Jul 13, 2009

Calm Before the Earnings Storm

Calm Before the Earnings Storm

July 13, 2009

“If you want to know what God thinks of money, just look at the people he gave it to.” Dorothy Parker.

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

INDU: -1.6%
SPX: -1.9%
COMPQ: -2.3%
RUT: -3.3%

After four straight weeks of declines, the market is testing technical support levels, settling in around the declining 200 day moving average. The S&P 500 has now pulled back 8% from the early June high. Based on a $50 EPS for 2009, the S&P is trading around 17.5 times. That EPS estimate has bounced around quite a bit over the past year, so making a market valuation determination is more art than science. UBS reported that US investors were net sellers of stocks for the fifth week in a row.

The International Monetary Fund said the global economic rebound next year will be stronger than it forecast in April as the financial system stabilizes and the pace of contractions from the U.S. to Japan moderates. They said in a revised forecast that the world economy will expand 2.5% in 2010, compared with its April projection of 1.9% growth. For 2009 they estimate a contraction of 1.4%, worse than the April forecast for a 1.3% drop.

Defensive stocks and securities (i.e. treasuries) once again led the markets this week. Healthcare and consumer staples once again were the best performing groups while basic materials and industrials were the worst performing groups. Healthcare’s relative strength has been moving up dramatically as concern settles in about economic growth.

Nouriel Roubini, an economist at New York University who accurately warned of the credit-market meltdown, said the U.S. economy will remain in recession for an additional six months and then experience a shallow recovery. As bad as the recession has been, it could have been worse, he said. "This is a great recession that could have ended up in a near depression."


Actual Consensus Prior
ISM Services 47.0 46.0 44.0
Oil Inventories -2.9 mil -2.8 mil -3.7 mil
Gasoline Inventories +1.92 mil +0.9 mil
Distillate Inventories +3.7 mil +1.8 mil
Consumer Credit -3.2 bil -$8.8 bil -$15.7 bil
Wholesale Inventories -0.8% -1.0%
Initial Jobless Claims 565K 603K 617K
Export Prices 0.8% 0.3%
Import Prices 0.2% 0.2%
Trade Balance -$26.0 bil -$30.0 bil -$29.2 bil
Michigan Sentiment 64.6 70.3 70.8

Initial jobless claims for the week were better than consensus at 565K. Unemployment, now at 9.5%, continues to rise and should exceed 10% sometime late in the fall. We expect that the unemployment condition won’t improve until late 2010, which should keep consumer spending in check despite the massive stimulus programs.

Wholesale inventories declined for a 9th straight month. The chart below, courtesy of Briefing.com, shows the inventory to sales ratio for the past 10 years. The decline from 2001-2008 has been attributed to more efficient inventory management systems. The jump from mid 2008 until recent is due to the rapid decline in sales in spite of massive cuts in inventories.

The June ISM services index was slightly ahead of consensus at 47 versus 46, and up from the May measurement of 44. This was the highest reading since Sept ‘08 when it was at 50, which serves as the cut off point between contraction and expansion. New orders rose to 48.6 from 44.4, export orders rose 7.5 points to 54.5, the highest since March ‘08. Prices paid also rose above 50 to 53. Inventories fell to 45.0% from 47.0%.

From Peter Boockvar: May Consumer Credit fell $3.2b to $2.5 trillion. Consumer credit outstanding is now at the lowest level since Dec ‘07 and May is the 8th month in the past 9 that has seen a decline. Most of the decline was in revolving credit which fell $2.9b while non revolving credit outstanding fell by $400mm. With respect to current economic activity, less credit use equates with less spending whether its due to rising unemployment, cut credit lines, or consumers wanting to pay down debt. Deleveraging is desperately needed in order to put this country back on a firmer foundation and no government policy is going to stop the deleveraging freight train at this point.

The following two charts come from Jim Furey of Furey Research Partners. The first shows that the year over year change in total hours worked has troughed near the end of recessions, and the current level is approaching an all-time low of -4%.

Jim’s second chart shows the changes in the rate of unemployment, and how this recession’s rate has superseded that of the previous seven recessions. Jim argues that the rate of change has peaked, and that the end of the recession is near.

Pension Problems
Al Lockwood, a successful midcap manager at Roxbury Capital and amateur equity strategist, recently sent me a note reiterating the concerns I have expressed regarding the funding status of corporate pension plans.

“S&P recently put out a report about the effect on the global equity declines pension funding status. In 2007, pensions in aggregate were overfunded by $63 billion, but by year end 2008, they were underfunded by $308 billion, a 22% shortfall to their obligations. Other Post Employment Benefits, which are typically not funded, add another $257 billion to the total.

If the stock markets do not miraculously rebound, future cash flows and earnings will be severely impacted. Assuming EPS of $60 normalized (who knows what normal is anymore?) I estimate the aggregate earnings for the S&P 500 are about $550 billion. That means that the current unfunded obligation would wipe out all earnings if companies were to fund in one year, which they won't. ”

The Wall Street Journal also had an article this week on public pension plans entitled “Public Pensions Cook the Books”.

“Some plans want to hide the truth from taxpayers. Public employee pension plans are plagued by overgenerous benefits, chronic underfunding, and now trillion dollar stock-market losses. Based on their preferred accounting methods these plans are underfunded nationally by around $310 billion.

The numbers are worse using market valuation methods (the methods private-sector plans must use), which discount benefit liabilities at lower interest rates to reflect the chance that the expected returns won’t be realized. Using that method, University of Chicago economists Robert Novy-Marx and Joshua Rauh calculate that, even prior to the market collapse, public pensions were actually short by nearly $2 trillion. That’s nearly $87,000 per plan participant. With employee benefits guaranteed by law and sometimes even by state constitutions, it’s likely these gargantuan shortfalls will have to be borne by the unsuspecting taxpayer.”

Scary stuff!

Consumer-loan delinquencies rose to 3.23% in the first quarter, the ABA says, as payrolls contracted. Unpaid balances on delinquent credit-card accounts rose to a record 6.60%.

Longer term readers know that I am bearish on the dollar and inflation long term, although I don’t anticipate inflation to be an issue until 2011 or2012. Niels Jensen takes the opposing view, and I thought I’d share his comments.

“We are effectively caught in a liquidity trap. The Bank of England, the European Central Bank and the Federal Reserve have all flooded their banking system with enormous amounts of liquidity in recent months but what has happened? Instead of providing liquidity to private and corporate borrowers as the central banks would like to see, banks have taken the opportunity to repair their balance sheets. For quantitative easing to be inflationary it requires that the liquidity provided to the market by the central bank is put to work, i.e. lenders must lend and borrowers must borrow. If one or the other is not playing along, then inflation will not happen.

This is illustrated in chart 3 (below) which measures the growth in the US monetary base less the growth in M2. As you can see, the broader measure of money supply (M2) cannot keep up with the growth in the liquidity provided by the Fed.”

As we all know, California is now issuing IOU’s since they have passed the July 1st deadline for setting a new fiscal budget. In an effort to cut state spending, the governor has ordered state offices to close three days a month. Honestly, will anyone notice the missing services?

The irony is that the one true “green shoot” (again, I hate that term) in the economy has been government spending and hiring. What will happen now that the fiscal crisis of the states begins impacting employment?

I’m awaiting a new federal bailout plan for the states. Maybe they could call it IOU2?

The Long Term Market Cycles
From Art Cashin on CNBC via The Big Picture.

“David Rosenberg, formerly chief economist at Merrill Lynch and now at Gluskin Sheff was a guest host on CNBC’s Squawkbox this morning. During the discussion he alluded to an 18 year cycle in the market. Not to quibble but many traders have thought of it as the 17.6 year cycle. Here’s how I outlined it back in May 2002: Yesterday, as the elders were being asked about the hiding place of the great Bull Market one of the fogeys mentioned the “near 18 year cycle.” Like the fat and lean years, it refers to so-called “easy” times to make money in the market versus times requiring much harder work. The fogeys suggested it was near 18 years because it was approximately 17 years, 7 months. For ease of explanation to the juniors, one of the fogeys decimalized the number as 17.6 years so they could use their calculators. He then postulated this example - Let’s say the markets topped out in about February 2000. Let’s call that 2000.2. Subtract 17.6 and your back in about July 1982 (1982.60). The Dow was around 900. So you could see why those were a fat (easy) 17 years. Take away 17.6 again and you are back around January of 1965 and the Dow is around 900. (Yup - just like 1982.) Many twists and turns in those 17 years. Lots of chances to make money. But you had to work for every penny. Take away 17.6 again and you are back around May of 1947. The war is over. The Dow is around 170. Lots of prosperity ahead. Take away 17.6 and you are back around Sept of 1929 and the Dow is around 350. He began to go on. The juniors had had enough. Folks don’t like to hear that you can do well only if you do your homework everyday. Having lived through two of those cycles, we can attest to the work cycle.”

Retail Sales
Same store sales (year over year growth at stores open more than one year) for the month of June were reported this week. Looking at 27 retailers, 15 missed their same store comp estimate, 11 beat, and one was in line. On an absolute basis, 22 of the 27 posted negative comps. The average decline was -7.6%. Retail Metrics reports that June comps fell 4.3% overall.

The consumer continues to struggle.

Oil has been weak the past three weeks, including a $10 drop this week, after a doubling off its bottom (see the June 15th note http://weeklymarketnotes.blogspot.com/2009/06/japan-to-rescue.html). As we have discussed, the commodity moved well ahead of the fundamentals, partially in anticipation of a global recovery (which we feel is premature), partially over concerns about the dollar (again, which may be premature despite the abuse being place on the dollar), partially due to the ill-conceived cap and trade proposal, and partially due to speculators.

Now the head of the CFTC, Gary Gensler, is holding hearings to explore whether traders, index funds and ETFs should be limited in their holdings of energy futures. “Our first hearing will focus on whether federal speculative limits should be set by the CFTC to all commodities of finite supply, in particular energy commodities, such as crude oil, heating oil, natural gas, gasoline and other energy products,” Gensler said in the statement. “This will include a careful review of the appropriateness of exemptions from these limits for various types of market participants.”

Gensler said the CFTC is reviewing exemptions from position limits for “bona fide hedging,” after seeking public comment on whether the exemption should continue to apply to traders who are in the market for financial reasons, rather than those that actually use the commodity.

One of the factors Gensler cited is the recent volatility of oil. The chart below, courtesy of the IMF and Bloomberg, show the increase in volatility which now approaches that of the Gulf War and the OPEC price wars.

As one Senator said this week “We don’t mind people making money, but when the price goes from $35 to $70 it’s too much.”

I wonder if a move to $60 would meet his approval?

Al Franken to Senate-Get Ready for Another Al Franken Decade

The Democrats in the Senate now have a filibuster proof majority with the Senate race in Minnesota finally being settled. After nine months of legal shenanigans, comedian Al Franken has won the seat, giving the Dems 60 seats in the Senate.

As someone who feels that gridlock is the best we can hope for from our elected officials, the House and Senate majorities concern me.

Real Estate
A high end real estate banker told us that home refinancing deals are very difficult right now, and are often requiring cash down to get the LTV in line given the weakness in sales comps. This is the reverse of the past few years, when homeowners were treating their homes like a piggy bank, refinancing and pulling out excess equity. The sales comps have been challenged since the bulk of the transactions have been REO and short sales.

Late payments on home-equity loans (HELOC) rose to a record in the first quarter as 18 straight months of job losses left more borrowers unable to pay their debts, the American Bankers Association reported. Delinquencies on home-equity loans climbed to 3.5% of all accounts from 3.0% in the fourth quarter, and late payments on home-equity lines of credit climbed to a record 1.9%.

The chart below, courtesy of Housing Bubble Bust.com, shows that housing valuations have historically moved in lockstep with GDP. Beginning around the end of last decade, housing values soared ahead of GDP, and are now crashing back towards GDP.

Goldman Sachs and Market Manipulation
The prosecutor who filed charges against a former Goldman Sachs employee, who purportedly stole a proprietary trading program, said “The bank has raised the possibility that there is a danger that somebody who knew how to use this program could use it to manipulate markets in unfair ways.”

Presumably the traders at Goldman would know how to use the software, does that mean they could be manipulating markets? I guess that’s why they are called the “Bandits of Broad Street.”

A Fickle Public
The most recent Rasmussen poll shows President Obama’s support among independents has fallen, and his approval rating is at the lowest levels since he took office. A mere 28% strongly approve of the job he is doing versus an early year high of 45%. Those who strongly disapprove of him is at 46%, near the 2009 high of 48%. It appears he has been losing support amongst independents, who were key supporters during last year’s election.

More Conflicts of Interest
From The Big Picture: This exchange occurred during an interview former Assistant Secretary of Treasury Paul Craig Roberts by of Max Keiser:

Max Keiser: “Does the US Secretary of the Treasury work for the people or does he work for the banking system on Wall Street?”

Dr. Paul Craig Reports: “He works for Goldman Sachs.”

He also called the attempts to bail out the banking system to-date “a fraud.”

Earnings kick in full force this week. As I have been stating over the prior few weeks, this set of earnings will have to exceed consensus and carry a positive tone about business conditions to support further gains by the market. I have pulled my position all the way back to net neutral, and will probably look for opportunities to move net short as earnings season unfolds.

Have a great week.


“Well done is better than well said." - Benjamin Franklin

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