Dec 29, 2008

December 28, 2008

December 28, 2008

I hope that you and your family had a wonderful Christmas, and best wishes for a Happy New Year.

Weekly percentage performance for the major stock averages
Based on last Friday's official settlement...

INDU: -.74%
SPX: -1.70%
NDX: -2.61%
COMPQ: -2.18%
RUT: -1.95%

Capital Flows
I have discussed capital movement and pricing quite a bit over the past few months. One of the indicators I have been watching is the TED spread, the spread between US treasuries and LIBOR. The spread has dropped significantly since it peaked in early October, a sign that capital pricing is improving. The absolute level is still quite high, reflecting the concern which still exists regarding the capital markets, but the direction is a positive which should be viewed as positive for the markets.

In general the economic data was soft once again as poor housing data led the way. Existing home sales were down almost 9% and new home sales hit a 17 year low. The median resale price showed the biggest decline since record keeping began in 1968 and was probably the biggest drop since the 1930s, down 13%.

Mortgage applications showed a big jump last week, up 48% as refinancing activity picked up due to a drop in conforming 30 year rates to 5.1%. Jumbo loans, which typically are priced at a 25bps premium to conforming mortgages, are now roughly 215bps above that rate. The difference can be attributed to government support of the conforming market. That gap will need to close, with either jumbo rates coming down or conforming rates moving back up.

Personal consumption was down 3.8%, which the overly optimistic are spinning as a renewed focus on savings. Real consumption was up for the first time in six months, posting a 0.6% increase.

Holiday Sales
Everyone has been expecting a weak holiday shopping season, and while the final numbers are certainly not in yet, some preliminary numbers have been coming in over the past couple of days. Bloomberg reports that consumer spending on women’s clothing, electronics and jewelry during November and December were down 20%, the biggest drop in four decades. The CEO of retail advisory firm Financo said “It’s been difficult, much more difficult than anyone expected.” Macy’s, among many others, has been offering up to 70% off. Additionally, more than a dozen retailers have filed chapter 11 or chapter 7, including Circuit City, Linens & Things, and Mervyn’s. Like I said a few weeks ago, wait until after Christmas to buy those big screen TVs, they may just be giving them away.

Bucking the soft retail trend, announced Friday that they had posted their “best ever” holiday season. This may have been helped by the weather, which was pretty rough across the entire country for the past few weeks, keeping shoppers indoors. Amazon appears to have been bucking the online trend as ComScore reported that e-commerce spending (ex-travel) fell 17% year over year in the month of November. Although this is not surprising given the weak economy and five fewer post-Thanksgiving shopping days this year, this is weaker than we expected. (ComScore data courtesy of Credit Suisse).

Wanna Be A Bank?
The Federal Reserve approved GMAC LLC (the financing arm of General Motors, which happens to be 51% owned by Cerberus, the owners of Chrysler) to become a bank holding company. The Fed used their “emergency powers”, as opposed to their everyday powers, to approve the GMAC conversion to a bank. The Fed feels this move will help GMAC fund vehicle sales by GM (I didn’t realize those finance guys could actually help GM to make better products, but I’ll leave that alone for now).

A spokesman for GM’s National Dealer Council said that GMAC financing has been down 90% since they have been unable to access the debt market, and the banks won’t make auto loans either. He felt that a GMAC default might force 40% of GM’s dealers to close. While I never want to see a business go under and people lose their jobs, if you’ve followed my thoughts on the Big 3, one of my recommendations has been to streamline their dealership structure, and this may have been their chance.

GMAC was unable to tap the credit markets of late (like everyone else) because they had almost $8 billion in losses! Hmm, let’s see, the free market won’t lend them money because they managed to lose $8 billion making loans, yet the government is willing to let them become a bank. Now it makes sense, it was obviously just a classification issue. As an auto lender, your primary job is to make money on your loans, but as a US bank you only need to make the loans, and then our government will bail you out of the bad ones. GMAC certainly fits the description.

I’m going to use my emergency powers to turn myself into a bank. Please send your deposits to my home address.

Emerging Markets
ISI, which in my view is one of the better macro economic research firms, reported on Friday that their sales to China survey had fallen to 45.3 versus the high 60’s in the middle of the year and the 70’s in late ’07. While a bit late, they are now calling this the most severe global recession since the 1930s. The data fro China continues to be concerning, and I will continue to keep you posted.

I find it somewhat interesting to note the very strong correlation between the US and the Emerging Markets (EM). Economic activity in the emerging markets had been quite robust while US growth was somewhat anemic during this decade. Common portfolio wisdom has dictated investing in emerging markets as a way of diversifying away from the US, however, as this global slowdown (and in fact virtually every US recession) matures, it is quite obvious that the diversification benefits of holding emerging markets in your portfolio is greatly exaggerated. While the emerging economies may add additional performance to your portfolio during an expansion, in my view this should not be considered portfolio diversification, but instead should be viewed as adding additional risk to the portfolio with the goal of somewhat higher returns on the equity portion of your portfolio.

Obviously I’m skeptical that there is actually a “diversification” benefit from the emerging markets. In my view diversification into another asset should provide downside protection when one or more of your other assets declines. In this case, the emerging market assets tend to drop more, not less than the US. So where is the diversification benefit?

I’m sure that this view is probably put a good percentage of readers into overdrive, I’d love to hear your comments on this topic.

After staging an impressive rally since July, the dollar has stalled against the Euro. Much of the strengthening in the dollar was due to the unwinding of the high risk strategies involving the dollar and partially due to a flight to quality. As the dust begins to settle somewhat on the global financial crisis, the dollar is evolving as anything but quality. The fed has printed and committed to print dollars quite liberally over the past six months, and now the dollar is weakening once again. There are many economists concerned about deflation; however, I continue to beat the drum that says we will be battling inflation, more than likely sometime in 2010 or 2011.

According to the NY Times, courtesy of the Big Picture, there are presently $11.3 trillion in US mortgages outstanding. Of that total, $750 billion, or 7%, are option ARMs, which of course contributed to the current mortgage problem. Remember that the option ARM is a mortgage that starts with a low rate which later can, and usually does, spike up a couple years after funding. The NYT reports that of the $750 billion still outstanding, $119 billion (16%) was originated by Wachovia.

California vs. Chile
The question we must ask is who is smarter, the people running the state of California or those running Chile? Today in California we are some $48 billion under water with no viable way of raising the capital required to balance our budget. How did we get here? A large chunk of California’s tax base is dependent upon capital gains taxes. I don’t know about you, but I would view this as a variable revenue stream, not one that I would depend upon year in and year out. For some reason, those rocket scientists running California not only assumed the capital gains taxes would be a stable source of income, they also projected annual growth to fuel an ever increasing socialized experiment in spending. Now that these tax receipts have fallen to nearly zero, as well as a whole host of other taxes due to the economic collapse, what does our legislature prescribe as the cure? Of course, more taxes (actually, they are defining them as user fees, but that is another story). Did any of them take Economics 101? Raising taxes during an economic crisis is a sure-fire way to ensure the crisis lasts a lot longer. Is it any wonder that even during the boom jobs fled this state in record numbers?

What about Chile? Their economy was very dependent upon copper exports, the price of which has fallen 68% since its record high in May. Disaster? You’d think so, especially if the legislature of California had their hands on this bounty. President Michelle Bachelet instead held back on the spending while this windfall came in, and managed to stash away $28 billion to protect their state run services. How did they do that? By basing their expenditures on copper at $1.37 per pound, less than 50% of this year’s average. Chile isn’t going to completely avoid this crisis, but they should come out smelling better than California, and certainly at this point their government has proven to be more fiscally responsible than that of the Golden State.

The impact has been a huge jump in California’s borrowing costs as yields are now at a four year high on the state’s tax backed debt. This jump has come without a downgrade, which in my view should be coming soon. Of course, the ratings agencies do tend to be late in their actions (see last week’s note), so let’s just say I’m downgrading California to a B rating. I’m sure the agencies will follow suit, say in 2011. Right now California general obligation bonds maturing in 2038 and carrying an interest rate of 5.25% are trading around 82 and yielding 6.7%, up 1.6% from September. I’m certainly not a muni-bond expert, however, in my view the yields will continue to rise on these bonds, and at some point the US government may have to step in to help the state. When the press coverage on this issue hits a crescendo, and cocktail party chatter moves from Bernie Madoff to California, it will be a good time to step in and buy those bonds, especially if you live in California and qualify for the tax exemption.

What Did You Say?
Joseph Stiglitz, a Columbia University economist and Nobel winner, said “there are many cases all over the world where Wall Street banks have made loans that were beyond countries’ ability to pay. The bankers are to blame because they enabled reckless lending at high interest rates”. What? Isn’t that what they are supposed to do, lend at higher rates to lower quality credits as opposed to the subprime crisis where they recklessly lent at low rates? The smart people in this world keep making stupid comments, which keeps me very busy.

Bad All Over
Thaker Proffitt & Wood, 160 year old NY law firm, closing down. You know things must be bad if even the lawyers can’t keep their doors open.

Also from ISI, their Quant report charts the performance of the ISI Risk-Preference Index which tracks the performance of aggressive stocks (high foreign exposure, high P/E, smaller market cap, etc) versus more defensive names (low foreign exposure, lower P/E, larger market cap, etc). Though the performance of this index has been choppy, since the start of the year more defensive names have been relative outperformers. In other words, investors have been reducing their exposure to risky assets, but interestingly, since the middle of November investors have once again began purchasing risky assets.

Final Comment
Happy New Year to all of you, and here is to a successful 2009. I haven’t finished loading charts onto my blog site, so that won’t be up for a week or so. I’ve found I’m really not very technologically savvy, so I’m hacking my way through that one.

Happy Holidays.


Dec 18, 2008

December 21, 2008

Merry Christmas

Weekly percentage performance for the major stock averages

Based on last Friday's official settlement...

INDU: -.59%
SPX: +.93%
NDX: +.87%
COMPQ: +1.53%
RUT: +3.81%

Volatility seems to be finally coming down, and now resides at levels we would have historically called very high, with the VIX closing just under 45 after peaking above 89 in October. Market volatility certainly feels more normal, especially when compared to the 5% daily movements we were experiencing during the past few months. I don’t know if this means we are returning to a more “normal” market period or not, but I do know that the pause in the volatility roller coaster ride is a welcome relief and almost enjoyable.

The Not So Big Three
GM and Chrysler received approval for $13.4 billion (or $17 billion, depending upon which version you read) in loans, enough to keep both of these teetering entities operating through March. As I mentioned last week, the resolute President Bush decided to rollover and play like a house Dem, pushing for funds from the TARP after he had taken a hard-line stance against using TARP funds initially. Why did he cave? There are a couple of theories out there, with the most likely being he didn’t want to be blamed for any more debacles under his watch, so he decided to push it off to the new administration. A sharp, if somewhat cynical investment banker friend posited that by backing down, Bush took one for the team and allowed the Senate Republicans to claim victory with their constituents when they blocked the original bill. If you recall those philanthropic fellows at Cerberus mentioned they would forgo any profits on their Chrysler acquisition if they received government funding. Now that they have received this funding, the obviously overburdened folks at Cerberus felt it was time for a public relations email, in which they said “concessions by all relevant constituencies” are needed to restructure Chrysler. We’ll see what the UAW, and more importantly their pensioners have to say about giving concessions.

Oil & The Dollar
I was actually preparing to write a piece on the firming of oil prices in the face of the dollar’s recent weakness, until the commodity took a $12 hit during the week, closing Friday at $33.87. As shown in the chart below, the relationship between the dollar and oil has been very strong (i.e. weak dollar leads to stronger oil prices) historically, however, with supply continuing to swamp global energy demand; it appears that the dollar is taking a backseat for the time being in determining the level of black gold. Since peaking at $1.60 per Euro in the middle of July, the Euro fell 23% by Halloween before a recent 13% bounce brought it back to almost $1.40.

Why has oil not kept up with the Euro? Demand for oil has fallen significantly, and in spite of significant announced production cuts by OPEC, supply continues to swamp demand. The chart below shows the number of active oil rigs since 1988. Even with the recent pullback you can see that global rig counts are still near an all time high. My favorite quote of the week came from a Kuwait Oil Minister, who said “we are having trouble finding customers”. This is oil, not Circuit City. Finding customers shouldn’t be a problem, unless the world is in a global recession and awash with oil.

More Money
The Bloomberg Financial Conditions index, an amalgamation of multiple yield spreads and indices in an effort to represent financial conditions in a single, normalized index. As you can see from the chart below, conditions have improved significantly since early October, however, during the last recession this measure bottom around -2.1, but now sits at a paltry -5.9! While it is up significantly from that dreadful bottom, indicating we have seen some thawing of the capital markets since the Lehman bankruptcy, the reality is that things are still tough out there and banks are not yet lending.

Bernanke continued Greenspan’s irresponsible dollar policy as the Fed lowered its target rate to a range of 0 to .25 percent. They are considering buying treasuries, which is quantitative easing and should further weaken the dollar. Earlier this week the dollar fell to a 13 year low versus the Yen on the back of the rate cuts, and has now dropped 21% vs. the Yen this year. Debasing your currency helps exports, helps the price of gold, fuels inflation, and makes paying back our enormous debt level cheaper.

Stephanie Pomboy, the proprietor of a macro economic shop called MacroMavens, commented on the dollar this week by saying “Either we are going to pay for our policy sins via higher interest rates or a weaker dollar. And for an economy that is as levered as the one in the US is, the former choice is not an option. So a weaker dollar is the natural valve.”

What gives with treasury bonds? The short end of the curve is yielding nothing, meaning you don’t get paid for lending money to the government, and the long end has come in significantly. The shape of the curve typically gives some indication as to the future of the economy, and while today’s curve is much more bullish than that inverted grotesqueness we experienced in the middle of 2006, it is still far from steep enough to indicate the end of the current economic malaise is within reach. The peaks of 1991 and 2002 preceded great growth markets, but stood at levels much higher than today. Both of those prior recessions were much tamer than the one we are presently experiencing, and I would guess that the curve needs to get one heck of a lot steeper to give us a viable signal that we are close to an economic bottom. Stay tuned!

Misc Corporate Stuff

As I discussed a few weeks ago, shippers are now cancelling ship orders. The Baltic Dry index, a measure of shipping rates for various size ships, is now an astounding 93% below its high in May. While the index has bounced slightly from its December 5th low, it is still exceptionally weak, an indicator that global trade continues to be weak.

On February 17, 2009, full-power TV stations will stop broadcasting in analog and switch to 100% digital broadcasting. This should be a small boon to the cable companies as older analog sets will require digital converters, which the cable companies are happy to provide at a small monthly fee, to broadcast TV signals.

S&P lowered their debt ratings on Goldman Sachs, Deutche Bank, UBS, Morgan Stanley, Royal Bank of Scotland, Barclays, and HSBC. This should serve to raise the cost of capital to each of these firms. While I applaud S&P for making this move, I can’t help but wonder what took them so long. These companies have fallen far from grace, yet S&P just gets around to downgrading their outlook? Wow! This is another job I think I could handle in about 10 minutes per week along with writing this letter and determining when the US enters and exits recessions.

Which stocks worked in the past few weeks’ rally? In general it has been those companies who are being perceived as beneficiaries of President-elect Obama’s proposed stimulus plan. Outside of the $600 billion/$750 billion/$800 billion/$1.5 trillion the President-elect has suggested, there is really very little information to speculate upon. Needless to say, the market is trying to guess ahead of this entire stimulus. Personally, when the time comes to move back into equities, I would follow the basic principal of business cycle investing and move towards the traditional early cycle stocks (consumer, financial and transports).

Too Big To Survive?

We have heard a ton of commentary over the past year about which firms are too big to fail, i.e. which companies deserve a government bailout. The list is growing by the week; however, maybe the list should be zero? This thought comes from an investment banking friend, who wonders if maybe goliaths such as JP Morgan and Citigroup (among many others) shouldn’t be deemed to big to survive. That’s right, too big! Maybe their very existence creates an enormous risk to the system? Our banker friend, who by the way is not some crazed anti-capitalist but instead a true conservative, both fiscally and socially speaking, further wonders if maybe some type of antitrust or other regulatory action might be required to reduce the size of these large institutions in an effort to minimize any impact of their potential collapse. This is certainly food for thought and something the new administration can chew on, or at least address in one of their many press releases.

Cheap Stocks
Wall Street strategists and analysts are marveling at stocks now trading close to cash. Recently we saw a list of stocks trading at less than 2x cash, without any significant debt burdens. While companies trading close to cash, generating positive cash flow, and lacking debt are certainly getting more attractive, I can’t help but remember the fall of 2002, when stocks were trading as low as 30% of the cash balances while generating positive cash flow and carrying no debt. While stocks are certainly getting cheaper, it is very dangerous to try and pick a bottom, especially when that bottom is based upon factors such as multiples of cash, which historically have little correlation to stock price performance.

While treasuries have been trading in their own bubble, with the short end of the curve yielding 0%, high yield and corporate grade bonds have yet to show significant improvements. In fact, it is my opinion that senior debt represents the greatest return opportunity of any asset class right now. Even high yield, which is carrying a 22% yield according to Merrill, is cheap even if we experience a significantly increased rate of default.

Economic Reports
CPI was down 1.7%, the fastest decline since the great depression. This gives fuel to those who are concerned about deflation. Personally, I think deflation is a temporary phenomenon we will experience before inflation spikes and the dollar falls into an abyss as we come closer to the end of this morass. Despite government efforts to halt the slide in housing, housing starts were down 19%. The Leading Economic Indicators were once again down, this time dropping 0.4%.

More Madoff
As if there weren’t already a crisis of confidence on Wall Street, Bernie Madoff decides to abscond with approximately $50 billion. This had to be a very elaborate scam, and I find it highly unlikely that he acted alone in this caper. Outside of the great tabloid fodder, my guess is that the end result will be significantly more transparency from hedge funds. Legitimate funds should have no qualms about opening up their books to profession investors or customers.

Commodity Odds and Ends

Intrepid Potash (IPI) announced this week that they anticipate production volumes of potash and langbeinite for the full year to be far below the previous guidance range and anticipates that its corresponding annual cost of goods sold for both potash and langbeinite will be higher than previous guidance. The higher cost per ton numbers are a function of the company strengthening its workforce and continuing infrastructure improvements while at the same time producing fewer tons in response to declining demand. In order to manage some variable cost elements, the Company has recently elected to reduce its contract labor in Carlsbad, New Mexico through the end of 2008 and into 2009 as long as the current market conditions exist.
As a result of entering 2009 with relatively higher than historical inventory levels, and in an effort to manage the supply demand balance, the Company currently anticipates that 2009 potash production will be below 800,000 tons.
IPI’s Chief Executive Officer, Bob Jornayvaz, states “We are evaluating the market in a real-time fashion and taking the appropriate actions to navigate the Company through this period of general market uncertainty. We will continue to actively monitor sales and production rates to manage inventory levels against the near-term market demand profile while at the same time being thoughtful about long-term fundamentals. We firmly believe that the macro potash trends of world population growth, improved diets and farmers investing for yield remain unchanged.”
I can only say “I told you so”.

January Effect
Traders Almanac says that the January effect now happens in December. Satya Pradhuman of Cirrus Research says that consumer services, telecom, consumer discretionary, tech and health care will benefit from a January effect since they are off over 30% from their peak and have the most companies trading under 2 times cash. Other factors Satya is looking for include positive cash flow, Forward P/E, Cash Adj. Debt Due in 2 Yrs, Analyst Est. Chg, Net Debt/Total Cap and YoY EBITDA change. I still believe we are seeing a bear market rally, however, as I mentioned earlier in this note I agree with Satya’s position on the various sectors as his recommendations are effectively the traditional early cycle groups.

Mortgage Rates
Mortgage rates have dropped significantly, nearing 5% in most parts of the country for conforming loans. Interestingly, most of the new mortgage activity has come in the way of refinancing as individuals are taking advantage of the lower rates to reset their mortgages. The goal, of course, of lower mortgage rates is to help the sagging housing market by encouraging affordable borrowing. Although credit is still tight, the problem isn’t financing, but in fact people’s sullen outlook for housing in general. Additionally, the stimulus has resulted in the housing market finding a short term bottom; however, it still isn’t low enough for the typical first time buyers who will be instrumental in repairing this market.

Recently a resort offered rooms for rent and was accepting as payment the stock of financial firms who’s stock had fallen significantly. A novel approach to bottom fishing on these stocks.

This unsubstantiated rumor about Citigroup, who evidently took money out of people’s checking accounts instead of automatically depositing funds into them. This is a very novel way to raise capital for a bank, but undoubtedly very low cost funds.

Tonight I discussed a lot of data points, but the summary is that I still think we have some upside risk to the market in the short run. Longer term, I see the market staying roughly between 800 and 950 (closed Friday at 887).

Final Point
I have joined the world of new media and have launched a blog site to house all the historical notes I have published. The site is almost fully operational, and once it is I will send you the link to the site. I have loaded all the old notes, and just need to spend some time putting together all the old charts and graphs and getting them to display properly. Any of you who are tech heads and want to give me a hand, feel free to call. The subscription link on the site should allow people to sign-up for the weekly notes directly from the site. Let me know what you think.

I wish you all a very Merry Christmas and a Happy New Year. Next week’s note will probably be a bit light; however, I expect to have a full year wrap up in the following week’s note.

As I write this note, the NIKKEI is up 1.2% while the Hang Seng is down 1.7%. Crude is up slightly at $43 after bottoming below $34 on Friday.


Ned W. Brines
(562) 430-3232

Dec 14, 2008

December 14, 2008

I’m going to be a bit light on the quips this week. I just came home from a funeral for one of my closest friends, and I apologize if tonight’s note is lacking its usual zest.

Weekly percentage performance for the major stock averages

Based on last Friday's official settlement...

INDU: -0.25%
SPX: -0.35%
NDX: +2.4%
COMPQ: +1.9%
RUT: +1.4%

The tech tape was robust this week, with NASDAQ leading the major indices performance, up almost 2.0% for the week. Most of the major indices were flat to slightly down, which is a major improvement over the past few months. December, which last week I cited as historically one of the best months for investing, has started out gangbusters by 2008 standards, with the S&P down 1.8% MTD, but up 7.7% if you exclude December 1st. Additionally, the market has now bounced 17% from its bottom of November 20th. As I have said in the past few weeks, we are certainly due for a bear market rally, which typically runs up from 20-40%. I still believe we are right in the middle of one of these bear market rallies, and you should use this opportunity to reduce your exposure to equities.

Two of the ongoing stories around the street supporting a market rally have been 1) reversion to the mean long term market returns and 2) cheap stocks. Regarding the former, look at the chart below, which suggests that the market has just recently reached its inflation adjusted long term mean. These types of analysis are always interesting, however, in my view they are a bit disingenuous since the beginning (in this case 1871) and end points are very influential in determining what the data ultimately looks like.

Last week the Treasury sold $30 billion in 4-week notes for 0% interest. This could be extremely bad for money market accounts focused on Treasuries. They could lose money if the yields aren’t large enough to cover their expenses-that’s right, losing money on your supposedly safe money market accounts. Many funds have already been waiving fees to keep returns from going negative, and now with no yield they are going to be hard pressed to maintain positive returns. This negative return could happen if the fund adds a monthly account fee that is charged to your account at the end of the month. It seems as though a new bubble has formed in Treasuries, otherwise, how can we explain people giving their money to the government without a return? One theory holds that the Fed is lowering rates to such a point as to encourage risk taking by making the returns on cash unappealing. More risk taking?? Didn’t we just conclude that chapter in our history?

One of our newly anointed kings of the economy, Nouriel Roubini, said earlier this week

“there’s still significant downside risk for the markets”,

“the bear market rally won’t last too long” ,

the idea of a “V-shaped recession is out the window”,

“the probability of something severe like Japan is still low. But this will last until the end of next year, and 2010 is going to feel like a recession even though we’re out.”

The amazing President-elect Obama is being credited with “stepping up his efforts to pull the economy out of a recession”. He accomplished this by “announcing” that he wants to introduce a stimulus plan which is heavy on infrastructure spending. While I want him to succeed, I can’t help but think that he hasn’t done anything but make announcements, which is very much in line with his political career so far. Essentially he has proven to be a great campaigner, yet has spent very little actual time filling his roll as a senator. I don’t think now is the time for someone to pretend to take action, and hope that the new president will be a bit more active governing and a bit less active seeking re-election.

President-elect Barack Obama will propose the largest infrastructure spending plans since the 1950s. The ramp up in spending will not immediately alleviate what will likely be the worst recession in at least 25 years as companies continue to announce cutbacks and reduce guidance. 3M has eliminated positions and reduced guidance, Dow Chemical will close plants and cut jobs, but McDonald’s offered upbeat same-store sales. It seems the consumer still has time for a Happy Meal.

Jobless claims jumped once again, this time to 573K vs. expectations of 525K. Typically we don’t see that kind of jump before the holidays, however, this year the layoffs are coming fast and furious heading into what should prove to be a very weak Christmas.

If You Can’t Beat ‘em, Rob ‘em…

Bernard Madoff, once the Chairman of NASDAQ and the founder/President of Bernard L Madoff Investments, apparently had a side business duping investors. There have been many charges over the years of various ponzi schemes, but this one takes the proverbial cake. Evidently Mr. Madoff found enough time to run an unregistered money-management business alongside his firm’s brokerage business, and somehow managed to siphon $50 billion for himself. In addition to his clients, anyone who did business with the firm is in jeopardy of losing capital.

If You Can’t Beat ‘em, Rob ‘em part 2..

I can’t imagine being in a more amazing place than Illinois last week. First, the Governor, Rod Blagojevich, announced that the state wouldn’t do business with the Bank of America unless they extended a loan to a company that evidently was on its way to bankruptcy. Later in the week this same governor was arrested for trying to sell President-elect Obama’s senate seat to the highest bidder. This might seem unusual for many of us, however in Illinois a corrupt governor is par for the course. Governor Blagojevich is the 4th of the past 7 governors of Illinois to be arrested, three of which have spent time in jail-Otto Kernor, Dan Walker, and George Ryan. Evidently the governor merely wanted an ambassadorship, a cabinet post, or just “a lot of money” in exchange for the open Senate seat. I appreciate his candor, but am wondering what category this was listed under on EBay? In the understatement of the week, a professor at the University of Illinois at Chicago said “We are the capital of corruption in the US.”

Follow Up

Last week, and a couple of times over the past few months, we have discussed the impact of the stock market decline on pension funds. Primarily we have discussed the impact on earnings. Bloomberg reports that pensions funds at “dozens of companies have joined the parade of businesses seeking relief from Congress amid this year's economic meltdown. Instead of money, they want legislation to suspend a federal law that would make them pump billions of dollars into retirement plans to offset stock-market losses as many struggle to find enough cash just to stay in business. They're pressing Congress to consider the issue this week before this year's session adjourns.” Stay tuned-this issue isn’t going away quickly.

Lending Environment
I have discussed the lending environment at length over the past two months. Recently, Steve Alexopoulos at JP Morgan, wrote “Zions indicated that C&I pressures are mounting, and noted some new concern with its Texas portfolio due to the slide in oil prices. Signature indicated that while deterioration is not yet evident, the bank is increasing reserve allocations to C&I loans. With the economy heading into a deeper recession, we believe C&I loans for the industry will see mounting losses over the next several quarters”. C&I loans have been the stalwarts for banks over the past 24 months, however, we have been discussing both the extreme exposure and potential credit problems of many of the small and regional banks to C&I. It appears we may be on the cusp of the second (third?)wave of the banking crisis.

Big 3 Bailout
What is going to happen with the Big 3 bailout? I haven’t the foggiest idea how this will end. My guess is that the government will blink and save the Big 3 by tossing them at least $14 billion. The Republican Senate gave President Bush a nice going away present by calling his bluff on not using TARP money to save the Big 3. The senate blocked the bill, and now the President is blinking by opening up the option of using TARP money, an option he initially deemed to be off the table. GMAC failed to become a bank this week, a move that would have given them FDIC backing and TARP funding. Who derailed this plan? Their debt holders, who wouldn’t swap enough of the outstanding debt to qualify to receive regulatory capital. It’s interesting to note that to purchase CDS on GMAC, you would have to pay $9.5million to protect $10 million in debt. The market is certainly telling us that the plan should be accepted, I wonder what the debt holders have been smoking?

The chart below tracks the sales and market cap of the Big 3 since 1999. Their market cap has closely tracked their sales, and the chart shows that their sales started dropping long before this economy went off a cliff as a result of strong overseas competition.

Bush Era Ending

At the end of every administration there are a slew of requests for amnesty. While this one evidently hasn’t been filed yet, it has been rumored that among those seeking presidential action are former junk-bond salesman Michael Milken. Mr. Milken, for those of you with short memories, was the villain behind the 1980’s M&A and junk bond craze. Among other exploits, he can almost single handedly be credited with turning Las Vegas into a destination resort from it’s humble roots as a small time, corrupt gambling town. He’s no Mark Rich, but who knows, anything can happen in Washington.

I have recently seen estimates suggesting that US wealth dropped $7 trillion in the past year. I’d guess that even with gas down to $1.75 per gallon, it will take a long time for the savings in gasoline to offset the loss of wealth from stocks and bonds.

Ecuador defaulted on their foreign debt for the second time in a decade, and sixth time overall. The President of Ecuador declared that the debt was illegal, and an investigation into its issuance will be launched. While the investigation is occurring, the government will withhold interest payments on the debt. Oil is the number one export for Ecuador, and I’d imagine that at $147 per barrel the government doesn’t mind tossing a few sheckles towards those who funded the government led drilling programs, however, at $41 per barrel all bets are off and its every man for himself. You have to wonder who was dumb enough to lend this country money after five prior defaults?

What did you Say?
In another issue of WDYS, this technical note comes from a friend who is obviously much smarter than your writer. I don’t know what in the world he is talking about, but really enjoy his comments about the Grand Supercycle that started in 1718. As you know, I am a student of history and the market, but this Grand Supercycle predates even my meager studies. Please feel free to skip the next three paragraphs unless you are having issues falling asleep or enjoy getting extremely confused. If you truly understand what he is talking about, take two aspirin and call me tomorrow (and explain it to me).

We continue to get Bullish confirmation from our indicators, as more and more generate buy signals. A pattern of higher highs would complete confirmation that wave (B) up is underway. Friday delivered new buy signals in our Call/Put ratio and in our Plunge Protection Team (PPT) Indicator. These signals join buys in the Monthly and Weekly Full Stochastics for the Industrials and the S&P 500, which have generated from levels where multi-week rallies start. We are in a Grand Supercycle Bear Market decline, wave {IV}, that started in October 2007. This is why we see so many huge 5 percent daily moves up or down, why we see so many 15 percent multi-week moves. It is correcting a Grand Supercycle wave {III} that started in 1718, three centuries ago. We believe the decline from October 2007 to November 20th, 2008, our last phi mate turn date, was wave (A) down, of Supercycle degree. It represents the first of three phases to this Grand Supercycle Bear market.

This Grand Supercycle Bear Market will consist of a wave (A) decline, a wave (B) up pause - either a rally or sideways triangle move, and wave (C ) down, which will be a catastrophic plunge that could change the world as we know it. Grand Supercycle degree waves change governments and nations. This degree of trend is larger than the Great Depression. That is how serious this Bear market is. That is the big picture.

Shorter term, wave (B) up started at our last phi mate turn date, and confirmation continues to roll in. This should take shape as an A-up, B-down, C-up Cycle degree move, a zigzag or flat, or as a five wave triangle that effectively will be a trading range. We believe we are inside the middle of wave A-up. That middle wave is primary degree wave (B) and is taking shape as a triangle sideways pattern in some indices, and as a flat in others. Once complete, wave (C ) up of A up should rally prices through Christmas into our next phi mate turn date, which we cover in detail this weekend. Pictures are easier than narrative when analyzing Elliott waves and patterns, and we show these labelings this weekend in charts on pages 15 and 17 at . If the degree of waves is one less than we show, it means this Bear Market could last into 2012. Our hope is it will end in 2010.

In a move sure to further the ongoing advancement of socialism in our country, Nancy Pelosi is recommending that Paul Volcker become our countries first “Car Czar”. I’ve lost count of all the proposed and existing Czars in our country, but I’m sure we are at least at four (including the Drug Czar).

Oil and such

Gasoline is tracking the near 5 year lows we are seeing in oil, at a 5 year low of $1.75 per gallon nationally. In response to ever declining demand, the Saudi’s announced plans to cut oil production once again. In the chart below, you can see that demand for oil has moderated, while the price (green line) has dropped precipitously after spiking earlier this year. Interestingly, the drop in gasoline prices resulted in an increase in oil purchases last month, up 71 million barrels. Goldman Sachs, which earlier in the year predicted oil to reach $200 per barrel, lowered their target to $45, with a predicted bottoming at $30 in Q1. They feel it will take production cuts of 2 million barrels per day to halt the current slide in price.

China Watch
China reported that exports declined 2.2% in November, the first time that has happened since 2001 and the biggest drop since modern record keeping began in 1995. Imports are also falling as their economy cools. Watch for a government led depreciation of the Yuan in an effort to stimulate their exports. I think it will be futile because it will be almost impossible for any government to debase their currency as much as the US has done with the dollar.

California reports that California's budget crisis is growing worse as its shortfall for its current fiscal year has increased to an estimated $14.8 billion from a previously estimated $11.2 billion. During a press conference broadcast on his office's website, the Republican governor Arnold Schwarzenegger said he would call top lawmakers into a meeting to stress the need for fast action by the Democrat-led legislature on balancing the budget of the government of the most populous U.S. state because it may be out of cash by the end of February. S&P was considering a downgrade of the state’s debt.

Rail Traffic

Total Industry
Major Commodity Groups

Current Week

Vs. 2007

Vs. 2006

4 Week Rolling Avg.

Vs. 2007

Vs. 2006

Quarter to Date

Vs. 2007

Vs. 2006

Year to Date

Vs. 2007

Vs. 2006

There was quite a bit more I wanted to address this week, but will put it off until next week’s note. I hope this finds you and your family enjoying the holidays and maneuvering through these markets successfully.

Thank you again for your support. As always, if you wish to be removed from this list, just let me know.


Ned W. Brines

O (562) 430-3232

Dec 7, 2008

December 7, 2008

Weekly percentage performance for the major indices
Based on last Friday's official settlement...

INDU: -1.9%
SPX: -2.1%
NDX: -0.75%
COMPQ: -1.7%
RUT: -2.8%

December, historically the second best month for the market, started out as though it was going to buck its bullish history, falling 9% on Monday. Some observers have attributed Monday’s performance as a thumb’s down to Obama’s appointment of Hillary Clinton to Secretary of State. The market’s performance the day after Paul Volcker’s appointment (market up 3.5%) and Timothy Geithner’s appointment (market up 6%), could indicate that Obama is losing his market moving touch or possibly running out of quality candidates.

According to the trader’s almanac, the only “free lunch” left on Wall Street starts in the middle of December. According to the authors, stocks which are selling at their year lows on December 15 will typically outperform the market by February 15. The lesson is that if you haven’t harvested your tax losses by then, it may pay to wait until Valentine’s Day before doing so.

Speaking of Wall Street, there is a phrase making its rounds around the street recently, which purportedly was made by an institutional salesman to his wife “don’t buy anything except food”. In the last two weeks I have heard this verbatim from at least six sources. I’m not sure where it actually came from, but the advice is probably a good rule as prices on all things discretionary should be coming down post what should prove to be a disastrous Christmas for retailers.

Market Bottom?
Now that the market has fallen over 40% year to date, and we have seen a couple of bear market rallies, the bottom callers are coming out in force to declare that a new bottom has been made. I agree the market is probably oversold, as evidenced by the chart below showing the relative strength hitting levels seen only six times since 1929 (see circles on bottom part of graph), and is probably due for another bear market rally. However, please don’t misread my comment as calling a market bottom. I think this bear market has a long way to go, and would be very leery of being involved in anything more than trading positions or patiently building long term positions until the economic picture becomes somewhat clearer. The market is weak, volumes are low, and I think we are very vulnerable to any additional systematic shocks.

An opposing view comes from David Kotok at Cumberland Advisors, who thinks now is a great time to buy. ”Stock’s aggregate value is well below one year’s GDP. This level is usually a strategic buying opportunity which is rare in history. We believe that the amount of stimulus in the federal pipeline in both monetary and fiscal form will encourage the 2009 forecast to become reality. Our asset allocation is 50% stocks and 50% bonds. Stocks are much lower than our normal range and bonds much higher. The wide credit spreads are the reason. In many jurisdictions the taxable equivalent yield of high grade tax-free municipal bonds is close to 10%. And that is based on present tax rates and does not include any estimate for higher tax rates in the future. Remember the higher the tax rates the greater the value of tax-free Munis. Inflation and debt loads will be an issue down the road. Investors who focus on them now are acting too far in advance of their arrival. In sum, the economic outlook seems bleak and foreboding. Stocks usually bottom when things appear to be only negative. Credit spreads are usually at their widest when that occurs. The sequence of restoration is usually credit markets first and then stocks.”

More along my thinking, David Rosenberg (aka Rosie) noted in his report last Sunday that the prior week’s pop was the eighth bear market rally since October 2007. These rallies have ranged in strength from ~8% to over 24%. Each one was treated "enthusiastically” as if a bottom had been made. Each one saw a subsequent lower low, excepting the most recent one that ended Friday.

These included:

The TAF (S&P 500 at 1500)
January 75 bp rate cut (1325)
The Bear Stearns deal in March (1270)
The fiscal package in April (1200)
The GSE conservatory in July (1200)
The TARP in October (1180)
Pre-election Rally (840)
The Citi bailout in November (750)
Rosenberg added late Sunday:

“This is now a five-day rally that has seen the S&P 500 surge 19%. Then again, we did see a 7-day rally tally up to 18.5% from late October to early November. And before that a 4-day rally in mid-October that netted equity traders an 8.5% spike. What is happening is that the bear market rallies are getting shorter and more flashy – but they are still bear market rallies. The ones we have seen thus far in this bear market have seen the S&P 500 rise nearly 10% and last 18 days on average. These are rallies, in our opinion, that investors should use as an opportunity to sell into.”

In my opinion, that’s good advice.

Retail comps for November were absolutely horrific in spite of the heavy discounting and relatively strong Black Friday results. Spending Pulse is reporting that electronics and appliance sales dropped 14%, luxury sales were up 2.4% (thank goodness for the rich), and ecommerce purchases rose 12%. Amongst the restaurants, only fast food saw an increase in traffic from November to September, according to RBC.

Com Score is reporting a 15% increase in online sales on Cyber Monday (the Monday after Thanksgiving), to $850 million, the second biggest online spending day ever. They also report that during the Christmas season to date, sales are down 2.2% from 2007. One thing to watch is that due to the late Thanksgiving this year, we have fewer shopping days between Thanksgiving and Christmas, which should add even more pressure to a very difficult retail period.

Holy cow, we’re in a recession!!!! For those of you who have listened to (or put up with) my blathering for a long time, you know that a year ago I said we had entered a recession. Well, I feel better now because the NBER, a distinguished group of economic types charged with determining when we officially enter and exit recessions, announced this week that we had indeed entered a recession-in December 2007!! I’m not exactly sure how many economists over at the NBER it takes to make this determination (too many) nor how much they are actually paid (too much), but if any of you know these folks, tell them I’d be happy to take on their recession dating duties for just 50% of their combined income. Don’t worry, using their most recent twelve months’ record as a bogey, I should still be able to write this letter and complete their job, leaving plenty of time for some fun. Who knows, I might even have time for a round of golf? One thing to note is that as of the day this recession was declared, it became the longest US recession since 1982.

Once again the economic reports this week were dreary, but the market seemed to shake that off and only posted a moderate loss for the week. The market even rallied Friday in spite of unemployment numbers that were the worst since 1974 (anyone remember that bear market?), adding 533K unemployed to the rolls (see chart below). Are we finally at a point where the market has discounted most of this bad news? Could be, or it could be that now that we are officially in a recession, the question the market wants answered isn’t how bad is the economic news (BTW-it’s bad), but when will it start getting better? The market will typically bottom well before a recession officially ends, and according to some market prognosticators, it typically bottoms when the official determination is made. That’s probably why the NBER guys wait so long to identify this as a recession, they wanted to give a signal to investors, much like Sherriff Brody to the good people of Amity, to let them know when it’s safe to go back into the water.

My good friends at ISI correctly called the last recession but were a bit late in recognizing this one. Now they are targeting an end to this recession in July 2009. Their assumptions include what they term “the very optimistic assumption credit markets unfreeze and auto production comes back on line”. I can certainly see a return to economic growth in the third quarter of next year (not a prediction, just recognizing we’ll have easy comps by then), but in my view those assumptions are more than a bit optimistic. Credit thawing by the middle of next year isn’t a certainty, but should at least be starting. The Libor-OIS spread has contracted significantly (see chart below) since we last looked at it in October. Remember that this shows banks confidence in lending to each other, one of the first key steps in getting banks back into the banking business of creating credit.

The second ISI assumption, getting auto production ramping, doesn’t have a chance of happening by the middle of 2009. Congress will eventually give the Big 3 their requested capital after some political grandstanding, however, demand isn’t going to come roaring back for autos when we are losing jobs at a faster rate than at anytime in modern history. People can’t afford to buy new cars, I don’t think the credit will be available, and the product offerings from the Big 3 still aren’t up to snuff (Ford being the possible exception).

Capitalism without Bankruptcy is Like Christianity without Hell
That quote came from Frank Borman, the former CEO of Eastern Airlines, experts in bankruptcy filings. Speaking of bankruptcy, Pilgrim’s Pride, the top chicken producer in the US, filed Chapter 11 due to rising grain costs and a poultry surplus. Their plan is to restructure and reduce both production capacity and debt in the face of a rapid decline in market prices. Chicken breast prices have dropped 16% this year while legs have dropped 25% (to maintain my “E” for everyone rating, I regretfully choose not to make any type of joke here-feel free to fill in your own). Corn is the primary feed stock for chickens, and prices rose 66% in the first half of 2008, primarily due to demand for food, livestock feed and ethanol. CEO Clint Rivers said “the federal government has helped spark a growing worldwide food crisis by mandating corn-based ethanol production at the expense of affordable food”. I agree, however, the noteworthy CEO neglects to place any blame on himself for spending over $1.1 billion acquiring Gold Kist, an Atlanta based competitor, in 2007 and shooting their debt load up to $2.7 billion. The timing of that purchase, when chicken prices were soaring, is akin to buying a house in Las Vegas in last 2006.

The Fed
Treasury yields (10 year notes) dropped to 2.5%, the lowest level in over 50 years. The driver of this bond market strength is a combination of flight to safety and anticipation of continued weak economic growth. According to Barron’s, the cost of five year credit-default swamps on US Treasury debt is now 65bps, up 15bps in the past week and 34bps in the past month. That doesn’t say much for expectations for the health of the US economy or stability of the dollar.

Speaking of the dollar, I think it makes sense to consider gold as an investment vehicle over the longer term. I have mentioned my view that once we get through this period of economic weakness, sometime in 2010 or 2011, we could experience the beginning of a giant inflationary period which will further debase the dollar. Allowing the dollar to collapse might actually be a smart strategy to pay down the enormous debt levels we have taken on at the federal level, using cheaper dollars. The impact could be a huge run in gold. Below I show a Bloomberg chart which ties gold prices to M2.

US mortgage delinquencies jumped to almost 7% last month while 3% of homes are actually in foreclosure. Bloomberg is reporting that 10% of Americans are now behind on their mortgage payments or were in foreclosure, the highest level since the survey began 29 years ago. Home resales dropped and prices declined the most on record in October, down 11.3. The Fed is coming to the rescue, and wants to buy delinquent mortgages and provide bigger incentives to banks for refinancing loans. These comments by the Fed drove mortgage rates down towards 5% for a 30 year fixed loan.

Personally, I feel that if the Fed wants to stimulate the economy and stabilize the housing market, they should create a program which cuts the mortgage rates on existing mortgages which are current in their payments. If you cut the rate or modify a mortgage for a delinquent homeowner, chances are the savings are only going to allow him to maintain his home. If you cut the rate for a borrower who is current on his payment, then you put more money in that person’s pocket, which he/she could presumably spend on consumable goods. A 1% cut on a $250,000 mortgage would save the homeowner roughly $150 per month. There could be complaints from investors owning these mortgages, however, if the Fed provides some type of guarantee on these loans, the market value could actually rise and the investor would be able to improve his position as well.

According to Market Rate Watch, mortgage rates nationwide for 30 year fixed loans are 5.5%, yet 5/1 arm are now being priced at 5.77%. My how times have changed.

Lehman part 1,000
If you don’t think that Lehman’s collapse had an impact on lending costs, look at the graphic below. Virtually the day Lehman went under, A1 rated commercial paper in Japan spiked by almost 180bps.

What Did You Say?
Today’s WDYS article comes from Barry Ritholz. He cited this clever funding idea, via former Treasury undersecretary (now at BlackRock) Peter Fisher: Issue 100-year bonds.

“If you issued a 100-year bond and had principal and interest pay down smoothly over the last 50 years, you create a great borrowing device for the Treasury that would let us move this hump of borrowing over the generational retirement that’s coming up,” Fisher, managing director and co-head of fixed income at BlackRock in New York, said in a Bloomberg Radio interview. That’s right — the idiot who eliminated the 30 year bond, just as the US entered its most irresponsible deficit creating spending spree in history, is now proposing the 100 year bond!

Six months ago, with gasoline prices pushing towards $5 per gallon, owning an SUV looked like one of the worst moves in consumer decision making since buying a Betamax. Last week I discussed the impact of lower oil prices and how it could benefit the consumer. In spite of my thoughts of the Big 3, lower oil and gasoline prices could also help SUV sales once again (assuming the freeze in consumer spending ever thaws). The quote of the week comes from a friend who is a very practical type. He told me that “at $4.50 per gallon, this thing (his SUV) was on its way out, but at $1.90 per gallon, I don’t care”.

A local proprietor and heavy consumer of lubricants was kind enough to share with me a letter sent by the President of one of his suppliers, North American Lubricants. In the letter, the President was explaining to his customers why they had experienced “severe and rapid increases” in lubricant prices when oil was screaming towards $150 per barrel, yet they haven’t yet seen immediate reductions in motor oil pricing as oil has cascaded back to $41 per barrel. The letter was definitely creative, discussing how “Force Majeure was declared on many supply contracts, as demand far out-stretched supply”. What? Supply is far larger than demand, that’s why the price of oil has dropped 72% since July. He should have been working for the Clinton spin team or at least at NBER. This guy is good.

Commercial Real Estate
Commercial real estate is feared to be the next big shoe to drop in the credit world. Rates have spiked, defaults are up, and transactions are grinding to a halt. Vacancies are skyrocketing as corporate America scales back to meet the ever decreasing economic activity. Almost 16 million square feet of office space is currently listed as available in large blocks in 68 office buildings in Manhattan, according to Colliers ABR, a commercial brokerage firm. That is nearly double the space available a year ago, both in terms of the number of large office blocks — which in New York usually means 100,000 square feet or more — and in terms of total square feet.

Pension Funds
A recent Mercer Report shows that US corporate pension plans saw their funded status fall by more than $130bln in November. Also, according to Credit Suisse (via this weekend’s Barron’s) S&P 500 pensions face a deficit of at least $200 billion. Big shortfalls will require additional contributions at a time when corporations in aggregate are facing a cash crunch. As a result of the way pensions are accounted for, the earnings impact could be even greater than the cash costs. Overall this should have a negative impact on S&P earnings for 2009.

State of Emergency
The municipal bond market has been battered as tax receipts have collapsed. California, who has a tax base very reliant upon capital gains taxes, just declared a state of emergency as they are running out of funds. This state of emergency means they can issue IOUs instead of paying vendors, contractors and employees. Wonder if you can buy food with those IOUs? Municipal bond yields are skyrocketing, with pricing predicting record default rates. This could be a nice buying opportunity for those in a taxable position. Just make sure to avoid project specific notes and focus more on general obligation bonds.

More from Ritholz

Barry was definitely on a roll this week.

“We interrupt the GM hearings for this brief moment of schadenfreude:

Harvard’s endowment has now blown through over $8 Billion, or 22% in the last four months. Correct me if I am wrong, but wasn’t Harvard’s endowment outperforming the broad indices for a long time? And didn’t their Board of Trustees fire/replace/chase away these outperforming managers because they were getting paid too much?

Let’s see, if this adds up:

Savings on fund management staff: $50 million

Losses on endowment fund: $8 billion and counting

Finding out the supposedly smartest college in the nation is run by idiots: Priceless.

Quote of the Week
The White Rabbit stood perfectly still with a million mile gaze. Finally he broke his silence. “When everyone agrees, no one is thinking.”

Closing Comments
I appreciate all the feedback. I am trying to keep this relevant, and appreciate everyone offering up suggestions and providing information flow in an effort to improve this note each week.

My favorite feedback came from an institutional broker and good friend, who told me he liked my “simple writing and that I didn’t use a lot of $3 words like other writers who, when you read their work you can tell how smart they are.” I’m sure that was meant as a compliment J , at least that’s how I’m going to view it.

Have a great week and as always, if you’d like to be removed from the list or if you have someone who’d like to be added, please let me know.


Ned W. Brines

0 (562) 430-3232

Nov 30, 2008

November 30, 2008

This week I eliminated the “funny” subject line since last week’s piece ended up being caught by many of your spam filters. I guess a note entitled “When I grow up I want to be a pirate” isn’t recognized by the spam filter for the economic importance of the subject matter and instead focuses on the bad joke potential.

Weekly percentage performance for the major averages
Based on last Friday's official settlement...

INDU: +9.75%
SPX: +12%
NDX: +9.2%
COMPQ: +10.7%
RUT: +16.3%

The Market
The S&P 500 was up 19% including the prior Friday, the best 5 day rally since 1933. In earlier notes I commented that the market risk is to the upside, and last week we saw exactly how that risky a short position in this market could be. The esteemed Barton Biggs, formerly of Morgan Stanley and now Traxis Partners, agrees that we could see a strong bear market rally, or as he put it “we are setting up for the mother of all bear market rallies.” As I’ve mentioned before, use market strength to take capital off the table, there will be plenty of opportunities to reinvest as the market traces out a bottom. Jeremy Grantham at GMO says that value investors are “paid to buy cheap assets and sell expensive assets” and that he feels the odds are “2:1 the market will be down a lot in ’09.”

If you are adding to stocks, focus on companies with solid balance sheets and self-funding business models. An area of focus might be companies benefitting from falling food and commodity prices. Historically, falling commodity prices have favored consumer related stocks. Although sales have been down at retail, restaurants, and even consumer staple companies, the later two have been benefiting from the downturn in commodity prices, helping to cushion the blow of slower sales.

It’s no surprise that market volatility has been spiking, however, Bespoke Investment group put out a chart last week showing the average daily change of the S&P500 over a 50 day average going back to 1928. You can see the results below, almost a 4% per day movement in the index!

The Economy
Data came in soft across the board, from Durable Goods Orders to home prices. Even so the market went up. Are expectations now so bad that even bad news is now getting a positive reaction? In my view, the answer is probably no. The market was oversold, having dropped a dramatic 49% since the middle of May and 43% since the beginning of September (see chart below), and was due for a rally.

This week we get ISM manufacturing data, domestic and total vehicle sales on Monday; Challenger Job Cuts, ADP Employment Change, nonfarm productivity, the ISM non-manufacturing composite, and unit labor costs on Wednesday; jobless claims, factory orders, and most importantly November same store sales comps on Thursday; and employment and consumer credit data on Friday.

The ECRI put out the chart below which shows their leading economic indicators (green) and coincident indicators (blue). Historically the leading economic indicators will turn positive just before the end of a recession (indicated by the gray shaded areas). We haven’t seen a turn yet, but will keep watching. The coincident indicators typically won’t turn towards a positive reading until the end of the recession.

The Fed
The Fed continued their drunken sailor on shore leave spending habits (no offense meant to you Naval folks), committing an additional $800 billion this week towards the mortgage and consumer debt markets. The first $600 billion is focused on GSE debt ($100 billion for Fannie Mae debt and $500 billion to the mortgage backed security market). The action looks like it had some effect as mortgage rates dropped nearly 50bps to 5.5% this week. The other $200 billion is focused on consumer and small bus loans. The goal of the plan is to encourage banks to begin lending again to both of these markets in an effort to stimulate the economy.

As we have discussed in the past, the Fed is trying to reflate the economy, which will help materials and energy, both of which have bounced hard since November 20th, although behind the returns of both the financial and consumer stocks.

Longer term, I feel the Fed’s actions are inflationary and will be hard on the dollar. Debasement of the dollar over the long term will favor gold. The strategy here is to be short inflation beneficiaries in the short to intermediate term, but long inflation beneficiaries in the longer term.

China just had its biggest rate cut in 11 years in response to their slowing economy. The Chinese PMI fell to 38.8 in November from 44.6 in October, the biggest decline on record. The economy appears to be deteriorating faster than expected by the nation’s top planning agency, a surprise to those who felt this combination of capitalism and a planned economy was a superior model immune to economic downturns. Export orders declined to 29 from 41 month over month (below 50 represents an economic contraction), and before the recent 11% rally, their stock market was down 72% YTD. JP Morgan thinks growth in Q4 may slow to 4%, far below the 11% many were expecting at the beginning of this year. Any way you slice it, China is slowing down right on schedule post their Olympic spending binge.

The New President
President-elect Obama continues to bring in war-tested economic advisors. He announced that Lawrence Summers, formerly the Treasury Secretary under President Clinton, would be returning to 1600 Pennsylvania Avenue as the White House Economic Director. More positively he named former Fed Chairman Paul Volcker as the head of a new White House panel to address the financial crisis-the President’s Economic Recovery Advisory Board. Volcker may be the last living central banker on the planet with a shred of credibility (street cred?), and hopefully his presence will be more than symbolic.

I’m not sure this represents the “change” Obama has been espousing, but, as he said last week “I’ll define what change is”. Sounds eerily similar to that famous quote from the last Democratic President “it depends on what the meaning of “it” is”. You have to love these guys for their ability to manipulate our language.

The Retail Environment
The markets have been anxiously awaiting Black Friday, that magical day after Thanksgiving when the Christmas shopping season officially begins. According to the National Retail Federation’s 2008 Black Friday survey, spending was up 7% over last year, reaching roughly $41 billion. Bargains were the main driver as discounting was very aggressive, which can’t help retail profitability. Somehow it seems like a Pyrrhic victory to announce strong sales, but not be able to profit from them due to the heavy promotional activity. It’s interesting to note that even with the huge discounts being offered by nearly all retailers, the discount stores still had the heaviest traffic. Online sales also look to have been very robust, although again amidst heavy discounting. The bottom line is that shoppers appear willing to spend, but the lure of a deal is more important this year due to the soft economy.

On a sad note, at a Long Island Wal-Mart, a worker was trampled to death as she opened the doors to the store. No discount is worth that tragedy.

The Oil Market
OPEC postponed their meeting on a second output cut, waiting until later in the month to gauge the impact of their first cut of 1.5 million barrels per day, or roughly 5% of their total output. The oil minster of Saudi Arabia feels that $75 is a “fair price” needed to support investment in new fields. While $75 may indeed be a fair price for a barrel of oil, the market doesn’t agree right now since that same barrel of oil fetches $53 (down from $147 in July). Personally, I enjoyed filling up my wife’s grocery getter yesterday for $2 a gallon and not having my credit card max out in the middle of the fill-up. In the last oil downturn, OPEC cut production multiple times, and it took over two years worth of cuts to get prices to stop falling.

The Ridiculous Market
A case of 1961 Chateau Latour sold for $170K over the weekend. My favorite quote from the auction: “you might as well buy something you’ll enjoy”. If they need any help enjoying that Latour, I’m happy to bring over the burgers!

Have a great week. As always, if you’d like to be removed from the list, or have anyone interested in being added, just let me know.


Ned W. Brines

(o) (562) 430-3232

Nov 24, 2008

When I Grow Up I Want To Be A Pirate!

Possibly the easiest money being made this year has been by pirates. I’m not talking about the Pittsburgh type, but the traditional puffy shirted, eye patch wearing, hook handed, sword bearing types roaming the high seas. Last week Somali pirates high jacked a Saudi oil tanker carrying 2 million barrels of oil. As I’ve commented in the past, oil prices are down nearly $100 per barrel since July, but still fetch an impressive $49 per barrel, putting the value of that cargo close to $100 million, not to mention the crew. The pirates are asking for a measly 25% commission, or $25 million, which is akin to the performance fees charged by some hedge funds. Some are now estimating that these pirates have amassed over $100 million in ransom payments since 1990. Now, $100 million over 18 years wouldn’t be enough to get most Harvard MBA’s interested, however, when you consider that the pirates probably pay no income or withholding taxes, have a relatively low overhead, have a great working environment near the ocean, and plenty of available labor with unemployment sky-rocketing around the world, this is a business which should see additional competitors over the next couple of years.

Weekly percentage performance for the major stock market indices
Based on last Friday's official settlement...

INDU: -5.4%
SPX: -8.0%
COMPQ: -8.5%
NDX: -7.9%
RUT: -11.0%

Looking at last week’s horrible performance is even more amazing when you consider the markets bounced 6% on Friday. Some are attributing this bounce to the Obama camp announcing Fed Governor Timothy Geithner as the new Treasury Secretary elect. If this is indeed true, let’s hope the President-elect has about 15 more cabinet candidates which the market deems as worthy as Mr. Geithner. I’m not sure Hilary as Secretary of State is worth 6%, but maybe 2%?

I know I’ll probably be heavily criticized for printing this because it is so obvious, however, for the benefit of some:

P +δ *CDS = R +δ * (100 − R)

I hope that settles that discussion once and for all!

Last week was another crazy week of economic data, with virtually all of it coming in negative. Rail volume, a great leading indicator for economic activity, is down 2% YTD. Coal and grain are up while autos are down 20%, forest (lumber) is down 12%, and metals are down 4%. I’ll keep watching for a turn here to help indicate that economic activity may be picking up.

Speaking of the economic indicators, they (the leading ones) came in at -.8% versus -.6%, and threw the market into more of a tailspin, if that’s possible. The leading indicators are supposed to be just that, and should turn positive (or less negative) some four-six months before the economy turns. Many experts have been suggesting we are at or near the market bottom, and that the market should bounce in anticipation of an economic recovery beginning in the spring of 2009. The LEI report threw some cold water on the timing of that economic recovery.

Other reports during the week included the empire manufacturing index coming in at an all time low, with capital expenditures, one of the drivers of the economy until early 2008, falling significantly. CPI and PPI both registered their largest drops since the 40’s. First-time claims for U.S. unemployment insurance rose to the highest level since September 2001. The total number of people on unemployment benefit rolls jumped to the highest level since 1983. Housing starts fell to 791,000, off 38% from a year ago. That’s the slowest pace of starts since data began being compiled in 1959. Starts are now down 65% from the early 2006 peak — this has become the very worst housing downturn on record.

This week’s scorecard:

Prior Period

Existing Home Sales
5.0 mil

5.2 mil

GDP QoQ (revised)


Consumer Confidence


Durable Goods Orders


Personal Income


Personal Spending


UoM Confidence


Initial Jobless Claims


Michael Donnelly “the good side of a recession is that we get price re-alignment”. Look at prices finally coming in, and the drop in crude (which should keep improving).

The market continued to be pounded this week. The list of new market highs, lows, and extreme readings is so long that I’m becoming numb to them. There were, however, a couple that caught my eye, with two of my favorites from Michael Santoli at Barron’s: 1) this is shaping up to be the markets worst year since 1872, and 2) according to BBH’s Andrew Burkley the current bear market is 284 days old, and down as much as both the 1929-’32 and ’37-‘38 bear markets over the same number of days. The ‘29-‘32 went on to lose 86%, while the ‘37-‘38 bounced 50% over the next six months before rolling over again. That’s comforting.

According to Marketwatch, from the October 2007 high of 1,565 to yesterday’s close of 800, the S&P 500 market capitalization lost $6.69 trillion. That’s almost $1 trillion more than entire 2000-03 bear market losses of $5.76 trillion. That is some real wealth destruction which won’t be coming back soon.

I stole this table from my good friend Scott Chronert at Citigroup in San Francisco. The table shows the performance of the Russell 2000 Small Cap index by sectors for both the ’99-’03 period and the ’07-’08 period. As you can see, the selling has been very thorough, taking down every group significantly. Looking at the energy sector makes me shake my head at the energy converts who were claiming that “this time is different” and that energy wasn’t another “internet bubble because the companies have real earnings and demand behind them”.


Consumer Disc

Consumer Staples









R2 Index

source: RUT, Factset

It seems to me that anyone interested in the market is now spending a lot of time trying to figure out exactly where and when we might see a bottom. I have been maintaining that the market is currently in the process of forming a bottom, but that we will probably find the major indices at comparable levels 12-18 months from now. I also think we will see a very serious rally sometime in the next few months, similar to the 1937 rally of 55% (from 8.50 to 13.40), which then proceeded to give back another 25% before settling into a long downtrend that bottomed at 7.50 in mid 1941. I continue to feel any strong rallies should be opportunities to lighten up on stocks, and weakness should be a time to build positions in strong, reliable companies with strong cash flows and no need for Wall Street capital over the next few years.

Merrill Lynch (aka Bank of America) has created its own matrix for finding a market bottom, and I have reprinted it below. Their conclusion is that we are getting closer, but not quite there.

The chart below shows the Dow this year versus 1929. Not that it matters, but can you guess which is which?

Contrarian Signal of the Week
According to a Merrill survey, 87% of fund managers say a recession is here to stay for the coming year. I agree, but this is the same survey that at June 30 showed only 24% of fund managers thought we would be heading into a recession. If these guys are now agreeing with me, I really need to thoroughly reexamine my positions.

The National Association for Business Economics survey shows 96% of respondents think we are in a recession versus 50% a year ago, when I thought we entered the recession.

Citigroup has taken its share of lumps and criticisms this year, however, the past few weeks have been horrendous for the stock, which was over $30 a year ago and closed Friday at $3.77. Earnings have been collapsing faster than John McCain’s poll ratings in October. Today (Sunday), the government agreed to protect $306 billion of loans and securities on Citigroup’s books against losses. They say that this is primarily to shore up confidence in the bank for their partners and customers. The boys (and girls) at the Treasury and Fed must have been bored after nearly four weeks of not working on a weekend long emergency. I find it interesting that this bailout happened during the weekend with the fewest top 10 college football teams in action this entire season.

Bloomberg has reported that the US government is now on the hook for $7.4 trillion, which is ½ of total production in the US last year. This calculation includes $2.4 trillion in commercial paper and $1.4 trillion from the FDIC for bank-bank loans. For comparison, the S&L bailout in the 1990’s cost $210 billion (inflation adjusted). The good book says that the children will pay for the sins of the parent, and I’m sorry William, Megan and Matthew, you’ll be paying for this your whole lives.

Last week I discussed the weak retail sales environment. According to Bloomberg, average same store sales comps were down 4.2% in October. Department stores were down almost 12%, drug and discount stores were up 2.5%, clothing down 3%, and restaurants up 2% (carried by McDonald’s, up 8%). Retailers are continuing to panic as foot traffic has been running soft and this year’s calendar results in fewer shopping days between Thanksgiving and Christmas versus the prior two years. Anecdotally, I have been surveying foot traffic and speaking to store managers, and all are extremely concerned about the upcoming holiday season (which might mean expectations are getting so low they could be easy to exceed). Today I went to the Long Beach Town Center, a big box retail center featuring a Sam’s Club, Wal-Mart, Lowes, Sports Chalet, movie theaters, and assorted other retailers. The place was absolutely packed, although it seemed the bulk of traffic was headed towards Sam’s and Wal-Mart to prepare for Thanksgiving. I intend to follow up this weekend, and will let you know if I see any changes.

Bear Markets
Not sure I need to add more to this chart.

Last Comment
I can imagine Henry Paulson using this quote in Congressional testimony when asked why he gave away over $7 trillion. “Try to imagine all life as you know it stopping instantaneously and every molecule in your body exploding at the speed of light.” Egon Spengler.

Please have a great Thanksgiving. As always, if you wish to be dropped from this list, just let me know.


Ned W. Brines

0 (562) 430-3232

Nov 16, 2008

We Are All Japanese Now

November 16, 2008

The comparisons to Japan have been rampant over the past few weeks as we continue to bailout banks and potentially other moribund industries. TARP-the government plan to bailout the mortgage business, has spent roughly $290bil of the initial $700bil on presumably helping banks deal with their mortgage portfolio problems. I say presumably because the Fed is refusing to let Congress know exactly where our tax dollars are being spent. One place we know they are going is to AIG, which asked for (and received) an increase in their bailout and much easier terms. Treasury Secretary Paulson now wants to turn TARP into his own vulture fund, investing wherever he sees the need. Stay tuned.

Speaking of Japan, they announced this evening they entered their first recession since 2001, with GDP dropping 0.4%. Japan, the world’s second largest economy, is struggling as a result of the global slowdown. Some Japanese economists are describing this as their worst recession since the early 90’s debacle. Hong Kong also said they have fallen into recession. So much for decoupling.

Weekly performance for the major market indices
Based on last Friday's official settlement...

INDU: -5.0%
SPX: -6.1%
NDX: -7.1%
COMPQ: -7.9%
RUT: -9.6%

Credit Markets

The Libor-OIS spread, which I have discussed numerous times, continues to drop, indicating an improving lending outlook between the banks. The spread is still high by historical standards, 160ps versus a 5 year average of 11bps, and double that of the pre-Lehman Brothers bankruptcy level of 87bps, but well below the peak of 360bps in early October.

While many feel that the stock market is getting “cheap”, it appears that real value is beginning to appear in the credit markets. I have had a number of meetings recently with investors whom I have a lot of respect, and almost all have mentioned the value in moving up the capital structure because of the extraordinary yields secured both by assets and (relatively) safe cash flows coverage. The level of fear can be seen in the chart below, which is the JPM High Yield spread over treasuries. The spread today, 776bps, is near the peak levels we saw in late 2002 and equal to those right after 9/11. High yields alone don’t make an investment a good one, however, the spreads certainly suggest there is plenty of fear priced into the markets, and maybe somewhere some of it is irrational (to borrow a quote from my least favorite former central banker AKA The Bubble King).

The Big Three

Last week we discussed GM coming hat in hand to the government seeking capital assistance. Rick Wagoner, GM’s CEO, is seeking help from the government. He figures that since any financial services company can get help, unless you were Lehman Brothers, then GM and its 200K+ employees deserve the same. The problem is that the current administration doesn’t seem to be interested in bailing out a poorly run manufacturing company burdened with excessive labor costs (see below), especially when those same employees were so instrumental in electing the opposition party. If Wagoner can hold out a few months, he might find a more receptive ear from the President-elect his unions were so helpful in electing. For those who were concerned that the President-elect would be a socialist, rest assured there is no cause for such concern even though he proclaimed this week that we need a “Czar to oversee the auto companies”. I’m sure that’s just more election rhetoric.

The Big Three (Ford, Chrysler and GM) are facing a plethora of problems, but two key problems are that they are making cars that no one seems to want (see SAAR sales below) and their labor costs dwarf those of their competitors (see chart below). I’d be surprised if any bailout occurs without significant concessions by the unions. The SAAR total measures the total sales of autos and trucks manufactured in North America. In October sales dropped 32%, with Toyota and Honda gaining share by posting 20% declines. GM was down 45% in the same period, Ford 30% and Chrysler 35%. This was the 12th straight month of declines, the longest US slide in 17 years.

Ultimate Sacrifice

Cerberus Capital Management, considered very shrewd investors, acquired Chrysler from Daimler Benz for $7 billion and the assumption of at least $13 billion in debt. In a selfless demonstration of patriotism, Cerberus management announced that if Chrysler received a government bailout or if the company was acquired using government money, Cerberus would forgo any profits. What???!!! I find it difficult to believe that there are any profits left for a company whose sales are down by 50% since being acquired. Paraphrasing Rob Reiner’s mother “I’ll have whatever those guys are having”.


Retail sales for October came in at -2.8%, the worst result since this measure began in 1992. Circuit City finally threw in the towel, filing for bankruptcy and Best Buy management said they saw a “seismic” slowdown in spending. It must be exceptionally bad for a management team to use that type of language to describe the current environment. Pre-Christmas sales on all good are pouring in, however, personally I’m waiting until after the holiday to pick the retail carcasses clean (OK, not really, but I thought that sounded good). Christmas expectations are so poor right now that it may not take a lot to give the market a bit of a bump, even though it should be temporary. Heavy discounting now means that post-Christmas sales will be enormous, and in many cases will be liquidation sales. Hold off on buying that new plasma, you may get paid to take it in January.

Unemployment claims hit 516K last week, and we are just starting to see major layoffs. Unemployment is going to continue rising for the foreseeable future.

This week look for the following economic reports: industrial production, capacity utilization, PPI, lots of housing, building and mortgage data, CPI, Philadelphia Fed survey, and the leading economic indicators. Volatility this week should remain high as these key reports are released.


Thanksgiving is coming, and that means tax loss selling. This year should be interesting as retail investors and institutional investors with December 31 tax years try to clear the decks of their 2008 losers. This could add a bit of additional selling pressure through the end of this month, however, we could see a touch of buying into year end if people are trying to reestablish their positions after the requisite 30 day waiting period. This is the time of year when we typically see the tax-loss selling candidate lists from the major brokerages. There aren’t any major brokerages left, and with 482 stocks in the S&P 500 down for the year, any lists that do come out are going to be long. I’ll show you the 18 winners-if you want to recognize some tax losses, sell anything else (just kidding):


It’s notable that the US education system focuses on the three R’s, however, this latest financial crisis should prove that basic finance should be a staple of our education system. We teach kids some basic tools, then throw them out into the world with a bunch of one-liners (such as “buy and hold”) to manage their personal finances. Last week I saw this headline in Opalesque, a hedge fund newsletter: Headline: “Man buys $11 hammer, uses it to break into store to steal $9 bottle of wine”. I think this proves my point.

Last Comments

I have a few final comments for this week:

Cash is king- both consumers and corporations with cash are going to find bargains galore. For companies with cash, acquisitions and market share gains will be their reward for conservative stewardship of shareholder capital. For consumers with cash, the next few years will create opportunities to acquire assets that will create long term value.
This past week we retested the lows on the major indices, and haven’t broken through to new lows. The technicians (those are the guys analyzing the charts) think we could be forming a bottom in the market. I still think the upcoming declines in earnings due to the weakening economy will keep pressure on the market, however, I think there is “risk to the upside”. Risk to the upside means that shorts and people out of the market risk missing a major bear market rally, which could be a 20-40% move. As I’ve mentioned in the past, if we see one of these moves, use the opportunity to lighten up on your exposure.
S&P operating earnings have peaked and should continue to fall. Earnings estimates for 2009 are too high, and will have to come in. The market looks cheap on 2009 estimates, but they are too high because margins are still estimated too high. Margins drop in a recession!
The new administration needs to keep in mind “When banks fall on Wall Street, they stop all traffic on Main Street”.
Last night my wife and I attended the annual HomeWord benefit dinner. I’m not sure how the fundraising went, but the program was phenomenal and I encourage any of you who are married or married with children to utilize the resources on their website ( Like all non-profits, their fundraising is down this year, so if you’re looking for a place to send all those extra dollars, give them some consideration.
I want to give a special thanks to the team at Bloomberg who have been so kind to allow me to use their data feeds to create this letter. Any chart or table you see with a black background is sourced from Bloomberg.

As I close tonight Asian markets are mixed.

As always, if you would like to be removed from the list, please let me know. I appreciate everyone’s feedback and criticisms, and am trying to keep this a relevant and quick read.

Have a great week.


office (562) 430-3232