January 11, 2009
Weekly Percentage Performance for the Major Indices
Based on last week’s official January 9th settlement...
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).
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.
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.
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.”
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
Link to blog: http://weeklymarketnotes.blogspot.com