After Capitulation, What?

Now that we’ve passed through all the valuation floors and fear dominates not only the trading floors, but the nation’s psyche as well, there’s no doubt we’ve reached the capitulation stage where investors surrender to fear, sell at any price (no matter how irrational) just because the pain of watching it go lower is too much to bear.

Capitulation is normally a one day sort of affair. What has made this one the worst in a century is that it has lasted for several days.

• What’s next?

What typically happens next is that investors realize that General Electric still needs to manufacture gas turbines, Chevron still needs to bring gasoline to a nation of drivers, and Safeway still needs to deliver food to a hungry nation. Commerce needs to go on. Furthermore, stocks purchased during this sort of sell-off typically rebound to the benefit of investors. In the 5 instances since 1970 when stocks have sold off 18% or more within an 8-week period, the market was up an average of 15% six months later. The essence of “buy low, sell high” is to invest during these troubled times.

There are many reasons to be more optimistic than the market (which isn’t saying much) from this point. First, the Fed and the Treasury Department have been very proactive in trying to get money flowing again. I have a list of more than a dozen major efforts to stimulate the economy using methods that just six months ago I would have thought impossible (and probably unconstitutional). These are steps taken save bondholders and depositors, to keep the doors open on companies determined to be “too big to fail,” and to get the bond markets moving again. The government has nationalized Freddie Mac and Fannie Mae, offered private equity financing to AIG, forced Bear Stearns and Wachovia to sell themselves to competitors, bailed out IndyMac Bank depositors, re-regulated the Fed discount window to give Goldman Sachs access to the government storehouse, insured money market fund deposits, arbitraged 0.75% T-Bill rates in order to buy much higher yielding commercial paper…and the really creative stuff has yet to be announced. Just think of the ideas that didn’t make it into the final plan!

In recent days, other nations have joined the effort with the European Central Bank, the Banks of England and Canada, the Swedish Bank, Hong Kong, China and others cutting interest rates and putting capital into their own private banking companies. Australia cut rates by 1%. Moreover, longer-term interest rates are falling internationally, which will eventually help get things moving again.

The bailout bill boosted FDIC insurance so that worried investors would bring money into the banking sector, rather than taking it out (as happened during the depression). The Treasury’s latest proposal, to invest directly into banks through buying preferred stock, may be ten times more effective than simply buying sub-prime assets off the bank’s books. The notion of the U.S. Government investing directly in U.S. companies through the purchase of commercial paper (very short-term bonds) could be extremely helpful, but all of these steps take a few days to get started and the market has never been known for its patience.

There’s no doubt that capitalism and “free markets” have a big, black eye. There will be many opportunities to place blame, at some point in the future. For now, though, the objective is to (as Warren Buffett said a few days ago in a great Charlie Rose interview) get the cardiac arrest patient up off the floor and moving again. There will be ramifications for the actions we’ve taken. However, the consequences of doing nothing would have been much worse.

Based on valuations, investors should buy stocks today. Unfortunately, based on valuations alone the rally probably should have started at least 2,000 points ago. For the most part, what I’m waiting for is some sign that all this money that the Treasury is putting into the banking sector is beginning to find its way into the hands of the businesses that need it. I need the bond markets to start functioning again, so that a sound bank or insurance company (if that’s not an oxymoron) will be able to roll over maturing debt on reasonable terms to the lender.

I am hearing that some institutional money market funds have closed to new deposits (of $25 million or more) because they don’t have any place to invest it. Commercial paper issuers have withdrawn from the market, or perhaps those funds are choosing to buy only Treasury Bills, but they cannot find enough bonds/notes in the market to invest new money. That is a great sign. Liquidity may be starting to pile up on the sidelines.

There are many reasons to be optimistic from here. Fear is the investor’s enemy. Where has the “don’t fight the Fed” crowd gone? Or the “lower oil prices are good for the economy” bunch?

I remain focused on how to take advantage of the sell-off by buying back in. When we get past this frightening phase, the market should be higher. I, frankly, don’t want to wait too long to buy. However, I do want to see signs that the massive liquidity add is having an impact before committing capital.

Douglas B. May, CFA, is President of May-Investments, LLC and author of GJretire.

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