August 24, 2009
“UPS and FedEx are doing just fine. It’s the Post Office that’s always having problems.” -- Barack Obama, trying to demonstrate the government can do a better job managing healthcare
Weekly percentage performance for the major indices
Based on last Friday’s official settlement...
INDU: 1.9%
SPX: 2.2%
COMPQ: 1.8%
RUT: 3.1%
Market
The week started softly following news out of Japan that the economy grew slower than expected in Q2. An interesting relationship has evolved as both oil and stocks rallied to their highest levels of the year. Much of this bounce has been attributed to hopes of an economic rebound in the US, which is the real question facing the market today. Are we seeing an economic recovery in the making or are the “improved” economic readings a result of easy comps and low expectations? We feel that it is a combination of the two, that comps are easy but the economy has seen its worst days for this cycle.
The market closed the week with a flourish on Friday, riding home to gains on lighter volume after a stronger than expected existing home sales report. The strength was focused in small caps, value and an interesting combination of sectors (industrials, basic materials and healthcare). Volume was very light for the week, even considering late August is typically a low volume month.
I have been questioned quite a bit the past couple of weeks about my position on the market. Early in the year we looked for a stall of the rally exiting 2008, a deeper correction, and then a more robust rally. We have seen all three, although the rally has been more robust than we every imagined-which is typical for markets. They run longer and correct harder than you ever anticipate. Where do we stand now? Still looking for a significant pullback, which has been a frustrating position to maintain. We are net neutral, and should the market move into the 1050 range (currently at 1026), then we will move net short.
Economy
Actual Consensus Prior
Empire Manufacturing 12.08 3.00 -.55
Housing Starts 581K 599K 587K
Building Permits 560K 577K 570k
PPI -0.9% -0.3% 1.8%
Core PPI -0.1% 0.1% 0.5%
Initial Claims 576K 550K 561K
Leading Indicators 0.6% 0.7% 0.8%
Philadelphia Fed 4.2 -2.0 -7.5
Existing Home Sales 5.24m 5.00m 4.89m
The big boom this week came from existing home sales, which increased for the fourth straight month as housing prices continue to decline. This is the first time in five years that this measure has increased four consecutive months. Strength was noted in the markets where pricing is down the greatest- over 50% in some markets. The strength was also noted at the low end, with starter homes and condo units strong while the middle and jumbo markets remain weak.
The chart below, courtesy of Briefing.com, shows housing starts and building permits since 1993, plotted over the past two recessions (gray bars). As you can see the decline from the peak has been dramatic, and while recently there has been an upturn, it pales in comparison to the drop. This week’s announcement of a 38% decline in housing starts was less than consensus. Building permits were also below expectations, primarily due to weakness in multi-family unit permits.
Much of the weakness in multi-family is being attributed to a substitution effect, whereby renters are choosing to rent homes versus apartments given their prices are approaching parity. Rents on single family homes are falling due to the high percentage of recent foreclosures being used as rentals. We discussed the potential of this occurring back in a November note, but are amazed how rapidly this has unfolded.
The index of Leading Economic Indicators also rose for the fourth straight month, and the Conference Board announced that the recession is near its bottom. Only three of the components were negative: building permits, money supply, and consumer expectations. The chart below, also courtesy Briefing.com, shows the leading and coincident indicators over the past thirteen years. The blue line shows the four month rise in the leading indicators, after a multi-year decline, and apparent stabilization of the coincident indicators.
The Philly Fed general economic index climbed above expectations. Factory output is up after record inventory cuts, and output gains in the autos seem to be helping. The inventory measure (positive means increasing inventories) spiked to 0.3 from -15.4.
The ECRI announced that their Weekly Leading Index rose to a 4 year high of 124 while the growth rate of the index rose to a 26 year high. The organization is calling for an economic recovery stronger than that of the early 1980’s.
PPIP
The alphabet soup of government programs designed to address the financial crisis is daunting. The PPIP (Public Private Investment Program) is a program that authorizes the Treasury to match funds from a private investor to buy distressed assets and also to provide 6x the capital in the form of credit. As an example, someone putting up $1billion would receive a matching amount from the US Treasury and then an additional $12 billion in credit. The credit is guaranteed by the FDIC.
As Barry Ritholtz said this week, “taxpayer dollars are subsidizing Chinese purchases of US assets at a discount. This is insanity!” Or as David Kotok said when discussing the lopsided risk return of PPIP “Heads you win $100; tails you get nothing.”
Credit Conditions
The Financial Times reported that for the first time in a single year, global issuance of corporate bonds has exceeded $1 trillion. The boom partially has been because of investor demand as well as a tightening of loan standards by banks. "Corporate bonds are the No. 1 asset choice. We are very overweight in corporate bonds. The spread of corporate-bond yields over government-bond yields more than compensates for any company default risk," said Richard Batty, investment director at Standard Life Investments.
Inflation
Capacity utilization measures the percentage of manufacturing capacity in production versus the available manufacturing capacity. The argument against inflation has hinged on the low level of capacity utilization-how can prices rise when excess manufacturing capacity exists (see chart below)? Our argument has been that the coming inflation in 2011 (give or take a year) won’t be the classic supply constraint induced inflation, but instead will be dollar induced. A decline in the dollar will result in inflation due to higher energy and import prices.
Natural Gas
Natural gas prices fell under $3.00, a dramatic decline especially given the concurrent run-up in oil. Natural gas is a local market, whereas oil is a global market, and local demand for natural gas is weak due to lower energy demand from electric utilities. Gas storage is at capacity, and we may see production begin shutting down as prices fall below the marginal cost of production.
Japan
Bloomberg reported that Japan experienced its first economic growth in five quarters, a 3.7% annual rate of expansion in the second quarter that missed consensus. While the Cabinet Office announced the results marked the end of its worst postwar recession, traders fear that Japan's recovery will stumble when the government completes its stimulus spending and dragged the Nikkei down to its lowest level in four months. "Growth was supported by stimulus packages and exports, but it's hard to believe they'll both keep lifting the economy at this pace," said Takahide Kiuchi, chief economist at Nomura Securities.
Real Estate
BB&T reported that The Portland Cement Association released its
Summer 2009 U.S. Cement and Construction Forecast. The PCA now believes total cement consumption will decline 22% in 2009 and then increase 11%, 13%, 11%, and 8% in 2010, 2011, 2012, and 2013, respectively. The previous forecast called for volumes to decline 18%
in 2009, increase 7% in 2010, 17% in 2011, 8% in 2012, and 8% in 2013.
The bank opines that even though the rate of growth for 2010 increases, it is due to the lower base in 2009. The PCA expects cement consumption in 2009 to be 75.3M metric tons, the lowest level since 1991. The reduction to 2009 leaves a lower starting point for 2010 and the PCA now sees cement consumption of 83.6M tons next year vs. a previous estimate of 85.3M tons. In fact, it now believes total consumption during the years of 2009–2013 will be about 19M tons less than previously forecasted with a reduction of about 4M–5M tons in each year except for 2010.
They cite that the reduced forecast is due primarily to disappointing trends in public construction, notably highways and streets, where despite the passage of the stimulus bill, bureaucratic delays and state deficits have muted the expected impact.
Retail Sales
Over the next few weeks we will be exploring retail sales capacity. An exceptionally high closure rate amongst retailers during this recession may actually benefit the survivors as competition is reduced and in the long run price increases could support better margins. Additionally, most retailers we have spoken with have renegotiated rents lower, providing an additional boost to margins.
On The Lighter Side
Some readers may not fully appreciate this one, but for those of us who grew up in the GI Joe era, this picture, sent in by a reader, is priceless. We thought it was worth including and hope you enjoy.
Conclusion
I am traveling this week on the east coast, so this week’s note is a bit brief (as will be next week’s note). Good luck this week.
Ned
"In their effort to bring the good times back, most central bankers have conveniently chosen to ignore the second-round effects of exceptionally loose monetary policy." Francisco Blanch, head of global commodities research at BofA/Merrill.
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