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Jeff Saut: Better Than a Recession


Not pretty, but not dire.

Editor's Note: The following article was written by Raymond James Chief Investment Strategist Jeff Saut. It has been reproduced with permission for the benefit of the Minyanville community.

"It is time to step back and recognize that the current situation isn't a liquidity issue and
hasn't been for some time now. Rather there is uncertainty about the underlying quality of assets which is a solvency issue driven by a breakdown in highly leveraged positions.Many of the special purpose entities and vehicles are comprised of pyramids of paper assets supported by leverage whose values are now unknown. If it were a simple liquidity problem the actions that the Federal Reserve has taken would have dealt with the problems by now. If one doubts this observation, think about what the Federal Reserve has done over the past several months in an attempt to provide liquidity to those who need it."
- Bob Eisenbeis, Chief Monetary Economist of Cumberland Advisors

"Oh yes, I'm the great pretender. Pretending that I'm doing well," except in this case it wasn't the Platters singing, but rather President Bush speaking about the economy last Friday. And while, like the President, I don't think the U.S. economy is going into a recession, it is clearly not doing very well. As I listened to the President, an email "popped" into my in-box from the astute folks at Cumberland Advisors, which I have reprised in this morning's missive because it speaks to the heart of the problem.

Indeed, for roughly a year I have suggested that the current environment is not a liquidity issue, nor even a credit crunch, but rather a collateral crunch. It's a collateral crunch because, as Cumberland articulates:

"There is uncertainty about the underlying quality of assets which is a solvency issue driven by a breakdown in highly leveraged positions. Many of the special purpose entities and vehicles are comprised of pyramids of paper assets supported by leverage whose values are now unknown."

Also, "Assets supported by leverage whose values are now unknown," is indeed the right perspective because my guess is that is what happened to Bear Stearns (BSC) last week. To be sure, in many instances the issuers of CDOs (collateralized debt obligation), CLOs (collateralized loan obligations), CDS (credit default swaps), et al, have the liability that some of those vehicles can be "put back" to said issuer. Consequently, the problems at Carlyle Capital could have caused Carlyle to "put" some of its CLOs/CDOs back to the issuer, which potentially was Bear Stearns since it is one of the largest issuers of such vehicles. And that, ladies and gentlemen, may be why on Wednesday Bear's president, Alan Schwartz, stated, "We don't see any pressure on our liquidity, let alone a liquidity crisis," yet on Friday had to be "bailed out" by none other than the Federal Reserve via JP Morgan (JPM).

For a number of quarters I have warned that before this financial fiasco was over there would likely be some "bodies floating." Plainly, Bear Stearns is one such "body"! Yet, despite all of the negative news of the past few weeks, the D-J Transportation Average (DJTA) has refused to confirm the DJIA's (DJIA) breakdown below its January 22nd closing low of 11971.19 with a similar breakdown by the Trannies below their respective January closing low, as can be seen in the attendant charts. Similarly, many of the other major market averages refuse to travel below their respective January closing and intraday lows.

Click to enlarge

Click to enlarge

Moreover, the S&P 100 (OEX) put/call and open interest ratios are bullish for the first time in more than a year! Meanwhile, the latest AAII sentiment poll is skewed bullishly. Listen to what Peter Eliades of Stock Market Cycles had to say about that:

"The report showed 43.3% bears and 31.1% bulls. Listen to this! The plurality of bears over bulls today, an apparently meager 12.2%, is huge on a relative basis. It is the highest plurality of bears over bulls since October 11th, 2002 (14.8%). But before that, you have to go back to January 6th, 1995, to find another plurality of bears over bulls greater than today's reading of 12.2%. For over 13 years, there has been such a pent-up and persistent bullishness among advisers that this is only the second plurality of bears over bulls over12% in the past 13 years."

Another point of view is offered up by Lowry's weekend missive:

"March 10th qualified as a 90% Down Day (points and volume were 90% to the downside). And, based on preliminary data, today's (Friday's) market action may also be another 90% Down Day. This would make a total, thus far, of nine 90% Down Days during the past three months... It is interesting to note that in the early months of this bear market, from August 2007 through November 2007, the 90% Down Days were relatively quickly followed by 90% Upside Days... But, during the past three months, investor psychology has become more negative, so the intervening rallies have not been able to produce a 90% Upside Day."

To this point, I entered last week thinking it was "kiss and tell" time for the equity markets given the abundance of downside non-confirmation. In last Wednesday's verbal strategy "call" I actually became constructive on the equity markets, and then had to recant those words in Thursday's Special Strategy Report, where I stated:

"The gist of Wednesday's discussion centered on Tuesday's 416-point Dow Wow, which I thought would certainly qualify as a 90% Up Day. Verily, I have never seen a session of such strength not qualify as a 90% Up Day! And while I did say in Wednesday's narrative that I had not seen a Wall Street Journal as of yet to verify if Tuesday's Triumph was indeed a 90% Up Day, I did state I could not imagine that it wouldn't be. And that, ladies and gentlemen, was a huge mistake, because in vetting the numbers it turns out that Tuesday 'missed' being a 90% Up Day."

Patently, they don't "call 'em surprises because you expect 'em" and Friday's Bear Stearns news was a shocker. That "shock" took the DJIA from "up" nearly 50 points at 9:40 a.m. to down some 300 points at10:00 a.m. And from there stocks never really regained their composure, causing one Wall Street wag to lament, "Stocks never bottom on a Friday as participants tend to brood over the weekend and show up on Monday in 'sell mode!'"

Which brings us to this week, and once again I am terming this week "kiss and tell time." Either the various indices will confirm the Dow's breakdown, or we will be left with a glaring downside non-confirmation. In either event, I believe that many of my recent "long" recommendations will not breach their respective reaction lows. To this point, I had a discussion with a particularly brilliant portfolio manager last week, who in addition to being adroit at valuing stocks, is skilled in the art of "game theory." His comments went something like this:

"Jeff, as a portfolio manager I have to buy something since I am not paid to sit on cash. One name that makes sense to me currently is Microsoft (MSFT). The shares are down nearly 30% since December 2007, the company is growing its earnings and is entering new markets. Further, China and India are becoming better business partners so while the piracy issue is still a problem, it should be less of one going forward, implying its patents will be 'sticker.' Moreover, Microsoft is loaded with cash and there are no CDOs on its balance sheet. Additionally, I think the proposed Yahoo! (YHOO) acquisition won't get done and that should give the stock at least some kind of rebound rally."

"Fair enough," I replied, "and would add that over 50% of Microsoft's revenues come from outside the U.S., which in my opinion is a decided plus." (MSFT is followed by my outside research correspondents).

The call for this week: I told the media all day Friday that my guess was that JPMorgan would buy out Bear Stearns by Monday because it made all the sense in the world. Indeed, while Morgan has always been a big player in derivatives, Wall Street has never considered the firm impactful in equities and research.

Therefore, in one fell swoop JPM could get the intellectual capital, the personnel, and a book-of-business that was decades in the making. Furthermore, with JPMorgan's balance sheet backing them up, many of Bear's structured vehicles will likely find better "footing." I think it is a brilliant move on Jamie Dimon's part. As for the equity markets, they are clearly involved in a "selling panic," while the commodity and Treasury markets are into "buying panics."

However, for the well-prepared investor this kind of volatility affords opportunity. Remember, the Japanese kanji symbol for the word "crisis" consists of two characters. One of them represents "danger," the other "opportunity." I continue to invest accordingly.
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