The new Fed Chairman has done little to instill calm in globally connected markets that respond instantaneously to even rumors of changing events. As we have previously indicated, the nature of Fed policy is changing markedly from a predictable process to an amorphous “read the tea leaves” strategy. This “Bernanke Market” focuses upon every word spoken with a particular emphasis upon what appears most uncertain or unpredictable. The Fed has done little to understand and respond to the complexities of the transition to a new Chairman and his new style.

The new Chairman's exchange with a CNBC reporter only highlights that there is a steep learning curve with the markets paying the price. It's clear that Bernanke does not yet understand the damaging nature upon real values his comments can induce. In such an environment, leveraged structures (especially the complex ones) can easily unravel, creating dysfunctional markets. The Asian Contagion, the Russian bond default, and Long Term Capital have all been examples in the past of disruptive events that have created irrational market behavior and significant valuation gaps. Furthermore, the growing SEC investigations of options grants have added to investor distrust - an all too familiar scenario.

In the coming weeks, we may learn of a highly leveraged hedge fund that unraveled or a financial institution that structured a leveraged transaction that went afoul. Although forced selling seems to have been a part of this precipitous selloff, the retail client is unlikely to have been the culprit. Since retail participation has been minimal since the recent market bottom of 2002, heavy selling coming from margin calls is unlikely.

From our perspective, the selloff reflects an institutional "panic" with program trading, technical violations, moving averages, and advisory services pointing out the new emerging bear market (the same folks who talked about the DOW making new highs just six weeks ago). It is obvious that no one knows with any degree of confidence precisely the multitude of factors that are unraveling this market – that in and of itself is part of the problem. What we do know is that the valuation gap between stocks and bonds has widened further. The measure of panic can be reflected in a 30 year bond yield near 5% and a 10 year near 4.90%.

In a world suddenly preoccupied with concerns about inflation, why would a 30 year bond yield such little real return? Why would bank stocks hold up so well in such a down market that is now facing an inverted yield curve? These factors point to fear and panic.

Such a valuation gap accelerates the leverage buyout, the stock buyback, and M&A strategies. The private equity firms have record cash levels and now have extraordinary opportunities: low debt to equity ratios position companies positively for leverage buyouts. The high levels of cash heighten buyback and dividend policies. These strategies further reduce the supply of equities, buttress earnings and lower P/E ratios. In times like these, investors are preoccupied with the uncertainty and instability of the market and care little about the valuation opportunities. "Fear always trumps value" is a saying that comes to mind. Until the fog of confusion begins to lift, the valuation opportunities will persist and volatility will remain elevated.

Lurking in the background of market disarray is the potential institutional failure and the web of relationships it will affect. Only time will tell the nature of the institutional damage, if any, that has occurred and whether the Fed is prepared to respond to the degree necessary to stabilize and calm markets.

If history is any guide, fear often exceeds the reality and markets overreact. However, the road to that realization is "less traveled." In the coming weeks the fog should become less dense. Structural damage, if any, should emerge. The Fed's inflation benchmarks will get greater clarity with the release of the PPI and CPI. The strength or fragility of the international markets will become more apparent.

In this environment, the relative valuation of the equity market to bond market (a 30% discount) is comparable to that which existed in the fall of 2002. Although a volatility premium may be incorporated into current market valuations, someone will take advantage of the valuation opportunities that exist.

 

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www.mastrapasqua.com ©2006 Mastrapasqua Asset Management Inc. The information and opinions contained in this report should not be treated as fact or as insight that will produce desired investment results over time. Investment conclusions always bear risk, and that risk may not be reasonable for any particular reader. Obviously the writer, even assuming good intentions, does not know of the reader's particular financial circumstance and therefore is not able to assess the propriety of whether a named security makes sense as part of a given individual, family, or institutional portfolio. Mastrapasqua Asset Management clients may, from time to time, own some of the companies mentioned. We hold out no obligation to give readers of this column advanced notification of when we may change an opinion. To our knowledge, none of the information contained in our column would, when it becomes publicly available, have an influence on the valuation of a particular stock. Investors should receive investment advice based on an assessment of their own particular investment circumstances and not on the basis of recommendations in this report. Past performance is not indicative of future results.