October 7, 2008 The following update is not only informative but cause to be optimistic. Good news - Bear Killing Season The market took another hit yesterday in what has turned into a global rout the likes of which are unprecedented. The Dow Jones Industrial Average was down over 800 points intraday before rallying to finish the day down 370 points. Some are calling the 500 point late day rally a key reversal. Time will tell, but there certainly has been enough damage and the market is oversold enough to stage a strong rally at any time. The credit crisis has spread to Main Street and the fear is that it will result in a deep recession. Some are even talking of depression. I think that is just fear mongering, but it has investors terrified nonetheless. There is no doubt that the economy will slow given the crisis and lack of credit availability, but the decline in the market may currently be overstating the economic weakness because the market is trading more on fear than rational behavior. The problem is that banks don't trust each other and have nearly stopped lending all together. Governments around the world are trying to get banks to lend. The $700 billion bailout package, in its simplest terms, is designed to take the bad loans off bank balance sheets so banks trust each other in order to make credit available again. Here in the U.S. we seem to be further along in the process of dealing with the situation than they are internationally. Its hard to believe but European banks have taken more write-offs than U.S. banks. As a result, even this past weekend European authorities had to step in and rescue several institutions. The Federal Reserve has been active in the past several days. The Fed announced that it is planning to double the outstanding Term Auction Facilities (TAF) balances to $900 billion in an attempt to improve liquidity by allowing depository institutions to borrow from the Fed using the same collateral that is accepted at the discount window. In addition, the Fed used its recently given authority granted under last week's financial-rescue legislation to effectively set a floor under its main interest rate that is lower than the 2% fed funds target rate. According to the legislation, the Fed may now pay interest on bank reserves. The Fed has done this while it continues to flood financial markets with liquidity, pushing down the overnight lending rate by about 0.75% to an effective 1.25% rate. It acts as a stealth rate cut. By paying interest on reserves, the Fed can pump more cash into the financial system without worrying the overnight lending rate will drop to zero at the end of each day as banks withdraw excess reserves. However, an adverse effect could result as a higher rate on payments may give banks too much of an incentive to keep funds at the central bank. The objective is to give banks an incentive to start lending again, and the more they are paid to hold their reserves, the less likely they'll be willing to lend. So it is imperative, in my opinion, for the Fed to cut rates. The FOMC meets next on October 29th and the fed funds futures market is currently pricing in a 100% chance of a 0.50% rate cut and a 52% chance of a 0.75% cut. There are rumors of a coordinated global rate cut effort. The Bank of England meets this week and is expected to cut rates by Thursday and the European Central Bank has backed off their normal inflation rhetoric and seems more inclined to cut rates. A global effort is what is needed since this is a global problem. It appears that a global effort may have begun. As I am writing this Update The Reserve Bank of Australia cut its overnight lending rate by 1.00%. Technically speaking the declines in the market have been unprecedented. For example, just yesterday new lows on the NYSE spiked to 1839 issues, a new record by far. That equates to nearly 50% of all securities that trade on the exchange, the highest since Black Monday. According to Jason Goepfert of the SentimenTrader, there have been only three other dates this extreme since 1965: 08/29/66, 05/21/70 and 10/19/87. All three were at, or very near, a market low. Also, at the intraday lows yesterday afternoon, down volume on the NYSE was running at a 116-to-1 pace over up volume. Those figures improved to 7-to-1 down to up volume by the close. Using closing figures, the only other days since 1950 that it was that high were 12/04/50, 09/26/55, 10/19/87, 10/26/87 and 10/27/97. In addition to the above there are many characteristics that suggest enough damage has been done to the market to reasonably consider most of the risk already taken out and the risk reward skewed to the upside. For example, implied volatility, measured by the CBOE Volatility Index (VIX) spiked to its highest level since the 1987 Crash. The VIX reached an intraday high of 58.24 yesterday. Readings above 40 have historically marked intermediate-term bottoms. At its worst intraday yesterday, the S&P was about 35% below its 2007 closing high and 22% below its 200-day moving average, both levels that have neared major lows in the past (6/22/62, 5/25/70, 8/27/74, 10/19/87, 7/19/02 and 10/4/02). In those cases the S&P 500 was up a month later 84% of the time by an average of 8.2%. There is a tremendous amount of potential suppressed buying demand that will be evident once confidence returns as there is currently over $4 trillion in cash sitting in money markets. That represents over 30% of the total U.S. market capitalization. By many measures the market is as oversold now as anytime since the 2002 bear market lows and yesterdays decline and intraday rebound could easily qualify as capitulation. Investor sentiment and consumer confidence are very pessimistic and valuations on both an absolute and relative basis are favorable for stocks. Finally, we are in bear killing season. According to Ned Davis Research the last 5 cyclical bear market bottoms have occurred between August 31st and October 19th. They were 10/19/87, 10/11/90, 8/31/98, 9/21/01, and 10/9/02.