Market waits on bailout

9/29/2008


Responding to a downward spiral in investor confidence, the U.S. Treasury and Federal Reserve have delivered aggressive action and an aggressive plan to buy up to $700 billion in troubled mortgage debt from financial institutions. As always, we’re inclined to let the stock market tell us whether the bailout is good news or bad news, but there is no denying it is big news. As you watch events play out, keep the following in mind:

The averages discount everything. The Dow Transports, historically a good barometer for the industrial economy, have moved within 2% of their July low of 4,653.13. A close below that level would put the Dow Theory in the bearish camp — and bring our recommended cash position to a range of 25% to 35%. The Dow Industrials are already in a clear downtrend, but a breakdown below the Sept. 17 closing low 10,609.66 would be discouraging. For now, subscribers should watch the averages and keep 15% to 25% of equity portfolios in cash. Our Focus List and Buy List hold 22% in Vanguard Short-Term Investment-Grade ($10.16; VFSTX), while our Long-Term Buy List has 20% in this low-risk bond fund.

There are no free lunches. No government plan can make bad debts disappear. Such plans transfer the debt to taxpayers, with $700 million equating to more than $2,000 for every man, woman, and child in the U.S. Does such a transfer make sense? Yes, to some extent, because the government’s annualized cost of funds is less than 4%. But increased government borrowing has a cost, as a higher budget deficit translates into expected increases in taxes or inflation. Higher taxes for debt repayment reduce the amount of money available to buy goods and services. Higher inflation erodes U.S. living standards and tends to erode the U.S. dollar’s value. Notably, the U.S. dollar has dropped since the bailout plan was announced.

Government assistance will come with a price. Congress seems unlikely to approve any bailout without measures imposing stricter regulation on the financial sector.

Earnings still matter. The bailout is an attempt to avert a catastrophe in the financial markets; it won’t restore the economy to good health. So far, corporate earnings outside the financial sector have held up well. But the guidance companies provide with third-quarter results, due in the second half of October, will be crucial.

It’s a small world. A U.S. recession seems discounted in stock prices. But if the breakdown in the financial markets and lower U.S. demand result in a global recession, U.S. stocks are likely to slump further. The 2003-to-2007 bull market was led by companies tied to overseas growth, and profit estimates for these companies are likely to drop if Asia joins the U.S. and Europe in recession.


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