Fooled By The Markets?

 

We had signed off last week suggesting that a near term recovery may be on the cards, but just stopped short of making a decisive call. That indecision was vindicated by this week's volatile trading action. Although there was a sharp rebound in the front-line indexes from their intra-week lows, stocks had a wild ride. On the back of sharp losses in equity markets world-wide on Monday and Tuesday, front-line indexes were slated for a disastrous opening (Dow futures down 550 two hours before the opening bell). Then news trickled in of the emergency 75 bps rate cut by the Fed and futures rebounded sharply, before reflexively giving up most of their gains as traders wondered what had suddenly gotten into the Fed. After opening 350 down on the Dow, stocks gradually rallied towards the close but still ended up negative for the day. Whatever 'shock and awe' the rate cut elicited quickly disappeared. Stocks opened on a negative note again on Wednesday in line with weak cues from global markets. After trading weak for first half of the day, front-line indexes staged a dramatic rebound towards the latter half. From being down 300 at one point, Dow Jones Industrials eventually closed up 300. This was the second largest intra-day reversal ever in absolute terms, although a far 30th in terms of percentages. Stocks added onto their gains on Thursday on the back of a global equity rally and the announcement of the Bush stimulus package. Stocks opened in the green again on Friday before losing ground in the latter half of the day.

 

 

The emergency 75bps rate cut this week came with just eight days left for next week's scheduled FOMC meeting. It was the single largest reduction in lending rate since the Fed began using it as its main policy target in 1988 in the wake of the Oct 1987 stock market crash. To be exact, it was the largest single-day rate reduction since 1982 and the first inter-meeting rate cut since the central bank acted in the aftermath of the 9/11 terrorist attacks.

 

 

 
 

A couple of weeks back, we had anticipated that an inter-meeting rate cut was certainly a possibility. We had also highlighted how the market consensus was gradually shifting towards the more aggressive 50 and 75 bps rate cuts as evidence mounted of a significant slowdown in economic activity in December. In this context, we are reminded of Bernard Baruch's words, successful speculation is about anticipating the anticipators. Although our timing was a bit skewed, the script seems to have played out just fine.

 

 

 

This week's action does suggest that a possible trading bottom may have been established. Although the rate cut elicited only a delayed response in the stock markets, the medicine seems to have worked. We got to a point this week where markets became completely oversold with sentiment hitting an extreme negative. The bottoming process actually started last week, affording enough clues for us to believe that a trading bounce was overdue. The front-line indexes now look set to enter a counter-trend rally - a 5-15% rally in 2 weeks-2 months. This rally could see the S&P 500 test 1380-1410-1440 levels. Having said that, it is worthwhile to bear in mind that this will only be a trading bounce, and not a change in trend. A reasonably deep recession is possibly on the cards; recessions are usually accompanied by earnings compression and lower - often, considerably lower - stock prices. Globally, several international benchmarks have entered a technical bear market, having declined over 20% from their recent highs. Most of them, though, look set for a trading bounce.

This week, we take a preview of the proposed Bush stimulus package and whether it will actually do the economy any good. We also seek to answer whether a rogue trading scandal at one of France's largest banks could have possibly fooled the Fed into taking a hasty decision.

 

 
 

What Stimulus? 

Hoping to give a quick adrenaline shot to the ailing economy, President Bush and House leaders struck a deal this week for a $150 billion fiscal stimulus package, including rebates for most tax filers of up to $600 for individuals, $1,200 for couples and, for families, an additional $300 a child. The deal capped a series of fast-paced and intense negotiations, in which the Bush administration and lawmakers in both parties agreed to numerous compromises after more than a year of acid relations. While efforts to provide a stimulus to the economy are laudable, any such legislation will only further add to our soaring fiscal deficit. So it is of utmost importance that we get as much 'bang for the buck' as possible.

Although the package includes a reasonably designed tax rebate, the two most targeted and economically effective measures under consideration - a temporary extension of unemployment benefits and a temporary boost in food stamp benefits - were zeroed out, apparently at the insistence of House Republican leaders. Moody's Economy.com estimates that for each dollar spent on extended UI benefits, $1.64 in increased economic activity would be generated. Increased food stamp benefits would generate new economic activity worth $1.73 per dollar spent. No other options rated as high. Further, every dollar in 'accelerated depreciation' - the principal tax cut in the package - would result in only 27 cents of increased economic activity. A 2006 joint study by the Congressional Budget Office and the Federal Reserve indicated that business tax cuts adopted in the last recession, that closely resemble those in the current package, had only modest stimulative effects. The business tax cuts also would cause states to lose at least $4 billion in state revenue, due to linkages between Federal and state tax codes. The proposal does not include any relief measures for the states. Consequently, many states could enact deeper and more painful budget cuts, acting as a drag on the economy.

On the positive side, the reasonably designed tax rebates are vastly superior to the earlier proposals mooted by the administration, under which more than 25 million low and moderate income working families would have been shut out. Most of those families would get a substantial rebate under the new package. Nevertheless, the rebates for working-poor families (who will spend, rather than save, the largest share of their rebate dollars) will apparently be smaller than those for middle and upper middle-income families.

Standard economic theory propounded by Milton Friedman suggests that for stimulus funds to be spent, they should go to people in temporary economic difficulty who are likely to be liquidity-constrained. But most of the measures that would have done just that appear to have been bargained away. Even the tax credits are apparently not fully refundable, so those who need it the most, and are most likely to spend it, will probably not get the full amount. But any stimulus plan, even if poorly designed, is probably better than no stimulus at all. Not enacting a stimulus package would leave the entire recession-fighting to the Fed and as we have pointed out below, the Fed may be running out of ammunition. As shown in the table below, lawmakers have a penchant for enacting stimulative legislations at the fag end of recession and the early stages of a recovery, thereby completely missing the point. With the added election incentives this year, we hope Congress can put together a package as speedily as it can.

 

 

 
 

 
 

Another Rogue Trader

The rogue trader's elite community had a new entrant this week : 31-year-old Jerome Kerviel. In one of the most unsettling disclosures in the banking industry in recent memory, Société Générale, France's second largest bank, announced that the rogue trader had made unauthorized bets on stock index futures, costing the bank I €4.9 billion ($7.2 billion), the largest trading loss in banking history. To put the figure in perspective : this loss exceeds the $6.6 billion Amaranth Advisors LLC lost in 2006 and is more than four times the $1.4 billion of losses piled up by Nick Leeson that brought down Barings Plc in 1995. SocGen now plans to raise €5.5 billion from its shareholders after the loss and large sub-prime related write-downs significantly depleted capital. The Bank of France, the country's banking regulator, is investigating the alleged fraud.

A letter by the Chairman posted on the company website indicates that the transactions were simple but were hidden through extremely sophisticated techniques. Kerviel used his intimate knowledge of the bank's risk control systems ('breached five levels of controls' - Christian Noyer, Governor, Bank of France) to build a massive long position on European stock index futures, amounting to some $73 billion. The trades were massively in the money by end-2007, but had started bleeding losses when the equity markets dived starting this month.

Société Générale has a reputation for its expertise in equity derivatives which has become a big money spinner for it. Risk Magazine has ranked it first or second during the past five years in client surveys of equity derivative firms. It earned the 'Equity Derivatives House Of The Year' tag from both RISK magazine and Banker, a London-based monthly magazine.

The accident highlights how vulnerable bank's security controls still are and how an insider with sufficient knowledge of the systems can still create havoc. Kerviel is no trading legend who let a transaction get out of hand. He was a low-level trader in the bank's 'Delta One' desk in western Paris, earning about €100,000 ($145,000) a year. Clearly, banks are yet to learn their lessons from 13 years ago, when a single trader by the name of Nick Leeson brought down a 233-year old British bank.

 
 

 

Fooled By The Markets? 

Details of this incident sparked speculation that the selling by SocGen, estimated to be 10% of market trades, caused the massive downside volatility earlier in the week. It is now apparent that the European Central Bank knew early on about the problems at SocGen, but the Fed apparently was caught napping. 

Some serious questions are now being asked. Was the Fed duped into a clumsy and panicked move by a cleanup operation at a French bank? Why did their French and ECB counterparts not tell the Fed about the happenings at SocGen? What was the motivation for an aggressive rate cut just seven days before a scheduled FOMC meeting?

We are on record in suggesting that the Fed has been largely behind the curve for much of last year. We have also suggested that the increasing gloom about the economy warrants an aggressive easing in monetary policy. But the timing here is baffling. Slashing rates with such aggression a little over a week before a scheduled meeting, smacks of panic. 'Downside risks to growth' surely exist; but the economy had not grown any weaker over a long weekend. Considering the inherent delay before changes in monetary policy affect spending, the sudden urgency seems odd. 

It is hard not to conclude from this sudden change of tack that the Fed acted mainly to shore up markets, which had alarmingly switched to panic mode in just a week. Indeed, the Fed noted that 'financial market conditions have continued to deteriorate'. Were the equity markets not functioning properly? Globally, equity markets are in a process of re-pricing risk and lofty valuations after a long bull market amidst an increasingly likely possibility of a concurrent US, European and Asian economic slowdown. Why should the Fed try to disrupt a market-based process of wringing out some excesses out of the system through a healthy capitulation? With Fed funds already at 4.25% before the cut, it would be fair to say that the Fed decided to use its limited ammunition to intervene, nay guarantee, equity prices. The Fed is charged with keeping employment high and inflation low, not back-stopping equity market punters. 

To be fair, the Fed may just be using equity prices, as many economic analysts do, as a useful aggregator of private and public information about near term prospects for economic growth. With all recent indicators suggest a significant deterioration in real economic activity over the past two months, a recession may be already upon us. Just as the 50 bps cut in April 2001 failed to prevent a recession, this one may fail as well. Bernanke probably simply intends to do what he can to mitigate the damage. But the action is so disproportionate (the sudden change in tack) and ill-timed that it will only further unsettle markets. With people pondering 'What does the Fed know?', we believe this action has only strengthened wide-spread belief that a recession has already begun.

The reactions in the past week have polarized the financial world. While the emergency rate cut was cheered on by some sections, others rightly have jeered. Bill Gross, manager of the world's largest bond fund, quipped that it is a sad state of affairs when the Fed has to cut interest rates just eight days ahead of a meeting to salvage equity markets. Barry Ritholtz, widely read blogger, columnist and a respected voice in financial media, remarked that the panicked rate cut would prove to be an historical embarrassment and that the Fed allowed itself to be bossed around by futures traders. 

The markets initially failed to view looser monetary policy and cheaper money as a nice surprise. Dow futures traded down over 550 points on Tuesday morning before the markets opened; after a gradual recovery through the day, the indexes finally closed down 'only' 128 points. Although the indexes rebounded strongly thereafter, we have a lingering suspicion that all the Fed may have achieved this week is merely delay the inevitable.