If Counter-Party Risk Is Reduced, It May Be Time For More Market Exposure

Suppose you are watching US equity markets.  You could be thinking of bailing out.  You might be someone who has been in cash, but you do not want to miss the “bottom.”  Whatever your position, you seek some magic indicator.

We have already provided the basics that should help readers make this decision.  Here is some extra color, but still not the full picture.  We are sorry.  It has been a busy time, and we presume that readers will understand that our first loyalty is to existing investors.

Meanwhile, here is some help for loyal readers.

The Key Question

The key question is the freeze-up in credit markets.  If ordinary businesses cannot get loans, holiday retail and auto is affected.  If the commercial paper market dries up, ordinary commerce cannot take place.

This is not a matter for political posturing or personal opinions.  Many people who have never run a business or a bank seem to have a strong opinion on how much leverage, how much liquidity, and what duration is “correct.”  Here at “A Dash” we think that anyone offering such an opinion should show some expertise and/or a successful business model to prove it.

Meanwhile, it is pretty obvious what the market wants.

Participants want to know that there is no counter-part risk, something that we highlighted for you last week.

People will not lend without knowing they will get paid back.  It freezes commercial paper.  It escalates LIBOR, and it causes a spike in CDS swaps.

So that is the problem, the most important problem, and possibly the only significant problem.  If it is not solved the economy may get much worse.  If it is, we may escape with a milder recession.

Some Evidence

Last week the counter-party risk issue had people focused on Morgan Stanley and the prospective infusion of funds from Mitsubishi.  Many traders in the put market were betting that Morgan Stanley would follow Lehman.  How else can one explain the October 5 put trading as high $2.  These put buyers were betting that there would be no Morgan Stanley by Friday.

As we write this, the companies are proceeding with the agreement.  The government may make the first cash infusion in a private company as part of the deal.  European banks have acted aggressively to address these questions.  An overall global solution has still not been achieved — something that would guarantee all trades between major banks.  Overnight futures are trading much higher on the promising news.

What to Watch

By following the “Dash Rule” a reader can evaluate the significance of any proposal.  Anything that reduces counter-party risk is “the nuts”, if we may borrow from the poker players.  Examples would include the following:

• A guarantee of inter-bank transactions.  Europe is doing it.  The hints are that the US will do the same.  This requires international cooperation, since no central bank can do it alone.  The Fed cannot regulate foreign banks.  It takes everyone, and it is complicated.
• Suspension of mark-to-market rules.  At some point this will get reviewed and debated.  The SEC study is now due on January 2nd.  (This is the government operating as rapidly as possible.)  Regardless of how one feels about the long-term merits, the market would celebrate a suspension.  Why?  We would not need to worry about whether a counter party would be around next week, based upon trades from some other distressed agency and the Paulson/Bernanke decision on whether the institution would live or die, and which investors would be protected.  Until this process is ended, we have a problem.
• Capital injections. These will help on a case-by-case basis.  Let us see whether it helps with overall liquidity.

Conclusion

We are watching other factors.  We also have a list of best stocks and sectors in the event of a rebound.

But this is our single best idea, and we are sharing it.  If the evidence suggests that the counter-party risk problem has been reduced, it is time for that first step toward more market exposure.  The specific stock picking can follow later.

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