Jun 28, 2009

Milton Freidman vs. Ben Bernanke

Milton Freidman vs. Ben Bernanke

“There are two kinds of people who lost money: those who know nothing and those who know everything. With two Nobel Prize winners in the house, Long-Term Capital clearly fits the second case.” – Henry Kaufman

June 29, 2009

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

INDU: -1.2%
SPX: -0.3%
COMPQ: 0.6%
RUT: 0.1%

This week marks the end of the 1st half of the year, and what a wild ride it has been. At one point the S&P 500 had fallen over 25% for the year, and is now up almost 2%. If you closed your eyes for the first half of the year you would have thought nothing had happened, yet the past six months have been full of action including major corporate bankruptcies, government takeovers of banks and auto manufacturers, accusations of strong-armed tactics by the Federal Reserve, and one major bear market rally.

I wondered how the year to date action would compare to my beginning of the year predictions (http://weeklymarketnotes.blogspot.com/2009/01/january-4-2009-happy-new-year-to-all-of.html). I won’t go through all of them, just the ones that appear to be really accurate (kidding). Actually, I’ll just cover a few of them.

1. I suggested the market would be range bound (which was correct), although I missed the bottom of the range by a country mile. I ball-parked 840-1020 for the full year while the actual range has been 666-950.
2. I said the economy would stay weak for 2009, but that we could see improvement throughout the course of the year if credit (among other factors) improved, which it has. I also said that credit would continue to loosen throughout the year and we could see more normal levels of credit measures (see chart below from Bloomberg, the 5 year Libor-OIS spread, which is almost back to normal levels).
3. I was (and still am) bearish on the dollar, but it has held up pretty well for the first half of 2009, although I still expect it to have issues. I recommended looking at China as a hedge to the dollar, and that market has outperformed the US handily.
4. As I read that note from January, I was surprised I was turning bullish on oil because I didn’t cover my shorts until later. I suggested a $60 year end price for oil, which is now at $69 after bottoming in the mid $30s. Oil has rebounded, and as I said a couple of weeks ago, I think it has overshot to the upside and there is another opportunity on the short side.
5. If you look closely at that note, I predicted the Lakers would win the NBA title (they did), and that the Angels would win their division (they moved into first place yesterday). California may be falling off a financial cliff, but our sports teams are looking good.

Based upon recent sector movement (see chart below courtesy Bespoke Investment Group), strengthening of treasuries, and fund net outflows, it appears investors are pulling back their risk exposure. The question is will this be a pause in the rally or the beginning of another correction? A few weeks ago we discussed a theory that the Q2 reporting period would be the inverse of Q1, that weaker numbers wouldn’t be met with rising stock prices. While that determination is yet to be made, the recent rotation to more defensive sectors (with the exception of technology, which continues to lead) certainly waives a yellow flag.

In global markets the MSCI has now officially entered the “correction” zone, falling by 10% from its recent high. Russia has technically entered another bear market, with its market down 20%. The Russians have been making a ton of noise about the dollar’s suitability as the global reserve currency, US financial and foreign policy, and our green energy efforts. It might be wise for them to take care of business at home, which remains one of the worst and most dangerous places to conduct business.

Of course, it also might behoove our government to begin leading the world again instead of following it, and to stop trying to recreate Europe here in North America.


Actual Consensus Prior
Existing Home Sales 4.77 4.82 mil 4.68 mil
House Price Index -0.1%
Durable Goods Orders 1.8% -0.9% 1.8%
Durable Orders ex-Transportation 1.1% -0.5% 0.4%
New Home Sales 342K 360K 344K
Initial Claims 627K 08K 612K
Q1 GDP-Final -5.5% -5.7% -5.7%
Personal Income 1.4% 0.3% 0.7%
Personal Spending 0.3% 0.4% 0.0%
PCE Core 0.1% 0.2% 0.3%
Michigan Sentiment 70.8 69.0 68.7

Durable goods orders jumped in May, rising 1.8% ex-transports versus an expected decline of 1.9%. Leading the way was a 68% jump in orders for commercial aircraft as Boeing received orders for 20 jets in May versus 17 in April. Orders for military equipment jumped 7.4%, computers 9.4%, and machinery 7.7%. Sustained new order growth is necessary to absorb the excess capacity here in the US and eventually (maybe late 2010 or 2011) turn around the massive job losses we are experiencing.

Personal income increased the most in a year, up 1.4% versus expectations of 0.2%, and personal spending rose 0.3%, just under consensus of 0.4%. The big jump in personal income has been attributed to tax cuts and Social Security payments from the stimulus package, which averaged $250 per recipient. Without that stimulus, personal income rose by 0.2% and wages and salaries dropped 0.1%. The savings rate jumped as well, hitting a 15 year high of 6.9%.

Last week we discussed the moderate decline in new unemployment claims and suggested it could be due to benefits expiring after 26 weeks. Bill King provided us with the chart below showing the “exhaustion rate”, the rate at which US workers are losing their unemployment benefits because they have been on the roles too long. In other words, they have exhausted their benefits. The scale is in percentage.

For the first time since 2007 the OECD has revised its forecast upwards. They said that the economic downturn in its 30 member countries has nearly reached bottom. It predicted weak growth of 0.7% next year, a modest improvement from its previous estimation of a 0.1% contraction.

Fed Open Market Meeting
The Fed met this week and left its bond purchase program, which is nearly $2 trillion of treasuries and mortgages, in tact. They pronounced that the rate of contraction in the economy is slowing and inflation will be “subdued for some time” in spite of rising commodity prices.


This week’s title derives from the Fed Chairman’s view that inflation is caused by the output gap, whose key indicator is capacity utilization. During the ‘90’s I worked for Roger Engemann, an economist by trade but a very successful money manager. Roger was a proponent of Freidman’s philosophy that inflation is a monetary phenomenon, dependent upon a stable dollar and commodity prices. My bias is to agree with Roger and Milton, and let B-52 Ben prove himself over time.

The reason hard assets (i.e. commodities) continue to work this early in the cycle is due to the perception that Bernanke’s actions will ultimately tank the dollar. This view has been accepted by our most important trading partner, China. China is the largest holder of US Treasuries, but has been cutting those holdings to buy commodities, primarily industrial metals.

The Chinese have been on again off again backers of the dollar, and this past week they decided to be off again. China’s central bank reiterated calls from the other BRIC countries (Brazil, Russia, India and China) for a “super sovereign currency” to replace the dollar. This is the third call by the Chinese for a new reserve currency this year.

The ECB has shunned further rate cuts for now, and the Euro has been much more stable than the dollar. ECB member Axel Weber said “the past has shown that an overly generous provision of liquidity in global financial markets in connection with a very low level of interest rates promotes the formation of asset price bubbles.”

According to Business week, China recently stepped up measures to block foreign companies from selling goods there and also rolled out policies to boost exports -- and there is little the U.S. can do about it. Many of the protectionist measures criticized by the U.S. are perfectly legal under the rules of the World Trade Organization.

I’m sure we can appease them with some soft talk and apologies.

On a separate topic in China, they blocked Google’s website this week. The government censors want Google to block access to foreign websites via the local Chinese version of Google. China has always been at odds with Google and the internet in general, however, these types of actions make me wonder whether the rebound we are hearing about from China isn’t trickling down far enough, and the government wants to make sure the masses are suppressed (or at least censored).

Corporate Sentiment
According to a Reuters/CNBC poll, CEOs in the U.S. are not nearly as negative about the economy as they were in the first quarter, but they plan to continue rolling back capital spending and eliminating jobs. "The signs appear less negative than they were last quarter, but no one is ready to suggest they are going to begin hiring to start growth," said Business Roundtable Chairman Ivan Seidenberg, chairman and CEO of Verizon Communications.

Long time readers know that I have been a critic of former Fed Chairman Alan Greenspan and his loose money policies, which not only helped to create the current financial crisis, but also baked inflation into the long term pie here in the US. Now he is on the inflation bandwagon, which of course makes me want to re-evaluate my position. He told Reuters:

“…the threat of inflation needs to be confronted because it poses a threat to economic recovery. Excess capacity is temporarily suppressing global prices. But I see inflation as the greater future challenge," Greenspan said. "If political pressures prevent central banks from reining in their inflated balance sheets in a timely manner, statistical analysis suggests the emergence of inflation by 2012."

I hate it when people whose opinions I completely disregard start adopting my stances.

Crude inventories had a drawdown of 3.8 million barrels versus expectations of a 950K barrel decline. Gasoline inventories rose by 3.9 million versus an expected decline of 1 million, and distillate inventories rose by 2.1 million versus an expected increase of 850K.

Mike Rothman of Cornerstone Analytics (www.thecornerstone.us.com) was kind enough to provide some supply/demand data for 2Q 2009. His research shows demand down 3.5 million barrels per day versus last year for the April/May timeframe. Mike feels that demand is actually running below that of the first quarter (could be the rise in prices at the pump). Further, he notes that inventories are at their highest levels since 1998 (when oil bottomed around $12 per barrel). On the flip side, non-OPEC supply has been declining more than anticipated.

Energy Legislation

The administration is pushing for caps on carbon emissions in an effort to push the US towards clean energy. As we have discussed in the past, the goal is a noble one, but the technology doesn’t exist to make this transition in the time frames proposed. In our April 20th note (http://weeklymarketnotes.blogspot.com/2009/04/less-bad-is-new-good.html), we compared the pros, cons and costs of alternative forms of energy, which demonstrated the technology is a number of years away from achieving grid parity.

The administration’s goals are in direct contrast with its other goals-restoring economic growth and employment and reducing dependence on foreign oil. The plan will force US producers of gasoline to purchase carbon dioxide allowances for CO2 coming from their plants AND for the autos that consume the fuel. Foreign producers wouldn’t be subject to the plant allowances, which would allow the offshore producers to develop fuels at a lower cost than domestic manufacturers. ConocoPhillips CEO Jim Mulva said the plan will “have an adverse impact to our industry, potential shutdown of refineries and investment and, ultimately, employment.”

The plan will push the cost of a gallon of gasoline up by $.77 to $1.00 per gallon. Electricity prices will also surge. According to President Obama “under my plan of a cap and trade system, electricity rates would skyrocket.”

Maybe when the refineries start closing the government can take them over in a massive bailout to save jobs? Sounds familiar.

The cartoon below was sent this week by a reader, and symbolizes where the US and China are headed.

Government Bailouts
From Casey Research: “In the wake of Penn Central filing for bankruptcy, America’s largest rail company at the time, Congress passed the Rail Passenger Service Act of 1970 and Amtrak was born. The new federal monopoly was expected to be self-sufficient by 1974. Today, 38 years of federal subsidies and over $33 billion tax dollars later, the company has yet to turn a profit.”

So what is Congress’s solution? Throwing the dysfunctional enterprise $13 billion more tax dollars over the next five years, plus another $1.3 billion towards infrastructure and security.

If the bureaucrats’ ongoing experiment with Amtrak is any indication of GM or Chrysler’s future, then American taxpayers are in for a world of hurt.

From Business Week: “If nothing is done about health care inflation in the U.S., rising costs could force small businesses to spend $2.4 trillion for health care in the next 10 years, effectively eliminating 178,000 jobs, according to a study by Jonathan Gruber, an economist at Massachusetts Institute of Technology. Reform could cut those costs to $1.8 trillion, reducing anticipated job losses by 72%, he said. "The notion that reform will lead to massive unemployment is simply unsupported by the data," Gruber said.

So, let me get this straight. We spend $2 trillion on a healthcare plan to save $600 billion? There was a former Presidential candidate who called this type of math “voodoo economics.”

All This for Just a Trillion Dollars?

Public works projects funded by the U.S. government's economic stimulus are boosting employment, according to data from a House committee. Stimulus spending had created or saved more than 21,000 jobs by the end of last month, according to the report. That compares with 1,288 jobs the committee linked to stimulus spending at the end of April.

Let’s toss in another trillion or two; maybe we can save 100K jobs.

Real Estate
According to ISI, the stock of unsold existing homes for sale continues to fall. In May, it fell 3.5% and is down 15.3% over the past year. The months-supply of homes for sale is down to 9.6 (10.2 on the current sales rate), though that reading is still elevated.

The problem of home sales falling through because of questionable appraisals is "snowballing," said Lawrence Yun, chief economist for the National Association of Realtors. "There's definitely a groundswell of frustration that's building right now," he said. The Appraisal Institute is worried that U.S. rules reward the fastest and cheapest appraisers rather than ones that are accurate in setting values.

Since I have written about the Somali Pirates on numerous occasions (Dave, I promise I’ll write about your Pittsburg Pirates when they do something newsworthy), I thought I’d include this from a website forwarded by a reader. I haven’t confirmed whether it’s legit or not, but it is entertaining (Tom, I know you’ll check Snopes for me, thanks).

Luxury ocean liners in Russia are offering pirate hunting cruises aboard armed private yachts off the Somali coast. Wealthy punters pay £3,500 per day to patrol the most dangerous waters in the world hoping to be attacked by raiders. When attacked, they retaliate with grenade launchers, machine guns and rocket launchers, reports Austrian business paper Wirtschaftsblatt. Passengers, who can pay an extra £5 a day for an AK-47 machine gun and £7 for 100 rounds of ammo, are also protected by a squad of ex special forces troops.

The yachts travel from Djibouti in Somalia to Mombasa in Kenya. The ships deliberately cruise close to the coast at a speed of just five nautical miles in an attempt to attract the interest of pirates.

"They are worse than the pirates," said Russian yachtsman Vladimir Mironov. "At least the pirates have the decency to take hostages, these people are just paying to commit murder," he continued.

Anyone have a free weekend?

Time to Retire, Permanently

Former IBM Louis Gerstner, who was the king of manipulating earnings while he was running the firm, told Bloomberg TV that short term capital gains should be 80%, gains held for six months 60%, and over five years 0%. He feels that would be beneficial to getting investors to think long term.

Personally, I’m opposed to capital gains taxes-period! However, if we are going to tax capital gains, why are we creating a “good versus bad” classification on the gains? Who cares how long it takes to make a profit?

The (not so) Golden State
Within a week, California will have to start issuing IOUs to pay its bills, the state's controller said. "Next Wednesday, we start a fiscal year with a massively unbalanced spending plan and a cash shortfall not seen since the Great Depression," Controller John Chiang said.

How did the Golden State get in such a pickle? There have been a handful of key issues that have led to this budget mess. First, the incessant gerrymandering that has occurred over the decades redrawing voting districts into partisan strongholds. The vast majority of districts in California have been created to ensure incumbents keep their office, which ultimately has led to districts leaning either heavily left or right. Second, as a result of the distrust arising from this process, the state’s voters have the ability to place initiatives on the ballot, designating spending, tax cuts, etc. This has led to a large percentage of the budget to be locked in by voter initiative, and has created caps on certain taxes and fees. Third, state contracts have a prevailing wage clause that requires union wages must be charged on all government contracts, even if someone else could do it cheaper. Our neighborhood found out the disadvantage of this law last year when we decided to air condition our local elementary school. The prevailing wage law required us to pay nearly double the amount of our other bids. Finally, during the late 90’s when somewhere near 90% of incremental state revenue was being derived from state capital gains taxes, the legislature irresponsibly ramped spending under the assumption that these tax revenues were a stable source of income instead of treating them as a non-recurring source of revenue. The capital gains taxes went away just as the spending on big projects began ramping.

The Big 3
Edmunds prepared a report for ABC News on the worst selling cars in America. Unsurprisingly, 11 of the bottom 15 selling cars come from either Chrysler or GM. The problems cited amongst the various models are consistent: cheap parts, poor build quality, and lack of styling. My favorite description was written for the Chevrolet Cobalt “an example of America's inability to build a decent compact automobile” and “less refined than competitors, bucket-of-bolts start-up noises, the last hurrah of an old design, anonymous looks.” So much for following the maxim of Lee Iacocca, who said “There is no great mystery to satisfying your customers. Build them a quality product and treat them with respect.”

Amazingly, the Cobalt is the #1 stolen car in America. Attention thieves, head to the nearest dealer, they have plenty!

Partially overshadowed by the other big celebrity passing this week, Farrah Fawcett lost her long battle with cancer. As a good friend said about the timing of her death “it’s like having your birthday on Christmas.” For those of you who had the poster in your room as a kid, and the older group who remembers her “creaming” Joe Namath in what has been ranked one of the 10 most memorable Super Bowl commercials ever, this one’s for you:

The economic calendar features the Case-Shiller Home price index, the ISM index, the usual assortment of employment data, and factory orders. Earnings have started trickling in, and should really start moving the following week.

Have a great week.


“If you are in a spaceship that is traveling at the speed of light, and you turn on the headlights, does anything happen?”- Steven Wright

Jun 22, 2009

Low Volume-Seasonal or Predictive?

“Healthcare is the single largest driver of our multi-trillion dollar deficit.”-Barrack Obama, US President

June 22, 2009

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

INDU: -2.9%
SPX: -2.6%
COMPQ: -1.7%
RUT: -2.7%

This past week represented the 6th pullback in the market since the March 9th low (see chart below courtesy Bespoke Investment Group). Volume for the month of June has been very light, giving the non-believers and more conservative something to gnaw on. Unfortunately, at this time of year volumes tend to ease off so the lack of the same doesn’t give us much to hang onto. As we have discussed in the past, I am expecting the market to be range bound, certainly for this year and more than likely for an extended time period.

Richard Russell of the Dow Theory Letters expressed concern about the volume trends this month, stating that “In order for a counter-trend rally in a bear market to be sustained, it requires steady or rising buying power plus short covering. Lowry’s Buying Power Index has been declining steadily since May 8. At yesterday’s market close, this Index (demand) was only 24 points higher than it was at the March 9 lows. Furthermore, volume is drying up. This is extremely negative action. Whenever buying power contracts during a rally in a bear market, the prevailing primary bear market forces immediately take over. For that reason, unless the trend of declining buying power soon halts and reverses, I believe that the March 9 lows will be attacked and violated.”

As we discussed a couple of weeks ago, it appears that expectations in the marketplace are for a perfect recovery, which is very unlikely. The best case scenarios, whereby the recession ends this quarter or next, still should leave us with an environment where it could take many quarters or even years for a sustainable market recovery. Remember that the relatively mild recession of 2001 ended around the 4th quarter of that year, yet the market didn’t see a true recovery until March 2003, and the market suffered its worst losses during 2002. Granted the market was coming from a much higher valuation level than where we started this bear market, however, the interest rate environment, credit markets, and consumer spending were all in much better condition than today.

This week’s market action included a shift from the inflation trade (i.e. late cycle commodity stocks) to a more defensive trade (healthcare and utilities) for the first time since early March. The chart below, courtesy of www.finviz.com, shows the sector performance of the S&P 500 last week, where healthcare was the only group posting a positive return.

The big news on the week was the new Obama Administration plan to change the focus of the Federal Reserve from maintaining stable monetary policy to that of maintaining economic growth. The plan also puts Fed in the position of asking the Treasury for permission to utilize some of its emergency powers. Should this come to pass, it would alter the Feds current position as an independent central bank to a more political body. This shift could further undermine an already weakening international view of our currency and economy.


Actual Consensus Prior Period
NY Manufacturing Index -9.41 -4.60 -4.55
May Housing Starts 532K 485K 454K
PPI 0.2% 0.6% 0.3%
Core PPI -0.1% 0.1% 0.1%
Building Permits 518K 508K 494K
Capacity Utilization 68.3% 68.4% 69.0%
Industrial Production -1.1% -1.0% -0.7%
Core CPI 0.1% 0.1% 0.3%
CPI 0.1% 0.3% 0.0%
Initial Jobless Claims 608K 604K 605k
LEI 1.2% 1.0% 1.1%

Housing starts jumped nicely above consensus and the prior month, but still are some 45% below the level of last year. Building permits also came in slightly better than anticipated. The headlines are screaming about an improvement in the housing market, and while these results are not as bad as prior months, they are still just marginally above the lows of January-February and represent very weak levels of activity.

PPI for May came in less than anticipated as declining prescription drug and apparel prices were offset by gains in energy prices.

While initial jobless claims went up by 3K to 610K this week, the number of people collecting unemployment insurance fell by 148K to 6.7 million. Many hailed this decline as a sign the economy is finding a bottom, however, what the figures don’t take into account is the large number of filers who have seen their 26 weeks of unemployment coverage expire. Personally, I feel the improved numbers, which are still bad, are nothing more than a measurement fluke, and we will continue to see unemployment rising for a number of quarters.

CPI came in significantly lighter than expectations (0.3%), posting a month over month increase in May of 0.1%. The key to the miss was a less than anticipated 0.2% gain in energy prices, where a strong gain in gasoline prices was offset by declines in fuel oil, electricity, and natural gas as well as a strong seasonal factor (unadjusted energy prices rose 4.0% month over month). Food prices posted a decline for the fourth straight month, down 0.2%. Excluding these two categories, core CPI rose a modest 0.1% with increases led by new and used cars, medical care services, drugs, and tuition costs. Helping to offset these gains were declines in tobacco products, clothing, airfares, personal care products, and services. Both rent and owners equivalent rent (which together account for 30% of the core CPI) posted modest increases of 0.1%.

Treasury Yields-Flight From Quality?
We have been speculating for some time about what is causing the back up in treasury yields. This past week we had three Fed Presidents espousing their views on the cause. What are their conclusions? Much like the three-handed economist, they each have a different viewpoint.

Better economic data? Yes. Inflation? Yes. Government deficits? Yes

China's investment in U.S. Treasuries fell to $763.5 billion in April, the lowest since June 2008. The drop "seems to stem from net selling of Treasury bills," said Chirag Mirani of Barclays Capital Research. China Daily (Beijing)

Treasuries were hit early in the week when the Treasury said it will auction a record $40 billion in two year notes while adding $2 billion to the 5-year ($37billion) and $1 billion to the 7-year auction ($27B). The curve was pushed steeper as concern over longer term inflation and excess issuance is being raised again.

Credit Conditions
The chart below, courtesy of Investment Postcards, shows the contraction in spreads fro investment grade bonds. While the improvement has been significant, it is only now back to levels normally found near the trough of recessions.

According to ISI, global liquidity spreads have returned to near normal, though there is still a slight premium for liquidity. They feel that the financial crisis is largely resolved, however, the economy's adjustment to reduced risk taking and deleverage will weigh upon global capital markets.

European Troubles
From the London Times: In the European Central Bank's June Financial Stability Report, policymakers warn that commercial banks in the Euro-zone could face an additional $283 billion in losses by the end of next year. "Hard-to-value assets have remained on bank balance sheets, and the marked deterioration in the economic outlook has created concerns about the potential for sizable loan losses," the ECB said. Lucas Papademos, vice president of the ECB, warned that "there is no room for complacency because the risks for financial stability remain high, also bearing in mind that the credit cycle has not yet reached a trough."

Consumer & Corporate Sentiment

While consumers continue to be cautious, corporations have also been cautious, issuing equity as quickly as possible in an effort to pay down debt. What will come next? Eventually I anticipate another M&A cycle given the under-levered businesses resulting from this debt retirement cycle.

Good news for investment bankers, maybe in late 2010 or 2011.

According to Bespoke Investment Group, the percentage of stocks in the S&P 500 above their 50-day moving averages fell to its lowest level in two months. As of Friday morning, 71% of the stocks in the index were trading above their 50-day moving averages. Health care, both consumer sectors, and telecom have seen the biggest decline in breadth, while the utilities sector has increased recently up to 91%. This increase in utilities breadth indicates that investors are rotating money into the most defensive sector as the market takes somewhat of a breather.

Steel producer Nucor raised its guidance last week. The second- largest U.S. steel producer by sales forecast a second-quarter loss that’s narrower than analysts estimated and reported an increase in orders.

Best Buy Co. posted disappointing sales in spite of heavy promotions and the loss of competitor Circuit City.

Fed Ex said the rate of volume drop has leveled off and that they are “seeing signs of stability in the economy.” They experienced a 1% decrease in ground yields on flat volume. They further stated rising fuel prices will have an impact on Q1 results and that they believe they will be poised for growth in the second half of their fiscal year as comparables get easier. The departure of DHL from the marketplace is creating new pricing opportunities for the company.

British Petroleum is saying that emerging market consumption is now driving global oil demand as they are consuming more than developed nations on an aggregate basis. This is giving new fuel (excuse the pun) to the bull case on energy as emerging market economies appear to be recovering earlier than developed economies.

That malfunctioning international body known as the World Bank raised its growth forecast for China for 2009 to 7.2% from their 6.5% forecast in March. They also advised the country to delay any additional stimulus until 2010.

While GDP estimates are rising in China, it is important to note that electricity consumption has not kept pace with the reported rise in economic activity. This could be due to lower manufacturing volume as exports remain weak, however, it could also be a signal that the reported gains are somewhat overstated. The current electricity consumption is more consistent with 1-2% GDP growth.

The market isn’t cheap on an historic basis. S&P earnings may show some growth this year, however, the growth is primarily coming from money losing companies such as GM and a host of banks being excluded from the benchmark. Additionally, with rates continuing to rise, the relative valuation continues to expand.

Long Short Equity Weightings
As this market appears to be topping out, I have been lowering my net long position and presently am down to 20% net long from 25% net long last week and a high of 30% net long in May. While my present target position has been 50% long, 40% short, I have been running higher on the long side since April. As I mentioned last week, I re-initiated shorts in the oil sector and am slightly long the consumer and telecom sectors.

Just Say No!

What would happen if you offered a subsidized program and no one participated? This is what happened as the Federal Reserve received no requests from investors for loans to buy new commercial mortgage-backed securities under the TALF emergency program. Among the acronym soup coming from the government, TALF is a program aimed at reducing borrowing costs and reviving U.S. economic growth.

Real Estate
The chart below is from Paul Kasriel Director of Economic Research at The Northern Trust Company and shows that in recent months the ratio of single-family house starts to sales of new single family home sales is at it lowest level in 47 years. This is not to gloss over the fact that there still is a large supply overhang of new homes for sale that either have been completed or are under construction as well as pending foreclosure activity that is expected to rise dramatically over the next few months.

The chart below, courtesy of StockCharts.com, shows that the CRB, which measures a basket of commodities, has pulled back recently. Remember that this pullback has occurred while oil has continued to move upward, albeit at a slower pace than the doubling in prices that has occurred since early March.

Just Say No to the Governator
According to the Washington Post, California's appeal for emergency financial aid was turned down by the Obama administration. U.S. officials are worried that if they give California what it wants, the federal government will be buried under an avalanche of similar requests from other states. I guess that’s opposed to the avalanche of requests last fall for TARP money from commercial banks?

Moody’s warned they might downgrade California municipal bonds as the state faces a liquidity crisis as early as July. Credit default swaps on the state’s debt have skyrocketed, and according to Barron’s the prices are suggesting that the market is viewing California as a worse credit than Mexico and comparable to Lebanon. Ouch!

Market Risks/Negatives
I just wanted to note some of my ongoing concerns in the market and economy: rising interest rates, spiraling deficits, inflation via a weak dollar, energy prices that may crimp consumer spending, health care costs, an increasing tax burden, and questionable government policies.

Market Opportunities/Positives

Giving equal time to the opportunities in the market, I view positives as excess capacity (see the chart below courtesy of John Mauldin), an available labor pool, improving credit conditions, expanding M2, dollar weakness which benefits exports, and a coinciding improvement in demand from emerging markets.


I have postulated that video games may benefit from the summer trend of staycations, and received these comments from a reader in the industry:

“2008 was still strong from PS3 and WII, guitar hero and call of duty world at war - the industry is investing significantly in some big new releases - DJ Hero (will be big hardware and software), Nintendo DSi - new handheld with many new titles, and both the XBOX 360 and PS3 come with a Blu Ray player which is still growing and will be marketed more thoroughly. Game Stop is opening another 400 stores in 2009. Nintendo has the new WII motion controller and many new games including Tiger Woods golf (no more little cartoon characters) and the new WII Resort and WII Fit plus. There are also a ton of new software titles gaining a lot of $'s - UFC Undisputed, Call of Duty 5, great new EA sports games, etc. We just got back from E3 the industry trade show and there is a lot of positive momentum and optimism for the second half of the year, not to mention big ad spends.”

Health Care Bill
The CBO analyzed the proposed health care bill, one of the President’s priorities, and found that it will cost $1,600,000,000,000 (trillion) over the next decade, excluding Medicare. Given the CBO’s tendency to underestimate government expenditures and overestimate revenues, I would suggest the price tag on this bill probably pushes towards $2 trillion!

Double Standard
Does anyone else find it a bit self-serving that the government, majority stakeholders in 2 of the Big 3, is taking our tax dollars and giving it to people in the form of financing and the Cash for Clunkers program in order to drive sales at their auto manufacturers? If anyone in the private sector were to engage in that type of activity, prison would be their next stop (after, of course, a tongue lashing by the politically correct).

Credit Cards
Reiterating what I said in an earlier note about the proposed credit card bill of rights, David Nelms, the CEO of Discover Financial Services, said recently adopted rules in the U.S. aimed at protecting credit card holders will likely lead to increased interest rates and fees. "There are many consumers that actually will not benefit," Nelms said. "Some of the unintended consequences are going to be difficult for customers."

Early or Late Cycle?
The big question facing investors is whether we should be focused on early cycle or late cycle stocks? The late cycle argument suggests that this time is different (those words always scare me), and that the emerging markets will lead us out of the recession. At this point in the cycle it is unusual for late cycle stocks to be leading the market, except if we were experiencing nothing more than a bear market rally.

The early cycle argument is based upon history, which has shown that during market cycles the early cycle stocks lead the recovery. As you know I have been an advocate of a traditional recovery and that we are experiencing a bear market rally. As with any market it is important to be flexible and let the data guide your opinion, not the other way around.

Cool Website
For winos like myself there is a new website for monitoring your wine cellar/collection called Vinfolio. It allows you to track, analyze, and monitor your portfolio of wine. Additionally, it allows you to buy and sell wine from other users. I plan to use it to help value our wine for insurance purposes.

Twittering in Iran
In response to last week’s elections in Iran, massive protests have been occurring. Despite a crackdown, news of the protests has been pouring out of the country via Twitter and YouTube. If you go to my site (http://weeklymarketnotes.blogspot.com) you can see an embedded video of some of the protesters. .

Scary Flight

A Continental owned 777 landed safely last week after the pilot died during the flight. Two other pilots were able to guide the plane in safely, and evidently the 250 passengers were unaware of the situation in the cockpit.

Sign of the Times
Frugality is the new mantra of US consumers, and it’s no different at the Brines household. Last week I went to Sam’s Club for our summer stocking of the backyard bar. For the first time I can ever recall, the checkout clerk didn’t ask me to sign a waiver stating that my alcohol purchase wasn’t to be resold. I guess I didn’t buy enough?

Note to the neighbors-looks like you’d better bring back up this summer.

I plan to continue moving my portfolio more towards neutral, especially as we enter earnings season. With the markets seemingly priced and anticipating a very robust recovery, I am expecting softness through the upcoming reporting season.

Have a great week and thank you as always for your constant feedback.


“Given the way North Korea has been belligerent to its neighbors and acting like a bully, they aren’t acting properly to join the world economy.”-President Obama

Jun 15, 2009

Japan to the Rescue!

June 15, 2009

Japan to the Rescue!

“I swore I was going to exclusively collect assets and not liabilities for the rest of my life. I swore never to take gambles I couldn’t back up, or that I couldn’t afford to lose. And, I’ve stuck with that ever since.” Tim Blixseth-founder of the defunct Yellowstone Club

Weekly percentage performance for the major indices

Based on last Friday’s official settlement...

INDU: 0.4%
SPX: 0.7%
COMPQ: 0.5%
RUT: -0.7%

A mere three months ago the possibility of the S&P 500 returning to 1000 seemed a long shot, yet here we are just a wisp from that level. The market is still down 40% from its late 2007 high, but it has bounced 40% off the early March low. The market has been consolidating over the past three weeks in the 920-950 range (see chart from Bespoke Investment Group below) and the VIX has contracted as well, sliding in at 28, a far cry from it’s peak around 80 late last year. The panic that was present in the markets has subsided as the consensus view is that the worst of the economic crisis is behind us.

What is in store for the market as we head towards the end of the second quarter? Many, including myself, believe the market has run beyond the level supported by the economic fundamentals, however, I don’t believe fighting a bear market rally coming off such a significant low is a way to sustain your capital. While I am anticipating a higher rate of disappointment in the Q2 earnings release series, I also anticipate some continued fuel being added to the fire of the market. Professional investors, who were rocked in 2008 as the markets imploded, have once again lagged the market, especially during the bounce. Many funds finally began getting conservative in late January and February, just before the market began its recent run. As June 30 approaches, these investors will probably feel compelled to “window dress” their portfolios. Window dressing, one of Wall Street’s most inane activities, occurs near the end of Q2 and Q4 (less significantly near the end of the other two quarters) as mutual fund managers tend to unload their losers and add to winning stocks. Why would they do this? So their mid-year and year end holdings look better to clients. Remember, its one thing to lose money, but quite another to have it on your holding list for a client meeting and actually have to explain your mistake.

The chart below, courtesy of Bob Bronson, compares this bear market with that of 1929-1932. While this market has been scary (red line) it is nowhere near the damage done in the prior period. The explanation for the entire chart is in the box, however, note the yellow highlighted declines, which are corrections of greater than 20%. I’m not a technician, but given this most recent rally has taken out the high level of the previous rally, my hunch is that this market may not play out like that horrible one 70 years ago.

Large cap stocks have finally begun to really join the rally, and last week outperformed small caps. While one week doesn’t make a trend, once again I am looking to upgrade my portfolio. While I continue to hold higher quality small cap names, in the large cap world it appears that high quality (high ROE, low debt, strong cash flow) is beginning to outperform low quality (high debt, low ROE).

The trade balance for April was in line at -$29.2 billion versus consensus of -29.0 billion. While global stock market returns suggest growth in emerging markets is stronger than in the US, exports fell to their lowest level in over three years at $121 billion. Exports to Japan, South America and Central America were especially weak. Imports of $150 billion were the lowest since 1994 as fuel (not oil), drilling equipment, computers and toys were weak. Oil imports rose due to the climb in the price of oil to an average of $46.60 in April, and should continue to increase the trade deficit as its price is now over $70. In spite of China’s reported resurgence in growth (which isn’t supported by their cumulative electricity consumption), demand from China remained weak as the trade deficit with China increased by $1.2 billion to $16.8 billion.

Retail sales for May were in line at 0.5%, but excluding autos they were also up 0.5% versus consensus of 0.2% and versus negative comps in April.

Continuing claims rose to 6.8 million as initial claims increased by 601K, just less than the estimate of 615K.

April business inventories were down 1.1% versus expectations of a 1.0% decline. March inventories were revised down as well.
The Michigan Consumer Confidence index for June came in at 69.0 versus an expectation of 69.5 and 68.7 for the month of May.

The End of the Recession?
The esteemed Ed Hyman of ISI, who successfully called the 1991 recession, said that the end of the recession has been signaled since unemployment claims came down and a there was a 40k drop in initial claims. Additionally he feels that the inventory drawdown's like the one announced this week could stimulate manufacturing activity. Inventories could be down more in 2Q than 1Q, and if that's correct, 3Q is almost certain to be up. Ed remarks "he is a little out of gas"...but our clients are generally looking at the bright side.

How does the length of this recession compare to prior recessions? I’m glad you asked. Chart of the Day has provided us with the chart below showing the average length of a US recession since 1902. The current recession has run longer than the average, and is quickly closing in on the #2 spot for length of recession.

Dollar and Treasuries

The IMF commented that a new reserve currency could replace the dollar. Adding to pressure on both the dollar and yields, Russia has announced they are moving some of their reserves from US Treasuries to IMF Bonds.

As you know I have been very critical of our treatment of the dollar by the Treasury and Fed, however, I’d still rather own US debt than IMF debt. This is the first time the IMF has ever issued debt, and while I haven’t studied it thoroughly, I am guessing it is being backed by their loans to struggling and emerging economies, which can’t be as secure as US debt.

Brazil, Russia and China all announced plans to buy billions of dollars in bonds from the International Monetary Fund, and India is expected to announce a similar move. Only Japan, still the largest holder of our debt (see table below courtesy Bloomberg), came out publicly during the week to say they still supported the US (ergo this week’s title). The Bloomberg table below shows the holdings of US treasuries by various foreign countries.

After peaking near 4%, the 10 year has pulled back to 3.77%. Could it be that the yields are finally becoming attractive enough to entice investors?

The stock market has been rising with interest rates simultaneously rising. This is the same formula that led to the 1987 crash. Stay tuned!

Shipping Volumes
The chart below, courtesy of The Big Picture, shows the decline in truck tonnage over the past four years. We still haven’t seen a pick up here, suggesting that end market demand is still quite weak.

Bank earnings should really begin improving during the 2Q earnings season. First, the steep yield curve heavily favors lenders. Second, before the accounting rules changed which eliminated mark to market, the banks had marked most of their troubled loans down. Many of those loans are performing, resulting in the banks over-reserving for loan losses the past few quarters. As those losses either come back on the books or are absorbed by new losses, bank earnings will get the boost. This is very similar to how banks used to smooth their earnings under the “old” accounting.

Commercial Real Estate
MetLife Inc., the biggest U.S. life insurer, said defaults will increase on commercial mortgages. “The worst is to come,” Chief Investment Officer Steven Kandarian said this week in an interview with Bloomberg Television in New York. “Typically there’s a lag between when the economy softens and when the defaults actually occur.”

I have often mentioned commercial real estate as the next shoe to drop.

Deterioration of Contract Law

It appeared early this week that the Supreme Court would add some sanity to the Chrysler bankruptcy as it agreed to hear an appeal led by Indian pension funds and consumer groups. The groups were unhappy with their treatment in the reorganization plan approved by the bankruptcy court. I outlined the details a couple of weeks ago, but effectively the government structured a deal which steals the company from the secured creditors and gives it to the unsecured creditors (also known as the union).

Unfortunately as the week progressed the high court denied the appeal. While UAW jobs may get saved in the short term by this deal, in the long term not only will the deal be of little help, it will also cost jobs. Creditors will demand higher returns on loans to unionized businesses since the value of their collateral will be impaired by a government willing to step in and take away that collateral.

Texas Instruments raised guidance for sales and earnings for the second quarter. This is the first company of significance I can recall raising sales guidance. The company attributed the better guidance to customers slowing the pace of inventory reductions and demand improving in Asia.

I may be a glutton for punishment, but I began shorting energy again this week. I’m certainly not short to the extent I was in the fall (-25% vs. -4%), but I started two small short positions this week.

This is an interesting conundrum as I’m negative on the dollar, which should help oil prices, but feel that the weak current fundamentals in oil will bring the price back down (and hopefully my short positions along with it).

How are the fundamentals of oil? Crude inventories dropped by 4million barrels to 362 million this week. The key to the drop has been refiners working off their excess inventories, while demand hasn’t yet picked up, investors are anticipated this uptick as the price has been pushed from the mid-30’s to the low 70’s. Demand may not get the chance to pick up as gasoline prices have pushed back towards $3.00 (actually over that level here in California), a level which in the past has proven to stem demand.

TARP Repayments

JPMorgan Chase, Morgan Stanley, Goldman Sachs and seven other large financial institutions were granted permission to repay the U.S. government $68 billion they received through the Troubled Asset Relief Program. Repayment of the rescue funds will allow the banks to get out from under federal restrictions placed on them through their participation in TARP. Bankers, including JPMorgan Chief Financial Officer Michael Cavanagh, cautioned that spending will likely remain tight because of economic uncertainty. "These are challenging times, and that's not going to change simply because we repaid TARP." President Obama says the bailout repayments are a positive sign but not a signal that troubles are over in the financial system.

After talking the market up in the early spring, it appears the administration is now talking things down in order to ensure their domestic agenda gets passed.

The Compensation Czar

The Senate is looking at a proposal changing financial firms’ pay practices by allowing shareholders, the Compensation Czar, or both to set executive pay. Congress would have to approve the authority for the nonbinding shareholder votes, covering everything from bonuses and salaries to severance packages.
The changes aim to ensure that even financial companies that free themselves of government stakes will be subject to universal guidelines aimed at reducing systemic risks. Treasury Secretary Timothy Geithner has repeatedly blamed pay practices keyed to short-term profits for contributing to the worst financial crisis since the 1930s.

This should be really bad for the city of New York, which derives the majority of its tax revenues from payroll taxes on high earning financial services employees. Remember the 70’s and 80’s, when crime was rampant in NYC, the subways were covered with graffiti, blackouts were rampant, and the city was begging for a federal bailout? It may not be far off with this legislation.

Consumer Sentiment

I try to go to Starbucks at least once a week. The unit by my house used to consistently have a line out the door, however, from February to April there was rarely anyone in line ahead of me. This past Wednesday the line was nearly out the door.

Another green shoot? (OK, feel free to abuse me for using that ridiculous term, I just couldn’t resist).

Ken Lewis
I’m no fan of Ken Lewis, but the poor guy got crucified on Capital Hill regarding the Merrill Lynch acquisition. According to Mr. Lewis, he had no idea what he was spending his firm’s billions on when he bought Merrill, only that Federal Reserve and Treasury officials were threatening him with his job if he didn’t comply.

Mr. Lewis spent most of Thursday being grilled by Congress regarding the Merrill acquisition. I watched as much as I could without absolutely becoming disgusted by Mr. Lewis’ inability to answer questions posed to him by the equally incompetent members of Congress. He is the CEO of America’s flagship bank, yet can’t answer simple questions?

I haven’t mentioned jobs I could do part time for quite a while, but I could certainly fill Mr. Lewis’ shoes (or the entire Congress for that matter), and I’m convinced it wouldn’t take me more than 5 or 6 hours per week to deliver equal results. Imagine what I could do if I did either job full time?

Speaking of Company Management
“Go for a business that any idiot can run - because sooner or later, any idiot probably is going to run it.” Peter Lynch

RealtyTrac (www.realtytrac.com) reported that foreclosure activity for May declined 6% from April to 321K, which still represented an 18% increase from May 2008. Bank repos (REOs), as opposed to defaults and scheduled foreclosure actions, were up 2% month over month. The company expects REO activity to increase over coming months as “foreclosure delays and moratoria implemented by various state laws come to an end.” The chart below, courtesy of RealtyTrac, shows the level of foreclosure activity across the country.

Mortgage rates have been rising with treasuries, and could be the final shoe to drop in the residential mortgage market. Barron’s reported that a sustained mortgage rate at 5.5% would lead to an additional 25% drop in the value of homes. Foreclosure rates would definitely continue rising, and housing inventory would skyrocket as more homes moved into negative equity. If this were to occur, it could set up for a great bottom in housing, probably in mid to late 2010.

Grain Prices Set to Rise
According to the Associated Press, crop prices could rise this year because of dwindling supplies of U.S. corn and soybeans, a prospect that raises fears of grain shortages and higher food costs.

Reserve grain supplies from last year's harvest are at low levels, with soybeans at their shallowest level in more than 25 years. The reserve stocks have been depleted by U.S. grain exports and by domestic demand for crop-based fuels such as ethanol and biodiesel. Global grain markets are left with a thinner cushion of surplus. The tightening supply could start to raise crop prices, which have been kept down by the global recession.

"The dynamics for higher food prices are already in place, but they are being masked by problems in the larger economy," said Greg Wagner, senior commodity analyst with Chicago-based AgResource Co.

Healthcare and Taxes
The Senate is looking to tax employer provided health care benefits exceeding $13,000 per year. The proposal is expected to raise over $400 billion to help pay for a new government health care plan. Unions under contract are exempt from the tax until their next contract is negotiated.

My prediction is that companies will simply lower health care benefits to their employees to avoid paying these taxes. Instead of raising more money to pay for nationalized health care, the plan will simply lower coverage for non-union employees.

Software Woes
From the Gartner Invest Team “our software team is taking more and more inquiries from end-users about restructuring their contracts with software vendors. Whether it's cutting prices or lengthening the term of the contract, pricing is under pressure. From an accounting perspective, this may not yet show up on the companies balance sheets. You can change the duration of long-term deferred revenue without lowering the amount.”

Something to watch on the technology front.

Ethical Breakdown
According to documents leaked in a case (insurers suing Lilly) pharmaceutical manufacturer Ely Lilly urged doctors to prescribe the drug Zyprexa for dementia. Zyprexa is an antipsychotic drug and there is no evidence the drug works for dementia. It has been shown that patients suffering from dementia and taking Zyprexa experienced multiple medical conditions, including death.

The insurance companies are suing for $6.8 billion in damages. The company has already pleaded guilty to federal misdemeanor charges.

Last week I mentioned possible staycation (people staying at home this summer) beneficiaries, and one was video games. While this is backwards looking information, NPD reported that video game sales fell 23% in May to $863 million, the first month below $1 billion since August 2007.

I hope you have a terrific week. As always, thanks to the three of you (out of almost 700 readers) who haven’t placed me permanently on your junk mail list.

Have a great week.


“I rarely think the market is right. I believe non dividend stocks aren’t much more than baseball cards. They are worth what you can convince someone to pay for it.” Mark Cuban-Owner Dallas Mavericks

Jun 7, 2009

New Bull Market?

“And, can we trust the data any more from the godless Communists in China any more than we can trust the data from the god-fearing socialists in the USA ?”-Barry Ritholz

June 8, 2009

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

INDU: 3.1%
SPX: 2.3%
COMPQ: 4.2%
RUT: 5.7%

After more than a year of waiting, the S&P 500 finally moved above a still declining 200 day moving average this week (see green line on the chart below, courtesy Bespoke Investment Group). A mere 10 weeks ago a move near this average was deemed a long shot, yet now the bulls are out in full force saying that this signals the market has entered new, bullish territory. While the onus is now definitely on the bear camp to prove their case about the market’s future direction, it is important to note that the 200 DMA is still declining, and will need to reverse for this market to be deemed anything beyond a bear market rally.

Beyond the technical action in the market, there are quite a few positives keeping this market moving forward. First, mutual funds had a net inflow of $14.7 billion in April after outflows of over $45 billion (combined) in February and March. Cash in money market funds remains high, and the pain in the market is still to the upside (i.e. an upside move will cause the most pain to investors waiting for a pullback). Corporate spreads have declined significantly (see High Yield Debt below), as has the stubbornly sticky credit markets-see the chart below of the Bloomberg financial conditions index, which has bounced back to pre-Lehman levels.

The ISM factory index rose to 42.8 versus consensus of 42.3 and up from 40.1 in April. New orders jumped to 51 from 47.2. The index of prices paid surged to 43.5 from 32, well above expectations of 35. For all of these measures, anything over 50 indicates expansion while under 50 indicates contraction. The new order number is especially important as a leading indicator.

The ISM services index came in just under consensus at 44.0 versus the expected 45.0 (see chart below from Briefing.com) and essentially flat from March. This is one of the few under consensus reports in key measures over the past couple of months

Personal spending was down 0.1% in April versus an expected decline of 0.2% and the prior month’s downwardly revised 0.3% decline. Personal income was up 0.5% versus an expected decline of 0.2%.

Construction spending showed some surprising life, rising 0.8% in April versus an expected decline of 1.5%.

Pending home sales jumped 6.7% in April, the biggest gain in seven years. Sales are being driven by foreclosure led declines in value as well as tax incentives for first time buyers. Actual sales have been lagging pending sales as lender approval and other transactional issues have increased the percentage of deals not closing.

Factory orders came in at 0.7% for April versus expectations of 0.9%. March was revised down (big surprise) to a decline of 1.9% versus a decline of 0.9%.

Jobless claims of 621K were in line with estimates. Nonfarm payrolls declined by 345K versus an expected decline of 520K, the best since September 2008. The unemployment rate jumped from 8.9% to 9.4% versus an expected 9.2%. This is the highest unemployment rate in 26 years. The upside in the payroll number came from an arcane measurement known as the birth/death rate, which attempts to model how many unreported jobs are created via new business formation. This calculation resulted in a net offset of 220K, the biggest adjustment in the past 10 years. Remember that unemployment, which isn’t expected to peak until sometime in late 2010, is a lagging indicator and tends to peak after the end of a recession.

Treasury yields continued backing up, with the short end of the curve making an enormous jump during the week. The move in the two, five, seven and ten year notes were significantly above historical average daily movements as the curve made an upward, flattening shift. The ten-year note hit a six month high of 3.84%.

The Bloomberg chart below shows how S&P 500 earnings per share (orange line) have fluctuated with the slope of the yield curve (white line, 2-10 year spread). A peak in the spread of the yield curve has coincided with a trough in earnings and vice versa. As we know, the curve tends to flatten or invert prior to a recession, and S&P earnings tend to peak just after the start of a recession. A rising spread has led market rebounds (steep curve tends to help bank profitability, which encourages more lending), and the subsequent flattening of the curve from its peak coincided with earnings recoveries. The effect has been especially pronounced since 1994.

The chart below, courtesy of Bespoke Investment Group, shows the recent uptick in the 30-year mortgage rate, which has coincided with the rise in the 10-year treasury yield. A continued rise in mortgage rates could begin to put a lid on the recent “less bad” activity in the housing market.

In one of the biggest surprises of all time (just kidding), GM filed for bankruptcy at the beginning of the week. The government has pledged to convert their $50 billion in loans ($20 billion of which has already been provided and the other $30 billion committed) into a 60% ownership stake. The company has an additional $120 billion in debt. The pre-filing plan suggests that a UAW healthcare plan will receive a 17.5% stake. Bondholders with stakes senior to the UAW and a larger dollar value are slated to get 10% equity and an additional 25% in warrants.

Holders of credit default swaps (remember those bad guys?) will be the winners in the deal as the bankruptcy triggers payment of those securities.

The New Dow 30
Long time Dow components General Motors (GM) and Citigroup (C) were removed from the Dow Jones Industrial Average, and were replaced by Cisco and Travelers. C is being removed because the bank is “in the midst of a substantial restructuring which will see the government with a large (34%) and ongoing stake” said a spokesman for Dow Jones.

I think adding the US Government to the Dow makes sense. After all, they run the auto, banking, and defense industries and are proposing to take over healthcare as well.

You Saw it Here First
GMAC, the financing arm of GM owned by the US Treasury, Cerberus Capital, and GM, recently launched a retail banking brand over the internet called Ally Bank. The bank, flush with $13.5 billion in government funds to expand auto lending, has been advertising CD rates over 2x that of the national average in an attempt to lure depositors. The American Bankers Association (ABA) is highly critical of the higher rates being paid by a risky bank being subsidized by the government.

Taxing the Rich

From Lee Geiger, Pensera Securities-“Last year Maryland created a “millionaires” tax bracket, raising taxes on the roughly 3,000 million-dollar income tax returns to hopefully generate an extra $106 million in revenue. But this year there were only 2,000 million-dollar returns, so “millionaires” paid $100 million less than they did last year. Depending on the rich to finance government is as effective as an Oprah Winfrey diet plan.”

TARP Repayments Clarified
The Federal Reserve Board outlined the criteria it will use to evaluate applications to redeem U.S. Treasury capital from the 19 bank holding companies (BHC) that participated in the Supervisory Capital Assessment Program (SCAP). Redemption approvals for an initial set of these large bank holding companies are expected to be announced this week. Applications will be evaluated periodically thereafter. Any banking organization wishing to redeem U.S. Treasury capital must first obtain approval from its primary federal supervisor, which then forwards approved applications to the Treasury Department. Any BHC seeking to redeem U.S. Treasury capital must demonstrate an ability to access the long-term debt markets without reliance on the Federal Deposit Insurance Corporation's Temporary Liquidity Guarantee Program (TLGP), and must successfully demonstrate access to public equity markets. In addition, the Federal Reserve's review of a BHC's application to redeem U.S. Treasury capital will include consideration of the following:

1. Whether a BHC can redeem its Treasury capital and remain in a position to continue to fulfill its role as an intermediary that facilitates lending to creditworthy households and businesses;
2. Whether, after redeeming its Treasury capital, a BHC will be able to maintain capital levels that are consistent with supervisory expectations;
3. Whether a BHC will be able to continue to serve as a source of financial and managerial strength and support to its subsidiary bank(s) after the redemption; and
4. Whether a BHC and its bank subsidiaries will be able to meet its ongoing funding requirements and its obligations to counterparties while reducing reliance on government capital and the TLGP.
5. Finally, all BHCs must have a robust longer-term capital assessment and management process geared toward achieving and maintaining a prudent level and composition of capital commensurate with the BHC's business activities and firm-wide risk profile.

Glad they clarified that!

Bank of America has now raised almost the entire $34 billion required by the stress tests after converting nearly $10 billion in preferred stock into equity. They may have an additional $10 billion to raise as the government attempts to blackmail them in their efforts to pay back their TARP loans (see above).

Public Opinion
An April survey by CNN showed 76 percent of Americans favored allowing GM to fall into bankruptcy rather than extending further government aid.

Green Shoots
OK-I haven’t used that term yet, even though it has been used close to 1 million times in print and other media. I was speaking with a regional distributor of outdoor products, who told me that his business at Home Depot and Lowes was up 25% in units and over 40% in dollar volume. His overall business is down 8% year over year. This compares to commentary in the late fall, when retailers wouldn’t even look at order books for the spring (https://weeklymarketnotes.blogspot.com).

Summer travel plans are really down this year. While it appears that local travel plans will remain solid, the recent rise in gasoline (now hovering at $3.00 per gallon in California) may keep the lid on auto travel.

What will families be doing with their kids this summer? How about a Staycation? Staying at home and enjoying the home front. Spending is actually picking up for items associated with staying home. I’m envisioning an increase in video game console sales as weary moms (and unemployed dads) try to keep their kids from driving them crazy this summer.

High Yield Debt
I have discussed the run up in high yield debt over the past few months (and the corresponding decline in rates). Brian Reynolds of WJB Capital provided the chart below depicting high yield spreads and the rapid decline from nearly 2000 bps to just above 1000 bps. This lower cost of funding is allowing companies to come back to the debt markets for much needed capital infusions. Issuance has been running very strong in the past eight weeks.

Stephen Shock, oil expert and author of the Shock Report, feels that oil prices are approaching levels where gasoline prices at the pump will retard consumer demand. Additionally, he feels longer term (2-3 years) there will be a supply crisis, however, he feels right now oil at $70+ is well ahead of its fundamentals. In his opinion there is a possible correction to the mid $40 range given the current supply-demand imbalance. Shock feels that the recent spike in oil prices is purely based upon speculators and there is no fundamental support for these higher prices. The chart below, courtesy of www.chartoftheday.com, depicts the movement in oil prices (inflation adjusted) over the past 40 years.

Global Recovery
The $64K question in this market is whether emerging market growth will offset slow growth in the developed nations? If so, then it should benefit materials and commodities, which has been reflected in the recent trading action. This should also be good for exporting companies and other weak dollar beneficiaries.

Who Invited This Guy to the Party?
(Bloomberg) - Former Federal Reserve Chairman Paul Volcker said a full economic recovery is years away, and the U.S. must eventually cut back on borrowing from abroad. While “truly massive fiscal and monetary stimulus is at work,” he said, “a full recovery will be a matter of years.” Volcker decried growing U.S. debt, saying the nation has long been spending beyond its means. The U.S. faces “an unimaginable budget deficit as far as one can see,” he said. “Foreign countries have been for a long while willing to finance our excess spending, but that process can’t continue forever,” he said.

Volcker said the recession, which began in December 2007, “is bound to be the longest recession since World War II and could turn out to be the deepest as well.” The impact of the recession and the government response will last a long time, he said.

“The federal government and the Federal Reserve have been forced to ride to the rescue by ways and means never before contemplated, implying both a degree of political intervention and political risk that are bound to preoccupy us for years,” Volcker said.

In addition, new regulations are necessary to prevent another crisis, he said. “In my view, as joined by many others, sweeping reforms are truly necessary, in banking, in markets, and in our regulatory institutions.”

Someone Might Actually Be Minding the Store!
Ben Bernanke gave his testimony to Congress this week, and amazingly made the comment that “large budget deficits threaten financial stability and the US can’t continue to borrow at the current rate to finance the shortfall.” This comes on the heels of both Geithner and Obama making similar comments. For a full text of the Chairman’s comments, click here: http://www.federalreserve.gov/newsevents/testimony/bernanke20090603a.htm.

Ed Yardeni’s famous bond vigilantes appear to be moving back in the driver’s seat and the spin-meisters are out in full force trying to appease them.

Quality trade
I will be running some analysis over the next few weeks about what appears to me to be a rotation (at least in the small cap world) from weak companies (low ROE, high debt, low profitability) into higher quality stocks.

I appreciate any info readers are finding on this topic.

Retail Comps
Retail stocks slumped hard on Thursday after reporting weaker than expected sales in May. Higher unemployment and a rising savings rate (estimated to now be over 5%) are crimping sales.

Some select retail comments from Briefing.com:

Abercrombie & Fitch Co. (ANF:US) fell the most in the Standard & Poor’s 500 Index, losing 9.7 percent to $28.63. The U.S. teen-apparel retailer said sales at stores open at least one year slumped 28 percent last month, more than the 25 percent decline estimated by analysts surveyed by Retail Metrics.

Other retailers that reported disappointing sales or earnings also slipped. Family Dollar Stores Inc. (FDO:US) lost 7.1 percent to $30.10. Limited Brands Inc. (LTD:US) retreated 5.4 percent to $12.56. Gap Inc. (GPS:US) decreased 5.5 percent to $17.22. Macy’s Inc. (M:US) fell 4.4 percent to $12.74. Nordstrom Inc. (JWN:US) dropped 5.4 percent to $21.58. Children’s Place Retail Stores Inc. (PLCE:US) fell 6.2 percent to $32.36.

Hot Topic Inc. (HOTT:US) slid 4.3 percent to $7.22 after earlier dropping 8.1 percent, the most intraday since May 21. The teen clothing and music retailer said its sales at stores open at least one year dropped 6.4 percent in May

Swine Flu
Bloomberg-The swine flu outbreak has overwhelmed the U.S. health-care system, a report said. Communication between government agencies and doctors isn’t well coordinated and the World Health Organization’s six-step pandemic-alert scale causes confusion, according to an analysis released today by the Robert Wood Johnson Foundation, the Trust for America’s Health and the University of Pittsburgh’s Center for Biosecurity. Worried citizens flood emergency rooms while undocumented immigrants and the uninsured delay getting medical care, the report said.

The H1N1 influenza virus has spread to more than 11,000 people in the U.S. and caused 17 deaths, according to the Centers for Disease Control and Prevention, in Atlanta. WHO is at phase 5 of its alert scale, meaning a pandemic is imminent, even as the bug causes little more than a fever and cough in most patients. Researchers say it is critical to address vulnerabilities in the system before a crisis strikes.

“H1N1 is a real-world test of our initial emergency response capabilities,” said Jeff Levi, executive director of the Trust for America’s Health, a nonprofit organization in Washington, in an e-mailed statement. “The country is significantly ahead of where we were a few years ago. However, the outbreak also revealed serious gaps in our nation’s preparedness.” The report includes 10 recommendations for strengthening the public-health infrastructure, including halting job cuts in state and local health departments, providing care for uninsured Americans during an emergency and helping health-care facilities prepare for a surge in new patients.

The work was supported by a grant from the Robert Wood Johnson Foundation, a Princeton, New Jersey-based endowment fund that provided $523.3 million in grants and contracts last year to support health programs in the U.S., according to its Web site. The family of Robert Wood Johnson started Johnson & Johnson, now the world’s largest health-care products company.

The Bloomberg table below tracks cases outstanding, confirmed deaths, and the price of pork belly futures. Hello bacon!

From John Mauldin: (JohnMauldin@InvestorsInsight.com)
“China's survival technique for the current recession is simple. Because exports, which account for roughly half of China's economic activity, have sunk by half, Beijing is throwing the equivalent of the financial kitchen sink at the problem. China has force-fed more loans through the banks in the first four months of 2009 than it did in the entirety of 2008. The long-term result could well bury China beneath a mountain of bad loans — a similar strategy resulted in Japan's 1991 crash, from which Tokyo has yet to recover. But for now it is holding the country together. The bottom line remains, however: China's recovery is completely dependent upon external demand for its production, and the most it can do on its own is tread water.

Crisis Over?
Michael Santoli of Barron’s astutely noted that many market indicators are now back to “pre-Lehman” levels. Recall our late November-January notes which highlighted how distressed debt and other securities moving out of Lehman were putting their various markets into extreme duress (http://weeklymarketnotes.blogspot.com). Now the S&P 500, VIX, and the 10-year treasury yield have all moved back to the same levels where they stood in September 2008, just before Lehman fell off the cliff. Additionally, credit measures such as LIBOR, the Libor-OIS spread, and the BFICUS have all moved back to levels last seen in September (see BFICUS chart above).

The market continues its upward move, and while I remain cautious my net long position remains at a nine month high 27%. As I have stated recently, I anticipate pulling this exposure back towards neutral.

The week ahead is light from an economic release standpoint. The biggest conferences this week are the William Blair Growth Stock conference in Chicago (one of my favorites), the Piper Jaffrey Consumer conference, and the Goldman Sachs global Healthcare conference.

Have a great week.


“Inflation is the modern way that governments default on their debt.” Mike Epstein, MIT

Ned W. Brines
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