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...
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!
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.
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.
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).
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.
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.
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