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
O (562) 430-3232

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