Oct 26, 2008

The Week Ended October 26, 2008

October 26, 2008

I’m feeling a ton of pressure today. Not because of the market, but because of something my friend Jeff Bronchik (pictured below), the esteemed CIO of Reed Connor Birdwell, said to me this week. I told him I would be sending this note out on a weekly basis, but only if I had something of value to say. Jeff, never one to pull a punch, said I’d be hard pressed to find something valuable to say on a monthly basis-I’m feeling pressure because he may be right. We all know Jeff is a great value investor, so I won’t question his determination of what is valuable, but come on buddy, this email is free! I’ll still try my best. Thanks for the support Jeff.

The Market

Based on last Friday's official settlement the major indices finished the week as follows:

INDU -5.4%
SPX -6.75%
NDX -8.2%
COMPQ -9.3%
RUT -10.5%

This market just keeps on giving. Despite assurances and threats from Congress and soon to be president Obama that the evil-doers on Wall Street are no longer allowed to earn anything above minimum wage, Bank of America is contemplating giving retention bonuses to the 15K Merrill Lynch brokers they just acquired. My back of the envelope calculation suggests they could be paying an additional $6-8 billion over a seven year period on top of the $50 billion initial price tag! I don’t even want to try and figure out how much of that is coming from the funds being provided by that same Congress, but the irony is thick.

Since I’m on the topic of Congress, I’d also like to mention Social Security. I think we can all agree that the only way SS can remain self-funding is for the population to continue expanding at a geometric rate-which isn’t happening in the US right now. What is a Congress to do? They’ve promised Americans (actually it was FDR who made the promise) a security net for old age, yet the funding is drying up because people aren’t making as many babies. While there are many proposals to fix the problem, including more propagating, my suggestion is not to take a page from Argentina, which earlier in the week decided to nationalize their nation’s private pension plans. I’m sure our Congress has contemplated this as part of the sweeping reform in which they are nationalizing banking, insurance, and eventually health care. What would happen to the pension recipients of the major corporations? First of all, they’re evil because they’re greedy enough to want their money back, with a return no less! Second, Congress didn’t promise them a safety net beyond social security, and after all we know that Congress would never break a promise. Third, quoting President Obama, it’s “time to spread the wealth”. This should be interesting to watch as we enter the Obama-Pelosi-Reid era of wealth redistribution. Welcome to France!

The Week’s Events

The coming week is full of economic releases, many of which are the first measures to be released since the credit markets effectively froze and the economy ground to a halt. This week look for home sale data, consumer confidence, durable goods, third quarter GDP, the University of Michigan Sentiment Indicator, and a Federal Reserve meeting (Tuesday and Wednesday). If you look at the table below, you can see that the market is anticipating a 50bps (1/2%) cut in the fed funds target rate to 1.0%. If we don’t get a cut, the markets could be disappointed. Of course, if we do get the cut, they could also be disappointed. Why? Because up to this point the market has had a major information advantage over the Fed, who seems to think the economy isn’t in a recession. A rate cut could signal that the Fed now realizes the obvious, and thus the dumb money is finally on board, a signal the economy is even worse than anyone might have imagined.


This past week earnings reports came in like a fire hose, and in general the market didn’t like what it heard. CEO’s were discussing slowing demand, an unclear outlook, and tight credit impacting their business. As bad as things have been on Wall Street and in the real estate market, the real economy has been sluggish but not yet in crisis. While we may or may not see an economic crisis, earnings are going to be impacted by this recession, and we are just starting to see estimates being cut. Jeremy Grantham thinks that S&P earnings could fall from the year end 2009 estimate of $95 to $60! That would suggest the market, which is priced at a meager 9x the current 2009 estimate, could actually be trading at 14.5x the lower number. While this market is beginning to look cheap, selectivity is still the key to investing profits.

The Crisis

The financial crisis is still going strong, although it appears the money markets are beginning to loosen some. The chart below shows the LIBOR-OIS spread, which has eased recently. Without getting too technical, this means capital availability and cost for banks to borrow from each other has improved. Could this be a first step towards improved credit conditions? I think so, but in an interview with Barron’s this weekend, Anna Schwartz (a co-author with famed economist Milton Freidman of “A Monetary History of the United States”) stated “Few who deal in the derivatives market have a clear notion of their responsibilities. We have a bewildering array of instruments with uncertain prices. And as a result, we don’t know who is solvent and who’s not. The problem comes from a lack of ability to price the instruments, not a lack of liquidity.” So while we may be taking a first step, it appears to be a very small one at the beginning of a very long road.


Speaking of liquidity, is anyone even considering the inflationary impact of the stimulus being created? Remember, the US has been off the gold standard for over 30 years, so we can freely print dollars to meet our financial obligations. My guess is that will be the only way we are able to pay for the trillions of dollars in bailout obligations being created by Paulson, Bernanke and Congress. Below you can see the quarterly rate of growth of M2 since 1968. Note the big spikes in early 1975 and September 2001. Both preceded large run-ups in inflation, oil, and corresponding drops in the dollar. What you don’t see on this chart are the October 2008 figures, which have jumped even higher than September. Eventually this will play out as higher inflation.


Most of you know I have been bearish on oil since very early 2008. It took six months of oil prices spiking to make me look dumber than normal, but after oil peaked at $147, it has now dropped by more than half to $64 per barrel. Even OPEC announcing a production cut late last week couldn’t prevent oil from continuing its slide. Historically, OPEC cuts have been made in reaction to declines in demand and have had very little success in supporting the price. In this case, the demand destruction has been significant as a result of the slowing global economy. The upside? Trilby Lundberg’s survey of 7K gas stations shows the average for a gallon of gasoline has fallen to $2.78, down $.88 in the past month. This could provide a bit of assistance to consumers facing continued increases in food costs while watching their retirement accounts and home equity shrink. A typical two-car family using a tank of gasoline per week per vehicle could be saving between $150 and $200 per month in fuel costs.

I don’t know if this week’s note meets Jeff’s “value” requirement or not, but I hope you find it helpful.

As always, let me know if you’d like to be removed from the list. Also, if you have any topics you’d like me to explore, I’d be happy to take a look.

Have a great week.


Oct 19, 2008

I hope you are well

October 19, 2008

Lot’s of crazy stuff going on during the past week. Following on the heels of the worst week in most of our lifetimes, this past week provided some relief as Monday opened with an upward explosion, the biggest up day in the market since the great depression (up 12%). There were quite a few possible catalysts, however, in my view the most important event was the government bailout plan getting the “tweak” I had been saying was needed for quite some time. Investing $250 billion along side the banks will provide up to $2.5 trillion in additional lending capacity, without requiring the banks to rely on each other. In my view this is going to help thaw the credit markets much faster than a nebulous plan to buy bad loans from the banks.

We are certainly not out of the woods, especially given the economic backdrop, which continues to deteriorate. The market apparently agrees because following Monday’s amazing performance, we also saw the market drop 9% on Wednesday, the biggest one day drop since October 1987. Even Ben Bernanke and Treasury Secretary Paulson now agree we are entering a recession! It must be nice to live in an ivory tower and not have to worry about sky-rocketing living costs, exploding unemployment, 401(K)’s turning into 101 (K)’s, a rapidly rising tax bill (for those still drawing paychecks), and all around economic malaise. Tell your kids to go to work for the government, evidently life there is always great no matter what is happening in the real world. I was a bit amazed to see that according to Merrill Lynch, 80% (+) of money managers now believe we are in recession versus about 25% in June. I understand the government types either missing or glossing over the economy, but these managers should be ashamed of themselves. The signs of recession have been in place since early/mid 2006. Maybe now that they are all getting negative we should start putting money back to work in the market (see Buffet comments below)?

Back here on earth there are some disturbing macro items I want to highlight. The first is the University of Michigan Survey of Consumer Confidence (chart below), which just slipped to a 30 year low last seen in early 1980. This measure appears to have peaked most recently at the end of 2006. This measure is typically tied to the employment outlook, but I think it is worth noting that during two prior lows (1990 and 2002) it only took an invasion of Iraq to turn this measure around. Would an attack of Iran suffice? How about Seattle? I’d say Sacramento, but a certain action hero occupies that town and I’m afraid we might get terminated.

From late 2005 to the middle of this year the Baltic Dry Index (chart below) went from one of those measures very few people followed to a momentum investor’s dream. This index measures the carriage rates of various sizes of ships, and during the great commodity and grain bull market this index spiked to all time records. As with most commodity goods and services, pricing has rolled over significantly as demand has ebbed in the global economic slowdown. Obviously this rapid decline in demand is taking its toll on the BDI, right in front of record ship deliveries (amazing how that tends to happen), the orders of which were placed while capacity utilization was at an all time high. Wonder if we’ll start seeing cancellations? I recently attended a dinner where a very young portfolio manager (see Merrill survey referenced above) was postulating about a certain ship building company who should be a great investment because of the large backlog of ships on their books. Hmm.

Look at the ISM below (or look out below)! The ISM has collapsed into recession territory, and based on prior drops it looks like it has quite a way to go. The ISM is a monthly measure of changes in production versus the prior month, and is one of the longest series of economic data in existence (since 1948). Tomorrow the Leading Economic Indicators are release (7:00 AM PST), and the street is looking for a decline of 0.1%. I’d be surprised if that was the extent of the decline coming on the heels of a 0.5% decline in August and a 0.7% decline in July.

Housing starts and building permits have collapsed since peaking near the end of 2005. If you haven’t looked at this yet, it’s obvious that while Congress, the Fed, the Administration, and many others never saw the housing downturn coming, someone must have seen it. Look at how the permits drop like a rock, from 2.3mil in September 2005 to 780K last month-almost in line with January 1991. If you remember much about that housing shock, we didn’t see the housing market begin to show real life until almost five years later. I’d argue this bubble was much bigger than that of the late 80’s and housing has quite a ways to go before it hits bottom, and even longer before it makes any meaningful upward movement again.

I showed this chart last week, but thought it was worth including again. This is the S&P 500 going back to 1928. The bottom chart is a bit more expanded than the last one I sent, and shows the monthly values of the RSI. Last Friday the RSI bottom out around 23, slightly below the lows of 1932 and 2002, but slightly above the low of 1974. Could this be a bottom indicator?

As I mentioned last week, after such a dramatic market collapse, we are probably due for a pretty healthy rally. Given the shaky economy, I would use the rally as an opportunity to take money off the table. Under any circumstance I’d be focused on upgrading the quality of my holdings. Stable, defensive companies with solid balance sheets, sustained margins being helped by collapsing commodity prices, and rock solid dividends make sense in this environment. High quality has outperformed low quality all year, and should continue to do so until we get closer to the end of the tunnel. Buffet is buying, citing the fear on the street as a sign it’s time to buy. I don’t like to try and outguess the Great One, but I still believe we’ll be seeing these market levels a couple more times before we finally say goodbye to the S&P in triple digits.

As I finish this note, the Nikkei is up 1.6% and the Hang Seng up 2.9%.

Have a great week. As always, if you’d like to be removed from this list, let me know.


Oct 12, 2008

October 12, 2008

Hi Everyone

These data points come courtesy of Ritholz (again), who is becoming my favorite guy to plagiarize, err, let me say quote. The guy really does come up with great stuff. Check out the dates on the RSI bottoms-1929, 1973, 2002 and 2008!!

I apologize for not getting this out sooner, but I was a bit swamped over the weekend. I have had the discussion with many of you that a “sellable rally” was coming soon. For those of you I haven’t spoken with, I think this is going to be one doozy of a sucker’s rally-a good chance to lighten up on some equity positions before the impact of a long recession sets in. The market was definitely in a classic oversold condition. Hopefully between Friday and today the market hasn’t finished its run.

As always, let me know if you’d rather not see these notes and I’ll drop you from the list. Believe me, you won’t hurt my feelings.


Relative Strength Indicator, SPX, 1928-2008

Ever since the beginning of the S&P500, the RSI's monthly indicator has only dropped below 30 on four occasions: 1929, 1973, 2002, and 2008.

All 3 prior instances were very close to lows.

Dow Components and the 200 Day Moving Average

All 30 Dow stocks are below their 200 day moving average -- a condition that has only occurred once before -- and the last time was right after the 1987 crash.

Percentage NYSE over 200 Day MA

The percentage of stocks trading over their 200 day moving average is at multi year lows:

Yet another historically excellent entry point.

Gold vs SPX

The cost of an ounce of Gold is now greater than the S&P500; This last occurred in the early phase of the 1982-2000 bull market -- around 1984.

The VIX (also known as the Fear Index) hit a multi-year high of 70.90, reflecting extreme levels of emotion in the markets. We like to look at this on a 50 day moving average

VIX Deviation From 50-Day Moving Average

Readings above 15 over the last 10 years have produced significant rallies. The present reading on this indicator is 26!

1998 Reading Market Up + 27 % (3 Months Later) and + 36 % (6 Months Later)
2001 Reading Market Up + 22 % (3 Months Later) and + 22 % (6 Months Later)
2002 Reading Market Up + 14 % (3 Months Later) and + 19% (6 Months Later)

If History bears out this should be a good buying opportunity with a 3 to 6 month horizon.


S&P500 is down 47% from its peak level one year ago. Transports are down 38%. These are relatively rare degrees of loss, and suggest a near term upside move.


The following two charts show the 2002 lows, and the current market. Can you tell them apart?

Highlight for answer: The first chart is 2002, the second chart is current as of 10/10/08