Falling knives 10/29/2008

Good afternoon,



In the continued vein of October as a rough month for American history, the gunfight in the O.K. Corral took place late in October of 1881. History is written by the winners and Hollywood loves literary license so to correct a few flaws in the representations of “Tombstone” and “Wyatt Earp,” we’ll disclose that the actual shootout took place outside the photographic studio of Camillus Fly (about a block away) and there is also some record that the Earps and Holliday lay in wait for the Clanton/McLaury Group. When it was all said and done though, there were more Earps than Clantons to justify what happened. I can’t take credit for the following, “the legend would remain limp if they called it the “Flare up at Fly’s Studio” so they called it the Gunfight at the O.K. Corral.”



There were no gunfights yesterday on Wall Street but there were lots of fireworks – hugely so !



Foreign markets were pummeled both Friday and Monday, as we had hoped to see here. Friday and Monday the yen had an unprecedented short covering the spike. A ferocious elimination of the yen “carry trade” (the strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate) caused much of the violent selling in the foreign markets. Late Monday night the yen spike abated and we had huge rallies around the globe. Amazingly investors all but shrugged off a stunningly low Consumer Confidence number. The carry trade theme went a bit further – the Nikkei suggested the BOJ was considering a rate cut. The anti-yen rally resumed with jet fuel. The afternoon was interesting to say the least – As Art Cashin so artfully put it – “It looked like one of those bargain table sales when folks realized there were suddenly more people than products.” The Dow closed at the sixth best daily percent gain in the history of the index.



Those folks expecting a huge rally today as a result of the 50bps rate cut missed the fact that it was already baked into the cake. Some pullback was expected and we got a bit. Interest rate policy is temporarily no longer of paramount importance to traders because the links between the cost of bank borrowing and corporate borrowing has broken down to some extent. A better indicator is the 3 Mos Libor -- the huge skew between the Fed Funds rate and the LIBOR (265 bps) is more telling since it usually it between 12 and 15 bps. It’s come down but has a ways to go.



This rally may have real legs as the bulls begin to take control. Thanks to the avarice of hedge funds and their investors the markets are at their most oversold in decades. However, as James Surowiecki noted, “If there’s a silver-lining in all this, it’s that investors who can endure past the present moment now have the chance to buy what at least look like very cheap stocks. Still it’s not surprising that investors have been unwilling to step up. It’s hard enough to catch a falling knife. But it’s nearly impossible when hedge funds are hurling it.”




Sources: Art Cashin - UBS, Merrill Lynch Research – proprietary PIA Research, The New Yorker – James Surowiecki. This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of October 29, 2008, and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by Merrill Lynch to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks. International investing involves additional risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.