The Treasury's new emergency measures do not change our negative views on the market. The contemplated action applies a tourniquet to a domestic and global financial system that was on the verge of bleeding to death. The plan, although not yet spelled out in detail, is highly likely to avert such a collapse. However, we should keep in mind that saving a patient from sudden death in the emergency room is not the same as curing a horrendous disease, and the financial markets and economy are still faced with major problems that the emergency measures will not cure.
The contemplated plan will include removal of illiquid mortgage assets from company's balance sheets, insurance of money market mutual fund assets, expanded lending to commercial banks and a temporary ban on short sales of financial stocks. The action was precipitated by the distinct threat of a run on the so-called shadow banking system that would have resulted in complete chaos in the financial and economic system. On September 16 the $60 billion Reserve Primary Fund, the oldest money market fund in existence, said it couldn't cash out investors in full as a result of losses on Lehman Bros. debt instruments. Over the next two days investors liquidated $145.3 billion of money market funds, a whopping 4.2% of all money market assets. It was obviously going to get a lot worse if no action was taken.
The short sale restriction we find to be a joke. We wonder why the government didn't intervene in the late 1990s when IPOs were opening up 2 times the offering price and speculative stocks were rising 30% a day. This doesn't effect Comstock very much since we never shorted without borrowing the shares first. Anyone that shorted without borrowing the shares should be accountable. In fact, Comstock actually never had a problem with the uptick rule that was abandoned last year. This does, to some degree, limit the new short positions, but this shouldn't be a problem with so many overvalued securities.
However, even if the plan is submitted to Congress over the weekend and the legislators pass it next week most of the major financial and economic problems still remain. The consumer is in bad shape with enormous debt burdens and a low savings rate at a time when employment is falling and unemployment is rising. A recession probably began in January and will steepen in the second half of the year. At the same time the European and Japanese economies are also falling into recession. S&P 500 reported earnings estimates have come down rapidly, and the index is now selling at a lofty 21 times 2009 estimates, at the high end of its historical range and usually accompanied with market peaks.
The Treasury's intervention cannot correct the overvaluation problems that exist presently in stocks and real estate (with the correction in commercial real estate just starting). You will find the extreme overvaluations in stocks by clicking on our study "Limbo, Limbo, How Low Can It Go" on the right side of our home page, and just read the 8/28/08 comment "What is the Real Housing Decline".
Furthermore the Treasury's intervention is highly risky. The previous takeover of Fanny, Freddie and AIG combined with the lending of money to various financial institutions has already cost hundreds of billions of dollars. Now Secretary Paulson concedes that the proposed bailout will cost additional hundreds of billions, and this may prove to be conservative. The U.S. Treasury will therefore have to come up with $1 trillion or more, resulting in an enormous increase in the federal deficit on top of the costs of financing the Iraq war.
The announcement of the program has understandably led to a giant sigh of relief that the global financial system is not collapsing over the next week or two. However, once the immediate euphoria runs its course, we think the market will still be faced with chronic problems that offer no easy solution. It is amusing to see some of the market mavens on TV state that the bailout was smart, successful, and saved the market from "Armageddon". We have to wonder why they were so positive on the stock market for the past year if it proved to be in so much trouble.
