Apr 20, 2009

Less Bad is the New Good

Less Bad is the New Good

April 19, 2009

“Everybody’s talking smack, but nobody’s got anything on the table.”-Bill Zabowski, GM bondholder

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

INDU: 0.6%
SPX: 1.5%%
NDX: 1.0%
COMPQ: 1.2%
RUT: 2.4%

The S&P 500 closed the week at 869, marking the sixth consecutive week of gains. Whether this ends up being a bear market rally (I’m still in this camp, although my perseverance is being tested) or a new bull market, this rally has proven that the “pain” is to the upside. Short sellers, who until now have been relatively unscathed in this bear market, are finally paying the piper as this rally takes the market ever closer to its 200 day moving average. The rally is being led by those stocks with the biggest short positions.

According to State Street bank, institutional investors are driving the stock market's recent rise. The firm, which monitors the buying and selling of $12 trillion in assets it holds as custodian, says monthly cash flows into equities are in the 98th percentile - close to a 12-year high!

The financials have soared during the rally, contributing roughly 25% of the gain S&P 500 (see chart below, blue). The red portion of the chart shows that on a weighted basis, the financials have really outperformed, contributing nearly twice their weight in the index. As I have been discussing the past few weeks, you can see that the more economically sensitive, early cycle groups have led this rally while the defensive groups (i.e. healthcare and consumer staples) have lagged.

The market certainly seems overbought given the S&P 500 now sits 28.5% above its 50 day moving average. This is the highest level since 1990 (and probably earlier), as shown in the chart below from Bespoke.

Economy Improving?
Personally I’m a bit concerned that many of the same people who missed the entire financial crisis until we were in the middle of it are now proclaiming things are better (sorry to call you out, Mr. Bernanke). I fall in the camp that the rate of decline may have slowed, but the economy is still going down at a rapid pace. Corporate earnings estimates are still too high for 2009 unless, of course, there are more accounting rule changes on the way.

The International Energy Agency is predicting 2009 demand for oil to fall to its lowest levels in five years as factories continue to slump. They are predicting demand of 83.4 million barrels per day vs. 85.8 million per day in 2008. US crude supplies are now at their highest level since July 2003.

March retail sales posted the first under-consensus economic data point in quite some time, declining 1.1% versus an expected increase of 0.3%. Sales excluding autos fell 0.9% versus flat expectations. Food and beverage stores were up 0.5% and health and personal care were up 0.4%. All other categories were down, led by electronics and appliances down almost 6%.

The most entertaining portion of the soft retail report was the talking heads on CNBC, who seemed shocked that sales were down. Are they living in the same economy as the rest of us?

The jobless numbers were slightly better than the expected increase of 9,000 to 663,000, although the prior week’s claims were upwardly revised by 9,000. It should be noted that the majority of last week’s drop occurred in states that posted sizable gains in prior weeks and that the start of the new quarter may have posed some seasonal adjustment issues. Nonetheless, the four-week moving average fell for the first time in 13 weeks to 651,000. Continuing claims in the prior week increased by 172,000 to a record high 6.022 million. As a result, the insured jobless rate inched up 0.1 point to 4.5%, the highest level in over 26 years.

Exports from the Port of Long Beach jumped nearly 27%, the most since October 2003, and more than the typical seasonal gain. Imports climbed almost 25%, the most in nearly four years. These are encouraging
signs that the trade freeze is thawing.

PPI was anticipated to be flat, but fell 1.2%, pulled down by a 5.5% drop in energy. The core PPI (ex food and energy) was flat after 0.4% and 0.2% increases in January and February.

March Core CPI came in at +1.8% vs. the +1.7% consensus. March reported CPI was -0.4% vs. -0.1% consensus.

Housing starts fell 10.8% and building permits fell 9% in March, both well short of estimates. Existing home sales seem to be benefiting from low mortgage rates while foreclosure and forced sales at depressed prices are accounting for a bulk of the activity. As lenders end the moratorium on foreclosures, filings have increased by 24% to 800K in the first quarter. Interestingly, mortgage applications declined last week for the first time in a month.

Industrial production was down 1.5% in March, the 5th consecutive decline. Expectations were for a 0.9% decline. Capacity utilization (see below from Bill King) dropped to an all time low of 69.3% (record keeping started in 1948).

The Michigan Consumer Sentiment Index came in at 61.9 versus a consensus of 58.5. This is an improvement over 57.3 the prior month.

The Philadelphia Fed Index went the way of the Empire Manufacturing Index and surprised the market with a better-than-expected reading. Specifically, the index checked in at -24.4 (consensus -32.0) for April versus -35.0 for March. The April reading still connotes contraction, but it suggests the pace of decline has slowed. The most notable component within the report perhaps is the jump in the six-month outlook for general business activity, which rose to 36.2 from 14.5. That was the fourth consecutive monthly improvement and leaves the reading well above the -10.4 level registered in December. As for the April report, the new orders index went to -24.3 from -40.7; inventories went to -40.2 from -55.6; prices paid held pretty steady at -31.5; prices received went to -41.4 from -32.6; shipments slipped to -35.7 from -26.5; unfilled orders moved to -19.5 from -22.8; and delivery time went to -17.1 from -30.8.

Shared Sacrifice
While the Obama administration has espoused a philosophy of “shared sacrifice”, and has been extremely critical of any corporation lavishing perks on its employees, apparently the walls of the White House are made of glass. In the first 60 days occupying the White House, the Obama’s hosted 50 social events. According to Dee Dee Myers, the former press secretary for Bill Clinton, the Obama social event calendar is twice the number of events held by the Bush administration and even surpasses the number held in the ‘party-loving’ Clinton White House.

I remember an adage about people who live in glass houses and wonder if it extends to those living in white houses?

From Karl Denninger: “Makes you wonder if having a Treasury Secretary who was a former CEO of Goldman Sachs had anything to do with this. Indeed, not only was Hank Paulson Goldie’s boy, but he was the same gentleman who so vociferously lobbied the SEC to allow the 5 largest investment banks to drop the net capital rule and leverage up 40 to 1. So not only did he help set up the disaster, but he then oversaw the greatest transfer of wealth in the planets history — several trillion dollars from taxpayers to the management and shareholders of inept, incompetent, wildly irresponsible companies.”

Note that Goldman reported a huge 1st quarter profit (see More Goldman below) this past week and many are attributing their quarterly success to the double dip gains on the AIG trade. Speculation is that they were hedged on their AIG exposure (possibly even short AIG stock), then collected 100 cents on the dollar when the government made all of AIG’s counterparties whole. Interestingly, they also announced they would be cutting their dividend as well as raising $5 billion in new equity to pay down their TARP loan.

More Goldman
GS reported a $1.8 billion gain in the first quarter, but there was some sleight of hand in those numbers. The company changed its fiscal year end from November to December, which means the month of December results became orphaned (the company reported the quarter ended November, and last week the quarter ended March, which meant that December results magically disappeared into the footnotes). Among some of the results for the month of December were $2.7 billion in “fair value losses”, in other words write downs of bad loans.

I wonder how much of the stronger bank earnings (see Citi below) gracing the headlines the past two weeks were due to more AIG Tomfoolery?

Citi reported full EPS this week (remember they pre-announced a couple of weeks ago), and a portion of their smallest loss since 2007 was directly attributable to the deterioration in their own credit quality. It seems that they were able to book a $2.7 billion gain from their own credit default swaps.

The continued deterioration in Citi’s credit quality actually resulted in a gain for the company!

Fair Value Accounting
Fair value accounting requires financial institutions to mark their holdings to market value. As I discussed in the April 5th note (http://weeklymarketnotes.blogspot.com) under “mark to imagination”, FASB (the accounting rules makers) recently announced a plan to eliminate fair value accounting. The FASB plan has recently been opposed by the CFA Institute for Financial Integrity (disclaimer, I am a member). The institute represents financial services professionals who have achieved the Charted Financial Analyst designation. In their letter to members, they stated “We also have undertaken considerable outreach to regulators, legislators, other organizations, and the media to represent investors and convey the negative implications of such hasty and damaging modifications to the transparency and accuracy of fair value reporting.”

Corporate Debt
According to Bloomberg, spreads on high-yield bonds have narrowed to their lowest point in over six months. The gap now sits at 15.85% over treasuries, down about 3% since the beginning of March. Issuance of high-yield debt is up over 15% from this point last year with $14 billion issued YTD.

California Taxes
From Mike Shedlock: “Like the proverbial frog in a gradually boiling pot of water, Californians apparently didn't notice taxes being elevated incrementally until they now have the highest income tax rate in the nation, the highest sales tax rate and the sixth-highest overall tax burden among the 50 states. Incredibly, tax-happy state legislators now want taxpayers to add another $16 billion in taxes to their burden by approving an initiative the lawmakers put on a May 19 special election ballot, on the heels of $12.9 billion in new taxes the Legislature itself imposed only two months ago.”

Oil to China
A deal to build a branch of the Eastern Siberia-Pacific Ocean pipeline toward China received final approval from the Russian government, the Itar-Tass news agency reported. At a meeting of the Russian Cabinet, Prime Minister Vladimir Putin said the branch will "create a stable and reliable sales market for oil" to be delivered to Russia's eastern customers.

China is continuing to use their dollar surplus to ensure a stable energy supply while we avoid any attempts to become energy independent.

Thank Goodness that’s settled

The U.S. and Chinese economies are so closely aligned that “China would not consider dumping Treasuries or other actions that would disrupt U.S. interests” said Richard Fisher, president of the Federal Reserve Bank of Dallas. "China cannot succeed if the U.S. does not succeed," he said.

Alternative Energy
US consumers pay average of $.11 per kilowatt-hour (kWh) for power derived from coal, natural gas, nuclear and hydroelectric. The proposed $10 per ton carbon tax would increase the price of coal-fired electricity by $.01 per kWh or 9%. In an effort to help the environment, the new administration is pushing renewable energy sources hard, regardless of the economic impact. Below I have shown some alternative energy sources, their costs, and some of the benefits/drawbacks of each. The pricing estimates are from Scientific American, and are estimates at full deployment (current pricing is much higher).

Solar-Thermal-At a cost of $.20-$.28 per kWh, this technology is expected to cost three times current sources. The advantage is that it may be one of the only renewable sources which allows for the storage of energy to meet peak demand. The drawbacks are the need to locate in deserts, far from existing transmission lines and available water for cooling.

Ocean Wave Power-The price is unknown at this point as the technology is still in its design phase. The advantage is that most of the population is located near the coasts. A major drawback will be designing a building that can withstand 50-75 years of heavy waves.

Geothermal-At a cost of $.062-$.076 per kWh, geothermal is actually cheaper than the existing technology. The advantage is that the supply is very reliable, and can generate to meet daily demand patterns. The downside is the pollution given off by the steam from underground water can be highly toxic and corrosive.

Solar-Photovoltaic-Right now this technology is one of the furthest along in commercial deployment; however, it is heavily subsidized by governments due to its high cost, $.47-$.71 per kWh. The major advantage is the ability to overlay the technology in heavily populated areas to save the cost of new distribution lines. The drawback-cost!

Wind-The US is undergoing a major wind generation deployment program over the next 12 years. The advantages include no cooling water requirements and its low cost of $.06-$.085 per kWh. The disadvantages are location (typically far from population centers) and most generation occurs at night, which doesn’t match the demand requirement patterns. There are also issues with birds and bats flying through the turbines.

Personal Credit
Capital One disclosed their March card metrics; reporting US a card net charge-off rate of 9.33% and 30 day delinquency rate of 5.08%.

According to Business Week: “Credit card defaults, which have risen dramatically in recent months, might be stabilizing, according to data from American Express. The company's disclosed that default rates rose only 0.2% to 8.8% in March. "We haven't solved all of the problems yet, but the market likes these little indications that maybe some of the worst has passed," said Darin Newsom, a senior analyst at DTN.”

Auto Subsidies
Congress is discussing a “cash for clunkers” program which would provide buyers of new autos manufactured in North America $5000 if they were trading in a car from model years 2001 or older. Does it make sense to encourage people to borrow more money during a major economic slowdown? Once again it seems to me that the government is pushing the solution of “more borrowing, more spending” to correct an economic slowdown caused by too much borrowing and too much spending.

TARP Fraud
ABC is reporting that former Treasury Secretary Paul O’Neill said that the heads of the major U.S. banks were summoned to Washington and told they were required to take the money “So that those who needed it would not be stigmatized.” What was the purpose of this policy? “To deceive the people so that the public would not know which banks were in danger of failing. Why didn't any of the CEO's, claiming not to need the money, have the courage to refuse?" O'Neill said in an e-mail to ABC News. "If banks now claim they want to return the money because they don't need it, why do they have to raise new capital to replace the money from we the people in order to repay the government?"

Last month JP Morgan Chase CEO Jamie Dimon told ABC News that banks should return the money only if they are strong enough to do so, rather than simply to increase their executive compensation payments. "When it gets returned, it shouldn't get returned so you can pay people. That is not why anyone wants to or should return the TARP money," Dimon told ABC.

The Fed to the Rescue
This comment came from Ben Bernanke, the same Fed Chairman who in 2007 said things were fine and in mid-2008 that the financial crisis would be limited to a few hundred billion in mortgage backed securities. Recent favorable data on auto sales, home construction and consumer spending are "tentative signs that the sharp decline in economic activity may be slowing." The Fed will raise interest rates and use other policy tools to "drain excess liquidity" when the time comes to turn from economic stimulus to heading off inflation, he said.

I feel confident, how about you?

From Jack McHugh: “trying to foster sustained growth in an economy weighed down by too much debt is like trying to start a sustainable fire using wet logs. The matches and gasoline (some stimulus and a low funds rate) didn’t work on our debt-soaked economy, so Mr. Bernanke is resorting to the blowtorches and rocket fuel (a lot of stimulus and quantitative easing). I don’t know enough about the chemistry of combustion to accurately predict what will happen next. But my advice would be to stand well back and wait to see what happens next.”

New Administration, Same Graft
Steven Rattner, head of the government's auto task force, disclosed that he was under investigation in an alleged kickback scheme involving New York State’s pension fund. The Wall Street Journal reported the probe last week.

According to RealtyTrac, foreclosure filings were reported on 803,489 U.S. properties in the first quarter, a 9 percent increase from the previous quarter and an increase of nearly 24 percent from Q1 2008.

Monday Morning Quarterback
From a speech by Barry Ritholtz: “If only the Fed let the 2000-2002 cap ex led recession run its course, I wouldn’t be here talking about monetary policy and political science. We have B52 Ben carpet bombing us with money and he won’t stop until we have completely inflated our way out of our massive debt that ironically, as I previously mentioned, is a hangover from the last period of easy money. So Ben wants us to drink more and more to somehow cure our hangover. He and Tim Geithner are trying to put Humpty Dumpty back together again. Humpty Dumpty was a consumer that borrowed too much, spent too much and saved too little. Their new creation, the TALF, is trying to jump start the securitization market so consumers can get access to easy credit again. Huh? What’s so bad about a recession if not allowing one to happen, gets us into this mess? Why can’t we just allow Mother Nature to run its course? Also, this whole talk about once the banking system gets fixed, everything will be fine, is a fallacy. Problems in the banking system are just the symptoms. The disease is the overleveraged consumer and implosion in the housing sector. When house prices stop going down, Voila! The banking system is fixed. I’ve never seen a period of history where one can print, borrow and spend their way to prosperity and without nasty unintended consequences as a result.”

Well said.

What does that mean?
Further regulation of the credit card industry is expected after an NBC weekend interview with presidential economic adviser Larry Summers indicated the White House will focus on credit card abuses.

What is credit card abuse anyway? Is it running multiple cards up to their limits and then defaulting on them? Somehow I don’t think that is what Mr. Summers has in mind.

WSJ reports the Obama administration said Medicare will use competitive bidding to buy wheelchairs, walkers and other medical products, but seniors won't be affected until 2011. The Centers for Medicare and Medicaid Services, the agency that manages the federal insurance program for the elderly and disabled, has said the prices it pays are too high. It sometimes pays several thousand dollars more than prices charged by Web vendors.

I’m a big proponent of improved stewardship with our tax dollars by our government, however, shouldn’t the administration be focused on the bigger picture items (i.e. trillions spent on bailing out the banks)?

From a Reader

Sorry about the tardiness of the note this week as Sunday was my youngest son’s first communion, and the celebration lasted a bit longer than we anticipated. If you have a complaint, please feel free to call the customer service hot line on the website (http://weeklymarketnotes.blogspot.com), leave a credit card number, and we’ll process your complaint quickly.
Just kidding, have a great week.

The market has opened weaker this morning on a weak Leading Economic Indicator release.


“The people who designed the plans are either in the pocket of the banks or they’re incompetent.”-Joseph Stiglitz, Nobel Prize Winner discussing TARP

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