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