Market Update - 8/5/08

What a day!! The major averages all rallied today in the final hour of trading. The major propellant was the Fed decision to hold interest rates steady at 2%. ISM data that came out in the morning provided the early impetus to the markets. It came it at 49.5 versus a reading of 49 expected by the economists. Anything below 50 represents contraction, but the market took this number to be a positive since it was higher than what we saw in June. Fed, today, acknowledged the impact of higher inflation on the economic growth. But the ongoing crisis in the financial markets coupled with a slowdown in the consumer spending might have swayed their way towards holding a steady path. Dallas Fed president, Fischer, was the only dissenting candidate. He advocated raising the rates, as he had done at the last meeting in June.

I think this was a good decision. The time is not ripe to start raising the rates so soon. Inflation is a problem, and they had to balance the deterioating aspects of a rise in inflation with the credit crunch and the worsening effect of increasing unemployment on the public. There are a lot of negatives still in this market and we have to sift through all of those before we start seeing any measure of economic growth. Some of those are -

1. Increasing Unemployment (which jumped to 5.7% in July).
2. A still weak housing market (most of the economists still feel that the prices will fall 10% or more from what they are today).
3. Credit Crunch (which is affecting not only big institutions but also people who would like to buy a new home today).
4. Higher Inflation (as a result of higher commodity prices amid a higher than normal demand for those, coming mostly from the developing Asian economies).
5. A risk that more banks could fail (resulting either from bad investments in sub-prime mortgages or CDO's in general).

The only positive that has come out in the last two weeks has been the decline in crude oil prices, which have fallen almost 20% from their peak set in July. This has buoyed the markets and has led to declines in the Energy and Materials sectors across the board. Some of that decline could also be attributed to an expectation that the high gas prices are finally affecting the consumer in the US. This could further lead to a slowdown in consumer spending, and hence the GDP which is a barometer of how the economy is coping up with all the stresses that are being levied on it. Consumer spending accounts for almost 70% of the GDP here in the US.

AIG had a big day today, with the stock rising 12% after an analyst at UBS stated that the worst may be behind this company. Freddie Mac reports tomorrow and Fannie on Friday. Both these reports have the potential to move the markets one way or the other. I am getting a little bit concerned about Freddie since they have a big concentration in Alt-A mortgages which are hard to value. If they need to mark those to market then it could end up costing them a lot of moolah!!
Also, they have to issue new shares as they have promised their regulator. This could again prove costly for the current shareholders since their market cap currently is roughly $5.5B. If they raise additional $5B, as they promised, then they will have to almost double the outstanding float. It will be interesting to see what they report tomorrow.

Today's rally should not be mistaken for a "the worst is behind us" rally. There still are a lot of negatives out there and unless the housing market shows an uptrend, we are in for a very long summer!!