The Greatest Stock Market Wisdom I Have Ever Heard!

It is an understatement to say that the stock market did not like the defeat of the bank rescue plan yesterday. No matter what your politics are, the defeat signaled to the financial markets that politicians are every bit as greedy as the Wall Street types they condemn. The election polls said the American people were against bailing out the banks, and a majority of politicians from both sides of the aisle, gave the people what they wanted. The only problem was that they did not give the country what it needed, which was a plan to unlock the banking system. You can talk all you want about bailouts or rescues, but the truth of the matter is a bank near you will be biting the dust in the near future if there is no plan forthcoming. In this regard, it is my understanding that the Senate is working on a plan. Let's hope they are more successful at formulating something that does the job. I have been through a lot of market turmoil in the 33 years I have been in the business, but the single most powerful wisdom I have ever heard in how to deal with bad markets came during the height of the 1987 crash. On that day, as you know, the market was down nearly 23% and people were just swept away with panic. Almost unbelievably, I got almost as many calls from non-clients as I did from clients asking what to do. Since everyone knew, even by mid morning, that the sell off was going to be unlike anything we had ever seen, there was some disagreement among the investment professionals at the firm I worked with at the time about what we should do. Cut bait, or ride it out, those were the choices on the table, and cut bait sure felt better than riding it out because we all knew that it was going to get a lot worse before it got better. A very successful elderly client strolled in on his way to lunch and announced to our huddled little group, "What are we buying boys?" We were all a bit taken aback because we were certainly not thinking about buying. Then he said something that I will never forget. He said, "You know, when you think about what is a safe place to put your money in times like these you have to remember one thing: If the greatest companies in the world are not worth anything, then nothing else is. I'm not talking about this little company or that one. I'm talking here about the great blue chip stocks. If they have survived for 50 years or more and have risen to leadership in their industries, it is not an accident. They know how to survive and prosper. They know how to make it through wars, recessions, oil embargoes, market corrections, and politicians of both stripes. They know how to adapt and change and remake themselves over and over. They know how to get close and stay close to their customers. They will survive this crisis and they will be stronger on the other side of it because they will not hide; they will use this great uncertainty to gain market share. You watch, a year from now; five years from now the great blue chip stocks will be higher, a lot higher." The man's words were echoed almost verbatim when I received a call from a very successful lady a few minutes later. She wanted to know what to buy. She had a substantial sum of money that she wanted to put in the market and wanted me to tell her what to buy. I tried to caution her, but she stopped me and said, "Look, Greg, I'm a big girl. I know the risks, but my husband and I have amassed thousands of acres of farm ground, and we did it by buying every time other people were afraid that farm ground was going down the tubes. Great companies are like great farm ground. They always come back and they always rise to the top. Stock traders don't know what they are buying and selling. They are just like commodity traders in that regard. They are not dealing in something that in their minds has true value. They are just selling prices, and the prices are falling, so they want to sell. Next week the prices will be rising ,and the traders will be right back in line trying to buy the very thing they sold last week. I'm not buying prices when I buy farm ground, I'm buying something that I know what to do with. The same goes for the great companies. They are not just prices; they make something that's valuable. They'll come out of this bad time, and I'm going to make a lot of money when they do." Neither of these people went to Harvard or Yale. Neither even had a college education, but both had amassed fortunes, and they knew exactly how they had done it: Go where others fear to tread. But stick with the best, because the best will survive and by surviving they will prosper you. The next few days and weeks will be volatile, but just remember the high-quality dividend paying companies that we own make products that we use everyday. One or two might run into trouble but in a portfolio of thirty stocks there will ultimately be a lot more winners than losers a year from now.

The Shortlist Shortens Again as JP Morgan Buys Washington Mutual

Last week I offered a shortlist of individuals and corporations whose wealth and power made them ideally suited to play roles in turning around the US banking system. On my list were Wells Fargo, JP Morgan, Warren Buffett, WalMart, and General Electric. I identified each participant because, in my judgment, their presence would be a vote of confidence to an increasingly fragile banking system that was having trouble raising capital. I reported on Wednesday that Warren Buffett had moved off the shortlist first by investing $5 billion in Goldman Sachs (GS) preferred stock, with warrants to purchase another $5 billion of common stocks. I fully expect more activity from Mr. Buffett and Goldman Sachs. Goldman has registered themselves as a bank holding company, which would mean they could eventually take deposits. Since this is a very low cost method of funding their operations, there is a good chance they are going to want to buy a good sized bank to enter this business. The second departee from the list is JP Morgan (JPM). JPM bought Washington Mutual after the FDIC closed the bank Thursday evening. You will recall that I thought Wells Fargo was the likely suitor for Washington Mutual, and that JPM was a good match for National City. It is now clear that JPM chose to go after WM to gain a West Coast presence. I still expect Wells Fargo (WFC) to make a major acquisition within the next few weeks. With GE deciding to strengthen the financial position of their GE Credit division, they become less likely to be a buyer of banking assets. Walmart would require a change in the laws to become a player. They have not said anything publicly about such a move, but they have made it clear in the past that they wanted to be in the banking business, and in light of the current crisis, their strong balance sheet would be a welcome addition as a possible acquirer. As I write this, the wire services are saying that an announcement about a plan to save the banks will be issued before the markets open on Monday. Politics has entered the mix which makes a deal more difficult, but I believe politicians on both sides of the aisle realize that without some sort of plan more banks will fail in the coming weeks, wiping out hundreds of billions of peoples' income producing assets. Perhaps as you read this, you think that is just what should happen. After all risk is risk, right? Here's the problem: bank's stocks have long been seen as so-called widows and orphan's stocks. Banks are owned by the same people who own utilities and telephone companies. They count on the income to live. The Washington Mutual take-over model undertaken by JP Morgan brought safety to depositors of the institution, but probably wiped out all equity and debt holders. Thus, JP Morgan gains a valuable assets, but it was done on the backs of conservative income investors as well as the bigwigs. Washington Mutual was aggressive and has paid the ultimate price. But had a rescue plan been in place like the one that Treasury Secretary Paulson proposed, it may have been possible for WaMu to have survived and given an opportunity for the shareholders and bondholders to have gradually made a comeback as new capital was made available to the bank. I have heard a lot of high sounding rhetoric about moral hazard and not bailing out the bank bigwigs. That misses the point that bank stocks are not like tech stocks. These bank stocks that everyone seems so anxious to let go down the tubes have been in business for generations, and many investors have such low bases in the stocks that they have been reluctant to sell. The tech craze largely affected younger and savvier investors. If banks are left to dangle in the wind and then fail, many innocent older people are going to be hurt. We tough nosed investors can say all we want about letting the bigwigs get their comeuppance, but before you drive your Hummer into that gathering of bigwig bankers on the street out in front of their building, remember, you will also be plowing through Aunt Minnie, grandmother, cousin Fred, and the endowment plan of the church on the corner. If this rescue plan turns into a lynch mob of bigwigs, we will be returning an evil for an evil, and the only winners will be the bigwigs from that other bank in that other city. The small investors' assets will die at the exact moment as does the bigwig's.

The Shortlist Just Got Shorter: Buffett Does What He Does Best

Last week I offered a shortlist of individuals and corporations whose wealth and power made them ideally suited to play roles in turning around the US banking system. On my list were Wells Fargo, JP Morgan, Warren Buffett, WalMart, and General Electric. I identified each participant because, in my judgment, their presence would be a vote of confidence to an increasingly fragile banking system that was having trouble raising capital.

We can take Warren Buffett off the list because he has done what he always seems to do: shocked the investment community with his activities. He announced the purchase of $5 billion of preferred stock of investment banker Goldman Sachs (GS), with warrants to buy an additional $5 billion of common stock.

What was so shocking about the purchases was that Mr. Buffett had a very bad experience a few years ago with Salomon Brothers, now a part of Citigroup. I will have to admit that I did not think Buffett would enter the canyons of Wall Street again. But there was an overriding issue with Goldman Sachs that trumped his previous bad experience on Wall Street. Goldman Sachs is considered the Gold standard of Wall Street. The saying goes that in every merger or acquisition deal that one chair is always reserved for Goldman. They are seen as the so-called smartest guys in the room, and they have proved it year after year.

This is actually Buffett's second acquisition in a week. Last week he announced his holding company Berkshire Hathaway (BRK/A) was buying troubled energy company Constellation Energy. A deal the company had with a French concern appeared to fall apart at the last minute, and Buffett stepped in to provide much needed capital.

My guess is that with Goldman's brains and Buffett's bucks and brains we may see more out of this terrific twosome.

Now if we can just get the other four members of the list up off their behinds and into the water, we'll get this economy and market turned around, and not have to wait on the hot air that seems to always hover over our nation's capital.

At the right is our model for Berkshire Hathaway's latest Fair Value. As you may remember, the model is based on BRK's historic relationships to growth in its book value and long-term interest rates. The model says BRK is currently approximately fairly valued at $128,000 per share. The model is suggesting that based on next year's predicted book value growth that in the next 12 months the stock may rise to near $137,000. That doesn't exactly put BRK in the cheap column, but with the newsmaking ability that Mr. Buffett has and his recent opening of his check book, I would not be suprised to see the $137,000 reached sooner rather than later.

We own BRK/B in our Capital Builder accounts. We offer this discussion for information only, and as we all know that past relationships will not necessarily work in the future. The reason we show the Valuation Model is because it has been reasonably accurate in the past at predicting BRK's price.

Ben and Hank's Plan Was Inevitable, And It Will Work

"The Fed and the US Government will ultimately put together some sort of bail out plan for the $300 billion in subprime bad debt. The amount is smaller than the S&L bailout in the late 1980s, and it is the only way to keep the real estate market from being a drag on the economy for years to come." Rising Dividend Blog March 25, 2008. This is a quote from my March 25, 2008 blog entitled Tough Questions, Controversial Answers. I was wrong by 60%, but right in principle that the US Government would eventually be forced to buy the bad mortgage debts from the banks to end the mortgage crisis. I heard many negative comments about that blog. I heard about free markets, moral hazards, and a host of other issues that didn’t mean a twiddle. I heard them, and I listened patiently, but I knew where this subprime debacle was heading. Now we are here at a figure of $700 billion instead of my $300 billion. Could the number have been smaller had Ben Bernanke and Henry Paulson moved faster? No, they have moved as fast as they could. Politicos cannot move much faster than the populace, and the people were not ready for a government bailout until recently. The following is a paraphrase of the last question of the March 24 blog. Question: What about the precedent of bailing out people and institutions who made unwise investments? Answer: It is not the Fed's job to impose moral judgment on society. It is their job to maximize sustainable economic growth and minimize inflation. One could just as easily use the argument about the moral hazard of people in the US who live directly in hurricane alley, or tornado alley, or wildfire alley, or earthquake alley, or any other dangerous alley in the country. Why should the rest of us have to pay when Katrina rips away New Orleans or Houston, or a tornado tears through a city in Kansas. These people all built homes or bought homes in harms' way. Shouldn't we just leave it to them to clean up their own piles of trash? No, that is not the way our country works. There is no hiding place from the storms of life -- physical or financial. Our country has stepped forth time and again to calm the storms and solve the problems in one economic sector or region of our country so that the troubles of that area do not spread to other areas and take us all down. Of course, there were egregious lapses of judgment on Wall Street, but they are paying for it in the hundreds of billions of dollars in write offs they have taken, bankruptcies they have filed, and in the tens of thousands of jobs that they have lost since the beginning of the subprime debacle. I don't like bailouts any better than most of our readers, but some bailouts are necessary when the foolishness of one group imperils the general populace. I believe the subprime-real estate crisis rises to that level. Had the government not bailed out the S&Ls in the late 1980s, the S&L problems would have lasted a decade, cost hundreds of billions of dollars, and slowed overall economic growth to a crawl. As it was, the Resolution Trust Corp. cleaned up the majority of the mess in only a few years at a fraction of the $500 billion at stake. In almost all economic crises, the death knell is the freezing up of valuable assets behind fear and risk aversion. In essence, when the government steps in, they act as an icebreaker by breaking apart the frozen assets and keeping them flowing, then putting the assets up for sale in an orderly basis. That is what happened in the S&L crisis. That is what I predict will happen in the subprime crisis. So, now we long-term investors wait and watch the politicians as they wrangle their political advantage out of the bail out package. While they spout and speak of things they know and care very little about, the markets will dangle in a cloud of unknowing, and as a result, will swing with the wind. When the package is delivered to the President for his signature, if it is along the lines of Secretary Paulson’s proposal, the markets will calm and the seeds of trust and confidence will sprout. If it includes tag-ons like more “bridges to nowhere,” the market will see through it like a cheap suit, and we will have more weeks of rough weather until the politicians get it right. I am not worried about the future because in a crisis US politicians usually get it right. Politicians are pawns of political pressure. Political pressure is beholden to the will of the public. The will of the public is not as far from the truth as many in the media elite would have us believe. The public are figuratively in the streets chanting for a stop to the financial carnage. They know that much of New Orleans is under sea level, but they reach out to New Orleanians as the storm surges over their seawalls anyway. That’s what’s so great about America. We are a nation that forgives and forgets and moves on. You say things have changed and it won’t happen this time. History says you’re wrong.

Here Is a Shortlist of People and Institutions Who Can Make the Financial Crisis End?

We are living through a financial riot, and it is not a comforting feeling. We have found that the rating agencies might not quite be on top of things the way we had come to believe over the years. We have found that financial statements from insurance companies and banks do not show the toxicity of the loans they call assets. We are reminded again of the many conflicts of interest that rage on Wall Street. We have learned that the bank down the street with its giant mirror of a building that always seemed to imply power, strength, and the sky's-the-limit is up to its cooling towers in loans that seem to have seeped up from the sewers. We are in a financial riot, but just like physical riots it will not last indefinitely. It will end and it will be the government who ends this financial riot just like it is government that ends physical riots. It is not shopkeepers who fight back the inflamed mob and quell the riot, it is government through the police or the army. But it will not be government who will rebuild the financial system. That is the job for private enterprise. This is not a third world country. We are not dependent on the United Nations to solve our problems. This is a fabulously wealthy country that has blessed many entrepreneurs and corporations with wealth beyond their wildest dreams. There is no shortage of capital to solve this crisis; there is a shortage of nerve and courage and the willingness to take some blows to give fresh capital and clear-headed management principals time to turn the financial system around. It time to cut loose the bodies of capital that can solve this problem. I believe the following short list of participants should be allowed or encouraged to help clean up the mess.

1. Wells Fargo (WFC) has dodged all the sludge so far, and they have made it clear that they are not in the turn-around business. I want to remind them; however that it was the ideas and leadership of a bunch of people from the old Norwest Bank out of Minnesota, who turned around the country-club banking types in California and enriched them in the process. John Stumpf, America needs your business acumen and banking genius to reach down into this mess and pick up something that you can correct. Many banks are selling for a fraction of their book values. What STAGE are you waiting for to get in the business of helping solve the banking crisis, and ultimately to enrich your company even more. You know its the truth. You just need to move. I think Washington Mutual is your best bet. They have a sales culture similar to yours. Unfortunately they have been selling the wrong products. If you give them the right products and risk management systems, they will rise.
2. JP Morgan (JPM) and Mr. Diamond, you cut a heckuva deal on Bear Stearns. However, you need to get a little more skin in the game this time. National City Bank (NCC) has lost its rudder. They are a natural fit to your old Bank One territory. National City has always been a good meat and potatoes bank. They fell into the sewer when they tried to join the caviar crowd in the subprime world. National City would offer incredible consolidation possibilities because of its overlap in your Bank One territories.
3. Wal-Mart (WMT), you have been trying to get into banking for years. In exchange for allowing you to get into the banking business, you should seriously look at Wachovia(WB). It's big. It's got the Sunbelt covered. It can provide you with the expertise to cross sell hundreds of investment products to your your millions of loyal customers both in the US and around the world. The government should change the rules to allow you to do it. You have capital coming out of your ears, and you have a bond with Mr. and Mrs. America that is among the strongest of any company on earth. You can help your fellow Americans the way you did in Hurricane Katrina and recently with Hurricane Ike.
4. Warren Buffett, what are you waiting for. You are worth$70 billion, your company is worth over $100 billion(BRK/A). You also need legislation to allow you to get into the banking business. Your party is in power currently in Washington. It ought to take you about 36 hours to be in business. J Pierpont Morgan is said to have saved the US from financial calamity at least twice by loaning money to the country. Here's your opportunity to join Mr. Morgan as a man whose legacy will live through the ages. Buy somebody smart in the banking business like you did with MidAmerican Energy and turn them loose amalgamating the banking system like MidAmerican has done in energy and power. It may not be shooting fish in a barrel, which is your preferred method of operation, but America is calling on you like it once did on J. Pierpont Morgan. I know you own bank stocks, but it not the same as owning the companies outright. You know that.
5. General Electric (GE): I know the Kidder Peabody purchase did not work, but the hubris on Wall Street is at an end for awhile and the complexity of your company would benefit from the expertise and business connections of an investment banking firm. JP Morgan is swinging in the breeze looking for a buyer. You have a AAA rating; you do business in every corner of the world; you are at the forefront of all the alternative energy solutions that have a chance of working. Your biggest problem is going to be helping your customers finance your technology. Morgan Stanley can do that. That is their business. They can also help guide you to important acquisitions in the areas of the world you want to be in and to the companies with bona fide products and capable management teams.

Ken Lewis, of Bank of America (BAC). I shudder every time there is a financial crisis because I know you will be there with your checkbook, even if nobody else is. Thank you for your bravery; thank you for your belief in America. I pray that your courage and strength of character will be blessed with strong profits for many years as a result of the moves you have made during this crisis.

I criticized your Lasalle Bank and Countrywide Financial purchases; I cringed with the Merrill Lynch purchase, but you appear to have paid pennies on the dollar in all cases and something seems to be speaking to you about the future that none of the rest of us are hearing. Call Warren Buffett. See if he'll fight this battle with you.

Moves like these will ultimately occur. I don't know if these people and companies will come forth, or if it will be other brave souls. This short list, however, if they put their shoulders to it, could solve our current problems.

Might the Fed Cut Rates Again? Lehman Brothers' Demise Probably Means Yes

A rate cut may be in your future. After rising inflation worries put the markets on the alert for a rate hike earlier this year, the thought that the Fed's next move might be to cut rates would seem a little far fetched. At one time, using Fed Funds trading as a guide, nearly 75% of money was being bet on the side of a rate hike by year end. That very high bet on rate hikes has diminished in recent months, but the great majority of investors still believe that the next rate action will be up. I have a hunch; however, that a rate CUT is now nearly a 50% possibility and my reasons are simple: With the stock market down nearly 15% from a year ago, investors have lost nearly $2 trillion. In addition, with real estate prices down about the same amount, homeowners have taken another $2 trillion in paper losses. Without adding to the list, investors have taken a $4 trillion hit. That is a deflationary force that has not taken hold yet because it takes most people a long time to quantify these kinds of losses. But almost every asset they thought they had a year ago is now worth far less. My belief is that as the magnitude of these losses gradually reaches more and more Americans' psyches, they will begin to pull back even farther on their impulse and status purchases. I am not alone in my view that deflation is the biggest worry in the next few years. Thirty-year Treasury bonds yield only about 4.4%, far lower than the near 5% they yielded a year ago. The long bond crowd used to be called the bond vigilantes because they voted their inflation views with their Quotrons. If they thought inflation was a real problem that was not being addressed directly enough by the Fed, they sold long bonds, driving bond yields higher. If they thought the Fed was being too aggressive, they would drive yields lower, signaling the Fed was too tight. Thirty-year yields have been falling in recent weeks. The worries about the banks and the investment banks have created some flight to safety, but another bond yield shows clearly that the bond vigilantes are beginning to feel like the Fed needs to cut rates: 90 day T-Bills. Ninety-day T-Bills are currently yielding 1.45%. With Fed Funds at 2%, the bond crowd is signaling they don't want to put big money in the banks. They would rather take a lower yield from the government than the higher Fed Funds rate from the banks. The average difference between Fed Funds and T-Bills over the last 30 years has been .25%. With the difference now .55%, and long bond yields falling, the bond vigilantes are saying deflation from a slowing economy is a bigger worry than inflation. I realize this may fly in the face of conventional thinking and current inflation stats, but I have always considered the bond vigilantes the smartest trading crowd on the street. You can be sure Mr. Bernanke is watching. To get through this rough patch with the banks, we must have a strong economy. The economy is losing too many jobs, thus soon at a bank near you, you might find a lower rate. Addendum: The Lehman Brothers situation. Unless there is a miracle of some sort, Lehman Brothers, the 158 year old Wall Street firm, will soon close its doors. A last minute attempt by Treasury Secretary Paulson to convince, badger, cajole, plead, and all the other verbs that cry out for somebody to do something, appears to have failed. Clients of Lehman should be OK. SEC rules requires that client positions be transferred to the next owner of the firm. That said, however, billions of dollars of capital will vaporize in the fear-induced selling that has gripped the shares of big Wall Street investment banks. As we have learned bit by painful bit, they are all up to their necks in bad loans and increasingly investors have given up on them; as has the US government, since it refused to bail out Lehman. Without the government's largess, no large bank, sovereign wealth fund, private equity firm, or investment bank was willing to take a chance on what was thought to be the smartest bond firm on the street. The markets will probably be rocky on Monday. Uncertainties will certainly abound, but the failure of institutions with failed strategies was inevitable, and the markets will be better for it in the long run. Just as inevitable was the fact that the US government would stop bailing out companies who appeared to have no moral, ethical, or financial compass by which to steer a new more profitable course. These companies bet the ranch on high risk debt: but they were dead wrong, and the ranch will soon have new owners. I look for most of the other pure investment banks to seek new owners in the days ahead. Even venerable Goldman Sachs seems to have lost some of its hubris. We are going to make it through this travail. There will be survivors and the survivors will have far less competition for business in a wide range of financial product offerings. Bank of America, Wells Fargo, and Barclays Bank appear to be the big winners so far. We'll keep you posted as the great disappearing of Wall Street firms continues.

Hank Paulson Got It Right on Fannie and Freddie

On Friday as I saw the 6.1% unemployment data released, I began writing a blog. Even though GDP was revised up, the meat and potato issues of lost jobs and homes were sure to cause the media to go on a "sky is falling, duck and cover" campaign that would leave most Americans wondering how we were ever going to get beyond this housing debacle, and in the process, freeze spending and weaken the economy in an even broader way. So I wrote that government must do more; that government must do what it could to stabilize all mortgage markets. To accomplish this, they must become direct participants in buying mortgages to push mortgage rates down, which would stimulate demand for housing and refinancing opportunities for those that qualified. Please read my Friday blog. It was not broadcast because I did not finish it until after 5:00 PM CDT. Late in the day, the Wall Street Journal carried a story that Hank Paulson, Treasury Secretary, was readying a takeover of Fannie Mae and Freddie Mac. In essence the US government was getting into the mortgage business. Hallelujah. This is something that I have been calling for since March, and this was the direct approach that I was advocating in the Friday blog and in previous ones. I repeat that I am a free market advocate to my bones, but the housing bubble threatens to set our economy on a decade-long bubble unwinding, which would produce sub par growth and economic malaise. The housing debacle has become a threat to our national security and that is a job for government to solve. Our friends on Wall Street and in the banking business have finally bitten off enough risk that they had choked the whole economy. The actions of Secretary Paulson will be debated and second-guessed, but I am convinced that they were necessary and that they will soon begin to bear fruit. Here's why. The weak link in the US economy is housing. If a floor is put under the housing market, the rest of the economy is still humming along reasonably well and will continue to do so. Oil prices and commodity prices are falling, which will have a positive psychological and economic effect on Americans consumption. High oil and commodity prices have not been overly worrisome to me from an inflationary standpoint because they have acted more like a tax on consumption. If these prices continue to fall, or even stay near current levels, inflationary pressure will diminish dramatically, and consumers can breathe a little easier and plan a little more long range. I believe Secretary Paulson's actions will be seen by worldwide investors as necessary and responsible and will cause money to begin flowing back into the US from foreign investors. The actions were bold, they were decisive, and even though I wish they would have happened a month ago, they will be rewarded with positive reactions in the US stock market. The government has more work to do to unfreeze the economy, but today's actions with Fannie Mae and Freddie Mac are a powerful message that Paulson and Bernanke are on the same page and will use every tool they have to produce an under girding to our economy. I also like the fact that the takeover of Fannie and Freddie has sunset provisions that will require the next administration and congress to act, or these changes will be gradually unwound.

The Fed and Treasury Must Become More Aggressive

Back at Purdue, when I used to play a lot of contract bridge, there was a saying that unfortunately I found to be too true: One peek is worth two finesses. It simply meant that if a player could catch sight of an opponent's hand he could see for sure what the opponent held as opposed to using laborious finessing techniques to find the truth of who held what. Yesterday the stock market was down 344 points without economic data that would justify such a sharp fall in prices. Late in the day, my assistant, Carol Stumpf, asked me why the market had fallen so much. It was actually a question that I had been thinking about and just before I answered her, the thought rang through my mind: One peek is worth two finesses. I answered her that bad news on employment during the day had caused some weakness, but that tomorrow (Friday) big numbers were coming out and my guess was that the data were going to be ugly. She asked me how I knew that, and I said that I didn't know for sure, but today's action (Thursday) of stocks told me that somebody knew something for sure. Tomorrow's employment data had leaked and the recipients of the leak had beaten the snot out of the market. So what does this leak have to do with the long-term view of the market? Nothing. It just shows that Wall Street is still up to their old tricks of peeking if they can and pounding us little people half to death with their trading in advance of our knowledge of the the facts. This may seem like a bit of a stretch, but consider this. The employment figures were, indeed, ugly today: unemployment jumped to 6.1%, the highest since 2003. And on the day of this seemingly ugly news, stocks are up nearly 35 points. Please don't try to tell me that the market is up today because there is good news. The market is up today because the short sellers yesterday are covering their shorts today. Many people who had no idea of what was going on were probably drug along in the sales frenzy from yesterday and will regret it in a few months. The bad employment news actually has a silver lining. It definitely puts the Fed on hold; they will not be raising rates anytime soon. Indeed, the rate cuts they have made thus far have not had time to do much to stimulate the economy. It is well known that Fed cuts take 6 months to a year to filter their way through the economy. Bill Gross of Pimco Investments, the largest bond fund in the US, also had a bit to do with yesterday's fall in stocks when he called on the government to start treating the current slow economy like a 1929 type situation. He said a tsunami of selling had caused the markets to freeze up because banks and other financial intermediaries were dumping anything of value to raise enough capital to stay viable. Bill Gross does a lot of lecturing to the government and the markets and I usually think he is full of himself, but in this case I don't think he is far from the truth. I believe, as I have said here previously, that the government needs to quit finessing the weak mortgage and real estate markets and get in these markets directly, especially the mortgage market. They need to be buyers of mortgages, which will drive down mortgage rates and entice people to buy the glut of unsold houses and also allow people with good enough credit to refinance to do so. The Fed has cut rates from 5.25% to 2.00%, yet mortgage rates have hardly budged because of the perceived risk of mortgages. The US government needs to get a lot more aggressive. If they would do this, the banks would also benefit because they could then sell some of the mortgages they have at good prices, freeing up funds that would enable them to make loans elsewhere. Consumers and businesses would benefit because the banks would be back in the banking business instead of in the risk aversion business. Ben Bernanke is considered to be one of the world's experts on reviving an economic collapse. In my judgment, we are a long way from an economy of the 1929 variety, but Mr. Bernanke can be sure that it never gets that bad if the Federal Reserve and the Treasury Department of the US government begin to take aggressive actions to bring stability back to the credit markets. The most expedient way to do that is for them to become direct buyers of a variety of asset classes from corporate bonds to mortgages --even the equity of certain important institutions. I remain convinced that this will ultimately happen, but I believe it would be far better to do this prior to any escalation in the crisis. The US Government is the lender of last resort. The ugly employment statistics today flickers like a 1950s neon sign: "Last Resort Ahead." If the Fed and Treasury do their jobs in a bold and creative way, the real estate market will turn sooner rather than later and with it the stock market, and in a year, today's employment statistics will seem like a aberration . If the Fed and Treasury do not take bolder actions, unemployment is probably going higher and the economy will soften by the fourth quarter. Here is the most important statement of this whole blog. The Fed has done a lot to provide liquidity and keep the economy chugging along; the problem is the banks. As a matter of survival, they have not passed on the rate cuts; they have kept the extra spread for themselves. Thus the Fed's actions have been muted. The US government needs to get directly into the "peeking" business. Not the dishonest kind like some bridge participants, but the kind that puts the Fed in the position of being a direct buyer and seller of a wide range of securities that will enable them to affect the markets in a more efficient way, instead of trying to finesse the economy through the banks.

Dow Jones Fair Valuation Model - 13,500

How cheap are stocks? You don't hear that question often these days, but we believe that is the appropriate question to ask as we pass through the one year anniversary of the subprime crisis. Bank write offs have been staggering and many analysts believe some of the write offs will later be recaptured as the markets unfreeze and normal business activity returns to banking and real estate. Even if earnings are not recaptured, losses at some point will cease and the banks will again begin reporting earnings, thus the earning we are seeing today for the major indices are understated significantly from what they are likely to be two to three years down the road. Having said this, we believe the Dow is undervalued even using 2008 projections for dividends and earnings. We have computed the "fair value" of the Dow Jones Industrials using current data from S&P on 2008 projected dividends, earnings, and AAA corporate bonds yields. Using these assumptions, we then ran the the data through our Valuation Model(click to expand), and we arrived at a fair value of 13,500, as shown on the chart above. The chart shows that the valuation bars, in blue, have followed closely the actual price (except during the mania of the late 90s) of the indices shown in red. With price now buried deep in the value bar for 2008, our model is signaling that stocks are undervalued. The standard error for the formula is about 900 points. That would mean that current "fair value" range for the index should be somewhere between 12,600 and 14,400 -- even the bottom range of the model is appreciably above the Dow's current level of 11,500. We believe the Dow is currently discounting a much slower overall earnings and dividend growth landscape than we are likely to experience, thus we continue to believe that stocks, even in these uncertain times, are undervalued. As we always say, our model is based on historical relationships and thus is not a guarantee of future results. It is, however, based on long-term relationships between growth, interest rates, and price. An important truth that most people miss is that the 30 companies in the Dow will likely raise dividends nearly an average of 10% for 2008, including Citigroup which cut its dividend 40%. That is a clear signal that these major multinational companies do not believe that the economy is going to fall off a cliff. We'll have a new reading of the valuation model on a regular basis.