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Jeff Saut: Liquidity, Volatility and Risk

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...you can throw all the liquidity you want at your friends but if their risk appetite is zero they will take that cash and stuff it in a money market account.

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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.


"Liquidity is a coward; when you need her most she runs away and hides!"

I did a plethora of media events last week. The reason is simple: the media is "long" volatility, meaning that when the markets swing wildly (a.k.a. volatility), the media's "juices" flow more rapidly.

For the past few years I have often spoken about volatility, suggesting that it was under-priced, for as surely as night follows day, periods of low volatility are followed by periods of increased volatility. For the most part those words fell on deaf ears as memories are short on the Street of Dreams. And why not? Except for brief declines in May and June 2006, and again in February and March 2007, the major market indices have traveled higher with very little volatility.

Such a low volatility skein left participants imbibed with the sense that every decline would be short and shallow and therefore was for buying. And that "short and shallow" cry was heard from 99% of the media's pundits late last week. I, on the other hand, am not so sure.

Since the beginning of the year I have warned that the ubiquitous "What, me worry?" attitude fostered by the stock market's relentless upward march was setting participants up for a downside "gotcha." I likened the upside sequence to putting the proverbial frog in a pot of tepid water and slowly turning the heat up.

Initially, the old wives' tale goes, the frog thinks each higher temperature is great, but eventually the amphibian is cooked. Similarly, stock market participants have become conditioned to believe that any correction will be small (5% to 7%), yet I have warned that such Panglossian sentiment flies in the face of stock market history.

Not so, however, suggested many pundits late last week, for corporate profits are strong and profits are the mother's milk of higher stock prices. And I agree, if your time-horizon is long enough, but consider this.

In December of 1999 the S&P 500 was changing hands at 1470 and its earnings were roughly $51 per share. Currently, the SPX's earnings are anticipated to be $94 (for 2007), or up 84% since 1999, and still the S&P is trading below where it was nearly eight years ago.

Or how about this, if you bought McDonald's (MCD) stock at its peak in 1972, profits (a.k.a. earnings) went up for the next ten years, yet you lost money owning the stock! Ladies and gentlemen, investors' psychology is also a key component in what determines a company's share price and psychology can change quickly, begging the question, "Did investors' psychology change last week?"

While only time will tell if psychology has changed, this question is not an unimportant one. Indeed, in a number of my media appearances last week I likened the recent "seizure" in the current financing apparatus to what happened in October 1989.

It was a heady time in 1989, replete with accommodating financing for the LBO (leveraged buy out) mania then reigning on Wall Street that was going to make investors rich. And then it happened. The financing for the proposed LBO of United Airlines (UAL) unraveled with a concurrent dramatic change in investors' psychology accompanied by a decline in equity prices.

Fast forward to the last few months. Financing has been extremely accommodating for the deal du jour, with banks creating bridge loans secure in the sense that investors would buy those loans and perpetuate the "Tinkers to Evers to Chance" financing sequence. In this case, however, I am not referring to the fabled double-play baseball artists of an era gone by, but Tinkers (being the buyout artists needing the money) to Evers (the banks creating bridge loans) to Chance (investors to buy those loans). Last week that sequence was called into question, causing one savvy seer to exclaim, "What happened to Chance?"

What happened to Chance, indeed, for it appears that Chance has walked off of the playing field and is waiting to see if the price decline in the "loans" is contained or is spreading?

Verily, "Liquidity is a coward, when you need her most she runs away and hides." It's an interesting and insightful phrase, but it is more than just liquidity that drives asset classes, in my opinion. For months I have made the argument that investors' risk appetites are more of a driver of asset classes than liquidity.

For example, you can throw all the liquidity you want at your friends but if their risk appetite is zero they will take that cash and stuff it in a money market account. Last summer around this time investors' risk appetites were small and I was bullish. However, after the equity markets bottomed and rallied sharply, risk appetites increased dramatically until they were at multi-decade highs. Consequently, participants need to see not only if psychology has changed, but if that change has reduced risk appetites. Regrettably, it will take days, if not weeks, before these questions can be answered.

In my joint interview last Thursday with former CNBC commentator Ron Insana, the astute Mr. Insana stated that it could take time to resolve such questions and was summarily taunted by his former colleagues for even suggesting that maybe a psychology change would make this decline more severe than those seen over the past four years. I quickly agreed with Ron and noted that the thing that worries me the most is the fact that the bond market believes something is wrong. Indeed, the benchmark 10-year T-note was yielding
over 5.3% on June 13, 2007, but fell to 4.75% last week in a "flight to quality." Over the years I have learned the hard way that the bond crowd is smarter than the stock crowd and the bond crowd is clearly worried!

A quick perusal of my notes also suggests that this decline may be different, for the 400-point Dow dive that occurred last February 27 saw the next day's action stabilize with the DJIA closing up by 52 points.

Unfortunately, that did not happen on Friday as the "brass band" cheering session, punctuated by President Bush's attempt to talk-up the markets, was to no avail with all of the indexes I follow closing near their lows for the day. The result left most indexes below their respective June lows, as well as below their various daily moving averages (DMAs). Indeed, every market index closed below its 50-DMA and some closed below their 200-DMAs. Also worth noting was that all of the S&P major market sectors closed sharply lower
for the week and among the sub-sectors only nondurable household products and biotech were positive.

Moreover, last Tuesday (-226 DJIA) and Thursday's (-311 DJIA) declines qualified as 90% downside days with both down volume and points lost 90% greater than up volume and points gained. In fact, on Thursday 479 of the 500 equities in the S&P 500 declined, pushing the advance/decline ratio to an extremely rare 1/18.

While some will argue that this is the kind of action seen at market lows, my proprietary indicators are nowhere near oversold levels. So what are we to do? Well, Ron Insana's word was "unknowable" in the short term and I agree. How this will play out is a function of who is carrying what position, how leveraged they are, and how those positions will interplay. What I do know is that by my pencil only the U.S. Dollar, crude oil, and Treasury Bonds rallied last week.

I also observed that the Japanese Yen was strong, suggesting that perhaps the Yen carry-trade is unwinding. My sense is that in the very short-term some sort of rally attempt will begin today/tomorrow, but I wouldn't trust it.

I would, however, use that weakness for selling partial long trading positions in my Volatility Index (VIX) holdings, which were instituted as a hedge against my long investment positions. As for committing some of the freed-up cash incurred from the rebalancing of my investment positions over the last few months, I am inclined to wait.

If you don't agree with that investment stance, I would stick with the multinational companies, preferably ones with a yield, like General Electric (GE).

The call for this week: I have repeatedly suggested that the "What, me worry?" attitude was setting investors up for a "fall" in that one of these times the market was going to start down and spill over into the long overdue 10%+ correction. Whether it is this week, next month, or next year is unknowable, but it is surely coming. I think there is enough damage that participants will wait and put on "rabbit ears" to deduce if the damage is contained or if it is spreading.
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