, while their bearish counterparts brace themselves for another painful plunge. There seem to be more of these predictions at the extremes than those in the middle simply calling for sideways movement.

Most vividly demonstrated by the banking sector is the notion that companies with strong balance sheets will weather the storm while those with suspect or faulty assets will, or have already, become historical footnotes. The same, of course, can be said for any industry in a downturn with no place to hide for those companies that have accumulated now-soured assets or too much debt. It might make sense, then, to look at the stock market in that same light by constructing an informal balance sheet of assets and liabilities that will impact the market's performance going forward. While not a crystal ball, such an exercise might provide a bit of perspective in a highly-skewed environment that has left investors enervated (as well as impoverished to various degrees). However, in compiling these competing lists of factors it becomes evident that neither side of the ledger can be used as a convincing argument to trump the other—at least not yet.

As an eternal market optimist, I'll start, of course, with the asset side, which actually has been getting longer of late. Last week featured a number of modestly hopeful signs which, when put together, could be the very early signs of an economic recovery. The banking sector, of all things, surprised the market with announcements from Bank of America, JPMorgan Chase, and even Citi, that each of them would be profitable for the first two months of the year. The financial sector, a central component of the market's nuclear waste site, responded accordingly.

Potential regulatory changes also cheered investors. It looks like the SEC is about to engineer the return of the uptick rule, which is generally viewed by traders as a move that would provide some support across the market in general. The commission is also seriously considering some significant adjustments in the mark-to-market rule, which at present compels banks and other financial institutions to value assets at arguably lower prices than they ultimately will be worth. Many have pointed to the rule as the principal reason behind the death spiral of a number of financial institutions that were forced to continually raise additional regulatory capital as they marked down their more illiquid assets. Bear Stearns and Lehman come to mind, although you would have to include idiotic decision-making along with the many other factors that brought about their demise. At any rate, a significant adjustment or suspension of the rule might help to prevent these outcomes in the future, many believe.

There were additional indicators of a return of animal spirits, best illustrated by an uptick in merger activity, long an important sign of economic vigor, and conspicuous by its absence in the recent environment. Last week Merck agreed to acquire Schering-Plough for a whopping $41 billion in cash and stock. This combination followed by a couple of weeks Pfizer's plan to merge with Wyeth. Last week also saw a resolution of the conflict between Genentech and Roche, which had made a hostile bid to acquire the 44% of Genentech shares it doesn't already own. Roche will pay a higher price in a now friendly transaction. These kinds of M&A developments are characteristic of a bull market, so they stand in vivid contrast to the kind of environment we have been suffering through for so many months now.

There was also some interesting price action in General Electric, which actually rose in response to its claim that a reduction in its S&P rating would not adversely affect its business. Of course, trading at a 75% discount to its value only a year ago, it can be argued that GE's price already reflects all its problems with its financial unit, unless investors become convinced the company is on its way to insolvency and the stock will become worthless. At any rate, it is difficult to remember the last time a high-profile company avoided damage to its share price in the face of a ratings downgrade.

Certainly the asset side would have to include some recent indications coming out of Congress that the new administration's anti-growth, anti-business social engineering program could be more difficult to enact than previously assumed. Some legislators, even on the left side of the aisle, appear to be having second thoughts about a range of proposals concerning certain tax deduction limits, farm subsidies, Medicare and Social Security cuts, and emission caps. Even the Business Roundtable's worst nightmare, the inaptly-titled "Employee Free Choice Act"—which, in the interests of full disclosure should be renamed "The Employee Card Check Intimidation Act"—might be creating some cold feet among some of its presumed supporters, even several influential senators. In short, as I pointed out a few days ago, a possibly-improving tax-and-spend picture coupled with diminished prospects for anti-business legislation, could help alleviate some considerable market indigestion over the new administration's policies.

Finally, an analysis of the market's considerable asset base must include the fact that perhaps we are reaching a point where recessions historically run out of steam. U.S. economic contractions in the last 50 years have an average duration of about eleven months. And perhaps we are approaching a time parameter endpoint which still features stocks at a 50% discount from their highs. These factors might entice investors back into the market with the record amount of cash that has been accumulated on the sidelines.

Perhaps, then, when reviewing the market's assets it's not surprising that the VIX last week had its biggest drop all year, a sign of less distress among investors and possibly a precursor to some badly-needed market stability.

Nevertheless, before we become convinced that investors can finally get some wind at their backs, we must shift over to the right side of the ledger. And it is there that many significant obstacles to a market recovery remain. As noted before in this space, much of this is a function of agenda-laden politics that translate into bad policy. However, not all of it is the result of policies that punish business interests in favor of social policies and economic redistribution, a pernicious form of open class warfare in the false pursuit of "fairness" from which no one will benefit. Some of it is simply a rush to legislate that is triggering the law of unintended consequences.

Still staring the market in the face is a plan to spend unimaginable amounts of taxpayer dollars likely to saddle the country with huge deficits for several generations. Despite some cracks in support, as noted before, the administration appears determined to spend the country out of a recession, a prescription that has not worked in the past and will not work now.

Besides the open-ended stimulus/bailout spending, the recent omnibus budget bill, which funds the government only until October, provides by now superfluous evidence that the administration, along with the majority party in Congress, knows no bounds when it comes to extending the federal government's breadth and reach. It is now sinking in to investors that the candidate who won will not shift more towards the center but instead continues to veer to the left. It cannot be lost on market participants that part of the platform on which he ran was a vow to eliminate the dreaded "earmarks" which have become the most potent symbol of special political interests run amok. Instead, the president signed a $450 billion bill containing more than 8,700 such earmarks, putting to rest any lingering hope that the budget process would be reformed. Instead, it looks to investors like business as usual, only on a grander scale.

Also undermining confidence is the market's awareness that the numbers just do not add up. To compensate for this disparity, the administration has engaged in a breathtaking exercise in "bootstrapping" by creating assumptions about the impact of programs that have nothing in common with economic reality in order to give their budget legitimacy. Thus, the budget assumes savings from the winding-down of the war in Iraq that significantly exceed those of many mainstream economists and military experts, while at the same time underestimating the cost of expanding significantly our commitment in Afghanistan. In that same self-serving vein, the budget also assumes economic growth forecasts that are completely out of line with a number of analyses coming from economists with no political agenda. Thus, while the budget incorporates GDP shrinkage of 1.2% in 2009 and 3.2% growth in 2010, the median forecast of economists is for contraction of 2% this year and growth of only 1.8% in 2010. Simple math reveals a budget assumption on negative GDP for this year that is 66% below the median estimate, and an assumption on growth next year that is 78% above the median. Reasonable people can differ, but these disparities cannot be explained.

Investor confidence continues to be undermined by the performance of the Secretary of the Treasury, who increasingly looks like an unfortunate selection, and not simply because of his income tax deficiencies. There has still been no fully-articulated or even comprehensible plan for removing illiquid and hard-to-value—the proverbial "toxic assets"—from the balance sheets of financial institutions. Perhaps this is attributable to Geithner's several false starts in hiring a number two for his department after several withdrawals from consideration—as well as more than a dozen other important posts within Treasury. Thus Geithner remains the weak link in an already porous lineup based on the administration's performance so far in addressing the financial crisis. Don't take my word for it. Just last week economists who participated in the Wall Street Journal's forecasting survey gave the president an average grade of 59 for his economic performance so far, while Geithner received an average of 51. And yes, just like grade school, this was based on a scale of 100.

It is the firmly held opinion here that the administration's economic policies—and I would include the voting majority in Congress in that definition—remains the largest single obstacle to renewed market confidence as well as an economic recovery. As long as the administration's prescription remains a radical mix of outlandish spending, confiscatory tax increases, and the expansion of already-bloated social welfare programs of every kind (as well as new ones not yet invented), all the while fomenting class resentment and business-bashing at every turn, investors will have much to fret over and will sit on their cash hoard even in the absence of earning any investment return. (T-bill returns already reflect the mattress-stuffing tendencies of terrified investors.) Conversely, any dilution of this agenda will accrue to the benefit of investors, if they come to believe that more responsible policies will eventually emerge.

Government as an obstacle to economic recovery has been described before with considerable eloquence. In the teeth of a deep recession having much in common with the current crisis, Ronald Reagan delivered his first inaugural address outlining his commitment to renew the country's prosperity and restore America's confidence. "In this present crisis," he said from the podium on the West Front of the Capitol, "government is not the solution to our problem; government is the problem." Nearly thirty years later his words ring true again.

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