Markets Seem To Be On The Mend

Quite a few posts lately; guess my mind is fertile lately.

The markets - stock, bond, and more - are smart. They know you have to start somewhere. If this recession started in 2007 because of housing and then escalated into more than a garden-variety recession and maybe mini-depression after the Lehman collapse froze all of the capital markets, it will have to first get out of the recession/depression through a combination of improving capital markets and then a return to house price stabilization, the underlying cause of the "bad" assets that plague the system.

The most important stories I read in the last 24 hours weren't about the bad housing sales in Vegas or the crummy auto numbers, but a return to some degree of health in the the bond market - convertibles, for example - a great way to finance for both growth and cyclical companies alike - and some big hedge funds queuing up to buy these same bad assets with leverage from the Fed.

Fixed-income securities like the ones that are for sale everywhere are almost never bought for cash by any large hedge fund; they are bought with borrowed money so returns are magnified and the hedge funds can make a lot of money within the timeframe of their performance, usually within three to six months but maybe as long as a year. If you see a bond offering that sells at 40 cents on the dollar, and you manage $500 million, you very well might want to magnify your returns by putting down $100 million and getting $600 million from the Fed to buy that asset. If it goes up 10 points, you make a lot of money -- much more than if you just outright bought $100 million of it.

I don't think people realize that fixed-income hedge funds always augment their returns by buying bonds with borrowed money, but there has not been anyone willing to lend that money -- no bank, no broker -- to do the trade. Consequently, all of the kinds of securities that are for sale are of no real interest to funds that can't borrow, and the brokers don't want to lend because every time anyone has bought this stuff, the buyer has lost money and the broker has lost money lending!

If you see that lending happening -- and it is happening already -- and you see the kind of asset-backed bonds being bought -- bonds backed by car loans (TALF), for example -- that's the thawing, that's the "better than expected" in the fixed-income markets like "better-than-expected" earnings. If you see convertible bond issuance, that's "better than expected" for the convertible bond market just like a beat of estimates in stocks. You have to think that way, because THAT FREES UP LENDING.

If you free up lending and housing becomes affordable, what you see is an increase in buying of homes, including the gain in pending home re-sales, which takes down some of the inventory that exists. When you combine that with a decline in cancellations for the homebuilders, and you know that housing starts are back to where they were when we had more than 100 million FEWER people yet affordability's lower than when we had that money, and we know that the freeze in fixed income gives us hope that there will be more mortgage lending, and you know the new buyers have an $8,000 credit, you get a chain of goodness that trumps anything out of GM or F or any individual company disappointment.

That's why I think it's a pretty good time to be in the stock market.