Thursday, April 23, 2009

Now What?

Please accept my apologies, I have been in Chicago with my extended family the past few days.

On Friday the S&P closed at just about 870, just about the level it held before the fiasco of the original Geithner speech about TARP II. A lot has happened since then. After that first abortive attempt to explain what the government was going to do the markets fell and broke the November lows dropping to a closing low of 676 in the first weeks of March. Since then a number of things have happened which have added fuel to the fire and spurred on quite a rally. 1.) An internal memo from Vikram Pandit remarked on the improved earnings picture for Citibank. 2.) The Fed announced that it would buy treasury bonds outright. 3.) Geithner redeemed himself by actually announcing a plan involving stress testing and recapitalizing the weaker banks and providing equity and leverage to the private sector to buy assets off the bank balance sheets. 4.) The TALF began functioning. 5.) The G20 recapitalized the IMF. 6.) Economic data while dismal, was no more dismal than actually forecast. 7.) the FASB has relaxed the mark to market accounting rules 8.) earnings have come out for most of the largest TARP recipients verifying the sunny internal memo of Mr. Pandit which began the entire rally.

The S&P traded up almost 200 points in that time, erasing all the losses in the decline that came after the inauguration rally and the disappointment over the initial Geithner plan. There has been a hot debate between market professionals over whether this constituted a “Bear Market Rally” or whether the worm had turned and the market, which many consider to be a leading indicator, would lead the economy higher. With this rally the market has largely written off Q1 of 2009 as an extension of the panic in Q4 2008 and is looking to the future.

It seems to also have a lot of faith in the resolve of the government. Interestingly over the past several sessions gold and the market have been moving in opposite directions. You would think that market declines would be indications of more deflationary pressure in the economy and that would take down gold but the markets are so confident that the government will print its way out of this crisis that as earnings worsen gold rallies.

That said the market did drop 4% on Monday and has largely traded sideways since then. So what does this mean? Is the bear market rally over? Will the bear market resume? Will we pause and then continue to climb the wall of worry? There is a good case to be made for either side. The bears would argue that we have certainly not seen anything convincing in the data on the macro-economy that would lead us to believe the economy had turned. They also think the optimism over the financial sector may be overdone because their earnings will naturally be high when banks borrow at the risk free rate, lend to a credit starved economy and don’t have to mark their mistakes to market. Optimists can point to analyst estimates of 2010 S&P earnings of $76 per share and say the S&P is a steal at 11 times today’s closing value of 859.

My view of this is the following. I think the rally has done a lot of work and I think the market is fairly priced if you think the economy will recover but slowly. The current analyst estimate for S&P 2009 earnings is $59 or a 14.5 multiple to today’s close. I think the $76 number for 2010 is almost certainly too high, the $59 number for 2009 is itself $3 lower than two weeks ago. That said you cannot ignore all of the things that have happened over the past few weeks. The market may have gone up very quickly but not without reason. The fact that banks have more leeway in valuing their assets means we are likely to see fewer write-down shocks which have spooked the market in the past. I think we will trade mostly sideways until the macro-data give a better indication of where we are in the recession. The two things that could shock the market are a disorderly bankruptcy of the auto-sector or a serious problem in the release of the Bank stress tests. I will write tomorrow about how to approach those things.

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