May 10, 2009
“When everybody starts looking really smart, and not realizing that a lot of it was luck, I get scared.” Raphael Yavneh
Weekly percentage performance for the major indices
Based on last Friday’s official settlement...
The market soared during the week as investors determined that the bad economic news was bad, but not bad enough to derail this rally. The S&P 500 is now up for the year (+2.9%) as more companies beat analysts’ profit forecasts than at any time since 2006. Banks, retailers and commodity related companies led performance during the week as the S&P bounced from its lowest valuation since 1985. Technology stocks have staged the biggest rally in the S&P 500 this year, adding more than 19 percent for the best start to a year since 1998, according to data compiled by Bloomberg.
The chart below (from Bespoke) shows the S&P for 2009.
While the market has run far in this rally, according to Chart of the Day, this rally doesn’t compare well in either percentage terms or number of days to the bear market rallies of the depression, which may indicate the market has further to go.
In my mind there are three questions that need to be considered before we can determine whether this is another bear market rally or that we have emerged from the grips of the mighty bear.
First, why are treasury bonds falling? Falling treasury bonds and rising stock prices have occurred prior to many market corrections, most famously during 1987. Are they falling because of the massive supply coming on to service the gaping budget deficits facing the US; are they falling due to a shift to more risky assets as the economic outlook improves; or are they falling due to inflation concerns?
Second, where are we in this economic cycle? If we have passed the bottom, as the market and some of the data seem to be suggesting, then any subsequent market appreciation will rely upon true economic improvement, which we haven’t seen yet. The economic data is not as bad as it was through the economic winter of December-February, but is still bad. Simplistically, if the bottom actually occurred in Q1 in the middle (chronologically) of the recession, then we wouldn’t emerge from this recession until Q3 or Q4 2010, significantly later than most forecasters are expecting.
Third, are there other systematic shocks lurking in the wings to match the credit market freeze of last fall? Some have suggested commercial real estate, however, the slowdown there seems to be orderly and similar to prior downturns. Personally, if there is another systematic shock, I don’t think it will be led by the banks given the scrutiny that has already occurred there. My sense is that possible sources of another shock would either be a foreign crisis (monetary); political upheaval in an economic or militarily significant country (think Latin America, India, Pakistan); a terrorist event; or policy changes affecting the standard business operating environment (think the US altering contract law).
Low Quality Reigns in April
That was the title of a piece published by Cirrus Research (proprietor Satya Pradhuman is an old friend and great small cap strategist) discussing returns in April. Satya stated “investors increasingly embraced business risk and collectively shed their defensive posture to fuel a powerful rally across risky assets. Eclipsing Mid Cap’s strong showing (+15.3%), Small Caps (+18.6%) experienced its biggest monthly gain since 1975! Micro Caps, up 19.8%, led overall for a second month. Up roughly 31% since February, Micro Caps are now +3.3% YTD. By comparison, Large, Mid and Small Caps stand at -3.2%, +2.9% and +4.6% YTD. Also of note, the Russell 2000 rose 42% from March 9th through the end of the April.”
The chart below (from Bespoke) shows that 92% of stocks in the S&P 500 are above their 50 day moving average. Does this mean the market is oversold or just that the market has been hit so hard over the past few months that the 50 DMA is depressed?
The Pending Home Sales Index for March was released and the market got what it was looking (hoping) for, which was a stronger-than-expected number. Specifically, pending home sales were up 3.2% from February versus a consensus estimate that called for a flat reading. At 84.6, the index level is 1.1% higher than the year-ago reading. According to Briefing.com, “The catch with the seemingly good housing news is that it feeds into the recovery argument, which is weighing on the Treasury market and is forcing rates higher there. That, in turn, will drive up mortgage rates and will lower the affordability factor for housing and slow demand.”
Construction spending came in at 0.3% versus a consensus of -1.6%.
The ISM services index came in at 43.7 vs. 42.2 consensus and 40.8 in the prior period. New orders showed an improvement to 47 from 39, consistent with the ISM manufacturing report. The market feels the uptick from March suggests the pace of contraction is slowing. The April report marked the seventh straight month the index has been below 50%.
From briefing.com: The April decline in payrolls of 539,000 was a smaller decline than the published economist median expectation of 600,000, but still represents bad economic news. Part of the smaller decline is explained by a 72,000 jump in government payrolls, which hardly helps the wealth-producing private sector. There, widespread losses occurred, including a drop of 149,000 in manufacturing and 110,000 in construction. The increase of 0.4% to 8.9% in the unemployment rate was in-line with expectations. The 2009 Obama administration budget (ended Sept. 30, 2009) called for a $1.7 trillion deficit. The economic assumptions assumed an 8.1% average unemployment rate for 2009. That looks like a very long stretch at this time, as the rate is likely to move higher the next few months. That implies that the deficit this fiscal year will be higher than forecast. Hourly earnings growth did not add much to consumer buying power. Hourly earnings were up $0.01 to $18.51 an hour, which is reported as a 0.1% increase. There have been hopes recently of a steadying in consumer spending leading to stabilization in economic trends this fall or later this year, but the data does not provide much support for that argument. These are still massive job losses and wage gains are minimal. Granted, payroll trends do lag overall economic trends, but unless businesses start to show a willingness to hire and not just to lay off fewer people, the market may be ahead of itself in looking at the recent economic data as harbingers of much better trends.
Fed Chairman Ben Bernanke says we are “likely to see further sizable job losses, increased unemployment in coming months” and that “the US economy should resume growth later in 2009.”
Additionally he commented that “consumer spending, which dropped sharply in the second half of last year, grew in the first quarter. In coming months, households' spending power will be boosted by the fiscal stimulus program, and we have seen some improvement in consumer sentiment.”
More Goldman Hooey
I could write a separate note each week chronicling the conflicts of interest and government impropriety related to Goldman Sachs. This week Stephen Friedman, Chairman of the New York Fed, resigned. Mr. Friedman is a member of Goldman’s board, a firm which also fell under his supervision since it is a bank holding company. According to the WSJ this week, this conflict of interest is a violation of Fed policy. Friedman was also overseeing the search for a new president for the New York Fed, a role that ultimately went to a former Goldman executive. Friedman denies any conflicts of interest in these events.
Interestingly, during his time as a regulator, Mr. Freidman bought 35K+ new shares of GS stock, booking a gain of $2 million.
(Not so) Stress(ful) Test Results
Thank goodness that’s over. The stress test results are in, and what a surprise, everything is really A-OK! After multiple well timed leaks of what was coming, as well as some aggressive negotiating by the banks as to how and what would be released, the long awaited stress test results were announced this week. The relief rally in the financials was dramatic, and helped pull the market up significantly (see Market section above).
The Federal Reserve determined that 10 U.S. banks need to raise a total of $74.6 billion in capital, a finding that Chairman Ben Bernanke said should reassure investors about the soundness of the financial system.
Citigroup climbed after the Fed said it needs only $5.5 billion in additional capital (reportedly negotiated down from $30 billion). Bank of America, determined to require $33.9 billion, also gained. Fifth Third Bancorp, Ohio’s largest lender, soared 25% as the central bank said it must raise a mere $1.1 billion.
From Barry Ritholtz: “Consider this simple fact: Treasury and the Fed want these banks to have Tier 1 common stock equal to 4% of risk-weighted assets. In other words, 25-to-1 leverage as safe for the future.
Hence, it is not a big stretch to conclude that the entire stress test exercise is a near charade, with foregone conclusions of deleveraging banks to still wildly over-extended positions.
Recall that before the 2004 SEC Bear Stearns exemption for the 5 biggest investment banks, net cap rules limited leverage to 12-to-1 for investment banks.
Is 25-to-1 leverage appropriate for depository banks? Well, maybe before the repeal of Glass Steagal — but with today’s toxic asset laden banks, 25-to-1 seems awfully friendly.
Why the generosity? According to Bloomberg, it’s to allow the banks to “grow” their way out of the mess through earnings. Instead of being an honest broker of the banks conditions, the Treasury Department is now a shareholder and cheerleader for bank profitability:
“Treasury Secretary Timothy Geithner is betting that U.S. banks can do something their Japanese counterparts were unable to accomplish in that country’s “lost decade” of the 1990s: earn their way out of trouble.
The stress-test results released yesterday by regulators found that the 19 largest banks face a $74.6 billion capital hole that may be filled mostly by private money. That compares with the hundreds of billions of dollars seen by outside analysts, including the International Monetary Fund, and takes into account banks’ projected earnings over the next two years.”
What a horrific idea.
Put on your rally caps, Uncle Sam is in da house . . .
Dollar & Inflation
From Bill King “Ben is now chagrined because his effort to prop up bonds, possibly to appease China (after Hillary’s trek there) by announcing a $300B monetization, has produced the opposite of the desired effect. Ben’s scheme has inflamed inflation concern, as it should have and will continue to do so.
In recent weeks we have also noted that the dollar is close to breaking down. This is the flipside of the inflation coin. And of course, this forces one to consider what China is thinking and what they might do.”
As part of the implied government guarantee, LIBOR rates continue to drop as US dollar 3 month fell for a 25th straight day and is now below 1% and the TED spread is at the lowest level since June ’08. In a sign that banks are still reluctant to lend to each other for any period of time other than very short term, the spread between 1 month LIBOR and 3 month LIBOR is still elevated at 59 bps vs. around 10 bps in calmer times. Below is a five year chart of the Bloomberg Financial Conditions index, showing that credit factors have improved since last fall, although significantly short of where they stood prior to the housing rollover.
According to the Financial Times the Federal Reserve's survey of senior loan officers found that banks continued to tighten lending standards in February through April, putting additional pressure on consumers and businesses. However, the survey found indications that the tightening might be starting to abate. For example, 80% of U.S. banks tightened standards for commercial real estate loans in January, while 65% did so in the past three months.
According to Bloomberg, “the Treasury will tell U.S. banks that have received taxpayer funds that they must raise debt without a Federal Deposit Insurance Corp guarantee as a condition for repaying the government, people familiar with the matter said. The Treasury will unveil conditions for repaying the Troubled Asset Relief Program money as soon as tomorrow, the people said on condition of anonymity.”
In my view the point is to keep banks that aren't solvent from paying back the loans as they attempt to appear solvent.
Residential Real Estate
From Zillow.com “A growing number of U.S. homeowners owe more than their properties are worth after prices extended their two-year decline in the first quarter.
Almost 21.8 percent of all owners were underwater as of March 31, the Seattle-based real estate data service said in a report today. At the end of the fourth quarter, 17.6 percent of homeowners owed more than their original mortgage, while 14.3 percent had negative equity three months earlier.
Property values dropped 14 percent from a year earlier in the first quarter, reducing the median value of all U.S. single- family homes, condominiums and cooperatives to $182,378, Zillow said. The gain in underwater homeowners will lead to more bank repossessions, the company said.”
Gold pulled back from nearly 1000 just prior to the market bottom on March 9th, all the way down to 850. The commodity has quietly moved its way back to 900 as treasuries began the slide I discussed last week. Could this be an indicator that the rise in Treasury yields is due to inflation concerns (see Market above)? I’d love to hear from you on this.
The Dow vs. Gold
From Chart of the Day: Today's chart presents the Dow divided by the price of one ounce of gold. This results in what is referred to as the Dow/gold ratio or the cost of the Dow in ounces of gold. For example, it currently takes 9.2 ounces of gold to “buy the Dow.” This is considerably less that the 44.8 ounces it took back in 1999. When priced in gold, the Dow is down 79% from its 1999 peak and the scale of the current two-month rally has not distinguished it from the many bear market rallies that have occurred over the past decade.
“U.S. stocks may continue their two- month rally as investor appetite for risk returns,” said Richard Bernstein, the former chief investment strategist at Bank of America Corp. “What’s happening is that we’re seeing a real rally and the world is not coming to an end,” Bernstein, 50, said in a Bloomberg Radio interview. “This rally has removed a lot of the risk aversion.”
CRB & Inflation
from Peter Boockvar
With the CRB index rising to within just 1% of its high of 2009, the implied inflation rate in the 10 yr TIPS has broken out to the highest level since Sept 30th at 1.575%. On Tuesday, Bernanke said that he expects inflation to be quite contained over the next couple of years while at the same time expecting the economy to start growing by year end. This goldilocks forecast sounds great but if he’s correct and the economy does stop contracting by Q4, it’s hard to believe that commodity prices will remain tame at the same time. Commodity producers over the past year have responded aggressively to the massive demand destruction seen and have underinvested in response and its not that easy to just ramp up again at a quick pace. It is also for this reason on the supply side, that if commodity demand just stops going down, prices should rise.
Chief Executive Officer John Chambers said business is beginning to level off for customers around the world, a “remarkable” shift that could set the stage for an economic recovery. Said could get to normal sales growth 3-5 quarters AFTER GDP has stabilized at normal levels.
President PT Barnum, oh, wait, President Obama says people are tightening their belts and Washington should too. He then introduced a record $3.5 trillion, 1050 page budget proposal. He called it “fiscally responsible”. As a senator he was one of the leading benefactors of special interest lobbyists, yet criticized many existing programs that are the result of “special interest lobbyists.”
The spin is dizzying, but I guess that’s the point.
Changes in Euroland
EC Central Bank President Jean-Claude Trichet announced the ECB voted for a 60 billion Euro plan to buy bonds. They also cut their main interest rate to 1%. This is a significant change in position after receiving strong resistance from inflation hawks in Germany.
As we have been discussing, treasury rates are bound to move up as the Fed goes crazy issuing their new “Obama Bonds”. The 10-year spiked to 3.3% this week on an exceptionally weak auction for 30 year notes.
I went back and looked at some of my predictions for 2009. The one I was searching for, relating to the market, is shown below:
Stock Market-as you know I have been maintaining that this is a good time to be accumulating great companies on the cheap, without getting overly exposed to equities. I continue to espouse that view, but still think we are in a long term trading range in the market. Currently the S&P has bounced over 25% from its November 21st low. Some are contending we are in a new bull market, whereas I maintain this is a bear market rally. As you may recall, I have been looking for strong bear market rallies, and have suggested using these rallies to sell your weaker holdings. The S&P is approaching the 950 level I felt would act as the upper band of its trading range. I am still looking for a flat 2009, however, I don’t invest based upon targets set at the beginning of the year, and urge you not to do so either. The S&P is now 931, and I truly feel that it will finish 2009 +/- 10%, which would suggest a range between 840 and 1020.
I am reprinting this as we hover around the same point we began 2009. Obviously my comment that the range would be “+/- 10%” was off a bit given the market fell in the 28% range. A climb to 1020 would suggest another 10%, and would place the index above its 200 DMA.
I still believe the market will be range bound; however, finding the top of this most recent run has been trying. While my portfolio remains net long, I have been frustrated by the rally amongst the low-quality companies, especially given my style favors higher quality at the expense of low quality.
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