MUTNODJMET'S MUSINGS

Dear Friends:

My very wise friend who works in the wonderful world of finance did me the favor of providing this piece for me to publish:


The One Thing That NEVER Changes is Human Nature

It sure is a lot better to be up 8% than down 8% in a day. This is one of those “vicious” countertrend rallies we talked about toward the end of last week. It could continue for a short time, but in order for us to be consistently bullish again – (1) credit spreads must move back to near the historic mean (400-500 basis point spread over 10-yr U.S. Treasuries instead of current 1100bp spread) and the (2) equity market stops making lower highs and lower lows. Accomplishing these would indicate the key perception changes we have consistently outline as needing to be reversed, have done so. Until the above two things happen, we will remain “out of the way” and generate slight tactical calls (buy depression and sell excitement) and sector biases depending on market activity as it takes place.

We Followed the Same Thought Process Last Cycle. As we were turning bullish in the summer of 2003 (Upside Ahead? 07/03), we used a chart produced many years ago (by Stone & Mead) that highlighted the typical psychology during a major stock market cycle. In mid-2003, credit had moved back below mean and the equity markets had successfully retested the 10/02 low, yet no one believed there could be meaningful upside ahead. We remained steadfastly bullish into 01/08 when credit spreads moved meaningfully above mean and an intermediate-term downtrend was in place (Pulling in the Horns – 01/08). We will make mistakes during the process, as we did by getting bullish again following the Bear Stearns bailout with the historic new issuance of credit, only to reverse course and go back to a tactical approach in early July as the credit market worsened significantly. Following the Bear Stearns bailout, the Treasury Department welcomed in new credit investors by saying they would backstop a financial failure, only to squash them by bowing to political pressure despite knowing what would happen given the unregulated credit derivatives market. We won’t make that mistake again. Credit investors will wait for sustainable improvement, and as a result, so will we.

A Picture is Worth a Thousand Words. We thought it would be appropriate given the financial market backdrop to use this fictitious graph (provided) to highlight the following about the current environment:

1. We are likely in toward the end of the panic phase and beginning of the deep pessimism phase that highlights the rapidly deteriorating fundamental news.
2. While we do know this was made up and not based on fact, it does appropriately denote key segments of the investment cycle.
3. Bottoms are made over time and not on a specific price point.
4. Absent a real retest, calling the recent low – “the low” is a total guess. It very well may be, but we have time to figure it out as the credit and global economic crisis gets addressed and relieved.

Update: My friend adds this:

There is a lot in here to say, and much remains to be seen how much the government's incursion into preferred shareholder of banking and finance institutions is a good idea. One wonders for example how they sleep nights after grabbing FNMA and FHLMC (Fanny May and Freddie Mac -- who had plenty of assets and cash flow with which to pay their dividends and notes) and washing out both the common and preferred shareholders who had financed those companies. They set themselves up to be the case of last resort when they did that, and then compounded their error in the Lehman situation. No one wants to commit capital when they don't have an assurance of who the government will choose/not choose to either bail out or invest in vs. who they won't, and how it will impact the existing equity and debt holders. At any rate, the current chart activity for the DJIA (Dow Jones Industrial Average) is very like the approx. 25% improvement we saw both after the 1929 crash and again in the 1987 crash. We will see the same lows on the DJIA as a retest, and only then will we be able to judge by the quality of the rally and the corresponding volume whether or not we have seen a real bottoming action. We can only hope at this point.