Tuesday, July 15, 2008

Can Anything Stop the Market's Downward Trajectory?

Back on March 31st, when Mock The Market was a mere one-month old, I wrote a post entitled "Are We In a Bear Market?"  Since I had virtually no readership at the time, I had to answer my own question, which was a resounding "yes."  Now that the market is down significantly since then, and everyone is clear on the fact that the worst is most definitely not over, what happens next?  What is going to stop the market from continuing to puke on itself like a three month old baby every single day?  Of all companies, GM finally did something that may be a step in the right direction.  GM eliminated the dividend.  This is a step that virtually every single bank needs to take to bolster confidence.  Any company that has significant liabilities supporting assets of an even marginally questionable nature absolutely cannot and should not pay a dividend until it is very clear that the US economy has stabilized.  Shareholders should understand the risks of purchasing stock and that a dividend is never a guarantee.  
After Bear Stearns failed, some pundits claimed that it was safe to buy stock in commercial banks and thrifts rather than investment banks because they funded their assets with deposits rather than less reliable borrowings in the money markets.  IndyMac's failure, however has now caused significant concern among investors that even institutions with a large deposit base are not safe if depositors panic and seek to withdraw money.  This is a particularly thorny issue for banks that hold a significant amount of illiquid assets.  If depositors rush for the exits and the bank does not hold sufficient amounts of liquid assets then the FDIC will have to step in again.
This brings us to the much bigger question that goes far beyond the average bank shareholder's suffering:  How much bailing out can the US government withstand?  What are the consequences of bailing out Fannie and Freddie and a host of other banks that are more than likely going to fail as the economy suffers?  Will the government also have to bailout GM?  What about the airlines?  Where do we draw the line and how bad is this really going to get?  Predictions range from the optimistic to complete and utter despair.  My opinion is that the eventual outcome will fall somewhere in the middle.  As I have stated many times before, I believe that many regional banks, specifically those that did significant amounts of construction lending in boom-to-bust areas will fail.  I also believe that some homebuilders will fail as well as some thrifts.  It is likely that another investment bank will need to be taken over.  But despite all of this, I still believe that it is a very positive sign that banks are facing the music, taking write-downs, and hopefully slashing dividends within the next few weeks.  It is what differentiates the US from Japan in the 90's. 
I think Paulson's plan to open the discount window to Fannie and Freddie is a very good idea.  It restored confidence in Fannie and Freddie's debt, which is crucial to the functioning of capital markets.  I am less crazy about the idea of the government taking an equity stake in Fannie and Freddie, but that alternative is much better than fully nationalizing the mortgage lenders.  Although the stocks of Fannie and Freddie have not reacted positively to the news, the alternative of doing nothing would have caused the market to be down significantly yesterday.  The upside to all of this is that stocks are cheaper.  They may not have bottomed yet but if you loved buying stocks last year when the Dow was at 14,000, you have to love them even more at 2005 prices.  Furthermore, unemployment is still low (remember when 6% was considered "full-employment?")  So maybe, just maybe the US economy is going to make it out of this mess very battered and bruised, but intact, and we aren't all going to have to move into our crazy uncle's bomb shelters.  That is my hope, at least.  If you've met my crazy uncle, you'll know exactly what I mean. 

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