Hopeful Signs in the Financial Markets

Given our long term perspective, it is hard to get too excited about the sizable gains that we have seen in this week’s market, although they are certainly a step in the right direction. In addition to today’s encouraging retail sales report, there are several other recent developments, which we think warrant consideration as we look for signs of an end to the market downturn.

Financial institutions may be getting healthier, or at least less sick. On Tuesday, according to an internal memo from Citigroup CEO, Vikram Pandit, Citi has earned a profit for the first two months of the year. As recently as last week, Citi shares traded for a low as $1.00 and many predicted that the stock could fall to zero. Pandit’s memo indicated that earnings for the first two months were $19 Billion and is confident about its capital strength. Based on this news, folks got the idea that the stock might be worth more than a dollar, which sparked a huge run-up in Citi’s price and contributed to significant gains in the financial sector as well as the broad market. Since Citigroup’s news of a profit on March 10th, we have heard from Citi chairman Richard Parsons, that they will not need any further government capital. The idea that struggling financial institutions may be moving off of life support is indeed welcome and should eventually bring more optimism about their ability to assist corporate America with its economic recovery.

Second, there is a good deal of talk about reviving the “uptick rule”. This is an arcane, but possibly important restriction on the market activities of short sellers. “Short sellers” sell stock which they do not own and hope to profit by declines in the stock’s price. The uptick rule only allows them to sell a stock short after the stock has risen in price, rather than continuing to “chase it down” as a stock’s price declines. There is a great deal of disagreement about the influence of this SEC rule, but the rule, which had been in effect since the 1930s, was only recently revoked – in July of 2007. It is oddly coincidental that the major market downturn began in earnest at about the same time as the suspension of this long-standing rule. It is our belief that the re-imposition of the uptick rule should, at least, arrest some of the downside volatility that the markets have experienced in the past few months.

Third, in a widely watched interview on CNBC on Monday of this week, Warren Buffet, chairman of Berkshire Hathaway and a widely respected long term investor, has called for the suspension of the mark-to-market rules “for regulatory capital purposes”. The mark-to-market rules have their foundation in providing transparency and certainty about the prices of securities held by banks and other companies. The general idea is that securities should be valued at market prices, rather than leaving the valuation to the discretion of the company that holds the security. In normal markets, and for liquid, actively traded securities, this method works just fine; however, recent problems in the credit markets resulted in many illiquid securities being traded at “fire-sale” prices, even by companies who had no intention of selling. Following the mark-to-market rules, all holders of these securities were required to “mark-to-market” thus reducing their capital for regulatory and accounting purposes.

To understand the mark-to-market concept in the recent difficult markets, it has been suggested that one consider the value of your home and then imagine what you could sell it for if you had to sell it by close of business today. Obviously, the value would be much below what you consider fair market value, perhaps you could not even sell it in a day. Would it then be worth zero? This example carries the idea to extremes, but perhaps it helps envision the problem.

In any event, we think Buffet is on point, as usual and there is a great deal of discussion around this issue. If acted upon, it could prove to be an elegant solution to the ongoing bank rescue process of repeated capital injections in the face of illiquid markets selling at distressed prices. Changing this rule will greatly assist in shoring up the capital structure of the banking system so that banks can begin lending again with greater confidence.

In conclusion, we will have to wait and see whether these seemingly positive developments are indicators for the market to begin functioning more rationally in the near future. Sooner or later, it will. We’re hoping for the best. Have a great weekend.

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