Crunchy Credit

If humility is a virtue, then the leaders of Citigroup may be some of the more virtuous people in New York. This week they agreed to sell $7.5 billion in convertible stock to an investment fund controlled by the government of Abu Dhabi, one of the United Arab Emirates. The terms of the transaction are complex and it is not entirely clear who gets the best end of the deal. Nonetheless. it is hard to portray as anything other than a bailout. Citigroup is, in effect, borrowing money at an 11% interest rate and giving up a 4.9% equity stake. A Wall Street Journal editorial summed it up well, saying "it strikes us as unfortunate, if not a tragedy, that America's largest bank had to go hat in hand to Arab sheiks because of bad management and blundering U.S. monetary policy."

Having been reduced to nothing less than a subprime borrower itself, Citi and its peers are increasingly selective about lending money to anyone else. The resulting "credit crunch" threatens to push the economy into recession. The fact that year-end is approaching exacerbates this situation, as lenders are reluctant to acquire new loans that will have to appear on their December 31 balance sheets. This suggests the situation may ease in January; whether it will be enough to matter is impossible to say at this point. Consumers who face a softening job market, rising fuel and food costs, falling home prices and tighter interest rates can hardly be blamed if they decline to stimulate the economy with exorbitant holiday spending.

With all this going on, why did the stock market stage a major rally on Tuesday and Wednesday, then hold on to its gains today? The market is back in "Bad news equals good news" mode. Traders are betting that economic weakness will allow the Fed to keep dropping interest rates, and Fed officials are dropping plenty of hints to support this notion. Meanwhile, a pullback in oil prices suggested inflation pressure could ease. This week's equity gains can easily be characterized as nothing but an "oversold bounce," and unless there is more follow-through soon it will become difficult to argue otherwise.

Taking a step back, intermediate-term relative strength is largely unchanged despite all the fireworks. The defensive trio of utilities, consumer staples and health care is still the place to be for equity investors. Selected foreign markets remain in uptrends but show signs of weakening.