Volatile January ends on an up-beat

US Federal Reserve Policy

The news of the month was an "emergency" cut of 0.75% in the Fed Funds rate on January 22nd, followed by an additional 0.50% cut on January 30th, for a total of 1.25% in a week.  This is the largest reduction in the Fed Funds rate ever.  By comparison, the Fed cut rates 0.50% after the 9/11 attacks, 0.375% after the October 1987 stock market crash. 

What made the Fed move so aggressively?  The Fed's January 30th statement cited "considerable stress in financial markets and tighter credit for some firms and households."  The statement also mentioned "a deepening of the housing contraction as well as some softening in labor markets."  While it is true the latest jobs report showed gains of only 17K jobs, the unemployment rate dropped to 4.9%.  Housing numbers have been terrible, but that been well known for months.  GDP dropped dramatically from 4.9% in Q3 2007, to 0.6% in Q4, but the contraction was entirely in construction - exports have surged. 

The one factor that is out of bounds with previous experience is the continuing global "margin call."  Too many banks, brokers, hedge funds, both US and international, own too many illiquid securities with too much borrowed money.  Collateral originally valued at par (100) is now marked down to 80, 60 even 40.  Fixed income securities, outside of conventional treasury or agency bonds, trade rarely, so their valuations have to be imputed from models.  The fastest way to goose the model is to drop the treasury curve yields, which are inputs into these models, and that what this 125 basis point cut has achieved.

The Fed has come under a lot of criticism for not acting faster and "being behind the curve."  However, the blame for the current crisis clearly lies in the hands of the managements of hundreds of private firms who chased after leveraged returns without regards to the risks.  As we mentioned previously, we think the Fed wouldn't mind if a couple of banks were forced out of business (to remind the rest to do their jobs.)  However, by mid-January, it looked like the global financial system was facing a "death spiral" of forced liquidation of loan collateral leading to plummeting prices, leading to more margin calls, and so was forced to act. 

US Stock Market

The S&P 500 delivered the 5th worst January performance ever.  In January, the S&P 500 lost 6.0% and the NASDAQ declined 9.9%.  Things looked particularly grim on January 21st, when we wrote our client bulletin "Closer to bear market - closer to the next rally."  US stocks slid into official bear territory (down over 20% from the last October's record) on January 22nd, and retested those lows on January 23rd.  The trigger of the US stock market sell-off was a 4-6% slide in European stocks on January 21st (US markets were closed for observation of Martin Luther King Day.)  Subsequently, we learned that a "rogue" trader at French bank Société Générale had fraudulently accumulated $75 billion of net long exposure in European stock market futures.  The fire sale of this position, which cost that bank over $7 billion, caused the precipitous fall in Europe, which spread to Asia and the US over the next 48 hours. 

By the end of the week, investors were either covering shorts or taking advantage of low prices.  Through February 1st, the S&P 500 rallied 6.5% and the NASDAQ rallied 5.3%.  The S&P 500 remains 11.6% below its mid-October high, the NASDAQ down 15.7%.  We're not sure if US markets will break into positive territory by the end of the first year, but with 75% of the bad news about CDO exposure already out and with the Fed in an accommodative mode, we see stocks higher by at least 10% (S&P 500 over 1600) by year end.

Additional observations:

• Financials (up 1.6%) and Consumer Discretionary (up 0.2%, which includes homebuilders and automobiles) are the top performing sectors of 2008 after being the worst performers in 2007.
• The Homebuilders index is up 28.7% on the year.  While most of that gain is short-covering, value investors are also buying shares, anticipating that construction (down 23% in 2007) will pick up later in 2008.
• International markets performed far worse than US markets, with most down over 20% and Japan down 30%.  We have made the point in the past that international investing offers less diversification than theory would suggest because international markets are highly correlated with the US when stocks are rising, but fall worse than the US in times of stress.  International markets have outperformed in the last 5 years primarily because the dollar has been falling.
• Oil is off 11.4% from record high set January 3rd.  Precious metals rallied sharply on fears of an uptick in US inflation, but are now falling back.  Agricultural commodities are 6-8% down from recent records.  This movement is consistent with a global, not just US, slowdown and reduces inflationary pressure which gives the Fed and other central banks room to cut rates. 
• Normally, a cut of 1.25% in dollar rates while rates in other currencies remaining constant would cause the dollar to fall sharply.  The dollar has remained in a tight trading range over the last two months and broken through the all-time low in the dollar index set last November.

Strategy

Calm is returning to both US and international markets, the relentless rise in energy prices and other commodities has reversed at least temporarily, interest rates are revisiting the 40 year low set in 2004, the relative strength of the dollar will draw assets back to the US and stock valuations as we detailed in previous commentaries are at the lowest levels in 18 years.  The last time we felt this good about stocks was in July 2002 (following the collapse of the tech stock bubble.)  While history never repeats exactly, US stocks rose 39% over the following 18 months. 

Also, please note that mortgage rates have dropped sharply in the last three months.  The rule of thumb is that if you can drop your mortgage rate by at least 1%, you'll come out ahead net of closing and appraisal costs.  Note also that if you are seeking a "jumbo" mortgage (an amount greater than $417,000), you may not see a preferential rate at this time.  Mortgage of less than $417K are readily packaged into mortgage backed securities issued by GNMA, FNMA and FHLMC, the quasi-governmental mortgage agencies.  Larger loans are serviced by private corporations.  As a result of the capital destruction experienced by many firms in this industry in the last 6 months, few firms are willing or able to make significant loans today (hence the 1.1% differential between loan types), but that situation should improve later this year.