Sunday, October 5, 2008

Prevailing Perception October 5, 2008

The sentiment in the global financial markets is decidedly negative, particularly after the passing of the bail-out bill did not result in any meaningful change in the markets. Credit markets are still frozen, banks are hoarding cash and non-financial companies are wondering if they will ever get a line of credit again.

The prevailing perception among lenders is that any loan they make will turn out to be a bad loan. The speed at which financial companies are imploding is breathtaking. The perception that any loan will turn out to be a bad loan is creating tremendous demand for cash. As cash is hoarded, fewer banks are able to get the capital they need, which in turn makes them weaker and an even worse credit risk. As the bank becomes a greater credit risk it needs to raise more capital, which it can't get, and thus any loan made to the bank becomes a bad loan.

We are truly in a period where perception is influencing reality.

US Equities: Strategic investors cutting sweetheart deals shows the amount of panic in the market. While having Warren Buffett put some money to work can be perceived as a vote of confidence in the US equity market, the reality is he is protected by 10% yields and warrants.

The other reality in the marketplace is that many hedge funds are facing redemptions. Many big funds are down over 20% on the year and large investors want their money back.

US Treasuries: The flight to quality trade continues, although it seems ridiculous. The fear sweeping the global financial markets has investors flocking to US government debt with almost zero yield and in some cases negative real rates of return. The trade is not about return on capital it is about return of capital.

Oil: It is amazing how quickly oil's star has faded. As the global slowdown trade takes hold the influence of oil is just not what it used to be. At this point, I would perceive a rally in oil as a positive. A rally may suggest that the global economy has found its footing and may be on the rebound.

Gold: Gold is probably one of the most interesting markets these days. Despite a rising dollar, fear has boosted the metal. I suspect that as investors flee other currencies in favor of the dollar they are searching for places to stash their cash. For now, gold is perceived to be better than a bank.

As we wade through this financial crisis, the perceived quality of the dollar could change, once investors begin to focus on the deteriorating financial condition of the US government. A falling dollar coupled with fearful investors could spark a nice rally in gold, I will be buying on a pullback.

Dollar: The perception that the dollar is the least worst option among global currencies has lead to a rally in the greenback. Again, this is a matter of return of capital vs. return on capital. If a suitable alternative to the dollar emerges, the focus will return to the US deficit and the extra $700 billion the government must finance. The fundamental story for the dollar has not improved, if anything it has become worse.

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