May 26, 2009

Better Earnings for the Financials?

Better Earnings for the Financials?

“We’re about to have a big problem. Foreclosures were bad last year? It’s going to get worse.” -Morris A. Davis, University of Wisconsin.

May 25, 2009

Weekly percentage performance for the major indices

Based on last Friday’s official settlement...

INDU: 0.10%
SPX: 0.47%
COMPQ: 0.71%
RUT: 0.37%

The market kicks off the summer with the S&P 500 just below 890. After last week’s hard decline, the week leading into Memorial Day was fairly muted. The big news on the week came from the treasury market, with yields continuing to move higher. On the corporate side of credit, high yield spreads continue to narrow as investors continue to increase their appetite for risk. According to Barron’s, high yield spreads have fallen from 2100bps to 1300bps over the past few months.

Many have asked about market valuation. The chart below, from, shows the PE Ratio of the S&P 500 going back to 1935. In my opinion this chart is somewhat misleading as it is based on the most recent four quarters of earnings-which is one of the worst periods for corporate earnings ever. If you use the $40 estimate that has been bounced around for 2009 S&P earnings, then the valuation would still be considered high, but a more reasonable 22 times.

Building permits and housing starts both missed consensus, coming in at 494K and 458K respectively versus expectations of 530K and 520K, a decline of over 50% from last year and down 3.3% from last month. The housing starts are the lowest on record (see chart below from Econoday). The positive spin suggest that maybe we are finally on our way to controlling the inventory of housing. There are still a record number of delinquent home loans. Surveys show that the number of people preparing to sell their homes or looking to do so if activity picks up or prices stabilize indicate an enormous potential inventory of unsold homes.

The index of leading economic indicators (LEI) gained 1%, the biggest gain since 2005, and ahead of the estimated 0.8% increase. Rising stock prices and consumer confidence led the increase. The negatives were money supply and bookings for capital goods.

Stock prices contributed 0.44% to the increase while the interest rate spread added 0.28%, consumer expectations 0.27%, jobless claims 0.16%, and the average workweek 0.13%.

The main drags on the April number were M2 -0.24%, building permits -0.09% and orders for nondefense capital goods -0.01%, which are estimated and subject to revision.

Unemployment claims came in at 631K as 6.7 million people are now collecting unemployment insurance. Estimates were for 625K. The prior week was revised upward from 637K to 643K.

The Philadelphia Fed Index came in less than expectations at -22.6 versus an estimate of -18.

The U.S. economy will return to growth in the second half of this year, but joblessness will continue to climb well into the second half of 2010, the Congressional Budget Office said. The agency expects unemployment to peak at 10.5% (remember last week I discussed the administration’s budget deficit estimates assumed 8% unemployment for this year, which is now at 8.5%).

When the U.S. economy shifts back in the direction of growth, it will be slowed down by a weak employment market, consumers who are limiting spending to boost savings and banks that are unloading problem assets, said Eric Rosengren, president of the Federal Reserve Bank of Boston. "My best judgment is that a rather slow recovery is likely," he said.

Economic Velocity
Much has been made about the rebound in manufacturing and transportation due to the ongoing inventory restocking. I discussed this again in last week’s note ( The chart below shows the inventory to sales ratio over the past two and a half years.

As you know, the anecdotal comments from our well-informed reader base make this note work. Over the weekend I spent time with a friend in the banking world, and he told me that lending in the middle markets is “on fire.” Companies are aggressively seeking capital, and banks (both small and large) are competing hard for the business. With the shadow banking system all but gone, the pricing on these loans has been quite attractive. Given the low cost of funds the banks are enjoying and the very steep yield curve, it would suggest that bank earnings (ex the write-offs of prior bad business) should be robust in Q2.

Supporting those comments, the KBW Bank Index rose 5.8 percent during the week after the cost of borrowing in dollars between banks dropped the most in two months, a sign credit markets may be thawing.

Changing the Gate
SAC Capital Advisors LLC, the $14 billion hedge-fund firm run by Steven Cohen, will allow investors to take their money out of its flagship fund every quarter. Clients previously had their money tied up in the SAC International fund for three years.

Personally, I think we will continue to see funds adopting measures to improve terms for investors, including greater transparency and access to capital.

When you are the owner…

The Wall Street Journal reports the Obama Administration plans to direct the Environmental Protection Agency and the Department of Transportation to jointly raise fuel economy standards and reduce greenhouse gas pollution so as to raise the overall fuel economy of automobiles to 35 miles a gallon by 2016, four years faster than federal law requires. As part of the agreement, the state of California has agreed to "stand down" from its effort to implement its own greenhouse gas emissions standards for automobiles, since the new federal rule would be as stringent as the state's standard. The current energy law (from 2007) requires automakers to achieve fuel economy of 35 mpg no later than 2020.

The proposed fuel savings of $2800 per driver will be more than offset by the higher prices of the cars, estimated to be $2K-$4K. While this plan is designed to help the domestic auto makers, I wonder how helpful it will be given most of the fuel efficient cars are made outside the US? According to Vince Farrell, only one of the top 10 fuel efficient cars sold today are made by a US company, Ford, which isn’t even owned by our government.

Additionally, it looks like the plan would include a “Cash to Clunkers” clause which will provide a $3500 subsidy to anyone trading in a car getting less than 18 miles per gallon as long as there is at least a 4 mpg improvement. A 10 mpg improvement would get you another $1000.

The positive is that a national standard that meets California requirements will mean automakers aren’t required to make special cars for California only.

Conspiracy Theory

There has been some speculation that government releases have been massaged to look better on the initial release, then are revised towards more negative numbers. I haven’t seen a reliable study on this, and personally assume it is because there is so much subjectivity in the measures. Any thoughts?

Consumer Credit
Dow Jones reported that the U.S. Senate overwhelmingly passed legislation to impose tough new restrictions on the credit card industry, handing President Barack Obama a decisive victory on a hot-button consumer issue. The legislation, approved on a 90-5 vote, would ban certain controversial practices and make it much harder for credit card issuers to raise rates on consumers. It also would place new restrictions on marketing cards, student loans and other credit plans to teenagers and college students. Credit card practices have become a potent political issue as the financial crisis has strained household finances and stoked anger over bank bailouts.

I’d say the end result here will be the elimination of teaser rates, more restrained consumer spending, and a lower rate of new card issuance. The next legislation will probably occur in two years, forcing credit card companies to provide cards to people with poor credit. This is very similar to the CRA passed during the Clinton years, which pushed lenders towards making home loans to borrowers with weaker credit after the S&L debacle led to a dearth of lending.

Does this sound familiar?

Californian’s Say No to the Governator!

Voters struck down Governor Schwarzenegger’s proposals to raise a slew of taxes to pay for the budget mess in California. The rebuke means certain budget cuts in California, $6 billion immediately according to the former Mr. Olympia.

Showing they continue to be in a non-charitable mood, voters also passed a bill which blocked legislatures from getting a raise in years when the budget wasn’t balanced.

Government Unsure of Role

I watched Timothy Geithner getting grilled by Congress on TARP. One Senator wanted to know why the government, as the owners of AIG, had to pay off 100% of their debts to Goldman Sachs and other investment banks. He commented “we own 80% of AIG, why can’t we tell them what to do?”

All of that for only $180 billion.

The VIX finally broke 30, for the first time since last September, before settling back at 32 on the week’s close. Remember this indicator of volatility peaked at nearly 80, and has been on a downward path since the market began its assent in March. While the index certainly isn’t near historically low levels indicating investor complacency (typically that would be the low teens), the fact that it has been cut in half suggests that investors feel the worst is behind them and it’s safe to go back in the water.

I mentioned this back in November, but it is worth repeating. The Chinese, holders of US debt up the whazoo, have been quietly but aggressively using this paper to acquire hard assets. The beneficiaries have been components in the CRB (see below) and oil.

Global Equity Returns
From Bespoke Group: “With global equity markets still in rally mode, below we highlight the year to date performance of the major indices for 83 countries around the world. After nearly every country was down earlier in the year, 62 out of the 83 are now up in 2009. Peru is up the most at 72.92%, while Costa Rica is down the most at -39.94%. And the BRIC (Brazil, Russia, India, China) countries are significantly outperforming the developed G-7 countries. Russia, India, and China rank 2nd, 3rd, and 4th in terms of year to date performance, and Brazil isn't far behind in 10th place.

Canada has been the best performing G-7 country with a gain of 12.62% in 2009, but it ranks 35th out of 83. The rest of the G-7 countries are bunched up in the 0%-5% range, which is closer to the bottom of the list than the top. And the US is the worst of the seven with gains of less than 1%. While the markets here in the states have rallied nicely off of their March lows, most other countries have bounced back even more 2009.”

Deficit Concerns

From Casey Research: The magnitude of the recession was underscored by the latest numbers from the U.S. Treasury: last month’s individual income tax receipts dropped 44% and corporate tax revenue plunged 65% compared to April 2008. Alarming news, as April is historically the biggest collection month of the year and usually results in a sizable budget surplus for the month.

Global Economy
From Eric Boucher at ISI: Japanese GDP fell a stunning 15% in the first quarter showing the world that with bad policy a 20 year slump is possible. In the Baltic's, the GDP decline is more stunning having fallen 35%. Fearing a currency collapse the central banks there remain tight.

The Fed and Quantitative Easing
The Fed has to be concerned since the US dollar index is lower by almost 6% (chart below courtesy Bespoke) since the day before the April meeting, the CRB (chart below courtesy Bloomberg) is higher by 12%, and the 10 yr bond yield up almost 20 bps.

I guess I’m just a cynic in thinking the Fed won’t be able to pull back on the gas pedal as soon as we see a whiff of inflation.

Weak dollar beneficiaries-from David Rosenberg

• Basic materials 87% inverse correlation
• Consumer staples 79% inverse correlation
• Industrials 62% inverse correlation
• Consumer discretionary 34% inverse correlation
• Utilities 28% inverse correlation
• Financials 22% inverse correlation
• Health care 18% inverse correlation
• Tech 5% positive correlation
• Telecom 13% positive correlation

So, the best performers typically would be basic materials (the stuff is
priced in dollars); staples (high foreign currency translation) and industrials
(relative improvement in export competitiveness).

Financials, health care, tech and telecom have more of a domestic content
and as a result screen the worst in a declining dollar environment.

Jack Welch Weighs In
According to Bloomberg, Jack Welch, former chief executive officer of General Electric Co., criticized the government for backing the bankruptcy of Chrysler to favor unions at the expense of creditors. Additionally he said President Barack Obama’s economic stimulus programs will cause massive budget deficits.

Debt Visual

No longer a cheerleader of easy money and now speaking like a three-handed economist, Alan Greenspan reversed course once again this week by saying “There is still a very large unfunded capital requirement in the commercial banking system in the United States and that’s got to be funded.” He also said that “until the price of homes flattens out we still have a very serious potential mortgage crisis.”

After watching this guy be horribly wrong for so many years, this comment makes me seriously consider that the mortgage crisis could be over next week.

Real Estate
A recent RealtyTrac survey showed that 55% of US adults have indicated they are interested in purchasing foreclosed properties. Most are expecting to pay 50% less than market value for those properties. In the same study they found that 24% of homes currently on the market have experienced at least one price decrease.

According to the Wall Street Journal, the Obama administration has instructed federal agencies to be less aggressive in claiming that federal regulations pre-empt state law. This can be terribly costly to companies operating in multiple states at a time when companies need to be conserving capital for stability, new capital purchases, inventory, rising tax burdens, and hopefully hiring.

UK Financial Problems
The UK, with a debt to GDP ratio of 0.7, had its credit rating outlook lowered from stable to negative by Standard & Poor’s. Their credit rating wasn’t actually lowered, but the odds of that happening have increased. In addition to their existing debt load, Britain must issue at least $344 billion in bonds by March 2010. A decline in their credit rating would push the cost of borrowing up as investors will require higher yields to compensate for a perceived increase in risk.

This should serve as a warning to the US, whose debt to GDP ratio is 0.8 and rising fast.

The Next Shoe to Drop
From David Rosenberg “How about pensions? The PFGC (Pension Fund Guaranty Corp), which backs the pensions for 44 million workers in the USA, stated that the looming additional failures in the auto, retail and health care sectors will end up aggravating what already is a record $33.5 billion deficit (this shortfall has tripled since last October!). In the final analysis, retiree benefits will end up being cut, companies will be required to pony up higher premiums to insure the pensions, or taxpayers will foot the bill as they will do for all the other massive fiscal policy measures undertaken by the Administration.”

Fundamental Disconnect

Technology stocks have really been moving the past few months, with NASDAQ leading the markets higher. The wind behind that run is that inventories of chips, boxes, etc all were cut well below sustenance levels, and now there is an inventory rebuild occurring. The question is whether end market demand will materialize to sustain this build activity or will we see another inventory drawdown? Consumer spending on electronics will be one key driver, but the other will be corporate IT spending, and it’s the later where the disconnect is really apparent. Historically financial services companies have been the leaders in technology adoption and spending, accounting for 1/3 of corporate IT spending. Today many of those companies are in retrenchment, or worse. Does this bode well for corporate IT spending in the second half of 2009?

A lot of readers are close to these two groups, I’d love to hear your feedback.

More AIG
Edward Liddy, the CEO/chairman at AIG who is serving for a $1 salary, evidently isn’t happy with the proposed bonus limits of 25% of salary, and has decided to leave the firm. Actually, Mr. Liddy has endured limitless criticism (some justified) for a role he assumed to help turn a listing ship. His resignation will take effect once a replacement has been found.

I’m not sure it behooves the government to beg successful people to take these roles in an effort to do their part to help the country, and then throw them under the bus repeatedly in an effort to deflect criticism away from Washington.

I had this piece in last week’s note, but eliminated it for space reasons. Now it seems appropriate given the UK credit issues, dollar weakness, treasury weakness, and inflation concerns beginning to arise once again. Personally, I have added to my gold position over the past month on weakness in the metal. I’m watching for an overshoot in the metal to the upside, and if the press keeps hyping it I will take some profits. The chart below is courtesy of Bespoke.

Treasury yields continue to head in the wrong direction. According to ISI, the back up in yields has occurred despite $100 billion dollars worth of purchases over the past six weeks.

Oil-Another Weak Dollar Beneficiary?

Does it strike anyone as unusual that oil continues to climb while inventories soar to the point that OPEC is considering more production cuts?

Why am I Being Punished, I Didn’t Do Anything Wrong?

I spoke with a friend over the weekend, and he wants to know why he is being persecuted for being conservative with his money. He works, but his taxes are going up. He saves, but higher sales taxes are eating into his savings. He and his family sold their house three years ago, rented and then later lived with his in-laws to save money. Recently they purchased another home at a discount to historical sales in the area. He hasn’t defaulted on loans, credit cards, or other debt, yet is watching his tax dollars bail out those who were less responsible. Now he is wondering why he shouldn’t just walk away from his obligations as well?

I guess that’s what is meant by the moral hazard of bailouts?

I hope you take the time to view the video clip this week. Thank you for all the positive comments on the embedded video clips. If I could embed them in the emails, I would do so.

I am contemplating taking this note from just an email to a .pdf document attached to the email. I appreciate your feedback on this as well.

Have a great week.


“I am humbled and awed by the past and ongoing sacrifices made by our men and women in uniform to ensure our continued freedom. Thank you and happy Memorial Day.”-me

No comments:

Post a Comment