Mar 30, 2009

March 29, 2009

March 29, 2009

“One determined person can make a significant difference; a small group of determined people can change the course of history.” Sonia Johnson

The market continued to rally this week as the S&P 500 rose another 6.2%, peaking at 832 on Thursday before pulling back slightly Friday. Monday was an enormous day with the market surging 7% on the Treasury’s PPIP announcement (see PPIP below). Monday’s move was the largest move in the market since 1938, which is rapidly becoming the favorite year of comparison for 2009. For those of you who aren’t aware, 1938 was a year when the market bounced significantly after a horrid 39% decline in 1937, rising 24% for the year and 55% from the March 31st low.

As I’ve been saying for a number of weeks, I am using the 830 level as a place to start moving my portfolio net neutral/short. Now that the market has tickled those levels, I have begun to move the portfolio in that direction. Where are my concerns? Everywhere!! This market continues to make a fool out of anyone who even sniffs a bit of success, and bear markets typically don’t end until everyone has been wiped out-longs and shorts.

The market action during this bounce continues to be robust and broad based. Financials, industrials, and technology have all been strong, and were the leading groups for the week. During the rally that died out after the New Year I said one of the reasons to doubt the validity of that rally was that it was being led by the late cycle stocks. It is my opinion that a new bull would need to be led by more of the traditional early cycle sectors (financials, consumer discretionary, and transportation). The transports actually performed well during the week, rising over 10%. In my view this current rally could have more staying power, and that makes me nervous given my portfolio positioning.

As always, I continue to keep an open mind when it comes to identifying the end of this bear market. Right now I still believe the market is range bound with a downward bias, and will continue to position as such.

According to the Traders’ Almanac, April has historically been a good month for stocks. April is the last month in the best six months of the market. Typically, however, stocks run up into the first half of the month and then fade once earnings for the first quarter are announced.

Last week I asked where the bubbles are forming, and the consensus among readers seems to be in the treasury market. Treasury yields are being artificially held down by Fed buying. The Fed cranking up the printing presses to make these purchases. To me this sounds eerily similar to the housing bust we just witnessed, whereby investors continued to bid up housing prices by using ultra cheap capital-until the underlying asset values wouldn’t support the leverage and the capital went away. What happens to the Fed Ponzi scheme when the world dumps the dollar? Bonds will collapse as well, sending yields and domestic inflation skyrocketing.

In general the economic releases have still been weak, but have been exceeding estimates. Many feel that beating expectations the first step towards a bottoming in the market as the dire circumstances of the economy may finally be priced into stocks.

Existing home sales came in at 4.7mil vs. 4.45 mil expectation, up 5% month over month. The big driver of growth (43%) was foreclosure sales. Sales of new single-family homes in February 2009 were at a seasonally adjusted annual rate of 337,000, according to estimates released jointly by the U.S. Census Bureau and the Department of Housing and Urban Development. This is 4.7 percent (±18.3%) above the revised January rate of 322,000, but is 41.1 percent (±7.9%) below the February 2008 estimate of 572,000. That range is enormous: 4.7% +/- 18%? That’s a range of -13% to +23%. That’s quite a margin of error, yet the markets jumped on the headline number as a sign the housing market has stabilized.

US durable goods orders rose 3.4% vs. expectations of -2.5%, the biggest increase in a year and a nice bounce after a 7.3% decline in January. New orders were up 3.9%.

Personal consumption (graph below) was down 4.3% vs. expectations of -4.4%.

Initial jobless claims were 652K, again stable around 650K. Continuing claims are now at 5.56 million.

The University of Michigan confidence index came in at 57.3 vs. an expectation of 56.8 and 56.6 in the prior period.

The final Q4 GDP came in at -6.3%, the worst drop since 1982.

PPIP is another $1 trillion plan, this one offered by the Treasury, to move toxic assets off the books of the banks by providing funding and guarantees to investors who will buy those assets. I wonder if the private firms considering stepping into this market in partnership with the government are pausing to analyze how much criticism and punitive taxes they will face if they are successful?

The Geithner Giveaway
From Josh Rosner
“While exclusions from TARP compensation limits should exist to protect the public bidders of assets in the Legacy Loan Program they should not exist for the five ‘largest and most sophisticated’ firms that will manage the Legacy Securities Program. This Geithner giveaway to managers that appear to have unlimited access to the Treasury Secretary, and to the White House, appears to be the real scam of the century. Isn’t the unfettered access and unlimited market power these firms wield reason enough to ask if they are being provided “protection” in their bids to grow to become systemically risky and globally dominant?

The “hunting license”, as the Legacy Securities Program has been termed, allows giant “F.O.T.” firms (“Friend’s of Tim”) to buy the assets anywhere they can find them (not just from banks - perhaps even from each other or their own separate funds). The details are scant. Is it dollar for dollar matching private/public funds? It appears but isn’t clear that it may include UST debt financing as well as equity. It seems to allow the winning firms time to present a plan to UST, take time to raise money, time to identify securities, try and buy back pieces of ARM and CMBS to reconstitute CDOs and “add value”. The program requires RMBS to originally have to have been AAA rated and ABS and CMBS to currently be AAA. Are they able to use this as a mechanism to bid up the value of their own separate portfolios?”

Treasury Market Woes

The UK failed to complete their bond offering this week, the first time in seven years, a sign investors don’t agree with their plans to halt the economic crisis there. Interestingly, the UK has been pursuing a similar strategy to the US-buying their own debt in an effort to manipulate yields downward.

In the US treasuries continued to fall after an auction of 5 year notes drew a yield of 1.849% vs. the 1.801% forecast. In the understatement of the week, Bulent Baygun, head of interest-rate strategy at BNP Paribas said “Prior to the auction the Fed conducted its purchases of Treasuries, which may have compressed interest rates below where they would have been otherwise.” Duh!

It appears that Paul Volcker, who has voiced his frustration at not having enough input into the economic bailout plans, will be named to head a review panel of the tax code. An administration official said the purpose was to “rebalance the federal tax code.” My only comment is “look out!”

Oil and Taxes

The Wall Street Journal reports the Obama administration's push to raise taxes on the oil industry is reigniting a battle the industry fought and won last year. Under pressure to narrow projected deficits of almost $10 trillion over the next decade, President Barack Obama's 2010 budget proposal calls for raising more than $31 billion over the next decade by eliminating the oil and gas industry's eligibility for various tax breaks. The plan would slap companies with a new excise tax on production in the Gulf of Mexico worth $5.3 billion between 2010 and 2019, and repeal the industry's eligibility for a manufacturing tax credit worth $13.3 billion in that period. The industry says the final cost of Mr. Obama's proposals on petroleum production could top $400 billion, once his plan to put a price on greenhouse-gas emissions is factored in. The Obama administration has generally justified its proposals by arguing that taxpayers deserve a better deal. Speaking to the American Petroleum Institute this month, Interior Secretary Ken Salazar cited a recent report by the Government Accountability Office that said the U.S. receives a low share of revenue for oil and gas resources compared with other countries. In an interview, Mr. Salazar signaled that the administration might reconsider some proposed tax increases on small, independent producers.

Did I read that correctly? We are now comparing our corporate taxes to countries such as Argentina, Brazil, Russia and Nigeria?

The dollar dropped against most major currencies after U.S. Treasury Secretary Timothy Geithner made comments that raised concerns about the currency's status. In response to a question about China's proposal regarding special drawing rights, Geithner said he is "open" to the idea. He quickly clarified that the dollar is still the world' premier reserve currency. I’m not sure if the Secretary qualified for his current position or not, but it is very apparent that he shouldn’t make any more public statements.

Regular gas rose to over $2 a gallon for the first time since November 20th. US refiners have cut production rates to the lowest level since 1992 due to low consumption. Consumption of gasoline was up 1.6% last week vs. the prior week and down 0.2% from a year ago.

From Peter Boockvar:

“Fed Pres Lockhart in a speech a few hours ago in Paris is summing up well what is the growing angst in the markets that the Fed is sowing the seeds for big inflation with their aggressive steps by saying, “there’s reasonable concern related to the growth of the balance sheet of the central bank in response to the economic difficulties we’re having, that this could over the long term fuel inflation if the monetary aggregates are not managed well and if the Fed doesn’t react at the right time to remove some of the stimulus.” We are thus relying on a Fed that thought subprime was contained at a loss of maybe $150b in 2007 to somehow reverse their massively aggressive initiatives at the exact right time.”

Dollar Part Deux
This week the G-20 will be meeting, and the two key topics will be how to deal with some of the really weak countries and discussions on a new global reserve currency. The Chinese (and apparently our Treasury secretary, see above) are pushing for a basket of currencies to move the world away from having the dollar serve as the global reserve currency. If this happens, watch out below! The dollar will collapse, resulting in skyrocketing prices for any product with foreign inputs.

Is anyone else bothered that the government’s solution for getting us out of this recession is the same factors that got us into this recession? It seems to me that if deficit spending and cheap capital were the cause of our present economic problems, then it seems unlikely deficit spending and cheap capital are the cure. Are we trading today for tomorrow? Why don’t we just swallow our medicine as opposed to throwing the burden onto our kids? This definitely won’t go down as “the greatest generation” as our parents and grandparents did.

Smart PM
From a recent email: “I remember giving a presentation at a Merrill conference in October of 2002, when the Nasdaq was at ~1,500, and I predicted then that it would take at least twenty years before the Nasdaq sustained itself above the old high of 5,000. Well, it is going on seven years and the Nasdaq is below 1,500 today. Thus, the Nasdaq needs to compound at more than 10% for the next 13.5 years to reach the March ’00 high. I believe the odds are rising that it may take the S&P 500 a decade or longer before sustaining itself above the 1,560 high in October ’07. Sure, there will be large and exciting rallies that get people optimistic again, but the reality is that corporate margins are going to be under duress for a number of years. And if inflation rears its ugly head in a couple of years, like I expect, P/Es are going to be suppressed. I will change my mind when I see lower U.S. income and cap gains tax rates, an emphasis on savings and investment, and our mercantilist trading partners stimulating a more internal-consumption oriented economy rather than an export-led economy…I know, wishful thinking.”

Conspiracy Theory

From yet another reader:

“Ten minutes before the market close yesterday afternoon some entity put in a huge S&P buy order. I'm now absolutely convinced that the trading desk at the Fed is playing games. The repercussions for this are going to be severe and terrible. In their zeal to put lipstick on this pig they are going to draw investors into a fake that is eventually going to cost them very dearly.

All eyes are also on the dollar as China and Russia seek to end its dominance as the world's reserve currency. People who dismiss this are missing the point. We have entered a new kind of cold war and it will involve trade and our currency. The games that they are playing in Washington to spend gigantic amounts of money are leading us down a very scary path and to sure confrontation with the rest of the world. I fear that Washington in their arrogance doesn't really appreciate the gravity of the situation. It would not take much for the rest of the world to send us a fiscal message, e.g., like the one that was just sent to the British. I'd watch the next auction of long Treasury bonds very carefully. I going to bet that a message is going to be sent loud and clear.”

The Big Three
From The Big Picture---“The Obama administration asked Rick Wagoner, 56, to leave the company (General Motors) and he agreed, an administration official said. Wagoner had said March 19 that he didn’t plan to resign. The likely replacement, unless the government hires from outside the company, would be Chief Operating Officer Fritz Henderson, said John Casesa, managing partner at New York-based consulting firm Casesa Shapiro Group.

The departure of Wagoner comes as President Barack Obama prepares an address tomorrow morning on his plans for the future of the U.S. auto industry. GM is surviving on $13.4 billion in U.S. loans and is asking for as much as $16.6 billion in additional aid to survive. Wagoner was asked to step down as part of the company’s restructuring, the official said.

“It’s very hard for the government to write a big check without giving some evidence of change,” Casesa said. “This will also give the government moral authority with the other stakeholders to make them sacrifice.”

Really? Heads will roll before writing big checks? Funny, I kinda remember a trillion dispensed without so much as a peep.

I am no fan of Wagoners, but I have to ask the geniuses behind the bank bailouts: When are you going to ask the TARP and bailout recipients to step down? Ken Lewis being asked to step aside after many years of running BofA ? How about Blankfein? Pandit? And the rest of the TARP recipients?

This inconsistency from the new administration is very disappointing.”

Thanks comrade

Czech prime minister (and EU president) Mirek Topolanek was somewhat critical of the Obama stimulus package when he described it as “a way to hell” and that it would “undermine the stability of the global financial market.”

The first quarter ends on Tuesday, and I wouldn’t be surprised to see the market run up late in the day as manager’s try to “window dress” their portfolios. Asian markets were extremely weak overnight, with the Nikkei and Hang Seng both down around 4.5%.

Have a great week and good luck.


Mar 22, 2009

What’s the Cure for Popped Bubbles? Why, More Bubbles, of Course

What’s the Cure for Popped Bubbles? Why, More Bubbles, of Course

March 22, 2009

In honor of St. Patrick’s Day: “May the saddest day of your future be no worse than the happiest day of your past.”

Weekly percentage performance for the major indices
Based on last Friday's official settlement...

INDU: .8%
SPX: 1.6%
NDX: 1.6%
COMPQ: 1.8%
RUT: 1.8%

This was another volatile week in the markets, with the rally continuing in the first half of the week, peaking on Wednesday with the Fed announcing a bazillion (just kidding) dollar subsidy program for treasuries and agency debt (see Fed below). The S&P 500 nestled right up to that 800 number I discussed last week, peaking at 794 on Wednesday before pulling back slightly to close at 772. The consensus is very confused right now-those who want to be bullish are concerned that stocks were actually down for two days at the end of the week, while those who want to be bearish are a bit skittish after watching the S&P race up 19% in just eight days. I’m sticking to my strategy outlined in the past few notes, moving more towards net neutral from slightly net long around the 800 level and tipping net short if the market moves into the 830 range.

I thought the internal action of the markets was more interesting than the moves of the indices this week. The financial and material stocks, typically not bed partners, led the market higher. The financials were strong on more confidence in the Treasury plan to stress test the banks, the Fed’s plan to flood the markets with more liquidity, and the possibility that, net of the massive write-downs, the underlying lending business might be profitable this quarter given the enormously steep yield curve (which the Fed engineered to help the banks).

The run-up in material stocks was a bit more confusing. The more bullish feel the move is a sign of an anticipated rebound in the global economy. The more bearish feel the move in materials is a reaction to the coming decimation of the dollar after the Fed completes its plan to inflate another US bubble to save us from the pain of a protracted recession. I have been discussing this for the past six months (the Feds actions are inflationary) and now it appears the market may be recognizing this as well (I guess that tells you which camp I fall into).

Many have questioned how we can have inflation when demand is slack and capacity utilization is at a very low 71%. The answer lies in the dollar. We could face a scenario where demand doesn’t return in the US, yet inflation occurs anyway due to the monetary phenomena called quantitative easing-where in effect the Fed prints trillions of dollars to inflate us out of our quagmire. This has never been done successfully (think Germany in the early part of the last century), however, the Fed is intent on continuing this Keynesian experiment. It is interesting to note there will be a G-20 meeting this week in which one of the topics will be moving the world from utilizing the dollar as the global reserve currency to some type of basket of securities. The rest of the world is beginning to recognize that we have not been good stewards of our currency, and they may no longer be willing to support our behavior, even though they are encouraging us to stimulate in the short run.

Oil rose this week even though OPEC announced that they would be leaving production unchanged. Although demand is still waning and inventories are building, the commodity moved up with the weakening of the dollar. It will be interesting to see if OPEC members will stick with their quotas if the rise in oil continues (see chart below). Many of the member countries are hurting from the $100 drop in the price of oil, and are more interested in pumping at $50 plus versus the mid $30 level touched in February.

PPI came in at 0.1% vs. estimates of 0.4%, but 0.2% vs. 0.1% ex food and energy (which is good for those who don’t eat or drive). The annualized measure was -1.3% vs. -1.4% and 4.0% vs. 3.8% ex food and energy.

Housing starts and building permits surprised to the upside on new condo starts (do we need more housing right now?). The measure jumped 22% vs. January with an increase of 83% in multi-family units. Mortgage applications were up 21.2% on strong refi activity. Purchase activity remains weak or non-existent.

Industrial production declined 1.4% vs. an expected decline of 1.3%. Capacity utilization was in line at 70.9%. CPI measured 0.2% vs. an expectation of 0% and 1.8% vs. 1.7% ex food and energy.

The Leading Economic Indicators for February came in at -0.4% vs. a -0.6% estimate. The increase in December was revised down to a decline, and January’s initial number was also revised down due to revisions in manufacturers’ new orders and real money supply. Six of ten indicators were up in February-interest rate spread, supplier deliveries, building permits, real money supply, and new orders. Negative contributors were average weekly jobless claims, unemployment insurance, stock prices, index of consumer expectations, and average weekly manufacturing hours.

Go Jim!
Jim Rogers of Soros and The Investment Biker fame says the US bailouts are adding to the risk of depression. “The US is taking assets from competent people and giving them to incompetent people. That’s bad economics.” He advised letting AIG go bankrupt, and insists we are repeating the mistakes of Japan in the 1990’s. “People should be prepared for inflation as governments worldwide are printing money to prop up economies at a time when commodities supply is under pressure.”

Shoot the Messenger
Based on new legislation introduced in the Senate yesterday, the SEC would be required to reinstate the uptick rule. “Abusive short-selling is tantamount to fraud and market manipulation and must be stopped now” said Senator Ted Kaufman.

Seriously? Does anyone actually believe that the market collapse was caused by short-selling and not failed economic, regulatory, and operational strategies? It makes more sense to blame your horoscope for the market decline.

As touched on earlier, the Fed announced they would be buying $750 billion in agency and other debt plus $350 billion in long term Treasuries, causing yields to plummet (see chart below) on the 10 year to 2.55%. The latest policy statement from the Federal Open Market Committee (FOMC) enticed buyers to enter the bidding process and initially pushed stocks markedly higher. Buyers rallied around financial stocks, which helped provide leadership to the broader market. The Fed will bolster its balance sheet by buying up to $300 billion of Treasuries during the next six months. The Fed will also purchase an additional $750 billion of agency mortgage-backed securities this year, bringing the total to $1.25 trillion.

Mortgage Rates
Since the Fed began buying mortgage backed securities in January, the spreads on mortgages over treasuries have dropped significantly (see chart below). This week the 30 year fixed rate hit its lowest absolute rate (4.96%) since 1971. Refi activity has been very strong; however, new purchase activity remains moribund.

The Dollar
The dollar starting to roll over as the Fed keeps printing new dollars. The newest commitments by the Fed will increase its balance sheet by $1.15 trillion. On the day of the Fed’s announcement the dollar fell 2.7%, the biggest drop in almost 40 years and is down 8% this month.

What happens if foreigners were to stop buying our debt, leaving the Fed as the only buyer? In short, the dollar collapses, rates sky-rocket, and the economy drags on in a slump. Unfortunately, this negative loop may have already started-looking at the chart below you can see that foreign purchases of US assets have declined dramatically. This very well could be a short term phenomena, but it is one which needs to be monitored very closely.

The Bottom
FDX announced earnings this week and saw profits fall 75% on the first decline in sales in at least 10 years. The decline in domestic air shipments was the 13th in a row. The firm says their outlook assumes continued weak global macroeconomic conditions and stable fuel prices. The company said operating results decreased significantly in the quarter, as the continued deterioration in global economic conditions led to lower shipment volumes at FedEx Express and FedEx Freight and a more competitive pricing environment.

The co thinks that this is about the bottom, saying that by Q4 they do not think there is going to be continued quarterly sequential declines. When asked about volumes bottoming, especially in international, and why they feel that way the company said that when “they were referring to the bottom they were referring QoQ sequentially in terms of big deep red numbers.”

Talk About Tax and Spend
According to insiders, the new administration inserted a provision in the $787 billion stimulus package that made it OK for companies such as AIG to pay bonuses to executives. Evidently having some remorse over passing the bill, House Democrats are voting on a proposed 90% tax on executive bonus payments by companies receiving more than $5 billion in federal aid. My favorite quote came from Ways and Means Chairman Charles Rangel “This is not going to happen again, the light is flashing and letting them know that America won’t take it.” The hypocrisy coming from Congress is nauseating.

NY rep Steve Israel, obviously confused about the bill he signed, said “We passed a recovery act; we did not pass a license to steal. The middle class will no longer subsidize pay for failure.”

Interestingly foreign employees of these companies aren’t subject to the tax.

Red Ink
President Obama’s new budget plan is estimated to result in deficits averaging $1 trillion a year for the next decade. The CBO projects a total of $9.3 trillion in deficit from 2010-2019, which is $2.3 trillion worse than the President’s predictions four weeks ago.

From Josh Rosner (via The Big Picture)

“The AIG bonus hearings on executive compensation the current “bonus bill” is a sideshow that avoids addressing the lack of enforcement of existing law.
To the layman it appears, had the law (below) been enforced, we would get to the root of the problem. Of course Congress has no interest in reducing the lobbying dollars they can collect from firms that rely on those TARP dollars. They would rather pretend to be ineffective populists than effective legislators and responsible public servants.

Doesn’t anyone feel that we could get more accomplished if we enforced the following law?”

§ 1352. Limitation on use of appropriated funds to influence certain Federal contracting and financial transactions

Problems South of the Border

Things in Mexico aren’t that rosy. Besides the spate of murders and kidnappings throughout the country, one of the leading employers (CEMEX) is now facing possible government assistance. According to Bloomberg, it seems the company is operating at very low levels of cash. Although I am not clear on the absolute level of debt, reports suggest that CEMEX’s debt levels could represent as much as 30% of the total private sector debt outstanding in Mexico.

What did you say?
From Barry Ritholtz:

“Washington Mutual’s holding company is suing federal regulators for billions of dollars, saying the fire sale of the bank’s assets to JPMorgan Chase violated its rights. The lawsuit was filed Friday in federal court against the Federal Deposit Insurance Corp., which seized the Seattle-based savings and loan in September. It was the largest bank failure in U.S. history.
Lawyers for the holding company, Washington Mutual Inc., argue that the bank was worth more than the $1.9 billion JPMorgan paid for it in a deal arranged by the FDIC. The lawsuit argues that if WaMu’s assets had been liquidated prudently, they would have been worth more than that.
An FDIC spokesman did not immediately return a call seeking comment Saturday.”
While Barry used much more colorful language than I to describe these cretins, the grandstanding and chest pounding by bankers, regulators and politicians are downright disgusting.

Eric Savitz, the long time and insightful tech writer at Barron’s, commented this weekend that the recent rally in the SOX (see chart) is lacking a key ingredient to help it sustain: end market demand. In my view, these stocks tend to trade based upon the current months’ production activity. Inventory plummeted so low coming out of the year end it overshot to the downside, and recently there has been some inventory replenishment. The stocks have rallied 16% from their recent bottom, about in line with the market.

Earnings and economic releases will be light this week. I expect the market could continue its most recent run upward and personally will continue to lighten my exposure. I feel I am well positioned if the market roles over, favoring healthcare, consumer and non-bank financials at the expense of technology, materials and energy. As I mentioned last week, I significantly reduced my net short position in energy. While I feel the fundamentals for energy are challenged at best, the dollar policy concerns me and creates a potential upside to oil.

Have a great week.


Mar 15, 2009

March 15, 2009

Weekly percentage performance for the major indices
Based on last Friday's official settlement...

INDU: 9.0%%
SPX: 10.7%
NDX: 9.8%
COMPQ: 10.6%
RUT: 11.9 %

Well, right on queue with the peak of the negative sentiment in the Investor’s Intelligence survey, the market rallied like a beast beginning Tuesday, with consumer, financials, industrials and energy leading the way while healthcare, utilities and staples lagged. One of the catalysts was a leaked memo from Citigroup CEO Vikram Pandit, which said they were having their best quarter since 2007. Now, compared to their roughly $110 billion loss in 2008, anything would be an improvement. Additionally, there was speculation that the government has finally created a plan to inject capital into the banks and get them to move bad assets off the books, helping to fuel a massive rally in the financial sector. Bill King asked a relevant question: “Why did taxpayers have to rescue Citi for a third time only two weeks ago if Citi is doing so well this year?”

More Market

The market’s rally this week is either a start to a new bull market or another bear market rally. Personally, I have been in the camp that we get a strong bear market rally in March/April, and this rally is setting up in traditional fashion. Remember the last rally, which ended in early January, was up roughly 20% from its intra-day lows. I expect this rally to exceed that, rising 20-25% from the mid-day low of 665, which would push the market to the 800-830 range. As I have mentioned in the past, I began letting my portfolio move to net long as the S&P 500 slid under the 750 level near the end of February, and plan to hold that position until the S&P approaches or breaks 800, at which time I will move back to neutral. A move towards 830-850 will get me net short once again. The market would need to clear the 850ish range, to break the string of lower highs and lower lows and possibly set up for a run to higher levels.

One smart Wall Street executive told me “it’s about time for the shorts to get steam-rolled in this market. I expect the market to top 1000 before running out of steam.”

Mortgage Rescue Plan
The NY Post reported that the Obama administration's $75 billion mortgage rescue plan appears to have been rushed into action and is missing crucial elements that doom it to failure, housing industry insiders tell The Post. The two most obvious things missing from the plan, which hopes to reach 9 million ailing homeowners, is that it doesn't include adequate property appraisals or risk management of the reworked loans, the sources said. Without these safeguards, they said, steadily declining home values will waste taxpayer money by putting homeowners back into over-valued homes with no equity and no free cash to maintain the home. "You're basically turning a nation of homeowners into renters," said one person who works exclusively with foreclosed homeowners. Another source, speaking on the condition of anonymity, poked fun at the Obama administration's requirement that stimulus money must go to "shovel ready" projects to ensure the most immediate effect, calling the mortgage modification plan "not shovel ready."

As you know I have been very bearish on oil since the beginning of 2008, although as recently as last week I lowered my net short position in energy stocks. Last week I was fortunate to speak with a very successful PM who is bullish both short term and long term on oil. Here is his reasoning:

“Today we have a demand for oil of 82-83 million barrels per day, which is 3 million less than production. This compares to a daily surplus of roughly 20 million barrels per day in the 80’s & 90’s and a surplus of 18 million per day in the late 90’s. Globally, we underinvested in industry capex from 1985-2002, at which point annual capex stood at $190 billion. Global capex eventually ramped to $450 billion over the past 7 years, with an expected cutback to $375-400 billion in 2009. Supply demand will get tighter as demand increases. If this recent pull back in oil were a supply issue, it would be bearish, but this is a demand issue and demand always normalizes.” He further stated that consumption will bottom at current levels based upon gasoline consumption, which has picked up in the US over the last month. Additionally, he expects (as do I) that weakness in the dollar will cause inflationary pressures and increase in oil prices.

More Oil

In other oil news, Exxon announced they have made a discovery off the coast of Brazil that may contain 8 billion barrels of recoverable oil. This field could be comparable in size to the Tupi field announced in late 2007, which also was estimated at 8 billion barrels. The fields may require $500 billion in infrastructure investments to extract the crude. Now that’s a stimulus package!

It seems that the airlines have been somewhat quiet in all this economic mess; however, volumes are down (but energy costs have declined also). Last year, with fuel costs soaring, the airlines added surcharges for everything from food to baggage. With the recent declines in fuel costs there has been no reduction in any of the surcharges. UBS says February unit revenue, channel checks, and communication from the airlines suggests weaker revenue trends have carried from February into March. The bank materially lowered their revenue forecast for Q1 and the full year, and also updates their fuel price assumption to the forward curve (lowering annual spot assumption to $1.37/gal from $1.50). The net effect of these changes is negative and should drive American and United to EPS losses in 2009. The bank expects consensus to fall soon but figures the market also anticipates this. The airline stocks are trading at around the same level they were back in July-when fuel prices were at their peak, EPS estimates called for huge losses, and liquidity was a great concern. Also, UBS anticipates announcements of additional capacity cuts as early as next week.

EE Times reports amid the IC downturn and a slump in lithography, Gartner Inc. has cut its capital spending forecast again. Worldwide capital equipment spending is forecast to total $16.9 billion in 2009, a 45.2 percent decline from $30.8 billion from 2008, according to Gartner (Stamford, Conn.). Gartner has worldwide capital equipment spending reaching $20.3 billion in 2010, a 20.1 percent increase from 2009. ''The dramatic crisis in world economics that came to light late in the third quarter and fully engulfed the fourth quarter of 2008 slowed capital spending in all segments of the semiconductor market,'' said Klaus Rinnen, an analyst with Gartner. ''The overspending on memory in the past three years, combined with a retrenching consumer market, presents little potential for any upside until 2010.'' This is the fourth time Gartner has cut its forecast in recent times. In October, Gartner projected that chip capital spending would decline 25.2 percent in 2008 and 12.8 percent in 2009. Then, in December, the firm said semiconductor equipment spending would decline 30.6 percent in 2008 and another 31.7 percent in 2009. Semiconductor equipment spending was projected to decline by 34.1 percent in 2009, according to a revised forecast by Gartner in January.

Gartner also recently cut its IC forecast. Worldwide semiconductor revenue is forecast to reach $194.5 billion in 2009, a 24.1 percent decline from 2008 revenue. Now, it appears that the market is much worse than expected amid the current and horrible downturn.

There is a proposal in Congress to raise taxes on stock trades to pay for the Wall Street bailout. Capital gains tax increases, dividend tax increases and now tax increases on trading-will there by anyplace left for the average investor to make any money or will we all be doomed to the soup kitchen line?

Bear Market End

From Merrill, er Bank of America, oh, what the heck, just give me a toaster with that new account:

“The timing for the end of the bear market is still October. As economists, trying to time the bottom comes down to trying to time the end of the recession because history teaches us that bear markets end roughly 60% of the way into the recession. Our in-house compass is now telling us that we are roughly 45% of the way through, which means without getting into too much detail, the timing of the end of the bear market, based on the economy, is still around October. That hasn’t changed.”

Moral Hazard
“American International Group Inc., the insurer that got four bailouts from the federal government, has been the subject of complaints from rivals who say the firm is under-pricing commercial coverage,” a regulator said. Competitors have said AIG was able to charge lower rates after getting government help, said New York Insurance Superintendent Eric Dinallo in an interview with Bloomberg Television today. Insurers including Hartford Financial Services Group Inc. have also applied for capital from the federal government, seeking to join more than 500 financial institutions that have received about $300 billion in government funds. Other insurers have complained that government aid gives a competitive advantage to the weakest firms at the expense of those that don’t need extra capital.

China Problems

In past issues I have discussed concerns with the Chinese holding massive ($1 trillion) amounts of US Treasuries. Last week Chinese Premier Wen Jiabao highlighted concerns about their huge US holdings. “We have lent a huge amount of money to the US, so of course we are concerned about the safety of our assets,” Jiabao said. According to the Financial Times, an unnamed Chinese official said “We hate you guys. Once you start issuing $1 trillion to $2 trillion, we know the dollar is going to depreciate.”

Jim Furey of Furey Research Partners put together the chart below, which shows that the rate of decline in commodity pricing historically as occurred near the end of a recession.

More Problems for the Decoupling Theory

There are a few brave souls still clinging to the decoupling theory, the one that posits China and a few other lucky countries can grow unscathed while the rest of the world stumbles. This theory has been thrown another curveball over the past week as China announced that exports, the key driver to their economic growth, had plummeted by 26% last month (their imports fell by a comparable percentage). Their gaping trade surplus, which was $39 billion in January, fell to under $5 billion in February.

Overall economic reports this past week continued to be soft, although there weren’t any dramatic misses to scare the markets.

Advanced retail sales for February came in at -.1% vs. a -.5% expectation. Excluding autos, retail sales were +.7% vs. -.1% expectation and 1.6% in January. Retail sales were a bit better overall, possibly as a result of the bump from lower gasoline prices (see the chart in my note last week

Consumer net worth was down $16.5 trillion, over 25%.

Wholesale inventories declined 0.7% vs. a -1.0% estimate. Business inventories fell 1.1% vs. a -1% expectation.

Mortgage applications were up 11.3% vs. a decline the prior month of 12.6%. Lower rates and a renewed interest among lenders to advertise better rates led to a surge in new applications. Let’s see if the banks will actually lend the money.

Initial jobless claims continued in the mid 600K range, coming in at 654K vs. expectations of 644K. Continuing claims now stand at 5.3 million.

The University of Michigan consumer confidence index was 56.6 vs. 55.0 and flat w/ last month (56.3).

The trade balance was -$36 billion vs. an expectation of -$38 billion. Total trade with the world is down 25% YTD vs. last year.

Unemployment in four states is now over 10% (Michigan 11.6%, S. Carolina 10.4%, California at 10.1%, and Rhode Island at 10.3%). In another of many understatements coming from the bureaucrats, Bernanke said that unemployment of 10% for a period of time is “certainly well within the realm of possibility.” On the upside (I think), it may take over 100K additional government jobs to administer the new $787B economic stimulus package.

ISI reports that their company surveys of retailers, auto dealers and homebuilders are still bad but not as bad as the end of the year. Back end companies (temporary employment, real estate, construction, technology, manufacturing, trucking, capital goods and shipping) continue to deteriorate.

Financial Conditions Watch
According to Bloomberg’s monthly Financial Conditions Watch report, the recovery in financial conditions experienced in late 2008 and the early portion of 2009 is beginning to lose traction. The report notes that the Fed has been unable to push real market interest lower-in fact they have risen by almost 700bps during the crisis since spreads have widened much more dramatically than the decrease in the Fed Funds rate (see chart below).

Additionally, improvements in the Libor-OIS spread and the TED spread have reversed over recent weeks. The overall improvement in credit conditions, as measured by Bloomberg’s Financial Conditions Index, can be seen in the chart below.

Congress approved a $410 billion to boost spending and will fund thousands of congressional pet projects, aka earmarks. I think my favorite is the $1.8 million for swine order and manure management research in Iowa.

Kudos to Senator David Vitter of Louisiana, who proposed eliminating the practice of giving member of Congress an automatic annual salary increase. He called the practice “offensive” at a time when constituents are struggling. According to Bloomberg, the majority in the Senate defeated this measure.

Big 3
Ford announced a contract agreement with their labor union that should save the carmaker $375 million this year. Ford is the only member of the Big 3 not to have requested or received a government loan. GM’s stock actually soared this week from $1.45 to $2.72 as the company announced they may not have to feed at the public soup kitchen line this month.

Life Insurers
From Scott Patterson and Leslie Scism in Thursday’s Wall Street Journal:

“This is as strong an argument for receivership/recapitalization as I’ve seen. The otherwise healthy life Insurance business is getting dragged through the muck by the collapsing banking and brokerage industries.”

“The tumbling financial markets are dragging down the life-insurance industry, an important cog in the U.S. economy, as mounting losses weaken the companies’ capital and erode investor confidence.

A dozen life insurers have pending applications for aid from the government’s $700 billion Troubled Asset Relief Program, and the industry is expecting an answer to its request for a bank-style bailout in the coming weeks. The government so far hasn’t said whether insurers will be eligible for the program.

Life insurers have taken a beating in recent weeks. The Dow Jones Wilshire U.S. Life Insurance Index has fallen 59% since the beginning of the year, leaving it down 82% since its May 2007 all-time high. The Dow Jones Industrial Average has lost 21% year to date, off 51% since its October 2007 record.”

Where’s the Gratitude?

After all the billions of dollars that have been pumped into the financial system, primarily to benefit Goldman Sachs (see prior notes at, you would think they could show some gratitude to the populace that is funding their bonuses by saying something nice. Instead, Goldman reduced their global GDP forecast to -1%. Now, if I were cynical (and I am), I’d say they might have held off on that negative outlook until they were done milking the US government for aid. Wait, they are done (at least for now), at least as long as there is a cap on executive pay associated with more handouts.

Speaking of Goldman, AIG finally released their use of bailout proceeds. It seems that $105 billion of the $165 billion in federal aid received by AIG has been paid to states, banks and brokerages. Who was the leading benefactor of that government handout? That favored step-child of the treasury-Goldman Sachs, which pulled in a cool $12.9 billion.

The Coolest Invention

Scientific America reported that scientists at the University of California Berkley invented the world’s smallest radio. It seems they were able to use a nanotube to create a single celled radio the size of a virus. A typical radio has four key parts: antenna, tuner, amplifier, and demodulator. The carbon nanotube provided all four functions, and only requires a small electrical charge (battery) and speaker to operate. The applications for this technology are limitless-think of hearing aids, radio-controlled chemotherapy delivery, and espionage to name just a few applications. To witness the radio working, click on

Did anyone notice the #6 seed become the winner of the Pac-10 basketball tournament? It’s time for March Madness, one of the greatest sporting events in all of athletics!

The power of the market rally was impressive, and posting the first positive week in the market in 2 ½ months certainly has encouraged a lot of discussion (once again) about whether we’ve seen the bottom of this market or not. I’m not convinced we’ve seen the bottom yet, but I am going to cautiously approach this bounce as yet another bear market bounce-anticipating this one will have even more power than the last. As always, I encourage you to use the strength to lighten up on weaker holdings.

Have a great week, and as always let me know if you’d like to be removed from the list. I appreciate all your comments and referrals.


Ned W. Brines
O (562) 430-3232

Mar 8, 2009

March 8, 2009

March 8, 2009

“Jim Cramer is like Vegas, he makes losing money fun.”-Ben Curtis

Weekly percentage performance for the major indices
Based on last Friday's official settlement...

INDU: -6.2%
SPX: -7.0%
NDX: -4.7%
COMPQ: -6.1%
RUT: -9.8 %

The market continued its fade into murky depths, with the major indices breaking 12 year lows. Sentiment is at an all time low (as measured by Investor’s Intelligence), an indicator which has some contrarian appeal. Over the past few months we have focused on what to do during the periodic bear market rallies, and while it is difficult to predict when we might see one, my sense is that we are nearing levels where a bounce is likely. I have been slowly increasing my net long position since the S&P500 broke the 750 mark (it closed Friday at 683), and will continue to do so as the market fades. Much like the 20% rally we saw from late November into the early part of January, this rally could be quite powerful. Once again I’d caution you to use the rally to lighten up on equities, not to chase the market. Momentum investing is extremely dangerous in a bear market.

DigiTimes (a technology publication) reports international spot market prices of polycrystalline silicon (poly-Si) solar cells have dropped from $2.1-2.2/watt in early 2009 to $1.7-2.0/watt currently. While this softer pricing is indicative of weakening demand for solar, the decline in the price of the key ingredient for the chips used in solar cells suggests that demand could pick up over time. As the green revolution continues sweeping through the globe, declines in solar pricing could make it a much more attractive alternative to coal or natural gas powered energy.

This was a very busy week for economic releases. The results were still firmly in the negative camp, although there were some upside surprises in relation to expectations, which could signify that economists are finally starting to grasp the depth of the economic problems which we face.

Personal spending was better than expectations and up for the first time in 7 months on post-holiday discounts, posting a gain of 0.6%. The PCE price deflator came in at 0.7%, higher than expectations.

The ISM non-manufacturing composite was in line with expectations at 41.6. The ISM manufacturing composite came in at 35.8 vs. the 33.8 estimate, still well in the contraction zone. The chart below shows the ISM since 1948. The most recent readings are near the trough levels of 1948, 1974, and the record low in 1980.

Initial jobless claims were better than expected at 639K vs. the 650K estimate and 667K in the prior week. The change in non-farm payrolls was -651K vs. expectations of -650K. The unemployment rate was 8.1% vs. expectations of 7.9%. Hourly earnings increased 3.6% vs. expectations of 3.8%. Weekly hours worked dropped to 33.3, the lowest level on record (see chart below)

Auto sales were horrific as the auto industry appears to be in a depression. Sales at GM were down 53%, Ford 48%, Toyota 40%, VW US 18%, Nissan 37%, Mercedes 21%, BMW 24% and Honda 40%.

Nonfarm productivity, one of Greenspan’s favorite indicators and a leading indicator for employment, fell 0.4% vs. an expected increase of 0.1%.

Treasuries surged this week on the soft employment reports, however, given the large issuance calendar, this rise may be short lived. There is some speculation that the government has been manipulating the treasury market for reasons beyond lowering the cost of capital to borrowers. With an expected $1.8 Trillion deficit for 2009, lowering the cost of treasuries saves the government a bundle on interest expense.

Credit Default Swaps

I have discussed the impact of these instruments many times over the past few months (derivatives used to hedge against losses or to speculate on the ability of companies to repay their debt). The Fed has approved plans to create a swap clearinghouse. The new clearinghouse will require members to have a net worth of at least $5 billion and an A rating. Additionally, each member will be required to contribute $20 million to a guarantee fund. By regulating this market the SEC (or other governing bodies) will have a better handle on the credit risk being assumed by the various market participants. Today, because of the private transaction nature of this market, there is no way to understand the full range of trades between the dealers, and specific risks taken on by financial institutions such as AIG and Goldman were unknown.

Government Handout
AIG went back to the trough for a fresh round of government funding, this time collecting $30 billion plus an easing of the terms on their previous, exceptionally generous loans from the government of $150 billion. The company managed to lose $62 billion in the 4th quarter and nearly $100 billion for the full year 2008, both of which are the largest losses in history.

Bailout Craziness
There has been much speculation over the past few months that the only reason AIG was saved after the Fed let Lehman Brothers fail was the Goldman Sachs connection to Henry Paulson (ex-chairman of Goldman) and many senior Treasury members. The short story is that Goldman apparently had little exposure to Lehman, however, they had a ton of counter-party exposure to AIG. Goldman was apparently saved on their swap positions through the AIG bailout, receiving up to 100% of their investment in many instances, which total in the billions.

More AIG
From Barry Ritholtz: “This was nothing more than a giant scam, perpetrated by the people who were running the AIG hedge fund. It was exempt from any form of regulation or supervision, thanks to the Commodities Futures Modernization Act. This ruinous piece of legislation was sponsored by former Senator Phil Gramm (R), supported by Alan Greenspan (R), former Treasury Secretary (and Citibank board member) Robert Rubin (D), and current presidential advisor Larry Summers (D). It was signed into law by President Clinton (D). It was the single most disastrous piece of bipartisan legislation ever signed into law. As you might have guessed by now, this portion of AIG is the INSOLVENT half.
Here is the question that every single taxpayer should be asking themselves: WHY AM I PAYING $1000 TO BAIL OUT THIS GIANT HEDGE FUND? Of all the many horrific decisions that Hank Paulson made, this may be his very worst. That is a very special description, given his track record of incompetence and cluelessness.”

This comment is from a reader who happens to be a senior financial executive at an insurance company and enjoys going through the footnotes/details of government plans:

“I just read the provisions of the Home Affordable (Retarded) Modification program (HARM) and found one bright spot in this otherwise ridiculous transfer of wealth proviso (thank you Barack, may I please have another).

If the option to forebear principal is selected, the servicer shall forbear on collecting the deferred portion of the Capitalized Balance until the earliest of (i) the maturity of the modified loan, (ii) a sale of the property, or (iii) a pay-off or refinancing of the loan.”

The net is that any principal amount reduced on a home loan must be repaid upon sale of the property.

Improved News on the Retail Front
While most retailers reported weak same store sales for February, Wal-Mart (WMT) announced they are seeing a reversal of the weak traffic trends that had been plaguing the stores, with comps up 5.1% in February. The company also bucked the global trend of dividend cuts by raising their annuals dividend by 15% to $1.09 per share.

The average price of a gallon of gasoline in the US is $1.93 per gallon. A few weeks ago I asked if anyone understood why the price in California, outside of the outlandish fuel tax burden faced by California residents, stood nearly $.50 higher. I finally found my answer through a reader who works for British Petroleum.

As most of us are aware, California has enacted a series of anti-pollution measures curtailing emissions from autos and industry, and has also required a special blend of gasoline unique to California. This gasoline is only made in a small number of refineries, which happen to be partially closed during this time of year for refurbishment, upgrading, and maintenance. This limit on who and how much of this special blend is produced puts upwards pressure on prices even when the general market isn’t experiencing any price increases.

The second item putting upward pressure on prices has to do with the blend itself. Because of the emission requirement, the refiners are required to use a very sweet crude oil as the base stock. This isn’t the WTI we typically see quoted when we are discussing the price of a barrel of oil, but instead this extra sweet crude is North Slope crude. This type crude is typically 10-15% more expensive per barrel than WTI.

Oil Stimulus
According to Longview Economics, the savings on energy spending as a percentage of GDP will fall to 2% from 4.9% and will provide $1.72 trillion in savings. This is 3x the amount of proposed stimulus for 2009 by the US, China and other governments.

A few weeks ago I discussed the oil market and contango-when oil futures are dramatically higher than prompt oil due to too much inventory. That situation has reversed back to a more normalized state called backwardization, where future oil is cheaper than current oil. Oil experts feel that this change is very significant, and could indicate that OPEC’s production cuts are finally starting to have an impact on the price of oil.

While I’m still very bearish on overall oil demand, given the normalization of the futures market and what I consider to be extreme bearishness, I have moderated my large short position in oil and energy stocks. I am concerned that with China starting to show some signs of life, OPEC successfully cutting production and meeting again later this week, and gasoline prices in the US hovering near 5 year lows, that there is some risk to the upside on oil and energy. My biggest concern is China using their dollar reserves to begin accumulating oil again to continue filling their Strategic Petroleum Reserve. While I certainly don’t see an oil run back to $100 or even to its 200 day moving average of $74, I am still going to moderate that short position.

European Handouts
The BOE began printing money to buy assets as they cut their benchmark interest rate to 0.5%, the lowest since 1694 (that’s not a typo). A policy maker stated “We’re moving into a new world in the UK from interest rate adjustment to quantitative easing.” Their primary purchases will be UK government bonds, known as gilts. The bank won’t be raising debt, just printing money and buying assets in an effort to raise the money supply.

Wow, talk about bad calls. Throughout recent notes I have been a proponent of owning healthcare stocks in this environment. This past week they took a beating as a follow up to the President’s proposed nationalization (or darn close to it) of the nation’s medical care. Some of the specifics can be found on my website under the link entitled “Fact Check: Obama Gets it Wrong on Health Care” ( Healthcare stocks should be a haven in this market, but the President is intent on extending the government reach into health care, which is being construed as bad for the group overall, especially the HMOs.

I haven’t moderated my net long position in healthcare at this point, but am reviewing it on a security by security basis to ensure I don’t have exposure to areas where aggressive cuts are being proposed.

Berkshire Hathaway, Warren Buffet’s company, had a bad week. First, the Gates Foundation, whose benefactor is Buffet’s good friend and fellow bridge-playing billionaire Bill Gates, reported selling shares in Berkshire. Next, CDS on Berkshire spiked to prices which suggest the company has a higher probability of defaulting on its debt than Vietnam. Finally, they announced they would be cutting back on manufacturing jobs and closing facilities at some of their businesses.

I guess it’s bad all over.

More on Pension Shortfalls
Public & state pension funds are facing a possible $1 trillion shortfall. The retirement plans attached to these funds are typically guaranteed by the states, which creates an environment where ridiculous pension benefits can be offered with little recourse should the plan fail. The pension assumptions for many of the plans are ridiculous. CALPERS has assumed a rate of return of almost 8%, yet delivered 3.3% for the ten years ended 12/31/08, including a 27% loss last year. Many states have been issuing pension bonds, the proceeds of which go into the state employee pension fund while the taxpayer is left holding the obligation to pay back any shortfall on the bonds.

I’m sure we’ll be addressing this more in the next few months.

China to the Rescue (or not)
Commodities took a jump and the market soared on Wednesday on speculation China would broaden its efforts to boost growth. Rumors swirled that the Chinese government would contribute even more to the global stimulus than the original $700 billion they announced last year. Copper, nickel, construction companies, and other cyclical stocks rose on the anticipation of an announcement Thursday. Treasuries fell, probably due to 1) the potential long-term inflationary impact of additional stimulus; 2) the Chinese will probably be selling some of their US Treasury holdings to fund the stimulus; and 3) global assets probably further fled the US as our status as a safe-haven continues to dwindle as a result of the fiscal response coming from Washington. On Thursday global markets fell after the Chinese announced that the speculation was nothing more than speculation and they wouldn’t be adding to their stimulus at this time.

In other news from China, the PMI came in at 49% vs. 45.3%, the highest level since the middle of ’08 and near the magic 50% level. New orders bounced over 50%, which could indicate better economic activity on the horizon for China.

MBA reports that 12% of mortgages are now behind or in foreclosure. That represents about 5.5 million homes.

Baltic Freight
The Baltic Freight index continued its climb (see chart below). While still 80% from the high of mid 2008, the index has risen nearly four-fold from the early December low of 660. Activity at the Port of Long Beach remains very weak, as indicated by employment activity there. A year ago there were over 1000 jobs per night (employees call into a phone bank, which tells them how many employees will be needed that night), yet in recent weeks that number has been in the 300 range.

Mortgage Backed Securities are Back
Dow Jones reports Wall Street is finding a way to salvage some of the toxic debt that torpedoed the financial industry. Wall Street banks this year have significantly ramped up efforts to repackage once-unwanted mortgage bonds to make them more enticing to investors. The bonds are stripped of risky loans, and presented to institutional investors with new triple-A ratings. That repackaging could translate to some surprising trading gains for banks such as Goldman Sachs Group (GS), Morgan Stanley (MS) and JPMorgan Chase (JPM) when they report earnings next month. If successful, the strategy could grow in popularity as the credit market opens up. "You'll see a surprise in trading books," said Ajay Rajadhyaksha, head of U.S. fixed income and securitized products research at Barclays Capital. The reincarnation of these mortgage-backed securities takes place as issuers repackage these bonds into two new bonds. They take the form of a senior bond with greater credit protection and a subordinate bond with the same credit support as the underlying bond. With lower-quality loans jettisoned, even if it makes up only 10% of the security, the value of the remaining bond would be enhanced.

I had a couple of people ask about the website ( and the content on it. The website includes the content you get every week in this email, but also contains some extra material. At times I have focused on specific topics more in depth, and posted those on the site instead of filling up this note with that information. Many of you have begun subscribing to the notes from the website itself as a way to receive those topical notes directly (to do this, go to the bottom of the right hand column and click on the “posts” tab under “subscribe to”). Additionally, in the right column you can find all the older notes (although there are a few still lacking the charts); links to other websites such as The Big Picture; some advertisements (they help pay for my coffee); and some video links to economic and market related presentations.

Take a look when you have some time. I hope that helps.

Last week was another in a long string of bad weeks. While I continue to be bearish longer term, I have continued moving my portfolio slightly longer (now approaching 10% net long) as the market fades. I anticipate riding the next rally with this slightly long portfolio, but cutting back the long exposure all the way up with the intention of becoming net short as the market nears the top of its trading range. The next rally could be bigger than the last given the depth of this recent sell-off, however, be wary of chasing it as the overall economy hasn’t shown the type of structural improvement needed for a sustainable rally.

Have a great week. As always, fell free to let me know if you would like to be dropped from the list or if there are topics you would like me to explore.

Be well


Ned W. Brines
O (562) 430-3232

Mar 1, 2009

Where's the Bubble?

March 1, 2009

“A society that does not have the will to let its warriors die fighting will not long survive. A civilization that values its very being less than the dignity of its sworn enemies should be morally prepared to fail.”-David Goldich, USMC

Where’s the Bubble?
Mr. Obama proposed his first budget since becoming President, and it’s a whopper, coming in at $3.6 trillion. The plan proposes to allow our budget deficit to balloon even further than it has in the past eight years. The actual deficit will probably be even higher given the optimistic projections in the budget, including a GDP growth rate over the next 10 years which exceeds that of the past 10 years. The President, never one to shy away from making a promise, also announced that the budget deficit would be cut in half by the end of his first term. I’ll be interested to see what the starting number will be when we measure that “half” in four years.

Anytime there is this much capital being thrown around, bubbles are sure to arise. We will be studying the budget proposal over the next few weeks, and attempt to take advantage of the resulting bubble(s).

The Market

In the February 1st note we discussed that February was historically “the worst month of the market’s best six months,” and this past month didn’t diverge from that trend. The results below, for the month of February, show some pretty dismal returns. The market is has fallen so far over the past 16 months that, according to Michael Santoli of Barron’s “…not 2% down from here, is a point at which half of the entire rise from the 1932 Depression low to the ultimate October 2007 high will have gone away.” That’s 75 years of returns, wiped out in 16 months!

Monthly percentage performance for the major indices
Based on last Friday's official settlement...

INDU: -11.7%
SPX: -11.0%
NDX: -5.4%
COMPQ: -6.7%
RUT: -12.3%

Portfolio Manager Quote

“I find that whenever I go home worried that the entire world financial system is going to collapse and I’m going to need to take up hunting and foraging to survive…it’s usually the point we get the rally…that being said I’m still working on the hunting and foraging since the rally will likely be short lived!!!” This could explain the big surge in fire-arm sales recently.

I wrote this in an IM exchange with a portfolio manager, friend and reader of this note. We were discussing the problem with the bank bailout plan, and I wrote: “the problem, as you know, is that 1) they are insolvent and 2) the government is trying a solution that will both concentrate money in the hands of the poor operators and also consolidate assets into fewer hands, which increases the systematic risk at a time they should be reducing it. Too big to survive should be the mantra.”

Instead of providing tough medicine to the problem, what we are getting is more “trickle in” funding of the banks, as evidenced by the deal with Citi this past week. While we as a country aggressively criticized the Japanese during their banking crisis, we are repeating the same mistakes and appear doomed to repeat their “lost decade”. We are probably in worse shape than the Japanese were at the time given our high level of government and consumer debt versus the Japanese, which at the time had a savings rate of close to 10%.

Government Disclaimer

The statement below is true.
The statement above is false

More Banks
From Ritholtz: “And that’s before we even get to the current issue of systemic risk, or the drag on the overall economy of having two massive Japan-like zombie banks hanging around. Given that we have already spent 300% of their market caps in terms of capital injections, and are on the hook for another 1500% of their valuations in terms of insured paper, these two banks are becoming vast money pits, ginormous black holes into which vast sums of taxpayers wealth disappear, never to be seen again in this universe.”

Even More Banks
From an email joke: “What worries me most about the credit crunch, is that if one of my checks is returned stamped 'insufficient funds' I won't know whether that refers to mine or the bank's.”

Citigroup (It’s no longer a bank)

Citigroup eliminated their dividend on preferred stock last week as the government provided them with more capital and converted their preferred shares. When will this charade end? Citi is basically worthless-the only reason the Fed and Treasury are trying to save them is to prevent the fallout of another Lehman-like collapse. The FDIC guarantees deposits at Cit, it’s about time they stepped in and took over this mess of a company and closed the taxpayer checkbook, which is writing checks which, as we wrote earlier, will “disappear, never to be seen again in this universe.”


The Case Shiller home index pricing dropped 18.5% in December, the biggest drop ever. The index measures prices across 20 cities in US. Highlights were a 34% drop in Phoenix, 33% in Las Vegas, and 31% in San Francisco. I read in today’s Orange County Register that the median home price in the OC has declined from $570K to $360K over the past 18 months.

Existing home sales were below the street forecast, coming in at 4.49 million for January, down almost 9% from last year. According to Seeking Alpha, 45% of those sales involved distressed properties (including foreclosures).

Durable goods orders were down 5.2% vs. consensus of -2.5%, and were down 2.5% ex transportation. That’s the sixth consecutive quarter of declines.

Initial jobless claims were once again worse than anticipated, 667K vs. 625K estimate. Continuing claims topped 5 million (5.1million) for the first time since record keeping began in 1967.

GDP for Q4 came in at -6.2% vs. expectations of -5.4%. The GDP price index was 0.5% vs. expectations of -0.1%. Are we starting to see the early stages of STAGFLATION? I think that stagflation may become the economic status quo given the outlook for government spending over the next four years.

Business investment dropped 21%, and spending on equipment and software dropped 29%.

Personal consumption was -4.3% vs. expectations of -3.7%. That is the first time purchases have dropped more than 3% in consecutive quarters since record-keeping began in 1947.

Due Warning
Robert Prechter of Elliot Wave International, who correctly advised massive shorting against the market in July 2007, is now recommending covering those shorts. “The market is compressed. When it finds a bottom and rallies, it will be sharp and scary for anyone who is short. I would rather be early than late.” Mr. Prechter first achieved notoriety by recommending shorting the market two weeks before Black Monday, 1987.

Health Care

I’ve published a note on the website ( which is titled “Fact Check: Obama Gets it Wrong on Health Care.” This note analyzes the President’s recent comments on health care costs. It’s worth reading.

Mr. Obama proposed his new budget last week, and some of the highlights are discussed here. The new plan proposes a 45% tax rate on estates larger than $7 million, repealing the expiration coming in 2010. The plan also proposes raising taxes on higher earners (those above $250K) by $1 trillion. Texas Rep Jeb Hensarling “You cannot help the job-seeker by punishing the job creator.” Hedge-fund and private equity managers will see their tax burdens triple as their carried interest, now taxed at capital gains rates, will be viewed as ordinary income and taxed at nearly 40% federal. Also, the plan proposes eliminating the more accurate corporate inventory accounting method of LIFO and replacing it with FIFO. The net of this inventory accounting change is to raise corporate tax liabilities during times of inflation, which as I have maintained is coming hard and fast.

I have included a link to Warren Buffet’s annual letter as well as some quotes from the letter, which can be found under the “March” section in the right hand column, entitled “Buffet’s Letter”.

This week’s note is a bit shorter and contains fewer charts than usual. The bulk of the week’s news revolved around the new budget plan, which I think is being analyzed quite adequately by the traditional press, having dubbed it “the Robin Hood budget.” As the House and Senate begin hashing through the plan, I will be providing more useful analysis of the plan. The bottom line on the plan is that it proposes a ton of spending, raises taxes on bigger earners, will result in even more massive deficits, and doesn’t seem to address the problems which we are facing today. In sum, it appears to be a backdoor way to increase government spending while the President has a “free ride” during the honeymoon period of his presidency.

As I write this the Hang Seng and Nikkei are both down almost 4%.

Have a great week.


Ned W. Brines
O (562) 430-3232

Buffet's Letter

Lanny Sachnowitz forwarded this note, and has included some great quotes from Mr. Buffet. The text of the full letter can be found at:

By the fourth quarter, the credit crisis, coupled with tumbling home and stock prices, had produced a paralyzing fear that engulfed the country. A free fall in business activity ensued, accelerating at a pace that I have never before witnessed. The U.S. – and much of the world – became trapped in a vicious negative-feedback cycle. Fear led to business contraction, and that in turn led to even greater fear.

This debilitating spiral has spurred our government to take massive action. In poker terms, the Treasury and the Fed have gone “all in.” Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once-unthinkable dosages will almost certainly bring on unwelcome aftereffects. Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation. Moreover, major industries have become dependent on Federal assistance, and they will be followed by cities and states bearing mind-boggling requests. Weaning these entities from the public teat will be a political challenge. They won’t leave willingly.


Amid this bad news, however, never forget that our country has faced far worse travails in the past. In the 20th Century alone, we dealt with two great wars (one of which we initially appeared to be losing); a dozen or so panics and recessions; virulent inflation that led to a 21.5% prime rate in 1980; and the Great Depression of the 1930s, when unemployment ranged between 15% and 25% for many years. America has had no shortage of challenges.

Without fail, however, we’ve overcome them. In the face of those obstacles – and many others – the real standard of living for Americans improved nearly seven-fold during the 1900s, while the Dow Jones Industrials rose from 66 to 11,497. Compare the record of this period with the dozens of centuries during which humans secured only tiny gains, if any, in how they lived. Though the path has not been smooth, our economic system has worked extraordinarily well over time. It has unleashed human potential as no other system has, and it will continue to do so. America’s best days lie ahead.


We’re certain...that the economy will be in shambles throughout 2009 – and, for that matter, probably well beyond – but that conclusion does not tell us whether the stock market will rise or fall.


Things went well on the capital-allocation front last year. Berkshire is always a buyer of both businesses and securities, and the disarray in markets gave us a tailwind in our purchases. When investing, pessimism is your friend, euphoria the enemy.


During 2008 I did some dumb things in investments. I made at least one major mistake of commission [adding to his ConocoPhillips position] and several lesser ones that also hurt. I will tell you more about these later. Furthermore, I made some errors of omission, sucking my thumb when new facts came in that should have caused me to re-examine my thinking and promptly take action.

Additionally, the market value of the bonds and stocks that we continue to hold suffered a significant decline along with the general market. This does not bother Charlie and me. Indeed, we enjoy such price declines if we have funds available to increase our positions. Long ago, Ben Graham taught me that “Price is what you pay; value is what you get.” Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.


[Regarding their Clayton Homes division]... Clayton’s lending operation, though not damaged by the performance of its borrowers, is nevertheless threatened by an element of the credit crisis. Funders that have access to any sort of government guarantee –banks with FDIC-insured deposits, large entities with commercial paper now backed by the Federal Reserve, and others who are using imaginative methods (or lobbying skills) to come under the government’s umbrella – have money costs that are minimal. Conversely, highly-rated companies, such as Berkshire, are experiencing
borrowing costs that, in relation to Treasury rates, are at record levels. Moreover, funds are abundant for the government-guaranteed borrower but often scarce for others, no matter how creditworthy they may be.

This unprecedented “spread” in the cost of money makes it unprofitable for any lender who doesn’t enjoy government-guaranteed funds to go up against those with a favored status. Government is determining the “haves” and “have-nots.” That is why companies are rushing to convert to bank holding companies, not a course feasible for Berkshire.

Though Berkshire’s credit is pristine – we are one of only seven AAA corporations in the country – our cost of borrowing is now far higher than competitors with shaky balance sheets but government backing. At the moment, it is much better to be a financial cripple with a government guarantee than a Gibraltar without one.


Local governments are going to face far tougher fiscal problems in the future than they have to date. The pension liabilities I talked about in last year’s report will be a huge contributor to these woes. Many cities and states were surely horrified when they inspected the status of their funding at year end 2008. The gap between assets and a realistic actuarial valuation of present liabilities is simply staggering.

The investment world has gone from underpricing risk to overpricing it. This change has not been minor; the pendulum has covered an extraordinary arc. A few years ago, it would have seemed unthinkable that yields like today’s could have been obtained on good-grade municipal or corporate bonds even while risk-free governments offered near-zero returns on short-term bonds and no better than a pittance on long-terms. When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary.

Clinging to cash equivalents or long-term government bonds at present yields is almost certainly a terrible policy if continued for long. Holders of these instruments, of course, have felt increasingly comfortable–in fact, almost smug – in following this policy as financial turmoil has mounted. They regard their judgment

confirmed when they hear commentators proclaim “cash is king,” even though that wonderful cash is earning close to nothing and will surely find its purchasing power eroded over time.

Approval, though, is not the goal of investing. In fact, approval is often counter-productive because it sedates the brain and makes it less receptive to new facts or a re-examination of conclusions formed earlier.

Beware the investment activity that produces applause; the great moves are usually greeted by yawns.

Derivatives are dangerous. They have dramatically increased the leverage and risks in our financial system. They have made it almost impossible for investors to understand and analyze our largest commercial banks and investment banks. They allowed Fannie Mae and Freddie Mac to engage in massive misstatements of earnings for years. So indecipherable were Freddie and Fannie that their federal regulator, OFHEO, whose more than 100 employees had no job except the oversight of these two institutions, totally missed their cooking of the books.

Indeed, recent events demonstrate that certain big-name CEOs (or former CEOs) at major financial institutions were simply incapable of managing a business with a huge, complex book of derivatives. Include Charlie and me in this hapless group: When Berkshire purchased General Re in 1998, we knew we could not get our minds around its book of 23,218 derivatives contracts, made with 884 counterparties (many of which we had never heard of). So we decided to close up shop. Though we were under no pressure and were operating in benign markets as we exited, it took us five years and more than $400 million in losses to largely complete the task. Upon leaving, our feelings about the business mirrored a line in a country song: “I liked you better before I got to know you so well.”

Improved “transparency” – a favorite remedy of politicians, commentators and financial regulators for averting future train wrecks – won’t cure the problems that derivatives pose. I know of no reporting mechanism that would come close to describing and measuring the risks in a huge and complex portfolio of derivatives.

Auditors can’t audit these contracts, and regulators can’t regulate them. When I read the pages of “disclosure” in 10-Ks of companies that are entangled with these instruments, all I end up knowing is that I don’t know what is going on in their portfolios (and then I reach for some aspirin).
Fact Check:
Obama Gets it Wrong on Health Care

This is an excerpt from a note written by Greg Scandlen at CHCC

During President Obama's "not-quite-a-state-of-the-union"
speech on Tuesday, he called for a new era of honesty and accountability in government -- "Finally, because we're also suffering from a deficit of trust, I am committed to restoring a sense of honesty and accountability to our budget." (1)

Unfortunately, he broke that promise even before he left the podium.
In discussing the need for health care reform, he said, "This is a cost
that now causes a bankruptcy in America every thirty seconds. By the end of the year, it could cause 1.5 million Americans to lose their homes. In the last eight years, premiums have grown four times faster than wages. And in each of these years, one million more Americans have lost their health insurance. It is one of the major reasons why small businesses close their doors and corporations ship jobs overseas."
But none of that is true. Let's look at the claims one at a time -
Health care "is a cost that now causes a bankruptcy in America every 30 seconds." There are 525,600 minutes in a year, so that rate of medically-induced bankruptcy would be 1,051,200 per year. But the total number of bankruptcies in 2007 was just 822,590 (2), and only a fraction of those, possibly as low as 5% according to a University of California study (3), were due to medical costs. Interestingly, the
population with the greatest growth in bankruptcy rates are those covered by Medicare. Since 1991, bankruptcies have actually decreased for people below age 65, but increased 125% for those between 65 and 75 and increased 433% for those over age 75. (4)

"By the end of the year, it could cause 1.5 million Americans to
lose their homes."

This one is a mystery. Sure, plenty of people are "losing their homes," about 3 million this year, but to think that half of those are due to medical bills rather than ARMs or lay-offs seems like a reach.

"In the last eight years, premiums have grown four times faster
than wages."

Actually, premiums have stabilized for the past five years at about 6% annual increase, while wages have been increasing about 4%, according to Mercer (5). Mr. Obama may have been thinking about the spike in 2002 when premiums rose 14% and wages rose about 3%, but that was a one-year exception and not representative. It's worth remembering, also, that some companies - notably those that have adopted
consumer directed plans - are seeing premium increases well below either inflation or the increase in wages. Watson Wyatt found that the "best performing" companies had a two-year cost increase of just one percent while other companies increased 10% over the same time (6).

"And in each of these years, one million more Americans have lost
their health insurance."

That's not true, either. According to the most recent report by EBRI in September, 2008 (7), the raw numbers of uninsured rose from 39.5 million in 2001 to 45 million in 2007. Raw numbers aren't the right way to count in any case due to population growth. The percentage of uninsured between 2001 and 2007 went from 14.8% to 15.3% according to the Census Bureau, which is lower than the percentage in 1995 (15.4%), 1996 (15.6%), 1997 (16.1%), or 1998 (16.3%). (8) (9)

"It is one of the major reasons why small businesses close their
doors and corporations ship jobs overseas."

Actually, it's not. At least not until someone mandates that employers provide coverage. Small employers may drop coverage but they don't go out of business because of health care costs. And the whole "ship jobs overseas" claim is a myth. (10) When American companies set up foreign affiliates it is generally to serve foreign markets, like Toyota and others have done in setting up American affiliates to serve the American market. To the extent there is an advantage in locating abroad, it has far more to do with local regulations, taxes, and wages than health care costs. So, let's hope that Mr. Obama starts taking his own advice and applies some "honesty and accountability" to his own speeches as well as to the national budget.