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Jeff Saut: Will System Hold Together?


IndyMac reminiscent of Bear Stearns.


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.

"The system will hold together" is a line spoken by Maxwell Emory (played by Hume Cronyn) in the 1981 movie Rollover. The film centers on a plot whereby Mr. Emory, who is the chairman of First New York Bank, is secretly moving "the Arabs'" money out of U.S. dollars and into gold using a mysterious bank account numbered 21214. When the plot is discovered, gold prices soar, the stock market crashes and Maxwell Emory puts a bullet through his head. I couldn't help reflecting on said movie late last week as rumors swirled that Fannie Mae (FNM) and Freddie Mac (FRE) were insolvent.

The result was a continuation of the crash in the "Bobbsey Twins'" (aka: Government Sponsored Enterprise, or GSEs) share price with an attendant swoon in the major market averages. Eerily, I wrote about Fannie Mae years ago in a report titled, "Measure Twice and Cut Once" (written April 28, 2005) suggesting that, in my opinion, nobody can figure out FMN's accounting and therefore its shares should be avoided. I concluded those comments by stating, "By our method of chart interpretation the financials have 'put in' a massive top and are now in 'bear mode.'

Additionally, the poster children of the financials, namely the over-loved Citigroup (C) and Fannie Mae, have completely broken down in the charts and should, from a technical perspective, be sold and/or reduced on rallies." That said, in my opinion these two GSEs will not be allowed to fail because the collateral damage would be global, as well as enormous, since their "paper" is held by institutions around the world. Also, allowing these GSEs to fail would accelerate the current credit crunch and send the housing complex even further into a death spiral.

While some are suggesting a "conservatorship" approach under the Federal Housing Enterprises Act, I peg the probability of that as low due to capital cushion/statutory capital issues. Similarly, we think the odds of a capital infusion by the government to be low, as is the government's implicit backing of the GSEs' debt.

I guess bringing the GSEs on to the federal balance sheet makes some sense because assertions that would increase the government's debt by $5.3 trillion are an overstatement. Indeed, the $5.3 trillion figure refers to the GSEs' holdings of mortgages/loan-guarantees, which are not the same thing as liabilities. Still, such a nationalization of the GSEs would require congressional approval and that would likely take a long time. My guess is the solution lies in either a private capital infusion, with certain guarantees like with Bear Stearns, or giving the GSEs the ability to draw on lines of credit from the Treasury Department and/or the Fed. In any event, I would be shocked if some action is not taken and taken quickly.

Manifestly, it appears the only entities showing decent growth in the mortgage business have been Freddie and Fannie, so impinging these two behemoths in any way would worsen an already dicey environment, which was punctuated yet again by the FDIC's seizure of IndyMac (IMB) over the weekend. Clearly the GSE 'gotcha' of last week cast a pall over Wall Street, which was already struggling with new all-time highs in the price of crude oil.

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Plainly, at least so far, I've been wrong with my "call" that the politicians are going to do anything and everything in an attempt to force the price of oil lower before the elections. Last week's price surge seemed to be driven by fears that Iran's 2.5 million barrels per day of oil exports will be interrupted, exhausting any spare OPEC capacity. While the GSEs' situation is worrisome, my sense is that the current market mauling is mainly about the vertiginous rise in crude's price.

Indeed, I've been adamant since the beginning of this year that the U.S. would not experience a recession in 2008, as defined by two negative quarters of GDP. However, I'm becoming increasingly worried about 2009's recession prospects unless crude "cracks" and cracks soon. Indeed, the "perfect storm" seems to be having an increasing impact on the American consumer. Most recently, I've argued that what we may experience is a "W" shaped economic pattern, often referred to as a "double dip." While it's true that as of yet we haven't had a severe economic slide (read: recession), said recession was prevented by the herculean efforts of the Federal Reserve and the politicians.

Those efforts muted the economic slowdown, but, in my opinion, have potentially only pushed the recession further out in time. Consequently, I think we are in the middle part of the "W" pattern where participants believe the worse is behind us. Unfortunately, unless the environment changes, and changes quickly, I think we will enter the right side of the "W" pattern, resulting in a double-dip. And, maybe this is what the equity markets are sniffing out.

Speaking to the equity markets, today is session 38 in the "selling stampede," and my oversold indicator remains more oversold than it has been in decades. In last week's letter I related that Lowry's point spread between its Selling Pressure Index (read: supply) and its Buying Power Index (read: demand) was at 265 points at the 1974 stock market "lows." Currently, that spread is over 500 points, the largest in the 75-year history of the Lowry's Organization, and therefore very oversold. Meanwhile, the Bespoke Investment group notes:

"Want another frustrating fact about this market? Recently, it seems that every time the market goes higher, it goes lower by a greater amount the next day. We quantified this by looking at every time this has happened in a 50-day period going back to 1940. You guessed it. We've just completed the most 'up one day, down the next' events in a 50-day period in nearly 70 years."

In this whipsaw environment, trading has been difficult.

However, my yield theme recommendations (read:dividends) are holding up pretty well. Some of the names that play to this theme and are favorably rated by my firm's fundamental analysts remain Linn Energy (LINE), Alaska Communication (ALSK), Embarq (EQ), Inergy (NRGY), LegacyReserves (LGCY), Magellan (MGG), and Teekay (TOO), to name but a few.

The call for this week: Friday felt like Bear Stearns II, since the news about the GSEs broke on Friday just like with Bear Stearns. Hopefully, this week will be a déjà vu dance of the week following the Bear Stearns' news with the financials leading the way to the upside. Yet, as Michael Steinhardt recently said, "There is rarely a moment such as this where as a contrarian, one sees so many reasons technically, [and] stock market-wise, to be bullish. I can't imagine a circumstance where a market is more available, more ripe, for a rally than this one. Still, this time it's different."

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