(From BARRON'S)
By Michael Santoli
Banking has always been a business in which the craziest, least-careful players begin to set the rules for everyone toward the end of a credit cycle. Once the late-cycle, easy-money experiments in financial "sinnovation" get rolling, the main options are to play along or opt out of the game, before it ends with loss and regret.
And so, with a fresh round of reports of opaque financial dealings, here we are again, where we've been before.
Until Thursday's first-of-the-month market rout that clipped 2.6% off the Dow and Friday's uneasy breakeven day amid a purge of financial stocks, the market seemed to have been building in expectations that this credit-market seizure would follow the 1998 script.
In that instance, there were also crowded trades in esoteric instruments, mutually destructive relationships among banks and hedge funds and a sudden yet timeless lesson in the hazards of excessive leverage. Then the Federal Reserve cut rates quickly, and, in retrospect, that cheap money provided the fuel for the climactic inflation of the tech bubble the next year.
A further comparison of 2007 and 1998 in terms of stock-market rhythms, economic context and policy-maker response is instructive.
The first half of 1998 saw the stock market barrel higher, scoring a 20% year-to-date gain on July 17 before faltering. Stocks then sank 19% to log a slim loss for the year by late August. About half the losses were recouped; then another scare brought the market back to the low.
Stocks didn't recover for good until after the Fed eased. Short-term rates were dropped from 5.5% to 4.75% in three steps between late September and mid-October. The market soared from mid-October to year end, finishing the year up 27%.
So far this year, the pattern has been roughly similar, with the magnitude of the moves smaller by about half. Stocks ran to a peak July 19, up 10% for the year, then succumbed to the credit turmoil, falling to a slim loss for the year in mid-August. The Fed has thus far cut rates from 5.25% to 4.5% in two steps.
One difference: This year, the indexes recovered more quickly to new highs without any help from the financial sector and, we now see, before investors had taken a full reckoning of the financial wreckage. The present mess, too, hits closer to home for many individuals, both literally and figuratively, given the key role mortgage debt has played.
In '98, we now know, while a vulnerable financial system needed an adrenaline shot of cheap money and a government-facilitated bailout, the real economy didn't, as it was growing 5%-plus in the quarter the troubles hit.
This time, Wall Street is begging for Fed help and the government might ultimately midwife another quasi-bailout, while the growth in the second quarter topped 5% and more recent GDP numbers have held up reasonably well. Estimates for the present quarter, though, are falling below 2%.
All these parallels simply provide context, not a script. For stocks, the '98 crisis ushered in a narrowly led, growth-centric, more-volatile climb in the indexes once the financial rupture was patched -- a move that proved to be the overshoot phase of that decade's bull market.
There's certainly a chance, though, that the vertical moves in oil and gold since the Fed cut the discount rate in mid-August -- and the directly related drop in the U.S. dollar -- have been hinting that another liquidity-propelled asset lift could follow this crisis.
Two weeks ago this column suggested it wasn't the moment to buy ravaged financial stocks, but was time to begin hunting for signs of investor capitulation in the group. That vigil continues. The news can always get worse, especially when dealing with financial dark matter that cast book values into question. But the selling Friday held hints of panic.
The S&P Financial Sector SPDR (ticker: XLF) ended well off its midday low and traded 160 million shares, triple the average and the most since the Aug. 16 market low. Merrill Lynch (MER) traded five times average volume and even traded up a bit after hours. It would be helpful if Street analysts turned more aggressively negative on the group before one could sound an all-clear.
One non-obvious beneficiary of the flight from financials has been the utilities sector. After six months of underperformance, the utilities have outpaced the market in the past month and appear set to challenge their old highs. One theory is that yield-oriented investors are selling 5%-yielding bank stocks and taking shelter here. The stickiness of Treasury yields at lower levels also lends support. Some utilities, of course, act as natural-gas plays. They're not cheap in historical terms, but the fact that utilities are systematically underowned by institutions is a plus.
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