A One-Two Punch

Story Highlights:

• US stocks reached the lowest levels of this bear market today, thanks to a one-two punch from the banking and economic fronts.
• Citigroup announced another round of government assistance, but this time the government isn't investing additional funds.
• US GDP for the fourth quarter was also revised lower, a reflection of the panic that snarled financial markets late last year.

(Editor's Note: MarketMinder does NOT recommend individual securities; the below is simply an example of a broader theme we wish to highlight.) _______________________________________________________________________________________

US stocks reached the lowest levels of this bear market today thanks to a one-two punch from banking and economic fronts. The first hit arrived when days of speculation came to fruition as the government announced plans to provide former financial giant Citigroup yet another helping hand.

Unlike previous efforts to bolster Citi's balance sheet, this round of government assistance doesn't involve doling out more cash to the struggling firm. Instead, the government agreed to convert the preferred shares it purchased with TARP funds into common shares. But it's not just the government converting its preferred shares. Private investors are being asked to convert their preferred shares too. In fact, the government will match, dollar for dollar, the preferred shares converted by private holders up to $25 billion. The hitch is preferred shares don't convert at current prices but at $3.25/share—a substantial premium to the current share price. This move will save Citi billions each year in preferred dividend payments, but the firm's main goal is boosting a rather obscure capital ratio. Because of the difference in the way preferred shares and common shares are accounted, the conversion will boost Citi's tangible common equity ratio, a capital adequacy measure that has only recently taken on significance as a barometer of a bank's health.

Citi shares plummeted almost 40% on the news because if the firm is successful in converting all preferred shares, existing common shareholders will be significantly diluted. In such a scenario, common shareholders will be left with 26% of the common shares outstanding. The government will hold 36%, and former private preferred shareholders will end up with 38%. Many see this as one step closer to nationalization for Citi—and it may be.

But even if Citi is nationalized, the market has already largely discounted this outcome (Citi is currently trading at $1.50 a share—a 97% drop from its 2007 peak), and it's extremely unlikely is in the cards. In fact, quite a few banks are still, even in this environment.

In addition to the Citi news, Q4 2008 US GDP was revised down from -3.8% to -6.2%. Much of the revision was due to lower inventory builds than originally reported. That makes a shockingly negative number, but it can actually be a positive looking forward. Inventories have been exceptionally low relative to sales during this downturn compared to previous recessions, which means there are fewer excess goods to be worked through before production picks up again. Investor panic last quarter had far-reaching ramifications. Stocks plunged, credit markets froze, and economic activity contracted. The steep drop in GDP is reflecting these events. Conditions are far from back to normal, but there are.

As we've written here many times, you shouldn't expect rosy economic news anytime soon. You can, however, expect stocks to move higher before good news arrives. The market retesting and exceeding prior lows isn't at all unusual during bear market bottoming periods. In fact, double or even triple bottoms are actually quite common. When the market does move higher, it will do so quickly and in earnest.