The Stress Test

As we write this, foreign markets have plunged over the weekend.  Stocks will open lower — much lower — at a frightening level.  Individual investors may well panic.  Some traders will see this as the indicator they have been seeking – a dramatically lower opening that provides a buying signal.

We reported our own short-term indicators (negative) and our intermediate-term indicators (waiting for the washout).  We will be buyers on the opening.

The Problem:  A Crisis of Confidence

There has quite obviously been a leadership crisis.  Any appearance by a government official — Bernanke, Paulson, Bush — seems to lead to another decline of 200 or so in the Dow.

What should we make of this?

During the weekend we have not only read the typical Internet sources, but talked with various fund managers and astute observers.  There are two common themes:

1. No one has any confidence in the various fiscal stimulus plans or in Fed Chair Bernanke.  No one.
2. The conclusions seem to be based upon market reaction, not actual economic data.

When there is such a unanimous viewpoint, it suggests opportunity.

Staying Calm

The best opportunities for trading and investing come when others react on emotion rather than facts.  Let us take a look.

Market commentary has dismissed anything positive, and has done so for at least a month.  Economic data suggesting economic growth of about 1.5% — jobless claims, ISM report, Michigan consumer confidence — is ignored.  None of these readings is close to normal recession levels, but the market sees a recession as a fait accompli.

Fiscal stimulus has been dismissed, largely because the President’s package lacked specifics.  This commentary comes from those who have no particular expertise in public policy development.

Almost no one in the blogosphere provides public policy insight, especially when combined with a knowledge of economics, politics, and hands-on investment experience.  Our individual accounts under management have beaten the S&P 500 by about 6 points per year for ten years.  How?  The biggest gains come when we find a solid contrarian theme.

The Plan for Fiscal Stimulus

The Bush plan has been criticized for a lack of specificity.  We are amazed at this reaction!

Anyone who understands politics knows that the key to policymaking is compromise.  Markets should give more credit to the President’s advisors, who urged him to take a moderate course.  Anyone really interested in understanding this should read the Pulitzer Prize winning work of Robert Caro, Master of the Senate:  The Years of Lyndon Johnson.

Politics is the art of compromise.  Republicans and Democrats alike have a motive to stimulate the economy during this election year.  They will probably get it done, with a combination of individual and business incentives.

They will be joined by additional Fed rate cuts.  Monetary and Fiscal policy will both be in force.  If a recession is imminent (something that has yet to be determined, despite the widespread commentary) these actions will mitigate the effects.  Meanwhile, stocks are already reflecting a severe reaction.

Bond Insurers

We are aware of the continuing speculation about bond insurers.  The worst-case speculation is a series of falling dominoes as credit market counter-parties cannot pay up.

This is exactly the sort of case where government acts swiftly and decisively.  The historical precedents include, among others,  Long Term Capital Management, Mexican Debt, Brady Bonds, and the Resolution Trust action after the Savings and Loan issues.

The key point to understand is that when private errors start to have major impacts on the general public, government gets in gear.  This will not be immediately apparent to the talking heads on CNBC or the Internet punditry, since they are not public policy experts.

When reading these discussions, one should compare the projected losses to the overall stock market losses — those hitting average investors and pension funds.  That is the comparison that government officials will make.  Our own estimate is that tomorrow’s opening losses alone — one day — will dwarf the entire cost of backing up the bond insurers.

Government officials look at cost/benefit analyses.

Our Conclusion

A crisis in confidence always provides a stress test.  Government may seem very slow to react.  A few weeks is really fast!  In "trader time" the reactions take an eternity.  In terms of actual economic impact, the delays are modest.

Despite the widespread speculation, no one really knows the extent of the slowing in economic growth.  Policy actions will have an effect, either to prevent or to mitigate a recession.

Meanwhile, equity investors seem to be selling without reason.  Short-term traders may look for indicators like our Gong Model.  Average investors should take a longer view.