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

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