stock market runup is unwarranted

The news today that the Dow Jones Industrial Averages was up 936 points, or 11.1%, has spread like wildfire. NASDAQ was up 11.8%. The S&P 500 was up 11.6%. Wow! That felt good, didn’t it? Problem is…not much has changed. In my last post I said that certain conditions had to be met that would ensure that a bottom had been reached in financial markets and that it was safe to invest again. Those conditions have not entirely been met.

Since last week there has been a one-page agreement signed by the G-8 nations that they will try their best to ameliorate the current financial crisis. However, the G-8 could not agree to act in concert to stave off any further damage. To me that is a mildly troubling sign.

There were rumblings out of the White House this evening that tomorrow it will announce that as much as $250 billion could be invested to shore up the equity in marginally-performing banks.

Yes, all of this is change, however, look at what needs to happen to truly stabilize the financial markets, financial institutions, and the economy:

• The leadership that led to this mess is still largely intact. Executives at poorly managed financial institutions have gone by the wayside. However, many of them are lurking around at still breathing institutions (e.g. Morgan Stanley) and some of them are still lurking around because whole swaths of executives had their jobs purchased by a healthier institution (e.g. Bank of America).

Worse, the Congressional leadership that oversaw the destruction of the pristine Depression-era legislation that was designed to prevent messes like the one we are all in now, still remains in power. It will take this election cycle and the mid-term elections two years from now, as well as a commitment from Americans to vote these folks out of office.

With a new President coming into office in January there will be new Regulators in place eventually, a new Treasury Secretary, and perhaps a new Federal Reserve Chairperson. The wheels are in motion for the people who contributed to this debacle to be gone, but we have not arrived at our destination.

• Old regulations must be restored and perhaps new ones put in place. Rather than boring you with the details of which regulations should be reenacted just know that much of the Depression era legislation that was put in place in 1933 and 1934 has been repealed. Those laws protected multiple generations of folks and, in my opinion, were necessary for the proper functioning of the financial industry.

There is discussion from both Presidential candidates that they will restore these regulations; let’s hope that once in office, the new President will keep his promise. The new regulation that is necessary has already been proposed and was over a year ago.

Much of this mess was created because the financial industry regulators do not have transparency into the markets. A large part of this opacity is due to the fact that hedge funds are for “qualified” investors only. Here the word “qualified” means investors who either have more than $1 million in net worth, or who have financial industry experience. You see, it’s assumed that these folks are sophisticated and do not need the protections afforded by the Securities Exchange Commission (SEC). So hedge funds are not required to report the details of their activities in the same way that other investors are required to report. Consequently, a huge percentage of trading activity and portfolio holdings and cross-holdings and hedging-schemes, etc. are all out of sight from regulation. This has to change.

Transparency is necessary for refined regulation. Pay attention to Congress and hope that they enact the recommendations that were made by Hank Paulson. If this doesn’t happen we may be back in this same place within our lifetimes. Ugh!

• The effects of the financial industry meltdown have not made their way through the economy, yet.   We will see a decline in gross domestic product (GDP).  The question is when, not if.

Anecdotally, many of the folks I know have cut waaaaay back on spending in the last 4-6 months. People have taken on a bunker mentality. That means that they stopped spending.

The 3rd quarter earnings season started October 1st. Pay very close attention to the results of consumer spending sensitive industries like retailers, restaurants, appliances, and automobile manufacturers.

One of the ways you can pay attention to this data without actually tuning into CNBC, reading the Wall Street Journal or Business Week, etc. is to simply watch the sizes of the deals that retailers are willing to grant to consumers to induce their spending. It’s my feeling that we have a recession on our hands and the economy is not likely to stabilize for at least a year.

• Layoffs. There is bound to be a season for these. And by season I mean that there is typically a snowball of layoffs. Businesses will have to scale back and there is going to be pain. It is my guess that there will be a large number of these.

When strong businesses, like Intel, Microsoft, Cisco, General Electric, etc. have announced layoffs then you will know that the recession is nearing its end. How’s that? These companies can weather economic storms better than most businesses. Once they have announced their layoffs (assuming that there any) then you know that they have tried to stave it off as long as possible. Their capitulation will be a good sign that the bottom has been reached.

• The technical definition of a recession is at least 2 consecutive quarters in a row of negative economic growth, as measured by GDP. We have not even had 1 quarter of negative economic growth at this point. That is likely to change and soon.

So pay attention to GDP. The first quarter of postive growth after a recession will be a lagging indicator that the economy has stabilized and turned for the better.

• Consumers! Consumers! Consumers! Confidence! You will know that a real recovery is underway when you drive by used car lots and you no longer see rows and rows of late-model SUVs for sale.

You will also know that a real recovery is underway when you no longer hear the economy being talked about at the grocery store, or the salon, or on the bus or subway, or by your taxi driver. All of these will be signs of consumer confidence returning. Pay attention to your own feelings of confidence.

Despite today’s run up in the financial markets. I think that both the earnings and economic news is going to be grim for some time and the financial markets will have to reflect that information. So spend this “treading water time” collecting cash and investigating investment options.

Oh, and if you would like to know how to investigate investment options then keep your fingers crossed that a publisher likes the opus on investing that I have been writing this year. The book is a recipe book that teaches you, from scratch, how to analyze businesses in the manner that I did throughout my career and how to intelligently and prudently purchase an interest in a business.

By the way, I am not a grumpus or curmudgeon, the financial markets being up 11% is a good sign, in my opinion. The runup is a recognition that some of the necessary changes that need to take place to restore the health of the economy have been undertaken. However, much work on the foundations of the economy remains to be done.

Big smiles sent out to everyone!

Jason