May 18, 2009

The Robin Hood Budget

The Robin Hood Budget

“I don’t know, but I think the worst of this may well be over.”
—Alan Greenspan, October 2006

May 18, 2009

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

INDU: -3.6%
SPX: -5.0%
COMPQ: -3.4%
RUT: -7.0%

The market paused from its upward march last week, with the major indices all falling. Small caps, which have had the largest bounce from the March 9th bottom (rising 36%), pulled back 7% while the large cap S&P 500 fell 5%. The pullback seemed orderly, without a hint of panic. Risk taking appears to be returning to the markets, time will tell whether this is too early in the recovery for this type of activity.

It is interesting to note that the market pulled back significantly on the first significant piece of economic data missing expectations in the last few weeks. Retail sales for April (see Economy section below) missed expectations and the results from March were adjusted downward, leading to an almost 4% one day decline. As I discussed last week, the market has been gorging itself on economic data that is bad, but not as bad as the expectations. This retail sales number serves as a reminder that while we may be past the worst portion of the recession, there is still a long way to go before this economy gets back on its feet.

The chart below, courtesy of Chart of the Day, clearly shows the carnage in S&P 500 earnings. The chart shows a decline in earnings of 90% over the past two years. Remember that these are inflation adjusted earnings. Given the recent Q1 results, 2009 earnings of $35-$40 seem feasible. When I mentioned $40 for 2009 earnings in a note in the fall, I received a number of emails strongly suggesting (OK, many of you said I was crazy) I was off base and that there was no way EPS would fall below $60.

The charts below, courtesy of The Bespoke Group, show the nature of the most recent market action. Within the S&P 500 we have seen a sector rotation towards defensive stocks (healthcare & consumer staples) over the past two weeks at the expense of both consumer discretionary and industrials. Could this indicate an overbought condition in the more economically sensitive groups, a reduction in risk appetite amongst investors, or a pending correction?

The trade deficit widened for the first time in eight months, jumping 5.5% to $27.6 billion on a decline in imports of goods while oil imports increased. A drop in exports of 2.4% resulting from a weak global economy also contributed to the jump in the deficit. Autos and capital good exports were weak. Import prices rose 1.6% versus, three times expectations.

Retail sales fell 0.4% for April, versus expectations of no change. March was revised down to a decline of 1.3% (estimates ranged from -0.8% to a gain of 1.1%). Weakness was noted in electronics, furniture, clothing and grocery stores. Retail sales ex-autos declined 0.5% versus an expected gain of 0.2%. Unemployment, higher fuel prices, and America’s newfound frugality conspired to keep sales in check.

Business inventories came in just under expectations with a decline of 1.0% versus expectations of -1.1%. One of the arguments about a potential economic rally later this year hinges on inventories across a wide variety of industries being replenished. Anecdotally I have picked up a handful of data points across a wide swath of industries saying that sales pipelines are starting to become more active. According to these sources, while orders have yet to pick up, the improved activity is still an improvement when compared to three months ago.

The University of Michigan consumer confidence index rose to 67.9 versus 65.1 last month (typically mid-month measures). The index hit a 30 year low in November at 55.3.

Industrial production fell in April, but at the slowest pace in six months and slightly better than consensus, falling 0.5% versus a consensus decline of -0.6%. The Empire Manufacturing index was down 4.6% versus expectations of a 12% decline.

Capacity utilization came in at 69.1% versus consensus of 68.8%.

Core (ex-food and energy) CPI for April was 0.3% versus expectations of 0.1%. The top line number was in line, flat. The core number year over year was up 1.9%. The larger than expected inflation reading was driven by a .4% gain in vehicle prices, a .4% gain in medical care and a 2.6% gain in other goods and services, made up of personal care and tobacco. Rents rose 2%.

Last week I discussed the rosy projections in the new budget deficit estimates. Monday, President Obama announced that the government is piling up larger deficits than estimated and thus raised his estimate of the deficit for this year to more than 4 times last year’s deficit, to $1.84 trillion (a 5% increase from prior estimates) and next year to $1.26 trillion, a 7.4% increase. He cited lower payroll and tax collections (see May 4 note) as well as higher costs of “economic stabilizers” such as food stamps and unemployment benefits. We have a higher unemployment rate today (8.9%) than assumed in the Obama budget (8.1%) for this year, an assumption they haven’t yet changed. Next year they are assuming 7.9% unemployment, which is a significant improvement, suggesting they expect a very robust economic rebound. Typically employment gains lag the economy, and hiring is rarely robust in the early stages of recoveries as companies cautiously rebuild their capacity. Consensus calls for 9.6% unemployment next year and 8.5% in 2011. I anticipate these budget deficit estimates to continue moving upwards, eventually topping $2 trillion.

It is interesting to note the Administration is also expecting 3.5% GDP growth by year end, well above expectations of 1.9%.

Shrinking Economy, Growing TARP
The economy continues to shrink, but the government largess continues. A couple of month ago we discussed the issues brewing in the insurance market. This week the Treasury announced that six insurers would receive access to TARP money. Hartford, Prudential, Allstate, Principal Financial, Lincoln National, and Ameriprise Financial are all eligible for funds. The initial commitment is $22 billion.

How did they get in trouble? As we discussed a couple of months ago, the insurance companies were selling variable annuities which promised minimum payouts. The underlying investments (stocks, bonds, real estate, etc) fell significantly, putting them in a precarious situation.

Why are we saving insurance companies? That’s a great question. They certainly aren’t critical to the functioning of the capital markets. They have proven to be reckless in their business practices by offering rates which they couldn’t deliver. As a money manager I am forbidden from promising a rate of return to my investors, yet these insurers not only have been able to promise an unachievable rate, the government bails them out when they can’t deliver that rate!

The government continues to shower its favorite industries with financial aid. As I have noted with the other TARP recipients and the United Auto Workers, I’m sure we will find that the insurance industry was a major donor to the most recent campaign. Who said buying influence was reserved for third world countries?

Roadblock for Nationalizing Healthcare

From ISI-“The leaders of several major stakeholder groups are meeting with President Obama today with the goal to lower the projected rate of growth for health care spending by 1.5% each year, which would mean $2 trillion less would be spent on health care over the next decade. In summary, the DC team believes this is more of a public relations tactic than a real effort to reduce costs and they remain very skeptical. Despite these promises, we believe major stakeholders will ultimately oppose the health care legislation introduced by the Democrats in the House and probably the Senate bill too.”

Remember that last fall the credit markets literally seized, with capital flows grinding to a halt and no lender feeling comfortable giving its capital to anyone else. All the various credit indicators reflected this fear. The TED spread (chart below courtesy Bloomberg) is representative of the fear that existed in the credit markets. Recently, over the past month, this measure has finally been able to break lose from the 100bps level, falling to a recent measure in the low 70bps range. While still above historical levels, this improvement foretells continued improvements in capital flows, which will be a key factor for the global economy in its efforts to recover.

Money Supply
From the Daily Dirtnap: “As I mentioned before, if we estimate M3 at $12 trillion (we don’t know what it is, they killed the statistic, remember) and we have done or committed to do about $3 trillion of quantitative (or credit) easing so far, then we have inflated our money supply about 25 percent. Twenty-five percent! I have heard the tired argument that the Fed is standing ready to remove liquidity from the system when the time arrives, but I would bet the left arm of my firstborn son that when that moment arrives, it will be politically unpalatable to do so.”

I have added a chart of year over year M2 growth below (again, courtesy of Bloomberg). Remember than when capital floods the economy the markets tend to benefit if the real economy doesn’t have a need for the excess capital. Given present the lack of economic activity, I wouldn’t be surprised if much of the recent market rally we have been experiencing is from the excess liquidity being provided by the Fed.

Congress and Investment Timing

According to Eric Singer “When Congress works – and by "works" I mean "meddles" – it destroys wealth. When Congress doesn't work, wealth grows by itself. From 1965 through 2008, looking at a total of 11,000 trading days, the annualized daily price gain of the S&P 500 Index is just 0.31 percent when Congress is in session. Out of session, that figure jumps to 16.15 percent, a daily difference of 50 times. As government power and influence grow, the trend has intensified in recent years. From 2000 through 2008, in-session performance of the S&P is –12.4 percent. The out-of-session performance: +8.8 percent. In other words, had you invested $10,000 only when Congress was in session from the beginning of 2000 through 2008, putting aside dividends, you'd have $4,615 today. Had you invested that same $10,000 only on days when Congress was on vacation, you'd have $13,416 today.”

Stress Test
Please go to the website ( to view a short video clip on the bank stress tests.

Oil continued its surge this week, moving above $60. As we showed recently, the number of operating rigs worldwide has declined by roughly ½ as the price of oil fell from $150 to almost $30. Demand has shown a very slight increase over the past two months, however, rising prices at the pump may function as a brake as consumers lose their recent gains in discretionary spending/saving they were enjoying as a result of lower gasoline prices. Locally, prices have risen from just under $2 to $2.70 per gallon in the past two months.

Also remember that oil is priced in dollars, and the global markets could be discounting the reckless treatment of the dollar by the Fed. See the chart below from Bespoke Group, which shows recent weakness in the dollar, which coincides with the rebound in oil.

One way to lower the inventory of excess homes on the market is to level them. That’s exactly what Guaranty Bank in Irvine did last week as they demolished 12 spec homes in Victorville. Squatters and thieves were destroying the homes, and the city was fining the bank for not completing the properties. The bank was left with the option of putting more money into the homes and trying to sell them or destroying them. They chose the later.

The Solution to the Global Financial Crisis

by Prieur du Plessis

In a small town on the South Coast of France, the holiday season is in full swing, but it is raining so there is not too much business taking place. Everyone is heavily in debt. Luckily, a rich Russian tourist arrives in the foyer of the small local hotel. He asks for a room and puts a Euro100 note on the reception counter, takes a key and goes to inspect the room located up the stairs on the third floor.

• The hotel owner takes the banknote in a hurry and rushes to his meat supplier to whom he owes E100.
• The butcher takes the money and races to his supplier to pay his debt.
• The wholesaler rushes to the farmer to pay E100 for pigs he purchased some time ago.
• The farmer triumphantly gives the E100 note to a local prostitute who gave him her services on credit.
• The prostitute quickly goes to the hotel, as she was owing the hotel for her hourly room used to entertain clients.

At that moment, the rich Russian comes down to reception and informs the hotel owner that the room is unsatisfactory and takes his E100 back and departs.

There was no profit or income. But everyone no longer has any debt and the small town’s people look optimistically towards their future.

Could this be the solution to the global financial crisis?

Misc from ISI
Taxes are moving up in Great Britain and in the US as well. Ed turned to a Swedish guest at our morning meeting and asked what their marginal rate was. It's 55% in Sweden with a 25% VAT. Marginal rates in NY will soon exceed 50% before social security or Medicaid taxes are added. State taxes are going up in CA, IL, and NJ. Just as the attack is on "millionaires," in the UK, politicians attack wealth while quietly lowering rates to levels that affect high income middle class earners. The Obama tax said to begin at $250,000 will now begin at $235,000 and the Administration is still seeking to lower deductions effective raising rates higher still.

Higher taxes are not being used to offset the massive and growing budget deficits which Nancy estimates to be $1.3 trillion in the US this year, but to offset the higher spending coming from the proposed health care legislation to be delivered later this year. No wonder why the dollar and bond markets are groaning. Jeff thinks the dollar is headed lower after completing a head and shoulders formation. A natural beneficiary of a weaker dollar is the materials sector of the S&P and everything else "real" out there. Mike Rothman thinks the speculators are creeping back into the oil market in anticipation of a weaker dollar.

Goodbye Capitalism?

In another potential blow to capitalism, Barney Frank and Barrack Obama announced plans to restructure the compensation system in the financial services industry. They aren’t simply proposing to cap pay on financial executives of firms accepting federal aid, but instead are proposing to establish guidelines on how compensation is determined across the entire industry.

We should all start practicing the phrase “Greetings Comrade!”

Real Estate
According to RealtyTrac, foreclosure filings in April were filed on 342K properties, up 1% from March and 32% from one year ago. Nevada, Florida and California lead the country in foreclosure activity. Nevada has a foreclosure rate (1 of every 68 homes) that is five times the national average.

Chrysler & GM

As Chrysler begins its bankruptcy proceedings, the company has proposed rejecting dealership agreements with approximately 800 of its 3200 dealers. Reportedly Fiat made the decision as to which dealers will be retained.

Meanwhile, GM is saying that bankruptcy is probable. GM is also planning to close 1000 dealers, with a reported inventory of $2.5 billion in unsold vehicles.

It is interesting to note that these cuts are coming just as dealers begin to see an improvement in their ability to get new flooring capacity. Many dealers have been unable to stock new cars since late summer due to the funding issues, and recent reports indicate that this funding is starting to flow once again. This should mean more profitability for those dealers left standing.

Money Manager Regulation

SEC commissioners voted 5-0 on a proposal that would subject investment advisers holding customer assets to surprise inspections by independent auditors. Some money managers would also face compliance audits to ensure they are adhering to securities laws.

Given the regulatory failures that allowed scam artists such as Bernie Madoff to operate for years without scrutiny, I expect this to be the tip of the iceberg in new oversight requirements for money managers. I’m not opposed to better oversight, however, I feel that more effective enforcement of the existing rules would probably suffice.

The problems at Fannie Mae just seem to continue. It appears they will require additional government aid as delinquency rates continue to rise. Barron’s is estimating an additional $19 billion will be required soon to keep the firm afloat. Additionally, it appears that delinquency rates in their prime portfolio are beginning to pick up, signaling a need for even more bailout funds.

And the cost of letting this company fail initially would have been what?

Death and Taxes
Finally providing an answer to a long running debate at the local sports bar, it appears that only death and taxes are a certainty, not pole dancing. Crunch Fitness, the health-club chain with cardio-strip tease and pole-dancing classes, may have marked the end of an era when it filed for bankruptcy last week after about a 25 percent membership decline since 2004.

Change of website and email address
Please note that in the next few weeks I will begin sending this note from a new email address, If you wish to continue receiving the note, please add this new address to your approved senders list so it doesn’t end up in your spam filter.

For those of you reading via the website, I also plan to change that address, but that will take a bit more time and I will keep you posted on the timing of that cutover.

Have a great week and happy Memorial Day. Next week’s note won’t be out until Monday evening given the holiday.

As always, please let me know if you’d like to be removed from this list.


“The third-rate mind is only happy when it is thinking with the majority. The second-rate mind is only happy when it is thinking with the minority. The first-rate mind is only happy when it is thinking.” A. A. Milne:

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