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...
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.
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.
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.
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.
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.
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” (http://weeklymarketnotes.blogspot.com). 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.
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 (http://weeklymarketnotes.blogspot.com) 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.
Ned W. Brines
O (562) 430-3232