Opportunities in smallcaps header image 2

Wallstreet descends from its cloud

June 27th, 2008 · No Comments

Since it’s inception, this blog has vented the view that there seemed to be a dissociation between the real problems in the real economy, and the markets ignoring them. We also argued something had to give. It has.

And it ain’t pretty. A 360 point drop in the Dow on Thursday took it way beyond the March low of 11.740. You might remember us expressing disbelief in April and May about the markets being within 10% of their all-time high (apart from the Nasdaq, obviously) when so much was amiss in the economy.

Falling dollar, rising inflation, souring commodity prices, the financial system just saved from total melt-down, house prices falling at unprecedented levels, consumer confidence at multiple year lows, unemployment starting to rise, etc. etc.. How could all this be going on while the markets holding up so well?

Well, one answer to that was that the economy stubbornly refuses (so far at least) to go officially into recession. In fact, growth figures for the first quarter have just been revised upwards and show 0.9% growth on an annualized basis. That in itself is not stellar, but in the light of the circumstances, it is. In fact, it’s downright stunning.

One reason is that after initial dithering, policy quickly changed gear and confronted these problems, although we remain skeptical of some of the measures. Fiscal stimulus should have been targeted at the poor and those who faced the possibility losing their house, as the first are likely to spend the greatest percentage of extra income, and the second can help stabilize a very nasty crash in the housing market.

But nevertheless, if you compare it to other parts in the world, for instance, Japan 1990, policy reaction was swift. The Fed’s rescue operation of Bear Stearns was unusual and will add to the moral hazard problem (speculators who reap all the benefits of their bets go right, but socialize the cost when they go wrong), but it was a crucial moment in saving the financial system.

Of course, with the slumping dollar, US exports are also doing very well. But we fear things in the real economy (as well as in the financial economy) might get worse before they get better, and policy options are now very limited.

In fact, monetary policy is facing an awkward dilemma, higher rates are necessary to shore up the dollarĀ  and combat inflation, but rates need to stay low to keep the economy from sliding into a serious recession. An awkward dilemma indeed, especially as rates may very well go up in other parts of the world, which would further undermine the dollar.

Whether a further fall in the dollar would give an additional boost to US exports can be doubted, as higher interest rates abroad will curtail demand, and hence demand for US products and services.

These are all themes we raised before, do we feel vindicated? Well, yes and no. Yes, because the markets are now taking in the reality that was visible before, but no because most of the stocks we follow have taken a beating.

Some of them are now at very low levels, but despite that, and despite that the likes of, say Trina Solar (TSL) and eFuture (EFUT) had very good earnings and news, there is absolutely no guarantee that with further falls in the market, these low levels will not become lower still.

Luckily, we have one bright star in InterOil. Further good news should be out shortly, and there is talk of a sort of road show for investment banks next week together with Raymond James. Another good DST test and some more big funds waking up to the new InterOil realities could be the beginning of the end of the large short count. We will know soon enough.

Tags: The Markets