When you trade stock options you need to forecast where market prices might go. We use technical and fundamental analysis to make our forecasts. It is important to understand how the global financial crisis will affect future sentiment.
The Cure Requires Some Pain
Solving the crisis will involve pain. The pain could be taken now, or deferred. The pain will involve further financial dislocation. It will hurt some more than others.
If current proposals by the Financial Accounting Standards Board (FASB) are adopted, that pain will be suffered earlier rather than later. The FASB is in the process of tightening requirements on how banks value their assets.
The stimulus packages fix the symptoms, not the causes. The financial crisis was not caused by consumers ceasing to spend. Therefore stimulating consumption does not fix the underlying causes. The underlying causes have not been widely agreed upon, let alone fixed. One of the underlying problems is the reduced ability of banks to lend money for sound business activity.
Banks have weakened their own ability to lend by making too many risky investments. Prudential regulations which limit how much risk banks take have been weakened. Much of that risk has now materialized. Regulation remains weak, and rescue programs continue to reward financial failure and immoderate risk taking.
Impaired Assets Limit Bank Lending
One reason banks are not lending adequately is their balance sheets are damaged. The amount which banks lend is limited to a multiple of their assets. Banks are reducing that multiple to more conservative levels again, so reducing the amount of credit they issue. But the value of many their assets has fallen, further reducing the amount they can lend.
Assets listed on balance sheets need valuations. Assets can be valued in many different ways, for example: purchase value; market value; theoretical value; or the expected value at some future sale date. One sensible way to measure value is “mark to market”, whereby the asset is valued at its current market price.
Some financial institutions might overstate the value of their assets. The balance sheets of many banks contain impaired assets such as CDOs, CDSs, and obligations by potentially unreliable counterparties. Some of those assets have no liquid standardized market, so it is very difficult to discover a true market value. See “A Fundamental Overview of the US Financial Sector“, in which a year ago we forecast much of how the crisis developed.
Bankruptcy occurs when the total assets are less than liabilities. You should never owe more than you have. The same applies to banks.
In April 2009 the FASB made it easier for banks to value some illiquid assets differently from true market value. It has been easy for banks to assign values to assets greater than their true market worth. Some assets were “marked to model”, which means their value is calculated theoretically using a mathematical model. Some refer to the practice as “marked to myth”, because input assumptions such as volatility can be open to much leeway and liberal interpretation.
Marking Assets Down to Market
In July, 2009, the FASB was considering reversing its April decision, so that all assets would now be marked to market. Many assets would thus be marked down to their true market value, which would become apparent during the next year as balance sheets are updated and disclosed.
Forcing financial institutions to value assets at market values will be painful. The real market value of some assets is well below the value carried on balance sheets. Some CDOs are worth as little as 16c in the dollar, whilst being marked well above that value. Marking to market will reveal some banks to be truly bankrupt. Some financial institutions will be revealed to be bankrupt.
But the alternative, to defer pain by maintaining the delusion of solvency, serves only to hide one of the underlying problems, to perpetuate bad practice, and to corrupt the “laissez faire” system. To hide a problem instead of facing up to it bravely, only perpetuates and amplifies the problem. The underpinning foundation upon which our capitalist system is built is that poor financial managers are allowed to fail and disappear to clear the way for those better able to manage finances.
There are early signs of a stock market rally. Some technical indicators are positive as we have advised in our free stock market briefings and rally courses.
Summary
If any market rally develops, it might be sustained until the shaky state of financial institutions influences wider market sentiment. So, if you trade stock options, prepare to trade the rally up, exit, then trade the next run down. It is impossible to determine how long any rally might be sustained. But if impaired financial institutions’ balance sheets turn sentiment negative, the next rally probably couldn’t be sustained for longer than a few months to a year or so.
Copyright © 2009 Nils Marchant.