The Three Big Stories

At "A Dash" we love links, and appreciate the efforts of those who faithfully follow all of the relevant news, the key posts by bloggers, and academic studies.

Those who regularly post links take on a special responsibility, making sure that the right information has been highlighted and helping investors and traders spot what is relevant.  They are the gatekeepers for information.

In general, more is better.  How can we have too many good links?

On weekends, tens of thousands of readers look to the linkfests from Barry Ritholtz.  Last weekend he  provided us, as usual, with the week in review, and the week in preview.  Barry does this faithfully whether he is traveling or on vacation.  He has assumed a responsibility and many depend upon his guidance.

We appreciate this work and the commitment it involves, so our comments should be considered in that context.

Missing the Big Picture?

At the end of each week, like other investment managers, we think about what were the big stories.  While it is fine to provide lists of links, the individual investor may find it more helpful to have some focus on the most important investment themes.  Even astute traders may find a need for focus.

Focus is Important

We have written about how investors can lose focus at times of market stress.  (Readers who paid attention have profited nicely.)  It is also possible to lose focus at times of opportunity.  We present here our three big themes from last week, something that everyone should have in mind right now.  (Perhaps we should do this on a regular basis — something we should consider).

  • Financial earnings.  Going into last week some observers, including the astute Doug Kass, believed that the earnings from investment banks might be more important than the Fed decision.  He correctly discerned that many investors were worried about how much bad paper they had, whether it had been marked to market correctly, and their prospects for future earnings.

Meanwhile, Scott Rothbort has written regularly on’s RealMoney site about risk controls at the big investment banks.   (full disclosure — I contribute there.  I find the work of Doug and Scott to be very valuable and well worth the fee.  I stated this before I was on board, as regular readers know.)  Scott’s analysis, unfortunately still not available to the general public, is that the big banks have an array of risk models, VAR analyses, and hedges, to protect their positions.

The earnings reports and the stock reactions showed that Scott was correct.  Even Bear Stearns stock rallied on the spectacular Goldman Sachs report.

By following Scott’s analysis, we made some nice profits for our investors ( long GS and MER) and we see this as a big story.

  • The Fed Decision.  The Fed chose to act preemptively on the economic threat.  Having tried a discount rate cut, and noting inflation (by their metrics) under control, the Fed moved to help credit markets and the economy.

Whatever one’s perspective before the decision, there are several immediate impacts that were recognized by most observers.  The prime rate was immediately reduced by 50 bps.  This is good news for business borrowers and those with home equity loans, often tied to the prime rate.  LIBOR rates (also used in many lending agreements) also fell.  Anyone with a quantitative recession  model should be reporting reduced odds.  The yield curve responded immediately.

  • The Reaction. Astute observers should note that any Fed decision would attract criticism.  Everyone has an opinion, including many who are less-informed than Ben Bernanke.  We have the impression that those who were caught short were the biggest complainers.  The basic arguments were dollar weakness, moral hazard, and the (questionable) notion that the Fed was acting out of fear.

Here is some analysis of the typical reactions:

Our Take

Investors can look at the main theme — improved economic prospects — or they can get pulled off onto some future inflation worry.  We suggest that readers carefully examine the sources of the worries — mostly those ill-positioned for a market rally and now seeking some new frightening prospect.

Journalists in both print media and television thrive on "worry" articles.  The leading financial blogs do the same.  Meanwhile, the forward earnings yield from stocks is attractive when compared to other asset choices.

With all of the negative commentary, investors have an unusual opportunity.  Going with the earnings, the Fed, and reasonable economic prospects provides the chance to be a contrarian with the odds on your side.

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  • RB September 26, 2007  

    Bear Stearns’ woes seem to have gotten to Malpass (signup required):
    “A key variable in the hardness of the landing is the value created by all the past liquidity.”
    He goes on to give a good description of some of the positives. Kasriel however seems to find that Malpass’ negatives were the bigger winners as described in Chart 2 here:

  • Mike September 26, 2007  

    Two “negative” comments about the current situation of the market.
    I put “negative” in quotes because the comments are from other people. One is a client, whom I may start calling ‘Mush’ for his bad calls on market direction. He called me six months ago to warn me of a potential 10% correction. The Dow was just over 13,000. The correction happened, and now the Dow is pushing 14,000. Just this week he has gone 75% fixed income because he believes a recession and a market correction are imminent. He’s a young man making good money, and his account size is modestly-sized. To me, he is the epitome of the retail customer right now–scared !@#$less. (In contrast, the clients I have who are more on the fearless side are having a solid year, up over 20%.) In my opinion, they are one of the reasons why the market can only drop so much. They aren’t out there as a whole with assets to sell, as they aren’t in the market. One need only look at what the market is saying. With all of the credit crunch news, we got 10% correction from top to bottom that has all but reversed itself (though there has been some re-shifting) with one 50 bps shaving of the fed funds. So who’s smarter? Mush or the market? I think I’ll go with the latter.
    The other negative comment I keep reading about is inflation. The article entitled “Inflation is Dead? Part II” written on September 24 and posted on the Big Picture is a prime example. As is so often the case, the author selectively omits a certain data point (the SAME thing he accuses the Fed of doing) to arrive at the conclusion that inflation is much greater than is being reported. In short, high energy prices means high inflation. (I’ve seen the even more esoteric one–high gold prices mean high inflation.) I quick visit to would support this belief. I wonder why it is that omitting food and energy from core inflation is such a bug up their butts, but focusing solely on energy and health care is like looking at a crystal ball, especially when EVERYONE (U.S., U.K., Australia, etc.) is looking at home prices depreciating.
    Shoot, other than gas, how is inflation hitting Mr. Average Joe? The average person doesn’t spend much on health care. Even with higher food prices, there are simply too many substitutes. Sure steaks and milk are expensive, but chicken and soy milk haven’t gone up. Most people have the wherewithal to stick to what their budget permits.
    One could make the argument that Mr. Average Joe was hit with inflation via higher housing prices, but that was really only for people who bought late in the boom (though one could fairly include taxes and insurance, as they have gone up in many areas). But inflation didn’t cause the housing boom. There was practically no inflation from 2000-2004.
    So in a nutshell I’m seeing both lay investors and more sophisticated writers with bearish attitudes. (There are bulls, to be sure, but can anyone really say these people, like myself, are painting a picture of the future as rosy as the bears are gloomy?) Yet the market just keeps right on trucking, and companies keep right on making money. Once again it appears a large part of the populace is trying to predict the future. The last time it happened most people were very positive about the future. Then the market tanked. Now the loudest–and seemingly most intelligent–are pretty negative. Hmmmm….

  • Bill September 26, 2007  

    Excellent take, Jeff. I like your big three issues analysis, but frankly what has shocked me most about the recent commentary is the scramble by those caught unprepared to insist that Bernanke was foolish/wrong/etc. and related attempts to chastize the markets for rallying in the face of this mishandling (or worse) of the situation(s) by the Fed.
    Frankly, if the bricks in the wall of worry are bloggers and mainstream media pundits, so much the better as far as I am concerned.
    Finally, while this is my first comment here, a belated thank you for many superb posts.

  • RB September 26, 2007  

    “especially when EVERYONE (U.S., U.K., Australia, etc.) is looking at home prices depreciating.”
    We’ll group you among those who “selectively omit” home prices from inflation on the way up but not on the way down.

  • Mike September 26, 2007  

    Not at all. But buying a home is a controllable decision on behalf of buyers. They didn’t HAVE to buy.
    I’m seeing lots of comparisons to 1970s-style inflation, but there are huge differences. The workforce was exploding during that time period with young, unproductive boomers entering the workforce here and around the world. (High inflation was a world-wide phenomenon. It wasn’t limited to the U.S. Same thing for the baby boom.) This pushed up consumer prices across the board. You couldn’t just substitute your way out of it. (Just like you can’t substitute your way out of higher gas prices today.)
    We aren’t seeing anything like that today. The inflation has been limited to a few areas. Other areas have seen decreasing prices.
    What’s interesting is that the inflation talk seems to be escalating. It sure seems more apparent now than it was four years ago, when real estate was on the upswing. My point was that I don’t see anyone making mention of the clear downtrend in housing, yet it’s a major downtrend. These same people ONLY point to higher energy, higher health care, and higher select food prices as their reason why CPI is some major government conspiracy.
    It’s my opinion that everything should be taken into account. The 1970s saw significant wage price inflation. We’re seeing none of that today, yet when it gets mentioned it’s as if that supports the inflationary viewpoint, when it in fact supports the opposite.

  • RB September 26, 2007  

    as you know, the inflation measures don’t include home prices, despite the known flaws of using rent as a proxy. Going along with your line of reasoning, inflation only matters for buyers from 2004 onwards but home price deflation matters for all homeowners and not just for buyers from 2007 onwards.
    Regardless, the Fed itself realizes that their measure of inflation is flawed. Couple of links from those at the Fed:
    Those at the Fed are starting to realize that they need better measures in an environment of persistently higher energy prices:
    Jeff’s policy here has been, I believe, to interpret what the Fed will do with regards to interest rates (which is to act according to core PCE) and not make any calls on inflation, per se — so as far as we are concerned from an investing and valuation standpoint, higher interest rates are not a threat currently.

  • Mike September 26, 2007  

    I actually think all the numbers matter, as it’s too easy to pick out figures that run counter to or support the prevailing trend. I see a lot of pundits pointing at one figure, such as higher energy prices, and saying the Fed is not only stupid but deceptive for how they report inflation.
    Regarding oil prices, the move from $10 to $80 was clearly significant. But will oil continue on this pace and be $640 in a few years? I have a difficult time believing that’s the case, so whatever growth rate oil has been adding to inflation will more than likely decrease.
    Interest rates rose from the 30s to the 40s to the 50s to the 60s to the 70s. They’ve been dropping ever since. Based on what’s going on here and around the world, that trend is continuing. And I’ve yet to see a stronger correlation for inflation than interest rates and workforce growth.

  • Bill aka NO DooDahs! September 26, 2007  

    Inflation is a monetary phenomenon, and has been running at high single-digit to low double-digit annualized growth rates since the Bretton Woods agreement was buried.
    If y’all want to refer to CPI/PCE or some other alphabet soup as a measure of consumer (or producer) prices, why not just type “CPI” or “PCE” instead of “inflation” – it not only saves keystrokes, it improves your accuracy.