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

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