July 20th, 2009
“Only a few people knew that debt ratios at major financial firms were 33 to 1 – a lethal level of risk. Nobody knew what Freddie Mac was doing. It was like letting your children play with loaded guns. Sooner or later someone will pull a trigger.” -- Felix Royathan
Weekly percentage performance for the major indices
Based on last Friday’s official settlement...
The market soared this week, erasing the effects of the four week correction in short order and blowing through the “neckline” of the developing and widely discussed head and shoulders formation. There were a number of catalysts, beginning with Meredith Whitney’s upgrade of Goldman Sachs the day before they reported record earnings. It’s truly amazing how profitable you can be when you borrow capital at virtually zero cost from the government, use your political contacts to put your chief rivals out of business, and then use sophisticated software to manipulate the market. All in a quarter’s work I suppose.
The table below, courtesy Bespoke Investment Group, shows how the S&P 500’s ten sectors have performed over various time periods since the March 9th bottom. Financials have rallied the most, with energy and telecom lagging significantly.
For the past week, basic materials, financials, and industrials led the rally. Healthcare, utilities and consumer goods lagged. The table below, courtesy Finviz.com, shows the weekly sector performance, which favored inflation beneficiaries, exporters, and financials.
The ongoing question is whether the economy has bottomed and if so, what type of recovery will we experience. There are strong arguments suggesting we are close to the end of the recession. Lakshman Achuthan of the ECRI says “the cyclical improvement in the economy is proceeding in a textbook sequence, from long leading indicators to short leading indicators to coincident indicators.” In fact, “there are now pronounced, pervasive and persistent upturns in a succession of leading indexes of economic revival.” The chart below, courtesy of the ECRI, shows the growth rates of the leading and coincident indexes have recently turned upwards.
Our view is that while the economy could technically emerge from the recession sometime in the next two quarters, growth will be extremely slow. Additionally, we feel there is a significant risk of a double dip recession, much like the one in the early 1980’s. What will this mean for the markets? Buy and hold will be a rough way to make any money in this type of environment.
Actual Consensus Prior
Core PPI 0.5% 0.1% -0.1%
PPI 1.8% 0.9% 0.2%
Retail Sales June 0.6% 0.4% 0.5%
Retail ex-auto 0.3% 0.5% 0.4%
Business Inventories -1.0% -0.8% -1.1%
Redbook Chain Store Sales -5.7%
Core CPI 0.2% 0.1% 0.1%
CPI 0.7% 0.6% 0.1%
Empire Manufacturing -.55 -5.0 -9.41
Capacity Utilization 68.0% 67.9% 68.2%
Industrial Production -0.4% -0.6% -1.2%
Crude Inventories -2.9 mil
Initial Claims 522K 553K 569K
Philadelphia Fed -7.5 -4.8 -2.2
Building Permits 563K 524K 524K
Housing Starts 582K 530K 562K
Retail sales for June were soft ex the heavily subsidized autos and gasoline sales. Backing both of those out of the mix and retail sells fell 0.2%, the fourth straight monthly decline.
The drop in business inventories was led by a decline in autos. The inventory-sales ratio is lower, but still not low enough to drive a massive inventory replacement cycle. The potential for a second half build-up in auto inventories is creating the backdrop for an economic recovery in the 2nd half of the year. Does this set us up for a weak 1st half of 2010 if these cars aren’t sold?
PPI jumped on higher food and energy prices (up 1.1% and 6.6% respectively). Even without those two volatile components, PPI was up much higher than expected. Intermediate goods and crude products were up 1.9% and 4.6%. This was the biggest jump in 14 months for this measure of wholesale prices.
CPI came in a bit higher than expected at 0.7%, fueled by a rise in gasoline of 17.3% which led an increase in the transportation index by 4.2%.
The -0.4% decline in industrial production was better than expected and the slowest decline in eight months. Capacity utilization fell to 68%, which is the lowest level since record keeping began in 1967. Manufacturing accounts for 12% of US GDP.
The Philadelphia Fed’s general economic index fell to minus 7.5 from a nine-month high of minus 2.2 in June. Negative numbers signal contraction. “The worst of times in manufacturing is behind us, but we haven’t even started to approach good times,” said Joel Naroff, president of Naroff Economic Advisors.
Filing for unemployment claim benefits fell last week to the lowest level since January, partially depressed by shifts in the timing of auto plant shutdowns.
Housing Starts and Building Permits data for June came in higher than expected. Starts for the June period rose 3.6% from May to an annualized rate of 582,000 (consensus 530,000) while permits increased 3.0% to an annualized rate of 563,000. Starts were down 46% year over year and permits were down 52% Y/Y, figures that seem to be lost in the headline numbers. Does the housing market need an increased level of starts given the excess supply of existing homes for sale? Doubtful.
Don’t Worry, Be Happy
According to the AP, with three months left to go in the budget year, the U.S. government's deficit has hit an all-time high of $1 trillion. The Congressional Budget Office predicted that by the end of the year, the deficit will be 13% of the country's GDP. That compares with a recent high of 6% of GDP in 1983 during the Reagan administration and 30.3% in 1943, when the U.S. spent a huge amount of money to fight World War II.
Remember, we are still waiting for much of the stimulus spending to hit, and are discussing nationalizing healthcare. How will we pay for all of this? By raising taxes, of course. This week’s Barron’s included a table showing that under the current proposals coming from the administration, marginal tax rates for residents making over $1 million in roughly 40 states will exceed 50%. Most of those falling into that category are small businesses, and the proposed increase in taxes for someone at $1 million in income/revenue totals $100,000 per year! Say goodbye to one employee.
American Express disclosed their June card metrics; reporting the annualized default rate declined 20 basis pts to 10.2% and the total 30+ days delinquent amount declined by $0.3bil to $1.5bil.
State by state GDP change
The chart below, courtesy the BEA, shows GDP for each state ranked by quintiles. Dark blue and light blue represent the fastest growth, while gold and pale yellow represent the slowest growth. As you can see, three areas (west, southeast, and Great Lakes area) are growing significantly slower than the rest of the country.
From the NY Times: “In California and a handful of other states, one out of every five people who would like to be working full time is not now doing so. It is a startling sign of the pain that the Great Recession is inflicting, and it is largely missed by the official, oft-repeated statistics on unemployment. The national unemployment rate has risen to 9.5 percent, the highest level in more than a quarter-century. Yet it still excludes all those who have given up looking for a job and those part-time workers who want to be working full time.”
The chart below, courtesy the NY Times, shows that when you include those who wish to be employed full time, the rates reach astronomical levels. As an example, the rate in Oregon reached 23%. It was 21.5% in both Michigan and Rhode Island and 20.3% in California.
John Mauldin’s piece from this week included the following two quotes:
“Thus Barro and Perotti are saying that each $1 increase in government spending reduces private spending by about $1, with no net benefit to GDP. All that is left is a higher level of government debt creating slower economic growth.”
“The most extensive research on tax multipliers is found in a paper written at the University of California Berkeley entitled The Macroeconomic Effects of Tax Changes: Estimates Based on a new Measure of Fiscal Shocks, by Christina D. and David H. Romer (March 2007) (Christina Romer now chairs the president’s Council of Economic Advisors). This study found that the tax multiplier is 3, meaning that each dollar rise in taxes will reduce private spending by $3.”
Makes you feel confident about the rapid encroachment of government in our daily lives, doesn’t it?
Government Healthcare Proposal
Here are some details, courtesy of Foster Friess, of the proposed healthcare plan.
“Washington politicians propose to cut health care costs by denying care and squeezing hospitals and doctors. Zeke Emanuel, Rahm Emanuel's brother, and key architect of the Obama health plan, argues for the ‘just allocation of health resources’ (i.e. rationing) in a way that ensures future generations are of the best mental and physical health. To do so, Dr. Emanuel cites that health services should not be guaranteed to “individuals who are irreversibly prevented from being or becoming participating citizens.” He continues, “An obvious example is not guaranteeing health services to patients with dementia.”
Wow! Sounds like the movie Logan’s Run, where they killed off anyone over 30 years old. I guess that makes sense-anyone with dementia is probably old, has no chance of becoming a “participating citizen”, and probably would require the government to pay a disproportionate amount of healthcare expenditures for the remainder of their lives versus someone who is younger.
For new readers, please don’t bombard me with notes about being against old people or insensitive, I’m just joking around.
Another Job I Could do in my Spare Time
President Obama announced that over 50 hours was spent negotiating the new healthcare proposal. Is that supposed to impress us? I spend more time than that every week writing a free newsletter (well, not quite 50 hours per week, but you get my point).
If the President and Congress feel that 50 hours spent on something is a lot of time, then I can guarantee that this new plan is full of pork and holes that will create more problems than it solves. The plan is over 1000 pages long, most members of Congress haven’t even read the entire plan, nor could they in the 50 hours spent creating it.
I mentioned Meredith Whitney’s upgrade of Goldman as a catalyst for last week’s rally. Earnings were another catalyst. Roughly 10% of companies have reported so far, and the overall results have been better than expected.
Dell reported seeing demand stabilization and expects a sequential revenue increase in the upcoming quarter. Intel also beat estimates and guided slightly higher. The company posted its strongest sequential growth from first to second quarter since 1988.
Goldman Sachs killed their quarter, reporting earnings of $4.93 per share versus a consensus of $3.54. Eliminating the company’s one time dividend of $426 million related to their TARP repayment and earnings were $5.71 per share. Return on equity in the quarter was 23% (annualized). The company generated almost $11 billion in trading and principal investment revenues in the quarter.
Taking advantage of the new ‘mark to imagination’ rules for financial assets, JP Morgan announced a strong quarter as well. While the company doesn’t expect profitability in their consumer loan businesses until 2011, overall profit rose for the first time in two years as investment banking fees were very strong. The company did increase its loss estimates for both prime and subprime mortgages. Losses for credit cards issued by Washington Mutual, which JPM acquired last September, are expected to approach 24% by year end.
Bank of America proved to be less adept than JPM at posting numbers as charge offs on their credit card trust rose to almost 14%, up from 12.5% in May.
General Electric posted a 47% decline in earnings as their finance, health care and NBC divisions were weak. They did report some improvement in their medical imaging and jet engine businesses.
In the transportation space, JB Hunt missed both earning and revenue estimates.
Hand Signals, Iran and the Bird
In an international version of sign language Iranian leaders flipped the US and its allies ‘the bird’ this week, a blow to our new international policy of coddling our enemies. Iran denounced foreign governments as “enemies” for encouraging last month’s protests over the election results. Secretary of State Hillary Clinton maintains that direct talks are still “the best vehicle” for bringing the Iranians out of isolation.
The Obama administration is surprised and frustrated that they haven’t been able to sway the attitude of the Iranians with our “extended hand.” Supreme Leader Khamenei said that they would “show an iron fist” towards countries it deemed to be “enemies”.
States in Trouble
It’s no surprise that state governments are in serious financial trouble. Besides being proliferate, irresponsible spenders, the governments are suffering from a dramatic drop in tax collections. The chart below, courtesy of the NY Times, shows the nearly 12% year over year drop in state tax revenues from the first quarter of 2008.
China reported that GDP rose 7.9% in the second quarter as the nation became the first of the major economies to rebound from the global recession. “The pace of the recovery is even quicker and stronger than we initially expected,” said Qu Hongbin, chief China economist at HSBC. “There’s clear evidence that this infrastructure-led recovery is going to be more sustainable than many people expected.”
China’s economy is the only one of the world’s 10 biggest still expanding. The chart below, courtesy of chartoftheday.com, shows the bounce in the FXI since it bottomed late in 2008.
RealtyTrac released their midyear 2009 U.S. Foreclosure Market Report, which shows a total of 1,905,723 foreclosure filings (default notices, auction sale notices and bank repossessions) were reported in the first six months of 2009, a 9% increase in total properties from the previous six months and a nearly 15% increase in total properties from the first six months of 2008. The report also shows that 1.2% of all U.S. housing units (one in 84) received at least one foreclosure filing in the first half of the year!
“In spite of the industry-wide moratorium earlier this year, along with local, state and national legislative action and increased levels of loan modification activity, foreclosure activity continues to increase to record levels,” noted James J. Saccacio, chief executive officer of RealtyTrac. “Unemployment-related foreclosures account for much of this increased activity, and the high number of borrowers who find themselves owing more on their mortgages than their homes’ are now worth represent a potentially significant future risk. Stemming the tide of foreclosures is a critical component to stabilizing the housing market, so it is imperative that the lending industry and the government work in tandem to find new approaches to address this issue.”
The chart below shows the foreclosure rates by county.
Novel Cure for Real Estate Woes
Nassim Taleb, who is (no correction this week) the author of the Black Swan, was interviewed by the Financial Times and made the following suggestion as a way to help solve the residential housing crisis:
“The only solution is to transform debt into equity across all sectors, in an organized and systematic way. Instead of sending hate mail to near-insolvent homeowners, banks should reach out to borrowers and offer lower interest payments in exchange for equity. Instead of debt becoming “binary” – in default or not – it could take smoothly-varying prices and banks would not need to wait for foreclosures to take action. Banks would turn from “hopers”, hiding risks from themselves, into agents more engaged in economic activity. Hidden risks become visible; hopers become doers.
It is sad to see that those who failed to spot the problem (or helped to cause it) are now in charge of the remedy. Just as the impending crisis was obvious to those of us who specialize in complexity and extreme deviations, the solution is plain to see. We need an aggressive, systematic debt-for-equity conversion. We cannot afford to wait a day.”
When Pop Culture Meets Politics
New Jersey Governor Jon Corzine (another Goldman alum, these people are everywhere) has reportedly selected a reality show winner as his running mate for the upcoming November election. Randal Pinkett, a winner of Donald Trump’s “The Apprentice”, has become the front-runner to take the Lieutenant Governor role. Currently Mr. Pinkett is busy in his job duties as an “entrepreneur, speaker, author, scholar and community servant.”
Corzine’s competitor, Republican Chris Christie, has not yet announced a #2 selection, but is rumored to be considering Sponge Bob.
This should be a very busy week for earnings. The economic calendar is light this week, with the leading economic indicators coming Monday, existing home sales Thursday, and the Michigan Consumer Sentiment on Friday.
I am leaving for vacation on the 24th and I’m not sure how much of a note I will be putting out next week. The following week’s (Aug 2nd) note will also be short and/or limited. I will be back to full publishing on August 9th.
Have a great week.
“We believe that stimulus packages, in all their forms, make the same mistakes that got us here. They will lead to extreme overshooting or extreme undershooting. They lead to more borrowing, by socializing private debt. But running a government deficit is dangerous, as it is vulnerable to errors in projections of economic growth. These errors will be larger in the future, so central bank money creation will lead not to inflation but to hyper-inflation…” – Nassim Taleb and Mark Spitznagel