Dec 27, 2009

Hello Santa Claus Rally

Hello Santa Claus Rally!

December 28, 2009

“Bankers and regulators have not come anywhere close to responding with necessary vigor” to the worst economic crisis in 70 years. There is a lot of evidence that financial weaknesses brought us to the brink of a great depression. The proposed changes are like a dimple.” -Paul A. Volcker, Dec. 8. at a conference in West Sussex, England.

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

INDU: 1.85%
SPX: 2.18%
COMPQ: 3.35%
RUT: 3.85%

Just when I make mention of how the seasonal trades have been so bad all year (think January effect, Sell in May and Go Away, and the summer doldrums to name a few, first year of Presidential Cycle), the Santa Claus Rally delivers with the reliability of a 400 pound elf riding behind eight reindeer. The last seasonal trade of the year working, albeit a bit early, after the rest failed seems an apropos way for a completely whacky year to end.

What has been working? Over the past month utility and industrial stocks have led the market higher. Technology continues to be strong. The only weakness can be found among the financials, which have lagged over the past month as the market has broken out to new post-crash highs.

The technicians are going nuts right now as the S&P 500 settles in around 1120. This level represents a roughly 50% retracement of the correction from 2007’s peak to the low in March. The technicians are now falling over themselves with the classic “if it goes higher, it will keep going, but if it can’t go higher, it will fall.” I’m not being critical of the technicians, just restating what I have read at least 20 times over the past few weeks. The chart below, courtesy, shows the S&P 500 from its 2007 peak. The blue, somewhat horizontal line is the 200 DMA, and might be just as important as the 1120 level. In next week’s 2010 preview I’ll discuss what I am expecting for 2010 (as well as reviewing all of 2009’s predictions).

As we exit the first decade of the new century, the question on most investor’s mind is whether the economy is recovering or not. Instead of going through the most recent week’s economic releases, I thought we’d take a page from Russell Investments and review some of the key economic indicators.

Corporate debt, as measured by the OAS, has improved dramatically from a year ago, although it is still elevated from long term historical levels. What does that mean? Typically a higher OAS suggests greater default risk and therefore higher risk premiums, while a lower OAS suggests greater availability of credit. Corporate debt issuance hit an all-time record in 2009 while the OAS declined throughout the year.

The VIX (measure of market volatility) is within its long term historical range at 24.5, moderating significantly from the peak of over 80 in late 2008. The VIX tends to reflect investor anxiety. I have found it to be a more effective indicator of short term market bottoms than tops.

The yield curve is the steepest in 30 years, reflecting some optimism regarding economic growth; concerns about inflation; and of course the heavy manipulation of the short end of the curve by the Fed. The amount of Treasury issuance is enormous and growing rapidly as someone has to pay for TARP, Cash for Clunkers, Job Creation Programs, etc. Wait until the healthcare bills start rushing in.

Mortgage delinquencies are off the charts and not yet stabilizing. This measure should continue deteriorating in 2010. Government efforts to assist borrowers are only exacerbating the problems and spreading the pain to all taxpayers, not just those who are delinquent.

Core inflation is low but worrisome, but as we have mentioned we don’t see a risk of a classic supply-demand driven inflation, but instead one created by a currency crisis.

Employment growth is non-existent. According to reader Jon Fisher, unemployment should peak at 10.4% and quickly fall to 8% by year end 2010. Where does he come up with that estimate? He cites a link between housing starts and unemployment, and feels that directional changes in housing starts lead to similar directional changes in employment. Jon writes “now that housing starts seem to have bottomed in April 2009, we should expect to see the completion of the cycle: A quick peak and decline in employment.”

Consumer spending is weak, but appears to be improving. This measure is heavily tied to consumer confidence and employment. If Mr. Fisher is correct regarding an employment rebound in 2010, then we would expect to see a similar improvement in consumer spending.

Economic growth (GDP) is improving but still heavily manipulated and fragile. The 3rd quarter measure was just revised down. Cash for Clunkers had a significant impact on the 3rd quarter. Fourth quarter activity could benefit from some very weak comparisons versus 2008. If the economy truly is on the road to recovery, why does the Fed insist on holding short term rates at zero?

Credit Conditions
The chart below, courtesy of Tim Iacono (author of “The Mess That Greenspan Made”), shows a reproduction of M3 and its moving averages. I say reproduction because the government stopped producing the M3 aggregate in 2006, which is too bad because it is/was probably the most complete measure of the supply of US dollars. During the ‘90’s we found that the 13 week moving average of M3 was a very accurate predictor of the stock market’s movements over the ensuing 13-26 weeks. Excess capital creation tends to find its way into the market until the economy needs or finds a way to utilize it. As you can see, M3 annualized growth peaked in late 2007/early 2008 at an unsustainable annualized rate of 17%, just before the credit crisis hit the red-line. What caused this acceleration in growth of M3? A new Fed Chief and an inverted yield curve.

How can the current growth rate be approaching or near zero while the government prints paper with reckless abandon? Because the banks are hoarding that capital to repair their badly damaged and in many cases insolvent balance sheets. If the banks were to start lending again, M3 growth would once again accelerate and inflation would be staring us in the face. The Fed would be forced to raise rates.

The Known Universe

The Big Picture published a great graphic via YouTube that shows the “discovered” portion of our universe.

Sovereign Debt
In my last note I discussed issues with Greece, Dubai World (I know, it’s technically not a sovereign issuer), Spain, and France, and said to watch out for the UK. Dubai has been thrown the expected life ring by Abu Dhabi, who generously agreed to provide $10 billion in aid to the Dubai Financial Support Fund.

What about the UK? Yields began spiking on UK debt (as well as Japan’s) as both those countries deteriorating fiscal conditions are actually making the US look like an economic super-power once again.

As a side note, PIMCO issued a thumbs down to US debt by reducing their US Treasury holdings and stashing the proceeds into cash.

Health Care
According to the Department of Health & Human Services, there were 16K fewer primary car physicians than needed in rural and inner city areas. As a way to control rising medical costs in 1997, Congress capped the number of hospital based residencies to 90K. Now, with millions of new people about to receive insurance, this shortage will only worsen. HHS is estimating a shortage of 159K doctors by 2025, without national coverage.

I’m sorry, but did they actually cap the supply of doctors in an effort to limit pricing? Wouldn’t increasing the number of doctors help to lower the price of medical care? More supply=lower prices.

Another instance of Congress not understanding the basics premise of supply and demand.

More on Health Care

In the first crucial test of whether they could hold the 60 votes needed to overcome solid Republican opposition, Senate Democrats voted unanimously in the middle of the night to press toward a final vote on legislation to overhaul the U.S. health care system. The final vote occurred Christmas Eve, and was passed after simply buying the vote of Nebraska Senator Nelson. The payoff? Offering to have the rest of the country pay for the Medicare and other healthcare related goodies for Nebraska residents.

“Any healthy system needs a way to correct error and remove waste. Nature has extinction, the economy has loss, bankruptcy, liquidation. Interfering in this process lengthens feedback loops. Error and waste are allowed to accumulate, and you ultimately get a massive collapse.

Capitalism is primarily attacked by two groups: utopians who wish to impose a more “compassionate” system, and political capitalists who want to enjoy the fruits of success without bearing the pain of failure. They use the coercion of the state to gain privileges, at the expense of everyone else.
As a country we’ve become less tolerant of economic failure. The result has been a series of interventions, such as meddling in the credit markets, promoting homeownership and creating a variety of safety nets for investors. Each crisis leads to an even greater crisis. The solution is always greater doses of intervention. So the system becomes increasingly unstable. The interventionists never see the bust coming, then blame it on “capitalism.”

-Kevin Duffy, Bearing Asset Management.

Crude oil jumped over the past two weeks as Iranian forces moved into Iraqi territory to take over a non-producing well. The timing is interesting as President Obama recently pledged Iraqi troop reductions and redeployments to Afghanistan. It seems the Iranians testing the resolve of our new President.

More Oil
After being pushed to the sidelines by war, Iraq, with its massive reserves, is again issuing licenses to foreign oil companies. This fulfills the conspiracy theory of the anti-Bush wing, who felt oil was the main reason for the war. This also puts a damper on OPEC as it reduces their control of Middle-East oil production. The catch is that they need Iraq to pump oil so the country can stabilize itself and counter the Iranians, stabilizing the volatile region.

Tax Give-Away
“The government is consciously forfeiting future tax revenues. It’s another form of assistance, maybe not as obvious as direct assistance but certainly another form. I’ve been doing taxes for almost 40 years, and I’ve never seen anything like this, where the IRS and Treasury acted unilaterally on so many fronts.”

-Robert Willens, an expert on tax accounting, commenting on the $38 billion or so tax gift given to Citigroup.

As Barry Ritholtz said “The looting of the Treasury, begun in panic under George W. Bush, continues in ignorance under Barrack W. Obama.”

Jobs and Elections
In prior notes we have demonstrated a high correlation between jobs and voter approval of the incumbent party. Lawrence Summers, director of the White House National Economic council, said that the Administration’s top priority is job creation and that the soaring budget deficit would be faced later, when unemployment is falling.

My interpretation is that re-election of the majority in the House and Senate is priority #1, and to achieve that job growth must be visible. The budget deficit not only isn’t the #1 priority, it isn’t on the radar because the Administration knows that the only way to stimulate any type of economic growth, and hopefully corresponding job growth, is by spending like crazy, not by showing fiscal responsibility.

More on Jobs
According to Business Week, Democratic leaders in the U.S. House said they want nearly $50 billion in extra infrastructure spending to stimulate job creation. The measure to boost housing and highway construction and the renovation of school buildings is a response to demand from rank-and-file Democrats for action to bolster the economic recovery and employment. When everything is added up, the plan exceeds $150 billion.

Left, Right, It’s all the Same

Ed Harrison---
“Don’t be fooled. Those who decry Obama’s policies as ‘socialist’ are doing so for purely political benefit. Are you telling me that Obama is governing in a vastly different way than George W. Bush at the end of his tenure? How exactly would John McCain have been any less socialist? Are you telling me McCain would have bankrupted Citi or BofA? It’s absolute nonsense. I would grant you that McCain would have sought to extend tax cuts for the rich. Otherwise, the cry of socialism is a purely political tactic using Obama’s dip in popularity in order to strip him and his party of any right-leaning independents he may have won in 2008.

The only difference between the established parties is the degree to which they believe in neoclassical laissez-faire economics. The right believes that markets are almost always right and see nearly no reason for government intervention except to lower taxes and promote free markets. The left believes that markets are almost always right too but they see more reason for government intervention in order to protect their traditional base of unions and the working class (think health care reform, taxes on the rich, and the auto bailouts).

However, in practice, those beliefs manifest themselves differently because of the political process and the power of lobbyists. It is what I have termed deregulation as crony capitalism. What the Obama Administration is doing has nothing to do with socialism; those who believe that are either political partisans or those hopelessly misinformed individuals falling prey to political partisans. The present policy is what Dylan Ratigan calls ‘Corporate Communism’ i.e. a pro-business status quo bias which favors incumbent firms over potential entrants, big business over small business, and corporate interests over consumer interests. It is no different than what we saw during the Clinton and George W. Bush Administrations.”

Queen Pelosi
OK, I know this is going to tick off a lot of you. I know the response lines are going to be on fire.

It seems that Speaker of the House Nancy Pelosi wasn’t happy with the C-20B Gulfstream III jet that comes with her job. She ordered a 200-seat, USAF C-32 Boeing 757 because of its greater range, which allowed her to reach California without refueling.

What’s the cost of this extravaganza? How about $120K per week in fuel, or $5.8 million per year in fuel costs, which doesn’t include the cost of the plane or crew. I have been told, but haven’t confirmed, that Newt Gingrich flew commercial when he was Speaker of the House.

Now, I’m not a tax expert, but I believe that when you use a company vehicle to commute back and forth to work, the value of that vehicle for that usage is considered taxable income. I’d love to see that tax bill.

I wonder what’s the impact of this trade on global warming?

I am hoping to get out a 2010 preview and 2009 summary next Sunday. If I am unable to get it completed due to the holiday schedule, I will have it out during the first week of January.

Happy New Year!


“A number of states are treated differently than other states,” Reid told reporters. “That’s what legislation is all about. Compromise.”

Dec 13, 2009

Is the Recovery Priced In?

Is the Recovery Priced In?

December 14, 2009

“We have not yet achieved self-reinforcing recovery. We are heavily dependent upon government support so far. We are on a government support system, both in the financial markets and in the economy.”—Paul Volcker

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

INDU: 0.80%
SPX: 0.04%
COMPQ: -0.18%
RUT: -2.42%

After racing up from under 700 to 1100 on weak economic news over the past nine months, the market now seems to be stalling as the economic news is actually coming in better than expected. What gives? More than likely this incipient economic recovery has already been priced into stocks, and then some. David Rosenberg contends that GDP growth of 4% for 2010 is priced into stocks, while the consensus for next year is starting to hover around 2.5%.

The chart below, courtesy of, shows the Russell 2000 (small cap indices) since 2002. After spending 4 ½ years inside narrowly defined trading channels (one up, one down), the indices collapsed, and recently recovered into its old downward trending trading range. The question is whether the index will be able to break through the resistance (dotted red line)? If so, it could be smooth sailing into the mid-700’s.

Many are labeling this period a “goldilocks” scenario for equities. Why? You have a slow recovery with no job growth (note we still have job losses), which means the Fed is more than likely planning on keeping an accommodative stance on rates. Additionally, the Fed has been creating record liquidity, which the economy isn’t absorbing and thus has found its way into the market. Classic supply/demand induced inflation (we’ll ignore collapsing currency induced inflation for today) isn’t on the horizon, so the Fed feels comfortable holding this stance.


Actual Consensus Prior
Consumer Credit -$3.5 bil -$9.3 bil -$8.8 bil
Wholesale Inventories 0.3% -0.5% -0.8%
Initial Claims 474K 455K 457K
Continuing Claims 5157K 5450K 5460K
Trade Balance -$32.9 bil -$36.8 bil -$35.7 bil
Treasury Budget -$120.3 bil $-131.6 bil -$176.4 bil
Retail Sales 1.3% 0.6% 1.1%
Retail Sales ex-auto 1.2% 0.4% 0.0%
Michigan Sentiment 73.4 68.8 67.4
Business Inventories 0.2% -0.2% -0.5%

The University of Michigan Consumer Sentiment index exceeded expectations and is rapidly approaching its pre-recession levels.

Although the market didn’t seem to respond, retail sales came in better than expected for November. Retail sales increased 1.3% for the month, which may bode well for retail stocks as we enter the holiday period. Weather, easy comps, and heavy discounting helped produce the positive result. Margins and profitability are a concern given the heavy discounting. The chart below, courtesy of Econompic, shows the growth in various sectors.

U.S. companies are set to begin hiring again next quarter, according to a survey by Manpower. "Companies are seeing some demand so they don't want to let anyone else go," said Jeffrey Joerres, CEO of Manpower. "They anticipate a slow but positive 2010."

Inventories are likely to decline over the near term to bring inventory-to-sales ratios back into line with company goals. Inventories typically rise once sales pick up. This relationship can be seen in the chart below.

More Bank Accounting Gimmickry

Robert Herz, chairman of the Financial Accounting Standards Board, is set to call on U.S. bank regulators to consider allowing financial institutions to break free from the Generally Accepted Accounting Principles (GAAP). "Handcuffing regulators to GAAP or distorting GAAP to always fit the needs of regulators is inconsistent with the different purposes of financial reporting and prudential regulation," Herz said in prepared text. "Regulators should have the authority and appropriate flexibility they need to effectively regulate the banking system."

Once again, let’s take insolvent banks and make them look solvent. Will this chicanery ever stop?

Hard to Believe, But More Bank Problems are Looming
U.S. banks will have to put structured-investment vehicles and other complex creations back on their balance sheets, in accordance with updated accounting rules. However, they urged regulators to phase in the rules. Sheila Bair, chairwoman of the FDIC, has sympathized with the banks' situation, with the agency indicating that it might consider their request.

Again, if you marked their loans to (or near) market value, brought all of these illiquid and in many cases worthless securities back onto the balance sheets, very few banks would be solvent today.

We are playing a very dangerous game of chicken.

Last Week’s Employment Report

I’m not sure I’ve ever had as many emails on a single topic as I received last week regarding the better than expected employment numbers. Based on the 80 or so emails I received, I’d conservatively guess that most of you aren’t believers. Here is an analysis, from Trim Tabs, that questions the government numbers:

“TrimTabs employment analysis, which uses real-time daily income tax deposits from all U.S. taxpayers to compute employment growth, estimated that the U.S. economy shed 255,000 jobs in November. This past month’s results were an improvement of only 10.2% from the 284,000 jobs lost in October.

Meanwhile, the Bureau of Labor Statistics (BLS) reported that the U.S. economy lost an astonishingly better than expected 11,000 jobs in November. In addition, the BLS revised their September and October results down a whopping 203,000 jobs, resulting in a 45% improvement over their preliminary results.

TrimTabs employment analysis, which uses real-time daily income tax deposits from all U.S. taxpayers to compute employment growth, estimated that the U.S. economy shed 255,000 jobs in November. This past month’s results were an improvement of only 10.2% from the 284,000 jobs lost in October.

We believe the BLS is grossly underestimating current job losses due to their flawed survey methodology. Those flaws include rigid seasonal adjustments, a mysterious birth/death adjustment, and the fact that only 40% to 60% of the BLS survey is complete by the time of the first release and subject to revision.”

Happier now?

As you know I’ve been bearish on the dollar, which recently closed above its 50-day moving average for three consecutive days for the first time since March, when it was still the globe’s safe-haven currency. Such technical indicators can be misleading, but this suggests there could be some short term upside to the greenback. Oil and gold both corrected this week on the rebound in the dollar. I took half my gold position off the table, and will look for another spot to add back to it. As I mentioned a few weeks ago, I have been looking for a correction in oil, and will be looking to initiate energy positions as oil comes in.

Climate Control on the Fritz

The climate talks in Copenhagen coming up this week will create more greenhouse gases than many African countries will produce over the same number of days. Between the limos, private jets, and hot air coming from the 192 delegates, the carbon footprint of this conference is enormous.

On another note, negotiators from smaller, less developed countries (which for some reason include China and India) are posturing before the meetings by telling the US and Europe to pound sand on climate control unless they are going to provide money to these countries. “No money, no deal” said Selwin Hart, an envoy from Barbados. The UN estimates these countries will need at least $145 billion per year! Who would pay for that $145 billion? Break out your checkbook, comrade.

I wonder if they’ll accept dollars?

One question, of course, is whether we are chasing windmills (get it?) trying to solve the green house gas problem? In a recent Wall Street Journal poll nearly 91% of respondents said they don’t believe that humans are responsible for climate change. At that rate, it’s going to be difficult to get the populace to sign off on another expensive piece of legislation.

Manufacturing Green Shoots

Sorry, I know the term “green shoots” is quite nauseating, and no longer part of popular vernacular, however, I couldn’t think of a better title for this section. According to the Associated Press, “U.S. counties with an economy dominated by manufacturing have been outperforming the national average for a variety of indicators of economic stress since March, according to The Associated Press Economic Stress Index. The index calculates stress based on a county's unemployment, bankruptcy and foreclosure rates. Recently, manufacturing counties have been enjoying some of the biggest employment gains of the recovery.”


Democrats Demonstrate they are as Dumb as Republicans
Much like Senator Phil Gramm, who insisted the recession was just in people’s minds, the Democrats are now complaining that Republican negative sentiment is holding down the economy.

Wow! When I say my daily prayers I must remember to be thankful for the morons running our country. It’s much too easy to dismiss this kind of brilliance.

Sentiment-All’s Well
Albert Edwards of Société Générale

“The current extremely low number of equity bears (the lowest since the market top of 2007, see chart below), the likelihood is that the next leg of the long-term structural valuation bear market is closer than people might realize.”

Dubai, Greece and Spain: Part of a Growing Club?

On the heels of the Dubai news a few weeks ago (their stock market is down 17% since then), S&P this week placed the Greece sovereign rating on CreditWatch negative. S&P also cut its outlook on Spain’s debt to negative, but didn’t lower their AA+ rating. "Those countries that had these high growth rates are now in trouble because much of that growth was financed by debt," said Paul De Grauwe, a professor of economics at Belgium's University of Leuven

Where’s the next looming problem? Keep an eye on the UK.

Trade War Continues Brewing
The FT reported that China, claiming that its investigation revealed subsidies that violated international trade rules, put duties on several specialty steel products that it imports from the U.S. and Russia. The Commerce Ministry accused both countries of illegal dumping.

Contract Law Survives!

Bloomberg reported that Republican lawmakers defeated a mortgage “cram-down” amendment that would have given federal judges the power to lengthen mortgage terms, cut interest rates and reduce loan balances for homeowners in bankruptcy court.

Had this passed, contract law as we know it would become moot.

I’ll Have What He’s Having
Roger Lowenstein, the author of ‘When Genius Failed’, called Congress “the drunk at the Fed’s punch bowl.” The easy money policy of Fed Chairman William Martin Jr. during the late 60’s (under pressure from Lyndon Johnson, who had a war and a huge domestic healthcare agenda to pay for, sound familiar?) led to runaway inflation in the 70’s. I would argue that the Greenspan/Bernanke era has featured cheaper money for a much longer time period than that of Martin, and will personally be surprised if we don’t experience something similar, or worse, than the 1970’s.

Fooled Me Once, Shame on Me…..

“The proportion of US borrowers who have slipped behind on mortgage payments will fall in 2010 for the first time since the financial turmoil began in a sign that the nation’s housing crisis is abating,” TransUnion forecast on Tuesday. After studying 27 million consumer records, TransUnion predicts that the rate of mortgage delinquencies will peak in early 2010 before falling towards the end of the year.

Interestingly, it seems that TransUnion made pretty much the same forecast last year, and it was wrong.

Last Year’s Forecast: “The national 60-day mortgage delinquency rate among mortgage borrowers is expected to continue to rise throughout 2008 from a value of 3.53% in the second quarter of 2008 to just over 4% by year end. This is primarily due to the continued economic weakness in certain segments of the country combined with the continuing fallout of the mortgage crisis. Later in 2009 the rise in mortgage delinquency rates will taper off as economic conditions improve and home prices begin to stabilize.”

Put this down as another job I could do in about 20 minutes a week.

Jobs and Elections

Why is the Administration, and more importantly the Dems who are facing reelection, in such a rush to stimulate the economy? Because they know that election results are based upon how people feel about employment and their pocketbook. Weak employment leads to a revolt against the incumbent party.

Recent victims of this reality include Jimmy Carter in 1980, George H. Bush in 1992, the Democratic Congress in 1994, Al Gore in 2000, and the Republicans in 2008.

“Japan’s economy expanded less than a third of the pace initially reported in the three months to September as companies slashed spending. Gross domestic product rose an annualized 1.3%, slower than the 4.8% reported last month,” the Cabinet Office said today in Tokyo. “The revision, which was deeper than the predictions of all but one of the 17 economists surveyed by Bloomberg News, also showed that price declines accelerated.”

They missed that one by a mile.

TBTF Alive and Well
I have harped on TBTF for over a year, contending that the big banks should instead be viewed as Too Big to Survive. One of the results of the bailouts and forced mergers can be seen below as the risk concentration (as measured by deposits) has increased dramatically over the past 10 years, with a significant increase in deposit concentration since the bailouts. Somehow having 35% of total US deposits in the hands of four poorly run, technically insolvent banks doesn’t make me feel confident.

This is the last full week of trading for 2009. Typically the week leading up to Christmas provides positive returns, however, seasonal trades have been backwards this year, so watch out. Institutional investors are typically quiet in the last few weeks of the year, so expect to see volumes continue to decline. The biggest domestic events for the remainder of the year will continue to come from Washington as the Fed meets, Congress tries to hammer out healthcare legislation, and the Administration tries to slip through major tax and spending plans. Outside of the US watch the sovereign debt markets as continued issues could put a damper on this fledgling recovery.

Please not that I will not be publishing next Sunday evening. I may try and get out a very short note Sunday morning if anything relevant occurs during the week. I am heading out of town with my wife for a few days of R&R before Christmas.

Have a great week and Merry Christmas.


“I’d be a bum on the street with a tin cup if the markets were always efficient.”—Warren Buffett

Dec 6, 2009

The Jobs Summit a Success-Just Look at the Employment Numbers!!!

The Jobs Summit a Success-Just Look at the Employment Numbers!!!

December 7, 2009

"Creditors need to take part of the responsibility for their decision to lend to the companies." --Abdulrahman al-Saleh, director general of the Department of Finance in Dubai.”

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

INDU: 0.77%
SPX: 1.33%
COMPQ: 2.61%
RUT: 4.43%

The market has continued to rotate into more defensive sectors as telcos, healthcare and utilities have been leading the market over the past month. Although this has been anything but a typical year in the market, a more defensive posture is not unusual given the uncertainty regarding the 2010 outlook and the enormous equity returns of 2009. The market has churned over the past couple of months as a sector rotation has occurred at the expense of the market leaders off the trough.

The dollar soared on the stronger than expected labor report Friday (see Economy section below), and for the third week in a row we saw a preview of what may come when the dollar regains support-an unwinding of the dollar carry trade. The Fed appears uninterested in raising rates or protecting the dollar, however, if the employment reports continue to stabilize, the Fed’s hand will be forced as treasury yields will rise in spite of the Fed’s desire to keep rates low. Over the past 15 years the Fed has primarily allowed itself to be led by the market in its rate decisions-raising after yields have risen, cutting after yields have fallen. Want a clue on when the Fed will raise rates? Watch the treasury market for that clue. Rising rates should help the dollar, which will hurt risky assets (think commodities, equities, emerging markets, etc) in the short run as funds are forced to sell their risky assets and cover the dollar short positions.


Actual Consensus Prior
Chicago PMI 56.1 53.3 54.2
Construction Spending 0.0% -0.5% -1.6%
ISM 53.6 55.0 55.7
Pending Home Sales 3.7% -1.0% 6.0%
ADP Employment Report -169K -150K -195K
Initial Claims 457K 480K 462K
Continuing Claims 5465K 5400K 5437K
ISM Services 48.7 51.5 50.6
Nonfarm Payrolls -11K -125K -111K
Unemployment Rate 10.0% 10.2% 10.2%
Average Workweek 33.2 33.1 33.0
Factory Orders 0.6% 0.0% 1.6%

Less than 24 hours after the President’s jobs summit where he promised “immediate action” for job creation, the employment report showed an improvement, posting a decline of 11K versus an anticipated decline of 125K. The unemployment rate ticked down to 10.0% from 10.2%. Temporary help, typically a leading indicator of future hiring needs, increased by over 50K in November.

The ISM Index was just below consensus. The index signals a slowdown in the rate of expansion in manufacturing, which also coincides with the lack of job growth in that sector. The ISM Services index came in light for November after positive reports in September and October. The index fell back under 50-the Mendoza line for determining whether the index is growing or contracting.

Inflation and Fed Policy

A key component of the Fed’s comfort with keeping rates so low is their belief that “with substantial resource slack likely to continue to dampen cost pressures and with longer term inflation expectations stable” inflation will remain subdued for some time. The Fed’s Charles Plosser doesn’t fully agree. He believes there is evidence “that finds that economic slack or low resource utilization is not a very reliable predictor of inflation” and “ultimately, inflation is a monetary phenomenon and there is no question that current monetary policy is extraordinarily accommodative.” He said with “competing views of the economic forecast and the underlying structure of the economy driving that forecast” it will be a challenge to “withdraw or restrict the massive amount of liquidity that we have made available to the economy.” Plosser said as the economy grows and real interest rates rise (market rates), “the fed funds rate should be permitted to rise with them.”

What Bubble?

Debt as a percentage of GDP as soared over the past 20 years. It now sits at a record 340% of GDP. This enormous creation of debt is emblematic (and probably the major driver) of the economic growth we experienced over that time period. The last great debt bubble took 10 years to unwind, but paled in comparison to this bubble. The chart below, courtesy of Ned Davis Research, shows total credit as a percentage of GDP.

Bank of America Paying Back TARP
OK, I know I have a tendency to be a bit cynical, but the timing of the Bank of America decision to repay their $45 billion of TARP funds strikes a chord as it comes right before bonus time.

Let me digress a bit and run through a quick summary of this BofA mess (the order of events may be off a touch, but directionally this is accurate). First, they buy a collapsed Countrywide. Then the Fed prods them into taking on Merrill. Then, in an effort to prop up their balance sheet they take on $45 billion (actually this came in a couple of tranches) of TARP funding to offset a combination of failing mortgages and Merrill/Countrywide losses. The value of their loan portfolios continued to drop until miraculously the accounting rules were altered. Prior to this magical day banks were required to accurately report the value of their loans at the going market rate for those loans (aka mark to market). After the magical date the banks were allowed to mark their loans at any value they wanted (aka mark to imagination). Utilizing mark to imagination accounting, Bank of America went from being completely insolvent to reporting positive earnings. Now the bank has been able to raise outside capital based upon these magical, mystical earnings, and is using that money to free itself from the constraints of the government’s policy capping senior executive pay companies relying upon government support. I would anticipate somewhere close to record bonus payments for a company where the only thing that has truly changed is how they report the value of their assets.

Somehow I doubt that as ill-conceived as this whole bailout has been, no one anticipated that banks would be able to create earnings out of thin air to the point that they could pay out huge bonuses, rewarding the guys who almost ran the economy into the ground yet one more time.

There used to be a day when investors could sue a company for issuing false financial statements, especially when those investors relied upon those statements when making their investment decision.

Retail Sales
U.S. retail chains reported a lower sales volume for November, despite a strong turnout on Black Friday. “It was a month that disappointed us and, I think, the industry," said Michael Niemira, chief economist for the International Council of Shopping Centers. Same-store sales dropped 0.3% in November compared with the same month last year, the trade group said.

Gluskin Sheff reported that 75% of retailers missed their sales target in November.

Making Hay in the Commercial Real Estate Market

We have often discussed how the shrewder (and stronger) companies have been taking advantage of the commercial real estate crisis by negotiating better deals and rates. Last week Lowe’s secured a $13 million loan to build a 102K square-foot facility on 13 acres in Quincy, MA. The company also finalized its lease agreement and will soon break ground in San Francisco, becoming the first big box DIY retailer in the city. Lowe’s will build a 107K sq. foot store on Bayshore Boulevard, on the same site where Home Depot gained approval for a new unit after battling with community activists and local businesses for more than a decade. The Atlanta retailer then withdrew its plans as part of its new construction cutbacks last May. Lowe’s has agreed to abide by some of the provisions set forth in Home Depot’s agreement with municipal and county authorities: a $75,000 contribution to workforce training for neighborhood residents; a $100,000 contribution to the San Francisco day labor programs; and a promise to hire three-fourths of the store’s retail employees from San Francisco.

Bottom Fishing
Brookfield Asset Management, one of Canada's biggest commercial-property owners, and Simon Property Group, the largest mall owner in the U.S., have been buying the debt of bankrupt General Growth Properties. Brookfield has accumulated nearly $1 billion in unsecured debt, possibly preparing a bid to acquire some or all of General Growth's portfolio. Meanwhile, Simon reportedly hired legal and financial advisers to assist in forming a bid.

If you are a reader of this note you either agree with my basic free market view or you like to be tortured each week by my writing. JP Morgan released an interesting table this week which partially explains why I am constantly in disagreement with the economic policies of the Obama administration. The chart below shows the percentage of cabinet appointments for the last 110 years (19 Presidents) with prior private sector experience. Mr. Obama’s administration is the least experienced of any in the measurement period.

I think this chart helps explain why the administration constantly comes out against capitalism and is so focused on state-sponsored solutions.

Bank Math
If a bank takes in a $50K deposit, then lends $500K on a home mortgage at 10:1 leverage, is it inflationary when they are forced by the Making Homes Affordable program to wipe out a portion of the debt? Since the seller’s purchasing power increased by $500K, and the buyer is only required to pay back some portion of that, say 50%, then isn’t this a backhanded way of increasing the money supply?

Anyone want to comment?

Oh Canada, eh?
Statistics Canada gave the official word that the country emerged from recession during the third quarter, but the 0.4% GDP expansion fell short of what experts were expecting. The growth was driven mostly by a jump in imports, at an annual rate of 36%, suggesting considerable vitality on the part of Canada's consumers.

Why Housing Prices Have Another Leg Down
I have discussed a number of times that the Fed has been the primary (and often only) purchaser of mortgage backed securities. They recently said that their $1.25 trillion buying program should be completed by March 2010. When that program ends, it is more than likely that mortgage rates will rise from today’s record lows. These low rates have allowed affordability to improve and the housing market to stabilize, for now.

Jim Welsh has noted that a significant portion of the recent rise in housing values is due to the increasing number of prime borrowers selling their houses or going into foreclosure due to joblessness. These higher priced homes are skewing the pricing data used by Case-Shiller. With nearly 8 million mortgages late or in foreclosure on top of the 3.5 million homes already for sale, there is a ton of inventory that needs to be moved over the next 12 months, just as rates may start rising.

The FHA is also getting stretched as they are now making roughly ¼ of all loans versus less than 5% historically. FHA only requires a 3.5% down payment, and as Welsh points out a first time buyer can use $7K from their $8K tax credit for the down payment on a $200K house and pocket $1K. Not surprisingly, the default rate on FHA loans is soaring as 14.5% of FHA loans are now delinquent. Additionally, 20% of the FHA loans made in 2007 are now over 90 days delinquent.

In case you’re interested, the FHA is now levered 188:1 versus their Congressional mandate of 50:1.

The Financial Times is reporting that the European Central Bank is expected to move forward with its exit plan from policies and measures aimed at battling the financial crisis. Although the central bank likely will keep its main interest rate at 1%, it is expected to make policy tweaks that indicate its intention to unwind emergency programs. The ECB will be rejecting the advice of Dominique Strauss-Kahn, managing director of the International Monetary Fund. Strauss-Kahn advised policymakers to err "on the side of caution, as exiting too early is costlier than exiting too late."

Bloomberg reported that India’s economy, marking its strongest growth in six quarters, expanded 7.9% in the third quarter compared with the same period last year. Manufacturing grew 9.2%, the strongest showing since June 2007.

Weekly Market Notes Update
Thank you again for all of your great input. I’d say 40-50% of this week’s content came from reader contributions.

Direct email distribution of the note is approaching 2000, and an unknown number are reading the note via various syndicated websites. Please note that due to the sheer size of the distribution list and to avoid boners like the one I made a couple of weeks ago when I accidently emailed out one of my distribution lists, I may start having you notified of the posting to the website and you’ll have to click on the link to view the note. I know that will create problems for some mobile readers and I am trying to figure out a workaround. As always please give me your feedback.

I have had countless requests to provide more actionable information for those who management their own portfolios, and in response to that I am exploring producing a monthly newsletter which would be focused on asset allocation. I would be creating a series of portfolios for various risk profiles, and making recommendations as to the funds to use (primarily ETFs but also some mutual funds) to achieve the desired investment objectives. If I move in this direction I anticipate a modest fee, possibly $200 per year (mama needs new shoes). I’d love to hear your feedback and thoughts on that as well.

Have a great week.


“The best approach here if at all possible is to use supervisory and regulatory methods to restrain undue risk-taking and to make sure the system is resilient in case an asset price bubble bursts in the future.” --Ben Bernanke, Federal Reserve Chairman

Nov 29, 2009

Black Friday Sales-Good or Bad?

Black Friday Sales-Good or Bad?

November 30, 2009

"Regardless of the dollar price involved, one ounce of gold would purchase a good-quality man's suit at the conclusion of the Revolutionary War, the Civil War, the presidency of Franklin Roosevelt, and today." - Peter A. Burshre

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

INDU: -0.08%
SPX: 0.01%
COMPQ: -0.35%
RUT: -1.28%

Markets around the globe declined Thursday and Friday on news that Dubai World (an investment company that manages investments and projects for the government of Dubai, which itself is part of the UAE) is asking for a 6 month reprieve on $60 billion in debt. While emerging markets dropped significantly on the news, the US market may have benefitted (relatively) by the Thanksgiving Holiday, a flight to quality, and the observation that for once US banks may not be the leaders in poor lending as estimates of US bank exposures are extremely small. The biggest risk may not be in the banks, but instead the unwinding of the massive carry trade involving the dollar. Even a short lived flight to quality has the potential to create a short squeeze on the dollar as the carry trade unwinds, and risky assets of all types endure commensurate selling pressure.

Sector performance for the week was defensive as telecom services, health care and utilities led while financials, basic materials, and technology lagged. During the past month conglomerates, healthcare, and basic material stocks have outperformed while financials have lagged badly (see chart below, courtesy

The preliminary Black Friday estimates from all sources are typically inaccurate and should be viewed with quite a bit of skepticism, a lot like preliminary government releases. That being said, I’ll dutifully provide the early estimates for Black Friday sales from the National Retail Federation, which show revenues up 0.5% vs. 2008. The NRF is reporting average revenue per consumer to have declined 8% while traffic jumped 13% both online and at bricks and mortar stores. As we have discussed over the past few weeks, expectations are low enough that any positive comps may be enough to fuel the market.


Actual Consensus Prior
Existing Home Sales 6.1 mil 5.7 mil 5.54 mil
Q3 GDP-second estimate 2.8% 2.8% 3.5%
GDP deflator 0.5% 0.8% 0.8%
Case Shiller Home Index -9.4% -9.1% -11.3%
Consumer Confidence 49.5 47.5 48.7
Personal Income 0.2% 0.1% 0.2%
Personal Spending 0.7% 0.5% -0.6%
PCE Prices 0.2% 0.1% -0.6%
PCE Prices-Core 0.2% 0.1% 0.1%
Initial Claims 466K 500K 501K
Continuing Claims 5423K 5565K 5613K
Durable Orders -0.6% 0.5% 2.0%
Durable Orders ex Transports -1.3% 0.6% 1.8%
Michigan Sentiment 67.4 67.0 66.0
New Home Sales 430K 404K 405k

The economic calendar was heavy for a holiday shortened week. Purchases of new homes in the U.S. rebounded more than anticipated in October as buyers rushed to take advantage of the government tax credit before it expired. Sales rose 6.2% to an annual rate of 430K, the highest level since September 2008. The median sales price fell 0.5% and the number of unsold homes reached a four-decade low. Home values may remain under pressure as builders are forced to compete with mounting foreclosures as unemployment climbs. The median sales price of new houses sold in October 2009 was $212K; the average sales price was $261K. The seasonally adjusted estimate of new houses for sale at the end of October was 239K. This represents a supply of 6.7 months at the current sales rate. The chart below, courtesy of, shows how far new home sales have fallen since the 2005 peak.

As expected, GDP for Q3 was revised downward from 3.5% to 2.8%. Government spending remains strong, being revised up from 7.9% to 8.3%. Personal consumption expenditures were revised downward from 3.4% to 2.9%. Durable goods were revised down from 8.1% to 7.2%, nondurable goods from 22.3% to 20.1%, and services from 1.2% to 1.05. The big reduction came from auto sales, which were revised down to 0.8% in spite of Cash for Clunkers.

Fixed investment was revised down from 2.3% to 0.3% on nonresidential and residential construction weakness. Nonresidential construction fell 15% in the quarter versus a preliminary estimate of -9.0%.

Inventories also dropped, slightly hurting GDP. Export sales were revised upwards, however, imports also increased. The rise in imports was larger than the gain in exports, resulting in a decline in the net export contribution.

The chart below, courtesy, shows real GDP since mid 2006.

Existing home sales also rose in October to 6.1 million, well in excess of consensus. This increase drove supplies to its lowest level since February (7 months).

Trouble in the Middle East

The Dubai World default threatens to be the biggest sovereign default since Argentina. There are some technicalities which could keep this from being classified as a sovereign default; however, given the nature of Dubai World’s relationship with Dubai and the UAE, it should definitely be classified as such. In the market section we mentioned the potential for the unwinding of the dollar carry trade, and for the second week in a row we saw a preview of this trade: the dollar rose, crude fell, gold was down, treasuries rose, and equities fell.

Dubai is the only UAE member not to have its own oil production. The building in the country over the past decade has been gargantuan as they have attempted to turn the small nation into a tourist destination rivaling Monaco. The country features some of the world’s tallest and most exotic buildings, including one that rotates 360 degrees each day, as well as the biggest man made islands in the world. Credit default swaps (CDS) rose dramatically during the week, up roughly 33%. CDS are contracts whose value increases when the market anticipates deterioration in the credit quality of the underlying debt.

Obama and China
This week President Obama visited what is arguably our most important trading partner and certainly our largest creditor, China. While it is always difficult to gauge the effectiveness of these diplomatic missions, the tone from the President relating to China’s treatment of their own currency didn’t appear to be especially well received.

SNL created a spoof on the meetings which seems to sum up the situation very well. The video clip can be viewed below. The best line from the Chinese Premier-“I supposed if I wanted my money, I could call and say I was a Wall Street Banker needing my bonus.”

Bank Lending
According to the FDIC, banks in the U.S. cut back the amount of money loaned to customers by $210.4 billion in the third quarter. The 2.8% reduction marks the sharpest drop since at least 1984. The biggest banks, which received billions of dollars in taxpayer bailouts, accounted for a disproportionately large part of the drop. "We need to see banks making more loans to their business customers," said Sheila Bair, the FDIC's chairwoman.

Taxes-from Miller Tabek

Miller Tabek makes the following observations about taxes:

“We bring this up because the list of tax increases that we know about apparently just got a big longer this weekend. We know that the top marginal tax rate is going to increase in 2011 to 39.6% from 35%. We know that the capital gains tax is set to increase 5 full percentage points while dividends are set to be taxed as ordinary income. We know that the upper income brackets will lose the ability to deduct mortgage interest from their state and local tax liabilities. We spoke on Friday of our horror at learning the payroll tax would increase to 1.95% for some individuals and we spoke earlier this fall of the impending tax related to the health care initiative. We know of all these tax increases and we have no doubt that upper income bracket consumption patterns (the top quintile accounts for anywhere from 40-50% of spending) will be affected. We would doubt the argument that it is enough to derail economic growth but it seems at least fair to say that consumption will be affected.”

Are You Kidding Me?
According to the NY Times, Wall Street funds apparently found a way to make big money from the residential-mortgage crisis and leave U.S. taxpayers with most of the risk. The process begins with a hedge fund or a private-equity fund buying a block of mortgages at a deeply discounted price. Then homeowners are offered a principal reduction on their mortgages in return for refinancing the debt into new mortgages backed by government-sponsored entities such as the Federal Housing Administration. The mortgages can then be sold to another government-backed entity, such as Ginnie Mae.

Will the mortgage games ever end?

Dollar and Stocks
According to ISI, the weak dollar benefits stocks about 67% of the time. One reason is the weaker dollar can give large multi nationals an earnings boost. Technology, materials and industrial benefit the most.

Real Estate
The band keeps on drumming in the real estate market. Despite the stock market’s massive run up from the March 2009 low, the fundamentals in real estate keep struggling to find a bottom. Each piece of good news (see Economy section above) is met by a comparable piece of bad news.

“The proportion of U.S. homeowners who owe more on their mortgages than the properties are worth has swelled to about 23%, threatening prospects for a sustained housing recovery. Nearly 10.7 million households had negative equity in their homes in the third quarter, according to First American Core-Logic, a real-estate information company based in Santa Ana. These so-called underwater mortgages pose a roadblock to a housing recovery because the properties are more likely to fall into bank foreclosure and get dumped into an already saturated market. Economists from J.P. Morgan said Monday they didn’t expect U.S. home prices to hit bottom until early 2011, citing the prospect of oversupply.”

Of those who took out mortgages at the 2006 peak, more than 40% are under water.

Go Brazil!
Octavio de Barros, Banco Bradesco’s chief economist, said rising exports, increased investment and strong domestic demand will drive Brazil's economy to 6.1% growth in 2010. He also said Brazil's exports will benefit from purchasing by emerging countries, particularly China. Brazil is expected to post 0.5% growth in GDP this year.

More on Gold
People (including us) have been so bulled up on gold that my contrarian nature makes me have second thoughts about holding the metal. The chart below (courtesy shows the relationship of gold and the dollar. As we have mentioned, gold is definitely at risk if the dollar carry trade unwinds.

Thursday the President will be holding a jobs summit, whatever that is. Employment remains a difficult issue, and for the incumbent party jobs are the key to maintaining power in the 2010 elections. The urgency was noted by Representative Barbara Lee, a California Democrat, who said this week “We have to create jobs, and we have to create them right away."

As we move towards year end, I’ll be reviewing my 2009 predictions (they can be found on the website in the January 4th note,, and at some point will be coming up with predictions for 2010. Although the market in 2008 and 2009 was a difficult place to make money, the macro environment certainly seemed simple to predict. I am anticipating that 2010 will be much more difficult to accurately predict, but am looking forward to the process. As always, I appreciate your thoughts and comments, and continue integrating them into the notes.

Have a great week.


“The Fed is a serial bubble blower worse yet, they have refused to hold the most aggressive and damaging speculators accountable for their own losses. Instead, they have participated in a massive socialization of risk, where profits remain private but losses are the taxpayers’ burden.”—Barry Ritholtz

Nov 22, 2009

Is the Data Really That Bad?

Is the Data Really That Bad?

November 23, 2009
“A proposal to give banking regulators authority to block accounting standards is “a terrible idea,” Paul A. Volcker

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

INDU: 0.46%
SPX: -0.19%
COMPQ: -1.01%
RUT: -0.27%

Federal Reserve Chairman Ben Bernanke actually admitted this week that a weak dollar could cause rising commodity prices and inflation, and the dollar responded with a small, but positive move. To my knowledge this is the first time anyone in charge of this country’s currency has admitted what every Econ 101 student already knows-a weak currency is inflationary. While the US dollar caught a slight bid this week, the fed funds futures continue to reduce its belief that he’ll follow words with actions. The odds of a 25 bps rate hike have now been pushed out to Sept 2010.

What is going on with the Treasury market? Yields on the short end are zero (or less), and on the longer end sitting at 3.356% and 4.295% for the 10 and 30 year respectively. The 2-10 spread at 266 basis points (2.66%) is the widest it has been since mid summer, which should help the banks if they ever start lending again.

Merrill put out a piece this week on asset allocation among institutional investors. Based on a survey they conducted with more than 100 institutional investors they found a tremendous strategic desire to move away from US equities, particularly large cap, and toward a more global mandate. Emerging market equities are the most desirable asset class over the next 12 months with 42% looking to add/increase investment. On a percentage basis, nearly as many investors (39%) seek to decrease investment in US large cap equities. This could result in $300-500bn flowing out of US large cap equities over the next 3-5 years from institutional investors.


Actual Consensus Prior
Retail Sales 1.4% 0.9% -2.3%
Retail Sales ex-auto 0.2% 0.4% 0.4%
Business Inventories -0.4% -0.7% -1.6%
Core PPI -0.6% 0.1% -0.1%
PPI 0.3% 0.5% -0.6%
Capacity Utilization 70.7% 70.8% 70.5%
Industrial Production 0.1% 0.4% 0.6%
Housing Starts 529K 600K 592K
Building Permits 552K 580K 575K
CPI 0.3% 0.2% 0.2%
Core CPI 0.2% 0.1% 0.2%
Initial Jobless Claims 505K 504K 505K
Leading Indicators 0.3% 0.4% 1.0%
Philly Fed 16.7 12.2 11.5

The leading economic indictors slowed dramatically in October from 1.0% to 0.3%, slightly less than consensus. Positive contributions from interest rate spreads, stock prices, jobless claims and the average workweek were offset by nondefense capital goods orders, deliveries, consumer expectations and building permits.
Initial unemployment claims rose slightly to 505K. The number of people receiving jobless benefits dropped, as did those getting extended payments.

Housing starts posted their worst decline of the year (-11%), and the lowest absolute number since the spring as the homebuyers credit expired and then was extended. Building permits also dropped by 4%. Mortgage applications just hit a 12 year low, which doesn’t bode well for housing turnover.

October Retail Sales rose 1.4%, .5% more than expected but ex auto’s they were up just 0.2%, 0.2% below forecasts. The Sept headline figure was revised lower by 0.8%, so taken together the Sept/Oct data is a touch light. Motor vehicles/parts sales rose 10.2% in Aug, fell 14.3% in Sept and rose 7.4% in Oct. Sales ex auto’s and gasoline rose 3%, right in line with expectations. Sales rose in the following categories: food/beverages, restaurants, health/personal care, clothing, department stores and online retailers. They fell in furniture, electronics, building materials and sporting goods.

We have been long gold as a hedge against a weak dollar, and the metal has performed as expected, rising to $1163 per ounce. Analysts have been raising their price targets as they tend to do when asset prices go up, and a legitimate question is whether the metal is in a bubble or not. We don’t think so, however, the chart below from The Big Picture shows the metal in relation to US Treasury Bond futures. Today’s ratio is comparable to the prior peak in gold roughly 29 years ago.

Our view is that the commodity won’t turn down until the Fed addresses the ills afflicting the currency. Although Greenspan, whoops, Bernanke (is there a difference other than the beard?) addressed concerns about the dollar’s collapse for the first time this week, with unemployment north of 10% it doesn’t appear the Fed will be acting anytime soon.

Look for a new peak in this chart!

Removing the Stimulus
Bank of Japan Governor Masaaki Shirakawa joined China Banking Regulatory Commission Chairman Liu Mingkang to warn that the loose money policy of the U.S. Federal Reserve could fuel an asset bubble. Shirakawa warned of "new, real and insurmountable risks to the recovery of the global economy" because of the Fed's policy. "The continuous depreciation in the dollar, and the U.S. government's indication that, in order to resume growth and maintain public confidence, it basically won't raise interest rates for the coming 12 to 18 months, has led to massive dollar arbitrage speculation," Liu said.

European Central Bank President Jean-Claude Trichet said the bank will gradually withdraw the emergency cash it has pumped into the economy in order to ensure it doesn’t fuel inflation. Trichet had previously signaled the ECB is unlikely to renew its offer of 12-month loans to banks after the third tranche in December.

The Chinese Central bank may raise deposit requirements for commercial lenders next year, according to Shanghai Securities News. At a forum in Beijing, former central bank deputy governor Wu Xiaoling said the Peoples Bank of China should be allowed more authority to choose monetary policy tools in 2010 as economic recovery has already become steady. Bank shares eased 1% in the local session overnight on back of the report.

More Accounting Shenanigans by the Banks

An amendment that is strongly supported by the banks is being considered which, in addition to removing mark-to-market accounting, allows a systemic regulator “to order the Securities and Exchange Commission, which now oversees the Financial Accounting Standards Board, to suspend or change any accounting rule that the council thinks is a threat to financial stability.”

“The amendment has been endorsed by the American Bankers Association, which says the SEC’s focus on helping investors is too narrow.”

What!? Reduce transparency even further for a group of zombie banks who almost took this country down as a result of their complete incompetence?


Commercial Real Estate

Goldman Sachs Group Inc. is underwriting $400 million of bonds backed by an Ohio real estate company’s shopping centers, the first sale to tap a U.S. program to unlock lending in the commercial mortgage market. The bond is backed by 28 properties owned by Developers Diversified Realty Corp. The Federal Reserve opened its Term Asset Backed Securities Loan Facility (TALF)in June to newly issued commercial mortgage-backed securities to stimulate lending and avert a wave of foreclosures as borrowers fail to refinance. There have been no new sales of the debt since June 2008, according to data compiled by Bloomberg.

“It would be good for the market psyche to actually see a new deal done,” said Kent Born, senior managing director at PPM America Inc., an investment manager in Chicago. “But as a practical matter it’s not going to get us back to the type of deals that were the bread and butter of the market merely two years ago.” Sales of commercial mortgage-backed debt slumped to $12.2 billion last year from a record $237 billion in 2007, according to JPMorgan.

Deals from JP Morgan and Bank of America are reportedly in the pipeline.

Tax Receipts Remain Weak

The chart below, courtesy the Rockefeller Institute, shows the cumulative changes year over year in income, sales, and property taxes for the US over the past five years. Typically tax rates have little to do with the actual amount of taxes collected, GDP is the primary catalyst to tax receipts. As you can see in the chart below, as of the end of the second quarter the rate of decline in tax receipts hadn’t yet bottomed. This decline is putting severe pressure on state and local governments at a time when the Federal government is attempting to stimulate the economy with massive deficit spending. Since state and local governments need to run balanced budgets, their resulting pullback is having a contra effect on the efforts of the Feds.

The headline in this weekend’s Orange County Register-State Officials Pay to Drop 18%!

An official of the International Energy Agency said the world is much closer to running out of oil than the agency's statistics had shown. Under pressure from the U.S., the IEA distorted statistics to show that more oil would be available, the official said. "The IEA in 2005 was predicting oil supplies could rise as high as 120 million barrels a day by 2030, although it was forced to reduce this gradually to 116 million and then 105 million last year," the official said. "The 120 million figure always was nonsense, but even today's number is much higher than can be justified, and the IEA knows this."

Healthcare and Taxes
According to ISI the proposed health care bill is dangerous for the health of small businesses. Provisions include a payroll tax of 8% of payrolls if small businesses do not offer health care. In addition, high income earners will get hit with a host of new payroll taxes taking marginal federal rates to 44% for the individuals earning more than $500,000.

Add on 11% state income tax in CA, 8.5% sales tax, and miscellaneous other taxes (including capital gains), and for the residents of some states the government is taking well over 60% of the incremental income above $500K.

This certainly seems like a back door way to cap pay without having the authority to explicitly do so.

ISI’s Ed Hyman notes 4 items that are pointing to higher inflation: gold, GSCI, the trade weighted dollar, and import prices ex fuel have begun to move up. The fed's favorite measure the 5-year forward TIP market is also stirring.

Multi-Family Housing
According to the Wall Street Journal, after losing billions on single-family residential loans, Fannie Mae and Freddie Mac are bracing for another round of losses, this time on apartment lending. Previous losses already forced the U.S. Treasury to pump more than $110 billion into the companies. Fannie, which has the highest delinquency for multifamily properties, saw apartment loans that were 60 days or more late on payment increase to 0.62% in September, up from 0.16% the same month last year.

Tax Burden
A couple of weeks ago I discussed the tax burden in California on the highest wage earners, which generated a number of responses and questions about Federal Taxes. (being acquired by Intuit) put out the following statistics regarding income taxes (this is federal income taxes only, and excludes capital gains, etc):

Top 1% (making over $500K) pay 41% of federal income taxes
The top 5% (making over $200k) pay 61% of federal income taxes
The top 10% (making over $100K) pay 71% of federal income taxes
The top 25% (making over $75K) pay 87% of federal income taxes
The bottom 50% (making less than $40K) pay 2.9% of federal income taxes
A full 47% of “tax units” will pay zero. Of 307 million Americans there are 152 million “tax units.”

The median income in the US is just over $50K per year.

Real Estate
I somewhat understand why the homeowner’s tax credit is in place, to somehow reward those willing to take on more risk or trying to get the housing market moving. But why are we providing tax breaks to homebuilders? This just increases supply in the same market where we are providing incentives to people to absorb that supply.

Government continues to amaze me with their basic misunderstanding of supply and demand. If they want home prices to stabilize or go up, and are willing to provide tax credits to accomplish this goal, then why are they also providing tax breaks to those who would increase the supply, thereby putting further pressure on prices?

More Real Estate
The outlook for the home market dimmed this week as residential construction and mortgage applications fell and loan delinquencies reached a record. “I don’t think the housing crisis is over,” Mark Zandi, chief economist with Moody’s, said. “I think we’re going to see another leg down.”

New home sales may begin to pick up by the start of the so-called spring selling season, said Toll Brothers Inc., the largest U.S. luxury homebuilder. Existing house sales may take longer. Residential construction and property sales led the way out of the previous seven recessions going back to 1960, said David Berson, chief economist of PMI Group, the mortgage insurer in Walnut Creek, California.
“You don’t pay a mortgage with economic output, you pay a mortgage with a paycheck,” Jay Brinkmann, MBA’s chief economist, said.

The share of all types of home loans with one or more payments overdue climbed to a record seasonally adjusted 9.6% in the third quarter, the Washington-based trade group said in a report yesterday.

There are signs that parts of the U.S. are rebounding. California, among the states where the housing bust started, is one of the few areas that’s beginning to recover. October home prices in Orange County, San Diego and the San Francisco Bay Area increased from a year earlier, MDA DataQuick, a San Diego property information service, said this week. The number of sales also increased in the Bay Area and Southern California.

Mortgage Rates
If the Federal Reserve is content letting the long end of the yield curve rise, it seems as though their goal of lowering mortgage rates may be at risk. The spread between the FHLM 30-year mortgage and 10-year yields is 84 basis points. Currently (data through May 6) the Federal Reserve has bought $366 billion of MBS and has the authority to buy up to $1.25 trillion.

Because of this massive buying, anything is possible with this spread, even inversion. Unless the Federal Reserve plans on driving mortgage rates lower than Treasuries, this spread cannot tighten much more than it already has. Once this spread cannot tighten any further, mortgage rates will be at the mercy of the Treasury market.

Velocity of Money

From Jim Furey of Furey Research Partners:

“Falling money velocity, as has been the case since 1Q08 is accompanied by declining inflation, lower interest rates and small-cap relative outperformance. Current money velocity is at its lowest level since ’81. Examining four key periods of declining money velocity since 1981, we make the following observations: i) core and headline inflation rates have fallen in each period by an average annualized rate of -17% and -14%, respectively; (i) the Fed Funds target rate has been reduced during each period by a -38% average annualized rate; and (iii) small-caps have outperformed large-caps on average by +5% annualized rate.

Implications of rising money velocity. Money velocity at 3Q09 posted a slight uptick from 2Q09, but it is too early to tell if it has begun a cyclical upswing, such as in ’87, ’94 and ’04. We do know that when it does start moving upwards, we can expect rising inflation, higher rates and small-caps to underperform large-caps, if past is prologue.”

Thanks Jim

Are the data points really that bad? The real estate market is still on life-support without government intervention. Will the stimulus be enough to turn that market, or will the cost associated with re-inflating that bubble be enough to sink us?

The other data is mixed, and that is to be expected at this point in the “recovery”. Anticipate continued mixed results on the economic front, with some deterioration as much of the low hanging fruit has been picked. The preliminary 3rd quarter GDP came in at 3.5%, but it looks like it will get revised down to 2.5%, which many are suggesting is purely due to government intervention. Certainly we have a long way to go.

With the leaders of the market rally (techs, small caps, financials, and inflation trades) pulling back while higher quality and more defensive names move to the forefront, it would appear that at minimum the market may pause into the end of the year. I am net neutral, with a long bias towards higher quality names and a short bias towards lower quality names.

Have a terrific Thanksgiving. Remember that Friday is a shortened trading day and the US markets will be closed on Thursday.


"The baby will talk when he talks, relax. It ain't like he knows the cure for cancer and he just ain't spitting it out."—Justin’s Dad

Nov 8, 2009

Don't Fight the Fed

Don’t Fight the Fed!

November 9, 2009

“How are you going to regulate systematic risk when you are the systematic risk?”—Senator Jim Bunning questioning Ben Bernanke

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

INDU: 3.2%
SPX: 3.2%
COMPQ: 3.3%
RUT: 3.1%

The success of the Fed’s plan to encourage investors to increase their risk and buy securities was made very clear to me this week during a conversation with a reader, who commented that he “needed to buy some stocks since his 5% CD’s were rolling over, and 1% just wasn’t that enticing.” I’m still baffled how leverage, risk, excessive liquidity and easy credit are the cure for a problem caused by leverage, risk, excessive liquidity and easy credit. As the title suggests, don’t fight the Fed, at least in the short term!

The market closed the week with strong gains, although volume was stronger on the down days than the up days during the week. Almost right on cue following our comments over the past two weeks that the transports could be signaling further downside in the markets, Wonderful Warren (aka the Oracle of Omaha), announced his intention to acquire Burlington Northern in his biggest acquisition ever, $44 billion, helping to spark a 6%+ increase in the transports for the week. Rolfe Winkler posted a chart this week (below) which shows Buffet’s recent investments have received quite a bit of support from the Fed, almost $134 billion worth. Is it possible that Buffet’s endorsement of recent government bailouts and his “buy America” pronouncement were procured in exchange for continued government support of his investment positions? The Burlington announcement makes this an interesting quid pro quo.

Earnings estimates have been rising steadily since the early summer months. Jeremy Grantham asserts that “earnings estimates in particular merely follow the market up, not the other way around as one would hope. So it is a law of nature that strong estimates will abound after a major market rally.” Expect to see earnings estimates continue rising into year end and early 2010, but eventually revenue growth will need to return to support the earnings. A reader wrote in last week asking what percentage of companies were beating earnings and revenue estimates. The answer, courtesy of Bank of America Merrill Lynch, shows that 80% of companies beat earnings estimates this quarter while 53% also beat revenue estimates.

Speaking of the Fed, for some reason they bothered to hold a meeting this week at which they unsurprisingly decided to leave rates unchanged. While the Fed rarely specifically spells out their plans for rates, translating the comments after this meeting leads us to believe that the Fed doesn’t plan to raise rates until the next bubble (i.e. financial asset values) is so big that when it pops the collective ear drums of the world will pop.

Don’t fight the Fed.


Actual Consensus Prior
Construction Spending 0.8% -0.2% -0.1%
ISM Index 55.7 53.0 52.6
Factory Orders 0.9% 0.8% -0.8%
ISM Services 50.6 51.5 50.9
Productivity-preliminary 9.5% 6.5% 6.6%
Initial Claims 512K 522K 532K
Continuing Claims 5749K 5750K 5817K
Nonfarm Payrolls -190K -175K -219K
Unemployment Rate 10.2% 9.9% 9.8%
Average Workweek 33.0 33.1 33.0
Hourly Earnings 0.3% 0.1% 0.1%
Consumer Credit -$14.8 bil -$10.0 bil -$9.9 bil

First time unemployment topped 10% for the first time since 1983 (see chart below courtesy, well above the Administration’s peak estimate of 8.5% they projected in February. Temporary employment, typically a leading indicator of hiring, rose for the third straight month, increasing 33.7K in October. Without that increase the employment picture would have been significantly weaker. Unofficial estimates of the “underemployed”, i.e. those wishing to be employed full time but unable to obtain employment, rose 1% to 17.5%. The second chart below, courtesy of Barry Ritholtz, shows the number of unemployed longer than 27 weeks, dating back to 1948. Even if the economy stabilizes and hiring moves back into a 150K-200K per month range, it could take 3-5 years to achieve prior levels of employment.

This is a Test
According to Bloomberg, some of the largest central banks, including the European Central Bank and the Bank of Japan, are starting to exit from stimulus measures implemented to tackle the financial crisis. ECB President Jean-Claude Trichet said the central bank will start to withdraw liquidity initiatives. "There are all kinds of risks," said Jim O'Neill, London-based chief global economist at Goldman Sachs. "We don't know how much of the improvement in markets is due to central banks' largesse, and neither do they. They're pretty nervous, but they've got to get out of it at some stage."

This is Another Fine Mess you’ve Gotten me into
The problem is, as Don Kohn said last month, they do not understand the monster they have unleashed:

“Our limited knowledge of the determinants of asset prices and their effects on credit has made it more challenging to respond to the crisis and explain our actions to the public. More generally, while most of the literature on the effects of monetary policy assumes that the federal funds rate is the single relevant tool for monetary policy, the financial crisis has shown that a wide array of policy measures, acting on the prices of different assets, may be needed in extreme circumstances. The research literature that could help gauge the potential impact of these measures and the exit from them is disappointingly sparse.”

As we have repeatedly questioned-who is going to buy all the paper on the Fed’s books when it decides to reverse its quantitative easing?

The coming week will mark the first offering of treasuries by the Treasury Department since the Fed completed its commitment to buy $300 billion of the paper. The $81 billion coming this week should reveal whether the markets are ready to support treasuries on its own or a continuation of the program will be required to quell a rise in rates.

Stay tuned.

While I typically don’t discuss specific positions in this note, I have commented often about our long position in gold. This week India helped us out by aggressively buying gold from the IMF- 200 tons. Now, I doubt they are planning to make jewelry with this much of the yellow metal, so it would appear that this is the first significant move by a central bank to diversify away from the Dollar and Euro.

Although I have been very critical of him, I am starting to miss the strong dollar days of Robert Rubin.

Jobs were foremost in voter’s minds this past week as Republicans won gubernatorial races over Democratic incumbents in Virginia and New Jersey. As we mentioned two weeks ago, voters typically vote based upon their wallets, and in New Jersey it was high tax rates undoing Mr. Corzine, the incumbent, while in Virginia it was the mere threat of higher taxes.

Stock Focus
I have mentioned my personal Starbucks indicator (again, full disclosure I have a position in the stock) in prior notes (the length of the line at my local SBUX) has been improving since roughly April, and the stock price has followed, rising from high single digits to just over $21. SBUX was also used as an example of a company negotiating better lease rates with an estimated annual savings of $500 million fueled by lower real estate costs. This past week the company announced solid earnings driven by cost cuts and improving, but still negative same store sales.

Cisco Systems (CSCO) announced order improvements in their quarterly conference call this past week. CEO John Chambers, who has been the canary in the coal mine for recessions and recoveries, was almost giddy during the Q&A session of the call. I sat with John (pre Reg FD) as he pre-announced downside to the quarter and a marked slowdown in capital spending in late 2000, and then listened to his call two years ago as he again lamented about a marked slowdown in orders.

Ford (F), the only U.S. automaker that did not seek bankruptcy protection, surprised analysts with a third-quarter profit of $997 million. Ford benefited from the government's "Cash for Clunkers", rebates, cost-cutting measures and market share gained after General Motors and Chrysler went bankrupt. At the same time, it gained market share faster than Japanese competitors Honda Motor and Toyota Motor even though consumers are favoring foreign makers again (see chart below courtesy BEA).

Alternative Energy
Speaking of autos, the alternative energy push will hurt the continually short sighted domestic auto industry. Barron’s showed that Toyota, Nissan, Hyundai, Honda and Panasonic are the top 5 holders of auto related alternate-power patents.

Where are the domestic auto makers? Most likely spending your tax money on healthcare benefits and political contributions.

I mentioned last week that I would be attending the 39th annual AEA Tech Classic in San Diego. While it isn’t surprising to see conference attendance down in this economic environment, both the number of financial services attendees and presenting companies was down significantly over prior years. I think this was my 14th time attending, so I have a decent perspective on the attendance. There were roughly 80 presenting companies compared to a few hundred in some prior years.

The conference organizers were giving away passes in the last week, which are typically priced near $2000.

Health Care-Politics as Usual
Health care reform squeaked through the House Saturday by a 220-215 vote as the threat of working during the Christmas holiday got the House version moving. The plan passed with virtually no discussion as speaker Pelosi squashed any attempts at questioning the bill or virtually any portion of the bill. Democrats must now be especially motivated to get this passed after viewing the results in Virginia and New Jersey, which could be a precursor to the 2010 elections. A loss of even a handful of seats next year could mean this type of bill won’t get passed in the next session.

It was interesting to note that one Republican voted for the bill while 29 Democrats voted against it.

Goodbye Sarbanes Oxley

“That the Democratic Party is the vehicle for overturning the most pro-investor legislation in the past 25 years is deeply disturbing,” said Arthur Levitt, a Democrat who was chairman of the Securities and Exchange Commission under President Bill Clinton. “Anyone who votes for this will bear the investors’ mark of Cain.”

Is anyone in Washington ever held accountable for their votes?

More on Mark to Imagination

From Floyd Norris “This year, a subcommittee of the House Financial Services Committee held a hearing at which legislators sought no facts but instead threatened dire action if the chairman of the financial accounting board did not promptly make it easier for banks to ignore market values of the toxic securities they owned. The board caved in, which may be one reason why banks are reporting fewer losses these days. But the board’s retreat was not enough to satisfy the banks. The American Bankers Association is now pushing Congress to give a new systemic risk regulator — either the Federal Reserve or some panel of regulators — the power to override accounting standards. The view of the bankers is that the financial crisis did not stem from the fact that the banks made lots of bad loans and invested in dubious securities; it was caused by accounting rules that required disclosure when the losses began to mount.”

The superciliousness continues.

Real Estate and Business Health

According to The Wall Street Journal, bankruptcy filings by U.S. businesses increased 7% in October, according to researcher Automated Access to Court Electronic Records. Last month, 7,771 businesses filed for bankruptcy, compared with 7,271 in September. The real estate and retail sectors suffered the most, said Jack Williams, a bankruptcy law professor at Georgia State University. “Almost any financial challenge could cause a business to file for bankruptcy in these difficult times,” Williams said.

Its no wonder vacancy rates for retail and office space are rising.

From Peter Boockvar: “China’s economic bounce has continued so far into Q4 as evidenced by both the October state enterprise and private sector weighted manufacturing indices which rose to the highest level since April ‘08. There will also likely be no change in economic policies for the foreseeable future according to the Minister of Commerce as he believes the global recovery is still fragile. While China cannot single-handedly lift global economic growth, it clearly remains the most important country in the world in terms of driving economic activity which so far has spilled over into many other countries via trade.”

The Cost of Moral Hazard

Asian Strategist Andy Xie wrote this past week
“Today, governments and central banks are celebrating their victorious stabilizing of the global financial system. To achieve the same, they could have saved Lehman with $50 billion. Instead, they have spent trillions of dollars, probably more than $10 trillion, to reach the same objective. Meanwhile, a broader goal to reform the financial system has seen absolutely no progress.”

“Because policy makers mistakenly think stimulus spending can bring back growth, they are pushing too hard. The eventual consequences are inflation and bubbles along the way. These bubbles will be short-lived. The current boom market is a good example.”

Andy has been the king of identifying emerging bubbles over the past 15+ years, his comments deserve respect.

The market will attempt to hold onto last week’s gains during a light week for economic and earnings releases. The upcoming holiday shopping season should be one of the key fundamental drivers of the market through year end. Expectations are low, which could set up for upside surprises and further market returns. Countering the low expectations for the holidays is the fact that earnings growth has been stretched across negligible revenue growth, an unsustainable situation. Either sales will need to improve or earnings growth will falter. Valuations seem extended, but are rarely the singular cause for either a rally or correction. Jeremy Grantham notes that the S&P 500 fair value is now 850, down about 200 points from here. Jeremy is a great investor and wonderful writer, and while quite prescient over the past 24 months, he has also under-valued the S&P 500 since 1998.

Have a great week.


“Practical men who believe themselves to be quite exempt from any intelligent influence are usually the slaves of some defunct economists.”—John Maynard Keynes