Insights & Advice

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The Benefit of the Doubt

The world’s stock markets continued their meteoric rise this week. Investors who were sitting in cash became increasingly nervous as the averages rose without as much as a hiccup. The S&P 500 surpassed my target of 840 on Thursday by five points before taking a bit of a break on Friday. As I mentioned last week, I will give this market the benefit of the doubt and set my sights 60 points higher at the 900 level.

Honestly, I would feel a bit more comfortable if the markets consolidated here or even had a pull back before attempting to climb higher to my next level but so far that has not happened. I suspect many investors are waiting for that pullback to invest. In my experience, when everyone is expecting the same thing the opposite often occurs.

“So what has the market so excited?” asked one of the many clients who called me this week. “I thought the unemployment numbers were God awful?”

They were. As of Friday, we are now at an 8.5% unemployment rate, the highest since 1983. But unemployment is a lagging economic indicator while the stock market always looks ahead. Many are betting that the bulls are looking over the valley of dismal economic numbers and buying the dawn of a recovery even if they still can’t quite see it yet. Clearly it is a gamble but with prices lower than they have been in over a decade many investors think it is worth the plunge. The bears insist this is nothing more than another bear trap. One that will close its jaws once it swallows up all those who put money into this rally.

Aside from that debate, the real catalyst for the market’s rise not only this week but since early March, is the change in the “mark to market” accounting rules of the Financial Accounting Standards Board or FASB.

Accounting is something that most writers avoid like the plague. However, sometimes, even a tiny change in the way accountants view an item on the balance sheet or income statement may have a huge impact. I believe one such rule, called FASB 157, is behind the 60% gain in banking stocks last month as well as much of the 26% gain in the stock market so far this year.

The Connecticut-based Financial Accounting Standards Board is the nation’s arbiter in all things accounting. This prestigious, private-sector organization establishes financial accounting and reporting standards for America’s businesses and has an important influence on accounting worldwide. Over the last several months, the Board has been under enormous pressure from Congress and the Federal Reserve to establish new guidance on how companies can value assets on their balance sheets. The politicians and industry lobbyists wanted the nation’s banks to be able to use “significant judgment” when valuing the price of some investments on their books instead of marking assets to market. Specifically, they are talking about the trillions in toxic assets like mortgage-backed securities that the banks hold and no one wants to buy.

Up until now those assets have been going for 20 cents on the dollar or less in inactive markets and transacted in what can only be termed distressed sales. However, the much anticipated rule change was announced this week. So now the banks will be able to use judgment in valuing the bad assets on their books. This will mean fewer write-downs, less losses and therefore higher stock prices.

. “Actually, the Board is only providing further guidance on ‘how’ not ‘when’ to use FASB 157,” explains Gary Schieneman, an old friend of mine and a former member of the FASB.

Gary and I worked together for years on Wall Street. He recently retired here in the Berkshires where he paints and teaches skiing at Catamount ski slope. He believes that what the FASB is doing is clarifying what constitutes an active market for selling securities and exactly what a distressed sale really means.

“As far as I’m concerned, it’s really not an issue of changing what is fair value, it just brings into the valuation process some additional means other than just market price.”

Still others see the maneuver as pure sleight of hand.

“I wish I could do that with my debt,” said one disgruntled real estate developer I know in Hillsdale.

As I’ve explained before, the problems of the financial sector is the tail wagging the market’s dog so what’s good for the banks (in this case the FASB ruling) is good for the markets. Next week we have quarterly company earnings on deck. I suspect the results for many firms could be ugly and should test the resolve of market bulls. It could also be the catalyst for a pullback that investors, including myself, have been waiting for.

Posted in A Few Dollars More, At the Market