February 16, 2009
“If the last 15 years has taught us anything, hasn’t it taught us that asset classes can be incredibly mispriced, along the lines of the 35 times inflated earnings for the S&P 500 in 2000?”-Jeremy Grantham
Weekly percentage performance for the major indices
Based on last Friday's official settlement...
I have long maintained in these notes that we would have a sucker’s rally followed by a pullback, and that is exactly what has occurred as we are moving close to the intraday low of November 21st and erasing the gains of December to early January. The chart of the S&P 500 below shows the trading range of roughly 800-975 we have been facing since the end of September. I have been suggesting fading the market at the top of this range and becoming more exposed near the bottom of the range. While we could experience a breakout in either direction from this range (my bias would be down), I will maintain this range-bound view until the market makes a sustainable move beyond those areas.
With the market falling a whopping 48% from the high of October 2007, many have suggested that the market is now cheap. If you have followed my thought process (I know, sometimes that’s like following a humming bird), you know that I am a proponent of longer term PE multiple compression caused by higher rates (see inflation and stimulus discussion in prior notes at http://weeklymarketnotes.blogspot.com). The chart below, courtesy of Bob Bronson at Bronson Capital Market Research, shows that we entered a period of declining PE ratios in mid 1999, and that he expects this cycle to bottom out somewhere near 7-10 times earnings from a current level in the mid-teens. Bob also maintains that over the past 138 years the movement in PE ratios can explain 50% of stock market returns.
I want to apologize to readers as apparently my political commentary has been interpreted as overly critical of the new President and his team of tax dodgers. I want to set the record straight that while I am a registered Republican, I try to deliver an equal dose of cynicism towards both parties because, let’s face, they are both completely incompetent. I feel that both parties are heavily and equally responsible for the economic mess we are now facing, yet not only will neither party them take any responsibility, they grandstand on C-SPAN while berating other contributors to the crisis. I’m not sure what label I could place on my political views, but I guess that Libertarian would be the closest. I abhor the graft and inefficiencies of the bureaucracy whose only success is in perpetuating itself. This note is meant to be apolitical, really just commenting on the actions of the government which impact the economy and markets.
It’s no secret that global trade has been slowing. John Mauldin of Millennium Wave Advisors, LLC produced the chart below showing the percentage change (quarterly) in global merchandise exports and global industrial production. As you can see, the rate of change has fallen to almost -15% since late 2007.
I have discussed the Baltic Dry Index (“BDIY”) in many prior notes. Bloomberg is reporting that the BDIY has bounced over 100% this year, fueling the currencies of commodity based economies such as Canada, Norway and Australia as investors look for some signs of economic strength. The BDIY has long been considered a leading indicator for commodities and may be being benefitting from the economic stimulus now being implemented in China. While the bounce is impressive, the BDIY is still 85% off its May 2008 peak of nearly 12,000.
Congress approved a $787 billion bailout plan which includes $500 billion in new government spending and $280 billion in tax breaks. While there was much grandstanding about stacking $100 bills to the moon, the reality is that the plan was really rushed as Congress and the Administration 1) want to look like they are addressing the problem and 2) are absolutely quaking in their boots that the economy might turn around without any of them taking action and therefore not being able to claim victory. Too Machiavellian? OK, then they wanted to rush in so they can’t get blamed for inaction if the economy takes another major leg down.
Tim Geithner, one of the men who will be spending your tax dollars (not his own since he doesn’t actually pay his tax bills) announced the “details” of a $2 trillion plan to unlock credit, although he neglected to provide any specifics. Part of his discussion revolved around a $1 trillion fund to buy illiquid assets and another to issue credit to consumers and businesses. He also discussed providing additional funds to banks, but this time with limits such as not using the money for corporate airplanes or bonuses. The biggest question, as with the initial plan in the fall, is at what price will these assets be sold? In general, the whole thing looks like a bigger version of last fall’s plan, but with a new name (Financial Stability Plan).
While we haven’t seen the details of the plan, one feature being discussed is a strategy to subsidize interest rate reductions by the mortgage loan servicers who handle mortgage payments. This would allow them to lower payments without shortchanging investors. If you remember, I suggested a similar plan in a note last fall, however, my twist was to make the investor eat some of the rate cut since it would probably be offset by the increased value of their mortgage pool now that the odds of default would be lower.
One of the scary aspects being discussed is that the administration would like to allow judges to change loan terms, effectively eliminating contract law, one of the backbones of our free markets. This so called “cram down” authority would kill the secondary mortgage market and raise rates for any new borrower since mortgage investors would require a higher interest rate to compensate for their inability to foreclose in the case of non-payment. The loans would effectively move from a classification of secured loan to an unsecured loan, and therefore would have to carry a higher interest rate to compensate the lender for the increase in credit risk.
I just want to double check my math here. The plan calls for $800 billion in stimulus to create or save 4 million jobs=$200K per job, at a cost of $26K per family over the next 10 years. How about this plan for stimulus: save ½ and give the 4 million people who will get these jobs $100K each. That should help get consumer spending going and keep them in their homes.
This week’s embarrassment had to be the perp walk of top bankers, who were getting ripped by Congress of all people. One Congressman berated the CEOs and asked why they haven’t been prosecuted. I mean, really, Congress is doing their best to blame the rest of the world for problems they helped to cause by their lack of oversight and their own greed, and yet have the nerve to go on TV to grandstand and attempt to humiliate (if that’s possible) these CEOs?
In response to the haranguing, Citi cancelled a $50 million jet that was already ordered, killing off more jobs at Lear or one of the other manufacturers. I guess we can surmise that the corporate jet market is definitely not one of the preferred businesses that the government wants to save in its new jobs program. Additionally, in a threat to my free beer and peanuts with baseball tickets I discussed last week, Citi is being pressured to end their naming rights deal with the New York Mets’ new stadium.
The second part of Jeremy Grantham’s year end commentary is now available, and I suggest reading it if you have time. There is a link on my site (http://weeklymarektnotes.blogspot.com) that will take you directly to Jeremy’s site. You will have to create a log-in ID to read the report entitled “Obama and the Teflon Men, and Other Short Stories” part 1 & 2.
Last week I included a chart showing the rapid rate of job losses during this recession. The chart below shows the unemployment rate since 1948 and how it has spiked in the past six months to 7.6%. Many experts feel the “real” rate is closer to 13%, but I think that you can see we are approaching nose bleed levels with no signs of abatement.
The Federal Reserve is looking to add more primary dealers to prepare for the surge in treasury issuance that will be coming later this year, possibly up to $2.5 trillion versus $892 billion in 2008. Primary dealers are banks that deal directly with the Fed on new debt auctions, and are required to bid at these auctions. The number of dealers has fallen recently with Lehman, Bear Stearns and now Merrill Lynch exiting the pool. The number of dealers peaked at 46 in 1988, but has since dwindled to twelve.
One reader sent in an email this week with the following comment: “My brothers have a boat dealership in Florida and sales for December were only 10% of their December average for the last ten years. Fortunately, they started to see a substantial uptick right after the first of the year but things are still relatively slow...just not as catastrophically slow as they were.”
Credit Market Thaw?
Bloomberg is reporting that high-yield issuance was approximately $2.4 billion this week, the highest since the week ended June 26th. Spreads on junk are the lowest they have been since October, but still sit above 1600bps (16%), with the absolute yields in the 18% range. According to Merrill, the yield on investment grade debt is 520 bps over treasuries, the lowest since October 7th. Could this be another (see last week’s note for a discussion of the TED spread and other credit market leading indicators at http://weeklymarketnotes.blogspot.com) sign that the credit markets are beginning to function more rationally?
It shouldn’t be a surprise that capital is moving given the massive increases we have seen in M2 growth. The chart below shows the year over year change of M2.
Not that the ratings agencies are worth a darn, but it is interesting to note that Amazon.com had their debt upgraded to investment grade this week. I can’t remember the last time I saw that occur for any company.
Citi announced that their charge-off rates on loans jumped to 7.8% in December from 4.2% in December 2007. American Express’s charge-off rate rose to 7.2% from 3.3%, and BofA’s rate increased to 8.5% from 5.2%. The new stimulus plan may push for more consumer lending, but with charge-off rates climbing, it appears that only the government itself would be foolish enough to extend consumer credit in this environment.
DigiTimes reports that Taiwan-based thin-film photovoltaic (PV) module makers are being asked by clients to renegotiate contract prices to lower levels because prices for thin-film PV modules on the spot market have dropped to levels 20-30% lower than the contract prices, according to industry sources. Spot prices of amorphous silicon (a-Si) thin-film PV modules have slipped to $1.5-1.6/watt for energy conversion rates of 5-7% and to $1.7-1.8/watt for those of 8-10%, the sources pointed out. As most of the existing supply contracts of a-Si thin-film PV modules were signed in the first half of 2008 when spot prices for such products stood at $2.5/watt at least, Taiwan-based makers are being asked by clients to lower the prices of their existing contracts, the sources indicated. While bad for the manufacturers, this decline in pricing could drive solar towards grid parity (i.e. the price point where solar is as economical as natural gas powered electrical production) and eventual mass adoption.
The university’s $29 billion endowment fund sold 67% of its stocks in the 4th quarter of 2008. From July-October the fund lost 22%, and may have fallen over 30% for the year ended this coming June.
Advanced retail sales climbed for the first time in 7 months, up 1% and up 0.9% ex autos. Spending on food, clothing, and a rise in gasoline are being credited with the increase. Declines were noted at building materials stores, furniture outlets, and department stores. Online and catalog sales rose 2.7%. Consumer spending is anticipated to drop again this quarter, which would be the first time purchases declined three quarters in a row since record keeping began in 1947.
The average cost of regular gasoline rose by $.10 to $1.78 a gallon. If you live in California, you know that gasoline is quickly running back towards $2.50. Add to that the discussions in Sacramento about raising taxes all over the board, and I’d say that any tax relief you may receive from the Federal relief fund is going to go straight to Sacramento. Tax increases now will kill any chance of recovery in the Golden State, whose politicians may be more corrupt and incompetent than those in the US Congress. In response to the weakness in tax receipts, the Governator has threatened eliminating 20K state employees, joining the long list of corporate layoffs we have been witnessing.
Jobless claims once again worse than expected, 623K vs expectations of 610K. Business inventories dropped 1.3% vs. expectations of a 0.9% drop. The University of Michigan consumer survey came in at 56 versus expectations of 60.
This is a quote from an email exchange I had with another PM. The comments are my response to a market positioning question. “I'm actually 5% net long. I'm not pretending we are in a bear or bull market, just a range bound market whose direction will ultimately be determined by the prospects of the economy-which I feel are better than three months ago but still very poor. I think we are past the "crisis", at least the most recent one, and have probably seen the lows in the market (assuming there aren't anymore systematic shocks coming), however, this doesn't mean we are anywhere close to either an economic or market recovery. In my view, the actions of the Fed and now the new bailout plan will have little impact on the economy, but will sow the seeds for long term currency devaluation, higher taxes, lower growth, and inflation. All of these will impact the long term multiple of equities and make credit much more expensive, placing a damper on any equity market or real estate recovery. I believe that stock picking will be very important, especially given the indices probably won't provide any meaningful return for a long time.”
I have commented a number of times in prior notes about those pesky Somalian Pirates and their devilish activities. It seems they may have recently met their match this past week as a Russian warship captured three of them off the Somali coast. According to Captain Igor Gygalo, the “detainees were in a state of narcotic intoxication.”
Spring training travel package sales are down 25% from last year. I don’t think that will bode well for the MLB given some of this year’s blockbuster pay packages. Something tells me my free beer and peanuts are going out the window fast.
The upcoming week is packed with economic releases and option expiration. The markets have been down five of the past six weeks, however, the VIX has calmed down and the selling doesn’t seem to be panicked. I’d rather see some panic selling in order to increase my long exposure. I’ll keep my very slight long position and add to it when either the market shows some intermediate signs of capitulation or it moves to the lower end of the more recent trading range.
Have a great week. Remember to check the link to Jeremy Grantham’s quarterly letter at http://weeklymarketnotes.blogspot.com.
Ned W. Brines
O (562) 430-3232
"The problem with socialism is that eventually you run out of other people’s money." -- Margaret Thatcher
“An economist is someone who sees something happen, and then wonders if it would work in theory.”-Ronald Reagan