Dow Down 508--Tomorrow Morning Could Be Ugly

Today was a scary market as the market started to decline as Mr. Bernanke was speaking. It rallied back a little until President Bush had a word or two to say about the economy and the financial crisis. The market proceeded to go down but was volatile as rumors of the Morgan Stanley deal with Mitsubishi was in trouble. Both companies denied this. Then there was Bank America saying they were going to raise $10B at a 32% discount from Monday's closing price while also cutting its dividend in half. They reported poor third quarter numbers. The fear in the market continued and finished very heavy with a big drop in the last hour of trading.

Thankfully the day was over but it wasn't as Alcoa reported very disappointing numbers. Next came Met Life. It pre-announced its third quarter numbers with many write-offs and an announcement that is is going to issue 75mm shares tomorrow which will raise about $2.7 billion if it is completed at today's closing price. Alcoa is typically the first company in the Fortune 500 to report quarterly numbers and it may be a prelude to a very very weak quarter. Does Met Life's announcement foreshadow trouble with other Life Insurance companies such as the Pru and Principal Financial?

The chatter continued globally all day as many countries in Europe are scrambling to shore up their own financial systems and ease the global credit crisis. As we have said in the past, the credit crisis is leading the charge but ultimately a weak economy will hurt companies, increase unemployment, stretch the consumer, and lead to a prolonged recession.

As we enter tomorrow, Asian markets and European markets are likely to have had major declines over night. Unless the Federal Reserve and its European counterparts announce some major interest rate cuts, I would anticipate the Dow could take a dive in the first two hours of the day and maybe bottom at 1000 points down if the market moved into a capitulation phase where volume increases and everybody is a seller. The Vix will reach new heights of fear but if you have maintained liquidity, new opportunities will be created in the market. Buy high quality stocks that do not have large capital requirements or sit on the sidelines until it is clear that the market has settled down and headed back up.

The Diving Market Came Back To Life

It looked like Armageddon as the Dow dropped almost 800 points during the day yesterday but it came back to fall only 370. The professional traders heard rumors and anticipated a cut in interest rates by the Federal Reserve Bank. The Fed is likely to cut rates as much as 3/4 to 1% to try and force banks to lend to each other which might loosen up the credit markets a little. We can also expect many countries to start to cut rates in order to improve the global credit bind we find ourselves in. This kind of coordinated action could propel stock markets to rally but I would expect it to be short lived.

Leverage needs to unwind and financial institutions still need to be recapitalized. The last I looked the economy is falling off a cliff everywhere. This market will bottom before the economy turns positive but stocks need to get decimated before that happens. Value will be created in some stocks everyday but massive selling needs to occur before the stock market as a whole can begin a new upward trend.

What Will Happen to the Export Engine?

Many investors for the past year or two have been gravitating to the companies who sell many products overseas. The export boom has driven the earnings of many global companies based in the United States. As the U. S. economy has weekend, those companies have stood tall and outperformed their domestic only brethren. Is the party over?

Economic trouble and the financial crisis have finally reached across our borders as financial institutions have required government bailouts in countries such as the United Kingdom, Germany, Belgium, Netherlands, Luxembourg, Italy, and Ireland. I am sure there are others that are having problems also but it is clear that Europe is following the slippery slope of the United States.

The Federal Reserve has been consistently injecting liquidity into the financial system as a means to unlock the illiquid credit markets and in order to stimulate lending amongst banks globally. Mr. Bernanke's European counterparts have been acting in concert to provide additional liquidity. It seems clear that the next move could be a coordinated drop in interest rates. Will this help? It is hard to say but it won't hurt. The scare of triggering inflation has been mitigated by the sudden collapse of commodity prices and the Fed is likely to let rates ratchet down to zero.

Corporations who have depended on that export demand to drive their businesses are likely to see some revenue softness in the next few quarters. Of course their bottom lines may not decline as much in the short-term as they benefit from lower commodity costs but in time, earnings will also slow. The stock market may appear cheap to many experts but if a global recession ensues, earnings projections will be cut, and stock prices will continue to fall. It is important in these declining markets to maintain sufficient liquidity in treasury bills and notes to be able to take advantage of the many opportunities ahead. If you are buying stocks in this volatile market, don't buy a full position right away. Buy a little at a time as the price declines and only buy well capitalized companies with plenty of free cash flow.

Where Will The New Trouble Rear Its Ugly Head?

The $700B Bailout Bill finally passed and as expected the stock market ran up on Friday morning in anticipation and came crashing down once it was likely to pass. As we have been saying it is a band-aid and the future will be driven not only buy the credit crunch and the financial sytem but by the economy. The economic truths were best displayed by last week's Institute for Supply Management's index of manufacturing which tumbled to 43.5% in September. This was the lowest reading since October 2001. A reading under 50 means manufacturing is contracting. We are in much worse shape today as October 2001 reflects 9/11 where all business in America came to a screeching halt but rebounded in Novermber. We shouldn't expect a sizable, if any increase, in this index in the near term. On Friday, the payroll employment number for September came out and there were 159,000 fewer jobs. This is not a pleasant number and I suspect the next few months could be worse. If the economy is not in a recession now, I would be shocked.



Just as it seems like all the bad news is out, Arnold Schwarzenegger, Governor of California, seems to be short a few pennies to pay the state's bills and payroll. He is now asking the Federal Government for a small loan of $7B. This is one of the next major problems facing the mighty America. I think Hank Paulson is waiting for the year to end quickly so he can hand off the baton to the next unlucky sole to take the position of the Secretary of the Treasury. The need for capital never seems to end in this crisis.



The municipal bond market, where all Cities and States raise money to fund their capital projects and supplement tax collection has come to a halt like many other credit markets. If the economy is sinking, then business will be softer, earnings will decline, and taxes will also shrink. City and State budgets are calculated with the expectation that their expenses will primarily be covered through the revenues generated by the tax base. Weakened companies pay smaller tax bills and since unemployment is rising, individuals will pay fewer taxes also. Where will the municipalities get the necessary revenue to pay salaries, bills, and pensions to the government workers? They might normally raise money in the municpal bond market but as I stated above, that market is not currently functioning as it should. There are two choices: slash costs as Governor Patterson of New York is attempting or go hat in hand to the Federal Government and ask for a loan as Governor Schwarzenegger is attempting.

If a plethora of Cities and States starts to run a deficit and need to turn to Mr. Paulson for a loan, this will be troubling. Not only is the government trying to fix the financial sytem, it will need to find billions more to keep the municipalities across America from defaulting. In 1979, New York City bonds yieded something like 14% and it looks like similar investment opportunities may be coming.

Wells Fargo Begins the Market Value Play

Today Wells Fargo announced an aggreement to merge with Wachovia. This is clearly a surprise to Citigroup which thought they were buying Wachovia in a deal brokered by the government. This deal will be challenged by Citi as they thought they had an exclusivity agreement but the Wells deal certainly looks like it is better for shareholders and perhaps taxpayers.

More importantly, this deal is great for the long-term trends of the markets and the economy. We have discussed value investors in the past and that is what Wells Fargo apparently sees in its merger with Wachovia as it expects this combination to create great value at a bargain price. This is likely to be the first of many other banking mergers that will consolidate the industry, strengthen the bankinging system, and ease the credit crisis. The process may take a year or two but today marks the beginning of a positive movement toward propelling our economy in the right direction.

Other signs to look for which will indicate a bottoming in asset values will be increased acquisition activity in the corporate sector. Large, well-capitalized companies will sift through their industries to find the competitors who are overleveraged or have weak business models. These companies likely have taken a beating in the stock market and can be acquired at discounted prices. We should also expect to see leveraged companies who have cash announce that they have bought back their debt at discounted prices. The purchase of a company's bonds at a discount will not only reduce the interest expense of the company but also result in a capital gain. Of course, the company will end up with less debt and a stronger balance sheet.

The bottoming of a market will need to see help from many places. In addition to the above examples, we can expect the so called "smart money" will begin to deploy some of the cash they have socked away as they read the tea leaves of the market. A vote of confidence from CEO's on the acquisition trail will clearly indicate there is value in the market and investors can now forge ahead to buy stocks and distressed debt.

The economy is still weak and will likely get softer but the stock market will likely bottom out before the economy does. Today is the most recent sign of positive events to come.

The VP Debate to The House Vote to The Economy

The much anticipated Vice Presidential Debate is over and both candidates held their own. The economic crisis was a focus but no new solution was articulated. Tomorrow we may move to the floor of The House of Representatives to see if a vote on the Bailout Plan will take place. It is likely nothing will occur unless there are enough votes to produce a "Yes" vote. Either way, the focus will shift back to the economy.

Today's stock market tanked again and the VIX fear index escalated to levels close to its high last week. Is it the uncertainty of the Congressional vote that drove the market down or the weakness in auto sales, durable goods, manufacturing, jobs, and eroding home prices? It is a little of both but ultimately it will only be the economic factors.

Today, a bunch of insurance company stocks took a beating. Why? The reality that the assets they hold will also have to be marked down has finally hit the radar screens of investors. Most industries are being plagued by the financial crisis or from the weakness in the economy. Today's stock market saw the fertilizer companies get creamed. Why? Commodity prices dropped on average 9.9% this week, so far. Lower prices mean lower margins for farmers. These farmers may produce fewer crops because of the lower profit potential and/or because they won't be able to borrow money to finance their businesses. Fewer crops means less fertilizer and thus lower earnings for fertilizer companies. Hence, lower stock prices for fertilizer producers.

It seemed like most industries were affected by today's market downdraft. Some of the industries that had many stock prices drop more than 1% today were homebuilders, gaming, auto parts, paper, broadcasting, technology, wireless, airlines, auto manufacturers, building materials, and cable. Homebuilders declined because of the reported drop in home prices. Airlines have been driven by oil prices but today oil prices dropped again. This decoupling indicates that the weakness in the economy is now the driving force. Auto manufacturers and auto parts companies are weak as even a company like Toyota, the number one global car company, is showing weakness. We can cover each industry in a similar manner but the bottom line is that the extensive weakness throughout the economy, the credit crisis, housing, and the tapped out consumer are finally leading the decline in the stock markets globally.

We will need a restructuring of America and it will be a painful process. Businesses will be deleveraged either with new equity or the bankruptcy process. Many value oriented investors have performed poorly this year but new opportunities will arise in this restructuring process. The wealth building will likely come from four areas. Opportunities in treacherous markets usually arise when fear is greatest. Strong, well-capitalized companies will suffer stock price declines with the rest of the market but will be long-term winners. Let's take Warren Buffetts' deals with Goldman Sachs and General Electric. Berkshire Hathaway clearly got sweet deals so I wouldn't say today's stock prices for those companies won't go lower. In fact, they probably will go lower. However, both companies will likely be survivors with much higher stock prices in five years. It takes guts and risk to buy them but a long-term investment style will likely prove that Mr. Buffett has picked winners again. The second lucrative investment will be in distressed mortgages that professionals buy from financial institutions. The third winner will be sifting through the commercial real estate market upon its true decline in the next couple of years. This may not be an opportunity for most investors but the puchase of a home at distressed prices will likely produce nice returns in a five to ten year time horizon. Finally, distressed corporate debt will garner excessive returns either because the prices moved back to par (100 cents on the dollar) or through a restructuring of a company in bankruptcy where the investor exchanges debt for equity.

Most investors will remain on the sidelines in these volatile markets and let the professional money managers take the risks in a down market. The key is to maintain cash in order to be able to buy stocks when the economy starts to get better and the stock market begins to rise again. Be patient because it may be a year or two away for that scenario to present itself.

What Will Happen If A New Plan Is Passed?

The Senate has passed a slightly altered Plan tonight and perhaps the House will move in the same direction as it meets tomorrow. I continue to believe that the plan might not have the best structure (See my alternative plan) but some Bill will be better than no Bill. Let's assume a Bailout Plan passes, what can we expect to happen in the economy and the markets? The Government will now proceed to buy distressed assets from the balance sheets of financial institutions with the intention of freeing up capital. The goal would be to improve lending and strenghthen the credit markets. It sounds good but first many of these financial institutions will need an injection of fresh capital. Why does Warren Buffett want the plan to succeeed? Many new opportunities to provide attractive equity capital will become available to him. Hence, the plan will allow for more dilution of current shareholders and perhaps lower stock prices.

Does the Bailout improve all the credit markets? Absolutely not. The worst is yet to come. We should expect to read alot about auto loans, credit cards, home equity loans, construction loans, and corporate loans. What we will hear and read about is Default, Default, Default. The consumer is tapped out as his/her home value has declined and his/her ability to borrow against it has disappeared. Instead of consolidating debt through a home equity line, credit cards will be used. The problem is that banks are tightening those credit lines also. It won't be so easy to get a new credit card with stricter credit standards being imposed. The consumer will feel pinched and may not be able to pay off those auto loans or home equity lines. How can this happen all at once? Well, the economy is clearly heading toward a severe recession and the unemployment rate will rise. Fewer jobs and lower incomes mean a weakened consumer.

The new Bill proposes to alleviate the homebuilding industry by removing the bad mortgages off the books of banks but if home prices continue to fall, it may be awhile before homeowners can sell their current homes to buy new ones; and it may cause new potential buyers to delay their home purchases. The Bill doesn't seem to focus on commercial real estate but that problem is brewing. The retail industry is suffering and bankruptcy's have begun. This will start to put some stress on shopping centers. During the past decade, commercial real estate also boomed. Leverage was easy and rents were rising. As businesses fail, rents will fall, competition for new tenants will rise, vacancies will be bountiful, and leverage will be a huge problem. We should expect to see cracks in the commercial real estate market. Furthermore, construction lending was another large profit center for banks, both large and small, but a weakened corporate environment will result in defaults on many of those loans also.

What is amazing during the past year is the strength of corporations. The LBO Boom created the greatest opportunity to add leverage to balance sheets while requiring only a sliver of equity. It was great for a while as private equity firms reaped huge profits after reselling selling those companies or recapitalizing them with huge dividends to themselves. However, the musical chair game is about to be over and not everyone will have a seat when the music stops. We should expect to see a plethora of corporate bankruptcies as the economy weakens, revenues decline, cash flow disappears, and the banks balk at providing new loans. Leverage is great when business is strong but it will kill a company on the way down. Many of the leverage buyouts have capital structures which could delay bankruptcies as the terms of the bank loans will forestall defaults but they won't prevent many forced restructurings. The domino effect could potentially negatively impact suppliers, competitors, and customers of these failed corporations.

Unfortunately, many of these issues won't only affect the United States. These will be global problems and will create a global recession. Buckle up and hold on tight. Invest in only high quality stocks where leverage won't be an issue and free cash flow is available.