Feb 9, 2009

February 9, 2009

“The problem with America is that it’s run by investment bankers, mostly from the same bank. How can Americans stand for it? Is Barack Obama from Goldman Sachs too?”-Sumit Kotari, Malaysian cab driver, in a conversation with William Pesek of Bloomberg News.

“During difficult times, the government should pay people to dig holes and then fill them up again”-John Maynard Keynes

Thank you to the twenty-eight of you who emailed asking why this week’s note didn’t arrive last night and to those who asked if I was alright. I am fine, thank you. My family and I went to Mammoth last Thursday, and didn’t get back until this evening. The snow was great, and the crowds were sparse. Also, to the one very funny email I received asking for a subscription refund, I’m sorry but my wife spent your $1 this weekend. You can try to get it from her, but after 15 years of marriage I have found that once a dollar gets into her hands, it isn’t coming back. Good luck and please let me know if you figure out how to get it back from her.

Economic Woes
Mammoth wasn’t all play for me this weekend; I was also working hard for all of you. I spoke with numerous locals, retailers and seasonal employees regarding the local economy, and the feedback was uniformly bad. Restaurants and shops started closing late last spring, and that trend has accelerated recently. It appears to me that about 1/3 of the retail doors in the Village were out of business. Intrawest (“IDR”), which recently purchased Mammoth from the McCoy family and another investment group, is apparently really struggling under the debt load they placed on the resort. Their response to the softness has been to lay off employees at the mountain and raise prices dramatically, which has further stymied the visitor count. I wouldn’t be surprised to see the family or another group step back in and buy the mountain back for a fraction of what IDR paid three years ago. In another twist to the story, IDR was purchased in 2006 by Fortress Investment Group, an alternative asset manager who has seen their market value plummet from a high in February 2007 of nearly $4 billion to $750 million as of today’s close.

The economic data points continue to limp in, however, based upon the market’s reaction (actually, it’s lack of reaction) it appears that some of the economic ugliness may finally be priced into the market.

Employment is an absolute disaster as initial jobless claims came in at 626K vs. 580K expectation, and the unemployment rate spiked to 7.6% vs. 7.2% in the prior month. How bad is the employment picture? Take a look at the chart below (courtesy of Barry Ritholtz) showing how the job losses this recession compare to those of prior recessions.

The ISM manufacturing index came in at 35.6 vs. the 32.5 estimate, which was also an increase from the 32.9 of last month. A measure below 50 indicates that domestic manufacturing is contracting. This month’s indicator suggests that there was a probable broadening of weakness in manufacturing as inventories expanded. Expanding inventories typically lead to further slowing in manufacturing unless there is a dramatic uptick in consumption, which doesn’t seem likely given the employment situation.

The ISM non-manufacturing index was 42.9 vs. the 39.0 consensus (again, under 50 is recession territory) and vs. 40.1 the prior month (December). The market reacted positively to this information as investors began considering that the rate of decline could be slowing. This second derivative of growth is a popular metric the market focuses upon, and one I will monitor closely.

More Keynes

This quote came from NPR: “Prescribing Keynesianism to some politicians is like prescribing crack to a coke addict. In the 1970s, the patient hit rock bottom. The U.S. had high unemployment, and the Keynesian solution stopped working. The national government spent and spent, but unemployment only got worse. Then came inflation, something Keynesians had no answer for.” I bring up Keynes this week since his theories are being relied upon as the rationale for the stimulus package being bandied about Washington.

I have mixed emotions about the stimulus package. At the risk of sounding like a three-handed economist, on one hand I see the need for a coordinated global stimulus plan to keep the global economy from completely seizing. On the other hand I think it’s about time we paid the price for all the over-spending (personal, corporate and government) of the past thirty years, and somehow additional spending doesn’t seem to be the proper cure. On the third hand, anything coming from Washington flat out stinks, except for the hilarious C-SPAN clips of Senators calling Wall Street executives stupid, greedy, and morons. I hope I can say this out loud, but wasn’t it the role of Congress to regulate the financial markets? If Congress had taken this role seriously, we wouldn’t have to endure endless hours of their grandstanding over this stimulus plan.

One of my favorite retail analysts and very old friend Tom Filandro of SIG, said last week that “An additional headwind facing specialists this January is the fact that gift card sales likely declined at a minimum of 5-10% this Holiday season, which meant lower overall post-holiday redemptions. The good news is January typically accounts for only 5-10% of annual sales, and it does appear inventories are well contained, in particular for forward deliveries of transitional spring floor sets. For January, we are forecasting a sector comp decline of 4-6% (vs. -2.7%), which would represent the seventeenth consecutive month of sector comp store sales declines.”


Technology stocks rallied last week in spite of very weak December Semiconductor Industry Association data that showed revenue down 6.5% in December on unit declines of almost 14% and ASP (average selling price) increases of 8%. The worst markets were flash, DSP, and microprocessors, all down in the 35-42%. There were many calls on Wall Street that a turnaround is coming as early as mid-year. Since peaking in January 2006, the Philadelphia Semiconductor Index (SOX-see chart below) has fallen 59% and has also fallen 58% from the July 2007 high. Using either date, it seems highly unlikely that the worst downturn in the history of the semiconductor market would end in such a short time period. During a normal cyclical downturn this would be a logical time to start bottom-fishing, however, as time progresses I think we are all seeing that this is anything but a normal downturn.

Supply & Demand
According to NAND memory (the memory in phones, iPods, etc) maker SanDisk, prices declined by 70% year over year as demand waned and overcapacity continues to pressure pricing.

Crude and gasoline inventories rose last week above expectations in the face of continued softening demand. Crude oil inventory rose by 7 million barrels versus an estimate of 3 million barrels.

The TED spread has fallen under 100bps (see chart below), a level breached in August 2007 during the early stages of the financial meltdown. Remember that the TED spread (i.e. three-month dollar LIBOR less three-month Treasury Bills) is a measure of perceived credit risk in the economy. When the risk of bank defaults is considered to be decreasing, the TED spread narrows. After peaking in early October at nearly 500bps, the TED spread has moved back towards normalcy, suggesting that the credit markets continue to thaw. Improvements in interbank lending precede improved commercial and consumer lending, although the timing of this improvement is a question.

During January the worst performing sectors were financials -27%, industrials -13%, telecommunications and consumer discretionary -11%. The best performing sectors were more defensive, with utilities and health care each down 1%.

After peaking at 5500 in May 2008, the Dow Transports have fallen 42% to a recent low of 3000. DOW Theory would suggest that these early cyclicals would need to rally along with the Dow Industrials to confirm a new bull market. Although the index jumped a bit last week on news that UPS would be cutting costs in the face of soft shipments, it still hovers near it’s low and hasn’t shown any significant improvement (see chart below).

Housing & the Economy
From the Wall Street Journal: “In the typical severe financial crisis, the real price of housing tends to decline 36%, with the duration of peak to trough lasting five to six years. Given that US housing prices peaked at the end of 2005, this means that the bottom won’t come before the end of 2010, with real housing prices falling perhaps another 8-10% from current levels.”

They continued “equity prices tend to bottom out somewhat more quickly, taking only three and a half years from peak to trough-dropping an average of 55% in real terms”. The S&P has dropped by that amount, but three and one-half years from peak (Sept 2007) to trough suggests a bottoming in early 2010.

Pending home resales jumped 6.3%. in December versus November and 2.1% year over year. Month over month strength was noted in the South and Midwest, while the West and Northeast showed further declines. Year over year the Northeast and Midwest were weak (both down double digits), the South was slightly up, and the West was up 18% on big foreclosure sales. Bank seizures have resulted in 19 million homes in the US standing vacant at year end.

According to Zillow.com, US homeowners lost approximately $3.3 trillion in property value during 2008. Additionally, they report that 1 out of 6 homeowners owe more than their homes are worth. Sounds like more homeowners can be expected to hand over their keys.

Private Equity

I was fortunate to recently be copied in an email thread between some very astute investors. While they have asked for anonymity, they have been gracious enough to allow me to reprint portions of the exchange below (the opinion comments are not mine, but one of the writers):

Secondary private equity funds. Remember the University of Virginia dilemma from a few weeks back about their potential 75% allocation to private equity (EOTM 11/10/2008)? Distressed private equity sellers abound, with discounts at 30% to 70% of net asset value. Discounts reflect deteriorating corporate fundamentals and balance sheets, longer holding periods and the degree of undrawn capital, as capital has become scarce again.

(GTM Query: like the rest of the capital/financing markets, until the secondary markets “clear”, the primary markets will be moribund. Hard to sell a “new issue” at PAR (whether new PE Fund or newly issued HLT Bank Loan or new CMBS) when can buy seasoned, performing securities at 30 to 70....)

...With deflation setting in (last Friday's GDP deflator was negative for the first time since 1954), cash maintains its purchasing power, and can be drawn on as risky assets become oversold.
(GTM Parable Proxies: whether its “cash is king” or “keep your powder dry” or (per JPM above) “capital has become scarce” or “cash maintains its purchasing power”, the message continues to stay in liquid, higher-quality, shorter-duration assets in order to avail the opportunities (still to come) when ‘risky assets become oversold’.

My opinion only, but believe high-yield debt (yes, a risky asset) has, in 30 short days, gone from ‘oversold’ to ‘overbought’. I’m taking the 10%-20% ST capital gains, and moving back into the higher Investment Grade debt assets....

Additional update on Secondary Private Equity Funds:
Just got off the phone with JP Morgan and they are “running” to market this month a “NEW $500 million Private Equity Secondary Buyout Fund”. Pouncing on the opportunity they set up below in Geoff’s comment. A bit self-serving on their part, but I would agree with the opportunity given the mad rush by individuals, endowments and pensions to create liquidity. Many forced to raise cash because of the de-leveraging has left them with capital calls they cannot make.

Are You Kidding Me?
I don’t want to bash other managers, but this one is amazing. Bloomberg reported that a particular hedge fund manager (I’ll leave out the name) is planning on starting a new fund after halting redemptions on his main fund. Why did he experience such dramatic redemptions last year? He was down at least 88% last year on his $2 billion fund. Talk about an optimist. If he (or many others in the same boat) is able to raise capital after that performance, then maybe I should attend that open tryout for the Angels next month.

It Must Be Nice
Manny Ramirez turned down a two-year deal with the Dodgers for $45 million with a third year option at $15 million. The Dodgers appear to be the only team making Manny an offer. Scott Boras, Manny’s agent, is the king of extracting big money from MLB owners, but he might want to check the economic condition and advise his client that it might not get any better than this. If Manny doesn’t take the deal, I’ll do it for a measly $15 million and won’t disrupt the dugout. Someone pass that along to McCourt for me, OK?

In an immediate response to the $45 million savings, MLB announced an overall reduction in the cost of beer and peanuts at games. Hmm, let’s see, my choice was cheaper beer or watching Manny pout over only making $22 million? Better pass me another Coors Light. In fact, let’s get rid of every player making over $5 million per year and have the beer and peanuts included in the price of the ticket! Talk about a national pastime.

Six and Counting
In my 2008 predictions I said that one of the candidates would get involved in a scandal. While we didn’t see a scandal directly involving the new President (outside of a couple of terrorists as best friends), he is certainly cavorting with some unscrupulous characters (I know, that’s redundant when talking about politicians). Since becoming President, six people close to the President (Senators Clinton and Daschle, Nancy Killefer, Tim Geithner, Representative Solis and Governor Blajdovich) have been involved in some type of questionable or illegal activity, all of which were greed related. The number of tax evaders on the list is staggering. Tom Daschle forgets to pay $125K in taxes? You or I would already be handcuffed, not returning to our post after giving up a higher profile one. Let’s hope this situation gets better fast.

In his first act as the new emperor, Mr. Obama has mandated a salary cap on executives of companies taking public assistance. Who can blame him? Vanity Fair reported that Merrill paid bonuses equal to 95% of their $10 billion bailout money. They are certainly not alone as Bank of America paid out 75%, Goldman 120%, Morgan Stanley 100%, Citigroup 46%, Wells 32%, and JP Morgan 54%. This represents combines bonuses of $85 billion on $140 billion of bailout money.

In response to the President’s proposal, Goldman Sach’s CFO David Viniar announced the firm would like to pay back their TARP funds.

In a sign of the problems with our government oversight (or lack of), Senator Dorgan of North Dakota wants to introduce an amendment requiring companies that accept bailout money to make their bonuses public. ATTENTION SENATOR, THAT INFORMATION IS ALREADY PROVIDED IN PUBLIC COMPANY FILINGS! In an unrelated story, it appears that Senator Dorgan was recently challenged to a battle of wits, but the challenger later withdrew his request because he felt it unfair to do battle with an unarmed man.

Final Comments
Many readers who have a mandate to be fully invested and don’t have the option to either hold cash or short stocks have asked where the best places to invest would be given those constraints. I have often mentioned fading the market on strength (i.e. cutting back your exposure) and adding on weakness. I have also suggested adding to stronger companies, those which don’t need access to capital for the foreseeable future, those with stable revenue and cash flow streams.

More specifically, I would favor stocks and the debt of companies in defensive sectors (healthcare and consumer staples). If you are more bullish, you would also consider more early cycle sectors such as transports, and if you are more defensive you would consider utilities. Energy and financials are the two wild cards given their unique issues. I would dramatically underweight energy. In my view most financials are nothing more than a crapshoot, although I’d love to hear feedback from you on where you see opportunities in this sector.

I hope this finds you well. As always, if you’d like to be dropped from this list, please let me know. Additionally, if you would like to read older posts, they can be found at http://weeklymarketnotes.blogspot.com. As many of you found out, I posted some of the Super Bowl ads on the website last week. I guess I should do that more often as traffic on the site last Thursday and Friday was six times normal.

Have a great week and enjoy the long weekend. I will be sending next week’s note out on Monday night.


Ned W. Brines
O (562) 430-3232

“The best thing to give to your enemy is forgiveness; to an opponent, tolerance; to a friend, your heart; to your child, a good example; to a father, deference; to your mother, conduct that will make her proud of you; to yourself, respect; to all men, charity.” - Benjamin Franklin

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