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Sunday, August 19, 2007

Fed saves the day, what about tomorrow?

The Fed's reduction in the discount rate on Friday turned what was shaping up to be another bad day in the markets into cause for celebration and hope on Wall Street. And, of course, it resulted in a big rally.

The Fed's action had two immediate benefits:
  1. It restored investor confidence and let Wall Street know that the Fed was willing to act to ensure proper functioning of financial markets and prevent damage to the economy
  2. It provided another shot of liquidity in addition to the billions of dollars that the Fed had already provided through a series of repos
These benefits are desirable and even necessary but are they enough to get the bull market back on track?

My worry is that the root cause of the market's problems has not been addressed. That root cause includes the sub-prime mess but is not limited to sub-prime. There has been a period where risk has been virtually ignored in all kinds of lending. We are seeing the worst of it in real estate but there are also many examples to be found in the financing for leveraged buy-outs, for example. Witness the proliferation of "covenant-lite" debt that has found its way into hedge fund and bank portfolios.

In this kind of situation, those investors who typically can be relied upon to buy the debt being offered from these various kinds of deals are now insisting on either higher risk premiums or tighter terms and conditions. This has analysts declaring a "credit crunch" is taking place. Some might simply call it prudent lending.

Two Questions --
  1. Will the Fed's increase in liquidity convince investors to go back to taking on risky, low-quality debt? Probably not.
  2. Will the Fed's increase in liquidity prevent low quality debt instruments like bonds based on sub-prime loans from losing value and causing investor losses? Again, the answer is no.
So my outlook on the market remains at an improved level long term but not overly optimistic in the near term. As described above, there are still problems lurking that will affect hedge funds and especially financial and real estate stocks. If the economy does slow, it would put further pressure on the many companies that have been taken private and possibly cause a downward reevaluation of their debt, as well.

I think investors will enjoy the Fed's liquidity move for another session or two and then begin to worry about the undiscovered debt bombs that are still out there. This will take the wind out of the market's sails and stall the recovery for a while.

A period of time with no bad news about hedge funds imploding or lenders going belly up is what is needed to restore investor confidence in the long-term ability for stocks to resume the bull market. Hopefully, we won't have to wait too long.

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