Q2 Outlook plus Stench from the NY Fed

April 1, 2010
There follows our market outlook for stocks and bonds as we go into Q2 of 2010, some thoughts on financial reform, some ideas on books, and a poke in the eye of the New York Fed.

In the US stock market, we are fully invested and have been for over a year. We see the US stock market headed higher in the nearer term. Our target for the S&P 500 is 1250-1300, and we are getting closer. That has been our target since the bottom in March 2009. We believe the stock market will fully close the “Lehman Gap” and reach the pre-Lehman, pre-AIG failure levels.

After that 1250-1300 level is reached, it becomes harder for stocks to continue their advance. There is a mountain of shares that are owned at prices above the 1300 reference on the S&P 500 Index. They represent shares bought on the way down from the top of the market in 2007. Those shareholders are looking to get out and they remain psychologically damaged from the onslaught of the financial crisis. They represent lots of selling pressure on a market that will attempt to rally above 1300.

Also, there are higher taxes and more government restrictions coming. That will be a weight on stock prices in the future and will slow their ascent.

In addition bonds, other than Treasury bonds, have wider spreads, because they are carrying a continuing fear premium about future inflation and future higher interest rates. This premium presents an opportunity to a bond buyer. We do not own and would not buy Treasury bonds. We do own and would buy high-grade tax-free municipal bonds and high-grade taxable Build America Bonds. We like both, depending on the income-tax status of the investor.

In the municipal bond market it is necessary to do your own detailed credit work. The credit rating agencies are not trusted by investors and that is for good reason. It will take years for their image to be repaired. In our firm we do our own internal credit work in addition to observing what the rating agencies do. There are 60,000 separate state and local government issues trading in the United States. They are not ALL going to default. The fear mongering about them is overdone. It makes dramatic headlines but it is unrealistic.

Not only bonds present opportunity. Stocks are headed higher, and the coming quarterly earnings season will reveal continuing pleasant upside profit surprises. Non-US stocks also present opportunities. We only use ETFs, and favor some selected non-US markets.

In the policy arena, we are now past the debilitating national healthcare debate. It is what it is. It will cost what it will cost. It will benefit where it benefits and harm where it harms. Let’s get over it.

The next debate on the front burner is financial reform. This is very risky and the politics are driven by more arcane and complex issues, which are harder for Main Street to grasp. Try and explain accounting rules and derivatives in a 20-minute speech to a general audience and you will quickly find out what I mean. We do not write this to criticize Main Street. Our criticism is directed at Wall Street, which continues to obfuscate and avoid transparency while inviting retribution from politicians. Our proposed cure for both the politicians and the Wall Streeters is to invoke Singapore law. But that requires the politicians to agree, so our expectation for anything but more opacity and complexity and unethical behavior is sustained.

Because of this lack of comprehension of our financial systemic intricacies, there is room for much mischief in the Dodd & Co. legislation. And there is much in the way of threats to the independence of our central bank. We worry more about this than the healthcare issue. Why? Because it impacts the very essence of our nation’s financial wellbeing. But we must also remember that the central bank brought retribution on itself by its failures.

It is important to understand that the narrative of this financial crisis period is not being properly written. It is being colored either by insufficient information on the part of writers and analysts, or it is being managed by those whose agendas conflict with telling the truth.

Let’s back these allegations up with some examples. Truth first! Has the behavior that occurred inside the Federal Reserve Bank of New York been fully revealed? There are hundreds of people working in the markets area of the NY Fed. What did they know and when did they know it? What did the leadership of the NY Fed know and when did they know it? Geithner specifically. And what about the directors? Fuld was on the NY Fed board. As Lehman CEO, is it conceivable that he didn’t know about repo 105? Does anyone believe that he didn’t know it would change his balance sheet? Can we accept that the CEO didn’t know that he had a UK legal opinion because a US firm wouldn’t give one? If he did know, was he in a conflict position while sitting on the board of the agency that was his potential savior and with whom he had primary dealer status? When Lehman had a $3bn repo rejected by another Fed primary dealer because it was worthless, did the Fed catch it? If yes, what action was taken? If not, why not?

By the way, another primary-dealer CEO also sat on the NY Fed board at the same time. What was his obligation as a Fed director? What was his duty when he saw a $3bn piece deemed worthless by his own people? Once they rejected Lehman and protected their firm, was their obligation over? Maybe yes if the CEO didn’t sit on the board of the NY Fed. But he did sit there, and therefore he wore two hats.

The NY Fed continues to stink up the joint by trying to avoid transparency unless and until it is forced to do so. Bloomberg News sued the Fed for disclosure and finally succeeded after a judge found in favor of journalism. The New York Fed now has listed the CUSIP numbers of the assets in the limited partnership created during the Bear Stearns Affair. Maiden Lane number 1 is now public. This pile of junk even includes short positions in AMBAC and MBIA debt instruments. Check the NY Fed website for details. Query: is a short position in AMBAC the proper use of a section 13/3 emergency loan of the central bank, authorized by the Fed’s Board of Governors and implemented by the NY Fed?

Remember that it is an accident of history which places the NY Fed in a unique position among the twelve regional Fed banks because it houses the Fed’s portfolio. The NY Fed president is also in a unique position in the Fed’s policy decision-making structure. He is a permanent voting member of the FOMC unlike his eleven other regional bank presidents who have to rotate their voting status.

In this writer’s view the behaviors at the NY Fed during Geithner’s reign were appalling and need full Congressional examination. The nest needs to be opened and any infestation of rats needs to be exhumed. Repo 105 and the special year-long examination of Lehman offer the first clues. And think about it: these revelations came about because a bankruptcy judge ordered it. They were not found by the Fed; they were not dereived from any criminal investigation. Where was the oversight of the NY Fed? Where were/are the legal arms of criminal investigation? And how much of this will be discussed and debated and placed into consideration BEFORE some new legislation commits this country to a financial regulatory system that we will have to live with until the next crisis?

So will the reformers read the detail? Will the Dodd reform bill address these issues? Not if the narrative is incorrectly written.

Look at Barry Ritholtz’s book, Bailout Nation. Barry sets forth some of policy errors that led up to the crisis. Recently he criticized and corrected the New York Times. Barry is right on the mark. Here is the link.

Andrew Ross Sorkin has written one of the best books on the crisis. Too Big to Fail belongs on a serious reader’s list because it is insightful into the behaviors of those who made these decisions and now claim they saved us from a disaster.

We also suggest Niall Ferguson’s The Ascent of Money. This is a real tour de force of the world’s financial history, and it is written with a wonderful style.

Our meager contribution to the literature is now available. In Invest in Europe Now, my co-author, Vincenzo Sciarretta, and I have tried to compare the US market with the Eurozone. We wrote the book last year and closed the transcript well before the Greece situation erupted on the front pages. Our conclusions are strategic and remain unchanged. Our structure focuses on changes for the worse in the US. Email me and I will send you the preface.

But one issue must remain in focus. We know that all these policy decisions are made in real time with imperfect information. They are subsequently defended with incomplete narratives. And the political forces refuse to admit errors and amend or correct them. That is difference between government agents and journalists or private authors.

Would Ritholtz have written another chapter if he had known about repo 105? Would Sorkin’s book be different? Would Ferguson’s chapter on insurers have additional commentary if he had known about AIG? Would Vince and I have mentioned Greece? The answer is simply yes, yes, yes and yes. Now if we can only get the Chris Dodds of this world to say the same thing before they do more damage. Oh well! Wishful thinking. It is what it is.

Markets will improve for a while longer as the very low interest-rate polices of the central banks persist. Enjoy it while it lasts. We remain fully invested for now; we may see a short correction but we expect to close the Lehman Gap. After that, we cannot say.

David R. Kotok, Chairman and Chief Investment Officer