Watch Out for this Market

And the Game Goes On…
March 21, 2008

Surge, plunge, rocket or drop: What will the Dow do?

The Fed injected $400 billion last week. It capped its cash infusion on Palm Sunday with a 25 basis point cut to the discount rate ordinarily charged on direct loans to banks, but now also extended to securities dealers.

But $400 billion couldn’t save a mighty Bear. J.P. Morgan Chase, backed by benevolent Ben, stole Bear Stearns, Wall Street’s fifth-largest investment bank, for $2 per share Monday. “The building [itself] is worth $8 per share,” a midlevel Bear Stearns executive told The Wall Street Journal.

So it goes.

The Dow “plunged” on the news. 

Thankfully, Messrs Goldman, Lehman and Morgan fared much better. Their shoes, for the moment, are still varying shades of white. The survivors beat the street by 25%, 13%, and 45%, respectively, Tuesday. The Fed quickly threw fuel into the fire. It slashed rates another 75 basis points later that day.

Mr. Market, that duplicitous little imp, smiled. The Dow Jones industrial average rocketed by 3.5%, or 420 points, its largest gain in more than five years, on the day’s events. He, like our friends at The Daily Reckoning, knows America’s central bank now bestows greenbacks at about half the rate of consumer price inflation.

We said the Fed had a choice: a debilitating recession or destructive inflation.

We vote for recession. Bernanke, however, opts for inflation.

Inflation benefits debtors at the expense of creditors, since debtors can pay back their borrowing in a less valuable currency. Wise investors flee bonds and their negative real returns. They often buy stocks, or better yet, stocks tied to tangible assets (commodities).

But what thou giveth thou can taketh away. The Dow fell 293 points Wednesday. Commodities also took the plunge. Oil retreated $5 per barrel, its greatest one-day fall since Jan. 17, 1991 — the day the first Gulf War started. Wheat and gold also took a dive. Commodities as a whole, as measured by the CRB Index, dropped 5.7%.

Profit-taking? Perhaps? Up, down and all around, nobody knows where the market may land. That’s because Wall Street keeps holding its cards close to the vest. No one really seems to know which financiers owe what, and to whom.

The market, unfortunately, can’t shrug. That’s because, for better or worse, the financial services industry has morphed into becoming the harbinger of the American economy. Our friends at The Economist point out: “The American financial services industry’s share of total corporate profits [rose] from 10% in the early 1980s to 40% at its peak last year (see chart below). Its share of stockmarket value grew from 6% to 19%.”

In the ‘60s, Americans made widgets. Tangible assets bought and sold on the world market. Today, we make the structured products, and increasingly complex financial instruments whose tangible value often depends on the merits of an untested equation. The devastation at Long-Term Capital Management should have taught us that equations, like humans, are often flawed.

But Mark Twain once said: “History doesn’t repeat itself, but it does rhyme.” That’s certainly true. But we doubt even he could imagine our tendency to repeat the same foolish behavior so quickly.

A dichotomy exists in the American economy. We’ve substituted financial services production for real production. And we’ve done this by aggressively playing with debt. Risk, in the minds of financial wizards, was not a four-letter word.

U.S. financial assets as a percent of GDP keep growing at a seemingly interminable pace:

The S&P 500 depends a great deal on the financial service industry’s success. Financials serve as the S&P’s largest component (nearly 20%). In fact, 40% of the S&P depends on big banks, Big Oil and big discretionary spending:

We believe those three will have a tough time running together much longer. High oil and overall spending can’t go on forever. Less spending means fewer financial transactions. In other words, the ripple effect could be rather painful for S&P holders.

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Despite conventional wisdom, rising tides do not raise all ships. It’s no secret that certain sectors can carry a market. Nathan Lewis, author of Gold: The Once and Future Money, notes that during the great bull market of the late ‘90s, most stocks actually fell.

“The stock market,” Lewis points out, “as measured by popular market indexes, headed into stratosphere from 1997-2000, but most stocks actually fell, and most businesses stagnated. At the end of 1999, the year the S&P 500 gained 19.5% and the Nasdaq composite index 85.6%, a full 70% of NYSE-listed stocks were lower than they were the year earlier.”

We believe big banks and Big Oil have carried this market the last five years. See this chart of the S&P 500: 

Going forward, we believe the S&P will need something else. In the ‘90s, it was dot-coms. This decade offered big builders and big banks. Going forward, another sector must carry the flag.

Perhaps health care will take the lead. There are plenty of baby boomers that need plenty of attention.

Materials, specifically those destined to fix our public roads, bridges, schools and dams, are another place to look. It’s no secret that American infrastructure keeps crumbling…collapsing bridges, exploding steam pipes, Cajun levees.

The American Society of Civil Engineers now warns that the United States has fallen so far behind in maintaining its infrastructure that it would take more than $1.5 trillion over five years just to bring it back up to standard.

It’s a win-win for Wall Street, too. The municipal underwriting business takes off. Banks now repackage municipal debt like mortgage debt. The fees keep rolling. Seven-figure-bonus days are here once again.

The banks knew that if disaster struck, as it has, someone else (usually taxpayers) would bear the cost. Washington facilitates the deal. And the game goes on.

Good Friday,
Christopher Hancock

P.S.: In my Free Market Investor, I have been working on this theme for quite awhile. So far, it has paid off beautifully. We are up double digits on a number of our plays, and that comes during one of the largest bear markets we’ve seen in awhile. To get in on these elite stocks, check out this report now…

Editor’s Note: As always, send any questions or concerns to us here: jim@pennysleuth.com