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...
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.
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.
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.
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