Sunday, October 19, 2008

Hank the Plumber

While the world was focused on Joe the Plumber, his brethren Hank the Plumber, a.k.a. Treasury Secretary Henry Paulson, went to work fixing the global financial plumbing.


The global financial crisis may not be over, but there are a few signs that things are changing. It is helpful to break down the structure of the crisis in three basic elements. These three components need to be addressed before we can declare the crisis over:


1. Financial Institution Solvency, a.k.a. The “blockage” in the commode

2. Interbank Lending, a.k.a. The Plumbing

3. Real Economic Spillover, a.k.a. The Bathroom Floor


Financial institution solvency has been the biggest reason behind the global fear based liquidation. Investors have been afraid that any investment, whether it is equity or debt, would result in a loss because the company they invested in was insolvent. Truth became irrelevant, simply the perception of insolvency lead to investor withdrawal and ultimately resulted in actual insolvency. Both Lehman Brothers and AIG are perfect examples; once they were perceived to be weak they both experienced a “run on the bank” event.


The hope that this week offered on the financial institution solvency front is the direct investment in banks by the US government under the TARP plan. The government has accomplished two goals with this use of the money. First, they have taken the fear of insolvency away by providing much needed capital and an implicit government backing. Second, they have provided capital directly to the system where, if used properly, can begin to repair the economy.


The intended outcome of this action was to restore some faith in the financial institutions. We saw the result of that restoration in the interbank lending market on Friday when both JP Morgan and Citibank reported lending in the market. This is critical to getting the financial plumbing back in working order. In terms that Joe the Plumber would relate to: Direct TARP investment in the banks is the Draino and lending in the interbank market is the toilet beginning to flush.


Now we have to deal with the spillover into the real economy. Just like a plumbing back-up some “stuff” has spilled over the bowl. At this point we have been so concentrated on unplugging the plumbing that we have no idea how bad the real economy is damaged. On Friday, the University of Michigan consumer confidence survey dropped from 70.3 in September to 57.5 in October, this is the lowest level the since the survey started in 1978. The unanswered question is how long and by how much the American consumer will retract. Based on consumer sentiment, people are still not willing to use the bathroom.


US Equity Markets


The Rule of 11 has proven useful again(see last week's post). The US equity markets had a roller coaster week but were able to hold the lows made the prior week. Warren Buffet made his debut as JP Morgan, circa 1909, when he announced in the New York Times that he was spending his own money to buy US equities. This is classic discovery period behavior, and Buffet is the classic investor during this period, central casting could not have done a better job.

Mr. Buffet wrote that markets typically bottom before the economy turns and suggested that “if you wait for the robins, you may miss the spring.” I have never much liked the storms and mud the spring brings and my boots are not as high as Mr. Buffet’s. Therefore my style is to wait until I see the nest being built in preparation for the robin’s eggs.


US Treasuries


Yields ticked higher this week and resulted in a bit of flattening to the curve. However, Friday’s action in the interbank market may be more important than Treasury yields. LIBOR did come down as the credit markets began to thaw. I am still on the sidelines of this market until I get a clearer picture on the real economy.


Gold


Last week I mentioned that gold was probably my favorite market right now. There have been some dramatic changes in this market that could lead to demand outstripping supply.

In brief, a change in the global gold hedging book, strong investment demand and a resumption of interbank lending all are positive signs for gold.


Dollar


The dollar did not do much this week as I think most investors are like me and are waiting for some more definitive economic news. However, the consumer sentiment number does not bode well for the economy and eventually I believe the flight to quality bid in the dollar will recede. And as the saying goes, when the tide goes out, we can see who was swimming naked.


Oil


New lows in oil this week caused panic in the OPEC nations. So much so that they have decided to push their meeting up and “discuss” cutting output. My inclination is that a cut in output is all but inevitable. OPEC nations have built up considerable wealth and power as they reaped the profits from high oil prices. I do not think they are willing to give up their position, especially when they control the spout.

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