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%
Russell 2000 -34.8%
Crude Oil -53.5%
Weekly Percentage Performance for the Major Indices
Based on last week’s official January 2nd settlement...
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.
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.
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.
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.
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.”
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.
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