After the Market Crash Liquidity Starts to Repair Banking System

By: Paul_J_Nolte

Another historical week – the largest one day decline since the '87 crash and the largest one day gain since the '29 crash. OK, so the market is/has crashed – now what? Liquidity in the form of government and Federal Reserve funds are flooding the markets, buying nearly everything from bad bank debt to actual bank stock. Some have argued we are moving to a socialist society, but we'll leave the politics for someone else to discuss. Unfortunately the liquidity has not made it into the hands of those with loans outstanding or for those wanting to enter loan arrangements. The banking system is acting as a sponge, sopping up any and all liquidity it can find to repair very poor balance sheets.

Oh, and by the way, the economy doesn't look too good either, with a consumer that has contracted spending for three straight months and is very fearful of further job losses – sentiment is not surprisingly very poor. BUT, the silver lining to this backdrop is the huge decline (50%) in energy prices, some easing in various loan rates between banks, an indication that some lending between institutions is beginning to occur. Let's not forget that the patron saint of investors – Warren Buffett – is buying with both hands. It will take some time, but the gloom will lift and the markets will rise, however the ride will still be very bumpy.

The week was one of the best of the year in terms of net number of stocks rising for the week. Volume moderated some from the frenetic prior week and actually may be signaling that the worst is over for the market. While we still want to be cautious about buying, we are getting signals from many areas of our work indicating that equities should be purchased over the coming months and that above average returns may be seen over the next 3-5 year period. The time to sell, in our opinion, has passed and the time to buy is upon us.

This is not an easy thing to do when nothing but bad news is shouting out from newsprint and televisions everywhere, but unless one believes the US is going the way of the Dodo, opportunities to buy the markets at such cheap valuations. Our work indicates that the market is already discounting a severe recession (that we are already in) and we are within shouting distance of valuation levels only seen after 1929 and 1973-74.

Investors have taken to looking at arcane measures of risk in the bond market – the TED spread and LIBOR rates. While many participants look at these measures, it is rare to be watching these reported breathlessly in the media. Think of these as measures of liquidity, the spread in rates between Treasury and Euro rates and over night rates for banks loaning money among themselves.

We are beginning to see these rates come down; a sign that the money tossed at the financial system is finally beginning to have an impact. Compounding this bit of good news is the very steep yield curve, which historically has predicted a more robust economic environment. A steep yield curve also benefits banks balance sheets; as they are able to borrow (pay CD rates) at rates well below those rates that they are willing to loan money out. Currently the bond model is negative, however it has just turned down, we will give it a couple of weeks before we declare bond prices trending higher.

By Paul J. Nolte CFA
http://www.hinsdaleassociates.com
mailto:pnolte@hinsdaleassociates.com

Copyright © 2008 Paul J. Nolte - All Rights Reserved.
Paul J Nolte is Director of Investments at Hinsdale Associates of Hinsdale. His qualifications include : Chartered Financial Analyst (CFA) , and a Member Investment Analyst Society of Chicago.

Disclaimer - The opinions expressed in the Investment Newsletter are those of the author and are based upon information that is believed to be accurate and reliable, but are opinions and do not constitute a guarantee of present or future financial market conditions.

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