Jan 26, 2009

January 26, 2009

January 26, 2009

Weekly percentage performance for the major indices
Calculated from last Friday's official settlement...

INDU: -2.5%
SPX: -2.1%
NDX: -1.8%
COMPQ: -3.3%
RUT: -4.6%

In response to a request by a couple of readers, I have increased the font size of this week’s note. For those of you who have asked for an increase in quality, I’m working on that 


This week, strategists at Society Generale forecast global profits will drop 45%, or over $1 trillion this year. By my calculations roughly 1/3 of the S&P 500 companies have reported 4th quarter numbers, and almost half have missed and/or guided estimates down. The environment for business is getting much more difficult. The key question for the market is when the fundamentals of the economy will see a bottom?

State Street announced net unrealized losses of $6.3 billion on their portfolio of investment securities in Q4. They also cut 1700 jobs and had to use capital to prop up some of their stable value funds, purchasing $2.5 billion in securities from the funds and contributing $450 million in cash. As expected, the asset management side of the business struggled, but so did the custodial side (custody banks keep records, track performance, and lend securities) as assets under custody fell 21% to $12 trillion. The stock dropped about 50% on the announcement.

IBM beat earnings, and missed on revenues. During the last recession IBM held up like a rock, but really used their balance sheet to manufacture their earnings. I haven’t looked into this quarter’s release in detail to determine whether they are doing the same, but it is something you should watch out for if you are thinking about investing in IBM.

MSFT announced soft earnings and announced a 3% layoff, the first in the company’s history. Both earnings and sales missed estimates. The company also announced they would be freezing management pay and cutting travel 20%. The entire PC chain appears to be in trouble as corporate demand wanes.

Southwest air posted a second consecutive quarterly loss. The company had been making bets that fuel prices would rise (obviously they haven’t been reading my letter), which hurt net income by about $100 million. The company also delayed the delivery of some new planes. The company also said they are seeing major softness in post-January bookings.

Apple beat on over $10 billion in sales during the quarter. Following their traditional script, they guided below consensus again.

Caterpillar announced they are cutting 20K jobs and will miss 2009 revenue and earnings expectations as demand wanes. The company’s revenue estimate for ’09 is roughly 40% less than that of the street, which to me says that even though we’ve seen a number of earnings cuts by analysts, the estimates are still too high. CAT management said that demand “evaporated” in the 4th quarter and the “results were worse than even we were anticipating, and we had lowered expectations considerably.”

For anyone who is thinking that just because the US has been in a recession for over 12 months it is time for the economy to start turning need only look at these results to realize that the global economy is still spiraling downward. The contrarian view might be that once the companies start accepting the weakness in the economy, we are hitting the bottom. I’m staying neutral and looking for that fat pitch before stepping in hard in either direction.

Pfizer announced that they will be buying Wyeth for $68 billion and expect to cut 10% of jobs and close five plants. The company is acquiring Wyeth in an attempt to replace its aging pipeline of drugs as generic competition eats away at their core franchise drugs. The combination cash/stock deal is valued at $50 per share, a 15% premium to Friday’s close and 29% above the price of last Thursday, when the talks were announced.

I have discussed the overcapacity and declining demand in the DRAM market in a number of prior notes. Qimonda, a German DRAM and flash memory manufacturer filed for insolvency last week. This filing has been anticipated for over a year. I had a dinner at CES last January (2008) with industry insiders who assured me that Qimonda wouldn’t survive the year. Even though they missed the timing by 23 days I’ll give them credit for being correct. Assuming Qimonda completely liquidates, this will help alleviate a small portion of the memory-chip glut, although it certainly won’t cure the glut.

Well, it looks like the Italians are finally going to pay us back for helping them with their post WWII rebuilding effort. Fiat agreed to take a 35% stake in Chrysler. Chrysler will still need the $4 billion in loans from the US Treasury since Fiat won’t be putting money into the deal, just providing platforms to manufacture fuel-efficient and small cars. They will also share some distribution, and Fiat and Alfa Romeo will return to the US after a 15-year absence. The deal should allow both companies to save money by sharing their excess manufacturing capacity.

I continue to believe that the auto manufacturers would be better off selling their manufacturing capacity to a third party and just focusing on design, branding and marketing. Basic business strategy tells us to focus on what you do best and outsource the rest. The Big 3 doesn’t seem to manufacture anywhere near the quality or cost efficiency of the Japanese or German companies, so why not outsource that portion and focus on the area where you might be able to make a difference?

As a side note, one of the main reasons Fiat left the US was the poor reputation of their products, even worse than that of the Big 3. I remember the nickname for Fiat-Fix It Again Tony. Personally, I owned an Alfa Romeo many years ago, and it was more finicky than a cat. If you started the car, it had to be warmed up all the way to 180 degrees, otherwise it needed to have the plugs removed and cleaned to get it to start again.

Right about the time I sent last week’s note commenting on the damping of market volatility, the VIX jumped 20% (on inauguration day), then it fell 18% the next day, only to rise another 20% the following day. The chart below is a daily view of the VIX for the past year, look at the movement for the prior week.

Treasuries, which I discussed as being in a bubble a few weeks ago, were absolutely wracked last week as the yield on the 30-year bond rose from a low of 2.5% in mid-December to 3.39% (as of Monday morning, see chart below). The two year is yielding .87%. The Fed has been buying short term treasuries in an effort to keep interest rates low, however, the markets have stopped cooperating as evidenced by the recently rising yields. It seems to me that it will be hard for the Fed to keep rates down when they continue with inflationary policies such as increasing the money supply and adding to their balance sheet at the same time the government plans to issue a significant amount of additional debt to pay for the stimulus plan outlined by the new Administration.

Oil hit $32 last week, equaling its low of the past five years (see chart below), before bouncing during the week ($48 this morning). The rally paused mid-week when the US government announced a bigger than anticipated increase in reserves to 333 million barrels. I wonder how much of that oil is sitting on ships, trying to benefit from the Contango trade discussed in last week’s note (http://weeklymarketnotes.blogspot.com). Additionally, refinery runs dropped by 2% in response to continuing soft demand, which in my view is the real cause of the weakness in oil prices.

I have made many comments in the past about the oversupply of ships. Bloomberg is now reporting that ships with a combined capacity of 3.9 million cargo boxes are schedule to be delivered by the end of 2010. These orders were mostly placed in 2007, represented by the blue line in the chart below. It appears that irrational exuberance arose in this market during the late stages of the economic cycle. Despite concerns echoed by many, we were assured that “this time it’s different.” Remember that if you ever hear the term “this time it’s different,” get as far away from the inevitable bubble as you possibly can and get ready to short it when it starts popping (see my commodities discussion in the January 4th note for an example).

The chart below is the Baltic Dry Index, which measures the rates of an amalgamation of various sizes of ships and is an indicator of demand for shipping, a key component of global trade. The spike in pricing during 2007 was the catalyst for all the new ship orders I just discussed.

Housing starts fell by 16%, and building permits missed estimates. Initial jobless claims came in at 589K, about 50K above (worse than) consensus.

This week we get the leading economic indicators, Case-Shiller Home Price Index, Consumer Confidence, 4th quarter GDP (-5.5%), durable goods, and UOM consumer confidence.

Since I’m writing this on Monday morning, I have the Leading Economic Indicator data for December, which came in at 0.3% versus consensus of -0.2%. This is quite a turn from the -1.0% and -.4% we saw in October and November. I haven’t had a chance to really analyze the details, but positive contributions by money supply (not a big surprise), the interest rate spread, consumer goods orders, and manufacturer’s orders for non-defense capital goods offset weakness in the employment measures, building permits, and deliveries. Remember that the December number can be a bit weird since the Conference Board trues up the measures in the last month of the year with their annual revisions to the benchmark. Overall, four of the ten indicators increased while six decreased.

Financials were an absolute disaster last week, as the banking groups in the S&P fell 15% last week. On the upside, gold was the best performer (up 16%) followed by the oil and gas drillers (up 15%) and managed healthcare (up 10%).

As I mentioned earlier, the market was exceptionally volatile during the past week. The market did seem to find a bottom, just below the first standard deviation I discussed in last week’s note (http://weeklymarketnotes.blogspot.com), or roughly 805 on the S&P.

More Financials
From Barry Ritholtz, “The selloff in the financial sector might very well be the cumulative conclusion reached by a preponderance of traders that this sector cannot be rescued by mere recapitalization alone. The market, looking to open down 200 points, and closing in on those November lows, may also be sensing the inevitable nationalization.

The Brits, soon to nationalize Barclays, have the right idea: Go Swedish. Wipe out shareholders, bond holders, and all the bad debt and junk paper these firms hold. Zero it out, spin out the assets with clean balance sheets.”
“The case for full nationalization is far stronger now than it was a few months ago,” said Adam S. Posen, the deputy director of the Peterson Institute for International Economics. “If you don’t own the majority, you don’t get to fire the management, to wipe out the shareholders, to declare that you are just going to take the losses and start over. It’s the mistake the Japanese made in the ’90s.”

Does anyone else find it ironic that we got ourselves into this economic mess by issuing cheap credit to those who weren’t qualified to borrow, and now our government is attempting to push yields to all time lows and encouraging banks to lend to those who might not be able to afford it? Now Congress is howling because the banks aren’t lending cheap enough and have tightened their lending standards. These are the same banks the government just staked with billions because of their poor lending standards, profitless spreads, and reckless business practices. I don’t know about you, but I’m getting the sense we may be heading towards the nationalization of the banking system.

The Obama Administration rode into town last week, and the first official act of the new President, after staying out until 3:00 AM, was to suspend the 9/11 terror trials. Additionally, he announced that the detention facility at Guantanamo Bay would be closed.

Second, the Administration accused the Chinese of manipulating their currency, with Treasury nominee Timothy Geithner acting as the mouthpiece during his grilling by Congress. I’d guess this is the first salvo in a brewing trade war that will feature tariffs (again, discussed in last week’s note). Before ticking off the Chinese, it is important to remember that they have lent us $1 trillion, and we are going to need to borrow a heck of a lot more, maybe an additional $2 trillion. I think it’s obvious why US Treasury CDS are spiking (CDS are the cost of insuring debt, and a rising price means the market views the risk of default as increasing).

Auto woes should continue as the President is reportedly clearing the way for tighter emissions standards for cars and light trucks. The auto makers claim it will cost additional billions to meet the new standards, which target a 30% reduction in emissions by 2016. While I would love to see more efficient cars and reduced emissions, given the financial condition of the auto industry, it doesn’t seem like an appropriate time to be adding a financial burden to the industry.

Education and the Media
My children attend public school in Southern California. Last Tuesday they came home telling me that they had spent almost the entire day watching TV coverage of the inauguration. I’m wondering why the last Bush inauguration didn’t receive similar treatment four years ago?

Also, maybe it’s my slightly conservative bias, but does anyone else find it ironic that the media has portrayed the last three Democratic Presidents (Carter, Clinton and Obama-all attorneys, by the way) as “geniuses”, yet Nixon, Regan, and the Bushes have been portrayed as either evil or dolts? In the case of Bush II, there are certainly questions, but the other three were quite intelligent. For more on Bush II, I hope you enjoy the next section.

More Politics
I have made a lot of cynical comments about the new President, and I want to make sure I give equal coverage to the incompetence of both parties. My old friend Brian Huerta sent me a link to the BBC website which has some great Bushisms. Let’s face, whether you were a Bush fan or not, you have to admit you are going to miss watching him stumble around for words during the Q&A portion of his press conferences. I’ve included a few below, and if you want to read more, I have given the whole article a spot on my website (http://weeklymarketnotes.blogspot.com/2009/01/bushims.html).

"There's an old saying in Tennessee - I know it's in Texas, probably in Tennessee - that says, fool me once, shame on... shame on you. Fool me - you can't get fooled again."

"I want to thank my friend, Senator Bill Frist, for joining us today. He married a Texas girl, I want you to know. Karyn is with us. A West Texas girl, just like me."

"Rarely is the question asked: Is our children learning?"

"As governor of Texas, I have set high standards for our public schools, and I have met those standards."

"Too many good docs are getting out of the business. Too many OB/GYN's aren't able to practice their love with women all across the country."

Final Comments
This note was a bit rushed as I hadn’t planned on writing a note this week. The markets are up across the board this morning on the strength of the LEI I discussed earlier.

As usual, if you wish to be removed from the list, just let me know. If you want to see older notes, they are available at http://weeklymarketnotes.blogspot.com, although I still haven’t finished loading all the historical charts (but plan to do so).

Have a great week.


Ned W. Brines
o (562) 430-3232

Jan 22, 2009


January 22, 2009

These quotes are courtesy of the BBC and my friend Brian Huerta. Please enjoy.

"They misunderestimated me."
Bentonville, Arkansas, 6 November, 2000

''I know what I believe. I will continue to articulate what I believe and what I believe - I believe what I believe is right." Rome, 22 July, 2001
"There's an old saying in Tennessee - I know it's in Texas, probably in Tennessee - that says, fool me once, shame on... shame on you. Fool me - you can't get fooled again."
Nashville, Tennessee, 17 September, 2002

"There's no question that the minute I got elected, the storm clouds on the horizon were getting nearly directly overhead."
Washington DC, 11 May, 2001

"I want to thank my friend, Senator Bill Frist, for joining us today. He married a Texas girl, I want you to know. Karyn is with us. A West Texas girl, just like me."
Nashville, Tennessee, 27 May, 2004

"For a century and a half now, America and Japan have formed one of the great and enduring alliances of modern times."
Tokyo, 18 February, 2002

"The war on terror involves Saddam Hussein because of the nature of Saddam Hussein, the history of Saddam Hussein, and his willingness to terrorise himself."
Grand Rapids, Michigan, 29 January, 2003

"Our enemies are innovative and resourceful, and so are we. They never stop thinking about new ways to harm our country and our people, and neither do we." Washington DC, 5 August, 2004

"I think war is a dangerous place." Washington DC, 7 May, 2003

"The ambassador and the general were briefing me on the - the vast majority of Iraqis want to live in a peaceful, free world. And we will find these people and we will bring them to justice."
Washington DC, 27 October, 2003

"Free societies are hopeful societies. And free societies will be allies against these hateful few who have no conscience, who kill at the whim of a hat."
Washington DC, 17 September, 2004

"You know, one of the hardest parts of my job is to connect Iraq to the war on terror."
CBS News, Washington DC, 6 September, 2006

"Rarely is the question asked: Is our children learning?"
Florence, South Carolina, 11 January, 2000

"Reading is the basics for all learning."
Reston, Virginia, 28 March, 2000

"As governor of Texas, I have set high standards for our public schools, and I have met those standards."
CNN, 30 August, 2000

"You teach a child to read, and he or her will be able to pass a literacy test.''
Townsend, Tennessee, 21 February, 2001

"I understand small business growth. I was one."
New York Daily News, 19 February, 2000

"It's clearly a budget. It's got a lot of numbers in it."
Reuters, 5 May, 2000

"I do remain confident in Linda. She'll make a fine Labour Secretary. From what I've read in the press accounts, she's perfectly qualified."
Austin, Texas, 8 January, 2001

"First, let me make it very clear, poor people aren't necessarily killers. Just because you happen to be not rich doesn't mean you're willing to kill."
Washington DC, 19 May, 2003

"I don't think we need to be subliminable about the differences between our views on prescription drugs."
Orlando, Florida, 12 September, 2000

"Too many good docs are getting out of the business. Too many OB/GYN's aren't able to practice their love with women all across the country."
Poplar Bluff, Missouri, 6 September, 2004

"Will the highways on the internet become more few?"
Concord, New Hampshire, 29 January, 2000

"It would be a mistake for the United States Senate to allow any kind of human cloning to come out of that chamber."
Washington DC, 10 April, 2002

"Information is moving. You know, nightly news is one way, of course, but it's also moving through the blogosphere and through the Internets."
Washington DC, 2 May, 2007

"I know the human being and fish can coexist peacefully."
Saginaw, Michigan, 29 September, 2000

"Families is where our nation finds hope, where wings take dream."
LaCrosse, Wisconsin, 18 October, 2000

"Those who enter the country illegally violate the law."
Tucson, Arizona, 28 November, 2005

"That's George Washington, the first president, of course. The interesting thing about him is that I read three - three or four books about him last year. Isn't that interesting?"
Speaking to reporter Kai Diekmann, Washington DC, 5 May, 2006

"I have a different vision of leadership. A leadership is someone who brings people together."
Bartlett, Tennessee, 18 August, 2000

"I'm the decider, and I decide what is best."
Washington DC, 18 April, 2006

"And truth of the matter is, a lot of reports in Washington are never read by anybody. To show you how important this one is, I read it, and [Tony Blair] read it."
On the publication of the Baker-Hamilton Report, Washington DC, 7 December, 2006

"All I can tell you is when the governor calls, I answer his phone."
San Diego, California, 25 October, 2007

"I'll be long gone before some smart person ever figures out what happened inside this Oval Office."
Washington DC, 12 May, 2008

Jan 19, 2009

January 19, 2009

January 19, 2009

“Gold functions as a protection against your central bank doing stupid things”, Felix Zulauf, Zulauf Asset Management.

Weekly percentage performances for the major indices

Based on last Friday's official settlement...

INDU: -3.7%
SPX: -4.6%
NDX: -2%
COMPQ: -2.75%
RUT: -3.1%

It seems appropriate to discuss politics this week as we observe the end of one administration and the beginning of a second. President Bush leaves office with the economy in tatters, but touting a security record that we haven’t experienced a terrorist attack since 9/11. How bad is the economy? During the Bush years our country experienced its weakest job growth since 1965, up only 1.3% during his eight years in office. Since Truman, the only time the economy showed weaker job growth was during the Bush I term.

The inauguration of Barrack Hussein Obama occurs this week, and what a celebration it will be. Personally, with the economy struggling, I think the new President should skip all the inaugural parties and celebrations, take his oath of office, and get to work. The country, at least the media, certainly seems tired of the Bush presidency, and is awaiting Obama’s arrival with a messiah like expectation. The reality is that our economy is in a deep mess, and despite what will certainly be a steady stream of press releases from Mr. Obama, it is doubtful there is much he will be able to accomplish in the short term. My bigger concern is that expectations, and possibly the market, will become over-sized before crashing back to earth. Let’s remember that outside of running a masterful campaign and being a strong orator, Mr. Obama has virtually zero experience running anything, much less a country on the brink of economic disaster. I wish him well, but also hope he doesn’t over reach and exacerbate an already dicey situation.

While we are discussing politics, Roland Burris was confirmed by the Senate as the new junior Senator from Illinois, replacing Mr. Obama. You may recall I discussed Mr. Burris’ nomination and then the immediate rejection of that nomination a couple of weeks ago. It seems that Mr. Burris, while not accused of any wrong-doing other than being a long time Illinois politician (which means he must be guilty of something), was nominated by Governor Blagojevich. If you recall, the good governor has been arrested and apparently will be prosecuted for trying to sell this same seat to the highest bidder. So much for a change in Washington-sounds like the SOS to me.

Typically when I discuss the economic reports for the week, I include the estimate or consensus for that measure. A reader recently asked the significance of showing these estimates. Presumably the estimate is what is priced into the market, give or take a few points. When the actual numbers are reported, the variance can have an impact on the market, either positive or negative, depending upon the direction of the variance. Typically all of the economic data isn’t market moving, but watching an amalgamation of key data, the variances, and the rate of change can help give some insight as to what is happening in the economy. I hope that helps.

The November Trade deficit narrowed the most in 12 years to $41 billion ($51 billion estimate) on falling oil prices and waning consumer demand. Imports from China declined significantly, resulting in a deficit with them of $23 billion. Textile, steel and other manufacturers are now saying that they expect Obama to make good on his campaign promises for industry quotas on Chinese imports (remember my comments last week on the Smoot-Hawley Tariff Act of 1930 http://weeklymarketnotes.blogspot.com/2009/01/january-11-2009-weekly-percentage.html) A German official commented that we would face an all out “trans-Atlantic trade war” if Obama’s policies focus on preserving the outdated structures of US carmakers. A trade war could further cripple the global economy.

The Producer Price Index (PPI) was up 4.3% vs. expectations of 4.1% (ex food and energy) and -.9% vs. -1.1% including food and energy. The Consumer Price Index (CPI) was up .1% vs. expectations of -.2%, and up 1.8% ex-food and energy. This represented the smallest gain since in this measure since 1954.

US exports also fell by 6% in November, echoing the information in last weeks ISM report. The Empire manufacturing was -22 vs. expectations of -25, and down from -28
The Philadelphia Fed Business Outlook Survey was -24 vs. a -35 estimate. Industrial production measured -2% vs. expectations of -1%, and capacity utilization was 73.6% vs. expectations of 74.5%.

Initial jobless claims were 524K vs. a 503K estimate.

There is evidence that the credit markets are starting to loosen up. While not even close to where they were in late 2006 when the cracks in the system became apparent, this movement is definitely positive. Presently the improved credit conditions are not yet impacting borrowers; however, this is the first step to getting capital flowing once again.

The TED spread, the difference between Libor (3 month bank loans) and 3 month treasuries, fell to under 100bps for the first time since Aug 15 (see chart below). The TED spread is a measure of perceived credit risk in the economy. This is because T-bills are considered risk-free while LIBOR reflects the credit risk of lending to commercial banks. The Fed’s target is somewhere around 10bps.

Also, the Libor-OIS spread (a measure of money market stress) fell below 100bps for the first time since the Lehman collapse. When the LIBOR-OIS spread increases, it indicates that banks believe the other banks they are lending to have a higher risk of defaulting on the loans, so they charge a higher interest rate to offset that risk.

As I have mentioned in recent weeks, mortgages rates are cheap on an absolute basis as the Fed has been pushing programs to lower mortgage rates. The problem is that the spreads are still quite large with treasury yields near the lows experienced in 1945. While purchase activity remains soft due to concerns surrounding the economy, the employment picture, affordability, and what I hear are overly conservative appraisals, refi activity has been robust. In my view solid borrowers who can refi and save on their monthly mortgage payment are best suited to help consumer spending in this country.

The retail landscape continues to be rough, and threatens to inflict more pain on the real estate sector. This week Circuit City announced they would completely shut their doors (over 550 stores and 30,000 employees) by March 31 after they were unable to come to terms with investors and lenders on a restructuring plan. The clearance sale started this past weekend. I went into my local Circuit City (which has been open about one year), and it was the most crowded I’ve ever seen it. Although I had heard of prices being reduced by 30% in other locations, this location was having a 10% off sale. Most of the people I spoke with were coming back later, waiting for the prices to come down even further. Ironically the store carried the TV I had purchased 18 months ago at Sam’s Club for $795, and noted it was “on sale” for $1199. I think that pricing differential is indicative of the competitive problems Circuit City has been facing from Sam’s, Costco, Best Buy, and the internet.

Morgan Stanley, Citibank and Royal Dutch are holding physical oil, looking for suitable vessels to hold the oil until the price recovers later in the year. The biggest owner of supertankers, Frontline Ltd, said about 80 million barrels of crude oil are being stored in tankers around the world, the most in 2 decades. Contango pricing (where futures fetch better prices than current or spot rates) is allowing this arbitrage to occur. Buy the oil now, sell the higher priced futures, then pay for storage and deliver the physical oil sometime in the future. This arbitrage won’t last long. It is certainly good for shippers, who had seen volume and pricing begin easing in recent months. They are now charging $75K per day for the big ships. The spread right now is about $1.10 per barrel per month, with the typical tanker holding two million barrels; the potential profit is just north of $2 million per month. This assumes, of course, the tanker doesn’t run into Somali pirates!

The S&P 500 touched 815 on Thursday as the VIX spiked uncontrollably (it was up 10% intraday before correcting). This 815 intraday low is below the range I discussed in my January 4th note (http://weeklymarketnotes.blogspot.com/2009/01/january-4-2009-happy-new-year-to-all-of.html) of 840-1020. Remember this is a rough range. If you are trading the market, use the other indicators (like the spiking VIX and the moving averages) to help you with your timing.

If you look at the chart below, you can see S&P 500 volatility has been tempered somewhat during this most recent downturn. The five somewhat horizontal lines represent the regression line (red line), first and second standard deviations of the market since September. You can see that on Thursday the market bounced off its first standard deviation line (gray line) whereas prior bounces (October 10 and November 14) came at or below the second standard deviation line (green line). Does this mean the markets are normalizing some? It is too early to tell, but if the market continues with this type of dampened volatility (as I expect), it will make trading ranges narrower and less defined over the coming months. That makes trading tougher.

We may have received the first piece of good news for the market and economy in quite some time as the Wall Street Journal forecasting survey of economists showed that the economy isn’t improving. If this group has turned negative (remember that as a group they were raging bulls as recently as March 2008), then we must be nearing some sort of short term bottom. Stay tuned-I am still very cautious but this is the kind of mood swing I like to see.

The chart below are courtesy of Bob Bronson (http://weeklymarketnotes.blogspot.com, Bob Bronson link), who recently has added me to his service. The chart compares the magnitude and length of four downturns, as well as the length of the base following the downturns. The four periods are 1929 (down 89% and 3 years to hit bottom); 1962 (down 29% and less than one year to bottom); 1987 (down 36% and two months to bottom); and 2008. Bob has tons of historical information and analysis on his site. As I sift through it, I will periodically include items in this letter.

For the next few weeks I will be commenting on earnings. While I don’t expect to spend too much time on the details of each company, I will be discussing the general trends.

My good friend Satya Pradhuman, the proprietor of Cirrus Research (http://www.cirrus-res.com/index) who was also the former small cap strategist from Merrill Lynch, wrote this week that “Sell-side analysts didn’t start lowering their numbers until about six weeks ago (except in financials).” His note highlighted the following four items:
- Earnings Estimates in the US are at historical lows. Earnings upgrades in the US, UK and Europe are three to four standard deviations below their respective historical averages.
- Estimates downgrades have hit Consumer Discretionary, Consumer Services and Financials especially hard. The near 90% rate of cuts in estimates has not been seen in 30 years of data. Consumer Staples, Health Care and Transports have been affected to a lesser degree.
- Earnings estimates now plummeting in Europe and the UK. Small Cap earnings upgrades in Europe and the US have declined to historical lows of below 13%. In the UK this metric appears to be somewhat behind at 23%, implying that this market has more ground to loose in the current global slump.
- A delay in recovering forecasts is a concern for momentum-based variables, such as earnings revisions and price momentum, which gain from a market setting that reflects benign and even pessimistic expectations. Factors such as Return on Equity and Realized Earnings Growth appear most useful.
Thanks Satya.

From Barry Ritholz: RealtyTrac (realtytrac.com) reported this week that in 2008, the U.S. had a total of 3,157,806 foreclosure filings default notices, auction sale notices and bank repossessions on 2,330,483 U.S. properties. This was an 81% increase over 2007, and a 225% percent increase from 2006. The report also shows that 1.84 percent of all U.S. housing units (one in 54) received at least one foreclosure filing during the year, up from 1.03 percent in 2007. Housing es muy malo.

Financial service stocks lagged the market last week. Citigroup announced they were breaking up (are they following our “too big to survive theme”?). The Bank of America received an additional $20 billion from the US government via TARP after losses at the recently acquired Merrill Lynch were bigger than they expected. Was there an unannounced government guarantee to that acquisition ala JP Morgan and Bear Stearns? Seems like it to me.

If my memory serves me correctly, Band of America also owns Countrywide. This should get very interesting.

Will Insurance Companies be the Next to Fall?

I received an email this week from an insurance executive/friend who brings up concerns about writers of variable annuities, specifically citing Hartford and Lincoln. I’ll quote him here (my comments in red):

“They’ve all been punished pretty good but I think it’ll get worse for them. Reason is twofold: the guarantees (income streams, minimum death benefits, etc) they offered on the annuities they wrote are really expensive and the M2M (that means mark to market) is going to be brutal. Also, their hedge programs weren’t adequate and, if I recall, at least one of them was a dynamic hedger, so in addition to the piss poor program, they also incurred major fees. I’m not sure about Pru but I’d be cautious (their issues are probably more on the asset side). Met is presumably too big to fail (famous last words except the life industry is actually very capital adequacy-minded… it’s not just lip service). Look for a general down grade of the industry once numbers are published.”

In other words, they have big guaranteed cash flow liabilities, they aren’t properly hedged, their cost structure is bloated, and their asset values are questionable. I’ve heard this music before, and the song was terrible.

More Oil
Oil, which is now under $35 per barrel, continues to suffer from a lack of demand. Personally, I’m curious why we haven’t been seeing the recent declines in oil prices at the pumps? In fact, I recently paid more for a gallon of gasoline than I have in months. I understand that California typically runs higher than the rest of the country, but it seems to me that gasoline should be a heck of a lot lower than it is today. If anyone has been tracking this closely, I’d appreciate you comments.

Final Comment
As always I appreciate your support and comments. The charts are about 60% loaded into the website. If you have comments you’d like to share with the group, please feel free to either send me an email or post them yourself on the site. I appreciate all the referrals of new readers-I think the quality of the readers of this letter is terrific. New readers can catch up on the older notes on the website.

I’m not sure if I will be able to get a note out next week or not. I am going rock climbing with one of my sons, I guess it will depend on when we get back in town and whether I survive or not. If I can’t get the note out, I look forward to reconnecting with you in two weeks.

The Asian markets are down over 3% as I write this note.

Have a great week.


w (562) 430-3232

Jan 12, 2009

January 11, 2009

Weekly Percentage Performance for the Major Indices

Based on last week’s official January 9th settlement...

INDU: -4.8%
SPX: -4.5%
NDX: -3.2%
COMPQ: -3.7%
RUT: -4.9%

After peaking just above a 20% rally from the November lows, the market finally pulled back this last week to post its worst weekly loss since that November bottom. The culprit was horrible earnings reports (see “Earnings” section below), more horrible economic numbers (see “Economy” section below), and what must be a coming realization that this economy probably won’t be turning around anytime soon.

The last bear market lasted from March 2000 until March 2003, three years during what should be deemed a mild recession. It’s a given that stocks, especially technology stocks were exceptionally expensive at that time, contributing to the market pounding. The key to that last recession, and possibly the cause of the major meltdown we are experiencing today, is that the Fed was aggressively cutting rates and printing money during that time period. All of that cheap money found its way into consumer pockets, houses, and eventually the market, ironically keeping the consumer flush while the corporate world experienced a recession.

This recession (or depression) is different in that it is obviously led by the consumer, who is suffering from a debt-purchasing led hangover of global proportions. I would guess that this downturn is an order of magnitude more severe than the tech bubble implosion, and much broader reaching as it has impacted virtually every asset class and market around the world.

What’s my point? Similar to what I have been saying for months-that if it took three years for the last bear to turn during a mild recession, it will take quite a bit longer for this bear to turn in what is the worst economic crisis this country has seen since the Great Depression. Don’t get fooled by these rallies, no matter how good they feel. Sell the rallies and led the pundits ride the markets back down. Sell when the market feels good and add cautiously when there is despair in the air.

When does this all end? It really depends upon the impact of the global stimulus packages from the various governments. The size of the packages isn’t the key, but instead how and where they focus the stimulus. In our case, spending on roads and other government led infrastructure will, in my opinion, be a poor and inefficient use of capital. The programs eat up too much in the way of bureaucracy, time and overhead to be effective. Tax breaks along with spending directed towards government programs where the money enters the private sector directly will get capital moving much faster.

If all goes REALLY WELL, I’d say we could be looking at economic improvement sometime in 2010. If things don’t go well, we could be looking at an economy and market that is sideways for five or more years.

I have discussed the downside of this stimulus in the past-debasement of the dollar, massive inflation and enormous deficits. There would be additional ramifications (negative of course, it seems like we never get positive ramifications these days) in the form of higher taxes, stagnant economic growth, lower stock market multiples, higher interest rates, and enormous government intervention in multiple industries. Sounds like the 1968-1982 period, where the market was basically flat. Even in that flat market, there were significant bear market rallies and pull backs, plenty of opportunity for wise investors to profit.

The Fed has been buying Freddie Mac and Fannie Mae mortgage backed securities in an effort to drive down consumer borrowing costs, and mortgage rates have grudgingly obliged as the rate on 30-year conforming loans approach 5%. These purchases are part of a $600 billion plan which also includes buying the company’s bonds in an effort to lower their borrowing costs, which hopefully helps the moribund housing market. As part of TARP, the Fed is also spending $200 billion to finance new auto, credit card and student loans.

Corporate spreads are still near record highs, although absolute levels are reasonable due to extremely low treasury yields. According to Merrill Lynch, investment grade spreads are 6.0% above treasuries, down from 6.5% in early December (see this chart in the Jan 4 note at http://weeklymarketnotes.blogspot.com). Bloomberg reports that $135 billion in US bonds need refinancing in 2009 and many of these companies will face higher borrowing costs.

The Bank of England cut their benchmark interest rate to 1.5%, which is the lowest it has been since that central bank was founded in 1694!

Commercial Real Estate Follow Up
Last week I commented on construction and commercial real estate lending and the potential impact on banks during 2009. I received a number of emails from readers involved in this market, and I posted a couple of them (anonymously) on the website. If you are interested in reading more on this subject, take a look at http://www.weeklymarketnotes.blogspot.com/ under January, the post entitled “Commercial Real Estate”. I am hoping to add more detailed information on various topics on the site, including comments by readers who have expertise in these fields. I hope that this will allow us to share more knowledge.

The drumbeat of soft economic numbers continued last week, throwing cold water on the bear-market rally. The ISM non-manufacturing composite was actually up slightly from the prior report, and came in ahead of the consensus 36.5 at 40.6, still in recession territory but slightly improved. Factory orders were down 4.6% vs. a 2.3% estimated decline. Pending home sales were down 4% versus the consensus decline of 1%.

The biggest market impact came from the two employment reports. On Wednesday, the ADP employment change showed a loss of almost 700K jobs versus the consensus loss of 495K (although there was some changes to their methodology). Then, on Thursday, BLS reported the change in non-farm payrolls for December posted a loss of 525K jobs, the most since the war ended in 1945, although this was in line with expectations. Total job losses in 2008 were 2.6 million, and unemployment hit a 15 year high of 7.2%. Many pundits expect the unemployment rate to approach double digits in the coming year.

A few quotes from ISI:
* The picture is weak for capital goods shipments and orders. Turbines orders and shipments have done well and this seems consistent with the construction spending report. Tech shipments froze up, but tech orders rebounded. Aircraft orders are very weak.
* It appears that previously placed orders for durable and nondurable goods are being cancelled or delayed as final demand has weakened. The order book -unfilled new orders - dropped for a second consecutive month. Manufacturing inventories remain bloated relative to shipments.
* The service PMI somewhat surprisingly rose to 40.6% in Dec from 37.3% in Nov. While it climbed, this index is still deep in recession territory (my note-this is the ISM I discussed above).

Sector strategy
I have touched on sector strategy periodically, however, now that the New Year has begun; it is probably a good time to discuss this again. During the recent rally, late cycle, inflation beneficiaries such as energy and materials were leading the market up. To me this leadership is one reason I feel we are probably experiencing a bear market rally which will ultimately fail. Rarely do the prior bull market’s leading sectors lead the way out of the bear. What makes more sense is for new groups, in this case early cycle stocks such as consumer and possibly some technology stocks, to lead a recovery. Until we see these groups lead (primarily consumer), I am convinced that each subsequent rally we experience will be another head fake.

Another factor supporting my position is inflation and deflation. Right now we are experiencing deflation, which is typical after a business cycle ends. When the cycle starts to improve, the economy and market will favor those companies which benefit from deflation, which are typically the early cycle companies. Later in the business cycle, when inflation kicks in (and as I have discussed inflation will be big this time around), the late cycle inflation beneficiaries (metals, materials, energy) will benefit, assuming there is sufficient global demand.

ISI feels that some of the keys to watch for a better market & economy would be semiconductor performance, tighter credit spreads, value outperforming growth, and small cap stocks outperforming large cap stocks.

From Merrill Lynch-“Protecting one's own turf, building deeper moats and other protectionist rhetoric will likely carry though as a major theme in 2009. Higher import tariffs and security of supply issues are likely to help the commodity complex according to Rosie (David Rosenberg) and it offers a decent hedge should our deflation call not materialize.”

One of the biggest mistakes made during the Great Depression was the passage of the Smoot-Hawley Tariff Act in 1930. Most historians agree that this act was responsible for extending the length of that downturn by years. It is discomforting to consider all the protectionist rhetoric which has been occurring recently and remembering back just 12 months ago when both Democratic candidates were trying to outdo each other with protectionist promises. I think they are both coming into power next week, so it should be interesting to watch this debate unfold.

2008 Mutual Fund Performance

Scott Chronert, from Citigroup in San Francisco, wrote that “Money managers faced a slew of challenges in 2008, dealing with poor absolute performance, the pressures of redemptions/internal operations, and ongoing headline scandals that shake investor confidence. Our mutual fund work shows that many active managers also struggled with relative performance. Only a quarter (26.1%) of growth investors and a little more than a third (33.9%) of value investors outperformed their respective indices (based on an equal weight quintile analysis of YTD Morningstar Fund data as of 12/31/08). Growth fund managers relative to the index were underweight healthcare (26.41% of the Russell 2000 Growth), a sector that showed its defensive characteristics and outperformed the index by almost 800 bps. Value fund managers were relatively underweight Financial Services (39.56% of the Russell 2000 Value), which, unlike their large cap peers, proved somewhat resilient throughout the year and managed to catch a bid during the year end rally (+7.9% in December).” Thanks Scott.

More Pension
ISI is estimating the unfunded US Pension liability will grow to $513 billion this year. I have discussed this in the past and the potential impact on S&P Earnings for 2009. In addition to collapsing demand, compressed profit margins, and increased borrowing costs, it appears that companies will be facing massive earnings hits from pension expenses which will put the $64 S&P 500 earnings estimate (from Zacks) at risk. I have seen estimates as low as $20, although most people are more seriously discussing $40-$45. If ISI is correct, the impact on earnings could be so significant that any arguments now being made about the market being cheap could be rendered moot as the S&P is now trading at 20 times the $45.

The VIX, the most widely used measure of S&P 500 volatility, has been slinking it’s way back up after hitting a near term low on January 2nd of 39. Recall that the measure, which can be interpreted as the market’s measure of fear, peaked at nearly 90 on October 24th, but has averaged only 21 over the past 10 years. Prior work I conducted has shown that the VIX above 30 has typically signified a buying point in the market, however, as with most long term measures this one also misfired during the most recent crisis. It’s interesting to note that the old peak of 49.4 occurred September 20, 2001 after the markets had reopened post 9/11.

Corporate earnings began trickling in this week, and needless to say they were weak. Intel missed Q4, announcing a revenue decline of 23% and a $1 billion shortfall from their reduced guidance of just six weeks ago. That release shows how rapidly the environment is continuing to deteriorate. Time Warner took a $25 billion write down on their AOL and cable assets.

The retail space was a disaster as same store comps demonstrated what everyone has been expecting-an extremely weak Christmas selling season. Some of the culprits included Bed Bath and Beyond lowering guidance; Coach Stores lowering guidance (I guess even the rich are hurting); Wal-Mart, Macy’s and The Gap all cutting numbers. Comps at the Gap were down 14%, Macy’s -4%, Sears -7%, American Eagle Outfitters -17%, and Zumiez -12%.

Target was a bit ahead of plan, only declining 4.1% while Ninety-Nine Cent Stores’ comps were up 4%. Game Stop (a video game retailer) beat their comps as well. Overall, US same store sales fell 1% in December, which was the third consecutive monthly decline.

There was a positive data point during the week. Schnizer Steel reported that for their second quarter ending February 2009, ferrous prices are similar to 2006 and the first half of 2007. Prices appear to have stabilized and overall demand has picked up from the November quarter.

We know that the banks have been struggling, and that they still face more road blocks ahead. Mike Mayo, the Deutsche Bank financial services analyst and one of the truly great independent thinkers on Wall Street, put out a report last week concluding the slowing economy, weakening employment picture, and massive levels of household debt (see chart below), would result in US banks experiencing loan losses approaching levels not seen since the Great Depression.

Russia, which supplies 25% of Europe’s natural gas, cut off exports through Ukraine, blaming Ukraine for the problem. Later they cut off all shipments to Europe. Gazprom, the successor company to Russia’s state-owned gas company, claims that the Ukraine has been siphoning off gas destined for other buyers. Negotiations have been ongoing, and as I write this CNN is reporting that Russia will not proceed with a previously agreed upon deal, which included third party monitoring, to resume shipments to Ukraine. Weather in Europe is frigid, and natural gas prices have risen 20% on the week in Europe.

Sign of the Times?
I spoke to a very high-wage earning friend this week who has rarely held back on his spending in the two decades we have been friends. He informed me that in response to the economic situation, they are cutting back on everything possible. Now, I respect and admire his effort at austerity, but I also have known his wife for many years and am doubtful she will go along with this scorched earth policy of spending restraint.

Politics as Usual?

PE Obama warned that without government steps the unemployment rate could reach double digits. The basic plan is to spend and then spend some more, then tax later. Mr. Obama said “only government can provide the short-term boost necessary to lift us from a recession this deep and severe.” He also plans to crack down on “reckless greed and risk-taking” on Wall Street, but ironically made no comment about cracking down on the “reckless greed and risk-taking” in the nation’s capital.

The yet to be inaugurated Obama was the most liberal Senator until the general election, and the cynic in me can’t help but think he’s pulling the old Texas Two-Step. First, ramp the size and scope of government dramatically, then raise taxes down the line to pay for it. A huge ramp in spending and taxes could never be accomplished during a more “normal” economic period; however, these are not normal times. Congressional rules requiring balancing spending and revenues (government code word for taxes) have been temporarily thrown out the window, but when/if things settle down, the tax and spend crowd is going to happily begin raising taxes and fees on everything and everybody that can produce.

GM announced they have found no interested buyers for Saab. Why would they think that a brand with plummeting sales would be purchased by anyone in their right minds (of course, they did buy it themselves, but that’s another story)? Also, they haven’t been able to find a buyer for Hummer either. What’s a car maker to do?

The Bailout Winners
You would think if the government is stepping in to save US corporations in order to spare jobs, the equity holders (i.e. owners of the companies) would get wiped out at a minimum, and maybe even the bond holders. Not only are both these groups keeping their holdings, they are benefitting significantly from the deals. In the case of GMAC, the debt holders who accepted the mid-December debt swap received 70 cents on the dollar for their bonds. PIMCO, which initially agreed to participate in the swap, later reneged. When the government agreed to convert GMAC to a bank holding company, the value of the PIMCO held bonds rose from $.44 to $.80 on the dollar. While their judgment can be questioned for buying GMAC debt when the economy began teetering in late 2006, I certainly wouldn’t want to play poker against these guys. They just went all-in and won a huge pot against the US Taxpayers.

Follow Up
The Somali pirates that I discussed in the November 24th, 2008 note (http://weeklymarketnotes.blogspot.com) have apparently been paid $3 million for the release of the Saudi Arabian oil tanker they had captured. Their initial demand of $25 million was obviously out of the question given the 20% drop in oil prices since they took the tanker. The big losers were the Saudis, who not only paid the $3 million, but watched the value of their $100 million cargo decline by $20 million while they negotiated. Like I said before, I definitely want to be a pirate when I grow up. It has to pay almost as well as a well orchestrated Bernie Madoff scam, yet certainly is a lot more fun.

Comments from QB Partners: “Fundamentally, we reiterate our strong view that the US can’t grow or tax its way out of current and accelerating economic malaise that the credit de-leveraging has initiated. Policymakers know this. The only way out is to inflate away the value of US debt and inflate nominal wages by distributing new money and credit. They have begun to meaningfully debase the currency and we don’t expect them to stop until the US dollar has little purchasing power and/or they change the global monetary regime. Ultimately, we believe a coordinated global currency devaluation is the only possible resolution (consider it a form of pre-packaged bankruptcy of the global central banking industry).

… the true brilliance of the US economy, above all else. The US has enjoyed intergenerational productivity – and has avoided a lasting aristocracy - because each subsequent generation has had to work. Through its legislative initiatives and activist central bank (regardless of political party), the US has inflated away the real wealth of its people as nominal levels of output, wages (and debt) increase. Is this all a conspiracy? We doubt it is anymore, but we do recall the remark credited to Mayer Amschel Rothschild, the founder of the Rothschild banking dynasty; “give me control of a nation’s money and I care not who makes her laws.”

Final Thoughts
I don’t sit down each week with an agenda to write a gloomy or bullish note, I just write about what I see coming from the data points. This week’s note seems a bit gloomier, but I think that is only because now that we are past the crisis portion of this downturn the prospects are very slim for a recovery anytime soon. Recovery in one year would be phenomenal, almost a miracle. Longer than that is more realistic, and doesn’t bode well for a US economy reliant upon debt and leverage. I think the reason the long downturn in the 1930’s was called the Great Depression is because after years of a sluggish economy, optimism waned and people were depressed. As I think about what kind of world and opportunities my children will face, it is somewhat depressing. Hopefully I’m wrong.

As I write this the Hang Seng is down 3%.

Have a great week. Next week’s note will not come out until Monday night as it is a holiday weekend. Enjoy the day off!


Ned W. Brines
(562) 430-3232
Link to blog: http://weeklymarketnotes.blogspot.com

Jan 9, 2009

Commercial Real Estate

This is the first time I've tried posting something only on the website, not in the weekly email, let me know what you think. In response to a number of inquiries about my commercial real estate comments last week, a number of readers responded with information and opinions on the marketplace. Since this is not my area of expertise,I have shown their comments below, without attribution to protect their privacy.

If you ever want to post anything to this site and don't mind people knowing it was you, just click on the "comments" link below. If you want to stay anonymous, just send your thoughts in an email and I will either include them in the weekly note or post them ala these notes.

First note:


As long as you are writing, how about some prognostications regarding commercial real estate. My biggest question right now is where are CAP rates going to go? I am seeing a little movement for retail triple net properties, but not much. I have heard some people say that we may see 9 Caps on investment property, I am saying BS.

Second note:

In regards to cap rates...I can give you more details and specific numbers in a couple weeks when I get caught up at the office, but here is a quick my quick take.

Capitalization Rates vary based on a wide array of items including but not limited to Property Location, Property Type, Tenant Quality, Projected Cash Flows (Lease Terms), etc. With this being said cap rates will continue to edge upwards during the majority of 2009 and probably pick up pace in 2010 and 2011 and start to max out at that time.

1. Smart money is slowly (very slowly right now) coming back into the real estate market, which means investors are buying based on "income requirements" as opposed to "appreciation requirements". (Sounds like the equity market eh?) Since this is the case, Capitalization and Yield Rates need to be above Interest Rates to attract buyers. (duh!) But not too long ago, say the end of 2007, buyers believed that they could afford to purchase a property with a cap rate well below their interest rate since "...rents and property values were sure to be much higher in a year or two...". (Look for those dudes to give their properties back to the bank in 2009 unless they already have.)

2. But due to the slow inflow of new buyers, it is putting pressure on the sellers and supply is increasing rapidly, forcing those who need to sell to dump prices. Recently I ran across a portfolio of multiple-family residential properties that were listed at single digit mulitpliers (price divided by one year of gross income) in an area that in 2006 had 15+/- multipliers. In cap rate terms, this is like going from a 4% to a 7%. And a good friend of mine recently sold a mid-size apartment property on the water for a 12 multiplier, when 2 years ago it would have sold for an 18-20 multiplier. Although these are both multi-family residential examples, I can give you the same story with Retail and Office.

3. Fear of rapid inflation, in the long run, is another factor driving the cap rates higher. Real estate investors typically look at a 10-year hold period. Personally I am not a fortune teller, but my son has a Magic 8 Ball and when I asked it "what does a $10 Trillion Deficit mean to the our economy?", the answer was HYPER- INFLATION, with a sub-note that said "...if I had a dollar tomorrow for every dime I have today I would be a rich man...". A quick rule of thumb on Yield Rates (used in Discounted Cash Flow Analyses) is they typically are just slightly less than Capitalization Rates plus Inflation Rates (everything else being equal).

4. Lenders are increasing spreads (interest rates), Debt-Coverage Ratios, requiring greater reserves, lowering LTVs, and on top of all that don't have as much money to lend. There is a slight chance of this turning around with the strengthening of our socialist government, but don't hold your breath. This is again putting pressure on sellers to lower prices, which increases cap rates.

Don't get me started on Retail Sales, Unemployment, Corporate Cut Backs, etc. I mean I can go on for days with this stuff.

In a nut shell, look for cap rates to increase in 2009. So a Credit Tenant (Fast-Food/Retail/Drug/etc.) with a long-term NNN lease in Orange County that once sold for a 4% cap in 2006/7 will be selling for a 6% to 7% cap in 2009. That is a 30% to 40% drop in value! Check out www.loopnet.com if you want to see the latest listings.

That is all I can muster in my 30 minute dinner break.

Jan 5, 2009

January 4, 2009

Happy New Year to all of you, I hope you had a wonderful holiday. We spent ours with good friends, great food (thanks Carlene), and good wine. As Elvis Presley once said “Try to surround yourself with people who can give you a little happiness, because you can only pass through this life once, Jack. You don’t come back for an encore.”

This week’s note is going to be a bit different than other notes, and longer. Typically I try to incorporate the prior week’s events with my own observations, and then weave in the important events for the following week. Tonight I’m going to do a short summary on 2008, some predictions for 2009, and also summarize last week.

2008 Percentage Performance

Dow Jones Industrial Average -33.8%
S&P 500 -38.5%
NASDAQ -40.5%
Russell 2000 -34.8%
Crude Oil -53.5%
Gold +5.8%

Weekly Percentage Performance for the Major Indices
Based on last week’s official January 2nd settlement...

INDU: +6%
SPX: +6.5%
NDX: +6.5%
COMPQ: +6.5%
RUT: +6%

Last week was very strong from a performance standpoint; however volume was very light, so it is tough to make much of this trend. I even had trouble making trades in my measly account because of liquidity issues. Also, as I have discussed in the past, the holiday weeks near the end of the year tend to be positive as tax loss selling subsides.

One strong note last week was the advance decline, which was 2900/290, or about 10:1. This is actually quite bullish, however again last week’s performance must be taken in context of the volume, or lack of volume.

I have my new Stock Trader’s Almanac 2009, which regular readers will note I quote quite liberally. This week I am looking at the well publicized January Barometer, which postulates that how the month of January trades determines the market’s direction for the entire year. The barometer has a .741 batting average, which, by the way, is three times the level required to earn $10 million per year in major league baseball (and people wonder why I have a batting cage in the backyard for my kids?). It seems that the first five trading days have an even better record of predicting the direction of the market. Since 1950 there have been 36 up First Five Days and during 31 of those years the market was up, an 86% batting average. In the 22 years exhibiting down First Five Days, the record was less impressive with 50% of the years being up and 50% being down.

Home prices fell 18% through October according to S&P/Case-Shiller index and has now fallen every month since January 2007. Phoenix and Las Vegas were down 33% and 32% respectively. It shouldn’t be surprising that these markets have been pummeled given the abundance of sand to build on in these areas. My grandmother, who was a very astute investor, once told me to “never buy real estate in the desert, it’s much too easy to expand the city limits.” Good advice, I’d say.

In an interview with Bloomberg, the CEO of homebuilder Lennar said “Frankly, we’re in the midst of a downward spiral and the momentum is building”. Those are some pretty frightening words coming from the CEO of a public company after four years of softening markets. The chart below shows the index since 1968.

Courtesy of our friends at the Big Picture, the chart below is the same index going back to 1890, but adjusted for inflation. The dotted line is an estimate of home prices continuing to correct until 2015, when the long term appreciation on homes will equal the long term inflation rate. And you thought I was bearish? Personally, I feel the residential real estate market in the US could find a bottom as early as late 2009, assuming the government finally let’s housing drop one more leg to a point where affordability is in line with historical averages.

Consumer Confidence came in at 38.0 versus an estimate of 45.5, reiterating the unstable condition and poor outlook of the US consumer. Initial jobless claims did come in better than anticipated, although 490K is not a number to celebrate.

The ISM Manufacturing report was absolutely horrid as orders, inventories, and demand were all rotten. The economy is deemed to be expanding when the ISM is at 50 or higher, and contracting under 50. This month the measure came in at 32.4. The chart below, (1948-2008) which we have looked at in the past, shows the destruction in production activity as the index is nearing the all time lows set in 1980.

This week look for same store comp sales on Thursday. This is going to be an important release because it will give us a good look at how Christmas was for the retailers. More importantly, watch the market action around the release. Over the past couple of weeks we have seen the market react positively to seemingly negative news. Does this mean that finally the market has taken a view of the economy that is too negative? The comps response should tell us whether this is indeed the case as the estimates are pretty dour. If the report comes in at or below estimates and the market trades up, it might be time to consider being longer in the market than we have at any time since starting this letter.

Corporate News
There was a lot of negative news coming out of the technology world last week. Technology has become more tied to the consumer over the past decade as cell phones, MP3 players, video game consoles, etc have consumed a larger portion of semiconductor output. Micron, the large DRAM manufacturer, announced a big loss, write-downs, and capital spending cuts in response to weakening demand and pricing. The company’s gross margins were negative, and management expects them to decline further.

DigiTimes reported that due to weakened demand and increased uncertainty, DRAM makers including Micron Technology, Hynix Semiconductor and Powerchip Semiconductor have each announced capital spending reductions for 2009. Meanwhile, market watchers believe that Samsung Electronics, Elpida Memory, Nanya Technology, Inotera Memories and ProMOS Technologies will also announced capital spending reductions for the coming year. While this is negative for the capital equipment manufacturers, it may set them up for a rebound in 2010 or 2011.

Global demand for chemicals, a very cyclical industry, has declined dramatically with the weak economy. Dow Chemical, which made an offer to purchase Rohm & Haas last summer, could now be facing a severe funding crisis in their effort to close this $15 billion transaction. Unrelated to the deal, Kuwait reneged on a $9 billion commitment to a joint venture with DOW. Given the state of the chemical market, it appears that DOW may be placed in the uncomfortable and very expensive position of reneging on the Rohm deal themselves. The company is already facing significant credit rating concerns by the ratings agencies, and the loss of the Kuwaiti capital could push their funding costs to an unsustainable level, assuming they choose to continue with the Rohm deal. I think it’s interesting that the all cash deal for Rohm exceeds the equity market cap of DOW.

Speaking of credit, there are only six non-financial US companies which receive S&P’s AAA rating-Automatic Data Processing, Exxon Mobil, General Electric, Johnson & Johnson, Microsoft, and Pfizer. Moody’s concurs on five of the six, excluding Pfizer. Toyota is the only non-financial borrower outside the US with a top rating. While impressive, let’s remember that Moody’s and S&P are the same rating agencies who felt that subprime mortgage backed securities deserved top ratings.

It seems that capital structure decisions made in the early part of this decade are coming back to roost as companies borrowed cheaply to buy back stock, yet are now in a cash crunch. The New York Times, Gannet, Home Depot, Macys, and many others treated their balance sheets like home equity lines of credit and recklessly borrowed. I remember having a CFO in my office last spring, telling me that investors had been prodding him to lever up to buy back stock. I told him that while an efficient use of capital can increase the overall enterprise value of the company, levering up heading into a global recession was a recipe for disaster and a sure way to destroy enterprise value. As we are all being reminded now, leverage is a two-edged sword whose cut is very painful.

Dow Jones reported that ComScore released their online holiday spending results, which fell 3% from a year earlier and were well below its earlier prediction of flat sales. That was the first decline since the research company began tracking e-commerce in 2001. "The combination of having five fewer shopping days between Thanksgiving and Christmas and the severe economic headwinds faced by consumers has made this a really tough season for retailers, both offline and online," said comScore Chairman Gian Fulgoni. From Nov. 1 to Dec. 23, the last day to purchase online with the possibility of delivery by Christmas Eve, online spending totaled $25.5 billion. That figure excludes auctions and large corporate purchases. In the fourth quarter, e-commerce spending has declined 4.3% to $36.8 billion and is likely to be the first full quarter in which spending dropped since comScore began tracking e-commerce.

Global Stuff
The geopolitical has reared its head again with Hamas and Israel locked in a deadly and ugly struggle. Oil prices reacted predictably as they always do when there is unrest in this section of the world. India and Pakistan are rattling their nuclear sabers in another verbal duel. Somewhat below the radar but troublesome nonetheless is the Russia-Ukraine dispute over alleged past due natural gas bills. Russia is threatening to cut off gas to the Ukraine. Europe uses gas for about half its heat and about 80% of that flows through Ukrainian pipelines. With Russia having used about one-quarter of its currency reserves trying to defend the ruble, it is hard to see how far they might take this, but Europe (and the Ukraine) needs gas more urgently than Russia needs cash. What Europe doesn’t need is additional complexity as they try to figure out the best policy for confronting the economic crisis. Economic weakness tends to increase global instability.

2008 Predictions
We all know that 2008 was the second worst year in the market behind 1931. I have read many comment’s about whether this poor performance could have been predicted or not. I thought I’d throw my hat in the ring as a prognosticator and share with you my thoughts from a year ago. Below is a list of predictions I attempted to include in my letter to clients for the year ended 2007. Because of corporate reasons I won’t get into, I was unable to publish these predictions. Some of them were obviously meant to be less than serious. Additionally, I was never able to edit them or refine them because the entire idea was bounced back to me as “inappropriate” to send to clients (didn’t want to scare them, I guess). The bold text is my analysis of the prediction. Enjoy.

1. The massive consolidation in the commodity sector will continue-Right-check out the chart below of the CRB

2. The Beijing Olympics will be a spectacular showcase of China’s new economic power-Right. I thought it was pretty cool

3. The US economy will continue to be soft but opportunities will continue to be present in faster growing economies outside the US-Half right, the US was soft, but global economies were softer

4. The soft economy will benefit growth investing over value-Wrong-they both were bad

5. Healthcare troubles will continue as both Democrats and Republicans will target healthcare in their election rhetoric-Draw-there were more problems than healthcare as the economy took over the election

6. The 2008 election will rival the 2000 election for absurdity, and at least one candidate will drop out due to scandal-Wrong-hey, I also thought Obama was too liberal to win a general election.

7. The credit markets will continue to struggle, especially in the first half of the year. New market participants will find niches to profitably operate and new products will be created to replace the old ones-Right, if you count TARP and all the government bailout programs as new products

8. Home prices in the US will continue to decline. Additionally, some states’ Attorney General with political aspirations will file suit against a mortgage lender, saying they forced borrowers to take money to buy houses they couldn’t afford-Right

9. One major retailer and one major financial service company will file for bankruptcy-Right, but boy did I underestimate this one

10. Two hedge funds will become famous for out-maneuvering the credit crisis, but one will later falter when their assets swell on the notoriety and they can’t repeat their success-Draw-I’m not sure I can tell you if a fund that was successful early in the crisis has closed (besides Madoff), but there are a ton closing their doors

11. When we look back at 2007 it will be apparent that Warren Buffet was short the US real estate market by virtue of only holding 0.001% of his total net worth in his $250,000 residence-Wrong, mainly because his net worth has dropped dramatically in the back half of the year and that house now probably represents 0.002% of his net worth

Net score 6.5 right, 4.5 wrong, which is about 60%.

Also, I have cherry picked a few quotes from that letter which were on track (if you want to see the quotes that missed, I’ll put them up on the blog site later this week, right now it’s just time to beat my drum).

“While we feel a soft-landing is priced into the market, a hard landing is not. Should the Fed’s actions prove to be ineffective or too late, an ensuing recession would be negative for all equities…”-It’s funny when you look back at your writing from the past-retrospectively this is kind of a “duh” statement.

“We anticipate that during the first portion of 2008 the US economy will continue to remain soft, hindered by a continued decline in the housing market, below trend consumer spending, and tight credit markets. Home prices have not yet bottomed and additional bankruptcies are likely in the housing and mortgage sectors. Incremental consumer spending will track the housing market. The credit markets will continue to struggle, especially in the first half of the year. As a result, investors will need to tread cautiously in these areas during 2008.”-I think this would have been good if I hadn’t made the disclaimer “especially in the first half of the year”.

Stock Market Outlook
This is the section where I get to be really wrong again. Remember these are my observations and opinions at this point in time, and they will definitely change, especially in an environment as volatile as this one. The market prediction is going to have a lot of disclaimer as I don’t want you to trade or invest based on my market outlook for the year.

1. Stock Market-as you know I have been maintaining that this is a good time to be accumulating great companies on the cheap, without getting overly exposed to equities. I continue to espouse that view, but still think we are in a long term trading range in the market. Currently the S&P has bounced over 25% from its November 21st low. Some are contending we are in a new bull market, whereas I maintain this is a bear market rally. As you may recall, I have been looking for strong bear market rallies, and have suggested using these rallies to sell your weaker holdings. The S&P is approaching the 950 level I felt would act as the upper band of its trading range. I am still looking for a flat 2008, however, I don’t invest based upon targets set at the beginning of the year, and urge you not to do so either. The S&P is now 931, and I truly feel that it will finish 2008 +/- 10%, which would suggest a range between 840 and 1020.
2. Economy-will definitely stay weak throughout the course of the year, but I see the potential for improvement throughout the year. Credit (see below), the snake that put us here, will be the key to an incremental improvement. I do not expect robust economic growth for a very long time (years?) as I feel the structural problems resulting from the financial crisis will keep a heavy hand on the economy.
3. Corporate earnings-they are going to be bad, the question is will they be worse than anticipated? I think so, which means the street consensus of $42 for 2009 S&P earnings will be too high and the market still isn’t cheap. Besides demand, items having a negative impact on EPS will be rising debt costs and pension shortfalls (see the December 14, 2008 note at http://weeklymarketnotes.blogspot.com/).
4. USC will get ripped off by the BCS again, the Angels will win their division but won’t advance beyond the ALCS, and the Lakers will win the NBA. Is anyone else bothered that the largest revenue generating sport at the college level won’t let their champion be determined on the field?
5. Inflation-I’ve been pounding on the inflationary impact of the Fed action for the entire year, and will continue to do so. Remember I have been saying we won’t see the impact of this inflation until 2010 or 2011. Supply/demand needs to come back in balance in retail, commodities, etc, before inflation can accelerate. The supply/demand imbalances will eventually occur due to both declines in supply and eventual increased demand. For 2009 inflation will remain tame, but it is definitely lurking out there and if the dollar continues to falter, we may experience inflation without an increase in demand (stagflation).
6. Dollar-the dollar is a real mess. We have sacrificed the dollar to stabilize the global economy. At the risk of sounding like a parrot of Wall Street, gold still appears to be the best place to hedge your dollar exposure. More gutsy investors might look at the Brazilian Real or to China as a hedge against the dollar. In the long run you will no longer need a wallet, but a wheel barrel may come in handy to carry your cash.
7. Commercial real estate- these loans could be the straw that breaks the back of the regional banks. Remember that many banks skirted the residential mortgage problems (relatively speaking) because they didn’t hold those mortgages. Not so with the commercial loans, which are typically held by the originating bank. Most of these loans will require a second stage of financing to either allow a builder to exit the property via sale or to allow a developer to lock in permanent financing when construction is completed. Unless the credit markets improve dramatically, the banks are going to be holding the keys to a lot of commercial properties. Additionally, the problems in the retail sector are negatively impacting existing retail centers.
8. The master of spin, President-elect Obama, is going to continue to put out press releases in an effort to coax the economy into acting better.
Eventually his plan to spend like crazy will accepted by the Senate and Congress, after they add their billions in pork to the bills. After all, these guys have never seen a spending bill they wouldn’t support, as long as it includes goodies for their home states. I’m guessing that whatever size stimulus package comes out, there will be at least an additional 25% in pork. As I said before, our grandchildren will be paying for this bailout.
9. Credit-my contrarian (I think) call is that credit continues to loosen throughout the course of 2009. My guess is that, ex any additional systematic shocks like the Lehman bankruptcy, we achieve more normal levels of credit spreads in Libor and the TED spread. Once capital begins flowing between the banks, they will be more willing to lend it back into the economy and giving us a shot at a 2010 recovery.
10. Housing-no change here. This market needs to find a bottom, but won’t until the government stops trying to artificially prop it up. Once we find stability, there is a ton of inventory that needs to be absorbed. I can see a bottoming process lasting another 3-5 years in this market.
11. More Credit- I’ve been saying invest in corporate bonds, but after reading the umpteenth article today reiterating that stance, I’m not so sure. Higher quality paper has rallied lately (see the chart below showing the spread on AAA paper versus 10 Year Treasuries), so looking down the credit curve towards high yield makes sense, although it is much more risky.

12. Oil-the forward curve for oil (below) is predicting oil will be at $60 per barrel by year end 2009, an increase of 27% from Friday’s close. I have been negative on oil for so long I feel like this is an area I need to reverse course. With the dollar collapsing and supply cuts being announced (I’m not sure if they actually ever happen or not), plus the instability rearing its ugly head in the Middle East, I can see oil rising from here. It seems to me that even though we could see the price of the commodity increase some this year, the service companies will suffer as budgets are reset to account for the 70% drop in price since July.

My Position
As I have discussed in the past, I have been market neutral with my shorts heavily concentrated in the IME (industrial, material and energy) stocks, and also have been short beta. Last week I repositioned, moving to beta neutral and also primarily sector neutral (slightly net short energy, but net long industrials and healthcare). Also, continuing a strategy I have used over the years, I am entering the year more conservatively positioned, waiting for the market to throw me that fat pitch. By conservatively positioned I am now 40% long and 35% short, for a net long position of 5%, whereas coming into year end I was 80% long and about the same short.

What Conflict of Interest?

The quote below is from Barry Ritholz’ new book, Bailout Nation, regarding Harvey Pitt, the former SEC chairman:

“In an era of corporate accounting scandals, Pitt had close ties to the accounting industry. And for inexplicable reasons, Pitt met with the heads of companies under active SEC investigation. As a Wall Street lawyer, Pitt had “recommended that clients destroy sensitive documents before they could be used against them – advice that seemed to find echoes in the SEC’s investigations into Enron and its shredder-happy auditor, Arthur Andersen.” Pitt had to recuse himself from many of the SEC’s votes — they were frequently about the clients he had represented as a defense attorney. By July of 2002, Senator (and future GOP presidential candidate) John McCain was calling for Pitt’s resignation.” Pitt, not surprisingly, demoralized the agency. To investor advocacy groups, having Pitt as SEC chief was like putting Osama bin Laden in charge of Homeland Security.

Thank You for Confirming What I Already Said
In the December 21, 2008 note under “Too Big to Survive” (see http://www.weeklymarketnotes.blogspot.com/) I talked about comments from an investment banker friend who suggested that breaking up financial institutions deemed “too big to fail” was a good idea due to the risk to the system that their existence created. In Sunday’s op ed section of the New York Times, there is an enormous article by David Einhorn and Michael Lewis (“How to Repair a Broken Financial World?) in which they quote me (just kidding)-

“Not as chaotically as Lehman Brothers was allowed to fail. If a failing firm is deemed “too big” for that honor, then it should be explicitly nationalized, both to limit its effect on other firms and to protect the guts of the system. Its shareholders should be wiped out, and its management replaced. Its valuable parts should be sold off as functioning businesses to the highest bidders — perhaps to some bank that was not swept up in the credit bubble. The rest should be liquidated, in calm markets.”

Blog Update
The blog site is close to being completed. I haven’t had as much time over the holidays to work on it as I had hoped. Even though they know not to bother me when I’m in my office, just having three kids running around the house during Christmas break has been a bit distracting as I find myself heading out to toss the ball with them or administer pop quizzes in math, science and religion (let me tell you, those go over like a lead balloon during vacation).

The address for the site is: http://www.weeklymarketnotes.blogspot.com/. All the old notes can be found in the right hand column under their respective dates, just click on them for access. The most recent note will appear in the main window. I am posting the notes right after I send them, so if you don’t have email access, but do have web access, you can read them online. If you want to be notified of any updates to the site, click on “subscribe to: Post Comments” at the bottom of the page.

You may also post comments by clicking the “Post a comment” link at the bottom of each note. Remember these will not be anonymous as other readers will see them. When you send me emails with comments and opinions, those will remain anonymous as usual.

I haven’t finished integrating the charts into the older notes, only in tonight’s note and the December 28th, 2008 note. I finally found out that to integrate the charts, I needed to isolate the HTML code of the chart, then insert it into it’s proper position……blah blah blah. Holy cow, I still don’t even know what HTML code is and now I’m inserting it into a website!

There is a section in the right hand column entitled “links to websites you might like”, which includes a list of sites which I reference in my notes. Feel free to click on those for more information. I am trying to keep that list narrow, showing only those sites which I think have value.

You will also notice Ads by Google. Those ads should be related to the financial markets. If you see any inappropriate or irrelevant ads, please let me know so I can contact Google. Feel free to liberally click on those ads (just kidding) as I get paid by Google per click (I don’t know the rate, but I’m thinking it’s probably $.000000000000000000000000001 per click) and this is how I’m feeding my kids right now.

The “video bar” section searches YouTube for videos on the economy, the stock market and investing. If you point your cursor at a video, it will give you a short description of its contents. These videos are randomly served by Google, and I don’t endorse any of them. Again, if you find any inappropriate content amongst these, please let me know as I can easily remove the video links. They are there for your benefit, and if they aren’t helpful it will take me five minutes to remove them.

Final Comments
As you may, or may not know, this market letter is my first attempt at writing after managing money for many years. It began as a result of numerous requests for information about what was going on in the markets and evolved into the weekly note I am now sending out. I have never considered myself a writer, however, I have enjoyed putting this together each week and hope you find it a worthwhile read. Many of you have provided me with valuable information, viewpoints and feedback, which I greatly appreciate and typically try to incorporate into the notes to ensure I’m addressing topics of interest. Keep in mind that the list of readers is very impressive, spanning business owners, CEOs, CFOs, investor relations professionals, global sales directors, head hunters, fund managers, analysts, strategists, corporate leaders, real estate developers, industry experts, ministers, airline pilots, investment and commercial bankers, salespeople, professional athletes, engineers, accountants, attorneys, politicians, consultants, and a slew of other readers in various fields. The list of readers is now approaching 300 (amazingly nearly 50 of those are not relatives). I act as a conduit between these various parties to improve the information flow in an effort to make us all better informed investors.

Quote for 2009 Trading

“A good trader has to have three things: a chronic inability to accept things at face value, to feel continuously unsettled, and have humility”-Michael Steinhardt

Good luck in 2009. While I doubt that 2009 will be as eventful as 2008, it will definitely be a difficult year in the markets. I hope to see you and as usual appreciate your feedback and comments.


Ned W. Brines
o (562) 430-3232