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Best Market Reentry Indicator: Reduced Counterparty Risk

by: Jeff Miller October 13, 2008 | about stocks: MS / MTF    
Jeff Miller

Jeff Miller

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Suppose you are watching US equity markets.  You could be thinking of bailing out.  You might be someone who has been in cash, but you do not want to miss the "bottom."  Whatever your position, you seek some magic indicator.

We have already provided the basics that should help readers make this decision.  Here is some extra color, but still not the full picture.  We are sorry. It has been a busy time.

Meanwhile, here is some help.

The Key Question

The key question is the freeze-up in credit markets.  If ordinary businesses cannot get loans, holiday retail and auto is affected.  If the commercial paper market dries up, ordinary commerce cannot take place.

This is not a matter for political posturing or personal opinions.  Many people who have never run a business or a bank seem to have a strong opinion on how much leverage, how much liquidity, and what duration is "correct."  We think that anyone offering such an opinion should show some expertise and/or a successful business model to prove it.

Meanwhile, it is pretty obvious what the market wants:

  • Participants want to know that there is no counter-party risk, something that we highlighted for you last week.
  • People will not lend without knowing they will get paid back.  It freezes commercial paper.  It escalates LIBOR, and it causes a spike in CDS swaps.

So that is the problem, the most important problem, and possibly the only significant problem.  If it is not solved, the economy may get much worse.  If it is, we may escape with a milder recession.

Some Evidence

Last week the counter-party risk issue had people focused on Morgan Stanley (MS) and the prospective infusion of funds from Mitsubishi (MTF).  Many traders in the put market were betting that Morgan Stanley would follow Lehman (LEH).  How else can one explain the October 5 put trading as high $2.  These put buyers were betting that there would be no Morgan Stanley by Friday.

As we write this, the companies are proceeding with the agreement.  The government may make the first cash infusion in a private company as part of the deal.  European banks have acted aggressively to address these questions.  An overall global solution has still not been achieved -- something that would guarantee all trades between major banks.  Overnight futures are trading much higher on the promising news.

What to Watch

By following the "Dash Rule" a reader can evaluate the significance of any proposal.  Anything that reduces counter-party risk is "the nuts", if we may borrow from the poker players.  Examples would include the following:

  • A guarantee of inter-bank transactions.  Europe is doing it.  The hints are that the US will do the same.  This requires international cooperation, since no central bank can do it alone.  The Fed cannot regulate foreign banks.  It takes everyone, and it is complicated.
  • Suspension of mark-to-market rules.  At some point this will get reviewed and debated.  The SEC study is now due on January 2nd.  (This is the government operating as rapidly as possible.)  Regardless of how one feels about the long-term merits, the market would celebrate a suspension.  Why?  We would not need to worry about whether a counter party would be around next week, based upon trades from some other distressed agency and the Paulson/Bernanke decision on whether the institution would live or die, and which investors would be protected.  Until this process is ended, we have a problem.
  • Capital injections.  These will help on a case-by-case basis.  Let us see whether it helps with overall liquidity.

Conclusion

We are watching other factors.  We also have a list of best stocks and sectors in the event of a rebound.

But this is our single best idea, and we are sharing it.  If the evidence suggests that the counter-party risk problem has been reduced, it is time for that first step toward more market exposure.  The specific stock picking can follow later.

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This article has 5 comments:

  •  
    Oct 13 01:48 PM
    Yep. We could have avoided a lot of this with going right after the guarantee of interbank transactions. It's like cardiac arrest. You have to use the carrot AND the stick to jump start the heart here. Frankly, what's the rush? Let things dump a little so you can buy into a lower bottom... that's what everybody in a position of power and knowledge is doing. Sad thing is that it's at the expense of the national economy and the common man, but welcome to the brave new world of economic engineering meets human corruption.
    Reply
  •  
    Oct 13 03:27 PM
    Ameri-Bubble


    Bubble, bubble, the Empire’s in trouble:
    So we’ll pass a bill….a magic pill and
    Print more fiat cash on the double!

    Sleight of hand throughout the land
    The Money Master’s stock in trade.
    They’ll cure our ills with dollar bills
    More than all the grains of sand.

    “Buy and hold”, “We’re oversold!” the traders will avow.
    “The Dow will rise…it would not be wise
    To pull your wager out right now.”

    So they lobby the shills on Capitol Hill
    For their Giant Ponzi Scheme.
    While the bankers insist…the pols assist
    In funding a Socialist’s wet dream.

    Do the voters protest? Is there civil unrest?
    “Not while there’s distractions galore!
    The media is there to avert the electorate’s stare,
    And if not, they’ll start a war.”

    “Buy on the dips!” The Kudlow’s quip
    “This market is bound to rise.”
    And the Keynesian’s unite in the dead of the night
    To give Krugman the Nobel Prize!

    And now we float upon this bulbous boat
    That distorts everything we see
    In futile hope that we don’t interlope
    With pointy-edged reality.

    For when our denial bubble pops,
    Our lifestyles will drop,
    It will suddenly become clear
    That all the wealth they stole through stealth
    Was never really here.

    ©2008 Jim Valeri
    Reply
  •  
    Oct 13 03:28 PM
    Quantitative Hedger:

    "...but welcome to the brave new world of economic engineering meets human corruption."

    Correcto mundo!

    I think the banks are totally insolvent and now the central banks are giving cover to them... At the expense of every man, woman and child on the planet.

    If this sucker doesn't go down in a few weeks or months, they must be putting something in the water supplies of Asia, Europe and the United States... It is nothing but a total scam...

    Oh! I've got some property in Florida I went to sell you... It comes with a pet rock.
    Reply
  •  
    Oct 13 03:34 PM
    Jim:

    And talking heads from Bloomberg quip
    What you think and see, aren't really there
    CNBC and ABC
    Will then create value from thin air
    Reply
  •  
    Oct 13 03:37 PM
    Wow! The Dow is up about 700...

    That must be several $billion taxpayer $$$ a point!

    Sorry CNBC and NBC... GE is down about 3.5 percent. Don't worry though. Bush and Paulson won't forget your buddy Buffett while they are passing out the corporate welfare.
    Reply
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