The Strangest Financial Crisis

So, when I looked at the early quotes on ten year treasuries on Friday afternoon, when word of the looming S&P downgrade began to surface, quotes suggested a rise in rates to about 2.55%-2.60%. I thought that was a fairly reasonable reaction since the loss of a grade might be worth a dozen or so basis points in higher yield.

What I did not expect was that rates would plunge today to the lowest levels since the worst of the 2008 panic. This is why I call it the strangest financial crisis. Under most, or all, circumstances the fears surrounding a country's sovereign debt cause the two following reactions:

1. Interest rates spike like mad
2. The currency collapses
3. The equity markets collapse

Well, one of those happened. The other two did not. Hell, the dollar actually rose slightly: http://www.bloomberg.com/apps/quote?ticker=UUP:US

Normally, when people are told there is a bomb in the building, they run out of it for the refuge of other structures. That did not hold today, not one bit. Instead, what seems to have happened is that the markets fear the consequences for economic growth more than they do the downgrade itself. Normally, the channels affecting economic growth would be a spike in real interest rates and a collapse in the integrity of financial markets. In this case, the concern appears to be that our current rate of economic growth is as good as it's going to get because the downgrade has precluded any possibility of stimulative action by the government. Further, the ripple effect of downgrades to private and municipal issuers is likely part of what is at work here as well.

It is also possible that markets are anticipating a major hit to consumer confidence as people pull in their horns in anticipation of future interest rate increases, which I will point out is not a rational behavior. Much like someone prone to panic attacks can induce one due to the fear of one coming on, the markets can collectively do the same thing. The fear of future consumer... fear probably motivated some of the indiscriminate selling today, and it was indiscriminate.

A further mechanical cause is the incredible plunge in oil. It's down almost 20% in a few weeks. This has caused mass liquidations by hedge funds, who have to liquidate virtually everything, including shares in damn good names. I am struck by a plunge like this in United Technologies (UTX), one of the best run companies in the world with a tremendous track record of strong earnings growth and healthy dividends:

Hell, even a company like Church and Dwight (CHD), which is basically immune to recessions and will benefit from the plunge in petroleum prices, has taken a clipping:

The banks got slaughtered, which is understandable. If indeed U.S. interest rates are heading higher, banks' margins will get squeezed. Fair enough. Also, Bank of America (BAC) is one sick puppy these days. Seeing a collapse of this magnitude in a premier financial stock is not reassuring:

Still, the basic theme to take away is simple. The market has rapidly priced in a significant reduction in economic growth prospects and the related effect on earnings growth. This is not principally a U.S. debt crisis and should not be labeled as such. If it were, money would not have sought out U.S. treasuries in such massive quantities today. We are faced with a market that is rapidly pricing in deflation due to a weak economy, which explains the dual decline in stock prices and bond yields. Concerns about inflation are radically misplaced at this time. All of the inflation of the past several months has been driven by food and energy. Those are dead now. Their declines will be seen in CPI over the next few months and year over year inflation will vanish.

At this point, continue to hold cash for the moment. A bounce back, possible a big one (+500 pts or so) or two will happen in the next week or so, but that will probably be greeted with a fresh low sometime thereafter. These things never go straight down then straight up. Even 1998 with LTCM, which is the closest to that trajectory, did not follow that pattern. Stabilization was followed by new lows before a solid bottom was formed. The opportunity will come, but it isn't here quite yet.

A September 11th Financial Retrospective

Shocking events such as September 11th usually have dramatic effects on the financial markets because financial markets are made up of individuals and if individuals suddenly, all at once, feel uneasy about the world, things can get ugly in a hurry. After the 9/11 terrorist attacks, the markets certainly reflected this.

Just as a little refresher, the first plane hit the WTC before the markets had opened and they were instantly shuttered. If one has been in that part of New York City, I am sure they can see why. It's uncomfortably close to the NYSE and American Stock Exchange. Leaving the markets open all day as the rest of the events unfolded could have led to a truly unfathomable sell off. With all of the rumors of as many as 40 planes high jacked, false reports of a bomb at the State Department, and everything else, we would have easily broken the 10% decline barrier that causes a one hour shut down at the NYSE and probably would have broken the 20% barrier as well. In fact, I think there would have been an outside chance at the 30% barrier as well. Rumor and fear were really out of control. Though I didn't have a brokerage account, I do have to say that watching the cascading collapse of the twin towers would have probably been enough to put in market sell orders.

Even though the markets were closed that Tuesday, and the next three days for that matter, time did not blunt the sell off much when the markets finally reopened on September 17th, 2001. While the 17th was certainly the worst day of that week, the rest of the week was certainly not exactly a walk in the farmer's market. By the close of business on Friday September 21st the Dow had dropped about 15%. The total U.S. market capitalization dropped nearly $2 trillion. At the end of the day, however, September 11th had relatively little economic impact. Bear in mind that the recession we were in at the time had started in March 2001. By November, it was over. Outside of the airlines and the hotels, very few companies had to cut their earnings forecasts due to 9/11. Some tech companies were still cutting their forecasts from the ever deflating technology bubble, but that's a different story altogether.

To be a bit more succinct, 9/11 had nearly squat all for economic impact outside of the financial market shock and even that was a very small effect in terms of a permanent impact. In fact, the disruption to air traffic had a very positive effect in reducing oil demand and therefore prices by nearly a third before they slowly started to crawl back. Further, and this is the more interesting part by far, were the opportunities created by the panic.

My favorite example is United Technologies (UTX), which is also one of the all time great stocks generally if you are interested in accumulating core positions. One of United Technologies' businesses is of course aircraft engines and of course if the airline industry was hurting they would buy fewer planes and therefore aircraft manufacturers would buy fewer engines. However, investors in their panic seemed to forget that United Technologies also has a large defense business that was bound to do quite well in an environment of increased defense expenditures. The results speak for themselves.

Bear in mind that this is from 9-10-2001 to 9-11-2006 so this does not show the gain from the bottom, but rather the gain from before 9/11. As you can see, UTX took an approximately 35% hit as a result of 9/11, which is far worse than the market as a whole, but that was quickly erased and then it went on a tear, which has seen it add another 80% to that rally beyond this chart. From the bottom it is up 220%, which is pretty damn good compared to an overall market that is up around 10% or so. The market in general, though it is hard to see here, recovered all of its post 9/11 losses within about six weeks or so and the Dow closed a full 1,000 points above its pre-9/11 levels by March of 2002. Then of course, the accounting scandals of that year, persistent slow economic growth, and fears of a double-dip recession sent the market far below its 9/21/2001 closing lows.

To conclude, whenever an upsetting event like a terrorist attack or natural disaster occurs, at some point your mind may perversely wonder "How will this affect my investments?". The answer is almost invariably that it will not affect your investments as much as the market would seem to indicate in its initial reactions and in those moments you can make a lot of money. Now, a genuine financial crisis like 2008, on the other hand, is quite a different story.

Interesting Perspective on Bottom Fishing in Europe

There's a good Wall Street Journal article about the dangers of some of the more popular European ETFs. The principal issue that the authors highlight is that these indexes may be too heavily tilted toward the banks. As someone who lost a fair amount of money on bank stocks during the worst of our financial crisis, I am more discerning about bottom fishing than I used to be, so this caught my attention.

I still think there might be some money to be made in the broad ETFs like EWP, but indeed the better way to play this rout of European stocks is to look for the companies least effected by the crisis, but that have gotten destroyed anyway. The article mentions Telefonica (TEF), which has gotten absolutely clobbered and now yields over 8% with an 8-9 PE, depending on which earnings estimates you use. That's not bad and also Telefonica is unlikely to suffer severe damage. Communications outlays are not as vulnerable as other forms of consumer discretionary spending.

The same goes for stocks here. United Technologies (UTX) is down from $77 to $66 and it really isn't that likely to be effected by primary, secondary, or even tertiary effects of the European crisis.

What do you all think? Does this view make sense to you?