Friday's rise in equity prices and Treasury yields will be more than reversed

The equity market, including many financial stocks, closed the week with a sharp rally concentrated in the final hour of trading. For Friday alone, the equity indices were up some 6% or more. Moreover, there are indications this strong rally will extend into Monday's opening, judging by the outsized 7% equity advance in some of the futures market. But, this is still just another bear market rally.

The abrupt Friday turnaround from the steep equity price slide earlier in the week, as well in prior weeks, was primarily prompted by President elect Obama's late Friday choice of New York Fed Chairman Tim Geithner as the new Treasury Secretary. That choice encouraged a more optimistic outlook on the survival of key financial institutions since Tim Geithner has been instrumental in developing the Federal Reserve and Treasury rescue efforts. However, considering that those efforts have not as yet led to any observable or meaningful progress in ending the credit crisis or its consequences, it must be assumed that the market rally merely reflects relief that Geithner is a known not an unknown player. The major financial institutions that received Treasury capital injections are down 46% just since the middle of October. And, for some of these institutions the rate of stock price decent is accelerating. The hope is Geithner will save them. Hope springs eternal, even in the Fall.

I will be more hopeful when more meaningful steps are taken to end the plunge in home prices and financial institution distress. Suspend the pernicious mark to market accounting rules that force institutions to take losses and write down capital that put their very existence in jeorpardy when they have no intention to sell the depressed asset. Provide government guarantees for interbank lending. Buy vacant homes offered at depressed prices. End foreclosures for owner occupied homes for individuals making any good faith effort(a variant of FDIC Director Bair's proposal). Refinance mortgages to reduce the payments to a more reasonable percentage of after-tax income, such 25% to 30%, as lending guidelines suggest. Provide increased tax subsidies to puchasers of existing homes. Reintroduce the uptick rule in short selling.

Despite the markets latest flirtation with misplaced euphoria, equity prices were still down 5% for the week. The Dow Jones industrial average at 8046.42 was down 16% the past two weeks and is down 43% from its 14164.53 October 9,2007 peak. With that decline it already ranks as one of the worst cyclical drops since the 1930's depression. But, the Nasdaq composite index, largely technology stocks, is down far more. Though the Nasdaq composite was up on Friday to 1384.35, it was still down 73% from its bubble bursting March 10,2000 high of 5048.52. But there appears no basis for confidence that the outlook for corporate profits, credit availability, or economic recovery will be improving any time soon.

Treasury yields also rebounded sharply on Friday. The Treasury ten-year yield, for example, closed the week at 3.23%, up from 3.14% on Thursday. But those 10-year yields are still down substantially from 3.73% the previous Friday and 3.79% the Friday before that. The Treasury market benefited from a massive flight to the safety of direct US Government obligations as the equity market appeared to be in a virtual free fall. The Friday selloff was partly profit taking and a temporary reversal of investment flows back into the equity market.

Despite these Friday moves and potential for an extention into next week, the trend toward lower equity prices and lower Treasury yields is likely to remain very much in place. With the recession only now deepening precipitously and likely to get far worse before it gets better, and with more intense fears of deflation a near certainty, still lower equity prices and Treasury yields appear inevitable. Citibank this week announced massive layoffs. There are more such announcements to come among banks, hedge funds and insurance companies as more of their losses come to light. And Fannie Mae and Freddie Mac losses are soaring. Producer prices slumped 2.8% seasonally adjusted in October from September, a record one-month decline. Consumer prices fell 1% seasonally adjusted in October from its September level. This is also the largest one-month slide on record and a hint of coming outright deflation that suggests the Fed will be forced to cut its funds rate even below the current 1.0% level. The yield spread between Treasury inflation protected debt(TIPs) and regular Treasury coupon yields, which the Fed uses as a guide to action, indicates a market deflation expectation of more than 0.5% over the next five years, an ominous development. Initial claims for unemployment benefits are at new cyclical highs, suggesting worse unemployment news to come. A 10% peak unemployment rate is now increasingly likely, as is a 4% to 6% drop in fourth quarter real GDP.

The auto manufacturers are in a financial squeeze reflecting plunging consumer and business demand for their products, high production costs, onerous contracts with their dealer networks and crippling healthcare and pension benefit costs for retirees as well as current workers. These so called "legacy costs" are nowhere near as burdensome for their competitors. In bankruptcy all contracts are nullified and subject to change by negotiation or by the bankruptcy court. The Democrats are committed to temporarily aiding the companies to survive but not if they will remain addicted to Federal assistance.

Philip Braverman, President
Braverman economic and Financial consulting
One Hewitt Square #249
East Northprt, New York 11731

Email address:philipbraverman@Gmail.com