May 3, 2009


“More and more of our imports are coming from overseas.”-George W. Bush

May 4, 2009

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

INDU: 1.7%
SPX: 1.3%
COMPQ: 1.5%
RUT: 1.7%

The market resumed its winning ways this week, with most major averages rising by 1.5%. It is interesting to note that as this rally approaches its second full month, the average stock is up over 50% while the indexes have increased in the 30% range. As I have discussed recently, the smaller companies have been leading this rally. This “junk” rally is reminiscent of the 2003 rally, which featured low priced and smaller capitalization stocks leading the market right after the Iraq invasion.

According to Bespoke, both Consumer Discretionary and Technology broke above their 200-day moving averages this week. The firm feels this is definitely a positive technical formation for the two sectors, as it signals the end to a long-term downtrend and the confirmation of an uptrend. It's also positive for the overall market that two cyclical sectors are the first ones to break above their 200-day moving averages.

So far 338 companies have reported earnings, with 232 meeting or beating expectations while 106 have missed. Even though expectations are being exceeded, the first quarter results will be the 7th straight quarter of declining EPS. The table below shows earnings for the S&P 1500 by sector. Note the negative growth in every sector except health care and utilities, and also the large positive surprises in materials and financials.

There has been much discussion in the press recently of the old adage “Sell in May and go away” as May marks the beginning of the worst six months in the market. For those not familiar with this, there is analytical support showing that during the months May-October the market has historically underperformed the November-April time frame by a significant amount. In the tech world we used to say ‘buy at Montgomery, sell at H&Q’, which is difficult given neither of those investment banks still exist. Given the recent run up in the market, 2009 might be one of those years where selling in May makes sense.

I have often advised using market strength to lighten up on weaker holdings and market weakness to add to stronger holdings. Given the large move in this market and the strength of the lower capitalization stocks, a rotation to quality from the junky leaders of this rally might be advised. I would focus on market leaders with strong balance sheet and little or no need for additional financing over the next 24 months.

Bear market rallies are not only commonplace, they occur frequently even in the worst downturns. The chart below (courtesy TBP and Alpha Trends) shows eight large rallies that occurred during the depression, with the smallest rising 19% and the largest 122%.

First quarter real GDP dropped at a 6.1% annual rate in part because the inventory contraction sliced a whopping 2.8% off the reading. Real final sales, excluding inventories, fell at a 3.4% annual rate. The inventory decline reflects sharply lower production.

Real personal consumption expenditures rose at a stronger than expected 2.2% annual rate. In a typical business cycle, consumer spending picks up first, and this might be a signal of better times to come. Bears will note that the gain comes off horrible fourth quarter spending, and that January and February are light consumer months in which gains can be exaggerated by strong seasonal factors.

Investment in software and equipment fell at a 33.8% annual rate. Nonresidential construction spending (offices) fell at an amazing 44.2% annual rate. Residential construction spending continued to plunge, and was down at a 38.0% annual rate.

Government spending fell at a 3.9% annual rate as state spending and defense spending contracted. This was another factor in the overall weaker GDP number compared to estimates.

Benefiting GDP was a tremendous drop in imports due to weak domestic demand. Imports are subtracted from GDP, so declining imports are additive to GDP. Some have estimated that without this benefit GDP may have declined by 12% in the first quarter.

Consumer confidence for April came in at 39.2 versus the 29.7 consensus and the prior reading of 26.0.

The Case Shiller home price index was down 18.6% year over year versus an expected decline of 18.7% and 19% in prior period.

The chart below, courtesy of Bill King, shows continuing jobless claims since 1967. As you can see we are well above any prior highs, suggesting that consumer spending will be slow to rebound in this recession.

Bloomberg reported that Obama's Economic Recovery Advisory Chairman Paul Volcker feels the economy is leveling off and that more stimulus is not needed. He also says that no large systemically important banks will fail.

Consumer spending fell 0.2% in March, the first drop of 2009, versus an expected decline of 0.1%. Personal income was down 0.3%.

The Chicago Purchasing Manager’s index fell again to 40.1 versus 31.4 last month and consensus of 35.0. Under 50 signals a contraction.

In spite of prodding for increased consumer spending by the administration, the savings rate climbed again, to 4.2% from 4% in the prior month and up from 0% in April 2008.

ISM for April was 40.1, indicating more declines but still better than forecasts of 38.4 and the 36.3 reading in March. It appears that the inventory correction during late Q4 and Q1 is beginning to correct as orders improve. New orders climbed to 47.2 versus 41.2 in March, and export orders improved from 39 to 44.

The Michigan Consumer Sentiment index for April rose to 65.1, its highest level since September, just before the market collapsed.

First Birds, Now Swine
Stocks reacted negatively to an outbreak of swine flu, apparently emanating from Mexico. The peso broke down. For Mexico, this is a quadruple whammy. First, tourism falls due to a murderous rage going on in the country, then the US falls into recession, oil prices collapse, and now a swine flu outbreak.

Domestically an outbreak like this could further depress travel, although it may help select healthcare stocks providing flu vaccines, treatments and prevention devices such as masks. Joe Biden (for those who don’t know, he’s the Vice President whose foot in mouth speaking style is beginning to make W look like Disraeli) made comments on TV this week encouraging people to avoid travel and public places.

Hickey and Walters (Bespoke) wrote “The 1918 Spanish Flu was a global flu pandemic that affected nearly half of the world's population at the time (or up to one billion people). The 1918 outbreak was the worst of the 20th century, and it fell under the H1N1 virus subtype, which is the same subtype as the current swine flu outbreak. It's estimated that the 1918 flu killed anywhere from 20 million to 100 million people, which would have equaled a mortality rate of 2.5%-5% of those infected.

The 2009 swine flu is still new to the public, but it is beginning to stoke fear since 152 people have died from it in Mexico as of now. The current swine flu is nowhere near as bad as the 1918 flu pandemic.”

Mexico City officials estimate they are losing $85 million in economic activity per day, and that activity is down 30% since April 24th. A big problem has been absenteeism, people just not showing up for work.

The Little 2
GM opened the week with a $27 billion debt for equity swap in an effort to avoid bankruptcy proceedings.

Aiming to give Chrysler a "new lease on life," U.S. President Barack Obama put the troubled automaker into what he hopes will be a quick restructuring in federal bankruptcy court. The action all but guarantees that Chrysler's future will be guided by Italian automaker Fiat, which pledged to form an alliance with Chrysler despite the bankruptcy filing. Talks reportedly broke down as a small group of debt holders were the obstacle to securing a deal as they held out for a better deal from the U.S. government. Four banks with 70 percent of Chrysler's $6.9 billion debt had agreed to erase it for $2 billion, or less than 30 cents for each dollar held. That left Chrysler's fate in the hands of about 40 hedge funds with about 30 percent of the debt. To entice the hedge funds into going along with the banks, the government on Wednesday afternoon added $250 million to the $2 billion that the banks had settled for, while the funds asked for an additional $250 million.

All this tussling over a company which just announced sales down 48% for the month.

I don’t want to sound cynical, but is anyone else just a bit concerned that the largest contributors to the 2008 election really seem to be making out in the nationalization of the financial system and the auto industry? Last week I discussed Goldman Sachs and Citigroup being the largest political donors of the past 20 years (along with AT&T). What about the UAW? This “non-political” organization was a major Obama contributor, and now in what appears to be a quid pro quo, the Administration has proposed taking a major equity stake in both GM and Chrysler, giving a huge stake to the UAW, and cutting out secured debt holders!

Barron’s provided some analysis of the two deals as proposed by the government:

Chrysler: Banks in the 1st lien position get $.29 on the dollar; Cerebus and Daimler in the 2nd lien position get zero, the US government in the third lien position gets 8% of the company, and the unsecured UAW gets 55% of the equity and a $4.6 billion note.

GM: Banks in the fist lien position have an uncertain recovery, the government’s first lien position gets 50% of the equity, unsecured bondholders get 10% of the equity (their stake is 50% greater than that of the government), and the unsecured UAW (with a stake 1/3 smaller than the unsecured bondholders) gets 39% of the equity.

This government action reminds me of the early days of FDR when he asked for and received the power to “reapportion private wealth and income throughout the nation, in his own judgment.”

Look out healthcare!

Shipping Costs
Shipping costs, which fell from a peak of $177K per day last July to $7K per day in mid-April, are expected to rise soon. Single hulled tankers will be banned beginning next year, which would remove approximately 20% of the global fleet from the market. The catch is that funding isn’t available to complete production of the replacement ships. Most of the orders in the pipeline (141 out of 143) are being built by shipyards in S. Korea, China, and Japan.

Hickey and Walters (Bespoke) write that the Baltic Dry Index is used to track the globalization trade, as it measures the supply and demand for the shipment of goods around the world based on transport costs. The Baltic Dry Index (see chart below) has had some big ups and downs this year, going on multiple winning and losing streaks. This year alone, the index has had a 17-day winning streak, a 21-day losing streak, and it's currently on another 9-day winning streak. The trend in 2009 has been upward, however, as the index is up 145%. And it's still important to remember that we're working off a very low base after the globalization bubble burst last year. The index is still off 84% from its highs in May of 2008.

We haven’t had a “Duh” section for a while, but this week the government gets one for stating the obvious. The “stress-tests” for banks are suggesting that Bank of America and Citigroup may need additional capital.

The fact that we send our tax dollars to the people in Washington so that they can create irrelevant processes which eventually allow them to tell us what we already know helps clarify why we fought for independence 250 or so years ago.

According to BCA Research, China’s economy may be rebounding. “The export sector remains the weakest link in the economy but the government-sponsored infrastructure construction boom has been quickly gaining momentum, partially offsetting collapsing external demand. Credit expansion, fiscal expenditure and capital spending have all accelerated strongly, and industrial production has also stabilized. Importantly, consumer spending has remained reasonably buoyant, rising at a more than 15% annual rate in real terms during the past quarter.”

The BCA estimate (see graph below) points in the same direction as the PMI, leading them to conclude that “although there is still no ‘all-clear’ sign, the Chinese economy may have reached an important bottom and should gradually recover throughout the remainder of this year.”

Because it is so heavily dependent upon exports, particularly to the U.S., China can't return growth to its economy on its own, says China's minister of commerce, Chen Deming. He said the economies of the entire world, and particularly the U.S., must improve before China's economy can recover.

Investors have been spooked by the deal for the IMF to sell 403 tons of gold, at a time Indians, traditionally the most reliable buyers, are on strike. That 500 tons of scrap gold has come to the markets this year is a bad news/good news story: it’s a huge amount for markets to absorb, but it proves anew that gold is a precious asset in tough times. Gold stocks should really shine when the dollar finally falls, and people begin to get genuinely worried about inflation’s return.

What the?
We’ve discussed the inflationary impact of the Fed’s actions many times in this note. Ben Bernanke is now saying that once they recognize that the economy has turned, they will begin offering interest on bank reserves to encourage the banks to hold excess reserves instead of lending.

Are you kidding me??? Let’s analyze that comment.

The Fed is going to time the change in the economy? Isn’t this the same Fed that didn’t recognize we were in a recession until 10 months after it started?

The Fed has been pouring money into banks to encourage them to lend, and when activity starts picking up they’re going to encourage the banks not to lend? What banker is going to avoid making a loan and earning the associated fees so they can leave their assets in an interest earning account?

Fed Borrowing
The Fed banks are holding total capital of just $45.7 billion against the sum total of $2.19 trillion in assets, meaning the Fed is leveraging its capital 48-to-1. That compares to only 27-to-1 two years ago.

Government Borrowing
In the second quarter, the U.S. needs to borrow $361 billion, a new high for the April-to-June period and the third straight quarter of record borrowing, the Treasury Department said. The government's latest projection of the federal deficit for the budget year ending Sept. 30 is $1.75 trillion, almost four times last year's figure of $454.8 billion, which was itself an all-time high.

Real Estate
Mortgage delinquencies increased to a seasonally adjusted 7.9% of all loans in the fourth quarter, the highest in records going back to 1972, according to figures from the Mortgage Bankers Association in Washington. Loans in foreclosure rose to 3.3%, up from 2.0% from a year earlier.

Stress Tests Not So Stressful
From The Big Picture: Of the many issues that arise via the banking bailouts we have seen, perhaps the most pernicious is how corrosive the process becomes. It corrupts even the most well intended parties. The latest example is the stress tests, which run the risk of being window dressing. As noted last week, the Stress Tests themselves weren’t very stressful. And, now that some of the results are coming in, the cure for inadequate capital is not more capital, but an accounting trick — converting preferred stock to common. As Paul Kasriel of Northern Trust described it, this amounts to nothing more than Accounting Alchemy — the financial equivalent of lead into gold. Thus, we see the major test for the sector was inadequate to cleanly identify potential weakness. And even by that soft standard, the cure is inadequate. US banks are suffering a solvency problem, and what they need is more capital, not an accounting sleight of hand. Yet that is precisely what they are getting — the same clever financial engineering that led to the crisis in the first place. All Treasury needs is more leverage and a few derivatives and the transformation into the financial Borg will be complete.”

More Stress Test
From Bloomberg: “At least six of the 19 largest U.S. banks require additional capital, according to preliminary results of government stress tests, people briefed on the matter said. While some of the lenders may need extra cash injections from the government, most of the capital is likely to come from converting preferred shares to common equity, the people said. The Federal Reserve is now hearing appeals from banks, including Citigroup Inc. and Bank of America Corp., that regulators have determined need more of a cushion against losses, they added.

By pushing conversions, rather than federal assistance, the government would allow banks to shore themselves up without the political taint that has soured both Wall Street and Congress on the bailouts. The risk is that, along with diluting existing shareholders, the government action won’t seem strong enough.”

All this goes to show is that receivership was the correct approach to this in the first place. Instead, we get “Gentleman B” stress tests and nonsense accounting gimmicks. The Treasury and Federal Reserve can no longer be considered honest brokers of the process. They too have been corrupted by the ugly process of rationalizing insolvent banks ongoing existence.

A/D Line
The advance/decline line climbed to its highest level of 2009 this week, a sign to technical analysts that the Standard & Poor’s 500 Index may keep rallying after jumping 30 percent since March 9. The measure added 2,031 points, or 8.1 percent, to 27,210, the highest since Oct. 6. The increase represents the difference between the number of NYSE stocks that rose and fell. The index was set at zero in August 1996.

The Best Way to Rob a Bank is to Own One

The comments below are from former S&L regulator turned author William Black: “I think, first, the policies are substantively bad. Second, I think they completely lack integrity. Third, they violate the rule of law. This is being done just like Secretary Paulson did it. In violation of the law. We adopted a law after the Savings and Loan crisis, called the Prompt Corrective Action Law. And it requires them to close these institutions. And they're refusing to obey the law.

So, now we get in trouble, and what do we do? We adopt the Japanese approach of lying about the assets. And you know what? It's working just as well as it did in Japan.

The Bush administration and now the Obama administration kept secret from us what was being done with AIG. AIG was being used secretly to bail out favored banks like UBS and Goldman Sachs. Secretary Paulson's firm, that he had come from being CEO. It got the largest amount of money. $12.9 billion. And they didn't want us to know that.”

Treasuries continue experiencing one of their longest losing streak ever, falling again in the face of massive refunding needs. The curve continues to steepen (see below) indicating either pending growth and/or inflation. Personally I think the move is reflective of future inflation caused by debasement of the dollar.

High Yield
High yield debt has rallied as treasuries have fallen, certainly in line with the wishes of the Fed as they have attempted to encourage risk taking by forcing treasury yields so low as to make them unattractive. The chart below (Bespoke) shows the high yield ETF (HYG) and how it compares with the 7-10 year treasury ETF (IEF). As you can see, the HYG has rallied, signifying smaller risk premium for high yield debt. These types of moves in corporate credit markets typically lead or coincide with better equity market performance. However, these types of declines in treasuries often coincide with equity market declines.

$100 million in Savings
Please go to to see a 60 second video providing an interesting and entertaining example of how the proposed and much ballyhooed $100 million cut the President discussed compares to the entire budget.

Earnings will continue this week. I am looking to continue rotating into higher quality positions as well as to lighten up on my overall net exposure. The risk, as always, is a continued low-quality move to the upside.

Have a great week.


“I am remaking America”, Barrack Hussein Obama on his 100th day in office.

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