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

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